Global

Special Report

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

Highlights A 400k b/d addition to OPEC 2.0’s official production cut of 1.2mm b/d will have little effect on actual supplies. The market already has seen ~ 2.0mm to 2.5mm b/d of output removed from the market via excess voluntary cuts (e.g., from Saudi Arabia and others) and involuntary cuts (e.g., from Iran and Venezuela). The incremental 400k b/d would just be another target for free-rider states to ignore. However, if Iraq and other states with on-and-off compliance at the margin can be persuaded to follow through on producing at lower quotas following OPEC 2.0’s meetings today and tomorrow, markets could rally as actual output falls (Chart of the Week). A rally on the back of lower OPEC 2.0 production would support the IPO of Saudi Aramco, which is expected to price while the producer coalition is meeting in Vienna. Production from the “Other Guys” – our moniker for all producers excluding Gulf OPEC, US shale and Russia – will account for a lesser and lesser share of global output. New production – much of it from the last of the big conventional projects sanctioned prior to the 2014 price collapse – from Norway, Brazil, Guyana and the US Gulf of Mexico will come on strong in 2020 – but most of this has been priced in already. The rate of growth of US shale-oil production will slow. Feature Brent crude oil prices could get a boost from OPEC 2.0, if free-rider states – specifically Iraq and states with marginal quota compliance shown in the Chart of the Week – actually were to abide by production cuts they agree to. This would be amplified if cuts are extended to end-June, from end-March. The impact would be marginal, to be sure, given most of the production cuts that matter to the market already are in place – i.e., Saudi Arabia’s overcompliance of ~ 400k b/d, and Iran and Venezuela’s involuntary production cuts of ~ 1.8mm b/d resulting from US sanctions, as of October 2019. Ahead of the Vienna meetings today and tomorrow, the putative leaders of the producer coalition – the Kingdom of Saudi Arabia (KSA) and Russia – have been lobbying at cross purposes. KSA is seeking support for deeper cuts and an extension to mid-year of the deal. Russia is lobbying to keep the original deal’s expiry at end-March, and also is seeking to have its ultra-light crude (i.e., condensates) production excluded from its quota, as it is from OPEC members’ production calculations. Russia is creating additional volumes of condensate – ~ 800k b/d this year of its total 11.2mm b/d output – to dispose of as it ramps natural gas production to new feed markets, particularly China.1 Our expectation is the production-cutting deal will be extended to end-June with an official target of 1.6mm b/d removed from the market. Whether the new deal matters to the market will depend on the actions of heretofore free-rider OPEC 2.0 states. Prices could go up, but market share for the producer coalition will remain under pressure (Chart 2). Chart of the WeekAdditional OPEC 2.0 Cuts Could Be Bullish For Crude Oil Chart 2OPEC 2.0 Market Share Under Pressure Saudi Aramco IPO Due To Price Follow-through by all OPEC 2.0 members on additional production cuts would benefit Saudi Arabia, as it is expected to price the Saudi Aramco IPO while the producer coalition is meeting in Vienna. The Aramco IPO price is expected to value the company between $1.5 and $1.8 trillion. We recently looked at the IPO and believe Aramco will be valued closer to $2 trillion than to $1 trillion, the literal range in which the offering was being valued by banks and analysts.2 To briefly recap, in the first six months of this year, Aramco produced 10.0mm b/d of crude oil and condensates. Aramco accounted for 12.5% of global crude output in 2016 - 18 and reported in its red herring that its proved liquids reserves were ~ five times larger than the combined proved liquids reserves of the five major independent oil companies. Aramco’s 3.1mm b/d of refining capacity makes it the fourth largest integrated refiner in the world. In 2018, Aramco’s free cash flow amounted to almost $86 billion. Net income last year was $111 billion, more than the combined profits of the next six largest oil companies in the world. For its first year as a public company, Aramco has indicated it will pay an annual dividend of $75 billion. Improving compliance with the OPEC 2.0 production-cutting deal is of obvious importance for the Aramco IPO. The member states are quick to stress they support the deal and will do their part, but free riding has been a problem in terms of compliance. As we noted above, full compliance will lower OPEC 2.0 crude oil production from current levels, but Saudi Arabia’s voluntary over-compliance, coupled with the involuntary production losses from Iran and Venezuela already are doing most of the work in restraining production. The “Other Guys” Continue Treading Water Since 2010, most of the growth in world oil production came from three regions: US onshore shale-oil producers, Gulf OPEC and Russia. These regions added 14mm b/d of supply between 2010 and 2019. The “Other Guys” often are overlooked in the oil market, but they still accounted for 45% of global oil production this year on average. Production from the “Other Guys” – our moniker for all producers excluding Gulf OPEC, US shale and Russia – has been falling as a share of global production for years, due to a lack of domestic and foreign direct investment in their energy sectors. We expect their production will remain flat next year and could start falling in 2021. The “Other Guys” often are overlooked in the oil market, but they still accounted for 45% of global oil production this year on average: Their combined output was ~ 45mm b/d of crude and liquids (Chart 3). The “Other Guys’” production is mostly long-cycle projects and these countries do not possess spare capacity. Thus, they are reacting to oil prices and maximizing production now, if they can. Even so, their share of global production continues to fall (Chart 4). Chart 3The "Other Guys" Production Is Stagnant Chart 4The "Other Guys" Market Share Plummets The 3- to 5-year lag between final investment decisions and first production for projects in these states strongly suggests the global oil market is entering a period of lower supply additions from the “Other Guys,” given the last mega-projects were probably sanctioned in 2014 while prices still were above $100/bbl for both Brent and WTI. The "Other Guys’" rig count recovered, along with oil prices, since the 2016 downturn. However, this is still a low level of rigs vs. the 2010-2014 period – a period during which production from this group barely grew despite prices averaging more than $100/bbl. We expect their rig count to remain weak next year (Chart 5). Conventional production takes time to ramp up, therefore we should not expect a large increase in production over the next few years. Chart 5The "Other Guys" Rig Counts Will Remain Under Pressure Oil Supply Looks Tighter Toward 2021 Globally, the last of the big projects sanctioned prior to the oil-price collapse beginning in 2H14 and lasting to 1H16 are coming online in Norway, Brazil, Guyana and the US Gulf. Up to this year, US onshore production was the sole growing region globally. If capital discipline caps growth prospects in key US shale basins, global oil supply will grow only modestly in 2020 and 2021. For the most part, the “Other Guys” haven't been attracting the capital needed to sustain and grow their production. Given the ongoing drive by E&P companies globally to return capital to shareholders via buybacks or dividends, and the insistence of capital markets to fund only solid, profitable projects, capital likely will remain constrained for the “Other Guys.” States that were able to attract capital prior to the 2014 oil price collapse – Canada, Brazil, Norway, Guyana and the US – are expected to increase production next year; however, we believe much of this production increase already has been priced in by the market, as it has been by BCA (Chart 6). In our balances, we have oil production for Canada up 50k b/d next year vs 2019; Brazil +330k b/d and Norway +360k b/d. This is 740k b/d ex-Guyana in 2020. Guyana is still doing exploratory drilling and recently announced they expect to have their first commercial flows online this month. Oil markets are expecting initial commercial flows of ~ 120k b/d between December and 1Q20, and a ramp to 750k b/d by 2025, which would be significant. We will be updating our balances in two weeks, in our final publication of the year. Up to this year, US onshore production was the sole growing region globally. If capital discipline caps growth prospects in key US shale basins, global oil supply will grow only modestly in 2020 and 2021 (Chart 7). US shale output reaches ~ 9.35mm b/d on average next year in the Big Five basins (Permian, Eagle Ford, Bakken, Niobrara and Anadarko), in our modeling. This amounts to an 800k b/d increase in our US lower 48 production estimate for the US, vs. a 900k b/d increase we expected earlier.3 Chart 6"The New Guys" Production vs. The "Other Guys" Production Chart 7US Shale Oil Production Growth Will Slow Going forward, it is important to re-emphasize that even the prolific shales in the US are being constrained by investors demanding the shale guys either return capital to shareholders via share buybacks or steady dividends and dividend increases. If they don’t accommodate investor interests, these shale producers – and all oil producers for that matter – will simply be denied access to funding markets. Capital is, finally, the binding constraint on the growth of global oil supplies. This has not always been the case, as we’ve noted. 2020 Could See Stronger Prices Markets generally are responding as expected to more accommodative financial conditions globally, which will allow oil demand growth, particularly in the EM economies, to revive in 2020. As a result, we are maintaining our expectation for growth of 1.4mm b/d next year, which is up 300k b/d from our expectation for growth this year. The rebound in demand we expect next year will force prices higher to incentivize additional supply and the release of inventories – mostly in 2H20. This will push the entire futures curve up, especially nearby futures, which will steepen the backwardation in Brent and WTI futures. Bottom Line: Further actual production cuts by OPEC 2.0, emerging threats to US shale growth, and stagnant output from the “Other Guys” facing off against higher demand growth next year could result in higher prices than we currently expect for 2020 – i.e., $67/bbl for Brent and $63/bbl for WTI.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com   Market Round-Up Energy: Overweight Brent prices remain stuck between $60/bbl and $65/bbl awaiting clear signals about the US-China trade negotiations and OPEC 2.0’s decisions on its supply management beyond March 2020. Money managers are increasing their net long position, expecting bullish news on both these developments. They are increasing their Brent exposure to 414k long contracts vs. 64k short. Base Metals: Neutral SHFE copper inventories fell 11% on a week on week basis to 120k MT as of last Friday. Combined, the LME, COMEX and SHFE fell by 6%. The larger decline in Chinese inventory is partly attributed to the reduced import quotas on copper scraps, which limited the total available supply to meet domestic demand. As discussed in last week’s report, fundamentals in the two largest components of the LMEX – i.e. copper and aluminum – are tight and the rebound in demand showing up in our proprietary indicators will support prices. We remain long the LMEX tactically. Last week, we recommended getting long the LMEX index. We have subsequently learned the LME ceases trading the index. We will, nonetheless, continue to track the reported level of the index, as if it were tradeable. Precious Metals: Neutral Closing at $1479/bbl on Tuesday, gold prices broke out of the narrow range in which the metal has traded over the past month. Gold’s daily-return 1-year rolling correlation with the U.S. dollar is at its weakest level since 2011 and is below the 5th percentile of its distribution since 2004. On the other hand, the correlation with U.S. 10-year TIPS yields is strengthening and is now above the 95th percentile of its distribution. As safe-haven demand dissipates – alongside the rebound in global growth we expect – we believe these correlations will move back to their historical relationships, supporting gold as the U.S. dollar depreciates. Ags/Softs: Underweight CBOT Corn March Futures Contracts rallied at the beginning of the week on the back of a blizzard in the Midwest that stalled the already delayed corn harvest, which the USDA reported to be 89% complete as of Dec. 1, well behind the five-year average of 98%. After reaching multi-months highs last week, wheat futures fell due to profit taking and weaker than expected export figures. Soybean fell for the eighth straight day on Monday, with the most active contract closing at $8.73/Bu, the lowest in six months. A possible delay in the US-China trade deal together with expectations of a bumper crop in Brazil remain headwinds to prices.   Footnotes 1     Please see Russia to press OPEC+ to change its oil output calculations published by reuters.com November 27, 2019. 2     Please see our Special Report Aramco’s IPO: The Tie That Binds KSA And China, published November 15, 2019.  It is available at ces.bcaresearch.com. 3    We discuss further risks to shale oil production growth in Lingering Oil-Demand Weakness Will Fade, including the high levels of flaring in the Permian and Bakken basins.  This report is available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q3 Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades

Special Report

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

Feature Recommended Allocation In late November, BCA Research published its 2020 Outlook titled Heading Into The End Game, an annual discussion between BCA’s managing editors and the firm’s longstanding clients Mr. and Ms X.1 We recommend GAA clients read that document for a full analysis of the macro and investment environment we expect in 2020. In this Monthly Portfolio Outlook, we focus on portfolio construction: how we would recommend positioning a global multi-asset portfolio for the 12-month investment horizon in light of that analysis. First, a brief summary of the BCA macro outlook. We believe the global manufacturing cycle is starting to bottom out, partly because of its usual periodicity of 18 months from peak to trough, and also because of easier financial conditions, and some moderate fiscal and credit stimulus from China (Chart 1).  Central banks will remain dovish next year despite accelerating growth. The Fed, in particular, worries that inflation expectations have become unanchored (Chart 2) and, moreover, will be reluctant to raise rates ahead of the US presidential election. This environment implies a moderate rise in long-term interest rates, with the US 10-year Treasury yield rising to 2.2-2.5%. Chart 1Reasons To Expect A Rebound Chart 2Unanchored Inflation Expectations Worry The Fed For an asset allocator, this combination of an improving manufacturing cycle and easy monetary policy looks like a very positive environment for risk assets (Chart 3). We, therefore, remain overweight equities and underweight fixed income. We have discussed over the past few months the timing to turn more risk-on and pro-cyclical in our recommendations.2 Since we are increasingly confident about the probability of the manufacturing cycle turning up, this is the time to make that change. Consequently, the shifts we are recommending in our global portfolio, shown in the Recommended Allocation table and discussed in detail below, add to its beta (Chart 4).   Chart 3A Positive Environment For Risk Assets Chart 4Raising The Beta Of Our Portfolio Chart 5Some Signs Of Risk-On Still Missing Nonetheless, we still have some concerns. China’s stimulus (particularly credit growth) remains half-hearted compared to previous cyclical rebounds in 2012 and 2016. We expect a “phase one” ceasefire in the trade war. But even that is not certain, and it would not anyway solve the long-term structural disputes. To turn fully risk-on, we would want to see signs of a clear rebound in commodity prices and a depreciation of the US dollar, which have not yet happened (Chart 5). The 2020 Outlook proposed some milestones to monitor whether our scenario is playing out and whether we should turn more or less risk-on. We summarize these milestones in Table 1. Given these uncertainties, to hedge our pro-cyclical positioning we continue to recommend an overweight in cash, and we are instituting an overweight position in gold. Table 1Milestones For 2020 Chart 6Recessions Are Caused By Inflation Or Debt How will this cycle end? All recessions in modern history have been caused either by a sharp rise in inflation, or by a debt-fueled asset bubble (Chart 6). The Fed will likely fall behind the curve at some point as, after further tightening in the labor market, inflation starts to pick up. How the Fed reacts to that will determine what triggers the recession. If – as is most likely – it lets inflation run, that could blow up an asset bubble (and it was the bursting of such bubbles which caused the 2000 and 2007 recessions); if it decides to tighten monetary policy to kill inflation, the recession would look more like those of the 1970s and 1980s. But it is hard to see either happening over the next 12-18 months. Equities: As part of our shift to a more pro-risk, pro-cyclical stance, we are cutting US equities to underweight, and raising the euro zone to overweight, and Emerging Markets and the UK to neutral. US equities have outperformed fairly consistently since the Global Financial Crisis (Chart 7) – except during the two periods of accelerating global growth, in 2012-13 (when Europe did better) and 2016-17 (when EM particularly outperformed). The US today is expensive, particularly in terms of price/sales, which looks more expensive than the P/E ratio because the profit margin is at a record high level (Chart 8). The upside for US stocks in 2020 is likely to be limited. In 2019 so far, US equities have risen by 29% despite earnings growth close to zero. Multiples expanded because the Fed turned dovish, but investors should not assume further multiple expansion in 2020. Our rough model for US EPS growth points to around 8% next year (sales in line with nominal GDP growth of 4%, margins expanding by a couple of points, plus 2% in share buybacks). Add a dividend yield of 2%, and US stocks might give a total return of 10% or so. Chart 7US Doesn't Always Outperform Chart 8US Equities Are Expensive To play the cyclical rebound, we prefer euro zone stocks over those in EM or Japan. Euro zone stocks have a higher weighting in sectors we like such as Financials and Industrials (Table 2). European banks, in particular, look attractively valued (Chart 9) and offer a dividend yield of 6%, something investors should find appealing in this low-yield world. EM is more closely linked to China and commodities prices, which are not yet sending strong positive signals. We worry about the excess of debt in EM (Chart 10), which remains a structural headwind: the IMF and World Bank put total external EM debt at $6.8 trillion (Chart 11). Table 2Equity Sector Composition Chart 9Euro Zone Banks Are Especially Cheap Chart 10EM Debt Remains A Headwind Japan is another likely beneficiary of a cyclical recovery. But, before we turn positive, we want to see (1) signs of a stabilization of consumption after the recent tax rise (retail sales fell by 7% year-on-year in October), and (2) clarification of a worrying new investment law (which will require any investor which intends to “influence management” to get prior government approval before buying as little as a 1% stake in many sectors). For an asset allocator this combination of an improving manufacturing cycle and easy monetary policy looks very positive for risk assets. We raise the UK to neutral. The market has been a serial underperformer over the past few years, but this has been due to the weak pound and derating, rather than poor earnings growth (Chart 12). It now looks very cheap and, with the risk of a no-deal Brexit off the table, sterling should rebound further. The UK is notably overweight the sectors we like (Table 2). However, political risk makes us limit our recommendation to neutral. Although the Conservatives look likely to win a majority in this month’s general election, which will allow them to push through the negotiated Brexit deal, subsequent arguments over the future trade relationship with the EU will be divisive. Chart 116.8 Trillion In EM External Debt Chart 12The UK Has Been Derated Since 2016   Fixed Income: We remain underweight government bonds. Stronger economic growth is likely to push up long-term rates (Chart 13). Nonetheless, the rise in yields should be limited. The Fed looks to be on hold for the next 12 months, but the futures market is not far away from that view: it has priced in only a 60% probability of one rate cut over that time. The gap between market expectations and what the Fed actually does is what our bond strategists call the “golden rule of bond investing”. US inflation is also likely to soften over the next few months due to the lagged effect of this year’s weaker growth and appreciating dollar. We do not expect the 10-year US Treasury to rise above 2.5% – the current FOMC estimate of the long-run equilibrium level of short-term rates (Chart 14). Chart 13Growth Will Push Up Rates...   Chart 14...But Only As Far As 2.5%   Within the fixed-income universe, we remain positive on corporate credit. But US investment-grade bond spreads are no longer attractive and so we downgrade them to neutral (Chart 15). Investors looking for high-quality bond exposure should prefer Agency MBS, which trade on an attractive spread relative to Aa- and A-rated corporate bonds. European IG should do better since spreads are not so close to historical lows, risk-free rates should rise less than in the US, and because the ECB is increasing its purchases of corporate bonds. Chart 15US IG Spreads Are Close To Historical Lows Chart 16US Caa Bonds Have Some Catching Up To Do We continue to like high-yield bonds, both in the US and Europe. But we would suggest moving down the credit curve and increasing the weight in Caa-rated bonds. These have underperformed this year (Chart 16), mainly because of technical factors such as their overweight in the energy sector and relatively smaller decline in duration.3 With a stronger economy and rising oil prices, they should catch up to their higher-rated HY peers in 2020. To play the cyclical rebound, we prefer euro zone stocks over those in EM or Japan. Currencies: Since the US dollar is a counter-cyclical currency (Chart 17), we would expect it to weaken against more cyclical currencies such as the euro, and commodity currencies such as the Australian dollar and Canadian dollar. But it should appreciate relative to the yen and Swiss franc, which are the most defensive major currencies. We expect EM currencies to continue to depreciate. Most emerging markets are experiencing disinflation (Chart 18), which will push central banks to cut rates and inject liquidity into the banking system. This will tend to weaken their currencies. Overall, we are neutral on the US dollar. Chart 17The Dollar Is A Counter-Cyclical Currency Chart 18Disinflation Will Push EM Currencies Down Further     Commodities: Industrials metals prices are closely linked to Chinese stimulus (Chart 19). A moderate recovery in Chinese growth should be a positive, and so we raise our recommendation to neutral. But with question-marks still lingering over the strength of the rebound in the Chinese economy, we would not be more positive than that. Oil prices should see moderate upside over the next 12 months, with supply tight and demand growth recovering in line with the global economy. Our energy strategists forecast Brent crude to average $67 a barrel in 2020 (compared to a little over $60 today). Chart 19Metals Prices Depend On China Chart 20Gold: Short-Term Negatives, But Remains A Good Hedge   Gold looks a little overbought in the short term, and less monetary stimulus and a rise in rates next year would be negative factors (Chart 20). Nonetheless, we see it as a good hedge against our positive economic view going awry, and against geopolitical risks. If central banks do decide to let economies run hot next year and ignore rising inflation, gold could do particularly well. We, therefore, raise our recommendation to overweight on a 12-month horizon.     Garry Evans, Senior Vice President Chief Global Asset Allocation Strategist garry@bcaresearch.com Footnotes 1    Please see "Outlook 2020," dated November 22 2019, available at bcaresearch.com 2   Please see, for example, last month’s GAA Monthly Portfolio Update, “Looking For The Turning-Point,” dated November 1, 2019, available at gaa.bcaresearch.com 3   For a more detailed explanation, please see US Bond Strategy Weekly Report, “Caa-Rated Bonds: Warning Signs Or Buying Opportunity,” dated 26 November 2019, available at usbs.bcaresearch.com GAA Asset Allocation

Highlights Investors should remain overweight global stocks relative to bonds over the next 12 months and begin shifting equity exposure towards non-US markets. Bond yields will rise next year as global growth picks up, while the dollar will sell off. The extent to which bond yields increase over the long term depends on whether inflation eventually stages a comeback. Today’s high debt levels could turn out to be deflationary if they curtail spending by overstretched households, firms, and governments. However, high debt levels could also prompt central banks to engineer higher inflation in order to reduce the real burden of debt obligations. Which of these two effects will win out depends on whether central banks are able to gain traction over the economy. This ultimately boils down to whether the neutral rate of interest is positive or negative in nominal terms. While there is little that policymakers can do to alter certain drivers of the neutral rate such as the trend rate of economic growth, they do have control over other drivers such as the stance of fiscal policy. Ironically, a structural shift towards easier fiscal policy could lead to a decline in government debt-to-GDP ratios if higher inflation, together with central bankers' reluctance to raise nominal rates, pushes real rates down far enough. This suggests that the endgame for today’s high debt levels is likely to be overheated economies and rising inflation.   Stay Bullish On Stocks But Shift Towards Non-US Equities We returned to a cyclically bullish stance on global equities following the stock market selloff late last year, having temporarily moved to the sidelines in June 2018. We have remained overweight global equities throughout 2019. Two weeks ago, we increased our pro-cyclical bias by upgrading non-US stocks within our recommended equity allocation at the expense of their US peers. Our decision to upgrade non-US equities stems from the conviction that global growth has turned the corner. Manufacturing has been at the heart of the global slowdown. As we have often pointed out, manufacturing cycles tend to last about three years – 18 months of weaker growth followed by 18 months of stronger growth (Chart 1). The current slowdown began in the first half of 2018, and right on cue, the recent data has begun to improve. The global manufacturing PMI has moved off its lows, with significant gains seen in the new orders-to-inventories component. Global growth expectations in the ZEW survey have rebounded. US durable goods orders surprised on the upside in October. The regional Fed manufacturing surveys have also brightened, suggesting upside for the ISM next week (Chart 2). Chart 1A Fairly Regular Three-Year Manufacturing Cycle Chart 2Some Manufacturing Green Shoots     Unlike in 2016, China has not allowed a major reacceleration in credit growth this year. Instead, fiscal policy has been loosened significantly. The official general government deficit has increased from around 3% of GDP in mid-2018 to 6.5% of GDP at present. The augmented budget deficit – which includes spending through local government financing vehicles and other off-balance sheet expenditures – is on track to reach nearly 13% of GDP in 2019. This is a bigger deficit than during the depths of the Great Recession (Chart 3). As a result of all this fiscal easing, the combined Chinese credit/fiscal impulse has continued to move up. It leads global growth by about nine months (Chart 4). Chart 3China Has Been Stimulating, Fiscally Chart 4Chinese Stimulus Should Boost Global Growth The dollar tends to weaken when global growth strengthens (Chart 5). The combination of stronger global growth and a softer dollar will disproportionately benefit cyclical equity sectors. Financials will also gain thanks to steeper yield curves (Chart 6). The sector weights of non-US stock markets tend to be more tilted towards deep cyclicals and financials. As a consequence, non-US stocks typically outperform when global growth picks up (Chart 7). Chart 5The Dollar Is A Countercyclical Currency Chart 6Steeper Yield Curves Will Benefit Financials In addition, valuations favor stocks outside the US. Non-US equities currently trade at 13.8-times forward earnings, compared to 18.1-times for the US. The valuation gap is even greater if one looks at price-to-book, price-to-sales, and other measures (Chart 8). Chart 7Non-US Equities Usually Outperform When Global Growth Improves Chart 8US Stocks Are Relatively More Expensive Trade War Remains A Key Risk The US-China trade war remains a key risk to our bullish equity view. President Trump continues to send conflicting signals about the status of the talks. He complained last week that Beijing is not “stepping up” in finalizing a phase 1 agreement, adding that China wants a deal “much more than I do.” This Wednesday he struck a more optimistic tone, saying that negotiators were in the “final throes” of deal. However, he made this statement on the same day that he decided to sign the Hong Kong Human Rights and Democracy Act into law, a decision that was bound to antagonize China. According to our BCA geopolitical team, Trump had little choice but to sign the bill. The Senate approved it unanimously, while the House voted for it 417-1. Failure to sign it would have resulted in an embarrassing veto by the Senate. The key point is that the new law does not force Trump to take any immediate actions against China. This suggests that the trade talks will continue. In fact, from China's point of view, Congress’ desire to pass a Hong Kong bill may provide a timely reminder that getting a deal done with Trump now may be preferable to waiting until after the election and potentially facing someone like Elizabeth Warren who is likely to make human rights a key element of any deal to roll back tariffs. Waiting For Inflation If global growth accelerates next year, history suggests that bond yields will rise (Chart 9). Looking further out, the extent to which bond yields will continue to increase depends on whether inflation ultimately stages a comeback. Right now, most of our forward-looking inflationary indicators remain well contained (Chart 10). However, this could change if falling unemployment eventually triggers a price-wage spiral. Chart 9Stronger Economic Growth Will Put Upward Pressure On Government Bond Yields Chart 10An Inflation Breakout Is Not Imminent     Many investors are skeptical that such a price-wage spiral could ever emerge. They argue that automation, globalization, weak trade unions, and demographic changes make an inflationary outburst rather implausible. We have addressed these arguments in the past1 and will not delve into them in this report. Instead, we will focus on one argument that also gets a fair bit of attention, which is that high debt levels will prove to be deflationary. Are High Debt Levels Inflationary Or Deflationary? Total debt levels in developed economies are no lower today than they were during the Great Recession. While private debt has fallen, public debt has risen by roughly the same magnitude, leaving the overall debt-to-GDP ratio unchanged (Chart 11). Meanwhile, debt levels in emerging markets have risen substantially. A common rebuttal to any suggestion that inflation might rise over the medium-to-longer term is that high debt levels around the world will cause households, firms, and governments to pare back spending. While this may be true, it could also be argued that high debt levels could prompt central banks to engineer higher inflation in order to reduce the real burden of debt obligations. So which effect will win out? Given the choice, it is likely that most policymakers would opt for higher inflation. This is partly because high unemployment and fiscal austerity are politically toxic. It is also because falling prices make it very difficult to reduce real debt burdens. The experience of the Great Depression bears this out: Private debt declined by 25% in absolute terms between 1929 and 1933. However, due to the collapse in nominal GDP, the ratio of debt-to-GDP actually increased more in the first half of the 1930s than during the Roaring Twenties (Chart 12). Chart 11Global Debt Levels Remain High Chart 12The Experience Of The Great Depression Shows Deleveraging Is Impossible Without Growth   Means, Motive And Opportunity Chart 13A Kinked Relationship: It Takes Time For Inflation To Break Out There is a big difference between wanting to engineer higher inflation and being able to do so. The distinction between success and failure ultimately boils down to a seemingly technical question: Is the neutral rate of interest – the interest rate consistent with full employment and stable inflation – positive or negative in nominal terms? When the neutral rate is above zero, central banks can gain traction over the economy. Even if the neutral rate is only slightly positive, a zero rate would be enough to keep monetary policy in expansionary territory. When monetary policy is accommodative, the unemployment rate will tend to drop. Eventually the “kink” in the Phillips curve will be reached, resulting in higher inflation (Chart 13). In contrast, when the neutral rate is firmly below zero, monetary policy loses traction over the economy. Since there is a limit to how deeply negative policy rates can go before people decide to hold cash, the central bank could find itself out of ammunition. This could set off a vicious circle where high unemployment causes inflation to drift lower, leading to an increase in real rates. Rising real rates will then further curb spending, causing inflation to fall even more. Drivers Of The Neutral Rate Two of the more important determinants of the neutral rate of interest are the growth rate of the economy and the national savings rate. If either the savings rate rises or economic growth slows, the stock of fixed capital will tend to pile up in relation to GDP, leading to a higher capital-to-output ratio.2 As Chart 14 shows, this has already happened in Europe and Japan. An increase in the capital-to-GDP ratio will drag down the rate of return on capital. A lower interest rate will be necessary to ensure that the capital stock is fully utilized. Chart 14Capital Stock-To-Output Ratios Have Risen Realistically, there is not much that policymakers can do to raise trend GDP growth. While looser immigration policy would allow for a faster expansion of labor force growth, this is politically contentious. Increasing productivity growth is also easier said than done. Fiscal Policy And The Neutral Rate In contrast, policymakers already have a ready-made mechanism for lowering the savings rate: fiscal policy. The fiscal balance is a component of national savings. If the government runs a larger budget deficit in order to finance tax cuts or higher transfer payments to households, national savings will decline and aggregate demand will rise. Is the endgame for today’s high debt levels deflation or inflation? The answer is inflation. Since one can think of the neutral rate as the interest rate that brings aggregate demand in line with the economy’s supply-side potential, anything that raises demand will also lift the neutral rate. Once the neutral rate has risen above the zero bound, monetary policy will gain traction again. This implies that central banks should never run out of ammunition in countries whose governments can issue debt in their own currencies. While higher inflation stemming from fiscal stimulus will erode the real value of private sector debt obligations, won’t the impact on total debt be offset by the increase in public debt? Not necessarily. True, larger budget deficits will raise the stock of government debt. However, nominal GDP will also rise on account of higher inflation. Standard debt sustainability equations state that the government debt-to-GDP ratio could actually fall if higher inflation pushes real policy rates down far enough. As discussed in Box 1, such an outcome is quite likely when inflation accelerates in response to an overheated economy, but the central bank nevertheless refrains from raising nominal rates. The Final Verdict We are finally ready to answer the question posed in the title of this report: Is the endgame for today’s high debt levels deflation or inflation? The answer is inflation. People with a 30-year fixed rate mortgage will always favor inflation over deflation. And there are more voters who owe mortgage debt than own mortgage debt. Chart 15Germany's Competitive Advantage Over The Rest Of The Euro Area Is Deteriorating Politics is moving in a more populist direction. Whether it is left-wing populism of the Elizabeth Warren/Jeremy Corbyn variety or right-wing populism of the Donald Trump/Matteo Salvini variety, the result is usually bigger budget deficits and higher inflation. Even in those countries where populism has been slow to take hold, there may be pragmatic reasons for loosening fiscal policy. For example, Germany’s trade surplus with the rest of the euro area has fallen in half since 2007, largely because German unit labor costs have increased more than elsewhere (Chart 15). As Germany loses its ability to ship excess production to the rest of the world, it may end up having to rely more on easier fiscal policy to bolster demand. Of course, the path to higher inflation is paved with interest rates that stay lower for much longer than the economy needs to reach full employment. This means we are entering a period where first the US economy, and then many other economies, will start to overheat, and yet central banks will still refrain from tightening monetary policy until inflation rises well above their comfort zones. Such an environment will be positive for stocks for as long as it lasts, even if it eventually produces a mighty hangover.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com   Box 1 When Does A Large Budget Deficit Lead To A Lower Government Debt-to-GDP Ratio?   Footnotes 1    Please see Global Investment Strategy Special Report, “1970s-Style Inflation: Could It Happen Again? (Part 2),” dated August 24, 2018. 2   This point can be seen through the lens of the widely used Solow growth model. In steady state, the desired level of investment in the model is given by the formula: I=(a/r)(n+g+d)Y where a denotes the output elasticity of capital, r is the real rate of interest, n is labor force growth, g is productivity growth, d is the depreciation rate, and Y is GDP. Savings is assumed to be a constant fraction of income, S=sY. Equating savings with investment yields: r=(a/s)(n+g+d). A decrease in the growth rate of the economy (n+g) shifts the investment schedule downward, leading to a lower equilibrium rate of interest. This initially makes investing in fixed capital more attractive than buying bonds. Over time, however, the marginal return on capital will fall as the capital stock expands in relation to GDP.    Strategy & Market Trends MacroQuant Model And Current Subjective Scores Strategic Recommendations Closed Trades

An analysis on Brazil is available below. Feature Chart I-1Poor Performance By EM Stocks, Currencies And Commodities I had the pleasure of meeting again with a long-term BCA client Ms. Mea last week during my trip to Europe. Ms. Mea and I meet on a semi-annual basis, where she has the opportunity to query my analysis and view. In our latest meeting, she was more perplexed than usual by the global macro developments and financial market dynamics. Ms. Mea: All the seemingly positive news on the trade front is pushing up global share prices. In fact, a substantial portion -if not all -of the global equity price gains have occurred on days when there has been positive news surrounding the US-China trade negotiations. Given EM financial markets were the most damaged by the trade war, one would have thought that EM markets would outperform in a rally stemming from progress in negotiations. Yet this has not occurred. EM currencies have failed to advance (a number of currencies are in fact breaking down), EM sovereign credit spreads are widening and the relative performance of EM vs. DM share prices has relapsed (Chart I-1). What is causing this disconnect? Answer: The disconnect is due to a somewhat false narrative that the global trade and manufacturing recession as well as the EM/China slowdown were primarily caused by the US-China trade confrontation. The principal reason behind the global manufacturing and trade recession has been a deceleration in Chinese domestic demand. The latter can only partially be attributed to the US-China trade tariffs and tensions. Chart I-2 illustrates that mainland exports are not contracting while imports excluding processing trade1 are down 5% from a year ago. This implies that China’s growth slump has not been due to a contraction in its exports but rather due to weakness in its domestic demand. The principal reason behind the global manufacturing and trade recession has been a deceleration in Chinese domestic demand. The basis as to why mainland exports have held up so well is because Chinese exporters have been re-routing their shipments to the US via other countries such as Vietnam and Taiwan. Critically, the key force driving EM currencies and risk assets has been Chinese imports (Chart I-3). Mainland imports continue to shrink, with no recovery in sight. This is the reason why EM risk assets and currencies have performed so poorly, even amid the global risk-on environment. Chart I-2Chinese Imports Are Worse Than Exports Chart I-3China Imports Drive EM Currencies   Ms. Mea: Are you implying that a ceasefire in the trade war will not help Chinese growth rebound, and in turn support EM economies? The “Phase One” agreement and possible reductions in US tariffs on imports from China may help the Middle Kingdom’s exports, but not its imports. Crucially, the Chinese authorities will likely be reluctant to augment their credit and fiscal stimulus if there is a “Phase One” deal with the US. Absent greater stimulus, China’s domestic demand is unlikely to stage a swift recovery. In the case of a “Phase One” agreement, a mild improvement in business confidence in China and worldwide is likely, but a major upswing is doubtful. The basis is that business people around the world have witnessed the struggles faced by the US and China in their negotiations. They will likely doubt the ability of both nations to reach a structural resolution – and rightly so. Investors should realize that the Chinese economy does not depend on exports to the US nearly as much as is commonly believed. Importantly, global investors are miscalculating China’s negotiating strategy and tactics. We put much greater odds than many other investors on the possibility that China will continue to drag out the negotiations without signing the “Phase One” agreement. This could easily derail the global equity rally. Investors should realize that the Chinese economy does not depend on exports to the US nearly as much as is commonly believed. China’s shipments to the US have been around 3.3% of GDP, even before the trade war began. The value-added to the economy/income generated from China’s exports to the US is less than 3% of its GDP. In contrast, capital spending accounts for the largest share (42%) of China’s GDP. In turn, investment outlays are driven by the credit cycle and fiscal spending, rather than by exports. Chart I-4China: Stimulus And Business Cycle Ms. Mea: Turning to stimulus in China, the authorities have been easing for about a year. By now, the cumulative effect of this stimulus should have begun to revive the mainland’s domestic demand. Why do you still think China’s business cycle has not reached a bottom? Answer: Indeed, our credit and fiscal spending impulse has been rising since January. Based on its historical relationship with business cycle variables – it leads those variables by roughly nine months – China’s growth should have troughed in August or September (Chart I-4). However, the time lags between the credit and fiscal spending impulse and economic cycle are not constant as can be seen in Chart I-4. On average, the lag has been nine months but has also varied from zero (at the trough in early 2009) to 18 months (at the peak in 2016-‘17). Relationships in economics – as opposed to those in hard sciences – are not constant and stable. Rather, correlations and time lags between variables vary substantially over time. In addition, the magnitude of stimulus is not the only variable that should be taken into account. The potential multiplier effect is also significant. One way to proxy the multiplier effect is via the marginal propensity to spend by households and companies. In our opinion, the prime cause behind households’ and businesses’ reluctance to spend is the weak property market. Our proxies for Chinese marginal propensity to spend by companies and households have been falling (Chart I-5). This entails that households and businesses in China remain downbeat, which caps their expenditures, in turn offsetting the positive impact of stimulus. In our opinion, the prime cause behind households’ and businesses’ reluctance to spend is the weak property market. Without rapidly rising property prices and construction volumes, boosting sentiment and growth will prove challenging. We discussed the current conditions and outlook of China’s property market in last week’s report. Construction is the single largest sector of the mainland economy, and it is in recession: floor area started and under construction are all shrinking (Chart I-6). Chart I-5China: A Weak Multiplier Effect Chart I-6China Construction Is In Recession   It is difficult to envision an improvement in manufacturing and a rebound in demand for commodities/materials and industrial goods without a recovery in construction. Notably, Chart I-6 displays the most comprehensive data on construction, as it encompasses all residential and non-residential construction by property developers and all other entities. Ms. Mea: Why are some global business cycle indicators turning up if, as you argue, the global manufacturing slowdown originated from Chinese domestic demand and the latter has not yet turned around? Answer: At any point of the business cycle, it is possible to find data that point both up and down. Our ongoing comprehensive review of global business cycle data leads us to conclude that the improvement is evident only in a few circumstances, and is not broad-based. In particular: In China and the rest of EM, there is no domestic demand recovery at the moment. China and EM ex-China capital goods imports are shrinking (Chart I-7). Chinese consumer spending is also sluggish (Chart I-8). The rise in China’s manufacturing Caixin PMI over the past several months is an aberration. Chart I-7EM/China Capex Is Very Weak Chart I-8No Recovery For Chinese Consumers     In EM ex-China, Korea and Taiwan, narrow and broad money growth are underwhelming (Chart I-9). These developments signify that EM policy rate cuts have not yet boosted money/credit and domestic demand. We elaborated on this in more detail in our recent report. The basis for such poor transmission is banking-system health in many developing countries. Banks remain saddled with non-performing loans (NPLs). The need to boost provisions and fears of more NPLs continues to make banks reluctant to lend. Besides, real (inflation-adjusted) lending rates are high, discouraging credit demand. In the US and euro area, consumption – outside of autos – as well as money and credit growth have never slowed in this cycle. The slowdown has largely been due to exports and the auto sector. The latter may be bottoming in the euro area (Chart I-10). This might be behind the improvement in some business surveys in Europe. Chart I-9EM Ex-China: Money Growth Is At Record Low Chart I-10Euro Area’s Auto Sales: Is The Worst Over?   European business survey data are mixed, but the weakest segment - manufacturing – remains lackluster. In particular, Germany’s IFO index for business expectations and current conditions in manufacturing have not improved (Chart I-11, top panel). Similarly, the Swiss KOF economic barometer remains downbeat (Chart I-11, top panel). The only improvement is in Belgian business confidence, and a mild pickup in the euro area manufacturing PMI (Chart I-11, bottom panel). Chart I-11European Manufacturing And Business Confidence   In the US, shipping and carload data are rather grim. They are not corroborating the marginal improvement in the US manufacturing PMI. Overall, at this point there are no signs that domestic demand is recovering in China and the rest of EM, which have been the epicenter of the slowdown. The improvement is limited to some data in the US and Europe. Consistently, US and European share prices have been surging, while EM equities have dramatically underperformed. Ms. Mea: What about lower interest rates driving multiples expansion in both DM and EM equities? Answer: Concerning multiples expansion, our general framework is as follows: So long as corporate profits do not contract, lower interest rates will likely lead to equity multiples expansion. However, when corporate earnings shrink, the latter overwhelms the positive effect of a lower discount rate on multiples, and share prices drop along with lower interest rates. DM corporate profits are flirting with contraction, but are not yet contracting meaningfully. Hence, it is sensible that US and European stocks have experienced multiples expansion. In contrast, EM corporate earnings are shrinking at a rate of 10% from a year ago as illustrated in Chart I-12. The basis for an EM profit recession is the downturn in Chinese domestic demand and consequently imports. EM per-share earnings correlate much better with Chinese imports (Chart I-13, top panel) than US ones (Chart I-13, bottom panel). Chart I-12EM Profits And Share Prices Chart I-13EM EPS Is Driven By China Not The US   In fact, we have documented numerous times in our reports that EM currencies and share prices correlate well with China’s business cycle/global trade/commodities prices, more so than with US bond yields. This does not mean that EM share prices are insensitive to interest rates. They are indeed sensitive to their own borrowing costs, but not to US Treasury yields. Chart I-14 demonstrates that EM share prices move in tandem with inverted EM sovereign US dollar bond yields and EM local currency bond yields. Similarly, emerging Asian share prices correlate with inverted high-yield Asian US dollar corporate bond yields (Chart I-14, bottom panel). Chart I-14EM Share Prices And EM Bond Yields Chart I-15Chinese Bond Yields Herald Relapse In EM Stocks And Currencies In short, EM share prices typically sell off when EM borrowing costs rise – regardless if it is driven by mounting US Treasury yields or widening credit spreads. Looking forward, exchange rates hold the key. A relapse in EM currencies will push up both the US dollar and local currency bond yields in many EMs. That will in turn warrant a setback in EM share prices. Ms. Mea: What about the correlation between EM performance and Chinese local rates? Answer: This is an essential relationship. Chart I-15 demonstrates that EM share prices and currencies have a strong positive correlation with local interest rates in China. The rationale is that all of them are driven by China’s business cycle. Relapsing interest rates in China are presently sending a bearish signal for EM risk assets and currencies. Ms. Mea: What does all this mean for investment strategy? A few weeks ago, you wrote that if the MSCI EM equity US dollar index breaks above 1075, you would reverse your recommended strategy. How does this square with your fundamental analysis that is still downbeat? Answer: My fundamental analysis on EM/China has not changed: I do not believe in the sustainability of this EM rebound in general, and EM outperformance versus DM in particular. The key risk to my strategy on EM stems from the US and Europe. It is possible that US and European share prices continue to rally. EM share prices typically sell off when EM borrowing costs rise – regardless if it is driven by mounting US Treasury yields or widening credit spreads. Notably, the high-beta segments of the US equity market and the overall Euro Stoxx 600 index are flirting with major breakouts (Chart I-16A and I-16B). If these breakouts transpire, the up-leg in US and European share prices will be long-lasting. This will also drag EM share prices higher in absolute terms. This is why I have placed a buy stop on the EM equity index. Chart I-16AUS High-Beta Stocks Chart I-16BEuropean Equities: At A Critical Juncture   That said, I have a strong conviction that EM will continue to underperform DM, even in such a scenario. Hence, I continue to recommend underweighting EM versus DM in both global equity and credit portfolios. As we have recently written in detail, the global macro backdrop and financial market dynamics in such a scenario will resemble 2012-2014, when EM currencies depreciated, commodities prices fell and EM share prices massively underperformed DM ones (Chart I-17). Further, I am not arguing that the current global trade and manufacturing downtrends will persist indefinitely. The odds are that the global business cycle, including China’s, will bottom sometime next year. The point is that EM share prices have decoupled from fundamentals – namely corporate earnings growth – since January. The point is that EM share prices have decoupled from fundamentals – namely corporate earnings growth – since January (please refer to Chart I-12 on page 8). This is an unprecedented historical gap, making EM stocks, currencies and credit markets vulnerable to continued disappointments in EM corporate profitability. Ms. Mea: What market signals give you confidence in poor EM performance going forward? Answer: Even though the S&P 500 has broken to new highs, multiple segments of EM financial markets have posted extremely disappointing performance. These include: Small-cap stocks in EM overall and emerging Asia as well as the EM equal-weighted equity index have struggled to rally (Chart I-18). Chart I-17EM Underperformed During 2012-14 Bull Market Chart I-18Various EM Equity Indexes: Failure To Rally Is A Bad Omen   Various Chinese equity indexes – onshore and offshore, small and large – have failed to advance and continue to underperform the global equity index. EM ex-China currencies and industrial commodities prices have remained subdued (please refer to Chart I-1 on page 1). Ms. Mea: Would you mind reminding me of your country allocation across various EM asset classes such as equities, credit, currencies and fixed-income? Answer: Within an EM equity portfolio, our overweights are Mexico, Russia, central Europe, Korea and Thailand. Our equity underweights are Indonesia, the Philippines, Turkey, South Africa and Colombia. We continue recommending to short an EM currency basket including ZAR, CLP, COP, IDR, MYR, PHP and KRW. Today, we add the BRL to our short list (please refer to the section below on Brazil). As to the country allocation within EM local currency bonds and sovereign credit portfolios, investors can refer to our asset allocation tables below that are published at the end of each week’s report and are available on our web site. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Brazil: Deflationary Pressures Warrant A Weaker BRL The Brazilian real is breaking below its previous support. We recommend shorting the BRL against the US dollar. The primary macro risk in Brazil is not inflation but rather mounting deflationary pressures. Inflation has fallen to very low levels, to the bottom of the central bank’s target range (Chart II-1). Deflation or low inflation is dangerous when there are high debt levels. The Brazilian government is heavily indebted. With nominal GDP growth still below government borrowing costs and a primary budget balance at -1.3% of GDP, the public debt trajectory remains unsustainable as we discussed in previous reports (Chart II-2). Chart II-1Brazil: Undershooting Inflation Target Chart II-2Public Debt Dynamics Are Still Not Sustainable   The cyclical profile of the economy is very weak as shown in Chart II-3. Tight fiscal policy and a drawdown of foreign exchange reserves have caused money growth to slow. That in turn entails a poor outlook for the economy, which will reinforce the deflationary trend. Accordingly, Brazil needs to reflate its economy to boost nominal GDP, which is the only scenario where the nation escapes a public debt trap. Yet, fiscal policy is straightjacketed by the spending cap rule, which stipulates that government spending can only grow at the previous year’s IPCA inflation rate. Federal government spending is set to grow only at the low nominal rate of 3.4% in 2020. Hence, monetary policy is the sole tool available for policymakers to reflate. Both bond yields and bank lending rates remain elevated in real terms. This hampers any recovery in the business cycle. Notably, the marginal propensity to spend by companies and consumers is declining, foreshadowing weaker economic activity ahead (Chart II-4). Chart II-3Brazil: The Economy Is Weak Chart II-4Brazil: Propensity To Spend Is Declining   The central bank is determined to reduce interest rates further. As such, they cannot control the exchange rate. Indeed, the Impossible Trinity thesis states that in an economy with an open capital account (like in Brazil), the authorities cannot control both interest and exchange rates simultaneously. Minister of Economy Paulo Guedes stated in recent days that tight fiscal and easy monetary policies are consistent with a lower currency value. Brazilian policymakers are open to the idea of a weaker exchange rate and will not defend the real. Their currency market interventions are intended to smooth volatility in the exchange rate but not preclude depreciation. In fact, currency depreciation is another option to boost nominal growth that the nation desperately needs. Brazilian policymakers are open to the idea of a weaker exchange rate and will not defend the real. Their currency market interventions are intended to smooth volatility in the exchange rate but not preclude depreciation. Commodities prices remain an important driver of the Brazilian real (Chart II-5). These have failed to rebound amid the risk-on regime in global financial markets. This suggests that the path of least resistance for commodities prices is down, which is bad news for the real. Brazil’s current account deficit is widening and has reached 3% of GDP (Chart II-6). Notably, not only are export prices deflating but export volumes are also shrinking (Chart II-6, bottom panel). Chart II-5BRL And Commodities Prices Chart II-6Widening Current Account Deficit   Chart II-7The BRL Is Not Cheap Meanwhile, the nation’s foreign debt obligations – the sum of short-term claims, interest payments and amortization over the next 12 months – are at $190 billion, all-time highs. As the real depreciates, foreign currency debtors (companies and banks) will rush to acquire dollars or hedge their dollar liabilities. This will reinforce the weakening trend in the currency. Finally, the Brazilian real is not cheap - it is close to fair value (Chart II-7). Hence, valuation will not prevent currency depreciation. Bottom Line: We are initiating a short BRL / long US dollar trade. Investors should remain neutral on Brazil within EM equity, local bonds and sovereign credit portfolios. Investors with long-term horizon should consider the following strategy: long the Bovespa, short the real. This is a bet that Brazil will succeed in reflating the economy at the detriment of the currency. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Andrija Vesic Research Analyst andrijav@bcaresearch.com     Footnotes 1    Processing trade includes imports of goods that undergo further processing before being re-exported.   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations