Geopolitics
Highlights The political path of least resistance leads to fiscal profligacy - in the U.S. and beyond. The response to populism is underway. The U.S. midterm election is market-relevant. Gridlock between the White House and Congress does, in fact, weigh on equity returns, after controlling for macro variables. The Democratic Party's chances of taking over Congress have fallen, but remain 50% in the House of Representatives. A divided House and Senate is the worst combination for equities, but macro factors matter most. China is clearly rebooting its "reform" agenda as Xi Jinping becomes an irresistible force. We remain long H-shares relative to EM, for now. Emerging markets - including an improved South Africa - will suffer as politics become a tailwind for U.S. growth and a headwind for Chinese growth. Feature The bond market has been shocked into action this month by the twin realizations that the Republican-held Congress is not as incompetent as believed and that the Republican Party is not as fiscally conservative as professed. When combined with steady U.S. wage growth and rising inflation expectations (Chart 1), our core 2018 theme - that U.S. politics would act as an accelerant to growth - has been priced in by the bond market with impressive urgency.1 The tax cuts alone were not enough to wake the bond market. First, the realization that a tax cut would pass Congress struck markets in late October, when it became increasingly clear that the $1.5 trillion Tax Cuts And Jobs Act would indeed pass the Senate. Second, the bill's passage along strict party lines - including the slimmest of margins in the Senate thanks to reconciliation rules - convinced investors that there would be no further compromises down the pipeline. The real game changer was the realization that the political path of least resistance leads towards profligacy. This happened with the signing into law of the February 9 two-year budget compromise (the Bipartisan Budget Act of 2018) that will see fiscal spending raised by around $380 billion.2 The deal failed to gain the support of a majority of Republicans in the House, despite House Speaker Paul Ryan's support, but 73 Democrats crossed the aisle to ensure its passage. They did so despite a lack of formal assurances that the House would consider an immigration bill. The three-day shutdown in late January has forced Democrats, who largely took the blame, to assess whether they care more about preserving their liberal credentials on fiscal policy or immigration policy. The two-year budget agreement is a testament to their concern for the former. The deal will see the budget deficit most likely rise to about 5.5% of GDP in FY2019, up from 3.3% in last year's CBO baseline forecast (Chart 2). Chart 1Rising U.S. Inflation Expectations Chart 2Fiscal Policy Gets Expansive Adding to the newly authorized fiscal spending could be a congressional rule-change that reintroduces earmarks - leading to a potential $20 billion additional spending per year. There is also a 10-year infrastructure plan that could see spending increase by another ~$200 billion over the next decade. The new budget compromise, combined with last year's tax cuts, will massively increase U.S. fiscal thrust beyond the IMF's baseline (Chart 3). The IMF's forecast, done before the tax cuts were passed, suggested that fiscal thrust would contract by about 0.5% of GDP this year, and would only slightly expand in 2019. Now we estimate that fiscal thrust will be a positive 0.8% of GDP in 2018 and 1.3% in 2019. These figures are tentative because it is not clear exactly how much of the spending will take place this year versus 2019 and 2020. Our colleague Mark McClellan, author of BCA's flagship The Bank Credit Analyst, has stressed that the impact on GDP growth will be less than these figures suggest because the economic multipliers related to tax cuts are less than those for spending.3 Our theme that the political path of least resistance will lead to profligacy is not exclusive to the U.S. After all, populism is not exclusive to the U.S, with non-centrist parties consistently capturing around 16% of the electoral vote in Europe (Chart 4). Chart 3The Budget Deal And Tax Cuts##br## Will Expand U.S. Fiscal Thrust Chart 4Populism Will Fuel Fiscal##br##Spending Beyond The U.S. Policymakers are not price-setters in the political marketplace, but price-takers. The price-setter is the median voter, who we believe has swung to the left when it comes to economic policy in developed markets after a multi-year, low-growth, economic recovery.4 Broadly speaking, investors should prepare for higher fiscal spending globally on the back of this dynamic. Aside from the U.S., the populist dynamic is evident in the world's third (Japan), fourth (Germany), and sixth (the U.K.) largest economies. Japan may have started it all, as a political paradigm shift in 2011-12 spurred a historic reflationary effort.5 Geopolitical pressure from China and domestic political pressures on the back of an extraordinary rise in income inequality, and natural and national disasters, combined to create the political context that made Abenomics possible. While the fiscal arrow has somewhat disappointed - particularly when PM Shinzo Abe authorized the 2014 increase in the consumption tax - Japan has still surprised to the upside on fiscal thrust (Chart 5). On average, the IMF has underestimated Japan's fiscal impulse by 0.84% since the beginning of 2012. Investors often understate the ability of centrist, establishment policymakers to rebrand anti-establishment policies - whether on fiscal spending or immigration - as their own. In January 2015, we asked whether "Abenomics Is The Future?"6 We concluded that rising populism in Europe would require a policy response not unlike the policy mix favored by Tokyo. Today, the details of the latest German coalition deal between the formally fiscally conservative Christian Democratic Union (CDU) and the center-left Social Democratic Party (SDP) means that even Germany has now succumbed to the political pressure to reflate. The CDU has agreed to fork over the influential ministry of finance to the profligate SPD and apparently spend an additional 46 billion euros, over the duration of the Grand Coalition, on public investment and tax cuts. Finally, in the U.K., the end of austerity came quickly on the heels of the Brexit referendum, the ultimate populist shot-across-the-bow. The new Chancellor of the Exchequer, Philip Hammond, announced a shift away from austerity almost immediately, scrapping targets for balancing the budget by the end of the decade. The change in rhetoric has carried over to the new government, especially after the Labour Party pummeled the Tories on austerity in the lead up to the June 2017 election. The bond market action over the past several weeks suggests that investors have not fully appreciated the political shifts underway over the past several years. Bond yields had to "catch up" to the political reality essentially over the course of February. However, the structural upward trajectory is now in place. The end of stimulative monetary policy will accelerate the rise in bond yields. Quantitative easing programs have soaked up more than the net government issuance of the major economies. Chart 6 shows that the flow of the major economies' government bonds available for the private sector to purchase was negative from 2015-2017. This flow will now swing to the positive side as fiscal spending necessitates greater issuance and as central banks withdraw demand. Real interest rates may therefore be higher to the extent that government bonds will have to compete with private-sector issuance for available savings. Chart 5Japan's Abenomics Leads The Way To More Spending Chart 6Lots Of Bonds Hitting The Private Market Bottom Line: The U.S. electorate chose the populist, anti-establishment Donald Trump as president with unemployment at a multi-decade low of 4.6%. The message from the U.S. election, and the rise of anti-establishment parties in Europe, is that the electorate is restless, even with the post-Great Financial Crisis recovery now in its ninth year. Policymakers have heard the message, loud and clear, and are adjusting fiscal policy accordingly. Over the course of the next quarter, BCA's Global Investment Strategy expects the rapid rise in bond yields to peter out, but investors should use any bond rallies as an opportunity to reduce duration risk. BCA's House View calls for the 10-year Treasury yield to finish the year at about 3.25%.7 Our U.S. bond strategists expect the end-of-cycle level of the nominal 10-year Treasury yield to be between 3.3% and 3.5%.8 Does The U.S. Midterm Election Matter? The three-day government shutdown that ended on January 22 has hurt the chances of the Democratic Party in the upcoming midterm election. The Democrats' lead in the generic congressional ballot has gone from a high of 13% at the end of 2017 to just 9% today (Chart 7). As Chart 8 illustrates, this generic ballot has some predictive quality. However, it also suggests that for Democrats, the lead needs to be considerably larger than for Republicans to generate the type of seat-swing needed to win a majority in the House of Representatives in 2018. Chart 7Democrats Have Lost Some Steam Chart 8Democrats Need Big Polling Lead To Win Majority There are three reasons for this built-in advantage for the Republican Party in recent midterm elections. First, the Republicans dominate the rural vote, which tends to be overrepresented in any electoral system that draws electoral districts geographically. Second, redistricting - or gerrymandering - has tended to favor the Republican Party in the past several elections. While the Supreme Court has recently struck down some of the most egregiously drawn electoral districts, the overall impact of gerrymandering since 2010 overwhelmingly favors the GOP. Third, midterm elections tend to have a lot lower voter turnout than general elections, which hurts the Democrats who rely on the youth and minority vote. Both constituencies tend to shy away from participation in the midterm election. Does the market care who wins the House and Senate? On the margin, yes. If the current GOP control of the White House, House of Representatives, and Senate were to be broken, markets might react negatively. It is often stated that gridlock has a positive effect on stock prices, as it reduces the probability of harmful government involvement in the economy and financial markets. However, research by our colleague Jonathan LaBerge, which we have recently updated, suggests otherwise. After controlling for the macro environment, gridlock between the White House and Congress is actually associated with modestly lower equity market returns.9 This conclusion is based on the past century of data. For most of that period, polarization has steadily risen to today's record-setting levels (Chart 9). As such, the negative impact of gridlock could be higher today. Table 1 illustrates the impact of four factors on monthly S&P 500 price returns. The first two columns demonstrate the effect on returns of recessions and tightening monetary policy, respectively, whereas the last two columns measure the effects of executive/legislative disunity and reduced uncertainty in the 12-months following presidential and midterm elections.10 The table presents the beta of a simple regression based on dummy variables for each of the four components (t-statistics are shown in parentheses). Chart 9U.S. Polarization Has Risen For 60 Years Table 1Divided Government Is, In Fact, Bad For Stocks As expected, the macro context has a much larger impact on stock returns than politically driven effects. The impact of political gridlock is shown to be negative regardless of timeframe. The takeaway for equity investors is that, contrary to popular belief, political gridlock is not positive for stock prices after controlling for important macro factors. Absolute results are similarly negative, with the average monthly S&P 500 returns considerably larger during periods of unified executive and legislative branches (Chart 10). Intriguingly, the less negative constellation of forces is when the president faces a unified Congress ruled by the opposing party. We would reason that such periods force the president to compromise with the legislature, which constitutionally has a lot of authority over domestic policy. The worst outcome for equity markets, by far, is when the president faces a split legislature. In these cases, we suspect that uncertainty rises as neither party has to take responsibility for negative policy outcomes, making them more likely. Chart 10A Unified Congress Is A Boon For Stocks In the current context, gridlock could lead to greater political volatility. For example, a Democratic House of Representatives would begin several investigations into the Trump White House and could potentially initiate impeachment proceedings against the president. But as we pointed out last year, impeachment alone is no reason to sell stocks.11 The Democrats would not have the ability to alter President Trump's deregulatory trajectory - which remains under the purview of the executive - nor would they be likely to gain enough seats to repeal the tax cut legislation. Yet given President Trump's populist bias, center-left Democrats could find much in common with the president on spending. This would only reinforce our adage that the political path of least resistance will tend towards profligacy. The only thing that President Trump and the Democrats in Congress will find in common, in other words, will be to blow out the U.S. budget deficit. Bottom Line: The chances of a Democratic takeover following the midterm elections have fallen, but remain at 50% for the House of Representatives. A gridlocked Congress is mildly negative for equity markets, taking into consideration that macro variables still dominate. Nonetheless, investors should ignore the likely higher political volatility and focus on the fact that President Trump and the Democrats are not that far apart when it comes to spending. China: The Reform Reboot Is Here And It Is Still Winter He told us not to believe the people who say it's spring in China again. It's still winter. - Anonymous Chinese government official referring to Liu He, the top economic adviser.12 The one risk to the BCA House View of a structural bond bear market - at least in the near term - is a peaking of global growth and a slowdown in emerging markets. The EM economies, which normally magnify booms in advanced economies, particularly in latter stages of the economic cycle, are currently experiencing a relative contraction in their PMIs (Chart 11). BCA Foreign Exchange Strategy's "carry canary" indicator - which shows that EM/JPY carry trades tend to lead global industrial activity - is similarly flashing warning signs (Chart 12).13 Chart 11EM Economies Underperforming Chart 12Yen Carry Trades Signal Distress At the heart of the divergence in growth between EM and DM is China. Beijing has been tightening monetary conditions as part of overall structural reform efforts, causing a sharp deceleration in the Li Keqiang index (Chart 13). In addition, the orders-to-inventories ratio has begun to contract, import volumes are weak, and export price growth is slowing sharply (Chart 14). Chart 13Li Keqiang Index Surprises Downward Chart 14China's Economy Weakens... The Chinese slowdown is fundamentally driven by politics. Last April we introduced a checklist for determining whether Chinese President Xi Jinping would "reboot" his reform agenda during his second term in office. We define "reform" as policies that accelerate the transition of China's growth model away from investment-driven, resource-intensive growth. Since then, political and economic events have supported our thesis. Most recently, interbank lending rates have spiked due to China's new macro-prudential regulations and monetary policy (Chart 15), and January's total credit growth clocked in at an uninspiring 11.2% (Chart 16). Tight credit control in the first calendar month typically implies that credit expansion will be limited for the rest of the year (Chart 17). A strong grip on money and credit growth is entirely in keeping with the three-year "battle" that Xi Jinping has declared against systemic financial risk.14 Chart 15...While Policy Drives Up Interbank Rates Chart 16January Credit Growth Disappoints... Chart 17... And January Credit Is The Biggest In short, we have just crossed the 50% threshold on our checklist, confirming that China is indeed rebooting its reform agenda (Table 2). Going forward, what matters is the intensity and duration of the reform push. Three events at the start of the Chinese New Year suggest that the market will be surprised by both. Table 2How Do We Know China Is Reforming? First, the National People's Congress (NPC), which convenes March 5, is reportedly planning to remove term limits for the president and vice-president, thus enabling Xi Jinping to remain as president well beyond March 2023. Xi was already set up to be the most powerful man in China's politics through the 2020s,15 so we do not consider this a material change in circumstances: the material change occurred last October when "Xi Thought" received the status of "Mao Zedong Thought" in the Communist Party's constitution and reshaped the Politburo to his liking. The point is that Xi's position is irresistible which means that his policies will have greater, not lesser, effectiveness as party and state bureaucrats scramble to enact them faithfully.16 Chart 18Crackdown On Shadow Lending Has Teeth Second, the Communist Party is reportedly convening its "Third Plenum" half a year early this year - that is, in late February and early March, just before the annual legislative meeting that begins March 5. This is a symbolic move. The third plenum is known as the "reform plenum," and this year is the fortieth anniversary of the 1978 third plenum that launched China's market reform and opening up to the global economy under Deng Xiaoping. However, the last time China convened a third plenum - in 2013 when Xi first announced his agenda - the excitement fizzled as implementation proved to be slow.17 As we have repeatedly warned clients, China's political environment has changed dramatically since 2013: the constraints to painful structural reforms have fallen.18 If the third plenum is indeed held early, some key decisions on reform initiatives will be made as we go to press, and any that require legislative approval will receive it instantly when the National People's Congress convenes on March 5.19 This will be a "double punch" that will supercharge the reform agenda this year. It is precisely the kind of ambition that we have been expecting. Third, one of the most important administrative vehicles of this new reform push, the Financial Stability and Development Commission (FSDC), has just made its first serious move.20 On February 23, China's top insurance regulator announced that it is taking control of Anbang Insurance Group for one year, possibly two, in order to restructure it amid insolvency and systemic risks. Anbang's troubles are idiosyncratic and have received ample media attention since June 2017.21 Nevertheless, China's government has just seized a company with assets over $300bn. Clearly the crackdown on the shadow financial sector has teeth (Chart 18). Anbang's case will reverberate beyond the handful of private companies involved in shadow banking and highly leveraged foreign acquisitions abroad. Beijing's focus is systemic risk, not merely innovative insurance products. The central government is scrutinizing state-owned enterprises (SOEs) and local governments as well as a range of financial companies and products. We provide a list of reform initiatives in Table 3. Table 3China Is Rebooting Economic Reforms What is the cumulative effect of these three developments? Basically, they raise the stakes for Xi's policies dramatically this year. If Xi makes himself president for life, and yet this year's third plenum is as over-hyped and under-delivered as in 2013, then we would expect China's economic future to darken rapidly. China will lose any pretext of reform just as the United States goes on the offensive against Beijing's mercantilism. It would be time to short China on a long-term time line. However, it would also spell doom for our positive U.S. dollar outlook and bearish EM view. If, on the other hand, Xi Jinping couples his power grab with renewed efforts to restructure China's economy and improve market access for foreigners, then he has a chance of deleveraging, improving China's productivity, and managing tensions with the U.S. This is the best outcome for investors, although it would still be negative for Chinese growth and imports, and hence EM assets, this year. The next political indicator to watch is the March 5 NPC session. This legislative meeting will be critical in determining what precise reforms the Xi administration will prioritize this year. The NPC occurs annually but is more important this year than usual because it installs a new government for the 2018-23 period and will kick off the new agenda. In terms of personnel, there is much speculation (Table 4).22 Investors should stay focused on the big picture: four months ago, the news media focused on Xi Jinping's Maoist thirst for power and declared that all reform efforts were dead in the water. Now the press is filled with speculation about which key reformer will get which key economic/financial position. The big picture is that Xi is using his Mao-like authority in the Communist Party to rein in the country's economic and financial imbalances. His new economic team will have to establish their credibility this year by remaining firm when the market and vested interests push back, which means more policy-induced volatility should be expected. Table 4China's New Government Takes Shape At National People's Congress The risk is that Beijing overcorrects, not that reforms languish like they did in 2015-16. Our subjective probability of a policy mistake remains at 30%, but we expect that the market will start to price in this higher probability of risk as the March political events unfold. As Liu He declared at Davos, China's reforms this year will "exceed the international community's expectations."23 The anti-corruption campaign is another important factor to monitor. In addition to any major economic legislation, the most important law that the NPC may pass is one that would create a new nationwide National Supervisory Commission, which will expand the Communist Party's anti-corruption campaign into every level of the state bureaucracy. In other words, an anti-corruption component is sharpening the policy effectiveness of the economic and financial agenda. In the aforementioned Anbang case, for instance, corporate chief Wu Xiaohui was stung by a corruption probe in June 2017 and is being tried for "economic crimes" - now his company and its counterparty risks are being restructured. The combination of anti-corruption campaign and regulatory crackdown has the potential to cause significant risk aversion among financial institutions, SOEs, and local governments. Add in the ongoing pollution curbs, and any significant SOE restructuring, and Chinese policy becomes a clear source of volatility and economic policy uncertainty this year that the market is not, as yet, pricing (Chart 19). On cue, perhaps in anticipation of rising domestic volatility, China has stopped updating its home-grown version of the VIX (Chart 20). Chart 19Market Expects No Political Volatility Yet Chart 20Has China Halted Its Version Of The VIX? We would not expect anything more than a whiff, at best, of policy easing at the NPC this March. For instance, poverty alleviation efforts will require some fiscal spending. But even then, the point of fiscal spending will be to offset credit tightness, not to stimulate the economy in any remarkable way. Monetary policy may not get much tighter from here, as inflation is rolling over amid the slowdown (Chart 21),24 but anything suggesting a substantial shift back to easy policy would be contrary to our view. More accommodative policy at this point in time would suggest that Xi has no real intention of fighting systemic risk and - further - that global growth faces no significant impediment from China this year. In such a scenario, the dollar could fall further and EM would outperform. We expect the contrary. We are long DXY and short EUR/JPY. We remain overweight Chinese H-shares within emerging markets, but we will close this trade if we suspect either that reform is a fig leaf or that authorities have moved into overcorrection territory. Otherwise, reform is a good thing for Chinese firms relative to EM counterparts that have come to rely on China's longstanding commodity- and capital-intensive growth model (Chart 22). Chart 21Monetary Policy May Not Tighten From Here Chart 22Tighter-Fisted China Will Hit EM Bottom Line: Xi Jinping has rebooted China's economic reforms. The new government being assembled is likely to intensify the crackdown on systemic financial risk. Reforms will surprise to the upside, which means that Chinese growth is likely to surprise to the downside amidst the current slowdown, thus weighing on global growth at a time when populism provides a tailwind to U.S. growth. What It All Means For South Africa And Emerging Markets We spent a full week in South Africa last June and came back with these thoughts about the country's economy and the markets:25 The main driving force behind EM risk assets, year-to-date, has been U.S. TIPS yields and the greenback (Chart 23). Weak inflation data and policy disappointments as the pro-growth, populist, economic policy of the Trump Administration stalled have supported the ongoing EM carry trade. The actual emerging market growth fundamentals and politics are therefore unimportant. Chart 23Weak Inflation And Dollar Drove EM Assets Chart 24Market Likes Ramaphosa, Unlike Zuma In the near term, South African politics obviously do matter. Markets have cheered the election of Cyril Ramaphosa to the presidency of the African National Congress (ANC), a stark contrast to the market reaction following his predecessor's ascendancy to the same position (Chart 24). However, the now President Ramaphosa's defeat of ex-President Jacob Zuma's former cabinet minister and ex-wife, Nkosazana Dlamini-Zuma was narrow and has split the ANC down the middle. On one side is Ramaphosa's pragmatic wing, on the other is Dlamini-Zuma's side, focused on racial inequality and social justice. Chart 25Chronic Youth Unemployment Chart 26Few Gains In Middle Class Population For now, the ANC bureaucracy has served as an important circuit-breaker that will limit electoral choices in the 2019 election to the pro-market Ramaphosa, centrist Democratic Alliance, and radical Economic Freedom Fighters. From investors' perspective, this is a good thing. After all, it is clear that if the South African median voter had her way, she would probably not vote for Ramaphosa, given that the country is facing chronic unemployment (Chart 25), endemic corruption, poor healthcare infrastructure, and a desire for aggressive, and targeted, redistributive economic policies. South Africa stands alone amongst its EM peers when it comes to its tepid rise in the middle class as a percent of the population (Chart 26) and persistently high income inequality (Chart 27). We see no evidence that the electorate will welcome pro-market structural reforms. Chart 27Inequality Remains Very High Nonetheless, Ramaphosa's presidency is a positive given the recent deterioration of South Africa's governance, which should improve as the new regime focuses on fighting corruption and restructuring SOEs. Whether Ramaphosa will similarly have the maneuvering room to correct the country's endemically low productivity (Chart 28) and still large twin deficits (Chart 29) is another question altogether. Chart 28A Distant Laggard In Productivity Chart 29Twin Deficits A Structural Weakness Will investors have time to find out the answer to those latter questions? Not if our core thesis for this year - that politics is a tailwind to U.S. growth and a headwind to Chinese growth - is right. In an environment where the U.S. 10-year Treasury yield is rising, DXY stabilizes, and Chinese economy slows down, commodities and thus South African assets will come under pressure. As our colleague Arthur Budaghyan, BCA's chief EM strategist, recently put it: positive political developments are magnified amid a benign external backdrop. Conversely, in a negative external environment, positive political transformations can have limited impact on the direction of financial markets. Bottom Line: Markets are cheering Ramaphosa's ascendancy to the South African presidency. We agree that the development is, all other things being equal, bullish for South Africa's economy and assets. However, the structural challenges are vast and we do not see enough political unity in the ANC to resolve them. Furthermore, we are not sure that the global macro environment will remain sanguine for long enough to give policymakers the time for preemptive structural reforms. To reflect the potential for a positive political change and forthcoming orthodox macro policies, we are closing our recommendation to bet on yield curve steepening in South Africa, which has been flat since initiation on June 28, 2017. However, we will maintain our recommendation to buy South African 5-year CDS protection and sell Russian, even though it has returned a loss of 17.08 bps thus far. We expect that Russia will prove to be a low-beta EM play in the next downturn, whereas South Africa will not be so lucky. On a different note, we are booking gains of 2525bps on our short Venezeulan vs. EM 10-yr sovereign bonds, as our commodity team upgrades its oil-price forecast for this year. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 2 Please see the Congressional Budget Office, "Bipartisan Budget Act of 2018," February 8, 2018, available at www.cbo.gov. 3 Please see BCA The Bank Credit Analyst Monthly Report, "March 2018," dated February 22, 2018, available at bca.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Monthly Report, "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "Japan's Political Paradigm Shift: Investment Implications," dated December 21, 2012, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Monthly Report, "Is Abenomics The Future?" dated February 11, 2015, available at gps.bcaresearch.com. 7 Please see BCA Global Investment Strategy Weekly Report, "A Structural Bear Market In Bonds," dated February 16, 2018, available at gis.bcaresearch.com. 8 Please see BCA U.S. Bond Strategy Weekly Report, "The Two-Stage Bear Market In Bonds," dated February 20, 2018, available at usbs.bcaresearch.com. 9 Please see BCA U.S. Investment Strategy Weekly Report, "A Party On The QE2," dated November 8, 2010, available at usis.bcaresearch.com. 10 We include the last factor in the regression because it could be that the market responds positively in the post-election period, irrespective of the election outcome, simply because political uncertainty is diminished. 11 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 12 Please see Tom Mitchell, "Xi's China: The Rise Of Party Politics," Financial Times, July 25, 2016, available at ft.com. See also BCA Geopolitical Strategy and China Strategy Special Report, "Five Myths About Chinese Politics," dated August 10, 2016, available at www.bcaresearch.com. 13 "Carry Canary" indicator tracks the performance of EM/JPY carry trades. These trades short the Japanese Yen and long an emerging market currency with a high interest rate (Brazilian real, Russian ruble, or South African rand), and as such they are highly geared to a positive global growth back-drop. Please see BCA Foreign Exchange Strategy Weekly Report, "The Yen's Mighty Rise Continues ... For Now," dated February 16, 2018, available at fes.bcaresearch.com. 14 The other two battles are against pollution and poverty. 15 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Weekly Report, "Xi Jinping: Chairman Of Everything," dated October 25, 2017, available at gps.bcaresearch.com. 17 Please see BCA Geopolitical Strategy Monthly Report, "Reflections On China's Reforms," in "The Great Risk Rotation - December 2013," dated December 11, 2013, available at gps.bcaresearch.com. 18 Please see BCA Geopolitical Strategy Special Report, "China: Party Congress Ends ... So What?" dated November 1, 2017, available at gps.bcaresearch.com. 19 Consider that the standard political calendar would have called for Xi to make personnel adjustments at the second plenum (which was held in January), then to formalize those personnel changes at the legislature in March, and then to announce reform initiatives at the third plenum in the fall, leaving implementation until late in the year or even March 2019. Instead, all of this will be done by March of this year, leaving the rest of the year for implementation. 20 The Financial Stability and Development Commission was created last July at an important financial gathering that occurs once every five years. We dubbed it a "Preemptive Dodd Frank" at the time because of China's avowed intention to use it to tackle systemic financial risk. Please see BCA Geopolitical Strategy Weekly Report, "The Wrath Of Cohn," dated July 26, 2017, available at gps.bcaresearch.com. The FSDC's purpose is to coordinate the People's Bank of China with the chief financial regulators - the banking, insurance, and securities regulatory commissions (CBRC, CIRC, and CSRC) and the State Administration of Foreign Exchange (SAFE). There is even a possibility under discussion (we think very low probability of happening) that the FSDC will preside above the central bank - though the precise organizational structure will remain unclear until it is formalized, probably during the March legislative session. 21 Anbang is part of a group of companies, including Foresea, Fosun, HNA, Ping An, and Dalian Wanda, that have been targeted over the past year for shady financial doings, corruption, excessive debt, and capital flight. In particular, Anbang was integral to the development of universal life products, which have been highly restricted since last year. These were not standard insurance products but risky short-term, high-yield shadow investment products. Investors could redeem them easily so there was a risk that purchasers could swamp insurance companies with demands for paybacks if investment returns fell short. This would leave insurance companies squeezed for cash, which in turn could shake other financial institutions. The systemic risk not only threatened legitimate insurance customers but also threatened to leave insurance companies unable to make debt payments on huge leveraged buyouts that they had done abroad. Anbang and others had used these and other shadow products to lever up and then go on a global acquisition spree, buying assets like insurance subsidiaries, hotels, and media/entertainment companies. The targeted firms are also in trouble with the central government for trying to divest themselves of China's currency at the height of the RMB depreciation and capital flight of 2015. They were using China's shadow leverage to springboard into Western assets that would be safe from RMB devaluation and Chinese political risk. The government wants outward investment to go into China's strategic goals (such as the Belt and Road Initiative) instead of into high-profile, marquee Western assets and brands. 22 Particularly over whether Xi Jinping's right-hand man, Liu He, will be appointed as the new central bank governor, to replace long-serving Governor Zhou Xiaochuan, and/or whether he will replace Vice Premier Ma Kai as chairman of the FSDC. It is important whether Liu He takes the place of central banker or chief reformer because those roles are so different. Making him PBoC chief would keep a reformer at the helm of a key institution at an important point in its evolution, but will raise questions about who, if anyone, will take charge of structural reform. Giving him the broader and more ad hoc role of Reformer-in-Chief would be reminiscent of Zhu Rongji at the historic NPC session in March 1998, i.e. very optimistic for reforms. Of course, Liu He is not the only person to watch. It is also important to see what role former anti-corruption czar Wang Qishan gets (for instance, leading U.S. negotiations) and whether rising stars like bank regulator Guo Shuqing are given more authority (he is a hawkish reformer). 23 Please see Xie Yu and Frank Tang, "Xi picks team of problem solvers to head China's economic portfolios," South China Morning Post, dated February 21, 2018, available at www.scmp.com. 24 Please see BCA China Investment Strategy Weekly Report, "Seven Questions About Chinese Monetary Policy," dated February 22, 2018, available at cis.bcaresearch.com. 25 Please see BCA Geopolitical Strategy Special Report, "South Africa: Crisis Of Expectations," dated June 28, 2017, available at gps.bcaresearch.com.
Highlights The best recession indicators are not flashing red, but volatility is rising as the end of the cycle approaches; U.S. fiscal policy is surprising to the upside, as we expected; The next recession will usher in an inflationary political paradigm shift, with wealth transferred from Baby Boomers to Millennials; Expect a new U.K. election ahead of March 2019, but do not expect a second referendum unless popular opinion swings decisively against Brexit; Stay short U.S. 10-year Treasuries versus German bunds; short Fed Funds Dec 2018 futures; and initiate a short GBP/USD trade. Feature February has been tough for global markets, with the S&P 500 falling by 5.9% since the beginning of the month. Several clients have pointed out that the market may be sniffing out a recession and that the "buy the dip" strategy is therefore no longer applicable. It is true that markets and recessions go together (Chart 1), but it is not clear from the data that the equity market alone predicts recessions correctly. Chart 1Bear Markets & Recessions: Unclear Which One Leads The Other BCA's House View is that a recession is likely at the end of 2019.1 This view is in no small part based on our political analysis.2 President Trump ran on a populist electoral platform and populist policymakers globally have a successful track record of delivering higher nominal GDP growth than their non-populist counterparts (Chart 2). We assume that the Powell Fed will respond to such higher growth and inflation prospects no differently from the Yellen Fed and that it will restrict monetary policy to an extent that will usher in a mild recession by the end of next year. Chart 2Populists Deliver (Nominal) GDP Growth Of course, predicting recessions is extraordinarily difficult. Being six months early or late would still be an achievement, but the implications for the equity market would likely be considerably different. If our "late 2019" call is actually an "early 2019" recession, then equity markets may indeed be at or near their cyclical peaks. A "buy on dips" strategy may work for the next quarter or so, but superior returns over the course of the year may be achieved with a bearish strategy. To help guide clients through the uncertainty, our colleague Doug Peta, chief strategist of BCA's Global ETF Strategy, has recently updated BCA's methodology for identifying the inflection points that usher in a recession.3 In our 70-year history as an investment research house, we have picked up two definitive truths: valuation and technical indicators cannot call a recession. So what can? We encourage clients to pick up a copy of Doug's analysis.4 The report highlights the three BCA Research recession indicators: the orientation of the yield curve, the year-over-year change in the leading economic indicator (LEI),5 and the monetary policy backdrop. Charts 3, 4, and 5 show how successful the three indicators are in calling recessions. In our 50-year sample period, the yield curve has successfully called all seven recessions with just one false positive. However, it tends to be overly eager, preceding the onset of a recession by an average of nearly twelve months. When we combine the yield curve indicator with the LEI, the false positives go away. Chart 3The Yield Curve Has Called Seven Of The Last Eight Recessions... Chart 4... And So Has The Leading Economic Indicator To confirm the recession signal and make it more robust, we also consider the monetary policy backdrop. Over the nearly 60 years for which BCA's equilibrium fed funds rate model has calculated an estimate of the equilibrium policy rate, every recession has occurred when the fed funds rate exceeded our estimate of equilibrium. In other words, recessions only occur when monetary policy settings are restrictive. Today, none of the indicators are even close to pointing to a recession, with the LEI at a cyclical peak. However, the yield curve and monetary policy are directionally moving towards the end of the cycle. Taken together, they suggest that the only controversy about our late 2019 recession call is that it is so early. So why the market volatility? Because wage growth in the U.S. has begun to pick up in earnest (Chart 6), revealing that BCA's concerns about inflation may at last be coming true. Investors, after more than a year of rationalizing weak inflation by means of dubious concepts (Amazon, AI, robots, etc.), may be reassessing their forecasts in real time, causing market turbulence. Chart 5Tight Policy Is A Necessary,##br## If Not Sufficient, Recession Ingredient Chart 6Wages Picking##br## Up In Earnest There is of course a political explanation as well. Our colleague Peter Berezin correctly called the end of the 35-year bond bull market on July 5, 2016.6 The timing of the call - mere days after the U.K. EU membership referendum - was not a coincidence. As Peter mused at the time, "the post-Brexit shock running through policy circles leads to a further easing in fiscal and monetary policy." He was not speaking about the U.K. alone, but in global terms. Indeed, the populists have begun to deliver. Ever since President Trump's election, we have cautioned clients not to doubt the White House's populist credentials.7 After a surge in bond bearishness immediately following the election, investors lost faith in the populist narrative due to the failure of Congress to pass any significant legislation, as if Congress has ever been a nimble institution under previous presidents. But investors are beginning to realize that their collective political analysis was extremely wrong. Not only have profligate tax cuts been passed, as we controversially expected throughout 2017, but Congress is now on the brink of a monumental two-year appropriations bill that will add nearly 1% of GDP worth of fiscal thrust in 2018 higher than what the IMF expected for the U.S. (Chart 7). In addition, Congress has set in motion the process to re-authorize the use of "earmarks" - i.e. legislative tags that direct funding to special interests in representatives' home districts (Chart 8).8 Chart 72018 Fiscal Thrust Was Unexpected Chart 8Here Comes Pork! By our back-of-the-envelope accounting, Congress is about to authorize just shy of $400bn in extra spending over the next two years.9 If earmarks are allowed back into the legislative process, we could see up to another $50bn in spending. An infrastructure deal, which now also looks likely given that the Democrats have realized that their "resistance"/ "outrage" strategy does not work against the Trump White House, could add significantly to that total. We are already positioned for these political developments through two fixed-income recommendations. We are short U.S. 10-year Treasuries vs. German Bunds, a recommendation that has returned 27.7 bps since September 2017. In addition, we are short the Fed Funds December 2018 futures, a recommendation that has returned 43.17 bps since the same initiation date. In addition, we went long the U.S. dollar index (DXY) on January 31, right before the stock market correction and precisely when the greenback appeared to bottom. Should investors prepare for runaway inflation this cycle? Is it time to load up on gold? We do not think so. The fiscal impulse from the two-year budget deal will become negative in 2020. The capex incentives from the tax cut plan are also front-loaded. The paradigm-shifting impact on inflation will require a policy paradigm shift. And we expect such a shift only after the next recession. To put it bluntly, U.S. voters elected a TV game show host due to angst at a time when unemployment stood at 4.6% (the rate on November 2016). Who will they elect with unemployment rising to 6% in the aftermath of the next recession, or God forbid if that next recession is worse than we think it will be? Policymakers are unlikely to sit around and wait for an answer to that question. Extraordinary measures will be taken to prevent the median voter from lashing out against the system when the next recession hits. Inflation, which is a redistributive mechanism, will be employed to transfer wealth from savers (mainly well-to-do retirees) to consumers (their children). In large part, this will be a generational wealth transfer between Baby Boomers (or at least those with some savings) and their Millennial children. Given that Millennials have become the largest voting bloc in the U.S. as of the 2016 election, this will be a populist policy with firm backing in the electorate. The next recession will therefore usher in the inflationary era of the next decade, regardless of how painful the actual recession is. In the meantime, we recommend that clients with a 9-to-12 month horizon continue to "buy on dips," given that a recession is not on the horizon. However, with the U.S. 10-year yield approaching 3%, China moderately slowing down (with considerable risk to the downside), and the U.S. dollar slide arrested, we think that the outperformance of EM equities is over. Brexit: We Can't Work It Out10 The EU agreed on January 29 to its negotiation guidelines for the temporary transition period after the U.K. officially leaves the bloc in March 2019.11 The British press predictably balked at the conditions - the term "vassal state" has been liberally bandied about - which in our view included absolutely nothing out of the expected. The EU conditions for the transition period are not the fundamental problem. Rather, the problem is that the "Vote Leave" campaign was never honest with its promises. Boris Johnson, the most prominent supporter of Brexit ahead of the vote and now the foreign minister in Prime Minister Theresa May's cabinet, famously quipped after the referendum that "there will continue to be free trade and access to the single market."12 The problem with that promise, however, was that it was predicated on using London's "superior negotiating position" vis-à-vis the EU in order to force the Europeans to redefine what membership in the Common Market means. As we pointed out in our net assessment ahead of the Brexit referendum, the problem with exiting the EU but remaining in the Common Market is that the issue of sovereignty is not resolved (Diagram 1).13 As such, Johnson and other Brexit supporters argued that they could change the relationship by forcing the EU to change how the Common Market works. Diagram 1Common Market Membership Is Illogical Except for one problem: the U.K.'s negotiating position is not, never was, nor ever will be, superior. Anyone with a rudimentary understanding of how trade works can understand this. For example, the U.K. is a significant market for Germany, at 6% of German exports (right in line with the 6% of total EU exports that go to the U.K.). However, the EU is a far greater destination for British exports, with 47% of all exports going to the bloc.14 As we expected, the EU has surprised the conventional wisdom by remaining united in the face of negotiations. And as we also predicted, the Tories are now completely divided.15 PM May will attempt to hammer out an internal deal on how to approach the transition deal. But her political capital is so drained by the disastrous early election results that there is practically no way that she can produce a set of negotiating guidelines that will not be pilloried in the press. As such, we expect a new election to take place in the U.K. ahead of March 2019, perhaps sooner. We do not see how May's negotiating position will satisfy all wings of the Conservative Party. In addition, we see no scenario by which the ultimate exit deal with the EU gets enough votes in Westminster. Investors betting on that election replacing a second Brexit referendum would be wrong. A Jeremy Corbyn-led, Labour government will only turn against Brexit once the polls definitively turn against it. This has not yet happened, as the gap between supporters and opponents of Brexit in the polls, while widening in favor of opponents, remains within a margin of error (Chart 9). As such, Corbyn would scrap the Tory-led negotiations with the EU and ask Brussels for even more time - and thus more market uncertainty! - in order to produce a Labour-led Brexit deal.16 In order for the probability of Brexit to definitively decline, the polls have to show that "Bregret" or "Bremorse" is setting in. Without a move in the polls, U.K. politicians will continue to pursue Brexit, no matter how flawed their tactics may be. Policymakers are ultimately not the price makers but the price takers. On the issue of Brexit, the U.K. median voter is only slightly miffed regarding the outcome. Current polls suggest that Labour could win the next election, albeit needing to rule with a coalition (Chart 10). This would prolong the uncertainty facing the economy. Not only is Corbyn the most left-leaning politician in a major European economy since François Mitterand, but also his coalition would likely include the Scottish National Party and potentially the Liberal Democrats. Keeping all their priorities aligned could be even more difficult than the balancing act PM May is performing between soft-Brexiters, hard-Brexiters, and the Democratic Unionist Party. Chart 9Bremorse: Rising, But Not Definitive Chart 10Anti-Brexit Forces On The Rise Meanwhile, on the economic front, the situation is not much better. Our colleague Rob Robis, BCA's chief bond strategist, recently penned a critical assessment of the U.K. economy.17 As Rob pointed out, the OECD leading economic indicator is decelerating steadily and pointing to a real GDP growth rate below 2% in 2018 (Chart 11). The biggest factors that will weigh on growth will be a sluggish consumer and softer capex. Household consumer growth has been slowing since early 2017, driven by diminishing consumer confidence (Chart 12, top panel). High realized inflation, which has sapped the purchasing power of U.K. workers who have not seen matching increases in wages, is weighing on confidence (third panel). Consumers were able to maintain a decent pace of spending during a period of stagnant real income growth by drawing on savings, but that looks to be tapped out now with the saving rate down to a 19-year low of 5.5% (bottom panel). Chart 11U.K. Growth Set To Slow Chart 12The U.K. Consumer Looks Tapped Out Making matters worse, U.K. consumers are not seeing much of a wealth effect from the housing market. The January 2018 readings of the year-over-year growth rate of U.K. house prices from the Halifax and Nationwide indexes came in at 1.9% and 3.1% respectively (Chart 13). In addition, the net balance of national house price expectations from the Royal Institution of Chartered Surveyors (RICS) has steadily declined since mid-2016 and now sits just above zero (i.e. equal number of respondents expecting higher prices and falling prices). The same indicator for London was a staggering -47% in January 2018. Apparently, foreigners are no longer interested in a Brexit discount. Our global bond team goes on to point out that political uncertainty is also weighing on U.K. business investment spending. Capital expenditure growth slowed to 4.3% year-over-year in nominal terms in Q3 2017 and is even lower in real terms (Chart 14). Chart 13No Wealth Effect ##br## From Housing Chart 14Brexit Gloom Trumps ##br##Export Boom For U.K. Companies Putting all of this together, neither our global bond team nor our foreign exchange team expect the Bank of England to raise interest rates, despite the market pricing in 36 bps of rate hikes over the next twelve months. As Chart 15 illustrates, inflation across a broad swath of components is likely to slow sharply in the coming months as the trade-weighted pound has stopped depreciating. Thus, the pass-through from a lower exchange rate is beginning to dissipate.18 In the long-term, we understand why investors are itching to bet on Brexit never happening. But to get from here to there, the market will have to riot. And that means more downside to U.K. assets. Chart 15U.K. Inflation:##br## Less Pass-Through From The Pound Chart 16GBP:##br## Stuck In A Rut Bottom Line: BCA's FX strategist, Mathieu Savary, has pointed out that the trade-weighted pound is testing the upper bound of its post-Brexit trading range (Chart 16). As our FX and bond teams show in their respective research, the economics currently at play make it unlikely that the pound will be able to punch above the ceiling of this range. Our political assessment adds to this view. In fact, we expect that the coming political uncertainty, including an early election prior to March 2019, is likely to take the pound back to the floor of its trading range. As such, we are recommending that clients short cable, GBP/USD. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Global Investment Strategy Weekly Report, "The Timing Of The Next Recession," June 16, 2017, available at gis.bcaresearch.com. 2 Please see BCA Special Report, "Beware The 2019 Trump Recession," dated March 7, 2017, and "2018 Outlook - Policy And The Markets: On A Collision Course," dated November 20, 2017, available at bcaresearch.com. 3 Please see BCA Special Report, "Timing The Next Equity Bear Market," dated January 24, 2014, and "Timing Equity Bear Markets," dated April 6, 2011, available at bcaresearch.com. 4 Please see BCA Global ETF Strategy Special Report, "A Guide To Spotting And Weathering Bear Markets," dated August 16, 2017, available at etf.bcaresearch.com. 5 The ten components of leading economic index for the U.S. include: 1. Average weekly hours, manufacturing; 2. Average weekly initial claims for unemployment insurance; 3. Manufacturers' new orders, consumer goods and materials; 4. ISM® Index of New Orders; 5. Manufacturers' new orders, nondefense capital goods excluding aircraft orders; 6. Building permits, new private housing units; 7. Stock prices, 500 common stocks; 8. Leading Credit Index TM; 9. Interest rate spread, 10-year Treasury bonds less federal funds; and 10. Index of consumer expectations. Source: The Conference Board. 6 Please see BCA Global Investment Strategy Special Report, "End Of The 35-Year Bond Bull Market," dated July 5, 2016, available at gis.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Special Report, "U.S. Election: Outcomes & Investment Implications," dated November 9, 2016, and "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Weekly Report, "Upside Risks In U.S., Downside Risks In China," dated January 17, 2018, available at gps.bcaresearch.com. 9 We are referring to the Senate deal struck last week to authorize additional military spending ($80bn in FY2018 and $85bn in FY2019) and discretionary spending ($63bn in FY2018 and $68bn in FY2019), as well as to provide disaster relief in the amount of $45bn for both fiscal years. 10 Life is very short, and there's no time ... For fussing and fighting, my friend ... 11 Please see European Council, "Brexit: Council (Article 50) adopts negotiating directives on the transition period," dated January 29, 2018, available at consilium.europa.eu. 12 Please see "UK will retain access to the EU single market: Brexit leader Johnson," Reuters, dated June 26, 2016, available at uk.reuters.com. 13 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "With Or Without You: The U.K. And The EU," dated March 17, 2016, available at gps.bcaresearch.com. 14 This is not a coincidence. The whole point of the EU is that it is the world's richest consumer market. As such, it has massive negotiating leverage with all trade partners. As a side note, this throws into doubt the logic that the U.K. can get better trade deals by leaving the bloc. The first test of that premise will be its negotiations with the EU itself. 15 Please see BCA Special Report, "Break Glass To Brexit: A Fact Sheet," dated June 17, 2016, available at bca.bcaresearch.com. 16 Investors should remember that Westminster voted decisively 319 to 23 to reject the Liberal Democrats' amendment seeking a referendum on the final Brexit agreement. Only nine Labour MPs voted in favor of the amendment after Jeremy Corbyn instructed his party to abstain. 17 Please see BCA Global Fixed Income Strategy Weekly Report, "A Melt-Up In Equities AND Bond Yields?" dated January 23, 2018, available at gfis.bcaresearch.com. 18 Please see BCA Foreign Exchange Strategy Weekly Report, "The Euro's Tricky Spot," dated February 2, 2018, available at fes.bcaresearch.com.
Highlights Even though our baseline scenario calls for four rate hikes out of the Fed this year - more than markets have priced in - gold will be supported by increasing inflation and inflation expectations, heightened geopolitical risks, and greater volatility in equity markets. Further out, we expect gold will provide a good hedge against a likely equity downturn, as the bull market turns into a bear market in 2H19. For now, keep gold as a strategic portfolio hedge. Energy: Overweight. After popping above $70 and $66/bbl last week, Brent and WTI prices retreated ~ $2.00/bbl on the back of a stronger USD and increased rig counts in the U.S. shales, particularly in the prolific Permian Basin, where 18 rigs were added. We continue to expect Brent and WTI prices to average $67 and $63/bbl this year. Base Metals: Neutral. Spot copper continues to trade on either side of $3.20/lb on the COMEX. We remain neutral, given our view upside risk - chiefly supply-side disruptions at the mine and refined levels - will be balanced on the downside by a stronger USD and a slowdown in China. Precious Metals: Neutral. Gold will draw support from rising inflation and inflation expectations this year and next (see below). Ags/Softs: Underweight. NAFTA negotiations ended this week in Montreal with the U.S. rejecting proposals from Canada to advance the talks. However, the U.S. side stated it would seek "major breakthroughs" at the next round of negotiations in Mexico City beginning February 26, according to agriculture.com. Feature Gold Price Risks Skewed To The Upside Price risk in gold will remain skewed to the upside this year, even as our base case scenario calls for limited gains from here. Higher inflation and inflation expectations, which normally would be bullish for gold, will be countered by Fed policy-rate hikes, which will boost the USD and lift real rates in our base case (Chart of the Week). Inflation's Revival Would Support Gold ... Despite above-trend global growth last year, subdued inflation limited the Fed's willingness to proceed with interest rate normalization in earnest. However, we do not put this down to structural forces, and instead expect core inflation to be near its bottom.1 In fact, inflation's soft readings are typical of the expected 18-month lag between U.S. economic growth and a pick-up in inflation, and as our Global Investment Strategists point out, several key indicators including the ISM manufacturing index, the New York Fed's Inflation Gauge, as well as BCA's proprietary pipeline inflation index are already moving in this direction (Chart 2).2 Chart of the WeekInflation And U.S. Financial Variables Matter Chart 2Signs Of Life In U.S. Inflation Inflation tends to pick up once the unemployment rate falls below the 5% mark. With the latest unemployment reading coming in at 4.1%, the U.S. economy has reached the steep end of the Phillips Curve - a workhorse model used by the Fed, which depicts the trade-off between unemployment and inflation. Indeed, BCA's Global Investment Strategists expect the U.S. unemployment rate to continue falling to a 49-year low of 3.5% by year-end. These further declines in the unemployment rate will push up wages, pressuring service inflation (Chart 3). At the same time, we expect the lagged impact of the weak USD will begin to show up in goods price inflation, along with higher energy prices. While some components of the Fed's preferred inflation gauge may face a slowdown in price pressure - most notably rent - this will likely be mitigated by accelerating prices in other components, such as health care, which we expect will return to its historic trend. In fact, U.S. inflation expectations - supported by higher energy prices and a strong December core CPI reading - have already started to increase (Chart 4). As our U.S. Bond Strategists point out, by the time core inflation returns to the Fed's target, the 10-year TIPS breakeven inflation rate will be between 2.4% and 2.5%.3 Chart 3At The Steep End Of The Philips Curve Chart 4A Breakout In Inflation Expectations Thus the 2018 inflation outlook is showing signs that it is in the process of bottoming, and will soon begin its ascent. We expect core PCE inflation, the Fed's preferred gauge, to reach the central bank's 2% target by year-end. This pick-up in inflation and inflation expectations is positive for gold, which we've shown to be an attractive hedge against rising prices. However, inflation's comeback will likely embolden the Fed to proceed more aggressively with its hiking cycle. ... But A Hawkish Fed Counters Inflation ... While our modelling showcases an inverse relationship between real rates and gold prices, what is crucial to our outlook is our expectation of how the Fed will proceed with its interest rate normalization process this year. Given that gold's correlation with inflation is strengthened during periods of low real rates, the ideal condition for gold would be for the Fed to stay behind the inflation curve. But we are not expecting that just yet.4 Rather than waiting to see the "whites of inflation's eyes," our expectation is the Fed will tighten ahead of inflation. This has in fact already materialized with three hikes in 2017 amid muted inflation. Upward surprises in U.S. growth, coupled with an upward trend in inflation will keep the Fed on its normalization path with greater confidence. We expect four rate hikes in 2018 - above both market expectations and what is implied by the "dot plot". Net, the pre-emptive Fed rate hikes we expect will lead to higher real rates, and will limit gold's upside this year. ... As Does A Stronger Greenback An increase in U.S. real rates vis-à-vis other economies, as well as a shift in the composition of global growth to favor the U.S., will support the USD. In addition to higher real rates, this would also limit gold's upside in 2018. Stronger growth ex-U.S. last year weakened the USD. This year, we expect the U.S. economy to outperform. Financial conditions have eased in the U.S. relative to the rest of the world, while fiscal policy is expected to be comparatively more favorable in the U.S. The U.S. surprise index has reflected this shift in comparative growth, outperforming most regions (Chart 5).5 While the Euro has been exceptionally resilient, the fallout from a stronger currency will eventually begin to show up in slower growth. The EUR/USD cross has diverged from the spread in expected policy rates, leaving the euro looking expensive (Chart 6). Since the beginning of the year, spreads have widened in favor of the dollar, while the USD has weakened. Although we do not expect the ECB to hike until mid-2019, our expectation of four Fed rate hikes this year will support the greenback. This will push spreads back in line. Such decoupling is not the norm, and we expect a 5% appreciation in the dollar in broad trade weighted terms.6 Chart 5Economic Surprises Favor The U.S. Chart 6EUR Looks Expensive Still, The Fed Could Surprise, And Tilt Dovish Chart 7A Policy Change Would##BR##Tolerate Higher Inflation A risk to our base case outlook is a change in the Fed's monetary policy framework. Here we note an increasing number of statements advocating the exploration of an alternative policy framework have been emerging from the Fed. This line of attack observes the Fed's current 2% inflation target is unsatisfactory, as it is too close to the zero-lower bound on interest rates, thus constraining the Fed's ability to exercise expansionary monetary policy when rates are low.7 Alternative policy proposals include price-level targeting, as well as an increase in the inflation target. Additionally, former Fed Chair Bernanke recently proposed a temporary price level target be implemented during low-rate periods.8 The net effect of these alternatives would be a higher inflation rate - above the current 2% target (Chart 7). If the Fed were to adopt a new monetary policy framework, it will likely occur before the next recession - in order to allow it to better respond to economic weakness. While we do not expect a regime change this year, these discussions and an eventual shift, may make the Fed more dovish this year, and more likely to tolerate higher inflation in the future. This would be an upside risk to gold, as it would assume its role as a store-of-value against higher inflation. The net effect of such a policy change - were it to occur - would be higher inflation expectations, lower real rates, and a weaker USD, all of which would bid up the gold market. Bottom Line: The revival of U.S. inflation and inflation expectations will bolster gold. However, our expectation that the Fed will continue hiking ahead of a realized uptick in inflation, and more aggressively than is currently priced in the market, will increase real rates and limit gold's upside potential. A stronger USD on the back of higher real rates, as well as a shift in global growth in favor of the U.S., will work against gold this year. Geopolitical Risks: Understated In 2018 We expect geopolitical risks to support gold prices this year. Gold's safe-haven attributes will be highlighted by a combination of events spread across the calendar year, which we believe will put a floor under the metal's price (Chart 8).9 Political and economic policy uncertainty will remain elevated this year (Chart 9). Our Geopolitical Strategists see this year's gold-relevant risks stemming from two main factors: (1) U.S. political risks, and (2) Exogenous tail risks. The former is likely to be a more significant source of upside pressure. Chart 8Gold Outperforms During##BR##Geopolitical Crises Chart 9Elevated Policy Uncertainty##BR##Supports Gold U.S. Foreign Strategy Risks Will Keep Gold Bid U.S. political risks are rooted in President Trump's strategic decisions, and boil down to two mutually exclusive schemes ahead of the midterm elections: Domestic Strategy or Foreign Strategy (Table 1). Our Geopolitical strategists note: "... policymakers often play "two-level games," with the domestic arena influencing what is possible in the international one. As Donald Trump loses political capital on the domestic front, his options for affecting policy will become constrained. However, the U.S. constitution places almost no constraints on the president when it comes to foreign policy."10 Trump's propensity to take on a more aggressive stance in foreign policy - which would be boosted by an unfavorable outcome in the immigration bill - will set the stage for a volatile year, supporting gold via its ability to hedge against geopolitical risks (Chart 10). Table 1Trump's Two-Level Game Chart 10Trump Will Look To Revive His Political Capital In addition to the U.S. political risks, many low-probability high-impact risks will keep volatility elevated this year and could support gold as a strategic portfolio hedge in 2018. Most notable are the following: A meaningful slowdown in China would have a negative impact on the global economy, as well as increase the risk of a monetary policy mistake in the U.S. The Fed's monetary policy decision is important for EM growth, while EM growth contributes to U.S. inflation, this feedback system makes the expected slowdown in Chinese growth relevant to the U.S. monetary stance. If China slows more than expected, this would reduce the global demand for commodities and goods, diminishing U.S. inflation expectations, potentially forcing the Fed to reassess its rate hike pace. If no adjustments are made, the Fed risks overshooting the equilibrium interest rate, increasing the risk of an equity correction. A downward rate hike adjustment, would keep the USD and real rates at low levels. A global oil-supply disruption caused by a collapse of the Venezuelan economy would lead to a short-lived spike in oil prices (Chart 11). In low-spare-capacity environments - as we are in today - oil prices become more responsive to supply shocks. Based on our simulations, a 600k b/d drop in Venezuelan oil supply in 2018 could spike oil prices by ~$10/bbl, leading to higher cost-push inflation. Our modelling shows U.S. CPI is highly responsive to oil price variation. This spike in headline inflation would push gold prices higher. Chart 11Cost-Push Inflation Risk From Venezuela Collapse In addition to U.S.-Iran tensions, we see other potential catalysts to instability in the Middle East - mainly regarding a severe deterioration of the U.S.-Turkish relationship, and Iraqi-Kurdish clashes ahead of Iraqi elections. Lastly, Europe: Italian elections and Euro-skepticism are a longer-term risk; however, news around the Italian elections in March has the potential to fuel talk of a potential breakup, which could lift gold.11 Bottom Line: Increased tensions due to Trump's controversial foreign strategy (China and Iran), as well as exogenous tail risks throughout the year will keep risks elevated in 2018, supporting gold prices. In fact our geopolitical strategists believe risks are understated this year, increasing the utility of gold's ability to hedge against political turmoil. Gold Outperforms In Equity Bear Markets In addition to its ability to hedge against rising inflation and increased geopolitical risks, gold outperforms during equity downturns and amid market volatility.12 Specifically, during periods of negative equity returns, gold outperformed the S&P500 79% of the time, with an average excess return of 3.7%. Furthermore, gold outperforms equities 60% of the time in periods of rising VIX with an average excess monthly return of 1.6% in these periods, and only 30% of the time in decreasing VIX periods with an average monthly excess return of -1.8% (Chart 12).13 We expect the equity bull market to remain intact throughout 2018. An equity downturn is not expected before 2H19. Nevertheless, we expect volatility to increase this year as investors fret about the sustainability of the bull market, and amid heightened geopolitical tensions. Moreover, domestic U.S. developments - e.g., the evolution of Special Counsel Robert Mueller's investigation; a larger-than-expected Democrat win in the midterm elections or a Fed policy mistake - could affect investor sentiment and trigger a rise in volatility and a temporary sell-off in S&P 500. In our view, consumer confidence is a key contributor to the current equity bull market and currently stands at very elevated levels (Chart 13). Thus, any meaningful disappointment could derail this high-confidence environment. Chart 12Gold Outperforms Amid##BR##Volatility & Equity Downturns Chart 13High Confidence##BR##Environment At Risk Therefore, we believe the larger-than-expected tail risks and the monetary and political risks in the U.S. are not fully reflected in the gold market (Chart 14). The above risks assessment would suggest a fatter right tail in out-of-the-money gold options. Chart 14Rising Volatility Will Support Gold Chart 15Understated Geopolitical Risks This Year Bottom Line: While geopolitical risks were overstated in 2017, they are understated this year (Chart 15). Thus we do not expect a repeat of last year's low-VIX high-confidence environment. Rather gold will gain support from increased equity volatility this year. Roukaya Ibrahim, Associate Editor Commodity & Energy Strategy RoukayaI@bcaresearch.com Hugo Bélanger, Research Analyst HugoB@bcaresearch.com 1 Please see BCA Research The Bank Credit Analyst Special Report titled "The Impact of Robots on Inflation," dated January 25, 2018, available at bca.bcaresearch.com. 2 Please see BCA Research Global Investment Strategy Weekly Report titled "Three Tantalizing Trades - Four Months On," dated January 19, 2018, available at gis.bcaresearch.com. 3 Please see BCA Research U.S. Bond Strategy Weekly Report titled "It's Still All About Inflation," dated January 16, 2018, available at usbs.bcaresearch.com. 4 Please see BCA Research Commodity & Energy Strategy Weekly Report titled "Go Long Gold As A Strategic Portfolio Hedge," dated May 4, 2017, available at ces.bcaresearch.com. 5 Please see BCA Research Global Investment Strategy Weekly Report titled "Four Key Questions On The 2018 Global Growth Outlook," dated January 5, 2018, available at gis.bcaresearch.com. 6 Please see BCA Research Global Investment Strategy Weekly Report titled "The Indefatigable Euro," dated January 26, 2018, available at gis.bcaresearch.com. 7 Please see "Fed Officials See Benefits In Letting Inflation Run Above Target," dated January 19, 2018, available at Bloomberg.com. 8 Please see https://www.brookings.edu/blog/ben-bernanke/2017/10/12/temporary-price-level-targeting-an-alternative-framework-for-monetary-policy/ 9 Please see BCA Research Commodity & Energy Strategy Weekly Report titled "Balance Of Risks Favors Holding Gold," dated October 12, 2017, available at ces.bcaresearch.com. 10 Please see BCA Research Geopolitical Strategy Weekly Report titled "Watching Five Risks," dated January 24, 2018, available at gps.bcaresearch.com. 11 For a comprehensive analysis of this issue, please see BCA Research Geopolitical Strategy Special Report titled "Five Black Swans In 2018," dated December 6, 2017, available at gps.bcaresearch.com. 12 Please see BCA Research Commodity & Energy Strategy Weekly Report titled "Go Long Gold As A Strategic Portfolio Hedge," dated May 4, 2017, available at ces.bcaresearch.com. 13 Excess returns = (Gold - S&P 500) monthly returns. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017
Highlights The U.S.'s twin deficits do not explain the drop in the USD; Global growth is the biggest factor for the USD, and growth depends on China's economic reforms; The U.S. is turning more hawkish on China trade despite Beijing's reform-induced vulnerability; U.S. and Chinese political dynamics suggest upside risks in the former and downside in the latter; Go long DXY. Feature American policymakers scrambled to walk back Treasury Secretary Steven Mnuchin's "weak dollar" comments last week. Investors were left to wonder why Mnuchin broke with the long-held official position of favoring a strong dollar. Was it a "shot across the bow" of China, warning Beijing that the U.S. would engage in currency manipulation if it was not given concessions on trade? Or was it an admission that the U.S. would run large "twin deficits" - a budget deficit and a current account deficit - going forward? We don't have a good explanation for what Mnuchin said in Davos.1 But we can say with some conviction that the "twin deficit" explanation, which has been brought up in almost every client conversation so far this year, is wrong. Chart 1Twin Deficits: Why The Panic? Chart 2Because The Narrative Is Scary First, who says that the U.S. is about to widen its twin deficit (Chart 1)? The concern arises periodically in the marketplace but is often grossly off the mark in predicting the path of deficits or the dollar (Chart 2). We expect the budget deficit to hold steady in 2018, if not contract. Why? Because the fiscal deficit almost always contracts in the eight quarters before a recession, barring, in some cases, one or two quarters just before the recession hits (Chart 3). Unless investors have a high-conviction view that a recession is afoot in the next two quarters, they should ignore the dire predictions about the U.S. budget deficit. Chart 3The Deficit Is Not A Problem... Yet Chart 4Bond Market Not Sniffing Out Any Twin Deficit Crisis If the risk to the U.S. economy is to the upside, as we believe due to the tax cuts and unleashing of animal spirits, then deficits will come down regardless of additional tax or spending policy.2 In the long term, yes, the budget deficit will almost certainly expand due to entitlement spending, the impact of automatic stabilizers during a recession, and the loss of revenue from tax cuts. But long-term deficit concerns are the purview of the bond market, not currency traders. So what is the bond market telling us? Chart 4 shows that the yield curve tends to steepen as the twin deficit widens; both tend to occur during and after recessions. Today, however, the curve continues to flatten. Another fixed-income market indicator that tends to track budget deficits is the 30-year swap spread, which falls during recessions as budget deficits expand. But today the swap spread is not falling, it is increasing and doing so at the fastest pace since the 2008 recession (Chart 5). This may be a sign of resurgent animal spirits as banks throw caution - and concerns over Obama-era overregulation - to the wind. Credit demand is rising in the economy, which should increase both the velocity of money and growth. Concerns over the widening fiscal deficit are not being reflected in this indicator. Finally, our currency strategist, Mathieu Savary, has pointed out that a widening twin deficit only impacts developed economies' currencies about 50% of the time over 12 month periods. In other words, expansion of the twin deficit predicts currency moves about as well as flipping a coin. What really matters is how central banks respond to the causes and economic effects of the twin deficits. Protectionism, on the other hand, ought to be bullish for the dollar.3 As such, a potential trade war between China and the U.S. should not be the reason for the dollar's deepening doldrums. And while we are generally open to alarmism on trade protectionism - due to the fact that President Trump has few constitutional or political constraints holding him back on this issue - there is still not enough evidence to say whether the Trump administration will impose across-the-board tariffs on China. (See next section.) Could dollar weakness, conversely, be the result of a Plaza Accord 2.0 orchestrated between Chinese and American policymakers to depreciate the greenback in order to avert the need for protectionist policies? We doubt it. First, the U.S. and China economic dialogue has faltered. Second, the dollar would not have declined following the Plaza Accord had the Fed not aggressively cut rates from 1984 to 1985 by 423 basis points (Chart 6). And the Fed is obviously not cutting rates today, it is hiking them. Chart 5No Sign Of Deficit Here Chart 6The Fed Is More Important Than Politics... So, what matters for the U.S. dollar? Higher domestic inflation would matter as it would incentivize the Fed to tighten more than the market expects. Even here, however, recent history warrants caution on this view. Between 2004 and 2006, the Fed tightened 440 basis points and yet the dollar declined 11% from the start of the tightening cycle to its end (Chart 7). This is because the rest of the world's growth outpaced U.S. growth, particularly that of emerging markets, which grew at an annual 19%. We therefore come full circle to the single biggest issue on our forecasting horizon: Chinese policy. China is the most important variable for the U.S. dollar at the moment as it can single-handedly tip the global growth balance back towards the U.S., given its expected contribution to global growth (Chart 8). Chart 7...But Not More Important Than Global Growth Chart 8China Really Matters For Global Growth Our view is that Chinese policymakers are acting as an accelerant to BCA's House View that the Chinese economy will experience a benign slowdown. Risks are skewed towards the downside. We recently dedicated our monthly Crow's Nest Webcast solely to this issue and we highly encourage our clients to listen to it on replay.4 In today's weekly, we briefly assess where our Chinese view stands and then turn to U.S. politics. News Flash: Chimerica Has Been Dead Since 2012 Two critical aspects of our China view are coming together. The first is U.S. policy, which is becoming more aggressive after a year in which Trump showed restraint for the sake of North Korean negotiations.5 The second is China's renewed focus on domestic economic reforms.6 The "symbiotic" relationship between the U.S. and China is in decay, as we have argued since 2012.7 As China's economy grows, so grows its capacity for challenging the United States in the strategic sphere (Chart 9). Meanwhile the two economies have diverged markedly since U.S. households began to deleverage in 2008 (Chart 10). Chart 9China's Capabilities Are Growing Chart 10China No Longer Addicted To U.S. Demand The mainstream media is about to become more attuned to this reality now that the Trump administration has published a series of high-level reports declaring that U.S. strategy toward China is changing. Here are a few choice quotations: "China is a strategic competitor using predatory economics to intimidate its neighbors while militarizing features in the South China Sea." (Department of Defense, National Defense Strategy, 2018) "Long-term strategic competitions with China and Russia are the principal priorities for the Department." (Department of Defense, National Defense Strategy, 2018) "[High-level bilateral dialogues] largely have been unsuccessful - not because of failures by U.S. policymakers, but because Chinese policymakers were not interested in moving toward a true market economy." (U.S. Trade Representative, 2017 Report to Congress On China's WTO Compliance, 2018) "The United States also will take all other steps necessary to rein in harmful state-led, mercantilist policies and practices pursued by China, even when they do not fall squarely within WTO disciplines." (U.S. Trade Representative, 2017 Report to Congress On China's WTO Compliance, 2018) "The United States ... is seeking fundamental changes to China's trade regime, including the overarching industrial policies that have continued to dominate China's state-led economy." (U.S. Trade Representative, 2017 Report to Congress On China's WTO Compliance, 2018) "China and Russia want to shape a world antithetical to U.S. values and interests. China seeks to displace the United States in the Indo-Pacific region, expand the reaches of its state-driven economic model, and reorder the region in its favor." (President Trump, National Security Strategy of the United States of America, 2017) We expect to find echoes of this tough rhetoric in Trump's State of the Union Address on January 30, which will air as we go to press. Already commentators have declared that the U.S. is entering a "post-engagement" phase in the U.S.-China relationship.8 The U.S. and China will continue to engage. What is important is the Trump administration's shift toward more aggressive economic statecraft. Trump's view, made amply clear on the campaign trail, and now officially U.S. policy, holds that China is a mercantilist as well as a revisionist power and that it has initiated a trade war against the U.S. Thus the real policy change lies not in naming China a "strategic competitor" antithetical to U.S. values, but in declaring that normal "WTO consistent" remedies are no longer sufficient and the U.S. will have to resort to "all other steps necessary." The question is whether the U.S., in adopting unilateral measures, will pursue trade remedies on an item-by-item basis, as it has done so far, or break out of the mold and levy broader tariffs to try to achieve "fundamental changes" as quoted above. Trump's recent tariffs on solar panels and washing machines adhered closely to U.S. institutional procedures and penalized U.S. ally South Korea as well as China: if this is the trajectory that the U.S. intends to take, then markets can breathe a sigh of relief.9 The basic trade data show that the U.S. has continued to expand imports from China despite past incidents of presidents slapping on tariffs (Chart 11). Chart 11China And U.S.: Ships Passing In The Night However, the U.S. is likely to draw a harder line than that. The same data also show that the U.S. is not gaining much access to the Chinese market over time, while China has greatly diminished its exposure both to exports and to U.S. trade as a whole. Furthermore, the Trump administration is accusing China of trying to gain superior technology from the U.S. in a way that jeopardizes its security and sovereignty in the pursuit of a better strategic position. This is said to include coercion and corruption of U.S. firms in China, favoring the manufacturing sector by squeezing out competition, preferring domestic-sourced goods over foreign goods, and jeopardizing U.S. companies' intellectual property and network security. The key grievances are forced technology transfer, the "Made in China 2025" industrial strategy, "indigenous innovation" rules, and the new Cyber-Security Law.10 A test case for the U.S.'s harder line will be the ongoing investigation into China's intellectual property theft, which is due by August but is expected to elicit action by Trump sooner. Trump has a range of actions he can take either within or without the WTO. Going outside the WTO would give him greater flexibility, for instance, to impose a "fine," as he called it, for the cumulative "big damages" of China's intellectual property theft - but it would also enable China to claim that the U.S. itself is violating WTO trade rules.11 How will China respond to this turn in U.S. policy? It will continue to focus on rebooting its economic reforms. Reform is both necessary for its own interests, as we have outlined in the past, and expedient in that it enables China to try to deflect and delay U.S. pressure.12 This is not to say that China will not retaliate to particular U.S. moves, but simply that it will prefer to minimize conflict unless and until the Trump administration demonstrates via broad and sweeping trade measures that Beijing has no choice but to engage in open trade war. China's recent declarations that it will accelerate economic reforms aimed at trade and investment openness - particularly in financial services but also more generally - are geared toward allaying Washington. Xi Jinping's right-hand economist, Liu He, who is a key figure, made this clear at the World Economic Forum in Davos, where he said that China's reform and opening up this year would "exceed international expectations." Politburo Standing Committee member Wang Yang made a similar point late last year, saying that the "Made in China 2025" program would not discriminate against foreign or private firms.13 Simultaneously, leading technocrats are calling attention to China's vulnerability as it attempts delicate financial reforms. Guo Shuqing of the China Banking Regulatory Commission has warned of "black swan" or "gray rhino" events as he continues with his financial regulatory crackdown, and he has been echoed by the vice-secretary general of the National Development and Reform Commission.14 These statements are prudent - as it is always risky for highly leveraged countries to tinker with financial tightening - and useful because Beijing wants to warn the U.S. against pushing too hard since it is both "making progress" and vulnerable to instability. We certainly expect the reforms to have a significant, adverse impact on China's economic growth this year. In the latest developments, the policy crackdown is spreading to local governments, where fiscal tightening could ensue (Chart 12). Local governments lack stable sources of revenue, have large hidden debts, face an intensifying debt repayment schedule over the next three years, and have recently begun to cancel infrastructure projects under central government scrutiny (in Inner Mongolia, Gansu, and other provinces, and reportedly even in Xi's favored province of Zhejiang). Furthermore, the reforms have involved a crackdown on shadow lending that has sent non-bank credit into a steep decline (Chart 13). While some market estimates suggest that bank loans could grow by 13%-15% in 2018, such estimates cut against the policy grain. Assuming that non-bank credit does not grow any faster in 2018 than it did in 2017 (9.7%), China can afford to let new bank loans grow at 9.7% and still keep its total social financing (TSF) at its five-year annual average growth rate of 14.5%. Policymakers will not be able to soften their line easily, as several key players are newly appointed and must establish their credibility from the outset. Chart 12Local Government Finances Under Scrutiny Chart 13Shadow Bank Crackdown To Weigh On Credit Growth Our view is that Trump will harden the line despite China's promises both of deeper internal reforms and greater opening up. But the timing is impossible to predict. The real fireworks may be reserved until closer to the U.S. midterm election, as campaigning heats up in the fall. That would be the time for Trump to try to rally his voters by means of a clash of economic nationalisms with China. Beyond the top U.S. grievances cited above, we would highlight the U.S. approach toward China's state-owned enterprises (SOEs). Preferential policies for SOEs are a structural issue that the U.S. is now criticizing. At the party congress in October, President Xi Jinping pledged not only to reform the SOEs but also to make them bigger and stronger. Hence there is a potential collision course. The precise implementation of China's reforms could determine whether the U.S. pursues the issue further. China's State-Owned Assets Supervision and Administration Commission has so far reaffirmed Xi's comments at the party congress but, in keeping with the subtlety of Xi's policies, has also suggested there may be room to intensify reforms. The combination of Trump's economic policies, and China's intensifying reforms, will result in the U.S. economy outperforming expectations relative to China while U.S. corporations will outperform their Chinese counterparts (Chart 14). China will experience higher volatility, both in general and in relation to the U.S., and Chinese companies that suffer from reforms will underperform U.S. companies that benefit most from tax cuts (Chart 15). This is ironic given the popular narrative that the U.S. is suffering from chaotic democratic politics while China's centralized authoritarian model reigns triumphant. Of course, we do think Xi has key capabilities to drive reforms further in his second term than in his first, so these U.S.-China divergences will continue for the next 6-to-12 months at least. China's slowdown and increase in equity volatility should create a policy response: more fiscal spending and credit expansion. The comparison of relative U.S. and Chinese credit impulses suggests that China extends more credit as relative volatility rises (Chart 16). Our view, however, is that China's credit impulse will continue disappointing this year as Beijing prioritizes reform over growth. The credit numbers in January are the next data set to watch, in addition to the aforementioned local government spending. Investors should brace for more uncertainty as the Lunar New Year approaches (Feb. 16). Chart 14U.S. Earnings Surprise Relative To China Chart 15Xi Adds Volatility Relative To Trump Bump Chart 16China's Credit Impulse Disappoints Bottom Line: The Trump administration has issued an ultimatum of sorts on trade. Yet China claims to be redoubling its efforts at reforming and opening up its economy - party to deflect the pressure. We are almost certain that Trump will take further punitive actions, but it is too soon to say when or if he will engage in sweeping measures that threaten to destabilize China and thus initiate a trade war. The political context heading into the U.S. midterm vote will be crucial. Is America Having A Macron Moment? It is unfortunate when one's forecast is challenged only weeks after it is conceived. But that appears to be happening to our view, articulated in late December, that investors should expect no significant legislation to come out of Congress following the passage of the tax cuts.15 Bad news for our forecast is perhaps good news for U.S. policy initiatives and the overall quality of U.S. governance. President Trump has softened his stance on immigration, stating that he would be willing to grant citizenship to roughly 1.8 million "Dreamers" - young adults who came to the U.S. as illegal immigrants.16 Clearing the immigration hurdle would mean that Congress can focus on passing a budget for FY2018 that would see both defense and discretionary spending levels significantly raised. It would also relegate the never-ending saga of the debt ceiling to the dustbin, at least for the duration of this political cycle. Trump also followed up his immigration proposal by sketching a $1.7 trillion infrastructure investment plan (albeit a vague one). Chart 17Bipartisanship = Steeper Bull Market? Could we be approaching a "Macron moment" in U.S. politics? A moment when the "silent majority" rises up and sends a message to politicians that it has had enough of polarizing extremes? Previous such moments have included President Reagan's collaboration with congressional Democrats and President Clinton's with Republicans, which underpinned that glorious stock market run between August 12, 1982 and March 24, 2000 (Chart 17). Both presidents passed significant economic and social reforms during that time. Chart 18Peak Partisanship? Chart 19Independents On The Rise Yes, polarization remains at extreme levels (Chart 18), but that could also mean that it is reaching its natural limits. Rather than dwell on the high levels of polarization, which are baked into the "expectations cake," we would point out that the percentage of Americans who identify as independents is now fast approaching the combined total who identify as either Republican or Democrat (Chart 19). Ominously for Republicans - who hold both the House and the Senate - midterm electoral sweeps have almost always occurred along with the share of independents crossing the 40% mark (Table 1). Table 1Sweep Elections Coincide With High Independent Affiliation Meanwhile, President Trump's conciliatory tone on immigration was met with howls of protest from conservative activists. This is despite the fact that his proposal essentially exchanges leniency for Dreamers for considerably tougher immigration laws in general, which would align the U.S. with its developed market peers.17 Conservative activists are, however, massively out of step with the rest of America. Polls show that immigration is not high on the list of priorities for most Americans, and that most Americans continue to believe both that immigration is a positive and that immigration intake should remain at current levels (Chart 20). Chart 20Americans Are Neither Anti-Immigrant Nor All That Concerned About Immigration Our gut call that President Trump was itching to move to the political middle appears to be correct.18 Whether this becomes investment relevant will ultimately depend on whether the Democrats reciprocate. If Democrats go by data, they will. The government shutdown imbroglio has cost them a double-digit lead in the generic congressional ballot (Chart 21). As a political strategy, the shutdown was a miserable failure. Furthermore, the 2016 election stands as clear evidence that "outrage" does not work. Clinton picked up almost a million more voters in California than President Obama yet failed to beat his performance where it mattered: the Midwest. If Democrats continue to run on a "resistance" platform in order to satisfy their activist base, they will fail to win the House. Chart 21Government Shutdown An 'Own Goal' For Dems Ironically, the best strategy for Democrats ahead of the midterm election is to cooperate with Trump. The swelling ranks of independent voters will reward them if they do so. That same strategy, however, will paradoxically boost Trump's chances in 2020. Bottom Line: The market is, of course, ideologically nihilist. But a move to the middle - which benefits everyone involved except House Republicans - would be positive for stocks and the economy. Key bellwethers going forward are how Democrats react to Trump's immigration proposal and whether Trump moves to the middle on trade deals, starting with NAFTA, whose sixth round of negotiations just ended inconclusively (although not negatively) in Montreal. Investment Implications From the perspective of global asset allocation, the most important issue today is Chinese economic and regulatory policy. Yes, U.S. inflation is important, but whether it moves the dollar - and therefore commodities and EM assets - will depend on the pace of the current Chinese slowdown. China is therefore the most "diagnostic variable" in 2018. If our House View that inflation is coming back in the U.S. is right and our Geopolitical Strategy view that risks to growth in China are to the downside is also right, then investors should go long the U.S. dollar and underweight EM and EM-leveraged assets. If, on the other hand, we are wrong, then investors should load up with EM risk assets to the hilt right now. It is that simple. For what it is worth, we are putting our moderate-conviction view to the test and opening a long DXY trade. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com 1 But on a completely unrelated note we would like to remind our clients that, over the past 24 months, Mr. Mnuchin was the executive producer of How to Be Single, Midnight Special, Batman v. Superman: Dawn of Justice, Keanu, The Conjuring 2, Central Intelligence, The Legend of Tarzan, Lights Out, Suicide Squad, Sully, Storks, The Accountant, Rules Don't Apply, The Lego Batman Movie, Fist Fight, CHiPs, Going in Style, Unforgettable, King Arthur: Legend of the Sword, Wonder Woman, The House, Annabelle: Creation, The Lego Ninjago Movie, and The Disaster Artist. 2 Please see BCA Geopolitical Strategy Weekly Report, "Upside Risks In U.S., Downside Risks In China," dated January 17, 2018, available at gps.bcaresearch.com. 3 Please see BCA Global Investment Strategy Special Report, "U.S. Border Adjustment Tax: A Potential Monster Issue For 2017," dated January 20, 2017, and Weekly Reports, "Trump and Trade," December 9, 2016, and "The Elusive Gains From Globalization," dated November 25, 2016, available at gis.bcaresearch.com. 4 Please see BCA Research Webcasts, Geopolitical Strategy Crow's Nest, "China: How Is Our View Working Out?" dated January 25, 2018. 5 Please see BCA Geopolitical Strategy Weekly Report, "BCA Geopolitical Strategy 2017 Report Card," dated December 20, 2017, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, and "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Special Report, "Power And Politics In East Asia: Cold War 2.0?" dated September 25, 2012, "Sino-American Conflict: More Likely Than You Think," dated October 4, 2013, and "Sino-American Conflict: More Likely Than You Think, Part II," dated November 6, 2015, available at gps.bcaresearch.com. 8 Please see Daniel H. Rosen, "A Post-Engagement US-China Relationship," Rhodium Group, January 19, 2018, available at rhg.com. 9 In fact, in the case of washing machines, the U.S.-based GE Appliances stands to gain from the tariff and has been owned by China's Haier Electronics Group since 2016. 10 Several clients have asked us about China's Cyber-Security Law, which has been in the process of implementation since July 2017 and will go fully into effect by the end of 2018. The law is meant to give the Chinese government the option of exercising control over all networks in the country. State security agencies are deeply involved in its enforcement and oversight. Foreign business interests fear that the law's new obligations will be onerous and potentially damaging - including potential violations of corporate security over intellectual property, source code, supply chain details, and data storage and transmission. 11 Please see Stephen E. Becker, Nancy Fischer, and Sahar Hafeez, "Update on US Investigation of China's IP Practices," Lexology, January 8, 2018, available at www.lexology.com. 12 Please see BCA Geopolitical Strategy Special Report, "How To Read Xi Jinping's Party Congress Speech," dated October 18, 2017, available at gps.bcaresearch.com. 13 Wang has served as the top interlocutor with the U.S. in the U.S.-China Comprehensive Economic Dialogue. 14 Please see "China eyes black swans, gray rhinos as 2018 growth seen slowing to 6.5-6.8 percent: media," Reuters, January 28, 2018, available at www.reuters.com. "Gray rhinos," coined by author Michele Wucker, refer to high-probability, high-impact risks, whereas the proverbial "black swan" is a low-probability, high-impact risk. These terms have both been making the rounds more frequently in Chinese policymaking circles since last year. 15 Please see BCA Geopolitical Strategy Special Report, "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 16 What is fascinating about Trump's statement is that he cited the 1.8 million figure. There are actually only about 800,000 people who officially participated in President Obama's Deferred Action for Childhood Arrivals program. But estimates suggest that another 1,000,000 young adults are in the U.S. illegally, yet did not register. Trump has come under criticism from conservative, anti-immigration groups for essentially moving the goalposts beyond what even the Democrats had wanted. 17 Canada, for example, has a purely merit-based immigration system that is considerably tough on family reunification. (Reunification has even been suspended because of a large backlog.) In Europe, family reunification laws are extremely strict. Even spouses are not automatically allowed residency status in several major European countries unless they fulfill various conditions. 18 Please see footnote 2 above.
Highlights U.S. equities 'melted up' in January as tax cuts made the robust growth/low inflation sweet spot even sweeter. Ominously, recent market action is beginning to resemble a classic late cycle blow-off phase. The fundamentals supporting the market will persist through most of the year, before an economic downturn in the U.S. takes hold in 2019. The repatriation of overseas corporate cash will also flatter EPS growth this year via buyback and M&A activity. The S&P 500 could return 14% or more this year. Unfortunately, the consensus now shares our upbeat view for 2018. Valuation is stretched and many indicators suggest that investors have become downright giddy. This month we compare valuation across the major asset classes. U.S. equities are the most overvalued, followed by gold, raw industrials and EM assets. Oil is still close to fair value. Long-term investors should already be scaling back on risk assets. Investors with a 6-12 month horizon should stay overweight equities versus bonds for now, but a risk management approach means that they should not try to squeeze out the last few percentage points of return. In terms of the sequencing of the exit from risk, the most consistent lead/lag relationship relative to previous tops in the equity market is provided by U.S. corporate bonds. For this reason, we are likely to take profits on corporates before equities. EM assets are already at underweight. We still see a window for the U.S. dollar to appreciate, although by only about 5%. A lot of good news is discounted in the euro, peripheral core inflation is slowing and ECB policymakers are getting nervous. Monetary policy remains the main risk to a pro-cyclical investment stance, although not because of the coming change in the makeup of the FOMC. The economy and inflation should justify four Fed rate hikes in 2018 no matter the makeup. The bond bear phase will continue. Feature Chart I-1Investors Are Giddy U.S. equities 'melted up' in January as tax cuts made the robust growth/low inflation sweet spot even sweeter. Ominously, though, recent market action is beginning to resemble the classic late cycle blow-off phase. Such blow-offs can be highly profitable, but also make it more difficult to properly time the market top. Our base case is that the fundamentals supporting the market will persist through most of the year, before an economic downturn in the U.S. takes hold in 2019. Unfortunately, the consensus now shares our upbeat view for 2018 and many indicators suggest that investors have become downright giddy (Chart I-1). These indicators include investor sentiment, our speculation index, and the bull-to-bear ratio. Net S&P earnings revisions and the U.S. economic surprise index are also extremely elevated, while equity and bond implied volatility are near all-time lows. From a contrarian perspective, these observations suggest that a lot of good news is discounted and that the market is vulnerable to even slight disappointments. It is also a bad sign that our Revealed Preference Indicator moved off of its bullish equity signal in January (see Section III for more details). Meanwhile, central banks are beginning to take away the punchbowl as global economic slack dissipates. This is all late-cycle stuff. Equity valuation does not help investors time the peak in markets, but it does tell us something about downside risk and medium-term expected returns. The Shiller P/E ratio has surged above 30 (Chart I-2). Chart I-3 highlights that, historically, average total returns were negligible over the subsequent 10-year period when the Shiller P/E was in the 30-40 range. Granted, the Shiller P/E will likely fall mechanically later this year as the collapse of earnings in 2008 begins to drop out of the 10-year EPS calculation. Nonetheless, even the BCA Composite Valuation indicator, which includes some metrics that account for extremely low bond yields, surpassed +1 standard deviations in January (our threshold for overvaluation; Chart I-2, bottom panel). An overvaluation signal means that investors should be biased to take profits early. Chart I-2BCA Valuation Indicator Surpasses One Sigma Chart I-3Expected Returns Given Starting Point Shiller P/E As we highlighted in our 2018 Outlook Report, long-term investors should already be scaling back on risk assets. We recommend that investors with a 6-12 month horizon should stay overweight equities versus bonds for now, but we need to be vigilant in terms of scouring for signals to take profits. A risk management approach means that investors should not try to get the last few percentage points of return before the peak. U.S. Earnings And Repatriation Before we turn to the timing and sequence of our exit from risk assets, we will first update our thoughts on the earnings cycle. Fourth quarter U.S. earnings season is still in its early innings, but the banking sector has set an upbeat tone. S&P 500 profits are slated to register a 12% growth rate for both Q4/2017 and calendar 2017. Current year EPS growth estimates have been aggressively ratcheted higher (from 12% growth to 16%) in a mere three weeks on the back of Congress' cut to the corporate tax rate.1 U.S. margins fell slightly in the fourth quarter, but remain at a high level on the back of decent corporate pricing power. A pick-up in productivity growth into year-end helped as well. Our short-term profit model remains extremely upbeat (Chart I-4). The positive profit outlook for the first half of the year is broadly based across sectors as well, according to the recently updated EPS forecast models from BCA's U.S. Equity Sector Strategy service.2 The repatriation of overseas corporate cash will also flatter EPS growth this year via buyback and M&A activity. Studies of the 2004 repatriation legislation show that most of the funds "brought home" were paid out to shareholders, mostly in the form of buybacks. A NBER report estimated that for every dollar repatriated, 92 cents was subsequently paid out to shareholders in one form or another. The surge in buybacks occurred in 2005, according to the U.S. Flow of Funds accounts and a proxy using EPS growth less total dollar earnings growth for the S&P 500 (Chart I-5). The contribution to EPS growth from buybacks rose to more than 3 percentage points at the peak in 2005. Chart I-4Profit Growth Still Accelerating Chart I-5U.S. Buybacks To Lift EPS We expect that most of the repatriated funds will again flow through to shareholders, rather than be used to pay down debt or spent on capital goods. Cash has not been a constraint to capital spending in recent years outside of perhaps the small business sector, which has much less to gain from the tax holiday. A revival in animal spirits and capital spending is underway, but this has more to do with the overall tax package and global growth than the ability of U.S. companies to repatriate overseas earnings. Estimates of how much the repatriation could boost EPS vary widely. Most of it will occur in the Tech and Health Care sectors. Buybacks appear to have lifted EPS growth by roughly one percentage point over the past year. We would not be surprised to see this accelerate by 1-2 percentage points, although the timing could be delayed by a year if the 2004 tax holiday provides the correct timeline. This is certainly positive for the equity market, but much of the impact could already be discounted in prices. Organic earnings growth, and the economic and policy outlook will be the main drivers of equity market returns over the next year. We expect some profit margin contraction later this year, but our 5% EPS growth forecast is beginning to look too conservative. This is especially the case because it does not include the corporate tax cuts. The amount by which the tax cuts will boost earnings on an after-tax basis is difficult to estimate, but we are using 5% as a conservative estimate. Adding 2% for buybacks and 2% for dividends, the S&P 500 could provide an attractive 14% total return this year (assuming no multiple expansion). Timing The Exit Chart I-6Timing The Exit (I) That said, we noted in last month's Report and in BCA's 2018 Outlook that this will be a transition year. We expect a recession in the U.S. sometime in 2019 as the Fed lifts rates into restrictive territory. Equities and other risk assets will sniff out the recession about six months in advance, which means that investors should be preparing to take profits sometime during the next 12 months. Last month we discussed some of the indicators we will watch to help us time the exit. The 2/10 Treasury yield curve has been a reliable recession indicator in the past. However, the lead time on the peak in stocks was quite extended at times (Chart I-6). A shift in the 10-year TIPS breakeven rate above 2.4% would be consistent with the Fed's 2% target for the PCE measure of inflation. This would be a signal that the FOMC will have to step-up the pace of rate hikes and aggressively slow economic growth. We expect the Fed to tighten four times in 2018. We are likely to take some money off the table if core inflation is rising, even if it is still below 2%, at the time that the TIPS breakeven reaches 2.4%. We will also be watching seven indicators that we have found to be useful in heralding market tops, which are summarized in our Scorecard Indicator (Chart I-7). At the moment, four out of the seven indicators are positive (Chart I-8): State of the Business Cycle: As early signals that the economy is softening, watch for the ISM new orders minus inventories indicator to slip below zero, or the 3-month growth rate of unemployment claims to rise above zero. Monetary and Financial Conditions: Using interest rates to judge the stance of monetary policy has been complicated by central banks' use of their balance sheet as a policy tool. Thus, it is better to use two of our proprietary indicators: the BCA Monetary Indicator (MI) and the Financial Conditions Indictor. The S&P 500 index has historically rallied strongly when the MI is above its long-term average. Similarly, equities tend to perform well when the FCI is above its 250-day moving average. The MI is sending a negative signal because interest rates have increased and credit growth has slowed. However, the broader FCI remains well in 'bullish' territory. Price Momentum: We simply use the S&P 500 relative to its 200-day moving average to measure momentum. Currently, the index is well above that level, providing a bullish signal for the Scorecard. Sentiment: Our research shows that stock returns have tended to be highest following periods when sentiment is bearish but improving. In contrast, returns have tended to be lowest following periods when sentiment is bullish but deteriorating. The Scorecard includes the BCA Speculation Indicator to capture sentiment, but virtually all measures of sentiment are very high. The next major move has to be down by definition. Thus, sentiment is assigned a negative value in the Scorecard. Value: As discussed above, value is poor based on the Shiller P/E and the BCA Composite Valuation indicator. Valuation may not help with timing, but we include it in our Scorecard because an overvalued signal means investors should err on the side of getting out early. Chart I-7Equity ScoreCard: Watch For A Dip Below 3 Chart I-8Timing The Exit (II) We demonstrated in previous research that a Scorecard reading of three or above was historically associated with positive equity total returns in subsequent months. A drop below three this year would signal the time to de-risk. Table I-1Exit Checklist To our Checklist we add the U.S. Leading Economic index, which has a good track record of calling recessions. However, we will use the LEI excluding the equity market, since we are using it as an indicator for the stock market. It is bullish at the moment. Our Global LEI is also flashing green. Table I-1 provides a summary checklist for trimming equity exposure. At the moment, 2 out of 9 indicators are bearish. Cross Asset Valuation Comparison Clients have asked our view on the appropriate order in which to scale out of risk assets. One way to approach the question is to compare valuation across asset classes. Presumably, the ones that are most overvalued are at greatest risk, and thus profits should be taken the earliest. It is difficult to compare valuation across asset classes. Should one use fitted values from models or simple deviations from moving averages? Over what time period? Since there is no widely accepted approach, we include multiple measures. More than one time period was used in some cases to capture regime changes. Table I-2 provides out 'best guestimate' for nine asset classes. The approaches range from sophisticated methods developed over many years (i.e. our equity valuation indicators), to regression analysis on the fundamentals (oil), to simple deviations from a time trend (real raw industrial commodity prices and gold). Table I-2Valuation Levels For Major Asset Classes We averaged the valuation readings in cases where there are multiple estimates for a single asset class. The results are shown in Chart I-9. Chart I-9Valuation Levels For Major Asset Classes U.S. equities stand out as the most expensive by far, at 1.8 standard deviations above fair value. Gold, raw industrials and EM equities are next at one standard deviation overvalued. EM sovereign bond spreads come next at 0.7, followed closely by U.S. Treasurys (real yield levels) and investment-grade corporate (IG) bonds (expressed as a spread). High-yield (HY) is only about 0.3 sigma expensive, based on default-adjusted spreads over the Treasury curve. That said, both IG and HY are quite expensive in absolute terms based on the fact that government bonds are expensive. Oil is sitting very close to fair value, despite the rapid price run up over the past couple of months. This makes oil exposure doubly attractive at the moment because the fundamentals point to higher prices at a time when the underlying asset is not expensive. Sequencing Around Past S&P 500 Peaks Historical analysis around equity market peaks provides an alternative approach to the sequencing question. Table I-3 presents the number of days that various asset classes peaked before or after the past major five tops in the S&P 500. A negative number indicates that the asset class peaked before U.S. equities, and a positive number means that it peaked after. Table I-3Asset Class Leads & Lags Vs. Peak In S&P 500 Unfortunately, there is no consistent pattern observed for EM equities, raw industrials, U.S. cyclical stocks, Tech stocks, or small-cap versus large-cap relative returns. Sometimes they peaked before the S&P 500, and sometime after. The EM sovereign bond excess return index peaked about 130 days in advance of the 1998 and 2007 U.S. equity market tops, although we only have three episodes to analyse due to data limitations. Oil is a mixed bag. A peak in the price of gold led the equity market in four out of five episodes, but the lead time is long and variable. The most consistent lead/lag relationship is given by the U.S. corporate bond market. Both investment- and speculative-grade excess returns relative to government bonds peaked in advance of U.S. stocks in four of the five episodes. High-yield excess returns provided the most lead time, peaking on average 154 days in advance. Excess returns to high-yield were a better signal than total returns. This leading relationship is one reason why we plan to trim exposure to corporate bonds within our bond portfolio in advance of scaling back on equities. But the 'return of vol' that we expect to occur later this year will take a toll on carry trades more generally. We are already underweight EM equities and bonds. This EM recommendation has not gone in our favor, but it would make little sense to upgrade them now given our positive views on volatility and the dollar. An unwinding of carry trades will also hit the high-yielding currencies outside of the EM space, such as the Kiwi and Aussie dollar. Base metal prices will be hit particularly hard if the 2019 U.S. recession spills over to the EM economies as we expect. We may downgrade base metals from neutral to underweight around the time that we downgrade equities, but much depends on the evolution of the Chinese economy in the coming months. Oil is a different story. OPEC 2.0 is likely to cut back on supply in the face of an economic downturn, helping to keep prices elevated. We therefore may not trim energy exposure this year. As for equity sectors, our recommended portfolio is still overweight cyclicals for now. Our synchronized global capex boom, rising bond yield, and firm oil price themes keep us overweight the Industrials, Energy and Financial sectors. Utilities and Homebuilders are underweight. Tech is part of the cyclical sector, but poor valuation keeps us underweight. That said, our sector specialists are already beginning a gradual shift away from cyclicals toward defensives for risk management purposes. This transition will continue in the coming months as we de-risk. We are also shifting small caps to neutral on earnings disappointments and elevated debt levels. The Dollar Pain Trade Market shifts since our last publication have largely gone in our favor; stocks have surged, corporate bonds spreads have tightened, oil prices have spiked, bonds have sold off and cyclical stocks have outperformed defensives. One area that has gone against us is the U.S. dollar. Relative interest rate expectations have moved in favor of the dollar as we expected at both the short- and long-ends of the curve. Nonetheless, the dollar has not tracked its historical relationship versus both the yen and euro. The Greenback did not even get a short-term boost from the passage of the tax plan and holiday on overseas earnings. Perhaps this is because the lion's share of "overseas" earnings are already held in U.S. dollars. Reportedly, a large fraction is even held in U.S. banks on U.S. territory. Currency conversion is thus not a major bullish factor for the U.S. dollar. The recent bout of dollar weakness began around the time of the release of the ECB Minutes in January which were interpreted as hawkish because they appeared to be preparing markets for changes in monetary policy. The European debt crisis and economic recession were the reasons for the ECB's asset purchases and negative interest rate policy. Neither of these conditions are in place now. The ECB is meeting as we go to press, and we expect some small adjustments in the Statement that remove references to the need for "crisis" level accommodations. Subsequent steps will be to prepare markets for a complete end to QE, perhaps in September, and then for rates hikes likely in 2019. The key point is that European monetary policy has moved beyond 'peak stimulus' and the normalization process will continue. Perhaps this is partly to blame for euro strength although, as mentioned above, interest rate differentials have moved in favor of the dollar. Does this mean that the dollar has peaked and has entered a cyclical bear phase that will persist over the next 6-12 months? The answer is 'no', although we are less bullish than in the past. We believe there is still a window for the dollar to appreciate against the euro and in broader trade-weighted terms by about 5%. First, a lot of euro-bullish news has been discounted (Chart I-10). Positive economic surprises heavily outstripped that in the U.S. last year, but that phase is now over. The euro appears expensive based on interest rate differentials, and euro sentiment is close to a bullish extreme. This all suggests that market positioning has become a negative factor for the currency. Chart I-10Euro: A Lot Of Bullish News Is Discounted Second, the chorus of complaints against the euro's strength is growing among European central bankers, including Ewald Nowotny, the rather hawkish Austrian central banker. Policymakers' concerns may partly reflect the fact that peripheral inflation excluding food and energy has already weakened to 0.6% from a high of 1.3% in April last year (Chart I-10, fourth panel). Third, U.S. consumer price and wage inflation have yet to pick up meaningfully. The dollar should receive a lift if core U.S. inflation clearly moves toward the Fed's 2% target, as we expect. The FOMC would suddenly appear to have fallen behind the curve and U.S. rate expectations would ratchet higher. Chart I-10, bottom panel, highlights that the euro will weaken if U.S. core inflation rises versus that in the Eurozone. The implication is that the Euro's appreciation has progressed too far and is due for a pullback. As for the yen, the currency surged in January when the Bank of Japan (BoJ) announced a reduction in long-dated JGB purchases. This simply acknowledged what has already occurred. It was always going to be impossible to target both the quantity of bond purchases and the level of 10-year yield simultaneously. Keeping yields near the target required less purchases than they thought. The market interpreted the BoJ's move as a possible prelude to lifting the 10-year yield target. It is perhaps not surprising that the market took the news this way. The economy is performing extremely well; our model that incorporates high-frequency economic data suggests that real GDP growth will move above 3% in the coming quarters. The Japanese economy is benefiting from the end of a fiscal drag and from a rebound in EM growth. Nonetheless, following January's BoJ policy meeting, Kuroda poured cold water on speculation that the BoJ may soon end or adjust the YCC. Recent speeches by BoJ officials reinforce the view that the MPC wants to see an overshoot of actual inflation that will lower real interest rates and thereby reinforce the strong economic activity that is driving higher inflation. Only then will officials be convinced that their job is done. Given that inflation excluding food and energy only stands at 0.3%, the BoJ is still a long way from the overshoot it desires. On the positive side, Japan's large current account surplus and yen undervaluation provide underlying support for the currency. Balancing the offsetting positive and negative forces, our foreign exchange strategists have shifted to neutral on the yen. The Euro remains underweight while the dollar is overweight. Similar to our dollar view, we still see a window for U.S. Treasurys to underperform the global hedged fixed-income benchmark as world bond yields shift higher this year. European government bonds will also sell off, but should outperform Treasurys. JGBs will provide the best refuge for bondholders during the global bond bear phase, since the BoJ will prevent a rise in yields inside of the 10-year maturity. Our global bond strategists upgraded U.K. gilts to overweight in January. Momentum in the U.K. economy is slowing, as a weaker consumer, slower housing activity, and softer capital spending are offsetting a pickup in exports. With the inflationary impulse from the 2016 plunge in the Pound now fading, and with Brexit uncertainty weighing on business confidence, the Bank of England will struggle to raise rates in 2018. FOMC Transition Monetary policy remains the main risk to a pro-cyclical investment stance, although not because of the coming change in the makeup of the FOMC. An abrupt shift in policy is unlikely. There was some support at the December 2017 FOMC meeting to study the use of nominal GDP or price level targeting as a policy framework, but this has been an ongoing debate that will likely continue for years to come. The Fed will remain committed to its current monetary policy framework once Powell takes over. Table I-4 provides a summary of who will be on the FOMC next year, including their policy bias. Chart I-11 compares the recent FOMC makeup with the coming Powell FOMC (voting members only). The hawk/dove ratio will not change much under Powell, unless Trump stacks the vacant spots with hawks. Table I-4Composition Of The FOMC Chart I-11Composition Of Voting FOMC Members 2017 Vs. 2018 In any event, history shows that the FOMC strives to avoid major shifts in policy around changeovers in the Fed Chair. In previous transitions, the previous path for rates was maintained by an average of 13 months. Moreover, Powell has shown that he is not one to rock the boat during his time on the FOMC. It will be the evolution of the economy and inflation, not the composition of the FOMC, that will have the biggest impact on markets at the end of the day. Recent speeches reveal that policymakers across the hawk/dove spectrum are moving modesty toward the hawkish side because growth has accelerated at a time when unemployment is already considered to be below full-employment by many policymakers. The melt-up in equity indexes in January did little to calm worries about financial excesses either. The Fed is struggling to understand the strength of the structural factors that could be holding down inflation. This month's Special Report, beginning on page 21, focusses on the impact of robot automation. While advances on this front are impressive, we conclude that it is difficult to find evidence that robots are more deflationary than previous technological breakthroughs. Thus, increased robot usage should not prevent inflation from rising as the labor market continues to tighten. The macro backdrop will likely justify the FOMC hiking at least as fast as the dots currently forecast. The risks are skewed to the upside. The median Fed dot calls for an unemployment rate of 3.9% by end-2018, only marginally lower than today's rate of 4.1%. This is inconsistent with real GDP growth well in excess of its supply-side potential. The unemployment rate is more likely to reach a 49-year low of 3.5% by the end of this year. As highlighted in last month's Report, a key risk to the bull market in risk assets is the end of the 'low vol/low rate' world. The selloff in the bond market in January may mark the start of this process. Conclusions We covered a lot of ground in this month's Overview of the markets, so we will keep the conclusions brief and focused on the risks. Our key point is that the fundamentals remain positive for risk assets, but that a lot of good news is discounted and it appears that we have entered a classic blow-off phase. This will be a transition year to a recession in the U.S. in 2019. Given that valuation for most risk assets is quite stretched, and given that the monetary taps are starting to close, investors must plan for the exit and keep an eye on our timing checklist. The main risk to our pro-cyclical portfolio is a rise in U.S. inflation and the Fed's response, which we believe will end the sweet spot for risk assets. Apart from this, our geopolitical strategists point to several other items that could upset the applecart this year:3 1. Trade China has cooperated with the U.S. in trying to tame North Korea. Nonetheless, President Trump is committed to an "America First" trade policy and he may need to show some muscle against China ahead of the midterm elections in November in order to rally his base. It is politically embarrassing to the Administration that China racked up its largest trade surplus ever with the U.S. in Trump's first year in office. A key question is whether the President goes after China via a series of administrative rulings - such as the recently announced tariffs on solar panels and white goods - or whether he applies an across-the-board tariff and/or fine. The latter would have larger negative macroeconomic implications. 2. Iran On January 12, President Trump threatened not to waive sanctions against Iran the next time they come due (May 12), unless some new demands are met. Pressure from the U.S. President comes at a delicate time for Iran. Domestic unrest has been ongoing since December 28. Although protests have largely fizzled out, they have reopened the rift between the clerical regime, led by Supreme Leader Ayatollah Ali Khamenei, and moderate President Hassan Rouhani. Iranian hardliners, who control part of the armed forces, could lash out in the Persian Gulf, either by threatening to close the Straits of Hormuz or by boarding foreign vessels in international waters. The domestic political calculus in both Iran and the U.S. make further Tehran-Washington tensions likely. For the time being, however, we expect only a minor geopolitical risk premium to seep into the energy markets, supporting our bullish House View on oil prices. 3. China Last month's Special Report highlighted that significant structural reforms are on the way in China, now that President Xi has amassed significant political support for his reform agenda. The reforms should be growth-positive in the long term, but could be a net negative for growth in the near term depending on how deftly the authorities handle the monetary and fiscal policy dials. The risk is that the authorities make a policy mistake by staying too tight, as occurred in 2015. We are monitoring a number of indicators that should warn if a policy mistake is unfolding. On this front, January brought some worrying economic data. The latest figures for both nominal imports and money growth slowed. Given that M2 and M3 are components of BCA's Li Keqiang Leading Indicator, and that nominal imports directly impact China's contribution to global growth, this raises the question of whether December's economic data suggest that China is slowing at a more aggressive pace than we expect. For now, our answer is no. First, China's trade numbers are highly volatile; nominal import growth remains elevated after smoothing the data. Second, China's export growth remains buoyant, consistent with a solid December PMI reading. The bottom line is that we are sticking with our view that China will experience a benign deceleration in terms of its impact on DM risk assets, but we will continue to monitor the situation closely. Mark McClellan Senior Vice President The Bank Credit Analyst January 25, 2018 Next Report: February 22, 2018 1 According to Thomson Reuters/IBES. 2 Please see U.S. Equity Sector Strategy Special Report "White Paper: Introducing Our U.S. Equity Sector Earnings Models," dated January 16, 2018, available at uses.bcaresearch.com 3 For more information, please see BCA Geopolitical Strategy Weekly Report "Upside Risks In U.S., Downside Risks In China," dated January 17, 2018, available at gps.bcaresearch.com. Also see "Watching Five Risks," dated January 24, 2018. II. The Impact Of Robots On Inflation Media reports warn of a "Robot Apocalypse" that is already laying waste to jobs and depressing wages on a broad scale. Technological advance in the past has not prevented improving living standards or led to ever rising joblessness over the decades, but pessimists argue that recent advances are different. The issue is important for financial markets. If structural factors such as automation are holding back inflation by more than in previous decades, then the Fed will have to proceed very slowly in raising rates. We see no compelling evidence that the displacement effect of emerging technologies is any stronger than in the past. Robot usage has had a modest positive impact on overall productivity. Despite this contribution, overall productivity growth has been dismal over the past decade. If automation is increasing 'exponentially' and displacing workers on a broad scale as some claim, one would expect to see accelerating productivity growth, robust capital spending and more violent shifts in occupational shares. Exactly the opposite has occurred. Periods of strong growth in automation have historically been associated with robust, not lackluster, wage gains, contrary to the consensus view. The Fed was successful in meeting the 2% inflation target on average from 2000 to 2007, when the impact of the IT revolution on productivity (and costs) was stronger than that of robot automation today. This and other evidence suggest that it is difficult to make the case that robots will make it tougher for central banks to reach their inflation goals than did previous technological breakthroughs. For investors, this means that we cannot rely on automation to keep inflation depressed irrespective of how tight labor markets become. Recent breakthroughs in technology are awe-inspiring and unsettling. These advances are viewed with great trepidation by many because of the potential to replace humans in the production process. Hype over robots is particularly shrill. Media reports warn of a "Robot Apocalypse" that is already laying waste to jobs and depressing wages on a broad scale. In the first in our series of Special Reports focusing on the structural factors that might be preventing central banks from reaching their inflation targets, we demonstrated that the impact of Amazon is overstated in the press. We estimated that E-commerce is depressing inflation in the U.S. by a mere 0.1 to 0.2 percentage points. This Special Report tackles the impact of automation. We are optimistic that robot technology and artificial intelligence will significantly boost future productivity, and thus reduce costs. But, is there any evidence at the macro level that robot usage has been more deflationary than technological breakthroughs in the past and is, thus, a major driver of the low inflation rates we observe today across the major countries? The question matters, especially for the outlook for central bank policy and the bond market. If structural factors are indeed holding back inflation by more than in previous decades, then the Fed will have to proceed very slowly in raising rates. However, if low inflation simply reflects long lags between wages and the tightening labor market, then inflation may suddenly lurch to life as it has at the end of past cycles. The bond market is not priced for that scenario. Are Robots Different? A Special Report from BCA's Technology Sector Strategy service suggested that the "robot revolution" could be as transformative as previous General Purpose Technologies (GPT), including the steam engine, electricity and the microchip.1 GPTs are technologies that radically alter the economy's production process and make a major contribution to living standards over time. The term "robot" can have different meanings. The most basic definition is "a device that automatically performs complicated and often repetitive tasks," and this encompasses a broad range of machines: From the Jacquard Loom, which was invented over 200 years ago, on to Numerically Controlled (NC) mills and lathes, pick and place machines used in the manufacture of electronics, Autonomous Vehicles (AVs), and even homicidal robots from the future such as the Terminator. Our Technology Sector report made the case that there is nothing particularly sinister about robots. They are just another chapter in a long history of automation. Nor is the displacement of workers unprecedented. The industrial revolution was about replacing human craft labor with capital (machines), which did high-volume work with better quality and productivity. This freed humans for work which had not yet been automated, along with designing, producing and maintaining the machinery. Agriculture offers a good example. This sector involved over 50% of the U.S. labor force until the late 1800s. Steam and then internal combustion-powered tractors, which can be viewed as "robotic horses," contributed to a massive rise in output-per-man hour. The number of hours worked to produce a bushel of wheat fell by almost 98% from the mid-1800s to 1955. This put a lot of farm hands out of work, but these laborers were absorbed over time in other growing areas of the economy. It is the same story for all other historical technological breakthroughs. Change is stressful for those directly affected, but rising productivity ultimately lifts average living standards. Robots will be no different. As we discuss below, however, the increasing use of robots and AI may have a deeper and longer-lasting impact on inequality. Strong Tailwinds Chart II-1Robots Are Getting Cheaper Factory robots have improved immensely due to cheaper and more capable control and vision systems. As these systems evolve, the abilities of robots to move around their environment while avoiding obstacles will improve, as will their ability to perform increasingly complex tasks. Most importantly, robots are already able to do more than just routine tasks, thus enabling them to replace or aid humans in higher-skilled processes. Robot prices are also falling fast, especially after quality-adjusting the data (Chart II-1). Units are becoming easier to install, program and operate. These trends will help to reduce the barriers-to-entry for the large, untapped, market of small and medium sized enterprises. Robots also offer the ability to do low-volume "customized" production and still keep unit costs low. In the future, self-learning robots will be able to optimize their own performance by analyzing the production of other robots around the world. Robot usage is growing quickly according to data collected by the International Federation of Robotics (IFR) that covers 23 countries. Industrial robot sales worldwide increased to almost 300,000 units in 2016, up 16% from the year before (Chart II-2). The stock of industrial robots globally has grown at an annual average pace of 10% since 2010, reaching slightly more than 1.8 million units in 2016.2 Robot usage is far from evenly distributed across industries. The automotive industry is the major consumer of industrial robots, holding 45% of the total stock in 2016 (Chart II-3). The computer & electronics industry is a distant second at 17%. Metals, chemicals and electrical/electronic appliances comprise the bulk of the remaining stock. Chart II-2Global Robot Usage Chart II-3Global Robot Usage By Industry (2016) As far as countries go, Japan has traditionally been the largest market for robots in the world. However, sales have been in a long-term downtrend and the stock of robots has recently been surpassed by China, which has ramped up robot purchases in recent years (Chart II-4). Robot density, which is the stock of robots per 10 thousand employed in manufacturing, makes it easier to compare robot usage across countries (Chart II-5, panel 2). By this measure, China is not a heavy user of robots compared to other countries. South Korea stands at the top, well above the second-place finishers (Germany and Japan). Large automobile sectors in these three countries explain their high relative robot densities. Chart II-4Stock Of Robots By Country (I) Chart II-5Stock Of Robots By Country (II) (2016) While the growth rate of robot usage is impressive, it is from a very low base (outside of the automotive industry). The average number of robots per 10,000 employees is only 74 for the 23 countries in the IFR database. Robot use is tiny compared to total man hours worked. Chart II-6U.S. Investment In Robots In the U.S., spending on robots is only about 5% of total business spending on equipment and software (Chart II-6). To put this into perspective, U.S. spending on information, communication and technology (ICT) equipment represented 35-40% of total capital equipment spending during the tech boom in the 1990s and early 2000s.3 The bottom line is that there is a lot of hype in the press, but robots are not yet widely used across countries or industries. It will be many years before business spending on robots approaches the scale of the 1990s/2000s IT boom. A Deflationary Impact? As noted above, we view robotics as another chapter in a long history of technological advancements. Pessimists suggest that the latest advances are different because they are inherently more threatening to the overall job market and wage share of total income. If the pessimists are right, what are the theoretical channels though which this would have a greater disinflationary effect relative to previous GPT technologies? Faster Productivity Gains: Enhanced productivity drives down unit labor costs, which may be passed along to other industries (as cheaper inputs) and to the end consumer. More Human Displacement: The jobs created in other areas may be insufficient to replace the jobs displaced by robots, leading to lower aggregate income and spending. The loss of income for labor will simply go to the owners of capital, but the point is that the labor share of income might decline. Deflationary pressures could build as aggregate demand falls short of supply. Even in industries that are slow to automate, just the threat of being replaced by robots may curtail wage demands. Inequality: Some have argued that rising inequality is partly because the spoils of new technologies over the past 20 years have largely gone to the owners of capital. This shift may have undermined aggregate demand because upper income households tend to have a high saving rate, thereby depressing overall aggregate demand and inflationary pressures. The human displacement effect, described above, would exacerbate the inequality effect by transferring income from labor to the owners of capital. 1. Productivity It is difficult to see the benefits of robots on productivity at the economy-wide level. Productivity growth has been abysmal across the major developed countries since the Great Recession, but the productivity slowdown was evident long before Lehman collapsed (Chart II-7). The productivity slowdown continued even as automation using robots accelerated after 2010. Chart II-7Productivity Collapsed Despite Automation Some analysts argue that lackluster productivity is simply a statistical mirage because of the difficulties in measuring output in today's economy. We will not get into the details of the mismeasurement debate here. We encourage interested clients to read a Special Report by the BCA Global Investment Strategy service entitled "Weak Productivity Growth: Don't Blame The Statisticians." 4 Our colleague Peter Berezin makes the case that the unmeasured utility accruing from free internet services is large, but so was the unmeasured utility from antibiotics, radio, indoor plumbing and air conditioning. He argues that the real reason that productivity growth has slowed is that educational attainment has decelerated and businesses have plucked many of the low-hanging fruit made possible by the IT revolution. Cyclical factors stemming from the Great Recession and financial crisis are also to blame, as capital spending has been slow to recover in most of the advanced economies. Some other factors that help to explain the decline in aggregate productivity are provided in Appendix II-1. Nonetheless, the poor aggregate productivity performance does not mean that there are no benefits to using robots. The benefits are evident at the industrial level, where measurement issues are presumably less vexing for statisticians (i.e., it is easier to measure the output of the auto industry, for example, than for the economy as a whole). Chart II-8 plots the level of robot density in 2016 with average annual productivity growth since 2004 for 10 U.S. manufacturing industries (robot density is presented in deciles). A loose positive relationship is apparent. Chart II-8U.S.: Productivity Vs. Robot Density Academic studies estimate that robots have contributed importantly to economy-wide productivity growth. The Centre for Economic and Business Research (CEBR) estimated that labor productivity growth rises by 0.07 to 0.08 percentage points for every 1% rise in the rate of robot density.5 This implies that robots accounted for roughly 10% of the productivity growth experienced since the early 1990s in the major economies. Another study of 14 industries across 17 countries by the Centre for Economic Performance (CEP) found that robots boosted annual productivity growth by 0.36 percentage points over the 1993-2007 period.6 This is impressive because, if this estimate holds true for the U.S., robots' contribution to the 2½% average annual U.S. total productivity growth over the period was 14%. To put the importance of robotics into historical context, its contribution to productivity so far is roughly on par with that of the steam engine (Chart II-9). It falls well short of the 0.6 percentage point annual productivity contribution from the IT revolution. The implication is that, while the overall productivity performance has been dismal since 2007, it would have been even worse in the absence of robots. What does this mean for inflation? According to the "cost push" model of the inflation process, an increase in productivity of 0.36% that is not accompanied by associated wage gains would reduce unit labor costs (ULC) by the same amount. This should trim inflation if the cost savings are passed on to the end consumer, although by less than 0.36% because robots can only depress variable costs, not fixed costs. There indeed appears to be a slight negative relationship between robot density and unit labor costs at the industrial level in the U.S., although the relationship is loose at best (Chart II-10). Chart II-9GPT Contribution To Productivity Chart II-10U.S.: Unit Labor Costs Vs. Robot Density In theory, divergences in productivity across industries should only generate shifts in relative prices, and "cost push" inflation dynamics should only operate in the short term. Most economists believe that inflation is a purely monetary phenomenon in the long run, which means that central banks should be able to offset positive productivity shocks by lowering interest rates enough that aggregate demand keeps up with supply. Indeed, the Fed was successful in meeting the 2% inflation target on average from 2000 to 2007, when the impact of the IT revolution on productivity (and costs) was stronger than that of robot automation today. Also, note that inflation is currently low across the major advanced economies, irrespective of the level of robot intensity (Chart II-11). From this perspective, it is hard to see that robots should take much of the credit for today's low inflation backdrop. Chart II-11Inflation Vs. Robot Density 2. Human Displacement A key question is whether robots and humans are perfect substitutes. If new technologies introduced in the past were perfect substitutes, then it would have led to massive underemployment and all of the income in the economy would eventually have migrated to the owners of capital. The fact that average real household incomes have risen over time, and that there has been no secular upward trend in unemployment rates over the centuries, means that new technologies were at least partly complementary with labor (i.e., the jobs lost as a direct result of productivity gains were more than replaced in other areas of the economy over time). Rather than replacing workers, in many cases tech made humans more productive in their jobs. Rising productivity lifted income and thereby led to the creation of new jobs in other areas. The capital that workers bring to the production process - the skills, know-how and special talents - became more valuable as interaction with technology increased. Like today, there were concerns in the 1950s and 1960s that computerization would displace many types of jobs and lead to widespread idleness and falling household income. With hindsight, there was little to worry about. Some argue that this time is different. Futurists frequently assert that the pace of innovation is not just accelerating, it is accelerating 'exponentially'. Robots can now, or will soon be able to, replace humans in tasks that require cognitive skills. This means that they will be far less complementary to humans than in the past. The displacement effect could thus be much larger, especially given the impressive advances in artificial intelligence. However, Box II-1 discusses why the threat to workers posed by AI is also heavily overblown in the media. The CEP multi-country study cited above did not find a large displacement effect; robot usage did not affect the overall number of hours worked in the 23 countries studied (although it found distributional effects - see below). In other words, rather than suppressing overall labor input, robot usage has led to more output, higher productivity, more jobs and stronger wage and income growth. A report by the Economic Policy Institute (EPI)7 takes a broader look at automation, using productivity growth and capital spending as proxies. Automation is what occurs as the implementation of new technologies is incorporated along with new capital equipment or software to replace human labor in the workplace. If automation is increasing 'exponentially' and displacing workers on a broad scale, one would expect to see accelerating productivity growth, robust capital spending, and more violent shifts in occupational shares. Exactly the opposite has occurred. Indeed, the report demonstrates that occupational employment shifts were far slower in the 2000-2015 period than in any decade in the 1900s (Chart II-12). Box II-1 The Threat From AI Is Overblown Media coverage of AI/Deep Learning has established a consensus view that we believe is well off the mark. A recent Special Report from BCA's Technology Sector Strategy service dispels the myths surrounding AI.8 We believe the consensus, in conjunction with warnings from a variety of sources, is leading to predictions, policy discussions, and even career choices based on a flawed premise. It is worth noting that the most vocal proponents of AI as a threat to jobs and even humanity are not AI experts. At the root of this consensus is the false view that emerging AI technology is anything like true intelligence. Modern AI is not remotely comparable in function to a biological brain. Scientists have a limited understanding of how brains work, and it is unlikely that a poorly understood system can be modeled on a computer. The misconception of intelligence is amplified by headlines claiming an AI "taught itself" a particular task. No AI has ever "taught itself" anything: All AI results have come about after careful programming by often PhD-level experts, who then supplied the system with vast amounts of high quality data to train it. Often these systems have been iterated a number of times and we only hear of successes, not the failures. The need for careful preparation of the AI system and the requirement for high quality data limits the applicability of AI to specific classes of problems where the application justifies the investment in development and where sufficient high-quality data exists. There may be numerous such applications but doubtless many more where AI would not be suitable. Similarly, an AI system is highly adapted to a single problem, or type of problem, and becomes less useful when its application set is expanded. In other words, unlike a human whose abilities improve as they learn more things, an AI's performance on a particular task declines as it does more things. There is a popular misconception that increased computing power will somehow lead to ever improving AI. It is the algorithm which determines the outcome, not the computer performance: Increased computing power leads to faster results, not different results. Advanced computers might lead to more advanced algorithms, but it is pointless to speculate where that may lead: A spreadsheet from 2001 may work faster today but it still gives the same answer. In any event, it is worth noting that a tool ceases to be a tool when it starts having an opinion: there is little reason to develop a machine capable of cognition even if that were possible. Chart II-12U.S. Job Rotation Has Slowed The EPI report also notes that these indicators of automation increased rapidly in the late 1990s and early 2000s, a period that saw solid wage growth for American workers. These indicators weakened in the two periods of stagnant wage growth: from 1973 to 1995 and from 2002 to the present. Thus, there is no historical correlation between increases in automation and wage stagnation. Rather than automation, the report argues that it was China's entry into the global trading system that was largely responsible for the hollowing out of the U.S. manufacturing sector. We have also made this argument in previous research. The fact that the major advanced economies are all at, or close to, full employment supports the view that automation has not been an overwhelming headwind for job creation. Chart II-13 demonstrates that there has been no relationship between the change in robot density and the loss of manufacturing jobs since 1993. Japan is an interesting case study because it is on the leading edge of the problems associated with an aging population. Interestingly, despite a worsening labor shortage, robot density among Japanese firms is falling. Moreover, the Japanese data show that the industries that have a high robot usage tend to be more, not less, generous with wages than the robot laggard industries. Please see Appendix II-2 for more details. Chart II-13Global Manufacturing Jobs Vs. Robot Density The bottom line is that it does not appear that labor displacement related to automation has been responsible in any meaningful way for the lackluster average real income growth in the advanced economies since 2007. 3. Inequality That said, there is evidence suggesting that robots are having important distributional effects. The CEP study found that robot use has reduced hours for low-skilled and (to a lesser extent) middle-skilled workers relative to the highly skilled. This finding makes sense conceptually. Technological change can exacerbate inequality by either increasing the relative demand for skilled over unskilled workers (so-called "skill-biased" technological change), or by inducing companies to substitute machinery and other forms of physical capital for workers (so-called "capital-biased" technological change). The former affects the distribution of labor income, while the latter affects the share of income in GDP that labor receives. A Special Report appearing in this publication in 2014 focused on the relationship between technology and inequality.9 The report highlighted that much of the recent technological change has been skill-biased, which heavily favors workers with the talent and education to perform cognitively-demanding tasks, even as it reduces demand for workers with only rudimentary skills. Moreover, technological innovations and globalization increasingly allow the most talented individuals to market their skills to a much larger audience, thus bidding up their wages. The evidence suggests that faster productivity growth leads to higher average real wages and improved living standards, at least over reasonably long horizons. Nonetheless, technological change can, and in the future almost certainly will, increase income inequality. The poor will gain, but not as much as the rich. The fact that higher-income households tend to maintain a higher savings rate than low-income households means that the shift in the distribution of income toward the higher-income households will continue to modestly weigh on aggregate demand. Can the distribution effect be large enough to have a meaningful depressing impact on inflation? We believe that it has played some role in the lackluster recovery since the Great Recession, with the result that an extended period of underemployment has delivered a persistent deflationary impulse in the major developed economies. However, as discussed above, stimulative monetary policy has managed to overcome the impact of inequality and other headwinds on aggregate demand, and has returned the major countries roughly to full employment. Indeed, this year will be the first since 2007 that the G20 economies as a group will be operating slightly above a full employment level. Inflation should respond to excess demand conditions, irrespective of any ongoing demand headwind stemming from inequality. Conclusions Technological change has led to rising living standards over the decades. It did not lead to widespread joblessness and did not prevent central banks from meeting their inflation targets over time. The pessimists argue that this time is different because robots/AI have a much larger displacement effect. Perhaps it will be 20 years before we will know the answer. But our main point is that we have found no evidence that recent advances in robotics and AI, while very impressive, will be any different in their macro impact. There is little evidence that the modern economy is less capable in replacing the jobs lost to automation, although the nature of new technologies may be affecting the distribution of income more than in the past. Real incomes for the middle- and lower-income classes have been stagnant for some time, but this is partly due to productivity growth that is too low, not too high. Moreover, it is not at all clear that positive productivity shocks are disinflationary beyond the near term. The link between robot usage and unit labor costs over the past couple of decades is loose at best at the industry level, and is non-existent when looking across the major countries. The Fed was able to roughly meet its 2% inflation target in the 1990s and the first half of the 2000s, despite IT's impressive contribution to productivity growth during that period. For investors, this means that we cannot rely on automation to keep inflation depressed irrespective of how tight labor markets become. The global output gap will shift into positive territory this year for the first time since the Great Recession. Any resulting rise in inflation will come as a shock since the bond market has discounted continued low inflation for as far as the eye can see. We expect bond yields and implied volatility to rise this year, which may undermine risk assets in the second half. Mark McClellan Senior Vice President The Bank Credit Analyst Brian Piccioni Vice President Technology Sector Strategy Appendix II-1 Why Is Productivity So Low? A recent study by the OECD10 reveals that, while frontier firms are charging ahead, there is a widening gap between these firms and the laggards. The study analyzed firm-level data on labor productivity and total factor productivity for 24 countries. "Frontier" firms are defined to be those with productivity in the top 5%. These firms are 3-4 times as productive as the remaining 95%. The authors argue that the underlying cause of this yawning gap is that the diffusion rate of new technologies from the frontier firms to the laggards has slowed within industries. This could be due to rising barriers to entry, which has reduced contestability in markets. Curtailing the creative-destruction process means that there is less pressure to innovate. Barriers to entry may have increased because "...the importance of tacit knowledge as a source of competitive advantage for frontier firms may have risen if increasingly complex technologies were to increase the amount and sophistication of complementary investments required for technological adoption." 11 The bottom line is that aggregate productivity is low because the robust productivity gains for the tech-savvy frontier companies are offset by the long tail of firms that have been slow to adopt the latest technology. Indeed, business spending has been especially weak in this expansion. Chart II-14 highlights that the slowdown in U.S. productivity growth has mirrored that of the capital stock. Chart II-14U.S. Capex Shortfall Partly To Blame For Poor Productivity Appendix II-2 Japan - The Leading Edge Japan is an interesting case study because it is on the leading edge of the problems associated with an aging population. The popular press is full of stories of how robots are taking over. If the stories are to be believed, robots are the answer to the country's shrinking workforce. Robots now serve as helpers for the elderly, priests for weddings and funerals, concierges for hotels and even sexual partners (don't ask). Prime Minister Abe's government has launched a 5-year push to deepen the use of intelligent machines in manufacturing, supply chains, construction and health care. Indeed, Japan was the leader in robotics use for decades. Nonetheless, despite all the hype, Japan's stock of industrial robots has actually been eroding since the late 1990s (Chart II-4). Numerous surveys show that firms plan to use robots more in the future because of the difficulty in hiring humans. And there is huge potential: 90% of Japanese firms are small- and medium-sized (SME) and most are not currently using robots. Yet, there has been no wave of robot purchases as of 2016. One problem is the cost; most sophisticated robots are simply too expensive for SMEs to consider. This suggests that one cannot blame robots for Japan's lack of wage growth. The labor shortage has become so acute that there are examples of companies that have turned down sales due to insufficient manpower. Possible reasons why these companies do not offer higher wages to entice workers are beyond the scope of this report. But the fact that the stock of robots has been in decline since the late 1990s does not support the view that Japanese firms are using automation on a broad scale to avoid handing out pay hikes. Indeed, Chart II-15 highlights that wage deflation has been the greatest in industries that use almost no robots. Highly automated industries, such as Transportation Equipment and Electronics, have been among the most generous. This supports the view that the productivity afforded by increased robot usage encourages firms to pay their workers more. Looking ahead, it seems implausible that robots can replace all the retiring Japanese workers in the years to come. The workforce will shrink at an annual average pace of 0.33% between 2020 and 2030, according to the Japan Institute for Labour Policy and Training. Productivity growth would have to rise by the same amount to fully offset the dwindling number of workers. But that would require a surge in robot density of 4.1, assuming that each rise in robot density of one adds 0.08% to the level of productivity (Chart II-16). The level of robot sales would have to jump by a whopping 2½ times in the first year and continue to rise at the same pace each year thereafter to make this happen. Of course, the productivity afforded by new robots may accelerate in the coming years, but the point is that robot usage would likely have to rise astronomically to offset the impact of the shrinking population. Chart II-15Japan: Earnings Vs. Robot Density Chart II-16Japan: Where Is The Flood Of Robots? The implication is that, as long as the Japanese economy continues to grow above roughly 1%, the labor market will continue to tighten and wage rates will eventually begin to rise. 1 Please see Technology Sector Strategy Special Report "The Coming Robotics Revolution," dated May 16, 2017, available at tech.bcaresearch.com 2 Note that this includes only robots used in manufacturing industry, and thus excludes robots used in the service sector and households. However, robot usage in services is quite limited and those used in households do not add to GDP. 3 Note that ICT investment and capital stock data includes robots. 4 Please see BCA Global Investment Strategy Special Report "Weak Productivity Growth: Don't Blame The Statisticians," dated March 25, 2016, available at gis.bcaresearch.com 5 Centre for Economic and Business Research (January 2017): "The Impact of Automation." A Report for Redwood. In this report, robot density is defined to be the number of robots per million hours worked. 6 Graetz, G., and Michaels, G. (2015): "Robots At Work." CEP Discussion Paper No 1335. 7 Mishel, L., and Bivens, J. (2017): "The Zombie Robot Argument Lurches On," Economic Policy Institute. 8 Please see BCA Technology Sector Strategy Special Report "Bad Information - Why Misreporting Deep Learning Advances Is A Problem," dated January 9, 2018, available at tech.bcaresearch.com 9 Please see The Bank Credit Analyst, "Rage Against The Machines: Is Technology Exacerbating Inequality?" dated June 2014, available at bca.bcaresearch.com 10 OECD Productivity Working Papers, No. 05 (2016): "The Best Versus the Rest: The Global Productivity Slowdown, Divergence Across Firms and the Role of Public Policy." 11 Please refer to page 27. III. Indicators And Reference Charts As we highlight in the Overview section, the earnings backdrop for the U.S. equity market remains very upbeat, as highlighted by the rise in the net earnings revisions and net earnings surprises indexes. Bottom-up analysts will likely continue to boost after-tax earnings estimates for the year as they adjust to the U.S. tax cut news. Our main concern is that a lot of good news is now discounted. Our Technical Indicator remains bullish, but our composite valuation indicator surpassed one sigma in January, which is our threshold of overvaluation. From these levels of overvaluation, the medium-term outlook for equity total returns is negligible. Our speculation index is at all-time highs and implied volatility is low, underscoring that investors are extremely bullish. From a contrary perspective, this is a warning sign for the equity market. Our Monetary Indicator has also moved further into 'bearish' territory for equities, although overall financial conditions remain positive for growth. It is also disconcerting that our Revealed Preference Indicator (RPI) shifted to a 'sell' signal for stocks, following five straight months on a 'buy' signal. This occurred because investors may be buying based on speculation rather than on a firm belief in the staying power of the underlying fundamentals. For now, though, our Willingness-to-Pay indicator for the U.S. rose sharply in January, highlighting that investor equity inflows are very strong and are favoring U.S. equities relative to Japan and the Eurozone. This is perhaps not surprising given the U.S. tax cuts just passed by Congress. The RPI indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. Our U.S. bond technical indicator shows that Treasurys are close to oversold territory, suggesting that we may be in store for a consolidation period following January's surge in yields. Treasurys are slightly cheap on our valuation metric, although not by enough to justify closing short duration positions. The U.S. dollar is oversold and due for a bounce. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation Chart III-6U.S. Earnings Chart III-7Global Stock Market And Earnings: ##br##Relative Performance Chart III-8Global Stock Market And Earnings: ##br##Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations Chart III-10U.S. Treasury Indicators Chart III-11Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot Chart III-30U.S. Growth Outlook Chart III-31U.S. Cyclical Spending Chart III-32U.S. Labor Market Chart III-33U.S. Consumption Chart III-34U.S. Housing Chart III-35U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Mark McClellan Senior Vice President The Bank Credit Analyst
Highlights The U.S. government shutdown showed that the path of least resistance is for more fiscal spending; President Trump is turning to trade and foreign policy amid a lack of popularity at home; North Korean diplomacy is on track, but U.S.-China relations and Taiwan are potential black swans; Iran and the U.S. are playing a risky double game that will add geopolitical risk premium to oil; NAFTA will be a bellwether for Trump's future actions on issues that carry greater constraints, like Iran and China; Book profits on French vs German industrials and China volatility; close U.S. curve steepener and long PHP/TWD. Feature This weekend, investors woke up to the nineteenth government shutdown since 1976, a product of "grand standing" on both sides of the aisle. Our low-conviction view, which we elucidated last week, is that President Donald Trump will be forced to migrate to the middle on policy as the midterm election approaches.1 Chart 1Trump Hitting (And Building!) A Wall Despite a roaring stock market, strong economic fundamentals, and decade-low unemployment, President Trump's popularity continues to flounder. There is now even a perceptible decline in his support among GOP voters. Key problems for Trump have been the failure to repeal the Affordable Care Act and the intensification of the Mueller investigation (Chart 1). We suspect that he will try to preempt an electoral disaster in November by means of bipartisan deal-making and more orthodox policies. The government shutdown, although not entirely unexpected, undermined the view that President Trump is thinking about moderating his stance. That said, the Democrats are as much, if not more, to blame. With the Republicans in charge of Congress and the White House, it is clear that the Democrats thought that voters would ultimately see the shutdown as the GOP's fault. This was a dangerous assumption given that current polling suggests the Democrats have more to lose. One positive about the short-lived imbroglio is that it was the first government shutdown in twenty years that had little to do with government spending, whether the appropriations bill explicitly or entitlements. While immigration is an intractable issue, the disagreement between Republicans and Democrats is not about dollars. This is good news for the markets as it means that more spending will likely be necessary to grease the wheels of compromise. Our mantra continues to be that the political path of least resistance will lead towards profligacy. While the media's focus is on domestic politics, the real risks remain in the international arena. The two are connected. As political science theory teaches us, policymakers often play "two-level games," with the domestic arena influencing what is possible in the international one. As Donald Trump loses political capital on the domestic front, his options for affecting policy will become constrained. However, the U.S. constitution places almost no constraints on the president when it comes to foreign policy. To this arena we turn, starting with China-U.S. relations and the other potential risks in Asia (the Korean Peninsula and Taiwan). We also briefly turn to Iran and NAFTA. What binds all these risks is that it is essentially up to President Trump whether they become market-relevant or not. Korean Diplomacy Is On Track In mid-September North Korean tensions peaked (Chart 2).2 Leader Kim Jong Un chose to demonstrate known missile capabilities rather than escalate the crisis. Chart 2Markets Have Called Kim's Bluff Chart 3North Korea Is Running Out Of Cash We expected this choice given Pyongyang's considerable military constraints. Kim is a rational actor following his father Kim Jong Il's nuclear negotiations playbook.3 Just as brinkmanship reached new highs, Kim Jong Un declared victory and offered to play nice. Specifically, he launched his most advanced missile yet on November 28 (the Hwasong-15) and immediately thereafter North Korean state media declared that North Korea has "finally realized the great historic cause of completing the state nuclear force," complete with a fireworks celebration in Pyongyang.4 Kim confirmed this message personally on January 1 while offering an olive branch to South Korea for the New Year. Apparently, then, Kim is responsive to the United States' threats of devastating military retaliation against any attack. Kim is also responsive to the fact that China's President Xi Jinping has joined the U.S. coalition imposing sanctions on the North (Chart 3), squeezing North Korea's economy. The deep drop in exports to China suggests that the North will run into foreign-exchange problems if it does not adjust its posture - not to mention shortages of goods like fuel that China is gradually cutting off (Chart 4). In short, the U.S. established a credible military threat in 2017, just as it did with Iran in 2012 (Chart 5). China responded to the U.S. and established a credible economic threat of its own. Kim has de-escalated. Kim said in his New Year declaration that he would only use his nuclear deterrent if the U.S. committed an act of aggression. Rhetoric about destroying American cities is gone. Meanwhile Kim has engaged South Korea in direct negotiations, with military-to-military talks possibly to follow, and both sides will make a display of friendship at the Olympic Games in South Korea in February. Chart 4China Is Enforcing Sanctions Chart 5Credible Threat Cycle: North Korea Mirrors Iran While our view that diplomacy will reduce tensions is on track, we caution that the underlying disagreement is driven by North Korea's weapon capabilities and remains unresolved. The North Korean issue is not a red herring and the diplomatic route may continue to be bumpy from time to time.5 Markets could still be rattled by surprise North Korean provocations. Nevertheless, we do not expect a replay of the 2017 level of "fire and fury" that caused the U.S. 10-year treasury yield to drop from 2.31% to 2.05% between June and September 2017. If the North should jerk back toward a belligerent posture and decisively throw away this opportunity for diplomacy, then we will watch closely to determine whether its provocations truly alter the status quo and whether the U.S. shows any sign of greater willingness to respond with force. Otherwise we will simply monitor the diplomatic talks and watch for any signs of internal stress in North Korea as global sanctions tighten.6 Bottom Line: Korean risks remain market-relevant as the crisis is not resolved and talks are just beginning. Nevertheless, diplomacy is taking shape. We remain long the Korean two-year government bond versus the ten-year on the back of global trends and continued de-escalation. China-U.S. Relations May Sour Anyway Over the past year we have warned clients that U.S.-China tensions are the fundamental source of geopolitical risk globally and in Asia Pacific; that North Korea is a derivative of this fact; and that China's cooperation in policing North Korea would only temporarily dissuade the Trump administration from imposing punitive measures on China over trade. Despite China's assistance with North Korea, Trump will be driven by domestic American politics to slap tariffs on China in addition to those levied on January 22.7 First, Trump is committed to an "America First" trade policy and to economic nationalist voters. Thus he may need to show more muscle against China ahead of the midterm elections. This is particularly true for the key rust-belt states that handed him the election in 2016, where four Democratic senators' seats are in competition in November (not to mention nine other senate seats that could be swayed for similar reasons) (Chart 6). It is politically embarrassing to Trump that China racked up its largest trade surplus ever with the U.S. in his first year in office and is on track to continue racking up surpluses (Chart 7). While Beijing has vowed to open up market access and import more goods and services, these promises have yet to impress (Chart 8). Chart 6Trump's Base Expects Protectionism Chart 7China's Exports To U.S. Are Growing... Administrative rulings on several trade disputes early this year will give Trump ample opportunity to take additional trade action against China. The critical question, however, is whether Trump will continue to focus on item-by-item trade remedies (perhaps at an accelerated pace), or whether he goes beyond previous administrations and demands that China make progress on structural and systemic issues. The latter is more politically difficult and would have greater macro consequences. The U.S. has recently suggested that it made a mistake by bringing China into the WTO. This comes after the December WTO meeting in which the administration was able to secure a joint statement with Japan and Europe that increased the pressure on China.8 At the same time, Trump is weighing a significant decision (due by August, but possible any day now) on China's alleged systemic intellectual property theft, which Trump says is likely to require a "fine" (penalty). And comments by White House officials suggest that the administration may be going after China's promotion of state-owned enterprises (SOEs) as well as forced technology transfers (Chart 9).9 These are structural demands on China that will create much bigger frictions than tariffs on a few sub-sectors. Chart 8...While Imports Remain Tepid Chart 9Foreign Firms Forced To Transfer Tech Second, assuming that the U.S. and international community reach some kind of deal to reduce Korean tensions over the next six-to-eighteen months - for instance, a missile-test moratorium and corresponding easing of sanctions. It is likely still to be a complicated and ugly deal, as Pyongyang has no intention of giving up its nuclear and missile capabilities. The U.S. will have to make unpopular compromises with a rogue regime, comparable to the Iranian nuclear deal of 2015. The deal will leave a bitter taste in Trump's mouth and the administration will likely blame China for failing to prevent the North from achieving its nuclear status. It will rotate to address other long-standing disagreements with China, and may well look for compensation for Korea by taking a harder line on trade. Bottom Line: Korean diplomacy may delay or soften Trump's trade policies but cannot change his domestic political calculus. The Trump administration is more, not less, likely to impose further punitive trade measures on China as the midterm election draws near. We expect Chinese equity volatility to remain high. We are closing our recommendation to go long the CBOE China ETF Volatility Index, which has appreciated by 26.5%. This is not an investable index but an indicator of volatility in ETFs. A Fourth Taiwan Strait Crisis? The rumor is going around that China and Taiwan are on the verge of a "Fourth Taiwan Strait Crisis." Clients all over the world - from Hong Kong to San Francisco to Toronto - are asking us about cross-strait tensions and the risk of war. As we go to press, Taiwanese President Tsai Ing-wen has just publicly acknowledged that war is possible. Taiwan could indeed be a geopolitical "black swan." It was one of our top five black swans for 2016,10 and several extraordinary events that year suggested that our concerns are warranted: China cut off all communication with the island; the Taiwanese navy accidentally fired a missile towards the mainland on the Communist Party's birthday; and a U.S. president-elect spoke directly with a Taiwanese president for the first time since 1979, creating an uproar in Beijing.11 Today, in the wake of Xi Jinping's concentration of power at the nineteenth National Party Congress,12 and Beijing's heavy-handed crackdown on Hong Kong throughout 2017,13 there is renewed concern that China is about to stage a major intervention to rein in Taiwan. There is even talk that China could be preparing to mount a surprise attack.14 The rumors are arising from a confluence of events. On the mainland side, Xi is personally powerful and has made it a priority to lead China into a "New Era" of greater Chinese influence globally. This means that a decision to take bolder action on Taiwan could come from individual whim rather than a collective decision within the party (which would tend to maintain the status quo). Xi has also taken personal control of the military through promotions, and reasserted that the "party controls the gun," making it less likely that he would meet institutional resistance in any major foreign policy initiative. Finally, Xi has hardened Communist Party policies toward Taiwan, reflected in increased military drills, controversial new air traffic routes, and tougher language in the five-year policy blueprint that he presented to the party congress. On the Taiwanese side, the Democratic Progressive Party (DPP), which is the party that leans toward independence from the mainland, dominates the country's politics. The DPP not only won the presidency but also won legislative control for the first time in the January 2016 election.15 The DPP is also the leading party on lower levels of government. And young Taiwanese people increasingly identify as exclusively Taiwanese.16 While President Tsai has been relatively pragmatic so far, her party has fewer domestic political constraints than in the past - leaving room for the party's more radical side to have more influence or for Tsai to overreach. Internationally, Tsai has allies in Trump and Prime Minister Shinzo Abe of Japan - both nationalists who favor Taiwan and harbor deep suspicions about the reviving communism emanating from Beijing. Hence we still see Taiwan as a potential black swan event in the coming years. However, we would put a near 0% subjective probability on the likelihood that China will spring a massive surprise attack in the near future. Why? Xi is not yet breaking the status quo: Xi has not yet shown himself to be a reckless revisionist. China's foreign policy assertiveness is a gradual process that began in the mid-2000s - it traces the country's growing economic importance and need for supply-line security (Chart 10). Xi has trod carefully in both the East and South China Seas, and both of these strategic thrusts are connected with China's security vis-à-vis Taiwan, as well as vis-à-vis the U.S. and Japan. There is no reason to think that China is ready to launch a multi-front attack against the combined forces of the U.S., Taiwan, Japan, and the rest of the American alliance system. North Korea's new missile capabilities do not tip the scales in China's favor either. Incidentally, even Xi's tougher rhetoric at the party congress echoed the 2005 "Anti-Secession" law, so that more evidence would be needed to conclude that a drastic policy shift is under way.17 China may even want to avoid antagonizing the Taiwanese ahead of local elections later this year. Trump is not yet breaking the status quo: Trump's Asia policy has been consistent with that of previous administrations.18 And Trump's moves to assure Taiwan of U.S. commitment to its defense are status quo. After all, the Democratic Party is historically more enthusiastic about supplying Taiwan with arms (Chart 11). Trump has assured Xi Jinping he will adhere to the "One China" policy; and it is rarely observed that Trump's controversial phone call with Taiwanese President Tsai followed the first-ever tête-à-tête between a Chinese president and his Taiwanese counterpart.19 As long as Trump upholds the norm, the U.S. remains committed to Taiwan's defense yet will refuse to let Taiwan lock it into excessive tensions with China. This policy actually reduces the probability of a miscalculation by Beijing or Taipei. By contrast, the probability would rise if China and Taiwan perceived that the U.S. was withdrawing from its commitments, as Taiwan might want to suck the U.S. back in, or China might see Taiwan as vulnerable. Incidentally, if the Trump administration is not rushing into conflict over Taiwan, then Japan's Abe administration certainly is not. Tsai is not yet breaking the status quo: President Tsai has so far played a pragmatic role. While she is dissatisfied with the "1992 Consensus," which holds that there is only "One China" but two different interpretations of it, she has not rejected the status quo, and she has not implied that Taiwan should be its own state (either of which would cause a huge reaction from the mainland). And there is no serious prospect of a popular independence referendum ("Twexit"?) on the horizon, which would assuredly prompt Beijing to aggressive measures. Chart 10China's Assertiveness Grows With Trade Chart 11Trump Has Not Changed Status Quo In order for us to increase the probability of a Taiwanese war, we would have to see one of these three players start behaving in a way that truly violates the status quo that has prevailed since the U.S. and China normalized relations in 1979. The real risk for Taiwan comes if the U.S. and China fail to arrest the secular decline in relations that began in the mid-2000s. A serious misunderstanding between these two would have a range of global repercussions, and could lead to miscalculation over Taiwan. Unfortunately, a miscalculation is conceivable within Trump's and Tsai's terms, which last until 2020. Consider the following scenario as an example. The U.S. is currently demanding that China assist with the North Korean problem, and may believe that it can compensate China by delaying any punitive trade measures. However, China may be expecting something else - it may be expecting the U.S. to downgrade relations with Taiwan. (In other words, China says, we diminish the North Korean threat to the U.S. mainland, you diminish the Taiwanese threat to the Chinese mainland.) Instead of giving China what it wants, the U.S. may provide Taiwan with new weapon capabilities in response to China's militarization of the South China Sea. In this way, U.S.-China competition could shift to the Taiwan Strait in the aftermath of any Korean settlement. In the meantime, we see Taiwan as vulnerable to China's discrete economic sanctions, which China has not hesitated to use in this or other diplomatic spats (Chart 12).20 Chart 12Mainland Tourists Punish Rebel Taiwan Bottom Line: What is clear to us is that U.S.-China tensions continue to grow and Taiwan could become more frightened, or more emboldened, in the "security dilemma" between them. But until we see signs that any of the relevant powers are actively attempting to break the status quo, we see war as a distant prospect. More likely, today's robust trade between China and Taiwan could suffer a hit due to politics, and tit-for-tat cross-strait sanctions could be imposed. We are closing our tactical trade of long Philippine peso / short Taiwanese dollar for a loss of 5%. This was a speculative play on the divergence in diplomatic relations with China. Taiwan has allowed its currency to rise to avoid antagonizing President Trump, while China and Taiwan have so far avoided the diplomatic crisis that we expect eventually to occur, as outlined above. Iran: Could America Pivot Back To The Middle East? BCA's Geopolitical Strategy correctly forecast the U.S.-Iran détente two years before the nuclear deal was agreed in the summer of 2015.21 At the heart of this call was our read of global forces, namely the paradigm shift in the global distribution of power away from American hegemony towards multipolarity (Chart 13). As the U.S. pivoted its geopolitical focus towards China, Iran became a thorn in its side, forcing it to maintain considerable presence in the Middle East. Without a formal détente with Iran - of which the Joint Comprehensive Plan of Action (JCPOA) is the fulcrum - such a pivot to Asia would be extremely difficult. On January 12, President Trump imperiled our forecast by threatening not to waive sanctions against Iran the next time they come due (May 12).22 To avoid that fate, President Trump wants to see three major changes to the JCPOA: An indefinite extension of limits on Iran's uranium enrichment; Immediate access for inspectors to all nuclear sites; Adding new provisions to limit development of ballistic missiles. These additions are likely to kill the deal, although Trump appears to have directed his comments to the European signatories only. This could potentially create a loophole in the crisis, by allowing Europe to agree to new thresholds for re-imposing sanctions outside of the deal's framework. Pressure from the U.S. president comes at a delicate time for Iran. Domestic unrest has been ongoing since December 28. Although protests have largely fizzled out, they have reopened the rift between the clerical regime, led by Supreme Leader Ayatollah Ali Khamenei, and moderate President Hassan Rouhani. In a surprising statement, President Rouhani said, "it would be a misrepresentation and also an insult to Iranian people to say they only had economic demands ... people had economic, political, and social demands." He went on to say that "We cannot pick a lifestyle and tell two generations after us to live like that ... The views of the young generation about life and the world is different than ours." We agree with President Rouhani. First, 49% of Iran's population is under the age of 30 (Chart 14). Meanwhile, the Supreme Leader and the twelve members of the "Guardian Council" - which has the power to veto parliamentary legislation and to vet presidential candidates - have an average age of 73.23 As with the 2009 Green Revolution, which was brutally repressed, Iran's demographics provide the kindling for a potential regime change. Chart 13American Hegemony Ended,##br## Global Multipolarity Ascending Chart 14Iran's Youth:##br## A National Security Risk Second, Iran's economy is clearly not the main reason for the angst. While unemployment is elevated at 12%, it is only slightly above its two-decade average. Meanwhile, inflation is well below its average, with real GDP growth at 5.8% by the end of 2016 (Chart 15). Considering that inflation peaked at 44%, and real GDP growth bottomed at -16% during the most severe sanctions, the current situation is not dire. What has irked the population is that while the private sector suffered throughout the sanctions ordeal, government spending remained elevated (Chart 16). This is not merely because of automatic stabilizers amidst a deep recession. Instead, Iran has elevated its military spending as new geopolitical opportunities presented themselves in the region (Chart 17). It currently spends more on its military as a percent of GDP than any peer in the region (save for Saudi Arabia, its chief rival). It is openly engaged in military conflict in both Syria, Iraq, and Yemen, while it continues to support allies militarily, economically, and diplomatically across the region, particularly Hezbollah in Lebanon. Chart 15Economic Situation Poor But Not Dire Chart 16Government Felt No Pain During Sanctions Chart 17Iran Overspends On Military Third, Chart 18 shows that Iran is becoming "dangerously wealthy." Both the 1979 Islamic Revolution and the 2009 Green Revolution occurred at, or near, the peak of Iran's wealth. The 25 years preceding each event saw the country's GDP per capita triple and double, respectively. Chart 18Wealth Is Also A National Security Risk Political scientists Ronald Inglehart and Christian Welzel have empirically shown that wealth changes people's basic values and beliefs, from political and economic beliefs to religion and sexual mores.24 This is the process of modernization. Economic development gives rise to cultural changes that make individual autonomy, gender equality, and even democracy likely. Iran has essentially come full circle since 1979. We suspect that the conservative hardliners in the regime understand the revolutionary context well. After all, they were themselves in their 30s when they rebelled against the old corrupt regime. As such, they will welcome President Trump's pressure as it gives them a raison d'être and an opportunity to undermine the moderate President Rouhani who staked his presidency on the success of the nuclear deal. The risk in this scenario is that the domestic arena of the ongoing "two-level game" will prevent both the U.S. and Iran from backing away from a confrontation. Iranian hardliners, who control part of the armed forces, could lash out in the Persian Gulf, either by rhetorically threatening to close the Straits of Hormuz - as they did repeatedly in 2011 - or by boarding foreign vessels in international waters.25 Geopolitical tensions would therefore serve to undermine President Rouhani's embrace of diplomacy and to de-legitimize any further protests, which would be deemed treasonous. For Trump, a belligerent Iranian response to his pressure would in turn legitimize his suspicion of the nuclear deal. What about the global constraints of multipolarity that compelled the U.S. to seek a détente with Iran in order to pivot to Asia? They remain in place. As such, President Trump's simultaneous pressure on Iran and China runs counter to U.S. strategy, given its limited material resources and diplomatic bandwidth. It is therefore unsustainable. What we cannot forecast, however, is whether the White House will realize this before or after it commits the U.S. to a serious confrontation. Bottom Line: Domestic political calculus in both Iran and the U.S. make further Tehran-Washington tensions likely. The two countries are playing a dangerous two-level game that could spiral out of control in the Middle East. For the time being, however, we expect merely a minor geopolitical risk premium to seep into the energy markets, supporting our bullish BCA House View on oil prices. NAFTA: Of Global Relevance On a recent client trip through Toronto and Ottawa we were unsurprisingly asked a lot of questions regarding the fate of NAFTA. The deal is not just of importance to Canada but to the world. It is a bellwether for our low-conviction view that President Trump is going to moderate to the middle on policy issues ahead of the midterm elections. We encourage clients to read our November Special Report titled "NAFTA - Populism Vs. Pluto-Populism."26 In it, we cautioned clients that the probability of NAFTA being abrogated by Trump is around 50%. Why so high? Because there are few constraints: Economic: The U.S. economy has been largely unaffected by NAFTA (Chart 19) and would likely experience no disruption if Trump abrogated the deal and began negotiations on bilateral trade agreements with Canada and Mexico. Political: Investors and the media are overstating the importance of the Midwest automotive and agricultural sectors to Trump's base. Trump's Midwest voters knew well his view on NAFTA when they voted for him. In fact, they voted for him because of his NAFTA view. Investors have to realize that Americans do not support unbridled free trade (Chart 20). Constitutional/Legal: There is an argument that Congress could stop President Trump from withdrawing from NAFTA, but the only way to do so would be to nullify his executive orders or legislate a law that prevents the president from withdrawing. However, given the point from above, Congress is afraid to go against the median voter. The immediate implications for investors are that both the CAD and MXN could face downside pressure following the Montreal round of negotiations ending January 29. Both fell by 1.2% and 1.9% respectively in the week of trading following the third round of negotiations in September (Chart 21). Chart 19U.S. Economy:##br## Largely Unaffected By NAFTA Chart 20America Belongs To##br## The Anti-Globalization Bloc Chart 21NAFTA Negotiations##br## Are FX-Relevant More broadly, NAFTA is an important bellwether for the direction of Trump's policy. He has practically no constraints to abrogating the deal. If his intention is to renegotiate two separate deals - or simply reactivate the 1988 Canada-U.S. Free Trade Agreement - then it makes sense for him to end NAFTA and score political points at home. As such, if he does not, it will indicate that the White House is not truly populist but has been captured by the Republican establishment. Bottom Line: If President Trump does not abrogate NAFTA, which comes with few constraints, then he has clearly decided to throw his lot in with the U.S. establishment, which has consistently been more pro-trade than the American voter. This would be highly bullish for investors as it would suggest that the (geo)political risk premium would dissipate going forward. In fact, the decision on NAFTA could be a broad indicator for future decisions on trade relations with China, Iranian sanctions, and policy writ large. For if Trump sides with the establishment on an issue with minimal constraints, then he is more likely to do so on issues with greater constraints. This month, we are closing our 2/30 curve steepener recommendation, which is down 90bps since inception. The two alternative ways we have played rising U.S. growth and inflation prospects - shorting the 10-year Treasury vs. the Bunds and shorting the Fed Funds December 2018 futures - are in the money, 27bps and 46bs respectively. We are keeping both open for now. In addition, we are closing our long French industrial equities relative to German industrials for a gain of 10.26%. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Upside Risks In U.S., Downside Risks In China," dated January 17, 2018, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Can Equities And Bonds Continue To Rally?" dated September 20, 2017, available at gps.bcaresearch.com. 3 The playbook is really Nikita Khruschev's. 4 Please see "NK celebrates completion of nuke arsenal with fireworks," The Korea Herald, December 2, 2017, available at www.koreaherald.com. 5 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," dated April 19, 2017, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Special Report, "Five Black Swans In 2018," dated December 6, 2017, available at gps.bcaresearch.com. 7 Trump decided to impose tariffs on solar panels and washing machine, mostly affecting China and South Korea, on January 22. On steel and aluminum, Trump has until late April to decide, i.e. 90 days after reports from the Commerce Department due Jan. 15 and Jan. 22. Please see Andrew Restuccia and Doug Palmer, "White House preparing for trade crackdown," Politico, dated January 7, 2018, available at www.politico.com. 8 The U.S. Trade Representative's latest edition of an annual report to Congress over China's compliance with World Trade Organization (WTO) commitments declares that the U.S. "erred in supporting China's entry into the WTO on terms that have proven to be ineffective in securing China's embrace of an open, market-oriented trade regime." Please see "Joint Statement by the United States, European Union and Japan at MC11," December 2017, and "USTR Releases Annual Reports on China's and Russia's WTO Compliance," dated January 2018, available at ustr.gov. 9 Please see Lesley Wroughton, "Trump administration says U.S. mistakenly backed China WTO accession in 2001," Reuters, January 19, 2018, available at www.reuters.com. 10 Please see BCA Geopolitical Strategy Special Report, "Scared Yet? Five Black Swans For 2016," dated February 10, 2016, available at gps.bcaresearch.com. 11 Please see "China cuts communication with Taiwan," Al Jazeera, June 25, 2016, available at www.aljazeera.com; "Taiwan mistakenly fires supersonic missile killing one," BBC, July 1, 2016, available at www.bbc.com; Mark Landler and David E. Sanger, "Trump Speaks With Taiwan's Leader, An Affront To China," New York Times, December 2, 2016, available at www.nytimes.com. 12 Please see BCA Geopolitical Strategy Special Report, "China: Party Congress Ends ... So What?" dated November 1, 2017, available at gps.bcaresearch.com. 13 Please see "U.S.-China: From Rivalry To Proxy Wars" in BCA Geopolitical Strategy, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 14 Xi Jinping is rumored to have told Communist Party leaders in 2012 that the country would invade Taiwan by 2020. Please see Ian Easton, The Chinese Invasion Threat: Taiwan's Defense and American Strategy in Asia (Project 2049 Institute, 2017). 15 Please see BCA Geopolitical Strategy Special Report, "Taiwan's Election: How Dire Will The Straits Get?" dated January 13, 2016, available at gps.bcaresearch.com. 16 National Chengchi University's long-running data series on Taiwanese identity shows that 58% of Taiwanese people identify as Taiwanese, and 70% under the age of 40. However, 77.5% of twenty-year olds also support the political status quo, i.e. do not seek political independence. Please see Marie-Alice McLean-Dreyfus, "Taiwan: Is there a political generation gap?" dated June 9, 2017, available at lowyinstitute.org. 17 Please see Richard C. Bush, "What Xi Jinping Said About Taiwan At The 19th Party Congress," Brookings Institution, October 19, 2017, available at www.brookings.edu. 18 Even the North Korea threat portfolio was bequeathed to him from former President Barack Obama, and it is being managed largely by the Pentagon and navy. 19 In other words, the incoming Trump administration implied that if China's leader Xi Jinping can speak directly to Taiwan's leader Ma Ying-jeou, then U.S. President Donald Trump can speak to Taiwanese President Tsai Ing-wen. This is a sign that alliances are alive and well, and that there are tensions, but it is not a harbinger of war. 20 Please see BCA Geopolitical Strategy Special Report, "Does It Pay To Pivot To China?" dated July 5, 2017, available at gps.bcaresearch.com. 21 Please see BCA Geopolitical Strategy Special Report, "Out Of The Vault: Explaining The U.S.-Iran Détente," dated July 15, 2015, available at gps.bcaresearch.com. 22 The JCPOA did not actually legislate the removal of sanctions against Iran as the Obama administration was unable to get the Republican-controlled Senate to agree. Instead, the president has to use his executive authority to continue waiving sanctions against Iran. 23 That is only two years away from the average life expectancy in Iran. 24 Please see Ronald Inglehart and Christian Welzel, Modernization, Cultural Change, and Democracy, Cambridge: Cambridge University Press, 2005. 25 Iranian military personnel - almost always the Navy of the Iranian Revolutionary Guards - seized British Royal Navy personnel in 2007 and U.S. Navy personnel in 2016. 26 Please see BCA Geopolitical Strategy Special Report, "NAFTA - Populism Vs. Pluto-Populism," dated November 10, 2017, available at gps.bcaresearch.com.