Economy

Highlights We expect tensions from the Sino-US trade war to marginally ease in 2020, in the run-up to the US presidential election. The “Phase One” trade deal will likely be signed with a good possibility of some tariff rollbacks. Chinese policymakers will roll out more stimulus to secure an economic recovery in 2020, and external demand will improve. But we expect growth in both the domestic economy and exports to only modestly accelerate. During the next 6 to 12 months, investors should remain bullish on both Chinese A shares and investable stocks, while keeping in mind that relative outperformance, particularly for A-shares, could be frontloaded in the first half of the year. Despite sharply rising amount of defaults, Chinese onshore bonds are priced at a much higher premium than warranted by their default risk. We continue to favor Chinese onshore corporate bonds in both absolute terms and in relative to duration-matched government bonds. Feature BCA Research recently published its special year end Outlook report for 2020, which described the macro themes that are likely to drive global financial markets over the coming year. In this week’s China Investment Strategy report we elaborate on the Outlook, by reviewing our four key themes for China in the year ahead. Key Theme #1: Tension From The Trade War With The US Will Ease In 2020 Despite the harsh rhetoric and threats of retaliation from both the US and China, we expect that the real risks to the global economy from the Sino-US trade war will decline in 2020. In trade negotiations next year, both President Trump and President Xi will need to adjust to their respective constraints. Both President Trump and President Xi will need to adjust to their respective constraints next year. Trump must sustain a strong domestic economy to increase his re-election odds. He will cater to the US economy and financial markets, by trying to de-escalate trade tensions and keeping negotiations going with China. This means he is likely to hold off on tariffs on China, and quite possibly even agree to roll back tariffs to August 2019 or April 2019 levels (Chart 1). Chart 1Some Tariff Rollback Is Possible President Xi also faces economic constraints as the Chinese economy is on an unsure footing.  The buildup in leverage in the non-financial sector over the past decade has prevented Chinese policymakers from aggressively stimulating the economy by relying on the old debt-oriented policies. Chinese policymakers are concerned about employment stability.1 The private sector, which accounts for 80% of all job creation in China, has been disproportionally hit by the trade war and tariffs compared to the more domestically oriented state-owned enterprises. These economic constraints suggest that it is in China’s best interest to avoid any further friction with the US. Therefore, the “Phase One” trade deal will likely be signed, with a good possibility of some tariff rollbacks. Trade talks will continue in the run-up to the US presidential election, and any escalation will probably occur in non-trade, non-tariff areas. This means that policy uncertainty surrounding the Sino-US trade war will decline in 2020. Bottom Line: We expect tensions from the Sino-US trade war to marginally ease in 2020. However, the risk to this base case view is high and geopolitical uncertainty remains elevated, as suggested by our Geopolitical Strategy team.2 Trade war tensions could re-emerge, which potentially could end the global business cycle and equity bull market. Key Theme #2: Stimulus Versus Shock: Approaching An Inflection Point We presented some simple “arithmetic” in May showing that in order for investors to be bullish on Chinese stocks, the impact of China’s reflationary efforts needed to more than offset the negative shock to the economy from tariffs.3 In other words, a bullish Chinese equity scenario required Stimulus – Shock > 0. In terms of China’s real economy, 2019 essentially panned out to be a Stimulus – Shock =0 scenario, with a “half strength” reflationary response (measured by its credit impulse) barely offsetting the trade shock to the economy (Chart 2). So far on an aggregate level, the shock from tariffs on China’s economy has had a limited direct impact.  This is because exports to the US account for only 3.6% of China’s aggregate economy, whereas domestic capex accounts for more than 40% (Chart 3). Our calculation suggests a 10% annualized decline in export growth to the US would shave off 0.4 percentage points from China’s nominal GDP growth. Chart 2This Year, Measured Stimulus Has Just Offset Shocks To The Economy Chart 3Domestic Demand Much More Important Than Exports To The US Additionally, evidence suggests that a large portion of China’s exports to the US has been rerouted through peripheral countries, such as Taiwan and Vietnam (Chart 4). This fact explains why China’s exports have been in-line with the trend of global trade this year (Chart 5). Chart 4Chinese Exports Finding Alternative Routes To The US... Chart 5...And Total Exports Have Been Holding Up Chart 6China's Economic Slowdown Predates The Trade War It is important for investors to remember that China’s current economic slowdown predates the trade war and is due to its domestic financial deleveraging campaign that began in early 2017. The trade war exacerbated an existing downward trend in the economy, but was not the cause of it (Chart 6).  In 2020, while we expect a ceasefire in the trade war and a potential rollback of tariffs would ease the shock to China’s economy, we also believe that more pro-growth policy support is underway.4 From an investment perspective, this means both China’s economic conditions and corporate earnings will improve, supporting a bullish cyclical outlook for China-related assets. Still, several reasons point to the overall scale of stimulus being less than that of 2015-16, and the upside to China’s export growth will likely be limited given elevated geopolitical uncertainties. Therefore, it is unrealistic to expect a material acceleration in Chinese economic growth in 2020: China is still falling short of its target to double urban income by 2020. Chart 7A 6% Growth Next Year May Just Make The Cut Next year will mark the final year for Chinese policymakers to accomplish the goal of “Doubling GDP by 2020”. Without the recent upward revision to the level of its 2018 nominal GDP by 2.1%, China's economy would have to expand by at least 6.1% in 2020 to achieve the goal. The upward revision allows a lower economic growth rate in 2020 to reach the goal (Chart 7). China is still falling short of its target to double urban income by 2020 (Chart 8). While keeping economic growth and employment stable remains a top priority, the recent slight improvement in employment should provide some relief to Chinese policymakers (Chart 9). Chart 8China Is Falling Short Of Urban Income Target... Chart 9...But There Is Some Relief In The Labor Market     Monetary policy will remain accommodative, with room for further cuts to interest rates and the reserve requirement ratio (RRR). Nonetheless, we think Chinese policymakers will only allow monetary policy to loosen incrementally and modestly, while keeping a lid on corporate leverage. According to a recent article published by Yi Gang, the governor of China’s central bank, the PBoC will be keen to avoid another boom-bust cycle.5  Fiscal stimulus will continue to take the center stage in supporting growth in 2020, as noted in our November 20th China Investment Strategy Weekly.6  We expect that the National People’s Congress in March 2020 will approve higher quotas on issuing local government bonds, and loosened capital requirements will likely further boost local governments’ infrastructure project funding and expenditures. Transportation and urban development infrastructure projects will likely to continue receiving the most policy support in 2020. Other areas such as environmental protection, education, and social security will continue to be the Chinese government’s focus. These areas are unlikely to translate into immediate economic growth, but will improve China’s long-term economic and social structures. In contrast, compared to the 2015-2016 cycle, housing construction will receive less fiscal support (Chart 10). Overall, we expect the Chinese government to set next year’s real GDP growth target between 5.5 - 6.0%, a half of a percentage point lower than the growth target for 2019. Despite slower real output growth, nominal GDP and economic conditions will bottom in the first quarter of 2020, subsequently pushing up core inflation and reversing an ongoing deflation in the industrial sector (Chart 11). Chart 10Transportation And Urban Development Projects Are Again In Favor Chart 11Nominal Output Will Tick Up Soon   Bottom Line: Chinese policymakers will roll out more stimulus to secure an economic recovery in 2020, and external demand will improve. But we expect growth in both the economy and export to only modestly accelerate. Key Theme #3: Improved Earnings Outlook Supports A Cyclically Bullish View On Chinese Stocks A combination of further policy support, improved earnings and decreased trade tensions should provide tailwinds to Chinese stocks in 2020. Chinese stocks will outperform the global benchmark over a cyclical time horizon (6- to 12-months), for the following reasons:   Valuations are depressed relative to global averages: the forward P/E ratios of both China’s onshore A-shares and offshore investable stocks are well below the global benchmark (Chart 12).  While the forward P/E ratio of the A-share index is hovering around 12 times, the investable market has particularly suffered a setback from uncertainties surrounding the trade war. Even taking into account that structural weakness in the Chinese corporate earnings growth justifies for a lower multiple than the global average, both Chinese onshore and offshore stocks are offering even deeper discounts than their peaks in 2018, compared to global benchmarks. Chart 12Valuations Of Chinese Stocks Are Depressed Chart 13Chinese Corporate Earnings Closely Track Economic Conditions Both the economy and earnings growth will improve: We expect the Chinese economy to bottom in the first quarter of 2020. Given the close correlation between the coincident economic activity and earnings cycle, we expect earnings to also improve in 2020 (Chart 13).  Improved corporate earnings next year will be the catalyst for the currently cheap multiples in Chinese stocks to re-rate, and re-approach their early 2018 high. Our Earnings Recession Probability Model shows that the probability of an upcoming earnings recession has dropped to 35% from its peak of 85% in early 2019 (Chart 14).  Additionally, Chart 15 highlights that the 12-month forward EPS momentum has turned modestly positive. Chart 14Probability Of An Upcoming Earnings Recession Has Significantly Dropped Chart 1512-Month Forward EPS Momentum Has Turned Modestly Positive There are, however, a few caveats to our bullish cyclical view on Chinese stocks. First, while it is not our base case view, geopolitical risks, particularly the Sino-US trade war, could end the global business cycle and equity bull market in 2020. Within the context of falling global stocks, we think Chinese domestic A shares would passively outperform global benchmarks, as A shares are mostly driven by China’s domestic credit and economic growth, and are less sensitive to trade frictions. But investable stocks would clearly underperform in this scenario. The odds are decent that all of the outperformance of Chinese stocks in 2020 will be frontloaded in the first half of the year. Secondly, the odds are decent that all of the outperformance of Chinese stocks in 2020 will be frontloaded in the first half of the year. We expect credit growth, infrastructure spending and the economy to improve in the first quarter. If the “Phase One” trade deal is also signed during that period, onshore A shares and investable stocks will significantly outperform their global counterparts in the first and possibly the early part of the second quarter. However, in the second half of next year, if the Chinese economy stabilizes but stimulus does not ramp up further, then the upside potential in both bourses may be capped as investors will question whether Chinese stocks will continue to gain ground in relative terms. We will closely monitor Chinese credit growth and trade negotiations throughout 2020 to determine if there is more eventual upside potential to economic growth, and thus Chinese earnings prospects, than we currently believe.  While we recommend a cyclically bullish stance towards Chinese stocks for next year, our tactical (i.e. 0-3 month) stance remains neutral. We expect to align our tactical and cyclical stances soon, and are awaiting confirmation of a hard data improvement alongside a breakout of key technical conditions to do so.7 Bottom Line: During the next 6 to 12 months, investors should remain bullish on both Chinese A shares and investable stocks within a global equity portfolio. However, investors should also keep in mind that the relative outperformance, particularly for the A-share market, could be frontloaded in the first half of 2020. Key Theme #4: We Continue To Favor Chinese Onshore Bonds, Despite Default Concerns  Chart 16Global Investors Are Piling Into The Chinese Bond Market Despite sharply rising defaults, Chinese onshore bonds are still priced at a much higher premium than warranted by their default risk. This view is increasingly shared by global investors, as evident in the capital flows into China’s onshore bond market (Chart 16). While the total amount of bond defaults in the first eleven months of 2019 was an astonishing 120.4 billion yuan, they account for only half percent of China’s total onshore bonds issued.  A 0.5 percent default rate is in line with global ex-US, and 160 bps below the default rate in the US (Chart 17). Yet, Chinese corporate bond spreads are about 150-175 bps higher than their US counterparts, an overpriced risk premium in our view (Chart 18). Recently, despite mounting defaults, China’s corporate bond spreads have continued to narrow. This suggests that investors do not expect the record-high level of defaults in the past two years to damage China’s corporate sector in the near future. Moreover, China’s monetary policy remains ultra-loose, liquidity conditions have been largely stable, RMB devaluation and capital outflows have both been under control, and the Chinese economy is expected to bottom in the next quarter. Chart 17Chinese Default Rate Well Below Global Average Chart 18The Risk Premium Assigned To Chinese Corporate Bonds Seems Overdone Bottom Line: We continue to favor Chinese onshore corporate bonds in both absolute terms, and in relative to duration-matched government bonds.   Jing Sima China Strategist jings@bcaresearch.com     Footnotes 1    “China to take multi-pronged measures to keep employment stable,” State Council Executive Meeting, December 4, 2019. 2   Please see Geopolitical Strategy Special Report "2020 Key Views: The Anarchic Society," dated December 6, 2019, available at gps.bcaresearch.com 3   Please see China Investment Strategy Weekly Report "Simple Arithmetic," dated May 15, 2019, available at cis.bcaresearch.com. 4, 6, 7   Please see China Investment Strategy Weekly Report "Questions From The Road: Timing The Turn," dated November 20, 2019, available at cis.bcaresearch.com. 5   https://www.chainnews.com/articles/745634370915.htm Cyclical Investment Stance Equity Sector Recommendations

Highlights Global growth will rebound in 2020, led by the US and China, putting upward pressure on global bond yields. Maintain below-benchmark overall duration exposure. Central banks will stay dovish until policy reflation has clearly turned into inflation, limiting how high bond yields can climb in 2020 but sowing the seeds for a far more bond-bearish backdrop in 2021. Expect mild bear-steepening pressure on global yield curves, led by rising inflation expectations. Accommodative monetary policy and faster growth will delay the peak in the aging global credit cycle. Stay overweight global corporate debt versus sovereign bonds. Returns on global fixed income will be far lower in 2020 than in 2019, given rich valuation starting points. Country and sector selection will be more important in driving fixed income outperformance. For sovereign bonds, favor countries where yields are less sensitive to change in overall global yields; for credit, favor sectors with lower interest rate durations and lower spread volatility. Feature BCA Research’s Outlook 2020 report, outlining the main investment themes for next year from the collective mind of our strategists, was sent to all clients in late November.1 In this report, we discuss the broad implications of those themes for the direction of global fixed income markets in 2020. In a follow-up report to be published in the first week of the new year, we will translate those themes into specific recommended allocations and weightings within our model bond portfolio framework. A Summary Of The 2020 Outlook Chart 1Expect A Cyclical Rise In Global Yields In 2020 The main conclusions from the Outlook 2020 report were cyclically bullish looking out over the next twelve months, but more cautious beyond that. The downturn in global growth seen in 2019 is projected to end in response to several headwinds that have become tailwinds: a small wave of Chinese stimulus and reflation; more stimulative global monetary policies; the substantial easing of global financial conditions as risk assets have rallied worldwide; a fading drag on global manufacturing from inventory destocking; both China (weak growth) and the US (the 2020 US election) have good reasons to de-escalate the trade war in 2020. This backdrop should push global bond yields moderately higher in 2020, while maintaining a backdrop that is once again favorable for risk assets on a relative basis versus government debt (Chart 1). A critical element to this story is the supportive monetary policy backdrop. Central banks worldwide, led by interest rate cuts from the US Federal Reserve and a resumption of asset purchases from the European Central Bank (ECB), are now running more stimulative policies in response to this year’s global manufacturing slump and elevated level of political uncertainty. Policymakers will maintain accommodative monetary policy through 2020 to try and bring depressed inflation expectations back up to central bank targets. This will create a “sweet spot” for global risk assets, with improving economic growth and accommodative monetary policy. A repeat of the spectacular total return numbers seen across the majority of asset classes in 2019 is unlikely, but global equity and credit markets should solidly outperform government bonds. Yet all that monetary stimulus does not come without a price. Policymakers will maintain accommodative monetary policy through 2020 to try and bring depressed inflation expectations back up to central bank targets. This will create a “sweet spot” for global risk assets, with improving economic growth and accommodative monetary policy.  A revival of inflationary pressures in 2021 will force central banks to raise rates much more aggressively. Combined with a China that remains wary of promoting excess leverage, this will drive the current prolonged global business cycle expansion to its recessionary endgame, taking equity and credit markets down with it. This will eventually trigger a new decline in global bond yields as policymakers shift back to easing mode, but from much higher levels than today. Our Four Main Key Views For Global Fixed Income Markets In 2020 The following are the main implications for global fixed income investment strategy based off the conclusions from the 2020 BCA Outlook: Key View #1: Maintain below-benchmark overall duration exposure. The pickup in global growth that we expect in 2020 has its roots in two locations: China and the US. For China, policymakers are keenly aware that the current growth slowdown cannot continue, as it has already pushed nominal GDP growth below 8% (Chart 2). For an economy as highly leveraged as China, slowing nominal growth is lethal and must be avoided to prevent a surge in private sector defaults and rising unemployment. Already, China has delivered significant policy stimulus in 2019: the reserve requirement ratio has been cut by 400bps; taxes have been cut by 2.8% of GDP; capital spending at state-owned enterprises has increased; the currency has depreciated; and, more recently, monetary policy has been eased via traditional interest rate cuts. These measures have eased our index of Chinese monetary conditions and triggered a surge in the China credit impulse, which leads Chinese import growth (i.e. China’s most direct impact on the global economy) by nine months. There are signs that Chinese growth is already bottoming out, as evidenced by the recent pickup in the China manufacturing PMI. Expect more signs of improvement in the first half of 2020. The BCA global leading economic indicator (LEI) has been rising since January of this year, and the global LEI diffusion index is signaling that the upturn will continue in 2020 (Chart 3). With global financial conditions at highly stimulative levels thanks to the robust performance of risk assets in 2019, the backdrop is already conducive to faster global growth. BCA’s geopolitical strategists are of the view that a “détente” in the US-China trade war is still the most likely base case scenario, which would go a long way in reducing the growth-inhibiting effects of elevated uncertainty (bottom panel). Chart 2A Boost To Global Growth From China In 2020 Chart 3Lower Uncertainty + Easy Financial Conditions = Faster Growth As for the US, the lagged impact of the Fed’s 75bps of rate cuts this year has boosted domestic liquidity conditions in a pro-growth fashion. The BCA US Financial Liquidity Indicator, which leads not only US growth but also leads the BCA global LEI and commodity prices by 18 months, is already signaling that US economic momentum is set to bottom out in early 2020 (Chart 4). This signal is in addition to the leading properties of US financial conditions (middle panel), which suggests a reacceleration of real GDP growth back above trend is about to unfold. Chinese policy reflation has typically been a good leading indicator for US capex and is heralding a rebound in investment spending (bottom panel). The pickup in global growth would also help revive the dormant euro zone economy, which has been hit hard though plunging export demand and overall weakness in the manufacturing sector. The entire slump in euro area real GDP growth since the start of 2018 can be attributed to plunging net exports, while domestic demand has held steady (Chart 5). The increase in the China credit impulse and our global LEI diffusion index – both leading indicators of euro area export growth – are signaling that euro area export demand is already in the process of bottoming out (bottom two panels) and should gain momentum in the first half of 2020. Chart 4US Growth Is Poised To Accelerate Chart 5The Drag On European Growth From Trade Will Soon End This better growth backdrop will put moderate upward pressure on global bond yields in 2020. This better growth backdrop will put moderate upward pressure on global bond yields in 2020. Key View #2: Expect mild bear-steepening pressure on global yield curves, led by rising inflation expectations. While we expect bond yields to drift higher in the next 6-12 months, the upside will be capped with central banks likely to stay dovish until policy reflation has clearly turned into higher inflation. Interest rate markets will not begin to price in expectations of tighter monetary policy without evidence of actual inflation picking up. The Fed, ECB, Bank of Japan and other central banks have all stated publicly that they will maintain current accommodative policy settings until realized inflation has sustainably returned to target levels, typically around 2%. This would be a major change in the modus operandi of these policymakers, who have typically signaled rate hikes based simply on forecasts of higher inflation. The implication is that interest rate markets will not begin to price in expectations of tighter monetary policy without evidence of actual inflation picking up (Chart 6). Chart 6Central Banks Will Stay Dovish Until Inflation Sustainably Accelerates A critical ingredient for global inflation to begin moving higher again is a softer US dollar (USD). The year-over-year growth rate of the trade-weighted USD is correlated to global export price inflation and commodity price inflation, more generally (Chart 7). The typical drivers of the USD are all pointing in a more bearish direction: Chart 7The USD Is Critical For Global Reflation Chart 8Global Real Yields & Inflation Expectations Will Drift Higher In 2020 the Fed has cut interest rates multiple times since the summer and is expanding its balance sheet via repo operations and treasury bill purchases; global (non-US) growth is bottoming out, and capital tends to flow out of the USD into more cyclical currencies in Europe and EM when global growth is accelerating; elevated policy uncertainty, which tends to attract inflows into the safety of the USD, is starting to diminish. The combination of improving global growth and a softer USD would normally be enough to generate a significant increase in global bond yields. Yet we do not expect the sort of move higher in the real component of bond yields signaled by our global LEI diffusion index in 2020 (Chart 8, top panel). While real yields should move higher alongside faster growth, if there is no expected tightening of monetary policy as well, the move in real yields will be more limited. The grind higher in global bond yields that we expect in 2020 will come first through faster inflation expectations and, much later in the year, higher real bond yields when central bankers (starting with the Fed) begin to signal a need to turn more hawkish. The grind higher in global bond yields that we expect in 2020 will come first through faster inflation expectations and, much later in the year, higher real bond yields when central bankers (starting with the Fed) begin to signal a need to turn more hawkish. This suggests that inflation-linked bonds should perform reasonably well in countries where inflation is likely to accelerate the fastest, like the US. Faster inflation expectations will also result in some bear-steepening of global government bond yield curves in the first half of 2020 (Chart 9). There is very little curve steepening discounted in bond forward rates in the developed markets – a consequence of the general flatness of yield curves – which suggests that yield curve steepening trades could prove to be profitable in 2020. Chart 9Expect A Mild Bear-Steepening Of Global Yield Curves Chart 10The Fed Has Dis-Inverted The Treasury Curve In the case of the US, the Fed’s recent easing actions have pushed short-term interest rates below longer-term Treasury yields, removing the yield curve inversion that sparked recession fears among investors during the summer of 2019 (Chart 10). With the Fed likely to sit on its hands for most of next year, even as US growth and inflation are likely to improve, this will put additional bear-steepening pressure on the US Treasury curve. In Europe, bond markets have already discounted a very significant impact from the ECB restarting its Asset Purchase Program, which only began last month. Investment grade corporate bond spreads, as well as Italy-Germany government bond spreads, have narrowed substantially despite a weak euro area economy (Chart 11, bottom panel). Meanwhile, the term premium on 10-year German bunds is back to the deeply negative levels middle panel) seen when the ECB was expanding its balance sheet at a 30-40% pace, rather than the 5% pace implied by the current announced pace of purchases of 20 billion euros per month (top panel). This potentially leaves longer-term European yields exposed to the same bear-steepening pressures seen in other bond markets, even within the context of a renewed ECB bond-buying program. Chart 11European Bonds Already Discount A Very Dovish ECB Chart 12The Wild Card For Bonds Markets In 2020: Fiscal Policy A potentially big wild card for global bond markets next year will be fiscal policy, which can also exacerbate yield curve steepening pressures. Any sign of a push toward more government spending, particularly in Europe where there has been such reluctance to open the fiscal taps, would result in a sharper upward move in global bond yields than we are expecting. This is not because of a supply effect related to more government bond issuance that would require higher yields to attract buyers. It is because fiscal stimulus (Chart 12) would push growth to an even faster pace that would bring forward the date when inflation returns to policymaker targets and tighter monetary policy could commence. This would follow a similar path to the curve steepening dynamics described earlier, with a fiscal boost to growth pushing up longer-term inflation expectations before starting to push up short-term interest rate expectations. Key View #3: Stay overweight global corporate debt versus sovereign bonds. Investors should expect another year of corporate bond outperformance versus sovereign debt in the developed economies. The combination of faster global growth, somewhat higher inflation and accommodative monetary policies laid out in the BCA Outlook 2020 report will delay the peak in the aging global credit cycle. This means investors should expect another year of corporate bond outperformance versus sovereign debt in the developed economies. Low borrowing rates are already helping to extend the credit cycle by making it easier for highly indebted borrowers to service their debts. This can be seen in the US, where interest coverage ratios (using top-down data for the non-financial corporate sector) remain above the levels that have preceded previous recessions (Chart 13). Low borrowing rates are also helping indebted borrowers in Europe, particularly in Italy and Spain where the banking system is now far less exposed to non-performing loans than during the peak years of the 2011-12 European Debt Crisis (Chart 14). Chart 13Low Rates Helping Extend The US Credit Cycle Chart 14Low Rates Helping Ease Stress In European Banks Declining Non-Performing Loans Are A Positive For The European Periphery Chart 15A Cyclically Positive Backdrop For Global Corporates According to our checklist of indicators to watch for an end of the corporate credit cycle in the US – tight monetary policy, deteriorating corporate sector financial health, and tightening bank lending standards – only corporate financial health is flashing a warning signal according to our Corporate Health Monitor as we discussed in a recent report.2 In fact, our global Corporate Health Monitor is rolling over – a trend that should continue as growth improves in 2020 – which should support global corporate bond outperformance versus government debt next year (Chart 15). Key View #4: Returns on global fixed income will be far lower in 2020 than in 2019. Country and sector selection will be more important in driving fixed income outperformance in 2020. The start of 2020 looks far different in terms of fixed income valuations compared to the beginning of 2019. For example, the 10yr US Treasury yield started the year at 2.72% and is now 1.83%, while the 10yr German bund yield started this year at 0.24% and is now MINUS-0.31%. These lower yields reflect the slower pace of global economic growth and monetary policy easing delivered by the Fed and ECB. Yet at the same time, corporate credit spreads have narrowed in both the US (the high-yield index OAS is down from 526bps to 360bps) and the euro area (the investment grade index OAS is down from 152bps to 100bps). These massive rallies in global bond markets this year resulted in both lower government bond yields and tighter credit spreads - even with slower global growth that would normally be a trigger for wider spreads/higher risk premiums. Looking at the current valuation of government bond yields in the major developed markets from a long-run perspective, it is difficult to make the case that it is attractive. Medium-term real bond yields remain well below potential GDP growth rates, a consequence of central banks keeping policy rates well below neutral levels suggested by measures like the Taylor Rule (Chart 16). Chart 16Global Government Bonds Are Expensive Without the initial starting point of cheap valuations, fixed income return expectations for 2020 should be tempered. This means that rather than loading up on maximum duration risk and/or credit risk to capture big yield and spread moves, bond investors should be more selective in country, maturity and credit exposure to generate outperformance in 2020. Chart 17Favor Lower-Beta Government Bond Markets In 2020 For government bonds, that means focusing country exposures on lower-beta markets where yields are less correlated to moves in the overall level of global bond yields. Our preferred way to measure this is to look at the beta of monthly yield changes for the benchmark 10-year government yields of the major developed market countries to the overall Bloomberg Barclays Global Treasury index yield for the 7-10 year maturity bucket, over a rolling three-year window. We define a “high-beta” bond market as having a yield beta of 1.25 or higher, and a “low-beta” bond market as having a yield beta of 0.75 or lower. Under that definition, global bond investors should underweight higher-beta Canada, the US and Italy, and overweight low-beta Japan and Spain (Chart 17). Bond markets with betas between 1.25 and 0.75 (Germany, Australia, Sweden, the UK) can also be considered on their own fundamental merits. Of that list, we see Germany and Australia having a better chance of outperforming the UK and Sweden, given the greater odds that the Bank of England or Riksbank could signal a need to hike rates in 2020 compared to the ECB or Reserve Bank of Australia. Chart 18Stay Overweight Global Spread Product In 2020, But Be Selective For spread product, that means focusing exposure on sectors that are less risky, either defined by interest rate duration or spread volatility (i.e. spread duration). With credit spreads remaining near the low end of long-run historical ranges for nearly all major markets (Chart 18), it is hard to find examples of spread product being cheap in absolute terms. On a risk-adjusted basis, however, negatively-convex spread product like US and euro area high-yield debt and US agency MBS actually look more interesting in the rising yield environment we expect in 2020, since the interest rate durations of those fixed income sectors fell as bond yields declined in 2019. Thus, we recommend owning high-yield corporates over higher-duration investment grade corporates in the US and euro area, while also favoring US agency MBS over higher-quality credit tiers of US investment grade corporate credit.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see The Bank Credit Analyst, “Outlook 2020: Heading Into The End Game”, dated November 22, 2019, available at bca.bcaresearch.com. 2 Please see BCA Research Global Fixed Income Strategy Weekly Report, “The Lowdown On Low-Rated High-Yield”, dated November 27, 2019, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

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

Special Report

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