Policy

Highlights We would fade fears of an “earnings recession.” EPS growth should increase during the remainder of this year. While high debt burdens around the world may exacerbate deflationary pressures by restraining spending, they may also motivate policymakers to raise inflation in order to reduce the real value of outstanding debt. Ultimately, whether high debt levels turn out to be deflationary or inflationary depends on the extent to which policymakers have both an incentive and the means to increase inflation. The spread of political populism has made governments more inclined to boost nominal incomes by allowing economies to overheat. Central bankers have also become increasingly convinced that they should wait to see “the whites of inflation’s eyes” before tightening monetary policy any further. With inflation expectations still well anchored, it may take at least another 18 months for inflation in the U.S. to break out, and longer still elsewhere. Stay bullish on global stocks for now. However, be prepared to dial back equity exposure late next year, while shifting bond duration to a maximum underweight. Feature Fade Fears Of An “Earnings Recession” We upgraded global stocks in December following the post-FOMC meeting selloff. Our recommendation to go long the MSCI All-Country World Index has gained 9.0% since we initiated it. Although our enthusiasm for stocks has waned somewhat given the recent run-up, we continue to see upside for global bourses over the next 12-to-18 months. Admittedly, earnings growth has come down sharply from a year ago. To some extent, this reflects base effects (U.S. EPS rose by 23% in Q1 of 2018, thanks in part to the tax cuts). However, slower global growth and higher tariffs have also taken their toll. The good news is that the trade war is likely to stay on hiatus over the coming months. We also expect nominal GDP growth in the U.S. and the rest of the world to pick up by the middle of this year. Chart 1 shows that earnings growth tends to move in lock-step with nominal GDP growth. Chart 1Earnings And Nominal GDP Growth Move In Lock-Step Equity prices usually bottom when earnings growth bottoms (Chart 2). Analyst estimates based on IBES data foresee EPS growth troughing in Q1 and then accelerating modestly over the remainder of the year. If this happens, global equities will move higher over the coming months. What’s The Bigger Risk? Deflation Or Inflation? Last week, we argued that the next global economic downturn would probably be sparked by a surge in inflation which forces central banks to raise interest rates more aggressively than they would like.1 Given the absence of inflationary pressures today, and the still-ample spare capacity that exists in many economies, we noted that such an outcome is far from imminent. This implies that the global expansion still has plenty of room to run, thus justifying an overweight stance towards risk assets. One common objection to this thesis posits that deflation, rather than inflation, is the main risk to the global economy. And unlike its inflationary cousin, the next deflationary shock could be lurking just around the corner. Italy serves as a good example of the dangers of high debt levels. While many things can contribute to deflationary pressures, elevated debt levels are often cited as being the most important. An excessive debt burden can lead to a prolonged period of deleveraging. Since borrowers typically spend a larger share of their cash flows than lenders, overall spending could decline, leading to lower prices and wages. High debt levels can also make an economy vulnerable to interest-rate shocks. This is particularly the case when a country is reliant on external debt or issues debt in a currency it does not control. The Italian Lesson Italy serves as a good example of the dangers of high debt levels. Italy entered the euro area with one of the highest public debt ratios in the world. Private debt also soared in anticipation of euro membership as well as during the period leading up to the Global Financial Crisis, almost doubling as a share of GDP between 1998 and 2008 (Chart 3). Chart 3Italy's Debt Inferno Worries about high indebtedness, poor growth prospects, and contagion from Greece sent the 10-year Italian bond yield to nearly 7.5% on November 9, 2011. Yields tumbled after Mario Draghi pledged to do “whatever it takes” to preserve the common currency, but rose again last April after Italians brought an anti-austerity populist government into power. Today, the Italian government finds itself in the unenviable position of having to devote 3.4% of GDP to interest payments, more than double the euro area average (Chart 4). Domestic investors own less than half of Italian government debt, so most of those interest payments do little to stimulate domestic spending. Chart 4The Italian Government's Interest Payments Are Higher Than Elsewhere In The Euro Area The Inflation Solution When debt reaches elevated levels, faster nominal growth via higher inflation becomes an increasingly appealing solution for reducing debt ratios. A one percentage-point increase in nominal GDP will cut debt-to-GDP by half a percentage point when it stands at 50%, but by three full percentage points when it stands at 300%. Given the attractiveness of inflating away debt burdens, why don’t more governments pursue this strategy? Part of the answer is politics. The long history of hyperinflation in Europe and many other economies has cast a long shadow over how central banks operate. Unanticipated inflation also redistributes wealth from creditors to debtors. While the latter usually outnumber the former, the former typically have more political sway. Means And Opportunities Political will is a necessary condition for generating inflation, but it is not a sufficient one. Policymakers also need to possess the ability to accomplish their goal. What determines whether they will succeed? The answer, to a large extent, is the level of the neutral rate of interest. The neutral rate of interest is the long-term interest rate that is appropriate for the economy. When interest rates are above the neutral rate, growth will tend to fall below trend, while inflation will decline. Conversely, when rates are below their neutral level, the economy will grow at an above-trend pace and inflation will accelerate. Many things can influence the neutral rate of interest. These include: Trend GDP growth: Faster growth will incentivize firms to expand capacity in anticipation of rising demand. This will push up the neutral rate of interest. National savings: Lower taxes and increased government spending will drain national savings, while stimulating aggregate demand. This will push up the neutral rate of interest. Likewise, a decrease in private-sector savings — whether it be the result of easier access to credit or greater optimism about future income growth — will raise the neutral rate. The capital intensity of the economy: Economies that require a lot of physical capital will tend to have a higher neutral rate of interest. By the same token, economies where the capital stock needs to be replenished quickly in order to offset depreciation will have a higher neutral rate of interest.  The exchange rate: A weaker exchange rate will boost net exports. This resulting increase in aggregate demand will translate into a higher neutral rate of interest. With the exception of the currency effect, all of the factors listed above are captured by the canonical Solow growth model which undergraduate economics students usually encounter in their studies (See Appendix 1 for a derivation of the neutral rate of interest in this model). Inflation And The Neutral Rate Economists tend to define the neutral rate in real terms. However, when thinking about inflation, it is useful to consider the neutral rate’s nominal counterpart. Conceptually, the nominal neutral rate of interest can be either negative or positive. When the nominal neutral rate is negative, even a policy rate of zero will be insufficient to allow the economy to overheat. One might call this outcome the “strong form” version of the secular stagnation thesis. In contrast, when the neutral rate is low, but still positive, an interest rate of close to zero will be low enough to allow the economy to overheat, which will eventually generate inflation. One may refer to this as the “weak form” version of the secular stagnation thesis. Political will is a necessary condition for generating inflation, but it is not a sufficient one. The Danger Of Strong-Form Secular Stagnation In situations where the strong form version of secular stagnation prevails, deflationary pressures will feed on themselves. If an economy suffers from a chronic shortfall of aggregate demand, inflation is liable to drift lower. A lower inflation rate will push down the nominal interest rate that is consistent with any given real rate. For example, if the economy requires a real rate of -1% in order to grow at trend and inflation is 2%, a 1% nominal rate will suffice. But if inflation is 0%, then the policy rate would need to be -1%, which may be difficult to achieve. Japan serves as a case study for how this vicious circle can unfold. Following the simultaneous bursting of the property and stock market bubbles in the early 1990s, the Japanese private sector entered a prolonged deleveraging cycle. Inflation drifted steadily lower, ultimately falling into negative territory during the 1997-98 Asian Crisis (Chart 5). High debt levels in Japan were deflationary because the nominal neutral rate of interest was negative. Even if the Bank of Japan wanted to, it was greatly constrained in its ability to raise inflation. Chart 5Japan: A Case Study In Strong-Form Secular Stagnation Europe Is Not Japan… Yet Next to Japan, the euro area comes the closest to meeting the criteria for strong form secular stagnation. The euro area has low trend growth, owing to its slow population growth rate, as well as a banking system that is still focused on deleveraging. There is a silver lining, however: Despite the many woes the euro area has experienced, long-term inflation expectations are still over 100 basis points higher than in Japan (Chart 6). Fiscal policy is also turning somewhat more accommodative. Our base case is that the ECB will be slow to unwind its balance sheet and will only raise rates if the economy is showing more verve. This should be enough to move inflation towards target over the next two years. Chart 6Long-Term Inflation Expectations In The Euro Area Are Still Well Above Japanese Levels Inflation In The U.S. When inflation does break out early next decade, it will probably happen first in the United States. A large structural budget deficit and the revival of credit growth to the household sector following an intense period of deleveraging have boosted the neutral rate of interest. An overheated labor market is driving up real wages, which will lead to more consumer spending. December’s weaker-than-expected retail sales report will prove to be a fluke. Not only was it influenced by the sharp drop in the stock market and worries about a pending government shutdown (both of which have reversed), but the report itself was probably compromised by delays in the collection of data, which may have pushed some responses into January (historically, the weakest month for retail sales). This interpretation is consistent with strong holiday sales reported by online retailers and solid growth in the Johnson Redbook index of same-store sales. The latter captures over 80% of the sales surveyed by the Department of Commerce in its retail sales report, and featured a 9.3% year-over-year increase in sales in the final week of December, the fastest since the start of this series in 1997 (Chart 7). Chart 7The December Retail Sales Report Was Probably A Fluke Yes, corporate debt in the U.S. is high, but it is not particularly elevated relative to most other countries (Chart 8). Despite the collapse in equity prices and the spike in credit spreads late last year, U.S. corporations are still eager to expand capacity (Chart 9). This is not an economy teetering on the brink of recession. Chart 8U.S. Corporate Debt Is Not Extreme By Global Standards Chart 9U.S. Capex Plans Have Come Off Their Highs, But Remain Solid Policymakers in the U.S., and in much of the world, have grown more comfortable in letting economies overheat. Whether it be Trump’s unfunded tax cuts or the “Green New Deal” championed by the more liberal members of the Democratic Party, fiscal stimulus is in, austerity is out. Policymakers in the U.S., and in much of the world, have grown more comfortable in letting economies overheat. Even mainstream voices have given their nod of approval. Just this week, former IMF Chief Economist Olivier Blanchard argued that the U.S. could safely increase public debt without endangering economic stability.2 Meanwhile, central banks have increasingly bought into the mantra, famously espoused by Larry Summers, that they should wait to see the “the whites of inflation’s eyes” before tightening monetary policy.3 What this mantra overlooks is that inflation is a highly lagging indicator. By the time you see the whites of a tiger’s eyes, you are already destined to be its dinner. Investment Conclusions The spread of populist economic policies offers a one-two punch to inflation. Not only are populist prescriptions apt to stimulate demand, but that stimulus will raise the neutral rate of interest, thereby giving central banks greater traction to further boost spending by keeping rates below their neutral level. For investors, this implies a dichotomy between the medium-term and longer-term asset market outlook. Easy money policies are a boon to risk assets when they are first introduced, as they typically combine low interest rates with fast nominal GDP growth. But the path to higher rates is lined with lower rates, meaning that the longer central banks keep rates below their neutral level, the more economies will overheat, and the larger the eventual inflation overshoot will be. As growth outside the U.S. begins to accelerate in the second half of 2019, the dollar will come under downward pressure. As such, investors should overweight global equities and high-yield credit for the next 12 months. However, be prepared to dial back equity exposure late next year, while shifting bond duration to a maximum underweight. In terms of regional equity allocation, we continue to see global growth bottoming by the middle of this year. As growth outside the U.S. begins to accelerate in the second half of 2019, the dollar will come under downward pressure. The resulting reflationary impulse will be manna from heaven for the more cyclically-sensitive sectors of the stock market, as well as Europe and EM. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com   Laura Gu Research Associate Footnotes 1      Please see Global Investment Strategy Weekly Report, “Minsky’s Corollary,” dated February 8, 2019. 2       Olivier Blanchard, “Public Debt and Low Interest Rates,” Peterson Institute for International Economics and MIT American Economic Association (AEA) Presidential Address, (January 2019); Noah Smith, “The U.S. Can Take on a Lot More Debt Within Limits,” Bloomberg Opinion, (February 2019). 3      Lawrence Summers, “Only raise US rates when whites of inflation’s eyes are visible,” Financial Times, (February 2015). Strategy & Market Trends MacroQuant Model And Current Subjective Scores Tactical Trades Strategic Recommendations Closed Trades

Special Report

Highlights In their current form and size, perpetual bonds issuance and the central bank bills swap program are unlikely game-changers for the banking system in China. However, this mechanism constitutes monetization of banks’ capital and bad assets, i.e., recapitalization of banks, by the PBoC via quantitative easing. Hence, this scheme can be presently viewed as a bazooka that has not yet been loaded by the government. If the authorities pursue this program on a large scale without forcing banks to acknowledge and write off bad assets, banks would regain power to expand their balance sheets, fostering a cyclical economic recovery. Nevertheless, the growth model based on continuous “out of thin air” money and credit expansion inevitably leads to falling productivity growth and rising inflation. Therefore, the economic outcome over the course of several years would be stagflation, which is profoundly bearish for the currency. Feature The Chinese authorities recently launched a Central Bank Bills Swap (CBS) program to boost liquidity and facilitate issuance of commercial banks’ perpetual bonds. Box I-1 on pages 12-13 elaborates on the scheme and provides more detail about the program. Under the CBS program, Chinese banks can buy each other’s perpetual bonds, then exchange these bonds for central bank bills and pledge those bills at the People Bank of China (PBoC) to receive funding. Insurance companies are also allowed to purchase perpetual bonds, but they cannot pledge them with the central bank for funding. What are the macro implications of this program? Can the government use this scheme to recapitalize the banking system? Does the CBS program amount to quantitative easing? Will it be sufficient to boost credit growth in China in 2019? We have conditional answers to these questions – i.e., they all depend on the extent to which the scheme is actually utilized by the authorities. On the one hand, the CBS program could potentially become a proverbial bazooka used by the government to recapitalize the banking system via the PBoC monetizing banks’ bad assets. By doing so, the PBoC would be expanding its balance sheet by injecting excess reserves into the banking system – i.e., quantitative easing. Consequently, it could help banks accelerate credit and money growth, in turn helping the economy. The long-run collateral damage in this scenario, however, would be an RMB depreciation. On the other hand, the authorities could limit the usage of the scheme via various regulatory approvals and norms. In such a case, the impact of the program on money/credit growth and the real economy as well as on the exchange rate would be limited. In other words, it might end up being no more than a tool to help the four large banks meet BIS's TLAC requirements. At the moment, there is not enough information to determine whether the program will be a game changer for the banking system in China, leading to a surge in credit and broader economic recovery. Both total assets and broad credit growth among banks remain very weak for now (Chart I-1). In other words, it is a bazooka that has not been loaded, and may never be loaded because of the potential for seriously negative ramifications over the long term. Chart I-1Chinese Banks: Total Assets And Broad Credit Growth Consequently, we maintain our view that China’s growth will continue to disappoint in the first half of 2019, and that China-related plays, including many emerging markets (EM), remain at risk of a renewed selloff. Bank Recapitalization? In theory, the issuance of perpetual bonds along with the CBS program can be used to recapitalize the banking system. Each bank can buy perpetual bonds issued by other banks up to 10% of their core Tier-1 capital. These banks can get cheap financing from the PBoC by swapping these perpetual bonds with central bank bills, and then pledging those bills at the central bank to get funding. Hence, under this scheme, the PBoC will be financing purchases of perpetual bonds, which means the monetary authorities will indirectly be funding banks’ recapitalization. It is an “open secret” that Chinese banks would be considerably undercapitalized if they were forced to recognize non-performing assets. The non-performing loan (NPL) ratio currently stands at 1.9%, and the special-mention loans ratio is at 3.2%; and the sum of both is at 5.1% of total loans (Chart I-2, top panel). NPL provisions presently amount to 3.4% of total loans. Chart I-2Chinese Banks Are Massively Under-Provisioned When expressed as a share of total risk-weighted assets, the aggregate NPLs and special-mention loans are equal to 4.2% (Chart I-2, bottom panel). At 2.8% of risk-weighted assets, NPL provisions are extremely inadequate. Assuming non-performing assets turn out to be 10% of total risk-weighted assets, some 40% of banks' capital would be wiped out, according to our simulation presented in Table I-1. This is after accounting for existing provisions and assuming a 20% recovery rate of non-performing assets. Provided that risk-weighting assigns a zero weight to banks’ claims on the government, a 50% risk weight to claims on households and a 100% weight to claims on companies, the assumption of 10% of non-performing assets in total risk-weighted assets is reasonable. This is especially the case when the enormous credit boom of the past 10 years is taken into consideration. As a result, in this scenario the capital adequacy ratio (CAR) will drop from its current level of 13.8% to 9.4%. This will bring the CAR below the regulatory minimum of 11%. To raise the CAR to the regulatory minimum of 11%, the banking system would require RMB 2 trillion of capital. This is greater than the maximum potential demand for perpetual bonds that we estimate to be up to RMB 1.4 trillion. To estimate this number, we assumed all banks purchase perpetual bonds in amounts equal to 5% of their core Tier-1 capital and all insurance companies buy perpetual bonds in an amount equal to 5% of assets. This is not an underestimation of potential demand for perpetual bonds since there are currently limitations on banks’ ability to issue and purchase these bonds as elaborated in Box I-1 on pages 12-13. In short, it is not clear if perpetual bond issuance and the CBS will be sufficient to undertake full recapitalization of the banking system and allow banks to accelerate their balance sheet expansion to finance an economic recovery. Bottom Line: In their current form and shape, perpetual bonds and the CBS program are unlikely to be a game-changer for the banking system in China. However, if the authorities eliminate limitations and change regulatory norms, the scheme could potentially be used to recapitalize China’s banking system. This is why this scheme can presently be viewed as a bazooka that has not yet been loaded by the government. Does CBS Represent QE? Its Impact On Liquidity And Money Supply The CBS program is a form of quantitative easing (QE). It will expand the PBoC’s balance sheet and banking system liquidity (excess reserves at the central bank), as elaborated in Box I-1 and Diagram I-1 on pages 12-14. If pursued on a large scale, this scheme would constitute monetization of banks’ capital and their bad assets by the central bank. The mechanism is already in place, but the extent to which authorities will use it to recapitalize banks remains unclear. Even though the CBS program will expand banking system liquidity – i.e., excess reserves at the central bank – it will not – however - affect broad money supply. The basis is simple: Banks’ excess reserves at the central bank are not part of the broad money supply in any country. Banks use excess reserves to settle payments between one another and with the central bank. Banks do not lend out excess reserves. Further, only a central bank can create excess reserves, and it does so “out of thin air.” In brief, excess reserves rather than corporate and individual deposits constitute genuine banking system liquidity. Barring lending to or buying assets from non-banks – which does not typically occur outside of QE programs – central banks do not create broad money or deposits.1 Money/deposits, the ultimate purchasing power for economic agents, is created by commercial banks “out of thin air,” as we have discussed and illustrated in our series of reports on money, credit and savings.2 Having adequate capital and liquidity as well as positive risk appetite, banks can expand their balance sheets, i.e., originate loans and buy various securities. When banks make loans or purchase assets from non-banks, they simultaneously create deposits and new purchasing power. Chart I-3 demonstrates that in recent years, excess reserves in China’s banking system have been flat, yet banks’ assets and the supply of money has expanded tremendously. The opposite can also occur: Banks’ excess reserves can mushroom, but banks may actually be reluctant to grow their balance sheets. This was the case after the Lehman crisis with U.S. banks and in the wake of the European debt crisis with euro area banks. Chart I-3China: Excess Reserves And Broad Money Finally, we have elaborated at great length in our past reports that China’s money and credit excesses do not stem from its high household savings rate. Rather, like any credit bubble in any country, China’s leverage is due to the creation of credit/money “out of thin air.”2 Bottom Line: Perpetual bond issuance and the CBS program will expand the banking system’s excess reserves, but not broad money supply. Besides, it is not certain that excess reserves will accelerate loan growth. Credit origination by banks depends on many other factors such as banks’ willingness to expand their risk assets, loan demand and the regulatory regime and norms. Deleveraging Has Not Yet Started One cannot discuss the potential for a monetary bazooka in China without an update on the status of deleveraging. The fact is that deleveraging in China has not even begun: Credit is still expanding faster than nominal GDP growth. The most common way to measure leverage/debt is to compare it with the cash flow that is used to service debt. Nominal GDP is a measure of cash flow in an economy from a macro perspective. The debt-to-asset ratio is a poor measure of leverage because asset valuations are often subjective: Assets are valued by debtors themselves. Besides, apart from distressed credit investors, one does not want to be a creditor to a country or company that has to sell assets to service its debt. Stock and bond prices of debtor countries or companies tailspin when the latter have to sell assets to service debt. The top panel of Chart I-4 illustrates that China’s enterprise and household domestic credit/debt is still expanding at an annual rate of close to 10% at a time when nominal GDP growth has slowed to 8%. Chart I-4China: Deleveraging Has Not Even Begun Consistently, the debt to GDP ratio has not declined at all (Chart I-4, bottom panel). In this context, a rhetorical question is in order: Should China ramp up money/credit growth and monetize banks’ NPLs, given that deleveraging has yet to take place? Economic Ramifications Of Deploying The Bazooka What would be the economic ramifications if the Chinese authorities once again promote and allow unrelenting money/credit expansion “out of thin air” to bail out zombie banks and companies? Cyclically: If the authorities compel banks to acknowledge NPLs and write them off as and when the PBoC finances their recapitalization, banks may not be in a position to accelerate loan growth. This scenario entails that credit growth and hence cyclical sectors in China would remain weak for a while. In contrast, if the authorities pursue recapitalization of banks without forcing them to acknowledge and write off bad assets, banks would regain their power to expand their balance sheets, fostering a cyclical economic recovery. Structurally (in the long term): The growth model based on continuous “out of thin air” money and credit expansion inevitably breeds economic inefficiencies, falling productivity growth and rising inflation. In short, the economic outcome over the course of several years would be stagflation. Chart I-5 illustrates that China’s ICOR (incremental capital-to-output ratio) is rising, or inversely that the output-to-capital ratio is falling. This entails worsening economic efficiency and slowing productivity growth. Chart I-5Symptoms Of Rising Inefficiencies Chart I-6 shows a potential stylized roadmap for the Chinese economy in the years ahead if the credit and money bubbles are inflated further without corporate restructuring, bankruptcies, the imposition of hard budget constraints and meaningfully improved capital/credit allocation. The red line represents potential GDP growth, and the dotted red line is our projection. In any economy, the potential growth rate is equal to the sum of growth rates of the labor force and productivity. China’s labor force is no longer expanding and will begin shrinking in the coming years (Chart I-7). Hence, going forward, the sole source of potential GDP growth in China will be productivity growth. Productivity growth has been slowing and will continue to do so if structural market-oriented reforms are not implemented (Chart I-8, top panel). Besides, the industrialization ratio has already risen a lot (Chart I-8, bottom panel). Chart I-7China: No Tailwind From Labor Force Chart I-8China: Productivity Is Slowing With the potential GDP growth rate in China declining, future fiscal and credit stimulus may lead to higher nominal – but not real – growth. The latter will be constrained by a slowing rate of potential real GDP growth. Higher nominal but weaker potential (real) growth entails rising inflation. The combination of higher inflation along with the need to maintain very low nominal interest rates to assist debtors is bearish for the currency. In such a scenario, there will be intensifying depreciation pressure on the yuan from the tremendous overhang of RMBs in the banking system (Chart I-9). The PBoC’s foreign exchange reserves of $3 trillion will not be sufficient to backstop the enormous amount of RMB (money) supply of RMB 210 trillion – which is equivalent to US$30 trillion (Chart I-10). Chart I-9Helicopter Money In China Chart I-10PBoC FX Reserves Are Equal To 10% Of Broad Money Supply If broad money supply continues to expand at an annual rate of close to 9-10% or above, downward pressure on the yuan will escalate immensely, and the Chinese authorities will have no choice but to close the capital account completely and also heavily regulate current account transactions. Bottom Line: If the authorities do not restrain the PBoC’s financing of perpetual bond issuance via the CBS and in the interim do not force banks to write off bad assets, the upshot will be the monetization of banks’ bad assets by the PBoC. This will constitute the ultimate socialist put for banks and zombie debtors, as well as for the entire economy. Business cycle swings, bankruptcies and deflation are inherent features of a market-driven/capitalist economy. A socialist put via promoting unlimited money and credit creation entails long-term stagflation – lower productivity growth and rising inflation. This is very bearish for the currency. Investment Conclusions To be sure, the above analysis suggests that the bazooka has not been loaded and the Chinese economy is not about to stage an imminent recovery. BCA’s Emerging Markets Strategy team maintains its bearish stance on China-related plays worldwide. We are closely monitoring China’s money and credit aggregates as well as indicators from the real economy to gauge when China’s business cycle will revive. So far, these indicators continue to point south. EM risk assets and currencies have recently been boosted by the Federal Reserve’s dovish turn. But as we argued in last week’s report, this will prove short-lived. Global trade, China’s growth and commodities prices are the key drivers of EM financial markets, not the Fed. Provided our negative outlook for these three factors due to the ongoing slowdown in China, we continue to recommend a negative stance on EM in absolute terms, and underweighting EM stocks and credit versus their U.S. peers. The dollar’s weakness stemming from the downshift in U.S. interest rate expectations is running out of steam. Chart I-11 shows that the broad trade-weighted dollar is trying to find support at its 200-day moving average. Conversely, the EM stocks index and copper prices are struggling to break above their 200-day moving averages (Chart I-11, middle and bottom panels). Chart I-11Dollar And EM / Commodities: Mirror Images We believe the dollar is poised for a breakout, and EM and copper are due for a breakdown. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Lin Xiang, Research Analyst linx@bcaresearch.com   Box 1 Issuance Of Perpetual Bonds And CBS Program The authorities are promoting the issuance of perpetual bonds and the CBS program as a scheme for the country’s big-four banks to raise capital to meet BIS ’s Total Loss-absorbing Capacity (TLAC) requirements for globally systemically important banks. Limitations and other details on the perpetual bonds issuance and CBS program: 24 out of 30 banks listed on the A-share market are presently qualified to issue perpetual bonds as their assets exceed RMB 200 billion, a threshold established by the PBoC. Perpetual bonds will boost the Tier-1 capital of issuing banks. Banks are allowed to purchase perpetual bonds issued by other banks in amounts up to 10% of their core Tier-1 capital. Only primary dealers (46 banks and 2 brokers) can exchange qualified perpetual bonds they hold for PBoC bills, with a maximum exchange period of three years. The incentive for banks to purchase perpetual bonds will for now be low because these bonds consume large amounts of capital. The risk weights for these perpetual bonds ranges between 150-250%. How Does It Work? As Diagram I-1 on page 14 illustrates, when Bank B purchases perpetual bonds from Bank A, the former transfers excess reserves to the latter. The amount of outstanding deposits, i.e., money supply, is not affected at all. Hence, there is no direct impact on the broad money supply. Banks do not require deposits to make loans and buy securities. Banks need excess reserves at the central bank to pay for or settle payments with other banks. When Bank B transfers excess reserves to Bank A, the aggregate amount of excess reserves in the banking system does not change. Bank B can swap these perpetual bonds with central bank bills, and then pledge these bills at the PBoC to get excess reserves. As it does so, Bank B will replenish its excess reserves. Consequently, the amount of excess reserves in the banking system will expand, as will the PBoC’s balance sheet. Overall, the issuance of perpetual bonds and CBS swaps lead to both bank recapitalization and banking system liquidity (excess reserves) expansion. Why has the PBoC decided to fund the issuance of perpetual bonds? Without PBoC funding, demand for perpetual bonds might be very low, and yields on them could spike. Higher yields could lure away capital from other corporate bonds, producing higher borrowing costs in credit markets. On the positive side, the monetary authorities will not only recapitalize a number of large banks but will also do so by capping borrowing costs in the credit markets and injecting more liquidity into the banking system. On the negative side, yields of these perpetual bonds will not be determined by the market. Rather they will be artificially suppressed by potential open-ended PBoC funding. This will preserve China’s inefficient credit allocation system and misallocation of capital in general. In a market economy, the authorities will typically force banks to raise capital in securities markets or privately. More issuance, especially when it comes from many banks simultaneously, typically pushes down the prices of bank stocks and bonds. The basis is securities issuance often dilutes existing shareholders and is also negative for bondholders. This threat of dilution and losing money incentivizes existing shareholders and bondholders of a bank to impose discipline on the bank’s management. Consequently, banks would be better run and capital allocation would be more efficient than it would otherwise be in a system where such oversight and incentives are absent. In brief, the market mechanism deters banks from risky and speculative behavior and contributes to the long-term health of the banking system, as well as the efficiency of capital allocation in the real economy. By allowing banks to purchase each other’s bonds, and with the PBoC financing it, China is not imposing the much-needed market discipline on bank shareholders, bondholders and by extension, bank management. This does not promote efficient capital allocation and higher productivity growth in the long run. Footnotes 1      Money supply is the sum of all deposits in the banking system. Hence, we use terms money and deposits interchangeably. 2      Please see the Emerging Markets Strategy Special Report “Misconceptions About China's Credit Excesses”, dated October 26, 2016, Special Report “China's Money Creation Redux And The RMB?”, dated November 23, 2016, Special Report “Do Credit Bubbles Originate From HIgh National Savings?”, dated January 18, 2017, Special Report “The True Meaning Of China's Great 'Savings Wall'”, dated December 20, 2017 Special Report “Is Investment Constrained By Savings? Tales Of China and Brazil”, dated March 22, 2018, available at www.bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Special Report

Highlights So What? India is overcoming the economic constraints to its strategic rise.  Why? India faces rising political risk once again as public opinion puts Modi’s tenure in power at risk. However, India will continue to improve its economy, as outside pressures will force it to act coherently as a nation. Stay on the sidelines for now but remain constructive over the long run. Feature “An enemy of my enemy is my friend.” This is to paraphrase Kautilya, a philosopher of the Mauryan Empire, circa 200 BC. Kautilya was the Indian Machiavelli and wrote the Arthashastra to give hard-nosed political advice to rulers who wanted to know how kingdoms and states really behave rather than how they ought to behave.1   The quotation is no less true today than it was in ancient times. It explains why risks are rising to our view that Prime Minister Narendra Modi will remain in power after the election in April or May. This reinforces our underweight position on Indian risk assets over a 12-month time horizon. The quotation also explains why China’s growing influence in South Asia will drive India to continue reforming its economy and befriend the United States, thus supporting an optimistic view of India’s economic and investment potential in the long run (Chart 1). What Is India’s Grand Strategy? India’s geopolitical predicament stems from the fact that it is a relatively rational geographic unit, but one whose political unity is extremely difficult to maintain. Almost every side of the subcontinent is demarcated by forbidding geology: the Himalayas, the Bay of Bengal, the Arabian Sea, the thick jungles of Burma. Even the northwest, the traditional route of invaders, hosts vast obstacles like the Hindu Kush and Thar Desert. Any kingdom that takes shape can soon dream of expanding its borders to a natural stopping place (Map 1). Yet formidable obstacles stand between the cradles of Indian civilization – the Indus and Ganges Rivers – and the river ways and coastal outlets of the south. The Vindhya-Satpura mountains, the Deccan plateau, and the eastern and western Ghats make it extremely difficult for a northern power to govern the various cultures of the southern cone.  This geography ensures that empires are always trying and failing to unify the subcontinent into a coherent whole. As a result, India rarely projects power beyond it. When it does, the projection is short-lived.2    Historically India has seen the rise of five major empires that dominated the subcontinent: the Mauryans, the Guptas, the Mughals, the British, and the modern Republic of India (Chart 2). The Mughals and many other invaders periodically streamed in from the northwest – most often from modern-day Afghanistan and northern Pakistan, but also from Iran and southern Pakistan. Meanwhile several European empires invaded from the sea and established coastal settlements. The British East India Company settled in Bengal and then drove west and south, cutting off the French who had settled on the southeastern shores.   The modern Republic of India, founded in 1947 after Mahatma Gandhi and his followers harassed the British into leaving, feared that the United States would follow in Britain’s footsteps, being the world’s preeminent naval power. The Indians also distrusted the U.S.’s constructive relations with China and Pakistan that aimed to “contain” the Soviet Union. The Soviets, by contrast, could apply great pressure on Pakistan’s flank in Afghanistan and thus proved useful to India. They could also sell India weapons and capital goods as founding Prime Minister Jawaharlal Nehru pursued a socialist path of economic development.  The collapse of the Soviet Union coincided with a balance-of-payments crisis in India in 1991 that resulted in the abandonment of the old command-style economy and the adoption of modern capitalism under the reforms of Narasimha Rao. India also supported the U.S.’s intervention in the region after September 11, 2001 as a way of maintaining pressure on Pakistan’s back door. From this brief history we can glean a few solid points about India’s grand strategy: An Indian empire must establish control along the Indus or Ganges rivers, or both; An Indian empire must assimilate or drive out foreign rulers and unify the north and south; An Indian empire must strive to become the kingmaker across the subcontinent, through influence if not conquest; An Indian empire must fend off an invasion from the sea. The result of Rao’s reforms, India’s achievement of nuclear status in 1998, and nearly three decades of economic growth have been an India that is clearly an emerging “great power.” According to our Geopolitical Power Index, India is today on the cusp of supplanting Russia as the world’s third most powerful state (Chart 3). It surpassed the U.K., its former colonial master, in 1993. Chart 3India On Cusp Of Overtaking Russia In Comprehensive National Power Like China in East Asia, India is modernizing its vast army, developing a blue-water navy, and carving out a sphere of influence in South Asia (Chart 4). Also like China, India’s ambitions of regional hegemony are frustrated by its neighbors. India’s rivalry with Pakistan is foundational and existential – it is as if China faced Taiwan with nuclear weapons. Chart 4India's Military Clout Quietly Rising Today the fragile world order that prevailed in the wake of the Cold War is under severe strain. China’s grand regional ambitions are provoking a harsh reaction from the United States, which is setting up a new “containment policy” to limit China’s technological advance. The U.S. is withdrawing military forces from the Middle East and South Asia as it becomes energy self-sufficient and looking to counter-balance China with its free hand. Meanwhile China’s influence on the subcontinent is growing – already it is a rival to India as a trade partner for India’s South Asian neighbors (Chart 5). The Sino-Indian rivalry has often been overstated – the Himalayas are more than a hindrance. But China’s Belt and Road Initiative (BRI) means that this logic is increasingly out of date. Historically, India faced overland invasions from the northwest and maritime invasions from the northeast. The Belt and Road – of which Pakistan is probably the most comprehensive beneficiary – potentially threatens India from both directions sometime in the future. Chart 5China Encroaching In India's Sphere Of Influence Of course the U.S. and India still face tensions between each other – foremost being the impending withdrawal from Afghanistan and the U.S. “maximum pressure” policy towards Iran (Chart 6). There are also trade tensions with the Trump administration and a broader problem of inconsistent U.S. outreach to India. Nevertheless the logic of “the enemy of my enemy is my friend” suggests that over the long run the U.S. will grow warmer with India as a regional counterweight to China, while India will wish to become less isolationist and cultivate its relationship with the U.S. as a counter both to Pakistan and China. Simply put, China is making historic advances into India’s neighborhood in South Asia and the Indian Ocean basin. Chart 6A Good Sign For U.S.-India Ties: Cooperation On Iran This logic also suggests that India will be driven to continue reforming its economic structure so as to preserve internal unity and South Asian influence. If its economy languishes, it will lose preponderance within its neighborhood and become vulnerable to foreign aggression. Bottom Line: India and the U.S. are likely to see an ever-strengthening strategic partnership. They will overcome hurdles to the relationship because of their mutual need to counter China’s regional ascendancy. India’s Economic Hang-Up India has been ineffective in establishing an international presence because it has only reluctantly and haltingly reformed its economy. Today India’s middle class – measured by the share of adults with total wealth from  $10,000 to $100,000 – is less than 10%, comparable to the Philippines and Thailand. China’s is now above 50%, according to Credit Suisse’s Global Wealth Report (Chart 7).    This weakness stems in great part from policy decisions, namely the dogged pursuit of socialism through the latter stages of the Cold War. The same ruling ideology that prized independence also prized self-sufficiency, doubling down on import-substitution and thus missing the chance to industrialize with the export-oriented Asian Tigers in the 1970s or China in the 1980s. The result of insufficient measures to limit the state, curtail monopolies, contain inflation, and promote trade and private enterprise has been a chronic shortfall of national savings (Chart 8), which are needed to invest in capital projects and boost productivity (Chart 9).3   Chart 8India Lacks National Savings Chart 9India's Lagging Productivity Many of these historic hang-ups have begun to change, however, first under the reforms of the 1990s-2000s and more recently under the government of Prime Minister Narendra Modi since 2014. As a result, there are a number of “truisms” about India’s economy that are no longer true. For instance, while India’s government is said to be small and weak due to its federal structure – which empowers the states – the truth is that its government is not notably smaller than that of other comparable emerging markets (Chart 10). There is no doubt that it is harder for India’s leaders to drive their agenda than it is for Russia’s and China’s leaders, but this is due to the type of government rather than the size. India inherited liberal democracy and rule of law from the British and its own revolutionary leaders built on this foundation, providing relative stability despite its patchwork of languages, ethnicities, and castes. Democratic checks and balances have led to better governance. Chart 10India's Government Neither Small Nor Weak The contrast has had clear effects on demography. India has a strong demographic foundation and hence a large internal market and robust labor force growth. China, by contrast, is suffering from the distortive effects of the “One Child Policy” on its working age population. As a result India’s population will increasingly provide the global labor force as China’s workers become scarcer and rise in cost (Chart 11) and as trade conflicts between China and the West drive investors to relocate supply chains. This is also a risk to India, of course, if job creation lags. But that is where other economic improvements come in. Cumulatively, Modi’s policies have improved the trajectory of a capital formation relative to consumption, which will increase productivity, potential growth, and job creation (Chart 12). Chart 12Modi Corrected India's Investment Trajectory On openness to trade, India has largely closed the gap with China and other comparable EMs like Indonesia (Chart 13). And while India has long been highly restrictive toward foreign investment, it is much less so than China (Chart 14), and a slew of policies to ease restrictions has resulted in a surge in foreign direct investment that only recently came off the boil (Chart 15). Chart 13India Not So Closed To Trade Anymore Chart 15Modi Opened India To Foreign Investment Further, while India remains broadly under-invested and has not managed to rebalance its overall economy toward manufacturing, it has created some bright spots within the manufacturing sector, such as autos (Chart 16).4 Modi’s government has significantly improved other conditions that will encourage private investment: the ease of doing business, global competitiveness, infrastructure effectiveness, and human capital (Chart 17). Chart 16Cars A Bright Spot In Indian Manufacturing Bottom Line: India’s grand strategy has historically suffered because internal unity and regional influence could not be achieved with a floundering economy. Over recent decades, however, India’s reforms have accumulated into substantial improvements – and the Modi administration has made some key improvements. But Will Modi Survive? Our baseline case for the general election due in April or May is that Modi and his ruling Bharatiya Janata Party (BJP), along with their allies in the National Democratic Alliance (NDA), will remain in power, if narrowly. However, in recent weeks the public opinion polling has taken a turn for the worse for Modi (Chart 18), raising the odds of a hung parliament or opposition victory. Modi still remains well ahead of Rahul Gandhi, the dynastic leader of the opposition Indian National Congress and its United Progressive Alliance (UPA), in terms of popularity (Chart 19). But in some polling he is barely holding onto a double-digit lead. Meanwhile Gandhi’s sudden viability as a candidate is a significant change from only a year ago. Nevertheless the range of seat projections for the lower house of parliament, the Lok Sabha, is very wide and suggests that Modi’s coalition could still win a majority, as long as the opposition’s current rally breaks (Chart 20).   A critical election dynamic points back to Kautilya’s ancient advice. Recently, two major parties in Uttar Pradesh – the key bellwether state – have joined forces to avoid stealing each other’s votes and thus help the opposition take seats. If this scheme works, then the NDA could be outmatched at the polls.5 For investors, however, the key takeaway is that Modi’s reform agenda is past its peak and policy uncertainty can only rise from here: Modi’s seats will certainly shrink from the landslide of 2014 – the BJP is likely to lose its single-party majority, weakening Modi and his party members on their reform agenda. The support of their NDA allies will have to be bought with favorable policy tradeoffs (Chart 21); The high tide of Modi’s movement has already come and gone in the state governments, where the BJP recently lost Madhya Pradesh, Rajasthan, and Chhattisgarh, among others (Map 2). It is possible to lose these states and still win the general election, as largely occurred in 2004 and 2009, but state governments are a decisive factor in implementing federal policies and Modi’s influence is now clearly on the wane; Estimates of the NDA’s future gains in the Rajya Sabha, the upper house, suggest that even if Modi stays in power, he will never obtain a majority there (Diagram 1) – meaning that lower house bills other than supply bills will be subject to a veto; Diagram 1Modi Unlikely To Gain Majority In Upper House … Ever Modi is unlikely to have enough seats in the two houses to have the option of driving key legislation through a joint session of parliament. This is a rare occurrence but it would be a valuable ace up the sleeve. Modi’s reform movement has already seen high tide. He will struggle to institute reforms if he is weakened in parliament and the states. This is even truer if a hung parliament occurs, or if the UPA ekes out a slim majority. In essence, the next Indian government will likely be hobbled if Modi’s polling and performance do not recover from here – and even then he will not reclaim the political capital of his first term in office. It would be a mistake, however, to believe that reforms cannot get done without Modi. Prime Minister Rao came from the Congress Party, after all. Moreover, it is possible for India to undertake major reforms with a weak coalition or minority government. This was the backdrop of the critical pro-market reforms of the 1990s. But this implies that there would need to be a market riot to induce additional reform momentum, as was the case at that time, and India is not at a comparable crisis point today.  Bottom Line: Modi’s reform momentum is over. The next government will be weaker and less able to drive major pro-productivity reforms. But eventually reform momentum will recover, driven by the geopolitical forces outlined above. Does Modi Matter? What is the basis for Modi’s loss of momentum? The gist of the problem is that Modi’s reforms were structural and therefore entailed substantial economic and social costs. As a result, Modi has lost support. The good news is that Modi’s achievements thus far will continue to yield benefits for India. To highlight a few: The creation of a single market by means of the Goods and Services Tax (GST) is a significant reform that will ensure a strong legacy for Modi in the long run. However, the new tax obviously does not get voters enthused. The new Bankruptcy Law has helped to cleanse economic inefficiencies. But it has resulted in layoffs and financial deleveraging, weighing on credit growth and the broader economy. Demonetization, the sudden replacement of key denominations of money in circulation, has helped to formalize gray and black parts of the economy. But it was executed in a hugely disruptive manner and various scandals have arisen in the wake of it, hurting the ruling party. Controlling the fiscal deficit has been a federal government objective that has had some success. However, Modi and the state governments are more recently boosting spending ahead of the election to avoid what otherwise would be a negative fiscal thrust this year. This is a factor that should play to Modi’s advantage, although it has not so far. It also highlights the difficulty of fiscal consolidation over the long run (Chart 22). Chart 22Election Cycle Fiscal Easing Is The Norm More concerning, both for Modi and for India, is the unemployment rate. Even the official unemployment rate is rising despite the fast clip of economic growth and the pro-growth reforms (Chart 23). A leaked government statistical report suggests that unemployment has indeed gone up and labor participation has fallen more than the government is willing to admit. Chart 23Even Official Unemployment Is Rising The jury is still out on the extent of the current growth slowdown. Some estimates suggest that the output gap is closed, others say slightly negative. While there has been a soft patch in wage growth – particularly among the important 40% of the population that still works on the farm (Chart 24) – the latest data show improvement. Unit labor costs are ebullient and suggest that employee compensation is rising (Chart 25). The reality could make all the difference for Modi’s coalition at the ballot box. Chart 24Rural Wages Improving... But Is It Enough? Chart 25Will Workers Reward Modi? More importantly, if India cannot keep unemployment down amidst significant labor force growth, then Modi will only become the near-term casualty of a more profound problematic trend. Another long-term concern is Modi’s political pressure on the Reserve Bank of India. This has resulted in the replacement of two orthodox and credible central bankers under Modi’s watch. The result is a noticeably dovish policy shift, as confirmed by the cut of the repo rate to 6.25% (from 6.5%) on February 7. This cut and later cuts may be supported by global growth fears but will raise suspicions of political influence. Any damage to the central bank’s credibility will have lasting negative effects since the election result cannot reverse it (at least not fully). It will feed inflation expectations marginally and insofar as it does it will worsen the conditions for sustainable private sector capital investment. However, inflation is currently low and other reforms – such as the RBI’s adoption of inflation-targeting and ample domestic grain production – will help to offset any new monetary policy risk. Bottom Line: Modi’s reform legacy is mostly positive for India structurally, although the erosion of central bank independence is a critical exception. Investment Implications In the short run, cooperation among Modi’s political opponents poses a risk of removing him from power and short-circuiting his reform agenda. In the long run, cooperation between China and India’s South Asian neighbors poses a risk of undermining India’s grand strategy, driving it into the arms of the United States. In both cases Kautilya’s ancient wisdom is on display.   In the first case, a Modi defeat would be negative for India’s policy continuity, currency, and risk assets. The upside to our baseline view of a Modi victory is not high, however, unless Modi and the BJP surprise to the upside and win a substantial majority. This is unlikely unless the polling changes. In the second case, the geopolitical environment will pressure India to continue reforming and improving its economy so as to maintain internal stability, influence its neighbors, and ward off unwanted foreign influence. With China’s Belt and Road putting pressure on India’s strategic interests, leaders in New Delhi will have a continual motivation to focus on improving the economy as well as seeking alliances. This is the only way to ensure India retains its influence within its neighborhood.  For now, investors should steer clear of the Indian currency and risk assets in absolute terms because Modi’s reforms are priced in; election cycle dynamics are undermining monetary and fiscal policy; and the risk of sharp policy discontinuity is rising. On a relative basis, India may also underperform EM in the short term while oil prices rise: oil prices and India’s equity performance relative to EM are negatively correlated.6 Beyond that, however, India is a structural opportunity. Capital investment in China, which has powered much of the structural bull market in commodities and EM assets over the past two decades, is declining, while India’s is improving (Chart 26). Capex is the key to improving India’s productivity and keeping inflation in check even as the demographic dividend pushes up growth rates. Although many EM economies will suffer from a slowdown in Chinese capex, India is not overly exposed to China or global trade, and it is further along than other EMs in its process of bank deleveraging, which opens the prospect of a new credit cycle that will improve its investment outlook (Chart 27).    Chart 26China Capex Down, India Capex Up Chart 27Deleveraging Enables A New Credit Cycle   Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1      Kajari Kamal, “Kautilya’s Arthashastra: Indian Strategic Culture and Grand Strategic Preferences,” Journal of Defence Studies 12:3 (2018), pp. 27-54, available at idsa.in 2      The medieval Chola Kingdom sailed across the Bay of Bengal and as far as Malacca in 1025. Please see  Manjeet Singh Pardesi, “Deducing India’s Grand Strategy of Regional Hegemony from Historical and Conceptual Perspectives,” Institute of Defense and Strategic Studies, Working Paper 76 (April 2005), available at www.rsis.edu. For an in-depth study of India’s strategic history, see Graham P. Chapman, The Geopolitics of South Asia: From Early Empires to the Nuclear Age (Burlington, VT: Ashgate, 2009). 3      Please see BCA Emerging Market Strategy Special Report, “Capital Rationing Is Deterring Growth,” February 28, 2012, and “India’s Inflation: How Serious Is The Problem?” January 26, 2010, available at www.bcaresearch.com. 4      Please see BCA Commodity and Energy Strategy Weekly Report, “India’s Commodity Demand, With Or Without Modi,” February 7, 2019, available at ces.bcaresearch.com. 5      Please see Milan Vaishnav and Jamie Hintson, “As Uttar Pradesh Goes, So Goes India,” Carnegie Endowment for International Peace, February 5, 2019, available at carnegieendowment.org. 6      Please see BCA Emerging Markets Strategy Weekly Report, “EM: Sustained Decoupling, Or Domino Effect?”June 14, 2018, available at ems.bcaresearch.com.  

Special Report

Highlights China’s recently released pro-auto-consumption policy will lead to a moderate 5-8% recovery in auto sales/production this year. However, the impact from the stimulus will be much less than the previous two episodes in 2009 and 2016. The value of Chinese auto sales is likely to increase by RMB 200 billion to 350 billion, which is about 0.2-0.4% of the country’s nominal GDP in 2018. New-energy cars will continue to gain market share with supportive policies. Meanwhile, domestic brand car manufacturers will likely benefit most from the upcoming recovery in the Chinese auto market, while American car producers will benefit the least. We recommend preparing to go long Chinese auto stocks in the domestic market in absolute terms, subject to the terms of a trade agreement with the U.S. In addition, we continue to overweight domestic consumer discretionary stocks versus the benchmark, and versus domestic consumer staples. Feature China is the world’s largest car producer and consumer – its domestic sales account for about 30% of global auto sales (Chart 1, top panel). The country experienced a 3% contraction in auto sales and production through last year, the first year of negative annual growth in 28 years. The contraction rapidly accelerated into the double digits over the past few months (Chart 1, bottom panel). Chart 1Chinese Auto Industry: Policy Stimulus = Recovery In 2019 As the auto sector is an important driver of China’s economic growth, whenever the industry has shown signs of weakness, the central government has typically implemented a series of supportive policies designed to stimulate the domestic auto market. The authorities successfully did this in 2009-2010 and 2016-2017. Late last month, they again announced a set of pro-auto-consumption policies. The question going forward is how effective these measures will be in boosting auto sales. We believe the recovery will be rather moderate compared with the 2009-2010 and 2016-2017 episodes. Chances are that the growth of auto sales and production will recover to 5-8% in 2019. As a result, we recommend preparing to go long Chinese auto stocks in absolute terms, subject to the terms of a trade agreement with the U.S. Cyclical And Secular Forces Shaping Auto Sales A comparison of the current auto market to the one that prevailed in 2009 and 2016 is helpful to gauge the extent of the strength of the pending auto sales recovery expected this year. Box 1 shows the recently released pro-auto-consumption plan by the Chinese government, which focuses on six aspects, including promoting auto replacement, NEV sales, auto sales in rural areas, pick-up truck sales, development of the second-hand car market, and auto sales in cities that have restricted auto sales policies.   BOX 1: China’s Stimulus Package For Domestic Auto Industry The recently released pro-auto-consumption plan by the Chinese government includes: Promoting auto replacement: Providing subsidies to consumers who scrap their older, higher-polluting cars for new, lower-emission or zero-emission cars; Encouraging NEV sales: Providing subsidies to advanced NEV sales and giving more privileges to new energy trucks; Promoting auto sales in rural areas: Providing subsidies to rural residents who scrap their tricycles to buy a truck with cylinder capacity equal or less than 3.5 tons, or a passenger car with cylinder capacity equal or less than 1.6L; Promoting pick-up truck sales: Widening access areas within cities for pick-up trucks; Accelerating the development of the second-hand car market: Allowing second-hand car trades across different cities and provinces; Loosening auto sales restrictions in cities that have restricted auto sales policies. Regarding the amount of subsidies, the government did not provide details.   Putting it all together, we believe that this time the impact from the stimulus will be much more muted than the previous two episodes in 2009 and 2016. First, there is no sales tax reduction measure in this round of stimulus. The most important driver for the auto market recovery in 2009 and 2016 was a sales tax reduction in passenger cars with cylinder capacity equal to or less than 1.6L from 10% to 5% (Chart 2). However, this time, there is no such cut. While the government is maintaining zero sales tax on new energy vehicles (NEV), the sales tax on all automobiles remains at 10% this year. Chart 2The Lessons From The 2009 And 2016 Episodes Second, domestic pent-up demand for automobiles is much lower than it was in both 2009 and 2016. The car ownership rate, defined as the number of passenger cars per 1000 households, has risen significantly to 453 in 2018 (Chart 3). This means that nearly half of Chinese households already own at least one car as of 2018. In comparison, the car ownership rate was only 91 in 2008 and 318 in 2015. Chart 3Less Pent-Up Demand For Autos In 2019 Than Before Third, Chinese households’ debt levels have surged in the past few decades, constraining their ability to purchase cars and other goods (Chart 4, top panel). While many investors compare the cross-country household debt burden relative to GDP, Chinese household debt has already risen to nearly 120% of households’ disposable income, surpassing the U.S. (Chart 4, bottom panel). Chart 4Increasing Households' Debt Burden Constrains Ability To Buy A Car Fourth, while the recent stimulus packages aim to promote auto sales in rural areas, the difficulty of getting auto loans is much higher for the average rural household than for the average urban household, as the former generally have much lower income levels. In addition, peer-to-peer lending, which has become a major source of auto loans in recent years due to lower lending standards compared with banks, has collapsed since last year (Chart 5). With tightening regulations, the difficulty of acquiring auto loans through peer-to-peer lending is currently higher than before. Chart 5Rising Difficulty To Get An Auto Loan Lastly, there has been a structural decline in consumers’ willingness to buy cars due to increasing traffic congestion, limited parking space and more advanced public transportation. Moreover, more mature car rental markets and the rising use of car-sharing services have also helped reduce the need to buy a car, to some extent. This is a major difference from 2009-2010 and 2016. In Chart 6, both falling households’ marginal propensity to consume and declining consumption loan growth suggest a decreasing willingness to consume among Chinese consumers. Chart 6Chinese Consumers: Falling Willingness To Consume With all the aforementioned cyclical and structural forces in place, the impact on domestic auto sales from the recent stimulus package will be smaller in 2019 than in 2009 and 2016. That said, these policies will still be supportive, and likely sufficient to lift auto sales from contraction back to positive growth this year. Estimating the magnitude of the impact remains challenging, however, due to lingering uncertainty about the size of government subsidies. Based on all six measures listed in Box 1, the scale of subsidies provided by the government will be the major determinant for auto sales growth in China in 2019. In general, the bigger the subsidies, the stronger the push on auto sales. In 2009, both the central government and local government provided subsidies for stimulating auto sales. This time, while the financing sources could still be both central and local governments, local governments’ ability to finance auto consumption stimulus is diminishing due to their much higher debt levels and weaker revenues from land sales than in the past. For now, our view is that the impact from the stimulus will be much less significant than the previous two episodes in 2009 and 2016. Auto sales growth was 4.7% and 3% in 2015 and 2017, respectively. With recently announced stimulus, we expect the growth will be higher than in those years. Bottom Line: We expect that the growth of Chinese auto sales/production volumes will rebound to 5-8% this year, much slower than the 45% growth seen in 2009 and 14% growth in 2016. With a similar growth rate in value terms, Chinese auto sales are likely to increase by RMB 200 to 350 billion, which is about 0.2-0.4% of the country’s 2018 nominal GDP. The Winners And Losers At 5-8%, growth will be equivalent to a 1.5-2 million-unit increase in domestic auto sales. This will lead to a similar increase in auto production, as most cars are domestically produced. In terms of fuel use, automobiles can be classified as gasoline cars, diesel cars and new-energy cars. Chart 7 shows that gasoline cars currently hold 84% market share. In terms of brand, automobiles can be categorized as Chinese brands, Japanese brands, German brands, American brands, Korean brands and others. Chart 8 shows their market structure, with Chinese brands currently accounting for 42% of total market share. As the Chinese auto market is set to have a moderate recovery this year, which kinds of cars will benefit most, and which will benefit least? Even though China plans to gradually reduce its subsidies on NEVs to zero in 2021, several factors suggest that NEVs will still be the biggest winner, taking more market share from both gasoline and diesel cars. The government is aiming to increase the NEV market share from 4.5% currently to 20% by 2025. Assuming total sales rise to 32 million units in 2025 from current levels of 28 million (about 2% annual growth), this would imply that NEV sales will surge to 6.4 million units from 1.3 million currently, which is equal to 26% annual growth over the next seven years (Chart 9). Chart 9NEV Sales: Plenty Of Upside In addition to governments continuing subsidies, the sales tax on NEVs will be held at zero until the end of 2020, a big advantage over non-NEV vehicles, which carry the 10% sales tax. In addition, in cities that have license restrictions on car sales or have time or area restrictions on on-road autos, NEVs are not constrained by such policies, which is an attractive privilege for car buyers to consider. For example, in Shanghai, it costs over 80,000 RMB to buy a license plate for a non-NEV car if the potential buyer is lucky enough to be selected by random draw. In comparison, buying a NEV allows the buyer to have a free license plate. Current NEVs can achieve recharge mileage of 300-450 kilometers, with a price of RMB 100,000 to RMB 150,000 per unit. While the recharge mileage is sufficient for most daily use, prices are no longer substantially higher than prices for traditional gasoline or diesel cars. Major global and local NEV producers are expanding their production in China. For example, Tesla last month started building its mega electric car manufacturing plant in Shanghai, which will initially produce 250,000 cars per year, and eventually ramp up to half a million. This will be about five times the number of vehicles the company currently produces in the U.S. Most NEVs that have been sold in China are Chinese-brand NEVs. However, with China further opening up its auto sector and allowing more foreign NEV producers to invest and produce cars in China, Chinese NEV producers will face increasing competition and may lose some market share to foreign NEV producers. Meanwhile, Chinese NEV-related supportive policies will likely benefit both local and foreign NEV producers as the government is determined to develop the domestic NEV market and encourage NEV sales. That said, local producers will still enjoy slightly more favorable policies than foreign ones. Given that the government is promoting smaller-engine passenger car sales in rural areas and encouraging the replacement of old diesel cars with NEVs, sales and production of gasoline cars may also increase slightly, while diesel cars are likely to rise the least. In terms of brand, Chinese and American brands lost share to Japanese and German brands last year. We believe Chinese brands will benefit most from this year’s government-led auto market recovery for two reasons (Chart 10, top panel): Chart 10Chinese Brands Will Benefit Most From This Year’s Policy Stimulus The authorities will likely favor local brand producers in terms of benefitting from the subsidies they give to car buyers. In addition, local brand cars in general have lower prices than foreign brands, which could be the most attractive feature for price-sensitive rural residents. In the meantime, as the government encourages local auto replacement, this may benefit Japanese and German brands (Chart 10, second and third panels), as buyers with replacement needs will likely upgrade their cars to ones of higher quality and better reputation. Among American cars, while we are positive on American NEV car sales in China, we still expect American cars to continue to lose market share due to weakening sales of American non-NEV car sales (Chart 10, bottom panel). American cars are generally more expensive than Chinese-brand cars, and they are often perceived as slightly lower quality than either Japanese or German brands. Moreover, the ongoing trade dispute may bias Chinese buyers against buying an American car. Bottom Line: We believe NEV producers and Chinese-brand car producers will benefit most from this year’s government-led auto market recovery. Investment Implications There are several important conclusions that stem from our research. First, while rebounding auto production will likely lift demand for many metals, housing construction is artificially supporting demand and is set to decelerate over the coming year (Chart 11). Consequently, we do not believe that accelerating auto production alone is a license to be long industrial metals over the coming year. Chart 11Weakening Property Market Weighs More On Commodity Market Second, within the equity space, we recommend that global investors prepare to go long domestic auto stocks on an absolute basis after the outcome of the U.S.-China trade talks emerges later this month. Rebounding auto production will likely lead to a cyclical improvement in auto producer earnings, which in combination with deeply oversold conditions bodes well for the 6-12 month outlook (Chart 12). Chart 12Look To Long Domestic Auto Stocks In An Absolute Term U.S. negotiators are seeking increased access to the Chinese auto market, which implies that the outcome of the negotiations carries some event risk for domestic producers (particularly if China’s concessions on this front turn out to be large). But our sense is that we are likely to recommend an outright long position favoring domestic automakers barring a trade deal with deeply negative implications for domestic producer market share. Third, our bullish bias towards Chinese auto producers and our constructive outlook for the home appliance market supports two of our existing trades favoring consumer discretionary stocks. Chart 13 highlights that production and sales volume for several home appliance products is depressed, and stands to benefit from a flurry of policy announcements late last month that were intended to support the industry. Chart 13Home Appliances: Rebound Soon On Stimulus As Well Both auto producers and home appliance manufacturers belong to the consumer discretionary sector, and we recommend maintaining a long domestic consumer discretionary position versus both the domestic benchmark and relative to consumer staples (both trades were initiated on November 141). While domestic consumer discretionary stocks are expensive vs. the domestic benchmark on a P/B basis (Chart 14), the sector’s relative P/E ratio is trading at the very low end of its historical range and the trade has eked out modest positive gains since initiation. Chart 14Remain Overweighting Consumer Discretionary Sector Our long discretionary / short staples trade has faired much worse, down 11% since initiation due to a significant rally in consumer staples stocks (rather than losses in the discretionary sector). We recommend that investors stick with the trade over the coming 6-12 months despite the loss, as Chart 15 highlights that the discretionary / staples trade could not be more extreme in terms of relative performance or valuation. Our bet is that this trade will reverse course in 2019, for a meaningful period, in response to a cyclical tailwind from policy. Chart 15Stay Long Discretionary / Short Staples   Ellen JingYuan He, Associate Vice President Emerging Markets Strategy EllenJ@bcaresearch.com   Footnotes 1 Please see BCA Research’s China Investment Strategy Special Report “Chinese Household Consumption: Full Steam Ahead?”, published November 14, 2018. Available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights Uncertainty & Growth: There is currently a strong link between depressed global growth expectations and elevated levels of economic policy uncertainty (U.S.-China trade tensions, Brexit, etc). Monetary Policy: A growing number of central banks have taken “risk management” measures to try and prevent a deeper downturn in actual economic activity by shifting to a less hawkish policy bias – even with tight labor markets. Implications For Bond Yields: We do not expect the current soft patch for global growth to extend into a more prolonged period of weak activity, given that global policy rates remain at highly stimulative levels. This will set up the next wave of rising global bond yields, but likely not until the latter half of 2019 (and focused mostly on U.S. Treasury yields). Feature Central Banks Take Out Some Insurance The list of global central banks taking a more cautious stance on monetary policy expanded last week. The Bank of England and Reserve Bank of Australia both cut their growth forecasts for 2019 and signaled that there was no chance of interest rate increases in the near term. This follows similar guidance provided in recent weeks by the U.S. Federal Reserve, the Bank of Canada and Sweden’s Riksbank. There was even a dovish surprise in the emerging world, with the Reserve Bank of India delivering an unexpected rate cut last week. In Europe, the European Central Bank (ECB) has not yet shifted its already highly-dovish policy guidance (no rate hikes until at least September), but ECB President Mario Draghi recently noted that the downside risks to European growth have increased. The European Commission went a step further and downgraded its growth forecasts for 2019 last week. The Bank of Japan cut its inflation forecast for 2019 last month, also indicating that monetary policy would remain unchanged over at least the rest of the year. The language used by all of these policymakers to explain their dovish turn was eerily similar, highlighting elevated global uncertainty weighing on growth expectations and, through plunging asset prices, tightening financial conditions (Chart of the Week). The sources of that uncertainty are well known to investors: U.S.-China tariff negotiations, slowing global trade, Brexit, domestic U.S. political squabbles (i.e. government shutdowns over “The Wall”). Until those developments begin to get resolved, uncertainty will continue to weigh on economic confidence. Chart of the WeekThe “Risk Management” Approach To Setting Monetary Policy 21st Century central bankers mostly subscribe to a “risk management” approach to policymaking. This means setting policy dovish enough to cut off downside tail risks to growth during periods of elevated uncertainty about the economic outlook – especially when inflation is below policymaker targets. Yet central bankers remain devoted followers of the Phillips Curve framework. There is a limit to how dovish they can become while unemployment is low and wage growth is increasing. This limits how far government bond yields can fall if growth does not slow enough to cause unemployment to rise. So far, the softer global growth seen in recent quarters has not resulted in any increase in unemployment rates in the major developed economies. Of course, employment is a lagging variable. If the current soft patch for growth extends into a more prolonged slowdown in the coming months, resulting in companies cutting hiring or shedding labor to protect weakening profitability, then there is room for bond yields to continue to fall as markets begin to price in easier monetary policy. That is not our expectation. The U.S. economy remains on solid footing, and we anticipate additional policy actions from China to stabilize economic growth and put a floor under global trade activity. This will eventually cause central bankers to move back to a less dovish policy stance more consistent with trends in unemployment and inflation, with the U.S. Fed leading the way on that front in the latter half of 2019. The eventual result will be higher U.S. Treasury yields, both in absolute terms and relative to government bond yields of the other major developed economies. Bottom Line: There is currently a strong link between depressed global growth expectations and elevated levels of economic policy uncertainty. Central banks are taking the appropriate “risk management” measures to prevent a deeper downturn in actual economic activity by shifting to a less hawkish policy bias – even with tight labor markets. The Link Between Economic Confidence & Monetary Policy The pro-risk rally that opened 2019 endured its first test last week, with several major market prices – including the S&P 500 index, U.S. high-yield spreads, the 10-year Italy-Germany government bond yield differential and the DXY index of the U.S. dollar - bouncing off key medium-term moving averages (Chart 2). Purely from a technical analysis perspective, a test of the primary trends established in the latter half of 2018 (bearish equities and credit, bullish the U.S. dollar) was to be expected, particularly given the severity of the past selloff in global equity markets. Chart 2The First Test For The 2019 Risk Rally Investor sentiment towards global growth, however, remains pessimistic. Nervousness over the outcome for the U.S.-China trade talks, with the March 1 deadline fast approaching, is an obvious source of concern given how slowing Chinese import demand has spilled over so dramatically into weaker global trade activity (Chart 3). Yet there are several other dates for investors to fret about in the near term, including the deadline for a deal to avert another U.S. government shutdown (this Friday), the U.S. debt ceiling deadline (also March 1) and “Brexit day” in the U.K. (March 29). Chart 3A China-Led Slowing Of Global Trade Yet this current soft patch for the global economy is occurring alongside an extreme divergence between plunging growth expectations and more stable readings on current economic conditions. The fall in expectations is visible in the most countries, according to data series that measure confidence for businesses, consumers and investors. One such set of data that we pay close attention to is the ZEW survey. The ZEW survey, produced by a prominent German economic think tank, is most well-known for the data related to Germany itself. The ZEW also produces similar survey data measuring readings on “current conditions” and “expectations” for other major developed economies: the U.S., U.K., Japan, France, and Italy (as well as an aggregate measure for the entire euro area). This makes the ZEW data useful for conducting cross-country analysis of economic sentiment, as the survey structure and questions are consistent for each country. Looking at the individual country readings from the ZEW data, shown in Charts 4 and 5, it is clear that the depressed readings on global growth sentiment are similar across all major countries. Yet at the same time, the individual ZEW Current Conditions indices, while off their cyclical peaks, are exhibiting more diverse trends. The U.S., in particular, stands out as having a very robust reading on Current Conditions, which lines up with the overall firmness of the U.S. economic data. Chart 4A Co-Ordinated Decline Of Expectations, Not Actual Growth Chart 5The European Growth Slump Is Broad-Based The strong correlation between the ZEW Expectations readings suggests that there is a common factor causing market participants to become more worried about the outlook for global growth. These can all be summarized under “uncertainty”, for which we also have data available at the country level from the Economic Policy Uncertainty indices developed by researchers Scott Baker, Nick Bloom and Steven Davis.1 In Charts 6 and 7, we plot the Policy Uncertainty indices against the ZEW growth expectations indices for the individual countries/regions for which the ZEW conducts its surveys. The growth expectations data is shown inverted to correlate with the Policy Uncertainty indices. The visual relationship shows that the current period of elevated Policy Uncertainty has occurred alongside the plunge in growth expectations, seen most strongly in the U.S., U.K. and Italy. Chart 6Uncertainty Slamming Sentiment Hardest In The U.S. & U.K. Chart 7Germany Weathering The Storm Better Than Italy & France But can this link between uncertain and growth expectations result in an actual slowing of economic activity? Can slumping expectations become a self-fulfilling prophecy? One way to look at this is to see how growth expectations evolve relative to current economic growth. We show those gaps between the Current Conditions and Growth Expectations components of the ZEW survey in Charts 8 and 9. A rising line indicates a wide gap between Current Conditions and Expectations and vice versa. We also add real GDP growth in each panel of the charts, to compare that “ZEW Gap” to actual growth outcomes. Chart 8The “ZEW Gap” Now At Levels That Have Heralded Past Downturns … Chart 9… Within Europe Too … The current gap between the two measures is at or near the widest levels seen in the history of the ZEW data dating back to the early 1990s. The previous times that the ZEW Gap reached such levels, economic growth slowed for all the countries in the ZEW survey – most notably in the run-up to the recessions in the early 1990s, early 2000s and 2009. The ZEW Gap also accurately signaled the recessions seen within the euro area after the 2011 European Debt Crisis. The first implication of this result is large discrepencies between strong current growth and expectations almost always resolve themselves with actual weaker growth, if not outright recession – not a good sign for the global economy in the coming quarters. Yet one major difference between today and those prior episodes of a wide ZEW Gap is the level of monetary policy accommodation. In those prior episodes that ended in recession, central bankers raised policy rates to restrictive levels that eventually caused the growth slowdown. This can be seen in Chart 10, where we plot the ZEW Gaps vs the “Monetary Policy Gaps”, defined as the difference between actual central bank policy rates and an estimate of neutral rates derived from a simple Taylor Rule formula.2 Chart 10...But Monetary Policy Is Not Tight This Time Today, central banks are maintaining policy rates far below levels of neutral consistent with long-run potential growth and economies operating at or beyond full capacity – even with inflation rates that are below central bank targets. This should help cushion the blow from weakening growth expectations stemming from the current period of elevated economic uncertainty. The root cause of all recessions is always monetary policy that becomes too restrictive. Typically, that occurs directly through central banks hiking rates above neutral and actively engineering a growth slowdown. It can also occur if an external shock to growth is severe enough to depress economic activity faster than policymakers can identify the slowdown and respond with easier monetary policy. The latter appears to be the outcome that investors are most worried about today. Yet with central banks now turning more dovish in response to elevated uncertainty, at a time when monetary policy appears already highly stimulative, the odds of a monetary policy error crushing growth are low. We are more worried about the opposite outcome, where policymakers are giving more stimulus to a global economy that does not necessarily need it, given that overly tight monetary policy is not the main problem at the moment. In other words, policymakers who have become more dovish today will need to become less dovish later, if and when the current laundry list of uncertainties begin to get resolved. We think that is only a real issue in the U.S. at the moment, though. Our Central Bank Monitors continue to indicate that tighter monetary policy is still required in the U.S. (Chart 11), unlike the Monitors from the U.K., euro area and Japan – the other countries where we have looked at the expectations/uncertainty relationship. Thus, we expect U.S. Treasury yields to have more upside than German Bund, U.K. Gilt or Japanese government bonds over the next 6-12 months. Chart 11The Message From Our CB Monitors - Stay Underweight U.S. Treasuries Bottom Line: We do not expect the current soft patch for global growth to extend into a more prolonged period of weak activity, given that global policy rates remain at highly stimulative levels. This will set up the next wave of rising global bond yields, but likely not until the latter half of 2019 (and focused mostly on U.S. Treasury yields).   Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Footnotes 1 The full set of global Policy Uncertainty Indices, with data downloads and methodological descriptions, can be found at  www.policyuncertainty.com. 2 Neutral Policy Rate = Potential GDP growth + central bank inflation target + (0.5 x (current inflation minus central bank inflation target)) +( 0.5 * the IMF estimate of the output gap)). Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Treasury Yields & Data Surprises: Our model suggests that positive data surprises are more likely than negative ones during the next couple of months, meaning that the 10-year Treasury yield is biased higher. Positioning data show no long or short consensus among bond investors, but we think below-benchmark portfolio duration will pay off over both short term (0-3 months) and medium term (6-12) investment horizons. Monetary Policy: The Fed cited tighter financial conditions and slower global growth as the two main reasons for pausing the rate hike cycle. Both of those risks appear poised to ease in the coming months. Expect rate hikes to resume in the second half of 2019. Inflation: Year-over-year core inflation appears tame at the moment, but that will change during the next few months as base effects shift from a headwind to a tailwind. Wage acceleration and core services (excluding shelter and medical care) inflation will be the main drivers. Feature It didn’t take very long. Just two days in fact. Two days after Chairman Powell made the Fed’s pause official we learned that the economy added 304k jobs in January (vs. 165k expected) and that the ISM Manufacturing PMI rebounded to a very healthy 56.6 (vs. 54.0 expected). In short, just as the Fed capitulated on rate hikes, the economic data made that decision look offside. Granted, the bond market does not yet see it this way. The economic data surprise index has moved firmly into positive territory, but Treasury yields have so far refused to follow suit, bucking the typical correlation (Chart 1). Still, we can’t help but feel that consensus economic expectations remain overly downbeat, and that this could set the bond market up for a nasty near-term shock. Chart 1Market Set Up For A Surprise Bond Market At Risk In prior research, we documented the strong correlation between economic data surprises and changes in the 10-year Treasury yield.1 We found that if the U.S. economic surprise index ends a given month in positive territory, there is a good chance that the 10-year Treasury yield increased during that month, and vice-versa (Chart 2A). This relationship also holds reasonably well for 3-month and 6-month investment horizons (Charts 2B & 2C). This is a good thing to know, but it is only useful if we can also predict future economic data surprises. That is certainly no easy task. However, we can exploit what we know about market behavior to give ourselves a slight advantage. For instance, we know that investors revise down their economic expectations after a long string of data disappointments, making it easier for future data to surprise on the upside. Similarly, a long string of positive data surprises usually leads to unrealistically strong expectations, setting the market up for a letdown. This dynamic causes the economic surprise index to be a mean reverting series, and we find that we can explain 55% of its historical variation using the following 3-factor auto regressive model: ESIt+1 = 0.87*(ESIt) – 0.25*(ESIt-1) – 0.16*(ESIt-2), where ESIt is the surprise index’s value in the current month Notice that next month’s index value is a positive function of the current month’s value, but a negative function of the values from each of the prior two months. At present, our model predicts that the surprise index will reach 18 one month from now (see the ‘X’ in Chart 1). As shown in Table 1, a reading of 18 from the surprise index coincides with a higher 10-year Treasury yield 53% of the time. Table 1End-Of-Period Surprise Index Levels And Whether The 10-Year Yield Rose Or Fell During That Period (2003 – Present) Bond Market Positioning Investor positioning and data surprises are closely related concepts. When investor economic expectations are downbeat, it is highly likely that bond market participants also carry a lot of duration risk. A large “net long” duration exposure can make the ensuing bond sell-off worse when the data inevitably surprise to the upside. At present, the JPMorgan Duration Survey shows that investors are neither severely long nor short duration risk (Chart 3). Speculators in 10-year Treasury futures are slightly net short (Chart 3, panel 2), and sentiment surveys report that investors are somewhat bearish on bonds (Chart 3, bottom panel). In general, positioning still has a slightly bearish tinge, but is much closer to neutral than it was a few months ago, prior to the sharp plunge in yields. Chart 3Positioning Close To Neutral Bottom Line: Our model suggests that positive data surprises are more likely than negative ones during the next couple of months, meaning that the 10-year Treasury yield is biased higher. Extreme “net long” bond market positioning would exacerbate any related near-term sell-off, but surveys indicate that positioning is close to neutral. This leads us to expect higher yields in the next few months, but no major market dislocation. The Fed’s Dovish Pivot We have not published a regular Weekly Report since the FOMC signaled a pause in its rate hike cycle on January 30. Since then, many have speculated that the Fed’s rate hike cycle is already over and the market has eagerly taken that message on board. As of last Friday’s close, the overnight index swap curve was priced for 11 bps of rate cuts during the next 12 months and 23 bps of rate cuts during the next 24 months. Data Dependence  Unfortunately for bond bulls, the case for rate cuts is simply not supported by the economic data. In fact, a look at the reasons used to justify the Fed’s dovish pivot reveals that the pause in rate hikes will almost certainly prove temporary. In his post-meeting press conference, Chairman Powell attributed the Fed’s dovish turn to the following factors: Tighter financial conditions Slower global growth Government-related risks (i.e. Brexit, U.S./China trade discussions, and the U.S. government shutdown) Financial Conditions Financial conditions tightened sharply near the end of last year, as can been seen by looking at the three components of our Fed Monitor (Chart 4). Our Fed Monitor is a composite indicator designed to predict whether rate hikes or rate cuts are more likely going forward. It includes 44 variables related to either economic growth, inflation or financial conditions. Chart 4Financial Conditions Have Already Eased The most important thing to note from Chart 4 is that all of the Monitor’s recent decline was driven by tighter financial conditions. The economic growth and inflation components of the Monitor remain firmly in “tight money required” territory. This is important because financial conditions can ease as quickly as they can tighten. Ironically, now that the Fed has telegraphed a more supportive policy stance, a rally in risk assets during the next few months is much more likely. As that transpires it will drive our Monitor deeper into “tight money required” territory, and rate hikes will be back on the table. Global Growth The second factor that Powell mentioned was the slowdown in global growth, driven principally by weakness in China and the Eurozone (Chart 5). Interestingly, at the European Central Bank’s (ECB) latest press conference, ECB President Mario Draghi also blamed “softer external demand” for the weakness in European economic data. Chart 5Global Growth Slowdown Driven By China The logical conclusion is that China has been the catalyst for the global slowdown and that the Eurozone economy has come under pressure because of that region’s greater reliance on China as a source of demand. The fact that the Eurozone is more sensitive to Chinese growth than the U.S. is a topic that our Foreign Exchange Strategy service has covered in great detail.2 The Fed obviously cares more about the domestic economy than overall global growth, but weakness abroad has a habit of migrating stateside via a stronger dollar.3 It would certainly help the case for rate hikes if Chinese (and hence global) growth at least stabilized. On that front, some timely global growth indicators are sending positive signals. Our China Investment Strategy team’s Market-Based China Growth Indicator has rebounded strongly (Chart 6), global industrial mining stock prices have jumped (Chart 6, bottom panel), and the CRB Raw Industrials index may finally be turning a corner (Chart 6, panel 2).4 Chart 6Global Growth Indicators Sending A Positive Signal... But for any rebound in those financial market indicators to prove lasting, we will ultimately need to see confirming evidence in the Chinese economic data. Specifically, the money and credit growth data that tend to lead Chinese economic activity (Chart 7). Our China Investment Strategy team’s Li Keqiang Leading Indicator – a composite of six money and credit growth indicators – has flattened off at a low level. Looking at its components individually, those that capture the recent RMB depreciation have pressured the index higher (Chart 7, panel 2), while those that measure broad credit growth remain depressed (Chart 7, bottom panel). Our Global Investment Strategy team has argued that Chinese policymakers’ desire to suppress credit growth will soon abate, since credit growth has already fallen close to the rate of nominal GDP growth.5 Chart 7...But A Lot Depends On China Bottom Line: It seems increasingly likely that financial conditions will ease and that the global growth slowdown will moderate in the coming months. Geopolitical tail risks remain, but they are unlikely to impact the Fed’s reaction function if financial conditions are easing and global growth is on solid footing. The end result is that the Fed will resume rate hikes in the second half of this year, and Treasury yields will move higher as a result. Investors should maintain below-benchmark portfolio duration. The End Of QT At January’s press conference, Chairman Powell was also quizzed repeatedly about the Fed’s balance sheet policy. This is not surprising given that the Fed had just announced that it will operate monetary policy using its current “floor system” indefinitely. This means that it will continue to supply the banking system with more reserves than it demands, and will control interest rates by paying interest on excess reserves and through the overnight reverse repo facility. We explained in detail the differences between a floor system and the pre-crisis “corridor system” in a 2014 Special Report.6 Practically, the continuation of the floor system means that the Fed’s balance sheet run-off will end earlier than if it were to return to a corridor system. The latter requires a paucity of bank reserves while the former requires an abundance. Unfortunately, as we discussed in a recent report, and as Chairman Powell explained at his press conference, nobody knows exactly how much more reserve drainage can take place before the Fed’s floor system ceases to function and the Fed loses control of interest rates.7 From Powell’s press conference: [I]n managing the federal funds rate, we’d rather have it set by our administered rates. So that implies you’d want [outstanding bank reserves] to be a bit above what that equilibrium demand for reserves is. And again, there’s no cookbook here, there’s no playbook. No one really knows. The only way you can figure it out is by surveying people and market intelligence and then, ultimately, by approaching that point quite carefully. In other words, the Fed will continue to shrink its balance sheet – draining reserves from the banking system in the process – until it decides that any further reserve drain will cause the funds rate to break through the upper-end of its target band. There is already some evidence of pressure on this front. The effective federal funds rate has been inching toward the upper-end of its target range in recent months, and the 99th percentile of the daily effective fed funds rate has actually been above the target range. This means that, for the past couple months, a few federal funds transactions every day have occurred outside the Fed’s target range (Chart 8). If this situation persists, then it will hasten the Fed’s decision to cease the run-off of its balance sheet. Chart 8Fed Funds Rate Inching Higher Our sense is that the Fed will cease the unwinding of its balance sheet at some point this year or early next year. However, we don’t view that decision as very important from an investment standpoint. It has been the longstanding view of this publication that any possible impact on bond yields from the Fed’s balance sheet policy pales in comparison to the impact from its interest rate policy. We will elaborate on this view in forthcoming research alongside our Global Fixed Income and U.S. Investment Strategy services. For today, we will simply remind readers of our golden rule of bond investing: If Fed rate hikes exceed what is currently priced into the market, then long duration positions will underperform over that time horizon, and vice-versa.8 All other factors are subordinate to that golden rule. Will Tame Inflation Prevent Further Rate Hikes? At January’s press conference, Chairman Powell noted that one reason why the Fed felt comfortable pausing its rate hike cycle was that inflation appeared relatively tame. Once again, the Chairman accurately described the fact that year-over-year core inflation has moderated during the past few months. Year-over-year core CPI inflation is down to 2.21% as of December, from a peak of 2.33% last July. Data on the Fed’s preferred PCE measure has been delayed due to the government shutdown, with a December update expected on March 1. However, this is another situation where the evidence could look a lot different in a few months. The last three monthly core CPI prints have come in at right around 0.2% month-over-month. If that pace is maintained going forward, then year-over-year core CPI will fall a bit further in the near-term, but will then start rising at a rapid pace (Chart 9). By the middle of this year the discussion surrounding inflation could look a lot different. Chart 9Expect Inflation To Pick-Up By The Middle Of The Year Of course, the simple extrapolation in Chart 9 assumes that core inflation will continue to print at a 0.2% monthly rate. Given the low unemployment rate, accelerating wage growth and persistent elevated monthly hiring numbers, we see no reason why this shouldn’t be the case. However, many clients we talk to have strong doubts that core inflation will move higher. This sentiment is reflected in long-maturity TIPS breakeven inflation rates that remain well below “well anchored” levels. One of the most common questions we receive from clients is: Where will inflation come from? A good starting point to answer that question is to split core CPI into its main components (Chart 10): Chart 10The Components Of Core CPI Shelter (42% of core) Goods (25% of core) Medical Care (8% of core) Services excluding shelter and medical care (25% of core) After making this decomposition we can attempt to identify unique drivers for each component. For shelter inflation, the rental vacancy rate and home price appreciation are the most important variables. Home prices have decelerated in recent months but the rental vacancy rate remains near historically low levels. Taken together, our shelter CPI model shows that shelter inflation should stay near its current level for the next six months (Chart 10, top panel). Core goods inflation tends to track non-oil import prices with a relatively long lag (Chart 10, panel 2). The current message from import prices is that core goods inflation should level off in the coming months, but should not reverse its recent uptrend. The best determinant of trends in core services (excluding shelter and medical care) inflation is wage growth (Chart 10, panel 3). Here we see that services inflation has responded strongly to accelerating wage growth in recent months and is now running at a healthy 2.6% year-over-year pace. With the unemployment rate at 4%, further wage acceleration is probable. Bottom Line: Year-over-year core inflation appears tame at the moment, but that will change during the next few months as base effects shift from a headwind to a tailwind. Wage acceleration and core services (excluding shelter and medical care) inflation will be the main drivers.   Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy Weekly Report, “How Much Higher For Yields?”, dated October 31, 2017, available at usbs.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report, “The Dollar And Risk Assets Are Beholden To China’s Stimulus”, dated August 3, 2018, available at fes.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, “An Oasis Of Prosperity?”, dated August 21, 2018, available at usbs.bcaresearch.com 4 The Market-Based China Growth Indicator is a composite measure of financial market variables that are highly levered to the Chinese economy. For further details please see China Investment Strategy Weekly Report, “Trade Is Not China’s Only Problem”, dated November 21, 2018, available at cis.bcaresearch.com 5 Please see Global Investment Strategy Weekly Report, “China’s Savings Problem”, dated January 25, 2019, available at gis.bcaresearch.com 6 Please see U.S. Bond Strategy Special Report, “Cleaning Up After The 100-Year Flood”, dated June 10, 2014, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, “The Fed In 2019”, dated December 18, 2018, available at usbs.bcaresearch.com 8 Please see U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Special Report

Highlights The Fed’s role is commonly misunderstood, even by sophisticated investors: It seeks to lean against the business cycle, not eliminate it entirely. The idea of the “Fed put” has gone too far: The Fed is indifferent to mundane market moves; it only cares about big swings that could have a material impact on the economy. Investors hoping for an at-the-money put to indemnify them against potential losses will be sorely disappointed. The dual mandate is alive and well: Monetary policy may be better situated to defending price stability than promoting full employment, but the employment mandate was a key catalyst for lower-for-longer rates, and the negative unemployment gap better explains the current tightening cycle than still sluggish inflation prints. The Fed’s propensity to lean against the cycle means that economic strength will prove self-limiting while the expansion is in its latter stages: Risk assets can rally while the Fed’s on hold and economic data are robust, but the stronger the data, the harder the Fed will ultimately have to clamp down. Feature The ranks of BCA researchers include quite a few people who’ve done graduate work in Economics. The modern BCA was initially seeded with Bank of Canada alumni, and the current head of the Bank of Canada, Stephen Poloz, is a BCA alumnus. BCA’s tagline is Independent Investment Research Since 1949, however, not Independent Economic Research. We care about the future direction of the economy only insofar as it informs our expectations for the future direction of financial markets. Financial markets have lately been hypersensitive to all things Fed-related. That helps to make a macro researcher feel wanted, but the Fed fixation has gone so far that the tail is now wagging the dog. In this Special Report, we take a step back to look at the Fed’s role in relation to the business cycle. It is the first in a series of Fed-themed Special Reports in which we attempt to place the Fed’s actions in a market context. The next installment will dig into the link between wage gains and consumer price inflation, and we plan a multi-part series, in collaboration with our fixed-income strategists, on the ins and outs of QE and what investors might expect from its reversal. What The Fed Does Not Do Exhibit A of what the Fed does not do can be found in last week’s Barron’s, where the economics column was headlined, “Can the Fed Stave Off the Next Recession?” Despite popular misconceptions, the Fed’s job is not to prevent recessions, or even to delay their onset. It’s a subtle distinction, but the Fed’s job vis-à-vis the business cycle is to mitigate the effects of recessions so as to maximize long-run economic output. That entails the extraordinary measures the Fed undertook in the wake of the crisis, to prevent dire cyclical swings from metastasizing into permanent economic losses (hysteresis, in economics argot), and reining in boom excesses, which often amounts to inducing a recession before excesses grow larger and potentially more harmful. The Fed also does not act to shield investors from losses. Talk of a “Fed put” initially arose the day after 1987’s Black Monday, with a seemingly innocuous press release: The Federal Reserve, consistent with its responsibilities as the Nation’s central bank, affirmed today its readiness to serve as a source of liquidity to support the economic and financial system. Those 30 words, signaling the Fed’s willingness to fulfill its function as the lender of last resort in the wake of a specific event with the potential to spark a crisis, have now had a half-life of 30 years and counting. The enduring notion of the Fed put may also have been helped along by the district banks’ efforts to keep the system functioning in the days after Black Monday. New York Fed president Corrigan twisted lenders’ arms to keep credit flowing so the crash would not infect the banking system and the real economy.1 The Chicago Fed didn’t let the letter of the law keep it from “help[ing to] engineer a solution” when one of the biggest derivatives market participants “ran short of cash.2” The statement, and the vigorous offstage exertions, marked a watershed in terms of the Fed’s public profile. Before Alan Greenspan, monetary policy actions were regarded as something akin to state secrets. Wall Street firms employed “Fed watchers,” who were charged with studying the tea leaves to determine if the Fed had adjusted policy. As late as January 1990, the Bank Credit Analyst could devote an entire Special Report to the question, “Has the Federal Reserve Eased?” We push back against the widespread Fed-put notion that the Fed will do its best to ward off, or mitigate, run-of-the-mill market downdrafts. It is a subtle distinction to be sure, but it’s more accurate to say the Fed attempts to ward off, or mitigate, market crises. With the credit crisis following closely on the heels of the dot-com bust, the Fed-put concept got legs, but stretching the idea to the fourth-quarter selloff is misguided. The Fed simply reacted to a tightening of financial conditions that lessened the need for additional near-term hikes (Chart 1). Straight-talking Jay Powell put it well at the press conference following the January FOMC meeting: Chart 1An Extreme Swing [W]hen there are changes [in financial conditions,] and those changes are sustained for a period of time, then they become important for us because they have important macroeconomic implications. So we don’t react to … most things that happen in the financial markets. But when we see a sustained change in financial conditions, then that’s something that has to play into our thinking. In fact, our policy works through changing financial conditions so it’s sort of the essence of what we do. Bottom Line: The Fed does not try to prevent recessions, which are a natural counterpoint to expansions. It simply tries to lean against cyclical extremes with the goal of increasing long-run output. Investors and the media overrate the “Fed put.” The Fed only leans against outsized market swings with the potential to destabilize the broader economy. The Fed’s Dual Mandate As directed by the Federal Reserve Reform Act of 1977, and subsequently adjusted by common understanding, the Fed has a dual mandate to promote price stability and full employment. In line with the price stability mandate, the Fed has set a 2% annual target for its preferred inflation measure, the price index for personal consumption expenditures (PCE). The PCE price index has persistently undershot the Fed’s target since the crisis (Chart 2), and in an attempt to raise inflation expectations and persuade the public that it will enforce the minimum speed as well as the speed limit, the Fed has lately stressed that its inflation target is “symmetric,” indicating that it is equally concerned about undershoots and overshoots. Chart 2Mandate 1: Price Stability Full employment is more difficult to quantify because it varies over time and is not directly observable. It is best described with reference to the natural rate of unemployment (“u-star,” or, “u*”) that accrues from structural factors independent of the cycle. The Congressional Budget Office estimates that u-star is currently 4.6%, similar to the FOMC’s 4.5% median estimate. Since the introduction of the dual mandate, the unemployment rate has only occasionally fallen below u-star (Chart 3, bottom panel). Those occasions have all eventually ended in recessions and (typically) lengthy stretches of excess unemployment.3 Chart 3Mandate 2: Full Employment The Fed’s Reaction Function Inflation and unemployment don’t matter all that much to markets in themselves; their import instead derives from the way they affect Fed policy. The Fed’s theoretical inflation reaction is straightforward; it moves to cut off above-target inflation on the grounds that unstable prices hold output below potential by undermining economic actors’ ability to plan confidently for the future. The Fed would be expected to react similarly to long-term inflation expectations that go beyond its comfort zone. The empirical record generally supports the theory: from the late ‘80s to the late ‘90s, when inflation had come off the boil, but was still well above today’s 2% target, the Fed hiked rates when core inflation accelerated (’87 through early ’89, and ’94 through mid-’95, Chart 4). Once core PCE inflation regularly fell below the 2% target, the Fed has hiked when both series have turned up and core CPI has exceeded 2% (early ’97, mid-’99, and mid-’04), and when both series accelerated but were still well below 2% (December 2015).4 Over the last 30 years, the fed funds rate’s relationship with the Cleveland Fed’s long-term inflation expectations series has been even stronger than its relationship with measured inflation (Chart 5). Chart 4When Core Price Indexes Rise, The Fed Hikes   Chart 5Managing Expectations The Fed’s unemployment reaction is less clear, as befitting the uncertain relationship between monetary policy and employment.5 Ever since the dual mandate became law, however, the Fed has hiked rates every time the unemployment rate has fallen below the estimated natural rate of unemployment (Chart 6, bottom panel). Viewed in conjunction with core inflation measures (Chart 6, top panel), the reaction function becomes clearer: when the unemployment gap is negative, and inflation is above 2%, the Fed hikes. The holistic reaction function is consistent with the Phillips Curve argument that inflation and unemployment are inversely related (Chart 7). Delving into the controversy around the Phillips Curve is beyond the scope of this survey, but the practical takeaway for investors is that the Fed still generally subscribes to the Phillips Curve relationship, and can therefore be expected to hike when unemployment falls below its natural rate. Chart 6Accelerating Inflation + Negative Unemployment Gap = Rate Hikes   The Limits Of Monetary Policy We have repeatedly made the point that monetary policy is a blunt instrument that works with long and variable lags. Combined with a dual mandate that focuses on lagging indicators like inflation and the unemployment rate, the Fed is almost certainly condemned to leaning too hard against the cycle at both the bottom and the top. Responding to delayed feedback, it is likely to provide too much accommodation after the economy has already troughed and to clamp down too hard after it’s already peaked. That said, central bankers must be doing something right. Recessions have become shallower and less frequent as the business cycle has become much more stable than it was in the 60 years before World War I (Chart 8). Inflation has been docile ever since the Volcker Fed brought it to heel. The U.S. economy’s post-crisis outperformance versus its developed-world peers owes a great deal to the Fed’s and other domestic regulators’ willingness to act swiftly, boldly and creatively to counteract the effects of the crisis. Chart 8The U.S. Economic Ride Has Gotten Much Smoother Investment Implications We continue to believe that unnecessary fiscal stimulus, by artificially boosting aggregate demand above the economy’s capacity to satisfy it, will eventually produce inflation. We further believe that an extremely tight labor market will generate upward wage pressure. Though possible, it is not our base case that firms will boost productive capacity sufficient to meet a temporary pickup in demand. It is also not our base case that labor force participation will increase enough to prevent additional hiring from pushing year-over-year compensation gains to 3% and beyond. Inflation pressures have been slower to emerge than we expected, but when they eventually appear, the Fed can be counted upon to attempt to contain them. Once it does, Treasuries will suffer, especially at longer maturities. The economy eventually will, as well, and equities and spread product will perform poorly in the ensuing recession. However, the Fed’s newfound commitment to patience, and inflation’s delay in pressuring the Fed to abandon it, is likely to push out our projected outcomes. The delay will ultimately make the overshoots larger. The Treasury selloff will be worse because yields will stay lower for longer while the Fed remains on the sidelines, and they will rise more than they otherwise would because the Fed will have to drive rates higher to combat inflation that’s been afforded more time to germinate. Spread product and equities will presumably post larger gains while the Fed pauses, and the economy builds up more momentum than it otherwise would, followed by larger losses when the Fed ultimately has to get more aggressive. Economic strength at this point of the cycle is self-limiting, but the limit now appears to be a little further away than we previously estimated. We maintain our recommended positioning – overweight equities and spread product, significantly underweight Treasuries, and equal-weight cash – with the caveats that volatility is likely to be elevated in the latter stage of the cycle and that trade tensions remain a meaningful threat. Generalizing beyond the current cycle, monetary policy settings matter a great deal for relative asset-class returns. The Fed’s predictable reaction to the business cycle should be incorporated into the asset-allocation decision process.   Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com   Footnotes 1 Greenspan, Alan. The Age of Turbulence: Adventures in a New World, Penguin (New York): 2007, p.108. Greenspan disavowed knowledge of the details, but suggested that Corrigan, “the Fed’s chief enforcer,” “bit off a few earlobes” while encouraging bankers to keep in mind that, “‘if you shut off credit to a customer just because you’re a little nervous about him, but with no concrete reason, he’s going to remember that’.” 2 Greenspan, p. 110. 3 The u* series shown in Chart 3 is a retrospective estimate. Research cited by Chairman Powell in his 2018 Jackson Hole address suggests that faulty real-time estimates of u* are a potential source of policy errors. https://www.federalreserve.gov/newsevents/speech/files/powell20180824a…, accessed February 6, 2019. 4 The Fed targets the headline PCE price index series, but we show the core PCE price index because it is a robust predictor of the headline series. 5 According to a St. Louis Fed blog post intended to explain everyday economic concepts, “the links between monetary policy and employment are weak and inexact.” https://www.stlouisfed.org/open-vault/2018/august/federal-reserve-dual-mandate, accessed February 4, 2019.

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