Policy

Special Report

Highlights Many on the left have embraced Modern Monetary Theory because it seemingly provides a politically expedient way to increase social welfare spending without raising taxes. Money-financed budget deficits can be justified when an economy is stuck in a liquidity trap, but can be extremely inflationary once full employment is reached. Investors should regard MMT as simply an extreme example of the increasingly permissive attitude that policymakers are adopting towards inflation and larger budget deficits. The path to high rates is lined with low rates, meaning that an extended period of accommodative monetary policy is usually necessary to stoke inflation. Investors should maintain a bullish bias towards global equities for now, but be prepared to turn bearish late next year as inflation begins to accelerate in the United States. An earlier turn to a more defensive posture on stocks may be necessary if Bernie Sanders, or some other far-left candidate, emerges as the likely victor in the next presidential election. Feature Print Some Money And Feel The Bern You know that an economic theory has reached the big leagues of policy debate when the Fed Chair is asked about it during his congressional testimony. This is exactly what happened on February 26, 2019, when Senator David Perdue questioned Jay Powell about his views on Modern Monetary Theory, or simply MMT as it is often called. Rather ironically given its name, MMT plays down the influence of monetary policy over the economy. Its adherents argue that Congress, and not the Fed, should be responsible for maintaining full employment. MMT proponents abhor the idea of a “balanced budget.” They contend that worries about sovereign debt levels are overblown. The U.S. government can always print money to finance itself. Fiscal deficits matter, but only to the extent that excessive deficits can cause inflation. The theory’s backers are a bit cagey about exactly how much inflation they are willing to tolerate or what they would do if, as in the 1970s, inflation and unemployment both rose together. Whether one thinks MMT is crackpot economics is not the point. What matters is that its supporters are growing in number. They include Stephanie Kelton, Bernie Sanders’ former economic advisor, and one of the speakers at BCA’s forthcoming annual New York Investment Conference. In my personal opinion, Sanders stands a very good chance of winning the 2020 presidential election. This makes MMT about as market-relevant as anything out there. In the following Q&A, we discuss the details of MMT and what it means for investors: Q: How does Modern Monetary Theory differ from standard Keynesian economics? A: MMT is almost indistinguishable from Keynesian economics when an economy is stuck in a liquidity trap, an environment where even interest rates of zero are not enough to revive demand. What really separates the two schools of thought is that MMT proponents tend to see liquidity trap conditions as the normal state of affairs, whereas most Keynesians see them as the exception to the rule. Q: Who’s right? The Keynesians or the MMTers? A: That remains to be seen. Near-zero rates have been the norm for most of the last decade, and much longer in Japan. This is a key reason why MMT has grown in popularity. The future may be different, however. Output gaps are shrinking and some of the structural forces which have held down rates over the last decade may fade. For example, the ratio of workers-to-consumers has peaked around the world, which may result in a decline in global savings (Chart 1). This could push up interest rates. Chart 1The Worker-To-Consumer Ratio Has Peaked Globally Q: Does the tendency of MMT backers to see the world as chronically ensnarled in a liquidity trap explain why they seem to consistently argue for bigger budget deficits? A: It does. If an economy needs negative interest rates to reach full employment, but actual rates are constrained by the zero-lower bound, anything which incrementally adds to aggregate demand will not result in higher rates. This means that increased government spending will not crowd out private investment – indeed, quite to the contrary, bigger budget deficits will “crowd in” private spending by boosting employment. The standard MMT prescription is to run a budget deficit that is large enough, but no larger, to maintain full employment. In effect, this means taking any excess private-sector savings – that is, savings which cannot be transformed into private investment or exported abroad via a current account surplus – and having the government absorb them with its own dissavings. Q: So MMT supporters are assuming that the government is competent and agile enough to tighten and loosen fiscal policy at exactly the right time? Good luck with that. A: Yes, that is a common problem with most left-wing theories: They assume that the government should not be trusted with anything unless it is run by fellow leftists, in which case it should be trusted with everything. To make the fiscal response timelier, MMT supporters have proposed creating a government job guarantee. The basic idea is that the government would hire more workers when the private sector is hunkering down, while shedding workers when the private sector is expanding. In theory, automatic fiscal stabilizers of this sort could help dampen the business cycle. The consensus among MMT backers in the U.S. is that a $15 wage would be high enough to offer a tolerable standard of living without enticing many people to opt for government work when suitable private-sector employment is available. MMT supporters are assuming that the government is competent and agile enough to tighten and loosen fiscal policy at exactly the right time. Unfortunately, as is often the case with such ideas, the devil is in the details. For example, does the $15 wage include potentially generous government benefits? What will the government do if someone shows up for work but decides to just loaf around? What about low-skilled workers who would be more productive in the private sector but are instead diverted into government make-work projects? Inquiring minds want to know. Q: And the price tag could be huge! Wouldn’t an extended period of large budget deficits – even if justified by economic circumstances – cause debt levels to spiral out of control? A: A prolonged period of large budget deficits would most certainly lead to a significant increase in the government debt burden. However, if the interest rate on government borrowing is lower than the growth rate of the economy, as MMT supporters tend to assume, the debt-to-GDP ratio will eventually stabilize.1 In such a setting, the government could just roll over the existing stock of debt indefinitely, while issuing enough new debt to cover interest payments. No additional taxes would be necessary. Chart 2 shows this point analytically. Right now, projected GDP growth is higher than 10-year government borrowing rates for most countries (Chart 3). That’s the good news. The bad news is that there is no guarantee that this will remain the case indefinitely. If interest rates ever rose above GDP growth for an extended period of time, debt dynamics would quickly become unsustainable. MMTers argue that the government can borrow at any rate it wants because they see the currency as a public monopoly.  Q: Isn’t it crazy to assume that interest rates will always stay below GDP growth? A: Not according to MMTers. They argue that the government can borrow at any rate it wants. This is because they see the currency as a public monopoly. As long as a government is able to issue its own currency, it can create money to pay for whatever it purchases, and by definition, money pays no interest. This means that the interest rate can always be held below the growth rate of the economy. The only reason policymakers may wish to raise interest rates is if inflation is getting out of hand. However, even then, most MMT adherents would prefer that the government tighten fiscal policy either by hiking taxes on the rich or cutting spending programs they don’t like (the military is usually high on their list). Raising rates is widely seen by MMT supporters as simply providing a handout to bondholders. Q: It sounds like MMT basically cuts the Fed and other central banks out of the loop. A: That’s right. MMTers contend that monetary policy has little impact on the economy. In fact, many MMT advocates believe that higher rates raise aggregate demand by putting more income into bondholders’ pockets. It’s a very odd argument. Yes, corporate investment tends to respond more to animal spirits than to changes in interest rates. However, there is little doubt that rates affect housing, the currency, and asset prices (and all three, in turn, affect animal spirits). It is almost as if the 1982 recession – an episode where the Volcker Fed took interest rates to 19% – never happened. Q: An odd argument, but perhaps not a surprising one? A: That’s where the “Magic Money Tree” moniker comes in. When an economy is suffering from high unemployment, there really is a free lunch: Putting more people to work can increase someone’s spending without decreasing someone else’s. However, when an economy is at full employment, scarcity becomes relevant again. If a government wants to spend more, it has to convince the private sector to spend less, which it normally does by raising interest rates. MMTers like to throw out the old chestnut about how budget deficits endow the private sector with financial assets such as cash or government bonds. But if additional government spending leads to higher inflation, an increase in the volume of financial assets will simply result in the erosion of the value of existing financial assets. There may be times when more government spending is beneficial even in a full-employment economy, such as funding for basic scientific research or public infrastructure. However, there may also be times when increased government spending is wasteful and comes at the expense of valuable private-sector investment. MMT does not distinguish between the two cases because its adherents seem to deny that any such trade-off exists. Q: It sounds like MMTers want to have their cake and eat it too. A: Exactly. The political appeal of MMT is that it seemingly promises European-style welfare spending without Europe’s level of taxes. Just print more money! Let us ignore the fact that the Fed actually pays interest on bank reserves. Under the current rules, increasing the monetary base would not be costless for the government if that money ended up back at the Fed in the form of excess reserves, as it surely would. The bigger problem is that a large increase in government spending, which is not matched by much higher taxes, will quickly cause the economy to overheat. At that point, policymakers would either need to rapidly tighten fiscal policy, aggressively hike interest rates, or face hyperinflation and a plunging currency. Q: That seems like an obvious point. Why don’t MMTers see it? A: It gets back to what we discussed at the outset – MMTers regard the world as being chronically stuck in a liquidity trap. The prevailing view among MMTers is that there is still a lot of spare capacity globally, including in the United States, where the unemployment rate has fallen below official estimates of NAIRU (the Non-Accelerating Inflation Rate of Unemployment). MMT supporters tend to be skeptical of these NAIRU estimates, believing them to be biased upwards. MMTers see the world as being chronically stuck in a liquidity trap. The prevailing view among MMTers is that there is still a lot of spare capacity in the world. To be fair, the methodology used by the OECD and many other statistical agencies to calculate the full employment rate, which effectively just smooths out past values of the actual unemployment rate, has probably understated the degree of labor market slack in a few countries (Chart 4). Chart 4AThe Unemployment Rate Versus NAIRU (I) Chart 4BThe Unemployment Rate Versus NAIRU (II) That said, we doubt that NAIRU is overstated in the United States. Both the Fed and the OECD peg NAIRU at 4.3%, slightly below the CBO’s estimate of 4.6%. As it is, the current CBO estimate is nearly one percentage point below the post-1960 average (Chart 5). Back in the 1960s and 1970s, most economists thought NAIRU was lower than it actually turned out to be (Chart 6). This caused the Fed to keep rates below where they should have been. Chart 5U.S. NAIRU Is Estimated To Be The Lowest On Record Chart 6The Fed Continuously Overstated The Magnitude Of Economic Slack In The 1970s Q: Let’s bring this back to market strategy. What does the increasing popularity of MMT mean for investors? A: Investors should regard MMT as simply an extreme example of the increasingly permissive attitude that policymakers are adopting towards inflation. The idea that central banks should raise rates preemptively to avoid overheating is slowly giving way to the belief that they should wait to see the “whites of inflation’s eyes” before tightening monetary policy. Meanwhile, on the fiscal side, austerity is out, and big deficits are in. None of this should be all that surprising. Attitudes towards inflation move in generational cycles. The generation that grew up during the 1930s was highly sensitized towards deflation risk. As a result, policymakers focused on increasing employment, even at the expense of higher inflation. In contrast, the generation that came of age in the 1970s favored policies that clamped down on inflation. For today’s generation, the stagflation of the seventies is a distant memory. “Maximum employment” is the name of the game again. It often takes several years for an overheated economy to produce inflation. This is particularly true when the Phillips curve is quite flat, as appears to be the case today. To the extent that the Fed raises rates over the next 12 months, it will be in response to better-than-expected growth. The stock market should be able to do well in that environment. However, as we get into late-2020 or early-2021, inflation may begin to move materially higher, forcing the Fed to crank up the pace of rate hikes. At that point, equity prices will drop and a maximum short duration stance towards government bonds will be warranted. Q: Just in time for Bernie Sanders’ inauguration! You predicted Trump would win, but Crazy Bernie? Come on, seriously? A: My guess is that Trump was the only Republican candidate who could have beaten Hillary Clinton in 2016, while Clinton was the only Democratic candidate who could have lost to Trump. Had it been Bernie versus Trump, Trump would have lost. Given how close the election turned out to be, Sanders would have probably prevailed.   This is not just idle speculation. During the tail end of the 2016 primary season, head-to-head polls showed Sanders leading Trump by about 10 points, compared to a 3-point lead for Clinton (Chart 7). The final results would have been more favorable for Trump, but given how close the election turned out to be, Sanders would have probably prevailed. A strong economy will help Trump this time around. However, demographic trends continue to move against Republicans. Trump also made a strategic mistake during his first two years in office by focusing on Republican pet issues like corporate tax cuts and gutting Obamacare, rather than securing funding for the border wall, which was his signature campaign promise. For its part, the Democrat establishment will try to stymie Sanders again, but having recently watered down the “superdelegate” rules, it will be in a much weaker position to do so than last time. Q: Yikes, President Bernie doesn’t sound good for stocks! A: In our client conversations on “tail risks” facing the markets, Bernie Sanders almost never comes up. Admittedly, a lot can change in the next 12 months, including the possibility that Joe Biden will enter the race. Biden is more moderate than Sanders and has broad-based appeal. This means that it is still too early to make any significant changes to portfolio strategy. However, if Bernie Sanders, or some other far-left candidate, begins to do well in the polls, markets may start to get antsy later this year.     Peter Berezin Chief Global Investment Strategist peterb@bcaresearch.com       1      Please see Global Investment Strategy Weekly Report, “Is There Really Too Much Government Debt In The World?” dated February 22, 2019.     Strategy & Market Trends MacroQuant Model And Current Subjective Scores Tactical Trades Strategic Recommendations Closed Trades

Special Report

Highlights So What? Optimism over a U.S.-China trade deal is becoming excessive. Why? Presidents Trump and Xi appear to want a deal but their late March summit is not yet finalized. Several news reports supporting the bullish consensus are overrated. The odds of a “grand compromise” that entails China implementing U.S. structural demands are 10%. The odds of trade war escalation are 30%. China’s policy stimulus is a better reason than trade talks to become more constructive on Chinese and China-sensitive risk assets. Feature The Chinese equity market is rallying enthusiastically as the annual “Two Sessions” legislative meeting convenes (Chart 1). The basis for the rally is evidence of greater policy support for the economy along with a general belief that the U.S. and China are close to concluding a trade deal, possibly at a fourth summit between President Donald Trump and Xi Jinping that may be held in late March. The NPC session will build on the optimism with Premier Li Keqiang’s promise of more “forceful” policy support and the passage of a new foreign investment law that promises fair treatment to foreign companies. Chart 1Positive Trade Signals, But Market Getting Ahead Of Itself Our view is that the trade signals are broadly positive – implying a 70% chance that tariffs will either remain frozen or decrease in the scenario analysis below – but that the market is getting ahead of itself both in terms of the likelihood of a “structural deal” and in terms of the positive market impact from any deal. The market impact will depend on the depth of the concessions that China offers the United States. If the concessions are significant, President Donald Trump will be able to roll back tariffs to a considerable extent – trade policy uncertainty will fall, China’s economic outlook will improve, and Trump’s reelection odds (and hence U.S. economic policy continuity) could increase marginally. If China’s concessions are slight, tariff rollbacks will be limited or non-existent and the deal will stand on shaky ground, ensuring elevated policy uncertainty in the aftermath of the agreement and raising the probability of a relapse into trade war ahead of the 2020 election. Trump may feel he has to prove his protectionist credentials anew against a trade critic in the general election. Will the outcome be positive enough to surprise Chinese and global markets that have already discounted a lot of positive news? From where we sit, this is unlikely. More likely, investors will be underwhelmed by a lack of resolution or the shallowness of a deal. The risk to this view is the aforementioned structural deal that involves substantial Chinese concessions combined with a major reduction in U.S. tariffs and sanctions. But even in this case investors will face additional trade uncertainty relating to the U.S. Section 232 investigation into auto imports, on which Trump must decide by May 18, underscoring the point that trade alone is not a firm basis for bullish investment recommendations over the course of H1 2019. The continued strength of the U.S. economy and China’s policy stimulus provide a more realistic basis for global risk assets to rally over the 6-12 month horizon. Presidential Momentum For A Trade Deal We remain pessimistic about U.S.-China relations in general and the prospects for a structural trade deal in particular. This is reflected in our subjective trade-deal probabilities, which hold that an additional extension is as likely as a final deal this month and that the risk of a relapse into trade war remains elevated at 30% (Table 1). Table 1Updated Trade War Probabilities Fundamentally, our pessimism stems from our view that the U.S. and China are locked in the early chapters of an epic struggle for supremacy in Asia Pacific that will reduce their ability to engage cooperatively (Chart 2). Chart 2China, U.S. In Geopolitical Power Struggle Critically, the economic impact of a trade war is not prohibitive for either country. China is not as reliant on exports as it once was. In addition, neither the U.S. nor China is too reliant on trade with the other to make a trade war unthinkable, as was the case with Canada and Mexico (Chart 3). Chart 3Economic Impact Of A Trade War Is Not Prohibitive China is economically vulnerable but is politically centralized, as symbolized by Xi Jinping’s aggressive purge of the Communist Party on the basis of corruption (Chart 4). The ruling party can and will accept the worst international economic outcomes since 1989-91, if it believes this is necessary for regime survival. Chart 4Regime Survival is Paramount Meanwhile the U.S. is economically insulated and performing relatively well (Chart 5), and is not politically divided on the question of China. A bipartisan, hawkish consensus has developed that will be discussed below. Just as we argued correctly that this trade war would occur, so too we believe it has a fair chance of reigniting. This could be due to policy miscalculation, unforeseen events, or the likelihood that Trump will face heat from the left-wing ahead of the election if he gives China as easy of a deal as he gave to Canada. Chart 5The U.S. Economy Is Strong But Softening... Nevertheless we accept that there is top-level momentum in favor of a deal for the time being, and this comes from both Presidents Trump and Xi. In China, delaying tactics are the standard way of coping with an angry Washington, as the perception in Beijing is that economic and technological advancement give it greater leverage over time. Moreover, the economy is weakening on several fronts, private sector sentiment is bearish, and the easing of fiscal and monetary policy is of unclear effectiveness (Chart 6). These are all reasons for Xi to seek at least a temporary reprieve. Chart 6...While the Chinese Economy Is Weak But Stimulating In the United States, Trump faces a difficult election campaign due to his relatively low job approval with voters (Chart 7). His polling has recently improved with the settlement of the FY2019 budget and avoidance of a second government shutdown, and this is despite his controversial decision to press forward unilaterally on southern border security. But he will be running for office late in the business cycle and is vulnerable to an equity bear market and recession. This explains why he has shown risk aversion since October on market-relevant issues ranging from NAFTA, Iran, and China. A trade deal with China offers the possibility not only of satisfying a campaign promise (renegotiating the terrible trade deals of the past) but also of a substantial boost to investor sentiment and key parts of the U.S. economy via Chinese cash. Thus it is reasonable to assess that Trump and Xi can satisfy their political preference for a deal in the short run. If Xi does not gratify Trump’s campaign platform as a great deal-maker, he will give impetus to Trump to form a grand protectionist coalition. Such a coalition could eventually succeed in constricting China’s technological development, as exemplified by the U.S.’s campaign against Chinese telecoms equipment maker Huawei. Fundamentally, China still depends on the West for the computer chips that are essential building blocks for its manufacturing sector (Chart 8). However, while this is a reason for Xi to play ball, it is far from clear that Xi will rapidly implement deep structural changes demanded by the United States. Xi has good reason to fear that Trump will continue the tech war on national security grounds despite any trade deal. Plus, either Trump or a Democratic president could take new punitive trade measures after 2020, given the underlying strategic struggle. For these reasons China is likely to slow-walk any structural concessions. We recognize that our 35% probability that trade talks will be extended cannot last forever. Assuming that Trump and Xi confirm the time and place of a fourth summit, the probability of some kind of deal will rise toward 70%. We doubt very much that Trump and Xi will attend such a summit without a high degree of confidence in the outcome, unlike the Trump-Kim summit in Hanoi, which suffered from inadequate preparation. Yet even if the probability of a deal rises to 70%, we still think there would remain a 30% chance of either an unexpected extension or a disastrous breakdown in negotiations – and we are not yet at that 70% mark. Bottom Line: Until a Trump-Xi summit is finalized in the context of continued progress in trade negotiations, we maintain our pessimistic probabilities for the trade negotiations, with a 30% chance of total collapse and a 35% chance of a further extension of talks beyond March. Remain Vigilant On The Trade Talks It is debatable whether momentum in favor of a U.S.-China trade deal has increased over the past two weeks as much as the news flow suggests. First, Trump’s extension of the tariff deadline – which he originally envisioned as a pause for a month “or less” – could just as easily lead to additional extensions rather than a quick resolution. This will be clear if a Trump-Xi summit does not materialize in late March. A logical time for the two to meet would be at the G20 summit in Osaka, Japan on June 28-29, which would prolong the trade policy uncertainty for nearly four months from today. Second, reports suggest that China, like the EU, is demanding that all Trump’s tariffs be removed as part of any trade deal. If true, this demand is more likely to result in a failure to make a deal than a total tariff rollback. The reason is that the U.S. needs to retain the ability to adjust Section 301 tariffs based on China’s actual degree of implementation of any commitments it makes to reduce forced technology transfers, economic espionage, and intellectual property theft. Several of these commitments are enshrined in the new foreign investment law that would pass through China’s legislature over the next two weeks (Table 2), but the U.S. will want to ensure that the law is actually implemented. Table 2New Foreign Investment Law Would Be A Positive For U.S.-China Negotiations If the U.S. rolls back all Section 301 tariffs it will lose a convenient legal standing from which to dial the tariffs back up if necessary. It is more likely that part or all of the 10% tariff on $200 billion worth of goods will be rolled back (our short-term trade deal scenario with 25% odds) than that the entire Section 301 tariffs will be rolled back (our best-case trade deal scenario with a 10% probability). The degree of rollback will be a critical indicator of the durability of any deal, as it will make a material difference for China’s export-manufacturing outlook (Chart 9). Thus far, China’s economy has counterintuitively benefited from the trade war due to tariff front-running. Chart 9The Degree Of Tariff Rollback Matters Third, the disagreements between President Trump and his hawkish lead negotiator, U.S. Trade Representative Robert Lighthizer, are likely overstated in their ability to increase the odds of finalizing a deal. There are two arguments for the view that Trump is losing faith in Lighthizer. The first is that he blames Lighthizer’s tough tactics for the equity market selloff. This may not be valid given that stocks continued to sell off after Trump sided with the trade doves and agreed to a trade truce with Xi Jinping. In December the S&P 500 suffered the worst monthly performance since February 2009 and the worst December performance since 1931. The second argument is more substantial and comes from Trump’s public interchange with Lighthizer over the use and value of memorandums of understanding (MOUs). The interchange was awkward and suggests that tensions exist between Trump and his top negotiator.1 However, the episode may have an important implication. Whatever the reason for the disagreement, Lighthizer gained the assent of two Chinese negotiators – Vice Premier Liu He and U.S. ambassador Cui Tiankai – in his declaration, on camera, that the term MOU would be dropped in preference for the term “trade agreement.” The result is that while the deal is still not going to be a “Free Trade Agreement” that requires legislative ratification, the language of the final document will be if anything more, not less, binding. This episode cannot possibly accelerate a final deal. It is hard to believe that Lighthizer is not secretly happy with the result of his dust-up with the president. It is well known – and frequently complained about by Lighthizer and other Trump administration officials – that China has very active diplomacy and makes many international agreements that are more nominal than real in their results. As a simple example, China typically agrees to a larger value of outbound investment than is ultimately realized (Chart 10). In fact, Lighthizer is at the forefront of the administration’s repeated and explicit aim to pin China down to better implementation and enforcement of any agreement. Indeed, in both of Lighthizer’s reports on the Section 301 investigation that motivate the tariffs, he refers to a well-known September 2015 commitment, between President Xi and former U.S. President Barack Obama, not to conduct cyber-espionage against each other’s countries. Lighthizer shares the view of the broader U.S. political establishment that China only temporarily enforced this commitment and later ramped up its hacking to steal trade secrets.2 Chart 10China Known For Overpromising Fourth, Trump’s failure to conclude a peace and denuclearization deal with North Korean leader Kim Jong Un in Hanoi, Vietnam does not increase the odds of a U.S.-China deal – it is either neutral or negative for U.S.-China talks. Whether intentional or not, the summit reminded the Chinese that Trump’s “art of the deal” requires the willingness to walk away from a bad deal. As mentioned, we view the odds of Trump walking away from a China deal at 30%. But the deeper problem is that Trump expects China’s assistance with North Korea as a condition of the trade deal. Whenever Trump thinks that China is not providing enough assistance, he threatens to walk away from talks with Kim. This occurred in May 2018 and has apparently occurred again. The failure of the summit is a failure of U.S.-China diplomacy in the sense that China could not or would not convince Kim Jong Un to offer more concrete steps toward denuclearization. This reflects negatively on the trade talks if it reflects anything at all. Bottom Line: Aside from the presidential momentum behind a trade deal, none of the recent news reports or leaks form a basis for upgrading the probability of a final agreement in late March. Will It Be A “Structural Deal”? Lighthizer is not isolated in driving a hard bargain with China: he enjoys the support of both parties in the U.S. Congress. At his recent testimony on U.S.-China trade to the House Ways and Means Committee, bipartisanship was a key theme. Democrats as well as Republicans voiced support for Lighthizer as the top negotiator due to his strict stance on China’s trade practices, while Lighthizer himself praised both Trump and Democrats such as House Speaker Nancy Pelosi for being skeptical about China’s trade practices as far back as 2001. The takeaway is that Trump needs deep concessions from China – what the top Democrat on the committee called “a structural deal” – in order to defend any trade deal against domestic critics and skeptical voters on the campaign trail in 2020. In other words, there is unanimity in Congress, as there was in May 2018, that Trump should not sacrifice his leverage for a deal limited to Boeings and soybeans but should instead obtain victories on core disagreements: national security, foreign exchange rates, market access, and intellectual property. The MOUs – now “agreements” – that are reportedly being drafted address these core disagreements. Therefore signs of progress in producing final drafts should be seen as evidence that the odds of a final deal are improving: Forced tech transfers: Raising equity caps for foreign investment in key sectors is a headline way to reduce the leverage that Chinese companies have used to extract technology (Table 3). There are other arbitrary licensing and permitting practices that could also be curtailed. Table 3Foreign Investment Equity Caps Intellectual property: China’s purchases of U.S. intellectual property are conspicuously small, especially when considering that China is not yet an innovation giant in terms of international IP licensing receipts relative to the amount that it pays out.3 If the U.S.’s IP trade balance with China were equivalent to its balance with South Korea, it would result in a $36.7 billion improvement in the U.S. balance (Chart 11). Services: China is a major growing market for U.S. service exports but Washington frequently complains about denial of market access, for instance in financial and legal services. Services exports also underscore the above point about intellectual property (Chart 12). Foreign exchange: The U.S. is asking China not to maintain a more market-oriented currency but rather to promote a stronger currency relative to the dollar, perhaps referring to the yuan’s undervaluation according to purchasing power parity (Chart 13). It is impossible for Trump to accept a deal that does not include some text on the currency since he has hammered the issue of Chinese currency manipulation on the campaign trail and is trying to talk down the greenback. South Korea agreed to a currency annex and Japan is likely to do the same, and that makes it even less feasible for China to get off the hook. Non-tariff barriers: The U.S. has a long roster of complaints about China’s trade practices, including subsidies to state-owned companies, dumping, and inadequate health, environmental, and labor standards. Changing these practices will raise the costs of production in China. Changes to non-tariff barriers can also increase American market access in a way that goes beyond the simultaneous demands for lower tariffs on U.S. imports (Chart 14). Chart 13China Not Off The Hook On Currency Manipulation If China pledges improvements on these issues then it could justify substantial tariff rollback, perhaps the entire 10% tariff on $200 billion. This scenario, the best version of our 25% trade deal scenario, would comprise a positive surprise for markets in the current environment. It still could fall short of a grand bargain justifying a total tariff rollback, unless implementation is swift and decisive, which is highly improbable. A lesser but still market-positive surprise would be an American agreement to reduce pressure on Huawei (comparable to the deal reached in May 2018 on that other besieged Chinese tech company, ZTE). Still less positive outcomes would be a partial reduction in the tariff rate or an American agreement to expand or expedite exemptions to existing tariffs. The last would indicate relatively low expectations about the depth of China’s concessions. Bottom Line: Until the actual details of any Chinese structural concessions and American tariff relief are known, the durability of any U.S.-China trade deal cannot be assessed. This warrants at best cautious optimism regarding the trade talks: the two sides are working on draft texts about the right things. Investors will not be positively surprised by an agreement that does not include structural concessions of the nature above as well as substantial American tariff rollback, which is needed to verify American confidence in China’s commitments. Investment Implications The outcomes that are currently available to investors leave substantial room for prolonged trade policy uncertainty (Chart 15). Any further extension of trade talks means that uncertainty will persist at current levels. A deal that includes limited structural concessions means that uncertainty will ease but remain elevated relative to pre-2018 levels, due to the persistent threat of Section 301 tariffs that the U.S. will wield in order to secure Chinese concessions. A failure of negotiations means a dramatic escalation in uncertainty; this is our 30% risk due to the geopolitical and technological struggle underway. We allot only a 10% chance to a grand bargain that includes deep structural reforms and full tariff rollback. Chart 15Trade Uncertainty Will Persist As a final consideration, investors should be aware that the better the U.S.-China trade deal, the higher the probability that Trump imposes tariffs on auto and auto part imports pursuant to the Section 232 investigation into the impact of these imports on national security, which concluded February 17. The Commerce Department’s recommendations are still unknown but it is not a stretch to imagine that the administration has discovered a national security threat. However, this determination alone does not require Trump to impose tariffs. If he is to impose, he has until May 18 to do so. The full value of U.S. auto and auto parts imports is larger than the value of Chinese imports that currently fall under Trump’s tariffs. It is very unlikely that the U.S. will match this size of tariffs against the EU (Chart 16). Certainly it will not do so if the U.S.-China conflict remains unresolved, since it seems a stretch to believe the equity market can sustain both trade wars at the same time. The Trump administration has already found that the China tariffs without negotiations were disruptive to the U.S. equity market and economy, and the U.S. has told the European Union and Japan that it will not impose tariffs as long as negotiations are underway. To do so would be practically to foreclose the possibility of a trade agreement prior to the 2020 election, at least in the case of the EU. Thus it is only after any U.S.-China deal that the risk of EU impositions rises. We take the view that Japan is likely to conclude an agreement with the Trump administration quickly, possibly even before the China deal but almost certainly shortly afterwards. Trump administration officials will also likely intervene on behalf of South Korea due to the strategic need to stay on the same page regarding North Korea, which itself led to the successful renegotiation of the two countries’ existing trade agreement last year (which included autos but did not explicitly exempt Korea from Section 232 auto tariffs). This leaves the EU, which is quarreling with the U.S. over a range of issues: trade, Iran, Russia, China, Brexit, Syria, etc. Our base case is that the U.S. will not impose sweeping Section 232 tariffs on the EU due to the negative impact this would have on the U.S. auto industry, which is rooted in the electorally critical Midwest; the aforementioned risk to the equity market and economy; and the fact that neither the U.S. public, nor Congress, nor the corporate lobby are supportive of a trade war with Europe. Tariffs would also harm the Trump administration’s broader attempt to galvanize Western countries against the strategic challenge of China, Russia, and Iran. Nevertheless, the risk of such sweeping tariffs is non-trivial because Trump does not face legal constraints in imposing them – he can act unilaterally, just as he did with the early Section 232 tariffs on steel and aluminum, which broadly remain in force. A negative trade shock to the EU at a time of economic weakness may not overwhelm the positive trade impact of a U.S.-China deal in the context of China’s policy stimulus, but it would take the shine off of any risk-on exuberance following a China deal. In the end, China’s risk assets are likely to continue benefiting from domestic policy stimulus plus the 70% likelihood that tariffs will not go up. BCA’s Geopolitical Strategy remains cyclically positive Chinese stocks relative to emerging market stocks over a 12-month horizon given China’s more robust stimulus measures and the above trade view. We are shifting our long China Play Index to a trade as opposed to a portfolio hedge. We are also long copper. We would anticipate that the trend for CNY-USD will be flat to up as long as negotiations proceed in a positive manner. BCA’s China Investment Strategy is tactically positive Chinese stocks relative to the global MSCI benchmark on the same basis, but is awaiting more evidence of a stabilization in the earnings outlook before recommending that investors shift to an outright overweight over the cyclical horizon. Still, our China team placed Chinese stocks on upgrade watch in their February 27 Weekly Report, signaling that the next change in recommended allocation is likely to be higher rather than lower.4   Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com     Footnote 1 News reports had indicated that Lighthizer and his Chinese counterparts were negotiating six MOUs – on forced tech transfer and cyber theft, intellectual property rights, services, currency, agriculture, and non-tariff barriers to trade – in pursuit of the March 1 deadline. When asked about the time horizon of the MOUs at a public press conference with the Chinese trade delegation in the White House, President Trump said that MOUs were not the same as a “final, binding contract” that he wanted as an outcome of the talks. Lighthizer spoke up in defense of MOUs, leading the president to publicly disagree with him. Lighthizer then declared that the term “MOU” would no longer be used and instead the two sides would use the term “trade agreement.” 2 This was the same summit at which Xi Jinping declared in the Rose Garden that China had no intention to militarize the South China Sea – an even more frequently cited example of divergence between China’s official rhetoric and policy actions on matters of strategic consequence. 3 Please see Scott Kennedy, “The Fat Tech Dragon: Benchmarking China’s Innovation Drive,” CSIS, August 2017, available at www.csis.org. 4 Please see China Investment Strategy Weekly Report “Dealing With A (Largely) False Narrative,” dated February 27, 2019, available at cis.bcaresearch.com.

Special Report

Highlights European Growth: Europe’s economy is slowing, while core inflation remains subdued. The ECB must now contemplate the need for a monetary policy ease so soon after ending its bond buying program. Likely ECB Options: The ECB will likely have no choice but to initiate a new round of LTROs – likely to be announced in either April or May – to prevent an unwanted tightening of credit conditions at a time of slowing economic growth. Fixed Income Implications: Stay below-benchmark on euro area duration, with inflation expectations likely to rebound alongside a more dovish ECB and rising global oil prices. Stay underweight Italian government bonds and neutral overall euro area corporate credit exposure, however, until there are more decisive signs that growth is stabilizing. Feature Back in December, the European Central Bank (ECB) - confident that the euro zone economy was healthy enough to allow the slow process of policy normalization to begin - ended its Asset Purchase Program and signaled that rate hikes could commence as soon as late 2019. Just two months later, the central bank is faced with an unexpectedly persistent and broad-based growth slump. Markets now expect no change in short-term interest rates until well into 2020. By most conventional measures, the ECB is running a very accommodative monetary stance, with a €4.7 trillion balance sheet and negative interest rates (both in nominal and inflation-adjusted terms). On a rate-of-change basis, however, policy has become incrementally less stimulative, with the balance sheet no longer expanding and real interest rates unchanged from levels of a year ago (Chart 1). An additional potential tightening of liquidity conditions is on the horizon with the ECB’s long-term funding operations for euro zone banks (LTROs and TLTROs) set to begin rolling off next year. Chart 1The ECB Needs To Ease Policy Somehow Our ECB Monitor indicates that fresh monetary easing will soon be required if the current downtrend in growth persists. Given the persistent fragilities within the European banking system, not only in Italy but increasingly in core countries like Germany, a combination of slowing economic momentum and tightening monetary liquidity is a potentially toxic brew. Weaker growth raises the specter of a rise in non-performing loans held by banks that also have significant sovereign debt exposures (the so-called “Doom Loop”). In this Special Report, we consider the policy options that the ECB could realistically deliver in the coming months - given the state of the economy, inflation and banking system – with the associated investment implications for European fixed income markets. Our conclusion: the ECB will be forced to take a dovish turn as an insurance policy against tighter credit conditions and weak growth. Eurozone Economy: Broad-Based Mediocrity The ECB has categorized the current downturn, which has pushed real GDP growth in the Eurozone to a below-trend pace of 1.7% and triggered a technical recession in Italy, as simply the product of a bunch of idiosyncratic country-specific shocks (a cut in Germany auto production due to changing emissions standards, Italy-EU fiscal policy debates that raised the cost of capital in Italy, and political unrest in France damaging consumer spending). The biggest shock, however, has been exogenous. Trade policy uncertainty and a weakening Chinese economy have both been a major drag on growth for euro zone countries that rely heavily on exports, in general, and Chinese import demand, in particular. The “one-off shocks” narrative is incorrect because the slowdown has been broad-based. The majority of countries within the euro zone are suffering slowing GDP growth, falling leading economic indicators and decelerating headline inflation, according to our diffusion indices for each (Chart 2). The previous three times such a synchronized slowdown unfolded (2001, 2009 and 2012), the ECB responded with a full-blown rate cutting cycle. Inflation trends today, however, make it a bit more difficult for the ECB to consider any such possible shift in a more dovish direction. Chart 2ECB Typically Eases After A Broad-Based Economic Downturn The overall unemployment rate for the region is 7.8%, well below the OECD’s estimate of the full employment NAIRU1 rate. In contrast to our diffusion indicators for the economy, the majority of euro area countries (83%) have unemployment rates lower than NAIRU (Chart 3). The previous two times labor markets were so tight in the euro area, wage inflation reached 4%, core inflation climbed beyond 2.5% and the ECB pushed policy interest rates to between 4-5%. Today, a large majority of countries are witnessing faster wage growth and core inflation, but the overall level of both is still relatively low (2.5% and 1%, respectively). Chart 3ECB Policy Is Already Very Easy So from the point of view of the state of overall growth and inflation, the ECB is in a difficult position. Euro area growth has slowed, but not by enough to ease the nascent inflation pressures in labor markets. The story gets more complex when looking at growth and inflation at the individual country level. For the four largest economies in the region – Germany, France, Italy and Spain – the latter two remain a source of concern. Unemployment in both Spain and Italy remains in double-digits, with headline and core inflation rates at 1% or lower (Chart 4). Italy’s manufacturing PMI is now at 47.6 and Spain’s is now at 49.9, both below the 50 level indicating an expanding economy. Chart 4Italy & Spain Are Becoming An Issue (Again) Credit growth exhibits a similar pattern. Total bank lending is contracting on a year-over-year basis in Italy (-4.3%) and Spain (-2.1%), while still growing at a positive, albeit decelerating, rate in Germany (+1.5%) and France (+5.3%). The most recent ECB Bank Lending Survey for the fourth quarter of 2018 showed that lending standards were becoming more stringent in Italy and Spain than in Germany or France (Chart 5). In Italy, where the growth downturn has been deeper and borrowing costs have gone up due to the Italian populist government’s repudiation of EU deficit limits, banks are actually tightening lending standards. Chart 5Credit Conditions Tightening At The Margin The last thing the ECB wants to see now is a sustained credit contraction in the large economies where growth and banking systems are the most fragile – most notably, Italy. Bottom Line: Europe’s economy is slowing, while core inflation remains subdued. Weakness is more pronounced in the Peripheral countries compared to the Core, especially Italy. The ECB must now contemplate the need for a monetary policy ease so soon after ending its bond buying program. Italy’s Banks Are Still A Huge Headache For The ECB European banks have struggled to generate acceptable profits in recent years against a backdrop of sluggish economic growth, negative interest rates and increased regulatory capital requirements. Bank equity values remain near post-2008 crisis lows, with Italian bank stocks severely underperforming their competitors within the euro zone (Chart 6). Credit spreads for Italian banks are also far more elevated than those of their euro area peers, a reflection of the higher yields and wider spreads on Italian government bonds (which, given Italy’s BBB sovereign credit rating, means that the floor on Italian yields and credit spreads is higher than those of other euro zone countries with better credit ratings). Chart 6Italy's Fiscal Problems Impacting The Banks Even given the economic fragility in Italy, Italian banks remain reasonably well-capitalized. According to the data from the European Banking Authority (EBA), Italian banks have a Common Equity Tier 1 (CET1) capital ratio of 13.8%, well above the minimum levels required by Basel III bank regulations and close to the overall euro area CET1 ratio of 14.7% (Chart 7). The problem for Italian banks, however, remains the high level of non-performing loans (NPLs). EBA data shows that Italian banks have an NPL ratio of 9.4%, nearly three times the total euro area NPL ratio of 3.4%. While this is a substantial improvement from the near-20% NPL ratio seen after the 2011 European debt crisis, the absolute level of NPLs remains high. The other major risk for Italian banks is their large holdings of Italian sovereign bonds, which raises the risk of mark-to-market losses hitting the banks’ capital position as government bond yields rise (i.e. the “Doom Loop”). The ECB’s bond purchases have helped to reduce the share of Italian sovereign debt held by Italy’s banks from 25% to around 19% over the past five years (Chart 8). Yet with Italy’s sovereign credit rating now BBB – on the cusp of junk – Italian bank balance sheets remain heavily exposed to sovereign debt risk. The ECB has tried to mitigate the impact of its extraordinary monetary stimulus on the profitability of Europe’s banks by offering longer-term loans (against acceptable collateral) at low interest rates. These programs, known as Long-Term Refinancing Operations (LTROs), have mostly been used by banks in Italy and Spain, which have taken up a combined 56% of all outstanding LTROs (Chart 9). Chart 956% Of ECB LTROs Have Gone To Italy & Spain The most recent LTRO operation launched in 2016 was a Targeted LTRO (TLTRO) that tied the extension of ECB funding directly to the amount of new loans made by any bank that received the funding. Those TLTROs were offered at the ECB’s Marginal Deposit Rate of -0.4%, effectively providing a 40bps subsidy for new bank lending. The impact on loan growth from the TLTROs was far greater in Italy and Spain, where the share of total bank lending funded by LTROs in each country is now 10% compared to 4% for all euro area bank loans (Chart 10). Chart 10LTROs Funding 10% Of Bank Lending In Italy & Spain The TLTROs extended in 2016 had a maturity of four years, which means that the loans will begin to mature next year.2 If the ECB lets these operations expire without any offering of a new program, then banks that have used that cheap liquidity will be faced with one of two choices: replace that funding with bank debt at much higher market interest rates, or reduce the size of their loan books (i.e. delever their balance sheets). For Italy’s banks, replacing all of that cheap TLTRO funding with expensive bank debt is highly unlikely. According to the Bank of Italy’s latest Financial Stability Report, bank debt represents as large a share of overall Italy bank funding as the TLTROs (around 10%), but the growth rate of that debt has been contracting at a -15% to -20% rate over the past couple of years (Table 1).3 This is how rising Italian sovereign bond yields translate into higher bank debt yields and market funding costs, restricting lending activity. Table 1Italian Banks Have Slashed Expensive Debt Market Funding Already, Italian banks have been cutting back on lending to the most risky borrowers, according to Bank of Italy data (Chart 11). The growth rates of loans deemed “risky” and “vulnerable” contracted at a faster pace in 2018 than during 2015-17, while loans extended to “solvent” and “safe” borrowers grew more quickly in 2018 than the prior three years. These trends are likely to continue with credit standards now being tightened by Italian banks according to the ECB Bank Lending Survey. An additional factor for the banks to consider is the upcoming implementation of the Basel III regulatory requirement that banks must maintain a minimum amount of funding with a maturity greater than one year (the Net Stable Funding Ratio, or NSFR). Even though the current round of TLTROs do not begin to expire until June 2020, they will turn into “short-term” funding as of June of this year when it comes to banks calculating their NSFR. That ratio is not yet binding, but banks will likely seek to plan ahead for their long-term funding and will seek guidance from the ECB. So the ECB is now faced with the prospect of letting the TLTROs begin to expire next year, placing 4% of total euro area bank lending and 10% of Italian and Spanish bank lending at risk. Given the current fragile state of growth in the euro area, especially in Italy, the central bank would be taking a huge gamble by risking an even deeper downturn through banks shrinking their loan books. The easiest way to prevent that outcome – more LTROs. Bottom Line: The ECB will likely have no choice but to initiate a new round of LTROs – likely to be announced in April or May - to prevent an unwanted tightening of credit conditions amid slowing economic growth. The ECB’s Likely Next Move? New LTROs With More Dovish Forward Guidance The ECB Governing Council meets this week. There will be a new set of economic projections prepared for this meeting, and the ECB has typically chosen to make changes to its monetary policies alongside shifts in its economic forecasts. ECB President Mario Draghi has already noted that the growth risks in the euro zone are now tilted to the downside. Even noted monetary hawks like German Bundesbank President Jans Weidmann and Dutch Central Bank President Klaas Knot – both candidates to replace Draghi when his term expires in October – have toned down their calls for monetary tightening given the weak growth in their own economies. We expect the ECB to follow a dovish script at the March ECB meeting, along these lines: Downgrade the ECB’s growth forecasts Delay the date when inflation is projected to return back to 2% target Extend forward guidance on the first rate hike out to “mid-2020 or later” (which only validates current market pricing) A pessimistic assessment of the outlook for bank lending based on elevated bank funding costs impairing the transmission of ECB’s “highly accommodative” monetary policy A discussion about the need for a new LTRO program to replace the ones that start expiring in 2020 Step 4 in that script could be delayed until the April or May ECB meetings, to allow for more time to see how the economic data unfolds. Almost all of the current downturn in real GDP growth can be attributed to the plunge in net exports – the contribution to growth from domestic demand has been stable over the past year (Chart 12). Thus, the ECB will likely want to see if the current indications of a U.S.-China trade deal, combined with more stimulus from China’s policymakers, puts a floor under the downturn in euro area trade activity. Chart 12ECB Growth Forecasts Require A Rebound In Exports Step 5 in our March ECB meeting script can also be delayed to April or May, but the ECB is not likely to wait longer than that and run the risk of letting the current slowing of euro area credit growth turn into a full-blown contraction due to the end of cheap funding (Chart 13). Chart 13Tightening Lending Standards: Trigger For A New LTRO? There has also been some speculation that the ECB could satisfy both the hawks and doves on the Governing Council by announcing a hike in the ECB Overnight Deposit rate at the same time as a new LTRO program. The Overnight Deposit rate represents the floor of the ECB’s policy interest rate corridor, with the Marginal Lending rate representing the ceiling and the Main Refinancing rate acting as the midpoint of the corridor. Yet with the ECB maintaining such a large balance sheet, with €1.2 trillion in excess reserves, the effective short-term interest rate (1-week EONIA) has traded near the Overnight Deposit Rate floor. Thus, lifting only the Overnight Deposit Rate, which is -0.4% and has been blamed for damaging the earnings of euro area banks, would effectively be the same as a traditional hike in the ECB’s main interest rate tool, the Main Refinancing Rate (Chart 14). Chart 14The ECB Cannot Bottom Line: Offering a new LTRO, but perhaps for only a shorter time period than the expiring TLTROs (i.e. two years instead of four), seems to be the best solution for the ECB. This will prevent a potential liquidity-driven bank credit crunch in the most vulnerable parts of the European economy – Italy and Spain. Fixed Income Investment Implications Of Our ECB View 1. Duration: the benchmark 10-year German Bund yield had fallen as low as 0.09% in the most recent global bond rally, largely driven by a collapse in inflation expectations. The ECB’s likely dovish guidance on rate hikes will prevent any meaningful rise in real Bund yields. Inflation expectations, however, do have a lot more upside if BCA’s bullish oil forecast is realized – especially so if the ECB also takes a more dovish turn (Chart 15). Stay below-benchmark on euro zone duration, and stay long inflation-linked instruments like CPI swaps. Chart 15Stay Below-Benchmark On European Duration Exposure 2. Italian Sovereign Debt: A new LTRO program, combined with more dovish forward guidance, should help prevent the current Italian growth downturn from intensifying. However, a weak economy will sustain pressure on Italian sovereign spreads. Stay underweight for now, but look to upgrade when growth stabilizes (Chart 16). Chart 16Stay Cautious On Euro Area Spread Product Until Growth Bottoms 3. Euro Area Corporates: A more dovish ECB will help stabilize corporate credit spreads in the euro area, but like Italian sovereign debt, signs of more stable growth are required before spreads can meaningfully compress. Stay neutral for now.   Robert Robis, CFA, Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Non-accelerating inflation rate of unemployment. 2 The loans were offered in four allotments in June 2016, September 2016, December 2016 and March 2017. Hence, the loans will mature in June 2020, September 2020, December 2020 and March 2021. 3 The November 2018 Bank of Italy Financial Stability Report can be found here: https://www.bancaditalia.it/pubblicazioni/rapporto-stabilita/2018-2/index.html Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Feature Recommendations Two Key Questions For Asset Allocators Stocks have rallied this year – MSCI ACWI is up 17% from its late December low – despite the fact that economic growth outside the U.S. has continued to deteriorate. The PMI in Germany has fallen to 47.6, in Japan to 48.5, and the average in Emerging Markets to 49.5 (Chart 1). Chart 1PMIs Ex-U.S. Still Falling U.S. growth remains robust, though recent data have showed some signs of weakness. The Citigroup Economic Surprise Index has fallen sharply, capex indicators have slipped, and December retail sales were terrible (Chart 2). The New York Fed NowCast for Q1 is now pointing at only 1.2% real GDP growth. Most of the slippage, however, was caused by the six-week government shutdown, and should be reversed in Q2. And the retail sales number appears “rogue”, perhaps caused by irregular data-collection methods during the shutdown, since other retail data do not support it (Chart 2, panel 3). The tightening of financial conditions in the last months of 2018 – which has now partly reversed – may have added to the slowdown (Chart 3). BCA’s view is that U.S. GDP growth is likely to come in well above 2% in 2019, slower than last year’s 2.9% but still above trend. Chart 2Should We Worry About U.S. Growth Too? Chart 3Financial Conditions Now Easing Our recommendation, therefore, is to continue to overweight equities (particularly U.S. equities), which should be supported by decent earnings growth (our top-down model points to 12% EPS growth for the S&P500 this year, compared to a bottom-up consensus forecast of only 5%), reasonable valuations, and sentiment that appears still to be damaged by the Q4 sell-off (Chart 4). Chart 4Environment Still Positive For U.S. Equities Two key questions will determine which asset allocation will be optimal this year. First, how long will the Fed stay “patient” and keep rates on hold? The futures market has almost completely priced out the possibility of any rate hikes in 2019, and even assigns a 15% probability of a cut (Chart 5). We still see upside risk to inflation, with core PCE likely to print above the Fed’s target of 2% by mid-year, partly because of the year-on-year base effect (in January 2018, monthly inflation was especially high), but also because underlying inflation pressures remain (Chart 6). Chart 5Is The Fed Really Going To Cut Rates? Chart 6Inflation Pressures Haven't Gone Away The market has misunderstood two of the Fed’s recent messages. Its mooted plan to end balance-sheet reduction by year-end is not intended as part of monetary policy. It is simply that bank excess reserves will have reached USD1-1.2 trillion, the level required to operate monetary policy using current tools, rather than those used before 2007 when reserves were zero (Chart 7). Second, recent discussions about changing the Fed’s inflation target from 2% a year to a price-level target will probably become effective only when the effective lower bound is hit in the next recession and, anyway, no decision will be taken until mid-2020. Chart 7Excess Reserves Will Be At Equilibrium Soon The market has taken this talk as dovish. We read recent comments by Fed Chairman Jay Powell to mean that if, by June, the economy is robust, risk assets are still rebounding, and inflation is ticking up, the Fed will continue to hike, maybe two or three times by year-end. This implies long-term bond yields will rise too. Equities may wobble initially but, as long as the Fed is hiking because growth is solid and not because of an inflation scare, this should not undermine the 12-month case for equity outperformance. The second key question is whether China has now abandoned its focus on deleveraging and switched to a 2016-style liquidity-driven stimulus. Certainly, the January total social financing number pointed in that direction, with new credit creation of almost 5 trillion RMB ($750 billion) and the first signs of an easing of restrictions on shadow banking (Chart 8). But the jury is still out on whether this is the massive reflation the market has been waiting for. Premier Li Keqiang criticized the increase, saying, “the increase in total social financing appears rather large…it may also bring new potential risks”. A PBOC official commented that the big increase was “due to seasonal factors” and emphasized that China was not embarking on “flood irrigation-style” stimulus. The recent more positive noises on the U.S./China trade war may also alleviate the pressure on China to stimulate. Chart 8First Signs Of Chinese Reflation? If and when Chinese growth does rebound, this will have major implications for asset allocation. It would signal a bottoming of the global cycle, which would favor stocks in Emerging Markets, Europe and Japan. It would push up commodity prices, and imply a weaker dollar. For now, we are not positioning ourselves like this, since global growth remains weak. Nonetheless, the first signs of a bottoming are appearing with, for example, the diffusion index of the global Leading Economic Index (which often leads the LEI itself) turning up (Chart 9). We may shift in this direction mid-year, and are now making some minor changes to our recommendations (see below) to hedge against this risk. But for the moment we prefer U.S. equities, expect further USD appreciation, and remain cautious on EM. Chart 9Is The LEI Close To Bottoming? Equities: We prefer U.S. equities given their better growth, reasonable valuations, and depressed sentiment (despite their outperformance year-to-date). But we are watching for an opportunity to increase our weighting in Europe, where growth still looks poor but may rebound in H2 due to fiscal stimulus, improving wage growth, a dovish turn by the ECB, and an eventual recovery in exports to China (Chart 10). We still see problems in EM, since earnings growth expectations need to be revised down further and stock prices have risen prematurely on expectations of a Chinese recovery (Chart 11). But we reduce the size of our underweight bet, to hedge against Chinese credit growth continuing to accelerate. We are also raising our recommendation for the industrials sector (with its large weight in capital goods companies dependent on exports to China) to overweight for the same reason.  We fund this by cutting consumer staples to underweight. We also raise our weighting on the energy sector, given our positive view on oil prices (see below). This gives our sector weightings a slightly more cyclical tilt, in line with our macro view. Chart 10Some Good News In Europe Too Chart 11EM Has Further Downside Fixed Income: It has been a conundrum this year why equities have risen and credit spreads tightened significantly, but the 10-year Treasury yield remains stuck below 2.7%. One explanation is that inflation expectations have been dampened by the crude oil price and if, as we forecast, oil continues to recover, the inflation component of the yield will rise (Chart 12). U.S. yields have also been dragged down by weak growth in other developed markets, where bond yields have therefore fallen. The spread between U.S. and German and Japanese yields reached record high levels in late 2018 (Chart 13). The term premium also is deeply into negative territory because many investors remain highly bearish and have hedged this view by buying Treasuries. If our view of robust U.S. growth, rising inflation, and more Fed hikes is correct, we would see 10-year Treasury yields rising towards 3.5% over the next 12 months. Accordingly, we are underweight global government bonds. We raised credit to neutral last month, but continue to have some qualms about this asset class, and prefer equities as a way of taking exposure to further upside for risk assets. Besides high leverage among U.S. corporates, we are worried about the deterioration in the quality of the credit market, since duration has been extended, covenants weakened, and the average credit rating fallen (Chart 14). Chart 12Inflation Expectations Driven By Oil Chart 13U.S. Yields Pulled Down By Europe And Japan Chart 14Deterioration In Credit Market Fundamentals Currencies: We see some more upside in the U.S. dollar over the next few months, given U.S. growth and monetary policy relative to the euro area and Japan (Chart 15). This may reverse, however, if global cyclical growth rebounds in the second half. The dollar is particularly vulnerable if macro conditions change, since it looks around 10% overvalued relative to other major DM currencies, and speculative positions are predominantly long dollar (Chart 16). Chart 15Relative Rates Support USD Chart 16But Dollar Vulnerable To Macro Shifts Commodities: With demand likely to grow steadily this year, but supply under pressure because of production cuts by OPEC and Canada, lower U.S. shale oil output, and disruptions in Venezuela and elsewhere, our energy strategists see drawdowns in inventories throughout the year (Chart 17). They forecast Brent to average $75 a barrel during 2019 (compared to $66 now), with WTI $5 a barrel lower. Industrial commodities continue to be driven by China which means, given our view expressed above, that we may see further weakness short-term, with a possible rebound in H2 (Chart 18). Chart 17Oil Supply/Demand Is Tight Chart 18When Will Metal Prices Bottom?   Garry Evans Chief Global Asset Allocation Strategist garry@bcaresearch.com   GAA Asset Allocation  

Special Report

Highlights Korean stocks are facing downside risks over the next several months. Exports will continue to contract on falling semiconductor prices and retrenching global demand. Growth deceleration and low inflation will lead the central bank to cut rates in 2019. Within an EM equity portfolio, we are downgrading Korean tech stocks from overweight to neutral but remain overweight the non-tech sector. We are booking gains on our strategic long positions in EM tech versus both the broader EM equity benchmark and materials. The KRW/USD exchange rate is at a critical technical juncture. Investors should wait to buy on a breakout and/or sell on a breakdown of the tapering wedge pattern. Feature   Decelerating and lately contracting South Korean exports have been a major drag on the economy and stock market (Chart I-1). The country is heavily reliant on manufacturing, with exports of goods contributing to nearly half of real GDP. Chart I-1Korean Stocks: Unsustainable Rebound? Although exports are currently shrinking, Korean domestic stock prices still rebounded. The rebound has mostly been driven by the information technology (tech) sector (Chart I-2). Is this recent rally justified by underlying fundamentals? Will share prices continue to rise in 2019? Our inclination is ‘no’ to both questions. There are still dark clouds on the horizon for both Korea’s business cycle and stock market. We are downgrading Korean tech stocks to neutral from overweight within a dedicated EM equity portfolio. However, we are maintaining our overweight in non-tech stocks relative to the EM equity benchmark. Lingering Risks In The Semiconductor Industry Korea’s dependence on the semiconductor sector has risen considerably in the past several years: Semiconductor exports have risen from under 10% to slightly above 20% of total goods exports (Chart I-3). As such, the outlook for semiconductor exports is a critical factor for future economic growth. Chart I-3Korea: Increasing Reliance On The Semiconductor Sector Table 1 lists the top 10 major exported goods from Korea, together contributing about 72% of total exports. Semiconductors are by far the largest component. Last year, overseas sales of semiconductors alone contributed to some 90% of growth in Korean exports, and about one-third of the country’s nominal GDP growth. Notably, Korea produces the largest quantity of DRAM and NAND memory chips in the world. Last year, Korean semiconductor companies accounted for about 70% of global DRAM and 50% of NAND flash global sales revenue. In 2019 Korean semiconductor exports will likely contract due to further deflation in DRAM and NAND memory prices (Chart I-4). Chart I-4Memory Prices Are Plunging The 2016-2017 surge in DRAM and NAND flash prices was due to supply shortages relative to demand. Last year, NAND prices plunged and DRAM prices began to fall as their supply-demand balances shifted to oversupply. This year, the glut will worsen. Demand Global demand for DRAM and NAND memory is slowing. Memory demand from the global smartphone sector – one important end-user market for DRAM and NAND memory chips – is contracting. According to the International Data Corporation (IDC), the global mobile phone sector is the biggest end-market for both DRAM and NAND memory chips, with nearly 40% market share in each. As major markets like China and advanced economies have entered the saturation phase of mobile-phone demand, global smartphone shipments are likely to decline further in 2019 (Chart I-5, top panel). Chart I-5Global Memory Demand Is Slowing DRAMeXchange1 expects global smartphone production volume for 2019 to fall by 3.3% from last year. In addition, the significant surge in bitcoin prices greatly boosted cryptocurrency mining activity in 2016-‘17 as miners quickly expanded their computing power. This contributed to strong DRAM demand and in turn higher semiconductor prices between June 2016 and May 2018. With the bust of bitcoin prices, this demand has vanished, which will further weigh on prices (Chart I-5, bottom panel). Supply High semiconductor prices in 2016-2017 boosted global production capacity expansion of DRAM and NAND memory chips. Based on data compiled by the IDC, global DRAM and NAND flash capacity expanded by 5.7% and 4.3% respectively in 2018 from a year earlier. As most of the global new capacity was added in the second half of 2018, the output of DRAM and NAND in 2019 will be higher than last year. Moreover, DRAM capacity will grow an additional 4% this year. Because of rising supply and slowing demand, both DRAM and NAND markets are in excess supply and have high inventories. DRAMeXchange forecasts that average DRAM prices will drop by at least another 20% in 2019, while NAND flash prices will fall another 10% from current levels. DRAM and NAND flash memory are the largest components of Korean tech producers. Yet they also sell many other tech products such as analog integrated circuits, LCD drivers, discrete circuits, sensors, actuators, and so on. Apart from the negative impact of declining global DRAM and NAND flash prices, the country’s semiconductor exports will also suffer from slowing demand in China in 2019. China, the biggest importer of Korean semiconductor products, has already shown waning demand. Its imports of electronic integrated circuits and micro-assemblies have contracted over the past two months in both value and volume terms (Chart I-6, top and middle panels). This mirrors a similar contraction in Korean semiconductor exports over the same period (Chart I-6, bottom panel). Chart I-6Weakening Chinese Semiconductor Demand Bottom Line: Korean semiconductor producers will likely face a contraction in their sales in 2019 due to weakening demand and deflating semiconductor prices. Diminishing Competitive Advantage Korea has been losing its competitive edge in key sectors like automobiles and smartphones. Even though the country remains highly competitive in the global semiconductor industry, it is beginning to show early signs of losing competitiveness there too. Improving competitiveness among other producers as well as a slowing pace of technological improvement and rising production costs are major reasons underlying Korea’s diminishing global competitiveness. Automobiles Korean auto manufacturers have lost market share in the global auto market. In China, the world’s biggest auto market, Korean brands’ market share has declined significantly in the past four years, losing out to both Japanese and German brands (Chart I-7, top three panels). Chart I-7Korea: Losing Market Shares In China's Auto Market Korean car companies have established auto manufacturing plants in China over the past decade. As a result, all Korean cars sold in China are produced within China, and automobile exports to China from Korea have fallen to zero (Chart I-7, bottom panel). Due to Korean auto manufacturers’ diminishing competitive advantage, Korean automobile production and exports peaked in 2012 in terms of volumes, and have been on a downtrend over the past seven years (Chart I-8, top panel). Chart I-8Further Decline In Korean Auto Output And Exports Is Possible While demand for Korean cars in the EU remains resilient, sales volumes in the U.S., China and the rest of world have been on a downward trajectory (Chart I-8, bottom three panels). Smartphones In the global smartphone market, Korea’s major smartphone-producing company – Samsung – has been in fierce competition with Chinese brands, and it seems to be losing the battle. Chart I-9 shows that while Samsung’s smartphone sales declined 8% year-on-year last year, smartphone sales from major Chinese smartphone producers (Huawei, Xiaomi, Oppo and Vivo) continued to grow at a pace of 20%. Chart I-9Korea: Losing Market Shares In Global Smartphone Market From 2012 to 2018, China’s share of global smartphone shipments rose from 6% to 39%. By comparison, Samsung’s share declined from 30% to 21% over the same period. Semiconductors Korean semiconductor companies – notably Samsung and SK Hynix – will likely remain the biggest producers in the memory market, given their advanced technology. However, there are still signs that Korean semiconductor companies will face increasing challenges in protecting their market share. Based on IDC data, Korean semiconductor companies’ share of global DRAM capacity will inch lower to 65% in 2019 from 65.4% in 2017, while their share of NAND capacity will decline to 53.8% from 57.5% during the same period. Meanwhile, China is focusing on boosting its self-sufficiency in terms of semiconductor production. At the moment there is still a three- to four-year technological gap between China and Korea in DRAM and NAND mass production, though the gap is likely to narrow. In the meantime, the U.S. will continue to create obstacles to prevent the rise of the Chinese semiconductor sector. However, these factors will only delay – not avert – the sector’s development and growth. We believe China will remain firmly committed to develop its semiconductor sector, particularly memory products, irrespective of the cost of investment necessary to do so. Similar to what has transpired in both automobile and smartphone production (Chart I-10), China will slowly increase its penetration in the semiconductor market with increasing capacity and a narrower technology gap over the next five to 10 years. After all, the world’s biggest semiconductor demand is in China. Chart I-10China: A Rising Star In Global Auto And Smartphone Market Significant increase in labor costs = falling export competitiveness for all sectors Korean President Moon Jae-in’s flagship economic policy, “income-led growth,” has resulted in dramatic increases in minimum wages since he took office in 2017, further damaging Korea’s competitiveness. The nation’s minimum wage was hiked by 7.3% in 2017, 16.4% in 2018 and will rise by another 11% to 8,350 KRW or $7.40 an hour, in 2019. As the president remains committed to meeting his campaign pledge of lifting the minimum wage to 10,000 KRW an hour, or about $8.90, this would require a further 20% increase in the next year or two. In addition, the government has also limited the maximum workweek to 52 hours since last July for businesses with more than 300 workers. Last month, the Cabinet further approved a revision bill whereby workers are eligible to receive an additional eight hours of wages every weekend for 40 hours of work that week. The new wage regulations have become a substantial burden on employers in all industries. The impact is more severe on small- and medium-sized enterprises (SMEs). According a recent survey, about 30% of SMEs have been unable to pay workers due to the state-set minimum wage. It is also affecting large manufacturers. According to a joint statement released in late December by the Korea Automobile Manufacturers Association and the Korea Auto Industries Cooperative Association, local automakers’ annual labor cost burdens will increase by at least 700 billion won (US$630 million) a year. As for auto parts manufacturers, a skyrocketing financial burden due to the new policy may threaten their survival. In addition, despite the KORUS FTA agreement reached between Korea and the U.S. last September, Korean auto manufacturers still fear they will be subject to new tariffs in 2019. On February 17, the U.S. Commerce Department submitted a report about imposing tariffs on imported automobiles and auto parts to U.S. President Donald Trump, who will make a decision by May 18. Our Geopolitical Strategy Service (GPS) team believes the odds of U.S. administration imposing auto tariffs on imported cars from Korea are small as this will be against the KORUS FTA agreement.2 Our GPS team also believes Japan is less likely to suffer a tariff than the EU, and even if Japan suffers a tariff along with the EU, Japan will negotiate a waiver more quickly than the EU. In both cases, Korea is likely to sell more cars in the U.S., but it will continue to face strong competition from Japan. Bottom Line: In addition to weakening global demand, a deterioration in Korea’s competitive advantage, due in large part to improving competitiveness among other producers and rising domestic wages, will negatively affect Korean exports. What About Domestic Demand? Record fiscal spending in 2019 will boost public sector consumption considerably, offsetting weakening consumption in the private sector. As the new wage policy will likely result in more layoffs and additional shuttering of businesses, domestic retail sales growth will remain under pressure (Chart I-11). Hence, an unintended consequence of the government’s higher income policy will be weaker aggregate income and consumer spending growth. Chart I-11KOREA The New Wage Policy May Trigger More Layoffs And Weaken Retail Sales Manufacturing and service sector jobs, including wholesale and retail trade and hotels and restaurants, account for 17% and 23% of total employment, respectively. Of all sectors, these two lost the most employees in January from a year ago. Meanwhile, due to the government’s deregulation of loans in 2014, Korean household debt has increased at a much faster pace than nominal income growth (Chart 12, top panel). As a result, Korea’s household debt has rapidly risen to 86% of its GDP as of the end of the third quarter of last year, from 72% four years ago – (Chart I-12, bottom panel). Elevated household debt at a time of rising layoffs will increase consumer anxiety and weigh on household spending. Chart I-12High Household Debt Will Weigh On Spending In order to combat an economic downturn, the government last month approved a record 467 trillion won ($418 billion, 26.5% of the country’s 2018 GDP) budget for 2019, up 9.5% from last year. The last time the budget increased by such a big scale was in 2009, when spending rose 10.7% in the wake of the global financial crisis. In addition, the government will front-load spending – with 61% of the budget to be spent in the first half of 2019. Household spending and government expenditures account for 48% and 15% of real GDP, respectively, while exports equal about 50% of real GDP. Hence, the increase in fiscal spending will not entirely offset the contraction in exports and slowdown in consumer spending. This entails a considerable slowdown in economic growth in 2019. Bet On Monetary Easing With growth disappointing and both headline and core inflation well below 2% (Chart I-13), the central bank will cut rates in 2019. Chart I-13Bet On A Rate Cut So far, economic growth has decelerated in the past 10 months, and recent data shows no signs of recovery. The country’s manufacturing sector is in contraction, with manufacturing PMI holding below the 50 boom-bust line in January (Chart I-14). Meanwhile, South Korea's unemployment rate rose to a nine-year high in January, with most of the job losses in the manufacturing and construction sectors. Chart I-14Manufacturing Sector: Still In Contraction Saramin, a South Korean job search portal, surveyed 906 firms in South Korea last month, 77% of which expressed unwillingness to hire new employees due to higher labor costs and negative business sentiment. Retail sales volume growth recently tumbled to 2-3%, pointing to faltering domestic demand (Chart I-11 above, bottom panel). The fixed-income market is not pricing in a rate cut in 2019. Therefore, investors should consider betting on lower interest rates. Shrinking exports and rate cuts will likely undermine the Korean won. Bottom Line: Economic deceleration and low inflation will lead the central bank to cut interest rates in 2019. Investment Implications The following are our investment recommendations: Downgrade the Korean tech sector from overweight to neutral within the EM space. We are reluctant to downgrade to underweight because many other emerging markets and sectors within the EM universe have poorer structural fundamentals than Korean tech. The tech sector accounts for 38% of the MSCI Korea Index, and 27% of the KOSPI in terms of market value. The stock with the largest weight in the MSCI Korea equity index is Samsung Electronics, with a share of 25%, followed by SK Hynix, with a ~5% share. Both are very sensitive to semiconductor prices. Specifically, semiconductor sales accounted for 31% of Samsung’s revenue, but contributed 77% of Samsung’s operating profit last year (Table I-2). Falling prices reduce producers’ profits by more than falling volumes.3 Hence, profits of semiconductor producers in Korea and globally will shrink in 2019. This will lead to a substantial selloff in Korean tech stocks (Chart I-15). Chart I-15Falling Memory Prices Will Trigger A Sell-Off In Korean Tech Stocks Meanwhile, China accounts for 33% of Samsung’s revenue, making it the largest market (Chart I-16). The ongoing economic slump in China’s domestic demand implies weaker demand for Korean shipments to China, which account for 28% of its exports and 14% of its GDP. ​​​​​​​ We are booking gains on our strategic long position in the Korean tech sector versus the EM benchmark index first instituted on January 27, 2010. This trade resulted in a 136% gain (Chart I-17, top panel). Chart I-16Taking Profits On Our Overweight Tech Positions Consistently, we are also taking profits on our long EM tech / short EM materials stocks trade, a strategic recommendation initiated on February 23, 2010 that has yielded a 186% gain (Chart I-17, second panel). The basis for this strategic position was our broader theme for the decade of being long what Chinese consumers buy and short plays on Chinese construction, which we initiated on June 8, 2010.4 Stay overweight non-tech equities within the EM space. The fiscal stimulus will have a considerable positive impact on the economy. Besides, Korean non-tech stocks have been weak relative to the EM equity benchmark, and in a renewed EM selloff they could act as a low-beta play (Chart I-17, bottom panel). We initiated our long Korean non-tech sector versus the EM benchmark index on May 31, 2018, which has so far been flat. The KRW/USD exchange rate is at a critical technical juncture. Investors should wait and buy on a breakout or sell on a breakdown of the tapering wedge pattern. The KRW/USD has been in a tight trading range over the past eight months (Chart I-18) and is approaching a major breaking point – i.e., any move will be significant, which we expect will largely depend on the movement of the RMB/USD. Chart I-18Tapering Wedge Patterns The natural path for the RMB would have been depreciation versus the U.S. dollar. However, China may opt for a flat exchange rate versus the U.S. dollar given its promises to the U.S. within the framework of forthcoming trade agreements. We have been shorting the KRW versus an equally weighted basket of USD and yen since February 14, 2018. We continue to hold this trade for the time being. Investors should augment their positions if the KRW/USD breaks down or close this trade and go long the won if the KRW/USD breaks out of its tapering wedge pattern. With respect to fixed income, we continue to receive Korean 10-year swap rates as we expect interest rates to fall meaningfully. Local investors should overweight bonds versus stocks.   Ellen JingYuan He, Associate Vice President Emerging Markets Strategy ellenj@bcaresearch.com     Footnotes 1 DRAMeXchange, the memory and storage division of a technology research firm TrendForce, has been conducting research on DRAM and NAND Flash since its creation in 2000. 2 Please see the Geopolitical Strategy Weekly Report, "Trump's Demands On China", published April 4, 2018. Available at gps.bcaresearch.com. 3 Please see the Emerging Markets Strategy Weekly Report “Corporate Profits: Recession Is Bad, Deflation Is Worse”, dated January 28, 2016, available at www.bcaresearch.com 4 Please see the Emerging Markets Strategy Special Report “How To Play Emerging Market Growth In The Coming Decade”, dated June 8, 2010, available at www.bcaresearch.com. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Special Report

Highlights So What? The yellow vest movement has not soured our optimistic view on France – if anything, it tells us it is time to turn more bullish. Why? The constraints on Macron pursuing reforms are overstated; he has no choice but to double-down.  France has multiple tailwinds: strong demographic trends, comparative advantages in exports, and an increasingly pro-business market environment.  Also … The roadmap for the European Union to change structurally is set, though it will need political will to materialize. Feature “La réforme oui, la chienlit non!” Charles De Gaulle, May 1968 “France is only herself when she leads fights that are bigger than herself.” Emmanuel Macron, August 2018 “When France sneezes the rest of Europe catches cold.” Prince Clemens von Metternich, 1848   In May 2017, the election of 39-year-old Emmanuel Macron brought an end to the seemingly unstoppable tide of populist nationalism in the developed world. As it turned out, the median voter in France was not as angry as the median voter in the U.K. and the U.S.  The reforms implemented since the French election have hardly made headlines outside of domestic media. The struggles of Italy, akin to la commedia dell’arte, and the jousting between London and Brussels, have drawn more attention. More recently, the yellow vest protests have reaffirmed the usual stereotypes about France. Behind the headlines, however, one cannot ignore the market relevance of what is happening in France. Thought to be condemned to stagnation by the rigidity of its labor market and the size of its state, the country is now looking to undo the malaise of the past two decades. The only surprise about the protests is that they did not occur sooner in Macron’s term. In this Special Report, we assess the ongoing yellow vest protests, review the reforms conducted since 2017, and give Macron favorable chances of reforming France further. We also highlight structural tailwinds that will support the French economy in the long run. Finally, we briefly go over the European Union’s roadmap for reforms. How Relevant Are The Yellow Vest Protests? Where there are reforms, there are protests. Or, as an astute client once told us: Buy when blood is in the streets. Had there been no protest against President Macron’s reforms, it would have signaled they lacked teeth. Protests were inevitable as soon as Macron set in motion his ambitious pro-growth and pro-business reform agenda. The yellow vest movement is not a coherent force led by a clear leadership. The demands of the group are many: lower taxes, better services, less of the current reforms (specifically in education), and more of other reforms. But despite this lack of clarity, the protesters have convinced most of the public that the reform agenda should pause, or at least slow down (Chart 1). What started on social media as a protest against the fuel tax in rural areas has evolved into a movement against President Macron. This transition occurred in part because a large segment of the population believes that Macron’s reforms have mainly benefited the wealthy. In fact, 77% of respondents in a recent poll view him as the “president of the rich.” The modification of the “wealth tax” – which mostly shifts the focus toward real estate assets instead of financial assets – was highly criticized for favoring the wealthiest households. It resonated strongly with the perception that past governments helped the wealthiest households to accumulate more wealth at the expense of the middle class. But it is not clear how intense or durable this popular sentiment will be, given that this type of inequality is not extreme in France and has not been rising (Chart 2). Chart 2What Income Inequality? Public support for the protests has hovered around 70% for several weeks since they started in November 2018, but is now coming down (Chart 3). There are now more respondents who think that the protests should stop than those who believe they should continue (Chart 4). As a sign of things to come, a demonstration against the yellow vests and in support of Macron and his government – held by the “red scarves” – managed to gather more people on the streets of Paris than the regionally based yellow vests have done in the capital city.1 Who are the yellow vests? The profile is shown in Diagram 1. They are mostly rural, mostly hold a high school degree (or less), and overwhelmingly support anti-establishment political leaders Marine Le Pen (right-wing leader of the National Rally) or Jean-Luc Mélenchon (left-wing leader of La France Insoumise). This suggests that the movement has failed to cross the ideological aisle and win converts from the center. Diagram 1The Profile Of A 'Yellow Vest' Protester How many French people are actually protesting? Although there was a slight pickup in protests at the beginning of January, nationwide numbers are not high. In fact, they are far from what they were back in November and therefore would have to get much larger for markets to become concerned anew (Chart 5). If we are to compare these protests to those in 1995 or 2010, the numbers pale in comparison (Table 1). For instance, the protest of December 1995 brought a million people onto the streets while the demonstrations against the Woerth pension reform in 2010 lasted for seven months and gathered close to nine million protesters across eight different events (Chart 6).   Table 1In A Glorious History Of Protests, 'Yellow Vests' Are A Footnote   Instead we would compare the yellow vest protests to the 15-month long Spanish Indignados in 2011, which gathered between six and eight million protesters overall, and the U.S. Occupy Wall Street protests that same year. The two movements were similarly disorganized and combined disparate and often contradictory demands. In both cases, the governments largely ignored the protesters. In the Spanish case, the right-of-center government of Mariano Rajoy plowed ahead with painful, pro-market reforms that have significantly improved Spain’s competitiveness. Thus the yellow vests should not have a major impact on Macron’s reform agenda. Although they have dragged his approval rating to historic lows (Chart 7), there is no constitutional procedure for the French president to lose power. The president’s mandate runs until 2022 and he has a solid 53% of the seats in the Assemblée Nationale. In other words, despite the consensus view – including among voters (Chart 8) – that he will not be able to implement the reforms he had planned, he still has the political power to push forward new initiatives. Chart 7...Although Macron Wishes He Was Sarkozy! Nevertheless, Macron will certainly have to adjust course to calm the protesters. For example, the recent increase in the minimum wage that the government announced in response to the demonstrations was not supposed to be implemented until later in the presidential term. The reforms brought forward in response to the protest are highlighted in Table 2. This should help reduce the movement’s fervor or otherwise its support. Table 2Macron’s Reforms: The Scorecard More importantly, Table 2 provides a list of the main reforms that have been implemented, proposed, or are yet to be completed since the election. The pace and breadth of these reforms come close to a revolution by the standards of the past forty years.2 What really matters is how these reforms tackle the following three key issues: the size of the state, the cost of financing such a large state, and the inflexible labor market. Macron is making progress on the latter two.  Labor reforms, effective since the beginning of 2018, simplify a complex labor code to allow for more negotiations at the company level, leaving unions outside the process. They also establish ceilings on damages awarded by labor courts, which represent a real burden on small and medium-sized French companies. The objective is to better align firm-level wage and productivity developments and encourage hiring on open-ended contracts. Education and vocational reforms aim at reducing the slack in the economy by reallocating skills. The youth unemployment rate, and the percentage of the youth population not in education, employment, or training, are both high (Chart 9). This is very relevant for the labor market given that the lack of skilled labor is the most important barrier to hiring (Chart 10), more so than regulation or employment costs. Chart 9Stagnant Youth Employment Figures... Chart 10...Are A Product Of Skill Deficiencies And Economic Uncertainty The administration’s weak spot is the large size of the state, which is undeniably at the root of the French malaise. At 55% of GDP, total government spending makes the French state the largest amongst developed economies (Chart 11). Although cutbacks have been announced, they have not materialized yet. These would include bringing the defense budget back to 2% of GDP, decreasing the number of deputies in the National Assembly by 30%, and cutting 120,000 jobs in the public sector. On the bright side, polls show that the French people understand the need to pare back the state. Indeed, 71% are in favor of the announced 100 billion euro cuts in government spending by 2022. Even Marine Le Pen campaigned on the promise of cutting the size of the public sector. Despite having a relatively good opinion of government employees, the majority of respondents approve of increasing work hours and job cuts for redundant government employees (Chart 12). The fundamental problem of a large public sector is that it has to be financed by taxing the private sector. This has fallen on the shoulders of businesses. However, under Macron, the corporate tax rate is set to decline progressively from 33.33% to 25% by 2022 – a cut of 8.3% in the corporate tax rate over four years (Chart 13). Chart 13Respite Coming For The Private Sector Bottom Line: The yellow vest protests were to be expected – they are the natural consequence of Emmanuel Macron’s push to reform the French economy and state. However, when compared to previous efforts to derail government reforms, the numbers simply do not stack up. Their disunited and broad objectives are likely to limit the effectiveness of the movement going forward. The global media’s focus on the protests ignores the structural reforms that Paris has already passed. This is a mistake as the reforms have been significant thus far, though much remains to be done. What To Expect Going Forward? Macron stands in what we call the “danger zone” of the J-Curve of structural reform (Diagram 2). Cutting the size of the state might be what he needs to get out of that zone over the course of his term. Diagram 2In The Danger Zone Of The J-Curve Unlike the last two presidents, Macron’s term has begun with a whirlwind. If he stops now, it is highly unlikely that he will recover his support levels. As such, there is no strategic reason why he would reverse course. His popularity is already in the doldrums. His only chance at another term is to plow ahead and campaign in 2022 on his accomplishments. He just needs to ensure that he will not plow into a rock. As expected, Macron has not made any mention of changing course on his most business-friendly reforms, which we see as a signal to investors that despite the recent chaos, the plan remains the same. Pension reforms, however, will likely be postponed given the ongoing protests. Macron hoped to introduce a universal, unified pension system by the middle of 2019 to replace an overly complex and fragmented system in which 42 different types of pension coexist, each one with its own calculation rules. Though protests (both yellow vest and otherwise) have been unimpressive by historical standards (Table 1), it might be too risky for the government to push the pension reform so close to these events. Bottom Line: Macron has turned France into one of the fastest-reforming countries in Europe. Do not read too much into the lows in approval rating and the protests. Macron has no choice but to own the reform agenda and try to campaign on it in 2022. France Is Not Hopelessly Condemned To Stagnation No country elicits investor doom and gloom like France. It is like the adage that Brazil has been turned on its head: France is the country of the past and always will be. However, we think that such pessimism ignores three important structural tailwinds.  Demographics From 2015 to 2050, the age distribution will remain broadly unchanged (Chart 14). The same cannot be said of Italy or Germany, where low fertility rates and ageing populations will permanently shift the demographic picture. Indeed, France has the highest fertility rate amongst advanced economies and less than 20% of the population is older than 65 (Chart 15). And France is far from relying on net migration to keep its population growing; migration represented only 27% of total population growth between 2013 and 2017, lower than in the U.S., the U.K. and Germany even if we were to exclude the migration crisis (Chart 16).   Chart 15France Has Healthy Demographics… Whenever one mentions France’s positive demographics, criticism emerges that the high fertility rate is merely the result of migrants having lots of kids. This is not entirely correct. While data is scarce due to nineteenth century laws prohibiting censuses based on race or religious belief, data from neighboring European states shows that the birth rate among migrants and citizens of migrant descent essentially declines to that of the native population by the second generation, which in France remains at the replacement level.3 Solid population growth will be a boon to the French economy. A stable dependency ratio – the ratio of working-age to very old or very young people – should limit the burden on government budgets. Further, France will avoid the downward pressure on aggregate household savings associated with an ageing population, the negative implications of a smaller pool of funds available to the private sector, and the resulting inflationary pressures. We also expect the structural rise in European elderly labor force participation to finally take effect in France. The aftermath of the Great Recession and the burden of having to provide for unemployed youth should spur French retirees to work longer. At 3.1%, France is still some way behind Germany at 7% and the average of 6% for European countries (Chart 17). Chart 17Time For Pépère To Get Back To Work Together, these forces imply a higher long-term French potential growth. Based on demographic divergence alone, the European Commission expects French nominal GDP to overtake German nominal GDP by 2040. The French Savoir-Faire France has lost competitiveness in the global marketplace. French export performance has suffered from decades of rigidities and high unit-labor costs while some of France’s peers, such as Germany, benefited greatly from an early implementation of labor reforms (Chart 18). While pro-growth and pro-market reforms ought to reverse some of these trends, France can still rely on a manufacturing savoir-faire that gives it a strong foothold in high value-added sectors of manufacturing, such as in transportation, defense, and aeronautics. Chart 18The Hartz Reforms Gap Table 3 lists the 10 largest export sectors as a share of total exports for France and Germany. These two economies share five similar categories of exports amongst their largest exports, representing respectively 23.8% and 24.3% of their total exports. However, France displays a substantially higher revealed comparative advantage (RCA) in its flagship sectors.4 In other words, the level of specialization of these sectors relative to the world average is higher in France than in Germany. Going forward, it is precisely this level of specialization in the high value-added sectors that will support the French manufacturing industry. Table 3France Vs. Germany: Closer Than You Think We also view the bullish trends for defense spending and arms trade, and the burgeoning EM demand for transportation goods, as important tailwinds for French manufacturing. France is the world’s fourth-largest global defense exporter and will benefit from shifting geopolitical equilibriums caused by multipolarity. France is also well positioned in the transportation sector where its exports to EM countries represent 20% of its overall transportation exports – a share that more than doubled in the past 15 years (Chart 19). While this trend is currently declining with the end of Chinese industrialization, we expect that it will resume over the next several decades as more EM and FM economies grow. Chart 19EM: A Growth Market For France France Is Much More Business-Friendly Than You Think A surge in the number of businesses created followed the election of the French president. Last year, more than 520,000 new businesses were created (Chart 20). Chart 20The New 'Start-Up Nation' The ease of doing business has improved on various metrics and the economy-wide regulatory and market environment should continue on this trend, as measured by the OECD product market regulation indicator (Chart 21). For instance, it takes only three and a half days to set up a business in France and no more than five steps, which is much easier than in most European countries. France also ranks 10th on the Global Entrepreneurship Index – a measure of the health of entrepreneurship ecosystems in 137 countries. It appears prepared for more tech start-ups as it ranks amongst the top countries on the Technological Readiness Index. Overall, France is now a much more attractive destination for investments (Chart 22). It appears that Brexit uncertainty is also driving some long-term capital investments. Between 2016 and 2017, the number of FDI projects in France jumped by 31% and Paris has become the most attractive European city for foreign direct investments (Chart 23). Chart 23Paris: The City Of (Love) FDI Cyclical View Despite the end of QE, markets do not expect the ECB to start hiking rates in the next 12 months – the expected change in ECB policy rate as discounted by the Overnight Index Swap curve is only 7 bps. This means the private sector will keep benefiting from extremely low lending rates, nearing 2%. Bank loans to the private sector will continue growing at a solid pace (Chart 24). Chart 24Banks Are Itching To Lend A lower unemployment rate and accelerating wage growth are positive for both consumer spending and residential investment. Average monthly earnings have strongly rebounded in the past five quarters (Chart 25). These two trends could put a floor under deteriorating household confidence and support consumer spending (Chart 26). Should household confidence rebound, consumers might spend more and stimulate the economy given their high savings rate. Chart 25Consumers Are Primed To Consume Chart 26But Protests Have Dented Confidence How does this dynamic translate in economic growth? Despite the setback experienced by the euro area – due to weaker external demand, or “vulnerabilities in emerging markets” to use the European Central Bank’s (ECB) own words – and the negative economic impact of the yellow vests, French real GDP grew by 1% (annualized) in the fourth quarter. The concessions made by Macron to answer the protests will bring the budget deficit close to 3.2% of GDP – from an earlier projection of 2.8%. The fiscal thrust will contribute positively to GDP growth (Chart 27), though 2020 may witness a larger fiscal drag.  Chart 27Macron Has Given Up On Austerity Bottom Line: The overall fundamentals of the economy are not as bad as the pessimists say. Cyclical and structural tailwinds will support the French economy going forward and should be reinforced by reforms. Can Europe Be Set En Marche Too? Macron’s presidency offers the European Union a window of opportunity to change structurally. He is already perceived as the “default leader” of Europe and might be the answer to the EU’s desperate need for strong leadership. What we have so far looks like a roadmap for a roadmap, but some progress could materialize this year. The European Stability Mechanism (ESM) – the European instrument for economic crisis prevention – is supposed to be granted new powers. At the Euro Summit in December, the ministers agreed on the terms of reference of the common backstop to the euro zone bank resolution fund (SRF), which would allow the ESM to lend to the SRF should a crisis or number of crises suck away all its funds. It would be ready from 2024 to come up with loans for bank resolution. While this may appear to be too late to make a difference in the next recession, we would remind clients that all dates are malleable in the European context. The possibility of the ESM playing a role in a potential sovereign debt restructuring in the future, like a sort of “European IMF,” was also discussed. However, some – including the ESM’s leadership – argue that such an expanded role will necessitate a greater injection of capital, which obviously Berlin must accept. Second, the stalled Banking Union project requires Berlin’s intimate involvement. In fact, Germany remains practically the only member state against the European Deposit Insurance Scheme (EDIS). This deposit insurance union would go a long way toward stabilizing the Euro Area amid future financial crises. However, a high-level working group should report by June 2019. As such, with Merkel sidelined and Macron taking leadership of the reform process, there could be movement on the EDIS by mid-year. Bottom Line: As Merkel exits the stage, France is likely to seize the opportunity to take the leading role from the Germans. By delivering the reforms he promised during his campaign and thus performing effectively at home, Macron hopes to obtain the legitimacy to set the EU en marche as well. Some material progress could be achieved as early as June this year. Stay tuned.   Jeremie Peloso, Research Analyst jeremiep@bcaresearch.com Footnotes 1      According to the government, 10,500 “red scarves” marched in Paris on January 27, 2018. 2      Sans the guillotine! 3      Rojas, Bernardi, and Schmid, “First and second births among immigrants and their descendants in Switzerland,” Demographic Research 38:11 (2018), pp. 247-286, available at https://www.demographic-research.org/Volumes/Vol38/11/Ariane Pailhé, “The convergence of second-generation immigrants’ fertility patterns in France: The role of sociocultural distance between parents’ and host country,” Demographic Research 36:45 (2017), pp. 1361-1398, available at https://www.demographic-research.org/Volumes/Vol36/45/Kulu et al., “Fertility by Birth Order among the Descendants of Immigrants in Selected European Countries,” Population And Development Review 43:1 (2017), pp. 31-60, available at https://doi.org/10.1111/padr.12037  4      A country displays a revealed comparative advantage in a given product if it exports more than its “fair” share, that is, a share that is equal to the share of total world trade that the product represents.  

Highlights Fed: With financial conditions easing and core inflation more likely to rise than fall, the majority of Fed officials will feel justified lifting rates again in the second half of this year. The best way to position for the resumption of rate hikes is to sell the 5-year or 7-year part of the Treasury curve and buy a duration-matched barbell consisting of the short and long ends of the curve. These sorts of positions currently offer positive carry, meaning you get paid as you wait for the market to price rate hikes back in. Corporate Spreads: Maintain an overweight allocation to corporate bonds (both investment grade and high-yield) with the exception of the Aaa credit tier. But be prepared to reduce exposure when spreads reach our target levels. Economy: Tracking estimates for 2018 Q4 and 2019 Q1 real GDP have fallen significantly during the past two weeks. The decline in tracking estimates is heavily influenced by an abnormal December retail sales report. That impact will reverse in 2019. Feature The Federal Reserve’s “on hold” strategy is now well known and has been completely discounted in the market. In fact, the overnight index swap curve is priced for 9 bps of rate cuts during the next 12 months and 21 bps of cuts during the next 24 months (Chart 1). Chart 1Primary Dealers Still Looking For Hikes At this point, the only thing that’s unclear is how the Fed will respond to the economic data going forward. Will it be eager to re-start rate hikes at the first sign of calm? Or perhaps the Fed is leaning toward a strategy where the next move will be a rate cut in the face of flagging economic growth? Survey Says Unfortunately, last month’s FOMC meeting was not accompanied by an updated Summary of Economic Projections. We therefore don’t know how policymakers have revised their rate hike expectations since December. However, the New York Fed’s Survey of Primary Dealers was updated in January, and it shows that the median primary dealer still expects two rate hikes this year. The only change between the December and January surveys is that the median primary dealer now expects one of the 2019 rate hikes in June and the other in December. In the December survey, both 2019 rate hikes were anticipated before the end of June (Chart 1). Typically, the median primary dealer and the median FOMC participant have very similar views on the future interest rate trajectory. Counting The Minutes The next stop on our search for clarity is the minutes from the January FOMC meeting, which were released last week. The January minutes provide a lot of insight into the thought processes of different FOMC participants. Unfortunately, they also reveal a serious lack of cohesion amongst the group. All in all, the document might confuse more than it clarifies. A few key excerpts from the document drive this point home. Referring to “global economic and financial developments”: Many participants observed that if uncertainty abated, the Committee would need to reassess the characterization of monetary policy as “patient” and might then use different language. This suggests that many Fed participants view the pause in rate hikes as a result of slower non-U.S. growth and tighter financial conditions. They also suggest that if global growth improves and financial conditions ease it would be appropriate to abandon a “patient” stance. … several […] participants argued that rate increases might prove necessary only if inflation outcomes were higher than in their baseline outlook. This second statement is much more dovish than the first. It suggests that several participants think that even improving global growth and an easing of financial conditions would not be sufficient to re-start rate hikes. They would also need to see inflation come in stronger than expected. Several other participants indicated that, if the economy evolved as they expected, they would view it as appropriate to raise the target range for the federal funds rate later this year. Finally, this last statement reveals that several other participants disagree with the view that an unexpected rise in inflation is a pre-condition for further rate hikes. What can we make of all this mess? The first thing that seems clear is that all Fed members view easier financial conditions as a pre-condition for further rate hikes. In this regard, we are already well on our way. Financial conditions have eased considerably since the start of the year, with the stock-to-bond total return ratio up sharply and credit spreads, the VIX and the dollar all off their highs (Chart 2). Chart 2Financial Conditions Are Easing Second, all FOMC participants need more confidence that inflation will return to target before re-starting rate hikes, but this bar seems higher for some than for others. Year-over-year core and trimmed mean CPI are currently running at 2.15% and 2.19%, respectively. This is slightly below the 2.4% level that is consistent with the Fed’s inflation target (Chart 3).1 The minutes suggest that some FOMC participants would be comfortable re-starting rate hikes as long as core inflation moves higher in the next few months and approaches the Fed’s target from below. Some others, however, may need to see an overshoot of the Fed’s inflation target before recommending rate hikes. Chart 3Core Inflation Needs To Move Higher Depressed inflation expectations, as seen in the TIPS market or the Michigan Consumer Sentiment survey, are a related issue (Chart 3, bottom 2 panels). The Fed will probably want to see upward movement in both of these measures before resuming rate hikes. In fact, New York Fed President John Williams warned last week that the “persistent undershoot of the Fed’s [inflation] target risks undermining the 2 percent inflation anchor.” He added that “the risk of the inflation expectations anchor slipping toward shore calls for a reassessment of the dominant inflation targeting framework.”2 Williams has long been an advocate for a monetary policy framework where the Fed targets an overshoot of its inflation target in the future to “make up” for undershooting its target in the past, i.e. some form of price level targeting. The Fed is currently conducting a year-long investigation into whether it should switch to this sort of regime and we learned last week that the Fed will announce the results of its investigation in the first half of 2020. Our own sense is that the Fed will eventually adopt some sort of “history dependent” inflation target as a way to avoid continuously bumping up against the zero-lower bound on interest rates. But this change will not occur this year and maybe not even next year. Of course, the more immediate concern for bond investors is whether inflation pressures will be meaningful enough in the next few months for the Fed to resume rate hikes in 2019. We expect they will be. We have previously shown that base effects alone will pressure year-over-year core CPI higher as we head toward mid-year.3 Meanwhile, other signs also point toward rising core inflation (Chart 4): Chart 4Inflation Pressures Building The New York Fed’s Underlying Inflation Gauge is running close to 3% (Chart 4, top panel). The ISM Manufacturing PMI is off its highs, but is still consistent with rising year-over-year core CPI (Chart 4, panel 2). Our CPI Diffusion Index is deep in positive territory, pointing to further near-term upside in the core measure (Chart 4, bottom panel). Bottom Line: With financial conditions easing and core inflation more likely to rise than fall, the majority of Fed officials will feel justified lifting rates again this year. January’s FOMC minutes imply that several Fed members want to see an overshoot of the inflation target before advocating for the resumption of rate hikes, but until the Fed changes its inflation targeting regime they will likely be out-voted. The Best Way To Trade The Fed We continue to recommend a below-benchmark duration bias in U.S. bond portfolios, on the view that rate hikes will exceed depressed market expectations on a 12-month horizon. However, this is not the most attractive way to position for the resumption of Fed rate hikes. The best way to trade the Fed in the current environment is by initiating a duration-neutral yield curve trade where you buy a barbell consisting of the long and short ends of the curve, and sell the 5-year or 7-year maturity. In a prior report we demonstrated that the 5-year and 7-year Treasury yields are most sensitive to changes in our 12-month fed funds discounter.4 That is, when the market starts to price-in more Fed rate hikes, the 5-year and 7-year Treasury yields increase more than other maturities. Similarly, the 5-year and 7-year yields fall the most when our discounter declines. Clearly, this means that if you are short the 5-year/7-year part of the curve versus the wings, you will make money as rate hikes are priced back into the market. Usually the problem with implementing such a trade is that it has negative carry. That is, the 5-year or 7-year bullet typically offers a greater yield than what you would earn on a duration-matched 2/10 or 2/30 barbell. If you don’t time the trade properly, you end up losing money waiting for Fed rate hike expectations to move. However, this is not a problem at the moment. In fact, duration-matched barbells are now positive carry propositions relative to 5-year and 7-year bullets (Chart 5). Chart 5 Barbell Yields Greater Than Bullet Yields In other words, if you think rate hikes will resume at some point, you are currently getting paid to wait for the market to catch on. The only way to lose money in this sort of trade is if our 12-month fed funds discounter falls further from its current -9 bps level. We view that as an unlikely scenario. Bottom Line: The best way to position for the resumption of Fed rate hikes is to sell the 5-year or 7-year part of the Treasury curve, and buy a barbell consisting of the long and short ends of the curve. We currently recommend being short the 7-year and long the 2/30 barbell. This trade has positive carry, meaning that you will earn money as you wait for rate hikes to get priced back in.  Corporate Spread Targets As we have discussed in prior reports, we think the Fed’s pause opens up a window where corporate bond spreads have room to tighten during the next few months.5 However, we also acknowledge that the window for outperformance is limited. Once financial conditions ease and the Fed resumes rate hikes, the environment will quickly become more difficult for corporate bonds. For this reason, in last week’s report we presented Chart 6. The diamonds in Chart 6 show where corporate 12-month breakeven spreads are today relative to past “Phase 2” periods, which are environments similar to today when the yield curve is quite flat but still positively sloped.6 We argued that we would be quick to reduce corporate bond exposure when the breakeven spreads reach the historical median for Phase 2 periods, i.e. when the diamonds fall to the 50% line in Chart 6. However, we acknowledge that this is not a helpful guide for investors who don’t have timely access to our valuation metrics. So this week we present Charts 7A and 7B. These charts estimate the option-adjusted spread (OAS) levels for each credit tier of the Bloomberg Barclays corporate bond indexes that would be consistent with the 50% line in Chart 6. To make these estimates we need to assume that the average duration of each index remains constant. The results show the following spread targets: For Aa we target 55 bps. The current OAS is 61 bps. For A we target 84 bps. The current OAS is 94 bps. For Baa we target 128 bps. The current OAS is 161 bps. For Ba we target 186 bps. The current OAS is 236 bps. For B we target 298 bps. The current OAS is 391 bps. For Caa we target 571 bps. The current OAS is 813 bps. We do not recommend an overweight allocation to Aaa-rated corporate bonds, where spreads are already expensive relative to past Phase 2 periods (Chart 7A, top panel). Chart 7aInvestment Grade Spread Targets Chart 7BHigh-Yield Spread Targets   Bottom Line: Maintain an overweight allocation to corporate bonds (both investment grade and high-yield) with the exception of the Aaa credit tier. But be prepared to reduce exposure when spreads reach our target levels. Economic Update We will finally receive GDP data for the fourth quarter of 2018 on Thursday, and investors should ready themselves for a weak number. In fact, the most recent tracking estimates from the New York Fed have real GDP coming in at 2.35% in Q4 and a mere 1.20% in 2019 Q1 (Chart 8). Chart 8Poor GDP Tracking Estimates ... It will come as no surprise that the trend in GDP growth is vital to our interest rate call. In fact, we showed in a recent report that when year-over-year nominal GDP growth falls below the 10-year Treasury yield it is often a good signal that monetary policy has turned restrictive and that interest rates have peaked for the cycle.7 With that in mind, if we add 1.2% expected real growth in Q1 to the 1.7% average growth rate of the GDP deflator (Chart 8, bottom panel), we can roughly estimate nominal GDP growth of 2.9% in Q1. This remains above the current 10-year Treasury yield, suggesting that monetary conditions would still be accommodative, but just barely. However, we expect the Q1 tracking forecast to improve as new data come in. According to the New York Fed’s model, the weak December retail sales report trimmed 0.41% from its Q1 growth forecast and this report increasingly looks like an aberration. In contrast to the retail sales number, the Johnson Redbook index of same-store sales is growing at a rate close to 5%, and indexes of consumer confidence remain elevated (Chart 9). Chart 9...Driven By Abnormal Retail Sales Even the Fed staff’s economic report, as presented in the January FOMC minutes, suggests that December should have been a good month for consumer spending: The release of the retail sales report for December was delayed, but available indicators – such as credit card and debit card transaction data and light motor vehicle sales – suggested that household spending growth remained strong in December. Bottom Line: However, we expect the Q1 tracking forecast to improve as new data come in. According to the New York it seems likely that the partial government shutdown influenced the collection of the December retail sales data and led to an abnormal print. Since the retail sales data feed directly into GDP, the impact will be felt in the next GDP report. But the impact will prove fleeting.   Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Footnotes 1 The Fed’s target is for 2% PCE inflation. CPI tends to run about 0.4% above PCE. 12-month core PCE is currently 1.88%, but data only go to November. This is why we refer to CPI in this report, which has data through January. 2 https://www.newyorkfed.org/newsevents/speeches/2019/wil190222 3 Please see U.S. Bond Strategy Weekly Report, “Caught Offside”, dated February 12, 2019, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, “Don’t Position For Curve Inversion”, dated January 22, 2019, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, “Buy Corporate Credit”, dated January 15, 2019, available at usbs.bcaresearch.com 6 For more detail on the different phases of the economic cycle please see U.S. Bond Strategy Special Report, “2019 Key Views: Implications For U.S. Fixed Income”, dated December 11, 2018, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, “Running Room”, dated January 29, 2019, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Special Report

Highlights The Phillips curve, which encouraged economic policymakers of the sixties and early seventies to believe in a mechanical tradeoff between inflation and unemployment, fell into disrepute once stagflation strangled the U.S. economy. We do not view the idea that there is an inverse relationship between the unemployment rate and wage gains as controversial. This weak form of the Phillips curve simply formalizes the interplay between supply and demand in the labor market. We have found, however, that any reference to the Phillips curve has the potential to provoke strong reactions from investors. The criticism that the link between compensation gains and consumer prices is questionable has merit. Over the last 30 years, changes in compensation have exhibited a sporadic correlation with changes in consumer prices. Even if the empirical evidence between labor market tightness and inflation is somewhat wobbly, the Fed remains squarely in the Phillips curve camp, and its take on the relationship is the only one that matters for monetary policy. The investment implication is that labor market strength will prove self-limiting. An unemployment rate bound for 3.5% or lower will pull the Fed back off the sidelines, ultimately bringing down the curtain on the expansion and the equity bull market. Feature The stagflation of the seventies was a near-death experience for the Phillips curve and its proposition that unemployment and inflation are inversely related. As both Milton Friedman and Edmund Phelps had predicted, the trade-off could not survive beyond the short term because workers would adjust their expectations as they caught on to the pattern, demanding wages that kept pace with inflation even when unemployment was high. Duly modified, the Phillips curve’s appeal was rekindled, and the Phelps-Phillips expectations-augmented version has gone mostly unchallenged within the economics profession ever since. The Fed and other policymakers may have given up on the notion that they could manage their economies via a mechanical tradeoff between inflation and unemployment, but the inverse relationship remains a pillar of their macroeconomic models. We don’t find the idea that the unemployment rate and wage inflation are inversely related the least bit controversial, as it fully accords with the laws of supply and demand. Unemployment’s link to consumer price inflation is uncertain, however, and even the narrow unemployment/wages form of the Phillips curve relationship we favor often invites controversy. Discussing upward wage pressures within the context of consumer price inflation and the Fed’s reaction function can elicit spirited resistance. As one client put it in a January meeting, “it is unbecoming for BCA to subscribe to these sorts of cost-plus notions of inflation.” This Special Report examines the record in an effort to determine the influence the Phillips curve thesis will have on policy and markets going forward. It asks the following questions along the way: What is the Phillips curve? Where does inflation come from? Is there a relationship between wage inflation and price inflation? Where does the Fed stand? What impact will a falling unemployment rate have on the economy and financial markets? A Brief History Of The Phillips Curve The Phillips curve arose from a study of the unemployment rate and wages in the U.K. from the mid-nineteenth to the mid-twentieth centuries. William Phillips discovered a consistent inverse relationship between the unemployment rate and changes in wages: high unemployment was associated with muted wage gains, and low unemployment was associated with robust wage gains. He posited that the unemployment rate revealed the level of tightness in the labor market, and the extent to which employers had to compete to attract workers. Other researchers extended the relationship from wage inflation to price-level inflation and suggested that policy makers could use the tradeoff between unemployment and inflation to fine-tune the course of the economy. The stagflation of the seventies blew up the notion of a mechanical tradeoff, but a modified form of the inverse relationship between unemployment and wage gains resides at the heart of mainstream macroeconomic forecasting models. Those models have become more sophisticated, and now include the concept of a natural rate of unemployment, but the inverse relationship between unemployment and inflation remains at their core. Investor skepticism aside, the Phillips curve is deeply embedded in orthodox economic narratives relating inflation and unemployment. As New York Fed President Williams put it last Friday in the first line of a speech discussing the issues raised in a new Phillips curve paper, “The Phillips curve is the connective tissue between the Federal Reserve’s dual mandate goals of maximum employment and price stability.1” Where Does Inflation Come From? Thousands of dissertations have grappled with this subject without providing a definitive solution, but there are two broad explanations we find most compelling. The first is that inflation responds to the level of slack in the economy. That’s to say that inflation is a by-product of the relative balance between aggregate supply and aggregate demand. When the output gap is wide (demand falls well short of the economy’s capacity), inflation is unlikely to find a footing. When the output gap is closed (demand and capacity are in balance) or negative (demand exceeds capacity), inflation will gain traction unless imported capacity bridges the gap. For the second, we combine the idea that inflation expectations play a central role with Milton Friedman’s always-and-everywhere admonition. The stable inflation of the last couple of decades has coincided with stable inflation expectations. The causation mostly appears to run from (trailing) inflation to expectations (Chart 1), but expectations surely influence economic actors’ price negotiations and open the door to a monetary influence. Inflation expectations are likely to be well anchored under a central bank that convinces households and businesses of its commitment to price stability. When the monetary authority lacks inflation credibility, inflation expectations may become unmoored and impel economic actors to insist upon higher wages and selling prices to keep pace with a rising price level. Chart 1Seeing The Future In The Recent Past The expectations-augmented Phillips curve makes it clear that inflation is a function of inflation expectations just as surely as it is a function of the unemployment rate. The more firmly expectations are anchored, the more unemployment has to drift from its natural rate (NAIRU, or u-star (u*)) to move the inflation needle. In other words, when expectations are as well-anchored as they have been since the crisis, wages will be so unresponsive to changes in the unemployment rate that the Phillips curve will appear to be broken. Believing that inflation will permanently remain at 2% or lower, workers feel no urgency to press for larger wage/salary increases. The Empirical Record – Unemployment And Wages The seventies played havoc with the Phillips curve, but over the last twenty-five years, the inverse relationship between changes in the unemployment rate and wage gains has held up very well once the unemployment rate has reached threshold levels at or near u-star. When there is ample slack in the labor market, wages are nearly insensitive to changes in the unemployment rate. When the unemployment rate moves from 10% to 9%, 9% to 8%, or 8% to 7%, there are multiple qualified candidates for every job opening and employers have no reason to bid wages higher (Chart 2, top panel). Below 5%, roughly around u*, employers have to compete for workers and wage gains are very sensitive to moves in the unemployment rate (Chart 2, bottom panel). Chart 3 illustrates the threshold concept, segmenting the last 30 years of observations by their relationship to the unemployment gap. Observations for which the unemployment gap is greater than or equal to 2% are shown in gray; their best-fit line with wage gains is nearly flat. Positive, but small, unemployment-gap observations are shown in orange; their best-fit line is steeper and indicates a more robust correlation with moves in wages. Negative unemployment-gap observations are colored blue; they have the steepest best-fit line and exhibit the tightest correlation with changes in wages. A skeptic might seek more convincing evidence, but period-to-period noise in the data limits the amount of variation in wages explained by the unemployment rate (just under 40% over the last 30 years). Noting that the unemployment gap tends to persist in negative and positive territory for extended periods, we measured the annualized rate of wage gains for negative-gap and positive-gap phases. The results were robust, with wage gains in negative-gap phases consistently topping gains in positive-gap phases (Chart 4). Both groups exhibited remarkably consistent growth rates – the three complete negative-gap phases featured wage gains of 3.8%, 3.8% and 3.9%, while the three positive-gap phases had wage growth of 2.7%, 2.5% and 2.4%. At 3%, the current negative-gap phase has already separated itself from the last three decades’ positive-gap phases, though the 3.8% level is still a ways away. Chart 4Mind The Gap The Empirical Record – Wage Inflation And Price Inflation If businesses were omniscient, omnipotent and able to adjust selling prices in real time – something like Amazon, in another words – they might seek to preserve their profit margins by instantaneously raising prices to offset wage gains. Wage inflation and price inflation would then move together in lockstep without any lags. Businesses do not have unlimited power or unlimited knowledge, however, and neither do workers. There are information and expectation lags, and price-making/price-taking status is fluid. The empirical record over the 50-plus years covered by the average hourly earnings series shows that the wage-price relationship is constantly shifting. Under a cost-push inflation framework, tightness in the labor market shows up in consumer prices after employees negotiate raises, and employers subsequently raise prices to recoup lost profits. In a demand-pull model, businesses perceiving signs of excess demand take the opportunity to raise prices, spurring employees to demand raises to preserve their purchasing power. There is room for both models, as BCA’s analysis of wage/price dynamics over the years has shown that leadership between prices and wages regularly shifts. For the purposes of this report, it is sufficient to note that the wage/price skeptics have a point. A decade-by-decade review of year-on-year gains in average hourly earnings (“AHE”) and core CPI shows that correlations between AHE and consumer prices regularly make big swings. The ‘60s, ‘80s and ‘00s were pretty good to Phillips curve adherents (Chart 5), but the ‘70s, ‘90s and the current decade mocked them, featuring repeated instances of outright decoupling (Chart 6). The bottom line is that the direction of causation between wages and consumer price inflation, as well as the sensitivity of the relationship, is fluid. The empirical record does not support the idea that wage inflation translates to overall inflation in a consistent and timely fashion. Chart 5Moving In Lockstep One Decade... Chart 6... Decoupling The Next The Fed’s Reaction Function Wage gains exhibit little sensitivity to changes in the unemployment rate when there is a lot of slack in the labor market. Even at lower levels of unemployment, inflation expectations can temper wages’ sensitivity to the unemployment rate. There is assuredly an inverse relationship between wages and unemployment, nonetheless, and wage gains are especially sensitive when the unemployment gap is negative. The jury is out on the relationship between unemployment and inflation, however. The direction of causation is not constant and the response lags between the series can be quite long. Inflation expectations play a sizable role, and are capable of smothering wage gains in times of low unemployment if they’re well-anchored, or goosing them even in times of high unemployment if they’re spiraling upward. Believing in the Phillips curve relationship requires a lot of assumptions, and if the theory were brand-new today, it might have a hard time surviving peer review. Markets don’t take their cues from peer-reviewed journals, however. When it comes to interest rates and the entire gamut of financial assets impacted by monetary policy, the Fed has the last word. What it believes about the Phillips curve is much more important than whether or not its conclusions have iron-clad empirical support. It has long been BCA’s view, informed by our contacts within the Fed, the former central bankers who sat on our Research Advisory Board, the Bank of Canada veterans who have worked at BCA, and careful observation of the Fed’s own comments and research, that the Fed maintains a Phillips curve view of the world. The Fed has plenty of company in this regard. Nearly all central banks are Phillips curve believers; in the absence of a mainstream alternative model of inflation, they all have to fall back on the expectations-augmented hypothesis. Investors and economics enthusiasts can rail against the Phillips curve’s empirical shortcomings, and posit that globalization, robotics/AI, Amazon and the gig economy have rendered it null and void. Those theories have not been confirmed by the data,2 however, and until the profession unites behind an alternative narrative, the Phillips curve will continue to heavily influence monetary policy. New York Fed President Williams clearly subscribes to the tell-‘em-what-you’re-gonna-tell-‘em/tell-‘em/tell-‘em-what-you-just-told-‘em method of constructing speeches. One need look no further than his remarks last Friday, when discussing a paper co-authored by former Fed governor Frederic Mishkin, for his view. “[T]he Phillips curve is very much alive in very tight labor markets,” he said near the beginning of his remarks. “[T]he Phillips curve is alive and kicking,” he said more than halfway through. “In summary, the Phillips curve is alive and well,” he said in conclusion, in case anyone in the audience had been napping. The bottom line for an investor today is that the Fed’s reaction function ensures that labor market strength will ultimately prove to be self-limiting. Assuming that Baby Boomer retirements will stifle further gains in the labor force participation rate, the unemployment rate is likely to ratchet lower across 2019.3 As it dips further and further below NAIRU, the Fed can be counted upon to remove accommodation, ultimately triggering a recession (Chart 7). Chart 7Expansions End When Unemployment Rises Investment Implications As the Fed’s pause allows the economy to regather momentum, hiring and wage growth should be well supported. The accompanying decline in the unemployment rate will drive the Fed to revive its tightening campaign. The irony is the longer the Fed grants the economy, and investors, a respite by holding its fire, the more accommodation it will have to remove to stamp out inflation pressures. It will take until 2020 for the Fed to complete its tightening campaign, but we expect the terminal fed funds rate in this cycle will be at least 3.25 to 3.5%, far above the OIS curves’ projection that fed funds will end 2020 at 2.25%. Such a wide disparity between our expectations and market expectations leaves considerable room for the Treasury curve to shift out along all maturities. We expect the curve will ultimately invert, but the process will follow a bear-flattening course, and long maturities will suffer the worst capital losses. We therefore advocate underweighting Treasuries in all fixed-income portfolios, while maintaining below-benchmark duration in all bond sleeves. We expect that Fed tightening will bring the curtain down on the equity bull market before the recession officially begins (Chart 8). Until it does, however, we expect the Fed’s forbearance to help the economy generate evident momentum, pushing risk-asset values higher. We continue to recommend that investors overweight equities and spread product for now, but the clock is ticking. Watch the unemployment gap for the cue to position portfolios more defensively. Chart 8Inducing A Recession Is Tantamount To Inducing A Bear Market Doug Peta, CFA, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com     Footnotes 1      Williams, John C., “Discussion of ‘Prospects for Inflation in a High Pressure Economy: Is the Phillips Curve Dead or Is It Just Hibernating?’” Remarks at the U.S. Monetary Policy Forum, New York City, February 22, 2019. https://www.newyorkfed.org/newsevents/speeches/2019/wil190222 2      Please see the September 2017 Bank Credit Analyst Special Report, “Did Amazon Kill the Phillips Curve?” available at bcaresearch.com. 3      Holding the participation rate constant, the U.S. economy has to create 110,000 jobs a month to keep the unemployment rate at a steady state. Please see the Atlanta Fed’s online jobs calculator at https://www.frbatlanta.org/chcs/calculator.aspx.