Economy

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

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

Special Report

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

Special Report

Highlights Chile is undergoing a paradigm shift from a neoliberal economic model to a Welfare State. It will not be a smooth transition, as the political and business elites are resisting such a transformation. Indeed, protesters will continue to renounce the status quo until their demands are satisfied. Hence, the clash between these two predispositions will ensure that political volatility persists and financial markets continue selling off. Feature Chart I-1The CLP Is Not Very Cheap The current socio-political turmoil in Chile has taken the world by surprise. What seemed to be a periodical increase of 3.75% of public transport fares in October ended up being the trigger for the country’s longest and most violent uprising in 30 years. These protests have had a drastic effect on Chilean markets: Equities are down 8% in local currency terms and the peso has depreciated 9% versus the dollar since October 21st. Will the selloff in Chilean markets continue? Are the Chilean peso and equities cheap enough for value investors to step in? Odds are that the protests will endure, and financial markets remain at risk. According to the Real Effective Exchange Rate (REER) based on unit labor costs – our most favored currency valuation measure – the peso is only slightly cheap (Chart I-1). Yet, odds are that the peso will undershoot and will approach one and a half or two standard deviations below its fair value due to collapsing growth on the back of ongoing protests and political uncertainty, a rising risk premium on Chilean assets, as well as a further decline in copper prices. This entails another 12-15% depreciation versus the USD in the coming months. Investment conclusions for equities and fixed-income markets are presented at the end of this report. Politicians Are Playing With Fire In an attempt to quell protesters, the government and the opposition have scheduled a referendum in April for a new Constitution. While it might be tempting to interpret this positively, odds are that it will be insufficient to calm protesters and allow the authorities to regain control over the situation. The government will ultimately meet the popular demands of protesters, albeit not immediately. We expect Chile to move towards a Welfare State-style of government, but not towards Socialism. It seems Chile's political elite is still underestimating the depth and gravity of the popular frustration. By setting a national vote five months away (with a subsequent election in November of next year), the government and the opposition are not dealing with the issues “head on.” This will test the patience of the protesters and risks continued violence on the streets. Hence, we expect the protest to linger at least until the referendum in April. Consequently, the selloff in financial markets will persist. The Roots Of Public Discontent It is important to note that the current uprising is not against President Sebastián Piñera specifically but against the entire political class, including the opposition. National polls from CADEM, one of Chile’s most respected polling companies, suggest voters disapprove of both Piñera’s party and the center-left opposition. In a survey conducted in April of this year (several months before the protests began), there were only two political parties with a net positive approval rating: Renovación Nacional (Piñera’s party) and Revolución Democrática, which was founded by students in the wake of the 2011 national protests. Since then, the President’s approval rating has fallen from 36% to 12%. It is therefore safe to assume the President’s party currently has a net disapproval rating. This means that the only party that Chileans view in a positive light is one led by students – not politicians. This nationwide distrust in the political and economic elites is evidenced by the historically low voter turnout of 49% in the 2017 general election. Voters have become increasingly frustrated at politicians in the past decade as their main demands have not been addressed. These include the provision of an effective social safety net and programs as well as more inclusive economic growth. The roots of the discontent are income inequality, a poor social security net and stagnating median incomes. Income Inequality Chart I-2GINI Coefficient Across Various Nations Income Distribution: Although Chile has made some progress over the past 20 years in terms of reducing its Gini coefficient, income inequality remains very high. Chart I-2 shows that even though the Gini coefficient has drifted lower it remains high. A falling/low Gini coefficient entails diminishing/ low inequality. Among OECD nations, Chile currently stands as one of the most unequal countries in terms of income distribution (Chart I-3), only surpassed by South Africa. Moreover, it also ranks as the fourth country with the highest P90/P10 disposable income ratio, which is defined as the ratio of the top 10% of the income distribution (wealthiest individuals) versus the bottom 10% (poorest individuals) (Chart I-4). According to CADEM, Chileans cite income inequality as the number one reason for the civil unrest. Chart I-3Chile: High Income Inequality Relative To Other Nations Chart I-4Disposable Income Is Highly Concentrated In Chile Tax policy: Chile has the lowest corporate tax rate in Latin America (Chart I-5A). This has made the country an attractive destination for large international conglomerates, as well as incentivized investment by domestic corporations. Yet, it has also exacerbated income inequality and capped the government’s capacity to fund social programs and education. Moreover, even though the top personal marginal tax rate in the country is in line with those in the rest of Latin America, it still falls short compared to the OECD average (Chart I-5B). Overall, Chile has low tax rates for individuals and corporations. Low tax rates are typically correlated with a higher degree of income and wealth inequality, as public investment in social services is sacrificed at the expense of shareholders/business owners. Chart I-5AChile: Low Corporate Tax Rates Chart I-5BChile: High Incomes Are Not Taxed Heavily ​​​​​​ Oligopolies versus SMEs: Even though Chile is perceived to be a very business friendly economy, the country still lacks a high level of competition that is present in many OECD countries. In particular, small and medium enterprises (SMEs) are disfavored against large businesses. SMEs in Chile suffer from high interest rates on their loans relative to large firms and from excessive regulatory burdens (Chart I-6). Likewise, government support for new and existing companies is quite dismal. Among OECD members, Chile has the second-lowest direct government funding and tax incentives for businesses. These barriers to new businesses have allowed large domestic and international companies to dominate the marketplace and accumulate wealth at the expense of small businesses and individual entrepreneurs. The latter has contributed to the discontent with the economic and political elites. Chart I-6Small And Medium Businesses Are In An Inferior Position Chart I-7Workers' Share Of Income Is Depressed Employees’ share of national income: The share of wages and salaries of national income has been between 36-40% while operating profits have hovered around 50% (Chart I-7, top panel). By comparison, in the US, wages and salaries make up 54% of GDP, while corporate profits amount to just 24% (Chart I-7, bottom panel). Such a small share of the pie going to employees in Chile explains the popular discontent against the economic elite. Lack Of A Social Safety Net Over the past few weeks, Chilean protesters’ key demands have been a restructuring of social security programs, more investment in healthcare and increased funding for public primary and secondary education. Essentially, Chileans want the state to play a larger role in securing basic social services. Pension System: Once highly praised by institutions such as the IMF and World Bank as well as many renowned economists as a revolutionary system to guarantee pensions with a minimal impact on public finances, Chile's problematic pension system is currently one of the most dire economic issues facing the country. Mandatory pension contribution rates are among the lowest in the world. New retirees are facing the consequences of a fully employee-based contribution plan, under which the government claimed people would be able to retire with a very high share of their salary. However, average retirees are currently receiving monthly pension payments equivalent to or less than the minimum wage. Among OECD nations, Chile currently stands as one of the most unequal countries in terms of income distribution, only surpassed by South Africa. Low government spending on social programs: Government expenditures on social programs as a percentage of GDP is among the lowest in the OECD. Moreover, Chile ranks at the bottom in terms of cash transfers as a percentage of disposable income (Chart I-8). The OECD defines cash transfers as the agglomeration of social payments such as unemployment insurance, pension benefits, education transfers and health subsidies. Chile also lags both advanced and developing economies when it comes to public spending on healthcare, pensions, education and unemployment benefits (Chart I-9). This has created a system in which lower- and middle-income employees must pay out-of-pocket for basic social services. In short, Chileans are protesting due to a lack of financial security. Chart I-8Chileans Don’t Receive Help From The Government Chart I-9Public Expenditure On Social Programs Stagnating Income Growth Real GDP per capita has been stagnating in Chile in recent years – its growth rate falling to its lowest level since the mid-1980s (Chart I-10). Real income per-capita growth is contingent on labor productivity growth, which has been consistently decelerating for two decades. The drop in productivity growth can be attributed to two factors. First, small and medium firms tend to be snubbed in favor of large domestic and international firms, as we discussed above. Yet SMEs have been successful in generating higher productivity growth than large ones (Chart I-11). The lack of preferential regulatory treatment and more expensive financing for SMEs has hindered their expansion and development, capping overall productivity growth. Importantly, SMEs employ 65% of the labor force, and their subdued expansion has resulted in weaker income growth across the nation. Chart I-10Labor Productivity Has Been Decelerating Chart I-11Small Firms Are The Most Productive Chart I-12Real Capex Has Stagnated Second, real gross fixed capital investment has been stagnant since 2014 (Chart I-12). Falling capital expenditures lead to lower productivity and therefore stagnant real income levels as technology and production processes become antiquated. Further, large bouts of immigration, particularly from Venezuela, have expanded the labor force and dampened wage growth among middle- and low-income workers. As a share of the population, foreign-born residents have risen from 2.3% in 2015 to 7% in 2019. This influx of new workers has also expanded non-formal employment. Notably, labor informality in Chile is presently 30% of employment. While these workers do not declare taxes on their income, their salaries tend to be lower than the minimum wage, and they do not qualify for social programs such as social insurance and healthcare. This has dampened employee income growth and promoted a sense of financial insecurity. Where Is Chile Headed? The government will ultimately meet the popular demands of protesters, albeit not immediately. We expect Chile to move towards a Welfare State-style of government, but not towards Socialism. Under a Welfare State system the government prioritizes the provision of a social security net, such as healthcare, state-funded education and generous pension benefits and unemployment insurance, while not interfering in the functioning of the economy and/or financial markets. Chile also lags both advanced and developing economies when it comes to public spending on healthcare, pensions, education and unemployment benefits. In the past decade, mandataries from both sides of the political spectrum – both the ruling and opposition parties – have been reluctant to finance a larger social security net. Yet Chile can actually afford to do so. First, Chile has a low tax burden as a percentage of GDP and has ample room to expand taxation (Chart I-13). Second, at 27% of GDP, Chile’s public debt is among the lowest in the world (Chart I-14). 40% of if its public debt is local currency and 42% is inflation-linked. Its fiscal overall and primary budget deficits are 2.2% and 1.2% of GDP, respectively. Chart I-13Chile's Government Budget Is Small Chart I-14Chile: Gross Public Debt Is Minimal   Therefore, to finance these social policies, the government can raise marginal tax rates for wealthy individuals and large corporations, and it can issue more debt. Given the starting point of government debt is so low, Chile is not facing a fiscal crunch in the foreseeable future. In the meantime, without substantial reforms in social spending and the pension system, it will be difficult to pacify protesters. Investment Recommendations The peso: We continue recommending shorting the peso versus the US dollar. Chart I-15Chilean Equities: More Downside Chart I-16Chilean Equities Are Inexpensive Equities: Stay neutral on this bourse within an EM equity portfolio. While the outlook is still downbeat, it may be too late to move to underweight. Chilean equities in US$ terms have already broken below their 6-year and 12-year moving averages (Chart I-15). We argued in an October Report that the protests imply a structural de-rating for Chilean equities. Chilean stocks have always traded at a premium versus the EM aggregate, mainly due to the perceived socioeconomic stability of the country and the extreme orthodox liberal policies that were pursued in the past 30 years. According to our Cyclically-Adjusted P/E ratio, Chilean equities are inexpensive (Chart I-16). Another 16% drop in share prices in local currency terms will push this valuation ratio to one standard deviation and a 58% decline to two standard deviations below fair value. Chart I-17Take Profits On Swap Rates Fixed income: Today we are closing our recommendation of receiving 3-year swap rates. The rationale is that as the peso continues to depreciate, it is likely that interest rates may rise further in the near term. This position was initiated on May 31st, 2018 and has produced a gain of 125 basis points (Chart I-17).     Juan Egaña Research Associate juane@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes

Highlights Structurally overweight US T-bonds versus core European bonds. Our preferred expression is long T-bonds versus Swiss bonds. US yields can fall a lot more than European yields, and European yields can rise a lot more than US yields. Structurally underweight the overvalued dollar versus undervalued European currencies. Our preferred expression is long SEK/USD. Structurally underweight price-sensitive European export sectors. Undervalued European currencies cannot fall much further, and those European exporters that depend on price competitiveness will struggle to outperform. But structurally overweight soft luxuries. Despite President Trump’s threat to tariff French products, soft luxuries retain very strong pricing power and sustainable long term demand growth from rising female labour participation rates globally. Fractal trade: The 65-day fractal structure of global equities suggests that they are vulnerable to a near-term countertrend move. Feature Chart of the WeekLike-For-Like, Structural Inflation Is Lower In the US Than In Europe A seemingly trivial disagreement between Europeans and Americans on how to measure inflation turns out to be the culprit for three major distortions in the world right now: Deeply divergent monetary policies across the developed economies. Huge valuation anomalies in the foreign exchange markets. President Trump’s threat of a trade war to counter the huge trade surpluses that Europe and China are running against the US. The inflation measurement disagreement wouldn’t really matter if inflation were running in the mid-single digits. But when inflation is near zero, the seemingly trivial difference in inflation measurement methodologies has ended up generating massive distortions. European And American Inflation Are Not The Same European inflation excludes the maintenance and upkeep costs associated with owning your home, whereas US inflation includes these costs at a hefty 25 percent weighting, making owner occupied housing by far the largest single item in the US inflation basket. By omitting the largest item in the US inflation basket, European inflation is subtly yet crucially different to American inflation. The European statisticians argue that unlike all the other items in the inflation basket, there is no independent market price for the ongoing cost of home ownership, and therefore this cost should be excluded. The American statisticians argue that the ongoing cost of home ownership is the single largest expense for most people and, as such, it should be ‘imputed’ from a concept known as ‘owner equivalent rent’ – essentially, asking homeowners how much it would cost to rent their own home. Different definitions of inflation will trigger very different policy responses from central banks. Both the European and American approaches have their merits and drawbacks, and it is not our intention to endorse one approach over the other. Our intention is simply to point out that the two approaches can give very different results for inflation – and therefore trigger very different policy responses from inflation-targeting central banks, with their consequent economic and political repercussions. If Americans used the European definition of inflation, then headline inflation in the US today would be running at the same sub-par rate as in the euro area, 1 percent, and well below the Fed’s 2 percent target (Chart I-2 and Chart I-3). More important, the five year annualised rate of inflation – let’s call it US structural inflation – would have been stuck below 1 percent since 2016 (Chart I-1 and Chart I-4). Under these circumstances, it would have been impossible for the Fed to hike the funds rate eight times, as it did through 2017-18. Chart I-2Like-For-Like, Headline Inflation Is Identical In The US And The Euro Area... Chart I-3...And Core Inflation Is ##br##Very Similar   Chart I-4Using The European Definition Of Inflation, The Fed Couldn't Have Hiked Rates Instead, what if Europeans used the American definition of inflation? European inflation does not include owner equivalent rent, but it does include housing rent for those that do rent their homes. In the US, these two items tend to move in lockstep (Chart I-5). If we assume the same for Europe, we can deduce that a US type weighting for owner equivalent rent would have boosted the headline inflation rate in the euro area by 0.3-0.4 percent through 2014-16, and by a possible 0.5 percent in Sweden through 2013-15 (Chart I-6 and Chart I-7). Under these circumstances, it would have been very difficult for the ECB and Riksbank to take and maintain policy rates deeply in negative territory, as they did through 2015-19. Chart I-5Owner Equivalent Rent Tracks ##br##Housing Rent Chart I-6Using The American Definition Of inflation, Euro Area Inflation Would Have Been Higher... Chart I-7...And Swedish Inflation Would Have Been Much Higher The Different Definitions Of Inflation Have Created Dangerous Distortions If Europeans and Americans were using the same definition of inflation then, one way or the other, their monetary policies would not be as deeply divergent as they are now. One important implication is that European currencies would not be as undervalued as they are now. If Europeans and Americans were using the same definition of inflation then their monetary policies would not be as deeply divergent as they are now.  Based on the ECB’s own analysis, the euro area is over-competitive versus its top 19 trading partners – meaning the euro is undervalued – by at least 10 percent. Moreover, the ECB admits that this sizable undervaluation only appeared after the ECB and Fed started taking their monetary policies in opposite directions in 2015 (Chart I-8). Chart I-8The Euro Is Undervalued By More Than 10 Percent Put the other way, the dollar would not be as overvalued as it is now. In turn, the stronger dollar has created its own dangerous spill-overs. As we explained last week in The Hidden Sales Recession Of 2015… And Why It Matters Now, the surging dollar in 2015 could not have come at a worse time for China. Given that the Chinese economy was already slowing sharply, and the yuan was pegged to the dollar, the resulting loss of Chinese competitiveness just exacerbated the slump. Forcing China to loosen the dollar peg in August 2015. All of which brings us neatly to the hot topic of 2019, and likely 2020 too – President Trump’s threat of a trade war to counter the huge trade imbalances that Europe and China are running against the US. As it happens, President Trump has a good point. Trade wars almost always stem from trade imbalances; and trade imbalances almost always stem from exchange rate manipulations or, at least, exchange rate distortions that advantage one economy to the detriment of another. The euro's undervaluation only happened after monetary policies diverged in 2015. Most of the euro area’s €150 billion trade surplus with the US appeared after 2015, so it cannot be a structural issue. In fact, the evolution of the trade imbalance has tracked relative monetary policy between the Fed and ECB almost tick for tick (Chart I-9), via the exchange rate channel and the over-competitiveness of the euro which the ECB fully admits. Chart I-9Excessively Divergent Monetary Policies Caused The Euro Area's Huge Trade Surplus With The US Of course, neither the ECB nor the Fed are deliberately targeting trade or the exchange rate; they are targeting inflation. But to repeat, they are targeting different definitions of inflation. Crucially, with a backdrop of near zero inflation, small definitional differences in inflation can generate huge economic and financial distortions, with dangerous political consequences. The Compelling Structural Opportunities The definitional difference between European and American inflation explain many of the economic and financial distortions we are witnessing now, as well as the dangerous political consequences. The main counterargument is that the inflation definitions are what they are; neither the ECB nor the Fed are likely to change them anytime soon. Nevertheless, there are compelling structural opportunities. Since 2015, American inflation has outperformed European inflation for one reason and one reason only: owner equivalent rents have surged by almost 20 percent relative to other prices (Chart I-10 and Chart I-11). The historic evidence suggests that such a pace of outperformance is unsustainable structurally and, absent this tailwind, US and European headline inflation rates have to converge, one way or the other. Chart I-10An Unsustainable Surge In US Owner Equivalent Rent... Chart I-11...Has Lifted US Headline ##br##Inflation In this inevitable convergence, the asymmetric starting point of bond yields favours a long US T-bonds, short core European bonds structural position. Because, if the inflation convergence is downwards, T-bond yields will fall much further than European yields; whereas if the inflation convergence is upwards, European yields will likely rise more than T-bond yields. Our preferred structural expression is: long US T-bonds, short Swiss bonds. For currencies it is the opposite message. The overvalued dollar is likely to underperform, at least versus other developed market currencies. Given that Swedish inflation has been the most understated by the exclusion of owner equivalent rents, combined with the Riksbank’s intention to exit negative interest rate policy imminently, our preferred structural expression is: long SEK/USD. American inflation has outperformed European inflation for one reason and one reason only: owner equivalent rents have surged by almost 20 percent relative to other prices. Lastly, European export growth – even in Germany – has been heavily reliant on a cheapening euro (Chart I-12). Undervalued European currencies cannot fall much further, and those European exporters that depend on price competitiveness will struggle to outperform. Even those multinationals that sell their products in dollars will lose out in the accounting translation back into a strengthening domestic currency. Hence, structurally underweight price-sensitive European export sectors. Chart I-12Without A Weaker Euro, Most European Exporters Will Struggle To Outperform The one exception to this is the soft luxuries sector. Despite President Trump’s threat to tariff French products, soft luxuries retain very strong pricing power and sustainable long term demand growth from rising female labour participation rates globally. Stay structurally overweight soft luxuries. Fractal Trading System* The 65-day fractal structure of global equities suggests that they are vulnerable to a near-term countertrend move. Accordingly, this week’s recommended trade is to short the MSCI All Country World versus the global 10-year bond (simple average of US, euro area, and China), setting a profit target and symmetrical stop-loss at 2.5 percent. In other trades, long NZD/JPY and long SEK/JPY both achieved their profit targets of 3 percent and 1.5 percent respectively. Against this, long Poland versus World reached its 4 percent stop-loss. The rolling 1-year win ratio now stands at 65 percent. Chart I-13MSCI All-Country World Vs. Global 10-Year Bond When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated  December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System   Cyclical Recommendations Structural Recommendations Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations    

Highlights China’s PMIs continue to flash a positive signal, but the hard data trend remains negative. There has been a notable improvement in China’s cyclical sectors (versus defensives) over the past month, but broad equity market performance has been flat-to-down. China’s lackluster equity index performance in the face of rising PMIs suggests that investors can afford to wait for an improvement in the hard economic data before tactically upgrading to overweight. Cyclically, we continue to recommend an overweight stance towards both the investable and A-share markets versus the global benchmark, favoring the former over the latter. Feature Tables 1 and 2 on pages 2 and 3 highlight key developments in China’s economy and its financial markets over the past month. On the growth front, China’s November PMIs were clearly positive, and the rise in the official manufacturing PMI above the 50 mark is notable. However, the odds continue to favor a bottoming in the economy in Q1 rather than Q4, in large part because China’s “hard” economic data has continued to deteriorate during the time that the Caixin PMI has been signaling an expansion in manufacturing activity. In this vein, China’s November update for producer prices and total imports have high potential to be market-moving, and should be closely monitored. Table 1China Macro Data Summary Table 2China Financial Market Performance Summary Within financial markets, China’s cyclical sectors have outperformed defensives, which is consistent with the positive message from China’s PMIs. But China’s broad equity markets have been flat-to-down versus the global index over the past month, suggesting that investors can afford to wait for confirmation of a hard data improvement before upgrading their tactical stance to overweight (from neutral). Cyclically, we continue to recommend an overweight stance towards both the investable and A-share markets, but favor the former over the latter in a trade truce scenario. In reference to Tables 1 and 2, we provide below several detailed observations concerning developments in China’s macro and financial market data: Both measures of the Li Keqiang index (LKI) that we track indicated no obvious improvement in Chinese economy activity in October. The BCA China Activity indicator, a broader coincident measure of China’s economy, also moved sideways in October and (for now) remains in a downtrend. Thus, based on the “hard data”, Chinese economic activity has not yet bottomed. Chart 1A Moderate Strength Economic Recovery Will Begin In Q1 The components of our LKI leading indicator continue to tell a story of easy monetary conditions and sluggish money & credit growth (Chart 1). The indicator itself remains in an uptrend, but it is a shallow one that does not match the intensity of previous credit cycles. While the uptrend in the indicator suggests that China’s economy will soon bottom, the shallow pace suggests that the coming rebound in growth will be less forceful than during previous economic recoveries. The uptrend in headline CPI is a notable macro development, with prices having risen 3.8% year-over-year in Oct (the fastest pace in almost eight years). This rise has been driven almost entirely by a surge in pork prices, which have risen over 60% relative to last year (panel 1 of Chart 2). While some investors have questioned whether the rise in headline inflation will cause the PBoC to tighten its stance at the margin, we argued with high conviction in our November 20 Weekly Report that this will not occur.1 Panel 2 of Chart 2 shows that periods of easy monetary policy line up strongly with periods of deflating producer prices, arguing that the PBoC will see through transient shocks to headline inflation. China’s October housing market data highlighted three points: housing sales are modestly improving, the pace of housing construction has again deviated from the trend in sales, and housing price appreciation is slowing in Tier 2 and Tier 3 markets. For now, we are inclined to discount the surge in floor space started, given previous divergences that proved to be unsustainable. The bigger question is whether investors should be concerned about slowing housing prices. Chart 3 shows that floor space sold and property prices have been negatively correlated over the past three years, in contrast to a previously positive relationship. Deteriorating affordability and tight housing regulations have contributed to this shift in correlation, which helps explain why the PBoC’s Pledged Supplementary Lending (PSL) program has been so closely related to housing sales over the past few years. While the growth in PSL injections is becoming less negative, it has not risen to the point that it would be associated with a strong trend in sales. As such, we continue to see poor affordability as a threat to further housing price appreciation, absent stronger funding assistance. Poor affordability will continue to be a headwind for China’s housing market. Chart 2The PBoC Will See Through Transient Shocks To Headline Inflation Chart 3Poor Affordability Will Continue To Weigh On Housing Demand Chart 4Investors Need To See Concrete Signs Of A Hard Data Improvement China’s November PMIs were quite positive, which legitimately increases the odds that China’s economy is beginning the process of recovery. However, we see two reasons to believe that the odds continue to favor a bottoming in the economy in Q1 rather than Q4. First, while they improved in November, several important elements of the official PMI remain in contractionary territory, particularly the new export orders subcomponent. Second, while the Caixin PMI has now been above the 50 mark for 4 consecutive months, China’s hard data has continued to deteriorate since the summer (Chart 4). Given the historical volatility of the Caixin PMI, we advise investors to wait for concrete signs of a hard data improvement before firmly concluding that China’s economy is recovering. Over the last month, China’s investable stock market has rallied roughly 1% in absolute terms, while domestic stocks have fallen about 3%. In relative terms, A-shares underperformed the global benchmark, while the investable market moved sideways. In our view, the underperformance of China’s domestic market reflects increased sensitivity to monetary conditions and credit growth compared with the investable market,2 and a weaker credit impulse in October appears to have been the catalyst for A-share underperformance. Over the cyclical horizon, earnings will improve in both the onshore and offshore markets in response to a modest improvement in economic activity, suggesting that an overweight stance is justified for both markets. But we think the investable market has more upside potential in a trade truce scenario. The outperformance of cyclical versus defensive sectors is sending a positive signal, but investors can afford to wait for better economic data before tactically upgrading. Chart 5A Positive Sign From Cyclicals Versus Defensives Within China’s investable stock market, it is quite notable that cyclicals have outperformed defensives over the past month on an equally-weighted basis (Chart 5). Interestingly, key defensive sectors such as investable health care and utilities have sold off significantly, and equally-weighted cyclicals have also outperformed defensives in the domestic market. The outperformance of cyclicals and underperformance of defensives is consistent with the positive message from China’s PMIs, but the fact that this improvement is occurring against the backdrop of flat-to-down relative performance for China’s equity market suggests that investors can afford to wait for confirmation of a hard data improvement before upgrading their tactical stance to overweight. In this vein, China’s November update for producer prices and total imports have high potential to be market-moving, and should be closely monitored. China’s government bond yields fell slightly in November, potentially reflecting expectations of further modest easing. Our view that monetary policy will likely remain easy over the coming year even in a modest recovery scenario suggests that Chinese interbank rates and government bond yields are likely to range-trade over the coming 6-12 months. We expect onshore corporate bonds to continue to outperform duration-matched government bonds in 2020. Chinese onshore corporate bond spreads eased modestly over the past month. Despite continued concerns about onshore corporate defaults, the yield advantage offered by onshore corporate bonds have helped the asset class generate a 5.4% year-to-date return in local currency terms. Barring a substantial intensification of the pace of defaults, we expect onshore corporate bonds to continue to outperform duration-matched government bonds in 2020. The RMB has moved sideways versus the US dollar over the last month. USD-CNY had fallen below 7 in October following the announcement of the intention to sign a “phase one” trade deal, but the move ultimately proved temporary given the deferral of an agreement. We would expect the RMB to appreciate following a deal of any kind (a truce or something more), and it is also likely to be supported next year by improving economic activity. Still, it would not be in the PBoC’s best interests to let the RMB appreciate too rapidly, because an appreciating Chinese currency would act as a deflationary force on China’s export and manufacturing sectors. As such, we expect a modest downtrend in USD-CNY over the coming year.   Qingyun Xu, CFA Senior Analyst qingyunx@bcaresearch.com Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1    Please see China Investment Strategy Weekly Report "Questions From The Road: Timing The Turn," dated November 20, 2019, available at cis.bcaresearch.com 2   Please see China Investment Strategy Special Report "A Guide To Chinese Investable Equity Sector Performance," dated November 27, 2019, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Special Report

Highlights Economy & Inflation: The macro backdrop in Japan remains bond friendly for JGBs; growth momentum is only starting to bottom out, but will lag the recovery heralded by improving global leading economic indicators, while inflation remains closer to 0% than the BoJ's 2% target. BoJ Options: The BoJ has limited policy choices available to provide more stimulus, with negative policy rates crushing Japanese bank profitability and the central bank already owning massive amounts of JGBs and ETFs. 2020 Japan Bond Strategy: Dedicated bond investors should overweight Japan in global government bond portfolios over the next year, as a complement to an overall below-benchmark duration exposure. Expect some mild yield curve steepening pressure if the BoJ attempts to use its limited remaining policy tools, like targeting shorter maturities for its asset purchases, to try and alleviate the pressure on banks from negative rates and a flat yield curve. Feature Chart 1The Role Of Japan In Global Bond Investing Is Complex In a year where the majority of global bond markets have delivered stellar returns, Japanese fixed income performance has predictably languished in 2019 compared to the other developed economies. Despite a cyclically weak economy with very low inflation, Japanese government bond (JGB) yields have been locked in narrow ranges at or below 0% throughout the year. Monetary policy is a big reason for that, as the Bank of Japan (BoJ) has run of out of fresh stimulus options to try and push JGB yields even lower. In this Special Report, we make the case for owning JGBs as a low-beta, defensive asset in global fixed income portfolios over the next 6-12 months – a period when improving growth is expected to exert upward pressure on global bond yields, but where JGB yields are expected to remain anchored with Japan likely to lag the global upturn (Chart 1). The Japanese Growth & Inflation Backdrop Is No Threat To JGBs Japan’s economy has suffered alongside the global industrial downturn in 2019, with the Japanese manufacturing PMI struggling below 50 for seven consecutive months. Both business investment and exports have been contracting, in response to the slump in global and trade and increase in uncertainty related to the US-China tariff war. The underlying trend in consumer spending – the largest component of Japan’s economy – is more difficult to interpret, however, because of the volatility surrounding the October hike in the consumption tax. On October 1st, Japanese Prime Minister Abe’s government finally passed its long-desired hike in the consumption tax rate from 8% to 10%, in a bid to begin chipping away at Japan’s massive fiscal debt burden. The timing of the move, which had been twice delayed previously, appears ill-advised given the overall weakness in the economy. That can be seen in the response of consumer demand to the tax increase. Japanese consumers, quite rationally, front-loaded purchases in September in advance of the tax hike, but that surge was followed by a collapse in nominal retail sales in October of -14% on a month-over-month basis (Chart 2). This was much larger than the decreases seen after the previous consumption tax increases in 1997 and 2014. This may seem surprising given that the Japanese unemployment rate is a stunningly low 2.4%, suggesting a tight labor market that should be boosting wage growth and consumer confidence. Quite the opposite is happening, however, as consumer confidence is depressed and wage growth is contracting in real terms (bottom panel). Even more unusual is that real disposable income growth for Japanese households is now up to 5% (year-over-year), after stagnating for much of the previous decade. The acceleration is due to more people, especially women and senior citizens, having joined the labor force and found work – on a “per worker” basis, income growth is much less impressive and is more in line with stagnant wage growth. Therefore, unless there is clear acceleration of wages, a sustainable improvement in aggregate consumption is not expected. In the absence of an unlikely consumer boom, a pickup in global trade and manufacturing activity is a necessary requirement to stabilize the Japanese economy where the manufacturing sector is relatively larger than that of other major developed countries (20% of GDP).1 On that front, the news is getting better with the recent improvement seen in the global manufacturing PMI, global ZEW and our own global leading economic indicator (LEI). Looking at the overall conditions in Japan's manufacturing sector, however, there are still mixed signals indicating that a true bottom has been reached (Chart 3): Chart 2Challenging Times For Japanese Consumers Chart 3A Trough In Japanese Manufacturing the Markit manufacturing PMI did rise modestly in November, but remains at only 48.9 (top panel); the most recent Tankan survey from the BoJ showed that both large and small firms in the manufacturing sector expect business conditions to worsen (second panel); real capital spending growth did perk up in the third quarter in the GDP accounts, but additional gains are unlikely given the still moderate reading on manufacturing business confidence (third panel); machine tool orders continue to contract on a year-over-year basis, although the growth in domestic orders may be stabilizing; foreign orders remain depressed due to weakening Chinese demand for automotive and electronic equipment (bottom panel). Chart 4Japan"s Non-Manufacturing Sector Is Struggling Turning to the services sector, which accounts for around 80% of the Japanese economy, the data also show only moderate growth. This is mainly because demand for services is less influenced by global economic conditions, and more related to the tight labor market and rising household income growth. Even given that better fundamental backdrop, however, it is still not clear that services can drive growth in the Japanese economy in 2020 (Chart 4): Chart 5Past The Worst For Japanese Exports while the Tankan survey of large non-manufacturing firms has stayed at the same high level seen since 2014, the data for smaller firms has weakened steadily throughout 2019; the Markit services PMI index has remain solidly above the 50 boom/bust line all year long, yet overall sales for non-manufacturers contracted by -3.1% on a year-over-year basis in the third quarter of the year according to Japan’s Ministry of Finance. One potential ray of hope for Japanese growth comes from exports. While growth in total nominal exports is still contracting by –9.2% on a year-over-year basis, the recent pickup in our global LEI is heralding a potential bottoming in export momentum (Chart 5). In particular, the emerging market sub-component of our global LEI is signaling a potentially sharp pickup in demand for Japanese exports to Asia (middle panel). A similar optimistic message is given regarding Chinese demand, based on the modest improvement in the OECD China LEI (bottom panel). Yet these developments are still in the early stages and could be derailed by a breakdown of the US-China trade negotiations (not the base case scenario of BCA’s geopolitical strategists). Summing it all up, the Japanese economy remains in a fragile state after absorbing multiple blows from trade uncertainty, contracting global manufacturing activity and, more recently, an ill-timed hike in the consumption tax. While some data is showing signs of bottoming, the momentum is unlikely to be strong enough in 2020 to generate much upward pressure on Japanese bond yields. Japanese Inflation Remains A No-Show Japan remains the poster child for the global low inflation backdrop of the post-crisis decade. Even an economy with an unemployment rate near record lows can still not generate inflation sustainably above 0%. Headline CPI inflation is now at only 0.2%, while and core CPI inflation is slightly higher at 0.7% (Chart 6). The former is being dragged down by the lagged impact of lower oil prices and the stubbornly firm Japanese yen. More worrisome, however, is that services CPI inflation dipped slightly below 0% in November (middle panel), in line with the contraction seen in the domestic corporate goods prices and import prices indices (bottom panel). Chart 6Inflation Remains WELL Below The BoJ"s Target Chart 7Not A Consistent Story From Japanese Inflation Expectations Market-based inflation expectations, measured using either CPI swap rates or breakevens from inflation-linked bonds, are also hovering close to 0% (Chart 7). In a bit of a surprise, survey-based measures of inflation expectations produced by the BoJ are closer to the 2-3% range, even though realized inflation only reached that range once, on an annual calendar year basis, since 1991 – in 2014, unsurprisingly another year with a consumption tax increase. The market-based inflation indicators are more important for bond investors, however. It will take a sustained increase in realized inflation before the JGB market begins to worry about inflation again. Perhaps that can begin to happen in 2020 if Japanese and global growth improves, coming alongside some yen weakness. More likely, next year will be another year of mushy inflation readings from Japan as the economy tries to emerge from the slowdown seen in 2019 and the unnecessary tightening of fiscal policy coming from the consumption tax hike (which is likely to cause a temporary, but not sustained, blip in realized inflation rates in 2020). Bottom Line: The macro backdrop in Japan remains bond friendly for JGBs; growth momentum is only starting to bottom out, but will lag the recovery heralded by improving global leading economic indicators, while inflation remains closer to 0% than the BoJ's 2% target. There’s Not Much New The BoJ Can Do The BoJ remains in a bind with regards to future monetary policy decisions. Inflation remains far below its target, while the economy is struggling to generate above-potential growth. Yet unemployment remains exceptionally low and, by the BoJ’s own estimates, Japan’s economy is operating with no spare capacity (i.e. the output gap is a positive number). For a traditional central bank that believes in the tradeoff between spare capacity/unemployment and inflation, like the BoJ, the data is sending a very confusing message about the next policy move. Can A Weaker Yen Solve Japan’s Low Inflation Problem? Chart 8The Balance Of Payments Remains Yen-Supportive The BoJ’s job in setting the right policy to get Japanese inflation higher would be made a lot easier if the yen were not so stubbornly firm. On a trade-weighted basis, the yen is 10.1% above the low seen in 2018 and 22.9% above the 2015 low (Chart 8). This has happened despite the disappointing performance of the Japanese economy and the negative interest rates that have typically made the yen a good funding currency for global carry trades. While there has been likely been some safe-haven demand for the yen given the global growth uncertainties and sharp decline in non-Japanese bond yields in 2019, the root cause for the yen strength is more fundamental. Our colleagues at BCA Research Foreign Exchange Strategy published a Special Report last week, reviewing the balance of payments of the major global currencies.2 Going through the components for Japan, the current account balance remains firmly positive at 3.4% of GDP, despite the fact that the trade balance is now negative. The main reason for that is the steady 4% of GDP in the investment income balance – an inevitable result given Japan’s massive net foreign asset position. On the capital account side, there has been a steady increase in net foreign direct investment (FDI) outflows over the past several years, as more Japanese companies have moved productive capacity offshore (and fewer foreign companies invest in Japan). In addition, portfolio outflows have been gaining momentum with Japanese investors ramping up their purchases of foreign long term assets. Add it all up and Japan's basic balance (the current account plus net FDI) is now negative for the first time since 2015 (bottom panel). Thus, Japan’s balance of payments may now finally be in a position to generate some yen weakness that can help boost domestic inflation – if some of the uncertainties over global growth and the US-China trade negotiations begin to dissipate, as we expect in 2020. So what can the BoJ do? The BoJ has maintained a negative policy interest rate for 45 months since cutting rates below zero in February 2016. Yet according to our BoJ Monitor, there is still a need for additional monetary policy easing to combat weak growth and inflation (Chart 9). Chart 9The BoJ"s Policy Options Are Limited Interest rate markets do not expect the BoJ to do much with short-term interest rates in 2020, with only -5bps of cuts discounted in the Japanese overnight index swap (OIS) curve. BoJ officials have not outright dismissed the possibility that another rate cut could happen, but policymakers have learned that negative rates are lethal for the profits of the banking system. That can be seen in Japan, where bank profits have contracted -19.4% over the past year as negative borrowing rates have become more deeply entrenched. Other parts of the Japanese financial system, like insurance companies and pension funds that need income to meet payouts and liabilities, also suffer from negative interest rates on domestic fixed income assets. Therefore, the BoJ cutting policy rates deeper into negative territory is a very unlikely outcome, even if the economy and inflation continue to struggle, as the risks to the financial system would be worsened. So what else can the BoJ do to provide further monetary stimulus, if necessary? The choices are limited. The BoJ could alter its forward guidance to signal to the market that rates will remain low for a very long time, but that would have a limited effect with rate levels already so low. The central bank could also ramp up its pace of asset purchases, but that will also prove difficult as it owns nearly 50% of outstanding JGBS and nearly 80% of outstanding ETFs. Buying more assets would likely not generate any easier financial conditions, and would simply further disrupt the liquidity of Japan’s financial markets. A March 2019 academic study found that the impact on Nikkei 225 stock returns from the BoJ ETF buying has grown smaller over time despite the increased purchase amounts.3 Chart 10More Room For The BoJ To Buy Shorter Maturity Bonds The BoJ could lower its “Yield Curve Control” target yield for 10-year JGBs to below 0%, but that would also prove difficult as the BoJ already owns a whopping 75% of all outstanding 10-year JGBs (Chart 10) – a figure that would likely need to increase if global bond yields continue to drift higher in 2020, as we expect, forcing the BoJ to buy more 10-year JGBs to ensure that yields do not rise. A unique option might be for the BoJ to purchase foreign bonds. This would potentially help further weaken the yen, which would help increase exports and inflation. Although given the current global backdrop of populism and trade protectionism, a policy specifically designed to weaken the yen would likely not be greeted warmly by other countries. In our view, there is only one plausible option that the BoJ could consider to ease policy further in 2020 to fight low inflation – choosing a different maturity point for its Yield Curve Target. For example, instead of targeting a 10-year JGB near 0%, the BoJ could target a 5-year JGB near 0%. The BoJ owns a lower share of outstanding bonds in that part of the curve (around 45%, by our calculations). The net result could be a steeper JGB curve, which could help ease the drag on profits of the Japanese banks from negative longer-term yields and a flat curve (Chart 11). One thing is for certain: none of the conditions that we have long believed would be necessary before the BoJ would consider abandoning its yield curve target and letting yields rise – a USD/JPY exchange rate between 115 and 120; core CPI inflation and nominal wage inflation both above 1.5%; and clear signs of JGB overvaluation - are currently in place (Chart 12). The BoJ has to continue to stay accommodative, even if other central banks turn less dovish as global growth improves in 2020. Chart 11Shifting BoJ Purchases Could Generate A Steeper JGB Curve Chart 12These Must ALL Happen Before The BoJ Lifts Its JGB Yield Target   Bottom Line: The BoJ has limited policy choices available to provide more stimulus, with negative policy rates crushing Japanese bank profitability and the central bank already owning massive amounts of JGBs and ETFs. Overweight Low-Beta JGBs In Global Bond Portfolios In 2020 Chart 13Overweight Low-Beta JGBs In 2020 As we have discussed in previous reports, yield betas of developed market sovereign bonds to changes in the “global” bond yield are a good tool to use when considering fixed income country allocation decisions when yields are rising everywhere.4 We are currently recommending overweight allocations to government bonds in countries with more dovish central banks and/or where yields are low in relative terms – namely, Germany, Japan and Australia. Not by coincidence, those are also countries whose government bonds have the lowest yield betas among the major developed economies. The rolling 52-week yield betas for JGB yields to the “global” yield (defined as the yield-to-maturity of the Bloomberg Barclays Global Treasury index) is shown in Chart 13. We show the betas for different maturity “buckets” across the yield curve, and we also present the same betas for US Treasuries and German government bonds for comparison. The betas for JGBs are consistent but positive across the entire yield curve, around 0.5 or less. German yields have a similar beta at shorter maturities but a beta close to 1.0 at the longer-end of the curve. US Treasuries, to no surprise, are the highest beta market, with yield betas of 1.5 or more across the entire yield curve. The positive low beta for JGBs means that Japanese bond yields will still move in the same direction as global yields, but with far less volatility. Thus, during the period when global government bonds are rallying, low-beta markets like Japan underperform versus global benchmarks. That has been the story in 2019, when much of the world needed to ease monetary policy but Japan was already at very accommodative policy settings. When global yields are rising, however, lower beta markets should see smaller yield increases and better relative performance. That will be the story for JGBs in 2020, given the strong likelihood that Japan will lag the global economic rebound that we expect next year and the BoJ will be forced to, once again, be the most dovish central bank among the major economies. Bottom Line: Dedicated bond investors should overweight Japan in global government bond portfolios over the next year, as a complement to an overall below-benchmark duration exposure. Expect some mild yield curve steepening pressure if the BoJ attempts to use its limited remaining policy tools, like targeting shorter maturities for its asset purchases, to try and alleviate the pressure on banks from negative rates and a flat yield curve.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Ray Park, CFA Research Analyst ray@bcaresearch.com Footnotes 1 Based on the value added from manufacturing as % of GDP. Other countries, by comparison: China: 29%; Germany: 21%; World: 16%; US: 11%. Source: United Nations and World Bank. 2 Please see BCA Research Foreign Exchange Strategy Special Report, “Updating Our Balance Of Payments Monitor” dated November 29, 2019, available at fes.bcaresearch.com. 3 Kimie Harada and Tatsuyoshi Okimoto, "The BOJ’s ETF Purchases and Its Effects on Nikkei 225 Stocks", RIETI Discussion Paper Series 19-E-014, March 2019. 4 Please see BCA Research Global Fixed Income Strategy Weekly Report, " Cracks Are Forming In The Bond-Bullish Narrative", dated October 23, 2019, available at gfis.bcaresearch.com.