Economy

Dear Clients, In our final publication of the year, we bring you a recap of this past week’s significant events in Sino-US relations and the key messages from the Central Economic Work Conference. Accordingly, we are upgrading our tactical stance towards Chinese stocks from neutral to overweight.  Our publishing schedule will resume on January 9, 2020 with our monthly Macro and Market Review. Our China Investment Strategy team wishes you a happy holiday season and a prosperous New Year! Best regards, Jing Sima, China Investment Strategist Highlights We are upgrading our tactical call on Chinese stocks from neutral to overweight. Recent developments in the Chinese investable equity market point to a risk-on sentiment. The fact the US and China have reached an agreement likely marks the beginning of a truce, which could potentially last through the US presidential election in November 2020. The CEWC statement from last week reinforces our view that China's leadership feels the urgency to stabilize the economy now outweighs the desire to continue financial deleveraging.  Feature Signals from the Chinese investable equity market have titled in a bullish direction. This shift is accompanied by two modestly bullish developments:  First, the annual China Economic Work Conference (CEWC) concluded on December 12 with support for a more reflationary stance for the coming year. Then, a day later, the US and Chinese officials confirmed they have agreed on a Phase One trade deal.  The combination of these developments provides a sufficient basis to upgrade our tactical (0-3 month) stance on Chinese stocks from neutral to overweight (within a global equity portfolio), to be consistent with our bullish cyclical (6-12 month) stance. Equity Market Signals Have Become Bullish In our previous reports, we highlighted that the relative performance of some sectors in the Chinese investable equity market reflects China’s policy direction and financial market conditions, supporting our bullish/bearish calls on Chinese stocks. Recently, two of the three equity market telltale signs that we have been watching have turned favorable for a bullish view on Chinese stocks (Chart 1A and 1B): Chart 1ACountercyclical Sector Stock Performance Points To Improvement In Economic Activity Chart 1BThe Breakdown Of Defensive Stocks Suggests A Return Of Risk-On Sentiment Chart 1A (top panel) shows that the relative performance of investable utility stocks have broken down, signifying that market participants anticipate the slowdown in China’s economy will soon bottom.  Investable healthcare stocks have not breached their 200-day trend, but are headed in that direction (Chart 1A, bottom panel). Key equity market signs have turned supportive for a bullish tactical call on Chinese stocks. Cyclical stocks are outperforming defensives in both China’s onshore and offshore markets, reflecting improved investor sentiment towards China’s economic outlook (Chart 1B). Bottom Line: Key equity market signs have turned supportive for a bullish call on Chinese stocks for the next 0 to 3 months. Phase One Trade Deal: Unimpressive But Pragmatic Adding to this bullish shift in equity market signals was the first of two positive fundamental improvements over the past week. The US and China reached agreement on a Phase One deal just a few days before the 15% tariff increase on $160 billion of Chinese export goods to the US was scheduled to come into effect. Reportedly, the two sides agreed to pause the 15% tariff scheduled for December 15 and lower the tariff on about $120 billion of Chinese imports to 7.5%.  However, the 25% tariffs on the first $250 billion of Chinese imports will remain in place (Chart 2). Chart 2Tariff Rollbacks Unimpressive... Chart 3...But China's Promise To Buy American Goods Helps Trump Claim Victory In return, China agrees to, in the next two years, boost imports of American goods and services by a total of $200 billion from their levels in 2017 (Chart 3).  While no specific number has been confirmed from the Chinese side, in a news conference, Chinese officials said that China “will expand imports of some agriculture products currently in urgent need, such as pork and poultry.” Given that both sides picked low hanging fruit in the Phase One deal, the tougher issues to be discussed in Phase Two could lead to a breakdown in negotiations, which potentially could unravel the Phase One tariff rollbacks. Nevertheless, the agreement serves an interim purpose for both President Trump and President Xi: it allows Trump to claim a short-term political victory on his trade negotiations with China, and gives Xi some breathing space to focus on domestic economic challenges.  Bottom Line: While the Phase Two negotiations, when commencing, will be a risk to the Phase One trade deal, the current agreement likely marks the beginning of a truce, which could potentially last through the November’s presidential election in 2020. CEWC: Reinforcing Reflationary Bias For 2020 In addition to the trade deal, another bullish factor for stocks is the fact that Chinese policymakers will proactively fine-tune economic policy to mitigate the impact from the US tariffs that remain in effect and to ensure stable economic growth in the coming year. President Xi at last week’s Central Economic Work Conference (CEWC) urged that Chinese policymakers must “make contingency plans” to combat challenges from both domestic and external environment. At the three-day annual CEWC this year, Chinese central and local government officials set the direction and strategy of China’s economic policy for the coming year. The meeting also reveals the challenges Chinese policymakers are facing, and the areas they will likely mobilize monetary resources to tackle. Investors can therefore benefit from insights into both the direction and constraints of China’s near-term policy framework. We highlight four investment-relevant messages from this year’s CEWC: A Greater Emphasis On Growth Stability The tone from this year’s CEWC reflects an urgency to stabilize the economy and meet growth targets. The tone from this year’s CEWC reflects an urgency to stabilize the economy and meet growth targets. The statement from the meeting mentioned “stability” 31 times, compared with 22 in 2018.1  The statement also reiterated the importance of doubling GDP and per capita income by 2020. This suggests that a growth imperative remains the top priority and reinforces the leadership’s reflationary policy stance for next year. We previously projected that the Chinese government would allow a lower GDP growth target for 2020, between 5.5 and 6.0%. However, we think growth targets to be set at next March’s National People’s Congress (NPC) are more likely to be in a “reasonable range” (verbiage used in the CEWC statement) between 5.8 and 6.2%. As noted in our December 11 report,2 the Chinese economy needs to increase by 6% in 2020 to double its size from the 2010 level in real terms. While China’s real GDP statistics are suspiciously smooth and largely invalid when it comes to equity market pricing, the deviation between market expectations and the actual GDP growth target range set at NPC can help investors gauge how much more (or less) ammunition Chinese policymakers are willing to deploy to support the economy in that year. China is falling short of its target to double real urban per capita income next year from 10 years ago (Chart 4). Nominal wage and salary per capita growth has experienced a sharp drop since the third quarter of 2018 and probably contributed to the subdued appetite for consumption (Chart 5). Chart 4Household Income: Rural Overshooting; Urban Falling Short Chart 5Wage Growth Only Started Stabilizing Recently   To meet the target, urban per capita income will need to grow at an above-real GDP rate of 10% in 2020, almost doubling the growth in 2018 and 2019.  Given the still weak domestic economic conditions, we are not optimistic that China will be able to double the growth rate of urban income per capita in 2020 from 2019. Additionally, income typically lags economic activity. Even if China’s economic slowdown bottoms in the first quarter of 2020, it is unlikely we will see significant improvement in income until a few quarters later. Therefore, we think policymakers will likely focus on overall economic and employment growth stability, and poverty reduction through improving rural income in 2020 (Chart 4, top panel). A Shift In Policy Priorities The new year marks the final year of the “Three Major Battles” against financial deleveraging, poverty elimination, and pollution. In this year’s CEWC statement, for the first time in three years, the order of the battles has been rearranged with financial deleveraging ranked behind poverty reduction and environment protection. The PBoC will stay on a mild rate-cutting cycle throughout next year. The shift in policy priorities suggests that the pressure to deleverage has greatly eased. Banks’ asset balance sheets will expand at a faster rate, while the pace of reduction in shadow banking will likely continue to moderate (Chart 6). The description of monetary policy stance was amended to “maintaining a flexible and appropriate monetary policy” from last year’s “appropriately loose or tight.” The change points to a more dovish tone, confirming our assessment that the PBoC will stay on a mild rate-cutting cycle to lower corporate funding costs throughout the next year3 (Chart 7). Chart 6In 2020, Expect Faster Bank Balance Sheet Expansion Chart 7The PBoC's Rate-Cutting Cycle Will Continue Next Year   At this stage, we do not anticipate the Chinese policymakers will entirely abandon financial risk containment or significantly loosen financial regulations. Rather, we think the reduced pressure on deleveraging and lowering of funding costs will provide moderate support for the private sector, specifically small- and medium-sized enterprises.  A slew of new policies announced before the CEWC, including an adjustment to some of the parameters in the Macro-Prudential Assessment (MPA) framework to encourage lending to the private sector,4 will help strengthen the impact of PBoC’s countercyclical measures. A Bigger Fiscal Push This year’s CEWC statement indicated policymakers will continue to fine-tune a proactive fiscal policy, but unlike last year, the meeting did not specify further cuts to taxes. The statement suggests fiscal support to the economy will mainly focus on infrastructure, and listed transportation, urban and rural development, and the 5G networks to be the government’s main investment projects next year. Chart 8Local Governments Have Borrowed More Than They Spent In 2019, infrastructure investment was subdued, despite increased quotas for local government special-purpose bond issuance. Our research shows that local government infrastructure expenditures in 2019 have consistently lagged behind their borrowing (Chart 8). The gap between local government infrastructure funding deficit and borrowing has only started flattening in the third quarter of this year. The delayed conversion from borrowing to spending means local governments have accumulated more spending power for 2020. In order to encourage local governments to speed up spending, the central government is also likely to further loosen up project restrictions. A bigger fiscal push by the central government, coupled with a frontloading of 2020 local government special-purpose bond issuance, will likely boost infrastructure spending to around 10% in the first two quarters, doubling the growth in the first eleven months of 2019.5  More robust fiscal stimulus will lead to an increase in the debt load of local governments, but Chinese policymakers are caught between a rock and a hard place and therefore must choose the least risky tools to stimulate the economy.  In our view, local government bonds are still a better option over local government financing vehicles (LGFVs) or other illicit channels. Social Housing Gets Another Boost Surprisingly,6 last week’s CEWC statement again emphasized the importance of shantytown renovation (Chart 9). While this implies there would likely be a significant monetary boost to social housing in the coming year, the statement also indicated that policymakers would not want property prices to dramatically change in either direction. Even though local governments have been granted more flexibility to fine-tune their local housing policies, we think the possibility of a broad-based regulatory easing in the housing market remains low in 2020. Therefore, government subsidies in social housing in 2020 will unlikely to lead to another property market boom like that of 2016. Chart 9Social Housing Gets Another Fiscal Boost If the scale of the cyclical policy support in 2020 is still moderate, then we think the stimulus may delay, but not entirely derail China’s progress in structural rebalancing, particularly if the current financial regulations remain in place. The CEWC statement also mentioned deepening reforms of state-owned enterprises (SOEs), and a “three-year SOE reform executive plan”, which we will be closely monitoring in the coming year. Last year’s reference to “striving for stronger, better and larger state assets” was replaced this year by “accelerating the reform of SOEs and optimization of SOE resource allocation”, implying there will be a greater emphasis on the quality and efficiency of SOEs’ assets. These plans can potentially impact SOE profit margins and accelerate the pace of industry consolidation among SOEs. The statement also dedicated a lengthy and detailed segment to "promoting high-quality development", covering topics ranging from the reform of the agricultural supply side to accelerating the implementation of regional development strategies. Further details are expected after next March’s NPC in Beijing. At that time, we will have a Special Report to consider some of the strategic and regional planning initiatives discussed at the meeting and their market implications. Bottom Line: The past week’s CEWC reinforces our view, that the Chinese leadership’s urgency to stabilize the economy has shifted to overweigh the desire to continue financial deleveraging.  Monetary policy will only moderately loose further, but fiscal stimulus may overshoot in the first half of 2020.  Investment Conclusions We have been cyclically overweight Chinese stocks on the basis of a bottoming in the economy in the first quarter of 2020, and the likelihood of an eventual trade deal.  Tactically however, we have been more cautious because of the potential for further near-term downside in the economic data, and the uncertainty surrounding the timing and nature of a trade deal. While the tariff reduction in the trade deal announced last week is somewhat disappointing, the combination of a trade agreement, bullish equity market signals, and the positive messages from last week’s CEWC warrant an upgrade to our tactical stance on Chinese stocks from neutral to overweight. As such, our cyclical and tactical calls are now both aligned in favor of Chinese stocks within a global equity portfolio. As a final point, we noted in last week's report that there are decent odds that all of the outperformance of Chinese stocks in 2020 will be frontloaded in the first half of the year. In the new year, we look forward to providing an ongoing assessment of whether Chinese economic growth has more or less potential upside than we currently expect, along with the attendant investment implications of our analysis. Stay tuned!   Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1   http://www.gov.cn/xinwen/2019-12/12/content_5460670.htm http://www.xinhuanet.com/english/2019-12/12/c_138626531.htm 2   Please see China Investment Strategy Weekly Report "2020 Key Views: Four Themes For China In The Coming Year," dated December 11, 2019, available at cis.bcaresearch.com 3, 5 Please see China Investment Strategy Weekly Report "Questions From The Road: Timing The Turn," dated November 20, 2019, available at cis.bcaresearch.com 4   http://www.gov.cn/premier/2019-12/14/content_5461147.htm 6   In our last week’s China Investment Strategy 2020 Outlook report, we had projected less monetary support to this sector in 2020. Cyclical Investment Stance Equity Sector Recommendations

Special Report

This is the final report of the year from BCA’s Global Fixed Income and US Bond Strategies. Our regular publication schedule will resume on January 7, 2020. We wish you a happy, healthy and prosperous new year.   Highlights Interest Rate Policy: The Fed’s next interest rate move will be a hike, but it probably won’t occur until 2021. It will not occur until either long-maturity TIPS breakeven inflation rates reach our target band of 2.3%-2.5% or financial asset valuations reach extreme levels. We provide several indicators to monitor to assess the timing of the next Fed hike. Balance Sheet Policy: The era of balance sheet shrinkage is over. The Fed will continue to grow its balance sheet in 2020, and will also tweak regulations to make banks more indifferent between holding Treasury securities and reserves. Strategic Review: The exact form of any new policy strategy is uncertain, but we expect the Fed to make an announcement in mid-2020 that makes it clear that it will explicitly target above-2% inflation for some unspecified period of time in order to re-anchor inflation expectations and make up for past inflation misses. Feature Last week, both our Global Fixed Income Strategy and US Bond Strategy services published their key fixed income views for 2020.1  Those reports presented investment ideas that we think will be profitable next year, but only discussed Fed policy to the extent that it informs those views. This Special Report delves into exactly what we expect to see from the US Federal Reserve in 2020. Specifically, we consider what the Fed will do with its interest rate and balance sheet policies in 2020, and also what might result from the Fed’s ongoing strategic review. Interest Rate Policy The final FOMC meeting of 2019 took place last week, and we learned that the Fed’s reaction function underwent a significant dovish shift between the September and December meetings. Currently, only 4 FOMC participants expect to lift rates in 2020 while the remaining 13 expect the funds rate to stay in its present range between 1.5% and 1.75% (Chart 1). Back in September, 9 participants thought the fed funds rate would be above 1.75% by the end of 2020. Chart 1Fed Will Stay On Hold In 2020, Market Still Priced For Cuts The yield curve is still discounting a slight decline in the funds rate next year, and the Fed will of course deliver more rate cuts if economic growth deteriorates. However, given our positive global growth outlook for 2020, we think rate cuts are unlikely.2 Rather, we expect a flat fed funds rate next year followed by rate hikes in 2021. The Fed’s reaction function underwent a significant dovish shift between the September and December meetings.  If our economic view pans out, then getting a sense of what will be required for the Fed to lift rates is the most pressing monetary policy issue. On that front, we continue to believe that inflation expectations and financial conditions are the two most important factors to monitor.3  Recent remarks from Fed officials have only strengthened our conviction in that view. Inflation Expectations & The Fed’s Phillips Curve Model Last week, when Chair Powell was asked what it will take to lift rates again, he said that he wants to see “a significant move up in inflation that’s also persistent”. This scripted response reveals a lot about the Fed’s reaction function in 2020, and about the importance of inflation expectations. To see why, let’s consider the Expectations-Augmented Phillips Curve, the typical model that the Fed uses to assess trends in inflation. An example of this sort of model, taken from a 2015 Janet Yellen speech, is presented in Box 1.4 Box 1The Fed's Inflation Model According to the Fed’s model, core inflation is determined by: (i) inflation expectations, (ii) resource utilization and (iii) relative import prices. But inflation expectations are especially important because they determine inflation’s long-run trend. As explained by former Chair Yellen: Chart 2The Importance Of Inflation Expectations … economic slack, changes in imported goods prices, and idiosyncratic shocks all cause core inflation to deviate from its longer-term trend that is ultimately determined by long-run inflation expectations. This is what Chair Powell means when he says he wants to see a “persistent” move up in inflation. He wants to make sure that inflation expectations return to levels that are consistent with the Fed’s target in order to re-anchor inflation’s long-run trend. The widespread consensus that the “Phillips Curve is flat” makes inflation expectations even more important in the minds of Fed policymakers. When people say that the “Phillips Curve is flat”, they mean that there is very little relationship between resource utilization and inflation. In other words, the coefficient b4 in Box 1 is very small. Logically, if the relationship between resource utilization and inflation is weak, then expectations become an even more important driver of core inflation. As Fed Vice Chair Richard Clarida recently said:5 A flatter Phillips Curve makes it all the more important that inflation expectations remain anchored at levels consistent with our 2 percent inflation objective. Simply put, the Fed needs to see a re-anchoring of inflation expectations before it lifts rates. Our sense is that this will be achieved when both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates reach a range between 2.3% and 2.5%. We are not yet close to those levels. The 10-year and 5-year/5-year forward TIPS breakeven rates currently sit at 1.71% and 1.79%, respectively (Chart 2). Meanwhile, household survey measures from the University of Michigan and the New York Fed also show very low inflation expectations (Chart 2, bottom 2 panels). With all this in mind, the big question for monetary policy is how long will it take for inflation expectations to rise back to “well anchored” levels? Will it occur next year, or not until 2021? How Long Until Inflation (And Inflation Expectations) Return To Target? Chart 3High Inflation No Longer A Worry We have long held the view that inflation expectations adapt only slowly to changes in the actual inflation data.6 In other words, inflation expectations are low today because actual inflation has been consistently below the Fed’s target for much of the past decade. This makes it very difficult for people to believe that inflation will be high in the future. In fact, when asked what CPI inflation is likely to average over the next 10 years, most forecasters think it will be in a range between 2% and 2.5%, consistent with the Fed’s target.7 This is similar to what forecasters thought in 2004 when TIPS breakeven rates were well-anchored within our target band (Chart 3). The main difference between 2004 and today is that in 2004 a sizeable minority thought inflation might average above 2.5% over the next 10 years. Now, almost nobody expects a significant overshoot of the Fed’s inflation target, and a sizeable minority think inflation will undershoot. The lesson we take from these survey responses is that in order for TIPS breakeven inflation rates to reach our 2.3%-2.5% target, more people need to expect a significant overshoot of the Fed’s 2% inflation target. This will only happen if actual inflation rises to the Fed’s target, or above, and stays there for a significant period of time. Long enough to bring the fear of high inflation back to the forefront of investors’ minds. To further quantify this notion, our Adaptive Expectations Model of the 10-year TIPS breakeven inflation rate pegs current fair value for the 10-year breakeven at 1.94% (Chart 4). The model’s fair value is primarily determined by the 10-year rate of change in core CPI, meaning that a prolonged period of year-over-year core inflation near (or above) the Fed’s target will be required before our model’s fair value pushes above 2.3%. So how long will it take before core inflation is sustainably running at, or above, the Fed’s target? While we expect core inflation to continue along its slow upward trend. It probably won’t be high enough to push long-maturity TIPS breakevens into our target range until 2021, or late-2020 at the earliest. Chart 4Adaptive Expectations Model Chart 5Trimmed Means Are Rising... At present, core PCE inflation is running at a year-over-year rate of 1.59%, considerably below the Fed’s 2% target. One point in favor of rising core inflation is that trimmed mean price measures are accelerating more quickly than core measures (Chart 5). This will tend to drag core inflation higher over time. However, there is still a long way to go before core inflation reaches the Fed’s target and many leading inflation indicators have moderated this year (Chart 6):   Chart 6...But Many Headwinds Remain Unit labor cost growth rebounded in the past few quarters, but has yet to break out of its post-crisis range (Chart 6, top panel). The New York Fed’s Underlying Inflation Gauge rolled over sharply in 2019 (Chart 6, panel 2). NFIB surveys of planned and reported price increases have also turned down (Chart 6, bottom 2 panels). Considering the main components of core inflation, we find that the strong month-over-month core inflation prints of June, July and August were driven mostly by accelerating goods prices (Chart 7). Goods inflation has reversed course since then, and should continue to be a drag on core inflation going forward. This is because core goods inflation follows import price inflation with a long lag, and some import price deflation is already baked in (Chart 8). Chart 7CPI Components Chart 8Expect Some Import Price Deflation On the flipside, we have also seen core services inflation (excluding shelter and medical care) inflect higher during the past six months (Chart 7, panel 4). Continued strength in this component is essential if overall core inflation is going to move up. Shelter is the largest component of core inflation and we expect it to trend sideways as we head into 2020. The rental vacancy rate has flattened off at a low level, and the Apartment Market Tightness Index is just barely in net tightening territory (Chart 9). Neither indicator is sending a strong signal in either direction. Chart 9Shelter Inflation Trending Sideways All in all, we see core inflation and TIPS breakeven rates moving slowly higher in 2020. But it will take some time before inflation is strong enough to push long-maturity breakeven rates into our target range of 2.3%-2.5%. Given the importance placed on re-anchoring inflation expectations, the Fed won’t hike rates again until our TIPS breakeven target is met. We don’t expect this to occur until 2021, or late-2020 at the earliest. The Financial Conditions Wildcard Chart 10The Importance Of Financial Conditions We mentioned above that the Fed’s interest rate policy will be determined by two factors: inflation expectations and financial conditions. In a perfect world, financial market valuations will stay at reasonable levels and inflation expectations will determine the timing of the next Fed rate hike. However, we must also consider what is likely to happen if it takes a very long time for inflation expectations to reach our target. The longer it takes, the longer that monetary conditions will be accommodative, and any extended period of easy money could lead to an asset bubble. Eventually, if valuations look bubbly enough, there may be a case for the Fed to sacrifice a bit on its inflation target and attempt to deflate a potentially de-stabilizing bubble in financial markets. This is not just a hypothetical situation. As Governor Lael Brainard remarked last December:8 The last several times resource utilization approached levels similar to today, signs of overheating showed up in financial-sector imbalances rather than in accelerating inflation. With greater focus on financial stability than in the past, it is conceivable that we could eventually see Fed tightening to head off an asset bubble. But we are not close to such bubbly conditions yet (Chart 10). The Financial Conditions component of our Fed Monitor is close to neutral, and while corporate bond spreads are tighter than average, they are well above the lows seen in the mid-2000s. Meanwhile, the S&P 500’s forward multiple is not yet back to its early-2018 level, let alone the highs of the late 1990s (Chart 10, bottom panel). Bottom Line: The Fed’s next interest rate move will be a hike, but it probably won’t occur until 2021. It will not occur until either long-maturity TIPS breakeven inflation rates reach our target band of 2.3%-2.5% or financial asset valuations reach extreme levels. Balance Sheet Policy 2019 was a tumultuous year for the Fed’s balance sheet policy. At the start of the year, the Fed was continuing the process of balance sheet shrinkage that started in October 2017. The goal was never to return the Fed’s balance sheet to its pre-crisis size. Policymakers had already decided that they would shift permanently to a floor system of monetary policy implementation. A floor system is one where the central bank supplies more reserves to the banking system than are demanded, pushing interest rates down toward a floor that is set by the Fed. In this case, the floor is the Fed’s overnight reverse repo facility (ON RRP). Using this facility, the Fed agrees to borrow any excess cash at the ON RRP rate in return for a security from the Fed’s balance sheet as collateral. To implement this policy correctly, the Fed’s balance sheet must remain large so that bank reserves are plentiful. The Fed thought that it was supplying more reserves than the banking system demanded, but banks found themselves hoarding liquidity for a few days in September. Everything was going smoothly until September when this strategy hit a snag. The Fed thought that it was supplying more reserves than the banking system demanded, but banks found themselves hoarding liquidity for a few days in September. The result was that the fed funds rate shot higher, and actually printed outside the Fed’s target band for one day (Chart 11).9 Chart 11The Fed Briefly Lost Control Of Rates In September Clearly, the Fed had actually not been supplying the banking system with more reserves than it wanted, otherwise overnight liquidity would have remained plentiful throughout September. Even more vexing is that surveys of primary dealers and market participants all showed that reserve supply was comfortably above demand (Chart 12), even though this turned out not to be the case. Chart 12The Fed Was Blindsided Though there are many questions that still need to be answered, the Fed quickly took action and intervened in the repo market to increase the daily reserve supply. It also re-started T-bill purchases at a rate of $60 billion per month, ending the period of balance sheet shrinkage. Then just last week, the Fed announced a program of term repo agreements that will increase overnight liquidity heading into the volatile year-end period. After all that, the Fed’s balance sheet is once again growing as we head into 2020. But there is much uncertainty about how the balance sheet will evolve during the next 12 months.  A Two-Pronged Strategy In 2020 the Fed will attack its balance sheet problems on two fronts. 1) Increase Reserve Supply First, it will purchase T-bills in order to increase the supply of reserves. Chart 13 shows how the Fed’s securities holdings and bank reserves will evolve in the first half of 2020, assuming that the Fed buys $60 billion of T-bills per month. We also assume that maturing MBS roll over into Treasury securities and that currency in circulation grows at a rate of 5% per year. Table 1 gives a breakdown of what the Fed’s balance sheet looks like today and what it will look like at the end of June, according to our assumptions. Chart 13The Fed's Balance Sheet Over Time But increasing the reserve supply will be a bit more difficult than that. For one thing, Table 1 shows that the Treasury Department’s General Account at the Fed is expected to grow by another $106 billion. All else equal, this will drain $106 billion of reserve supply. The Treasury depleted its cash holdings down to $130 billion in August, as it took extraordinary measures to stay under the debt ceiling. But now that the debt ceiling has been suspended until July 2021, the Treasury has been re-building its cash stores, targeting a level of $410 billion. Table 1Fed’s Balance Sheet: Projections Second, Table 1 assumes that Fed repos stay flat at $213 billion. But if the Fed decides to extricate itself from the repo market in the first half of 2020 then, all else equal, reserve supply will shrink by $213 billion. So far the Fed has provided very little guidance about its future presence in the repo market, but we expect it to err on the side of caution. That is, the Fed will not completely unwind its repo operations until it is confident that reserve supply is comfortably above demand. What we can say for certain is that the Fed will try to increase the reserve supply in early-2020. Then, at some point during the year, it will decide that the reserve supply is high enough and it will shift to purchasing only enough securities to keep pace with growth in non-reserve liabilities, holding reserve supply flat. It is unknown when that shift will occur, but whenever it does, the Fed’s balance sheet will still be growing, just more slowly. We can say decisively that the era of balance sheet shrinkage is over. At some point in 2020 the Fed will probably also introduce a standing repo facility. This will act as the mirror image of the current ON RRP, providing a ceiling on interest rates. The facility will promise to supply overnight cash at a stated rate in return for Treasury collateral. If reserve supply is sufficiently high, then the standing repo facility is irrelevant. It would merely be a safety measure in case of periods like last September when reserve demand spiked. 2) Decrease Reserve Demand Other than increasing reserve supply, the Fed will also take steps in 2020 to reduce the amount of reserves demanded by the banking sector. It will do this by tweaking some banking regulations that possibly encouraged banks to hoard reserves in September. The Liquidity Coverage Ratio is the regulation that requires banks to hold enough high-quality liquid assets (HQLA) to cover 30 days of cash outflows in a stressed scenario. Bank reserves and Treasury securities both count as HQLAs, as do other fixed income securities with a haircut. In theory, the Liquidity Coverage Ratio shouldn’t prevent banks from swapping reserves for Treasuries in the repo market. But banks also undergo frequent internal stress testing, in preparation for the Fed’s periodic stress tests, and those internal tests may place a premium on reserves over Treasuries. It is very likely that, in 2020, the Fed will take steps to make banks increasingly indifferent between holding reserves and Treasury securities. This should reduce overall reserve demand and make cash more freely available in the overnight repo market. Investment Implications With all that said, we place very little importance on the Fed’s balance sheet policy in terms of what it means for asset returns. Our longstanding view is that asset purchases were only an effective policy tool because they reinforced the Fed’s forward guidance about changes in the funds rate. In fact, any perceived correlation between changes in the size of the Fed’s balance sheet and financial asset prices is only because balance sheet policy was moving in the same direction as interest rate policy. That is, during the past few years, periods of Fed asset purchases have always coincided with easier interest rate policy and periods of balance sheet shrinkage have always coincided with tighter interest rate policy. It is the interest rate policy that determines movements in asset prices, not the balance sheet. Finally, in 2019, we witnessed a period when balance sheet policy diverged from interest rate policy and we were able to test our thesis. Between December 2018 and July 2019, the Fed was shrinking its balance sheet but also easing its forward rate guidance and preparing for rate cuts. Outstanding bank reserves fell by $124 billion, but the expected 12-month change in the fed funds rate fell from +11 bps to -88 bps. It is very likely that, in 2020, the Fed will take steps to make banks increasingly indifferent between holding reserves and Treasury securities. What happened during this period? Bond yields declined and the dollar depreciated (Chart 14). Meanwhile, risk asset prices shot higher (Chart 15). In other words, markets behaved as you would expect if the Fed were easing policy, clearly taking their cues from interest rate policy not the balance sheet. Chart 14Rates Policy Trumps Balance Sheet Part I Chart 15Rates Policy Trumps Balance Sheet Part II Bottom Line: The era of balance sheet shrinkage is over. The Fed will continue to grow its balance sheet in 2020, and will also tweak regulations to make banks more indifferent between holding Treasury securities and reserves. But more importantly, the Fed’s balance sheet policy is now completely de-linked from its interest rate policy. That being the case, investors should largely ignore trends in the Fed’s balance sheet and focus on interest rate policy as the main driver of asset returns. The Fed’s Strategic Review The Fed is currently undertaking a strategic review of its monetary policy strategy, tools and communications practices. Chair Powell has said that he expects the review to be completed by the middle of 2020, and it is likely that some important changes will be announced. According to the Fed, the review is taking place because “the US economy appears to have changed in ways that matter for the conduct of monetary policy.” Specifically, the Fed believes that the neutral fed funds rate – the rate consistent with stable inflation – is structurally lower. The Fed is concerned that this increases the risk of the fed funds rate being pinned at its effective lower bound (ELB), making it more difficult to consistently hit its inflation target. The review is about considering different strategies and tools that the Fed could use to more consistently hit its 2% inflation target in the future, but the 2% target itself is not up for discussion. The Fed has already decided that 2% inflation is most consistent with its price stability mandate. Policy Strategy Chart 16A Big Miss One thing that’s clear is that most Fed participants agree that some changes to policy strategy are necessary. There is widespread concern about the fact that the Fed has not hit its inflation target during the past decade. The Fed officially adopted a 2% target for PCE inflation in January 2012, but inflation has not come close to those levels since. Headline and core PCE have increased at average annual rates of only 1.3% and 1.6%, respectively, since 2012 (Chart 16). At the July and September FOMC meetings, the Fed discussed several different strategies that could make it easier to hit its inflation target. Most of the proposals fall into the category of “makeup strategies”, strategies where the Fed tries to make up for a period of below-2% inflation by targeting above-2% inflation for a stretch of time. In theory, most Fed members agree that such strategies make sense. From the September FOMC minutes:10 Because of the downside risk to inflation and employment associated with the ELB, most participants were open to the possibility that the dual-mandate objectives of maximum employment and stable prices could be best served by strategies that deliver inflation rates that over time are, on average, equal to the Committee’s longer-run objective of 2 percent. Promoting such outcomes may require aiming for inflation somewhat above 2 percent when the policy rate was away from the ELB, recognizing that inflation would tend to be lower than 2 percent when the policy rate was constrained by the ELB. The main problem with these sorts of makeup strategies is what Fed Governor Lael Brainard calls the time-inconsistency problem.11 For example, if inflation has been running well below – or above – target for a sustained period, when the time arrives to maintain inflation commensurately above – or below – 2 percent for the same amount of time, economic conditions will typically be inconsistent with implementing the promised action. In other words, when it comes time to deliver on its past promises, the Fed may not want to. But if it fails to deliver, it makes any future promises less impactful. Governor Brainard thinks that this problem can be mitigated by adopting a more flexible approach. That is, rather than following a strict rule that says that the Fed must aim for average inflation of 2 percent over a specific timeframe, it could simply opportunistically change its target inflation range based on the circumstances. She gives the following example: For instance, following five years when the public has observed inflation outcomes in the range of 1-1/2 to 2 percent, to avoid a decline in expectations, the Committee would target inflation outcomes in a range of, say, 2 to 2-1/2 percent for the subsequent five years to achieve inflation outcomes of 2 percent on average overall. We think it is very likely that something similar to Brainard’s plan will be announced when the review is completed in 2020. There is widespread consensus that the Fed should temporarily target an overshoot of its 2 percent inflation target to ensure that inflation expectations stay anchored near target levels. Opportunistically shifting the inflation target to 2%-2.5% on a temporary basis seems like the easiest way to communicate that goal. ELB Tools In addition to potential changes to policy strategy, the Fed has also been talking about potential policy tools that could be deployed the next time that interest rates reach the ELB. Policymakers took up this question in detail at the October FOMC meeting and generally agreed that the combination of forward guidance and asset purchases had been effective at delivering policy accommodation at the lower bound. Now that the committee is comfortable with these tools, we would expect them to be deployed very quickly the next time that the fed funds rate reaches zero. In all likelihood, if the funds rate reaches zero again, the Fed will quickly announce a round of asset purchases and pledge to keep rates on hold until some economic outcome – likely related to inflation – is met. The Fed also discussed the possibility of cutting rates into negative territory, but there is very little appetite for negative rates policy in the US. From the October FOMC minutes:12 All participants judged that negative interest rates currently did not appear to be an attractive monetary policy tool in the United States. Participants commented that there was limited scope to bring the policy rate into negative territory, that the evidence on the beneficial effects of negative interest rates abroad was mixed, and that it was unclear what effects negative rates might have on the willingness of financial intermediaries to lend and on the spending plans of households and businesses. If, during the next ELB phase, the combination of forward rate guidance and asset purchases does not appear to be working quickly enough, we think it’s most likely that the Fed will follow the Bank of Japan and simply extend these policies further out the yield curve. For example, the Fed would set a cap on some intermediate-maturity Treasury yield (say the 2-year yield), and pledge to buy as many securities as necessary to keep the yield below that cap. This potential tool was discussed at the October FOMC meeting, and it received a more favorable response than the negative rates policy. Results Of The Strategic Review The exact form of any new policy strategy is uncertain, but we expect the Fed to make an announcement in mid-2020 that makes it clear that it will explicitly target above-2% inflation for some unspecified period of time in order to re-anchor inflation expectations and make up for past inflation misses. This will make it even more important to use inflation expectations as our guide for detecting shifts in Fed policy, rather than the actual inflation data. In many ways, the Fed’s reaction function has already moved toward targeting expectations. The results of the 2020 strategic review will make that even more explicit. There is less urgency to announce any potential new tools for conducting policy at the ELB, and we do not expect much in that regard. Other than some ideas for further study.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see Global Fixed Income Strategy Special Report, “2020 Key Views: Delay Of Reckoning”, dated December 10, 2019, available at gfis.bcaresearch.com and US Bond Strategy Special Report, “2020 Key Views: US Fixed Income”, dated December 10, 2019, available at usbs.bcaresearch.com 2 For details on BCA’s economic outlook for 2020 please see The Bank Credit Analyst, “Outlook 2020: Heading Into The End Game”, dated November 22, 2019, available at bca.bcaresearch.com 3 Please see US Bond Strategy Weekly Report, “The New Battleground For Monetary Policy”, dated March 26, 2019, available at usbs.bcaresearch.com 4  https://www.federalreserve.gov/newsevents/speech/yellen20150924a.htm 5  https://www.federalreserve.gov/newsevents/speech/clarida20190926a.htm 6 Please see US Bond Strategy Weekly Report, “Adaptive Expectations In The TIPS Market”, dated November 20, 2018, available at usbs.bcaresearch.com 7 CPI inflation runs about 0.4%-0.5% above PCE inflation, so the Fed’s 2% PCE target translates to a 2.4%-2.5% target for CPI. 8  https://www.federalreserve.gov/newsevents/speech/brainard20181207a.htm 9 This September episode is discussed in detail in the US Bond Strategy Weekly Report, “What’s Up In US Money Markets?”, dated September 24, 2019, available at usbs.bcaresearch.com 10 https://www.federalreserve.gov/monetarypolicy/fomcminutes20190918.htm 11 https://www.federalreserve.gov/newsevents/speech/brainard20191126a.htm 12 https://www.federalreserve.gov/monetarypolicy/files/fomcminutes20191030.pdf

Highlights Easy monetary policy is the linchpin of our 2020 market views and investment strategy, … : As we outlined in our 2020 Key Views report, easy monetary policy should extend the economic expansion and the bull markets in risk assets. ... and last week’s FOMC meeting made it crystal clear that the Fed’s default policy setting for next year is easy: The meeting came and went without much of a fuss, but the FOMC revealed that it will take a major inflation surprise to bring it off the sidelines in 2020. The labor market still has plenty of momentum, and should help keep the real economy humming, … : Through November, 2019’s average net monthly job gains are snugly within the last nine years’ range, and the JOLTS and NFIB surveys point to more hiring and accelerated wage gains. … while trade tensions are apparently less likely to derail it: Details remained vague as we went to press, but Chinese and American trade negotiators have reportedly reached a Phase 1 agreement that will be executed soon. Feature Dear Client, This is our last report of 2019. Our regular publishing schedule will resume on Monday, January 6th. We wish you a happy, healthy and prosperous new year. Chart 1The Fed Stood Down In 2019 Why bother fighting the Fed? Central bankers exert tremendous sway over the economy and markets, and although they’re hardly infallible, they typically get their way over the timeframes that most investors are judged. It’s much easier to make money going with the monetary policy flow than it is to try to resist it, because resistance is only viable when the Fed is plainly behind the curve. Consistent money-making investment strategies revolve around deploying capital when the odds are in one’s favor, and they’re stacked in favor of risk assets when policy is easy, and against them when it’s tight. We missed the latest instance when the Fed was fighting a losing battle at this time last year, when we continued to stick with our below-benchmark-duration recommendation. The money markets called for a 25-basis-point rate cut in 2019 in defiance of the FOMC, which projected 50 basis points ("bps") of hikes (Chart 1). We sided with the Fed, and wound up on the wrong side of the 10-year Treasury rally from 2.70% at the beginning of January to under 1.50% at the end of August. Since the crisis, however, BCA has remained squarely in the easier-for-longer monetary policy camp, which has led us to recommend overweighting stocks throughout the longest US equity bull market on record. The importance of the Fed’s influence was all over the 2020 outlook we laid out last week. The common thread linking our market views and investment strategy is the expectation that monetary policy settings will remain amply accommodative until the election is over. Easy monetary conditions are not confined to the US; major central banks around the world are deliberately pursuing reflationary policy. With the wind of an additional year of generous accommodation filling their sails, we expect that equities and spread product will easily outperform Treasuries and cash in 2020. The Latest From The Fed Chart 2Same Outlook, Fewer Hikes The run-up to last week’s FOMC meeting was devoid of suspense, but members’ dot-plot projections and Chair Powell’s press conference supported our sense that promoting higher inflation expectations is the Fed’s foremost priority. Our base case remains that the Fed will stay on hold at least until its November meeting. Although the Fed remains at pains to remind investors that policy is not on a preset course, the committee clearly expects the growth-without-inflation sweet spot will last through 2020 and beyond. As a group, the 17 FOMC members dialed back their rate-hike expectations from the September meeting, rescinding a net 13 votes for 25-bps hikes in 2020 (Chart 2, top panel) and 7 in 2021 (Chart 2, bottom panel). Several of Powell’s comments at the press conference reinforced the take that the Fed is on hold for the foreseeable future. In his prepared remarks, he repeated the message from the July, September and October meetings that the Fed has not yet accomplished its full-employment mandate. “[W]ages have been rising, particularly for lower-paying jobs. [I]n low- and middle-income communities, … many who have struggled to find work are now finding new opportunities. [Broad-based employment gains] underscore … the importance of sustaining the expansion so that the strong job market reaches more of those left behind.” When the chair says that unemployment can be a full percentage point below NAIRU for an extended period without generating "unwanted upward pressure on inflation," ... He characterized low inflation as a mixed blessing, and was more explicit about the need to get it higher than he was in the past three meetings, when the committee actually cut rates. “While low and stable inflation is certainly a good thing, inflation that runs persistently below our objective can lead to an unhealthy dynamic in which longer-term inflation expectations drift down, pulling actual inflation even lower. In turn, interest rates would be lower as well and closer to their effective lower bound. As a result, the scope for interest rate reductions to support the economy in a future downturn would be diminished, resulting in worse economic outcomes for American families and businesses. … We are strongly committed to achieving our symmetric 2 percent inflation goal.” In the Q&A segment of the press conference, Powell amplified the boilerplate employment language with repeated assertions that the labor market still has some slack. [W]e think we’ve learned that unemployment can remain at quite low levels for an extended period of time without unwanted upward pressure on inflation. In fact, we need some upward pressure [on] inflation to get back to 2 percent. … [E]ven though we’re at three-and-a-half percent unemployment, there’s actually more slack out there. … I’ll say that the labor market is strong. I don’t know that it’s tight because you’re not seeing wage increases[.] … Ultimately[,] … to call it hot, you’d want to see heat. You’d want to see … higher wages. That take contrasts with the Congressional Budget Office’s 4.6% NAIRU estimate, but NAIRU is only a concept. To this point, the economy has been supporting an unemployment rate in the low-3s without overheating, and economists will only have a clear idea of where NAIRU is today well after the fact. The relevant point for investors is that an FOMC that believes the natural rate of unemployment is below its current 50-year low is an FOMC that has sworn off proactive tightening. ... you know the FOMC isn't going to tighten policy pre-emptively. The chair also elaborated on the inflation mandate by saying that “a significant move up in inflation that’s also persistent” is a personal prerequisite for tightening policy. Our US Bond Strategy colleagues interpret “persistent” as meaning that inflation expectations have to get back to the 2.3-2.5% range that is consistent with the Fed’s 2% inflation target. Taken together, the prepared remarks, the Q&A and the fairly significant downward adjustment in the dots – absent any change in the outlook – suggest that the Fed’s reaction function has shifted materially. It will take a significant pickup in inflation, or undeniable signs of froth in the financial markets, for the Fed to tighten policy. The Labor Market Remains On Track November marked the record 110th consecutive month that net nonfarm payrolls have expanded, and the rest of the employment situation report confirmed that the jobs machine continues to motor along eleven years into the expansion (Chart 3). The annual job gains have not been as large as they often were in the 1991-2001 expansion, but they have been remarkably steady since 2011, averaging an even 200,000 net additions per month without once dipping below 170,000 for a full year (Chart 4). The unemployment rate fell back to the 3.5% 50-year low first reached in September, and the broader unemployment rate, capturing discouraged workers and involuntary part-time workers, is just a tick above the dot-com boom’s 6.8% low (Chart 5). Chart 3The Job Gains Haven't Been As Big As They Were In The '90s, ... Chart 4... But They've Been Remarkably Steady Chart 5All Unemployment Measures Are Extremely Low Neither the JOLTS nor the NFIB survey offers any indication that employment gains are about to dry up. JOLTS job openings have exceeded the number of unemployed workers since early 2018, and job openings as a share of overall employment remain way above the last cycle’s peak (Chart 6). The NFIB survey’s share of small businesses with unfilled job openings is similarly extended (Chart 7, top panel), and the diffusion index of firms planning to expand payrolls in the next three months is around its dot-com highs (Chart 7, middle panel). Hiring momentum appears as if it will remain solid over the visible horizon. Chart 6Survey Says ... With labor demand exceeding readily available supply, wage gains ought to accelerate. The prime-age employment-to-population ratio remained at an 11-year high last month, shy of only its dot-com boom highs (Chart 8). The Phillips Curve using the prime-age employment-to-population ratio is not kinked, and exhibits a strong correlation with compensation gains (Chart 9). Chart 7... More Jobs Are On The Way Chart 8Prime-Age Employment Is Back To Its Pre-Crisis Peak   Average hourly earnings for production and nonsupervisory employees, which comprise about 80% of the labor force, have already been growing at a 3.7-3.8% clip, and the Conference Board’s consumer confidence survey (Chart 10, middle panel) and the quits rate (Chart 10, bottom panel) suggest that they can keep climbing. So, too, does the Fed’s pivot; it usually tightens policy to slow the economy when real wage gains reach today’s levels, but now it appears bent on abetting further gains (Chart 10, top panel). Chart 9There Will Be Upward Pressure On Wages, ... Bottom Line: The labor market is strong, and poised to stay that way for the immediate future, especially given that the Fed seems to be egging it on in an attempt to boost inflation expectations and spread the expansion’s gains more evenly. Chart 10... And The Fed Doesn't Mind At All Investment Implications A robust labor market should keep household income growing nicely, and fortified balance sheets will enable households to spend much of their income gains, supporting consumption. Government spending is certain to support the economy ahead of a hotly contested election. We have worried about volatile fixed investment’s potential to stymie growth, largely because of concerns that the uncertainty surrounding trade tensions could cause corporations to pull back on capex until they get a better sense of the rules of the road. The apparent breakthrough in the US-China trade negotiations may resolve some of that uncertainty. With the Fed seemingly settling in for an extended period of holding the target fed funds rate at 1.75%, the risk to our view may be that we’re being insufficiently bullish on the markets. Another year of generous accommodation, here and abroad, is likely to keep life insurers, pension funds and endowments avidly searching for yield. It will be hard to default while that search is afoot, and it will also be hard for spreads to widen in an appreciable way. The combination should allow spread product to continue to generate excess returns over Treasuries and cash, though we echo our US Bond Strategy colleagues’ preference for high-yield over investment-grade corporates. Easy policy also supports equity outperformance. Global ex-US acceleration will benefit international indexes more than US indexes, but US equities will still generate attractive absolute returns. S&P 500 earnings will pick up a little as the rest of the world begins to stir, though truly juicy equity returns will require multiple expansion. We are not yet ready to call for a couple of points of re-rating, but note that it would be consistent with the monetary policy backdrop, the historical sprint-to-the-finish equity bull market pattern, and investors’ need for investment destinations in a persistently low-yield world.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com

Special Report

Feature The purpose of this Special Report is to identify and provoke a healthy debate on the prevailing investment themes for the 2020s and to speculate on what the key US sector beneficiaries and likely losers may be. Every decade a dominant theme captures investors’ imaginations and morphs into a bubble. Massive speculation typically propels the relevant asset class into the stratosphere as investors extrapolate the good times far into the future and go on a buying frenzy. Chart 1 shows previous manic markets starting with the Nifty Fifty, gold bullion, the Nikkei 225, the NASDAQ 100, crude oil and most recently the FAANGs. Chart 1Manias: An Historical Roadmap What will be the dominant themes of the next decade? How should investors capitalize on some of these big trends? The purpose of this Special Report is to identify and provoke a healthy debate on the prevailing investment themes for the 2020s and to speculate on what the key US sector beneficiaries and likely losers may be. Theme #1: De-Globalization Picks Up Steam The first investment theme for the upcoming decade is the “apex of globalization” or “de-globalization”. We have written about this theme extensively at BCA Research and it is the mega-theme of our sister Geopolitical Strategy (GPS) service. Odds are high that countries will continue looking inward as the US adopts a more aggressive trade policy, China’s trend growth slows, and US-China strategic tensions intensify. The three pillars of globalization are the free movement of goods, capital, and people across national borders. We expect to see marginally less of each in the future. Chart 2 shows that we are at the conclusion of a period of tranquility. Pax Americana underpinned globalization as much as Pax Britannica before it. The US is in a relative decline after decades of geopolitical stability allowed countries like China to rise to “great power” status and rivals like Russia to recover from the chaos of the 1990s. Chart 2De-globalization Has Commenced De-globalization has become the consensus since the election of Donald Trump. But Trump is not the prophet of de-globalization; he is its acolyte. Globalization is ending because of structural factors, not cyclical ones. And its decline was pre-written into its “source code.” Three factors stand at the center of this assessment, outlined in our 2014 Special Report, “The Apex Of Globalization – All Downhill From Here”: multipolarity, populism and protectionism. Events have since confirmed this view. The three pillars of globalization are the free movement of goods, capital, and people across national borders. We expect to see marginally less of each in the future. Investment Implication #1: Profit Margin Peak The most profound and provocative investment implication from de-globalization is that SPX profit margins have peaked and will likely come under intense pressure, especially for US conglomerates that – on a relative basis to international peers – most enthusiastically embraced globalization. Reconstructed S&P 500 profits and sales data date back to the late-1920s. Historically, corporate profit margins and globalization (depicted as global trade as a percentage of GDP) have been positively correlated (Chart 3). Chart 3Profit Margin Trouble As countries are more outward looking, trade flourishes and openness to trade allows the free flow of capital to take advantage of profit-maximizing projects. Following the Great Recession and similar to the Great Depression, trade has suffered and trade barriers have risen. The Sino-American trade war has accelerated the inward movement of countries, including Korea and Japan, and has had negative knock-on effects on trade as evidenced by the now two-year old global growth deceleration. China’s response to President Trump’s election was to redouble its pursuit of economic self-sufficiency, which meant a crackdown on corporate debt and a fiscal boost to household consumption. Trump’s tariffs then damaged sentiment and trade between the two countries. Any deal reached prior to the 2020 US election will remain in doubt among global investors. The longer the trade war remains unresolved, the deeper the cracks will be in the foundations of the global trading system. Such a backdrop is negative for profit margins, as inward looking countries prevent capital from being allocated most efficiently. Moreover, the uprooting of supply chains due to the trade war hurts margins and the redeployment of equipment in different jurisdictions will do the same at a time when final demand is suffering a setback. In addition, rising profit margins are synonymous with wealth accruing to the top 1% of US families and vice versa. This relationship dates back to the late-1920s, as far back as our dataset goes. Using Piketty and Saez data, which exclude capital gains, it is clear that profit margin expansion exacerbates income inequality (top panel, Chart 4). Chart 4Heightened Risk Of Wealth Re-distribution Expanding margins lead to higher profits. Because families at the top of the income distribution are more often than not business owners, income disparities are the widest when margins are in overshoot territory. Eventually this income chasm comes to a head and generates political discontent. Populism has emerged on both the right and left wings of the US political spectrum – and since the rise of Trump, even Republicans complain about inequality and the excesses of “corporate welfare” and laissez-faire capitalism. Because inequality is extreme – relative to America’s developed peers – and political forces are mobilizing against it, the probability of wealth re-distribution is rising in the coming decades (middle panel, Chart 4). Labor’s share of national income has nowhere to go but higher in coming years and that is negative for profit margins, ceteris paribus (bottom panel, Chart 4). Drilling beneath the surface, the three secular US equity sector/factor implications of the apex of globalization paradigm shift are: prefer small caps over large caps prefer value over growth overweight the pure-play BCA Defense Index Investment Implication #2: Small Is Beautiful While a small cap bias is contrary to the cyclical US Equity Strategy view of preferring large caps to small caps, the issue is timing: the small cap preference is a secular view with a time horizon that spans the next decade. The small versus large cap share price ratio’s ebbs and flows persist over long cycles. Small caps outshined large caps uninterruptedly from 1999 to 2010. Since then large caps have had the upper hand (Chart 5). Were the apex of globalization theme to gain traction in the 2020s, small caps should reclaim the lead from large caps, especially in the wake of the next US recession. Similar to the death of the global banking model, companies with global footprints will suffer the most, especially compared with domestically focused outfits. One way to explore this theme is via domestic versus global sector preference. But a more investable way to position for this sea change, is to buy small caps (or microcaps) at the expense of large caps (or mega caps). Small caps are traditionally domestically geared compared with large caps that have significantly more foreign sales exposure. Chart 5It’s A Small World After All The closest ETF ticker symbols resembling this trade is long IWM:US/short SPY:US. Investment Implication #3: Buy Value At The Expense Of Growth Similar to the size bias, the style bias also moves in secular ways. Value outperformed growth from the dot com bust until the GFC. Since then growth has crushed value, even temporarily breaking below the year 2000 relative trough. This breakneck pace of appreciation for growth stocks is clearly unsustainable and offers long-term oriented investors a compelling entry point near two standard deviations below the historical mean (Chart 6). Chart 6Value Has The Upper Hand Versus Growth Financials populate value indexes, a similarity with small cap outfits. Traditionally, financials are a domestically focused sector with export exposure registering at half of the S&P’s average 40% level of internationally sourced revenues. On the flip side, tech stocks sit atop the growth table and they garner 60% of their revenue from abroad. This value over growth style preference will pay handsome dividends if the de-globalization theme becomes more main stream as countries become more hawkish on trade and the Sino-American war continues to erect barriers to trade that took decades to lift. The caveat? If President Trump strikes a short-term deal with China ahead of the 2020 election, the de-globalization theme will suffer a setback. But our geopolitical strategists expect a ceasefire at best, not a durable deal, and also expect the trade war to resume in some way, shape or form in 2021-22, regardless of the outcome of the US election. The closest ETF ticker symbols resembling this trade is long IVE:US/short IVW:US.  Investment Implication #4: Defense Fortress One final long-term playable investment idea from the apex of globalization is a structural bull market in defense stocks (Chart 7). Our October 2016 “Brothers In Arms” Special Report drew parallels with the late nineteenth century period of European rearmament, and the American and Soviet arms race of the 1960s. These movements were greatly beneficial to the aerospace and defense industry. Currently, the move by several countries to adopt more independent foreign policies, i.e. to move away from collaboration and cooperation toward isolationism and self-sufficiency, entails an accompanying arms race. Chart 7Stick With Pure-play Defense Stocks Table 1 China’s challenge to the regional political status quo motivates a boost to defense spending globally. In fact SIPRI data on global military spending by 2030 (Table 1) increases our conviction that this trade will succeed on a five-to-ten year horizon. Beyond the global arms race, two additional forces are at work underpinning pure-play defense contractors. A global space race with China, India and the US wanting to have manned missions to the moon, and the rise of global cybersecurity breaches. Defense companies are levered to both of these secular forces and should be prime sales and profit beneficiaries to rising space budgets and increasing cybersecurity combat budgets. The ticker symbols for the stocks in the pure-play BCA defense index are: LMT, RTN, NOC, GD, HII, AJRD, BWXT, CW, MRCY. Theme #2: Tech Sector Regulation, US Enacts Privacy Laws The second long-term geopolitical theme that we are exploring is the regulatory or “stroke of pen” risk that is rising on FAANG stocks – Facebook, Apple, Amazon, Netflix, and Google. These companies were this decade’s undisputed stock market winners. The US anti-trust regulatory framework was designed to curb broad anti-competitive actions of trusts. As Lina Khan discusses in her seminal article, these actions “include not only cost but also product quality, variety, and innovation.” However, through subsequent regulatory evolution, the Chicago School has focused the US anti-trust process on consumer welfare and prices. If President Reagan and the courts could change how anti-trust laws were administered in the 1980s, so too can future administrations and courts. Today the US Congress, on both sides of the aisle, is looking into regulatory tightening, while the judicial system will take longer to change its approach. Moreover, the impetus for tougher anti-trust policy is here. It comes from a long period of slow growth, income inequality, and economic volatility – such as in the 1870s-80s. This was certainly the case for Standard Oil in 1911, which became a nation-wide boogeyman despite most of its transgressions occurring in the farm belt states. Today, income inequality is a prominent political theme and source of consumer discontent. A narrative is emerging – which will be super-charged during the next recession – that growth has been unequally distributed between the old economy and the twenty-first century technology leaders. With regard to privacy, the news is equally grim for large tech outfits. The EU General Data Protection Regulation (GDPR), which came into force on May 2018, imposes compliance burdens on any company handling user data. In the US, California has signed its own version of the law – the Consumer Privacy Act – which will go into effect in January 2020. These laws give consumers the right to know what information companies are collecting about them and what companies that data is being shared with. They also allow consumers to ask technology companies to delete their data or not to sell it. While tech companies are likely to fight the new California law, and the US court system is a source of uncertainty, we believe the writing is on the wall. The EU is by some measures the largest consumer market on the planet. California is certainly the largest US market of the states. It is unlikely that the momentum behind consumer protection will change, especially with the EU and California taking the lead. The odds of a federal privacy law, following in the footsteps of the Consumer Privacy Act, are also rising. Investment Implication #5: Shun Interactive Media & Services Stocks These risks introduce a severe overhang for FAANG stocks. We are especially worried for the S&P interactive media & services index that includes GOOGL and FB. Tack on the threat of federal regulation and this represents another major headwind for profits and net profit margins that are extremely elevated for these near monopolies. Given that advertising revenue is crucial to the business model of social media companies (GOOGL and FB included), a significant uptick in privacy regulation will likely hurt their bottom line. With regard to profit margins, tech stocks in general command a profit margin twice as high as the SPX. Specifically, FB and GOOGL enjoy margins that are 500 basis points higher than the broad tech sector (Chart 8)! This is unsustainable and will likely serve as easy prey for policymakers. Our view does not necessarily call for breaking up these monopolies. The US will have to weigh the economic consequences of anti-trust policy in a context of multipolarity in which China’s national tech champions are emerging to compete with American companies for global market share. Nevertheless increased regulation is inevitable and some forced sales of crown jewel assets may take place. Moreover, the threat of a breakup will lurk in the background, creating uncertainty until key legislative and judicial battles have already been fought. That will take years. Finally, we doubt the tech sector will be left alone to “self-regulate” its incumbents and negotiate a price on consumers’ privacy. More likely, a new privacy law will loom overhead, serving as a negative catalyst for profit growth. Uncertainty will weigh on the S&P interactive media & services relative performance. Chart 8Regulation Will Squeeze Tech Margins The ticker symbols to short/underweight the S&P interactive media & services index are an equally weighted basket of GOOGL and FB (they command a 98% market cap weight in the index). Theme #3: SaaS, Artificial Intelligence, Augmented Reality And Autonomous Driving Are Not Fads The third big theme that will even outlive the upcoming decade is the proliferation of software as a service (SaaS). The move to cloud computing and SaaS, the wider adoption of artificial intelligence, machine learning, autonomous driving and augmented reality are not fads, but enjoy a secular growth profile. In the grander scheme of things today’s world is surrounded by software. Millions of lines of code go even into gasoline powered automobiles, let alone electric vehicles. Autonomous driving is synonymous with software, the Internet of Things (IoT) needs software, the space race depends on software, modern manufacturing and software are closely intertwined, phone calls for quite some time have been a software solution, and the list goes on and on. This tidal effect is hard to reverse and is already embedded in workflows across industries. Opportunities to penetrate health care and financial services more deeply remain unexplored and it is difficult to envision another competing industry unseating “king software”. These secular trends are not only productivity enhancing, but will also most likely prove recession-proof. When growth is scarce investors flock to any source of growth they can come by and we are foreseeing that when the next recession arrives, investors will likely seek shelter in pure play SaaS firms. Investment Implication #6: Software Is Eating The World Buying software stocks for the long haul seems like a bulletproof investment idea. But the recent stellar performance of software stocks that has moved valuations to overshoot territory. Our recommended strategy is to buy or add software stock exposure on any weakness with a 10-year investment time horizon. All of these secular trends have pushed capital outlays on software into a structural uptrend. Software related capex is not only garnering a larger slice of the tech spending budgets but also of the overall capex pie. If it were not for software capex, the contraction in non-residential investment in recent quarters would have been more severe (Chart 9). Private sector software capex is near all-time highs as a share of total outlays. Government investment in software is also reaccelerating at the fastest pace since the tech bubble. When productivity gains are anemic, both the business and government sectors resort to software upgrades in order to boost productivity. Cyber security is another more recent source of software related demand as governments around the globe are taking such risks extremely seriously (bottom panel, Chart 9). Given this upbeat demand backdrop and ongoing equity retirement, software stocks are primed to grow into their pricey valuations. Chart 9Software Is Eating The World Finally, this long-term trade will also serve as a hedge to the short/underweight position we recommend in the S&P interactive media & services index. The closest ETF ticker symbol resembling the S&P software index is IGV:US. Theme #4: Millennials Already Are The Largest Cohort And Will Dominate Spending The fourth long-term theme we anticipate will gain traction in the 2020s is the demographic rise of the Millennial generation. Much has been made of preparing for the arrival of the Millennial generation, accompanied by well-worn stereotypes of general "failure to launch" as they reach adulthood. However, "arrival" is a misnomer as this age cohort is already the largest and "failure" is simply untrue. According to the U.S. Census Bureau, Millennials are the US’s largest living generation. Millennials (or Echo Boomers) defined as people aged 18 to 37 (born 1982 to 2000), now number more than 80mn and represent more than one quarter of the US’s population. Baby Boomers (born 1946 to 1964) number about 75mn. Stealthily becoming the largest age group in the US over the last few years, Millennials per-year-birth-rate peaked at 4.3mn in 1990. Surprisingly, the pace matched that of the post-war Baby Boom peak-per-year-birth-rate in 1957 - the per-year average over the period was higher for the Baby Boomers (Chart 10). Chart 10Millennials Are The Largest Cohort This gap is now set to grow rapidly as the death rate of Baby Boomers accelerates. What is more, the largest one-year age cohort is only 25 years old, thus, Millennials will be the dominant generation for many years. It is unclear how these “kids” will impact the market as they become the most important consumers, borrowers and investors, but make no mistake: this is a seismic shift in economic power and it is here to stay. The Echo Boom is a big, generational demographic wave. A difficult and painful delay has not tempered its looming importance. Finally, this wave of echo-boomers is educated, relatively unburdened by debt (please see BOX in the June 11, 2018 Special Report on demystifying the student debt load as it pertains to Millennials), and as they inevitably “grow up”, form new households and have kids. They will borrow, spend, earn, but not necessarily save and invest to the same extent as the Boomers. And this will be an important long-term theme going forward. Near term we might already be seeing signs of their arrival and firms have begun to pivot accordingly. Investment Implication #7: Buy The BCA Millennials Equity Basket Millennials will boost consumption spending in a number of different ways. The relatively unburdened Millennial cohort will be entering prime home acquisition age soon and this should underpin the long-term prospects of the US housing market and derivative industries. Further, Millennials consume differently from their parents; social media, online shopping and smart phones are not the consumption categories of the Baby Boomers. With this in mind, we have created a basket of ten stocks that we think will be driven over the long term by the demographic rise of the Millennial. We note that these stocks are heavily weighted to the technology and consumer discretionary sectors, which is logical as Millennial consumption habits tend to be discretionary focused and technology-based. Beginning with consumer discretionary, we are highlighting AMZN, NFLX and SPOT as core holdings in our Millennials basket. AMZN’s heft dwarfs consumer discretionary indexes but it could fall in several categories; the acquisition of Whole Foods makes it a Millennials-focused consumer staples retailer and its cloud computing web services segment is a tech leader. NFLX and SPOT represent the means by which Millennials consume media, by streaming movies and music over the internet. The idea of owning physical media is rapidly becoming an anachronism. The home ownership themes noted in the report above lead us to add HD and LEN to the basket. Millennials are “doers” and are set to be the dominant DIYers in the next few years, making HD a logical choice. LEN, as the nation’s largest home builder, should benefit from the Millennials coming of age into home buyers. We are also adding TSLA to our basket as a lone clean tech-oriented equity. TSLA capitalizes on the increasing shift to clean energy of Millennials (the key reason why no traditional energy companies have a spot in our basket). The technology stocks in our Millennials basket are AAPL, UBER (which replaces FB as of today) and MSFT, together representing more than 9% of the total value of the S&P 500. AAPL’s inclusion in the list is predictable as the leading domestic purveyor of devices on which Millennials consume media content. FB is a predictable holding, with more than half of all Americans being monthly active users, dominated by the Millennial cohort. It has served our basket well since inception, but today we are compelled to remove it and replace it with UBER. UBER is a Millennial favorite and the epitome of the sharing economy. In reality UBER is a logistics company and while it is losing money it is eerily reminiscent of AMZN in its early days. Maybe UBER will dominate all means of transportation and its ease of use will propel it to a mega cap in the coming decade. Our inclusion of MSFT is based on its leadership in cloud computing, a rapidly growing industry. We expect the connectivity and mobile computing demands of Millennials will accelerate. The last stock we are adding to our basket is also the only financial services equity. Though avid consumers, Millennials have shown an aversion to cash, preferring card payment systems, including both debit and credit-based. Accordingly, we are adding the leader in both of these, V, to our Millennials basket (Chart 11). Chart 11Buy BCA’s Millennial Equity Basket Investors seeking long term exposure to stocks lifted by the supremacy of the Millennial generation should own our Millennial basket (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V). We would not hesitate to add other sharing economy stocks, including Airbnb, to this basket should they become investable in the near future. Theme #5: ESG Becomes Mainstream Investors are increasingly looking at allocating assets based on environmental, social, and governance (ESG) considerations, and this mini-theme has the potential to become a big trend in the 2020s. There are a number of factors that underpin ESG investing. First, Millennials are climate conscious and given that they already are the largest cohort in the US they will not only dominate spending, but also influence election results. Moreover, via social media Millennials can sway public opinion and participate in the ESG conversation. Second, ECB President Christine Lagarde recent speech to the Economic and Monetary Affairs Committee of the European Parliament is a must read.1 If the ECB were to explicitly focus on climate change policy as part of its monetary policy operations then this is a game changer. Green investment financing including “green bonds” could become mainstream. Keep in mind the as reported in the FT “the European Parliament has declared a climate emergency; the new European Commission (EC) has taken office on a promise of an imminent “green new deal”, and Commission president Ursula von der Leyen has vowed to accelerate emissions cuts.” Last Wednesday, the EC released “The European Green Deal” with a pretty aggressive time table. The EC president said “The green deal is Europe’s man on the moon moment” and presented 50 policies slated to get rolled by 2022 to meet revamped climate goals. The implication is that once ESG takes center stage at a number of these institutions it will be easier to become mainstream and propagate the world over. Third, large institutional investors are starting to adopt an ESG mindset, especially pension plans. These investors with trillions of dollars at their disposal can not only disfavor fossil fuel investment, but also undertake investments in “green projects” via private and public equity markets. Banks are also moving in the “greening of finance” direction and given that they are the pipelines of the global plumbing system, swift adoption will go a long way in taking ESG mainstream. Finally, the electric vehicle (EV) proliferation is another key driver on how the ESG theme will play out in the 2020s. As a reminder, in the US 50% of all energy consumption is gasoline related linked to automobiles. While battery technology still has limitations, EV is no longer a fad as the German and Japanese automakers are starting to make inroads on TSLA. These car manufacturers do not want to be left out, especially if this shift toward EV becomes mainstream in the 2020s. The Chinese are not far behind on the EV manufacturing front, however government policy can really become a game changer. If a number of countries and/or California mandate a large share of all new vehicles sold be EV, then the investment implications will be massive. Investment Implication #8: Avoid Fossil Fuels, Gambling, Alcohol And Tobacco… While there are a few ESG related ETFs, we would rather explore this theme’s investment implications of sectors to avoid in the coming decade. We are believers that ESG criteria will continue to gain in importance in institutional investment management decisions. Accordingly, we would tend to avoid ‘sin stocks’, including gambling, tobacco and alcohol; demand for their services is unlikely to decline but investment weightings should mean that share prices will underperform. Further, we think a clean energy shift will mean energy stocks will likely continue to be long-term underperformers (Chart 12). Chart 12Areas To Avoid As ESG Becomes Mainstream Final Thoughts On The US Dollar In this report, we tried to focus on the upcoming decade’s big themes that we deem will play out, and centered recommendations on US equities/sectors. We do not want to neglect some macroeconomic variables that tend to mean revert over time. Specifically, the US dollar, interest rates and most importantly US indebtedness, will also be key drivers of investment theses in the 2020s. Currently, debt is rising faster than nominal GDP growth with the government and non-financial business debt-to-GDP profiles on an unsustainable path (second panel, Chart 13). Granted, the saving grace has been generationally low interest rates as the debt service ratios have fallen (top panel, Chart 13). However, if the four decade bull market in Treasury bonds is over, or may end definitively with the next US recession sometime in the early 2020s, then rising interest rates are the only mechanism to concentrate CEOs’ and politicians’ minds. On the dollar front, Chart 14 highlights the ebbs and flows of the trade-weighted US dollar since it floated in the early-1970s. The DXY index has moved in six-to-ten year bull and bear markets. The most recent trough was during the depths of the Great Recession, while the (tentative?) peak was in late-2016. If history repeats, eventually the dollar will mean revert lower in the 2020s, especially given the fiscal profligacy of the current administration that may continue into 2024, assuming President Trump gets re-elected next November. Chart 13Unsustainable Debt Profiles Chart 14Greenback’s Historical Ebbs And Flows The US dollar remains the reserve currency of the world today, but that exorbitant privilege is clearly fraying on the edges as the balance-of-payments dynamics are heading in the wrong direction. Over the next five years, the US Congressional Budget Office (CBO) estimates that the US budget deficit will swell to 4.8% of GDP. Assuming the current account deficit widens a bit then stabilizes (usually happens when global growth improves), this will pin the twin deficits at 8% of GDP. This assumes no recession, which would have the potential to swell the deficit even further. The US saw its twin deficits swell to almost 13% of GDP following the financial crisis, but the difference then was that in the wake of the commodity boom the dollar was cheap (and commodity currencies overvalued). The subsequent shale revolution also greatly cushioned the US trade deficit. Shale productivity remains robust and US output will continue to rise, but the low-hanging fruit has already been plucked.   Another dollar-negative force is its expensiveness. By rising 35% since its trough, the USD has sapped the competitiveness of the US manufacturing sector, which is accentuating the American trade deficit outside of the commodity sector. If the ESG trend ends up hurting oil prices, the US current account will follow the widening deficit in manufactured products. Moreover, the US is lagging Europe on the green revolution. Either the US will have to import green technologies, or the US government will have to provide more subsidies to the private sector. Either way, both of these dynamics will hurt the US current account deficit further. Historically, the currency market is the main vehicle to correct such imbalances. Chart 15Twin Deficits Will Weigh On The US Dollar The apex of globalization will also hurt the greenback. In a world where all the markets are integrated, borrowers in EM nations often use the reserve currency to issue liabilities at a lower cost. This boosts the demand by EM central banks for US dollar reserves to protect domestic banking systems funded in USD. Moreover, some countries like China implement pegs (both official and unofficial) to the US dollar in order to maintain their competitiveness and export their production surpluses to the US. To do so they buy US assets. If the global economy becomes more fragmented and the Sino-US relationship continues to deteriorate structurally as we expect, then these sources of demand for the dollar will recede. Overlay the widening US current account deficit, and you have the perfect recipe for a depreciating trade-weighted US dollar. Finally, the US is likely to experience more inflation than the rest of the world following the next recession. The US economy has a smaller capital stock as a share of GDP than Europe or Japan, and American demographics are much more robust. This means that the neutral rate of interest is higher in the US than in other advanced economies. As a result, the Fed will have an easier time generating inflation by cutting real rates than both the ECB and the BoJ. Higher inflation will ultimately erode the purchasing power of the dollar and prove to be a structurally negative force for the USD.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com Matt Gertken Geopolitical Strategist mattg@bcaresearch.com Marko Papic Chief Strategist, Clocktower Group marko@clocktowergroup.com Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Mathieu Savary The Bank Credit Analyst mathieu@bcaresearch.com   References Please click on the links below to view reports: Peak Margins - October 7, 2019 The Polybius Solution - July 5, 2019 War! What Is It Good For? Global Defense Stocks! - October 31, 2018 The Dollar: Will The U.S. Invoke A "Nuclear" Option? - August 30, 2018 Is The Stock Rally Long In The FAANG? - August 1, 2018 Millennials Are Not Coming Of Age; They Are Already Here - June 11, 2018 Brothers In Arms - October 31, 2016 The End Of The Anglo-Saxon Economy?  - April 13, 2016 Apex of Globalization  - November 12, 2014 Footnotes 1           https://www.imf.org/en/News/Articles/2019/09/04/sp090419-Opening-Statement-by-Christine-Lagarde-to-ECON-Committee-of-European-Parliament