Economy

Special Report

In a report published early last August, I wrote that: “The perfect time for equity investing is when markets are cheap, earnings expectations are overly pessimistic and the monetary environment is highly accommodative. Currently, the opposite conditions exist: valuations are stretched, earnings expectations are euphoric and the Fed is in tightening mode. It does not seem a propitious time to be aggressive.” By the end of the year, the MSCI All-Country Index had declined by around 12%, with the S&P 500 down by a similar amount. Against that background, valuations improved, earnings expectations moderated and the Fed adopted a less hawkish tone. And, not surprisingly, investors and traders became much less bullish about the outlook, a positive development from a contrary perspective. As a result, BCA’s equity stance was upgraded to overweight from both a 3- and 12-month perspective. With no recession imminent and the Fed likely to raise rates by less than previously feared, we took the view that the path of least resistance for equities was up. There is no requirement at BCA for strategists to agree on the outlook. In fact, the opposite is true in that we encourage independent thinking and diverse ways of looking at the world. I have no strong reasons to disagree with the view that equities will end this year higher, and thus outperform bonds and cash. However, my concerns about the longer-run outlook, coupled with the potential for further late-cycle volatility, temper my comfort with an overweight position. Of course, this merely cements my reputation amongst colleagues as the resident BCA bear! What Troubles Me There rarely is a shortage of economic, financial or political issues to worry about. Even in the best of times, one can always find some problems and potential threats to the outlook. Contrary to my current reputation within BCA, I am not always bearish – I turned more positive on equities in the spring of 2009 and embraced the rally for most of the subsequent decade. However, notwithstanding the potential for equity prices to move higher this year, I perceive three particular challenges to an optimistic view of the outlook: The outlook for U.S. corporate earnings given the likelihood that labor’s share of income will rise from current unusually low levels. The financial markets’ addiction to easy money and low interest rates that may delay the normalization of monetary policy and encourage financial imbalances and excessive risk-taking. The unprecedented rise in U.S. federal deficits at a time of strong economic growth. There will be a price to pay down the road. Notably absent from this list is any mention of trade wars, Brexit, China, U.S. political dysfunction, recession risks and the many other issues that feature in news headlines. I do care about these things, but the three topics mentioned above are enough reason to be concerned, without piling on other problems. The Extraordinary Performance Of U.S. Profits, But… One of the most remarkable features of the past decade’s economic environment has been the impressive performance of U.S. corporate earnings. Despite the weakest economic recovery on record, profit margins have soared to an all-time peak (Chart 1). How on earth did companies manage that? Let’s start by noting what strong earnings growth did NOT reflect. Chart 1An Impressive Margin Performance First, there has not been above-trend growth in top-line revenues. The top panel of Chart 2 shows that S&P 500 sales have grown broadly in line with nominal U.S. corporate GDP over the past two decades. Second, related to the above point, there has not been a great environment for corporate pricing power. The corporate sector inflation rate has averaged a measly 1.2% during the past decade. Third, despite ongoing technological innovations, earnings have not benefited from a revival in productivity growth. Corporate sector productivity has grown at only a moderate 1.1% pace during the past 10 years, far below its historical average (third panel of Chart 2). Chart 2No Major Improvements Here! Finally, one other popular explanation – low interest rates - also can be ruled out as a major driver of the profit cycle. The large decline in interest rates since the Great Recession has clearly benefited some companies, but interest payments as a share of pre-tax profits have not shown much net change in the decade (final panel of Chart 2). In recent years, the lower level of rates has been offset by an increase in outstanding debt. We are left with two major drivers of the rise in margins: lower tax rates and, more importantly, tight control over labor costs. The effective tax rate paid by domestic non-financial companies averaged 21.7% between 2010 and 2017 compared with 26.7% between 2000 and 2007 (Chart 3). And the rate plunged further in 2018 in response to the large cut in the federal corporate tax rate from 35% to 21%. Had the effective tax rate continued to average 26.7% after 2010, after-tax profits of domestic non-financial companies would have grown at a much-reduced pace during the past eight years. Chart 3Corporate Tax Burdens Have Declined We finally come to the main explanation of remarkable earnings growth: the corporate sector’s success in capturing much of the benefits of higher productivity, rather than sharing it with labor. Historically, real employee compensation in the corporate sector rose in line with productivity, allowing both employees and the employers to enjoy the rewards of increased efficiencies. As a result, the shares of income going to capital and labor were among the most mean-reverting series in the economy (Chart 4). Chart 4A Major Divergence in Income Shares Everything changed around 2000 when real compensation began to stagnate, even as productivity continued to rise (Chart 5). Labor’s bargaining power was eroded by the combination of globalization and technological innovations, allowing companies to keep a tight grip on wage costs. The returns to capital soared while those to labor collapsed, with both moving to more than four standard deviations away from historical averages – an extraordinary divergence. If real employee compensation had continued to rise in line with productivity after 2000, then EBITD margins1 would be at their historical mean, rather than at a high extreme. Chart 5Labor Gets Left Behind The corporate sector’s ability to expand at the expense of labor has now come to an end. Wage growth has started to rise against the backdrop of an increasingly tight labor market. As a result, the labor share of income bottomed at the end of 2017 and the capital share peaked. Populist pressures against globalization also argue for an increased labor share.  The payoff to earnings growth from the drop in the corporate tax rate also will end this year. It was a one-off event with no further cuts in prospect. The bottom line is that the major tailwind (weak wage growth) behind strong U.S. earnings has turned into a headwind, while the secondary one (lower taxes) is ending. When it comes to S&P earnings (as opposed to the national income measure of profits), an additional supporting factor has been the decline in outstanding share balances that has boosted earnings per share. Many companies have taken advantage of low interest rates to raise debt and use the proceeds to buy back shares. However, with leverage now high and interest rates off their lows, the incentive for such financial engineering is diminishing. Debt growth has slowed and so should the pace of share buybacks (Chart 6). Chart 6Lots Of Financial Engineering The ever-optimistic analyst community remains unfazed about the above trends. According to IBES data, analysts’ individual company estimates imply long-run earnings growth of more than 16% a year for the S&P 500 universe (Chart 7). That is more than double average historical earnings growth. It was exceeded only by the insane optimism at the peak of the tech bubble in the late 1990s/early 2000, and we know how that ended! There can only be disappointment and an eventual marked downgrading of these earnings expectations. In my view, earnings will be lucky to grow at 3% a year over the long run from current elevated levels. Chart 7Euphoric Long-Run Earnings Estimates Some may argue that these long-term earnings estimates are irrelevant because investors pay them little attention. But there is a loose correlation between valuations and these earnings estimates, and while the price-earnings ratio (PER) has declined from its peak, it remains above its historical average. If long-term earnings estimates come down that should undermine the PER. Perhaps the causality is the other way: high valuations encourage analysts to inflate their earnings projections, but that would not be any more encouraging. Either way, it is a bearish chart. The Addiction To Easy Money The Fed’s gradual retreat from its hyper-easy policy stance was well telegraphed, but still unsettled the markets. That is the problem with addictions – the withdrawal period is always difficult. That has put the Fed in a tricky position as it must balance the need to prevent an overheated economy with the need to maintain financial stability. History suggests that the odds of the Fed getting it just right are slim. Adopting a cautious approach to tightening risks the worst of both worlds: falling behind the curve on inflation while encouraging financial speculation and imbalances. The Fed embraced an extended period of easy policy in the first half of the 2000s after the tech bubble burst, with the fed funds rate kept far below the growth in nominal GDP (Chart 8). If money is unusually cheap, then speculation and financial excesses are inevitable. The easy money period of the 1990s helped fuel the tech bubbles and the more extended period of easy money in the 2000s fueled the housing bubble. Once again, we have interest rates far below the growth in GDP and, not surprisingly, this has fed financial euphoria. Chart 8Monetary Policy Still Looks Accomodative The Fed has raised the federal funds rate by 225 basis points over the past three years, with nine increases of 25 basis points each. Four of the moves occurred in 2018 and have been blamed for financial problems in emerging economies and volatility in developed equity markets. Yet, all the Fed has done is bring the real fed funds rate out of negative territory. If a real funds rate of only 0.5% is enough to trigger extreme market volatility and threaten the economic expansion, then the system is much more vulnerable than generally assumed. There is much discussion in economic circles about the level of the real equilibrium interest rate – the rate consistent with the economy growing at trend, currently estimated to be around 2% a year. In the past, a simple rule of thumb was that real rates, over time, would have some approximation to the real growth in the economy. However, some studies (including by the Fed) argue that the real equilibrium rate may now be close to zero, far below the trend growth of the economy. If real rates close to zero are all that the economy can tolerate then that raises interesting questions. Does it mean that the economy’s growth potential could be much lower than 2%? Does it mean that if real rates have to be kept close to zero, then speculative activities in the markets will continue to build, ultimately threatening financial stability? Either way, it does not seem to be a positive story. Some worry that the Fed is making a mistake in both raising rates and unwinding its bloated balance sheet (aka QT or quantitative tightening). I believe this concern is hugely overstated. Contrary to popular opinion, the expansion in the Fed’s balance sheet did not lead to a surge of liquidity that drove asset prices sharply higher. Of course, the Fed’s bond purchases lowered yields and that forced money into riskier assets. However, there was no increased flood of money in the broader financial system. Quantitative easing (QE) led to a dramatic rise in bank reserves at the Fed, but there was no corresponding sustained surge in M2 – the measure of money supply that is more reflective of money available for economic and/or financial transactions. In other words, the money multiplier (the ratio of M2 to the narrow money) collapsed (Chart 9). This is because the credit system was impaired after the 2007-09 meltdown and the Fed was largely pushing on a string in its attempts to bring it back to life. The main way that Fed policy drove asset prices higher was keeping short rates close to zero because that gave investors a massive reason to take on more risk. Chart 9The Monetary Plumbing Has Blockages If QE was not the driving factor behind the bull market in stocks, then we should not be overly concerned about QT. Yes, investors will be forced to absorb more bond issuance as the Fed ceases to be a buyer. However, it is interesting to note that the current 10-year Treasury yield of 2.7% is no higher than five years ago, even though the Fed’s balance sheet has begun to shrink and the Fed has hiked rates nine times over the period (Chart 10). Chart 10Monetary Policy And Bond Yields The bottom line is that the Fed should continue on its path of reducing its balance sheet and not be timid about raising rates if the economy continues to grow in excess of a 2% pace. At some point there will be another recession and the Fed may well be blamed. But that is a lesser evil than feeding the addiction to easy money by prolonging the period of excessively low rates. Fiscal Profligacy The federal deficit is expected to reach around $1 trillion this year, around 5% of GDP. There is no precedent for such a large peacetime deficit during the late stage of an economic expansion (Chart 11). And, assuming current policies remain in place, the Congressional Budget Office (CBO) expects the deficit to rise rather than fall over the next few decades given the aging population’s impact on entitlement programs. Chart 11Fiscal Policy Has Become Pro-Cyclical There is no strong support for fiscal discipline in Congress. Neither party has the stomach to tackle the problem of entitlements, those on the right want more spending on defense, while those on the left want more spending on social programs. One should never be surprised that politicians prefer fiscal profligacy to austerity. It is no fun and is injurious to re-election prospects to advocate spending cuts and tax increases. When things start to get of hand, the burden of imposing fiscal discipline falls on the markets. Currently, markets do not appear fazed by fiscal trends. The 10-year Treasury bond yield remains below 3% and the gap between 30- and 10-year yields is low. If markets are worried about government finances, that gap tends to widen as investors demand a fiscal premium to hold longer-duration bonds (Chart 12). Chart 12Bond Investors Unfazed By The Deficit...For Now Presumably, investor complacency about the grim fiscal picture reflects a list of other more important economic and financial concerns that are suppressing yields. There will be a limit to this fiscal tolerance, but we just don’t know exactly where it is. Japan’s gross government debt has exceeded 200% of GDP throughout the past decade without a financial crisis, but that is a poor model for what the U.S. can manage. Japan does not need to borrow from abroad and thus finances its deficits internally. In contrast, the U.S. current account deficit is still running at around $500 billion a year and the country is, by far, the world’s largest international debtor. Yes, the dollar is the international reserve currency of choice and the U.S. receives the exorbitant privilege from that. However, that will not protect the U.S. currency or markets from an eventual loss of investor confidence. I accept that a fiscal-related bond/currency market crisis could be years away, and timing is everything! Nonetheless, the current lack of fiscal discipline does pose a threat to markets because it could limit the authorities’ room to enact stimulus in the next recession. How I Could Be Wrong I have strong convictions about the views I expressed, but that does not mean I will be proved right. Let’s examine some counter arguments. On earnings, my pessimism will be unfounded if the corporate sector manages to keep a tight grip on wages and/or there is a sustained marked improvement in productivity. Of course, we need to exclude subdued wages that arise because of an economic slowdown as that would undermine sales growth. It would be remarkable if the nascent upturn in wage growth suddenly reverses without a renewed rise in unemployment so I would put low odds on that. As far as productivity is concerned, there are lots of interesting innovations these days, but none seem to be game changers within a five-year horizon. Autonomous vehicles will certainly be huge for several sectors but widespread adoption is still some time away. However, it is important to keep an open mind on this and I will certainly change my view if the data improve meaningfully. Turning to monetary policy, I suppose it is possible that the Fed will miraculously calibrate policy to achieve a soft economic landing and maintain financial stability. They have never been able to do this in the past but there is a first time for everything. Needless to say, I am hugely skeptical but time will tell. Finally, on fiscal policy, you would have to be an extreme optimist to believe that politicians will suddenly enact the politically painful measures required to restore order to government finances. The current Administration has shown no signs of fiscal responsibility and the opposition have not raised this as an issue. If anything, there are calls for even more spending. History shows that governments generally skirt to the edge of a severe crisis before they reluctantly embrace austerity. In other words, I do not see much case to be optimistic here. Concluding Thoughts On average, the stock market is more likely to rise than fall. Since 1950, the S&P has recorded monthly gains 60% of the time. In other words, it generally has paid to be bullish. This was particularly true between end-1982 and end-2018 with the S&P 500 delivering above-average compound annual returns of around 11% a year (8% a year in real terms), despite two 50%+ market declines during the period. This was the greatest 36-year period for financial assets in history, driven by falling inflation and interest rates, major corporate restructuring that boosted profit margins, rising equity multiples and a huge expansion in credit growth. Looking ahead, the environment will be very different. Inflation and interest rates are more likely to rise than fall, profit margins will be under pressure, it would imprudent to expect sustained gains in multiples, and broad credit growth will not return to its earlier rapid pace. Thus, future returns will be a pale shadow of the past performance. Against the above background, I don’t think I am being overly pessimistic. However, I understand that many investors do not have the luxury of taking a long-term view. For those who are in a competition to beat their peers, it can be disastrous to stand on the sidelines while the market marches higher. Moreover, if returns are going to be modest by past standards, it puts a premium on market timing, as difficult as that may be. So I do not recommend ignoring the BCA view that equities will outperform bonds and cash this year. My concerns are for the long run. The obvious question is: how should one invest in a world of low returns? I doubt that piling into alternative investments will be the solution as these assets will be affected by the same macro forces as conventional assets. The answer is a rather boring and obvious one. In the absence of being a market-timing and stock/sector-selection genius or investing with such a person, capital preservation has become more important. When returns are low, it takes longer to recover from market losses. This means one should maintain a conservative portfolio bias with higher-than-normal levels of cash.   Martin H. Barnes, Senior Vice President Economic Advisor mbarnes@bcaresearch.com Footnotes 1 EBITD = earnings before interest, taxes and depreciation. This measure best reflects the performance of earnings as it relates to output, wages, prices and productivity.

Highlights We believe 2019 and 2020 will be a tale of two markets; … : The latter stages of the long post-crisis party may be rewarding, but the inflection points that will herald a bear market and a recession are not too far off. … the first will be broadly favorable for investors in risk assets, … : The combination of ample monetary accommodation and the indiscriminate fourth-quarter markdown in risk assets provides the springboard for one last advance. … but the second will mark the end of the post-crisis bull market, … : Nothing lasts forever, and we wouldn’t be overweight risk assets at this stage were it not for last quarter’s selloff. … as the Fed pulls the plug on the expansion: Our base-case scenario does not call for a deep or lengthy recession, but once Fed policy transits from accommodative to restrictive, the going will become much rougher for stocks, corporate bonds and the economy. Feature We spent the week of January 14th meeting with clients in South Africa. It is always good to exchange views with investors, especially when they are at a distant remove from the echo chamber which inevitably colors our perspective, no matter how much we try to resist it. It was also a pleasure to swap a week of winter at home for summer abroad, where our clients’ golf talk helped boil our views down to a simple analogy. We see the next twelve to twenty-four months as a double-breaker putt. 2019-20’s Double Breaker The undulating terrain of some golf-course greens sets up putts that break one way and then the other on their path to the hole. That is the way we view the next twelve-plus months, following the fourth quarter’s sharp, sudden tightening in financial conditions (Chart 1). The selloff pulled hard on the financial-condition reins, checking some of the pressure on the economy to overheat, and allowing the Fed to pause its rate-hiking campaign. Relieved investors immediately bid stocks higher, and corporate-bond spreads tighter, retracing nearly half of the tightening in financial conditions, but we expect the Fed to remain on the sidelines until June anyway. Chart 1A Swift Tightening In Financial Conditions A Fed pause delays the date when monetary policy will turn restrictive by a few months. We see the monetary policy inflection point as the key event presaging all of the inflection points that matter most to investors: the transition from an equity bull market to a bear market; the point at which credit performance deteriorates, and spreads widen, in earnest; and the transition from expansion to recession. The delay, and the lower entry points provided by the selloff, set the stage for a last hurrah in risk assets over the next six to nine months. With the Fed in the background, investors will be able to focus on the above-trend growth driven by the remaining fiscal thrust (Chart 2) and what we expect will be better calendar 2019 S&P 500 earnings than investors currently anticipate. Chart 2Fiscal Fuel Will Keep 2019 Growth Above Trend Better-than-expected conditions will ultimately prove to be self-limiting, however. The more momentum the economy gathers while the Fed is on hold, the more budding inflation pressures will become evident. The more that inflation pressures reveal themselves, the more forcefully the Fed will have to act to counter them. The upshot for investors is that the last burst of the good times will necessarily bring forth a slowdown, and they therefore confront a putt that will break twice over the next year or two: equities and spread product will outperform Treasuries and cash over the first stretch, but underperform over the next.1 Inflation Pressure Our oft-repeated view that the fiscal stimulus will promote inflation pressures is not at all controversial. Force-feeding stimulus into an economy already operating at capacity should lead to inflation. Businesses and other investors, recognizing that the above-trend boost in aggregate demand is temporary and unsustainable, will not expand capacity to meet it. Imports may relieve some of the pressure, but prices should nonetheless rise as aggregate demand exceeds aggregate supply. Inflation pressures emanating from the labor market provoke much more pushback. Investors, tired of hearing that a pickup in wages is right around the corner, harbor considerable doubts about the Phillips Curve, which posits that there is an inverse relationship between the unemployment rate and wage growth. We acknowledge that the 1960s belief in a mechanical tradeoff between inflation and unemployment – policymakers could have lower inflation if they were willing to tolerate higher unemployment, or lower unemployment if they were willing to tolerate higher inflation – was shattered by the stagflation of the 1970s. We further acknowledge that the relationship between unemployment and compensation is not linear. We continue to believe, however, that the laws of supply and demand apply, and that the relationship between compensation and unemployment has been slow to assert itself this time around because the Phillips Curve is kinked. That is to say that the sensitivity of wage growth to a drop in unemployment is a function of the level of the unemployment rate itself. A decline in unemployment from 10% to 9%, 9% to 8%, or 8% to 7% does not exert upward pressure on wages because there are many more qualified candidates than there are openings at such elevated unemployment rates (Chart 3, top panel). When the unemployment rate is 5% or less, on the other hand, wages do respond to unemployment declines because the lack of labor market slack ensures that employers have to compete to attract qualified candidates (Chart 3, bottom panel). Estimates of the United States’ natural rate of unemployment in recent years have typically hovered around 5%. Over the 50-plus years covered by the average hourly earnings (AHE) series, real AHE growth has tended to peak (Chart 4, bottom panel) following unemployment’s sub-natural-rate trough (Chart 4, top panel). It has not yet reached an elevated level, but wages did begin accelerating sharply a year after the unemployment gap turned negative in early 2017. With the unemployment rate on track to continue to fall throughout 2019 (it only takes about 110,000 net new jobs a month to hold it in place), we expect that real AHE growth has further to run. Chart 4Don't Count Dr. Phillips Out Just Yet Taking the analysis a step further to consider real wage growth relative to productivity growth exhibits an even stronger link with the unemployment gap. From the early ‘70s through 2001, when productivity and real wages grew at the same rate (Chart 5, middle panel), real wages fell behind productivity when the unemployment gap was positive and caught up when it was negative (Chart 5, bottom panel). Capital has seized a disproportionate share of the gains in productivity since 2002, with the real-wages-to-productivity ratio able to stabilize only when the unemployment gap turned negative from 2006 to 2008. Chart 5Productivity-Adjusted Real Wages Rise When Unemployment Bottoms We expect that the coming cyclical trough in the unemployment gap will be consistent with past troughs, which have been associated with cyclical peaks in compensation gains. The linkage between compensation and consumer prices isn’t firmly established, but investors don’t have to sweat it. As long as the Fed perceives a connection, which it clearly does, it can be counted upon to respond to higher wages by tightening policy. A swift recovery in oil prices – our Commodity & Energy Strategy service sees Brent crude averaging $80/barrel, and WTI averaging $74, across 2019 – will also help keep the Fed’s attention squarely focused on price stability after ten years of full-employment fixation. Bottom Line: Unnecessary fiscal stimulus will continue to exert upward pressure on prices, while an extremely tight labor market will place steady upward pressure on wages. The Fed will respond by removing accommodation, pushing the fed funds rate above the neutral level, and bringing down the curtain on the record-long expansion sometime in 2020. Upgrading Corporate Bonds We noted two weeks ago that the spread-widening in high-yield corporate bonds was extreme, and that overweighting spread product would mesh well with our renewed equity overweight. Our U.S. Bond Strategy colleagues have since upgraded credit,2 and we are following their lead. We now recommend that investors overweight equities, underweight fixed income and equal-weight cash. Within fixed income, we recommend that investors significantly underweight Treasuries while overweighting both investment-grade and high-yield corporate bonds. Consistent with our above-consensus inflation expectations, we prefer TIPs to nominal Treasuries. We harbor no illusions that a new credit cycle has begun. It is late in an already lengthy cycle, and we view the projected near-term decline in high-yield default rates as a final unwind of the default spike that accompanied the shale-drilling rout in 2016 (Chart 6). We do not expect a recession in 2019, but the next one is likely not too far off, and defaults begin to pick up well ahead of a recession. Our spread-product upgrade is an opportunistic short-term move, not a change in our cyclical view. Chart 6A New Credit Cycle Has Not Begun High-yield spreads widened so much in the fourth quarter, relative to their history, that their capital-gain prospects have flipped. We had been at equal weight, anticipating an eventual move to underweight, because spreads were unusually tight. The capital-gain stretch of the cycle was long gone, and excess returns over Treasuries were limited to coupon spreads that were likely to be eroded by capital losses as spreads widened ahead of an approaching recession. The lurch in spreads from the 25th percentile to the 75th percentile in double-B, B and triple-C bonds (Chart 7) restores potential capital gains as a cushion that should protect the coupon spread against unanticipated economic weakness. Chart 7Irrational Gloom The Fed’s newly conciliatory stance should support spread product just as it should support equities. All three monetary-policy elements of our bond strategists’ peak-spread checklist are issuing the all-clear signal: twelve-month fed funds rate hike projections have collapsed (Chart 8, second panel), gold has revived (Chart 8, third panel), and the dollar’s relentless upward march has finally been halted (Chart 8, bottom panel). Chart 8Monetary Policy Argues For Lower Spreads ... The jury is still out on the global-growth elements of our bond team’s peak-spread checklist. Our China Investment Strategy service’s Market-Based China Growth Indicator looks spry3 (Chart 9, third panel), and industrial mining stocks may be in the midst of bottoming (Chart 9, bottom panel), but the CRB raw industrials index is still scuffling (Chart 9, second panel). A blowout in spreads accompanied by a less-hawkish Fed and rebounding global growth would be a no-brainer reason to own spread product, but two out of three ain’t bad, and spreads would not have blown out in the first place if global growth were poised to surge. The biggest threat to our constructive economic and market views is a slowdown in China, and its uncertain direction is a risk to overweighting credit. On balance, though, we believe the current level of option- and default-adjusted spreads adequately compensate credit investors over the next three to six months, especially after factoring in the Fed’s benign turn. Chart 9... But The Jury's Still Out On Global Growth Bottom Line: We are upgrading spread product to take advantage of its fourth-quarter selloff and a Fed pause that may last until June, despite uncertainty around the global growth outlook.   Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com   Footnotes 1 The wise men and women gathered at the Barron’s annual roundtable foresee a similar setup, but with the direction reversed. They expect markets and the U.S. economy to encounter rough going in the first half of 2019 before conditions become more hospitable in the second half and in 2020, ahead of the next election. “Goodbye to Gloom,” Rublin, Lauren R., Barron’s, January 14, 2019, pp. 21-34. 2 Please see the January 15, 2019 U.S. Bond Strategy Weekly Report, “Buy Corporate Credit,” available at usbs.bcaresearch.com. 3 Please see the November 21, 2018 China Investment Strategy Weekly Report, “Trade Is Not China’s Only Problem,” available at cis.bcaresearch.com.

Special Report

Venezuela’s stability is deteriorating rapidly along the lines of our projections in recent years. Regime failure is at this point a high probability and poses immediate risks to global oil production. Our conviction is high because of the unprecedented combination of internal and external factors working against the regime: Economic collapse: Economic collapse has translated into total social collapse, as indicated by the large-scale emigration from the country (Chart 1). The current mass protests are the largest ever and are gaining momentum, while the opposition movement is coalescing into a single force against the regime as a whole for the first time. Political illegitimacy: What remained of the Maduro administration’s political legitimacy has eroded with his decision to ignore the results of the 2015 election and rig the election of 2018. The President of the National Assembly, Juan Guaidó, has declared himself President of the Republic based on an interpretation of the Venezuelan constitution and his leadership of the democratically elected National Assembly.1 International opposition: The erosion of Maduro’s legitimacy is reinforced by a rapidly changing international environment, with several countries becoming more assertive in opposing the regime. The United States and Colombia, on January 23, formally recognized Guaidó as president. They are joined by Canada and several other Latin American states, including Brazil, which is taking a more confrontational posture under the newly inaugurated President Jair Bolsonaro. This marks a rare coordination of North and South American states in pursuing a harder policy toward Venezuela. U.S. intervention: The United States, in particular, is taking a more interventionist stance through tighter sanctions. Indeed a limited U.S. military intervention is one of our top five geopolitical “Black Swans” for this year. Such an intervention could be further motivated by President Donald Trump’s need to distract from his domestic woes (Chart 2). His weak popular approval is comparable to that of President Ronald Reagan at this stage in Reagan’s first term, when he intervened in the small island state of Grenada. Venezuela is not Grenada, but the U.S. is also not considering outright invasion. Trump is facing a serious risk of becoming a “lame duck” due to the fall in his popularity amid the government shutdown and gridlock in Congress. A foreign policy response to a humanitarian crisis is an obvious way for him to try to increase his influence over the remainder of his term. Moreover, the U.S. diplomatic and defense establishment may agree on the need to reinforce the Monroe Doctrine against anti-democratic politics and growing Chinese (and Russian) influence in Venezuela. Chart 2Trump May Distract From His Woes What remains is to see whether the U.S. adds force (tougher sanctions) to its more aggressive diplomatic posture, and whether the Venezuelan opposition remains mobilized and unified in rejecting anything except a transition to a new government. The U.S. is already considering expanding sanctions, including a likely deathblow that would involve sanctioning Venezuelan oil imports and the export of diluents necessary to process Venezuela’s heavy sour crude. Within Venezuela, the opposition’s momentum and the role of the National Bolivarian Armed Forces will be decisive: so far there are small signs of fracture (Table 1), but no sign of a substantial turn against the Maduro regime.Sufficient popular pressure can create a “tipping point,” however, after which the military and security forces are no longer effective in executing the government’s writ and the socio-political situation declines beyond the ability of the regime to stay in power. Persistent large-scale protests concentrating on Maduro’s departure and/or a split in the security forces could precipitate the final stage of transition to a new interim government in the short to medium term. Table 1Military Insurgencies Have Been Small And Unsuccessful … So Far Impact On The Oil Market In this context, we are raising the likelihood of a collapse of that state to an 80% probability, from our prior assessment (33%). We use the word “collapse” to stand for Venezuela’s production falling to 250k b/d to feed domestic refineries, from ~ 1mm b/d at present. In our simulation of how a collapse could affect oil prices, we make the following assumptions based on recent history – i.e., the run-up to the re-imposition of U.S. sanctions against Iranian oil exports. These assumptions are driven by our prior belief that the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia, which we’ve dubbed OPEC 2.0, and the Trump administration will attempt to hold Brent crude oil prices at or below $80/bbl in the event of a collapse in Venezuela’s oil production. Here are our assumptions: Venezuela collapses next month; OPEC 2.0 responds with a one-month lag, and increases production by 500k b/d in March 2019. If Brent spot prices trade to $85/bbl, OPEC 2.0 raises production an additional 100k b/d. If prices continue to rise toward $100/bbl, OPEC 2.0 adds another 300k b/d to global supply. Further increases lead to the U.S. Strategic Petroleum Reserve (SPR) releasing 100k b/d as needed to reduce Brent prices to $80/bbl or less. If spot Brent prices rise toward $100/bbl, we assume there will be 200k b/d of demand destruction globally. Chart 3 shows how Brent and WTI prices would evolve per these assumptions. Because Venezuela’s production has fallen so much, we believe the collapse of that country’s oil industry can be managed by OPEC 2.0, and, if necessary, via U.S. SPR releases. Of course, a similar trajectory likely would occur in the event Venezuela’s oil industry collapses later.2 Chart 3A Venezuela Collapse Would Trigger OPEC 2.0 and U.S. Supply Responses In our simulation, the Brent spot price trades to $85/bbl in December 2019, and OPEC 2.0 adds an additional 100k b/d to global supply. Prices continue to rise, and we assume OPEC 2.0 member states release a combined 300k b/d in March 2020. The U.S. release 100k b/d of SPR in 2020. In addition, we do see demand destruction of 200k b/d in 2020, as prices reach close to $100/bbl. With all of this, prices are contained and start decreasing in mid-2020. Of course, whether these surges can be maintained indefinitely – i.e., until Venezuela comes back on line, or comparable crude grades can be shipped south from Canada – is an open question. Even so, there is no doubt that the leaders of OPEC 2.0 silenced more than a few critics by means of their 4Q18 production surge. KSA stands out in this regard, taking its November 2018 production over 11mm b/d from ~ 10mm b/d in 1H18 (Table 2). Table 2BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) As a practical matter, we have no way of knowing how OPEC 2.0 or the U.S. SPR would respond to a collapse in Venezuela’s oil industry. In these simulations, we’re making a call on how and when OPEC 2.0 might choose to release its spare capacity once again, as they did in the run-up to the U.S.’s Iran oil export sanctions last year (Chart 4). As the members of OPEC 2.0 – mostly KSA, when it’s all said and done – dig deeper into spare capacity, less is available to meet another unplanned outage – e.g., Libya or Nigeria lose significant barrels to civil unrest. That is, we are sure, a discussion OPEC 2.0 is and will be having among its members, and with the U.S. SPR. The global oil market still is exposed to a sharp loss of Iranian barrels on top of the loss of Venezuela’s supplies in the event that country’s oil industry collapses. This argues strongly for an extension of the waivers granted by the Trump administration in November for anywhere from 90 to 180 days, depending on how the Venezuela situation evolves. These waivers expire at the end of May. This would require us to change our balances assessment, should it occur.   Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com   Footnotes 1 Please see Articles 233, 333, 350 of the Venezuelan constitution. The domestic and international legal debate is beside the point: the effective power of the people, the security forces, and the international community will determine the outcome. 2 For more information on global supply and demand balances, and our most recent oil price forecasts, please see “OPEC Starts Cutting Oil Output; Demand Fears Are Overdone,” published by BCA Research’s Commodity & Energy Strategy today. It is available at ces.bcaresearch.com.  

Dear Client, I will be meeting clients in Europe next week. Instead of our usual weekly bulletin, I will be sending you a Special Report discussing how “The Most Important Trend In The World” – a trend that has been around for thousands of years and accounts for all of the economic growth the world has ever experienced – has recently reversed, and what this means for your investment decisions. This is one report you will not want to miss. Best regards, Peter Berezin, Chief Global Strategist Highlights China’s debt problem is a symptom of a deeper ailment: The country’s excessively high saving rate. While the authorities are taking steps to boost consumption, this is likely to be a drawn-out process. In the meantime, the economy will have to continue recycling savings into fixed-asset investment. Now that credit growth has fallen close to nominal GDP growth, the need to further suppress credit growth has abated. The 6-month credit impulse is already moving higher, and the 12-month impulse should follow suit by the middle of the year. As Chinese growth bottoms out this summer, global growth will start to reaccelerate. This will help boost global cyclical stocks as well as EM shares. Feature Global Growth Worries Weigh On Risk Sentiment Global growth is clearly slowing (Chart 1). Our tactical MacroQuant model, which did an exemplary job of flagging the Q4 selloff in stocks, is flashing amber again, after having turned more constructive in late December (Chart 2). Chart 1Growth Is Slowing   As we discussed last week, the world economy should stabilize by mid-year, paving the way for global equities to rise further from current levels.1 Until then, volatility will remain elevated. Many factors will influence the trajectory of global growth over next 12 months, but perhaps none more important than what happens to China. In this week’s report, we focus on one of the most critical problems facing the Chinese economy – a problem that surprisingly gets very little attention from market participants. China’s Savings Problem Saving is usually considered a virtue. At the individual level, that is certainly true. However, at the economy-wide level, saving can be a vice if it leads to a shortfall of spending, resulting in higher unemployment. This is precisely the problem that China confronts today. Simply put, the country consumes too little of what it produces. The result is a national saving rate of 45% of GDP, higher than any other major economy in the world (Chart 3). Chart 3China Saves A Lot The reasons for China’s high saving rate are long and varied. Just as the Great Depression instilled a sense of thrift among Americans who came of age in the 1930s, memories of the abject poverty that many older Chinese citizens endured during the Cultural Revolution have restrained the desire to spend needlessly. While the younger generation is more willing to live it up, it also faces severe constraints to spending more. The labor market remains challenging, even for those with a university degree. Sky-high property prices require young people to save a large fraction of their incomes in order to have any hope of owning a home. Looking out, there is little reason to expect China’s saving rate to fall rapidly. While the number of people entering retirement is steadily increasing, the share of the population in their prime savings years – ages 30-to-59 – has yet to peak (Chart 4). Chart 4China: Share Of Population In Its High Savings Years Has Yet To Peak In addition, an increasingly skewed male-female sex ratio has created an "arms race" of sorts among Chinese bachelors hoping to accumulate enough wealth to find a bride. One academic study concluded that this factor accounts for half of the increase in the household saving rate since the late-1970s.2 Unfortunately, China’s gender imbalance is only likely to worsen, given that the ratio of men between the ages of 25-and-39 and women between the ages of 20-and-34 – a proxy for gender imbalances in the marriage market – is projected to rise from 1.06 in 2011 to 1.34 by the middle of the next decade (Chart 5). Chart 5Not Enough Chinese Brides What To Do With Excess Savings? By definition, a country’s savings are either recycled into domestic investment or exported abroad via a current account surplus. The latter strategy served China well in the years leading up to the Great Recession, when the country’s current account surplus reached a whopping 10% of GDP (Chart 6). Just like Germany today, China was able to export its excess production with the help of a highly undervalued currency. Chart 6China: No Longer Exporting Savings Abroad Unfortunately for China, as its economy has grown in relation to the rest of the world, running massive trade surpluses has become more difficult. This is especially true today, when the country is being singled out by the Trump administration and much of the international community for alleged unfair trade practices. As China’s ability to churn out large current account surpluses declined, the government moved to Plan B: propping up growth by recycling the country’s copious savings into fixed-asset investment (see Box 1). This process saw households park their savings in banks and other financial institutions which, in turn, lent the money out to companies and local governments in order to finance various investment projects. Not surprisingly, debt levels exploded (Chart 7). Chart 7China: From Exporting Savings To Investing Domestically (And Building Up Debt) This strategy was feasible when China did not have a lot of debt and needed more factories, housing, and public infrastructure. But those days are long gone. The rate of return on assets among state-owned enterprises has now fallen below their borrowing costs (Chart 8). Our EM team estimates that 15%-to-20% of apartments in China are sitting vacant.3 Chart 8Rate Of Return On Assets Below Borrowing Costs For Chinese SOEs How To Boost Consumption There is only one long-term solution to China’s excess savings problem: Tackle it head-on by taking steps to increase consumption. The good news is that there is some scope to do so. The Chinese income tax structure is fairly regressive. Poor households face an effective income tax rate exceeding 40%. This is well above OECD norms (Chart 9). A more progressive tax system would boost spending among poorer households. It would also curb inequality, which has increased sharply since the 1980s (Chart 10). The saving rate among the richest 10% of Chinese earners is close to 50%. Policies that shift income from the rich to the poor would reduce overall household savings. Chart 10China: Inequality Has Risen In The Past Two Decades As a share of GDP, public-sector spending in China on education, health care, and pensions is close to half of the OECD average (Chart 11). If the government were to finance the increase in social spending by running larger budget deficits, this would help reduce overall national savings both by increasing the budget deficit and by discouraging precautionary household savings. Unlike in most countries, the poor in China are net savers, largely because they cannot rely on a publicly-funded social safety net (Chart 12). Recent tax changes, including an increase in the threshold at which income begins to be taxed and an expansion of deductions for childhood education, medical costs, and home loan interest and rent, are steps in the right direction. More Financial Repression? Over a longer-term horizon, the Chinese authorities are also likely to step up efforts to discourage savings by driving down real interest rates into negative territory. Since nominal interest rates are already low in China, the only way to reduce real rates is to raise inflation. The added benefit of higher inflation is that it would boost nominal GDP growth, thus putting downward pressure on the debt-to-GDP ratio. The catch is that negative real rates could destabilize the currency, fueling capital outflows. Negative real rates could also inflate asset bubbles, especially in the property market. The only way to square the circle is to tighten administrative controls, such as those relating to property speculation and capital flows, in order to preserve the benefits of negative real rates, while attenuating the costs. This suggests that hopes that the RMB will become an international reserve currency anytime soon are likely to be dashed. China Will Continue To Back Off From Its Deleveraging Campaign Realistically, the measures to boost consumption listed above will take time to implement. In the meantime, China’s economy continues to slow. Not only does a weaker economy endanger domestic stability, it also puts the Chinese government in a weaker negotiating position with the Trump administration over trade matters. This suggests that the government will continue to ease off its deleveraging campaign at least until growth recovers. Granted, one could have said the same thing last year. That is correct, but here is the thing: last year, credit growth was running at a much faster pace than today. Total social financing increased by only 11% year-over-year in December, not much higher than trend nominal GDP growth. On all three occasions over the past ten years when credit growth has fallen back towards nominal GDP growth, the government has allowed credit growth to accelerate (Chart 13). Chart 13China: Credit Growth Versus GDP Growth We do not expect growth to surge this time around. However, if monthly credit growth simply stabilizes at current levels, the credit impulse, which is just the change in credit growth, will turn positive. Chart 14 shows that the 6-month impulse is already moving higher. The 12-month impulse is still trending down, but if credit growth remains constant at its current pace, it will start hooking up this summer (Chart 15). Chart 14Rebound In Chinese 6-Month Credit Impulse Bodes Well For Metals   Chart 15The 12-Month Credit Impulse Will Turn Up If Monthly Credit Growth Even Merely Stabilizes Importantly, the Li Keqiang index, a broad real-time measure of economic growth in China, is highly correlated with the 12-month credit impulse. As Chinese growth bottoms out this summer, global growth will start to reaccelerate. This will help boost global cyclical stocks as well as EM shares. My colleague, Arthur Budaghyan, BCA’s chief emerging markets strategist, remains bearish on EM equities in both relative and absolute terms. While this publication does not have a strong view on the relative performance of EM versus DM shares, we do expect EM stocks to rise in absolute terms over the remainder of the year. Accordingly, we sold our March-2019 EEM put on January 3rd for a gain of 104%, and are now outright long the ETF as one of our recommended trades. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com   BOX 1 Do Banks Create Money Out Of “Thin Air”? Strictly speaking, banks can create deposits by issuing new loans without the need for economic savings (which economists define as the difference between what an economy produces and consumes). In that sense, banks can create money out of “thin air.” However, this does not mean, as is sometimes claimed, that economic savings are irrelevant to credit creation or that there is no effective limit on the volume of loans that banks can originate. Even if one ignores the presence of legal capital requirements, the public must still be willing to hold whatever deposits banks create. Just like the number of apples a society wishes to consume is simultaneously determined by the number of apples farmers wish to produce and the number of apples people wish to eat (with the price of apples equilibrating supply and demand), the answer to the question of whether loans create deposits or deposits create loans is always “both.” The aggregate volume of deposits that people wish to hold depends, among other things, on the level and distribution of net worth across society, as well as the rate of return that bank deposits offer compared to competing financial instruments (including cash, which pays nothing). A country’s net worth tends to be closely correlated with the value of its capital stock. Both are mainly determined by accumulated economic savings. Real interest rates are also largely determined by economic savings, especially at the global level, where rates adjust to ensure that world savings equals investment. The distribution of savings also matters. When some people wish to spend more than they earn, while others wish to do the opposite, debt levels will rise. The same is true for individual sectors of the economy. If there are some sectors that save a lot (such as households in China) and other sectors that borrow a lot (Chinese state-owned companies and local governments), debt levels will go up. Debt levels will also rise when people purchase assets using credit. Fresh economic savings are not necessary to finance the purchase of existing assets, but with the exception of undeveloped land and natural resources, economic savings are needed to create those assets (such as when a home is constructed or a factory is built). In China, a perfect trifecta of sky-high property prices, a high and uneven distribution of savings throughout the economy, and a financial sector that has been willing to intermediate savings without much regard for credit quality, have all contributed to the elevated debt levels we see today. Footnotes 1      Please see Global Investment Strategy Weekly Report, "Patient Jay," dated January 18, 2019. 2      Shang-Jin Wei and Xiao Zhang, "The Competitive Saving Motive: Evidence From Rising Sex Ratios And Savings Rates In China," Journal of Political Economy, Vol. 119, No. 3, 2011. 3      Please see Emerging Markets Strategy Special Report, “China Real Estate: A Never-Bursting Bubble?” dated April 6, 2018. Strategy & Market Trends MacroQuant Model And Current Subjective Scores Tactical Trades Strategic Recommendations Closed Trades

Highlights The Eurostoxx600’s short bursts of outperformance require either global technology to underperform or the euro to underperform. EM’s short bursts of outperformance usually coincide with the global healthcare sector’s short bursts of underperformance. Remain tactically overweight to Europe and EM, but expect to reverse position later in the year. The ECB is justified in setting an accommodative monetary policy, but it is not justified in setting an ultra-accommodative monetary policy. Soft inflation prints will cap the extent to which bond yields can rise in the near term. Italian BTPs are an attractive long-term proposition, especially relative to other euro area bonds. Feature Chart of the WeekEuro Area Inflation Appears To Be Underperforming... ...But Adjusted For Its 'Negative Space' It Is Not     “The music is not in the notes, but in the silence between”  – Wolfgang Amadeus Mozart As Mozart pointed out, true awareness lies not in appreciating what is there, but in appreciating what is not there. This is the concept of ‘negative space’: to understand an object, you have to understand the empty space that defines it. This week’s report extends the concept of negative space into the fields of investment and economics to make more sense of Europe’s recent past and its future. The Negative Space In Stock Markets Picking stock markets is a relative game. This means that what a stock market does not contain – its negative space – is often more important than what it does contain (Table I-1). This is not an abstract proposition, it is a mathematical truth. When a major global sector is strongly outperforming, a stock market’s zero or near-zero exposure to that sector will create a strong headwind to relative performance. And when the major sector is underperforming, its absence in the stock market will necessarily create a strong tailwind to relative performance. For the European stock market, the negative space is technology, a sector in which European equities have a near-zero exposure. But there is another factor to consider: the currency. The technology sector’s global profits are mostly translated into shares quoted in dollars, while European equities’ global profits are mostly translated into shares quoted in euros. It follows that the Eurostoxx600’s short bursts of outperformance require at least one of the following two conditions (Chart I-2): Chart I-2The Eurostoxx600 Usually Outperforms When Technology Underperforms Technology to underperform. Or: The euro to underperform. For emerging market (EM) equities, the negative space is healthcare, a sector in which EM has a near-zero exposure. Therefore unsurprisingly, EM’s short bursts of outperformance usually coincide with the healthcare sector’s short bursts of underperformance (Chart I-3). Sceptics will raise an obvious question: what is the cause and what is the effect? The answer is that sometimes EM is the driver of healthcare relative performance, and at other times vice-versa. Chart I-3EM Usually Outperforms When Healthcare Underperforms A sharp slowdown emanating from emerging economies would undoubtedly drag down global equities. In the ensuing bear market, the more defensive healthcare sector would almost certainly outperform the financials. Under these circumstances the direction of causality would clearly be from EM to healthcare’s relative performance. On the other hand, absent a major bear market, in a common or garden reassessment of sector relative valuations versus their growth prospects, the causality would run in the other direction: sector rotation would drive the relative performance of equity markets: healthcare’s underperformance would help EM to outperform; and technology’s underperformance would help European equities to outperform. As we have explained in recent reports, the major sectors – and therefore the major stock markets – are now in this latter configuration in a brief countertrend burst before reverting to their structural trends later this year (Chart I-4 and Chart I-5). So for the time being, remain tactically overweight to Europe and to EM.1 Chart I-4The Eurostoxx600 Outperformance Is A Countertrend Burst Chart I-5The EM Outperformance Is A Countertrend Burst The Negative Space In European Inflation And Unemployment On the face of it, inflation is structurally underperforming in the euro area versus the U.S. But on closer examination this is only because of what the euro area harmonised index of consumer prices (HICP) does not contain: owner occupied housing costs – which tend to rise faster than other items in the price basket. Adjusting for this negative space in the HICP, the euro area and the U.S. have both achieved the exact same modest structural inflation, which their central banks define as ‘price stability’ (Chart of the Week).   In a similar vein, the unemployment rate disregards changes in the labour participation rate. When people join the labour force – as they are in their tens of millions in Europe (Chart I-6) – the joining cohort tends to have a slightly higher unemployment rate given its inexperience in the formal labour market. So the joiners tend to lift the overall unemployment rate too. The paradox is that the percentage of the working age (15-74) population in employment also rises at the same time. Looking at this alternative measure of labour market health, the euro area employment market is in a structural uptrend and much healthier than it was at the peak of the last cycle in 2008 (Chart I-7). Chart I-6Europeans Are Joining The Labour Force In Their Tens Of Millions   Chart I-7The European Employment To Population Ratio Is In A Structural Uptrend Hence, once we adjust for what is missing in euro area inflation and the euro area unemployment rate, neither inflation nor employment market performance appear to be too cold or too hot. This means that the ECB is justified in setting an accommodative monetary policy, but it is not justified in setting an ultra-accommodative monetary policy. The Negative Space In Monetary Policy The negative space in monetary policy is literally the negative space, by which we mean that interest rates cannot go deeply into negative territory. With the deposit rate already at -0.4 percent, the ECB’s room for manoeuvre in the dovish direction is limited. On the other hand, neither can monetary policy get meaningfully hawkish in the near term. The simple reason is that the ECB, like other central banks, is now even more wedded to ‘data-dependency’. The problem with this is that the data on which the central banks depend is always backward-looking. So policy will reflect what was happening one or two months ago, rather than what is happening now. Specifically, the plunge in the price of crude oil will depress both headline and core inflation rates (Chart I-8). And the recent wobble in risk-asset prices has weighed down some sentiment surveys (Chart I-9). Having promised to be data-dependent, the central banks have effectively created ‘an algorithm’ for their policy setting, an algorithm which everyone can see and read. It follows that the data, especially soft inflation prints, will cap the extent to which bond yields can rise in the near term. Chart I-8The Plunge In The Price Of Crude Will Subdue Inflation Chart I-9The Stock Market Sell-Off Hurt Sentiment However, core euro area bonds are an unattractive long-term proposition. When yields are so close to their lower bound, there is little scope for a capital gain, even in a crisis. Whereas the scope for a capital loss is considerably greater. By contrast, Italian BTPs are an attractive long-term proposition, especially relative to other euro area bonds. Almost all of the 2.75 percent yield on 10-year BTPs is a premium for euro break-up risk. Yet the populists in Italy do not want to break up the euro. And despite their rhetoric, neither do the populists in the core countries. To understand why, we must explain the negative space of ECB QE. When the ECB bought BTPs from Italian investors, what the Italian investors did not do was deposit the cash in Italian banks. Instead, they deposited it in German banks – something that we can see very clearly in the euro area’s mirror-image Target2 imbalances (Chart I-10). Chart I-10ECB QE Has Exacerbated The Target2 Imbalances In effect, the core countries, through their equity in the Eurosystem, are holding a huge quantity of Italy’s €2.7 trillion of BTPs. Meaning that if the euro broke up, the core countries would be the ones picking up the tab. For the euro area’s future, this is the most important negative space of all. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System* There are no new trades this week. But all four of our open trades – long PKR/INR, industrials versus utilities, litecoin and ethereum, and MIB versus Eurostoxx – are in profit. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. The post-June 9, 2016 fractal trading model rules are: 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 Footnotes 1 Please see the European Investment Strategy Weekly Report, “Why 2019 Is The Mirror-Image Of 2018”, dated January 10, 2019, available at eis.bcaresearch.com. Fractal Trading Model Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades 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

Special Report

Highlights So What? It is too soon to adopt a cyclical overweight position on Chinese equities. Remain overweight only tactically. Why? China is still maintaining a disciplined approach to economic stimulus. The US-China trade talks are making tentative progress, but there is still a 30% chance of tariff rate hikes this year. The House Democrats show that the US’s tougher approach to China is a bipartisan policy consensus. Feature China released preliminary 2018 GDP data on January 21. The annual real growth rate was recorded at 6.6%, a fall from the 6.9% of 2017, although the latter has now been revised down to 6.8% (Chart 1). The big picture in 2018 is the slowest credit growth on record, the slowest retail sales growth since 2003, the weakest manufacturing output since 2014, and a negative export shock due to trade war (Chart 2). Chart 1China’s Slowdown In Perspective Chart 2A Rocky Road For Beijing The immediate question for investors in 2019 is whether the downside risk has become so pressing that President Xi will shift the policy gear from growth stabilization to total reflation. So far the evidence suggests that the policy stance has not changed from last July. Official rhetoric continues to eschew opening the stimulus floodgates. This disciplined approach is clear when examining the most recent reflationary actions: Fiscal Easing: Local governments are allowed to start issuing 1.39 trillion RMB in new bonds from the beginning of the year, rather than waiting until April or May like usual (Chart 3). This will create a substantial new fiscal boost in the first half of the year that could help stabilize the economy in the second half.1 This 1.39 trillion RMB is not the full-year quota (last year’s was 2.18 trillion RMB). If the government had wanted to create a “big bang” effect, it would have announced a very large new quota for the full year all at once – something approaching 3.4 trillion RMB. This is what the year’s total would be if new issuance grew at the average 55% growth rate since 2015 (Chart 4). But so far the government is focusing on “frontloading” rather than “expanding” the amount of new bonds allowed to be issued. The full-year quota is important to watch in March. Anything above 2.9 trillion RMB would mean a looser fiscal stance from last year. Otherwise, fiscal easing is focusing on tax cuts for households, small businesses, and consumers rather than new loans to SOEs as in the past. The new tax cuts in 2019, for small and medium-sized enterprises (SMEs), amount to about 200 billion RMB, according to government statements. This comes on top of a 1.3 trillion RMB tax cut that took effect at the end of last year. Therefore the minimum tax relief in 2019 is 1.5 trillion RMB or 2% of GDP. The impact is positive for consumer demand but unlikely to produce a rapid V-shaped turnaround in the growth rate, as was once the case with huge bursts of new loans to the corporate sector. Finally, depending on monetary policy, increases to fiscal spending will mostly serve to offset weak credit growth and the resulting drag on economic activity. Monetary Easing: The People’s Bank of China is, on balance, injecting liquidity into the system (net negative sterilization). Injections via the medium-term lending facility are also growing (Chart 5). However, the interbank rate had increased recently, so that recent central bank injections are mostly maintaining the easy conditions of H2 2018 (Chart 6). The extraordinary liquidity injections of January are preemptive attempts to ensure ample liquidity ahead of the Lunar New Year, when funds are tight. Chart 5PBoC Remains Supportive Chart 6Interbank Rates Pushed Back Down   Cuts in banks’ required reserve ratios (RRRs) have not yet triggered a clear revival in credit growth. The twelve-month credit impulse has not yet bottomed, even though broad money impulses are positive or moving into positive territory (Chart 7). Shadow financing remains weak. Regulatory tightening is suppressing non-bank lenders while private business sentiment remains troubled (Chart 8). Chart 7No Clear Bottom In Credit Impulse Yet Chart 8Shadow Financing Still Under Pressure​​​​​​​ Once the credit impulse bottoms and turns upward, there will likely be a 6-9 month lag before it lifts overall economic activity. In March at the National People’s Congress session, Premier Li Keqiang is expected to set the official GDP growth target at a range of 6%-6.5% for 2019, lower than 2018’s “around 6.5%.” Several of China’s provinces are downgrading their growth targets for this year (Chart 9). The various stimulus measures are apparently seen as limiting downside risks rather than creating a new upside risk. ​​​​​​​ As a result of the policy easing that is taking place, our Global Investment Strategy expects Chinese growth to stabilize and global growth to recover after H1.2 Bottom Line: The clear implication is that the Xi administration remains disciplined in its use of macroeconomic tools to ease fiscal and monetary conditions. We have not yet seen a “whatever it takes” moment. Nevertheless, the accumulation of easing measures suggests that the economy could stabilize by mid-year. A Sign Of Progress In The Trade Talks The most likely basis for a “whatever it takes” moment is either a sudden and sharp deterioration in the economy despite the various easing measures, or a renewed escalation of the trade war. For the moment we will assume that the economy will respond to stimulus measures, albeit with a lag, which would be conducive to a bottoming in mid-2019. In this case, what is the likelihood that the trade war will escalate again, with President Trump increasing the Section 301 tariffs from their current level of 10% on $200 billion worth of imports? We maintain that the odds of the two sides agreeing to a framework trade deal by the March 1 negotiation deadline are about 45%. We upgraded the odds of a deal in December given the tariff ceasefire reached on December 1. Since then the news flow has generally suggested that the two sides are making progress in the 90-day talks: a US delegation in Beijing went into an extra day of talks, and was attended by Vice Premier Liu He, the top economics adviser of President Xi Jinping. However, given the difficulty of the negotiations – the thorny issues like forced tech transfer – we also give 25% odds to an extension of negotiations, prolonging the tariff ceasefire beyond March 1. This adds up to a 70% chance that tariffs will not increase this year. The remaining 30% is the chance that the trade war escalates again (Table 1). Table 1Updated Trade War Probabilities​​​​​​​ The key question going forward: How pragmatic are Donald Trump and Xi Jinping? We have evidence that President Trump is pragmatic. He rapidly shifted his approach to Iran, by issuing the waivers on oil sanctions in November, and to China, by agreeing to the tariff ceasefire. He softened his stance to avoid an oil price shock and equity bear market in Q4 last year. Equity bear markets tend to coincide with recessions (Chart 10). And a recession would dramatically reduce Trump’s chances of reelection in November 2020 (Chart 11). Hence Trump is pushing for a short-term trade deal. He is now reportedly even considering a rollback of some tariffs in return for Chinese concessions.3   Chart 11… And Presidents Lose Reelection Amid Recession What about Xi? We have argued that Xi is somewhat pragmatic – at least, more so than the consensus holds. It is undeniable that Xi is a hardliner who has reasserted his personal control, and Communist Party dominance, to a degree not seen in recent memory. He is also aggressive on foreign policy, unlike his predecessors. These trends are deeply concerning both for China’s governance and for relations with the West. They help to support our view that US-China relations are worsening on a secular basis. Nevertheless, as things currently stand, the weak domestic economy and negative sentiment seem to be encouraging Xi to play for time – which is, after all, the traditional Chinese play in trade tensions with the United States. His administration has offered a handful of concessions – on soybeans, auto tariffs, and goods imports – in order to push the negotiations along. The most important potential concession, however, is the new draft law on foreign investment. This is the one concession so far that addresses the US’s structural demands on technology transfer and intellectual property (the grievances that motivate the tariffs). China has one of the most restrictive environments for foreign investment in the world (Chart 12) and this is one of the US’s chief complaints: both because of the inherent denial of market access and because FDI restrictions are used as leverage to extract technology. The National People’s Congress released a new draft law on December 26, 2018, updating a draft law issued by the Ministry of Commerce in 2015 that was never passed.4 An extraordinary meeting of the Standing Committee occurred in January to speed this draft along. The law would ostensibly: Protect intellectual property rights of foreign firms; Prohibit forced technology transfers – including by replacing earlier laws that required companies to operate as “joint ventures,” often exposing them to forced tech transfer. Grant equal treatment to foreign-invested enterprises within China, compared to state-owned and state-controlled enterprises; Implement a negative investment list so that foreign investors could assume that they are free to invest in areas not explicitly proscribed; Allow foreign firms to raise funds, including through initial public offerings on China’s domestic equity market. This law confirms our view that the 90-day negotiation period is tied to the Trump administration’s emphasis on the implementation of any agreements: in early March, China’s National People’s Congress can enact new laws that will ostensibly address US concerns and thus put its concessions in ink. On paper this law would go some way in assuaging US and other foreign investor concerns. However, without a strong central government commitment to enforce the law, it is doubtful that it would reduce the trade and investment practices in China that offend the United States. After all, China’s methods of tech transfer and IP theft are mostly executive rather than legislative in nature – they stem from positive actions by central and local governments, and state-controlled companies, rather than from gaps or loopholes in the legal framework. Even taking the law at face value, its implementation – which is slated for a period of no fewer than five years – could be a mixed blessing for foreign investors.5 For instance, companies with a small foreign ownership stake will now be qualified as foreign-invested companies, which could bring difficulties if the new law is not implemented fairly or in good faith. Many foreign-invested enterprises would have to restructure their ownership and operations in order to fit into the new foreign investment framework (e.g. variable interest enterprises). While foreign enterprises are supposed to receive equal treatment even in government procurement, it is not clear whether they will in the quasi-government sector. Expropriation of foreign assets may still be justified very broadly. The law could also be used as a substitute for lifting the caps on foreign equity ownership in enterprises and for resolving problems with intellectual property licensing and payment of royalties. Moreover, the law is likely to enshrine a tougher regime for national security risk reviews. The US has tightened scrutiny of Chinese investments through the Foreign Investment Risk Review Modernization Act (FIRRMA) over the past year, and China may wish to toughen its own stance. Ultimately China does not need a law to strike down foreign investments that it believes jeopardize national security, but the law could provide justification for retaliation when the US strikes down Chinese investment on similar grounds. Nevertheless, in general, this law is an example of the kind of concession that is necessary for Trump to save face if he is determined to agree to a short-term framework trade deal to help prevent a bear market. Will the US accept this new law as a substantial concession, worthy of rolling back tariffs? So far the feedback is not encouraging. The chief US negotiator, Trade Representative Robert Lighthizer, has reportedly told Senator Chuck Grassley that China has not made any “structural” concessions yet – which suggests that Lighthizer is not impressed by the mere rubber-stamping of a new law.6 Much will depend on the next round of negotiations, dated January 30-31, when Vice Premier Liu He will come to DC for the first time since his humiliation in May last year. At that time he negotiated a deal and the US and China released a joint statement, only to have Trump renege on it three days later. He would not be going back to the US if there were not a substantial commitment on both sides to seek progress. Ultimately Trump, not Lighthizer, will determine whether to pause or roll back the tariff rates. Trump may decide he needs a deal and therefore accept the new law as a sufficient concession. He would still have the possibility of disputing its implementation (or lack thereof) at a later date – for instance, just before the 2020 election. The durability of any framework deal will be measured in the irreversibility of China’s concessions and the extent to which Trump moderates the tariffs. At least some rollback would seem necessary to reciprocate China’s concessions if a framework deal is to be done. The tariffs were imposed in separate tranches with adjustable rates, so Trump can reduce the tariffs in various ways. Bottom Line: There is room for a short-term, tactical trade deal that allows for some tariff rollback, given that China is tentatively making concessions on core US demands. Talks could also be extended, with tariff rates remaining at their current levels. These two possibilities mean that a hike in tariff rates is not the likeliest scenario for most of 2019. However, the new law on foreign investment only tentatively answers what the US is really demanding. We continue to believe that US-China relations are getting worse on a secular basis and that improvements will be tactical (or at best cyclical) in nature. Democrats Are Not Pro-China One of the main reasons for thinking that Xi may offer short-term concessions to get a deal with Trump is also one of the main reasons for thinking that long-term concessions are out of reach: there is an across-the-board policy consensus taking shape in Washington demanding tougher policy on China. We have emphasized that this policy consensus is apparent not only from Trump’s election – as an avowed protectionist and China-basher within the Republican Party – but also from the hardening position of the US defense establishment, and the disillusionment of the corporate lobby, over the past decade (Chart 13). ​​​​​​​ It is also a bipartisan consensus in Congress. For instance, last year, the House draft of the aforementioned FIRRMA Act, tightening foreign investment scrutiny on China, passed by a 398-vote margin in June. The final version passed by a large margin in the House (359-54) and Senate (87-10) in the form of the John S. McCain Defense Authorization Act. The Taiwan Travel Act and the Asia Reassurance Initiative Act, which offended Beijing, both passed with unanimous consent in the Senate (and voice vote in the House). Now the new Democrat majority in the House is confirming that tougher rules on China are something that everyone can agree on. For example, the new Chairman of the House Ways and Means Committee, Representative Richard Neal (D, MA), has struck a hawkish tone on the 90-day trade talks. He has warned that the US Trade Representative has “an obligation to look beyond the political pressures of the moment and the easy, one-off transactions, and secure real and lasting change to China’s anti-competitive behavior.”7 Furthermore, Senator Chris Van Hollen (D, MD) and Representative Ruben Gallego (D, AZ) have joined with Republicans Tom Cotton (R, AR) and Mike Gallagher (R, WI) to propose legislation that would give “the death penalty” to Chinese tech companies such as Huawei and ZTE if they violate US sanctions laws or export controls.8 This is an extremely aggressive piece of legislation that President Trump will have to contain if he is to keep a deal with President Xi. This bipartisan effort should come as no surprise. The Democrats were the more skeptical party about both global free trade and China in recent decades. This is because they positioned themselves as the defenders of workers, wages, and manufacturing, notably in the Midwestern Rustbelt States. Democrats have also always criticized China’s human rights record, with President Bill Clinton famously calling China’s leaders “the Butchers of Beijing” during the 1992 presidential campaign (Chart 14). In the post-Cold War context, this protectionist strain was subdued as the free market consensus prevailed across the political spectrum. It was President Clinton who negotiated for China to enter the World Trade Organization – despite the opposition of many within his party, including current House Speaker Nancy Pelosi – in order to smooth the process of globalization underway. This context began to change after the Great Recession, as the US debt supercycle ended, China emerged as a major competitor, and the Barack Obama administration attempted to develop a Democrat response to new challenges. President Obama supported “Buy America” provisions in the crisis-era stimulus package and engaged in tit-for-tat tariffs with China. The Trans-Pacific Partnership (TPP) multilateral trade deal deliberately excluded China, particularly if it could not embrace the liberal reforms, and trade and cyber-security standards, included in the TPP’s provisions. Finally, President Obama and Secretary of State Hillary Clinton initiated the “Pivot to Asia,” an attempt to reduce US military commitments in the Middle East and reposition for a long-term strategic competition with China in the Asia Pacific. The Trump administration has continued the pivot to Asia in all but the TPP. Trump reportedly even considered naming Jim Webb, a Democratic former navy secretary and China hawk, as his new Secretary of Defense, to replace Secretary James Mattis. But the new policy consensus is best encapsulated by Mattis’s interim replacement, Pat Shanahan, who began his job as acting Defense Secretary this month by telling his staff to focus on “China, China, China.”9 Trump is now considering keeping Shanahan for a “long time.” Now, with Democrats coming back into power in the House, it is becoming even clearer that China faces hawkish trade policies from the Left as well as the Right. This has important implications. In the short term, this process suggests that President Xi may be incentivized to offer some concessions to President Trump, who wants to protect the business cycle and position himself as a successful dealmaker before 2020, rather than stonewalling and fueling the rise of the new anti-China consensus. In the long term, however, this process also suggests that Xi is unlikely to offer deep structural concessions, given that either Trump or a new Democratic administration could ultimately reject the terms of the deal. After all, if the stock market avoids a bear market and the economy strengthens, Trump could turn his back on the deal. In particular, the fired-up US economy is likely to widen the deficit, forcing Trump to give an explanation on the campaign trail (Chart 15).10 But if the economy goes into recession, Trump may have no other policy option to rally voters other than aggressive foreign policy – which could mean aggressive trade policy against China. Chart 15Trump Will Have To Explain This In 2020​​​​​​​ Subsequent to 2020, Trump will either have a renewed election mandate to pursue trade war – in which he is less vulnerable to recession timing – or a new Democratic administration will pick up where President Obama left off, with the Pivot to Asia … including the TPP and other multilateral initiatives. It is also entirely likely that the US and China could adhere to a framework trade deal and yet heighten their strategic standoff in other areas. First, the US is making progress in forming a coalition of nations against Huawei’s participation in 5G networks – China’s relations with Canada are deteriorating rapidly and now Germany, a critical swing player, is even considering a ban on Huawei.11 Second, Taiwan and the South China Sea could see more saber-rattling or incidents even as trade tensions stagnate. (North Korean diplomacy, by contrast, is continuing to progress as long as the US-China trade talks are progressing – Trump and Kim Jong Un are set to hold a second summit in late February.) Bottom Line: The “anti-China” turn in US policy is not limited to Trump. Rather, Trump was the catalyst for a new policy consensus that was already emerging in the Obama years. Democrats will likely take a tough stance on China trade, including pressuring Trump if he strikes a deal with Xi Jinping, in order to woo voters in the Midwest. Any future Democratic White House should be expected to continue pressing China on issues ranging from national security to cyber-security to human rights, while likely pursuing a more multilateral diplomatic approach than the current White House. Investment Implications BCA’s Geopolitical Strategy is tactically overweight Chinese equities ex-tech relative to emerging markets. We are closing our short China-exposed US companies relative to the S&P 500 for a gain of 1.7%. Meanwhile China Investment Strategy is tactically overweight Chinese equities relative to the MSCI World index. Tariffs remaining at their current level now appears to be the most likely scenario for this year. Holding all else constant, this scenario is positive for Chinese growth and China-related assets. But beyond a near-term pop for financial markets, we still need to see hard evidence that the accumulation of China’s easing measures will indeed stabilize its domestic economy. This suggests that it is too soon to give the “all clear” sign from a cyclical perspective. On the other hand, a verified failure of the current, substantive US-China attempt to negotiate a truce would have a deeper negative impact on sentiment and trade than the original outbreak of trade war in 2018, as there will no longer be a basis for optimism. The market will have to price an ultimate 25% tariff on $500 billion worth of goods. This will likely cause the CNY-USD exchange rate to plummet (Chart 16). This would, at least at first, send a deflationary impact across emerging markets and the world, causing another negative hit to global trade and hence a flight to quality. Chart 16A Trade War Escalation Will Send The Yuan Reeling​​​​​​​ The PBoC would most likely have to stage a defense of the currency while the State Council, judging by its actions in July 2018, would likely launch a large stimulus package of the sort that it has thus far avoided for fear of credit excesses. This would come at the cost of a still larger debt burden and misallocation of capital – undoing overnight the work that President Xi has put into mitigating these structural imbalances – but it would prevent a precipitous slowdown for the time being. A trade war-induced stimulus would ostensibly help reaccelerate the Chinese economy and global growth, but in our view financial markets would not respond all that happily to such a huge dose of volatility, trade uncertainty, and policy uncertainty at a time when the cycle will be very late anyway. The risk premium would go up sharply, at least for a time, raising the odds of a very sizeable earnings contraction before the economy begins to recover.   Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 Please see BCA Emerging Markets Strategy Weekly Report, “Dissecting China’s Stimulus,” January 17, 2019, available at www.bcaresearch.com. 2 Please see BCA Global Investment Strategy Weekly Report, “Patient Jay,” January 18, 2019, and “Low Odds Of An FCI Doom Loop,” January 4, 2019, available at www.bcaresearch.com. 3 Please see Steve Holland, Tom Brown, and Leslie Adler, “Trump says deal ‘could very well happen’ with China,” Reuters, January 19, 2019, available at af.reuters.com. 4 Please see “Foreign Investment Law of the People’s Republic of China (Draft) for comments,” National People’s Congress of the People’s Republic of China, December 26, 2018, available at www.npc.gov.cn. See also “Public Comments Sought on the Foreign Investment Law of the People’s Republic of China,” Ministry of Commerce, January 19, 2015, available at www.troutman.com. 5 Please see Lester Ross, Kenneth Zhou, and Tingting Liu, “China Rolls Out New Draft Foreign Investment Law,” January 10, 2019, available at www.wilmerhale.com. See also Manuel Torres and Diego D’Alma, “China Publishes New Draft Of Foreign Investment Law,” Garrigues, Commentary: Corporate China, January 17, 2019, available at www.garrigues.com. 6 Please see Humeyra Pamuk, “U.S. trade chief saw no progress on key issues in China talks: Senator,” Reuters, January 15, 2019, available at www.reuters.com. 7 Please see James Politi, “Washington’s China hawks fear Trump will yield in trade war,” Financial Times, January 12, 2019, available at www.ft.com. 8 Please see Diane Bartz and Christian Shepherd, “U.S. legislation steps up pressure on Huawei and ZTE, China calls it ‘hysteria,’” Reuters, January 16, 2019, available at ca.reuters.com. Note that Democrats have also joined proposals “to condemn gross human rights violations of ethnic Turkic Muslims in Xinjiang” and to restore Taiwan’s observer status in the World Health Organization in the first month of the congressional session. 9 Please see Robert Burns, “New Pentagon leader Shanahan says he is focusing on China,” Associated Press, January 2, 2019, available at www.pbs.org. 10 Please see BCA Global Investment Strategy Weekly Report, “The Next U.S. Recession: Waiting For Godot?” dated October 5, 2018, available at www.bcaresearch.com. 11 Please see Elizabeth Schulze, “Huawei could be banned from 5G in Germany,” CNBC, January 18, 2019, available at www.cnbc.com.