Government
Highlights Abenomics was working – prior to trade war and COVID-19 – and it will remain Japan’s economic policy setting, albeit in a new guise. This is true even if a dark horse candidate wins the Liberal Democratic Party’s leadership race. Japan’s strategic alliance with the United States is based on a shared interest to balance China’s rise and will not change regardless of the 2020 and 2021 elections. Abe failed to make peace with Russia, but Russo-Japanese relations remain the bellwether of a revolution in Russian policy toward China. We are far from that now. Stay long JPY-USD. The yen’s safe haven properties will buoy it during the coming three-to-six months of extreme political risk. The dollar is set to fall in the medium term due to US debt monetization, twin deficits, and global growth recovery. Feature Japanese equities have rallied despite trailing their American and global counterparts (Chart 1). Yet the good news for markets is now coinciding with the emergence of political uncertainty, as Prime Minister Shinzo Abe, now the longest-serving in Japan’s history, announced he will step down due to illness. Abe’s departure marks the end of a chapter in the country’s modern history and raises questions about the future of “Abenomics,” the eponymous economic policy consisting of ultra-dovish monetary policy, accommodative fiscal policy, and neoliberal structural reforms aimed at lifting productivity and growth. Chart 1Japan's Rally Trails Global Counterparts Chart 2… As Longest-Serving Prime Minister Steps Down Japanese leaders rarely last as long as Abe so the market will likely have to familiarize itself with more churn in top-level government policies going forward (Chart 2). But will the churn change the secular direction? No. Abenomics: A Concise Post-Mortem Chart 3Population And Workforce Decline The driver of Abenomics was not Abe, or his central bank Governor Haruhiko Kuroda, or even the long-dominant Liberal Democratic Party. It was geopolitics – an accumulation of social, political, economic, and strategic pressures demanding that the ruling elite shake up decades-long policies in pursuit of the national interest. Everyone knows that Japan’s population is aging and shrinking, but the key to understanding the Abe era is the recognition that the 2008 global financial crisis coincided almost exactly with the peak in Japan’s total population. This came 18 years after the working age population’s peak in the very year of Japan’s own financial crisis (Chart 3). The first crisis triggered Japan’s slide into price deflation; the second crisis threatened the permanent entrenchment of deflation along with a series of existential threats to the wellbeing of the nation. The driver of Abenomics was geopolitics, not Abe. First came global recession in 2008. Next the institutional ruling party – Liberal Democrats – fell from power for the first substantial period of time in modern memory in 2009. Then China fully emerged as a great power, brandishing its new foreign policy assertiveness and igniting a maritime-territorial clash and minor trade war from 2010 (Chart 4). Japan’s decline reached its nadir with a literal nuclear meltdown, following the devastating Tohoku earthquake and tsunami in 2011. The country’s strategic import dependency combined its ongoing financial instability, as shuttered nuclear plants required a surge in high-priced energy imports that wiped away Japan’s all-important current account surplus (Chart 5). Chart 4Geopolitical Status Anxiety Chart 5Nuclear Meltdown And Resource Anxiety The Liberal Democrats returned to power in a sweeping election victory after this ill-fated experiment with opposition rule. Party leader Shinzo Abe was relatively popular and willing to oversee a drastic overhaul of stale policies. Abenomics was never going to solve all of Japan’s deep structural challenges – population decline, massive debt, overregulation, lifetime employment. But its critics failed to recognize that the country had hit rock-bottom and policymakers had no choice but to stimulate, reform, and open up the economy. Otherwise they would go straight back into the political wilderness at the next election.1 Abenomics was about as successful as an overhyped political policy program can be: The economic boom drew in workers from all parts of society, particularly women, whose participation rate soared (Chart 6). Abe flung open the doors to immigration in a traditionally xenophobic country, attracting Chinese, Vietnamese, and Filipinos to live and work in Japan (Chart 7). Chart 6Abe Got People To Work Chart 7Abe Broke The Taboo On Immigration Kuroda at the Bank of Japan flew into action with aggressive asset purchases, triggering a sharp devaluation of the yen (Chart 8). Nominal GDP growth and core CPI trends both improved, critical to easing debt burdens, lowering real rates, stimulating economic activity, and shaking off the deflationary mindset (Chart 9). Chart 8Abe Kicked The BoJ Into Action Chart 9Abe Combatted Deflation Stagnant wages finally started to grow, with an extremely tight labor market (Chart 10). This was all the more remarkable due to the simultaneous surge in foreign workers. Corporate investment stabilized and turned upward, finally overcoming the long decline since 1990 (Chart 11). Chart 10Wage Growth Improved (Until Trade War, Pandemic) Chart 11Abe Revived Corporate Investment Abe also opened the door to foreign trade, taking on powerful vested interests, including his own party’s base, to join the Trans-Pacific Partnership (TPP) along with the United States in a bid to create an advanced new trade framework that sidestepped China. Chart 12Abe Opened The Doors, A Bonus With Or Without Trade War When US President Donald Trump pulled out of the bloc in accordance with his protectionist campaign promises, Abe led the charge in preserving it. Japan stands to benefit from opening up these markets whether the US-China trade war continues or not (Chart 12). This was generally effective leadership, but none of it happened by sheer force of personality. It happened because Japan glimpsed the specter of national failure in 2011 under the combined weight of internal malaise and external domination. Economic revival was as much about shoring up Japan’s national security as it was about improving Japanese lives and livelihoods. Abenomics was the economic component of a broader national revival. The goal was to become a “normal” nation, capable of self-defense and independent policy, and a pro-active world power at that. China’s rise and a distracted US will pressure Japan to maintain Abe’s policies. The drivers of Japan’s political earthquake in 2011 are not spent. COVID-19 dashed many of Abe’s gains in the fight against deflation. China’s rise is a greater challenge than ever before. The US is even more divided and distracted. The next prime minister would not be able to change course even if he wanted to do so. Suganomics, Kishidanomics … Ishibanomics? Chart 13Still No Alternative To Institutional Ruling Party The Liberal Democrats and their longtime coalition partners, New Komeito, have not only lost about 5% of popular support since their triumphant comeback in 2012, standing at 40% support today – and with some improvement since 2017. More importantly, their nearest rivals all poll under 5% of the popular vote (Chart 13). There is no political competition as yet. The ruling party will choose a new leader with little fanfare. Abe’s Chief Cabinet Secretary and chosen successor Yoshihide Suga is the frontrunner as we go to press. Political uncertainty, such as it is in Japan, will emerge ahead of the September 2021 election. Abe’s retirement and the aftermath of the global recession create an opening for disgruntled factions and opposition parties to challenge the ruling party. It will not succeed but it will portend a less predictable period in the absence of a unifying figure like Abe. In fact, Abe’s influence peaked in July 2019 when he lost a single-party super-majority in the House of Councillors, the upper house of parliament (Chart 14). The 2021 election now raises the prospect of additional erosion of support. Chart 14US-Japan Alliance Versus China Will Persist Opposition is particularly likely if Suga attempts to achieve Abe’s major unfinished task: the revision of Article Nine of the constitution to countenance Japan’s de facto armed forces and right to self-defense. At very least Suga will mark the return of the “revolving door,” in which weak prime ministers come and go in rapid succession. The top candidates for the leadership race lack differentiation: the leading contenders are dovish on monetary and fiscal policy, hawkish on national security and foreign policy, just like Shinzo Abe (Table 1). The exception is former Defense Minister Shigeru Ishiba, but a close examination of his statements and actions suggests that he does not pose a real risk to the policy status quo (Box 1 at bottom). Should Ishiba rise to power, now or later, we would be buyers of any risk premium in financial markets on his account. Table 1The Return Of The Revolving Door The prime minister over the 2021-22 period will have the occasion to appoint up to four members of the Bank of Japan’s Policy Board (Table 2). Theoretically, the appointment of neutral or less dovish candidates could lead to a 5-4 majority on the board by 2023. But this is very unlikely. Table 2Dovish BoJ Is Here To Stay First, it would require all vacant seats to be filled with members who hold hawkish views, which would mark a sharp departure from the current thinking both within the BoJ and the LDP. Second, Kuroda is still governor and could hold that post until 2028. Third, Japan’s economic demands will still require easy monetary policy, as the population will still be shrinking and the country’s vast debt pile will remain a burden. Fiscal austerity is impossible. There is no reason to expect Abe’s successors to be fiscal hawks either. Abe proved to be more of a hawk than expected, by going forward with statutory increases to the consumption tax rate. These are now complete, at 10%, with no future tax hikes scheduled. If Abe managed to create small positive surprises in fiscal thrust throughout his term despite this effort at fiscal consolidation, then his successor should be able to do so in the wake of COVID-19 without any consolidation as yet on the books (Chart 15). Chart 15Despite Mistakes, Fiscal Thrust Surprised To Upside Chart 16Fiscal Austerity Impossible Fiscal austerity is impossible as nearly 60% of the budget is dedicated to social spending for the graying and shrinking society as well as interest payments on the national debt – leaders will continue to avail themselves of the ancient imperial practice of tokusei, or debt forgiveness, rather than draconian spending cuts or tax increases that would drag down the economy and hence increase the debt even faster (Chart 16). Of course, the major failure of Abenomics will still dog Abe’s successors over the long run: the inability to lift Japanese productivity. Despite Abe’s attempts to shake up the labor market, spark corporate investment, reform corporate governance, and open up the economy to foreign trade, productivity has still declined, underperforming both the EU and the UK (Chart 17). Japan will continue to depend heavily on foreign demand, especially Chinese demand. In the short term this is positive, since China’s deleveraging campaign and the COVID-19 shock are giving way to another major bout of Chinese fiscal and credit stimulus. China will be forced to keep stimulating to cope with its secular slowdown and manufacturing dislocation. Japan is still a cyclical economy and stands to benefit (Chart 18). Chart 17No Quick Fix For Poor Productivity Chart 18Chinese Stimulus Will Be Steady In the long run, however, Japan’s future darkens considerably when its own demographic decline and deflationary tendencies are coupled with China’s inheritance of these same trends. The Communist Party is doubling down on import substitution and foreign policy assertiveness, ensuring that trade and strategic conflict with the US will escalate over time. Japan will remain allied with the United States, out of its own strategic interest, but will pay the price in periodic headwinds to growth. Its ability to relocate manufacturing to Japan is limited in all but the most sophisticated of industries. It will have to embrace ever more unorthodox monetary and fiscal policy while investing heavily in new technologies and emerging markets ex-China in search of growth. Geopolitically speaking, Shinzo Abe helped the United States formulate its new strategic plan of promoting a “free and open Indo-Pacific” and the spirit of this policy will outlive Abe and President Trump. The US’s “pivot to Asia” began under the Democratic Party, which will rejoin the Trans-Pacific Partnership, with a few tweaks, if it returns to power. The US and Japan are both interested in forming a grand coalition of nations surrounding China to contain its ambitions, whether military, political, or technological. China would be naïve not to see the quadrilateral security dialogue between these countries and India and Australia as the blueprint of a naval alliance designed to contain it. The Taiwan Strait, the South and East China Seas, Vietnam, the Philippines, and the Korean Peninsula will become the sites of “proxy battles” as the US and Japan strive to contain China. Japan will retain its safe haven status – in both the geopolitical and financial sense – while other countries will see a higher geopolitical risk premium. Japanese and Korean trade tensions will persist, unless the US takes a leadership role in strengthening the trilateral relationship. Russia has chosen to throw in its lot with China, which will not change anytime soon. But if Abe’s successor is able to get peace negotiations back on track, in pursuit of another of Abe’s major unfinished initiatives, then this would serve as an important bellwether of Russia’s own fear of China’s growing power. Investment Takeaways Chart 19Japanese Stocks Look Attractive... Japanese equities are exceedingly cheap and hence attractive over the long run, given that a new global business cycle is beginning and governments around the world are committed to providing as much support as they are able. At a dividend yield of less than 2.5%, the real return on Japanese stocks over the next ten years could be 20% (Chart 19). However, over the next three-to-six months, the world faces extreme uncertainty over the US election and rapidly deteriorating US-China relations. The Japanese economy is slowing and monetary policy, at the zero lower bound, will play a marginal role. The yen is set to appreciate as a safe-haven in this environment (Chart 20), and until there is a total divergence of the inverse correlation of the yen and Japanese equities, the latter will struggle to outperform those of other developed markets on a sustained basis. Chart 20... But Yen Rally Will Continue Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Box 1: Ishiba Is Not A Real Risk To The Policy Status Quo Shigeru Ishiba, while not favored to succeed Abe in the short run, is a compelling Japanese politician and one of the few Liberal Democratic leadership candidates who would mark a change with Abe, as Table 1 above indicates. If Ishiba looks to become prime minister, now or later, he would create some financial market jitters primarily because he would not symbolize seamless policy continuity. He is a major rival of Abe and has publicly criticized Abenomics, including in his 2018 book.2 He is reputed to be a hawk on monetary and fiscal policy. However, a close look at his record shows that he is not ideological and would not revolutionize Japanese national policy once in office. Ishiba is a careful and rational thinker and an institutional and establishment LDP politician. Both Ishiba and his father (Jiro Ishiba) were scions of the Tanaka/Takeshita factions whose base was agriculture, construction industry, defense industry, and the postal service.3 His is not the background of a radical fiscal hawk. One of Ishiba’s major concerns is generating growth outside of the major cities, but he does not take a slash and burn approach to the central government budget. For example, at a forum on Abenomics, the director of the Japanese Civilization Institute spoke with Ishiba in his capacity as Minister of Regional Revitalization. The moderator gave Ishiba the opportunity to denounce excess government spending and promote central spending cuts, saying, “Maybe you must arrange fiscal discipline more appropriately. Then, you can supply that money to regional areas.” Ishiba responded drily, “But I think regional areas must make their own money too.” The yen could rally on a bout of political uncertainty if Ishiba at any time looks likely to become LDP leader and he criticizes excessively easy economic policies. But, as we noted above in the report above, the BoJ Policy Board, not the prime minister’s office, will set monetary policy – and Ishiba would struggle to stack the board with hawks due to institutional resistance. Moreover in the wake of a global recession, the next prime minister will not have much ability to drive parliament into budget cuts or tax hikes. Ishiba would more likely seek to pursue deregulation. If he insisted on austerity, the economy would slump and his premiership would be ruined. Chances are he would listen to his advisers. The one policy that concerns Ishiba above all is national defense and security. Ishiba previously served as defense minister and was known for his hawkish tone, particularly over disputes in the East China Sea and domestic protests against the country’s new security law. More recently he differed with Abe’s constitutional revision – not over the need to normalize Japan’s self-defense forces, but because Abe tried to avoid an explicit mention of Japan’s right to maintain armed forces. If anything, Ishiba would be inclined to increase military spending. Yet his foreign policy is not a risk to the markets, beyond rhetoric, as he is also more willing to engage China than some other LDP leaders. Footnotes 1 In truth, something of a national awakening had already begun in the early 2000s under Prime Minister Junichiro Koizumi. This is reflected in the improvement of the fertility rate from 2005. But it fell to Abe to pick up where Koizumi had left off, fighting deflation and strengthening Japan’s international position. 2 See "Abe’s rival to declare bid to become Japan’s next leader," Nikkei, July 13, 2018, asia.nikkei.com. See a campaign synopsis at ishiba.com. 3 See Jojin V. John, "Developments in Japanese Politics: LDP Presidential Election and the Future of Prime Minister Shinzo Abe," Indian Council of World Affairs, August 29, 2018, icwa.in
Feature Over the last several years when I travelled to Europe, I would meet with Ms. Mea, an outspoken client of the Emerging Markets Strategy service. We have published our conversations with Ms. Mea in the past and this semi-annual series has complemented our regular reports. She has challenged our views and convictions, serving as a voice for many other clients. In addition, these conversations have highlighted nuances of our analysis, for her and to the benefit of our readers. With travel restrictions in force, this time we had to resort to an online meeting with Ms. Mea. Below are the key parts of our conversation from earlier this week. Ms. Mea: Let’s begin with your main thesis, which over the past several years has been as follows: China’s growth drives EM business cycles and financial markets overall. Indeed, as long as China’s growth dithers, EM growth and asset prices languish. However, since the pandemic started China has stimulated aggressively and there are clear signs that the economy is recovering. The latest surge in Chinese share prices confirms that a robust recovery is underway. Why do you not think China’s economy is on the upswing? Answer: True, we believe China’s business cycle is instrumental to EM economies’ growth and balance of payments. We upgraded our outlook for Chinese growth in our May 28 report as the National People’s Congress set the objective for monetary policy in 2020 to significantly accelerate the growth rate of broad money supply and total social financing relative to last year. Indeed, broad money growth as well as both private and public credit have accelerated since April and will continue to increase (Chart I-1). Domestic orders have also surged though export orders are still languishing (Chart I-2). Chart I-1China: Money And Credit Will Continue Accelerating Chart I-2China: Improvement In Domestic Orders But Not In Export Ones That said, financial markets, including the ones leveraged to China, have run ahead of fundamentals and a pullback is overdue. We have been waiting for such a setback to turn more positive on EM risk assets and currencies. Further, the snapback in business activity following the lockdown should not be confused with an economic expansion. As economies around the world reopened, business activity was bound to improve. Were any asset markets priced to reflect months or a whole year of closures? Even at the nadir of the global equity selloff in late March, we do not think risk assets were priced for extended lockdowns. The Chinese economy will likely eventually experience a robust expansion later this year but the nearterm outlook for global risk assets and commodities remains risky. In our view, the rally in global stocks and commodities has been much stronger than is warranted by the near-term economic conditions in a majority of economies around the world. In short, we have not been surprised at all by the economic data that has emerged since economies have reopened, but we have been perplexed by the markets’ response to these data. Even in China, which is ahead of all other countries in regards to the reopening and normalization of business activity, the level and thrust of economic activity remains worrisome. Specifically: China's manufacturing PMI new orders and the backlog of orders sub-components remain below the neutral 50 line (Chart I-3). The imports subcomponent of the manufacturing PMI has shown signs of peaking below the 50 line, portending a risk to industrial metals prices (Chart I-4). Chart I-3China Manufacturing PMI: Measures Of Orders Are Still Below 50 Chart I-4A Yellow Flag For Commodities Marginal propensity to spend for both enterprises and households continues to trend lower (Chart I-5). These gauge the willingness of consumers and companies to spend and, hence, reflect the multiplier effect of the stimulus. These indicators contend that the multiplier so far remains low/weak. Finally, with the exception of new economy stocks (such as Ali-Baba and Tencent) that have been exceptionally strong worldwide, Chinese share prices leveraged to capital expenditure and consumer discretionary spending had not been particularly strong before last week, as illustrated in Chart I-6. Chart I-5Marginal Propensity To Spend Among Chinese Households And Enterprises Chart I-6Chinese Stocks Had Been Languishing Till Late Outside New Economy Ones In a nutshell, the Chinese economy will likely eventually experience a robust expansion later this year but the near-term outlook for global risk assets and commodities remains risky. As to EM risk assets, the key risk to our stance is a FOMO-driven rally buoyed by the “visible hand” of governments. Ms. Mea: What is your interpretation of the latest policy push in China for higher share prices? Is it also a part of the “visible hand” of government? Don’t you think this could create another strong multi-month run like it did in early 2015? Answer: Yes, this is one of many instances of the “visible hand” of governments around the world. It is not clear why Beijing is boosting investor sentiment and explicitly promoting higher share prices given how badly similar efforts in 2015 ultimately ended. At the moment, we can only speculate that one or several of the following reasons are behind this move: Beijing is preparing for an escalation in the US-China geopolitical confrontation ahead of the US presidential elections. This latter is highly probable in our opinion.1 To limit the impact of this confrontation on their economy, they want to ensure that the stock market remains in an uptrend. The same can be said for the US authorities. Apparently, the “visible hands” of both Washington and Beijing have and will continue to push share prices higher in their domestic markets. Robust equity markets will become a prominent feature of the geopolitical confrontation between the US and China. In the long run, however, this is a very negative phenomenon for the world because the two of the largest and most prominent stock markets could increasingly be driven by the “visible hand” of their governments rather than by fundamentals. As a result, equity markets could regularly send wrong price signals and will no longer serve as an efficient mechanism of capital allocation. Chart I-7Foreign Inflows Into China Have Accelerated This Year Beijing has been luring foreign investors to buy onshore stocks and bonds and this strategy has become more vital in expectation of an escalation in the US-China confrontation. Chart I-7 shows that net inflows into onshore stocks and bonds have been surging. The more US investors buy into mainland markets, the more these investors will exercise pressure on the current and future US administrations to go soft on China. Like those US companies relying on Chinese demand, large US investment funds will have a notable exposure to Chinese financial markets and will accordingly lobby the White House and Congress to take a less adversarial stance toward China. This will reduce the maneuvering room of US politicians in this geopolitical confrontation. Finally, it is also possible that these latest media reports encouraging a bull market in China were not initiated by leaders in Beijing but were in fact spurred by mid-level bureaucrats. If that is the case, a full-blown mania akin to the one in 2015 will not be repeated and the latest frenzy surrounding Chinese stocks could end up being the final surge before a correction sets in. In brief, Chinese stocks, like other bourses worldwide, are in a FOMO-driven mania that might last for a while. Nevertheless, regardless of the direction of Chinese stocks in absolute terms, we reiterate our overweight stance on Chinese equities within the EM benchmark. Also, we have a strong conviction with respect to the merits of a long Chinese/short Korean stocks trade. Both these positions were initiated on June 18 before the latest surge in Chinese stocks. The “visible hands” of both Washington and Beijing have and will continue to push share prices higher in their domestic markets. Ms. Mea: What will it take for you to go long EM risk assets and currencies in absolute terms? Answer: EM equities, credit markets and currencies are driven by three, or more recently four, factors. We need to witness or foresee an imminent improvement in three out of four of these to go outright long. These factors include: (1) China’s business cycle and its impact on EM via global trade; (2) each individual EM country’s domestic fundamentals (inflation/deflation, balance of payments, return on capital, domestic economic cycles, monetary and fiscal policies, health of the banking system, domestic politics, etc.); (3) global risk-on and risk-off cycles that drive portfolio flows into EM. The direction of the S&P500 is an important trendsetter for these risk-on and risk-off cycles; (4) swings in geopolitical confrontation between the US and China. The first element – China’s impact on EM – is becoming positive. There could be a minor setback in mainland business cycles in the near term, but this should be used as a buying opportunity. As to structural problems in China like credit/money and property bubbles as well as the misallocation of capital, ongoing money and credit growth acceleration will fill in holes and kick the can down the road. That said, those structural problems will become even more challenging in the years to come. In short, Beijing is making credit, money and property bubbles even bigger. The second factor – domestic fundamentals in EM ex-China, Korea and Taiwan – remain downbeat. The COVID-19 outbreak has been out of control in a number of EM economies (Chart I-8). In addition, outside of China, Korea and Taiwan, EM fiscal stimulus has not been as large as in DM economies. Critically, the monetary transmission mechanism has been broken in several developing economies. In particular, central banks’ rate cuts have not translated to lower lending rates in real terms (Chart I-9). Chart I-8The COVID-19 Pandemic Has Not Peaked In Several Major EM Economies Chart I-9Lending Rates Are Still High In EM ex-China, Korea And Taiwan The basis is two-fold: First, banks saddled with non-performing loans are reluctant to bring down their lending rates and lend more; and second, the considerable decline in EM inflation has pushed up real lending rates (Chart I-9). The third variable driving EM financial markets – the S&P 500 – remains at risk of a material setback. If the S&P drops more than 10 or 15%, EM stocks, currencies and credit markets will also sell off markedly. Finally, there is the fourth aspect of the EM view – geopolitics – which could be critical in the coming months. The US-China confrontation will likely heighten leading up to the US elections. This will likely involve North and South Korea and Taiwan. Chart I-10EM ex-China, Korea And Taiwan: Stocks And Currencies Chinese investable stocks as well as Korean and Taiwanese equities altogether make up 65% of the MSCI EM benchmark. Hence, a flareup in geopolitical tensions will weigh on these three bourses. Outside these markets, EM share prices and currencies have already rolled over (Chart I-10). In sum, out of the four factors listed above only the Chinese business cycle warrants an upgrade on overall EM. The other three drivers of the EM view are still negative. This keeps us on the sidelines for now. Importantly, we have been gradually moving our investment strategy from bearish to neutral on EM. Specifically, we: Took profits on the long EM currencies volatility trade on March 5. Took large profits on the long gold / short oil and copper trade on March 11. Booked gains on the short position in EM stocks on March 19. Recommended receiving long-term (10-year) swap rates (or buying local currency bonds while hedging the exchange rate risk) in many EMs on April 23. Upgraded EM sovereign credit from underweight and booked profits on our short EM corporate and sovereign credit / long US investment grade bonds strategy on June 4. The only asset class where we have not yet closed our shorts is EM currencies. In fact, we now recommend shifting our short in EM currencies (BRL, CLP, ZAR, TRY, KRW, PHP and IDR) from the US dollar to an equal-weighted basket of the Swiss franc, the euro and the Japanese yen. Unlike the March selloff, the dollar could depreciate even if the S&P 500 and global stocks drop. Ms. Mea: What is the rationale behind switching your short positions in EM currencies against the US dollar to short positions versus the Swiss franc, the euro and Japanese yen? Wouldn’t the selloff in global stocks drive the greenback higher? Answer: We have been bullish on the US dollar since 2011, consistent with our negative view on EM and commodities prices and recommendation of favoring the S&P 500 versus EM. What is making us question this strategy are the following, in order of importance: First, the Federal Reserve is monetizing US public and some private debt. The amount of US dollars is surging. Meanwhile, the pace of broad money supply growth is much more timid in the euro area, Switzerland and Japan. Broad money growth is 23% in the US, 9% in the euro area, 2.5% in Switzerland, 5% in Japan and 11% in China. This will reduce investors’ willingness to hold dollars as a store of value, incentivizing them to switch to other DM currencies. Second, the pandemic is out of control in the US and this will damage its near-term growth outlook. More fiscal stimulus and more debt monetization will be required to revive the economy. Third, the Fed will not hike interest rates even if inflation rises well above their 2% target in the next several years. This implies that the Fed will prefer to be behind the inflation curve in the years to come, which is bearish for the greenback. Finally, the yen and the euro as well as EM currencies are cheaper than the US dollar (Chart I-11 and Chart I-12). Chart I-11The US Dollar Is Expensive, The Yen Is Cheap Chart I-12EM ex-China, Korea And Taiwan: Currencies Are Cheap The broad trade-weighted US dollar has yet to break down as per the top panel of Chart I-13, but we are becoming nervous about it. Unlike the March selloff, the dollar could depreciate even if the S&P 500 and global stocks drop. Ms. Mea: That is interesting. Has there ever been an episode where the US dollar depreciated while the S&P 500 sold off? Answer: Yes, it occurred in late 2007 and H1 2008. The 2007-08 bear market in global stocks can be split into two periods. During the initial phase of that bear market, the US dollar depreciated substantially despite the drawdowns in global equity and credit markets (Chart I-14, top and middle panels). Chart I-13Trade-Weighted Dollar And Asian Currencies: At A Critical Juncture Chart I-14In Late 2007 And H1 2008: The US Dollar Fell Amid An Equity Bear Market EM stocks performed in line with DM ones during the first phase (Chart I-14, bottom panel). The economic backdrop was characterized by the US recession and US banks tightening credit. In fact, EM growth was still robust during that phase even though the US economy was shrinking. Remarkably, commodities prices were surging – oil reached $140 per a barrel and copper $4 per ton in June 2008. The second phase of that bear market commenced in autumn of 2008 when Lehman went bust. The orderly bear market in global stocks gave way to an acute phase – a crash in all global risk assets. Business activity collapsed worldwide and the US dollar surged. In the current cycle, the order will likely be the reverse of the 2007-08 bear market. March 2020 witnessed a crash in global risk assets and the global economy plunged similar to the second phase of the 2007-08 bear market while the US dollar surged. The second stage of this recession could resemble the first phase of the 2007-08 bear market. There will be neither worldwide lockdowns nor a crash in business activity. However, the level of activity might struggle to recover as rapidly as markets have priced in or there might be relapses in economic conditions in certain parts of the world. This is especially true for the US and other countries where the pandemic has not been effectively contained. On the whole, the second downleg in the S&P 500 and global stocks will be less dramatic but could last for a while and still be meaningful (more than 10-15%). Critically, unlike the March 2020 selloff, the greenback will likely struggle during this episode for the reasons we outlined above. Ms. Mea: What about overweighting EM equities and credit versus their DM peers? Will EM equities, credit and currencies underperform their DM peers in the potential selloff that you expect? Wouldn’t USD weakness help EM risk assets to outperform even in a broad risk selloff? Answer: Yes, we can see a scenario where EM stocks and credit markets perform in line or better than their DM peers in a potential selloff. The key is the dollar’s dynamics. If the dollar rebounds, EM stocks and credit markets will underperform their DM counterparts. If the dollar weakens during this selloff, EM stocks and credit will likely perform in line with or better than their DM peers. In sum, a technical breakdown in the broad trade-weighted dollar and a breakout in the emerging Asian currency index – both shown in Chart I-13 – would lead us to upgrade our EM allocation in both global equity and credit portfolios. For now, we are only switching our shorts in EM currencies from the US dollar to an equally-weighted basket of the Swiss franc, the euro and the Japanese yen. Ms. Mea: What are some of your other current observations on financial markets? Answer: The breadth and thrust of this global equity rally has already peaked and is weakening. It is just a matter of time before a narrowing breadth translates into lower aggregate stock indexes for both EM and DM equities as illustrated by our advance-decline lines in Chart I-15. Chart I-15EM and DM Equity Breadth Measures Have Rolled Over Chart I-16Cyclicals And High-Beta Stocks Have Been Struggling Consistently, there has already been a decoupling between various sectors and industries. The rally has been solely focused on tech and new economy stocks. Equity prices in China and Taiwan have been surging while the rest of the EM equity index has been languishing. In the DM equity space, global industrials, US high-beta stocks and micro caps have already rolled over (Chart I-16). Further, our Risk-On/Safe-Haven currency index is flashing red for EM equities (Chart I-17). Chart I-17A Red Flag For EM Equities? Chart I-18Long Gold / Short Stocks Finally, EM share prices have outperformed DM stocks since late May mostly due to the sharp rally in Chinese, Korean and Taiwanese stocks. Hence, the breadth of EM equity outperformance has been subdued. Ms. Mea: To wrap up our conversation, I want to ask you what is your strongest conviction trade for the coming months? Answer: Our strongest conviction trade is long gold / short global or EM stocks (Chart I-18). This trade will do well regardless of the direction of global share prices, the US dollar, and bond yields. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes 1 Please see Geopolitical Strategy Special Report "Watch Out For A Second Wave (Of US-China Frictions)," dated June 10, 2020, available at gps.bcaresearch.com Equities Recommendations Currencies, Credit And Fixed-Income Recommendations
Dear Client, In lieu of our regular report next week, we will be sending you a Special Report from my colleague Jonathan LaBerge. Jonathan will be examining the global effectiveness of recent pandemic containment measures to judge both the odds of a second infection wave and what policy responses are likely to be effective in countering one were it to occur. I hope you find the report insightful. Best regards, Peter Berezin, Chief Global Strategist Highlights Fiscal deficits have soared in the wake of the pandemic, putting government debt-to-GDP ratios on a trajectory to reach post-WWII highs in many countries. Contrary to popular belief, there is little reason to think that fiscal relief will make it more difficult for governments to repay their obligations down the road. Larger budget deficits tend to increase overall national savings when the economy is depressed because private savings rise more than enough to compensate for the decline in government savings. The end result is a higher level of national wealth that governments can tax in the future. That said, there is more than one way to tax national wealth. For political reasons, higher inflation coupled with financial repression may prove to be more feasible than other forms of taxation. While inflation is not an imminent risk, it could become a formidable problem in two-to-three years. Investors should maintain below-benchmark levels of duration in fixed-income portfolios and favor inflation-linked securities over nominal bonds. Gold prices will rise over the long haul. The yellow metal should perform well even in the near term if the dollar weakens during the remainder of this year, as we anticipate. Real estate investors should reallocate capital away from densely populated urban areas towards suburbs and farmland. Stay Cyclically Overweight Equities Global equities continued to climb higher this week, as more countries reopened their economies. As we discussed three weeks ago in our report entitled “Risks To The U,” the main downside risk facing stocks is a second wave of the disease.1 While the number of new COVID-19 cases has declined in many countries, it continues to rise in others. As a result, the global tally of new cases remains broadly flat. The daily number of deaths seems to be trending lower, but that could easily reverse if social distancing measures are abandoned too quickly (Chart 1). Chart 1COVID-19: Global New Cases Remain Broadly Flat, While Deaths Seem To Be Trending Slightly Lower Chart 2Joined At The Hip Given this risk, we do not have a strong near-term (3-month) view on the direction of equities. Google searches for the “coronavirus” have closely correlated with equity prices and credit spreads (Chart 2). If fears of a new outbreak were to escalate, risk assets would suffer. Looking at a cyclical (12-month) horizon, we still recommend a modest overweight to stocks. Even if a vaccine does not become available later this year, increased testing should allow for a more economically palatable approach to containment strategies. Ample fiscal support will also help. As we provocatively asked in a report entitled “Could The Pandemic Lead To Higher Stock Prices?”,2 one can easily imagine a scenario where central banks keep rates near zero for the foreseeable future, while ongoing fiscal stimulus enables the labor market to reach full employment. Such an outcome could allow corporate profits to return to pre-pandemic levels, but leave the discount rate lower than before. The end result would be a higher fair value for the stock market. Although we would not counsel investors to bank on such a fortuitous outcome, the probability of it occurring is reasonably high – probably in the range of 30%-to-40%. This makes us inclined to favor stocks over a cyclical horizon. Will Indebted Governments Spoil The Party? One potential flaw in this bullish thesis is that massive government deficits could push up interest rates, crowding out private-sector investment in the process. As we argue below, such worries are misplaced for now. For the time being, bigger budget deficits will likely lead to an increase in overall savings, thus raising investment relative to what would have happened in the absence of any stimulus. That said, as we conclude towards the end of this report, there will come a time – probably in two-to-three years – when most economies are back to full employment. If budget deficits are still high at that point, inflation and long-term bond yields could end up rising substantially. Keynes To The Rescue The IMF expects budget deficits in advanced economies to exceed 10% of GDP in 2020, significantly higher than during the financial crisis. The sea of red ink is projected to push government debt-to-GDP ratios to fresh highs in many economies (Chart 3). Chart 3AGovernment Debt Levels Have Surged In The Wake Of The Pandemic Chart 3BGovernment Debt Levels Have Surged In The Wake Of The Pandemic Chart 4The Paradox Of Thrift: Not Just A Theory Should bond investors be worried? Not for now. One of John Maynard Keynes’ great insights was that an individual’s attempt to increase savings could lead to a collective decline in savings, a phenomenon he called the paradox of thrift. Keynes argued that if everyone tried to save more, the resulting contraction in spending would cause total employment to fall by so much that overall income would decline by more than spending. As a result, aggregate savings would fall. This is precisely what happened during the Great Depression and in the aftermath of the Global Financial Crisis (Chart 4). The paradox of thrift implies that bigger budget deficits in a depressed economy will lead to an increase in overall savings, as private savings rise more than one dollar for every dollar decline in government savings. S-I=CA One can see this point using the familiar macroeconomic accounting identity which says that the difference between what a country saves and invests should equal its current account balance.3 In the absence of a change in the current account balance, any increase in investment will translate into an increase in savings. If the government stimulates aggregate demand by increasing spending, cutting taxes, or boosting transfer payments, companies are likely to respond by investing more (or at least not cutting capital expenditures as much as they would otherwise). Thus, if fiscal stimulus raises investment, it will also raise aggregate savings. Chart 5Huge Spike In The US Personal Savings Rate This conclusion has important implications for bond yields. If bigger budget deficits lead to an increase in overall savings, there is no reason to expect real bond yields to rise very much, at least in the short term. The failure of bond yields to rise since March, when governments began to trot out one fiscal stimulus package after another, is a testament to this fact. So too is the stimulus-induced surge in the US personal saving rate, which reached a record high of 33% in April (Chart 5). All That Money Printing If bigger government budget deficits are, in some sense, self-financing, why are so many people convinced that the Fed and other central banks are effectively “monetizing” deficits by buying up bonds? Part of the answer has to do with how one defines monetization. Governments create money whenever they purchase goods or services or make transfers to the public by running down their deposits at the central bank. In theory, the public could use that money to buy government bonds, which would allow the government to replenish its account at the central bank. In practice, it is usually a bit more circuitous than that. Chart 6Commercial Banks Deposits, Bank Reserve Held At The Fed, And Fed Holdings Of Treasuries Have All Expanded This Year What normally happens is that the public places the money in a commercial bank deposit and the commercial bank then transfers the money to its account at the central bank. Next, the central bank buys the bonds from the government, crediting the government’s deposit account at the central bank in the process. Chart 6 shows that this is precisely what has happened this year: Commercial bank deposits, bank reserves held at the Fed, and the Fed’s holdings of Treasuries have all risen by roughly the same amount. Granted, there is a bit more to the story. If the central bank buys bonds, it will push down bond yields at the margin, allowing the government to finance itself more cheaply than it could otherwise. However, this is a far cry from the sort of “money printing” that many people have in mind. True debt monetization occurs when governments lose all access to outside financing, forcing the central bank to pick up the tab. Such situations invariably involve accelerating inflation and a collapsing currency, which often culminates in hyperinflation. This is clearly not the case today. Back To Full Employment The idea that bigger budget deficits can generate enough private savings to more than fully compensate for any loss in government savings is applicable only for economies with spare capacity. Once the economy reaches full employment, fiscal stimulus will not lead to more income or production since everyone who wants a job already has one. At that point, bigger budget deficits will cause the economy to overheat and inflation to rise, potentially forcing the central bank to raise rates. Higher interest rates will reduce investment. Higher rates will also put upward pressure on the currency, leading to a reduction in net exports and a corresponding deterioration in the current account balance. If investment and the current account balance both decline, then savings, which is just the sum of the two, must also fall. Strategies For Alleviating A Debt Burden Once the free lunch from fiscal stimulus disappears, the question of how to address the government debt accumulated during the downturn becomes paramount. There are four ways to reduce the ratio of government debt-to-GDP: 1) outgrow the debt burden; 2) tighten fiscal policy; 3) default; and 4) inflate away the debt. Outgrowing It At the end of the Second World War, many governments found themselves saddled with high levels of debt. In the US, the government debt-to-GDP ratio stood at 121% in 1945. In the UK, it hit 270%. In Canada, it reached 155%. For the most part, these governments did not repay the debt they incurred during the war. As Chart 7 shows, the nominal value of debt outstanding either rose or remained broadly constant following the war. What happened was that rapid GDP growth led to a shrinkage in debt-to-GDP ratios. Compared with the post-war period, the two drivers of an economy’s growth potential, labor force and productivity growth, are both weaker now. Thus, outgrowing the debt by raising the denominator of the debt-to-GDP ratio will be more difficult than in the past. It’s About g-r That said, the trajectory of the debt-to-GDP ratio does not depend solely on GDP growth; it also depends on the interest rate that the government pays to service its debt. Conceptually, it is the difference between the two that determines whether the level of any given budget deficit is sustainable or not. While trend GDP growth in advanced economies has declined since the 1950s, equilibrium interest rates have also fallen. As a consequence, the spread between growth rates and interest rates is only somewhat smaller in advanced economies today than it was in the 1950s and 60s and notably higher than it was in the 1980s and 90s (Chart 8). Indeed, as Chart 9 shows, g-r has been trending higher for hundreds of years! Chart 7The Case Of Outgrowing The Debt Burden Post-WWII Chart 8The Rate Of Economic Growth Has Been Higher Than Interest Rates Chart 9A Multi-Century Trend In The Spread Between Growth And Interest Rates Today, government borrowing rates in most economies are well below trend growth rates. No matter the size of the budget deficit, the ratio of debt-to-GDP will converge to a stable level as long as the interest rate the government pays on the debt is below the growth rate of the economy.4 A Gordian Fiscal Knot Of course, there is no guarantee that real rates will remain below the rate of trend growth. As we have discussed before, the exodus of baby boomers from the labor force, a peak in globalization, and rising political populism could all curtail aggregate supply, leading to a depletion of national savings.5 What would happen if governments allowed debt levels to reach very high levels only to find that the neutral rate of interest — the interest rate consistent with full employment and stable inflation — has risen above the growth rate of the economy? Raising the policy rate would be very painful in a high-debt environment because even a small increase in interest rates would lead to a large rise in interest payments. Faced with this reality, some governments might elect to tighten fiscal policy. An increase in taxes or a decline in government spending would not only create some resources to pay back debt, but it would also reduce aggregate demand, pushing down the neutral rate of interest in the process. Don’t Blame The Stimulus Ironically, all the fiscal relief efforts that governments have carried out over the past few months have probably left them better placed to pay back debt than if no stimulus had been undertaken in the first place. Box 1 illustrates this point with a numerical example, but the intuition for this claim can be seen easily enough. As noted earlier, fiscal stimulus in a depressed economy will raise overall savings. This means that after the pandemic is over, governments will have a larger tax base available to them than they would have had in the absence of any stimulus (although, obviously, the tax base would be even larger if the pandemic had never occurred). The Inflation Solution Chart 10Long-Term Inflation Expectations Remain Very Depressed Still, any decision to tighten fiscal policy down the road is going to be an inherently political one. What if governments do not have the political will to tighten fiscal policy even if the economy begins to overheat? Defaulting on the debt is always an option in that case, but not one that any sensible government would choose given the devastating impact this would have on the financial system and broader economy. Rather, it is conceivable that governments will lean on central banks to keep rates low and let inflation accelerate. While higher inflation will not boost real GDP, it will raise nominal GDP, allowing the ratio of government debt-to-GDP to decline. Investors currently assign very low odds to such an outcome. Long-term market-based inflation expectations remain very depressed (Chart 10). Yet, we think such an eventuality is more plausible than widely believed. As long as inflation does not spiral out of control, central banks are likely to welcome rising prices. A higher inflation rate would make monetary policy more effective by allowing central banks to bring real rates deeper into negative territory whenever the economy falls into recession. Higher inflation would also result in steeper yield curves, reoxygenating commercial banks’ profitability. Profiting From Higher Inflation The path to higher interest rates is paved with lower rates. In order to generate inflation, central banks will need to keep rates at very low levels even once the economy has returned to full employment. Given that unemployment is quite high today, inflation is not an imminent risk. However, it could become a formidable problem in two-to-three years. Investors should maintain below-benchmark levels of duration in fixed-income portfolios and favor inflation-linked securities over nominal bonds. While gold is no longer super cheap, it remains a good hedge against inflation. The yellow metal should also do well if the dollar weakens during the remainder of this year, as we anticipate. As a countercyclical currency, the dollar tends to fall whenever global growth picks up (Chart 11). Chart 11Gold Will Do Well When The Dollar Weakens As Global Growth Picks Up Chart 12Farmland Would Benefit From High Inflation Lastly, land will gain from low interest rates in the near term and higher inflation in the long term. Farmland and suburban land are particularly appealing. The pandemic has made remote working more commonplace. It has also highlighted the potential dangers of living in densely populated cities. Since most suburbs are built on top of land that was previously zoned for agriculture, farmland should benefit from the retreat from urban living, much like it did during the inflationary period of the 1970s (Chart 12). Box 1Saving More By Spending More Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1 Please see Global Investment Strategy Weekly Report, “Risks To The U,” dated May 7, 2020. 2 Please see Global Investment Strategy Weekly Report, “Could The Pandemic Lead To Higher Stock Prices?” dated April 23, 2020. 3 Gross Domestic Product (GDP) can be computed as the sum of consumption (C), investment (I), government spending (G), and net exports (X-M). Gross National Product (GNP) is equal to GDP except that the former includes net income from abroad (which is included in the current account balance). Thus, GNP=C+I+G+CA, or GNP-C-G=I+CA. Savings (S) is equal to GNP-C-G. Taken together, the two expressions imply S-I=CA, or S=I+CA. 4 Please see Global Investment Strategy Weekly Report, ”Is There Really Too Much Government Debt In The World?” dated February 22, 2019. 5 Please see Global Investment Strategy Weekly Report, “A Structural Bear Market In Bonds,” dated February 16, 2018. Global Investment Strategy View Matrix Current MacroQuant Model Scores
Highlights The coronavirus is a wild card that may have a significant impact on the global economy, … : The COVID-19 outbreak is unfolding in real time, half a world away, and its ultimate course is uncertain. For now, our China strategists think the worst-case scenarios are unlikely, but we will not remain constructive if the virus outlook materially worsens. … but as long as there is not a significantly negative exogenous event, the US economy will be just fine, … : From a domestic perspective, the US expansion is in very good shape. Easy monetary conditions will support a range of activities, and a potent labor market will give increasing numbers of households the confidence and wherewithal to ramp up consumption. … and if there’s no recession, there will not be a bear market: Recessions and equity bear markets coincide, with stocks typically peaking six months ahead of the onset of a recession. If the next recession doesn’t come before late 2021/early 2022, the bull market should remain intact at least through the end of this year. What We Do US Investment Strategy’s stated mission is to analyze the US economy and its future direction for the purpose of helping clients make asset-allocation and portfolio-management decisions. As important as the economic backdrop is, however, we never forget that we are investment strategists, not economic forecasters. We don’t belabor the state of every facet of the economy because neither we nor our clients care about 10- to 20-basis-point wiggles in real GDP growth in themselves. They do want us to keep them apprised of the general trend, though, and we are always trying to assess it. Ultimately, macro analysis benefits investors by providing them with timely recognition of the approach or emergence of an inflection point in the cycles that matter most for financial assets. We view investment strategy as the practical application of the study of cycles, and we are continuously monitoring the business cycle, the credit cycle, the monetary policy cycle and the squishy and only sporadically relevant sentiment cycle. This week, we turn our attention to the business cycle, and the ongoing viability of the expansion, which is already the longest on record at 128 months and counting. If it remains intact, risk assets are likely to continue to generate returns in excess of returns on Treasuries and cash. The Message From Our Simple Recession Indicator We have previously described our simple recession indicator.1 It has just three components, and all three of them have to be sounding the alarm to conclude that a recession is imminent. Our first input is the slope of the yield curve, measured by the difference between the yield on the 10-year Treasury bond and the 3-month T-bill.2 The yield curve inverts when the 3-month bill yield exceeds the 10-year bond yield, and a recession has followed all but one yield curve inversion over the last 50 years (Chart 1). The yield curve inverted from May through September last year, and the coronavirus outbreak (COVID-19) has driven it to invert again, but the unprecedentedly negative term premium (Chart 2) has made the curve much more prone to set off a false alarm. Chart 1An Inverted Curve May Not Be What It Used To Be ... Chart 2... When A Negative Term Premium Is Holding Down Long Yields The indicator’s second input is the year-over-year change in the leading economic index (“LEI”). When the LEI contracts on a year-over-year basis, a recession typically ensues. As with the inverted yield curve, year-over-year contractions in the LEI have successfully called all of the recessions in the last 50 years with just one false positive (Chart 3). The LEI bounced off the zero line thanks to January’s strong reading, and the year-ago comparisons are much easier than they were last year, but we are mindful that it is flirting with sending a recession warning. Chart 3Leading Indicators Are Wobbly, ... It takes more than tight monetary conditions to make a recession, but you can't have one without them. To confirm the signal from the yield curve and the LEI and make it more robust, we also consider the monetary policy backdrop. Over the nearly 60 years for which BCA’s model calculates an equilibrium rate, every recession has occurred when the fed funds rate has exceeded our estimate of equilibrium (Chart 4). Tight monetary policy isn’t a sufficient condition for a recession – expansions continued for six more years despite tight policy in the mid-‘80s and mid-'90s – but it is a necessary one. Our indicator will not definitively signal an approaching recession until monetary conditions turn restrictive. Chart 4... But The Fed Is Nowhere Near Inducing A Recession Bottom Line: In our view, the yield curve and the LEI both represent yellow lights, though the LEI has a greater likelihood of turning red, especially in the wake of COVID-19. Monetary policy is unambiguously green, however, and we will not conclude that a recession is imminent until the Fed deliberately attempts to rein in the economy. Bolstering Theory With Observation A potential shortcoming of our recession indicator is its reliance on a theoretical concept. The equilibrium (or natural) rate of interest cannot be directly observed, so our judgment of whether monetary policy is easy or tight turns on an estimate. To bolster our assessment of whether or not the expansion can continue, we have been tracking the drivers of the main components of US output. Going back to the GDP equation from Introductory Macroeconomics, GDP = C + I + G + (X - M), we look at the forces supporting Consumption (C), Investment (I) and Government Spending (G). (Because the US is a comparatively closed economy in which trade plays a minor role, we ignore net exports (X-M).) Consumption is by far the largest component, accounting for two-thirds of overall output, while investment and government spending each contribute a sixth. As critical as consumption is for the US economy, it is not the whole story; smaller but considerably more volatile investment is capable of plunging the economy into a recession on its own. The Near-Term Outlook For Consumption Chart 5Labor Market Slack Has Been Absorbed Consumption depends on household income, the condition of household balance sheets, and households’ willingness to spend. The labor market remains extremely tight, with the unemployment rate at a 50-year low, and “hidden” unemployment dwindling as the supply of discouraged (Chart 5, top panel) and involuntary part-time workers (Chart 5, bottom panel) has withered. The prime-age employment-to-population ratio trails only the peak reached during the dot-com era (Chart 6), which bodes well for household income. The historical correlation between the prime-age non-employment-to-population ratio and wage gains has been quite robust, and compensation growth has plenty of room to run before it catches up with the best-fit line (Chart 7). Chart 6Prime-Age Employment Has Surged, ... Chart 7... And Wages Will Eventually Follow Suit Chart 8No Pressing Need To Save, Or Pay Down Debt Households can use additional income to increase savings or pay down debt instead of spending it, but it doesn’t look like they will. The savings rate is already quite elevated, having returned to its mid-‘90s levels (Chart 8, top panel); households have already run debt down to its post-dot-com bust levels (Chart 8, middle panel); and debt service is less demanding than it has been at any point in the last 40 years (Chart 8, bottom panel). The health of household balance sheets, and the recent pickup in the expectations component of the consumer confidence surveys, suggest that households have the ability and the willingness to keep consumption growing at or above trend. Household balance sheets are healthy enough to support spending income gains; there's even room to borrow to augment them. The Near-Term Outlook For Investment Table 1GDP Equation Recession Probabilities Chart 9A Budding Turnaround We previously identified investment as the individual component most likely to decline enough to zero out trend growth from the other two components (Table 1), and it was a drag in 2019, declining in each of the last three quarters to end the year more than 3% below its peak. We expect it will hold up better this year, however, as the capital spending intentions components of the NFIB survey of smaller businesses (Chart 9, top panel) and the regional Fed manufacturing surveys (Chart 9, bottom panel) have both pulled out of declines. The trade tensions with China weighed heavily on business confidence in 2019, but the signing of the Phase 1 trade agreement lifted that cloud, and we expect that capex will revive in line with confidence once COVID-19 has been subdued. Government Spending In An Election Year Chart 10State And Local Revenues Are Well Supported Heading into the most hotly contested election in many years, we confidently assert that federal spending is not going to go away. Regardless of party affiliation, everyone in Congress sees the appeal of distributing pork to their constituents. Spending by state and local governments, which accounts for 60% of aggregate government spending, should also hold up well, as a robust labor market will support state income tax (Chart 10, top panel) and sales tax (Chart 10, middle panel) receipts. Healthy trailing home price gains will support property tax assessments, keeping municipal coffers full (Chart 10, bottom panel). Coronavirus Uncertainties The coronavirus epidemic (COVID-19) is unfolding in real time, generating daily updates on new infections, deaths and recoveries. Any opinion we offer on the economy’s future is conditioned on the virus' ongoing course. If it takes a sharp turn for the worse, with more severe consequences than we had previously expected, it is likely that we will downgrade our outlook. For now, we are operating under the projection that the virus will cause China’s first quarter output to contract sharply enough to zero out global growth in the first quarter. Our base-case scenario, following from the work of our China Investment Strategy service, is fairly benign from there. For now, we are expecting that the worst of the effects will be confined to the first quarter, and that the Chinese economy and the global economy will bounce back vigorously in the second quarter and beyond, powered by pent-up demand that will go unfilled until the outbreak begins to recede. Our China strategists continue to be heartened by Chinese officials' aggressive (albeit belated) measures to stem the outbreak, revealed in the apparent slowing of the rate of new infections in Hubei province, the epicenter of the outbreak (Chart 11, top panel), and in the rest of China (Chart 11, bottom panel). They also expect a determined policy response to offset the drag from the epidemic (Charts 12 and 13), as officials pursue the imperative of meeting their goal to double the size of the economy between 2010 and 2020. Chart 11Stringent Quarantine Measures May Be Gaining Traction Chart 12The PBOC Is Doing Its Part, ... Chart 13... By Easing Monetary Conditions If the economy is expanding, investors' bar for de-risking should be high. Bottom Line: Our China strategists’ COVID-19 view remains fairly optimistic, though it is subject to unfolding developments. Our US view is contingent on BCA’s evolving COVID-19 views. Investment Implications As we noted at the outset, we are not interested in the economy for the economy’s sake; we are only interested in its impact on financial markets. The key business-cycle takeaway for markets is that bear markets and recessions typically coincide, as it is difficult to get a 20% decline at the index level without a meaningful decline in earnings, and earnings only decline meaningfully during recessions. No recession means no bear market, and it also means no meaningful pickup in loan delinquencies and defaults. The bottom line is that it is premature to de-risk while the expansion remains intact. We reiterate our recommendation that investors should remain at least equal weight equities in balanced portfolios, and at least equal weight spread product within fixed income allocations, though we may turn more cautious as we learn more about the progression of COVID-19. Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Please see the August 13, 2018 US Investment Strategy Special Report, "How Much Longer Can The Bull Market Last?" available at usis.bcaresearch.com. 2 We use the 3-month/10-year segment instead of the more common 2-year/10-year because the 3-month bill is a cleaner proxy for short rates than the 2-year note, which incorporates estimates of the Fed’s future actions.