Real Estate

Special Report

Highlights The CAD and AUD have tactical upside; however, this may well prove to be the last hurrah before some serious declines play out. This time domestic – not global – factors will drive the CAD and AUD lower. Canada and Australia are hitting the end game for their respective debt supercycles as rising U.S. rates will lift the global cost of capital. Canadian and Australian house prices and debt loads are too elevated; a reversal of these excesses is likely to push these two countries toward liquidity traps. These liquidity traps will cause the R-star in Canada and Australia to fall, lagging well behind the U.S. Canada and Australia are uncompetitive, suggesting external demand will not come to their respective rescue, at least not until after the CAD and AUD have fallen significantly. The CAD may fall first, but the AUD has more downside ultimately; not only is Australia even less competitive than Canada, but the Aussie is also more expensive than the Loonie. Feature The Canadian and Australian dollars are in the process of rebounding. This is not surprising. By the end of 2018, both these currencies were deeply oversold, and the recent easing in global financial conditions, helped by the Federal Reserve’s pause, is fueling their rebound (Chart 1). Moreover, pessimism toward China has hit an extreme, yet Sino-U.S. trade relations seem on the cusp of improving and Chinese policymakers are increasingly trying to manage the downside in the Chinese economy. This setup is normally supportive for the Canadian and Australian dollars (Chart 2). Chart 1Financial Conditions Point To A Tactical Rebound In The AUD And The CAD...   Chart 2...So Does Chinese Reflation While we have been recommending that our more tactically minded clients play this rally,1  the longer-term outlook for the CAD and AUD remains poor. These countries are getting closer to the end of their respective debt supercycles. Consequently, the CAD and AUD need to trade at much larger discounts to fair value in order to be attractive. Way Too Much Debt Canada and Australia have become victims of their own success. Canada and Australia have seen real estate prices rise for more than two decades. At first, rising prices reflected solid valuations, growing populations and rising prosperity. However, things changed around the Great Financial Crisis. During this traumatic event, the Bank of Canada and the Reserve Bank of Australia both dropped interest rates by 4.25%. Since both countries’ banking sectors escaped the crisis unscathed, and households did not experience similar losses of wealth as those in the U.S., Ireland or Spain, credit growth remained strong. A real estate bubble became the natural consequence of this easy monetary policy. Banks pushed credit to households, and households – impressed by the solid performance of real estate prices, attracted by low interest rates, and enamored with the dream of easy riches – willingly took on mortgages and piled into the property market. A feedback loop ensued, whereby rising collateral values made credit even easier to access, fomenting further house price gains and even-easier credit conditions. Today, we stand at the end of this process. Vancouver and Toronto in Canada, and Sydney and Melbourne in Australia are some of the most expensive real estate markets in world in terms of price-to-income ratios, when one controls for population density (Chart 3). This has created major systemic risks for both countries. Few would care about the systemic risk created by elevated house prices if debt loads were small. However, in both countries, household indebtedness makes Americans circa 2007 look like a frugal bunch. In Canada, household debt has now reached 176% of disposable income, or 100% of GDP, while in Australia, the same ratios are 189% and 121%, respectively. This is well above the levels that prevailed in the U.S. in 2007 (Chart 4). Mortgage debt alone represents 108% and 140% of disposable income in Canada and Australia, respectively. Moreover, Canadian and Australian households also spend 14.5% and 15.6% of their incomes servicing debt, which also compares unfavorably with the U.S. in 2007. Chart 4ACanadians And Australians Make Americans Look Frugal Chart 4BCanadians And Australians Make Americans Look Frugal Canadian and Australian households thus seem close to having reached their maximum debt loads. Moreover, measures taken in Canada and Australia to limit foreign money inflows and constrain bank lending are beginning to bite. In both countries, real estate transactions are slowing, with property sales declining by 20% and 8% in Canada and Australia, respectively. House prices too are being hit. House prices in Vancouver and Toronto peaked by 2018, and in Sydney and Melbourne in 2017. Residential construction is likely to be the first victim. Real estate inventories in both these countries have been rising, courtesy of the frenetic pace of housing starts going on for decades. Today, residential investment represents 7% of GDP in Canada and 5% of GDP in Australia (Chart 5). Thus, slowing real estate activity could curtail Canadian and Australian GDP by 2% if we move back to the real estate environment that prevailed in the mid-1990s. This would also imply large hits to employment as construction, real estate and finance have created 336-thousand and 250-thousand jobs in Canada and Australia since 2009, respectively. Chart 5AA Decline In Construction Activity Would Be A Vicious Hit To Canada And Australia (1) Chart 5BA Decline In Construction Activity Would Be A Vicious Hit To Canada And Australia (2) Consumption too is likely to suffer. Without a growing wealth effect and with declining equity in their houses, Canadian and Australian households are likely to curtail consumption – consumption that has contributed 60% and 30% of Canada’s and Australia’s cumulative GDP growth since 2009. Already, we are seeing slowing Canadian and Australian retail sales – right behind drops in housing activity. The biggest and most dangerous risk is that Canada and Australia teeter on the verge of falling into a liquidity trap, like the U.S. after 2007. As Chart 6 illustrates, propelled by households binging on cheap money in the form of mortgages, Canadian and Australian banks have managed to maintain higher levels of return on equity after the financial crisis. This robust profitability will decline if non-performing loans, which so far remain low, grow in response to weakening house prices and fragile household financial health (Chart 7). Chart 6Canadian And Australian Banks Remain Profitable... Chart 7...As Long As NPLs Do Not Rise Rising NPLs and declining RoEs tend to limit the willingness of banks to lend. Just as crucially, the poor health of households and falling real estate prices is likely to also limit demand for credit. This combination was behind the sharp decline in the U.S. money multiplier in 2008. No matter how much reserves the Federal Reserve would inject in commercial banks via QE programs, broader money would not respond. A similar fate is likely to ensue in Canada and Australia (Chart 8). The velocity of money is also likely to fall if households are not willing to take on debt anymore and instead focus on rebuilding their financial buffers. Chart 8Canada And Australia Have Avoided A Liquidity Trap... So Far The consequence of this monetary constipation will be much lower interest rates. When an economy enters a liquidity trap, as was the case in the U.S. after 2007, in Japan since the 1990s, or in Europe after 2010, the neutral real rate of interest, the so-called R-star, falls to zero or even lower. Essentially, no matter how low interest rates fall, they cannot equilibrate the demand and supply for savings. Everyone wants to save, no one wants to borrow, and banks are unwilling to lend. This fate looks increasingly likely for both Canada and Australia over the coming two years. Bottom Line: The Canadian and Australian real estate markets have enjoyed incredible runs for more than two decades. Now, not only are real estate prices in these two nations very expensive, households have been left with prodigious debt loads. As real estate activity slows, residential construction will suffer, but most importantly, these two countries are likely to teeter toward becoming liquidity traps as banks curtail lending and households curtail borrowing. This will result in structurally lagging interest rates. Why Now? Betting on the end of the Canadian and Australian housing bubbles has so far been mugs games. Why is the situation different now? Because the U.S. economy is stronger. Until now, very low global interest rates have kept the Canadian and Australian housing bubbles afloat, but rising U.S. interest rates are now putting upward pressure on mortgage rates in both Canada and Australia (Chart 9). This simply reflects the fact that U.S. rates represent the ultimate opportunity cost of investing outside the international reserve currency, the U.S. dollar. After years of household deleveraging, the U.S. seems to be able to handle higher rates. However, because Canadian and Australian balance sheets are much weaker, their tolerance for higher rates is substantially lower. Chart 9Higher U.S. Rates Threaten Canadian And Australian Households BCA sees further upside for U.S. rates and thus for the global cost of capital. In other words, we do not anticipate the Fed’s pause to last beyond June. The following reasons underpin this view: The U.S. labor market is increasingly inflationary. The employment-to-population ratio for prime-age workers continues to rise, which historically has boosted labor costs (Chart 10). The New York City Fed Underlying Inflation Gauge points toward higher core inflation (Chart 11). Moreover, Ryan Swift argues in BCA’s U.S. Bond Strategy that an unfavorable base effect will dissipate after February, further reinforcing the upside risk to inflation.2  Being the only component of our Fed Monitor moving toward “easy money required” territory, the tightening in U.S. financial conditions last year was the lynchpin behind the Fed’s pause. The other components of the Fed Monitor have not deteriorated significantly, and they still argue in favor of further rate hikes (Chart 12). Thus, if the recent easing in financial conditions can persist, the Fed will hike again this year.   Chart 11Budding U.S. Inflationary Pressures   Chart 12The Fed Is Pausing Because Of Tightening Financial Conditions, Not The Economy Finally, U.S. productivity is set to pick up over the coming two years. Since a rising capital stock boosts productivity, the recent strength in capex augurs well (Chart 13). Moreover, the demand deficit created by the deleveraging of U.S. households has weighed on productivity. As U.S. credit growth picks up, so will productivity. This is important as rising productivity lifts the neutral rate, and thus creates more room for the Fed to lift interest rates. Chart 13Upside For U.S. Productivity Equals Upside For U.S. Rates Ultimately, all these factors point to higher U.S. rates. As such, it suggests that Canadian mortgage rates, and to a lesser extent Australian ones as well, will experience upward pressure – exactly at the time when households in these two countries are most vulnerable to higher rates. Bottom Line: Higher U.S. rates are the main reason why we expect the Canadian and Australian housing markets and economies to buckle now, finally heeding the call of doomsayers. Higher U.S. rates lift the global cost of capital. While U.S. households are in robust shape and therefore better able to handle higher rates, the same cannot be said about Canadian and Australian households. Can the External Sector Come To The Rescue? This is unlikely. After years of commodity booms and strong domestic demand supported by rising household wealth, the Canadian and Australian manufacturing sectors have been greatly diminished. Much capacity has vanished, and it will be difficult to replace the lost output from falling domestic demand by exports of manufactured goods. The Australian and especially the Canadian corporate sectors are also already heavily indebted, and thus, it could take quite some time before capacity is expanded. Complicating the situation, Canada and Australia are not competitive exporters anymore. As the top panel of Chart 14 shows, since 1980, U.S. unit labor costs have risen by 156%, but they have risen by 183% in Canada and by a stunning 282% in Australia. Productivity trends paint a similar, albeit less dramatic picture. Since 1980, U.S. labor productivity has risen 22% versus its trading partners; in Canada it has declined by 20%, and in Australia, by 5%. Consequently, both Canadian and Australia labor will have to cheapen. Historically, the mechanism through which labor costs decline is higher unemployment, which forces a painful adjustment in wages. These adjustments are likely to force both interest rates and currencies lower. Chart 14Canada And Australia Are Uncompetitive Could China come to the rescue? Via higher commodity prices, both Canada and Australia have been major beneficiaries of the Chinese economic boom. However, while China today is trying to contain its economic deceleration, Chinese policymakers remain fixated on controlling credit growth. This means that China is unlikely to go on another debt binge similar to what transpired in 2009 or in 2015-‘16. As a result, the recent uptick in commodity prices is unlikely to last long. More fundamentally, China is not only trying to move away from its debt-led growth model: It is also trying to move away from its investment-led growth model. This means that the commodity intensiveness of the Chinese economy is likely to decline. China’s emphasis on controlling air pollution will strengthen this trend. As Chart 15 illustrates, when the share of Capex as a percentage of Chinese GDP declines, so does the labor participation rate of Canada and Australia relative to the U.S. This decline in relative participation rates is associated with falling CAD and AUD values versus the U.S. dollar, a consequence of falling growth potential and interest rates. Chart 15AChanging Chinese Growth Model Points To Falling Canadian And Australian Participation Rates (1) Chart 15BChanging Chinese Growth Model Points To Falling Canadian And Australian Participation Rates (2) Bottom Line: Canada’s and Australia’s lack of manufacturing capacity, poor competitiveness, and China moving away from its investment-led growth model suggest that a deflationary environment will ultimately develop in these two nations, at least relative to the U.S. Moreover, the structurally negative outlook on consumption, debt growth and employment suggests that Canadian and Australian neutral rates are likely to fall relative to the U.S. These economic forces point to deeper lows this cycle in the CAD and AUD against the USD. Investment Implications Based on this economic backdrop, both the Canadian and Australian dollar could suffer significant downside in the coming years as their fair value is likely to fall, dragged by interest rates that will lag those in the U.S. However, if an asset is cheap enough, it may nonetheless be an attractive buy. The CAD and AUD do not fall into that camp. Today, the CAD trades in line with our long-term fair-value model, implying that if its fair value falls, the CAD provides zero insulation and will therefore also have to decline. The AUD is in an even worst spot as it currently trades above its fair value (Chart 16). Additionally, the Australian current account deficit is larger than Canada’s. Chart 16The CAD And AUD Are Not Cheap Enough To Compensate For Secular Risks In terms of timing, the Loonie could start weakening before the Aussie. The Canadian housing bubble is likely to collapse first as Canadian mortgage rates are more tightly linked to U.S. ones than Australian rates are. Moreover, the Canadian economy seems even more levered to rising real estate prices than that of Australia. However, a collapse in Vancouver and Toronto housing prices will promptly catalyze similar weaknesses in Sydney and Melbourne. Thus, while the CAD may be the first to take the great plunge, the AUD will not be far behind. Ultimately, the AUD will suffer the greatest decline. Obviously, the more onerous pricing of the AUD contributes to this assessment, but so does the greater lack of competitiveness in Australia than in Canada. Australia is likely to endure deeper deflationary pressures as its labor costs need greater adjustments. Furthermore, Australia already suffers from a larger degree of underutilized labor than Canada. Since the currency – not wages – is likely to withstand the bulk of the competiveness adjustment, this implies that the AUD has more work to do than the CAD. The more expensive valuations of Australian assets also handicap the Aussie versus the Loonie. Australian real estate is pricier than Canadian property, and Australian stocks are more expensive (Chart 17). This means that Australians could end up with deeper holes in their balance sheets than Canadians, and that Australia has scope to witness greater outflows of capital than Canada. Chart 17Canadian Financial Assets Are Cheaper Than Australian Ones... Where Australia shines relative to Canada is in terms of the ability of fiscal authorities to respond to an economic slowdown. Canadian public debt stands at 90% of GDP versus 41% of GDP in Australia. Canada’s cyclically-adjusted primary deficit is already deteriorating, while Australia’s is improving (Chart 18). This means that the Australian governments have deeper pockets and a greater capacity to support domestic demand than Canada’s. This could cushion the deflationary impact in Australia relative to Canada. That being said, the Japanese, Spanish or U.S. experiences argue that once a real estate bubble bursts, fiscal spending can cushion some of the pain, but it cannot eradicate the problem – at least not until banks are recapitalized and the private sector is once again ready to borrow, something that takes years of balance-sheet rebuilding. Chart 18...But Australia Has More Fiscal Space Bottom Line: Both the CAD and AUD are likely to experience substantial downside over the coming years. The CAD and AUD are not cheap enough to compensate for a BoC and RBA that will greatly lag the Fed. While the CAD may weaken first, the AUD will suffer more long-term downside. The Aussie is more expensive, Australia is less competitive than Canada, and it could suffer greater outflows of capital. Continue to underweight Australian and Canadian assets in global portfolios as the AUD and CAD will drag their performance down. Remain short AUD/CAD on a structural basis.   Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Weekly Report, titled “Global Liquidity Trends Support The Dollar, But…”, dated January 25, 2019, 2018, available at fes.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, “Buy Corporate Credit”, dated January 15, 2019, available at usbs.bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Duration: The U.S. economic data show few signs of restrictive monetary policy, despite the fact that the market is now priced for an end to the Fed’s rate hike cycle. Investors should position for further rate hikes this year. Practically, this means keeping portfolio duration low and avoiding the 5-year/7-year part of the Treasury curve. Corporate Spreads: Corporate breakeven spreads are too wide for this phase of the cycle, especially for the Baa and junk credit tiers. Our default-adjusted spread shows that high-yield bonds offer adequate compensation for default losses, in line with the historical average. Corporate Defaults: A simple model using gross nonfinancial corporate leverage pegs fair value for the 12-month speculative grade default rate at 4.1%. This fair value estimate should decline slightly in the months ahead, as long as pre-tax profit growth stays above 7%, the approximate rate of debt growth. Feature Fed rate hikes have been completely priced out of the curve. As of last Friday’s close, the overnight index swap market was priced for 2 basis points of rate hikes during the next 12 months and 9 bps of cuts during the next 24 months (Chart 1). The sharp drop in rate hike expectations is an overreaction, and investors should position for a near-term rise in rate expectations. The Fed’s rate hike cycle still has room to run before interest rates peak. Chart 1Market Says "No More Hikes" In this week’s report we survey the recent economic data, searching for any signal that interest rates are high enough to choke off the recovery. We conclude that monetary conditions remain accommodative, and that the Fed’s rate hike cycle will re-start in the second half of this year. Searching For Signs Of Tight Money Policymakers frequently talk about the concept of the neutral (or equilibrium) fed funds rate. In essence, the neutral rate is the interest rate that is consistent with trend economic growth and stable inflation. If the fed funds rate is set above neutral, then we should expect growth to slow and inflation to fall. Conversely, if the fed funds rate is set below neutral, we should expect growth to accelerate and inflation to rise. The slope of the yield curve can help distill this concept for bond investors. An inverted yield curve signals that the market is priced for interest rate cuts in the future. This is what we would expect to see in an environment where the fed funds rate is above neutral and monetary conditions are restrictive. Conversely, a very steep yield curve means that investors expect rate hikes in the future. This is usually consistent with accommodative monetary policy and an interest rate well below neutral. We find the neutral rate to be a useful concept, though like Fed Chairman Powell we think it is unwise to place too much stock in point estimates of its level.1 Such estimates are very difficult to make in real time, and tend to be heavily revised with hindsight.2 For investors, a wiser strategy is to look for signs in the economic data that interest rates are too high, and to use those signs to decide when interest rates have peaked for the cycle. We review a few of those potential signs below. Nominal GDP Growth One simple signal of restrictive monetary policy is when interest rates rise above the year-over-year growth rate in nominal GDP. In the last cycle, Treasury returns versus cash didn’t move materially higher until after year-over-year nominal GDP growth was below both the 10-year Treasury yield and the 3-month T-bill rate (Chart 2). At present, year-over-year nominal GDP growth is running at 5.5%. Though it is very likely to slow during the next few quarters, it still has a long way to go before it falls below 2.76%, the current 10-year Treasury yield. Chart 2GDP Growth Suggests That Monetary Policy Remains Accommodative Verdict: An assessment of nominal GDP growth shows that monetary policy remains accommodative. The Housing Market Given that the mortgage market provides the most direct link between interest rates and real economic activity, it makes sense that signs of tight money might show up first in the housing data. Empirical investigation backs up this claim. As was observed by Edward Leamer in his 2007 paper, of the ten post-WWII U.S. recessions, eight were preceded by a significant slowdown in residential investment.3 Our own reading of the data is consistent with this message. Downtrends in the 12-month moving averages of both single-family housing starts and new home sales preceded inflection points higher in excess Treasury returns in each of the past two cycles (Chart 3). Chart 3No Signal From Housing While these housing metrics certainly deteriorated during the past nine months, it appears that the worst is now behind us. The recent moderation in mortgage rates has already led to a significant bounce in mortgage purchase applications and a pop in homebuilder confidence (Chart 4). This will translate into increased housing starts and new home sales during the next few months. Chart 4Housing Rebound Underway Verdict: The housing data are most likely consistent with still-accommodative monetary policy. However, if single-family housing starts and new home sales do not respond as expected to the recent drop in the mortgage rate, then we will be forced to re-visit this view. The Labor Market Of all the available labor market statistics, initial unemployment claims tend to be the most leading and have historically provided the best signal of tight monetary conditions. In each of the past two cycles a significant increase in jobless claims has coincided with the inflection point higher in Treasury excess returns (Chart 5). While there was some concern toward the end of last year that claims were trending up, this has now been dashed and claims actually fell below 200k last week. Notice in Chart 5 that the 13-week change in claims remains negative. In prior cycles it rose above zero around the same time that Treasury returns started to improve.. Chart 5No Signal From Labor Market Verdict: The labor market data remain consistent with accommodative monetary policy. Bottom Line: It seems very likely that U.S. monetary policy remains accommodative. Nominal GDP growth and the labor market both strongly support this claim. The housing data have been weaker, but are already showing signs of rebounding. The implication for bond investors is that the Fed is not done lifting interest rates, even though the market is priced for exactly that outcome. Investors should maintain below-benchmark portfolio duration on the view that rate hikes will re-start in the second half of this year. The 5-year/7-year part of the Treasury curve is especially vulnerable to an increase in rate hike expectations. Investors should avoid this part of the curve, focusing on the very long and short maturities.4 The Weakness Is Global The analysis in the above section begs the question: If the economic data do not suggest that monetary policy is restrictive, then why is the market priced for an end to the Fed’s rate hike cycle? The answer is that everything is not rosy in the economic outlook. Specifically, we have already seen a significant slowdown in non-U.S. economic growth that weighed significantly on financial markets near the end of last year and is starting to impact the most externally-exposed segments of the U.S. economy. Chart 6 shows that a slowdown in the Global ex. U.S. Leading Economic Indicator (LEI) is now dragging the U.S. LEI down with it. Chart 6Global Weakness Infects U.S. Not surprisingly, the components of the U.S. LEI that have weakened are those related to financial markets and the corporate sector. Given that corporate profits are determined globally, a slowdown in global growth often shows up first in downward revisions to investors’ corporate profit expectations. This weighs on equity prices and causes business owners to re-assess their future investment plans. Consistent with this narrative, we have seen significant downward moves in ISM New Orders and NFIB Capital Spending Plans, shown averaged together in the top panel of Chart 7. Capital spending plans as reported in regional Fed surveys have also moderated (Chart 7, panel 2), and CEO confidence has plunged (Chart 7, bottom panel). All of these indicators suggest that weaker global growth will weigh on the nonresidential investment component of U.S. GDP during the next few quarters. Chart 7Weaker Nonresidential Investment... But while corporate investment is poised to weaken, the U.S. consumer is in rude health (Chart 8). Core retail sales are growing strongly, though the most recent data only extend through November. For more timely data we can look at the Johnson Redbook measure of same-store sales which has accelerated into the New Year (Chart 8, top panel). The University of Michigan survey of consumers shows that expectations dipped last month (Chart 8, panel 2), but also that consumers still view current conditions as extremely positive (Chart 8, bottom panel). Chart 8...And Resilient Consumer Spending The overall picture is reminiscent of 2015/16. The U.S. consumer and labor market are in good shape, but slowing foreign growth and a strong U.S. dollar are weighing on the corporate profit outlook and U.S. corporate investment spending. As in 2016, the solution is for the Fed to temporarily pause its rate hike cycle. This will allow the dollar’s uptrend to moderate and will take some pressure off the corporate profit and investment outlooks. With a Fed pause discounted in the market, the conditions are already in place for renewed optimism on the corporate sector. It is for this reason that we upgraded our recommended allocation to corporate bonds two weeks ago.5 We expect this optimism will cause financial conditions to ease during the next few months, allowing the Fed to resume its rate hike cycle in the second half of this year. Corporate Bond Valuation Update As mentioned above, we increased our recommended exposure to corporate credit (both investment grade and junk) two weeks ago, partly due to valuations that had become too attractive to pass up. The Breakeven Spread One of our preferred valuation techniques is to look at 12-month breakeven spreads for each corporate credit tier as a percentile rank versus history.6 We like this method for three reasons: First, focusing on each individual credit tier controls for the fact that the average credit rating of bond indexes can change over time. Second, using the breakeven spread instead of the average index option-adjusted spread allows us to control for the changing average duration of the bond indexes. Finally, we find that the percentile rank is often a better representation of credit spreads than the spread itself. This is because credit spreads often tighten to very low levels and then remain tight for an extended period of time. By showing us the percentage of time that a given spread has been tighter than its current level, the percentile rank gives a better sense of this pattern than the actual spread. At present, Baa-rated debt and all junk credit tiers have 12-month breakeven spreads at or above their historical medians. Aa and A rated bonds have breakeven spreads that rank near the 40th percentile, and Aaa-rated debt remains expensive with a 12-month breakeven spread below the 10th percentile since 1989. To appreciate how cheap these spreads are, especially for Baa-rated and junk credits, consider that the current 12-month breakeven spread for a Baa-rated corporate bond is 24 bps (Chart 9). In our analysis of the different phases of the economic cycle, we determined that in an environment where the slope of the 3/10 Treasury curve is between 0 bps and 50 bps (it is 18 bps today), the 12-month Baa-rated breakeven spread averages 18 bps.7 Chart 9Attractive Baa Valuation Given current index duration, if the 12-month Baa-rated breakeven spread returned to the 18 bps level that is typical for this stage of the cycle, it would imply a tightening in the option-adjusted spread from 169 bps to 129 bps – a 40 bps tightening! Default-Adjusted Spread Another valuation measure to consider is our high-yield default-adjusted spread. This is the excess spread available in the high-yield index after subtracting expected default losses. To determine expected default losses we use Moody’s baseline forecast for the 12-month default rate and our own forecast for the 12-month recovery rate. At present, this gives us a default-adjusted spread of 237 bps, right in line with the historical average (Chart 10). In other words, if default losses during the next 12 months match those embedded in our calculation, then investors should expect an excess return that is in line with the historical average, assuming also no capital gains/losses from spread tightening/widening. Chart 10In Line With Historical Average But how likely is it that default losses fall in line with that expectation? In its last Monthly Default Report, Moody’s revised its baseline 12-month default rate forecast up to 3.4%, from 2.6% previously. The new 3.4% forecast seems reasonable to us. A simple model of the 12-month trailing default rate based only on our measure of gross leverage for the nonfinancial corporate sector puts fair value for the 12-month default rate at 4.1% (Chart 11). Our measure of gross leverage is simply total debt divided by pre-tax profits. This measure fell during the past year because pre-tax profits grew by 17% and total debt grew by only 7%. Chart 11Default Expectations Going forward, profit growth will almost certainly moderate during the next 12 months, driven by the combination of weaker global growth and rising wage pressures. However, it needs to fall a long way, to below 7%, before our measure of leverage starts to rise. In other words, a further slight decline in our measure of gross leverage is a reasonable expectation at the current juncture, which would bring the fair value from our simple default rate model close to the current Moody’s projection. All in all, our default-adjusted spread tells us that high-yield bonds offer historically average compensation given reasonable default expectations. Bottom Line: Corporate breakeven spreads are too wide for this phase of the cycle, especially for the Baa and junk credit tiers. Our default-adjusted spread shows that high-yield valuation is in line with the historical average, given a reasonable expectation for default losses. Overall, we conclude that corporate spreads are attractive at current levels and we recommend an overweight allocation to both investment grade and high-yield corporate debt in a U.S. bond portfolio.   Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy Weekly Report, “The Powell Doctrine Emerges”, dated September 4, 2018, available at usbs.bcaresearch.com 2 Chairman Powell cites a few examples of this in his Jackson Hole address from last fall. https://www.federalreserve.gov/newsevents/speech/powell20180824a.htm 3 http://www.nber.org/papers/w13428  4 Please see U.S. Bond Strategy Weekly Report, “Don’t Position For Curve Inversion”, dated January 22, 2019, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, “Buy Corporate Credit”, dated January 15, 2019, available at usbs.bcaresearch.com 6 The 12-month breakeven spread is the spread widening required on a 12-month investment horizon for a corporate bond to break even with a duration-matched position in Treasury securities. It can be quickly approximated by dividing the bond’s option-adjusted spread by its duration. 7 For a more complete analysis of the economic cycle based on the slope of the yield curve please see U.S. Bond Strategy Special Report, “2019 Key Views: Implications For U.S. Fixed Income”, dated December 11, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Feature Conditions are falling into place in Brazil that will facilitate a recovery in physical property prices as well as the outperformance of real estate stocks. With the overall Brazilian equity index having rallied considerably, investors are now wondering which sectors of the market presently offer the most upside with the least risk. Our bias is that the risk-reward of property stocks is currently attractive both relative to the overall equity index as well as in absolute terms (Chart I-1). Chart I-1Good Risk-Or-Reward In Property Sector As such, we recommend investors begin accumulating Brazilian real estate stocks on weakness and other proxies that stand to benefit from a revival in both residential and commercial property markets. The Macro Case For Real Estate Following years of severe depression, fertile ground for strong growth in Brazilian real estate and related assets is finally developing: Interest rates are falling, employment and incomes are rising, and credit availability is improving amid substantial pent-up demand for properties. Barring an outright failure by the government to adopt pension reforms, which would cause major financial market turbulence, the economy will continue on a recovery path (Chart I-2). Please see page 7 for more details. Chart I-2Domestic Demand Bottoming... We upgraded our recommended allocation in Brazil from underweight to overweight across equity, fixed-income, currency and credit markets right after the October elections.1 We argued that the presidential election victory by pro-business candidate Jair Bolsonaro was set to revive sentiment and “animal spirits” among businesses, unleashing pent-up demand for capital expenditures and hiring. On the whole, the Brazilian economy is recovering from the most severe economic depression of the past several decades (Chart I-3). Consequently, there is a lot of pent-up demand for discretionary spending in general and properties in particular. Chart I-3...After The Worst Recession In Decades Our view remains negative on Chinese growth and commodities. Historically, Brazilian financial markets have never sustainably diverged from commodities prices, as illustrated in Chart I-4. Nevertheless, going forward the odds that Brazilian domestic plays could decouple from commodities prices are non-trivial. Chart I-4Can Brazilian Financial Markets Decouple From Commodities? Importantly, aggregate exports make up only 13% of Brazilian GDP (Chart I-5). This indicates that Brazil’s exposure to global demand in general and commodities in particular is not substantial. Besides, Brazil’s commodities exports are very diversified – overseas shipments of each commodity accounts for only a small portion of Brazilian exports and GDP (Table I-1). Chart I-5Brazil Is A Closed Economy! In Brazil, the property market is one of the few sectors that is least exposed to global growth and most leveraged to local interest rates and household income growth. Hence, this sector stands to outperform in a scenario where global cyclicals and commodities fare poorly while domestic income and spending recover. Notably, real estate is the most leveraged play on falling real interest rates. The rationale for why real estate is more sensitive to real rather than nominal rates is as follows: Property prices benefit from higher inflation – higher inflation lifts nominal household income, which improves affordability for buyers and renters. In addition, investors often buy properties as an inflation hedge. Provided property prices positively correlate with inflation but negatively correlate with nominal interest rates, it follows that they are very strongly inversely correlated with real (inflation-adjusted) interest rates. Confirming this, relative performance of property stocks to the overall market tracks real interest rate trends very closely (Chart I-6) Chart I-6Lower Real Rates Warrant Real Estate Stocks Outperformance Yields on inflation-indexed bonds – real rates – have recently broken down (Chart I-7). If Congress adopts social security reforms in the coming months, real interest rates could drop further. Chart I-7Real Rates Have Fallen To All-Time Lows In short, falling real rates will greatly benefit real estate prices and volumes. Some commentators might argue that Brazil’s low national savings rate will preclude real rates from falling. We discussed why a low national savings rate is not an impediment to a decline in real interest rates in our March 22, 2018 Special Report (please click on the link to access the report). Property Market: Post Depression… The majority of excesses have been wrung out of the physical property markets in Brazil over the past 5-6 years, and real estate prices and volumes are finally showing signs of recovery. Residential property prices have been flat in nominal terms over the past 5 years. Yet in real (inflation-adjusted) terms they have declined by 20%, and in U.S. dollar terms they are down 40% from their 2014 peak (Chart I-8). Chart I-8Apartment Prices Have Been Beaten Down Nationwide Property sales and prices in São Paulo have already begun rising, but not in Rio de Janeiro (Chart I-9). Typically, bull markets begin in financial and business centers and then spread to other cities and regions. Chart I-9Brazil: Apartment Prices Over the past two days, during our visit to clients in São Paulo, we witnessed very few cranes. Even in this financial and business center, property construction/supply remains extremely subdued. Vacancy rates in office spaces, residential property inventories, and the average sales time are all starting to fall (Chart I-10). These are all early signposts of revival. Chart I-10Signs Of Life Notably, the consumer debt-servicing ratio has fallen due to lower interest rates (Chart I-11). Mortgage rates remain high relative to the (SELIC) policy rate. However, odds are that this spread will narrow as confidence and appetite for mortgage lending among banks improves. Chart I-11Diminishing Household Debt Stress Bottom Line: Overall residential property prices across Brazil’s 11 largest metropolitan areas are slowly starting to rise in nominal but not in real terms yet (Chart I-12). The recovery is only beginning to take shape. Chart I-12Property Price Deflation Is Ending Pension Reforms Hold The Key At the moment, we believe pension reforms – not commodities prices – are the key to sustaining the positive momentum behind Brazil’s financial markets and economy. If Bolsonaro introduces pension legislation immediately, while his political capital is still high, then it will be a market-positive development. However, it is difficult to determine the odds of the passage of the social security reform bill, and the form in which it will be adopted. On one hand, the Brazilian Congress is as fragmented as ever. Bolsonaro’s PSL party holds only 52 seats, or 10% of the total. This means that the president has to convince 256 congressmen outside his party to vote for pension reforms in order to get the 308 votes required to pass this constitutional amendment (Chart I-13). His attempt to find a new way to form a coalition may backfire, at least initially, and he will also face obstructionist voting behavior from minor parties. On the other hand, Brazilian presidents eventually tend to succeed in forming coalitions that comprise a majority of seats. On paper, right-leaning parties have slightly more seats than the three-fifths majority needed for constitutional changes in the Chamber of Deputies. Moreover, many congressmen are new faces in politics and represent small parties. They have little political experience and may not go against a popular president at the very early stages of their congressional terms. It is reasonable to assume that they could side with the president and vote for the pension reforms, for several reasons: (1) distancing themselves from Bolsonaro may not help their own popularity; and (2) voters may well be focused on issues other than unpalatable pension reforms four years from now if the economy is doing well. Hence, voting for the pension reforms early in their term may be a reasonable political strategy for them. Importantly, it seems these reforms have the initial backing of both the military and the police establishments, even though their pensions will be negatively impacted by the changes. Specifically, Vice President and retired general Hamilton Mourão has hinted at the army’s and police’s support of the upcoming social security reforms proposal. In brief, the adoption of pension reforms will create positive tailwinds for investor and business sentiment and in turn support the economic recovery. Investment Recommendation Brazilian stocks have lately exhibited a low correlation with the EM overall equity index. This gives us comfort in arguing that even if our negative view on EM risk assets plays out, Brazilian domestic equity plays will likely have only moderate downside in absolute terms, and certainly outperform the EM equity benchmark on a relative basis. Therefore, we recommend investors begin accumulating Brazilian real estate stocks on weakness. Even though their valuations are not cheap, rising revenue and cash flow will improve their valuation metrics and boost their share prices. With respect to sector composition, the Brazilian real estate sector is comprised of 27 listed firms: 15 listed homebuilders, 7 mall operators, 3 commercial properties and 2 brokers.2 Their total market cap relative to the Bovespa is now around 1.2% – down from 2.4% in 2012 (Chart I-14). We recommend buying a mix of these companies to gain exposure to various parts of the Brazilian property market. Chart I-14More Upside In Real Estate Stocks   Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Andrija Vesic, Research Analyst andrijav@bcaresearch.com Footnotes 1      Please see Emerging Markets Strategy Special Alert "Brazil: A Regime Shift?" dated October 9, 2018, available on page 12. 2      We used the BM&FBOVESPA Real Estate Index (IMOB) in Chart 14. The Real Estate Index (IMOB) is compiled as a weighted average of 13 stocks. For more detail, please refer to: http://www.b3.com.br/en_us/market-data-and-indices/indices/indices-de-segmentos-e-setoriais/real-estate-index-imob.htm Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Our leading indicator for China’s old economy continues to point to slower growth over the coming months, which is consistent with the bearish message from China’s housing market and forward-looking export indicators. We would caution investors against interpreting the recent relative outperformance of Chinese stocks as a basis to become cyclically bullish, as it has largely reflected a “catchup” selloff in global stocks. We remain tactically overweight, in recognition of the fact that investors may bid up Chinese stocks on positive signs that a trade deal may be in sight. Onshore corporate bond spreads remain wide relative to pre-2017 levels, suggesting that it is too early to expect easier liquidity conditions to significantly improve domestic economic conditions. Feature Tables 1 and 2 on pages 2 and 3 highlight key developments in China’s economy and its financial markets over the past month. On the growth front, the primary trend for China’s old economy remains down, although measures of freight remain supported by trade front-running activity (which will wane over the coming months). Our Li Keqiang leading indicator continues to suggest that economic activity will slow from current levels, a conclusion that is reinforced by recent developments in the housing market and December’s PMI release. Table 1The Trend In Domestic Demand, And The Outlook For Trade, Remains Negative   Table 2Financial Market Performance Summary From an investment strategy perspective, we remain tactically overweight Chinese investable stocks versus the global benchmark in recognition of the fact that investors may bid up Chinese stocks on positive signs that a trade deal may be in sight. However, China’s recent outperformance has been passive in nature (i.e. reflecting declining global stocks), suggesting that Chinese stocks have simply been the winner of an “ugly contest” over the past few months. This is hardly a basis to be cyclically long, and we continue to recommend that investors remain neutral for now. In reference to Tables 1 and 2, we provide several detailed observations concerning developments in China’s macro and financial market data below: Bloomberg’s measure of the Li Keqiang index (LKI) fell in November for the third month in a row, although our Alternative LKI has risen due to a pickup in freight transport turnover. We showed in our December 5 Weekly Report that trade front-running has clearly boosted economic activity since Q1 of 2018,1 implying that freight volume growth is set to decelerate in the months ahead. Our Li Keqiang leading indicator ticked lower in December, after having risen non-trivially in the third quarter of 2018 (Chart 1). The December decline was caused by a pullback in the monetary conditions components of the indicator, which in turn was caused by the recent rise in CNY-USD. This echoes a point that we have made in previous reports, that the improvement in our leading indicator last year was not broad-based and that it does not yet herald a positive turning point for China’s old economy. Chart 1The Q3 Rise In Our Leading Indicator Was Not Broad-Based The October housing market slowdown that we highlighted in our November 21 Weekly Report continued into December,2 with floor space started and sold decelerating further (Chart 2). The latter, which typically leads the former, has returned to negative territory which, in conjunction with weaker Pledged Supplementary Lending from the PBOC, does not bode well for housing over the coming few months. House price appreciation remains strong outside of tier 1 cities, but a peak in our price diffusion indexes signals slower price gains are likely over the coming months. Chart 2China's Housing Market Activity Continues To Weaken On the trade front, nominal Chinese US$ import and export growth is now trending lower, confirming the negative signal provided by China’s manufacturing PMIs over the past few months. Notably, the new export orders components of both the official and Caixin PMIs declined in December, despite the tariff ceasefire that emerged during the G20 meeting at the end of November, suggesting that export growth is set to slow further in the first quarter of 2019. In relative US$ terms, Chinese investable stocks rose nearly 10% versus the global benchmark from mid-October until the end of 2018. However, as Chart 3 shows, this outperformance was entirely passive in nature, as Chinese stocks have not been trending higher in absolute terms. Chart 3Recent Equity Outperformance Has Been Passive, Not Active We remain tactically overweight Chinese investable stocks; the Chinese market remains deeply oversold in absolute terms, and signs of a potential trade deal over the coming few weeks may significantly improve global investor sentiment towards the country’s bourse. However, we would caution investors against interpreting the recent relative outperformance as a basis to become cyclically bullish, as it has largely reflected a “catchup” selloff in global stocks. The underperformance of Chinese health care stocks over the past two months has been stunning, with investable health care having fallen nearly 30% in relative terms since mid-November (Chart 4). However, this decline appears to have been caused by a sector-specific event (a massive profit margin squeeze due to a new government generic drug procurement program), and does not seem to imply anything about the outlook for Chinese consumers. Chart 4A Stunning, Idiosyncratic, Collapse In Health Care Stocks Despite the recent collapse in the health care sector, Chinese consumer discretionary (CD) stocks remain the largest losers within the investable universe, having declined over 40% in US$ terms over the past 12 months. The next twelve months may look quite different for CD, especially if China’s efforts to stimulate consumer spending succeed. The recent changes to the global industrial classification system (GICS) mean that Alibaba (China’s largest e-commerce retailer) is now included in the sector with a significant weight, overwhelming the heavy influence that auto producers used to wield. Auto stocks have struggled in the past due to China’s pollution controls, weak auto sales, and pledges to open up the auto sector (which would be negative for the market share of domestic firms). We will be watching over the coming several months for a pickup in retail goods spending combined with a technical breakout in relative performance as a sign to overweight Chinese consumer discretionary stocks relative to the investable index. Chinese interbank rates have fallen substantially over the past month (Chart 5), in response to additional efforts by the PBOC to boost liquidity in the financial system. Whether the additional liquidity (and lower borrowing rates) will feed into materially stronger credit growth remains to be seen, as we have presented evidence in past reports showing that China’s monetary policy transmission mechanism is impaired.2 Chart 5More Liquidity Has Lowered Interbank Rates Chinese onshore corporate bond spreads have creeped modestly higher since early-November, although by a small magnitude. While we remain optimistic that onshore defaults over the coming year will be less intense than many investors believe, onshore corporate bond spreads have been one of the more successful leading indicators of economic growth in China over the past two years, and remain wide by historical standards. This suggests that it is too early to expect easier liquidity conditions to significantly improve domestic economic conditions. While it is too early to call a durable bottom, the gap between CNY-USD and its 200-day moving average is steadily closing (Chart 6). The recent (modest) uptrend has been caused by two factors: 1) cautious optimism about the possibility of a durable trade deal with the U.S., and 2) retreating U.S. interest rate expectations. We would expect further weakness if the trade ceasefire collapses and President Trump moves forward with the previously-announced tariffs, but also a sizeable rally if a deal is negotiated. Chart 6A Tentative, But Noteworthy Improvement   Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com Footnotes 1      Please see China Investment Strategy Weekly Report “2019 Key Views: Four Themes For China In The Coming Year”, dated December 5, 2018, available at cis.bcaresearch.com. 2      Please see China Investment Strategy Weekly Report “Trade Is Not China's Only Problem”, dated November 21, 2018, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Special Report

Highlights The often-quoted 60% urbanization rate understates the extent of China’s industrialization. China is much more industrialized than generally perceived: the country’s industrialization rate is currently 82.5% – i.e., over 80% of jobs in China are already in non-agricultural sectors. This entails a slower rate of industrialization and urbanization going forward. Both rural-to-urban labor migration and expansion of existing cities will slow significantly over the next decade. Transforming rural areas into urban without migration will become the major form of urbanization over the next decade. Investment themes: Demand for urban property will slow considerably, while agricultural machinery sales may have sustainable growth ahead. Feature The scale of urbanization in China over the past two decades has been unprecedented in human history. China’s urban population has increased by 460 million from 1995 to 2017, outnumbering the total population of the U.S. and Japan combined. The extraordinary urbanization process, fundamentally driven by the country’s rapid and widespread industrialization process, had led to a massive migration of laborers from rural to urban areas, and in turn significant expansion of cities and a huge boom in the Chinese real estate market. Where is China now in terms of its industrialization and urbanization path? Will further urbanization be able to continue to support very high productivity growth as well as demand for its already bubbly property market? This report takes a closer look at the country’s progress of industrialization and urbanization. Industrialization Versus Urbanization Urbanization commonly refers to the increase in the proportion of people living in urban areas. For China, the National Bureau of Statistics (NBS) has two sets of data measuring the country’s urbanization rate – one uses the number of people who have resided in an urban area1 for at least six months within the period of one year, and the other uses the number of people who have only registered non-agricultural hukou.2 However, neither measure reflects the country’s industrialization level. Industrialization is defined as the transformation of an agrarian economy into an industrial one. One way to measure it is the share of employment in non-agricultural3 sectors of total employment. Based on this measure, China’s industrialization process is already reasonably advanced. Chart 1 shows that while only about 60% of the population lives in an urban area, as defined by the NBS (this is the often-cited measure by economists and strategists), World Bank data show that China’s industrialization rate is currently 82.5% – i.e., over 80% of jobs in China are already in non-agricultural sectors. This underscores that China’s development path is more advanced than is generally perceived by investors. Chart 1China: More Industrialized Than Perceived China’s urbanization rate cannot capture the fact that there are many non-agricultural jobs held by people living and working in areas administratively classified as rural. Therefore, the 60% urbanization rate understates the extent of China’s industrialization, and overestimates potential upside in future growth. The nation is already reasonably advanced in terms of moving labor from agriculture to non-agriculture industries. This conclusion is reinforced by comparing China with developed economies (the U.S., Japan and South Korea) based on standard urbanization rates and based on our measure of industrialization: The latter points to a much smaller gap between China and advanced countries than the former (Charts 2 and 3). Chart 2China Vs. Advanced Economies: A Much Smaller Gap In Industrialization Measure... Chart 3…Than In Standard Urbanization Measure China’s industrialization rate at 82.5% is similar to South Korea in the early-1990s (Chart 4, top panel). If in next 10 years China’s industrialization progresses in line with the South Korean experience during 1991-2001, this will mean China’s industrialization pace – defined as an annual increase in the industrialization rate – will slow materially to 0.6 percentage points per year over the next decade, from 1.4 percentage points per year over the past decade (Chart 4, bottom panel). Chart 5 demonstrates the close correlation between the pace of industrialization and real per capita GDP growth in both China and South Korea. What is clear from the chart is that as the pace of industrialization decelerates, per capita real income growth will slow further.   Chart 4Korean's Roadmap: Falling China's Industrialization Pace Ahead Chart 5Industrialization Pace Vs. Real Per Capita GDP Growth: Closely Correlated Indeed, industrialization has allowed massive rural-to-urban labor migration as well as enormous expansion of existing cities. Due to the high base, the pace of industrialization has already been slowing, and will continue to do so. Consequently, China’s industrialization-driven urbanization will also continue to lose steam, with ramifications for the economy and its various sectors. We discuss below each of the specific factors that are likely to contribute to China’s future urbanization path, and then conclude the report with the attendant implications for Chinese real estate and agricultural machinery sales. Falling Rural-To-Urban Migration Industrialization generally leads to urbanization by establishing manufacturing factories and generating job opportunities, which in turn induces the movement of agriculture labor to cities. Hence, rural-to-urban migration, triggered by industrialization, is typically the main driver of rising urbanization. Currently, rural-to-urban migration is falling, which is a negative signal for the pace of future urbanization. In China, the rural-to-urban migration process is indeed slowing – i.e., the number of new migrant workers moving from rural areas to cities has already decreased nearly by half, from an average of 9.3 million per year over 2009-2012 to 4.8 million per year over 2013-2017. If we exclude migrant workers aged 50 and above, the number of migrant workers (a stock variable) actually contracted last year (Chart 6). Chart 6The Number Of Young Migrant Workers: Actually Contracted In 2017 Several points suggest that the rural-to-urban migration process will likely progress at an even slower pace going forward: Declining industrial employment: Employment in industrial sectors has contracted across the board, implying less demand for migrant workers (Chart 7). Employment has contracted in all 30 industrial subsectors that the NBS monitors, and 29 of them currently have fewer employees than five years ago. Higher automation in factories, the government’s de-capacity reforms in some industries with excessive capacity (i.e., coal, steel, aluminum, cement and so on), and some labor-intensive industries (i.e. textiles) shifting to other low-labor-cost countries (i.e. Vietnam, Pakistan, Bangladesh, etc.) are all factors that have contributed to the reduction in industrial employment. Chart 7Declining Industrial Employment Aging migrant workers: The average age of migrant workers has already risen from 34 in 2008 to 39.7 last year, with 21.3% of total migrant workers now aged 50 and above. As they continue to age over the next five to 10 years, our sense is that a considerable proportion of these older migrant workers will likely move back out of urban areas because of the existence of a family support network in their villages/rural townships. Shrinking youth population in rural areas: China’s rural population has declined by 33% from its peak of about 860 million in 1995 to 577 million in 2017 (Chart 8, top panel). All else equal, the lower rural population base alone will result in smaller rural-to-city migration compared to the previous two decades. More importantly, as substantial numbers of the working-age population left their rural homes for cities, the proportion of elders in the rural population has significantly increased, while the proportion of young people has drastically decreased. The current 19-and-under cohort will be the major source of future rural-to-urban migration over next five to 10 years. Based on the NBS data, in rural areas the share of the population aged 50 and over rose to 33% in 2017, much higher than the 25% of the population aged 19 and younger. This contrasts with 18% and 36%, respectively, back in 1997. The increasing proportion of elders and the declining proportion of the young population segment in rural areas implies smaller rural-to-city migration scale going forward. Chart 8Rural-To-Urban Migration Will Continue To Decline Changing preferences of the rural population: In recent years, the agricultural hukou has become much more valuable than in the past. In China, the government always assigns a piece of land for farming to a person with an agricultural hukou when he or she is born. This does not apply to a person with a non-agricultural hukou. As the central government’s policy focuses more on rural development, more non-farming job opportunities will likely be created in the rural areas. Services that in the past could only be enjoyed in urban areas are now spreading into rural areas as well, suggesting farmers who have either kids or elder parents to take care of will be more willing to stay in rural areas. If we use the annual change in the rural population as an indicator to predict the scale of rural-to-urban migration, the migration started in 1996 and peaked in 2010, and will decline going forward (Chart 8, bottom panel). Bottom Line: The scale of rural-to-urban migration will likely continue to diminish in the next five to 10 years. Slower City Area Expansion China’s industrialization-driven urbanization is not only driven by rural-to-urban labor migration, but also by the process of expanding and developing existing urban areas. In Western parlance, this factor would be described as the intense development of the territories surrounding the core of a “metropolitan area.” By establishing manufacturing factories, developing public facilities (roads, highways, subways, schools, hospitals, recreation centers, etc.), and constructing residential/commercial buildings to accommodate massive influxes of migrant workers in the rural areas surrounding cities, these territories have quickly expanded and have been transformed into urban areas4 over the past two decades. Statistics show that the “city area” in China has expanded 150% since 2000, almost twice the 77% rate of growth in the urban population during the same period (Chart 9, top panel). Chart 9Overdevelopment Of City Area Expansion In these now formerly rural areas, local governments often bought land from local farmers and then either sold the land to real estate developers to construct new residential properties or commercial buildings or used the land to develop public facilities. As a result, living conditions and economic development in these rural areas have become “urban-like.” Looking forward, over the next five to 10 years, we believe city area expansion will slow considerably (Chart 9, bottom panel). First, local governments have already taken on massive debt to fund city area expansion over the past two decades, as part of an attempt to demonstrate the success of their economic development plans to the central government (which is usually measured by GDP). However, circumstances have changed. China’s central government now expects local governments to generate “high-quality” and environmentally-sustainable economic growth – and they are unlikely to measure the performance of local government officials simply based on GDP. In addition, containing debt/leverage (including that of SOEs and local governments) is a priority for the central government, implying that debt-fueled city area expansion is unlikely to continue. Moreover, Beijing has already shifted its policy focus from city-area expansion to rural-in-situ urbanization (discussed below). Bottom Line: Past overdevelopment and constraints on local governments suggest that city-area expansion in China will slow considerably in the next five to 10 years, constraining the country’s urbanization pace. Rising Rural-In-Situ Urbanization Going forward, the major driver of urbanization in China will be greatly different from the previous 30 years. Over the next five to 10 years, China’s urban population growth will be driven more by the rural-in-situ urbanization (urbanization without people migration) by transforming rural areas into urban. This is in contrast to urbanization through rural-to-urban labor migration and city-area expansion. The rural-in-situ urbanization – transforming townships/villages directly into towns – has become a policy focus of the central government. The Chinese central government released its first national urbanization plan in March 2014 and announced the “Rural Revitalization Strategic Plan 2018-2022” in September. Both strategic blueprints emphasize the goal of “rural-in-situ urbanization” over the next five to 10 years, to be achieved by building up villages directly into towns. There are currently about 7,000 specialty towns planned or under construction, and it seems more are on the way. However, given already high local government debt and lack of funds for a sizeable proportion of Chinese local governments, we believe a considerable portion of the development of these specialty towns will miss their initial expectations. We expect the rural-in-situ urbanization to be the major force of further urbanization in China (Chart 10). As noted above, the shifting demographic structure of China’s rural areas and the changing preferences of the rural population will also facilitate the rural-in-situ urbanization. Meanwhile, with the government’s policy support, disposable income per capita in rural areas will likely continue to grow faster than in urban areas, which may also help induce rural farmers to remain in rural areas (Chart 11). Chart 10Rising Rural-In-Situ Urbanization Chart 11Rural Vs. Urban: Higher Disposable Income Per Capita Growth Bottom Line: Over the next decade, China’s urbanization will be driven more by the rural-in-situ urbanization (without people migration) by transforming rural areas into urban. Rising “Organic” Urban Population Growth As a final point, “organic” urban population growth (births minus deaths) will likely account for a larger share of China’s rising urban population in the future. A larger urban population base, improving birth rate due to the end of the one-child policy and longer life expectancy (76.3 in 2016 vs. 74 in 2005) will result in a rising urban population going forward (Chart 12). Chart 12Rising "Organic" Urban Population Growth However, unaffordable housing and rising household debt levels (Chart 13) are generating pressure on new families, suggesting the demographic dividend of removing the one-child policy may be smaller than hoped. As a result, a rising urban-area population is unlikely to offset the slowing urbanization factors noted above. Chart 13Household Leverage: China And U.S. Structural Headwinds For Chinese Household Consumption Growth Growing Reluctance To Have More Kids Bottom Line: We believe China’s urban population growth will drift below 2.5%, the lowest in the past 30 years (Chart 14). Chart 14China's Urban Population Growth Will Drift Lower Investment Implications A declining pace of industrialization and changing forms of urbanization will have the following ramifications: Falling rural-to-urban labor migration points to diminishing property demand from migrant workers. This is structurally bearish for the Chinese residential real estate market, given that most residential construction has occurred in urban areas (Chart 15). Investors holding housing units in urban areas in expectations of rampant price appreciation due to continuous large-scale rural-to-urban migration will be disappointed in the long run. Chart 15Chinese Property Demand: Gloomy Outlook An emphasis on rural-in-situ urbanization suggests the government is aiming to improve the living conditions of rural households to enable them to live more similar to urban households. For income per capita in rural areas to rise faster, their productivity growth should grow more rapidly. To raise productivity in the agricultural sector, the government is aiming to implement farmland reforms as proposed by the “Rural Revitalization Strategic Plan 2018-2022.” The objective is to enable either the private sector or public sector to collate many small pieces of farmland into large ones. Large tracts of farmland will in turn allow for an improvement in productivity by applying modern agricultural techniques and machinery. Hence, we believe agricultural machinery sales may have sustainable growth ahead. The aging population and rising number of newborns suggest growth in healthcare, childcare and eldercare will outperform the real estate and raw materials sectors over the long run. Ellen JingYuan He, Associate Vice President Emerging Markets Strategy EllenJ@bcaresearch.com   Footnotes 1      The definition of urban area and rural area in China is based on the country’s administrative divisions defined by the government. In China, cities and towns are recognized as urban areas while townships and villages are considered to be rural areas. 2      The Hukou system is a governmental household registration process to define residence in mainland China. It determines a person’s access to housing, education, medical treatment, and social welfare in a city. 3      All sectors other than the agricultural sector (farming, fishery, forestry and animal husbandry). 4      There is no clear definition or standards for the transformation of rural areas to urban areas. In general, a rural area, where has become more developed in terms of economic development, more connected to the city or town in terms of transportation and public facility access, and the residents’ living condition is more like the urban residents, is more likely to be re-defined as urban area by the local government. CYCLICAL INVESTMENT STANCE

Special Report

Highlights Our Special Report on housing betrayed little concern, … : We noted the softness in housing, and its drag on U.S. growth, in our November 19 Special Report, but we concluded that it was not sending a more worrisome message about the U.S. economic outlook. ... which didn’t mesh with several of our clients’ assessments, … : Our conclusion was apparently out of step with a fair proportion of investors. The clients who contacted us are not convinced that the softness so far isn’t just the tip of the iceberg. … so we’ve been discussing it a lot, … : Some BCA strategists are also more uneasy about housing and what it may be saying about the fate of the expansion. The topic continues to be bandied about in our daily meetings, and it probably hasn’t been exhausted yet. … and we’re sharing the conversations with everyone now: Publicly airing our one-on-one discussions gives all clients a chance to listen in and also gives us a chance to expand upon our views. Though we stand by our original conclusion, engaging in dialogue has enhanced our understanding of the issues. Feature The stock market still feels a little shaky, but the S&P 500 bounced smartly off of 2,640 once again, the abbreviated day-after-Thanksgiving session aside. Our Global Investment Strategy colleagues’ MacroQuant model sees more near-term downside, but neither of our teams believes that the bull market is over. The economy is strong; monetary policy remains accommodative; and fiscal stimulus will continue to support growth in 2019, albeit to a lesser degree. We do not see the good times ending for risk assets or the expansion until the Fed intervenes to bring the curtain down. We will discuss our outlook for the coming year, and the way we expect the key cycles will evolve, next week. For now, we turn to the wave of client questions that followed our Special Report on housing two weeks ago. The general view seems to be that we are not taking the potential implications of disappointing housing data seriously enough. The highlights of our follow-up discussions appear below, but we continue to believe that the housing slowdown does not portend larger immediate problems. Q: What about the effect of the new $10,000 cap on the deductibility of state and local taxes in high-tax states? The $10,000 cap on state and local tax (SALT) deductions will hurt housing demand at the margin, as will lower limits on mortgage interest deductibility. People respond to incentives, and several households may choose to rent instead of buy now that homeownership subsidies have been dialed back. The 1986 Tax Reform Act provides a ready antecedent. The mortal wound it dealt real estate tax shelters set the stage for the commercial real estate downturn of the late ‘80s and early ‘90s, and it also contributed to the nearly decade-long stagnation in nominal home prices (Chart 1) that was quite nasty in inflation-adjusted terms (Chart 2). Chart 1The Last Tax-Code Revamp Squeezed Home Values...   Chart 2...Especially On An Inflation-Adjusted Basis The regional disparities in home sales do not suggest that the tax changes have been a primary driver of the softness. Households in states with high income-tax burdens are most likely to go from itemizing their deductions (the mechanism for claiming housing subsidies) to taking the standard deduction. If the SALT rule change were squeezing home sales, one would expect that the states with the highest income-tax rates would be experiencing the biggest declines. We tested that proposition by comparing population-weighted tax rates with the share of home sales in each region. Although the South has the lowest top marginal income tax rate by a mile (Table 1), it has lost nearly two percentage points, or 4%, of its national market share since this year’s peak in home sales (Table 2). The high-tax Northeast, on the other hand, picked up nearly one percentage point, or 9%, of market share. The onerously-taxed West has lost the same proportional share as the South, but its homes are also the least affordable – a family earning the median income barely qualifies for a standard mortgage to buy the median-priced house in that region (Chart 3, bottom panel). Table 1Regional Income Tax Rates   Table 2Regional Share Of National Home Sales   Chart 3Only The West Is A Stretch Bottom Line: Income tax changes reducing homeowner subsidies will surely dampen marginal demand for homes, but they have not yet had an observable effect on the regional data. Q: The decline in activity has been modest so far, but what if it’s the start of something bigger? How do you know it’s not 2006? Housing is an important part of the economy, and residential investment could become a problem if it weakens further. We did not mean to imply that investors can ignore what’s going on in the industry. Residential activity puts a lot of people to work, directly and indirectly, and drives big-ticket consumption of home improvements, appliances and home furnishings. Its status as a rate-sensitive pillar helps provide insight into the effect of monetary policy, a particular flash point right now. From the narrow perspective of whether or not housing is likely to tip the economy into a recession, however, the arithmetic is clear. According to the IMF’s latest projections, fiscal stimulus will add 40 basis points to real GDP in 2019. Merely offsetting the effect of next year’s fiscal thrust would require residential investment, which accounts for 3.3% of GDP, to contract by 12% on an annualized basis. Residential construction would have to grind to a halt to wipe out projected growth of 2.5%. Even following October’s new home sales dud, the housing market is nowhere near oversupplied (Chart 4). The supply/demand balance is night-and-day different from what it was ahead of the crisis. Back then, there was also a decade of excessive mortgage issuance that needed to be unwound. Housing remains an important component of the economy, but it has shrunk to the point that it is not in a position to overwhelm the preponderance of positive macro data. Chart 4Supply Is Tight Bottom Line: We are watching housing, as BCA always has, but the market’s aggregate undersupply gives us confidence that residential activity is not about to fall off of a cliff. Q: The value of the housing stock is so large that it wouldn’t take a bust to have major economic implications. Consumption would immediately be at risk, and the economy with it. It is true that homes account for a sizable portion of household net worth, but the widely-repeated notion that homes are the biggest asset on the aggregate household balance sheet is misleading. When considered in terms of homeowner equity (home value net of mortgage obligations), homes currently account for about 14% of aggregate household net worth. Pension entitlements and equity and mutual fund holdings each account for about a quarter of net worth, and cash and equity in non-corporate businesses each account for about an eighth (Chart 5). Homeowner equity’s share of household net worth has rebounded nicely from its crisis lows, but it is a full third below its 1980s and 2006 peaks. Chart 5Home Values Matter, But They're Far From The Whole Story The point is that a generalized decline in home prices might affect consumption less than investors fear. The wealth effect is real, but fluctuations in home values are not evident to homeowners in real time. While we estimate that consumption falls five cents for every dollar decline in home values, the two series do not always march in lockstep, as in the ‘90s and the initial post-crisis years, when consumption grew even as home prices shrank (Chart 6, bottom panel). With the market in a state of undersupply, we don’t see a reason to expect that home prices are at much risk. Chart 6Consumption And Home Price Appreciation Are Linked Bottom Line: Absent overbuilding, foolhardy lending, or a harmful structural change on the order of the imposition of the passive activity rules, there is no clear catalyst for severe home-price declines. The economy should be able to handle a modest home-price correction without too much ado. Q: Not so fast. The crisis demonstrated that there’s a direct link between housing and credit conditions. It doesn’t take a perma-bear to see how a decline in home prices could cause the banking system to seize up. Our BCA colleagues are quite familiar with our view that homes are the collateral for the U.S. banking system. That view is a broad generalization, but the crisis bore it out. Banks are vastly better capitalized than they were in 2007, however, and it is difficult to see a path to major declines in home prices. Busts follow booms because they’re a necessary cure for unsustainable excesses, but nothing extreme has occurred this time on either the supply or the price fronts. Although we are hardly card-carrying Austrians, we have a lot of sympathy for the view that ZIRP, NIRP and QE programs subjected financial markets to distortions. They abetted a search for yield that allowed questionable credits to attract capital and promoted a widespread relaxation of debt covenants. They additionally seem to have lit a fire under property values in jurisdictions where home prices have become detached from standard value metrics. In the main, however, those jurisdictions are not in the U.S. (Chart 7). Chart 7U.S. Housing Isn't The Problem In talking through the bank exposure issue with a client, we arrived at a simple rule: property markets that haven’t already received their comeuppance are the property markets that threaten wealth, confidence and banking systems. The U.S. got its comeuppance in the crisis: property values plunged, loans went bad en masse, banks and specialty lenders failed, the survivors were chastened, and new regulations were put in place to protect the bankers from themselves and the economy from banks. As the Fed continues on its slow march to remove monetary accommodation, it is entirely reasonable for a macro-minded investor to be on the lookout for wobbly property markets. S/he would be best served by studying the rest of the dollar bloc: Canada, Australia and New Zealand are all vulnerable; the United States is not. Q: The Kansas City market is bifurcated by price. Supply is constrained at lower price points, although the formerly red-hot move-up segment has slowed considerably since mortgage rates spiked. High-end homes are being discounted sharply, and the baby boomers’ 4,000-6,000-square-foot suburban behemoths, untouched since the ‘80s, cost as much as brand-new high-end construction once you factor in the work they’d need to make them appeal to today’s buyers. Meanwhile, the limited supply of homes for first-time buyers has multi-family apartments popping up on every block. A market based on location, location, location is inherently heterogeneous, but a lot of what is happening in Kansas City appears to be playing out nationally. The rapid rise in mortgage rates has dented demand across the board. We’ve been hearing rumblings about easy multi-family credit for a while, most memorably from a Texas client who told us in 2014 that a blueprint was all it took for an apartment developer to get a bank loan. There is no investment idea so good that it can’t be destroyed by too much capital, and it’s entirely possible that some developers, commercial real estate lenders, commercial mortgage-backed securities holders and apartment REITs could be vulnerable if entry-level supply surges. There is no sign right now that it will, however. According to the Harvard Joint Center for Housing Studies, “virtually all” of the nation’s metropolitan areas “had more homes for sale in the top third of the market by price than in the bottom third.” A limited supply of available land and rising construction costs push developers to migrate to higher price points. The trend toward more expensive homes has been in place across the entire 30-year history of the Harvard center’s annual survey: the share of smaller homes (1,800 square feet or less) has slid from 50 percent in 1988 to 36 percent in 2000 and 22 percent in 2017.1 The fate of the boomers’ homes touches on what may be the most compelling long-term issue: to whom will the baby boomers pass the baton? Will the millennials accumulate enough wealth to be able to take it? Will they want to, after living through the formative experience of the financial crisis? Will suburban and exurban homes go vacant as preferences shift to the density and walkability of town and city centers? Are wide swaths of the existing housing stock destined for obsolescence? We are not inclined to think so. Even if homeownership is suppressed by a lessened desire to own, or delays in starting a career in the wake of the crisis, millennials and their families will still need a roof over their heads. We expect that purchase and rental prices will correct for changes in location and decorating preferences; homebuyers will put up with dark cabinets, loud tile patterns and wall-to-wall shag carpeting if the price is right. Lower prices might be what’s needed to help solve a potentially thorny problem raised by a client in the antipodes: the transfer of wealth across generations. He sees barriers to homeownership for the middle class as a social and political powder keg. A transfer of wealth from older generations to younger generations, accomplished by property markdowns instead of punitive income and property taxes, could be far less disruptive for markets and may even help to ease inequality strains. Furthermore, buyers who get a deal on a property have more money available for other consumption, while those who pay up retain less dry powder to help keep the economy humming. Investment Implications Investors are well served to be alert for excesses that cannot be sustained, and it is a near certainty that a 10-year expansion nourished on extreme monetary accommodation would have bred more than a few. From our perspective, however, all of the worst ones exist beyond the borders of the United States. Virtually all of the post-crisis increase in private-sector leverage has been contained in the emerging markets. The wild residential party has been raging in the developed world’s other former British colonies: Canada, Australia and New Zealand face inevitably sharp declines in construction activity and home prices. We are neither congenital Pollyannas nor market cheerleaders. We are bent on sniffing out market and economic inflection points as adroitly as possible, but we’re convinced that investors who are looking for them in U.S. housing are barking up the wrong tree. The Fed is moving steadily toward inducing an inflection point, but it is not yet upon us, and when it arrives, the attendant distress is not going to be centered on the United States, which already underwent its trial by fire ten years ago. We remain vigilant, but we are constructive on the U.S. economy and risk assets, especially in relation to the rest of the world.   Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com   Footnotes 1The State of the Nation’s Housing 2018, Joint Center for Housing Studies of Harvard University, p.6.