Sovereign Debt

Highlights Global inflation will slow further, allowing central banks to ease policy. Liquidity indicators will have more upside as monetary policy will remain accommodative. Widening fiscal deficits, easing Chinese credit trends and rising U.S. consumer real income levels, all will allow improved liquidity to boost global growth in the second half of 2019. Important indicators are already flashing an increase in global growth. Yields have upside; keep a below-benchmark duration within bond portfolios. Commodity plays will perform well. The 12-month outlook for stocks remains positive, but they will churn over the coming six months. Equities will nonetheless outperform bonds. Favor cyclicals over defensives and international equities over the U.S. Feature Treasury yields are stuck near 2%, yet the S&P 500 is flirting with all-time highs. Investors are worried about global growth, still hoping that central banks will step in. The fears are well-placed: manufacturing has not stabilized, Asian trade is contracting, and the U.S. real estate sector is in the doldrums. Other concerns include the threat of U.S. President Donald Trump re-igniting the trade war and the U.S. corporate sector’s growing debt load. The positive news is that global inflation will remain low for the next 12 months or so. Without prices accelerating upward, global policymakers will continue to ease monetary and fiscal conditions. Consequently, nascent improvements in global liquidity conditions will blossom and growth will rebound in the second half of the year. Increased growth creates a paradox. At current levels, it is bearish for bonds and bullish for commodities. However, stock valuations will be undermined by higher bond yields, especially because earnings should experience additional downside this year. Consequently, the S&P 500 will churn sideways for the coming three to six months before taking off. In the meantime, stocks should outperform bonds. Blessed By Low Inflation The best news for the global economy is that inflation will stay low. Our U.S. Bond Investment Strategy colleagues recently showed that when the private sector does not quickly build large debt loads, rising inflation prompts all the post-war recessions.1  Today, the private sector’s debt vulnerability is limited. Nonfinancial private-sector leverage has only expanded by 2.1 percentage points of GDP since its trough four years ago (Chart I-1). In particular, after a drop from 134% to 106%, the household sector's debt-to-disposable income ratio has flat-lined for the past three years. Meanwhile, household debt-servicing costs as a percentage of after-tax income are at multi-generational lows. Even in the corporate sector, excesses are smaller than they appear. Despite accumulating US$5 trillion in credit since 2009, the nonfinancial corporate sector’s debt-to-asset ratio remains below its historical average of 22.4%. This sector is also generating free cash flows equal to 2.1% of GDP. Prior to recessions, the corporate sector consumed cash instead of generating it.2 Chart I-1No Excessive Debt Built-Up In The U.S. In this context, we are optimists because inflation is set to slow, leaving policymakers around the world a window to maintain generous monetary conditions and support growth. At the global level, we currently see a paucity of inflation. Among advanced economies, average core inflation is only 1.5%. Moreover, only 15% of these nations are experiencing rates of underlying inflation above the critical 2% level (Chart I-2). Chart I-2Global Inflation Will Stay Tame Going forward, risks are skewed toward a deceleration in prices. Inflation is the most lagging economic variable. Thus, the recent global economic slowdown will continue to exert downward pressure on prices. Singapore, a country highly dependent on trade, is an excellent barometer for global cyclical sectors. In the second quarter of 2019, Singapore’s annual GDP growth declined to 0.1%, its lowest level since the Great Financial Crisis. Historically, this has presaged a marked deceleration in global core CPI (Chart I-2, bottom panel). The weakness in global inflation also will translate into lower U.S. underlying inflation. U.S. import prices (excluding oil) are contracting by 1.4% on an annual basis. Despite U.S. tariffs, import prices from China are also shrinking by 1.5%, the deepest retrenchment since the deflationary scare of 2016. This will weigh on the price of U.S. goods. U.S. activity suggests imported disinflation will spill over into overall core CPI. Since 2009, the changes in the ISM manufacturing index and the annual performance of transport stocks relative to utilities have led core inflation (Chart I-3). Based on these relationships, core CPI should slow markedly. Pipeline inflation measures suggest this is a fait accompli. Core crude producer prices are melting, signaling lower inflation excluding food and energy. Chart I-3Deflationary Forces In The U.S. As Well Finally, there is only a slim chance that inflation will exceed 2.5% in the coming year, according to the St. Louis Fed’s Price Pressure Measure (Chart I-4, top panel). Import prices point toward lower goods prices, while core service CPI is quickly slowing and medical care CPI remains close to 2%, which is near record lows (Chart I-4, second panel). Meanwhile, shelter CPI shows little upward momentum (Chart I-4, third panel). Finally, the rebound in productivity growth to 2.4% is also limiting the inflationary impact of rising wages: unit labor costs are contracting at a 0.8% annual rate, despite a 3.1% year-over-year expansion in average hourly earnings (Chart I-4, bottom panel). Chart I-4Details Of U.S. CPI Evidence, therefore, points to inflation slowing down in advanced economies, even in the more robust U.S. Opening The Liquidity Spigots The lack of inflation allows central banks to ease policy in response to the slowdown in global growth. The Fed is set to trim rates by 25 basis points next week and again later this year. The ECB just telegraphed a rate cut and potentially a resumption of its QE program for September. The Reserve Bank of Australia has chopped rates twice this year, and the Reserve Bank of New Zealand, one time. Meanwhile, the People’s Bank of China has slashed the reserve requirement ratio (RRR) by 3.5% in the past 15 months. The Fed’s interest rate cuts are crucial for U.S. growth and emerging market liquidity conditions. Money moved into EM economies as interest rate markets priced in ever-deeper U.S. rate cuts after the Federal Open Market Committee’s dovish pivot this winter. As a result, EM currencies stabilized, allowing EM central banks to ease policy to support their sagging domestic economies. The Bank of India, the Bank of Indonesia, the Bank of Korea, the South African Reserve Bank, the Bank of Russia, Bank Negara Malaysia, and the Turkish Central Bank have all cut rates. Central banks in Brazil and Mexico are expected to follow suit.  Global policy easing should solidify an improvement in many global liquidity indicators and thus, support global growth in the next year: M2 growth in the U.S. bottomed last November. Concurrently, the growth of money of zero maturity in excess of credit has improved since late last year. This sends a positive signal for BCA’s Global Nowcast, BCA’s Global LEIs, and global and Asian export prices (Chart I-5). Chart I-5More Excess Money, More Activity Our U.S. Financial Liquidity Index continues to accelerate, corroborating the message about global growth conditions from our excess-money indicator (Chart I-6). Chart I-6Improving Global Liquidity Conditions Emerging Markets’ M1 is turning up, albeit at a depressed level. This improvement will likely morph into a recovery as EM and DM central banks ease policy. EM M1 has excellent leading properties on EM activity and profits. Gold, a traditional reflation gauge, has broken out as real rates remain depressed. Finally, TED spreads, both on a spot and a three-month forward basis, have tumbled to near all-time lows (Chart I-7). Plentiful global liquidity narrows these spreads. Moreover, their tightness indicates that there is minimal stress in the financial system. Also, TED spreads were more elevated and getting wider before previous recessions, during the euro area crisis and even during the 2015-16 slowdown. Chart I-7No Stress In TED Spreads Low inflation allows monetary authorities to nurture an improvement in liquidity, which would raise the odds that the cycle should soon bottom. Global Growth Indicators In addition to a supportive liquidity environment, important developments point toward a meaningful global growth pick in the second half of the year. At first glance, data continues to deteriorate. Aggregate capital goods orders in the U.S., Japan, and Germany are contracting at a 7.3% annual pace, the flash PMI numbers released this week were poor and the U.S. LEI shrunk last month on a sequential basis and only increased 1.6% year-on-year. However, these data points miss crucial undercurrents. Governments normally loosen fiscal policy – as measured by the changes in cyclically-adjusted primary balances – after a recession has begun. This time, governments are already expanding deficits. In the euro area, the fiscal thrust is moving from -0.3% of GDP to 0.4% of GDP, a 0.7% of GDP boost to growth compared to last year. In China, fiscal deficits are deepening. In response to large tax cuts and expanding subsidies to various sectors, Beijing’s official budget hole has grown from 3.7% of GDP in 2017 to 4.9% this year. Broader measures, which include provincial and local governments, and off-balance-sheet entities, recorded a deficit of 11% this year. In Japan, the government is implementing fiscal offsets as large, if not larger, than the upcoming VAT increase. Even in the U.S., fiscal policy will probably ease. The Congressional Budget Office tabulates a fiscal drag of 0.5% of GDP in 2020 because of the 2011 Budget Control Act. However, the national debt was set to hit its ceiling soon. In response, the GOP and the Democrats have agreed to a proposed funding measure that will ultimately boost spending by US$50 billion more than the previously tabulated fiscal retrenchment (Chart I-8). Chinese credit policy is also increasingly supportive of global growth. Adjustments to the RRR normally take approximately 12 months to affect China’s adjusted total social financing (TSF) (Chart I-9, top panel). Changes to the RRR also lead global industrial activity, albeit more loosely, by 18 months (Chart I-9, second panel). This last relationship exists because soon after the TSF expands, Chinese economic agents use the proceeds to invest or spend on durable goods. This process boosts Chinese imports and lifts global economic activity (Chart I-9, bottom panel). Moreover, as we argued last month, we expect China’s reflationary efforts to continue for the rest of the year.3 Chart I-9The Impact Of The Chinese Stimulus Is Only Starting To Be Felt China’s stimulus is showing early signs of working, despite regulatory constraints on the banking sector. Construction and installation spending by Chinese real estate firms troughed in June 2018 and are growing at a 5.4% annual pace. The growth of equipment purchases is a stunning 22%, near its highest yearly rate in three years. Additionally, China’s intake of steel and cement is surging. These developments normally materialize ahead of rebounds in the PMI or the Li-Keqiang index. Even the outlook for China’s auto sales may be improving. Vehicle sales in China fell by 15.8% in May. In June, they remained soft despite heavy discounts by auto manufacturers. However, vehicle inventories are falling, indicating that auto production is poised to pick up. Importantly, real income levels for U.S. consumers are on the rise. Real average hourly earnings are growing by 1.8% year-on-year, the highest in this cycle. This is a dividend from the recent uptick in productivity (Chart I-10). Mounting productivity both puts a lid on inflation and enhances real incomes. Chart I-10Productivity Is The Name Of The Game Additional developments warrant optimism over global growth: The performance of EM carry trades funded in yen is rebounding. Historically, this has been a reliable leading indicator of global industrial activity (Chart I-11, top panel). As carry traders buy EM currencies and sell the yen, they borrow funds from an economy replete with excess liquidity and savings (Japan) and inject them where they are needed to finance investment and consumption (the EM). In the process, they bid up EM currencies and inject liquidity in those countries, supporting growth conditions globally.  Chart I-11Positive Signs For Growth The annual performance of the sectors most sensitive to global growth conditions – global semi, industrials and materials stocks – is bottoming relative to the broader market. Normally, this happens ahead of troughs in BCA’s Global Nowcast (Chart I-11, middle panel). European luxury stocks are performing strongly, which also usually precedes rebounds in global economic activity (Chart I-11, bottom panel). Shipping costs are moving up. The Baltic Dry Index, a measure of the cost of shipping commodities, has surged by 270% since February 2019 to its highest level since 2013. Some have argued this gauge overstates the economy’s potential strength. However, the Harpex index, a measure of the cost of shipping containers, has risen by 30% in the same period. This concurrence of moves suggests that the Baltic Dry is probably correct about the direction of growth, but might be overstating the size of the rebound. Our composite momentum indicator for ethylene and propylene – two chemicals that enter into the production of pretty much everything that makes the modern economy work – is forming a bullish price divergence (Chart I-12). The price of these chemicals normally rises when global growth accelerates. Chart I-12Chemical Technicals Point To A Rebound Bottom Line: Global growth should be buoyed by several indicators, specifically a low inflation environment, an easing in both monetary and fiscal policy, a positive outlook for already improving global liquidity conditions, a healthy U.S. consumer, and the lagged impact of China’s stimulus. Investment Implications: Strong Crosscurrents For Stocks Bonds At this juncture, bonds may be the easier asset class to call; a below-benchmark duration is appropriate for fixed-income portfolios. Pessimism towards global growth is most evident in the prices of safe-haven assets. According to the CFTC, asset managers’ net-long positions in all forms of listed Treasurys contracts are hovering near all-time highs. This makes bonds vulnerable to positive economic surprises. The long-term interest rate component of the ZEW survey corroborates this message. Expectations for global long-term interest rates are near record lows. If a recession is avoided, then readings this low offer a powerful contrarian signal for bonds (Chart I-13). Chart I-13Bonds: A Contrarian Bet A potential uptick in growth would confirm this bond-bearish setup. The improvement in Chinese TSF and the strength in European luxury goods makers point towards higher yields (Chart I-14). Bond prices would also suffer if the average price of ethylene and propylene can heed the bullish signal from its momentum oscillator. Moreover, in the post-war era, on average Treasury yields typically bottomed 12 months ahead of inflation. Chart I-14Cyclical Dynamics Point To Higher Yields Given that bonds are expensive, there is a greater likelihood that positioning and cyclical forces will push up yields. Our bond valuation model shows that Treasurys are expensive and various estimates of global term premia have never been this negative. This reflects the belief that policy rates will stay low forever. However, if global growth picks up, then the Fed is highly unlikely to cut rates over the coming 12 months by the 90 basis points currently discounted by the OIS curve. Moreover, stimulating at this point in the cycle increases the risk of generating inflation down the road. Accelerating inflation would ultimately force global central banks to boost rates in the next three to five years by much more than expected, warranting higher term premia around the world. Therefore, we expect inflation expectations and term premia – but not real rates – to drive up yields, at least until global central banks abandon their dovish biases. Commodities Commodities and related assets are attractive. A measure of growth sentiment based on futures positioning in stocks, oil, copper, the Australian dollar and the Canadian dollar relative to bets on Treasury of all maturities and the dollar index shows that investors have not moved into commodity plays (Chart I-15). Moreover, traders who manage money on behalf of clients are also massively short copper, one of the most growth-sensitive commodities (Chart I-16). Chart I-15Investors Are Not Positioned For A Rebound In Growth Chart I-16Copper Is An Attractive Bet For A Growth Rebound The six-month outlook is particularly positive for the Australian dollar. The RBA has already moved aggressively to ease policy and the purging of excesses in the Australian economy is well advanced. Property borrowing for investments has collapsed by 35%, housing activity has contracted by 22%, and building permits have fallen by 20%. However, the Australian labor market remains robust and early indicators of real estate activity in major cities are stabilizing. External forces are also positive for the AUD. Strong steel prices, which have contributed to the rally in iron ore, coupled with quickly growing Australian LNG exports, will boost the terms of trade for the AUD. Moreover, the rebound in Chinese TSF, which we expect to gather momentum, creates another tailwind (Chart I-17, top panel). What’s more, rising ethylene and propylene prices, as well as rallying stock prices of European luxury goods makers, are strong supports for commodity currencies (Chart I-17, second and third panel). Chart I-17The AUD Looks Increasingly Interesting Silver is another attractive play. Last month, we argued that easy global policy would create an important support for gold.4 Since then, silver has broken out of a downward sloping trend line in place since 2016. Unlike gold, silver is still trading near very depressed levels (Chart I-18). Moreover, according to net speculative positions, gold is overbought on a tactical basis and ripe for a pullback, whereas silver is not nearly as popular with speculators. Our optimistic stance on global growth is congruent with an outperformance of silver relative to gold. Silver has more industrial uses than gold and the gold-to-silver ratio generally falls when manufacturing activity perks up. Chart I-18Silver To Shine Brighter Than Gold Equities The window to own stocks remains open. Stocks have more upside on a 9- to 12-month basis, but are set to churn over the coming three to six months. The risk of sharp but temporary corrections is elevated. Stocks rarely enter a bear market if a recession is far away. Stock prices perform well in the 12 months prior to the last half-year before a recession begins (Table I-1). If we expect growth to pick up over the next 6 to 12 months and policy to remain easy, then a recession will not occur before late 2021/early 2022. The improvement in our global liquidity indicators also supports a period of strong equity performance ahead (Chart I-19). Moreover, the 2-year/fed funds rate yield curve is inverted. Since the 1980s, after such inversions, the median 12-month return for the S&P 500 has been 14%. Stripping out recessionary episodes, the median returns would have been 18.6%, 13.1%, and 9.9%, over 12, 6 and 3 months, respectively (Table I-2). Chart I-19Liquidity Will Put A Floor Under Stock Prices Technically, stocks are also on a strong footing. The equal-weight S&P 500 has broken out, indicating robust breadth. Our composite sentiment indicator for U.S. equities is not flagging any euphoria among market participants (Chart I-20). BCA’s Monetary, Technical and Intermediate Indicators show one should own stocks. Chart I-20BCA's Indicators Favor Stocks Nevertheless, important negatives for stocks also exist. The rally in equities has been fueled by hope, as our U.S. Equity Strategy team has highlighted. Since December 2018, the rally has been driven by multiples expansion (Chart I-21). Meanwhile, Section II’s debate shows that Anastasios’s earnings models all point to low earnings growth later this year. The weakness in core crude producer price inflation will weigh on margins and corporate profits (Chart I-22). It will therefore become increasingly difficult to justify widening P/E ratios. Furthermore, the S&P 500 has moved well ahead of the performance implied by earnings estimates revisions (Chart I-23).5 Chart I-21Multiples Inflation Chart I-22Profits Still Face Near-Term Hurdles Chart I-23EPS Revisions And Stock Prices Have Dissociated From a valuation perspective, the S&P’s price-to-book, price-to-sales, or cyclically adjusted P/E ratio, all are demanding by historical standards, but justifiable if Treasurys only offer a 2% yield. This rally based on hope is vulnerable to our expectations of higher yields. Only once earnings rebound, which will pull down multiples in a benign fashion, can stocks resume their uptrend. U.S. stocks will probably churn for the rest of the year. The media made much of the S&P 500 hitting new highs in September last year and this month, but the U.S. benchmark is only 3.5% above its January 2018 peak. U.S. stocks have been very volatile, but have gone nowhere for 18 months; this pattern should hold. We are overweight stocks relative to bonds given that we recommend maintaining a below-benchmark duration for fixed-income portfolios. At 1.9%, the S&P 500 dividend yield is in line with the yield to maturity of 10-year Treasurys, while the wide equity risk premium suggests that stocks are a bargain compared to bonds. Also, the stock-to-bond ratio performs well when global industrial activity rebounds (Chart I-24). Chart I-24If Growth Helps Chemical Prices, It Will Help Stocks Outperform Bonds... Cyclical stocks will likely outperform defensive equities on rebounding global growth. The bullish configuration in the price of chemicals is consistent with a period of outperformance for cyclical equities (Chart I-25). Cyclicals also perform well when yields are moving higher, especially when central banks remain accommodative. A positive view on commodities fits within this pattern. Chart I-25...And Cyclicals Outperform Defensives European stocks are better placed than their U.S. counterparts in the coming six to nine months. European stocks outperform U.S. ones when the Chinese TSF moves up (Chart I-26), reflecting their higher sensitivity to the global business cycle. Additionally, European equities are trading at a large discount. The forward P/E and price-to-book of an equally weighted average of European stocks stand at 14.4 and 2.1 respectively, versus 20.7 and 4.1 for the U.S. Chart I-26Look Into Upgrading Europe At The Expense Of The U.S. Loan volumes will benefit from the large easing in European financial conditions resulting from the 166-basis-point drop in peripheral yields this year, with BTP yields falling to a near three years low following the ECB’s dovish tilt. This will remove some of the negative impact of soft net interest margins on bank profits. European banks could be an attractive trade. Finally, global auto stocks are trading at their lowest levels relative to the global equity benchmark since the beginning of the 2000s (Chart I-27). Moreover, global auto stocks trade at 44% discount to the broad market on a 12-month forward P/E basis, the largest handicap since 2009. This sector should perform well in the next year based on purged global auto inventories, robust consumer real income, falling interest rates and rebounding global growth. Chart I-27Autos Are A Contrarian Play Mathieu Savary Vice President The Bank Credit Analyst July 25, 2019 Next Report: August 29, 2019   II. What Goes On Between Those Walls? BCA’s Diverging Views In The Open BCA takes pride in its independence. Strategists publish what they really believe, informed by their framework and analysis. Occasionally, this independence results in strongly diverging views and we currently are in one of those times. Within BCA, two views on the cyclical (six to 12-months) outlook for assets have emerged. One camp expects global growth to rebound in the second half of the year. Along with accelerating growth, they anticipate stock prices and risk assets to remain firm, cyclical equities to outperform defensive ones, safe-haven yields to move up, and the dollar to weaken. Meanwhile, another group foresees a further deterioration in activity or a delayed recovery, additional downside in stocks and risk assets, outperformance of defensives relative to cyclicals, low safe-haven yields, and a generally stronger dollar. For the sake of transparency, we have asked representatives of each camp to make their case in a round-table discussion, allowing our clients to decide for themselves which view is more appealing to them. Global Investment Strategy’s Peter Berezin, U.S. Investment Strategy’s Doug Peta, and Global Fixed Income Strategy’s Rob Robis take the mantle for the bullish camp. U.S. Equity Strategy’s Anastasios Avgeriou, Emerging Market Strategy’s Arthur Budaghyan, and European Investment Strategy’s Dhaval Joshi represent the bearish group.6   The round-table discussion below focuses on the cyclical outlook. For longer investment horizons, most strategists agree that a recession is highly likely by 2022. Moreover, on a long-term basis, valuations in both risk assets and safe-haven bonds are very demanding. In this context, a significant back up in yields could hammer risk assets. The BCA Round Table Mathieu Savary: Yield curve inversions have often been harbingers of recessions. Anastasios, you are amongst those investors troubled by this inversion. Do you not worry that this episode might prove similar to 1998, when the curve only inverted temporarily and did not foreshadow a recession? Moreover, how do you account for the highly variable time lags between the inversion of the yield curve and the occurrence of a recession? Anastasios Avgeriou: The yield curve inverts at or near the peak of the business cycle and it eventually forewarns of upcoming recessions. This past December, parts of the yield curve inverted and now, BCA’s U.S. Equity Strategy service is heeding the signal from this simple indicator, especially given that the SPX has subsequently made all-time highs as our research predicted.2 The yield curve inversion forecasts a Fed rate cut, and it has never been wrong on that front. It served well investors that heeded the message in June of 1998 as the market soon thereafter fell 20% in a heartbeat. If investors got out at the 1998 peak near 1200 and forwent about 350 points of gains until the March 2000 SPX cycle peak, they still benefited if they held tight as the market ultimately troughed near 777 in October 2002 (Chart II-1). Chart II-1 (ANASTASIOS)The 1998 Episode Revisited With regard to timing the previous seven recessions using the yield curve, if we accept that mid-1998 is the starting point of the inversion, it took 33 months before the recession commenced. Last cycle, the recession began 24 months after the inversion. Consequently, December 2020 is the earliest possible onset of recession and September 2021, the latest. Our forecast calls for SPX EPS to fall 20% in 2021 to $140 with the multiple dropping between 13.5x and 16.5x for an SPX end-2020 target range of 1,890-2,310.3 In other words we are not willing to play a 100-200 point advance for a potential 1,000 point drawdown. The risk/reward tradeoff is to the downside, and we choose to sit this one out. Mathieu: Rob, you take a much more sanguine view of the current curve inversion. Why? Rob Robis: While the four most dangerous words in investing are “this time is different,” this time really does appear to be different. Never before have negative term premia on longer-term Treasury yields and a curve inversion coexisted (Chart II-2). Longer-term Treasury yields have therefore been pushed down to extremely low levels by factors beyond just expectations of a lower fed funds rate. The negative Treasury term premium is distorting the economic message of the U.S. yield curve inversion. Chart II-2 (ROB)Negative Term Premium Distorting The Economic Message Of An Inverted Yield Curve Term premia are depressed everywhere, as seen in German, Japanese and other yields, reflecting the intense demand for safe assets like government bonds during a period of heightened uncertainty. Global bond markets may also be discounting a higher probability of the ECB restarting its Asset Purchase Program, as term premia typically fall sharply when central banks embark on quantitative easing. This has global spillovers. Prior to previous recessions, U.S. Treasury curve inversions occurred when the Fed was running an unequivocally tight monetary policy. That is not the case today. The real fed funds rate still is not above the Fed’s estimate of the neutral real rate, a.k.a. “r-star,” which was the necessary ingredient for all previous Treasury curve inversions since 1960 (Chart II-3). Chart II-3 (ROB)Fed Policy Is Not Tight Enough For Sustained Curve Inversion Mathieu: The level of policy accommodation will most likely determine whether Anastasios or Rob is proven right. Peter, you have been steadfastly arguing that policy, in the U.S. at least, remains easy. Can you elaborate why? Peter Berezin: Remember that the neutral rate of interest is the rate that equalizes the level of aggregate demand with the economy’s supply-side potential. Loose fiscal policy and fading deleveraging headwinds are boosting demand in the United States. So is rising wage growth, especially at the bottom of the income distribution. Given that the U.S. does not currently suffer from any major imbalances, I believe that the economy can tolerate higher rates without significant ill-effects. In other words, monetary policy is currently quite easy. Of course, we cannot observe the neutral rate directly. Like a black hole, one can only detect it based on the effect that it has on its surroundings. Housing is by far the most interest rate-sensitive sector of the economy. If history is any guide, the recent decline in mortgage rates will boost housing activity in the remainder of the year (Chart II-4). If that relationship breaks down, as it did during the Great Recession, it would suggest that the neutral rate is quite low. Chart II-4 (PETER)Declining Mortgage Rates Bode Well For Housing Given that mortgage underwriting standards have been quite strong and the homeowner vacancy is presently very low, our guess is that housing will hold up well. We should know better in the next few months. Mathieu: Dhaval, you do not agree. Why do you think global rates are not accommodative? Dhaval Joshi: Actually, I think that global rates are accommodative, but that the global bond yield can rise by just 70 bps before conditions become perilously un-accommodative. Here’s where I disagree with Peter: for me, the danger doesn’t come from economics, it comes from the mathematics of ultra-low bond yields. The unprecedented and experimental panacea of our era has been ‘universal QE’ – which has led to ultra-low bond yields everywhere. But what is not understood is that when bond yields reach and remain close to their lower bound, weird things happen to the financial markets. I refer you to other reports for the details, but in a nutshell, the proximity of the lower bound to yields increases the risk of owning supposedly ‘safe’ bonds to the risk of owning so-called ‘risk-assets’. The result is that the valuation of risk-assets rises exponentially (Chart II-5). Because when the riskiness of the asset-classes converges, investors price risk-assets to deliver the same ultra-low nominal return as bonds.4   Comparisons with previous economic cycles miss the current danger. The post-2000 policy easing distorted the global economy by engineering a credit boom – so the subsequent danger emanated from the most credit-sensitive sectors in the economy such as mortgage lending. In contrast, the post-2008 ‘universal QE’ has severely distorted the valuation relationship between bonds and global risk-assets – so this is where the current danger lies. Higher bond yields can suddenly undermine the valuation support of global risk-assets whose $400 trillion worth dwarfs the global economy by five to one. Where is this tipping point? It is when the global 10-year yield – defined as the average of the U.S., euro area,5 and China – approaches 2.5%. Through the past five years, the inability of this yield to remain above 2.5% confirms the hyper-sensitivity of financial conditions to this tipping point (Chart II-6). Right now, I agree that bond yields are accommodative. But the scope for yields to move higher is quite limited. Chart II-6 (DHAVAL)Since 2015, the Global Long Bond Yield Has Struggled To Surpass 2.5 Percent Mathieu: Monetary policy is important to the outlook, but so is the global manufacturing cycle. The global growth slowdown has been concentrated in the manufacturing sector, tradeable goods in particular. Across advanced economies, the service and consumer sectors have been surprisingly resilient, but this will not last if the industrial sector decelerates further. Arthur, you still do not anticipate any major improvement in global trade and industrial production. Can you elaborate why? Arthur Budaghyan: To properly assess the economic outlook, one needs to understand what has caused the ongoing global trade/manufacturing downturn. One thing we know for certain: It originated in China, not the U.S.  Chart II-7illustrates that Korean, Japanese, Taiwanese and Singaporean exports to China have been shrinking at an annual rate of 10%, while their shipments to the U.S. have been growing. China’s aggregate imports have also been contracting. This entails that from the perspective of the rest of the world, China has been and remains in recession. Chart II-7 (ARTHUR)Global Trade Is Down Due To China Not U.S. U.S. manufacturing is the least exposed to China, which is the main reason why it has been the last shoe to drop. Hence, the U.S. has lagged in this downturn, and one should not be looking to the U.S. for clues about a potential global recovery. We need to gauge what will turn Chinese demand around. In this regard, the rising credit and fiscal spending impulse is positive, but it has so far failed to kick start a recovery (Chart II-8). The key reason has been a declining marginal propensity to spend among households and companies. Notably, the marginal propensity to spend of mainland companies leads industrial metals prices by a few months, and it currently continues to point south (Chart II-8, bottom panel).   Chart II-8 (ARTHUR)Stimulus Versus Marginal Propensity To Spend The lack of willingness among Chinese consumers and enterprises to spend is due to several factors: (1) the U.S.-China confrontation; (2) high levels of indebtedness among both enterprises and households (Chart II-9); (3) ongoing regulatory scrutiny over banks and shadow banking as well as local government debt; and (4) a lack of outright government subsidies for purchases of autos and housing. Chart II-9 (ARTHUR)Chinese Households Are Leveraged Than U.S. Ones On the whole, the falling marginal propensity to spend will all but ensure that any recovery in mainland household and corporate spending is delayed. Mathieu: Meanwhile, Peter, you have a much more optimistic stance. Why do you differ so profoundly with Arthur’s view? Peter: China’s deleveraging campaign began more than a year before global manufacturing peaked. I have no doubt that slower Chinese credit growth weighed on global capex, but we should not lose sight of the fact there are natural ebbs and flows at work. Most manufactured goods retain some value for a while after they are purchased. If spending on, say, consumer durable goods or business equipment rises to a high level for an extended period, a glut will form, requiring a period of lower production.  These demand cycles typically last about three years; roughly 18 months on the way up, 18 months on the way down (Chart II-10). The last downleg in the global manufacturing cycle began in early 2018, so if history is any guide, we are nearing a trough. The fact that U.S. manufacturing output rose in both May and June, followed by this week’s sharp rebound in the July Philly Fed Manufacturing survey, supports this view. Chart II-10 (PETER)The Global Manufacturing Cycle Has Likely Reached A Bottom Of course, extraneous forces could complicate matters. If trade tensions ratchet higher, this would weaken my bullish thesis. Nevertheless, with China stimulating its economy again, it would probably take a severe trade war to push the global economy into recession. Mathieu: Dhaval, you are not as negative as Arthur, but nonetheless expect a slowdown in the second half of the year. What is your rationale? Dhaval: To be clear, I am not forecasting a recession or major downturn – unless, as per my previous answer, the global 10-year bond yield approaches 2.5% and triggers a severe dislocation in global risk-assets. In fact, many people get the relationship between recession and financial market dislocation back-to-front: they think that the recession causes the financial market dislocation when, in most cases, the financial market dislocation causes the recession! Nevertheless, I do believe that European and global growth is entering a regular down-oscillation based on the following compelling evidence: 1. From a low last summer, quarter-on-quarter GDP growth rates in the developed economies have already rebounded to the upper end of multi-year ranges. 2. Short-term credit impulses in Europe, the U.S., and China are entering down-oscillations (Chart II-11). Chart II-11 (DHAVAL)Short-Term Impulses Rebounded... But Are Now Rolling Over 3. The best current activity indicators, specifically the ZEW economic sentiment indicators, have rolled over. 4. The outperformance of industrials – the equity sector most exposed to global growth – has also rolled over. Why expect a down-oscillation? Because it is the rate of decline in the bond yield that drove the rebound in growth after its low last summer. Furthermore, it is impossible for the rate of decline in the bond yield to keep increasing, or even stay where it is. Counterintuitively, if bond yields decline, but at a reduced pace, the effect is to slow economic growth.  Mathieu: A positive and a negative view of the world logically result in bifurcated outlooks for interest rates and the dollar. Rob, how do you see U.S., German, and Japanese yields evolving over the coming 12 months? Rob: If global growth rebounds, U.S. Treasury yields will have far more upside than Bund or JGB yields. Inflation expectations should recover faster in the U.S., with the Fed taking inflationary risks by cutting rates with a 3.7% unemployment rate and core CPI inflation at 2.1%. The Fed is also likely to disappoint by delivering fewer rate cuts than are currently discounted by markets (90bps over the next 12 months). Treasury yields can therefore increase more than German and Japanese yields, with the ECB and BoJ more likely to deliver the modest rate cuts currently discounted in their yield curves (Chart II-12). Chart II-12 (ROB)U.S. Treasuries Will Underperform Bunds & JGBs Japanese yields will remain mired at or below zero over the next 6-12 months, as wage growth and core inflation remain too anemic for the BoJ to alter its 0% target on 10-year JGB yields. German yields have a bit more potential to rise if European growth begins to recover, but will lag any move higher in Treasury yields. That means that the Treasury-Bund and Treasury-JGB spreads will move higher over the next year. Negative German and Japanese yields may look completely unappetizing compared to +2% U.S. Treasury yields, but this handicap vanishes when all three yields are expressed in U.S. dollar terms. Hedging a 10-year German Bund or JGB into higher-yielding U.S. dollars creates yields that are 50-60bps higher than a 10-year U.S. Treasury. It is abundantly clear that German and Japanese bonds will outperform Treasuries over the next year if global growth recovers. Mathieu: Peter, your positive view on global growth means that the Fed will cut rates less than what is currently priced into the OIS curve. So why do you expect the dollar to weaken in the second half of 2019? Peter: What the Fed does affects interest rate differentials, but just as important is what other central banks do. The ECB is not going to raise rates over the next 12 months. However, if euro area growth surprises on the upside later this year, investors will begin to question the need for the ECB to keep policy rates in negative territory until mid-2024. The market’s expectation of where policy rates will be five years out tends to correlate well with today’s exchange rate. By that measure, there is scope for interest rate differentials to narrow against the U.S. dollar (Chart II-13). Chart II-13A (PETER)Interest Rate Expectations Against The U.S. Should Narrow (II) Chart II-13B (PETER)Interest Rate Expectations Against The U.S. Should Narrow (I) Keep in mind that the U.S. dollar is a countercyclical currency, meaning that it moves in the opposite direction of global growth (Chart II-14). This countercyclicality stems from the fact that the U.S. economy is more geared towards services than manufacturing compared with the rest of the world. Chart II-14 (PETER)The Dollar Is A Countercyclical Currency As such, when global growth accelerates, capital tends to flow from the U.S. to the rest of the world, translating into more demand for foreign currency and less demand for dollars. If global growth picks up in the remainder of the year, as I expect, the dollar will weaken. Mathieu: Arthur, as you are significantly more negative on growth than either Rob or Peter, how do you see the dollar and global yields evolving over the coming six to 12 months? Arthur: I am positive on the trade-weighted U.S. dollar for the following reasons: The U.S. dollar is a countercyclical currency – it exhibits a negative correlation with the global business cycle. Persistent weakness in the global economy emanating from China/EM is positive for the dollar because the U.S. economy is the major economic block least exposed to a China/EM slowdown. Meanwhile, the greenback is only loosely correlated with U.S. interest rates. Thereby, the argument that lower U.S. rates will drive the value of the U.S. currency much lower is overemphasized. The Federal Reserve will cut rates by more than what is currently priced into the market only in a scenario of a complete collapse in global growth. Yet this scenario would be dollar bullish. In this case, the dollar’s strong inverse relationship with global growth will outweigh its weak positive relationship with interest rates. Contrary to consensus views, the U.S. dollar is not very expensive. According to unit labor costs based on the real effective exchange rate – the best currency valuation measure – the greenback is only one standard deviation above its fair value. Often, financial markets tend to overshoot to 1.5 or 2 standard deviations below or above their historical mean before reversing their trend. One of the oft-cited headwinds facing the dollar is positioning, yet there is a major discrepancy between positioning in DM and EM currencies versus the U.S. dollar. In aggregate, investors – asset managers and leveraged funds – have neutral exposure to DM currencies, but they are very long liquid EM exchange rates such as the BRL, MXN, ZAR and RUB versus the greenback. The dollar strength will occur mostly versus EM and commodities currencies. In other words, the euro, other European currencies and the yen will outperform EM exchange rates. I have less conviction on global bond yields. While global growth will disappoint, yields have already fallen a lot and the U.S. economy is currently not weak enough to justify around 90 basis points of rate cuts over the next 12 months. Mathieu: Before we move on to investment recommendations, Anastasios, you have done a lot of interesting work on the outlook for U.S. profits. What is the message of your analysis? Anastasios: While markets cheered the trade truce following the recent G-20 meeting, no tariff rollback was agreed. Since the tariff rate on $200bn of Chinese imports went up from 10% to 25% on May 10, odds are high that manufacturing will remain in the doldrums. This will likely continue to weigh on profits for the remainder of the year. Profit growth should weaken further in the coming six months. Periods of falling manufacturing PMIs result in larger negative earnings growth surprises as market forecasters rarely anticipate the full breadth and depth of slowdowns. Absent profit growth, equity markets lack the necessary ‘oxygen’ for a durable high-quality rally. Until global growth momentum turns, investors should fade rallies. Our four-factor SPX EPS growth model is flirting with the contraction zone. In addition, our corporate pricing power proxy and Goldman Sachs’ Current Activity Indicator both send a distress signal for SPX profits (Chart II-15). Chart II-15 (ANASTASIOS)Gravitational Pull Already, more than half of the S&P 500 GICS1 sectors’ profits are estimated to have contracted in Q2, and three sectors could see declining revenues on a year-over-year basis, according to I/B/E/S data. Q3 depicts an equally grim profit picture that will also spill over to Q4. Adding it all up, profits will underwhelm into year-end. Mathieu: Doug, you do not share Anastasios’s anxiety. What offsets do you foresee? Moreover, you are not concerned by the U.S. corporate balance sheets. Can you share why? Doug Peta: As it relates to earnings, we foresee offsets from a revival in the rest of the world. Increasingly accommodative global monetary policy and reviving Chinese growth will give global ex-U.S. economies a boost. That inflection may go largely unnoticed in U.S. GDP, but it will help the S&P 500, as U.S.-based multinationals’ earnings benefit from increased overseas demand and a weaker dollar. When it comes to corporate balance sheets, shifting some of the funding burden to debt from equity when interest rates are at generational lows is a no-brainer. Even so, non-financial corporates have not added all that much leverage (Chart II-16). Low interest rates, wide profit margins and conservative capex have left them with ample free cash flow to service their obligations (Chart II-17). Chart II-16 (DOUG)Corporations Have Not Added Much Leverage ... Chart II-17 (DOUG)...Though They Have Ample Cash Flow To Service It Every single viable corporate entity with an effective federal tax rate above 21% became a better credit when the top marginal rate was cut from 35% to 21%. Every such corporation now has more net income with which to service debt, and will have that income unless the tax code is revised. You can’t see it in EBITDA multiples, but it will show up in reduced defaults. Mathieu: The last, and most important question. What are each of your main investment recommendations to capitalize on the economic trends you anticipate over the coming 6-12 months? Let’s start with the pessimists: Arthur: First, the rally in global cyclicals and China plays since December has been premature and is at risk of unwinding as global growth and cyclical profits disappoint. Historical evidence suggests that global share prices have not led but have actually been coincident with the global manufacturing PMI (Chart II-18). The recent divergence is unprecedented. Chart II-18 (ARTHUR)Global Stocks Historically Did Not Lead PMIs Second, EM risk assets and currencies remain vulnerable. EM and Chinese earnings per share are shrinking. The leading indicators signal that the rate of contraction will deepen, at least the end of this year (Chart II-19). Asset allocators should continue underweighting EM versus DM equities. Chart II-19 (ARTHUR)China And EM Profits Are Contracting Finally, my strongest-conviction, market-neutral trade is to short EM or Chinese banks and go long U.S. banks. The latter are much healthier than EM/Chinese ones, as we discussed in our recent report.6  Anastasios: The U.S. Equity Strategy team is shifting away from a cyclical and toward a more defensive portfolio bent. Our highest conviction view is to overweight mega caps versus small caps. Small caps are saddled with debt and are suffering a margin squeeze. Moreover, approximately 600 constituents of the Russell 2000 have no forward profits. Only one S&P 500 company has negative forward EPS. Given that both the S&P and the Russell omit these figures from the forward P/E calculation, this is masking the small cap expensiveness. When adjusted for this discrepancy, small caps are trading at a hefty premium versus large caps (Chart II-20). Chart II-20 (ANASTASIOS)Continue To Avoid Small Caps We have also upgraded the S&P managed health care and the S&P hypermarkets groups. If the economic slowdown persists into early 2020, both of these defensive subgroups will fare well. In mid-April, we lifted the S&P managed health care group to an above benchmark allocation and posited that the selloff in this group was overdone as the odds of “Medicare For All” becoming law were slim. Moreover, a tight labor market along with melting medical cost inflation would boost the industry’s margins and profits (Chart II-21). Chart II-21 (ANASTASIOS)Buy Hypermarkets This week, we upgraded the defensive S&P hypermarkets index to overweight arguing that the souring macro landscape coupled with a firming industry demand outlook will support relative share prices (Chart II-22). Chart II-22 (ANASTASIOS)Stick With Managed Health Care Dhaval: To be fair, I am not a pessimist. Provided the global bond yield stays well below 2.5 percent, the support to risk-asset valuations will prevent a major dislocation. But in a growth down-oscillation, the big game in town will be sector rotation into pro-defensive investment plays, especially into those defensives that have underperformed (Chart II-23). Chart II-23 (DHAVAL)Switch Out Of Growth-Sensitives Into Healthcare On this basis: Overweight Healthcare versus Industrials. Overweight the Eurostoxx 50 versus the Shanghai Composite and the Nikkei 225. Overweight U.S. T-bonds versus German bunds. Overweight the JPY in a portfolio of G10 currencies. Mathieu: And now, the optimists: Doug: So What? is the overriding question that guides all of BCA’s research: What is the practical investment application of this macro observation? But Why Now? is a critical corollary for anyone allocating investment capital: Why is the imbalance you’ve observed about to become a problem? As Herbert Stein said, “If something cannot go on forever, it will stop.” Imbalances matter, but Dornbusch’s Law counsels patience in repositioning portfolios on their account: “Crises take longer to arrive than you can possibly imagine, but when they do come, they happen faster than you can possibly imagine.” Look at Chart II-24, which shows a vast white sky (bull markets) with intermittent clusters of gray (recessions) and light red (bear markets) clouds. Market inflections are severe, but uncommon. When the default condition of an economy is to grow, and equity prices to rise, it is not enough for an investor to identify an imbalance, s/he also has to identify why it’s on the cusp of reversing. Right now, as it relates to the U.S., there aren’t meaningful imbalances in either markets or the real economy. Chart II-24 (DOUG)Recessions And Bear Markets Travel Together Even if we had perfect knowledge that a recession would arrive in 18 months, now would be way too early to sell. The S&P 500 has historically peaked an average of six months before the onset of a recession, and it has delivered juicy returns in the year preceding that peak (Table II-1). Bull markets tend to sprint to the finish line (Chart II-25). If this one is like its predecessors, an investor risks significant relative underperformance if s/he fails to participate in its go-go latter stages. We are bullish on the outlook for the next six to twelve months, and recommend overweighting equities and spread product in balanced U.S. portfolios while significantly underweighting Treasuries. Peter: I agree with Doug. Equity bear markets seldom occur outside of recessions and recessions rarely occur when monetary policy is accommodative. Policy is currently easy, and will get even more stimulative if the Fed and several other central banks cut rates. Global equities are not super cheap, but they are not particularly expensive either. They currently trade at about 15-times forward earnings. Given the ultra-low level of global bond yields, this generates an equity risk premium (ERP) that is well above its historical average (Chart II-26). One should favor stocks over bonds when the ERP is high. Chart II-26A (PETER)Equity Risk Premia Remain Elevated (II) Chart II-26B (PETER)Equity Risk Premia Remain Elevated (I) The ERP is especially elevated outside the United States. This is partly because non-U.S. stocks trade at a meager 13-times forward earnings, but it also reflects the fact that bond yields are lower overseas. As global growth accelerates, the dollar will weaken. Equity sectors and regions with a more cyclical bent will benefit (Chart II-27). We expect to upgrade EM and European stocks later this summer. Chart II-27 (PETER)EM And Euro Area Equities Outperform When Global Growth Improves A softer dollar will also benefit gold. Bullion will get a further boost early next decade when inflation begins to accelerate. We went long gold on April 17, 2019 and continue to believe in this trade.  Rob: For fixed income investors, the most obvious way to play a combination of monetary easing and recovering global growth is to overweight corporate debt versus government bonds (Chart II-28). Chart II-28 (ROB)Best Bond Bets: Overweight Global Corporates & Inflation-Linked Bonds Within the U.S., corporate bond valuations look more attractive in high-yield over investment grade. Assuming a benign outlook for default risk in a reaccelerating U.S. economy, with the Fed easing, going for the carry in high-yield looks interesting. Emerging market credit should also do well if we see a bit of U.S. dollar weakness and additional stimulus measures in China. European corporates, however, may end up being the big winner if the ECB chooses to restart its Asset Purchase Program and ramps up its buying of European company debt. There are fewer restrictions for the ECB to buy corporates compared to the self-imposed limits on government bond purchases. The ECB would be entering a political minefield if it chose to buy more Italian debt and less German debt, but nobody would mind if the ECB helped finance European companies by buying their bonds. If one expects reflation to be successful, a below-benchmark stance on portfolio duration also makes sense given the current depressed level of government bond yields worldwide. Yields are more likely to grind upward than spike higher, and will be led first by increasing inflation expectations. Inflation-linked bonds should feature prominently in fixed income portfolios, especially in the U.S. where TIPS will outperform nominal yielding Treasuries. Mathieu: Thank you very much to all of you. Below is a comparative summary of the main arguments and investment recommendations of each camp. Anastasios Avgeriou U.S. Equity Strategist Peter Berezin Chief Global Strategist Arthur Budaghyan Chief Emerging Markets Strategist Dhaval Joshi Chief European Investment Strategist Doug Peta Chief U.S. Investment Strategist Robert Robis Chief Fixed Income Strategist Mathieu Savary The Bank Credit Analyst   Summary Of Views And Recommendations The Bulls… …And The Bears ​​​​​​   III. Indicators And Reference Charts The S&P 500 has limited cyclical downside for now, however, the short-term outlook is more troublesome. U.S. stocks are hovering near all-time highs, but they are not showing much conviction. Positive catalysts have moved into the rearview mirror now that a flurry of central banks have also cut rates, that it is certain that the Fed will cut rates next week, and that the ECB will follow in September. A volatile churning pattern will likely prevail over the coming three months. Our Revealed Preference Indicator (RPI) points to short-term risks. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive readings from the policy and valuation measures. Conversely, if strong market momentum is not supported by valuation and policy, investors should lean against the market trend. A pick-up in global growth is needed to help earnings, which would cheapen valuations enough to clear the short-term clouds hanging over the stock market. The cyclical outlook is brighter than the tactical one. Our Willingness-to-Pay (WTP) indicator for the U.S. and Japan continues to improve. However, it is slightly deteriorating in Europe. The WTP indicator tracks flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. In aggregate, the WTP currently suggests that investors are still inclined to add to their stock holdings. Hence, we expect global investors will continue to buy the dips, creating a floor under stock prices in the process. Our Monetary Indicator continues to move deeper into stimulative territory, supporting our cyclically constructive equity view. Global central banks are easing policy in unison, creating very accommodative liquidity conditions. The BCA Composite Valuation Indicator, an amalgamation of 11 measures, is in overvalued territory. However, it is not elevated enough to negate the positive message from our Monetary Indicator, especially as our Composite Technical Indicator continues to move further above its 9-month moving average. These dynamics confirm that equities have more cyclical upside and that dips should be bought. According to our model, 10-year Treasurys are now as expensive as at any point over the past five years. Moreover, our technical indicator is increasingly overbought while the CRB Raw Industrials is oversold, a combination that often heralds the end of bond rallies. Various rate-of-change measures for bond prices are flashing extremely overbought conditions as well. Additionally, duration surveys, positioning data, and sentiment measures are all showing that investors expect nothing but low yields. Considering this technical backdrop, BCA’s economic view implies that yields are likely to have bottomed earlier this month. On a PPP basis, the U.S. dollar remains very expensive. Additionally, our Composite Technical Indicator has formed a negative divergence with prices. The dollar’s recent strength could set it up for a substantial decline. If the dollar’s Technical Indicator falls below zero, the momentum-continuation behavior of the greenback will kick in. The USD would suffer markedly were this to happen. Monitor these developments closely. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation Chart III-6U.S. Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations Chart III-10Yield Curve Slopes Chart III-11Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield Components Chart III-13U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals​​​​​​​ COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot Chart III-30U.S. Growth Outlook Chart III-31U.S. Cyclical Spending Chart III-32U.S. Labor Market Chart III-33U.S. Consumption Chart III-34U.S. Housing Chart III-35U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Mathieu Savary Vice President The Bank Credit Analyst   Footnotes 1       Please see U.S. Bond Strategy Special Report, “The Risk From U.S. Corporate Debt: Theory And Evidence,” dated April 23, 2019, available at usbs.bcaresearch.com 2       The biggest concern with debt sustainability is the distribution of the debt. Aggregate ratios are currently flattered by the low debt loads and high cash holdings as well as cash generation power of the tech sector. Nonetheless, the low level of aggregate debt accumulation by the entire private sector, including households, points to a limited cyclical vulnerability to the economy created by leverage. However, this also means that a more-severe-than-usual default wave is likely to materialize outside the tech sector once a recession emerges. 3       Please see The Bank Credit Analyst Monthly Report “July 2019,” dated June 27, 2019, available at bca.bcaresearch.com 4       Please see The Bank Credit Analyst Monthly Report “July 2019,” dated June 27, 2019, available at bca.bcaresearch.com 5       Please see U.S. Equity Strategy Weekly Report, “Divorced From Reality,” dated July 15, 2019, available at uses.bcaresearch.com 6       To be fair to each individual involved, this is simplifying their views. Even within each camp, the negativity or positivity ranges on a spectrum, as you will be able to tell from the debate itself. 7       Please see BCA U.S. Equity Strategy Weekly Report, “Signal Vs. Noise,” dated December 17, 2018, available at uses.bcaresearch.com. 8       Please see BCA U.S. Equity Strategy Weekly Report, “A Recession Thought Experiment,” dated June 10, 2019, available at uses.bcaresearch.com. 9       Please see the European Investment Strategy Weekly Report “Risk: The Great Misunderstanding Of Finance,” October 25, 2018 available at eis.bcaresearch.com. 10     France is a good proxy for the euro area. 11     Please see Emerging Markets Strategy Weekly Report, “On Chinese Banks And Brazil,” available at ems.bcaresearch.com. EQUITIES:FIXED INCOME:CURRENCIES:COMMODITIES:ECONOMY:

Special Report

Highlights We continue to recommend overweighting Mexican local fixed-income markets, the peso and sovereign credit relative to their respective EM benchmarks. A new trade: Sell Mexican CDS / buy Brazilian and South African CDS. Continue holding the long MXN / short ZAR position. We have a lower conviction view that Mexican equities will outperform the EM benchmark. Feature Since the election of Andrés Manuel López Obrador – or AMLO, as he is commonly known – as President, investors have been worrying about Mexico’s fiscal policy and public debt sustainability. Specifically, investors have expressed concern over the debt dynamics of state-owned petroleum company Pemex and its impact on the country’s public debt. While these concerns are not groundless, on balance we find the risk-reward profile of Mexico’s sovereign credit and local currency bonds superior relative to their respective EM peers. Fiscal Sustainability: A Comparative Analysis We discussed debt sustainability in Brazil and South Africa in two of our recent reports, and concluded that their public debt dynamics are unsustainable without drastic fiscal reforms. However, a closer look at debt sustainability in Mexico reveals a different picture. Chart 1Public Debt Burden Including SOE Debt Mexico’s public debt level including the debt of state-owned enterprises is lower than those in Brazil and South Africa (Chart 1). Notably, Mexico’s public debt-to-GDP ratio has been flat over the past three years. Importantly, as detailed below, the two primary conditions for public debt sustainability – the level of government borrowing costs and the primary fiscal balance - are far superior in Mexico relative to Brazil and South Africa.   Government borrowing costs in local currency terms are only slightly above nominal GDP in Mexico. Brazil and South Africa score much worse on this measure (Chart 2). The primary fiscal balance in Mexico is much better than in Brazil and South Africa (Chart 3). In fact, Mexico is targeting a primary surplus of 1% for 2019. Chart 2Local Borrowing Costs Versus Nominal GDP Chart 3Primary Fiscal Balances Even with potential pension reforms, Brazil will continue to run primary deficits for the next few years. As we discussed in our recent report on Brazil, the government’s submitted draft on social security reforms will save only BRL190 billion over the next four years, or 0.7% of GDP per year. The current primary deficit is 1.5% of GDP. Unless nominal GDP growth and government revenue growth shoot up, the primary deficit will not be eliminated in the next four years. Unlike Brazil and South Africa, the growth of public sector debt in Mexico is not outpacing nominal GDP growth (Chart 4). Critically, the latter point is also true in Mexico if one includes state-owned enterprises’ debt. Brazil and South Africa sovereign spreads are currently only 40 and 85 basis points above those in Mexico, respectively. The spread will widen further in favor of Mexico, given the latter’s superior fundamentals (Chart 5). In terms of local currency bonds, real yields in Mexico are also on par with Brazil but are well above those in South Africa (Chart 6). Hence, Mexican local bonds offer relative value versus many of their EM peers. Chart 4Public Debt and GDP Growth Chart 5Sell Mexican CDS / Long South African and Brazilian CDS             Nominal local currency bond yields in Mexico are about 200 basis points above the EM GBI benchmark domestic bond yield index (Chart 7). This is great value. Clearly, Mexico’s fiscal worries are overblown relative to those in Brazil and South Africa. Besides, relative valuations of sovereign credit and local bonds adjusted for relative fundamentals warrant outperformance in Mexico versus the other two markets as well as against the respective EM benchmarks in the months ahead. Chart 6Real Bond Yields: Decent Value In Mexico Chart 7Nominal Bond Yields: Great Value In Mexico In addition, AMLO’s administration has proven to be committed to fiscal austerity. Last month, the Ministry of Finance reinforced this notion by announcing a reduction in public spending on social programs in order to balance the loss of fiscal revenue from decreasing oil revenues and lower GDP estimates. Mexico’s fiscal worries are overblown relative to those in Brazil and South Africa. Besides, relative valuations of sovereign credit and local bonds adjusted for relative fundamentals warrant outperformance in Mexico versus the other two markets as well as against the respective EM benchmarks in the months ahead. We view the primary fiscal target of 1% for 2019 as aggressive and potentially unattainable due to a shortfall in revenues. However, these actions prove that AMLO’s administration is not intending to run a large fiscal deficit to finance populist spending programs, as investors had feared. Adding Pemex To Public Finances Pemex’s financial position and the government budget’s reliance on oil revenues are an Achilles’ heel for Mexico’s public finances. Therefore, we have incorporated Pemex into the budget. The resulting fiscal deterioration is not calamitous. Specifically, international credit agencies estimate that Pemex needs an additional $13 billion to $20 billion in capital expenditures per year in order to maintain current operations and replenish reserves. This is in addition to its debt service obligations in the coming years, as shown in Table 1. Table 1Pemex Debt Servicing We have the following considerations on this issue: First, this year the government announced $5.7 billion of financing for Pemex in the form of direct investment, tax breaks, deductions for drilling and exploration costs and revenue recovered from oil theft. In addition, the government will also do a one-time transfer of $6.8 billion from its $15.4 billion budget stabilization fund in order to finance Pemex’s debt payments due by the end of this year. While Congress must first approve the use of these funds, odds are that the bill will pass as AMLO’s party holds a majority. That would bring total capital injection into Pemex to $12.5 billion for the year, almost enough to finance the company’s capital spending this year. Second, in order to revive operations at Pemex in the medium to long term, the government must maintain this level of investment on an annual basis. Essentially, AMLO’s administration will inevitably have to sacrifice part of the $29 billion in net oil transfers it receives every year to finance the oil company and prevent further downgrades to its credit rating. How large is this required Pemex financing as a share of the public budget? We performed a simulation including into the public budget all of Pemex’s payments and all its receipts from the government. While the overall fiscal position deteriorates, it is not unsustainable. The primary and overall deficits would widen to 1.9% and 4.4% of GDP, respectively, if the government eliminates all transfers to Pemex and if the company stops all payments to the government budget, including direct transfers and indirect oil taxes1 (Table 2, Scenario 1). Table 2Mexico: Pemex And Government Budget In such a scenario, Pemex would gain $ 29 billion each year to invest in exploration and production. Pemex is the largest fiscal challenge for Mexico. Yet, even including Pemex debt and required financing, the nation’s fiscal accounts are not worrisome. Chart 8Mexico's Budget Balance Adjusted For Financing To Pemex Third, provided Pemex’s capital spending needs could be met by half of this $29 billion, the government could provide the company just half of this amount (Table 2, Scenario 3). In this scenario, the oil company will have sufficient funds to invest. Meanwhile, the government’s primary and overall fiscal deficit will deteriorate only moderately to 0.7% and 3.2% of GDP, respectively (Chart 8 and Table 2). Finally, the importance of oil revenues – both directly from Pemex and via indirect taxation on the oil industry – have already declined as a share of total fiscal revenues – from 40% in 2012 to 18.3% currently (Chart 9). In short, Mexico’s budget is less reliant on oil revenues. If economic growth picks up, non-oil revenues will improve. Consequently, the government’s fiscal position will improve, giving it more maneuvering room to deal with Pemex. Bottom Line: Pemex is the largest fiscal challenge for Mexico. Yet, even including Pemex debt and required financing, the nation’s fiscal accounts are not worrisome. Cyclical Economic Conditions The Mexican economy is slowing and inflationary pressures are subsiding. Narrow money (M1) and retail sales growth are decelerating (Chart 10, top panel) Capital spending is contracting and non-oil exports will be in a soft spot over the next six months, according the U.S. manufacturing ISM new orders-to-inventory ratio (Chart 10, bottom panel). Core inflation is at 3.55% and is heading south. Chart 9Dependence On Oil Revenues Has Declined A Lot Chart 10Mexico: Cyclical Conditions   Barring major turmoil in EM currency markets that weighs on the peso, weakening growth and disinflation will lead the domestic fixed-income market to discount rate cuts. Mexico’s central bank is very hawkish and will be slow to ease policy. Yet, such a policy stance warrants a bullish view on domestic bonds. The basis is that the longer they delay rate cuts, the more they will need to cut in the future. Investment Strategy We have been recommending an overweight position in Mexico in EM local currency and sovereign credit portfolios, and are reiterating these strategies. Relative value investors should consider this trade: Sell Mexico CDS / buy Brazilian and South African CDS. The Mexican sovereign credit market has made a major bottom versus the EM benchmark and the path of least resistance is now up (Chart 11). EM local currency bond portfolios should continue overweighting Mexico while underweighting Brazil and South Africa (Chart 12). Chart 11Sovereign Excess Returns: A Relative Bull Market In Mexico Chart 12Total Return on Local Currency Bonds in Dollar Terms Similarly, among EM currencies, we favor the Mexican peso because it is cheap (Chart 13). Specifically, we continue to hold the long MXN / short ZAR position; investors who are not yet in this trade should consider entering it now. Chart 13The Mexican Peso Is Cheap Finally, in the EM equity universe, we are overweight Mexican stocks, but our conviction level is lower than in the case of fixed-income markets. The basis is that AMLO’s policies intend to weaken oligopolies and monopolies and undermine their pricing power. These policies are very positive for fixed-income markets and the exchange rate in the long run, as they entail lower inflation resulting from a more competitive environment. Yet, they could hurt profits of incumbent monopolies and oligopolies. This is why we recommend equity investors focus on Mexican small-caps. That said, from a macro perspective, resulting disinflation and lower local rates are also positive for equity multiples. Hence, the Mexican stock market will also likely outperform the EM benchmark in common currency terms.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Juan Egaña, Research Associate juane@bcaresearch.com     Footnotes 1 Indirect oil taxation includes different taxes for the oil fund for stabilization and development, such as rights on drilling and exploration, import and export duties on oil and gas and financing for oil and gas research.

Highlights We continue to recommend overweighting Mexican local fixed-income markets, the peso and sovereign credit relative to their respective EM benchmarks. A new trade: Sell Mexican CDS / buy Brazilian and South African CDS. Continue holding the long MXN / short ZAR position. We have a lower conviction view that Mexican equities will outperform the EM benchmark. Feature Since the election of Andrés Manuel López Obrador – or AMLO, as he is commonly known – as President, investors have been worrying about Mexico’s fiscal policy and public debt sustainability. Specifically, investors have expressed concern over the debt dynamics of state-owned petroleum company Pemex and its impact on the country’s public debt. While these concerns are not groundless, on balance we find the risk-reward profile of Mexico’s sovereign credit and local currency bonds superior relative to their respective EM peers. Fiscal Sustainability: A Comparative Analysis We discussed debt sustainability in Brazil and South Africa in two of our recent reports, and concluded that their public debt dynamics are unsustainable without drastic fiscal reforms. However, a closer look at debt sustainability in Mexico reveals a different picture. Chart 1Public Debt Burden Including SOE Debt Mexico’s public debt level including the debt of state-owned enterprises is lower than those in Brazil and South Africa (Chart 1). Notably, Mexico’s public debt-to-GDP ratio has been flat over the past three years. Importantly, as detailed below, the two primary conditions for public debt sustainability – the level of government borrowing costs and the primary fiscal balance - are far superior in Mexico relative to Brazil and South Africa. Government borrowing costs in local currency terms are only slightly above nominal GDP in Mexico. Brazil and South Africa score much worse on this measure (Chart 2). The primary fiscal balance in Mexico is much better than in Brazil and South Africa (Chart 3). In fact, Mexico is targeting a primary surplus of 1% for 2019. Chart 2Local Borrowing Costs Versus Nominal GDP Chart 3Primary Fiscal Balances Even with potential pension reforms, Brazil will continue to run primary deficits for the next few years. As we discussed in our recent report on Brazil, the government’s submitted draft on social security reforms will save only BRL190 billion over the next four years, or 0.7% of GDP per year. The current primary deficit is 1.5% of GDP. Unless nominal GDP growth and government revenue growth shoot up, the primary deficit will not be eliminated in the next four years. Unlike Brazil and South Africa, the growth of public sector debt in Mexico is not outpacing nominal GDP growth (Chart 4). Critically, the latter point is also true in Mexico if one includes state-owned enterprises’ debt. Brazil and South Africa sovereign spreads are currently only 40 and 85 basis points above those in Mexico, respectively. The spread will widen further in favor of Mexico, given the latter’s superior fundamentals (Chart 5). In terms of local currency bonds, real yields in Mexico are also on par with Brazil but are well above those in South Africa (Chart 6). Hence, Mexican local bonds offer relative value versus many of their EM peers. Chart 4Public Debt and GDP Growth Chart 5Sell Mexican CDS / Long South African and Brazilian CDS             Nominal local currency bond yields in Mexico are about 200 basis points above the EM GBI benchmark domestic bond yield index (Chart 7). This is great value. Clearly, Mexico’s fiscal worries are overblown relative to those in Brazil and South Africa. Besides, relative valuations of sovereign credit and local bonds adjusted for relative fundamentals warrant outperformance in Mexico versus the other two markets as well as against the respective EM benchmarks in the months ahead. Chart 6Real Bond Yields: Decent Value In Mexico Chart 7Nominal Bond Yields: Great Value In Mexico In addition, AMLO’s administration has proven to be committed to fiscal austerity. Last month, the Ministry of Finance reinforced this notion by announcing a reduction in public spending on social programs in order to balance the loss of fiscal revenue from decreasing oil revenues and lower GDP estimates. Mexico’s fiscal worries are overblown relative to those in Brazil and South Africa. Besides, relative valuations of sovereign credit and local bonds adjusted for relative fundamentals warrant outperformance in Mexico versus the other two markets as well as against the respective EM benchmarks in the months ahead. We view the primary fiscal target of 1% for 2019 as aggressive and potentially unattainable due to a shortfall in revenues. However, these actions prove that AMLO’s administration is not intending to run a large fiscal deficit to finance populist spending programs, as investors had feared. Adding Pemex To Public Finances Pemex’s financial position and the government budget’s reliance on oil revenues are an Achilles’ heel for Mexico’s public finances. Therefore, we have incorporated Pemex into the budget. The resulting fiscal deterioration is not calamitous. Specifically, international credit agencies estimate that Pemex needs an additional $13 billion to $20 billion in capital expenditures per year in order to maintain current operations and replenish reserves. This is in addition to its debt service obligations in the coming years, as shown in Table 1. Table 1Pemex Debt Servicing We have the following considerations on this issue: First, this year the government announced $5.7 billion of financing for Pemex in the form of direct investment, tax breaks, deductions for drilling and exploration costs and revenue recovered from oil theft. In addition, the government will also do a one-time transfer of $6.8 billion from its $15.4 billion budget stabilization fund in order to finance Pemex’s debt payments due by the end of this year. While Congress must first approve the use of these funds, odds are that the bill will pass as AMLO’s party holds a majority. That would bring total capital injection into Pemex to $12.5 billion for the year, almost enough to finance the company’s capital spending this year. Second, in order to revive operations at Pemex in the medium to long term, the government must maintain this level of investment on an annual basis. Essentially, AMLO’s administration will inevitably have to sacrifice part of the $29 billion in net oil transfers it receives every year to finance the oil company and prevent further downgrades to its credit rating. How large is this required Pemex financing as a share of the public budget? We performed a simulation including into the public budget all of Pemex’s payments and all its receipts from the government. While the overall fiscal position deteriorates, it is not unsustainable. The primary and overall deficits would widen to 1.9% and 4.4% of GDP, respectively, if the government eliminates all transfers to Pemex and if the company stops all payments to the government budget, including direct transfers and indirect oil taxes1 (Table 2, Scenario 1). Table 2Mexico: Pemex And Government Budget In such a scenario, Pemex would gain $ 29 billion each year to invest in exploration and production. Pemex is the largest fiscal challenge for Mexico. Yet, even including Pemex debt and required financing, the nation’s fiscal accounts are not worrisome. Chart 8Mexico's Budget Balance Adjusted For Financing To Pemex Third, provided Pemex’s capital spending needs could be met by half of this $29 billion, the government could provide the company just half of this amount (Table 2, Scenario 3). In this scenario, the oil company will have sufficient funds to invest. Meanwhile, the government’s primary and overall fiscal deficit will deteriorate only moderately to 0.7% and 3.2% of GDP, respectively (Chart 8 and Table 2). Finally, the importance of oil revenues – both directly from Pemex and via indirect taxation on the oil industry – have already declined as a share of total fiscal revenues – from 40% in 2012 to 18.3% currently (Chart 9). In short, Mexico’s budget is less reliant on oil revenues. If economic growth picks up, non-oil revenues will improve. Consequently, the government’s fiscal position will improve, giving it more maneuvering room to deal with Pemex. Bottom Line: Pemex is the largest fiscal challenge for Mexico. Yet, even including Pemex debt and required financing, the nation’s fiscal accounts are not worrisome. Cyclical Economic Conditions The Mexican economy is slowing and inflationary pressures are subsiding. Narrow money (M1) and retail sales growth are decelerating (Chart 10, top panel) Capital spending is contracting and non-oil exports will be in a soft spot over the next six months, according the U.S. manufacturing ISM new orders-to-inventory ratio (Chart 10, bottom panel). Core inflation is at 3.55% and is heading south. Chart 9Dependence On Oil Revenues Has Declined A Lot Chart 10Mexico: Cyclical Conditions   Barring major turmoil in EM currency markets that weighs on the peso, weakening growth and disinflation will lead the domestic fixed-income market to discount rate cuts. Mexico’s central bank is very hawkish and will be slow to ease policy. Yet, such a policy stance warrants a bullish view on domestic bonds. The basis is that the longer they delay rate cuts, the more they will need to cut in the future. Investment Strategy We have been recommending an overweight position in Mexico in EM local currency and sovereign credit portfolios, and are reiterating these strategies. Relative value investors should consider this trade: Sell Mexico CDS / buy Brazilian and South African CDS. The Mexican sovereign credit market has made a major bottom versus the EM benchmark and the path of least resistance is now up (Chart 11). EM local currency bond portfolios should continue overweighting Mexico while underweighting Brazil and South Africa (Chart 12). Chart 11Sovereign Excess Returns: A Relative Bull Market In Mexico Chart 12Total Return on Local Currency Bonds in Dollar Terms Similarly, among EM currencies, we favor the Mexican peso because it is cheap (Chart 13). Specifically, we continue to hold the long MXN / short ZAR position; investors who are not yet in this trade should consider entering it now. Chart 13The Mexican Peso Is Cheap Finally, in the EM equity universe, we are overweight Mexican stocks, but our conviction level is lower than in the case of fixed-income markets. The basis is that AMLO’s policies intend to weaken oligopolies and monopolies and undermine their pricing power. These policies are very positive for fixed-income markets and the exchange rate in the long run, as they entail lower inflation resulting from a more competitive environment. Yet, they could hurt profits of incumbent monopolies and oligopolies. This is why we recommend equity investors focus on Mexican small-caps. That said, from a macro perspective, resulting disinflation and lower local rates are also positive for equity multiples. Hence, the Mexican stock market will also likely outperform the EM benchmark in common currency terms.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Juan Egaña, Research Associate juane@bcaresearch.com     Footnotes 1 Indirect oil taxation includes different taxes for the oil fund for stabilization and development, such as rights on drilling and exploration, import and export duties on oil and gas and financing for oil and gas research.

Highlights Chinese credit origination surpassed expectations in March. Credit growth is now clearly trending higher, and the latest data suggest that economic activity is rebounding. This bodes well for global growth. The conventional wisdom is that China’s releveraging efforts represent “short-term gain for long-term pain.” We disagree. For the most part, Chinese releveraging is inevitable, desirable, and sustainable. Credit growth is inevitable because rising debt is necessary for transforming the country’s copious savings into fixed-asset investment. It is desirable for ensuring that GDP growth stays close to trend. It is broadly sustainable because the interest rate at which the government and much of the private sector are able to borrow is well below the economy’s growth rate. In fact, under a plausible set of assumptions, faster credit growth in China could lead to a lower debt-to-GDP ratio. Stronger global growth later this year should weaken the U.S. dollar. We are closing our long DXY trade for a carry-adjusted gain of 16.4% and exiting our long USD/CNY trade for a loss of 3.1%. We are also taking profits on our short AUD/CAD, short EUR/CAD, and short EUR/RUB trades of 1.6%, 3.9%, and 8.6%, respectively, and initiating two new currency trades: short USD/RUB and long EUR/JPY. The combination of a weaker dollar and faster Chinese growth should benefit EM and European stocks. Gold hit our limit buy order of $1275/ounce and we are now long the yellow metal. Feature A Blockbuster Month For Chinese Credit Growth After turning cautious for about six months, we moved back to being bullish on global equities in late December. We also sold our put on the EEM ETF on January 3rd for a gain of 104% in anticipation of a wave of Chinese credit stimulus. Credit growth blew past expectations in January, but surprised on the downside in February. This made the March release particularly important. In the end, the March data did not disappoint those who were hoping for a solid reading. New CNY loans rose by RMB 1690 billion, above Bloomberg consensus estimates of RMB 1250 billion. Our adjusted aggregate financing measure, which excludes a number of items such as equity financing but includes local government bond issuance, rose by 12.3% year-over-year, up from 11.6% in February (Chart 1). China’s credit impulse leads the import component of its manufacturing PMI (Chart 2). The credit impulse bottomed in November 2018, which should feed into higher imports over the coming months. This week’s release of better-than-expected data on industrial production, retail sales, and housing activity all suggest that the rebound in Chinese growth is already afoot. Chart 1Chinese Credit Growth Is Rebounding... Chart 2...Which Should Bode Well For Global Exports To China   Short-Term Gain For Long-Term Pain? At times like these, the bears are always ready with their standby argument: Sure, China may be stimulating, but all that credit growth will just make the debt bubble even bigger. Once the bubble bursts, there will be hell to pay. Long-term investors should steer clear of any growth-sensitive assets. It is a seductive argument. But it is wrong. Chinese releveraging is: 1) inevitable; 2) desirable; and 3) sustainable. The fundamental macroeconomic problem that China faces is that it consumes too little of what it produces. 1. Chinese Debt Growth Is Inevitable The fundamental macroeconomic problem that China faces is that it consumes too little of what it produces. The result is a national savings rate of 45%, by far the highest of any major economy (Chart 3). Chart 3China Still Saving A Lot Chart 4From Exporting Savings To Investing Domestically And Building Up Debt   There was a time when China was able to export a large part of its excess production. Its current account surplus reached nearly 10% of GDP in 2007. As its economy has grown in relation to the rest of the world, running massive trade surpluses has become more difficult. This is especially true today, when the country is being targeted by the Trump administration and much of the international community for alleged unfair trade practices. As China’s ability to churn out large current account surpluses declined, the government moved to Plan B: propping up growth by recycling the country’s copious savings into fixed-asset investment. This process saw households park their savings in banks and other financial institutions which, in turn, lent the money out to companies and local governments in order to finance various investment projects. Not surprisingly, debt levels exploded higher (Chart 4). As China’s population ages and more workers leave the labor force, savings will decline. However, this is likely to be a slow process. In the meantime, further debt growth is inevitable. 2. Chinese Debt Growth Is Desirable In an ideal world, Chinese households would consume more of their incomes, leaving only enough savings to finance high-quality private and public investment projects. That is not the world we are living in. In a far-from-ideal world, we need to think about second-best solutions. Yes, a sizable share of Chinese investment spending goes towards projects of dubious value. Yet, the same could have been said about Japan’s fabled “bridges to nowhere.” One may regard the construction of a seldom-used bridge as a misallocation of capital. But what is the counterfactual? If the bridge had not been built, would the workers have found productive work? If not, then there also would have been a misallocation of capital – human capital – which is arguably a much more serious problem. In any case, keep in mind that the rate of return on private investment depends on the state of the economy. If an economy is suffering from chronic lack of demand, only the most worthwhile projects will be undertaken. As the economic outlook improves, the set of viable projects will expand. It is only when all excess private-sector savings have been depleted, and interest rates are rising, that public spending starts to crowd out private investment. 3. Chinese Debt Growth Is Sustainable Even if one accepts the proposition that China needs continued debt growth to maintain full employment, is it still possible that all this additional debt will push the economy into a full-blown debt crisis? Most self-professed “serious-minded” observers would say yes. But then again, many of these same observers were predicting that Japan was heading for a debt crisis when government debt reached 100% of GDP in the late 1990s. Today, Japan’s government debt-to-GDP ratio stands at about 240% of GDP, and yet interest rates remain at rock-bottom levels. China will avoid a debt crisis for the same reason Japan has been able to avoid one. Much of China’s debt stock is composed of state-owned enterprise, local government, and other forms of quasi-public sector debt. Credit policy in China is often indistinguishable from fiscal policy. Given the abundant supply of savings in the economy, most of this debt can be internally financed at fairly low interest rates. The standard equation for government debt dynamics says that the change in the debt-to-GDP ratio, D/Y, can be expressed as:1 G - T is the primary budget deficit, r  is the borrowing rate, and g is the growth rate of the economy (it is irrelevant whether r and g are defined in nominal or real terms, as long as they are both expressed the same way). China will avoid a debt crisis for the same reason Japan has been able to avoid one. The Chinese 10-year government bond yield is currently four percentage points below projected GDP growth over the next decade, which is one of the biggest gaps among the major economies (Chart 5). Arithmetically, this means that China can have as large a primary fiscal deficit as it wants. As long as r remains below g, the debt-to-GDP ratio will converge to a stable level. Chart 6 shows this point analytically. In fact, it is possible that a permanently larger budget deficit could lead to a decline in the equilibrium debt-to-GDP ratio. How could that be? The answer is revealed by the equation above. If the debt-to-GDP ratio is fairly high to begin with and an increase in the primary budget deficit leads to higher inflation (and hence, lower real rates and/or faster nominal GDP growth), this could more than fully counteract the increase in the deficit. Chart 7Stronger Growth Coincided With Accelerating Inflation And Lower Real Rates This is not just a theoretical curiosity. Historically, Chinese inflation has risen while real rates have fallen whenever GDP growth has accelerated (Chart 7). Given China’s high debt levels, even a modest amount of additional inflation could put significant downward pressure on the debt-to-GDP ratio.2  Of course, all this is predicated on the assumption that faster credit growth will not cause interest rates to rise above the growth rate of the economy. For the portion of China’s debt stock that is either directly or indirectly backstopped by the central government, this seems like a safe assumption. After all, if credit/fiscal stimulus is simply being undertaken in response to inadequate demand, there is no need for policymakers to hike rates. Things get trickier when we look at private debt. In the past, the government has encouraged state-owned banks to roll over souring loans for fear that a wave of defaults would undermine the economy and endanger social stability. More recently, however, policymakers have been backing away from this strategy due to the well-founded view that it encourages moral hazard. Faster growth in China in the second half of this year will lift Chinese imports. This will be welcome news for the rest of the world. We expect the authorities to continue taking steps to instill market discipline by allowing failing firms to, well, fail. Realistically, however, the transition to a full market-based economy will take quite a bit of time. In the interim, the government will keep cutting taxes and increasing on-budget spending in order to ensure that any decline in employment among failing firms is offset by employment growth elsewhere. In such an environment, neither a debt crisis nor a deep economic slowdown appear likely. Investment Conclusions Faster growth in China in the second half of this year will lift Chinese imports. This will be welcome news for the rest of the world. Chart 9Germany Welcomes The Upturn In Chinese Credit Growth While the U.S. will benefit from a revival in Chinese growth, Europe will gain even more (Chart 8). Germany, in particular, should see a pronounced acceleration in growth. China’s credit impulse leads Chinese automobile spending which, in turn, reliably leads euro area automobile exports, as well as overall exports (Chart 9). The recent rebound in the expectations component of the German ZEW index, as well as in the manufacturing output component of the April flash PMI, suggests that green shoots are starting to sprout (Chart 10). Italy should also benefit from the steep drop in bond yields since last October (Chart 11). Italian industrial production strongly surprised to the upside in February, suggesting that the euro area’s third biggest economy may have finally turned the corner. Chart 10Tentative Green Shoots Out Of Germany Chart 11Italy: The Drop In Bond Yields Should Boost The EconomyThe ECB will not hike rates this year even if growth shifts into higher gear, but the market will probably price in a bit more monetary tightening in 2020 and 2021. This should help lift the euro. We recommend that investors position themselves for this by going long EUR/JPY. Relatedly, we are closing our short EUR/CAD trade for a gain of 3.9%.   The U.S. dollar tends to be a countercyclical currency, meaning that it moves in the opposite direction of the global business cycle (Chart 12). This countercyclicality stems from the fact that the U.S. is more geared towards services than manufacturing compared with most other economies (Chart 13). As such, when global growth accelerates, capital tends to flow from the U.S. to the rest of the world, translating into more demand for foreign currency and less demand for dollars. Chart 12The Dollar Is A Countercyclical Currency Chart 13The U.S. Is A Low-Beta Play On Global Growth A “patient” Fed and the prospect of stronger global growth in the second half of this year are bearish for the dollar. As such, we are closing our long DXY trade for a carry-adjusted gain of 16.4% and exiting our long USD/CNY trade for a loss of 3.1%. We are also closing our short AUD/CAD trade for a gain of 1.6%. Faster Chinese growth will boost metal prices, which is bullish for the Aussie dollar. Lastly, we are switching our short EUR/RUB trade (which is currently up 8.6%) into a short USD/RUB trade. A weaker greenback and stronger global growth will be manna from heaven for international stocks, especially when priced in U.S. dollars. Investors should prepare to move European and EM equities to overweight within a global equity portfolio during the coming weeks. A “patient” Fed and the prospect of stronger global growth in the second half of this year are bearish for the dollar. We are less keen on upgrading Japanese equities. While Japanese exporters will benefit from stronger Chinese growth, the domestic economy will be weighed down by the upcoming hike in the sales tax, which is slated to take place in October. Moreover, the yen is likely to experience headwinds as global bond yields rise in relation to JGB yields. Investors contemplating buying Japanese stocks should hedge any currency risk. Finally, the price of gold fell to $1275/ounce earlier this week, triggering our buy order. With the Fed on pause, the U.S. economy starting to overheat, and the dollar likely to trend lower, bullion could shine over the coming months.   Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Footnotes 1      Please see Global Investment Strategy Weekly Report, “Is There Really Too Much Government Debt In The World?” dated February 22, 2019, for a fuller discussion of this debt sustainability equation. 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Feature For a decade, mainstream economics has prescribed remedies for sluggish growth in the euro area on the basis of three articles of blind faith. First, that the ailment arises from structural impediments to growth; second, that in response to an ailing economy, ultra-loose monetary policy is always and everywhere effective; and third, that ‘Keynesian’ government stimuluses are at best a necessary evil and at worst a recipe for disaster. As a result, European policymakers have expended much time and energy attempting structural reforms, experimenting with ultra-loose monetary policy, while shirking government borrowing and spending. But have policymakers misdiagnosed the ailment? Chart of the WeekItaly’s Private Sector Is Paying Back Debt Why The Focus On Public Deficits And Debt Might Be Misplaced We frown upon government deficits. They are associated with crowding out and misallocation of resources. But when the private sector is running a financial surplus, the exact opposite is true. Government borrowing and spending causes no crowding out because the government is simply utilising the private sector’s surplus savings and debt repayments. And importantly, this deficit spending prevents a deflationary shrinkage of the broad money supply. Most people are aware of the size of government deficits. Few people are aware of the size of private sector surpluses; and the leakage from the national income stream that they create. By not making this connection, people might believe that government deficits are profligate. But if the private sector as a whole has a financial surplus, it makes sense for the government to borrow to support economic growth. In a similar vein, an economy’s debt sustainability depends on its total indebtedness, not on its public indebtedness or its private indebtedness in isolation. Debt becomes unsustainable when the marginal extra euro of debt results in misallocation of resources and mal-investment. At this point, the extra debt adds nothing to growth or, worse, it subtracts from growth. This is also the point at which lenders tend to be unwilling to provide the marginal loan. Therefore, debt reaches its sustainable limit when the economy has exhausted all productive uses for it. Deficit spending can prevent a deflationary shrinkage of the broad money supply. It does not matter whether these productive uses are funded with private debt or with public debt. For example, successful economies require investment in high-quality healthcare and education. Some economies fund this with private debt, while others fund it with public debt. This means that if productive private indebtedness is low, there is more scope for productive public indebtedness. Many people believe that Italy has one of the world’s most indebted economies. But this belief is wrong. Although Italy’s public indebtedness is high, Italy’s private indebtedness is one of the lowest in the world, making Italy’s total indebtedness less than that of France and the U.K., and broadly equal to that of the U.S. (Chart I-2-I-5). Crucially, Italy’s extremely low private indebtedness means that it could afford relatively high public indebtedness before reaching the limit of debt sustainability. Chart I-2Italy: Total Debt = 250% Of GDP Chart I-3France: Total Debt = 315% Of GDP Chart I-4U.K.: Total Debt = 280% Of GDP Chart I-5U.S: Total Debt = 250% Of GDP   Italy And Japan: Compare And Contrast In a normal world, the task of ensuring that private sector savings are borrowed and spent falls on the banks, which take in the savings and debt repayments and lend them out to others in the private sector who can make the best use of the funds. But if a dysfunctional banking system fails this task, the savings generated by the private sector will find no borrowers. The unrecycled funds become a leakage from the national income stream generating a persistent deflationary headwind for the economy. Welcome to Italy! Since 2008, the stock of loans to Italian households and firms has been stagnant while in real terms it has fallen (Chart of the Week). The upshot is that the real money supply has shrunk despite low private sector indebtedness, low interest rates and massive injections of ECB liquidity into the banking system. Japan’s public sector levering has been counterbalancing its private sector de-levering. After the 2008 global financial crisis Italian banks’ balance sheets were left unrepaired and undercapitalized. For an individual bank whose solvency is impaired, the right thing to do is shrink its loan book relative to its equity capital. But when the entire banking system is doing this simultaneously, the economy falls into a massive fallacy of composition: what is right for an individual bank becomes very deflationary when all banks are doing it together. Under these circumstances, an agent outside the fallacy of composition – namely, the government – must counter this deflationary headwind by borrowing and spending the un-recycled private sector savings. Welcome to Japan! The Japanese government has been doing precisely this for the past 25 years. Many people fret about the Japanese government’s persistent deficits and its ballooning public debt. What these people do not realise is that these persistent deficits are simply counterbalancing private sector de-levering. Hence, Japan’s all-important total (public plus private) indebtedness as a share of GDP has not been rising (Chart I-6). In Italy, the banking system has been dysfunctional for over a decade, preventing the private sector from borrowing (Chart I-7). Under these circumstances, the Italian government could borrow the private sector’s excess savings and debt repayments and put them to highly productive use, just like in Japan. Chart I-6Japan’s Persistent Deficits Have Been Counterbalancing Private Sector De-levering Chart I-7The Italian Banking System Has Been Dysfunctional Japan and Italy have quite similar demographics, but there is also a big difference. Despite the Japanese government’s persistent deficit and ballooning debt, the 10-year Japanese government bond seems not the slightest bit concerned and is yielding zero. Whereas in Italy, where the government finances are close to structural balance, the merest hint of a Keynesian stimulus sent the 10-year BTP yield rocketing towards 4 percent. Why? The answer is that Italy does not have its own central bank. The Japanese government bond yield is a direct function of the BoJ’s expected monetary policy. But the Italian BTP yield has two components: the ECB’s expected monetary policy plus a risk-premium for currency redenomination in the event that Italy left the euro. Italy’s problem is that even if modest deficit spending was the right policy, it would take time to prove. Meanwhile, bond vigilantes shoot first and ask questions later. The euro debt crisis was essentially a fear of currency redenomination which resulted from bond vigilantes running amok. When bond markets refuse to lend to sovereigns at a rational interest rate, maturing debt has to be refinanced at a penalising interest rate, causing an undeserved deterioration in the government’s finances. Thereby, the fear of redenomination could become a self-fulfilling prophecy. In Italy, the banking system has been dysfunctional for over a decade. The bottom line is that every economy has its own ‘tipping-point’ interest rate, at which its debt financing can flip from stability to instability. But we believe this interest rate is low everywhere. Modern Monetary Theory Simplified Modern Monetary Theory (MMT) is a hot topic of the moment. Our view is that its breakthrough is to establish the ‘appropriate’ public sector deficits in the context of private sector surpluses, and it simplifies to this question: In highly indebted economies, what is the interest rate needed to keep total (public plus private) indebtedness as a share of GDP stable, and prevent a deflationary shrinkage of the broad money supply? The answer differs slightly from economy to economy because private sector indebtedness is modestly rising in some places, stable in a few, while declining in others (Chart I-8).  But crucially, at a global level, total indebtedness is stabilising with the global bond yield within a historically depressed sideways channel (Chart I-9). Chart I-8Private Sector Indebtedness Is Not Rising As A Whole Chart I-9The Global Long Bond Yield Has Been In A Sideways Channel Admittedly, the global bond yield is now at the bottom of this channel. This means that from a tactical perspective, we can expect 10-year yields to go up about 50 bps before hitting the top of the channel. However, from a structural perspective, the interest rate needed to stabilise total indebtedness as a share of GDP now appears to be extremely low. And this means that structurally low bond yields are here to stay. Finally, I am excited to report that two of the main commentators on MMT – Richard Koo and Stephanie Kelton – are keynote speakers at our annual conference on September 26-27 in New York City. Suffice to say it will be an event not to be missed! Fractal Trading System* There are no new trades this week, leaving five open positions. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. *  For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com Dhaval Joshi, Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields   Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Special Report

Highlights Currency markets continue to fight a tug-of-war between deteriorating global growth and easing global financial conditions. Meanwhile, history suggests that the trade-weighted dollar should have been 10-15% higher, based on portfolio flows and interest rate differentials. The more-muted bounce is a cause for concern. As the battle unfolds, likely winners in the interim will be safe-haven currencies such as the yen. Watch the gold-to-bond ratio for cues on where the balance of forces are shifting, with a rising ratio negative for the dollar. We expect a day of reckoning to eventually arrive for the U.S. dollar, once investors shift their focus towards the rising twin deficits, de-dollarization of the global economy and low expected returns for U.S. assets. Feature The recent calm in developed currency markets seems very eerie, given the storm that has gripped global financial markets over the past week. Dismal manufacturing PMI readings from Europe and Japan last week sent equity markets into a tailspin. The closely watched U.S. 10-year versus 3-month spread inverted, triggering panic selling among investors who favor this spread as their most reliable recession indicator. Equity markets in Asia are off the year’s highs, while regional bond yields are holding close to trading lows. Outside of oil, commodity markets have also been soft. Despite these moves, the trade-weighted dollar has been relatively stable. Over the last few months, most currency pairs have been narrowly trading towards the apex of very tight wedge formations. This has severely dampened volatility (Chart 1). Over the longer term, the stability of these crosses relative to gold has spooky echoes of a fixed exchange rate regime a la Bretton Woods (Chart 2). Chart 1An Eerie Calm In Currency Markets Chart 2Fixed Exchange Rates Versus Gold?   In physics, centripetal systems tend to stay in equilibrium, while centrifugal forces can explode in spectacular fashion. In the post-Bretton Woods world, it has been very rare for periods of extended currency stability to persist. This means constantly monitoring both the trend and magnitude of imbalances between economies to gauge where the pressure points are, and in what direction the corresponding exchange rates might eventually give way. The balance of forces driving the dollar outlook seems like a natural starting point for this exercise.  Global Liquidity And The Dollar Judging by most measures of relative trends, the dollar should be soaring right now. The March Markit manufacturing PMI releases last week showed that while both Japan and the euro area remain in contraction territory, the U.S. reading of 52.5 puts it solidly above the rest of the world. It is true that the momentum of this leadership has been rolling over recently, but historically such large growth divergences between the U.S. and the rest of the world have generated anywhere from 10-15% rallies in the greenback over a period of six months (Chart 3). So far, the DXY dollar index is up 1.9% since October. Every time this measure has severely contracted in the past, the shortage of dollars has triggered a blowup somewhere. Until the U.S. Federal Reserve’s recent volte-face on monetary policy, relative yields also favored the greenback. The 2-year swap differential between the U.S. and the rest of the world pinned the DXY dollar index at 105, or 8% above current levels (Chart 4). Meanwhile, relative policy rates also suggest the broad trade-weighted dollar should be 6% higher. And even today, unless the Fed moves towards outright rate cuts, the dovish shift by other central banks around the world remains an immediate tailwind for the U.S. dollar. Chart 3USD Should Be Higher Based On Growth Divergences   Chart 4USD Should Be Higher Based On Swap Differentials   Internationally, the Fed’s tapering of asset purchases has been a net drain on dollar liquidity, despite a widening U.S. current account deficit. The Fed’s balance sheet peaked a nudge above US$4.5 trillion in early 2015 and has been falling ever since. This has triggered a severe contraction in the U.S. monetary base (Chart 5), and severely curtailed commercial banks’ excess reserves, which are now contracting by over 20% on a year-on-year basis. One of BCA’s favorite key measures of international liquidity is foreign central bank reserves deposited at the Fed. This is contracting at its worst pace in over 40 years. Every time this measure has severely contracted in the past, the shortage of dollars has triggered a blowup somewhere, typically among countries running twin deficits. Chart 5A Liquidity Squeeze Of Dollars To cap it off, last year’s change in the U.S. tax code to allow for repatriation of offshore cash helped the dollar, but not to the extent that might have been expected. On a rolling 12-month basis, the U.S. has repatriated back a net of about $US400 billion in assets, or close to 2% of GDP. Historically, this is a very huge sum that would have had the potential to set the greenback on fire – circa 10% higher (Chart 6). Chart 6USD Should Be Higher On Repatriation Flows Dollar liquidity shortages tend to be vicious due to their ability to trigger negative feedback loops. As the velocity of international U.S. dollars rises, offshore dollar rates begin to rise, lifting the cost of capital for borrowing countries. Debt repayment replaces capital spending and consumption once this reaches a critical threshold. The drop in output, prices, or a combination of the two, only exacerbates the debt-deflation problem.  The bottom line is that looking at historical trends, the dollar should be much higher than current levels. Practical investors recognize the need to pay heed to correlation shifts. Either our favorite liquidity indicators have stopped working outright or more realistically other forces are at play, explaining the relative stability in the greenback. A Counter-Cyclical Currency The first possibility is that the recent stability in the U.S. dollar has been in anticipation of better economic data in the second half of this year. We have shown many times in the past that the greenback is a countercyclical currency that tends to do poorly when global economic momentum picks up. Many investors are now fixated on China – specifically, whether the latest credit injection will be sufficient to turn around the Chinese economy, let alone the rest of the world. Meanwhile, as the U.S.-China trade talks progress, it will likely include a currency clause to prevent depreciation of the RMB versus the dollar. In reality, there is still scant evidence to support a bottoming in global growth, making it difficult to loop this back to dollar stability.  In reality, there is still scant evidence to support a bottoming in global growth, making it difficult to loop this back to dollar stability. Typical reflation indicators such as commodity prices, emerging market currencies and industrial share prices are off their lows but rolling over. March export data remained weak globally, even though compositionally there were some green shoots. Exports to China from Singapore jumped by 34% year-on-year, and those to emerging markets by 22% year-on-year. Japanese machine tool orders from China also showed some stabilization. Historically, these are necessary but not sufficient conditions to gauge whether we are entering a bottoming process (Chart 7). Another contradiction is at play: If the dollar rally is being held back by prospects of improvement in global growth, then gold should fare poorly and most currencies should be outperforming both gold and the greenback. Until yesterday’s sell off in gold, this was not the case. Suggesting some other explanation might be tempering the U.S. dollar’s rise. Chart 7Tentative Green Shoots In Global Trade?   Regime Shift? While U.S. residents have been repatriating capital domestically, foreign investors have been fleeing U.S. capital markets at among the fastest pace in recent years. On a rolling 12-month total basis, the U.S. saw an exodus of about US$200 billion in equity from foreigners, the largest on record (Chart 8). In aggregate, both foreign official and private long-term portfolio investment into the U.S. has been rolling over, with investor interest limited only to agency and corporate bonds. Foreigners are still net buyers of about $450 billion in U.S. securities, but the downtrend in purchases in recent years is evident. Interestingly, gold has also outperformed Treasurys over this period. The U.S. dollar remains the reserve currency of the world today, but that exorbitant privilege is clearly fraying on the edges. Vis-à-vis official flows, China has risen within the ranks to be the number one contributor to the U.S. trade deficit. At the same time, Beijing has been destocking its holding of Treasurys, if only as retaliation against past U.S. policies, or perhaps to make room for the internationalization of the RMB (Chart 9). In a broader sense, the fall in dollar deposits at the Fed might just represent an underlying shift in the global economy away from dollars and towards a more diversified basket of currencies. This makes sense, given a growing proportion of trading – be it in crude, natural gas, bulk commodities or even softs – is being done outside U.S. exchanges. Chart 8Foreigners Are Dumping U.S. Equities   Chart 9China Has Stopped Recycling Surpluses Into Treasurys   Data from the International Monetary Fund (IMF) shows that the global allocation of foreign exchange reserves towards the U.S. dollar peaked at about 72% in the early 2000s and has been in a downtrend since. Meanwhile, allocation to other currencies, notably the British pound, Swiss franc and the yen have been surging (Chart 10). At the same time, foreign central banks have been amassing tremendous gold reserves, notably Russia and China, almost to the tune of the total annual output of the yellow metal (Chart 11). This further helps explain why the dollar may not be as strong as it should be. It also explains the stability of these currency pairs relative to the price of gold. Chart 10The World Is Diversifying Away From Dollars Chart 11Central Banks Are Absorbing Most Gold Production The U.S. dollar remains the reserve currency of the world today, but that exorbitant privilege is clearly fraying on the edges as the balance-of-payments dynamics are heading in the wrong direction. Over the next five years, the U.S. Congressional Budget Office (CBO) estimates that the U.S. budget deficit will swell to 4.5% of GDP. Assuming the current account deficit widens a bit then stabilizes, this will pin the twin deficits at 8.1% of GDP. This assumes no recession, which would have the potential to swell the deficit even further (Chart 12). Chart 12A Twin Deficit Cliff For The Dollar The U.S. saw its twin deficits swell to almost 13% of GDP following the financial crisis, but the difference then was that in the wake of the commodity boom the dollar was cheap (and commodity currencies overvalued). The subsequent shale revolution also greatly cushioned the U.S. trade deficit. Shale productivity remains robust and U.S. output will continue to rise, but the low-hanging fruit has already been plucked. For one reason or another, foreign central banks are diversifying out of dollars. If due to the changing landscape in trade, this is set to continue. If it is an excuse to shy away from the rapidly rising U.S. twin deficits, this will continue as well. And if the U.S. dollar cannot sufficiently rally on “good news,” expect it to sink when the bad news eventually starts rolling in. That said, the timing remains uncertain.   Private Capital Flows Foreign official flows might have been fleeing the U.S. dollar because it has lost some luster as a reserve currency, but private capital will begin stampeding toward the exits when the return on invested capital (ROIC) for U.S. assets falls below their cost of capital. For investors with a long horizon, this may already be happening. Take 10-year government bonds for example. For the Japanese or German investor, borrowing in local currency and investing in the U.S. might seem like the logical course of action given negative domestic rates and a 10-year Treasury yield of 2.4%. However, this positive carry suddenly evaporates when one factors in hedging costs (Chart 13). Chart 13JGBs More Attractive Than Hedged Treasuries During bull markets, countries that have negative interest rates are subject to powerful outflows from carry trades. The impact of these are difficult to measure, but it is fair to assume that periods of low hedging costs (which tend to correspond to periods of lower volatility) can be powerful catalysts. As markets get volatile and these trades get unwound, unhedged trades become victim to short-covering flows. With many yield curves around the world inverting, the danger is that the frequency of this short-covering implicitly rises, since long-bond returns are falling short of spot rates. One winner as volatility starts to rise is the yen. Investors should consider initiating short USD/JPY positions today as a hedge. Outside the fixed-income space, what matters is that relative ROICs are higher than the cost of capital. Both are difficult to measure for many emerging or even developed economies across asset classes. However, for the equity market, a good starting point has always been valuations as exchange rates tend to move to equalize returns across countries. The forward P/E on the MSCI U.S., Europe and Japan indexes is 16.5x, 12.6x and 12.3x. The skew towards the U.S. is because market participants expect U.S. profits to keep outperforming, the U.S. currency to keep appreciating, or a combination of the two. However, empirically, current U.S. valuations suggest future earning streams have already been fully capitalized today (Chart 14). Chart 14AReturn On Capital Could Be Lowest In The U.S. (1) Chart 14BReturn On Capital Could Be Lowest In The U.S. (2) Chart 14CReturn On Capital Could Be Lowest In The U.S. (3) The expected 10-year annualized return for MSCI U.S. is 3.1%, versus 5.5% for MSCI Europe and 9.6% for MSCI Japan. If we assume the U.S. dollar is overvalued, as some models suggest, this will further erode future U.S. returns. Net equity portfolio flows into the U.S. are already negative, as shown in a previous chart. This means the day of reckoning for the U.S. dollar may not be far off when current tailwinds eventually fade.   Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights It may seem self-evident that most governments are overly indebted, but both theory and evidence suggest otherwise. Higher debt today does not require higher taxes tomorrow if the growth rate of the economy exceeds the interest rate on government bonds. Not only is that currently the case, but it has been the norm for most of history. Unlike private firms or households, governments can choose the interest rate at which they borrow, provided that they issue debt in their own currencies. Ultimately, inflation is the only constraint to how large fiscal deficits can get. Today, most governments would welcome higher inflation. There are increasing signs China is abandoning its deleveraging campaign. Fiscal policy will remain highly accommodative in the U.S. and will turn somewhat more stimulative in Europe. Remain overweight global equities/underweight bonds. We do not have a strong regional equity preference at the moment, but expect to turn more bullish on EM versus DM by the middle of this year. Feature A Fiscal Non-Problem? Debt levels in advanced economies are higher today than they were on the eve of the Global Financial Crisis. Rising private debt accounts for some of this increase, but the lion’s share has occurred in government debt (Chart 1). Chart 1Global Debt Levels Have Risen, Especially In The Public Sector Not surprisingly, rising public debt levels have elicited plenty of consternation. While there has been a lively debate about how fast governments should tighten their belts, few have disputed the seemingly self-evident opinion that some degree of “fiscal consolidation” is warranted. Given this consensus view, one would think that the economic case for public debt levels being too high is airtight. It’s not. Far from it. Debt Sustainability, Quantified Start with the classic condition for debt sustainability, which specifies the primary fiscal balance (i.e., the overall balance excluding interest payments) necessary to maintain a constant debt-to-GDP ratio (See Box 1 for a derivation of this equation).   An increase in the economy’s growth rate (g), or a decrease in real interest rates (r), would allow the government to loosen the primary fiscal balance without causing the debt-to-GDP ratio to increase (Chart 2).1 If the government were to ease fiscal policy beyond that point, debt would rise in relation to GDP. But by how much? It is tempting to assume that the debt-to-GDP ratio would then begin to increase exponentially. However, that is only true if the interest rate is higher than the growth rate of the economy. If the opposite were true, the debt-to-GDP ratio would rise initially but then flatten out at a higher level.2 A Fiscal Free Lunch The last point is worth emphasizing. As long as the interest rate is below the economic growth rate, then any primary fiscal balance – even a permanent deficit of 20%, or even 30% of GDP – would be consistent with a stable long-term debt-to-GDP ratio. In such a setting, the government could just indefinitely rollover the existing stock of debt, while issuing enough new debt to cover interest payments. No additional taxes would be necessary. In fact, stabilizing the debt-to-GDP ratio becomes easier the higher it rises. Chart 3 shows this point analytically.    Ah, one might say: If the government issues a lot of debt, then interest rates would rise, and before we know it, we are back in a world where the borrowing rate is above the economy’s growth rate, at which point the debt dynamics go haywire. Now, that sounds like a sensible statement, but it is actually quite misleading. As long as a government is able to issue its own currency, it can always create money to pay for whatever it purchases. If people want to turn around and use that money to buy bonds, they are welcome to do so, but the government is under no obligation to pay them the interest rate that they want. If they do not wish to hold cash, they can always use the cash to buy goods and services or exchange it for foreign currency. As long as a government is able to issue its own currency, it can always create money to pay for whatever it purchases. Wouldn’t that cause inflation and currency devaluation? Yes, it might, and that’s the real constraint: What limits the ability of governments with printing presses to run large deficits is not the inability to finance them. Rather, it is the risk that their citizens will treat their currencies as hot potatoes, rushing to exchange them for goods and services out of fear that rising prices will erode the purchasing power of their cash holdings. When Is Saving Desirable? The reason governments pay interest on bonds is because they want people to save more. However, more savings is not necessarily a good thing. This is obviously the case when an economy is depressed, but it may even be true when an economy is at full employment. Just like someone can work so much that they have no time left over for leisure, or buy a house so big that they spend all their time maintaining it, it is possible for an economy to save too much, leading to an excess of capital accumulation. Under such circumstances, steady-state consumption will be permanently depressed because so much of the economy’s resources are going towards replenishing the depreciation of the economy’s capital stock.  Economists have a name for this condition: “dynamic inefficiency.” What determines whether an economy is dynamically inefficient? As it turns out, the answer is the same as the one that determines whether debt ratios are on an explosive path or not: The difference between the interest rate and the economy’s growth rate. Economies where interest rates are below the growth rate will tend to suffer from excess savings. In that case, government deficits, to the extent that they soak up national savings, may increase national welfare.   r < g Has Been The Norm Today, the U.S. 10-year Treasury yield stands at 2.69%, compared to the OECD’s projection of nominal GDP growth of 3.8% over the next decade. The gap between projected growth and bond yields is even greater in other major economies (Chart 4). Granted, equilibrium real rates are likely to rise over the next few years as spare capacity is absorbed. Structural factors might also push up real rates over time. Most notably, the retirement of baby boomers could significantly curb income growth, leading to a decline in national savings. Chart 5 shows that the ratio of workers-to-consumers globally is in the process of peaking after a three-decade long ascent. Economic growth could also fall if cognitive abilities continue to deteriorate, a worrying trend we discussed in a recent Special Report.3 Chart 5The Global Worker-To-Consumer Ratio Has Peaked It may take a while before real rates rise above GDP growth. Still, it may take a while before real rates rise above GDP growth. As Olivier Blanchard, the former chief economist at the IMF, noted in his Presidential Address to the American Economics Association earlier this year, periods in U.S. history where GDP growth exceeds interest rates have been the rule rather than the exception (Chart 6).4 The same has been true for most other economies.5 Chart 6GDP Growth Above Interest Rates: Historically, The Rule, Not The Exception What’s Next For Fiscal Policy? Austerity fatigue has set in. In the U.S., fiscally conservative Republicans, if they ever really existed, are a dying breed. Trump’s big budget deficits and his “I love debt” mantra are the waves of the future. For their part, the Democrats are shifting to the left, with the “Green New Deal” proposal being the latest manifestation. The case for fiscal stimulus is stronger in the euro area than for the United States. The European Commission expects the euro area to see a positive fiscal thrust of 0.40% of GDP this year, up from a thrust of 0.05% of GDP last year (Chart 7). This should help support growth. Chart 7The Euro Area Will Benefit From A Modest Amount Of Fiscal Easing This Year Additional fiscal easing would be feasible. This is clearly true in Germany, but even in Italy, the cyclically-adjusted government primary surplus is larger than what is necessary to stabilize the debt ratio.6 Unfortunately, the situation in southern Europe is greatly complicated by the ECB’s inability to act as an unconditional lender of last resort to individual sovereign borrowers. When a government cannot print its own currency, its debt markets can be subject to multiple equilibria. Under such circumstances, a vicious spiral can develop where rising bond yields lead investors to assign a higher default risk, thus leading to even higher yields (Chart 8).   Mario Draghi’s now-famous “whatever it takes” pledge has gone a long way towards reassuring bond investors. Nevertheless, given the political constraints the ECB faces, it is doubtful that Italy or other indebted economies in the euro area will be able to pursue large-scale stimulus. Instead, the ECB will keep interest rates at exceptionally low levels. A new round of TLTROs is also looking increasingly likely, which should protect against a rise in bank funding costs and a potential credit crunch. Our European team believes that a TLTRO extension would be particularly helpful to Italian banks.  Even in Italy, the cyclically-adjusted government primary surplus is larger than what is necessary to stabilize the debt ratio. Despite having one of the highest sovereign debt ratios in the world, Japan faces no pressing need to tighten fiscal policy. Instead of raising the sales tax this October, the government should be cutting it. A loosening of fiscal policy would actually improve debt sustainability if, as is likely, a larger budget deficit leads to somewhat higher inflation (and thus, lower real borrowing rates) and, at least temporarily, faster GDP growth. We expect the Abe government to counteract at least part of the sales tax increase with new fiscal measures, and ultimately to abandon plans for further fiscal tightening over the next few years. In the EM space, Brazil, Turkey, and South Africa are among a handful of economies with vulnerable fiscal positions. They all have borrowing rates that exceed the growth rate of the economy, cyclically-adjusted primary budget deficits, and above-average levels of sovereign debt (Chart 9).   In contrast, China stands out as having the biggest positive gap between projected GDP growth and sovereign borrowing rates of any major economy. The problem is that the main borrowers have been state-owned companies and local governments, neither of which are backstopped by the state. Not officially, anyway. Unofficially, the government has been extremely reluctant to allow large-scale defaults anywhere in the economy. Despite all the rhetoric about market-based reforms, they are unlikely to start now. Historically, the Chinese government has allowed credit growth to reaccelerate whenever it has fallen towards nominal GDP growth. As we recently argued in a report entitled “China’s Savings Problem,” China needs more debt to sustain aggregate demand.7 Historically, the government has allowed credit growth to reaccelerate whenever it has fallen towards nominal GDP growth (Chart 10). The stronger-than-expected jump in credit origination in January suggests that we are approaching such an inflection point. Chart 10Historically, China Has Scaled Back On Deleveraging When Credit Growth Has Fallen Close To Nominal GDP Growth Investment Conclusions The consensus economic view is that deflation is a much harder problem to overcome than inflation. When dealing with inflation, all you have to do is raise interest rates and eventually the economy will cool down. With deflation, however, a central bank could very quickly find itself up against the zero lower bound constraint on interest rates, unable to ease policy any further via conventional means. While this standard argument is correct, it takes a very monetary policy-centric view of macroeconomic policy. When interest rates are low, fiscal policy becomes very potent. Indeed, the whole notion that deflation is a bigger problem than inflation is rather peculiar. Just as it is easier to consume resources than to produce them, it should be easier to get people to spend than to save. People like to spend. And even if they didn’t, governments could go out and buy goods and services directly. Looking out, our bet is that policymakers will increasingly lean towards the ever-more fiscal stimulus. If structural trends end up causing the so-called neutral rate of interest to rise – the rate of interest that is necessary to avoid overheating – policymakers will have no choice but to eventually raise rates and tighten fiscal policy (Box 2). However, they will only do so begrudgingly. The result, at least temporarily, will be higher inflation. Fixed-income investors should maintain below benchmark duration exposure over both a cyclical and structural horizon. Reflationary policies that increase nominal GDP growth will help support equities, at least over the next 12 months. Chart 11 shows that corporate earnings tend to accelerate whenever nominal GDP growth rises. We upgraded global equities to overweight following the December FOMC meeting selloff. While our enthusiasm for stocks has waned with the year-to-date rally, we are sticking with our bullish bias. Chart 11Earnings And Nominal GDP Growth Tend To Move In Lock-Step A reacceleration in Chinese credit growth will put a bottom under both Chinese and global growth by the middle of this year. As a countercyclical currency, the dollar will likely come under pressure in the second half of this year. Until then, we expect the greenback to be flat-to-modestly stronger. The combination of faster global growth and a weaker dollar later this year will be manna from heaven for emerging markets. We closed our put on the EEM ETF for a gain of 104% on Jan 3rd, and are now outright long EM equities. I do not have a strong view on the relative performance of EM versus DM at the moment, but expect to shift EM equities to overweight by this summer.8 Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com   Box 1 The Arithmetic Of Debt Sustainability   Box 2 Debt Sustainability And Full Employment: The Role Of Fiscal And Monetary Policy Policymakers should strive to stabilize the ratio of debt-to-GDP over the long haul, while also ensuring that the economy stays near full employment. The accompanying chart shows the tradeoffs involved. The DD schedule depicts the combination of the primary fiscal balance and the gap between the borrowing rate and GDP growth (r minus g) that is consistent with a stable debt-to-GDP ratio. In line with the debt sustainability equation derived in Box 1, the slope of the DD schedule is simply equal to the debt/GDP ratio. Any point below the DD schedule is one where the debt-to-GDP ratio is rising, while any point above is one where the ratio is falling. The EE schedule depicts the combination of the primary fiscal balance and r - g that keeps the economy at full employment. The schedule is downward-sloping because an increase in the primary fiscal balance implies a tightening of fiscal policy, and hence requires an offsetting decline in interest rates. Any point above the EE schedule is one where the economy is operating at less than full employment. Any point below the EE schedule is one where the economy is operating beyond full employment and hence overheating. Suppose there is a structural shift in the economy that causes the neutral rate of interest – the rate of interest consistent with full employment and stable inflation – to increase. In that case, the EE schedule would shift to the right: For any level of the fiscal primary balance, the economy would need a higher interest rate to avoid overheating. The arrows show three possible “transition paths” to a new equilibrium. Scenario #1 is one where policymakers raise rates quickly but are slow to tighten fiscal policy. This results in a higher debt-to-GDP ratio. Scenario #2 is one where policymakers tighten fiscal policy quickly but are slow to raise rates. This results in a lower debt-to-GDP ratio. Scenario #3 is one where the government drags its feet in both raising rates and tightening fiscal policy. As the economy overheats, real rates actually decline, sending the arrow initially to the left. This effectively allows policymakers to inflate away the debt, leading to a lower debt-to-GDP ratio. Note: In Scenario #2, and especially in Scenario #3, the DD line will become flatter (not shown on the chart to avoid clutter). Consequently, the final equilibrium will be one where real rates are somewhat higher, but the primary fiscal balance is somewhat lower, than in Scenario #1.   Footnotes 1          One can equally define the interest rate and GDP growth rate in nominal terms (see Box 1 for details).  2       Japan is a good example of this point. The primary budget deficit averaged 5% of GDP between 1993 and 2010, a period when government net debt rose from 20% of GDP to 142% of GDP. Since then, Japan’s primary deficit has averaged 5.1% of GDP, but net debt has risen to only 156% of GDP (and has been largely stable for the past two years). 3      Please see Global Investment Strategy Special Report, “The Most Important Trend In The World Has Reversed And Nobody Knows Why,” dated February 1, 2019. 4      Olivier Blanchard, “Public Debt And Low Interest Rates,” Peterson Institute for International Economics and MIT American Economic Association (AEA) Presidential Address, (January 2019). 5      Paolo Mauro, Rafael Romeu, Ariel Binder, and Asad Zaman, “A Modern History Of Fiscal Prudence And Profligacy,” IMF Working Paper, (January 2013). 6      The Italian 10-year bond yield is 2.83% while nominal GDP growth is 2.64%. Multiplying the difference by net debt of 118% of GDP results in a required primary surplus of .22% of GDP that is necessary to stabilize the debt-to-GDP ratio. This is lower than the IMF’s 2018 estimate of cyclically-adjusted government primary surplus of 2.14%. 7      Please see Global Investment Strategy Weekly Report, “China’s Savings Problem,” dated January 25, 2019. 8      Please note that my colleague, Arthur Budaghyan, BCA’s Chief EM strategist, remains bearish on both EM and DM equities and expects EM to underperform DM over the coming months. Strategy & Market Trends MacroQuant Model And Current Subjective Scores Tactical Trades Strategic Recommendations Closed Trades        

Highlights We would fade fears of an “earnings recession.” EPS growth should increase during the remainder of this year. While high debt burdens around the world may exacerbate deflationary pressures by restraining spending, they may also motivate policymakers to raise inflation in order to reduce the real value of outstanding debt. Ultimately, whether high debt levels turn out to be deflationary or inflationary depends on the extent to which policymakers have both an incentive and the means to increase inflation. The spread of political populism has made governments more inclined to boost nominal incomes by allowing economies to overheat. Central bankers have also become increasingly convinced that they should wait to see “the whites of inflation’s eyes” before tightening monetary policy any further. With inflation expectations still well anchored, it may take at least another 18 months for inflation in the U.S. to break out, and longer still elsewhere. Stay bullish on global stocks for now. However, be prepared to dial back equity exposure late next year, while shifting bond duration to a maximum underweight. Feature Fade Fears Of An “Earnings Recession” We upgraded global stocks in December following the post-FOMC meeting selloff. Our recommendation to go long the MSCI All-Country World Index has gained 9.0% since we initiated it. Although our enthusiasm for stocks has waned somewhat given the recent run-up, we continue to see upside for global bourses over the next 12-to-18 months. Admittedly, earnings growth has come down sharply from a year ago. To some extent, this reflects base effects (U.S. EPS rose by 23% in Q1 of 2018, thanks in part to the tax cuts). However, slower global growth and higher tariffs have also taken their toll. The good news is that the trade war is likely to stay on hiatus over the coming months. We also expect nominal GDP growth in the U.S. and the rest of the world to pick up by the middle of this year. Chart 1 shows that earnings growth tends to move in lock-step with nominal GDP growth. Chart 1Earnings And Nominal GDP Growth Move In Lock-Step Equity prices usually bottom when earnings growth bottoms (Chart 2). Analyst estimates based on IBES data foresee EPS growth troughing in Q1 and then accelerating modestly over the remainder of the year. If this happens, global equities will move higher over the coming months. What’s The Bigger Risk? Deflation Or Inflation? Last week, we argued that the next global economic downturn would probably be sparked by a surge in inflation which forces central banks to raise interest rates more aggressively than they would like.1 Given the absence of inflationary pressures today, and the still-ample spare capacity that exists in many economies, we noted that such an outcome is far from imminent. This implies that the global expansion still has plenty of room to run, thus justifying an overweight stance towards risk assets. One common objection to this thesis posits that deflation, rather than inflation, is the main risk to the global economy. And unlike its inflationary cousin, the next deflationary shock could be lurking just around the corner. Italy serves as a good example of the dangers of high debt levels. While many things can contribute to deflationary pressures, elevated debt levels are often cited as being the most important. An excessive debt burden can lead to a prolonged period of deleveraging. Since borrowers typically spend a larger share of their cash flows than lenders, overall spending could decline, leading to lower prices and wages. High debt levels can also make an economy vulnerable to interest-rate shocks. This is particularly the case when a country is reliant on external debt or issues debt in a currency it does not control. The Italian Lesson Italy serves as a good example of the dangers of high debt levels. Italy entered the euro area with one of the highest public debt ratios in the world. Private debt also soared in anticipation of euro membership as well as during the period leading up to the Global Financial Crisis, almost doubling as a share of GDP between 1998 and 2008 (Chart 3). Chart 3Italy's Debt Inferno Worries about high indebtedness, poor growth prospects, and contagion from Greece sent the 10-year Italian bond yield to nearly 7.5% on November 9, 2011. Yields tumbled after Mario Draghi pledged to do “whatever it takes” to preserve the common currency, but rose again last April after Italians brought an anti-austerity populist government into power. Today, the Italian government finds itself in the unenviable position of having to devote 3.4% of GDP to interest payments, more than double the euro area average (Chart 4). Domestic investors own less than half of Italian government debt, so most of those interest payments do little to stimulate domestic spending. Chart 4The Italian Government's Interest Payments Are Higher Than Elsewhere In The Euro Area The Inflation Solution When debt reaches elevated levels, faster nominal growth via higher inflation becomes an increasingly appealing solution for reducing debt ratios. A one percentage-point increase in nominal GDP will cut debt-to-GDP by half a percentage point when it stands at 50%, but by three full percentage points when it stands at 300%. Given the attractiveness of inflating away debt burdens, why don’t more governments pursue this strategy? Part of the answer is politics. The long history of hyperinflation in Europe and many other economies has cast a long shadow over how central banks operate. Unanticipated inflation also redistributes wealth from creditors to debtors. While the latter usually outnumber the former, the former typically have more political sway. Means And Opportunities Political will is a necessary condition for generating inflation, but it is not a sufficient one. Policymakers also need to possess the ability to accomplish their goal. What determines whether they will succeed? The answer, to a large extent, is the level of the neutral rate of interest. The neutral rate of interest is the long-term interest rate that is appropriate for the economy. When interest rates are above the neutral rate, growth will tend to fall below trend, while inflation will decline. Conversely, when rates are below their neutral level, the economy will grow at an above-trend pace and inflation will accelerate. Many things can influence the neutral rate of interest. These include: Trend GDP growth: Faster growth will incentivize firms to expand capacity in anticipation of rising demand. This will push up the neutral rate of interest. National savings: Lower taxes and increased government spending will drain national savings, while stimulating aggregate demand. This will push up the neutral rate of interest. Likewise, a decrease in private-sector savings — whether it be the result of easier access to credit or greater optimism about future income growth — will raise the neutral rate. The capital intensity of the economy: Economies that require a lot of physical capital will tend to have a higher neutral rate of interest. By the same token, economies where the capital stock needs to be replenished quickly in order to offset depreciation will have a higher neutral rate of interest.  The exchange rate: A weaker exchange rate will boost net exports. This resulting increase in aggregate demand will translate into a higher neutral rate of interest. With the exception of the currency effect, all of the factors listed above are captured by the canonical Solow growth model which undergraduate economics students usually encounter in their studies (See Appendix 1 for a derivation of the neutral rate of interest in this model). Inflation And The Neutral Rate Economists tend to define the neutral rate in real terms. However, when thinking about inflation, it is useful to consider the neutral rate’s nominal counterpart. Conceptually, the nominal neutral rate of interest can be either negative or positive. When the nominal neutral rate is negative, even a policy rate of zero will be insufficient to allow the economy to overheat. One might call this outcome the “strong form” version of the secular stagnation thesis. In contrast, when the neutral rate is low, but still positive, an interest rate of close to zero will be low enough to allow the economy to overheat, which will eventually generate inflation. One may refer to this as the “weak form” version of the secular stagnation thesis. Political will is a necessary condition for generating inflation, but it is not a sufficient one. The Danger Of Strong-Form Secular Stagnation In situations where the strong form version of secular stagnation prevails, deflationary pressures will feed on themselves. If an economy suffers from a chronic shortfall of aggregate demand, inflation is liable to drift lower. A lower inflation rate will push down the nominal interest rate that is consistent with any given real rate. For example, if the economy requires a real rate of -1% in order to grow at trend and inflation is 2%, a 1% nominal rate will suffice. But if inflation is 0%, then the policy rate would need to be -1%, which may be difficult to achieve. Japan serves as a case study for how this vicious circle can unfold. Following the simultaneous bursting of the property and stock market bubbles in the early 1990s, the Japanese private sector entered a prolonged deleveraging cycle. Inflation drifted steadily lower, ultimately falling into negative territory during the 1997-98 Asian Crisis (Chart 5). High debt levels in Japan were deflationary because the nominal neutral rate of interest was negative. Even if the Bank of Japan wanted to, it was greatly constrained in its ability to raise inflation. Chart 5Japan: A Case Study In Strong-Form Secular Stagnation Europe Is Not Japan… Yet Next to Japan, the euro area comes the closest to meeting the criteria for strong form secular stagnation. The euro area has low trend growth, owing to its slow population growth rate, as well as a banking system that is still focused on deleveraging. There is a silver lining, however: Despite the many woes the euro area has experienced, long-term inflation expectations are still over 100 basis points higher than in Japan (Chart 6). Fiscal policy is also turning somewhat more accommodative. Our base case is that the ECB will be slow to unwind its balance sheet and will only raise rates if the economy is showing more verve. This should be enough to move inflation towards target over the next two years. Chart 6Long-Term Inflation Expectations In The Euro Area Are Still Well Above Japanese Levels Inflation In The U.S. When inflation does break out early next decade, it will probably happen first in the United States. A large structural budget deficit and the revival of credit growth to the household sector following an intense period of deleveraging have boosted the neutral rate of interest. An overheated labor market is driving up real wages, which will lead to more consumer spending. December’s weaker-than-expected retail sales report will prove to be a fluke. Not only was it influenced by the sharp drop in the stock market and worries about a pending government shutdown (both of which have reversed), but the report itself was probably compromised by delays in the collection of data, which may have pushed some responses into January (historically, the weakest month for retail sales). This interpretation is consistent with strong holiday sales reported by online retailers and solid growth in the Johnson Redbook index of same-store sales. The latter captures over 80% of the sales surveyed by the Department of Commerce in its retail sales report, and featured a 9.3% year-over-year increase in sales in the final week of December, the fastest since the start of this series in 1997 (Chart 7). Chart 7The December Retail Sales Report Was Probably A Fluke Yes, corporate debt in the U.S. is high, but it is not particularly elevated relative to most other countries (Chart 8). Despite the collapse in equity prices and the spike in credit spreads late last year, U.S. corporations are still eager to expand capacity (Chart 9). This is not an economy teetering on the brink of recession. Chart 8U.S. Corporate Debt Is Not Extreme By Global Standards Chart 9U.S. Capex Plans Have Come Off Their Highs, But Remain Solid Policymakers in the U.S., and in much of the world, have grown more comfortable in letting economies overheat. Whether it be Trump’s unfunded tax cuts or the “Green New Deal” championed by the more liberal members of the Democratic Party, fiscal stimulus is in, austerity is out. Policymakers in the U.S., and in much of the world, have grown more comfortable in letting economies overheat. Even mainstream voices have given their nod of approval. Just this week, former IMF Chief Economist Olivier Blanchard argued that the U.S. could safely increase public debt without endangering economic stability.2 Meanwhile, central banks have increasingly bought into the mantra, famously espoused by Larry Summers, that they should wait to see the “the whites of inflation’s eyes” before tightening monetary policy.3 What this mantra overlooks is that inflation is a highly lagging indicator. By the time you see the whites of a tiger’s eyes, you are already destined to be its dinner. Investment Conclusions The spread of populist economic policies offers a one-two punch to inflation. Not only are populist prescriptions apt to stimulate demand, but that stimulus will raise the neutral rate of interest, thereby giving central banks greater traction to further boost spending by keeping rates below their neutral level. For investors, this implies a dichotomy between the medium-term and longer-term asset market outlook. Easy money policies are a boon to risk assets when they are first introduced, as they typically combine low interest rates with fast nominal GDP growth. But the path to higher rates is lined with lower rates, meaning that the longer central banks keep rates below their neutral level, the more economies will overheat, and the larger the eventual inflation overshoot will be. As growth outside the U.S. begins to accelerate in the second half of 2019, the dollar will come under downward pressure. As such, investors should overweight global equities and high-yield credit for the next 12 months. However, be prepared to dial back equity exposure late next year, while shifting bond duration to a maximum underweight. In terms of regional equity allocation, we continue to see global growth bottoming by the middle of this year. As growth outside the U.S. begins to accelerate in the second half of 2019, the dollar will come under downward pressure. The resulting reflationary impulse will be manna from heaven for the more cyclically-sensitive sectors of the stock market, as well as Europe and EM. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com   Laura Gu Research Associate Footnotes 1      Please see Global Investment Strategy Weekly Report, “Minsky’s Corollary,” dated February 8, 2019. 2       Olivier Blanchard, “Public Debt and Low Interest Rates,” Peterson Institute for International Economics and MIT American Economic Association (AEA) Presidential Address, (January 2019); Noah Smith, “The U.S. Can Take on a Lot More Debt Within Limits,” Bloomberg Opinion, (February 2019). 3      Lawrence Summers, “Only raise US rates when whites of inflation’s eyes are visible,” Financial Times, (February 2015). Strategy & Market Trends MacroQuant Model And Current Subjective Scores Tactical Trades Strategic Recommendations Closed Trades