Financial Markets
Feature Chilean stocks have surged recently following the victory of conservative businessman Sebastian Pinera in the presidential elections. Odds are that we could be witnessing the beginning of a period of Chilean outperformance against the EM equity benchmark, rather than just a short-term political relief rally. Pieces have fallen into place to produce a re-rating in Chilean equities relative to other emerging markets, as illustrated by the top panel of Chart I-1. The cyclically adjusted P/E ratio shows that Chilean stocks are cheap relative to their EM peers. Furthermore, Chilean stocks in common currency terms are presently near a 20-year bottom relative to EM equities (Chart I-1, bottom panel). Hence, just from a mean reversion perspective, Chile's performance relative to EM stocks has the potential to rise. Besides the above points, Chile's business cycle and monetary policy also warrant this bourse's outperformance versus the EM benchmark. A Sweet Spot For Equities There are several signs that the business cycle has passed its bottom and is slowly recovering (Chart I-2). Chart I-1Chilean Stocks Relative To EM Chart I-2Chilean Economy Is Reviving... Moreover, there are also several factors that will lead the Central Bank of Chile (CBC) to keep monetary policy easy for the coming 6-12 months. This will create a sweet spot for share prices where economic growth starts to pick up but the central bank does not tighten. Capital expenditures in real terms and the bank loan impulse to corporations - the second derivative of outstanding commercial loans - might have bottomed although they are still very weak (Chart I-3, top panel). Furthermore, residential and non-residential construction starts are still shrinking while the improvement in the housing loan impulse seems to be stalling (Chart I-3, bottom panel). This suggests that the capex and credit cycles - the two most interest rate-sensitive segments of the economy - remain feeble, justifying low interest rates for a while. Most importantly, there are no signs of inflationary pressures: the output gap is negative and widening, which historically has led to falling core inflation (Chart I-4). Chart I-3...But Interest Rate Sensitive Sectors Are Still Weak Chart I-4Chile: The Output Gap And Inflation A wide range of inflation measures - consumer services and trimmed mean inflation rates - are low and remain in a downtrend (Chart I-5). The key driver and measure of underlying genuine inflation is wages. Overall and key sectors' wage growth are either slowing or muted (Chart I-6). Chart I-5Chile: Inflation Is Low Chart I-6Chile: Wage Growth Is Tame Notably, the number of unemployed people is still rising while the number of job vacancies has plummeted to very low levels (Chart I-7). This heralds low wage growth and disinflationary pressures ahead. Chilean local rates, unlike high-yielding EM local fixed-income markets, will not rise if commodities prices relapse and the Chilean peso depreciates. On the contrary, the CBC can and probably will cut interest rates if the economic recovery is endangered. Therefore, we expect money supply in Chile to continue outgrowing the same measure for aggregate EM. This tends to help Chilean stocks outperform the EM equity benchmark (Chart I-8). Chart I-7Chile: A Lot Of Slack In Labor Market Chart I-8Upgrade Chilean Stocks Versus EM Finally, the health of the Chilean banking system is better than that of some other EM peers as the former is well provisioned and not exposed to foreign currency risk. This will also help this equity market to outperform. As to absolute performance in U.S. dollar terms, it depends on copper prices and the trend in EM absolute performance. Our base case remains that copper prices will relapse due to a deceleration in Chinese capital expenditures in general and construction (both infrastructure and property development) in particular (Chart I-9). This will drive both the Chilean peso (and probably equity prices) down. In a nutshell, the equity valuations in absolute terms are neutral. Chart I-10 illustrates that the cyclically adjusted P/E ratio for the MSCI Chile index is 21, around its fair value. Barring a reversal in EM risk assets (which we expect to start sooner rather than later), share prices could rise further. Chart I-9Downside Risks To Copper Prices Chart I-10Chile: Cyclically-Adjusted P/E Ratio Investment Conclusions We recommend EM dedicated equity investors to upgrade their allocation to Chile from neutral to overweight. The macro backdrop favors Chilean assets over their emerging markets peers. As such we recommend an overweight allocation in equity and corporate credit portfolios within their respective EM benchmarks. Can Chilean stocks outperform EM when copper prices fall? Chart I-11 suggests yes: historically there were periods when copper prices and Chile's relative equity performance versus EM were not correlated or even negatively correlated. Hence, our decision to upgrade Chilean stocks to an overweight while being negative on copper prices is not inconsistent. Chart I-11Copper Prices & Chilean Equities Versus EM: Not Always Positively Correlated For absolute return investors, the risk-reward profile for Chilean assets is not attractive if our baseline negative view on EM and industrial commodities prices plays out. Finally, we have been recommending to complement a short position in copper with a long leg in the Chilean peso. This allows traders to earn a bit of carry while waiting for copper prices to gap down. The CLP has lagged the recent spike in copper prices but we reiterate this position as risks to copper prices remain to the downside over the next six months. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations
GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of December 31, 2017. The model's allocation to Australia has proven to be quite volatile as evidenced by the large increase to Australia this month to 7% from 1.7% in last month. As a result, the other commodity country, Canada, is now back to underweight from neutral last month. There are no significant large adjustments in other countries, as shown in Table 1. Table 1Model Allocation Vs. Benchmark Weights As shown in Table 2 and Chart 1, Chart 2 and Chart 3, the overall model underperformed its benchmark by 80 bps in December as the model was underweight the U.K. versus EMU, yet the U.K. was the best performer in the month while EMU underperformed. Since going live in January 2016, the overall model has outperformed the benchmark by 47 bps, largely from the allocation among the 11 non-U.S. countries, which has outperformed its benchmark by 265 bps. The Level 1 model outperformed the MSCI World benchmark by 19 bps. Table 2Performance (Total Returns In USD) Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level1) Chart 3GAA Non U.S. Model (Level 2) Please see also on the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see the January 29, 2016 Special Report, "Global Equity Allocation: Introducing the Developed Markets Country Allocation Model." http://gaa.bcaresearch.com/articles/view_report/18850. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered too in making overall recommendations. GAA Equity Sector Selection Model The GAA Equity Sector Selection Model (Chart 4) is updated as of January 2, 2018. Chart 4Overall Model Performance Table 3Allocations Table 4Performance Since Going Live The model has turned more bullish on global growth as seen by a 2% increase in aggregate cyclical overweight. However, the model continues to reduce its overweight in the resources-based sectors, and has upgraded financials to overweight on the back of improving momentum. Finally, both utilities and telecom stocks have been moved further into underweight territory. For more details on the model, please see the Special Report "Introducing The GAA Equity Sector Selection Model," July 27, 2016 available at https://gaa.bcaresearch.com.
Highlights Global bourses celebrated solid earnings growth and the passage of U.S. tax cuts heading into year-end. The direct effect of the tax cuts will likely boost U.S. real GDP growth in 2018 by 0.2 to 0.3 percentage points. It could be more, depending on the impact on animal spirits in the business sector and any fresh infrastructure spending. The good news on global growth continue to roll in. Real GDP growth is accelerating in the major advanced economies, driven in part by a surge in capital spending. Nonetheless, record low volatility and a flat yield curve in the U.S. highlight our major theme for 2018; policy is on a collision course with risk assets because output gaps are closing and monetary policy is moving away from "pedal to the metal" stimulus. We expect inflation to finally begin moving higher in the U.S. and some of the other advanced economies. This will challenge the consensus view that "inflation is dead forever", and that central banks will respond quickly to any turbulence in financial markets with an easier policy stance. The S&P 500 would suffer only a 3-5% correction if the VIX were to simply mean-revert. But the pain would likely be more intense if there is a complete unwinding of 'low-vol' trading strategies. We will be watching inflation expectations and our S&P Scorecard for signs to de-risk. Government yield curves should bear steepen, before flattening again later in 2018. Stay below benchmark in duration for now and favor bonds in Japan, Italy, the U.K. and Australia versus the U.S. and Canada (currency hedged). Interest rate differentials in the first half of the year should modestly benefit the U.S. dollar versus the other major currencies. Investors should remain exposed to oil and related assets, and bet on rising inflation expectations in the major bond markets. The intensity of forthcoming Chinese reforms will have to be monitored carefully for signs they have reached an economic 'pain threshold'. We do not view China as a risk to DM risk assets, but even a soft landing scenario could be painful for base metals and the EM complex. Bitcoin is not a systemic threat to global financial markets. Feature Chart I-1Policy Collision Course? Global bourses celebrated solid earnings growth and the passage of U.S. tax cuts heading into year-end. Ominously, though, a flatter U.S. yield curve and extraordinarily low measures of volatility hover like dark clouds over the equity bull market (Chart I-1). The flatter curve could be a sign that the Fed is at risk of tightening too far, which seems incompatible with depressed asset market volatility. This combination underscores the major theme of the BCA Outlook 2018 that was sent to clients in November; policy is on a collision course with risk assets because output gaps are closing and monetary policy is moving away from "pedal to the metal" stimulus. Analysts are debating how much of the decline in volatility is due to technical factors and how much can be pinned on the macro backdrop. For us, they are two sides of the same coin. Betting that volatility will remain depressed has reportedly become a yield play, via technical trading strategies and ETFs. Trading models encourage more risk taking as volatility declines, such that lower volatility enters a self-reinforcing feedback loop. The danger is that this virtuous circle turns vicious. On the macro front, many investors appear to believe that the structure of the advanced economies has changed in a fundamental and permanent way. Deflationary forces, such as Uber, Amazon and robotics are so strong that inflation cannot rise even if labor becomes very scarce. If true, this implies that central banks will proceed slowly in tightening, and that the peak in rates is not far away. Moreover, below-target inflation allows central banks to respond to any economic weakness or unwanted tightening in financial conditions by adopting a more accommodative policy stance. In other words, investors appear to believe in the "Fed Put". Implied volatility is a mean-reverting series. It can remain at depressed levels for extended periods, especially when global growth is robust and synchronized. Nonetheless, we believe that the "outdated Phillips curve" and the "Fed Put" consensus views will be challenged later in 2018, leading to an unwinding of low-vol yield plays. For now, though, it is too early to scale back on risk assets. Global Growth Shifts Up A Gear... The good news on global growth continue to roll in. Easy financial conditions and the end of fiscal austerity provide a supportive growth backdrop. A measure of fiscal thrust for the G20 advanced economies shifted from a headwind to a slight tailwind in 2016 (Chart I-2). Our short-term models for real GDP growth in the major countries continue to rise, in line with extremely elevated purchasing managers' survey data (Chart I-3). The major exception is the U.K., where our GDP growth model is rolling over as the Brexit negotiations take a toll. Chart I-2Fiscal Austerity Is Over Chart I-3GDP Growth Models Are Upbeat Much of the acceleration in our GDP models is driven by the capital spending components. Animal spirits appear to be taking off and it is a theme across most of the advanced economies. G3 capital goods orders pulled back a bit in late 2017, but this is more likely due to noise in the data than to a peak in the capex cycle (Chart I-4). Industrial production, the PMI diffusion index and advanced-economy capital goods imports confirm strong underlying momentum in investment spending. Chart I-4Capital Spending Helping To Drive Growth In the U.S., tax cuts will give business outlays and overall U.S. GDP growth a modest lift in 2018. The House and Senate hammered out a compromise on tax cuts that is similar to the original Senate version. The new legislation will cut individual taxes by about $680 billion over ten years, trim small business taxes by just under $400 billion, and reduce corporate taxes by roughly the same amount (including the offsetting tax on currently untaxed foreign profits). The direct effect of the tax cuts will likely boost U.S. real GDP growth in 2018 by 0.2 to 0.3 percentage points. However, much depends on the ability that the tax changes and immediate capital expensing to further lift animal spirits in the business sector and bring forward investment spending. Any infrastructure program would also augment the fiscal stimulus. The total impact is difficult to estimate given the lack of details, but it is clearly growth-positive. ...But The U.S. Yield Curve Flattens... Bond investors are unimpressed so far with the upbeat global economic data. It appears that long-term yields are almost impervious as long as inflation is stuck at low levels. In the U.S., a rising 2-year yield and a range-trading 10-year yield have resulted in a substantial flattening of the 2/10 yield slope (although some of the flattening has unwound as we go to press). Investors view a flattening yield curve with trepidation because it smells of a Fed policy mistake. It appears that the bond market is discounting that the Fed can only deliver another few rate hikes before the economy starts to struggle, at which point inflation will still be below target according to market expectations. We would not be as dismissive of an inverted yield curve as Fed Chair Yellen was during her December press conference. There are indeed reasons for the curve to be structurally flatter today than in the past, suggesting that it will invert more easily. Nonetheless, the fact that the yield curve has called all of the last seven recessions is impressive (with one false positive). The good news is that, in the seven episodes in which the curve correctly called a recession, the signal was confirmed by warning signs from our Global Leading Economic Indicator and our monetary conditions index. At the moment, these confirming indicators are not even flashing yellow.1 Our fixed-income strategists believe that the curve is more likely to steepen than invert over the next six months. If inflation edges higher as we expect, then long-term yields will finally break out to the upside and the curve will steepen until the Fed's tightening cycle is further advanced. If we are wrong and inflation remains stuck near current levels or declines, then the FOMC will have to revise the 'dot plot' lower and the curve will bull-steepen. In other words, we do not think the FOMC will make a policy mistake by sticking to the dot plot if inflation remains quiescent. Rising inflation is a larger risk for stocks and bonds than a policy mistake. A clear uptrend in inflation would shake investors' confidence in the "Fed Put" and thereby trigger an unwinding of the low-vol investment strategies. A sharp selloff at the long end of the curve in the major markets would send a chill through the investment world because it would suggest that the Phillips curve is not dead, and that central banks might have fallen behind the curve. ...As Inflation Languishes For now there is little evidence of building inflation pressure in either the CPI or the Fed's preferred measure, the core PCE price index. The latter edged up a little in October to 1.4% year-over-year, but the November core CPI rate slipped slightly to 1.7%. For perspective, core CPI inflation of 2.4-2.5% is consistent with the Fed's 2% target for the core PCE index. The Fed has made no progress in returning inflation to target since the FOMC started the tightening cycle. A risk to our view is that the expected inflation upturn takes longer to materialize. The annual core CPI inflation rate fell from 2.3 in January 2017 to 1.7 in November, a total decline of 0.55 percentage points. The drop was mostly accounted for by negative contributions from rent of shelter (-0.31), medical care services (-0.13) and wireless telephone services (-0.1). These categories are not closely related to the amount of slack in the economy, and thus might continue to depress the headline inflation rate in the coming months even as the labor market tightens further. Recent regulatory changes, for example, suggest that there is more downside potential in health care services inflation. We have highlighted in past research that it is not unusual for inflation to respond to a tight labor market with an extended lag, especially at the end of extremely long expansion phases. Chart I-5 updates the four indicators that heralded inflection points in inflation at the end of the 1980s and 1990s. All four leading inflation indicators are on the rise, as is the New York Fed's Underlying Inflation Indicator (not shown). Importantly, economic slack is disappearing at the global level. The OECD as a group will be operating above potential in 2018 for the first time since the Great Recession (Chart I-6). Finally, oil prices have further upside potential. Higher energy prices will add to headline inflation and boost inflation expectations in the U.S. and the other major economies. Chart I-5U.S. Inflation: Indicators Point Up Chart I-6Vanishing Economic Slack The bottom line is that we are sticking with the view that U.S. inflation will grind higher in the coming months, allowing the FOMC to deliver the three rate hikes implied by the 'dot plot' for 2018. In December, the FOMC revised up its economic growth forecast to 2.5% in 2018, up from 2.1%. The projections for 2019 and 2020 were also revised higher. Growth is seen remaining above the 1.8% trend rate for the next three years. The FOMC expects that the jobless rate will dip to 3.9% in 2018 and 2019, before ticking up to 4.0% in 2020. With the estimate for long-run unemployment unchanged at 4.6%, this means that the labor market is expected to shift even further into 'excess demand' territory. If anything, these forecasts look too conservative. It is unreasonable to expect the unemployment rate to stabilize in 2019 and tick up in 2020 if the economy is growing above-trend. This forecast highlights the risk that the FOMC will suddenly feel 'behind the curve' if inflation re-bounds more quickly than expected, at a time when the labor market is so deep in 'excess demand' territory. The consensus among investors would also be caught off guard in this scenario, resulting in a rise in bond volatility from rock-bottom levels. How Vulnerable Are Stocks? How large a correction in risk assets should we expect? One way to gauge this risk is to estimate the historical 'beta' of risk asset prices to mean-reversions in the VIX. The VIX is currently a long way below its median. Major spikes to well above the median are associated with recessions and/or financial crises. However, as a starting point, we are interested in the downside potential for risk asset prices if the VIX simply moves back to the median. Table I-1 presents data corresponding to periods since 1990 when the VIX mean-reverted from a low level over a short period of time. We chose periods in which the VIX surged at least to its median level (17.2) from a starting point that was below 13. The choice of 13 as the lower threshold is arbitrary, but this level filters out insignificant noise in the data and still provides a reasonable number of episodes to analyze.2 Table I-1Episodes Of VIX 'Mean Reversion' The episodes are presented in ascending order with respect to the starting point for the 12-month forward P/E ratio. This was done to see whether the valuation starting point matters for the size of the equity correction. The "VIX Beta" column shows the ratio of the percent decline in the S&P 500 to the change in the VIX. The average beta over the 15 episodes suggests that stocks fall by almost a half of a percent for every one percent increase in the VIX. Today, the VIX would have to rise by about 7½% to reach the median value, implying that the S&P 500 would correct by roughly 3½%. Investment- and speculative-grade corporate bonds would underperform Treasurys by 22 and 46 basis points, respectively, in this scenario. Interestingly, the equity market reaction to a given jump in the VIX does not appear to intensify when stocks are expensive heading into the shock. The implication is that a shock that simply returns the VIX to "normal" would not be devastating for risk assets. The shock would have to be worse. Chart I-7Market Reaction To 1994 Fed Shock The episodes of VIX "mean reversion" shown in Table I-1 are a mixture of those caused by financial crises and by monetary tightening (and sometimes both). The U.S. 1994 bond market blood bath is a good example of a pure monetary policy shock. It was partly responsible for the "tequila crisis", but that did not occur until late that year. Chart I-7 highlights that the U.S. equity market reacted more violently to Fed rate hikes in 1994 than the average VIX beta would suggest. The VIX jumped by about 14% early in the year, coinciding with a 9% correction in the S&P 500. Investors had misread the Fed's intension in late 1993, expecting little in the way of rate hikes over the subsequent year. A dramatic re-rating of the Fed outlook caused a violent bond selloff that unnerved equity investors. We are not expecting a replay of the 1994 bond market turmoil because the Fed is far more transparent today. Nonetheless, the equity correction could be quite painful to the extent that the VIX overshoots the median as the large volume of low-volatility trades are unwound. A 10% equity correction in the U.S. this year would not be a surprise given the late stage of the bull market and current market positioning. Yield Curves To Bear Steepen Upward pressure on inflation, bond yields and volatility will not only come from the U.S. We expect inflation to edge higher in the Eurozone, Canada, and even Japan, given tight labor markets and diminished levels of global spare capacity. The European economy has been a star performer this year and this should continue through 2018. Even the periphery countries are participating. The key driving factors include the end of the fiscal squeeze in the periphery and the recapitalization of troubled banks. The latter has opened the door to bank lending, the weakness of which has been a major growth headwind in this expansion. Taken at face value, recent survey data are consistent with about 3% GDP growth (Chart I-3). We would dis-count that a bit, but even continued 2.0-2.5% GDP growth in the euro area would compare well to the 1% potential growth rate. This means that the output gap is shrinking and the labor market will continue tightening. Despite impressive economic momentum, the ECB is sticking to the policy path it laid out in October. Starting in January, asset purchases will continue at a reduced rate of €30bn per month until September 2018 or beyond. Meanwhile, interest rates will remain steady "for an extended period of time, and well past the horizon of the net asset purchases." If asset purchases come to an end next September, then the first rate hike may not come until 2019 Q1 at the earliest. Thus, rate hikes are a long way off, but the deceleration of growth in the Eurozone monetary base will likely place upward pressure on the long end of the bund curve (shown inverted in Chart I-8). Chart I-8ECB Tapering Will Be Bond-Bearish Canada is another economy with ultra-low interest rates and rapidly diminishing labor market slack. The Bank of Canada will be forced to follow the Fed in hiking rates in the coming quarters. In Japan, strong PMI and capital goods orders are hopeful signs that domestic capital spending is picking up, consistent with our upbeat real GDP model (Chart I-3). Recent data on industrial production and retail sales were weak, but this was likely due to heavy storm activity; we expect those readings to bounce back. Nonetheless, it is still not clear that the Japanese economy has moved away from a complete dependency on the global growth engine. We would like to see stronger wage gains to signal that the economy is finally transitioning to a more self-reinforcing stage. It is hopeful that various measures of core inflation are slightly positive, but this is tentative at best. That said, the BoJ may be forced to alter its current "yield curve control" strategy by modestly lifting the target on longer-term JGB yields later in 2018, in response to pressures from robust growth and rising global bond yields. Thus, the pressure for higher bond yields should rotate away from the U.S. in the latter half of 2018 towards Europe, Canada and possibly Japan. This could eventually see the U.S. dollar head lower, but we still foresee a window in the first half of 2018 in which the dollar will appreciate on the back of widening interest rate differentials. We are less bullish than we were in mid-2017, expecting only about a 5% dollar appreciation. China: Long-Term Gain Or Short-Term Pain? The Chinese cyclical outlook remains a key risk to our upbeat view on risk assets. Significant structural reforms are on the way, now that President Xi has amassed significant political support for his reform agenda. These include deleveraging in the financial sector, a more intense anti-corruption campaign focused on the shadow-banking sector, and an ongoing restructuring in the industrial sector. The reforms will likely be positive for long-term growth, but only to the extent that they are accompanied by economic reforms. This month's Special Report, beginning on page 19, highlights that 2018 will be pivotal for China's long-term investment outlook. In the short term, reforms could be a net negative for growth depending on how deftly the authorities handle the monetary and fiscal policy dials. We witnessed this tension between growth and reform in the early years of President Xi's term, when the drive to curtail excessive credit growth and overcapacity caused an abrupt slowdown in 2015. Managing the tradeoff means that China's economy will evolve in a series of growth mini cycles. China is in the down-phase of a mini cycle at the moment, as highlighted by the Li Keqiang Index (LKI; Chart I-9). The LKI is a good proxy for the business cycle. BCA's China Strategy service recently combined the data with the best leading properties for the LKI into a single indicator.3 This indicator suggests that the LKI will end up retracing about 50% of its late 2015 to early 2017 rise before the current slowdown is complete. The good news is that broad money growth, which is a part of the LKI leading indicator, has re-accelerated in recent months. This suggests that the current economic slowdown phase will not be protracted, consistent with our 'soft landing' view. The intensity of forthcoming reforms will have to be monitored carefully for signs they have reached an economic pain threshold. We will be watching our LKI leading indicator and a basket of relevant equity sectors for warning signs. We do not view China as a risk to DM risk assets, but even a soft landing scenario could be painful for base metals and the EM complex (Chart I-10). Chart I-9China: Where Is The Bottom? Chart I-10Metals At Risk Of China Soft Landing Equity Country Allocation For now we continue to recommend overweight positions in stocks versus bonds and cash within balanced portfolios. We also still prefer Japanese stocks to the U.S., reflecting our expectation for rising bond yields in the latter and an earnings outlook that favors the former. Chart I-11 updates our earnings-per-share growth forecast for the U.S., Japan and the Eurozone. We expect U.S. EPS growth to decelerate more quickly in 2018 than in Japan, since the U.S. is further ahead in the earning cycle and is more exposed to wage and margin pressure. European earnings growth will also be solid in 2018, but this year's euro appreciation will be a headwind for Q4 2017 and Q1 2018 earnings. European and Japanese stocks are also a little on the cheap side versus the U.S., although not by enough to justify overweight positions on valuation grounds alone. We have extended our valuation work to a broader range of countries, shown in Chart I-12. All are expressed relative to the U.S. market. These metric exclude the Financials sector, and adjust for both differing sector weights and structural shifts in relative valuation. Mexico is the only one that is more than one standard deviation cheap relative to the U.S. Nonetheless, our EM team is reluctant to recommend this market given uncertainty regarding the NAFTA negotiations. Russia is not as cheap, but is in the early stages of recovery. Our EM team is overweight. Chart I-11Top-Down EPS Projection Chart I-12Valuation Ranking Of Nonfinancial Equity Markets Relative To The U.S. A Note On Bitcoin Finally, we have received a lot of client questions regarding bitcoin. The incredible surge in the price of the cryptocurrency dwarfs previous asset price bubbles by a wide margin (Chart I-13). As is usually the case with bubble, supporters argue that "this time is different." We doubt it. Chart I-13Bitcoin Bubble Dwarfs All The Rest BCA's Technology Sector Strategy weighed into this debate in a recent Special Report.4 In theory, blockchain technology, including cyber currencies, can be used as a highly secure, low cost, means of transfer value from one person to the next without an intermediary. However, the report highlights that bitcoin is highly subject to fraud and manipulation because it is unregulated. Liquidity and accurate market quotes are questionable on the "fly by night" exchanges. Its use as a medium of exchange is very limited, and governments are bound to regulate it because cryptocurrencies are a tool for money laundering, tax evasion and other criminal activities. Another fact to keep in mind is that, although the supply of new bitcoins is restricted, the creation of other cryptocurrencies is unlimited. Would the bursting of the bitcoin bubble represent a risk to the economy? The market cap of all cryptocurrencies is estimated to be roughly US$400 billion (US$250 billion for bitcoin alone). This is tiny compared to global GDP or the market cap of the main asset classes such as stocks and bonds. The amount of leverage associated with bitcoin is unknown, but it is hard to see that it would be large enough to generate a significant wealth effect on spending and/or a marked impact on overall credit conditions. The links to other financial markets appear limited. Investment Conclusions Our recommended asset allocation is "steady as she goes" as we move into 2018. The policy and corporate earnings backdrop will remain supportive of risk assets at least for the first half of the year. In the U.S., the recently passed tax reform package will boost after-tax corporate cash flows by roughly 3-5%. Cyclical stocks should outperform defensives in the near term. Nonetheless, we expect 2018 to be a transition year. Stretched valuations and extremely low volatility imply that risk assets are vulnerable to the consensus macro view that central banks will not be able to reach their inflation targets even in the long term. The consensus could be in for a rude awakening. We expect equity markets to begin discounting the next U.S. recession sometime in early 2019, but markets will be vulnerable in 2018 to a bond bear phase and escalating uncertainty regarding the economic outlook. If risk assets have indeed entered the late innings, then we must watch closely for signs to de-risk. One item to watch is the 10-year U.S. CPI swap rate; a shift above 2.3% would be consistent with the Fed's 2% target for the PCE measure of inflation. This would be a signal that the FOMC will have to step-up the pace of rate hikes and aggressively slow economic growth. We will also use our S&P Scorecard Indicator to help time the exit from our overweight equity position (Chart I-14). The Scorecard is based on seven indicators that have a good track record of heralding equity bear markets.5 These include measures of monetary conditions, financial conditions, value, momentum, and economic activity. The more of these indicators in "bullish" territory, the higher the score. Currently, four of the indicators are flashing a bullish signal (financial conditions, U.S. unemployment claims, ISM new orders minus inventories, and momentum). We demonstrated in previous research that a Scorecard reading of three or above was historically associated with positive equity total returns in the subsequent months. A drop below three this year would signal the time to de-risk. Our thoughts on the risks facing equities carry over to the corporate bonds space. Our Global Fixed Income Strategy service notes that uncertainty about future growth has the potential to increase interest rate volatility that can also push corporate credit spreads wider (Chart I-15).6 Elevated leverage in the corporate sector adds to the risk of a re-rating of implied volatility. For now, however, investors should continue to favor corporate bonds relative to governments for the (albeit modest) yield pickup. Chart I-14Watch Our Scorecard To Time The Exit Chart I-15Higher Uncertainty & ##br##Vol To Hit Corporate Bonds Overall bond portfolio duration should be kept short of benchmark. We may recommend taking profits and switching to benchmark duration after global yields have increased and are beginning to negatively affect risk assets. While yields are rising, investors should favor bonds in Japan, Italy, the U.K. and Australia within fixed-income portfolios (on a currency-hedged basis). Underweight the U.S. and Canada. German and French bonds should be close to benchmark. Yield curves should steepen, before flattening later in the year. Interest rate differentials in the first half of the year should modestly benefit the U.S. dollar versus the other major currencies. Finally, investors should remain exposed to oil and related assets, and bet on rising inflation expectations in the major bond markets. Mark McClellan Senior Vice President The Bank Credit Analyst December 28, 2017 Next Report: January 25, 2018 1 Please see BCA Global ETF Strategy service, "A Guide to Spotting And Weathering Bear Markets," August 16, 2017, available at etf.bcaresearch.com 2 Note that we are not saying that a rise in the VIX "causes" stocks to correct. Rather, we are assuming that a shock occurs that causes stocks to correct and the VIX to rise simultaneously. 3 Please see China Investment Strategy Special Report, "The Data Lab: Testing The Predictability Of China's Business Cycle," November 30, 2017, available at cis.bcaresearch.com 4 Please see BCA Technology Sector Strategy Special Report, "Cyber Currencies: Actual Currencies Or Just Speculative Assets?" December 12, 2017, available at tech.bcaresearch.com 5 Market Timing: Holy Grail Or Fool's Gold? The Bank Credit Analyst, May 26, 2016. 6 Please see BCA Global Fixed Income Strategy service, "Our Model Bond Portfolio Allocation In 2018: A Tail Of Two Halves," December 19, 2017, available at gfis.bcaresearch.com II. A Long View Of China 2018 is a pivotal year for China, as it will set the trajectory for President Xi Jinping's second term ... and he may not step down in 2022. Poverty, inequality, and middle-class angst are structural and persistent threats to China's political stability. The new wave of the anti-corruption campaign is part of Xi's attempt to improve governance and mitigate political risks. Yet without institutional checks and balances, Xi's governance agenda will fail. Without pro-market reforms, investors will face a China that is both more authoritarian and less productive. Hearts rectified, persons were cultivated; persons cultivated, families were regulated; families regulated, states were rightly governed; states rightly governed, the whole world was made tranquil and happy. - Confucius, The Great Learning Comparisons of modern Chinese politics with Confucian notions of political order have become cliché. Nevertheless, there is a distinctly Confucian element to Chinese President Xi Jinping's strategy. Xi's sweeping anti-corruption campaign, which will enter "phase two" in 2018, is essentially an attempt to rectify the hearts and regulate the families of Communist Party officials and civil servants. The same could be said for his use of censorship and strict ideological controls to ensure that the general public remains in line with the regime. Yet Xi is also using positive measures - like pollution curbs, social welfare, and other reforms - to win over hearts and minds. His purpose is ultimately the preservation of the Chinese state - namely, the prevention of a Soviet-style collapse. Only if the regime is stable at home can Xi hope to enhance the state's international security and erode American hegemony in East Asia. This would, from Beijing's vantage, make the whole world more tranquil and happy. Thus, for investors seeking a better understanding of China in the long run, it is necessary to look at what is happening to its governance as well as to its macroeconomic fundamentals and foreign relations.1 China's greatest vulnerability over the long run is its political system. Because Xi Jinping's willingness to relinquish power is now uncertain, his governance and reform agenda in his second term will have an outsized impact on China's long-run investment outlook. The Danger From Within From 1978-2008, the Communist Party's legitimacy rested on its ability to deliver rising incomes. Since the Great Recession, however, China has entered a "New Normal" of declining potential GDP growth as the society ages and productivity growth converges toward the emerging market average (Chart II-1). In this context, Chinese policymakers are deathly afraid of getting caught in the "middle income trap," a loose concept used to explain why some middle-income economies get bogged down in slower growth rates that prevent them from reaching high-income status (Chart II-2).2 Chart II-1The New Normal Chart II-2Will China Get Caught In The Middle-Income Trap? Such a negative economic outcome would likely prompt a wave of popular discontent, which, in turn, could eventually jeopardize Communist Party rule. The quid pro quo between the Chinese government and its population is that the former delivers rising incomes in exchange for the latter's compliance with authoritarian rule. The party is not blind to the fate of other authoritarian states whose growth trajectory stalled. The threat of popular unrest in China may seem remote today. The Communist Party is rallying around its leader, Xi Jinping; the economy rebounded from the turmoil of 2015 and its cyclical slowdown in recent months is so far benign; consumer sentiment is extremely buoyant; and the global economic backdrop is bright (Chart II-3). Yet these positive political and economic developments are cyclical, whereas the underlying political risks are structural and persistent. China has made massive gains in lifting its population out of poverty, but it is still home to 559 million people, around 40% of the population, living on less than $6 per day, the living standard of Uzbekistan. It will be harder to continue improving these workers' quality of life as trend growth slows and the prospects for export-oriented manufacturing dry up. This is why the Xi administration has recently renewed its attention to poverty alleviation. The government is on target in lifting rural incomes, but behind target in lifting urban incomes, and urban-dwellers are now the majority of the nation (Chart II-4). The plight of China's 200-250 million urban migrants, in particular, poses the risk of social discontent. Chart II-3China's Slowdown So Far Benign Chart II-4Urban Income Targets At Risk Moreover, while China knows how to alleviate poverty, it has less experiencing coping with the greatest threat to the regime: the rapid growth of the middle class, with its high expectations, demands for meritocracy and social mobility, and potential for unrest if those expectations are spoiled (Chart II-5). Democracy is not necessarily a condition for reaching high-income status, but all of Asia's high-income countries are democracies. A higher level of wealth encourages household autonomy vis-à-vis the state. Today, China has reached the $8,000 GDP per capita range that often accompanies the overthrow of authoritarian regimes.3 The Chinese are above the level of income at which the Taiwanese replaced their military dictatorship in 1987; China's poorest provinces are now above South Korea's level in that same year, when it too cast off the yoke of authoritarianism (Chart II-6). Chart II-5The Communist Party's Greatest Challenge Chart II-6China's Development Beyond Point At Which Taiwan And Korea Overthrew Dictatorship This is not an argument for democracy in China. We are agnostic about whether China will become democratic in our lifetime. We are making a far more humble point: that political risk will mount as wealth is accumulated by the country's growing middle class. Several emerging markets - including Thailand, Malaysia, Turkey and Brazil - have witnessed substantial political tumult after their middle class reached half of the population and stalled (Chart II-7). China is approaching this point and will eventually face similar challenges. Chart II-7Middle Class Growth Troubles Other EMs The comparison reveals that an inflection point exists for a society where the country's political establishment faces difficulties in negotiating the growing demands of a wealthier population. As political scientists have shown empirically, the very norms of society evolve as wealth erodes the pull of Malthusian and traditional cultural variables.4 Political transformation can follow this process, often quite unexpectedly and radically.5 Clearly the Chinese public shows no sign of large-scale, revolutionary sentiment at the moment. And political opposition does not necessarily result in regime change. Nevertheless, it is empirically false that the Chinese people are naturally opposed to democracy or representative government. After all, Sun Yat Sen founded a Republic of China in 1912, well before many western democratic transformations! And more to the point, the best survey evidence shows that the Chinese are culturally most similar to their East Asian neighbors (as well as, surprisingly, the Baltic and eastern European states): this is not a neighborhood that inherently eschews democracy. Remarkably, recent surveys suggest that China's millennial generation, while not wildly enthusiastic about democracy, is nevertheless more enthusiastic than its peers in the western world's liberal democracies (Chart II-8)! Chart II-8Chinese People Not Less Fond Of Democracy Than Others China is also home to one of the most reliable predictors of political change: inequality. China's economic boom is coincident with the rise of extreme inequalities in income, wealth, region, and social status. True, judging by average household wealth, everyone appears to be a winner; but the average is misleading because it is pulled upward by very high net worth individuals - and China has created 528 billionaires in the past decade alone. A better measure is the mean-to-median wealth ratio, as it demonstrates the gap that opens up between the average and the typical household. As Chart II-9 demonstrates, China is witnessing a sharp increase in inequality relative to its neighbors and peers. More standard measures of inequality, such as the Gini coefficient, also show very high readings in China. And this trend has combined with social immobility: China has a very high degree of generational earnings elasticity, which is a measure of the responsiveness of one's income to one's parent's income. If elasticity is high, then social outcomes are largely predetermined by family and social mobility is low. On this measure, China is an extreme outlier - comparable to the U.S. and the U.K., which, while very different economies, have suffered recent political shocks as a result of this very predicament (Chart II-10). Chart II-9Inequality: A Severe Problem In China Chart II-10China An Outlier In Inequality And Social Immobility "China does not have voters" unlike the U.S. and U.K., is the instant reply. Yet that statement entails that China has no pressure valve for releasing pent-up frustrations. Any political shock may be more, not less, destabilizing. In the U.S. and the U.K., voters could release their frustrations by electing an anti-establishment president or abrogating a trade relationship with Europe. In China, the only option may be to demand an "exit" from the political system altogether. Note that there is already substantial evidence of social unrest in China over the past decade. From 2003 to 2007, China faced a worrisome increase in "mass incidents," at which point the National Bureau of Statistics stopped keeping track. The longer data on "public incidents" suggests that the level of unrest remains elevated, despite improvements under the Xi administration (Chart II-11). Broader measures tell a similar story of a country facing severe tensions under the surface. For instance, China's public security spending outstrips its national defense spending (Chart II-12). Chart II-11Chinese Social Unrest Is Real Chart II-12China Spends More On ##br##Domestic Security Than Defense In essence, Chinese political risk is understated. This conclusion may seem counterintuitive, given Xi's remarkable consolidation of power. But is ultimately structural factors, not individual leaders, that will carry the day. The Communist Party is in a good position now, but its leaders are all-too-aware of the volcanic frustrations that could be unleashed should they fail to deliver the "China Dream." This is why so much depends upon Xi's policy agenda in the second half of his term. To that question we will now turn. Bottom Line: The Communist Party is at a cyclical high point of above-trend economic growth and political consolidation under a strongman leader. However, political risk is understated: poverty, inequality, and middle-class angst are structural and persistent and the long-term potential growth rate is slowing. If we assume that China is not unique in its historical trajectory, then we can conclude that it is approaching one of the most politically volatile periods in its development. Chart II-13Xi's Anti-Corruption Campaign The Governance And Reform Agenda Since coming to office in 2012-13, President Xi has spearheaded an extraordinary anti-corruption campaign and purge of the Communist Party (Chart II-13). The campaign has understandably drawn comparisons to Chairman Mao Zedong's Cultural Revolution (1966-76). Yet these are not entirely fair, as Xi has tried to improve governance as well as eradicate his enemies. As Xi prepares for his "re-election" in March 2018, he has declared that he will expand the anti-corruption campaign further in his second term in office: details are scant, but the gist is that the campaign will branch out from the ruling party to the entire state bureaucracy, on a permanent basis, in the form of a new National Supervision Commission.6 There are three ways in which this agenda could prove positive for China's long-term outlook. First, the regime clearly hopes to convince the public that it is addressing the most burning social grievances. Corruption persistently ranks at the top of the list, insofar as public opinion can be known (Chart II-14). Public opinion is hard to measure, but it is clear that consumer sentiment is soaring in the wake of the October party congress (see Chart II-3 above). It is also worth noting that the Chinese public's optimism perked up in Xi's first year in office, when the policy agenda on offer was substantially the same and the economy had just experienced a sharp drop in growth rates (Chart II-15). Reassuring the public over corruption will improve trust in the regime. Second, the anti-corruption campaign feeds into Xi's broader economic reform agenda. Productivity growth is harder to generate as a country's industrialization process matures. With the bulk of the big increases in labor, capital, and land supply now complete in China, the need to improve total factor productivity becomes more pressing (Chart II-16). Unlike the early stages of growth, this requires reaching the hard-to-get economic conditions, such as property rights, human capital, financial deepening, entrepreneurship, innovation, education, technology, and social welfare. Chart II-14Chinese Public Grievances Chart II-15Anti-Corruption Is Popular Chart II-16Productivity Requires Institutional Change On this count, the Xi administration's anti-corruption campaign has been a net positive. The most widely accepted corruption indicators suggest that it has made a notable improvement to the country's governance. Yet the country remains far below its competitors in the absolute rankings, notably its most similar neighbor Taiwan (Chart II-17 A&B). The institutionalization of the campaign could thus further improve the institutional framework and business environment. Chart II-17AAnti-Corruption Campaign Is A Plus... Chart II-17B...But There's A Long Way To Go Third, the anti-corruption campaign can serve as a central government tool in enforcing other economic reforms. Pro-productivity reforms are harder to execute in the context of slowing growth because political resistance increases among established actors fighting to preserve their existing advantages. If the ruling party is to break through these vested interests, it needs a powerful set of tools. Recently, the central government in Beijing has been able to implement policy more effectively on the local level by paving the way through corruption probes that remove personnel and sharpen compliance. Case in point: the use of anti-corruption officials this year gave teeth to environmental inspection teams tasked with trimming overcapacity in the industrial sector (Chart II-18). And there are already clear signs that this method will be replicated as financial regulators tackle the shadow banking sector.7 Chart II-18Reforms Cut Steel Capacity, ##br##Reduced Need For Scrap These last examples - financial and environmental regulatory tightening - are policy priorities in 2018. The coercive aspect of the corruption probes should ensure that they are more effective than they would otherwise be. And reining in asset bubbles and reducing pollution are clear long-term positives for the regime. Ideally, then, Xi's anti-corruption campaign will deliver three substantial improvements to China's long-term outlook: greater public trust in the government, higher total factor productivity, and reduced systemic risks. The administration hopes that it can mitigate its governance deficit while improving economic sustainability. In this way it can buy both public support and precious time to continue adjusting to the new normal. The danger is that these policies will combine to increase downside risks to growth in the short term.8 Bottom Line: Xi's anti-corruption campaign is being expanded and institutionalized to cover the entire Chinese administrative state. This is a consequential campaign that will take up a large part of Xi's second term. It is the administration's major attempt to mitigate the socio-political challenges that await China as it rises up the income ladder. Absolute Power Corrupts Absolutely? The problem, however, is that Xi may merely use the anti-corruption campaign to accrue more power into his hands. As is clear from the above, Xi's governance agenda is far from impartial and professional. The anti-corruption campaign is being used not only to punish corrupt officials but also to achieve various other goals. Xi has even publicly linked the campaign to the downfall of his political rivals.9 In essence, the campaign highlights the core contradiction of the Xi administration: can Xi genuinely improve China's governance by means of the centralization and personalization of power? Chart II-19China's Governance Still Falls Far Behind Over the long haul, the fundamental problem is the absence of checks and balances, i.e. accountability, from Xi's agenda. For instance, the National Supervision Commission will be granted immense powers to investigate and punish malefactors within the state - but who will inspect the inspectors? Xi's other governance reforms suffer the same problem. His attempt to create "rule of law" is lacking the critical ingredients of judicial independence and oversight. The courts are not likely to be able to bring cases against the party, central government, or powerful state-owned firms, and they will not be able to repeal government decisions. Thus, as many commentators have noted, Xi's notion of rule of law is more accurately described as "rule by law": the reformed legal system will in all probability remain an instrument in the hands of the Communist Party. Likewise, Xi's attempt to grant the People's Bank of China greater powers of oversight in order to combat systemic financial risk suffers from the fact that the central bank is not independent, and will remain subordinate to the State Council, and hence to the Politburo Standing Committee. This is not even to mention the lamentable fact that Xi's campaign for better governance has so far coincided with extensive repression of civil society, which does not mesh well with the desire to improve human capital and innovation.10 Thus it is of immense importance whether Xi sets up relatively durable anti-corruption, legal, and financial institutions that will maintain their legitimate functions beyond his term and political purposes. Otherwise, his actions will simply illustrate why China's governance indicators lag so far behind its peers in absolute terms. Corruption perceptions may improve further, but there will be virtually no progress in areas like "voice and accountability," "political stability and absence of violence," "rule of law," and "regulatory quality," each of which touches on the Communist Party's weak spots in various ways (Chart II-19). Analysis of the Communist Party's shifting leadership characteristics reinforces a pessimistic view of the long run if Xi misses his current opportunity.11 The party's top leadership increasingly consists of career politicians from the poor, heavily populated interior provinces - i.e. the home base of the party. Their educational backgrounds are less scientific, i.e. more susceptible to party ideology. (Indeed, Xi Jinping's top young protégé, Chen Miner, is a propaganda chief.) And their work experience largely consists of ruling China's provinces, where they earned their spurs by crushing rebellions and redistributing funds to placate various interest groups (Chart II-20). While one should be careful in drawing conclusions from such general statistics, the contrast with the leadership that oversaw China's boldest reforms in the 1990s is plain. Chart II-20China's Leaders Becoming More 'Communist' Over Time Bottom Line: Xi's reform agenda is contradictory in its attempt to create better governance through centralizing and personalizing power. Unless he creates checks and balances in his reform of China's institutions, he is likely to fall short of long-lasting improvements. The character profiles of China's political elite do not suggest that the party will become more likely to pursue pro-market reforms in Xi's wake. Xi Jinping's Choice Xi is the pivotal player because of his rare consolidation of power, and 2018 is the pivotal year. It is pivotal because it will establish the policy trajectory of Xi's second term - which may or may not extend into additional terms after 2022. So far, the world has gained a few key takeaways from Xi's policy blueprint, which he delivered at the nineteenth National Party Congress on October 18: Xi has consolidated power: He and his faction reign supreme both within the Communist Party and the broader Chinese state; Xi's policy agenda is broadly continuous: Xi's speech built on his administration's stated aims in the first five years as well as the inherited long-term aims of previous administrations; China is coming out of its shell: In the international realm, Xi sees China "moving closer to center stage and making greater contributions to mankind"; The 2022 succession is in doubt: Xi refrained from promoting a successor to the Politburo Standing Committee, the unwritten norm since 1992. Markets have not reacted overly negatively to these developments (Chart II-21), as the latter do not pose an immediate threat to the global rally in risk assets. The reasons are several: Chart II-21Market Not Too Worried About ##br##Party Congress Outcomes Maoism is overrated: While the Communist Party constitution now treats Xi Jinping as the sole peer of the disastrous ruler Mao Zedong, the market does not buy the Maoist rhetoric. Instead, it sees policy continuity, yet with more effective central leadership, which is a plus. Reforms are making gradual progress: Xi is treading carefully, but is still publicly committed to a reform agenda of rebalancing China's economic model toward consumption and services, improving governance and productivity, and maintaining trade openness. Whatever the shortcomings of the first five years, this agenda is at least reformist in intention. China's tactic of "seeking progress while maintaining stability" is certainly more reassuring than "progress at any cost" or "no progress at all"! Trump and Xi are getting along so far: Xi's promises to move China toward center stage threaten to increase geopolitical tensions with the United States in the long run, yet markets are not overly alarmed. China is imposing sanctions on North Korea to help resolve the nuclear missile standoff, negotiating a "Code of Conduct" in the South China Sea, and promoting the Belt and Road Initiative (BRI), which will marginally add to global development and growth. Trump is hurling threatening words rather than concrete tariffs. 2022 is a long way away: Markets are unconcerned with Xi's decision not to put a clear successor on the Politburo Standing Committee, even though it implies that Xi will not step down at the end of his term in five years. Investors are implicitly approving Xi's strongman behavior while blissfully ignoring the implication that the peaceful transition of power in China could become less secure. Are investors right to be so sanguine? Cyclically, BCA's China Investment Strategy is overweight Chinese investible equities relative to EM and global stocks. Geopolitical Strategy also recommends that clients follow this view and overweight China relative to EM. Beyond this 6-12 month period, it depends on how Xi uses his political capital. If Xi is serious about governance and economic reform, then long-term investors should tolerate the other political risks, and the volatility of reforms, and overweight China within their EM portfolio. After all, China's two greatest pro-market reformers, Deng Xiaoping and Jiang Zemin, were also heavy-handed authoritarians who crushed domestic dissent, clashed with the United States from time to time, and hesitated to relinquish control to their successors. However, if Xi is not serious, then investors with a long time horizon should downgrade China/EM assets - as not only China but the world will have a serious problem on its hands. For Deng Xiaoping and Jiang Zemin always reaffirmed China's pro-market orientation and desire to integrate into the global economic order. If Xi turns his back on this orientation, while imprisoning his rivals for corruption, concentrating power exclusively in his own person, and contesting U.S. leadership in the Asia Pacific, then the long-run outlook for China and the region should darken rather quickly. Domestic institutions will decay and trade and foreign investment will suffer. How and when will investors know the difference? As mentioned, we think 2018 is critical. Xi is flush with political capital and has a positive global economic backdrop. If he does not frontload serious efforts this year then it will become harder to gain traction as time goes by.12 If he demurs, the Chinese political system will not afford another opportunity like this for years to come. The country will approach the 2020s with additional layers of bureaucracy loyal to Xi, but no significant macro adjustments to its governance or productivity. It is not clear how long China's growth rate is sustainable without pro-productivity reforms. It is also not clear that the world will wait five years before responding to a China that, without a new reform push, will appear unabashedly mercantilist, neo-communist, and revisionist. Bottom Line: The long-run investment outlook for China hinges on Xi Jinping's willingness to use his immense personal authority and concentration of power for the purposes of good governance and market-oriented economic reform. Without concrete progress, investors will have to decide whether they want to invest in a China that is becoming less economically vibrant as well as more authoritarian. We think this would be a bad bet. Matt Gertken Associate Vice President Geopolitical Strategy Marko Papic Senior Vice President Chief Geopolitical Strategist Geopolitical Strategy 1 Please see BCA Geopolitical Strategy Special Report, "Taking Stock Of China's Reforms," dated May 13, 2015, available at gps.bcaresearch.com. 2 Chinese policymakers are expressly concerned about the middle-income trap. Please see the World Bank and China's Development Research Center of the State Council, "China 2030: Building A Modern, Harmonious, And Creative Society," 2013, available at www.worldbank.org. Liu He, who is perhaps Xi Jinping's top economic adviser, had a hand in drafting this report and is now a member of the Politburo and shortlisted to take charge of the newly established Financial Stability and Development Commission at the People's Bank of China. 3 Please see Indermit S. Gill and Homi Kharas, "The Middle-Income Trap Turns Ten," World Bank, Policy Research Working Paper 7403 (August, 2015), available at www.worldbank.org 4 Please see Ronald Inglehart and Christian Welzel, Modernization, Cultural Change and Democracy: the Human Development Sequence (Cambridge: CUP, 2005). 5 For example, the collapse of the Soviet Union and the Arab Spring, as well as the downfall of communist regimes writ large, were completely unanticipated. 6 Specifically, Xi is creating a National Supervision Commission that will group a range of existing anti-graft watchdogs under its roof at the local, provincial, and central levels of administration, while coordinating with the Communist Party's top anti-graft watchdog. More details are likely to be revealed at the March legislative session, but what matters is that the initiative is a significant attempt to institutionalize the anti-corruption campaign. Please see BCA Geopolitical Strategy Special Report, "China's Party Congress Ends ... So What?" dated November 1, 2017, available at gps.bcaresearch.com. 7 China has recently drafted top anti-graft officials, such as Zhou Liang, from the powerful Central Discipline and Inspection Commission and placed them in the China Banking Regulatory Commission, which is in charge of overseeing banks. Authorities have already imposed fines in nearly 3,000 cases in 2017 affecting various kinds of banks, including state-owned banks. On the broader use of anti-corruption teams for economic policy, please see Barry Naughton, "The General Secretary's Extended Reach: Xi Jinping Combines Economics And Politics," China Leadership Monitor 54 (Fall 2017), available at www.hoover.org. 8 Please see BCA Geopolitical Strategy Special Report, "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 9 Please see Gao Shan et al, "China's President Xi Jinping Hits Out at 'Political Conspiracies' in Keynote Speech," Radio Free Asia, January 3, 2017, available at www.rfa.org 10 Xi has cranked up the state's propaganda organs, censorship of the media, public surveillance, and broader ideological and security controls (including an aggressive push for "cyber-sovereignty") to warn the public that there is no alternative to Communist Party rule. This tendency has raised alarms among civil rights defenders, lawyers, NGOs, and the western world to the effect that China's governance is actually regressing despite nominal improvement in standard indicators. This is the opposite of Confucius's bottom-up notion of order. 11 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 12 Xi faces politically sensitive deadlines in the 2020-22 period: the economic targets in the thirteenth Five Year Plan; the hundredth anniversary of the Communist Party in 2021; and Xi's possible retirement at the twentieth National Party Congress in 2022. At that point he will need to focus on demonstrating the Communist Party's all-around excellence and make careful preparations either to step down or cling to power. III. Indicators And Reference Charts Global equity indexes remained on a tear heading into year-end on the back of robust earnings growth in the major countries and U.S. tax cuts. There are some dark clouds hanging over this rally, as discussed in the Overview section. The technicals are stretched, but none of our fundamental indicators are warning of a market top. Implied equity volatility is very low, which can be interpreted in a contrary fashion. Investor sentiment is frothy and our Speculation Indicator is very elevated. Moreover, our equity valuation indicator has finally reached one standard deviation, which is our threshold of overvaluation. Valuation does not tell us anything about timing, but it does highlight the downside risks. Our monetary indicator also deteriorated a little more in December, although not by enough on its own to justify downgrading risk assets. On a positive note, earnings surprises and the net revisions ratio are not sending any warning signs for profit growth (although net revisions have edged lower recently). Moreover, our new Revealed Preference Indicator (RPI) continued on its bullish equity signal in November for the fifth consecutive month. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. Our Willingness-to-Pay (WTP) indicators are also bullish on stocks in the U.S., Europe and Japan. These indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. The small dip in the Japanese WTP in December is a little worrying, but we need to see more weakness to confirm that flows no longer favor Japanese equities. In contrast, Europe's WTP rose sharply in December, suggesting that investors are allocating more to their European equity holdings. We are overweight both Europe and (especially) Japan relative to the U.S. (currency hedged). U.S. Treasury valuation is still very close to neutral, even following December's backup in yields. There is plenty of upside potential for yields before they hit "inexpensive" territory. Similarly, our technical bond indicator suggests that technical factors will not be headwind to a further bond selloff in 2018. Little has change for the dollar. The technicals are neutral. Value is expensive based on PPP, but less so by other valuation metrics. We see modest upside for the greenback in 2018. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation Chart III-6U.S. Earnings Chart III-7Global Stock Market And ##br##Earnings: Relative Performance Chart III-8Global Stock Market And ##br##Earnings: Relative Performance FIXED INCOME: Chart II-9U.S. Treasurys And Valuations Chart II-10U.S. Treasury Indicators Chart II-11Selected U.S. Bond Yields Chart II-1210-Year Treasury Yield ComponentsChart II-13U.S. Corporate Bonds And Health Monitor Chart II-14Global Bonds: Developed Markets Chart II-15Global Bonds: Emerging Markets CURRENCIES: Chart II-16U.S. Dollar And PPP Chart II-17U.S. Dollar And Indicator Chart II-18U.S. Dollar Fundamentals Chart II-19Japanese Yen Technicals Chart II-20Euro Technicals Chart II-21Euro/Yen Technicals Chart II-22Euro/Pound Technicals COMMODITIES: Chart II-23Broad Commodity Indicators Chart II-24Commodity Prices Chart II-25Commodity Prices Chart II-26Commodity Sentiment Chart II-27Speculative Positioning ECONOMY: Chart II-28U.S. And Global Macro Backdrop Chart II-29U.S. Macro Snapshot Chart II-30U.S. Growth Outlook Chart II-31U.S. Cyclical Spending Chart II-32U.S. Labor Market Chart II-33U.S. Consumption Chart II-34U.S. Housing Chart II-35U.S. Debt And Deleveraging Chart II-36U.S. Financial Conditions Chart II-37Global Economic Snapshot: Europe Chart II-38Global Economic Snapshot: China
Dear Client, This is our final publication for the year. We will be back on January 5th. On behalf of the entire Global Investment Strategy team, I would like to wish you a Merry Christmas, Happy Holidays, and a Prosperous New Year! Best regards, Peter Berezin, Chief Global Strategist Highlights Global bonds have sold off in recent days, but the spread between long-term and short-term Treasury yields remains well below where it was at the start of the year. A flatter Treasury yield curve suggests that the ongoing U.S. business-cycle expansion is getting long in the tooth. Nevertheless, three factors dilute the potentially bearish message from the curve. First, the yield curve has flattened largely because short-term rate expectations have risen thanks to better economic data. Second, both the 10-year/2-year and 10-year/3-month spreads are still above levels that have foreshadowed poor returns for risk assets in the past. This is particularly true for equities. Third, a structurally low term premium has distorted the signal from the yield curve. The U.S. yield curve is likely to steepen over the next six months, before flattening again in the lead-up to a recession in late-2019. We reveal the One Number that will kill bitcoin. Feature A Harbinger Of Recession? The U.S. yield curve has steepened in recent days, but is still much flatter than it was at the start of the year. The 10-year/3-month spread currently stands at 113 bps, down 84 bps year-to-date. The 10-year/2-year spread has fallen from 125 bps to 62 bps. Numerous academic studies have highlighted the importance of the yield curve as a leading indicator of recessions.1 In fact, every U.S. recession over the past 50 years has been preceded by an inverted yield curve (Chart 1). Chart 1An Inverted Yield Curve Has Often Been A Harbinger Of A Recession The converse has generally been true as well: Most inversions in the yield curve have coincided with a recession. The only two exceptions were in 1967 - when credit conditions tightened and industrial production decelerated, but the U.S. still managed to avoid succumbing to a recession - and in 1998, when the yield curve briefly inverted during the LTCM crisis. Considering that recessions and equity bear markets typically overlap (Chart 2), it is not surprising that investors have begun to fret about what a flatter yield curve may mean for their portfolios. Chart 2Recessions And Bear Markets Usually Overlap Don't Worry... Yet Chart 3U.S. Growth Expectations Revised Higher We would not be as dismissive of a flatter yield curve as Fed Chair Yellen was during her December press conference. Policymakers and investors alike have been too quick to downplay the signal from the yield curve in the past. In 2006, they blamed the "global savings glut" for dragging down long-term yields. In 2000, they argued that the federal government's budget surplus was reducing the supply of long-term bonds. In both cases, the bond market turned out to be seeing something more ominous than they were. That said, there are three reasons why we would discount some of the more bearish interpretations of what a flatter yield curve is telling us. First, the flattening of the yield curve has occurred mainly because of an increase in short-term rate expectations, rather than a decrease in long-term bond yields. The increase in rate expectations has been largely driven by stronger growth data. The economic surprise index has surged far into positive territory and analysts are now scrambling to revise up their 2018 and 2019 U.S. GDP growth projections (Chart 3). The Fed now sees growth of 2.5% in 2018 and an unemployment rate of 3.9% by the end of next year. Back in September, the Fed expected growth of 2.1% and an unemployment rate of 4.1%. Second, our research suggests that the slope of the yield curve only becomes worrisome for the economy when it falls to extremely low levels. This conclusion is reinforced by the New York Fed's Yield Curve Recession Model, which uses the difference between 10-year and 3-month Treasury rates to estimate the probability of a U.S. recession twelve months ahead.2 The model's current recession probability stands at a modest 11% (Chart 4). The last three recessions all began when the implied probability was over 25%. Chart 4NY Fed's Yield Curve Model Suggests That The Probability Of A Recession Is Still Quite Low Third, the slope of the yield curve is weighed down by a structurally low term premium. The term premium measures the additional return investors can expect to receive by locking in their money in a 10-year Treasury note instead of rolling over a short-term Treasury bill for an entire decade. Historically, the term premium has been positive. Over the past few years, however, it has often been negative - meaning that investors have been willing to pay a premium to take on duration risk. Many commentators have attributed this peculiar state of affairs to central bank asset purchases, which they claim have artificially depressed long-term bond yields. There is some truth to this, but we think there is an even more important reason: Bonds today provide a good hedge against bad economic news. When fears of an economic slowdown mount, equities tend to sell off, while bond prices rise. This differs from the circumstances that existed in the 1970s and 1980s, when bad economic news usually meant higher inflation. To the extent that long-term bonds now serve as insurance policies against recessions, investors are more willing to accept the lower yields that they offer. Empirically, one can see this in the shift of the correlation between equity returns and bond yields. It was strongly negative up until the mid-1990s. Now it is strongly positive (Chart 5). A low term premium implies that the slope of the yield curve should be structurally flatter. That is exactly what we see today. Chart 6 shows that the 10-year/3-month spread would be well above its long-term average if the term premium were removed from the picture. This implies that investors have little to fear from the shape of today's yield curve, at least over the next six-to-twelve months. Chart 5Bond Prices Now Tend To Rise When Equity Prices Go Down Chart 6Stripping Out The Term Premium,##BR##The Yield Curve Is Not So Flat Rising Odds Of A Recession In Late-2019 Beyond then, things start to get dicey. The Fed's end-2018 unemployment rate projection of 3.9% is 0.7 percentage points below its long-term estimate of the unemployment rate. This means that at some point in the future, the Fed will need to lift interest rates above their "neutral" level in order to push the unemployment rate up to its equilibrium level. That's a risky gambit. There has never been a case in the post-war era where the unemployment rate has risen by more than one-third of a percentage point without a recession ensuing (Chart 7). Modern economies are subject to feedback loops. Once economic conditions begin to deteriorate, households cut back on spending. This leads to less hiring and even less spending. Bad economic news begets worse news. Chart 7Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Implications For Equities And Credit A flatter Treasury yield curve suggests that the U.S. business cycle is entering the home stretch. Nevertheless, as we pointed out two weeks ago, the 7th-to-8th innings of business-cycle expansions are often the juiciest for equity investors (Table 1).3 Table 1Too Soon To Get Out Chart 8 shows that the term spread today is still at levels that have signaled positive equity returns in the past. In fact, today's term spread is close to levels that prevailed in the second half of the 1990s, a period that coincided with the greatest bull market in American history. This message is echoed by our forthcoming MacroQuant model, which continues to flag upside risks for stocks over the next 6-to-12 months (Chart 9). Chart 8Current Term Spread Is Still Pointing##BR##To Positive Equity Returns Chart 9MacroQuant Still Positive##BR##On The Stock Market Globally, we favor euro area and Japanese equities (in local-currency terms) in the developed market sphere due to our expectation that the euro and yen will depreciate somewhat next year. Both the euro area and Japan also have greater exposure to cyclical sectors. This fits with our bias towards owning cyclicals over defensive stocks. Today's term spread is a bit more worrying for corporate credit. As our bond strategists have noted, a flatter yield curve is consistent with lower, though still positive, monthly excess returns for high-yield bonds (Chart 10).4 Again, the second half of the 1990s provides a potentially useful template: Despite a sizzling stock market, high-yield spreads actually widened as corporations loaded up on debt (Chart 11). The deterioration in our Corporate Health Monitor over the past five years suggests that a similar dynamic may be afoot (Chart 12). Chart 10Junk Monthly Excess Returns##BR##And The Yield Curve Chart 11Second Half Of 1990s: When High-Yield Spreads##BR##Rose With Stock Prices Chart 12Corporate Health Has##BR##Been Deteriorating Yield Curve Should Steepen Over The Coming Months Of course, much depends on what happens to the yield curve going forward. We suspect that it will flatten again towards the end of next year. However, it is likely to steepen over the next six months. U.S. GDP growth will remain above trend next year, as wages start to rise more briskly and firms boost capital spending to meet rising demand for their products. Fiscal policy should also help. Tax cuts will lift growth by 0.2%-to-0.3% in 2018. Higher disaster relief efforts following the hurricanes and a pending agreement to raise caps on discretionary spending will also translate into increased federal government spending. Investors have largely overlooked this source of fiscal stimulus, but increased spending will contribute almost as much to growth next year as lower taxes. Unfortunately, all this additional growth, coming at a time when the output gap is all but closed, is likely to stoke inflationary pressures. Our Pipeline Inflation Pressure Index has risen sharply since early 2016, while the ISM prices paid index has shot up. The New York Fed's Underlying Inflation Gauge has accelerated to an 11-year high of 3% (Chart 13). Historically, rising inflation expectations have led to a steeper yield curve (Chart 14). The implication is that investors should favor inflation-linked securities over government bonds. Chart 13U.S. Inflation Pressure Are Building Chart 14Rising Inflation Expectations Lead To A Steeper Yield Curve The One Number That Will Kill Bitcoin In a normal world, most reasonable people would regard a flatter yield curve and continued weak inflation readings as evidence that fiat money was, if anything, doing too good a job as a store of value. However, nothing is normal or reasonable about bitcoin.5 Chart 15Governments Will Want Their Cut:##BR##U.S. Seigniorage Revenue No one knows when the bitcoin bubble will burst. Only a tiny fraction of the public owns the virtual currency. The value of all bitcoin in circulation represents 0.35% of global GDP. At its peak in 1996, the value of all pyramid scheme assets in Albania amounted to almost half of GDP. Never underestimate the lure of easy money. While we do not know where the price of bitcoin will be ten months from now, we do have a good guess of where it will be ten years from today. And that price is zero, or thereabouts. When the U.S. Treasury issues a $100 bill, it gains the ability to buy $100 of goods and services with it. The government's cost is whatever it pays to print the bill, which is next to nothing. This so-called "seigniorage revenue" is set to reach $100 billion this year (Chart 15). That is the number that will kill bitcoin. There is no way the U.S. government will forsake this revenue in order to make room for bitcoin and other cryptocurrencies. Not when there are entitlements to pay and gaping budget deficits to finance. A variety of other countries have a love-hate relationship with bitcoin, partly because of their "the enemy of my enemy is my friend" attitude towards the dollar. But that will change when they see their tax bases eroding as more commerce gets done in the anonymous world of cryptocurrencies. Bitcoin's days are numbered. The only question is who will be holding the bag when the party ends. Peter Berezin, Chief Global Strategist peterb@bcaresearch.com 1 Please see Jonathan H. Wright, "The Yield Curve And Predicting Recessions," FEDs Working Paper No. 2006-7, May 3, 2006; Michael Owyang, "Is the Yield Curve Signaling a Recession?"Federal Reserve Bank Of St. Louis, March 24, 2016; and Arturo Estrella and Mishkin, Frederic S., "The Yield Curve as a Predictor of U.S. Recessions," Federal Reserve Bank Of New York, (2:7), June 1996. 2 Please see "The Yield Curve As A Leading Indicator: Probability of U.S. Recession Charts," Federal Reserve Bank Of New York. 3 Please see Global Investment Strategy Weekly Report, "When To Get Out," dated December 8, 2017. 4 Please see U.S. Bond Strategy, "Proactive, Reactive Or Right?" dated December 12, 2017. 5 Please see European Investment Strategy Weekly Report, "Bitcoins And Fractals," dated December 21, 2017; Technology Sector Strategy Special Report, "Cyber Currencies: Actual Currencies Or Just Speculative Assets?" dated December 12, 2017; Global Investment Strategy Special Report, "Bitcoin's Macro Impact," dated September 15, 2017; and Technology Sector Strategy Special Report, "Blockchain And Cryptocurrencies," dated May 5, 2017. 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Highlights As bitcoin has developed into a fledgling form of money, the best valuation framework for it is the quantity theory of money. This states that the bitcoin money supply (in dollars) times bitcoin's velocity of circulation = the amount of world GDP carried out in bitcoin. In the short term, excessive herding signals a likely countertrend reversal, and implies that the bitcoin price will retest $12,750 at some point in the next 130 days. In the long term, the wholesale acceptance of cryptocurrencies in the global economy will be deflationary. Feature Bitcoin's near-vertical price ascent to $19,000 has left many commentators crying "bubble!" The problem with this is that you cannot define an asset bubble simply from the behaviour of a price. You need to assess fundamental value, and the extent of deviation above this fundamental value. Conceivably, bitcoin's near-vertical price ascent could be a correction from an "anti-bubble", in which the price was a long way below its fundamental value and rapidly corrected upwards. Which begs the question: what is the best way to assess the fundamental value of bitcoin and other cryptocurrencies? Chart of the WeekCryptocurrencies Will Prevent Inflation, Just Like The Gold Standard A Valuation Framework For Bitcoin As bitcoin has developed into a fledgling form of money, one potential valuation framework is the quantity theory of money. This states that the money supply times its velocity of circulation equals nominal GDP. Given that the supply of bitcoin will not exceed an upper limit of 21 million coins, we can say that the bitcoin money supply (in dollars) is the bitcoin price times 21 million. We can then use the quantity theory to deduce: Bitcoin price times 21 million times bitcoin's velocity of circulation = Amount of world GDP carried out in bitcoin. If we additionally assume that bitcoin's velocity is similar to that of the stock of broad fiat money, 1.5, then we can rearrange and simplify the equation to approximately: Bitcoin price = Amount of world GDP carried out in bitcoin divided by 30 million So if the market was discounting that $0.5 trillion of world GDP would be carried out in bitcoin, then its price should be $16,700. Given the purported nefarious uses of cryptocurrencies at the moment, and an estimated size of the world's shadow economy at around $16 trillion, an assumption of $0.5 trillion of bitcoin use in the world economy does not seem excessive. On the other hand, nefarious use might make bitcoin's velocity of circulation a lot higher than conventional money. Which would pull bitcoin's fair price much lower. Suffice to say, the above assumptions are broad-brush and open to challenge. Nevertheless, despite the many caveats, the above framework is probably the most valid for valuing a cryptocurrency once it gains acceptance as a fledgling form of money. Putting Bitcoin Through Fractal Analysis The behaviour of price alone cannot gauge an asset bubble. But the behaviour of price alone can gauge a shortage of liquidity in the asset which implies a potential countertrend reversal. Liquidity is plentiful when the market is split between short-term momentum traders and longer-term value investors. This is because the two herds generally disagree with each other. If the price fluctuates up, the momentum trader wants to buy while the value investor wants to sell; and vice-versa. So the herds trade with each other with plentiful liquidity and little movement in price. This raises an obvious question. Can there really be any value investors in cryptocurrencies? The answer is potentially yes, if these investors believe that cryptocurrency acceptance will increase over time. And if they apply the aforementioned valuation framework from the quantity theory of money. Still, liquidity will periodically evaporate if too many value investors join the short-term momentum herd. Instead of dispassionately investing on the basis of a valuation framework, value investors get lured into participating in a strong rally, and their buy orders add fuel to the rally. A tipping point comes when all the value investors have joined the momentum herd. If a value investor then suddenly reverts to type and puts in a sell order, he will find that there are no buyers left. Liquidity has evaporated, and finding new liquidity might require a substantial reversal in the price to attract a buy order from an ultra-long-term deep value investor. As regular readers know, fractal analysis measures whether the herding behaviour in any financial instrument has reached its tipping point, signalling a likely end of its price trend. Today, the 130-day herding indicator for bitcoin is at a level which has indicated three previous countertrend reversals of at least one fifth of the preceding 130-day move (Chart I-2, Chart I-3, Chart I-4). Chart I-2Bitcoin: The 130 Day Fractal Dimension Signalled A Reversal In 2015 Chart I-3Bitcoin: The 130 Day Fractal Dimension Signalled Two Reversals In 2017 Chart I-4Bitcoin: The 65 Day Fractal Dimension Also Signalled Two Previous Reversals If this herding indicator signals a fourth countertrend reversal, it implies that the bitcoin price will retest $12,750 at some point in the next 130 days. Are Cryptocurrencies Inflationary Or Deflationary? On the face of it, the emergence of cryptocurrencies sounds inflationary. After all, if the general acceptance of cryptocurrencies for commercial transactions increases, there will be new money supply. And this new money supply will increase the nominal demand for goods and services. However, the truth is more nuanced. Unlike fiat money supply - which can expand without limit - each cryptocurrency has a defined limit to its supply. Although new cryptocurrencies can emerge, there seems to be a limit to the aggregate amount of cryptocurrency supply. The limiting factor is that it takes energy to create cryptocurrency through so-called 'mining'. Miners must compete to validate transactions that occur in a cryptocurrency. The competition takes the form of solving a mathematical problem - for example, finding the prime factors of a very large number. And the computational demands are energy sapping. Furthermore, the computational demands - known as 'proof of work' - get progressively more difficult for each additional new coin mined. Given that the computational resources in the world are finite and growing at a gentle and predictable rate, the implication is that the growth in the total amount of cryptocurrency is also limited. So while the emergence of cryptocurrencies does increase the money supply in the near-term (Chart I-5), a large-scale rejection of fiat money would make it impossible for uncouth policymakers to spike the overall money supply over the longer-term. Chart I-5Cryptocurrencies: Market Cap Is Now Non-Trivial Here's a further thought. Imagine if the proof of work computations, instead of being random mathematical calculations, solved useful problems that expanded the envelope of knowledge. This could boost real productivity, which is ultimately just a function of the stock of human ingenuity. In which case, any increase in money supply would be matched by an increase in potential real output. Interestingly, a recent paper from the Bank of Canada proposes that a wholesale acceptance of cryptocurrencies in the global economy could act as a new gold standard, whose effect would be mildly deflationary1 (Chart of the Week) and Table I-1). We fully agree with the Bank of Canada analysis. Table I-1No Persistent Inflation For 700 Years! The sting in the tail is that the analysis describes prices denominated in cryptocurrency terms. In fiat currency terms, the quantity theory of money implies that prices would rise2 - unless central banks reacted to the emergence of cryptocurrencies by shrinking the supply of fiat money. Would they? Very likely yes. If they didn't, the demise of fiat money would accelerate as people voted with their wallets and switched to superior stores of purchasing power. Nevertheless, we suspect that any central bank response would just delay the inevitable. As Larry Summers puts it: I am much more confident that the world of payments will look very different 20 years from now than I am about how it will look. And with that observation, I am signing off for 2017. I do hope you have enjoyed our provocative and counterintuitive insights this year. In the vast majority of cases, these insights have led to highly profitable investment recommendations. We promise to continue the success in 2018! Early next year, we will also unveil a major enhancement to our proprietary fractal trading strategy. So stay tuned. It just remains for me to wish you all a very enjoyable Festive Season and a prosperous 2018. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Bank of Canada Staff Working Paper, A Bitcoin Standard: Lessons from the Gold Standard https://www.bankofcanada.ca/2016/03/staff-working-paper-2016-14/ 2 Please see the Global Investment Strategy Special Report titled "Bitcoin's Macro Impact", dated September 15, 2017 available at gis.bcaresearch.com and Technology Sector Strategy Special Report titled "Cyber Currencies: Actual Currencies Or Just Speculative Assets?", dated December 12, 2017 available at tech.bcaresearch.com. Fractal Trading Model* As discussed in the main body of this report, this week's trade is to expect a countertrend reversal in bitcoin. Go short with a profit target at $12750 and stop-loss at $28000. In other trades, long silver has had a strong 1-week bounce while long U.K. personal products / short U.K. food and beverages reached the end of its 65 day maximum holding period and closed with a small 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. Chart I-6 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 Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions 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##br## - Interest Rate Expectations Chart II-6Indicators To Watch ##br##- Interest Rate Expectations Chart II-7Indicators To Watch ##br##- Interest Rate Expectations Chart II-7Indicators To Watch ##br##- Interest Rate Expectations
Dear Client, This is our last report of 2017. We will be back on January 4, 2018, with our customary recap of recommendations made this year. We wish you and your loved ones the very best this lovely season has to offer. Sincerely, Robert P. Ryan, Chief Commodity Strategist Commodity & Energy Strategy Highlights With GDP growth accelerating in ~ 75% of countries monitored by the IMF, we expect commodity demand - particularly for crude oil and refined products - to remain strong in 2018. On the supply side, OPEC 2.0 - the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia - will maintain its production discipline, which will force commercial oil inventories lower in 2018. As a result, we expect oil markets to continue to tighten in 2018, keeping upside risk to prices from unplanned production outages acute. This was clearly demonstrated in separate incidents in the U.S. and North Sea in the past two months, which removed more than 400k b/d from markets since November. Geopolitical risk will remain elevated, particularly in Venezuela, where operations at the state oil company were paralyzed after senior military officers assumed leadership positions there. Beyond 2018, we believe OPEC 2.0 will endure as a coalition. It will manage production and provide forward guidance consistent with a strategy to keep WTI and Brent forward curves backwardated. This will provide a supportive backdrop for the Saudi Aramco IPO, expected toward the end of next year, and will limit the volume of hedging U.S. shale-oil producers are able to effect. In turn, this will limit the number of rigs U.S. E&Ps can profitably deploy. Energy: Overweight. Our Brent and WTI call spreads in 2018 - long $55/bbl calls vs. short $60/bbl calls - are up an average 53.8%. We will retain these exposures into 2018. Base Metals: Neutral. We expect base metals to be supported through 1Q18, after which reform measures in China could crimp supply and demand, as we discuss below. Precious Metals: Neutral. We remain long gold as a strategic portfolio hedge against inflation and geopolitical risk, even though inflation remains quiescent (see below). Ags/Softs: Underweight. Fed policy will be critical to ag markets in 2018. We expect as many as four rate hikes next year, as the Fed continues with rates normalization (see below). Feature Our updated balances model indicates global oil markets will continue to tighten in 2018, as demand growth accelerates and OPEC 2.0 - the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia - maintains production discipline (Chart of the Week). Earlier this week, IMF noted improving employment conditions globally, which will continue to support aggregate demand and the synchronized global expansion in manufacturing and trade (Chart 2 and Chart 3).1 This acceleration of GDP growth rates globally will continue to support income growth and commodity demand generally. Oil-exporters have not participated in the global economic expansion to the extent of other economies, according to the Fund, which can be seen in the trade data (Chart 3). However, imports by Middle East and African countries are moving higher, and look set to post year-on-year (yoy) growth in the near future. Chart of the WeekOil Balances Will Continue to Tighten In 2018 Chart 2Global Upturn Boosts Manufacturing, ##br##Commodity Demand... The combination of continued production discipline from OPEC 2.0 and expanding incomes boosting demand will force crude and product inventories lower, particularly those in the OECD, which are the primary target of the producer coalition (Chart 4). Chart 3...And Global Trade Chart 4OECD Inventories Will Fall Below 5-year ##br##Average In BCA's Supply-Demand Assessment Unplanned Outages Mounting; Risk Remains Acute Unlike many forecasters, we continue to expect inventories to draw in 1Q18. This expectation is the direct result of our supply-demand modelling, and also is supported by our expectation that the risk of unplanned outages is increasing. This already has been demonstrated in the U.S. and U.K. North Sea, where more than 400k b/d of pipeline flows in November and December were lost. Of far greater moment, however, is the potential for unplanned outages in Venezuela. We believe the state-owned oil company there is one systemic malfunction away from shutting down exports entirely - e.g., a breakdown in pumping stations - as happened in 2002. Reuters reports the government of Nicolas Maduro appears to be consolidating power via an "anti-corruption" campaign, and is installing senior military officials with little or no industry experience in leadership roles inside PDVSA.2 Reuters notes, "The ongoing purge, in which prosecutors have arrested at least 67 executives including two recently ousted oil ministers, now threatens to further harm operations for the OPEC country, which is already producing at 30-year-lows and struggling to run PDVSA units including Citgo Petroleum, its U.S. refiner." The news service goes on to report, "Executives that remain, meanwhile, are so rattled by the arrests that they are loathe to act, scared they will later be accused of wrongdoing." We have Venezuela output at just under 1.90mm b/d, and expect it to decline to a little more than 1.70mm b/d by the end of 2018. Brent Expected To Average $67/bbl In 2018 We continue to forecast average Brent prices of $67/bbl and WTI at $63/bbl next year, given our assessment of global supply-demand balances, which drive our fundamental price forecasts: We expect global crude and liquids supply to average 100.23mm b/d in 2018, vs 100.01mm b/d expected by the U.S. EIA, while we have global demand coming in at 100.29mm b/d on average next year, vs the 99.97mm b/d expected by EIA (Chart 5 and Chart 6). Chart 5BCA's Expected Crude Oil Supply Vs. EIA's Chart 6BCA's Expected Demand Exceeds EIA's In 2018 Our expectations translate into a 2.55mm b/d increase in supply next year, vs a 1.67mm b/d increase in demand yoy (Table 1). Running the EIA's supply-demand assessments through our fundamental pricing models produces average Brent and WTI prices of $49/bbl and $47/bbl, respectively. EIA is expecting a 2.04mm b/d increase in supply next year, vs a 1.63mm b/d increase in demand. Table 1BCA Global Oil Supply - Demand Balances (mm b/d) In line with our House view, we are expecting some USD strengthening on the back of as many as four interest-rate hikes by the Federal Reserve in the U.S. (Chart 7). As we've noted in the past, we expect these effects to be felt more in 2H18. Along with higher U.S. shale-oil production driven by higher prices - we expect shale output to go up 0.97mm b/d next year to 6.64mm b/d - a stronger USD will keep Brent and WTI prices below $70/bbl next year. Oil Beyond 2018: OPEC 2.0 Endures OPEC 2.0 will remain an enduring feature of the oil market going forward, in our view. Allowing the coalition to fade away, and returning the global oil market to a production free-for-all once again serves neither KSA's nor Russia's interests. Following the IPO of Saudi Aramco toward the end of 2018, KSA will, we believe, want to maintain stability in the market, by demonstrating to capital markets that OPEC 2.0 can manage crude-oil supplies in a way that is not disruptive to its new-found investors. It is important to remember the Aramco IPO is only the beginning of the process of transforming KSA from a crude resource exporter into a vertically integrated global refining and marketing colossus. To eclipse Exxon as the world's largest refiner, Aramco would benefit from continued access to capital markets throughout the following decades, as well reliable cash flows to lower its cost of capital, service debt, and maintain whatever dividends it envisions. This cannot occur if oil markets are continually at risk of collapsing because production cannot be managed in a business-like manner. While Russia has not embarked on the same sort of transformation of its resource industry as KSA, it still has a very strong interest in maintaining stability in the crude oil markets, given its dependence on hydrocarbon exports. The Russian rouble moves in near-lock-step with Brent prices - since 2010, Brent prices explain ~80% of the movement in the rouble (Chart 8). It is obvious a collapse in global crude oil prices would, once again, have devastating effects on Russia's economy, as it did in 2009 and 2014. Such a collapse would trigger inflation domestically, as the cost of imports skyrockets, and threaten civil unrest as incomes and GDP are hobbled and foreign reserves evaporate. Chart 7Stronger USD Limits Oil-Price Appreciation In 2018 Chart 8Russia Cannot Afford An Oil Price Collapse Both KSA and Russia have a deep interest in maintaining oil's pre-eminent position as a transportation fuel for as long as possible. For this reason, neither wants to encourage prices that are too high - $100/bbl+ prices greatly encouraged the development of shale technology in the U.S. - nor too low, given the dire consequences such an outcome would have for both their economies. The common goals of KSA and Russia cannot be achieved by allowing OPEC 2.0 to dissolve, leaving member states to produce at will in the sort of production free-for-all that characterized the OPEC market-share war of 2014 - 15. To the extent possible, OPEC 2.0 must continue to manage member states' production in a manner that does not permit inventories to once again fill to the point where the only way to moderate over-production is to push prices through cash costs, so that enough output is shut in to clear the market. The most obvious way for these goals to be accomplished is by keeping markets relatively tight. This can be done by keeping commercial oil inventories worldwide low enough to keep Brent and WTI forward curves backwardated - particularly in highly visible OECD and U.S. storage facilities. A backwardated forward curve means the average price over a typical 2- or 3-year hedge horizon is lower than the spot price received by OPEC 2.0 producers. The deeper the backwardation, the lower the average price a U.S. shale producer can lock in by hedging. This limits the number of rigs that can be deployed by shale producers. This will require continual communication with markets to assure them sufficient spare capacity and easily developed production can be brought to market to alleviate any temporary shortage. In the meantime, OPEC 2.0 members with flexible storage will need to communicate these barrels will be readily available to the market. This management and forward-guidance should be easier for OPEC 2.0 to execute on, following its recent success in keeping some 1.0mm b/d of production off the market - largely in KSA and Russia - and member states' existing spare capacity and storage. We continue to expect the daily working dialogue of the OPEC 2.0 member states - most especially KSA and Russia - to deepen as time goes by, and for tactics and strategy to evolve as each gains comfort operating with the other. Whether OPEC 2.0 can pull this off remains to be seen. However, given the success of the coalition over the past two years, we are inclined to believe they will continue to develop a durable modus operandi supporting this outcome. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Analyst HugoB@bcaresearch.com Opposing Forces: Stay Neutral Metals In 2018 Chart 9Strong Global Demand Will Neutralize ##br##Impact of China Slowdown While we expect more upside to metal prices in the first half of 2018, slowing growth in China and a stronger USD will prevent a repeat of this year's stellar performance. While a deceleration in China is - ceteris paribus - most definitely a headwind to metal prices, we believe the impact may pan out differently this time around. The silver lining comes from the Communist Party's commitment to environmental reforms, which, in many cases, will manifest themselves in the form of less supply of the refined product, or demand for the ores. Either way, this alone is a positive for metals. China's Environmental Reforms Will Dominate in 1Q18 China's commitment to cleaning its air is currently shaping up in the form of winter cuts in major steel- and aluminum-producing provinces. While policies are hard to predict, we will keep monitoring the development and implementation of reforms from within China to assess how they will impact the markets. Outcomes from the Annual National People's Congress in March will give us a clearer indication of what to expect in terms of policy. For now, we see these reforms putting a floor under metal prices, at least in the beginning of 2018. Robust Global Demand Offsets Stronger USD & Slower Chinese Growth Xi's reforms will turn into a headwind for metal prices as they begin to impact the real economy in 2H18. Signs of weakness have already emerged in measures of industrial activity such as the Li Keqiang and Chinese PMI (Chart 9). In addition, the real estate sector has been showing some weakness since the beginning of the year. Annual growth rates in real estate investment and floor-space started are decelerating - a worrisome sign. Nonetheless, domestic demand remains robust, and policymakers in Beijing are approaching economic reforms gradually and with caution. Consequently we do not expect a major policy mistake to derail the Chinese economy. While Chinese growth will likely slow from above trend levels, a hard landing is most probably not in the cards. Another bearish risk comes from a stronger USD. We see the Fed as more committed to interest-rate normalization than markets expect, and consequently would not be surprised to see up to four rate hikes next year. Inverting the yield curve is a policy mistake incoming Chair Jerome Powell will try to avoid; however, we expect inflation to bottom in the first half of next year, giving the Fed room to accelerate its path of rate hikes. This will result in a stronger USD, which is bearish for commodities priced in U.S. dollars. In any case, these bearish factors will likely be offset by strong global growth, supported by a robust U.S. economy. Bottom Line: Xi's reforms will dominate metal markets in 2018 as bullish supply side environmental reforms duel against bearish demand-side economic reforms. Robust global growth will neutralize the impact of downside pressures. Stay neutral, but beware of modest USD strength. Low Inflation Retards Gold's Advance Once again, reality confounded theory: Inflation failed to emerge this year, even as systematically important central banks remained massively accommodative, and some 70% of the economies tracked by the OECD reported jobless rates below the commonly used estimate of the natural rate of unemployment (Chart 10). Chart 10Massive Monetary Accommodation Failed ##br##To Spur Inflation In The U.S. These fundamentals should be inflationary and supportive of gold. To date, they haven't been. We Expect Inflation To Revive The global economy has endured decades of low inflation going back at least to the 1990s. This has been driven by numerous factors. First, the expansion of the global value chain (GVC) over the past three decades has synchronized inflation rates worldwide, as our research and that of the BIS has found. As a result, U.S. wages and goods' inflation are now more dependent on global spare capacity. With the global output gap now almost closed, this disinflationary force will dissipate.3 Second, most measures of labor-market slack are now pointing toward tighter conditions, which, we expect, will strengthen the Phillips curve trade-off between inflation and unemployment next year. Inflation is a lagging indicator: Wage inflation lags the unemployment rate, and CPI inflation lags wage inflation. Investors should expect inflation to show up in 2018.4 Lastly, one-off technical factors, which depressed inflation last year - e.g. drop in cellphone data charges and prescription drug prices - also will fade. Once these big one-offs are no longer in annual percent-change calculations, inflation rates will rise. The Fed's Choppy Waters Against this backdrop, the Fed is embarking on a rates-normalization policy, which we believe will result in U.S. central bank's policy rate being increased up to four times next year. The risk of a policy error is high. Should the Fed proceed with its rate hikes while inflation remains quiescent, real interest rates will increase. This would depress gold prices, and, at the limit, threaten the current economic expansion by tightening monetary conditions well beyond current levels, potentially lifting unemployment levels. If, on the other hand, the Fed deliberately keeps rate hikes below the rate of growth in prices - i.e., it stays "behind the curve" - it risks being forced to implement steeper rate hikes later in 2018 or in 2019 to get stronger inflation under control. This could tighten monetary conditions suddenly, and threaten the expansion, pushing the U.S. economy into recession. There's a lot riding on how the Fed navigates these difficult conditions. Geopolitical Risks Will Support Gold On the geopolitical side, the risks we've identified in our October 12, 2017 publication - i.e. (1) U.S.-North Korea tensions, (2) trade protectionism of the Trump administration, and (3) ongoing conflicts in the Middle East-- will add a geopolitical risk premium to gold prices, supporting the metal's role as a safe haven.5 Bottom Line: We remain neutral precious metals, but still recommend investors allocate to gold as a strategic portfolio hedge against inflation and geopolitical risk. U.S. Policies Will Weigh On Ags In 2018 U.S. monetary and trade policy will dominate ags next year. Our modelling reveals that U.S. financial factors - real rates and the USD - are significant in explaining ag price behavior (Chart 11).6 Given that we expect the Fed to hike interest rates more aggressively than what the market is currently pricing in, we see grains as vulnerable to the downside. In addition, the risk that NAFTA is abrogated by the U.S. would weigh on ag markets, as Canada and Mexico are among the U.S.'s top three ag export destinations. Chart 11Bearish U.S. Monetary And Trade Policies ##br##Amid Healthy Inventories Will Weigh On Ags We expect ag markets will remain well supplied next year, and inventories will moderate the impact of supply-side shocks - most notably in the form of a La Nina event. The probability of a La Nina currently stands above 80%, and is expected to last until mid-to-late spring. U.S. Monetary Policy Is Relevant With U.S. inflation rates still subdued, there has been much talk about how soon the Fed will be able embark on its tightening cycle. A weaker-than-expected USD has been favorable for ag markets this year, and thus kept U.S. ag exports competitive. However, if and when the economy reaches the kink in the Philipps Curve, and inflation begins its ascent, the Fed will be able to proceed with its rate-hiking cycle. With the New York Fed's Underlying Inflation Gauge at a cycle high, we expect this scenario to unfold in the first half of 2018. This would give incoming Fed Chairman Jerome Powell ample room to hike rates which would - ceteris paribus - bear down on ag prices. FX Developments In Other Major Exporters Will Also Be Bearish The effects of higher U.S. interest rates are translated to ag markets via the exchange-rate channel. Commodities are priced in USD, thus a stronger USD vis-à-vis the currency of a major ag exporter will, all else equal, increase the profitability of farmers competing against U.S. exporters in international markets. Among the ag-relevant currencies, we highlight the Brazilian Real, EUR, Russian Rouble, and Australian Dollar as most likely to depreciate vis-à-vis the USD in 2018. Termination Of NAFTA Is A Risk For American Farmers U.S. farmers are keeping a close eye on NAFTA renegotiations, and rightly so. Canada and Mexico are the U.S.'s second and third largest agricultural export markets - accounting for 15% and 13% of U.S. agricultural exports in 2016, respectively. In fact, corn, rice, and wheat exports to Mexico accounted for 26%, 15%, and 11% share of U.S. exports of those commodities, respectively. However, as BCA Research's Geopolitical Strategy service points out, the long-run impact depends on the underlying reason for the termination of the trade agreement. If Trump is merely a "pluto-populist" - as they expect - NAFTA will simply be replaced by bilateral trade agreements, with no lasting economic disturbance. The risk is that Trump is a genuine populist. If this turns out to be the case, tariffs and a rejection of the WTO would make U.S. exports less competitive, and would become a bearish force in ag markets.7 The risk of a collapse in the NAFTA trade deal would be devastating for U.S. farmers. In fact, in a bid to reduce reliance on the U.S., Mexican Economic Minister Ildefonso Guajardo recently announced that they are working on a Mexico-European Union trade deal.8 In addition, Mexico signed the world's largest free trade agreement with Japan, and is currently exploring the opportunity to join Mercosur. Bottom Line: Weather-induced volatility is possible in the near term, as a La Nina event threatens to reduce yields. Nevertheless, U.S. financial conditions and trade policy will dominate ag markets in 2018. With markets underestimating the Fed's resolve regarding interest rate hikes, we see some upside to the USD. This will keep a lid on ag prices next year. 1 Please see "The year in Review: Global Economy in 5 Charts," published on the IMF Blog December 18, 2017. https://blogs.imf.org/2017/12/17/the-year-in-review-global-economy-in-5-charts/ 2 Please see "Paralysis at PDVSA: Venezuela's oil purge cripples company," published by reuters.com December 15, 2017. 3 The IMF estimates the median output gap for 20 advanced economies reached -0.1% in 2017 and will rise to +0.3% in 2018. Please see BIS https://www.bis.org/publ/work602.htm. The Bank for International Settlements in Basel describes the GVC as "cross-border trade in intermediate goods and services." 4 The U.S. unemployment has been under its estimated NAIRU for 9 consecutive months now. 5 Please see Commodity and Energy Strategy Weekly Report titled "Balance Of Risks Favors Holding Gold," dated October 12, 2017, available at ces.bcaresearch.com. 6 Our modelling indicates that U.S. financial factors are important determinants of agriculture commodity price developments. More specifically, a 1% move in the USD TWI and a 1pp change in 5 year real rates are associated with a 1.4%, and an 18% change in the CCI Grains & Oilseed Index, in the opposite direction. 7 Please see Global Investment Strategy Special Report titled "NAFTA - Populism Vs. Pluto-Populism," dated November 10, 2017, available at gis.bcaresearch.com. 8 Please see "Mexico sees possible EU trade deal as NAFTA talks drag on," dated December 13, 2017, available at reuters.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trade Recommendation Performance In 3Q17 Trades Closed in Summary of Trades Closed in
Dear Clients, This is the final publication for the year, in which we recap some of the key developments in 2017. We will resume our regular publishing schedule on January 4, 2018 with a brief market update. The China Investment Strategy team wishes you a very happy holiday season and a prosperous New Year! Best regards, Jonathan LaBerge, CFA, Vice President Special Reports Highlights 2017 served as a prime example of the periodic oscillation of Chinese economic policy between pursuing painful reforms and stimulating demand. While policymakers are merely attempting to control the private sector debt-to-GDP ratio, the risk of a tightening overshoot should not be discounted. Recent economic activity in China appears to have been driven by highly-polluting industries, in the context of strong public demand for an improvement in air quality. This raises the risk that environmental reforms over the coming few years could seriously curtail growth. The incredible returns from Chinese stocks this year means that investable equities are no longer "exceptionally cheap". Still, the range of valuation among Chinese investable sectors has increased, suggesting increased opportunity for alpha generation over the coming 6-12 months. Feature Following the publication of our special year end Outlook report for 2018,1 BCA's China Investment Strategy service recently expanded on our global view by outlining our three key themes for China over the coming year.2 As a year-end tradition, we dedicate this week's report to recapping some important developments of the past year and their longer-term implications. China's Mini Cycle In Requiem, From A Bigger Picture Perspective Chart 1Some Modest Deleveraging Achieved ##br##In The Corporate Sector 2017 saw the growth momentum of China's recent "mini cycle" peak, following a tightening in monetary conditions that began late last year. Part of the tightening in monetary conditions reflected normal countercyclical actions by the PBOC, but it also signified a strong desire on the part of policymakers to avoid significant further leveraging of the economy. As such, 2017 served as a prime example of the periodic oscillation of Chinese economic policy between promoting painful supply-side reforms and pushing demand-side countercyclical policies. Chart 1 highlights that policymakers did manage to achieve some modest outright deleveraging in the non-financial corporate sector in the first two quarters of the year, but at least half of this gain occurred because nominal GDP growth accelerated (i.e. the denominator of the debt-to-GDP ratio improved). No such deleveraging occurred in the household sector, which continued to see year-over-year debt growth of 24%. The struggling of Chinese policymakers to control the pace of credit growth reflects the inherent difficulty of China's new de-facto growth model, which shifted significantly in 2010. Chart 2 presents a stylized timeline of China's economic history over the past 15 years; rather than painting the rise in China's debt-to-GDP ratio in a sinister light, it underscores the unenviable lose-lose position facing Chinese policymakers in 2010. The chart describes how China's extremely rapid growth phase from 2002-2008 was followed by the global financial crisis and a normal rise in the debt-to-GDP ratio. This rise occurred due to a significant deceleration in nominal GDP growth, and standard counter-cyclical economic policy during an extremely challenging time for the global economy. However, following the onset of the economic recovery in 2009, it became clear that China's export-enabled catchup growth phase was durably over, and policymakers were faced with a hard choice: Either replace exports as a growth driver with debt-fueled domestic demand in order to buy the economy time to move up the value-added chain and to transition to a services-led economy (the "reflate" path), or allow the labor market to suffer the consequences of a sharp slowdown in export growth while preserving fiscal and state-owned firepower for some uncertain future opportunity (the "stagnate" path). Chart 2A Stylized Timeline Of China's Recent Economic History The well-known legacy of China's choice to pursue the "reflation" path is the significant and persistent gap between the growth rates of private non-financial credit and nominal GDP since 2010 (Chart 3). It is significant that this gap almost entirely closed in the first half of 2017, but a further deceleration in credit growth will be necessary to keep it closed given that nominal GDP growth is likely to decline over in the coming year. Chart 3No Overall Deleveraging,##br## But A Halt To Rising Leverage Table 1 underscores the lasting economic impact of the "sudden stop" experienced by China's external sector, even given the choice to pursue the "reflate" path, by presenting the contribution to real GDP growth by broad expenditure categories. Relative to the 2002-2008 average, the largest negative contributor to growth during the global financial crisis and its aftermath was from net exports, made up by a stimulus-induced acceleration in investment. However, over the following five years most of the deceleration in growth came from gross capital formation, as private producers adjusted to the new export environment by rapidly slowing their additions to new capacity. Absent new investment from China's state-owned sector (which occurred as part of the reflation plan), Table 1 strongly suggests that gross capital formation in China would have slowed much more aggressively than it did had policymakers not chosen to reflate the economy. Given this, many investors have a sanguine view on the risks posed by China's massive increase in debt-to-GDP, and are likely to view policymaker efforts to durably close this gap as a policy mistake. According to this perspective, global investors would be far less concerned if the post-2010 rise in debt had occurred explicitly on the government's balance sheet, and since most of the rise in non-financial corporate debt is attributable to the state-owned sector, it is quasi-sovereign in nature and thus not likely to be the source of a financial crisis. Table 1The Global Financial Crisis Caused A Lasting Economic Impact, ##br##Even Given China's Choice To Reflate Chinese policymakers would argue that their goal is simply to control China's debt-to-GDP ratio and to stop continued leveraging, not to put the financial system on an active deleveraging path that would risk destabilizing the economy. But even within this policymaker framework, there are two clear potential risks, both of which will need to be tracked over the coming year. The first is that the monetary tightening that has already occurred (and is still underway) causes debt service payments to become unbearable for state-owned firms, which forces a crisis that inflicts considerable short-term pain on the economy. The second is that other reform initiatives, those intended to pare back heavy-polluting industry (see below), to hasten the transition of China's economy to "consumer-led" growth, and to continue to crack down on corruption and graft end up negatively impacting the economy in a way that policymakers did not intend. Both of these risks will need to be monitored closely in 2018 and beyond. Bottom Line: 2017 served as a prime example of the periodic oscillation of Chinese economic policy between promoting painful supply-side reforms and pushing demand-side countercyclical policies. While policymakers are merely attempting to control the private sector debt-to-GDP ratio and are not pushing for active deleveraging, the risk of a tightening overshoot should not be discounted. Bumping Up Against The Environmental "Red Line" Another legacy of 2017 is the environmental impact of the recent economic mini cycle, and the lasting effect that poor air quality is likely to have on the country's reform agenda. Chart 4 presents one commonly used measure of air quality, termed PM2.5. It represents the concentration of airborne particulate matter that is 2.5 microns in size or smaller (smaller particles are more of a health risk), rescaled into an index. When using this measure, a value less than 50 is deemed to be good, whereas values above 50 are not ideal. At an index value of 150, PM2.5 concentrations become unhealthy for the entire population, not just sensitive groups. Chart 4Chinese Air Quality Deteriorated During ##br##This Growth Mini Cycle The chart shows the rolling 3-month average PM2.5 index for Beijing since 2010, along with the year-over-year change in the index. Three points are noteworthy: Over the past 8 years, Beijing's air quality has never been ranked as "good" for any significant period of time, and has typically contained moderate amounts of harmful particulate matter. Interestingly, at the onset of the recent growth mini-cycle in 2015, China's air quality deteriorated rapidly, nearly into unhealthy territory. This occurred again earlier in 2017, suggesting that the type of economic activity associated with growth over the past two years has been particularly negative for the environment. The slowdown in the Li Keqiang index over the past 6-9 months has corresponded with the largest year-over-year decline in Beijing's PM2.5 concentration since early-2015, when economic activity in China was slowing sharply. Given this, it is not surprising that President Xi's speech during the Party Congress in October emphasized the need to scale back highly-polluting heavy industry over the coming years. But if recent economic activity in China has been driven by these industries, this raises an obvious risk that environmental reforms over the coming few years could seriously curtail growth. This is especially true given that the Chinese public appears to be willing to sacrifice growth for an improvement in air quality (Chart 5). When outlining our key themes for 2018,3 we noted that next year's reform announcements will be highly significant not just because of the "what", but also the "how". We expect to see more details emerge in the lead up to the National People's Congress in March, but for now we are playing this theme by being long China's investable environmental, social, and governance (ESG) leaders index and short the investable benchmark (Chart 6). This trade is up 2% since we initiated it on November 16, and we expect further gains in 2018 if environmental reform remains a key priority for Chinese policymakers. Chart 5The Public Is Willing To Sacrifice Growth ##br##To Improve The Environment Chart 6Further Gains Likely##br## If The Environment Remains A Priority Bottom Line: Recent economic activity in China appears to have been driven by highly-polluting industries, in the context of strong public demand for an improvement in air quality. This raises the risk that environmental reforms over the coming few years could seriously curtail growth. A Year Of Spectacular Returns From Chinese Stocks. Now What? As of December 19, Chinese investable stocks (in US$) earned just over 50% in total return terms this year. Chart 7 shows that this ranks as the third largest annual gain among all major equity markets since 2010, behind only Russia and Brazil's commodity-fueled performance in 2016 (which was the mirror image of their spectacular losses in 2014/2015). Chart 7A Red Letter Year For Chinese Stocks There are two implications from China's amazing year-to-date equity market performance. First, it serves as a testament to the importance of tracking and playing economic mini cycles in China. BCA's China Investment Strategy service highlighted in February of this year that the economy would remain buoyant in the near term,4 and that investors should be overweight Chinese investable equities over the coming 6-12 months. Clearly this recommendation has panned out well. Second, it implies that Chinese stocks have re-rated significantly, and are no longer "exceptionally cheap". This means that the job of earning outsized returns from Chinese equities over the coming years will become more difficult, with investors possibly at some point needing to be selective in their allocation. The good news is that the range of valuation within China's investable market has increased, which implies more potential for alpha generation. In fact, Chart 8 highlights that this a global phenomenon, which appears to be at least somewhat related to the decline in intra-equity market correlation (panel 2). We plan on following up on the issue of sector-based alpha in the New Year, but for now there are no signs of a turnaround in the significant underperformance of investable value vs growth stocks (Chart 9). But given that the style dividend yield gap has grown to an elevated level (Chart 10), going long Chinese investable value / short investable growth is one of several potential trade ideas that we will be evaluating in the coming months. Stay tuned. Chart 8Lower Correlation Means Higher Valuation Dispersion Chart 9Chinese Value Stocks May Soon Attract Attentio Chart 10Value Is Now Particularly Valuable Bottom Line: The incredible returns from Chinese stocks this year means that investable equities are no longer "exceptionally cheap". Still, the range of valuation among Chinese investable sectors has increased, suggesting increased opportunity for alpha generation over the coming 6-12 months. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Please see BCA Special Report, "2018 Outlook - Policy And The Markets: On A Collision Course," dated November 20, 2017, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "Three Themes For China In The Coming Year", dated December 7, 2017, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Weekly Report, "Three Themes For China In The Coming Year", dated December 7, 2017, available at cis.bcaresearch.com. 4 Pease see China Investment Strategy Weekly Report "Be Aware Of China's Fiscal Tightening", dated February 16, 2017, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations