Economy

Highlights Our take on the key macro drivers of financial markets is quite similar to last year’s, … : Monetary policy is still accommodative; lenders are ready, willing and able; and the expansion remains intact. ... because the Fed and other central banks have reset the monetary policy clock, … : At this time last year, we projected that the Fed would be on the cusp of tightening monetary policy enough to induce a recession by the middle of 2020. Three rate cuts later, we now expect that policy won’t become restrictive until 2021. … pushing the inflection points investors care about further out into the future: The next recession won’t begin before monetary policy settings are tight, and stocks won’t peak until about six months before the recession starts. We are keeping close tabs on the trade negotiations and potential election outcomes, but we expect that 2020 will be another rewarding year for riskier assets: The equity bull market is likely to last for all of next year, and spread product will keep cranking out excess returns over Treasuries and cash for a while longer, too. Overweight equities and spread product. Feature Mr. and Ms. X made their annual visit to BCA last month, giving us an opportunity to gather our thoughts for 2020, while reviewing how our calls turned out in 2019. Both BCA and US Investment Strategy got the asset allocation conclusion right – overweight equities and spread product, while underweighting Treasuries – but the Fed did the opposite of what we expected heading into 2019, putting us on the wrong side of the Treasury duration call for most of the year. We still think investors are overly complacent about the potential for future inflation, but we concede that the future remains further off than we initially expected. Monetary policy settings got more accommodative nearly everywhere in the world in 2019, ... Our Outlook 2020 theme, as detailed in the year-end edition of The Bank Credit Analyst, is Heading into the End Game,1 and it is clear that the expansion is in its latter stages. We do not think that the end of the expansion, the equity bull market, or credit’s extended stretch of positive excess returns is at hand, however. The full-employment/low-inflation sweet spot is still in place, and the Fed has no plans to get in the expansion’s way, even if inflation begins to gain some traction. Its biggest policy priority is trying to get inflation expectations back to the 2.3 – 2.5% range consistent with its inflation target. Chart 1Globalization Hits A Wall Central banks around the world followed the Fed’s lead this year, cutting their policy rates in an attempt to shield their economies from potentially worsening trade tensions. Though no central banker would say it out loud, joining the rate-cutting parade also helped to defend against currency appreciation, as no one wants a strong currency when growth is in such short supply. The upshot is that global central banks are deliberately promoting reflation. That’s a supportive policy backdrop for risk assets, and while it may well lead to a bigger hangover down the road, it will ramp up the party now. Exogenous challenges remain. Trade tensions are a thorn in businesses’, consumers’ and investors’ sides. Even if US-China tensions die down, a belligerent US administration appears bent on using tariffs and other trade barriers as a cudgel to force concessions from other nations. The trade tailwind that boosted economic growth and investment returns across the last two decades has been stilled (Chart 1). Saber rattling by the US, or mischief from the usual rogue-state and non-state suspects, could also keep markets on edge. The looming election could give investors heartburn, and clients around the world remain anxious about the prospects of a Warren administration. Exogenous risks abound, but it is not our base case that a critical mass will coalesce to disrupt our view that generous-to-indulgent monetary policy settings will delay the day of reckoning, and keep the bull market going all the way through the coming year. As The Cycles Turn From our perspective, the practice of investment strategy is properly founded on the study of cycles. The key cycles – the business cycle, the credit cycle, and the monetary policy cycle – determine how receptive the macroeconomic backdrop is for taking investment risk. Investments made when the backdrop supports risk taking have a much better likelihood of generating excess returns over Treasuries and cash than investments made against an unfriendly macro backdrop. We therefore start every investment decision with an assessment of the key cycles. Determining whether the economy is expanding or contracting may seem like an academic debate with little practical application when the official business cycle arbiters don’t even determine the beginning and ending dates of recessions until well after the fact.2 Equity bear markets reliably coincide with recessions, however, and over the last 50 years, they have begun an average of six months before their onset (Chart 2). An investor who recognizes that a recession is at hand has a good chance of outperforming his/her competitors as long as s/he aggressively adjusts portfolio allocations in line with that recognition. Chart 2Bear Markets Rarely Occur Outside Of Recessions, ... Our key view, then, is that the start of the next recession is at least 18 to 24 months away. Tight monetary policy is a necessary, albeit not sufficient, condition for a recession (Chart 3), and we consider the Fed’s current monetary policy settings to be easy, especially after this year’s three rate cuts. A recession can’t begin until the Fed reverses those three cuts and, per our estimate of the equilibrium rate, tacks on at least three additional hikes. Tightening along those lines is decidedly not on the Fed’s 2020 agenda. Chart 3... And Recessions Only Occur When Monetary Conditions Are Tight Our recession judgment compels us to be overweight equities. Even if the next recession begins exactly halfway through 2021, history suggests that 2020 returns will be robust. Over the last 50 years, the S&P 500 has peaked an average of six months before the start of a recession, and returns heading into the peak have been quite strong, especially in the last four expansions (Table 1). Those results are consistent with bull markets’ tendency to sprint to the finish line (Chart 4). Table 1Stocks Don't Quit Until A Recession Is Near Chart 4Bull Markets End In Stampedes The Fed Funds Rate Cycle We estimate that the equilibrium fed funds rate is currently around 3¼%, and project it will approach 3½% by the end of next year. If we are correct that the Fed’s main policy aim is to prod inflation expectations higher, it follows that it will remain on hold at 1.75% well into 2020. A desire to avoid even the appearance of meddling in the election may well keep the FOMC sidelined until its November and December meetings. The implication is that monetary policy will have no chance to cross into restrictive territory before the first half of 2021. The bottom line for investors is that the day when the economy and markets will have to confront tight monetary conditions has been indefinitely postponed. The Fed has effectively deferred the inflections in the business cycle and the equity market to some point beyond 2020. A longer stretch of accommodation would also continue to fuel the equity bull market, as Phases I and IV of the fed funds rate cycle, in which the fed funds rate is below our estimate of equilibrium (Chart 5), have been equities’ historical sweet spot. Over the last 60 years, the S&P 500 has accrued all of its real returns when policy was easy (Table 2), while Treasuries have shined when it’s tight (Table 3). Chart 5The Fed Funds Rate Cycle Table 2Equities Love Easy Policy, … Table 3… When They Leave Treasuries Far Behind The Credit Cycle Our 30,000-foot view of the credit cycle is based on the banking mantra that bad loans are made in good times. When an expansion has been going on for a while, loan officers focus more on maintaining market share than lending standards, while managers of credit funds attract more assets, pushing them to find a home for their new inflows. Banks and bond managers are thereby pro-cyclical at the margin, keeping the good times going by lending to increasingly marginal borrowers and/or relaxing the terms on which they will lend. (They’re conversely stingy when real-time conditions are bad.) Lenders’ lagging/coincident focus keeps lending standards and borrower performance closely aligned in real time (Chart 6). Chart 6Standards Are Coincident In Real Time, ... Standards are a contrarian indicator over longer periods, though, because shoddily underwritten loans eventually show their true colors. We find a solid fit between corporate bond default rates and lending standards in the preceding 20 quarters (Chart 7). Lending standards tightened slightly in 2015, but were still quite easy in an absolute sense. A majority of banks tightened standards in 2016 amidst the oil rout, which could point to marginally better 2020-21 performance, but post-2010 standards have hardly been stringent. Chart 7... And Leading Over Five-Year Periods The stock of outstanding loans and bonds is therefore vulnerable. The relaxation of corporate bond covenants so soon after the financial crisis has not escaped the notice of bearish investors and reporters. It is not enough for an investor to identify a vulnerability, however; s/he also has to identify the catalyst that is going to cause a rupture. The challenge is that ultra-accommodative monetary policy delays the formation of negative catalysts. To the utter torment of an observer with an attraction to the Austrian School of Economics’ survival-of-the-fittest ethic, it is not at all easy to default in a ZIRP/NIRP world. The stock of $12 trillion of bonds with negative nominal yields (down from August’s $17 trillion peak) has ginned up a fervent search for yield among large institutional investor constituencies that have to meet a fixed distribution schedule, like life insurers and pension funds. These income-starved investors help explain why nearly any borrower, no matter how sketchy, can draw a crowd of would-be lenders simply by offering an incremental 50 or 75 basis points of yield. Borrowers default when no one is willing to roll over their maturing obligations; they get even more leveraged when lenders are climbing over each other to lend to them. It is also hard to default when central banks are deliberately pursuing reflation. Inflation makes debt service easier, and central banks are all-in for reflation as a means to bolster inflation expectations, defend against further trade tensions, and to ensure currency strength doesn’t undermine exports. The credit cycle is well advanced, and the Austrians may be at least partially vindicated when the ensuing selloff is worse than it would otherwise have been for having been delayed, but it looks to us like it has more room to run. The rapture remains out of reach for Austrian School devotees, who slot between Tantalus and New York Knicks fans on the cosmic persecution scale. Bonds We remain bearish on Treasuries and reiterate our below-benchmark duration recommendation, though we recognize that the 10-year Treasury yield is unlikely to rise beyond the 2.25-2.5% range in the next year. There’s only one more rate cut to price out of the OIS curve, and neither inflation expectations nor the term premium will return to normal levels quickly. The intermediate- and long-term outlook for the Federal budget is grim, given the size of the deficit while unemployment is at a 50-year low (Chart 8), but Dick Cheney will maintain the upper hand over deficit hawks for 2020 and several years beyond. We do think investors are complacent about inflation’s eventual return, though, and continue to advocate for TIPS over nominal Treasuries. It is tough to default in a ZIRP/NIRP world, when several institutional investor constituencies have a voracious appetite for yield. Chart 8The Budget Outlook Is Grim Chart 9IG Spreads Are Wafer Thin Our benign near-term view of the credit cycle makes us comfortable continuing to overweight spread product, subject to our US Bond Strategy colleagues’ preferences. They are only neutral on investment-grade corporates, given their scant duration-adjusted spread over Treasuries (Chart 9). They recommend overweighting high-yield corporate bonds instead, given that high-yield spreads still offer ample positive carry. They also recommend agency mortgage-backed securities as a high-quality alternative to investment-grade corporates, noting that their low duration (three years versus nearly eight for corporates) offers better protection against rising rates. Equities With monetary policy still accommodative, and the expansion still intact, the cyclical backdrop is equity-friendly. If we’re correct that policy won’t turn restrictive until early to mid-2021 at the earliest, the bull market should be able to continue through all of 2020. We do not foresee a return to double-digit earnings growth, but the upward turn in leading indicators across a wide swath of countries outside of the US suggests that a revival in the rest of the world could help S&P 500 constituents grow earnings by mid-single digits, via a pickup in non-US demand and some softening in the dollar. Net share retirements could even nudge earnings growth into the high single digits. If earnings multiples hold up (they’ve expanded at a 5.5% annual rate in Phase IV of the fed funds rate cycle, and don’t typically contract until Phase II), S&P 500 total returns could reach the high single digits, easily putting them ahead of prospective Treasury returns. Multiple expansion isn’t required to support an overweight equities recommendation, but we would not be at all surprised if it occurred. Bull markets often get silly as they sprint to the finish line, and it would be unusual if some froth didn’t bubble up before this bull market, the longest of the postwar era, calls it quits. The Dollar We expect the dollar to weaken against other major currencies in 2020. As the rest of the world finds its footing and begins to accelerate, the growth differential between the US and other major economies will narrow. The dollar will attract less safe-haven flows as the rest of the world’s major economies escape stall speed. Though we expect the countercyclical dollar will rally again when the next recession hits, weakening in 2020 is consistent with our constructive global growth view. Putting It All Together We are sanguine about the US economy, which continued to trundle along at a trend pace in 2019 despite a series of headwinds. It withstood 4Q18’s sharp equity selloff and bond-spread blowout that tightened financial conditions and made corporate and investor confidence wobble. It withstood the 35-day federal government shutdown that lasted nearly all of January. It kept marching forward despite the trade war with China, and it overcame, at least for now, the angst over the inverted yield curve. If the economy continued to expand at roughly its trend pace despite those obstacles, it may not really have needed 25-basis-point rate cuts in July, September and October. The thread connecting our macro views and investment recommendations is the idea that monetary policy settings are highly accommodative and are likely to stay that way until the 2020 election. We expect that risk assets will outperform against an accommodating monetary backdrop. The naysayers are as likely to be confounded by central banks in 2020 as they have been throughout the entire ZIRP/NIRP era. The scolds scouring the data to try to find signs of excesses, and the Chicken Littles who have been frightened by clickbait headlines and strategists deliberately pursuing pessimistic outlier strategies, get one thing right. The market selloffs when the equity and credit bull markets end will be worse than they would have been if the Fed and other central banks were not deliberately attempting to reflate their economies. But their timing is likely to be as bad now as it has been all throughout 2019 (and for the entire post-crisis period for card-carrying, sandwich-board-wearing Austrians). You can’t fight the Fed, much less the ECB, the Bank of Japan, the Bank of England, the Swiss National Bank, the Reserve Banks of Australia and New Zealand, and a broad swath of all of the rest of the world’s central banks.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Please see the December 2019 Bank Credit Analyst, “Outlook 2020: Heading Into The End Game,” available at www.bcaresearch.com. 2 The NBER’s Business Cycle Dating Committee announced in December 2008 that the last recession began in December 2007. It announced in September 2010 that it had ended in June 2009.

Special Report

Dear Client, I have been visiting clients in the US Midwest this week. In lieu of our regular report, we are sending you a Special Report from our Global Asset Allocation team. The report includes a review of recently published books that BCA Research strategists found most helpful in terms of understanding the global economy and how to invest. Next week, the Global Investment Strategy service will be publishing its economic and investment outlook for 2020 and beyond. Best regards, Peter Berezin, Chief Global Strategist Highlights To answer that question, the GAA team asked BCA Research’s strategists for suggestions of recent books that helped their understanding of the world economy or of how to invest. Their suggestions include books on artificial intelligence, the information in Google searches, debt crises, the growing monopolization of the US economy, and the death of “liberal hegemony”. Some recommendations are more esoteric: a textbook on climate economics, a paper on the Lewis Turning-Point, and the history of Russia’s 1917 default. Feature “What’s the best thing you read recently?” was the rather sharp question we were asked by a client not long ago. BCA Research believes that one of its roles is to contribute to the intellectual debate on what drives the economy and investment markets…indeed, simply what makes the world tick. Part of that is sharing interesting books (or articles or academic papers) that deserve to be widely read and discussed. The client question set us thinking. Twice in recent years, ahead of the holiday season, Global Asset Allocation has published a list of its favorite investment-related books  that clients might read during down-time over the break.1 So this time we polled our senior colleagues at BCA Research on what they had read this year that most aided their understanding of the global economy or investment. We asked them to limit their choice to something published recently (say, in the past year or two). The 12 items they picked follow (in no particular order). Most are well-known books, published this year and favorably reviewed. But some are a little more obscure (the lessons from Russia’s default of 1917, for instance). Our strategists also identified a must-read university-level textbook (on climate economics) and a seminal Richard Koo conference paper on why there is a lack of borrowers globally. We are sure you will find much here for stimulating and entertaining reading during the holidays. Life 3.0: Being Human In The Age Of Artificial Intelligence By Max Tegmark The only thing special about human intelligence is that it is the minimum level necessary to create a technologically advanced society. What happens when artificial intelligence reaches human capabilities? At that point, there will be an intelligence explosion, argues Max Tegmark in his new book Life 3.0. AI will be smart enough to figure out how to make itself even smarter which, in turn, will allow it to make itself smarter still. Forget about a Star Trek future. AI will blow through that in the blink of an eye. Within days, or perhaps even hours, AI will be constrained only by the laws of physics. When will this day arrive? No one really knows, although Tegmark notes that the median estimate among AI researchers is somewhere around 2050. Not imminent, but still within the lifetime of most investors. What role will finance and economics play in this brave new world? Scarcity is the bedrock on which economics is built. Diamonds cost more than water not because water is less useful – life could not exist without it – but because diamonds are much more scarce than water. Will the cornucopia produced by superhuman AI render the market mechanism obsolete? It is possible. Even before that fateful day when AI surpasses human capabilities, advances in AI technologies will leave their mark on society. Workers who can harness AI to increase their productivity will benefit. Workers who are displaced by AI will suffer. The demand for redistributive policies will grow. Efforts to rein in companies that gain monopolistic control over AI technologies will intensify. More worrying, superintelligent AI may eventually render all humans – including the original creators of the AI – obsolete. Tegmark spends a lot of time discussing the difficulty in getting advanced AI to understand, adopt, and retain the goals that its human masters try to program into it. The risk is not of a “Terminator” style scenario. Rather, it is that superintelligent AI will end up treating humans with the same ambivalence we treat ants: You may not purposely try to step on an ant while you are walking in the woods, but if you do, well, tough luck for the ant. Failure to apply to AI research the sort of safety engineering that made the lunar landing possible could be humanity’s ultimate undoing. Peter Berezin Chief Global Strategist Narrative Economics: How Stories Go Viral And Drive Major Economic Events By Robert J. Shiller Shiller’s Narrative Economics is a book within the realm of behavioral economics, but it is distinct in its focus on how ideas that turn out to have significant economic influence begin, spread, and die (if they die!). Shiller metaphorically links the adoption of economic narratives to the spread of diseases, noting that both occur through interpersonal contact. A framework exists to model the latter, and Shiller argues that this is an excellent starting-point to understand the spread of ideas with important economic implications. Like most behavioral research to date, the book is foundational rather than definitive: it presents a helpful conceptual framework to think about the “transmission” of influential economic ideas but, after reading the book, investors will not walk away with any specific tools to predict when and how economic narratives will influence macroeconomic behavior or asset prices. Still, we liked the book because it gets the reader thinking about how to identify narratives. Investors have already seen several false narratives emerge this cycle: the hyperinflationary nature of quantitative easing, that low interest rates mean low inflation (neo-Fisherian economics), comparisons to 1938 at the onset of US monetary policy normalization, the inevitably of debt deflation in China, and the imminence of a US fiscal crisis are just a few examples. The mere practice of identifying narratives should increase the ability of investors to identify which narratives are more likely to be right or wrong, and we would challenge our clients to read Shiller’s book with the narrative of secular stagnation in mind. True or false? Jonathan LaBerge, CFA Vice President, Special Reports Everybody Lies: Big Data, New Data, And What The Internet Can Tell Us About Who We Really Are By Seth Stephens-Davidowitz Stephens-Davidowitz argues that people’s personal Google search history amounts to digital truth serum, the opposite of one’s carefully curated public social-media footprint. The book examines the new age of Big Data from a sociological lens, and offers vital insights about the pitfalls of this new discipline – data science – which is still in its infancy. The critical premise is that people’s primordial need to look good, and equally, avoid looking bad, drives their digital behavior. A person’s search history reveals their inner hopes, dreams, fears, and anxieties in the same way that their social media presence obscures them. In this way, Big Data can be harnessed to uncover unaddressed suffering, political bias, inequality of opportunity, and a host of other social trends that direct questioning and surveys never will. Anyone with an interest in understanding how Big Data is shaping our reaction function to the world around us will enjoy this book. The thesis of social desirability bias is a useful framework for tempering our expectations about what we can and cannot hope to achieve through data analysis across a spectrum of real-world and business applications. To the extent that data is the new oil, investors need to understand how it is collected, filtered, and broadcast, in order to have any hope of deciphering signals from noise, in markets and beyond. Caroline Miller Senior Vice President, Global Strategy A Crisis Of Beliefs: Investor Psychology And Financial Fragility By Nicola Gennaioli and Andrei Shleifer This book is partly a re-telling of the events leading up to the 2008 financial crisis, but from a much different perspective than other accounts of that period. To explain the crisis, Gennaioli and Shleifer present a model based on how people form expectations and on what can happen when those expectations are shown to be divorced from reality. We found that this model can be easily applied to the corporate credit cycle, the pattern where long periods of tightening corporate bond spreads and rising corporate debt are interrupted by short bursts of spread widening and a flurry of defaults. We even wrote a Special Report making just that connection.2 The model presented in this book should be in the back of every corporate bond investor’s mind. Because investor expectations are “extrapolative rather than rational”, corporate spreads can tighten dramatically if the recent past was trouble free. But this also means that spreads will eventually become divorced from economic reality. When that happens, even a seemingly minor event can lead to sharp spread widening and economic pain. As corporate bond investors, our chief goal should be to identify when investor expectations have deviated too far from reality, knowing that once that happens, a shock can occur at any time. Ryan Swift Vice President, US Bond Strategy The Great Delusion: Liberal Dreams And International Realities By John J. Mearsheimer The Great Delusion is a worthy attempt at making sense of the contemporary geopolitical context. John Mearsheimer – father of the offensive realism school of international relations theory – posits that “liberal hegemony”, the policy of remaking the world in America’s moral image, is bound to fail, is failing, and ought to be replaced by a more restrained policy that accepts the guardrails of geopolitics: realism and nationalism. Realist thought has been woven into the sinews of BCA’s Geopolitical Strategy since 2011. As such, we have no qualms with his discourse, but do find it unusual that he equates nationalism with realism. The latter is an a priori force compelling policymakers into the path of least resistance – and thus quite diagnostic – whereas the former is an ideology, much as the global liberalism that Mearsheimer largely criticizes as an ordering principle. This is not merely a pedantic concern. Mearsheimer is at his best when he uses realist theory to hack away at the normative and moralistic fat hanging onto the red meat of analysis. He did so at the turn of the millennium when he correctly predicted that China and the US would eventually clash, that their enmity was inevitable. His Tragedy of Great Power Politics therefore remains one of our favorite geopolitical reads. However, whenever he treats nationalism as a tool of analysis, he is thrown off the scent. In that same classic he predicted that the European Union would collapse, thrown asunder by the forces of nationalism. That forecast has not proven correct. As long as the reader keeps this track record in mind, and separates the analytical tool (realism) from a normative one (nationalism), The Great Delusion will be a fantastic read. Marko Papic Consulting Editor, BCA Research Chief Strategist, Clocktower Group Bankers And Bolsheviks: International Finance And The Russian Revolution By Hassan Malik Financial historian Hassan Malik takes us back to the first era of unchecked globalization, the late 19th century. At the time, Russia was not just a major geopolitical power, but also an investment thesis that inspired many to plunge their wealth into its frozen tundra in the search of the “next industrialization” story.  What followed was one of the greatest sovereign defaults in history. Investors ignored the obvious signs of geopolitical and political risk, focusing instead on linear extrapolation of returns from similar narratives of industrialization. Given that the 1917 revolution was preceded by several major political crises, including a disastrous war in 1904-1906 and a revolution in 1905, the episode is a great warning sign to investors and illustrates the folly of a blind search for investment returns.  Malik argues that the 1917 default caused by the Bolshevik Revolution was the greatest default in history. Why is the ranking important? Because Russia in 1917 was not a peripheral economy – as Greece in 2012 and Argentina in 2002 were. It was a major economy at the center of an ever-more globalizing world economy. Malik implicitly criticizes the work of Carmen Reinhart and Kenneth Rogoff – which sits on the far end of the social science spectrum – whose This Time Is Different is built upon a dataset of cases in countries that few investors could locate on a globe (although the 1876 Guatemala default episode is a riveting read!). The point Malik makes is that it is better to spend a lot of time on a critical case than to draw broad conclusions from a bevy of irrelevant ones. Marko Papic Consulting Editor, BCA Research Chief Strategist, Clocktower Group Climate Economics: Economic Analysis Of Climate, Climate Change And Climate Policy By Richard S.J. Tol Richard Tol’s book provides the necessary background for investors who wish to integrate climate-change economics into their investment process. Tol teaches Climate Change and Environmental Economics at the University of Sussex. This is an unusual book to make it to our list as it is written in a textbook format. In fact, the book is used for teaching advanced undergraduate and graduate level courses. Be that as it may, it is an excellent introduction to the economics of climate change. Climate change – and especially climate economics – is a complex and evolving field. Tol’s presentation of the core science of climate change is one of the clearest and most balanced we’ve read. It mostly uses data from the IPCC and gives a condensed – only 230 pages – and clear rundown of the projected impact of climate change and the degree of uncertainty around it as supported by present research. Building on this scientific consensus and the neoclassical approach to climate economics, the author applies various theoretical frameworks to assess the uncertainty around the climate impact on the economy, determine the optimal policy prescriptions, and to understand the interaction between adaptation and mitigation policies, and the limitations of international agreements. Some of Tol’s conclusions about climate impacts are controversial and debatable – and are even more so in his academic work for which he is occasionally considered a "climate skeptic" or "lukewarmer." Notably, the book’s final chapter concludes that the impact of climate change will be only slightly negative, and that it is easily manageable with a modest carbon tax. Tol’s controversial opinions are secondary to the sound analysis of climate-change economics he provides. For investors, we believe the prudent course of action for portfolio construction is to consider the scientific consensus developing around climate change – and the impact it will have on policymakers – and to hedge or invest appropriately. Hugo Belanger Senior Analyst, Climate Change Special Project Team Principles For Navigating Big Debt Crises By Ray Dalio Low interest rates, central bank intervention and increasingly profligate governments continue to propel debt levels around the world to record highs. Rightly, investors have grown concerned about the looming threat that a major debt crisis poses to financial markets. But how do we spot when such a crisis will come? How it could play out? How will different assets react? Dalio attempts to answer these questions through the three parts of his book: In Part I, Dalio provides his framework for thinking about both inflationary and deflationary crises. Specifically, he describes the early warning signs of a debt bubble, how each type of crisis typically plays out, and the scenarios that result from different policy responses. Part II is a detailed account of the three most significant debt crises of the past century: the hyperinflationary crisis in Germany during the 1920s; the 1930s' Great Depression; and the 2008 Housing Crisis. Part III consists of shorter accounts of 48 debt crises from different countries around the world. While the book is an exceptional compendium of financial history, its real value comes not from its descriptions of what happened but rather from its analysis of why. Dalio uses his case studies to explain the different economic, financial, and political mechanisms at work during a debt crisis, elevating the book from a history lesson to a roadmap that investors can use to understand and navigate debt crises in the future. Juan Manuel Correa Ossa Senior Analyst, Global Asset Allocation The Other Half Of Macroeconomics And Three Stages Of Economic Development By Richard C. Koo Paper by Richard C. Koo written as part of World Economics Association Conferences, 2016: Capital Accumulation, Production and Employment: Can We Bend The Arc of Global Capital Toward Justice. In this paper, Dr. Koo presents his customary case that the problem ailing advanced economies today is a lack of borrowers, not a paucity of lenders. What makes this paper different is its emphasis on the cause of this absence of borrowers. It is because of the limited investment opportunities offered by advanced economies. To understand how we got to this point, Dr. Koo introduces the concept of the Lewis Turning-Point (LTP). This is the point of economic development where all the surplus labor (mostly former farm workers) has been absorbed by urban factories. Before the LTP has been reached, real wages are stagnant, inequalities are rife and consumption growth is limited. Post the LTP, workers have stronger bargaining power; as a result real wages boom, inequality declines, and consumption growth strengthens. Moreover, because consumption is strong and labor costs are rising, companies continue to invest to service growing domestic demand and to shift much of their production function toward capital, which raises productivity. The economy thus enters a golden age, similar to the one advanced economies experienced in the post-World War Two era until the late 1970s. Dr. Koo’s key insight is that with globalization and the entry into the global supply chains of emerging markets in general and China in particular, the world has moved back to a pre-LTP environment. As a result, wages are again stagnating, inequalities are rising, productivity is declining, and growth in advanced economies is anemic. As a corollary, investment opportunities become scarcer, which is why borrowers are lacking and interest rates are low. Dr. Koo argues that solving this problem is essential, otherwise democracy will suffer, populism will rise, and so will protectionism. He advocates for advanced economies to do more to stay at the leading edge of the technological frontier in order to create opportunities for growth and insulate labor from EM competition. This requires tax and regulatory reforms and investments in human capital. Mathieu Savary Vice President, The Bank Credit Analyst Identity: The Demand For Dignity And The Politics Of Resentment By Francis Fukuyama Francis Fukuyama’s Identity is an important book, coming as it does at a time when many institutions underpinning liberal societies are being challenged by the revival of nationalism defined by race, ethnicity, and religion.  This comes in the wake of sundry crises that have steadily eroded economic prospects of the middle class in numerous states – globalization, automation, immigration, financial crises, and polarization of incomes.  As jobs are lost, dignity and respect are lost.  This undermines democratic institutions, and paves the way for nationalism to fill the void. At the individual level, Fukuyama notes, “The nationalist can translate loss of relative economic position into loss of identity and status: you have always been a core member of our great nation, but foreigners, immigrants, and your own elite compatriots have been conspiring to hold you down; your country is no longer your own, and you are not respected in your own land.”  States crave respect and recognition as well.  “A host of new populist nationalist leaders claiming democratic legitimacy via elections have emphasized national sovereignty and national traditions in the interest of ‘the people,’” Fukuyama notes.  Fukuyama is at pains to stress a strong national identity is not necessarily evil.  Indeed it is necessary to reverse the trend toward nationalism in its more toxic forms.  Strong national identities promote security – larger states unified by common beliefs are able to marshal the resources necessary to govern and defend themselves.  Strong national identities allow democracy to thrive, under an implied contract between citizens and governments.  These functions and roles cannot be contracted out to international organizations, as Fukuyama observes: “The functioning of democratic institutions depends on shared norms, perspectives, and ultimately culture, all of which can exist on the level of a national state, but which do not exist internationally.” Rebuilding and sustaining democracies in an age of global, instantaneous communication – which can contribute to toxic nationalism, polarization and radicalization – remains the critical work of civilized society.  “We need to remember that the identities dwelling deep inside us are neither fixed nor necessarily given to us by our accidents of birth,” Fukuyama concludes.  “Identity can be used to divide, but it can and has also been used to integrate.  That in the end will be the remedy for the populist politics of the present.” Robert P. Ryan Chief Commodity & Energy Strategist Crashed: How A Decade Of Financial Crises Changed The World By Adam Tooze In 2007, former Federal Reserve Chairman Alan Greenspan said, “Thanks to globalization, policy decisions in the US have been largely replaced by global market forces. National security aside, it hardly makes any difference who will be the next president. The world is governed by market forces.” Historian Adam Tooze’s Crashed is a lengthy but highly readable attempt to show the folly of this statement – not cheaply to bash Greenspan, but rather to chronicle the monumental failure of the western political-economic consensus prior to the crisis and capture the magnitude of the shock that has transformed the world since. The chief value of the book for investors is that it refreshes one’s memory and understanding of the Great Recession and its aftermath within a global, rather than merely American, context. The author never loses sight of the truth that the underlying political and economic crisis is still unfolding. Events fall in their proper sequence, are weighed by the author with respect to their long-term consequences, and are placed into a larger puzzle that points to the “shape of things to come.” While many investors will feel they do not need another review of the causes and consequences of the Global Financial Crisis, the latter chapters are useful for providing an authoritative history of the post-crisis period – the latter stages of the European turmoil, the normalization of Fed policy, Brexit, and the rise of Donald Trump. We recommend the book. It is difficult to find “authoritative histories” that are not plodding. Tooze maintains a comfortable stride throughout. His tone can be a little inflated at times but he avoids academic pretensions in treating the most significant events and controversies. Our chief critique is that he is overly indulgent toward politicians in the emerging world, emphasizing their criticisms of western-led globalization to the neglect of their own corrupt mismanagement at home. Nowhere is this more apparent than in his treatment of the Chinese government. Nevertheless he generally rises to the occasion as a historian, maintaining a measured posture and casting a critical eye all around.  Matt Gertken Vice President, Geopolitical Strategist The Myth Of Capitalism: Monopolies And The Death Of Competition By Jonathan Tepper, with Denise Hearn The US economy has become increasingly concentrated over the past 30 years. Just two companies comprise 90% of beer sales, five banks control over half of banking assets, Delta Airlines has an 80% market share in Atlanta, 79% of households have access to only one high-speed internet provider, and even the funeral industry is an oligopoly. The result of this concentration, Tepper argues, has been higher prices, fewer start-ups, lower productivity, lower wages, higher income inequality, less investment, and a decline in localism and diversity. “Capitalism without competition is not capitalism,” he argues. Tepper dates the trend back to the 1970s and Judge Robert Bork’s attacks on anti-trust. Bork argued that high market share by one firm was probably due to economies of scale and greater efficiency; the only thing that mattered was “consumer welfare”, i.e. lower prices. Bork’s arguments were very influential with the Reagan administration and led to fewer mergers being blocked by the Department of Justice over subsequent decades. Tepper’s solutions to excess concentration include new anti-trust laws, tougher merger enforcement based on clear rules (for example, any industry should have six or more players), new laws on predatory pricing, a shorter time-limit on patents and copyrights, a limit to share buybacks – and even a ban on horizontal shareholdings (no shareholder should be able to buy more than 5% of shares in competitors in the same industry). This is an important book, with vigorous writing, good data, and detailed examples of distorting competition. But it is also rather polemical and over-written. While Tepper’s aim is to improve capitalism not replace it, some of his proposals on reregulation and his anti-business rhetoric will put off many readers. He is also weak on the legal framework of anti-trust regulation, and barely covers the situation outside the US (does Europe’s tougher competition policy work better?). Readers looking for a more sober and nuanced (but also less readable) treatment might prefer The Great Reversal: How America Gave Up On Free Markets by Thomas Philippon. Garry Evans Chief Global Asset Allocation Strategist Footnotes 1  Please see GAA Special Reports, “The Books Every CIO Should Read”, dated 7 December 2017, and “Investment Books Of The Year”, dated 12 December 2016, available at gaa.bcaresearch.com 2  Please see US Bond Strategy Special Report, “The Risk From US Corporate Debt: Theory And Evidence”, dated April 23, 2019, available at usbs.bcaresearch.com Strategy & Market Trends Strategic Recommendations Closed Trades

Highlights The Fed is the usual culprit for killing business cycles — but the Fed is on hold. This makes geopolitics the likeliest candidate to kill the cycle. The key geopolitical risks are US political turmoil, China’s economic policy, and the US-Iran confrontation. Nevertheless, policymakers are adjusting to the threat of recession, which points to a continuation of this long-in-the-tooth expansion. The US-China talks will be driven by Trump’s need for an economic boost ahead of the US election. If the economy or Trump’s approval rating fails anyway, then all bets are off. Go long gold as a strategic hedge. Feature Great power struggle, or “multipolarity,” continues to be our mega-theme in 2020. The world does not operate like a normal society, with a single government that possesses a monopoly on the use of force and ensures stability. Nations are individualistic, armed, and dangerous, creating what scholar Hedley Bull once called “The Anarchical Society.” This is not pure chaos, but rather a community of nations that lacks a clear and undisputed leader. Hence, quarrels break out often. Updating our geopolitical power index shows that the rise of China remains the most disruptive trend in global politics (Chart 1). The gap between the US and China has closed until recently, with China’s downshift in growth rates, but American fear is just being awakened (Chart 2). Given that Beijing threatens the US’s military and technological dominance over the long run, Washington will continue to develop a containment policy. Chart 1China's Geopolitical Rise Is Disruptive Chart 2China-US Power Gap Is Narrowing China is too big to quarantine, especially for a relatively unpopular first-term American president who eschews international coalition-building. The European Union’s decline in relative power is more marked than that of the United States, but China does not pose as much of a security threat to Europe. This trend exacerbates the already serious divergence in the trans-Atlantic alliance – which will worsen if Trump wins on November 3, 2020. Hence, globalization faces persistent challenges, as indicated by the falling import share of global output (Chart 3). This multi-decade process has peaked, creating a headwind for trade-exposed firms over the long run. What about the next 12 months? Will geopolitics kill the bull market? Not necessarily. Just as central bankers have cut interest rates to guard against deflationary risks (Chart 4), so the key governments are adjusting policies to avoid recessionary risks, especially with the memory of 2008 still fresh. Simply put: The Fed is on pause, Trump wants to be reelected, and China cannot afford a hard landing. Chart 3Globalization Faces Challenges Chart 4Policymakers Are Reacting To Deflationary Risks Clearly the risks to this view are elevated. The chief ones: (1) President Trump becomes a lame duck, cannot run on an economic platform, and thus makes a desperate attempt to win as a “war president” (2) Xi Jinping overestimates his advantage, in domestic or foreign policy, and makes a policy mistake (3) the US-Iran conflict spirals out of control due to Iran’s economic vulnerability. Other risks, such as Brexit, pale by comparison. Fear And Loathing On The Campaign Trail It is too soon to declare that Trump’s presidency is finished. On the contrary he is slightly favored to win reelection: • The Senate is unlikely to remove him from office. Republican support for the president is well above average despite evidence that Trump tried to get Ukrainian officials to investigate his political rival (Chart 5). The implication is that a year from now Democrats will have suffered a policy failure while Trump will have been cleared of charges. Chart 5Trump Still Popular Among Republicans • The odds of recession in the coming year are low. The US voter is buffered by rising real incomes and wages and high net wealth (Chart 6). To unseat a sitting president requires a recessionary backdrop that fundamentally discredits him and his party – not just slowing growth. Chart 6Pocketbook Voter Theory To The Test • Trump’s low approval rating does not prohibit him from reelection. While historically low, it is also historically stable. Our quantitative election model – which predicts Trump will win the Electoral College with 279 votes by clinging onto Pennsylvania – shows that Trump’s victory margin would increase if we looked not at the average level of his approval but at its change, momentum, or low range (i.e. stability). Table 1 shows the results of all four variations of his approval rating, with ascending chances of winning key swing states. Table 1All Measures Of Trump’s Approval Rating Get Him 270 Electoral College Votes Trump’s odds of winning will affect the US equity market throughout the year. As long as he remains competitive, i.e. neither scandal nor the economy cause his approval rating to break down, he will have reason to temper his policies to cater to US financial markets. Foreign and trade policies are Trump’s only ways to improve the economy and voter support. Trump’s only remaining way to boost the economy and improve voter support lies in foreign policy and trade policy. Specifically, he will stop increasing tariffs on China – and maybe even roll back tariffs to August 2019 or even April 2019 levels (Chart 7) – at least as long as the manufacturing recession persists. Chart 7Some Tariff Rollback Is Possible China is unlikely to implement painful structural changes when Trump could be gone in 12 months’ time. Strategic tensions outside of trade will undermine any ceasefire. Hence economic policy uncertainty will remain elevated even though it will drop off from recent peaks. Assuming the electoral constraint prevents Trump from levying sweeping tariffs on China or Europe, he will be limited to other foreign and trade policies to try to boost his approval rating or fire up his base: • We expect a third summit with Kim Jong Un of North Korea. Trump is rumored to be considering some troop reduction in exchange for progress on denuclearization (neither of which would be irreversible). • Otherwise Trump could turn to saber-rattling, since Pyongyang is threatening to resume long-range tests and the economic consequences of another round of “fire and fury” would be limited. • Trump could also rattle the saber against Iran, Venezuela, or other rogue states. If Trump becomes uncompetitive in the election, then the market will sell off. The market will have to price not only policy discontinuity (e.g. higher taxes), but also the chance of a progressive-populist taking the White House. Moreover, if a Democrat is able to unseat an incumbent president, the Democrats will take the Senate as well. Trump is a known unknown; this scenario would be an unknown unknown. The Democratic Party’s primary election will consume the first half of the year. It culminates in the Democratic National Convention, strategically chosen to take place in Milwaukee, Wisconsin on July 13-16. Wisconsin is one of three critical swing states. Will former Vice President Joe Biden win the nomination? A high conviction is not warranted. Biden is clearly the frontrunner, but we think a progressive can pull it off. A simulation of the Democratic Convention “pledged delegates,” based on November polling in the first four primary elections, shows Biden far short of a majority (Chart 8). He needs to outperform his polls, but this will be difficult given that he is well-known, has not performed well in debates, and will have Mayors Pete Buttigieg and Michael Bloomberg nipping at his heels in the Midwest and Northeast, respectively. Chart 8Do Not Discount A Progressive Win Over time, candidates will drop out, so it is more informative to look at the “centrist” candidates as a whole compared to the “progressives.” Here the early primary polling suggests that the progressives will come closest to victory (Chart 9). Chart 9Progressives Come Closest To Victory The trend within the party is to move to the left. Senators Elizabeth Warren and Bernie Sanders are tied as voters’ second choice – even Buttigieg supporters are split between Biden and Warren (Chart 10). What is unknown is whether Warren (or Sanders) can consolidate the progressive vote faster than Biden (or Buttigieg) consolidates the centrist vote. Chart 10If Biden Falters, Progressives Are Next In Line Chart 11Structural Imbalances Give Rise To Populism Trends pointing toward a progressive victory may not at first trouble the market, but any signs that a progressive is pulling ahead decisively will force investors to sharply upgrade the probability that he or she will win the White House. This will cause equity volatility, which could become self-reinforcing. A progressive nominee would force investors to recognize that populism and political risk are here to stay – which is our expectation given that they are motivated by polarization, inequality, and other structural imbalances in the United States (Chart 11). Left-wing or progressive populism is far more negative for corporate earnings than Trump’s right-wing or “pluto-populism.” Sanders or Warren present the worst case for investors because they favor trade protectionism in addition to higher taxes and minimum wages. Most presidents achieve their chief legislative priority in their first term and there is no reason to assume a progressive presidency would be any different. The implication is higher corporate taxes as well as individual taxes to pay for a sweeping expansion of the social safety net – positive for the economy perhaps but negative for corporate earnings. Chart 12A Progressive Win Threatens Key Sectors An extensive re-regulation of the US economy would occur regardless, since it falls under executive authority. It would affect the key equity sectors in the US bourse, technology and health (Chart 12), as well as energy and financials. The choice of a centrist Democrat like Biden (or Buttigieg) would be the least negative outcome for US equities of all the Democrats. The market would probably cheer a Trump versus Biden matchup for this reason. Biden favors higher taxes and regulation but is an establishment politician and known quantity. However, even Biden will be pulled to the left by the current within his party once in office; and Buttigieg will govern to the left of Biden. Trump’s reelection would spur a relief rally in US equities, but it would be short-lived. He would solidify low taxes and deregulation and would have a real chance of passing an infrastructure package. But he would also curtail labor force growth with his border wall and double down on trade protectionism – likely against Europe as well as China this time. His unpredictable and aggressive tendencies would be turbo-charged by a new popular mandate. We expect to cut back on risk exposure upon Trump’s reelection, assuming the bull market has survived to return him to office. A Democratic victory would mark another reversal in US policy orientation. Given our view that the White House call is also the Senate call, this would be the third time since 2008 that the country has witnessed a total reversal. Domestic American political risk will not end with the election: a legitimacy crisis could follow a narrow election, and institutional erosion continues regardless. It is too soon to call peak polarization, as the election will result in either a left-wing government bent on redistributing wealth or a right-wing Trump administration that exacerbates inequality. A centrist "return to normalcy" is possible with a Biden or Buttigieg victory. This reinforces our constructive cyclical view. Bottom Line: The chief risk from US politics in 2020 is Trump becoming a lame duck and resorting to belligerent foreign policy to try to win back voters through a rally around the flag. The chief risk of the Democratic nomination, and the general election, is a left-wing populist winning the White House. Any Democratic victory would likely bring the Senate, removing a key constraint. Over time the median voter is moving to the left. The Man Who Changed China Chart 13Xi Is Purging Misallocated Capital Xi Jinping undoubtedly represents a “new era” in China – a reassertion of Communist Party rule. The party faced a crisis of legitimacy amid the Great Recession and Arab Spring and was determined to regain political, economic, and social control. Xi had previously been anointed but was all too happy to take on the role of neo-Maoist strongman. Yet Xi’s playbook is close to that of President Jiang Zemin’s: centralize the party, repress dissent, modernize the military, restructure banks and the economy, upgrade the country’s science and technology, and expand China’s global influence. The difference is that while Jiang rode the high tide of globalization, Xi is riding the receding tide. Jiang culled two-thirds of the country’s state-owned enterprises, laying off over 40 million people, confident that a surge of new growth would ensue. Xi is also cracking down – allowing bankruptcies to purge misallocated capital (Chart 13) – but with a large debt load and shrinking labor force, he needs the state sector to put a floor under growth rates. The takeaway is that Xi will act pragmatically to boost growth when China’s stability is threatened, as he did in 2015-16. The trade war has already forced him to backtrack on the 2017-18 deleveraging campaign and stimulate the economy. The combined fiscal and credit impulse amounts to 6.6% of GDP from trough to now, and it hasn’t peaked. The implication is that Chinese growth – and global growth – will pick up from here (Chart 14). Chinese authorities are still trying to contain the growth in leverage, which has kept this year’s stimulus in check. But the chief banking regulator has also stated that as long as the macro-leverage ratio is not growing faster than 10%, this goal is met (Chart 15). Chart 14Chinese Growth Will Pick Up Chart 15China Says Leverage Already Contained The economy has not yet durably bottomed, so the state will continue adding support. The coming year is the third and final year of the “Three Battles” – against poverty, pollution, and systemic risk – as well as the final year of the thirteenth five-year plan. Beijing is falling short on its targets for real urban per capita income (Chart 16) and poverty elimination (Chart 17). A last-minute rush to meet these targets is likely and will require more fiscal stimulus. Chart 16Beijing Falls Short Of Urban Income Target... Chart 17...And Poverty Target This is not an argument for a blowout credit splurge. China is saving dry powder for a further escalation in the US containment strategy and a worse economic downturn. Do not expect a blowout Chinese credit splurge. The core constraint on policy is unemployment. Stimulus efforts have created a bottom in the employment component of the manufacturing PMI as well as a notable uptick in the demand for urban labor (Chart 18). To withdraw stimulus now – or tighten policy – would be to trigger a relapse in an economy that is ultimately at risk of a debt-deflation trap. Chart 18Chinese Stimulus Shows Up In Employment Chart 19A Banking Crisis Is A Risk To The Chinese Economy Tougher controls on credit and shadow banking have seen an uptick in corporate defaults and bank failures. With the government deliberately imposing pain on bloated sectors of the economy, financial turmoil could spread. Newspaper mentions of defaults, layoffs, and bankruptcies have only slightly subsided since stimulus efforts began (Chart 19). If bank failures spiral out of control, the economy will tank. The state will have to fight fires. Tariffs have accelerated the trend of firms relocating out of China, which began because of rising wages and a darkening business environment (Chart 20). A questionable trade ceasefire will not reverse the process as American and Asian companies are seeking a lasting solution, which requires them to set up shop elsewhere. China will want to mitigate the process, first by stabilizing domestic growth, and second by accepting Trump’s tactical trade retreat. Xi is also trying to avoid diplomatic isolation by courting trade partners other than the US, since the ceasefire is unreliable and the US containment strategy is presumed to continue. This involves outreach to the rest of Asia, Russia, and Europe, and even to distrustful neighbors like Japan and India. Europe is the swing player. China’s Asian neighbors, and Australia and New Zealand, have reason to fear Beijing’s growing clout and seek the US’s security umbrella. Russia and China are informal allies. But the European public is not interested in the new cold war – China does not threaten Europe from next door, like Russia does, and the Trump administration is threatening Europe with both trade war and Middle Eastern instability. European leaders are happy to take the market share that the US is leaving, as is clear from direct investment (Chart 21). Only a concentrated US diplomatic effort can address this divergence, which is not forthcoming in 2020. Chart 20Firms Are Relocating Out Of China Chart 21Europe Exploits US-China Rift A new Democratic administration, or a change in Trump strategy in the second term, could eventually produce a multilateral western coalition demanding that China open up and liberalize parts of its economy. But Europe will need to be convinced of the underlying reality that China is doubling down on the state-led industrial policies that provoked the Americans to begin with. Beijing is after economic self-sufficiency, indigenous innovation, and leadership in high-tech production and new frontiers. Its official research and development budget is not its only means for achieving this end (Chart 22) – it also has state-backed acquisitions and cyber campaigns. Germany and Europe have begun scrutinizing Chinese investment, separately from the United States. Chart 22Beijing Is After Economic Self-Sufficiency The danger to China – and the world – is that Xi Jinping might overplay his hand. He could overtighten money, credit, or property regulations and spoil the economy when global growth is vulnerable. His anti-corruption campaign is a telling reminder of his heavy hand in domestic affairs (Chart 23). Chart 23Xi Jinping Risks Overplaying His Hand Chart 24China Needs To Calm Things Down He could also suppress protesters in Hong Kong and rattle sabers over Taiwan or the South China Sea in a way that undermines the trade ceasefire. Or he could fail to bring the North Koreans to heel. These strategic tensions are significant only insofar as they undermine the trade ceasefire or provoke US-China saber-rattling. Failing to act as an honest broker in the Iran crisis would also irk Europeans and give them an excuse to side with the US. Bottom Line: China will continue modestly stimulating the economy next year to achieve a durable stabilization in growth. The risk of debt-deflation and rising unemployment ultimately necessitates this policy. Beijing can accept Trump’s tariff rollback for the sake of stability – China’s policy uncertainty relative to the rest of the world is off the charts and Beijing has an interest in calming things down (Chart 24). Yet Beijing will double down on indigenous innovation, while courting the rest of the world so as to preempt criticism and isolate the Americans. The risk is that Xi proves too heavy-handed when it comes to domestic leverage, the tech grab, strategic disputes, or trade talks with Washington. The Strait Of Hormuz Risk Chart 25US-Iran Conflict Still Unresolved In a special report earlier this year entitled “The Polybius Solution” we argued that while the US-China conflict is the major long-term geopolitical conflict, the US-Iran showdown could supersede it in the short term. This remains a risk for 2020, as the Trump administration’s confrontation with Iran is fundamentally unresolved (Chart 25). The Trump administration is still enforcing “maximum pressure” sanctions, which have reduced Iranian oil exports from 1.8 million barrels per day at their recent peak to 100,000 barrels per day in November (Chart 26). These are crippling sanctions that have sent Iran’s economy reeling. Chart 26Iran Remains Under Iran’s Supreme Leader Ayatollah Ali Khamenei has ruled out negotiations with Trump. They would be unpopular at home without a major reversal on sanctions from Trump (Chart 27). Chart 27Major US Reversal Prerequisite For Iran Talks Trump presumably aims to avoid an oil shock ahead of the election. The US and its allies have visibly shied away from conflict in the wake of Iran’s provocations, including the spectacular attack on eastern Saudi Arabia that knocked 5.7 million barrels of oil per day offline in September. However, this does not mean the odds of war are zero. The Americans or the Iranians could miscalculate. Both sides might think they can improve their standing at home by flexing their muscles abroad. Iran is a rational actor and would not normally court American airstrikes or antagonize a potentially lame duck president. Yet it is under extreme pressure due to the sanctions. It faces significant unrest both at home and in its sphere of influence (Iraq and Lebanon). Opinion polls show that the public primarily blames the government for the collapsing economy, and yet that American sanctions are siphoning off some of this anger (Chart 28). This could tempt the leaders to continue staging provocations in the Strait of Hormuz or elsewhere in the region. Chart 28Iranians Blame Tehran, Tehran Blames America Hardline military leaders and politicians currently receive the most favor in polling, while the reformist President Rouhani – undercut by the American withdrawal from the 2015 deal – is among the least popular (Chart 29). The Majlis (parliament) elections in February will likely reverse the reformist turn in Iranian politics that began in 2012. The regime stalwarts are gearing up for the supreme leader’s succession in the coming years. While a Democratic White House could restore the 2015 deal, that ship may have sailed. Chart 29Rouhani And Reformists In Trouble A historic oil supply disruption is a fatter tail risk than investors realize. Chart 30The Iranians May Take Excessive Risk Trump, under impeachment, could seek to distract the public. This was Bill Clinton’s tactic with Operations Infinite Reach, Desert Fox, and Allied Force in 1998-99. These operations were minor and not comparable to a conflict with Iran. However, Trump may be emboldened. On paper the US strategic petroleum reserve (along with OPEC and other petroleum reserves) could cover most major oil shock scenarios. According to Hugo Bélanger, Senior Analyst at BCA Research Commodity & Energy Strategy, a supply outage the size of the Abqaiq attack in September would have to persist for four months to cause enough price pressure to harm the US economy and decrease Trump’s chances of winning reelection. The simulations in Chart 30 overstate the gasoline price impact by assuming that global oil reserves remain untapped. Thus while the Iranians may take excessive risks, the Trump administration may not refrain this time from airstrikes. Bottom Line: While the Middle East is always full of risks to oil supply, Iran’s vulnerability and Trump’s status at home make the situation unusually precarious. A historic oil supply disruption is a fatter tail risk than investors realize. Europe Is A Price Taker, Not A Price Maker Just as the US and China have a shared incentive to avoid tariff-induced recession, so the UK and EU have a shared incentive to prevent a shock reversion to basic WTO tariffs. The December 31, 2020 deadline for the UK-EU trade deal, like the various deadlines for Brexit itself, can be delayed. Even Prime Minister Boris Johnson has proved unwilling to exit without a deal and even a hung parliament has proved capable of preventing him from doing so. The negotiation of a trade deal – which is never easy and always drags on – will be a lower-order risk in the wake of the past two years’ Brexit-induced volatility. Johnson will not be held hostage by hardline Brexiters given that Brexit itself will be complete. If our view on Chinese growth is correct, then Europe’s economy can recover and European political risk will be a “red herring” in 2020, as it was in 2019. Instead the EU presents an opportunity. Chart 31Euro Area Breakup Risk Has Subsided Euro Area break-up risk has subsided after a series of challenges in the wake of the sovereign debt crisis (Chart 31). There is not a basis for a reversal of this trend, at least not until a full-blown recession afflicts the continent. The rise in anti-establishment parties coincided with a one-off surge in migration that is finished – and successful populists from Greece to Italy have moderated on euro membership once in power. Germany is entering a profound transition driven by de-globalization and tensions with the United States. It is more likely to have an early election than the consensus holds. But it is fundamentally stable and supportive of European integration. In fact the great debate about fiscal policy poses an upside risk over the long run both for European equities and the European project. We remain optimistic on French structural reforms even though President Emmanuel Macron must overcome significant public opposition. An eerie quiet hangs over Russia, making it one of our “Black Swan” risks for 2020. Oil prices are not very high, which discourages foreign adventures, and President Vladimir Putin has spent his fourth term trying to consolidate international gains and improve domestic stability. But approval of the government is weak, the job market is deteriorating, and social unrest is cropping up. There is plenty of room to ease monetary and fiscal policy, but a sharp downturn could provide the basis for an aggressive foreign policy action to shore up regime support. The US election also presents the risk of renewed US-Russian tensions, whether over election interference or a Democratic victory. Investment Conclusions Geopolitics is the likeliest candidate to derail the global bull market in 2020. Nevertheless, policymakers are adjusting to their constraints. Trump and Xi are negotiating a ceasefire and a disorderly Brexit is off the table. Even Trump’s impeachment shows that the US system of checks and balances remains intact. After all, there is nothing to prevent removal from office if Trump further antagonizes public opinion and the Republican Senate. This means that policy uncertainty will decline on the margin in 2020, even as it remains elevated due to the danger of the underlying events. The nature of US economic imbalances suggests that the policy discontinuity of a Democratic victory on November 3, 2020 would be better for the economy (via household consumption) than it would be for corporate earnings. Policy continuity with the Trump administration suggests the opposite. On a sectoral basis we recommend going long US energy large cap stocks and short info-tech and communications. Energy has limited downside even if a progressive wins whereas tech has limited upside even if Trump wins. The BCA Research House View expects the US dollar to weaken as global growth rebounds, stocks to outperform bonds and cash, and developed market equities to outperform those of the United States. But a Republican victory in November would push against these trends as it is more bullish for the greenback and for US equities relative to global. As a play on the global growth rebound we expect, we recommend going long industrial metals. Like our colleagues at BCA Research Commodity & Energy Strategy, we are initiating this as a tactical trade but it may become strategic. We are reinitiating a tactical long Korea / short Taiwan equity trade. Taiwanese political risk is understated ahead of January’s election and the island is the epicenter of the US-China cold war. We are restoring our long gold trade as a strategic hedge. Populism and de-globalization are potentially inflationary, but they are also linked with great power competition which will increase the frequency of geopolitical crises. In either case, gold is the right safe haven to own.   Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com

Highlights We are upgrading Pakistani equities to overweight within an EM equity portfolio. Fixed-income investors should consider purchasing 5-year local currency government bonds. The balance-of-payments adjustment is probably over. Hence, the currency will be stable, allowing inflation and interest rates to drop. Feature The country’s macro dynamics have shown signs of stabilization. This has begun benefiting share prices in both absolute terms and relative to the EM equity benchmark. Chart I-1Pakistani Stocks: The Worst Is Over We downgraded Pakistani equities in March 2017  and put this bourse on our upgrade watch list this past May (Chart I-1). In the past two years, the country has been going through a severe balance-of-payments crisis and a correspondingly painful adjustment. In recent months, the country’s macro dynamics have shown signs of stabilization. This has begun benefiting share prices in both absolute terms and relative to the EM equity benchmark. Today we are upgrading Pakistani stocks to overweight within an EM equity portfolio and recommend buying 5-year local currency government bonds. The worst is over for the economy and its financial markets for the following reasons. First, the country’s balance-of-payments position will improve. In real effective exchange rate (REER) terms, the Pakistani rupee has depreciated 15% over the past two years (Chart I-2). This will boost exports and cap imports, narrowing both trade and current account deficits further (Chart I-3).   Chart I-2Considerable Depreciation In Pakistani Rupee… Chart I-3…Will Boost Exports And Cap Imports We expect exports to grow 5-10% next year. The country’s competitiveness has improved considerably, with its top commodities exports all having shown impressive growth in volume terms, despite weakening global growth (Chart I-4). Besides, in order to boost exports, the government has reduced the cost of raw materials and semi-finished products used in exportable products by exempting them from all customs duties in fiscal 2020 (July 2019 – June 2020). The government has also promised to provide sales tax refunds to the export sector. Chart I-4Increasing Competitiveness In Pakistan Exports In addition, falling oil prices will help reduce the country’s import bill. Remittance inflows – currently equaling 9% of GDP – have become an extremely important source of financing for Pakistan’s trade deficit. In the past 12 months, remittances sent from overseas have risen to US$22 billion, and have covered most of the US$28 billion trade deficit.   Financial inflows are also likely to increase in 2020 and will be sufficient to finance the current account deficit. The IMF will disburse roughly US$2 billion to Pakistan. Other multilateral/bilateral lending/grants and planned issuance of Sukuk or Euro bonds will provide the government with much-needed foreign funding.  As the economy recovers, net foreign direct inflows are also likely to increase. Net foreign direct investment received by Pakistan has grown 24% year-on-year in the past six months, with 56% of the increase coming from China. Overall, the improvement in Pakistan’s balance-of-payments position will continue, resulting in a refill of the country’s foreign currency reserves. Odds are that the central bank will purchase foreign currency from the government as the latter gets foreign funding. This will provide the government with local currency to spend. At the same time, the central bank’s purchases of these foreign exchange inflows will boost the local currency money supply – a positive development for the economy and stock market. Chart I-5 shows that the Pakistani stock market closely correlates with swings in the nation’s narrow money growth. The Pakistani central bank will soon start a rate-cutting cycle as the exchange rate stabilizes. This is a typical recovery process following a balance-of-payments crisis and substantial currency devaluation. Chart I-5Pakistan: Ameliorating Balance-Of-Payments Position Will Benefit Stock Prices Chart I-6Pakistan: Improving Fiscal Balance Second, Pakistan’s fiscal balance also shows signs of improvement. Pakistan and the IMF have agreed to set the target for the overall budget and primary deficits at 7.2% of GDP and 0.6% of GDP, respectively, for the current fiscal year (Chart I-6). This will be a considerable improvement from the 8.9% of GDP and 3.3% of GDP, respectively, last fiscal year. In early November, the IMF praised Pakistan for having successfully managed to post a primary budget surplus of 0.9% of GDP during the first quarter (July 1, 2019 – September 30, 2019) of its current fiscal year. The authorities are determined to maintain strict fiscal discipline. The country’s tax-to-GDP ratio is at about 12%, one of the lowest in the world, so there is room to expand the tax base. Third, the Pakistani central bank will soon start a rate-cutting cycle as the exchange rate stabilizes. This is a typical recovery process following a balance-of-payments crisis and substantial currency devaluation. Both headline and core inflation seem to have peaked (Chart I-7). Headline inflation fell to 11% in October, which already lies within the central bank’s target range of 11-12% for the current fiscal year. The policy rate is currently 225 basis points higher than headline inflation. As inflation drops and the currency finds support, interest rates will be reduced to facilitate the economic recovery. In addition, there has been much less public debt monetization by the central bank. After borrowing Rs3.16 trillion from the central bank in the previous fiscal year, the federal government has curtailed such borrowing to only Rs122 billion in the first three months of this fiscal year. Diminishing debt monetization will also help ease domestic inflation. Chart I-7Inflation Has Peaked Chart I-8Manufacturing Activity Is Likely To Recover Soon Fourth, manufacturing activity in Pakistan has plunged to extremely low levels, comparable to the 2008 Great Recession (Chart I-8). With a more stabilized local currency, easing domestic inflation and interest rate reductions, Pakistan’s economic activity is set to recover soon from a very low base.  Finally, Phase II of the China-Pakistan Economic Corridor (CPEC) is set to begin this month. Under Phase II of the CPEC, five special economic zones will be established with Chinese industrial relocation. Phase II will also bring forward dividends from Phase I projects. The nation’s infrastructure facilities built by China over the past several years have enhanced the productive capacity of the Pakistani economy. The significant increase in electricity supply and improved railway/highway transportation will promote higher productivity/efficiency gains. Bottom Line: We are upgrading Pakistani equities to overweight within the emerging markets space. Both absolute and relative valuations of Pakistani stocks appear attractive (Charts I-9 and I-10). Chart I-9Pakistani Stocks: Valuations Are Attractive In Absolute Terms... Chart I-10…And Relative To EM Equities Meanwhile, we recommend going long Pakistani 5-year local currency government bonds currently yielding 11.5%, as we expect interest rates to drop quite a bit (Chart I-11).  Chart I-11Go Long Pakistani 5-Year Local Currency Government Bonds   Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Special Report

Highlights To answer that question, the GAA team asked BCA Research’s strategists for suggestions of recent books that helped their understanding of the world economy or of how to invest. Their suggestions include books on artificial intelligence, the information in Google searches, debt crises, the growing monopolization of the US economy, and the death of “liberal hegemony”. Some recommendations are more esoteric: a textbook on climate economics, a paper on the Lewis Turning-Point, and the history of Russia’s 1917 default. Feature “What’s the best thing you read recently?” was the rather sharp question we were asked by a client not long ago. BCA Research believes that one of its roles is to contribute to the intellectual debate on what drives the economy and investment markets…indeed, simply what makes the world tick. Part of that is sharing interesting books (or articles or academic papers) that deserve to be widely read and discussed. The client question set us thinking. Twice in recent years, ahead of the holiday season, Global Asset Allocation has published a list of its favorite investment-related books  that clients might read during down-time over the break.1 So this time we polled our senior colleagues at BCA Research on what they had read this year that most aided their understanding of the global economy or investment. We asked them to limit their choice to something published recently (say, in the past year or two). The 12 items they picked follow (in no particular order). Most are well-known books, published this year and favorably reviewed. But some are a little more obscure (the lessons from Russia’s default of 1917, for instance). Our strategists also identified a must-read university-level textbook (on climate economics) and a seminal Richard Koo conference paper on why there is a lack of borrowers globally. We are sure you will find much here for stimulating and entertaining reading during the holidays. Life 3.0: Being Human In The Age Of Artificial Intelligence By Max Tegmark The only thing special about human intelligence is that it is the minimum level necessary to create a technologically advanced society. What happens when artificial intelligence reaches human capabilities? At that point, there will be an intelligence explosion, argues Max Tegmark in his new book Life 3.0. AI will be smart enough to figure out how to make itself even smarter which, in turn, will allow it to make itself smarter still. Forget about a Star Trek future. AI will blow through that in the blink of an eye. Within days, or perhaps even hours, AI will be constrained only by the laws of physics. When will this day arrive? No one really knows, although Tegmark notes that the median estimate among AI researchers is somewhere around 2050. Not imminent, but still within the lifetime of most investors. What role will finance and economics play in this brave new world? Scarcity is the bedrock on which economics is built. Diamonds cost more than water not because water is less useful – life could not exist without it – but because diamonds are much more scarce than water. Will the cornucopia produced by superhuman AI render the market mechanism obsolete? It is possible. Even before that fateful day when AI surpasses human capabilities, advances in AI technologies will leave their mark on society. Workers who can harness AI to increase their productivity will benefit. Workers who are displaced by AI will suffer. The demand for redistributive policies will grow. Efforts to rein in companies that gain monopolistic control over AI technologies will intensify. More worrying, superintelligent AI may eventually render all humans – including the original creators of the AI – obsolete. Tegmark spends a lot of time discussing the difficulty in getting advanced AI to understand, adopt, and retain the goals that its human masters try to program into it. The risk is not of a “Terminator” style scenario. Rather, it is that superintelligent AI will end up treating humans with the same ambivalence we treat ants: You may not purposely try to step on an ant while you are walking in the woods, but if you do, well, tough luck for the ant. Failure to apply to AI research the sort of safety engineering that made the lunar landing possible could be humanity’s ultimate undoing. Peter Berezin Chief Global Strategist Narrative Economics: How Stories Go Viral And Drive Major Economic Events By Robert J. Shiller Shiller’s Narrative Economics is a book within the realm of behavioral economics, but it is distinct in its focus on how ideas that turn out to have significant economic influence begin, spread, and die (if they die!). Shiller metaphorically links the adoption of economic narratives to the spread of diseases, noting that both occur through interpersonal contact. A framework exists to model the latter, and Shiller argues that this is an excellent starting-point to understand the spread of ideas with important economic implications. Like most behavioral research to date, the book is foundational rather than definitive: it presents a helpful conceptual framework to think about the “transmission” of influential economic ideas but, after reading the book, investors will not walk away with any specific tools to predict when and how economic narratives will influence macroeconomic behavior or asset prices. Still, we liked the book because it gets the reader thinking about how to identify narratives. Investors have already seen several false narratives emerge this cycle: the hyperinflationary nature of quantitative easing, that low interest rates mean low inflation (neo-Fisherian economics), comparisons to 1938 at the onset of US monetary policy normalization, the inevitably of debt deflation in China, and the imminence of a US fiscal crisis are just a few examples. The mere practice of identifying narratives should increase the ability of investors to identify which narratives are more likely to be right or wrong, and we would challenge our clients to read Shiller’s book with the narrative of secular stagnation in mind. True or false? Jonathan LaBerge, CFA Vice President, Special Reports Everybody Lies: Big Data, New Data, And What The Internet Can Tell Us About Who We Really Are By Seth Stephens-Davidowitz Stephens-Davidowitz argues that people’s personal Google search history amounts to digital truth serum, the opposite of one’s carefully curated public social-media footprint. The book examines the new age of Big Data from a sociological lens, and offers vital insights about the pitfalls of this new discipline – data science – which is still in its infancy. The critical premise is that people’s primordial need to look good, and equally, avoid looking bad, drives their digital behavior. A person’s search history reveals their inner hopes, dreams, fears, and anxieties in the same way that their social media presence obscures them. In this way, Big Data can be harnessed to uncover unaddressed suffering, political bias, inequality of opportunity, and a host of other social trends that direct questioning and surveys never will. Anyone with an interest in understanding how Big Data is shaping our reaction function to the world around us will enjoy this book. The thesis of social desirability bias is a useful framework for tempering our expectations about what we can and cannot hope to achieve through data analysis across a spectrum of real-world and business applications. To the extent that data is the new oil, investors need to understand how it is collected, filtered, and broadcast, in order to have any hope of deciphering signals from noise, in markets and beyond. Caroline Miller Senior Vice President, Global Strategy A Crisis Of Beliefs: Investor Psychology And Financial Fragility By Nicola Gennaioli and Andrei Shleifer This book is partly a re-telling of the events leading up to the 2008 financial crisis, but from a much different perspective than other accounts of that period. To explain the crisis, Gennaioli and Shleifer present a model based on how people form expectations and on what can happen when those expectations are shown to be divorced from reality. We found that this model can be easily applied to the corporate credit cycle, the pattern where long periods of tightening corporate bond spreads and rising corporate debt are interrupted by short bursts of spread widening and a flurry of defaults. We even wrote a Special Report making just that connection.2 The model presented in this book should be in the back of every corporate bond investor’s mind. Because investor expectations are “extrapolative rather than rational”, corporate spreads can tighten dramatically if the recent past was trouble free. But this also means that spreads will eventually become divorced from economic reality. When that happens, even a seemingly minor event can lead to sharp spread widening and economic pain. As corporate bond investors, our chief goal should be to identify when investor expectations have deviated too far from reality, knowing that once that happens, a shock can occur at any time. Ryan Swift Vice President, US Bond Strategy The Great Delusion: Liberal Dreams And International Realities By John J. Mearsheimer The Great Delusion is a worthy attempt at making sense of the contemporary geopolitical context. John Mearsheimer – father of the offensive realism school of international relations theory – posits that “liberal hegemony”, the policy of remaking the world in America’s moral image, is bound to fail, is failing, and ought to be replaced by a more restrained policy that accepts the guardrails of geopolitics: realism and nationalism. Realist thought has been woven into the sinews of BCA’s Geopolitical Strategy since 2011. As such, we have no qualms with his discourse, but do find it unusual that he equates nationalism with realism. The latter is an a priori force compelling policymakers into the path of least resistance – and thus quite diagnostic – whereas the former is an ideology, much as the global liberalism that Mearsheimer largely criticizes as an ordering principle. This is not merely a pedantic concern. Mearsheimer is at his best when he uses realist theory to hack away at the normative and moralistic fat hanging onto the red meat of analysis. He did so at the turn of the millennium when he correctly predicted that China and the US would eventually clash, that their enmity was inevitable. His Tragedy of Great Power Politics therefore remains one of our favorite geopolitical reads. However, whenever he treats nationalism as a tool of analysis, he is thrown off the scent. In that same classic he predicted that the European Union would collapse, thrown asunder by the forces of nationalism. That forecast has not proven correct. As long as the reader keeps this track record in mind, and separates the analytical tool (realism) from a normative one (nationalism), The Great Delusion will be a fantastic read. Marko Papic Consulting Editor, BCA Research Chief Strategist, Clocktower Group Bankers And Bolsheviks: International Finance And The Russian Revolution By Hassan Malik Financial historian Hassan Malik takes us back to the first era of unchecked globalization, the late 19th century. At the time, Russia was not just a major geopolitical power, but also an investment thesis that inspired many to plunge their wealth into its frozen tundra in the search of the “next industrialization” story.  What followed was one of the greatest sovereign defaults in history. Investors ignored the obvious signs of geopolitical and political risk, focusing instead on linear extrapolation of returns from similar narratives of industrialization. Given that the 1917 revolution was preceded by several major political crises, including a disastrous war in 1904-1906 and a revolution in 1905, the episode is a great warning sign to investors and illustrates the folly of a blind search for investment returns.  Malik argues that the 1917 default caused by the Bolshevik Revolution was the greatest default in history. Why is the ranking important? Because Russia in 1917 was not a peripheral economy – as Greece in 2012 and Argentina in 2002 were. It was a major economy at the center of an ever-more globalizing world economy. Malik implicitly criticizes the work of Carmen Reinhart and Kenneth Rogoff – which sits on the far end of the social science spectrum – whose This Time Is Different is built upon a dataset of cases in countries that few investors could locate on a globe (although the 1876 Guatemala default episode is a riveting read!). The point Malik makes is that it is better to spend a lot of time on a critical case than to draw broad conclusions from a bevy of irrelevant ones. Marko Papic Consulting Editor, BCA Research Chief Strategist, Clocktower Group Climate Economics: Economic Analysis Of Climate, Climate Change And Climate Policy By Richard S.J. Tol Richard Tol’s book provides the necessary background for investors who wish to integrate climate-change economics into their investment process. Tol teaches Climate Change and Environmental Economics at the University of Sussex. This is an unusual book to make it to our list as it is written in a textbook format. In fact, the book is used for teaching advanced undergraduate and graduate level courses. Be that as it may, it is an excellent introduction to the economics of climate change. Climate change – and especially climate economics – is a complex and evolving field. Tol’s presentation of the core science of climate change is one of the clearest and most balanced we’ve read. It mostly uses data from the IPCC and gives a condensed – only 230 pages – and clear rundown of the projected impact of climate change and the degree of uncertainty around it as supported by present research. Building on this scientific consensus and the neoclassical approach to climate economics, the author applies various theoretical frameworks to assess the uncertainty around the climate impact on the economy, determine the optimal policy prescriptions, and to understand the interaction between adaptation and mitigation policies, and the limitations of international agreements. Some of Tol’s conclusions about climate impacts are controversial and debatable – and are even more so in his academic work for which he is occasionally considered a "climate skeptic" or "lukewarmer." Notably, the book’s final chapter concludes that the impact of climate change will be only slightly negative, and that it is easily manageable with a modest carbon tax. Tol’s controversial opinions are secondary to the sound analysis of climate-change economics he provides. For investors, we believe the prudent course of action for portfolio construction is to consider the scientific consensus developing around climate change – and the impact it will have on policymakers – and to hedge or invest appropriately. Hugo Belanger Senior Analyst, Climate Change Special Project Team Principles For Navigating Big Debt Crises By Ray Dalio Low interest rates, central bank intervention and increasingly profligate governments continue to propel debt levels around the world to record highs. Rightly, investors have grown concerned about the looming threat that a major debt crisis poses to financial markets. But how do we spot when such a crisis will come? How it could play out? How will different assets react? Dalio attempts to answer these questions through the three parts of his book: In Part I, Dalio provides his framework for thinking about both inflationary and deflationary crises. Specifically, he describes the early warning signs of a debt bubble, how each type of crisis typically plays out, and the scenarios that result from different policy responses. Part II is a detailed account of the three most significant debt crises of the past century: the hyperinflationary crisis in Germany during the 1920s; the 1930s' Great Depression; and the 2008 Housing Crisis. Part III consists of shorter accounts of 48 debt crises from different countries around the world. While the book is an exceptional compendium of financial history, its real value comes not from its descriptions of what happened but rather from its analysis of why. Dalio uses his case studies to explain the different economic, financial, and political mechanisms at work during a debt crisis, elevating the book from a history lesson to a roadmap that investors can use to understand and navigate debt crises in the future. Juan Manuel Correa Ossa Senior Analyst, Global Asset Allocation The Other Half Of Macroeconomics And Three stages Of Economic Development By Richard C. Koo Paper by Richard C. Koo written as part of World Economics Association Conferences, 2016: Capital Accumulation, Production and Employment: Can We Bend The Arc of Global Capital Toward Justice. In this paper, Dr. Koo presents his customary case that the problem ailing advanced economies today is a lack of borrowers, not a paucity of lenders. What makes this paper different is its emphasis on the cause of this absence of borrowers. It is because of the limited investment opportunities offered by advanced economies. To understand how we got to this point, Dr. Koo introduces the concept of the Lewis Turning-Point (LTP). This is the point of economic development where all the surplus labor (mostly former farm workers) has been absorbed by urban factories. Before the LTP has been reached, real wages are stagnant, inequalities are rife and consumption growth is limited. Post the LTP, workers have stronger bargaining power; as a result real wages boom, inequality declines, and consumption growth strengthens. Moreover, because consumption is strong and labor costs are rising, companies continue to invest to service growing domestic demand and to shift much of their production function toward capital, which raises productivity. The economy thus enters a golden age, similar to the one advanced economies experienced in the post-World War Two era until the late 1970s. Dr. Koo’s key insight is that with globalization and the entry into the global supply chains of emerging markets in general and China in particular, the world has moved back to a pre-LTP environment. As a result, wages are again stagnating, inequalities are rising, productivity is declining, and growth in advanced economies is anemic. As a corollary, investment opportunities become scarcer, which is why borrowers are lacking and interest rates are low. Dr. Koo argues that solving this problem is essential, otherwise democracy will suffer, populism will rise, and so will protectionism. He advocates for advanced economies to do more to stay at the leading edge of the technological frontier in order to create opportunities for growth and insulate labor from EM competition. This requires tax and regulatory reforms and investments in human capital. Mathieu Savary Vice President, The Bank Credit Analyst Identity: The Demand For Dignity And The Politics Of Resentment By Francis Fukuyama Francis Fukuyama’s Identity is an important book, coming as it does at a time when many institutions underpinning liberal societies are being challenged by the revival of nationalism defined by race, ethnicity, and religion.  This comes in the wake of sundry crises that have steadily eroded economic prospects of the middle class in numerous states – globalization, automation, immigration, financial crises, and polarization of incomes.  As jobs are lost, dignity and respect are lost.  This undermines democratic institutions, and paves the way for nationalism to fill the void. At the individual level, Fukuyama notes, “The nationalist can translate loss of relative economic position into loss of identity and status: you have always been a core member of our great nation, but foreigners, immigrants, and your own elite compatriots have been conspiring to hold you down; your country is no longer your own, and you are not respected in your own land.”  States crave respect and recognition as well.  “A host of new populist nationalist leaders claiming democratic legitimacy via elections have emphasized national sovereignty and national traditions in the interest of ‘the people,’” Fukuyama notes.  Fukuyama is at pains to stress a strong national identity is not necessarily evil.  Indeed it is necessary to reverse the trend toward nationalism in its more toxic forms.  Strong national identities promote security – larger states unified by common beliefs are able to marshal the resources necessary to govern and defend themselves.  Strong national identities allow democracy to thrive, under an implied contract between citizens and governments.  These functions and roles cannot be contracted out to international organizations, as Fukuyama observes: “The functioning of democratic institutions depends on shared norms, perspectives, and ultimately culture, all of which can exist on the level of a national state, but which do not exist internationally.” Rebuilding and sustaining democracies in an age of global, instantaneous communication – which can contribute to toxic nationalism, polarization and radicalization – remains the critical work of civilized society.  “We need to remember that the identities dwelling deep inside us are neither fixed nor necessarily given to us by our accidents of birth,” Fukuyama concludes.  “Identity can be used to divide, but it can and has also been used to integrate.  That in the end will be the remedy for the populist politics of the present.” Robert P. Ryan Chief Commodity & Energy Strategist Crashed: How A Decade Of Financial Crises Changed The World By Adam Tooze In 2007, former Federal Reserve Chairman Alan Greenspan said, “Thanks to globalization, policy decisions in the US have been largely replaced by global market forces. National security aside, it hardly makes any difference who will be the next president. The world is governed by market forces.” Historian Adam Tooze’s Crashed is a lengthy but highly readable attempt to show the folly of this statement – not cheaply to bash Greenspan, but rather to chronicle the monumental failure of the western political-economic consensus prior to the crisis and capture the magnitude of the shock that has transformed the world since. The chief value of the book for investors is that it refreshes one’s memory and understanding of the Great Recession and its aftermath within a global, rather than merely American, context. The author never loses sight of the truth that the underlying political and economic crisis is still unfolding. Events fall in their proper sequence, are weighed by the author with respect to their long-term consequences, and are placed into a larger puzzle that points to the “shape of things to come.” While many investors will feel they do not need another review of the causes and consequences of the Global Financial Crisis, the latter chapters are useful for providing an authoritative history of the post-crisis period – the latter stages of the European turmoil, the normalization of Fed policy, Brexit, and the rise of Donald Trump. We recommend the book. It is difficult to find “authoritative histories” that are not plodding. Tooze maintains a comfortable stride throughout. His tone can be a little inflated at times but he avoids academic pretensions in treating the most significant events and controversies. Our chief critique is that he is overly indulgent toward politicians in the emerging world, emphasizing their criticisms of western-led globalization to the neglect of their own corrupt mismanagement at home. Nowhere is this more apparent than in his treatment of the Chinese government. Nevertheless he generally rises to the occasion as a historian, maintaining a measured posture and casting a critical eye all around.  Matt Gertken Vice President, Geopolitical Strategist The Myth Of Capitalism: Monopolies And The Death Of Competition By Jonathan Tepper, with Denise Hearn The US economy has become increasingly concentrated over the past 30 years. Just two companies comprise 90% of beer sales, five banks control over half of banking assets, Delta Airlines has an 80% market share in Atlanta, 79% of households have access to only one high-speed internet provider, and even the funeral industry is an oligopoly. The result of this concentration, Tepper argues, has been higher prices, fewer start-ups, lower productivity, lower wages, higher income inequality, less investment, and a decline in localism and diversity. “Capitalism without competition is not capitalism,” he argues. Tepper dates the trend back to the 1970s and Judge Robert Bork’s attacks on anti-trust. Bork argued that high market share by one firm was probably due to economies of scale and greater efficiency; the only thing that mattered was “consumer welfare”, i.e. lower prices. Bork’s arguments were very influential with the Reagan administration and led to fewer mergers being blocked by the Department of Justice over subsequent decades. Tepper’s solutions to excess concentration include new anti-trust laws, tougher merger enforcement based on clear rules (for example, any industry should have six or more players), new laws on predatory pricing, a shorter time-limit on patents and copyrights, a limit to share buybacks – and even a ban on horizontal shareholdings (no shareholder should be able to buy more than 5% of shares in competitors in the same industry). This is an important book, with vigorous writing, good data, and detailed examples of distorting competition. But it is also rather polemical and over-written. While Tepper’s aim is to improve capitalism not replace it, some of his proposals on reregulation and his anti-business rhetoric will put off many readers. He is also weak on the legal framework of anti-trust regulation, and barely covers the situation outside the US (does Europe’s tougher competition policy work better?). Readers looking for a more sober and nuanced (but also less readable) treatment might prefer The Great Reversal: How America Gave Up On Free Markets by Thomas Philippon. Garry Evans Chief Global Asset Allocation Strategist Footnotes 1    Please see GAA Special Reports, “The Books Every CIO Should Read”, dated 7 December 2017, and “Investment Books Of The Year”, dated 12 December 2016, available at gaa.bcaresearch.com 2   Please see US Bond Strategy Special Report, “The Risk From US Corporate Debt: Theory And Evidence”, dated April 23, 2019, available at usbs.bcaresearch.com