Economy

Highlights We always strive to develop new analytical methods to complement our focus on judging currencies based on global liquidity conditions and the business cycle. This week, we introduce a ranking method based strictly on domestic factors: We call it the Aggregate Domestic Attractiveness Ranking. Using this method alone, the USD, the NZD, the AUD, and the NOK are the most attractive currencies over the coming three months, while the JPY, the GBP, the EUR and the CHF are the least attractive ones. If we further filter the results using a valuation gauge, the USD, the NOK and the CAD are the most attractive currencies over the coming three months, while the CHF, the JPY and the GBP are the least attractive ones. Ultimately, the message is clear: if the dollar corrects, domestic factors suggest it will be shallow. However, buying pro-cyclical commodity currencies at the expense of countercyclical ones makes sense no matter what. Feature This publication places significant emphasis on understanding where we stand in the global liquidity and business cycle in order to make forecasts for G-10 currencies. However, we also like to refer to other methods to add supplementary dimensions to our judgment calls. In this optic, we have focused on factor-based analyses such as understanding momentum, carry and valuation considerations. This week, we take another approach: We build a ranking methodology using domestic economic variables only, intentionally excluding global business cycle factors. Essentially, we want to create an additional filter to be used independently of our main method. This way, we can develop a true complement to our philosophy rooted in understanding the global business cycle. With this approach, we rank currencies in terms of domestic growth, slack, inflation, financial conditions, central bank monitors, and real rates. We look at the level of these variables as well as how they have evolved over the past 12 months. After ranking each currency for each criterion, we compute an aggregate attractiveness ranking incorporating all the information. We then compare the attractiveness of each currency to their premiums/discounts to our Intermediate-Term Timing Models. Based on this methodology, the USD, the NOK and the CAD are the most attractive currencies over the coming three months, while the CHF, the JPY, and the GBP are the least attractive ones. Building A Domestic Attractiveness Ranking Domestic Growth The first dimension tries to capture the strength and direction of domestic growth. We begin by looking at the annual growth rate of industrial production excluding construction, as well as how this growth rate has evolved over the past 12 months. Here, the currencies of countries at the top right of the chart are most attractive, while those at the bottom left are least attractive. As Chart I-1 illustrates, Sweden is performing particularly well on this dimension, while the euro area, Switzerland, the U.K, and Japan are not. The U.S. stands toward the middle of the pack. When aggregating this dimension on both the first and second derivative of industrial production, Sweden ranks first, followed by the U.S. and Norway (Chart I-2). The U.K. and the euro area rank at the bottom. When trying to gauge the impact of domestic growth on each currency’s attractiveness, we also look at the forward-looking OECD leading economic indicator (LEI). As with industrial production, the currencies of countries at the top right of the chart are most attractive, while those at the bottom left are least attractive. This changes the ranking. New Zealand exhibits the highest annual growth rate, followed by the U.S. Meanwhile, when looking at how the annual rate of change has evolved over the past 12 months, Australia shows the least deterioration, and the euro area the most (Chart I-3). Putting these two facets of the LEI together, Australia currently ranks first, followed by the U.S. and New Zealand. Switzerland and the U.K perform the most poorly (Chart I-4). Slack Then, we focus on slack, observing the dynamics in the unemployment gap, calculated using the OECD estimates of the non-accelerating inflation rate of unemployment (NAIRU). Here, the currencies of countries at the top right of the chart are least attractive, while those at the bottom left are most attractive. Switzerland enjoys both a very negative and rapidly falling unemployment gap (Chart I-5). The U.K. also exhibits a clear absence of slack, but in response to the woes surrounding Brexit, this tightness is decreasing. Interestingly, the euro area looks good. Despite its high unemployment rate of 7.9%, the unemployment gap is negative, a reflection of its high NAIRU. Combining the amount of slack with the change in slack, Switzerland, New Zealand and the euro area display the best rankings, while the U.S. and Sweden exhibit the worst (Chart I-6). The poor rankings for both the U.S. and Sweden reflect that there is little room for improvement in these countries. Inflation When ranking currencies on the inflation dimension, we look at core inflation and wages. We assume that rising inflationary pressures are a plus, as they indicate the need for tighter policy. We begin with core inflation itself; the currencies of countries at the top right of the chart are most attractive, while those at the bottom left are least attractive. Canada and the U.S. both sport higher core inflation than the rest of the sample, as well positive inflationary momentum (Chart I-7). Switzerland displays both a very low level of inflation as well as declining momentum. U.K. inflation displays the least amount of momentum. On the core CPI ranking, the Canadian dollar ranks first, followed by the USD. Unsurprisingly, Japan and Switzerland rank at the bottom of the heap (Chart I-8).   We also use wages to track inflationary conditions as G-10 central banks have put a lot of emphasis on labor costs. Similar to core inflation, we measure each country’s level of wage growth as well as its wage-growth momentum. The currencies of countries at the top right of the chart are most attractive, while those at the bottom left are least attractive. This time, the U.S. and the U.K. display both the highest annual growth rate of wages as well as the fastest increase in wage inflation (Chart I-9). Meanwhile, Norwegian wage growth is very poor, but improving. The U.S. and the U.K. rank first on this dimension, while Switzerland and Canada rank last, the latter is impacted by its very sharp deceleration in wage growth (Chart I-10). Financial Conditions The Financial Conditions Index (FCI) has ample explanatory power when it comes to forecasting a country’s future growth and inflation prospects. This property has made the FCI a key variable tracked by G-10 central banks. Here we plot the level of the FCI relative to the annual change in FCI. A low and easing FCI boosts a nation’s growth prospects, while a high and tightening FCI hurts the outlook. Consequently, the currencies of countries at the top right of the chart are least attractive, while those at the bottom left are most attractive. While Switzerland has the highest level of FCI – courtesy of an overvalued exchange rate – the U.S. has experienced the greatest tightening in financial conditions (Chart I-11). Combining the level and change in FCI, we find that New Zealand currently possess the most pro-growth conditions, followed by both Sweden and Norway. On the other end of the spectrum, Japan and the U.S. suffer from the most deleterious financial backdrop (Chart I-12). Central Bank Monitors   We often use the Central Bank Monitors devised by our Global Fixed Income Strategy sister publication as a gauge to evaluate the most probable next moves by central banks. It therefore makes great sense to use this tool in the current exercise. The only problem is that we currently do not have a Central Bank Monitor for Switzerland, Sweden and Norway. Nonetheless, using this variable to create a dimension, we compare where each available Central Bank Monitor stands with its evolution over the past 12 months. The currencies of countries at the top right of the chart are most attractive, while those at the bottom left are least attractive. Currently, Canada and the U.S. show a clear need for tighter policy, without a pronounced fall in their respective Central Bank Monitors (Chart I-13). However, while the U.K. could stand higher rates right now, the British Central Bank Monitor is quickly falling, suggesting the window of opportunity for the Bank of England is dissipating fast. The euro area and Australia do not seem to justify higher rates right now. On this metric, Canada and the U.S. stand at one and two, while Australia and the euro area offer the least attractive conditions for their currencies (Chart I-14). Real Interest Rates   The Uncovered Interest Rate Parity (UIP) hypothesis has been one the workhorses of modern finance in terms of forecasting exchange rates. To conduct this type of exercise, our previous work has often relied on a combination of short- and long-term real rates, a formulation with a good empirical track record.1 Accordingly, in the current exercise, we use this same combination of short- and long-term real rates to evaluate the attractiveness of G-10 currencies. This dimension is created by comparing the level of real rates to the change in real rates over the past 12 months. The currencies of countries at the top right of the chart are most attractive, while those at the bottom left are least attractive. The U.S. dollar is buoyed by elevated and rising real rates, while the pound is hampered by low and falling real rates (Chart I-15). This results in the dollar ranking first on this dimension, and the pound ranking last (Chart I-16). Interestingly, the yen ranks second because depressed inflation expectations result in higher-than-average and rising real rates. Aggregate Domestic Attractiveness Ranking and Investment Conclusions   Once we have ranked each currency on each dimension, we can compute the Aggregate Domestic Attractiveness Ranking as a simple average of the ranking of the eight different dimensions. Based on this method, domestic fundamentals suggest that the USD, the NZD, the NOK and the AUD are the most attractive currencies over the next three months or so, while the JPY, the GBP, the EUR and the CHF are the least attractive ones (Chart I-17). Interestingly, this confirms our current tactical recommendation espoused over recent weeks to favor pro-cyclical currencies at the expense of defensive currencies. However, it goes against our view that the U.S. dollar is likely to correct further over the same time frame. This difference reflects the fact that unlike our regular analysis, the Aggregate Domestic Attractiveness Ranking does not take into account the global business cycle, momentum and sentiment. We can refine this approach further and incorporate valuation considerations. We often rely on our Intermediate-Term Timing Model to gauge if a currency is cheap or not. Chart I-18 compares the Aggregate Domestic Attractiveness Ranking of G-10 currencies to their deviation from their ITTM. Countries at the bottom left offer the most attractive currencies, while those at the upper right are the least attractive currencies. This chart further emphasizes the attractiveness of the dollar: not only do domestic factors support the greenback, so do its short-term valuations. The CAD, the NOK and the SEK also shine using this method, while the less pro-cyclical EUR, CHF and JPY suffer. The pound too seems to posses some short-term downside. Ultimately, this tells us that if the global environment is indeed unfavorable to the U.S. dollar right now, we cannot ignore the strength of U.S. domestic factors. Consequently, we refrain from aggressively selling the USD during the tactical anticipated correction. Instead, if the global environment favors the pro-cyclical commodity currencies on a three-month basis, it is optimal to buy them on their crosses, especially against the CHF and JPY. Meanwhile, the pound has very little going for it, and selling it against the SEK or the NOK could still deliver ample gains.   Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Footnotes 1  Please see Foreign Exchange Strategy Special Report, "In Search Of A Timing Model" dated July 22, 2016, available at fes.bcaresearch.com. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. has been mixed: January U.S. consumer confidence index surprised to the downside, coming in at 120.2.  U.S. unemployment rate in January increased to 4.0%, from a previous 3.9% reading; however, this data point was likely distorted by the government shutdown Non-farm payrolls in January surprised to the upside, coming in at 304k. The DXY index rebounded by 0.9% this week. Tactically, we remain bearish on the dollar, as we believe that the current easing in financial conditions will help global growth temporarily surprise dismal investor expectations. Nevertheless, we remain cyclical dollar bulls, as the Fed will ultimately hike more than what is currently priced this year, and as China’s current reflation campaign is about mitigating the downside to growth, not generating a new upswing in indebtedness and capex. Report Links: Global Liquidity Trends Support The Dollar, But... - January 25, 2019 So Donald Trump Cares About Stocks, Eh? - January 9, 2019 Waiting For A Real Deal - December 7, 2018 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 The recent data in euro area has been negative: The Q4 euro area GDP on a year-over-year basis fell to 1.2%, in line with expectations. Euro area headline inflation in January on a year-over-year basis decreased to 1.4%, from the previous 1.6% in December 2018, core inflation rose to 1.1%. January Markit euro area composite PMI fell to 51.0. Euro area retail sales in December fell to 0.8% on a year-over-year basis, from the previous 1.8%. In response to this poor economic performance, EUR/USD has fallen by 0.8% this week. We remain cyclically bearish on the euro, as we believe that the Fed will hike more than anticipated this cycle and that Europe is more negatively impacted by China’s woes than the U.S. is. Hence, slowing global growth will force the ECB to stay dovish much longer than expected. Moreover, our Intermediate Term Timing Model, is showing that the euro is once again trading at a premium to short term fundamentals. Report Links: 2019 Key Views: The Xs And The Currency Market - December 7, 2018 Six Questions From The Road - November 16, 2018 Evaluating The ECB’s Options In December - November 6, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: Annual inflation increased to 0.4% from previous 0.3%, core inflation increased to 0.7% from 0.6%, and inflation ex fresh food increased to 1.1% from 0.9%. December retail trade weakened to 1.3% from the previous 1.4%. Japanese unemployment rate in December has fallen to 2.4%. January consumer confidence index fell to 41.9, underperforming the expectations. USD/JPY has risen by 0.3% this week. We remain bearish on the yen on a tactical basis. The recent FOMC meeting kept the U.S. key interest rate unchanged, so did many other central banks. The resulting ease in global financial conditions could be a headwind for safe havens, like the yen. Moreover, U.S. yields are likely to rise even after the easing in financial conditions is passed, as BCA anticipates the Fed to resume hiking in the second half of 2019. This will create additional downside for the yen. Report Links: Yen Fireworks - January 4, 2019 2019 Key Views: The Xs And The Currency Market - December 7, 2018 Updating Our Intermediate Timing Models - November 2, 2018 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 The recent data in Britain has been negative: Markit U.K. composite PMI has surprised to the downside, falling to 50.3 in January; service PMI dropped to 50.1 while construction PMI fell to 50.6.  Halifax house prices yearly growth, surprised to the downside, coming in at 0.8%. Finally, Markit Services PMI also underperform, coming in at 50.1. The Bank of England rate decided to keep rates on hold at 0.75%. GBP/USD has lost 0.8% this week. On a long-term basis, we remain bullish on cable, as valuation for the pound are attractive. However, we believe that the current stalemate in Westminster, coupled with the hard-nose approach of Brussels has slightly increase the probability of a No-deal Brexit. This political uncertainty implies that short-term risk-adjusted returns remains low. Report Links: Deadlock In Westminster - January 18, 019 Six Questions From The Road - November 16, 2018 Updating Our Intermediate Timing Models - November 2, 2018 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia has been negative: Building permits in December has surprised to the downside, coming in at -8.4% on a month-over-month basis.  December retail sales has slowed down, coming in at -0.4%. Finally, in December, with exports contracted at a -2% pace, and imports, at -6% pace. The RBA decided to leave the cash rate unchanged at 1.5%. While it was at first stable, AUD/USD ultimately has fallen by 2% this week. Overall, we remain bearish on the AUD in the long run. The unhealthy Australian housing market coupled with very elevated debt loads, could drag residential construction and household consumption down. Moreover, the uncompetitive Australian economy could fall into a potential liquidity trap as the credit conditions tighten further. Report Links: CAD And AUD: Jumping Higher To Plunge Deeper - February 1, 2019 Waiting For A Real Deal - December 7, 2018 Updating Our Intermediate Timing Models - November 2, 2018 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 The recent data in New Zealand has been negative: The participation rate underperformed expectations, coming in at 70.9%. Moreover, employment growth also surprised to the downside, coming in at 0.1%. Finally, the unemployment rate surprised negatively, coming in at 4.3%. NZD/USD has fallen by 2.3% this week. Overall, we remain bullish on the NZD against the AUD, given that credit excesses are less acute in New Zealand than in Australia. Moreover, New Zealand is much less exposed to the Chinese industrial cycle than Australia. This means that is China moving away from its current investment-led growth model will likely negatively impact AUD/NZD. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 In Fall, Leaves Turn Red, The Dollar Turns Green - October 12, 2018 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 The recent data in Canada has been negative: GDP has fallen to 1.7% on a year-over-year basis from the previous 2.2%. The December industrial production growth came in at -0.7% month-on-month, a negative surprise. Canadian manufacturing PMI in January decreased to 53. On the back of these poor data and weaker oil prices, USD/CAD rose by 1.6% this week, more than undoing last week’s fall. We expect the CAD to outperform other commodity currencies like the AUD and the NZD, oil prices are likely to outperform base metals on a cyclical basis. Moreover, the Canadian economy is more levered to the U.S. than other commodity driven economies. Thus, our constructive view on the U.S. implies a positive view on the CAD on a relative basis. Report Links: CAD And AUD: Jumping Higher To Plunge Deeper - February 1, 2019 Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2   Recent data in Switzerland has been mixed: Real retail sales yearly growth improved this month, coming in at -0.3% versus -0.6% last month. However, the SVME Purchasing Manager’s Index underperformed expectations, coming in at 54.3. EUR/CHF has fell 0.2% this week. Despite this setback, we remain bullish on EUR/CHF. Last year’s EUR/CHF weakness tightened Swiss financial conditions significantly and lowered inflationary pressures. Given that the Swiss National Bank does not want a repeat of the deflationary spiral of 2015, we believe that it will continue with its ultra-dovish monetary policy and increase its interventionism in the FX market, in order to weaken the franc, and bring back inflation to Switzerland. Moreover, on a tactical basis, the ease in financial conditions should hurt safe havens like the franc. Report Links: Waiting For A Real Deal - December 7, 2018 Updating Our Intermediate Timing Models - November 2, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway has been negative: The December retail sales missed the consensus estimates, coming in at -1.80%. December credit indicator decreased to 5.4%. Registered unemployment rate in January has increased to 2.6%, surprising to the downside. USD/NOK has risen by 1.8% this week. We are positive on USD/NOK on a cyclical timeframe. Although we are bullish on oil prices, USD/NOK is more responsive to real rate differentials. This means, that a hikes later this year by the Fed will widen differentials between these two countries and provide a tailwind for this cross. Nevertheless, the positive performance of oil prices should help the NOK outperform non-commodity currencies like the AUD. We also expect NOK/SEK to appreciate and EUR/NOK to depreciate. Report Links: Global Liquidity Trends Support The Dollar, But... - January 25, 2019 Waiting For A Real Deal - December 7, 2018 Updating Our Intermediate Timing Models - November 2, 2018 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden has been negative: Consumer confidence surprised to the downside, coming in at 92. Moreover, retail sales yearly growth also underperformed expectations, coming in at 5.6%. Finally, manufacturing PMI came in line with expectations at 51.5. USD/SEK has risen by 2.2% this week. Overall, we remain long term bullish on the krona against the euro, given that Swedish monetary policy is much too easy for the current inflationary environment, a situation that will have to be rectified. However, given our positive view on the U.S. dollar on a cyclical basis, we are cyclically bullish on USD/SEK, since krona is the G-10 currency most sensitive to dollar moves. Report Links: Global Liquidity Trends Support The Dollar, But... - January 25, 2019 Updating Our Intermediate Timing Models - November 2, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Hyman Minsky famously said that “stability begets instability.” The converse is also true: Instability begets stability. None of the preconditions for a U.S. recession are in place yet. The Fed’s decision to press the pause button on further rate hikes ensures that it will take at least another 18 months for monetary policy to turn restrictive. Global growth should accelerate by mid-2019, as Chinese stimulus kicks in and the headwinds facing Europe dissipate. Investors should overweight global equities and underweight bonds over the next 12 months. The leadership role in the equity space will gradually shift outside the United States. Feature The Long Shadow Of The Financial Crisis   "Stability begets instability” declared Hyman Minsky in his widely cited, seldom-read book.1 By this, Minsky meant that periods of economic tranquility often encourage excessive risk-taking, sowing the seeds of their own demise. We would not quarrel with Minsky’s assessment, but we would point out that the converse is also true: Instability begets stability. Following periods of intense financial stress, lenders become more circumspect about whom they lend to, while borrowers become reluctant to take on debt. The result is economically bittersweet. On the plus side, the newfound caution of lenders and borrowers alike ensures that financial imbalances are slow to build up again. On the negative side, sluggish credit growth restrains spending. The net effect is a recovery that is often slow and uneven, but one which lasts longer than expected. Few Signs Of Major U.S. Economic Imbalances This is the world in which we find ourselves today. It took a decade following the subprime crisis for the U.S. to return to full employment. Much of Europe is not even there yet. Lenders continue to take risks. However, they have been quicker than usual to scale back exposure at the first sign of trouble. For example, as U.S. auto loan defaults began rising in 2015, banks tightened lending standards. As a result, the share of auto loans transitioning into delinquency peaked in Q4 of 2016 and has since drifted down modestly (Chart 1). Chart 1Lenders Are More Circumspect These Days: The Case Of Autos A similar thing happened when corporate credit spreads blew out in 2015 following the crash in oil prices (Chart 2). Banks tightened lending standards starting in late 2015. Once defaults peaked in early 2017, banks started easing standards. Chart 2Banks Were Quick To Tighten Lending Standards In 2015 Tellingly, the distress in corporate debt markets in 2015-16 did not cause the financial system to seize up, as evidenced by the fact that financial stress indices only increased marginally during that period. This suggests that financial imbalances never had a chance to rise to a level that threatened the overall economy. The Preconditions For The Next U.S. Recession Are Not Yet In Place Today, the U.S. private-sector financial balance – the difference between what the private sector earns and spends – stands at a healthy surplus of 2.1% of GDP. Both of the last two recessions began when the private-sector balance was in deficit (Chart 3). Chart 3The Private Sector Is Not Living Beyond Its Means The Way It Was Before The Last Two Recessions This raises an intriguing question: If the U.S. private sector is not suffering from any major imbalances, what is going to cause the next recession? That’s a very good question, with no obvious answer! The past two recessions were triggered by the bursting of asset bubbles – first the dotcom bubble and then the housing bubble. Today, U.S. equities are far from cheap, but with the S&P 500 trading at 16.1-times forward earnings, they are hardly in a bubble (Chart 4). The housing market is also on much firmer footing: The homeowner vacancy rate is near all-time lows, while the quality of mortgage lending has been very high (Chart 5). Chart 4While U.S. Stocks Are Not Cheap, They Aren't In A Bubble Chart 5Housing Fundamentals Are Solid Of course, recessions can occur for reasons other than the bursting of asset bubbles. The 1973-74 recession and the recessions of the early 1980s were triggered by a surge in oil prices, requiring the Fed to hike rates aggressively. Luckily, such an oil-induced recession is highly unlikely today. Inflation expectations are better anchored, while oil consumption represents a much smaller share of GDP than it did back then (Chart 6). In addition, the U.S. has become a major oil producer, which implies that the drag to consumers from higher oil prices would be partly offset by increased capital spending in the energy sector. At any rate, the ability of shale producers to respond to higher prices with additional output limits the extent to which prices can rise in the first place. Chart 6An Oil Price Shock Is Unlikely To Cause A Recession Past economic downturns have also been caused by major adjustments in the cyclical parts of the economy. As a share of GDP, cyclical spending is lower today than it has been at the outset of most recessions (Chart 7). The proliferation of just-in-time inventory systems has also reduced the influence that inventory swings have on the economy (Chart 8). Chart 7Cyclical Spending Is Not Extended A severe tightening of fiscal policy can also trigger a recession.2 Fortunately, the end of the government shutdown reduces the risk of such an outcome. Rightly or wrongly, voters blamed President Trump for the recent closure (Chart 9). As we speak, the Trump administration is negotiating with Democrats to avert another shutdown slated to begin on February 15. The key item of contention concerns funding for a border wall with Mexico. Even if a deal falls through, rather than shuttering the government again, Trump will probably pursue funding for the wall by declaring a national emergency. Our geopolitical strategists believe such an action will be challenged by the Democrats, but is likely to be upheld by the Supreme Court. Chart 9''I Am Proud To Shut Down The Government'' Global Growth Should Improve Admittedly, the external environment now has a greater influence on the U.S. economy than in the past. Nevertheless, given that exports are only 12% of GDP, it would take a sizeable external shock to knock the U.S. into recession. We think that such a shock is not in the cards. The trade war is likely to go on hiatus as Trump seeks to take credit for a deal with China. In addition, as we discussed two weeks ago, China will scale back its deleveraging campaign now that credit growth has fallen close to nominal GDP growth (Chart 10).3    Chart 10China: Time To Scale Back Deleveraging Euro area growth should reaccelerate over the coming months thanks to lower oil prices, a revival in EM demand, modestly more stimulative fiscal policy, and the palliative effects from the decline in government bond yields across the region. We have also argued that the risks of a “Hard Brexit” should abate.4   Waiting... And Waiting For Inflation To Rise When the next recession rolls around, it will probably be sparked by a surge in inflation, which forces the Fed to raise interest rates much more rapidly than it has so far. Here is the thing though: Inflation is a highly lagging indicator. It usually only peaks long after a downturn has started and troughs after the recovery is well underway (Chart 11).   Consider the example of the 1960s. The unemployment rate fell below NAIRU in 1964, but it took another four years for inflation to break out in earnest (Chart 12). The U.S. unemployment rate has been below NAIRU only since 2017. The unemployment rate in Germany and Japan has been below NAIRU for much longer, yet inflation remains stubbornly low in both countries (Chart 13). Chart 12It Took An Overheated Economy For Inflation To Take Off In The Late-1960s Chart 13The U.S., Japanese, And German Economies Are At Full Employment Cheer Up This leaves us with a striking conclusion: Perhaps the next U.S. recession is not around the corner, as some grumpy economists seem to think. Perhaps this economic expansion can endure beyond 2020. The recent U.S. data has certainly been consistent with that thesis. The ISM manufacturing index rose 2.3 percentage points to 56.6 in January. New orders jumped by 6.9 percentage points to 58.2. Payroll growth has also accelerated. Real aggregate earnings are up 4.2% from a year earlier, the fastest pace since October 2015 (Chart 14). Chart 14U.S. Labor Income Growth Has Been Accelerating Housing data are showing tentative evidence of stabilization. New home sales are rebounding, while mortgage applications are back near cycle-highs (Chart 15). Chart 15Housing Activity Is Stabilizing After Last Year's Weakness Reflecting these positive developments, the Citigroup economic surprise index has jumped into positive territory (Chart 16). The New York Fed’s estimate for Q1 2019 GDP growth has also moved up to 2.4%. Chart 16U.S. Economic Data Are Beating Low Expectations Investment Conclusions Recessions and bear markets usually overlap (Chart 17). With the next recession still at least 18 months away, it is premature to turn bearish on equities. We upgraded stocks in December following the post-FOMC sell-off. Although our tactical MacroQuant model is pointing to an elevated risk of a setback over the next few weeks, we continue to see global equities finishing the year 5%-to-10% above current levels. As global growth bottoms out mid-year, the leadership role in equity markets should increasingly move away from the U.S. towards EM and Europe. Chart 17Recessions And Bear Markets Usually Overlap Bonds are a tougher call. We do not expect the Fed to raise rates again at least until June. This will limit the upside for bond yields, as well as the dollar, in the near term. Nevertheless, with the fed funds futures pricing in no rate hikes for the next few years, even a modest shift back to tightening in the second half of this year and beyond will push up bond yields, dampening total returns to fixed income. Looking beyond 2019, the case for maintaining a short duration stance in fixed-income portfolios is very strong. The longer the Fed allows the economy to overheat, the greater the eventual overshoot in inflation will be. Inflation expectations have fallen over the past few months (Chart 18). They should have risen. Ultimately, Gentle Jay Powell’s decision to press the pause button on further rate hikes means that rates will end up peaking at a higher level during this cycle than they would have otherwise. Chart 18Inflation Expectations Have Declined   Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Footnotes 1      As argued in Hyman P. Minsky, “Stabilizing an Unstable Economy,” Yale University Press, (1986). 2      Severe episodes of fiscal tightening have normally followed military demobilizations. These include the recessions following WW1, WW2, and the Korean War, and to a much lesser extent, the 1990-91 recession which was exacerbated by cuts to the defense budget at the end of the Cold War. 3      Please see Global Investment Strategy Weekly Report, “China’s Savings Problem,” dated January 25, 2019. 4      Please see Global Investment Strategy Weekly Report, “Patient Jay,” dated January 18, 2019. Strategy & Market Trends MacroQuant Model And Current Subjective Scores Tactical Trades Strategic Recommendations Closed Trades

As the world’s second most populous country with an economy projected to grow over 7% annually, India’s potential as a commodity consumer is massive. However, years of distortionary and unfriendly policies have held back the Indian manufacturing sector – the prime consumer of commodities. This has translated into weak “consumption intensity” of industrial commodities. The past four years have witnessed a shift to more business-friendly policies. These policies and an eventual expansion of the manufacturing base will support steeper demand for industrial commodities over the longer term. India’s economic model stands in stark contrast with China’s, which became a voracious consumer of commodities as it industrialized. It is not “the next China” when it comes to metals demand, but it will play an important and growing global role. In terms of agricultural commodities, favorable demographic trends will raise aggregate demand, regardless of the success of India’s industrialization. Highlights Energy: Overweight. Russia’s production was down 42k b/d in January, a trifle compared to the ~ 450k b/d reduction by the Kingdom of Saudi Arabia (KSA) in December. Officials indicate Russia will cut production by 228k b/d in 1Q19. Base Metals/Bulks: Neutral. Indian steelmakers are seeking relief from increasing imports in the form of higher duties, as slowing Asian demand leads to higher shipments from China, Korea, and Japan, according to Reuters.1 Precious Metals: Neutral. Gold markets appear more confident in the Fed’s capitulation on its rates-normalization policy, at least in 1H19, as prices rallied above USD 1,320/oz in end-January. Gold traded slightly lower this week. We remain long as a portfolio hedge. Ags/Softs: Underweight. The USDA releases its WASDE report tomorrow. Feature The impact of China’s rapid industrialization since 2000 on commodity markets is well known. Its share of global consumption of copper and crude oil rose from a modest 10.9% and 6.0% in 2000 to 51.1% and 13.5%, respectively (Chart of the Week). As such, China fueled global demand growth over this period (Chart 2) and, in large part, is responsible for the commodity price boom that ensued. Chart of the WeekChina Now Dominates Industrial Commodity Demand With such a large chunk of demand originating in China, its economic health remains a dominant variable in accurately predicting the path of industrial commodity prices globally. However, with economic priorities shifting from the industrial sector to consumer-driven services, the era of insatiable Chinese commodity demand growth looks to be nearing its end. In search of a replacement to take up the slack, India has often been singled out as a potential leading source of commodity demand growth going forward, and for good reason: India is massive. In terms of population, it is roughly on par with China, boasting a population of 1.3 billion people. And while its share of global wealth is dwarfed by China’s, India’s economy is growing at a rapid pace. According to the most recent IMF projections, its GDP will expand at a 7.5%, and 7.7% clip this year and next – faster than China’s projected 6.2% for both years. Typically, as low income economies develop, their manufacturing sector outpaces economy-wide growth, raising the contribution of industry to overall GDP. Stronger activity in this sector correlates well with industrial commodity demand, which rises accordingly. Meanwhile ag demand is determined by both population and income growth. India, however, has missed the boat (Table 1). Its share of global demand is disproportionate to its current size and its future potential. Table 1India’s Consumption Of Industrial Metals Stands Out As Disproportionately Low In fact, the intensity of commodity usage per dollar of GDP is low even relative to countries at similar income levels (Chart 3). This is most clear in the case of metals. It can be put down to the relatively small role of manufacturing in India’s economy. India did not follow the traditional path of growing its manufacturing base first before re-orienting its economy towards services. Rather, the manufacturing sector has been held back by poor infrastructure and distortionary policies. In fact, services – such as financial services, business services, and telecom – already dominate India’s economy, accounting for 53.9% of GDP, compared to 16.7% in the case of manufacturing (Chart 4). This is in stark contrast with other economies such as China, Korea, and Thailand, in which manufacturing accounts for 29%, 28%, and 27%, respectively (Chart 5). Chart 5No Pickup In Manufacturing Yet Given that the services sector is relatively less metals- and energy-intensive, India’s contribution to global demand for industrial commodities has been disproportionately low. Bottom Line: India’s growth model to date is oriented toward the services sector. As a result, the intensity of industrial commodity demand there – measured as consumption per dollar of GDP – is significantly lower than its peers. This has prevented India from playing a larger role in global commodity markets. The Case For Greater Commodity Demand: Theories And Evidence Economist Walt Whitman Rostow postulated that economies develop through five distinct phases: Traditional society: subsistence agriculture, low level of technology, labor-intensive Preconditions to takeoff: regional trade, the development of manufacturing Take off: the beginning of industrialization Drive to maturity: rising living standards, economic diversification, strong use of technology High mass consumption: mass production and consumerism Along this path, economies in phases (2), (3), and (4) are the most notable in terms of rising appetite for industrial commodities. During these stages, the industrialization and urbanization processes require an expansion of electricity grids, infrastructure and housing. As such, these stages are characterized by high base metals demand. Yet as illustrated by the sigmoid, or S curve, the period of exponential growth in commodity demand eventually slows down and in many cases falls after the country reaches a certain level of GDP per capita (Chart 6). Evidence from metals and oil corroborate this theory. In fact, if we single out the commodity intensity path of DM economies as their incomes were rising, we find that commodity intensity there has already started to decline (Chart 7). This S-curve is also evident in the commodity intensity of emerging economies (Chart 8). China’s path to development stands out as an extreme case of high consumption usage. While not all economies follow China, the paths are similar. In the case of oil, it appears that the consumption intensity of countries that have developed more recently peaked at both a lower income level and a lower oil usage level than countries that developed earlier. This is clearly the case for Korea and Malaysia, and suggests that technology has raised the efficiency of oil. On this basis, we do not expect India’s commodity intensity to reach the same peaks as its more wealthy peers. However, India’s usage has remained stagnant and in some cases fallen. This highlights the relatively muted role of manufacturing in India’s economy. As India’s economy grows and evolves, this should change. We project India’s commodity intensity path as it grows its manufacturing base (Chart 9). Based on this exercise, we find that by the year 2040, India’s consumption of refined copper will account for 12% of global consumption -- up from 2% today.  The impact is more muted in the oil sector -- we expect it will account for almost 12% of global crude oil demand, from the current 5%. This trajectory reveals that the scope for rising demand is greater for metals than for the oil sector, implying that industrial commodities are set to benefit in the case of a boom in Indian manufacturing. Bottom Line: Both theory and evidence suggests that the intensity of India’s commodity usage is set to rise over time as its manufacturing sector expands. This is especially true in the case of metals. Even in our most conservative projection, India’s copper consumption is set to rise more than 10-fold by 2040. The Path Forward: “Make In India” While the Rostow model is instructive in framing our thinking on the path to development, it is a crude theory – not all countries will necessarily follow the same path to development. These are the lessons from economist Alexander Gerschenkron’s theory of economic backwardness, which highlights that countries’ growth paths may not be identical or replicable due to cross-country differences, and differences in the state of technology available at varying points of time. Applying these ideas to India means that while India is able to access current technology, which supports a more rapid industrialization process, its economic model is also very different. The China model rested on a powerful single-party state, with privileged access to the American market, that used its control of the financial system to funnel a swell of national savings into an aggressive industrialization effort. On the other hand, the India model required the government to move forward incrementally. Indian leaders had to pursue industrialization while grappling for democratic consensus in the context of extreme social diversity and a more restrictive trade environment. Thus, India is likely to mimic the circuitous path of emerging markets like Brazil or Mexico. Over the past four years, Indian policymakers have tried to unwind unfavorable business policies and spur growth in the manufacturing sector. The “Make in India” initiative of Prime Minister Narendra Modi seeks to encourage both foreign and domestic investment, and to raise the manufacturing sector’s contribution to GDP to 25% by the year 2025. In the process it aims to create 100 million jobs. This target is unrealistic. In fact, the manufacturing sector’s contribution to GDP has come down slightly, with economists blaming the demonetization drive and the chaotic, complicated and unclear roll out of the new Goods and Services Tax. Modi also faces tough elections this spring, which could put his initiative on ice. Nevertheless, there is a positive omen in the automobile industry. According to figures from the Society of Indian Automobile Manufacturers, roughly 4 million cars were manufactured last year – up from 3.2 million just five years ago (Chart 10). This is in line with India’s Automotive Mission Plan 2026, which aims for the auto industry to become one of the top three, accounting for 40% of the manufacturing sector and contributing 12% to India’s GDP by 2026. Chart 10An Encouraging Trend For Manufacturing Moreover, Modi’s impact has been a net positive in making India more welcoming for investment. While poor infrastructure, red tape, and restive labor laws are still constraining industry, measures of institutional performance are improving (Chart 11). This is a prerequisite for a brighter manufacturing future. As for the election, even if India’s opposition Congress Party should come to power, it will have learned from its five years in the political wilderness that Modi’s message of economic development resonates with the public. Their current stance on economic policy calls for import substitution, economic liberalization, and a faster pace of development – consistent with a growing manufacturing sector. Chart 11The Business Environment Is Improving The Business Environment Is Improving Bottom Line: While the “Make In India” campaign says as much about Modi’s flair for public relations as anything, India’s business environment is now more conducive to growth and investment. This bodes well for commodity demand going forward. Ags In The Age Of Manufacturing While a much-needed push in India’s manufacturing sector would clearly have a direct impact on its demand for industrial metals, the resulting improvement in the economy and employment would also raise incomes. In theory, this would support the consumption of agricultural commodities. Nonetheless, a couple of observations suggest that India is less of an opportunity for ags as it is for metals (Chart 12): In terms of the level of ag consumption per capita, rice usage is actually relatively high in India. While corn intensity levels are still quite low, wheat consumption per capita is near the level at which China plateaued. The differences across these grains likely reflects differences in preferred sources across countries and implies there is not as much room for catch up. Furthermore, ag consumption per capita generally plateaus at fairly low-income levels, in stark contrast to the industrial metals. A clear outlier is corn consumption in the United States, where high-usage patterns can be put down to the rising use of corn for ethanol production on the back of biodiesel mandates. We do not expect growth in ag consumption intensity on the back of rising incomes. Nevertheless, India’s population is projected to continue rising, in turn supporting aggregate food consumption there. That said, policies promoting India’s self-sufficiency in agriculture have generally prevented rising demand from spilling over into global markets. In fact, in terms of the trade balance, India is usually a net exporter of these grains, especially in the case of rice (Chart 13). This is a positive for India – in that it has so far avoided the risk of food shortage that occasionally rears its head – but it is a negative for global ag demand. Chart 13Self-Sufficiency Policies Insulate The Indian Ag Sector Bottom Line: Unlike industrial commodities, we do not anticipate a rise in per capita ag consumption in India. Nevertheless, a rapidly growing population will mean that aggregate demand for ags will grow briskly.    Roukaya Ibrahim, Editor/Strategist Commodity & Energy Strategy RoukayaI@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com Pavel Bilyk, Research Analyst Commodity & Energy Strategy PavelB@bcaresearch.com Footnotes 1      Please see “Exclusive: Indian steel firms seek higher duties on steel imports as prices drop,” published by Reuters.com on February 5, 2019. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade Recommendation Performance In 4Q18 Commodity Prices and Plays Reference Table Summary of Trades Closed in 2018  

Highlights The current trajectory in global share prices resembles what took place in 2000 and early 2001. The early 2001 rebound in global and EM stocks lasted several weeks only, despite ongoing easing by the Federal Reserve. Corporate profits – not the Fed – was the key driver in 2001 and remains the principal driver of global and EM stocks today. EM corporate profits are set to contract this year due to China’s continuing slowdown and weakening global trade. This suggests the current EM rally is unsustainable; continue underweighting EM. In Chile, bet on lower swap rates. Continue shorting the peso but overweight the local bourse within an EM equity portfolio. Feature The dovish shift by the U.S. Federal Reserve in the past month has boosted EM risk assets and currencies. Yet, we find that in the medium and long term there is a very low correlation between Fed policy and U.S. interest rates, on the one hand, and EM financial markets on the other. Instead, EM risk assets and currencies correlate with EM/China business cycles and global trade (Chart I-1). We have not detected any improvement in China/EM growth, nor in global trade (Chart I-1). What’s more, we expect Chinese growth and world trade to continue to weaken in the coming six months. Therefore, the EM rebound and outperformance will be reversed sooner than later. Chart I-1Global Growth Indicators Do No Confirm EM Rally Please note this is the view of BCA’s Emerging Markets Strategy team. BCA’s house view is presently positive on global risk assets and global growth. The basis for this difference between our current position and that of the majority of our colleagues is the outlook for China’s growth. A Replay Of 2016 Or 2001? Most investors are betting that 2019 will be a replay of 2016, when the Fed’s dovish turn and China’s stimulus propelled the EM and global equity rallies. It is enticing to compare the current episode in financial markets to the one that occurred only three years ago. To be sure, there are a lot of similarities: the global trade slowdown driven by China/EM, selloffs in global equity and credit markets, a dovish shift in the Fed’s stance and policy stimulus in China are all reminiscent of early 2016. Not surprisingly, this has created a stampede into EM. According to the most recent Bank of America Merrill Lynch survey, as of mid-January some 29% of investors were overweight EM stocks compared to 1% overweight in the U.S., 11% underweight in the euro area and 1% underweight in Japan. By now, the overweight in EM equities is most likely even higher, given the stampede into EM assets that has occurred over the past several weeks. This stands in contrast to the 33% underweight in EM equities in January 2016. It is apparent that the majority of investors are indeed extrapolating 2016 into 2019. We hold a different view and believe China’s slowdown will be more protracted than in 2015-’16, and that EM corporate earnings are set to contract (please refer to Chart I-5 on page 6). A key distinction between China’s current policy efforts and what was implemented in 2015-‘16 is the absence of stimulus for real estate. The odds are that China’s property market will continue to languish, weighing on household and business sentiment as well as spending. Further, the efficiency of monetary transmission mechanisms could be lower today than it was in 2016 due to the regulatory tightening on both banks and non-banks. The fiscal multiplier could also be lower due to the fragile sentiment among consumers and businesses. We discussed these issues in detail in our January 17, 2019 report. Remarkably, it appears that global share prices are tracking the pattern of 1998-2001 – their trajectories are identical in terms of both magnitude and duration (Chart I-2). Chart I-2Global Stocks Are Tracking Pattern Of 1998-2001 In Magnitude And Duration That said, there are substantial differences between today and 2001 in respect to the economic backdrops in the U.S. and China. Our focal point is to demonstrate that the Fed easing is not sufficient to prop up share prices if it does not lead to a recovery in corporate earnings. We conclude that the latest rebound in EM risk assets is probably late because neither the Fed’s pause nor China’s stimulus will revive EM corporate profits in the next nine months. In terms of market action, one can draw a number of parallels between the trajectory in global share prices today and in 2000-’01. Following an exponential rally in 1999, the global equity index peaked in January 2000 (Chart I-3). The equity selloff accelerated in the last quarter of 2000, with stocks plunging in December of that year. Chart I-3Is Rebound In Global And EM Stocks Late? Oversold conditions in global share prices and the Fed’s intra-meeting 50-basis-point rate cut on January 3, 2001, generated a 7% and 15% rebound in global and EM stocks, respectively. The bounce lasted from late December 2000 until early February 2001. The current trajectory in global share prices – the rollover in late January 2018, the top formation lasting several months followed by a dramatic plunge, the bottom in late December, 2018 and the subsequent rebound – closely resemble the path global share prices took in 2000 and early 2001 (Chart I-3, top panel). The same holds true for EM share prices (Chart I-3, bottom panel). Critically, the Fed continued to cut interest rates in 2001 and 2002, yet the bear market in global equities, including EM, persisted until March 2003 (Chart I-4A and I-4B, top panels). The culprit was shrinking corporate profits (Chart I-4A and Chart I-4B, bottom panels). Chart I-4AFed Easing Did Not Help Global Stocks In 2001 Chart I-4BFed Easing Did Not Help EM Stocks In 2001 Odds are that EM earnings are set to contract this year as discussed below and shown in Chart I-5. As a result, this view bolsters our conviction that EM equities are likely to roll over soon and plunge anew in absolute terms, and certainly underperform U.S. stocks. Bottom Line: There are many economic differences between today and 2001. Our main point is that the Fed easing-inspired rally in global equities in early 2001 lasted several weeks only and was followed by a new cycle low. The key factor was not Fed policy but corporate profits. Provided our view that corporate earnings in EM and global cyclical sectors will contract this year, the rally in these segments is not sustainable regardless of Fed policy. What Drives EM: Chinese Or U.S. Growth? Predicting the outlook for China and global trade correctly is key to getting the EM call right. First, China’s credit and fiscal spending impulse leads EPS growth of companies included in the EM MSCI equity index by nine months, and it currently points to continued deceleration and contraction in EM EPS in the months ahead (Chart I-5, top panel). The average of new and backlog orders within China’s manufacturing PMI also portends a negative outlook for EM corporate earnings (Chart I-5, bottom panel). Chart I-5EM Profits Are Heading Into Contraction The primary linkage between China’s credit and fiscal spending impulse and EM profits is as follows: China impacts EM and the rest of the world via its imports. This explains why EM share prices correlate with Chinese PMI imports (Chart I-6). Chart I-6Chinese Imports And EM Equities Second, China’s imports are to a large extent driven by capital spending, especially construction. Some 85% of mainland imports are composed of various commodities, industrial goods and materials, and autos. Consumer goods make up only about 15% of imports. Major capital expenditures in general and construction, in particular, cannot be undertaken without financing. This is why the country’s credit and fiscal spending impulse leads its imports cycles (Chart I-7). This impulse is presently foreshadowing a deepening slump in mainland imports and by extension its suppliers’ revenues and profits. Chart I-7Chinese Imports Are Heading South Third, as EM shipments to China dwindle, not only will EM corporate revenues and profits disappoint but EM currencies will also depreciate. The latter bodes ill for EM U.S. dollar and local currency bonds. The basis is that exchange rate depreciation makes U.S. dollar debt more expensive to service, and also pushes up local bond yields in high-yielding EM fixed-income markets. Fourth, The majority of developing economies sell more to China than to the U.S. Remarkably, global trade and global manufacturing decelerated in 2018, even though U.S. goods imports were booming (Chart I-8). Crucially, the more recent strength in the U.S.’s intake of goods was in part due to frontloading of shipments to the U.S. before the import tariffs went into effect on January 1, 2019. Chart I-8U.S. Imports Are Very Robust Yet despite robust U.S. demand, aggregate exports of Korea, Taiwan, and Japan have done poorly and their manufacturing have slumped (Chart I-9A and Chart I-9B). Chart I-9AAsian Exports: Flirting With Contraction Chart I-9BAsian Manufacturing: Flirting With Contraction This highlights the increased significance of Chinese demand and the diminished importance of U.S. domestic demand in world trade. In particular, at $6 trillion, EM aggregate goods and services imports, including Chinese imports (but excluding China’s imports for processing and re-exporting), is greater than the combined imports of the U.S. and EU, which currently stand at $4.7 trillion ($2.5 trillion plus $2.2 trillion, respectively). Finally, the media and many investors have exaggerated the impact of U.S. tariffs on the Chinese economy. We are not implying that the tariffs are not relevant at all, or that they have not damaged sentiment among mainland businesses and households. They have. The point is that China’s exports to the U.S. constitute 3.8% of Chinese GDP only (Chart I-10). This compares to Chinese capital spending amounting to 42% of GDP and total annual credit origination and fiscal spending of 26% of GDP. Chart I-10China's Exports To U.S. Are Small (3.8% of GDP) Overall, China’s growth slowdown in 2018 was not due to its plunging shipments to the U.S. – actually, the latter were rising strongly till December due to frontloading – but due to weakness in credit origination, primarily among non-banks (shadow banking). Bottom Line: The Chinese business cycle – not the U.S.’s – is the key driver of EM share prices and currencies and more important than the Fed. EM And The Fed On the surface, it seems that EM is tracking Fed policy. To us, however, this is akin to“not seeing the forest for the trees”. Investors need to stand back and examine the medium- and long-term relationships between U.S. interest rates, DM central banks’ balance sheets, and EM financial markets. In this broader context, the following becomes apparent: There is no stable correlation between EM share prices, EM currencies and EM sovereign credit, on the one hand, and U.S. 10-year bond yields, on the other (Chart I-11). Chart I-11EM And U.S. Bond Yields: No Stable Correlation Historically, the correlation between EM share prices and the Fed funds rate has been mixed, albeit more positive than negative (Chart I-12). On this 40-year chart, we shaded the periods when EM stocks did well during periods of a rising fed funds rate. These time spans are 1983-1984, 1988-1989, 1999-2000, 2003-2007 and 2017. Chart I-12EM Stocks And Fed Funds Rate: A Historical Perspective The only two episodes when EMs crashed amid rising U.S. interest rates were the 1982 Latin America debt crisis and the 1994 Mexican peso crisis. Yet, it is essential to emphasize that these crises occurred because of poor EM fundamentals: elevated foreign currency debt levels, negative terms-of-trade shocks, large current account deficits and pegged exchange rates. Dire EM fundamentals also prevailed before the Asian/EM crises of 1997-1998. However, these late-1990s crises occurred without much in the way of Fed tightening or rising U.S. bond yields. Remarkably, there is also no correlation between the size and the rate of change of DM central banks’ balance sheets, on the one hand, and EM risk assets and currencies on the other. In particular, Chart I-13 validates that the annual growth rate of G4 central banks’ balance sheets does not correlate with either EM share prices or EM local currency bonds’ total returns in U.S. dollars. Chart I-13Pace Of QEs And EM: No Correlation Finally, there is a low correlation between U.S. real interest rates and the real broad trade-weighted dollar (Chart I-14). Notably, Chart I-15 illustrates that the greenback often acts as a countercyclical currency, appreciating when global growth is slowing and depreciating when the global business cycle accelerating. Please note that the dollar is shown inverted on this chart. Chart I-14The U.S. Dollar And U.S. Real Rates Chart I-15The U.S. Dollar Is Countercyclical Bottom Line: Many analysts and investors assign more significance to the Fed policy’s impact on EM risk assets than historical evidence warrants. Unless Fed policy easing coincides with EM growth recovery, the Fed’s positive impact on EM will prove to be fleeting. Investment Considerations Widespread bullish bias on EM among investors currently and a continuous slew of poor growth data in China and global trade give us the conviction to argue that the current EM rally is not sustainable. Even if the S&P 500 drifts higher, EM stocks and credit will underperform their U.S. counterparts (Chart I-16). Chart I-16Stay Short EM / Long S&P 500 The EM equity index is sitting at a major technical resistance, and a decisive break above this level will challenge our view (Chart I-17, top panel). The same holds true for many EM currencies and copper (Chart I-17, bottom panel). However, for now, we are maintaining our negative bias. Chart I-17EM Equities And Copper Are Facing Resistance Within the EM equity universe, our overweights are Brazil, Mexico, Chile, Russia, central Europe, Korea, and Thailand. Our underweights are Indonesia, India, Philippines, South Africa, and Peru. We continue to recommend shorting the following EM currency basket versus the U.S. dollar: ZAR, IDR, MYR, CLP, and KRW. The full list of our recommended positions across EM equities, local rates, credit, and currencies is available on pages 17-18. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com   Chile: Favor Bonds Over Stocks Local currency bonds will outperform equities in Chile over the next six to nine months (Chart II-1). Chart II-1Chile: Favor Bonds Over Stocks The central bank is raising interest rates to cap inflation. However, we believe this is misguided because China’s ongoing deceleration along with lower copper prices, will slow growth in Chile over the course of this year. In addition, the current domestic inflation dynamics are less worrisome than the central bank contends. There is ongoing debate in the policy circles of Santiago over whether the recent large net immigration wave, particularly from Venezuela, is inflationary or disinflationary. On the one hand, net immigration expands the supply of labor and puts downward pressure on wages, and hence is disinflationary (Chart II-2). On the other hand, net immigration bolsters demand, and thereby inflation. Chart II-2Chile: Labor Force Is Expanding At 2% The central bank has acknowledged both effects but has cited that the latter will overwhelm the former. We disagree with this assessment and believe that current immigration in Chile will be more disinflationary. There are a number of factors that make us believe so: Both nominal and real wage growth are cooling off rapidly (Chart II-3). This corroborates the thesis that the expanding supply of labor is capping wage increases. Chart II-3Chile: Wage Growth Is Decelerating Central banks in any country need to be concerned with rising unit labor costs and service sector inflation. Energy and food prices are beyond a central bank’s control. Monetary policy should not respond to fluctuations in these prices unless there are second-round effects on wages and other prices.  There is presently no genuine inflationary pressures in Chile. The average of Chile’s core and trimmed mean inflation rates stands at 2.5%, and service sector inflation is at 3.7% (Chart II-4). This is within the central bank’s inflation target range of 3% +/-1%. Chart II-4Chile: Inflation Is Within Target Range Finally, Chile’s exports are set to shrink due to the ongoing deceleration in China and lower copper prices (Chart II-5). With exports accounting for 30% of GDP, a negative external shock will slow domestic demand too. This will be disinflationary. Chart II-5Chilean Exports Are About To Contract The fixed-income market in Chile is pricing in rate hikes (Chart II-6). We continue to recommend receiving 3-year swap rates. Even if the central bank continues to tighten, long-term interest rates will decline, anticipating rate cuts down the road. Chart II-6Chile: Receive 3-Year Swap Rates Chilean share prices, in absolute terms, are at risk from the EM and commodities selloff. However, we recommend dedicated EM equity portfolios overweight Chile. The economy is fundamentally and structurally solid, and local equity markets are supported by large local investment pools. Importantly, unlike many other commodity producers, currency depreciation in Chile does not stop the central bank from cutting interest rates. Banco Central de Chile does not target the exchange rate and will cut rates to mitigate the adverse external shock. This will ensure that business cycle fluctuations in Chile will be milder than in other developing economies where central banks tighten to defend their currencies. This is positive for Chilean stocks versus other EM bourses. Finally, the peso is at risk of depreciation from lower copper prices. Bottom Line: Local investors should favor domestic bonds over stocks. Fixed-income traders should bet on lower three-year swap rates. Dedicated EM investors should overweight Chilean equities. Currency traders should maintain a short CLP / long USD trade. Footnotes Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Our main leading indicator for China’s economy and the broad trend in coincident measures both suggest that investment-relevant Chinese growth is set to slow over the coming months. Even in a trade deal scenario, an earnings recession for Chinese investable stocks looks likely unless the flow of credit soon increases to an annual pace of RMB 26 Trillion. The recent trend in money & credit growth is not yet consistent with this outcome. The RMB has risen relative to several currencies over the past two months, meaning that it does not simply reflect a weaker dollar. The RMB rally is linked to the trade negotiations with the U.S., suggesting that further gains are likely if a genuine truce emerges. 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, our Li Keqiang (LKI) leading indicator continues to point to weaker activity over the coming 6-12 months, even though the LKI itself has actually trended higher over the past year. We maintain that trade frontrunning has caused this gap (which is in the process of unwinding), as broader measures of coincident activity have been trending lower and are poised to decelerate further. The growth rate of housing construction also seems set to decline, given that the current pace of starts is still running substantially above the pace of sales volume. Finally, while we do not expect the speed at which Chinese import and export growth decelerated in December to continue, the export components of China’s PMIs and the end of trade frontrunning both suggest that trade growth will remain weak over the coming few months. Table 1China Macro Data Summary   Table 2China Financial Market Performance Summary From an investment strategy perspective, we continue to recommend a neutral stance towards Chinese stocks within a global equity portfolio over a 6-12 month horizon, and remain tactically long until the end of this month. The recent outperformance of investable stocks vs. the global benchmark reflects global investor expectations of a trade deal between China and the U.S. later this month, but a deal alone will not reverse slowing domestic demand (which will negatively impact earnings). Even in a trade deal scenario, an earnings recession looks likely unless the flow of credit soon increases to an annual pace of RMB 26 Trillion, and the recent trend in money & credit growth is not yet consistent with this outcome. Finally, the rally in the RMB over the past two months does not simply reflect a weaker dollar, as it has risen relative to several currencies. The timing of the rally is clearly linked to the trade negotiations between the U.S. and China, suggesting that further gains are likely if a genuine truce emerges later this month. In reference to Tables 1 and 2, we provide several detailed observations concerning developments in China’s macro and financial market data below: Both the Bloomberg Li Keqiang index (LKI) and our alternative LKI rose to 9.3 in December, maintaining an uptrend that has been in place for the majority of the past 12 months. As we noted in last week’s report,1 this uptrend is not only in contrast to our leading indicator for China’s old economy, but also other coincident measures of economic activity. Chart 1 highlights that China’s investment-relevant economic activity is trending lower when broadly measured, implying that the uptrend in the LKI over the past 12 months is anomalous and is set to wane. Chart 1China's Investment-Relevant Economic Activity Is Trending Lower Our LKI leading indicator ticked down in December, as a rise in the RMB reversed some of the improvement in monetary conditions that had previously lifted the indicator. More important, however, is the very recent trend in the money & credit components of the indicator: while the YoY growth rates in M2, BCA’s calculation of M3, and adjusted total social financing (TSF) have recently stabilized, Chart 2 shows that the trend over the past three months has been down. We highlighted in last week’s report that Chinese credit growth needs to accelerate this year to avoid an earnings recession even assuming a trade deal with the U.S., and Chart 2 illustrates that the recent trend in money & credit growth is not yet consistent with this outcome. Chart 2The Recent Trend In Money & Credit Growth Is Down Based only on the trend in construction, China’s housing market is healthy and growing at a robust pace. However, fundamental support for the housing market is materially weaker: housing sales volume growth is in negative territory, growth in PBOC pledged supplementary lending injections has turned negative, and our house price diffusion indexes are rolling over from elevated levels. Housing sales volume has historically led the trend in construction, suggesting that China’s housing inventories are rising anew and that the pace of construction is set to cool significantly. The NBS and Caixin manufacturing PMIs for January provided conflicting readings: the former ticked up fractionally, whereas the latter deteriorated meaningfully further. The fact that the new export orders components of both PMIs moved higher in January suggests two things: 1) exporter sentiment is stabilizing (at a low level) in response to expectations of a trade truce with the U.S., and 2) the domestic demand outlook is weaker than the external outlook. This underscores that a framework trade deal with the U.S. at the end of the month is not, on its own, likely to lead to a significant reacceleration in the Chinese economy. Chinese investable stocks have rallied significantly in absolute US$ terms since the beginning of 2019, up over 11% year-to-date. Given that Chinese stocks are comparatively high-beta, most of this performance can be attributed to the rally in global stocks (up 8% YTD). However, it is notable that Chinese stocks outperformed global stocks both when the latter sold off aggressively in December, and in response to the recent global rally. This likely reflects global investor expectations of a trade deal between China and the U.S., which was the basis for our recommendation of a tactical overweight towards Chinese stocks in our December 5 Weekly Report.2 Chart 3 provides some additional evidence that global investors have driven the recent rally in investable stocks. First, panel 1 highlights that domestic stocks have underperformed investable stocks meaningfully over the past two months. Second, panel 2 shows that domestic infrastructure stocks, likely beneficiaries of a policy-driven reaccleration in domestic demand, have not rallied at all in absolute terms over the past few months. Chart 3Global Investors Drove The Recent Rally In Investable Stocks Within the equity sector space, the most notable development over the past month has been the substantial outperformance of Chinese consumer discretionary stocks (up almost 11% relative to global consumer discretionary in US$ terms year-to-date). For the most part, these gains reflect the idiosyncratic performance of Alibaba, due to recent changes to the global industrial classification standard (GICS).3 Prior to the changes, the automobiles & components industry group competed with retailing as a driver of the Chinese investable consumer discretionary sector; today, retailing accounts for 3/4ths of the index, with Alibaba accounting for all of the increase in retailer market cap (from 26% in November). Alibaba’s stock price recently bounced in response to a positive Q4 earnings surprise, but disappointing revenue growth underscores the challenges facing investable consumer discretionary stocks from deteriorating consumer sentiment in China.4 Despite the rally in China-related global financial assets over the past two months, Chinese onshore corporate bond spreads remain elevated in reflection of concerns over rising defaults (Chart 4). While we believe that investors are pricing in excessively high default rates over the coming year (i.e. the level of spreads is probably wider than warranted), the trend in onshore corporate spreads is highly informative and served as an early indicator that China’s economy was set to slow. Somewhat concerningly, the trend in spreads of different quality are not moving in a direction that would be consistent even with a stabilization in the Chinese economy. Panel 2 shows that AAA-rated corporate bond spreads have recently been trending higher, in contrast to that of bonds rated AA-. The former has reliably led the latter over the past year, implying that the odds of overall onshore spreads rising have gone up. Chart 4High-Quality Corporate Spreads Are Moving Higher The budding rally in the RMB that we identified last month has continued, with CNY-USD having recently broken above its 200-day moving average (Chart 5). Panels 2 and 3 highlight that this does not simply reflect a weaker dollar, as the RMB has risen relative to the euro and the basket of currencies included in the Bloomberg U.S. dollar spot index. It remains unclear whether this recent strength has been driven by trade talk-related intervention or market expectations of a trade deal, but its link to the negotiations is clear. This suggest that further gains are likely if a genuine truce emerges later this month. Chart 5A Genuine Rebound In The RMB   Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com     Footnotes   1 Please see China Investment Strategy Weekly Report “A Gap In The Bridge”, dated January 30, 2019, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report “2019 Key Views: Four Themes For China In The Coming Year”, dated December 5, 2018, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Special Report “GICS Sector Changes: The Implications For China”, dated September 26, 2018, available at cis.bcaresearch.com. 4 Please see China Investment Strategy Special Report “Chinese Household Consumption: Full Steam Ahead?”, dated November 14, 2018, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations