Bubbles/Crises/Manias

Highlights Our short EM equity index recommendation has reached our target and we are booking profits on this trade. The halt to economic activity will produce a global recession that will be worse than the one that took place in late 2008. We continue to recommend short positions in a basket of EM currencies versus the US dollar. In EM fixed-income markets, the duration of the ongoing selloff has been short, and large losses will trigger more outflows ensuring further carnage. Stay defensive for now. Russia is unlikely to make a deal with Saudi Arabia to restrain oil output for now. Feature The global economy is experiencing a sudden, jarring halt. The only comparison for such a sudden stop is the one that occurred in the fall of 2008, following Lehman’s bankruptcy. In our opinion, the global economic impact of the current sudden stop is shaping up to be worse than the one that occurred in 2008. That said, we are taking profits on our short position in EM equities. This position – recommended on January 30, 2020 – has produced a 30% gain.   EM share prices have reached the long-term support that acted as the ultimate floor during the bear markets in 1997-‘98, 2001-‘02, 2007-‘08 and 2015. Our decision to take profits reflects investment discipline. The MSCI EM stock index in US dollar terms has reached our target. In addition, this decision is consistent with two important indicators that we follow and respect: 1. EM stocks have become meaningfully cheap. Chart I-1 illustrates that our cyclically-adjusted P/E (CAPE) ratio for EM equities is about one standard deviation below its fair value – the same level when the EM equity market bottomed in 1998, 2008 and 2015. Chart I-1EM Equities Are Cheap According To The Cyclically-Adjusted P/E Ratio For this EM CAPE ratio to reach 1.5 standard deviations below its fair value – the level that is consistent with EM’s 2001-02 lows – EM share prices need to drop another 15%. 2. In term of the next technical support, EM share prices have reached the long-term support that acted as the ultimate floor during the bear markets in 1997-‘98, 2001-‘02, 2007-‘08 and 2015 (Chart I-2). Chart I-2EM Share Prices Are At Their Long-Term Support While share prices are likely to undershoot, it is risky to bet on a further decline amid current extremely elevated uncertainty and market volatility. The Global Downturn Will Be Worse Than In Late 2008 Odds are that the current global downturn is shaping up to be worse than the one that occurred in late 2008. From a global business cycle perspective, the current sudden halt is beginning from a weaker starting point. Global trade growth was positive back in August-September 2008 – just prior to the Lehman bankruptcy – despite the ongoing US recession (Chart I-3A). In comparison, global trade was shrinking in December 2019, before the COVID-19 outbreak (Chart I-3B). Chart I-3AGlobal Trade Growth Was Positive In September 2008… Chart I-3B…But Was Negative In December 2019   This is because growth in EM and Chinese economies was still very robust in the middle of 2008. Moreover, the economies of EM and China were structurally very healthy and were anchored by solid fundamentals. Still, the blow to confidence emanating from the crash in global financial markets and plunge in US domestic demand in the fall of 2008 produced major shockwaves in EM/Chinese financial markets. Provided the ongoing negative confidence shock and lingering uncertainty persist, odds are that the risk premium will initially overshoot before settling down. Consistently, risk markets will undershoot in the interim. This is in contrast with current cyclical growth conditions and structural economic health, both of which are very poor in EM/China going into this sudden stop.   In China, economic growth in January-February 2020 was much worse than at the trough of the Lehman crisis in the fourth quarter of 2008. Chart I-4 reveals that industrial production, auto sales and retail sales volumes all contracted in January-February 2020 from a year ago. The same variables held up much better in the fourth quarter of 2008 (Chart I-4). Business activity in China is recovering in March, but from very low levels. Reports and evidence from the ground suggest that many companies are operating well below their ordinary capacity – the level of economic activity remains well below March 2019 levels. US real GDP, consumer spending and capital expenditure shrunk by 4%, 2.5% and 17% at the trough of 2008 recession (Chart I-5). Odds are that these variables will plunge by an even greater magnitude in the coming months as the US reinforces lockdowns and public health safety measures. Chart I-4China Business Cycle Was Much Stronger In Q4 2008 Than Now Chart I-5US Growth At Trough Of 2008 Recession   Chart I-6US Small Caps: Overlay Of 2008 And 2020 About 50% of consumer spending in the US is attributed to people over 55 years of age. Provided COVID-19’s fatality rate is high among the elderly, odds are this cohort will not risk going out and spending. How bad will domestic demand in the US be? It is impossible to forecast with any certainty, but our sense is that it will plunge by more than it did in the late 2008-early-2009 period, i.e., by more than 4% (Chart I-5, bottom panel). Interestingly, the crash in US small-cap stocks resembles the one that occurred in the wake of the Lehman bankruptcy (Chart I-6). If US small-cap stocks follow their Q4 2008 - Q1 2009 trajectory, potential declines from current levels will be in the 10%-18% range. Bottom Line: The current halt in economic activity and impending global recession will be worse than the one that took place in late 2008. Reasons Not To Jump Into The Water…Yet Even though EM equities have become cheap and oversold and we are booking profits on our short position in EM stocks, conditions for a sustainable rally do not exist yet: So long as EM corporate US dollar bond yields are rising, EM share prices will remain under selling pressure (Chart I-7). Corporate bond yields are shown inverted in this chart. Chart I-7EM Stocks Fall When EM Corporate Bond Yields Rise Chart I-8Chinese And Emerging Asian Corporate Bond Yields Are Spiking The selloff in both global and EM credit markets began only a few weeks ago from very overbought levels. Many investors have probably not yet trimmed their positions. Hence, EM sovereign and corporate credit spreads and yields will likely rise further as liquidation in the global and EM credit markets persists. Consistently, bond yields for Chinese offshore corporates as well as emerging Asian high-yield and investment-grade corporates are rising (Chart I-8). EM local currency bond yields have also spiked recently as rapidly depreciating EM currencies have triggered an exodus of foreign investors. Rising local currency bond yields are not conducive for EM share prices (Chart I-9). Chart I-9EM Equities Drop When EM Local Bond Yields Rise EM ex-China currencies correlate with commodities prices (Chart I-10). Both industrial commodities and oil prices have broken down and have further downside. The path of least resistance for oil prices is down, given anemic global demand and our expectation that Russia and Saudi Arabia will not reach any oil production cutting agreement for several months (please refer to our discussion on this topic below). Finally, our Risk-On/Safe-Haven currency ratio1 is in free fall and will likely reach its 2015 lows before troughing (Chart I-11). This ratio tightly correlates with EM share prices, and the latter remains vulnerable to further downside as long as this ratio is falling. Chart I-10EM Currencies Move In Tandem With Commodities Prices Chart I-11More Downside In Risk-On/ Safe-Haven Currency Ratio   Bottom Line: Although we are taking profits on the short EM equity position, we continue to recommend short positions in a basket of EM currencies – BRL, CLP, ZAR, IDR, PHP and KRW – versus the US dollar. Liquidation in EM fixed-income markets has been sharp, but the duration has been short –only a few weeks. Large losses will trigger more outflows from EM fixed-income markets. Stay defensive for now. What We Do Know And What We Cannot Know Amid such extreme uncertainty, it is critical for investors to distinguish between what we know and what we cannot know. What we cannot know: With regards to COVID-19: The speed of its spread, the ultimate number of victims it claims and – finally – its impact on consumer and business confidence and psyche. Related to lockdowns: Their duration in key economies. These questions will largely determine this year’s economic growth trajectory: Will it be V-, U-, W-, or L-shaped? Unfortunately, no one knows the answers to the above questions to have any certainty in projecting this year’s global growth. The key factor that gives Russia an advantage over Saudi Arabia in terms of its ability to deal with a negative terms-of-trade shock is not only its better fiscal position but also its ability to depreciate its currency. What we do know: Authorities in all countries will stimulate aggressively so long as financial markets are rioting. Nonetheless, these stimulus measures will not boost growth immediately. With entire countries locked down and plunging consumer and business confidence, stimulus will not have much impact on growth in the near term. In brief, all policy stimulus will boost growth only when worries about the pandemic subside and the economy begins to function again. Both are not imminent. Hence, we are looking at an air pocket with respect to near-term global economic growth. As we argued in our March 11 report titled, Unraveling Of The Policy Put, the pre-coronavirus financial market paradigm – where stocks and credit markets were priced to perfection because of the notion that policymakers would not allow asset prices to drop – has unravelled.   In recent weeks, policymakers around the world have announced plans to deploy massive amounts of stimulus, yet the reaction of financial markets has been underwhelming. The reason is two-fold: Both demand shrinkage and production shutdowns have just started, and they will run their due course regardless of announced policy stimulus measures. Equity and credit markets were priced for perfection before this selloff, and investors are in the process of recalibrating risk premiums. Provided the ongoing negative confidence shock and lingering uncertainty persist, odds are that the risk premium will initially overshoot before settling down. Consistently, risk markets will undershoot in the interim. Bottom Line: DM’s domestic demand downturn is still in its initial phase, and there is little foresight in terms of the pandemic’s evolution. These are natural forces, and any stimulus policymakers enact are unlikely to preclude them from occurring. Reflecting the economic contraction and heightened uncertainty, the selloff in risk assets will likely continue for now. Do Not Bet On An Early Resuscitation Of OPEC 2.0 As we argued in our March 11 report, Russia is unlikely to make a deal with Saudi Arabia to restrain oil output in the immediate term. Russia may agree to restart negotiations, but it will not agree to reverse its position for some time. Both nations will be increasing crude output (Chart I-12). As a result, a full-fledged oil market share war is underway. Consistently, crude prices have experienced a structural breakdown (Chart I-13).  Chart I-12The Largest Oil Producers Are Ramping Up Output Chart I-13Structural Breakdown In Oil Prices   The key factor that gives Russia an advantage over Saudi Arabia in terms of its ability to deal with a negative terms-of-trade shock is not only its better fiscal position but also its ability to depreciate its currency. Russia has a flexible exchange rate, which will allow the currency to depreciate in order to soften the blow from lower oil prices on the real economy and fiscal accounts. The Russian economy and financial system have learned to operate with recurring major currency depreciations. Saudi Arabia has been running a fixed exchange rate regime since 1986 and cannot use currency depreciation to mitigate the negative terms-of-trade shock on its end. Even though Russia’s fiscal budget break-even oil price is much lower than that of Saudi Arabia’s, it is not the most important variable to consider in this confrontation. The fiscal situation in both Russia and Saudi Arabia will not be a major problem for now. Both governments can issue local currency and US dollar bonds, and there will be sufficient demand for these bonds from foreign and local investors. This is especially true with DM interest rates sitting at the zero-negative territory. Falling oil prices and downward pressure on exchange rates will trigger capital outflows in both countries. Russia has learned to live with persistent capital flight. In the meantime, capital outflows will stress Saudi Arabia’s financial system and, eventually, its real economy. This is in fact the country’s key vulnerability. We will be publishing a Special Report on Saudi Arabia in the coming weeks.  Bottom Line: Do not expect a quick recovery in oil prices. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1     Average of CAD, AUD, NZD, BRL, RUB, CLP, MXN & ZAR total return indices relative to average of CHF & JPY total returns.   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights Uncertainty & Yields: Global bond yields, driven to all-time lows as investors seek safety amid rioting markets, now discount a multi-year period of very weak global growth and inflation. Bond Portfolio Strategy: Maintain overall neutral portfolio duration exposure with so much bad news already priced into yields. Downgrade overall global spread product exposure to underweight versus governments on a tactical (0-3 months) basis given intense uncertainties on COVID-19 and oil markets. Model Bond Portfolio Changes – Governments: Upgrade countries that are more responsive to changes in the level of overall global bond yields and with room to cut interest rates (the US & Canada) to overweight, while downgrading sovereign debt with a lower “global yield beta” and less policy flexibility (Germany, France, Japan) to underweight. Model Bond Portfolio Changes – Credit: Downgrade US high-yield, euro area corporates and emerging market USD sovereigns & corporates to underweight. Feature Chart of the WeekOn The Verge Of Global ZIRP The title of this report is a quote from a worried BCA client this morning, discussing his daily commute into Manhattan from the New York suburbs. We can think of no better analogy for the mood of investors in the current market panic. After having enjoyed a decade of riding the gravy train of recession-free growth and robust returns on risk assets, all underwritten by accommodative monetary policies, worries about a deflationary bust following the boom have intensified. The global spread of COVID-19, the ebbs and flows of the US presidential election and, now, a stunning collapse in oil prices – markets have simply been unable to process the investment implications of these unpredictable events all at once. At times of such stress, the obvious thing to do is to stand aside and hedge portfolios while awaiting better visibility on the uncertainties. At times of such stress, the obvious thing to do is to stand aside and hedge portfolios while awaiting better visibility on the uncertainties. It is clear that global government bonds have been a preferred hedge, with yields collapsing to record lows worldwide. While most of the market attention has been on the breathtaking fall in US yields that has pushed the entire Treasury curve below 1% as the market has moved to discount a swift move to a 0% fed funds rate. New lows were also hit yesterday in countries that had been lagging the Treasury rally: the 10-year German bund reached -0.85% yesterday, while the 10-year UK Gilt fell to an intraday all-time low of 0.08% with some shorter-maturity Gilt yields actually dipping into negative territory (Chart of the Week). The common driver of yesterday’s yield declines was the 25% plunge in global oil prices after the weekend collapse of the OPEC 2.0 alliance between Russia and Saudi Arabia. The inflation expectations component of global bond yields fell accordingly, continuing the correlation with energy prices seen over the past decade. Yet the real component of global bond yields has also been falling, with markets increasingly pricing in an extended period of weak growth and negative real interest rates – especially in the US. Collapsing US Treasury Yields Discount A Recession, Not A Financial Crisis Chart 2Re-opening Old Wounds While this latest plunge in US equity markets has been both rapid and powerful, the damage only takes us back to levels on the S&P 500 last seen as recently as January 2019 (Chart 2). The turmoil, however, has reopened old wounds in markets that had suffered their own crises over the past decade, with European bank stocks hitting new all-time lows and credit spreads on US high-yield Energy bonds and Italian sovereign debt (versus Germany) sharply blowing out. The backdrop remains treacherous and global equity markets will likely remain under pressure until the number of new COVID-19 cases peaks outside of China (especially in the US). If there is one silver lining amidst the market carnage, it is that there appears to be few signs of 2008-style systemic financial stress. If there is one silver lining amidst the market carnage, it is that there appears to be few signs of 2008-style systemic financial stress. Bank funding indicators like Libor-OIS spreads and bank debt spreads have widened a bit over the past week but remain at very subdued levels (Chart 3). This is in sharp contrast to classic risk aversion indicators like the price of gold and the value of the Japanese yen versus the Australian dollar, which are closing in on the highs seen during the 2008 global financial crisis and 2012 European debt crisis. Chart 3A Growth Downturn, Not A Systemic Crisis We interpret this as investors being far more worried about a deep global recession than another major financial crisis. That is also confirmed in the pricing of US Treasury yields, especially when looking at the real yield. Chart 4Does The UST Market Think R* Is Negative? Chart 5Another Convexity-Fueled Bond Rally The entire TIPS yield curve is now negative for the first time, even with the real fed funds rate below the Fed’s estimate of the “r*” neutral real rate (Chart 4). The combination of low and falling inflation expectations, and plunging real yields, indicates that the Treasury market now believes that the neutral real funds rate is not 0.8%, as suggested by the Fed’s estimate of r*, but is somewhere well below 0%. With the fed funds rate now down to 0.75% after last week’s intermeeting 50bps cut, the Treasury market is not only pricing the Fed quickly returning to the zero lower bound on the funds rate, but staying trapped at zero for a very long time. The Treasury market is not only pricing the Fed quickly returning to the zero lower bound on the funds rate, but staying trapped at zero for a very long time. Yet that may be too literal an interpretation of the incredible collapse of US Treasury yields. The power of negative convexity is also at work, driving intense demand for long-duration bonds that puts additional downward pressure on yields. Large owners of US mortgage backed securities (MBS) like the big commercial banks have seen the duration of their MBS holdings collapse as yields have fallen. The result is that banks are forced to buy huge amounts of Treasuries (or receive US dollar interest rate swaps) to hedge their duration exposure of negative convexity MBS, hyper-charging the fall in Treasury yields – perhaps over $1 trillion worth of buying, by some estimates.1 This is a similar dynamic to what occurred last summer in Europe, when sharply falling bond yields triggered convexity-related demand for duration from large asset-liability managers like pension funds, further fueling the decline in bond yields (Chart 5). Yet even allowing that some of the Treasury yield decline has been driven by a mechanical demand for duration, a 10-year US Treasury yield of 0.56% clearly discounts expectations of a US recession, as well – which appears justified by the recent performance of some critical US economic data. In Charts 6 & 7, we show a “cycle-on-cycle” analysis of some key US financial and indicators and how they behave before and after the start of the past five US recessions. The charts are set up so the vertical line represents the start of the recession, and we line up the data for the current business cycle as if the latest data point represents the start of a recession. Done this way, we can see if the current data is evolving in a similar fashion to past US economic downturns. Chart 6The US Business Cycle Looks Toppy Chart 7COVID-19 Will Likely Trigger A Confidence-Driven US Recession The charts show that the current flat 10-year/3-month US Treasury curve and steady decline in corporate profit growth are both accurately following the path entering past US recessions. Other indicators like the NFIB Small Business confidence survey, the Conference Board’s leading economic indicator and consumer confidence series typically peak between 12-18 months prior to the start of a recession, but appear to be only be peaking now. The same argument goes for initial jobless claims, which are usually rising for several months heading into a recession but remain surprisingly steady of late – a condition that seems unlikely to continue as more companies suffer virus-related hits to their sales and profits and begin to shed labor. Net-net, these reliable cyclical US data suggest that the Treasury market is right to be pricing in elevated recession risk – especially with US cases of COVID-19 starting to increase more rapidly and US financial conditions having tightened sharply in the latest market rout. Bottom Line: Global bond yields, driven to all-time lows as investors seek safety amid rioting markets, now discount a multi-year period of very weak global growth and inflation – most notably in the US. Allocation Changes To Our Model Bond Portfolio The stunning fall in global bond yields has already gone a long way. Yet it is very difficult to forecast a bottom in yields, even with central banks easing monetary policy to try and boost confidence, before there is evidence that the global COVID-19 outbreak is being contained (i.e. a decreasing total number of confirmed cases). By the same token, corporate bonds (and equities) will continue to be under selling pressure until the worst of the viral outbreak has passed. We raised our recommended overall global duration stance to neutral last week – a move that was more tactical in nature as a near-term hedge to our strategic overweight corporate bond allocations in our Model Bond Portfolio amid growing market volatility. Yet with the new stresses coming from the collapse in oil prices and increasing spread of COVID-19 in the US and Europe, we are moving to a much more cautious near-term stance on global credit. Yet with the new stresses coming from the collapse in oil prices and increasing spread of COVID-19 in the US and Europe, we are moving to a much more cautious near-term stance on global credit. This week, we are making the following additional changes to our model bond portfolio to reflect the growing odds of a global recession: Downgrade global corporates to underweight versus global governments Maintain a neutral overall portfolio duration, but favor countries within the government bond allocation that are more highly correlated to changes in to the overall level of global bond yields. Chart 8Favor Higher-Beta Bond Markets With Room To Cut Rates Given how far yields have declined already, we think raising allocations to “high yield beta” countries that can still cut interest rates, at the expense of reduced weightings toward low beta countries that have limited scope to ease policy, offers a better risk/reward profile than simply raising duration exposure across the board. Such a nuanced argument is less applicable to global corporates, where elevated market volatility, poor investor risk appetite and deteriorating global growth momentum all argue for continued near-term underperformance of corporates versus government bonds. Specifically, we are making the following changes to our recommended allocations, presented with a brief rationale for each move: Upgrade US Treasuries and Canadian government bonds to overweight: Both Treasuries and Canadian bonds are higher beta markets, as we define by a regression of monthly yield changes to changes in the yield of the overall Bloomberg Barclays Global Treasury index (Chart 8). The Fed cut 50bps last week as an emergency measure and has 75bps to go before reaching the zero bound, which the market now expects by mid-year. Additional bond bullish moves after reaching the zero bound, like aggressive forward guidance, restarting quantitative easing and even anchoring Treasury yields in a BoJ-like form of yield curve control, are all possible if the US enters a recession. Meanwhile, the Bank of Canada (BoC) followed the Fed’s cut with a 50bp easing the next day and signaled that additional rate cuts are likely to prevent a plunge in Canadian consumer confidence. The collapsing oil price likely seals the deal for additional rate cuts by the BoC in the next few months. Downgrade Japanese government bonds to maximum underweight: Japanese government bonds (JGBs) are the most defensive low-beta market in model bond portfolio universe, thanks to the Bank of Japan’s Yield Curve Control policy that anchors the 10yr JGB yield around 0%. This makes JGBs the best candidate for a maximum underweight stance when global bond yields are not expected to rise in the near term, as we expect. Downgrade Germany and France to Underweight: The ECB meets this week and will be under pressure to ease policy given recent moves by other major central banks. A -10bps rate cut is expected, which may happen to counteract the recent increase in the euro versus the US dollar, but there is also possibility that ECB will increase and/or extend the size and scope of its current Asset Purchase Program. Given the ECB’s lack of overall monetary policy flexibility, and low level of inflation expectations, we see limited scope for the lower-beta German and French government bonds to outperform their global peers. Remain overweight UK and Australia: While both Australian government bonds and UK Gilts have a “median” yield beta in our model bond portfolio universe, both deserve moderate overweights as there is still the potential for rate cuts in both countries. The Reserve Bank of Australia (RBA) cut the Cash Rate by -25bps last week and they are still open to cut further to boost a sluggish economy hurt by wildfires and weak export demand from China. The RBA will stay more dovish for longer until we will see clear signs of a rebound of the Chinese economy from the COVID-19 outbreak. The Bank of England (BoE) will likely cut its policy rate later this month, or even before the next scheduled policy meeting, as COVID-19 is starting to spread through the UK. Downgrade US High-Yield To Underweight: US junk bonds had already taken a hit during the global market selloff in recent weeks, but the collapse in oil prices pummeled the market given the high weighting of US shale producers in the index (Chart 9). With additional weakness in oil prices likely as Russia and Saudi Arabia are now in a full-fledged price war, US high-yield will come under additional spread widening pressure focused on the weaker Caa-rated segment that contains most of the energy names. We recommend a zero weight in the Caa-rated US junk bonds, within an overall underweight allocation to the entire asset class. Downgrade euro area investment grade and high-yield corporates to underweight: COVID-19 is now spreading faster in Germany and France, after leaving Italy in a full-blown national crisis. The export-oriented economies of the euro area were already vulnerable to a global growth slowdown, but now domestic growth weakness raises the odds of a full-blown recession – not a good environment to own corporate bonds, especially with the euro now appreciating. Downgrade emerging market (EM) USD-denominated sovereigns and corporates to underweight: EM debt remains a levered play on global growth, so the increased odds of a global recession are a problem for the asset class – even with sharply lower interest rates and early signs of a softening in the US dollar (Chart 10). Chart 9Downgrade US Junk Bonds To Underweight Chart 10Still Not Much Broad-Based Weakness In The USD We will present the new specific model bond portfolio weightings, along with a discussion of the risk management implications of these changes, in next week’s report. Bottom Line: Maintain overall neutral portfolio duration exposure with so much bad news already priced into yields. Downgrade overall global spread product exposure to underweight versus governments on a tactical (0-3 months) basis given intense uncertainties on COVID-19 and oil markets. Upgrade high-beta countries with room to cut interest rates (the US & Canada) to overweight, while downgrading lower-beta countries with less policy flexibility (Germany, France, Japan) to underweight. Downgrade US high-yield, euro area corporates and emerging market USD sovereigns & corporates to underweight.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Ray Park, CFA Research Analyst ray@bcaresearch.com Footnotes 1https://www.wsj.com/articles/fear-isnt-the-only-driver-of-the-treasury-rally-banks-need-to-hedge-their-mortgages-1158347080 Recommendations Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Special Report

In lieu of the next weekly report I will be presenting the quarterly webcast ‘What Are The Most Attractive Investments In Europe?’ on Monday 17 February at 10.00AM EST, 3.00PM GMT, 4.00PM CET, 11.00PM HKT. As usual, the webcast will take a TED talk format lasting 18 minutes, after which I will take live questions. Be sure to tune in. Dhaval Joshi Feature The recent coronavirus scare seems to have added a fresh deflationary impulse into the world economy, at a time that central banks are already struggling to achieve and maintain inflation at the 2 percent target. Begging the question: will central banks’ ubiquitous ultra-loose monetary policy ever generate inflation? The answer is yes, but not necessarily where the central banks desire it. Universal QE, zero interest rate policy (ZIRP), and negative interest rate policy (NIRP) have already created rampant inflation. The trouble is that it is in the wrong place. Rather than showing up in consumer price indexes it is showing up in sky-rocketing asset prices. Feature Chart Ultra-Low Bond Yields Have Created The Greatest Asset-Price Inflation Of All Time Feature ChartUltra-Low Bond Yields Have Created The Greatest Asset-Price Inflation Of All Time The Greatest Asset-Price Inflation Of All Time Since 2014, ultra-loose monetary policy has boosted the valuation of equities by 50 percent. But that’s the small fry. The really big story is that ultra-loose monetary policy has boosted the value of the world’s real estate from $180 trillion to $300 trillion (Chart I-2).1 Chart I-2Ultra-Low Bond Yields Have Boosted The Value Of The World’s Real Estate By $120 Trillion Just pause for a moment to digest those numbers. In the space of a few years the value of the world’s real estate has surged by $120 trillion, equivalent to one and half times the world’s $80 trillion GDP. Moreover, it is a broad-based boom encompassing not just Europe, but North America and Asia too. Now add in the surge in equity prices, as well as other risk-assets such as private equity, corporate bonds and EM debt and the rise in wealth conservatively equals at least two times world GDP. To the best of our knowledge, there is no other time in economic history that asset prices have risen so broadly and by so much as a multiple of world GDP in such a short space of time. Making this the greatest asset-price inflation of all time. Yet central banks seem unmoved. To add insult to injury, Europe’s central banks do not even include surging owner-occupied housing costs in their consumer price indexes. This seems absurd given that the costs of maintaining owner-occupied housing is one of the largest costs that European households face. Europe’s central banks do not include surging owner-occupied housing costs in their consumer price indexes. Including owner-occupied housing costs would lift European inflation closer to 2 percent, eliminating the need for QE and negative interest rates. But its omission has kept measured inflation artificially low (Chart I-3), forcing European central banks to double down on their ultra-loose policies. Which in turn lifts risk-asset prices even further, and so the cycle of asset-price inflation continues. Chart I-3Using The US Definition Of Inflation, The ECB Wouldn't Need Ultra-Loose Policy European QE has spawned other major imbalances. Germany, as the largest shareholder of the ECB, now owns hundreds of billions of ‘Italian euro’ BTPs that the ECB has bought. But given the fragility of Italian banks, the Italians who sold their BTPs to the ECB deposited the cash they received in German banks. Hence, Italy now owns hundreds of billions of ‘German euro’ bank deposits. This mismatch between Germans owning Italian euro assets and Italians owning German euro assets combined with other mismatches across the euro area constitutes the Target2 banking imbalance, which now stands at a record €1.5 trillion. It means that, were the euro to ever break up, the biggest casualty would be Germany (Chart I-4). Chart I-4ECB QE Has Taken The Target2 Banking Imbalance To An All-Time High Meanwhile, the US Federal Reserve, to its credit, does include surging owner-occupied housing costs in its measure of consumer prices. As a result, US inflation has been closer to the 2 percent target enabling the Fed to tighten policy when the ECB had to loosen policy. This huge divergence between euro area and US monetary policies, stemming from different treatments of owner-occupied housing costs, has depressed the euro/dollar exchange rate and thereby spawned yet another major imbalance: the euro area/US bilateral trade surplus which now stands at an all-time high. Providing President Trump with the perfect pretext to start a trade war with Europe, should he desire (Chart I-5).  Chart I-5ECB QE Has Taken The Euro Area/US Trade Surplus To An All-Time High What Caused The Greatest Asset-Price Inflation Of All Time? Why did the past decade witness the greatest asset-price inflation of all time? The answer is that universal QE, ZIRP, and NIRP took bond yields to the twilight zone of the lower bound (Chart I-6). At which point, the valuation of all risky assets undergoes an exponential surge. Chart I-6The Past Decade Was The Decade Of Universal QE Understand that when bond yields approach their lower bound, bonds become extremely risky assets because their prices take on an unattractive ‘lose-lose’ characteristic. As holders of Swiss government bonds discovered last year, prices can no longer rise much in a rally, but they can collapse in a sell-off (Chart I-7). Chart I-7At Low Bond Yields, Bonds Become Much Riskier The upshot is that all (long-duration) assets become equally risky, and the much higher prospective returns offered on formerly more risky assets – such as real estate and equities – collapses to the feeble return offered on now equally-risky bonds. Given that valuation is just the inverse of the prospective return, this means that the valuation of risk assets undergoes an exponential surge. When bond yields approach their lower bound, bonds become extremely risky assets because their prices take on an unattractive ‘lose-lose’ characteristic.  An obvious question is: which valuation measure best predicts this depressed prospective return offered on equities? Most people gravitate to price to earnings (profits), but earnings are highly problematic – because even if you cyclically adjust them, they take no account of structurally high profit margins. The trouble is that earnings will face a headwind when profit margins normalise, depressing prospective returns. For this reason, price to earnings missed the valuation extreme of the 2007/2008 credit bubble and should be treated with extreme caution as a predictor of prospective returns (Chart I-8). Chart I-8Price To Earnings Missed The 2007/2008 Valuation Extreme A much more credible assessment comes from price to sales – or equivalently, market cap to GDP at a global level (Chart I-9). This is because sales are quantifiable, unambiguous, and undistorted by profit margins. Using these more credible prospective returns, we can now show that the theory of what should happen to risk-asset returns (and valuations) at ultra-low bond yields and the practice of what has actually happened agree almost perfectly (Feature Chart). Chart I-9Price To Sales (Or Global Market Cap To GDP) Is The Best Predictor Of Prospective Return Some Investment Conclusions It is instinctive for investors to focus first and foremost on the outlook for the real economy. After all, the evolution of the $80 trillion global economy drives company sales and profits. But the value of the world’s real estate, at $300 trillion, dwarfs the economy. Public and private equity adds another $100 trillion, while other risk-assets such as corporate bonds and EM debt add at least another $50 trillion. So even on conservative assumptions, risk-assets are worth $450 trillion – an order of magnitude larger than the world economy. Now combine this with the overwhelming evidence that risk-asset valuations are exponentially sensitive to ultra-low bond yields. A relatively modest rise in yields that knocked 20 percent off risk-asset valuations would mean a $90 trillion loss in global wealth. Even a 10 percent decline would equate to a $45 trillion drawdown. Could the $80 trillion economy sail through such declines in wealth? No way. Such setbacks would constitute a severe deflationary headwind, and likely trigger the next recession. Hence, though equities are preferable to bonds at current levels, a 50-100 bps rise in yields – were it to happen – would be a great opportunity to add to bonds. Meanwhile, the record high Target2 euro area banking imbalance means that the biggest casualty of the euro’s disintegration would not be Italy. It would be Germany. As all parties have no interest in such a mutually assured destruction, investors should go long high-yielding versus low-yielding euro area sovereign bonds. Finally, the record high euro area/US trade surplus is a political constraint to a much weaker euro versus the dollar. In any case, the ECB is close to the practical limit of monetary policy easing, while the Fed is not. Long-term bond investors should prefer US T-bonds versus German bunds or Swiss bonds. Long-term currency investors should prefer the euro versus the dollar. Fractal Trading System*  This week’s recommended trade is long EUR/CHF. As this currency cross has relatively low volatility, the profit target and symmetrical stop-loss is set at a modest 1 percent. In other trades, short NZD/JPY achieved its profit target, while long US oil and gas versus telecom reached the end of its 65-day holding period in partial loss having reached neither its profit target nor its stop-loss. The rolling 1-year win ratio now stands at 61 percent. Chart I-10EUR/CHF When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 Source: Savills World Research. The last data point is $281 trillion at the end of 2017, but we conservatively estimate that the value has increased to above $300 trillion in the subsequent two years. Fractal Trading System Cyclical Recommendations Structural Recommendations Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Special Report

Our top five geopolitical “Black Swans” are risks that the market is seriously underpricing. With the “phase one” trade deal signed, Chinese policy could become less accommodative, resulting in a negative economic surprise. The trade deal may fall victim to domestic politics, raising the risk of a US-China military skirmish. A Biden victory at the Democratic National Convention or a Democratic takeover of the White House could trigger social unrest and violence in the US. A pickup in the flow of migrants to Europe would fundamentally undermine political stability there. Russia’s weak economy will add fuel to domestic unrest, risking an escalation beyond the point of containment. Over the past four years, BCA’s Geopolitical Strategy service has started off each year with their top five geopolitical “Black Swans.” These are low-probability events whose market impact would be significant enough to matter for global investors. Unlike the great Byron Wien’s perennial list of market surprises, we do not assign these events a “better than 50% likelihood of happening.” We offer risks that the market is seriously underpricing by assigning them only single-digit probabilities when we think the reality is closer to 10%-15%, a level at which a risk premium ought to be assigned. Some of our risks below are so obscure that it is not clear how exactly to price them. We exclude issues that are fairly probable, such as flare-ups in Indo-Pakistani conflict. The two major risks of the year – discussed in our Geopolitical Strategy’s annual outlook – are that either US President Donald Trump or Chinese President Xi Jinping overreaches in a major way. But what would truly surprise the market would be a policy-induced relapse in Chinese growth or a direct military clash between the two great powers. That is how we begin. Other risks stem from domestic affairs in the US, Europe, and Russia. Black Swan 1: China’s Financial Crisis Begins Chart II-1A Crackdown On Financial Risk Could Cause China's Economy To Derail The risk of Xi Jinping’s concentration of power in his own person is that individuals can easily make mistakes, especially if unchecked by advisors or institutions. Lower officials will fear correcting or admonishing an all-powerful leader. Inconvenient information may not be relayed up the hierarchy. Such behavior was rampant in Chairman Mao Zedong’s time, leading to famine among other ills. Insofar as President Xi’s cult of personality successfully imitates Mao’s, it will be subject to similar errors. If President Xi overreaches and makes a policy mistake this year, it could occur in economic policy or other policies. We begin with economic policy, as we have charted the risks of Xi’s crackdown on the financial system since early 2017 (Chart II-1). This year is supposed to be the third and final year of Xi Jinping’s “three battles” against systemic risk, pollution, and poverty. The first battle actually focuses on financial risk, i.e. China’s money and credit bubble. The regime has compromised on this goal since mid-2018, allowing monetary easing to stabilize the economy amid the trade war. But with a “phase one” trade deal having been signed, there is an underrated risk that economic policy will return to its prior setting, i.e. become less accommodative (Chart II-2). When Xi launched the “deleveraging campaign” in 2017, we posited that the authorities would be willing to tolerate an annual GDP growth rate below 6%. This would not only cull excesses in the economy but also demonstrate that the administration means business when it says that China must prioritize quality rather than quantity of growth. While Chinese authorities are most likely targeting “around 6%” in 2020, it is entirely possible that the authorities will allow an undershoot in the 5.5%-5.9% range. They will argue that the GDP target for 2020 has already been met on a compound growth rate basis (Chart II-3), as astute clients have pointed out. They may see less need for stimulus than the market expects. Chart II-2Easing Of Trade Tensions May Re-Incentivize Tighter Policy Chart II-3Chinese Authorities Might Tolerate A Growth Undershoot In 2020   Similarly, while urban disposable income is ostensibly lagging its target of doubling 2010 levels by 2020, China’s 13th Five Year Plan, which concludes in 2020, conspicuously avoided treating urban and rural income targets separately. If the authorities focus only on general disposable income, then they are on track to meet their target (Chart II-4). This would reduce the impetus for greater economic support. The Xi administration may aim only for stability, not acceleration, in the economy. There are already tentative signs that Chinese authorities are “satisfied” with the amount of stimulus they have injected: some indicators of money and credit have already peaked (Chart II-5). The crackdown on shadow banking has eased, but informal lending is still contracting. The regime is still pushing reforms that shake up state-owned enterprises. Chart II-4Lower Impetus For Economic Support Due To Improvements In National Income? Chart II-5Has China's Stimulus Peaked?   An added headwind for the Chinese economy stems from the currency. The currency should track interest rate differentials. Beijing’s incremental monetary stimulus, in the form of cuts to bank reserve requirement ratios (RRRs), should also push the renminbi down over time (Chart II-6). However, an essential aspect of any trade deal with the Trump administration is the need to demonstrate that China is not competitively devaluing. Hence the CNY-USD could overshoot in the first half of the year. This is positive for global exports to China, but it tightens Chinese financial conditions at home. A stronger than otherwise justified renminbi would add to any negative economic surprises from less accommodative monetary and fiscal policy. Conventional wisdom says China will stimulate the economy ahead of two major political events: the centenary of the Communist Party in 2021 and the twentieth National Party Congress in 2022. The former is a highly symbolic anniversary, as Xi has reasserted the supremacy of the party in all things, while the latter is more significant for policy, as it is a leadership reshuffle that will usher in the sixth generation of China’s political elite. But conventional wisdom may be wrong – the Xi administration may aim only for stability, not acceleration, in the economy. It would make sense to save dry powder for the next US or global recession. The obvious implication is that China’s economic rebound may lose steam as early as H2 – but the black swan risk is that negative surprises could cause a vicious spiral inside of China. This is a country with massive financial and economic imbalances, a declining potential growth profile, and persistent political obstacles to growth both at home and abroad. Corporate defaults have spiked sharply. While the default rate is lower than elsewhere, the market may be sniffing out a bigger problem as it charges a much higher premium for onshore Chinese bonds (Chart II-7). Chart II-6CNY/USD Overshoot Would Tighten Chinese Financial Conditions Chart II-7Is China's Bond Market Sniffing Out A Problem?   Bottom Line: Our view is that China’s authorities will remain accommodative in 2020 in order to ensure that growth bottoms and the labor market continues to improve. But Beijing has compromised its domestic economic discipline since 2018 in order to fight trade war. The risk now, with a “phase one” deal in hand, is that Xi Jinping returns to his three-year battle plan and underestimates the downward pressures on the economy. The result would be a huge negative surprise for the Chinese and global economy in 2020. Black Swan 2: The US And China Go To War In 2013, we predicted that US-China conflict was “more likely than you think.” This was not just an argument for trade conflict or general enmity that raises the temperature in the Asia-Pacific region – we included military conflict. At the time, the notion that a Sino-American armed conflict was the world’s greatest geopolitical threat seemed ludicrous to many of our clients. We published this analysis in October of that year, months after the Islamic State “Soldier’s Harvest” offensive into Iraq. Trying to direct investors to the budding rivalry between American and Chinese naval forces in the South China Sea amidst the Islamic State hysteria was challenging, to say the least. Chart II-8Americans’ Attitudes Toward China Plunged… The suggestion that an accidental skirmish between the US and China could descend into a full-blown conflict involved a stretch of the imagination because China was not yet perceived by the American public as a major threat. In 2014, only 19%of the US public saw China as the “greatest threat to the US in the future.” This came between Russia, at 23%, and Iran, at 16%. Today, China and Russia share the top spot with 24%. Furthermore, the share of Americans with an unfavorable view of China has increased from 52% to 60% in the six intervening years (Chart II-8). The level of enmity expressed by the US public toward China is still lower than that toward the Soviet Union at the onset of the Cold War in the 1950s (Chart II-9). However, the trajectory of distrust is clearly mounting. We expect this trend to continue: anti-China sentiment is one of the few sources of bipartisan agreement remaining in Washington, DC (Chart II-10). Chinese sentiment toward the United States has also darkened dramatically. The geopolitical rivalry is deepening for structural reasons: as China advances in size and sophistication, it seeks to alter the regional status quo in its favor, while the US grows fearful and seeks to contain China. Chart II-9…But Not Yet To War-Inducing Levels Chart II-10Distrust Of China Is Bipartisan Chart II-11Newfound American Concern For China’s Repression One example of rising enmity is the US public’s newfound concern for China’s domestic policies and human rights, specifically Beijing’s treatment of its Uyghur minority in Xinjiang. A Google Trends analysis of the term “Uyghur” or “Uyghur camps” shows a dramatic rise in mentions since Q2 of 2018, around the same time the trade war ramped up in a major way (Chart II-11). While startling revelations of re-education camps in Xinjiang emerged in recent years, the reality is that Beijing has used heavy-handed tactics against both militant groups and the wider Uyghur minority since at least 2008 – and much earlier than that. As such, the surge of interest by the general American public and legislators – culminating in the Uyghur Human Rights Policy Act of 2019 – is a product of the renewed strategic tension between the two countries. The same can be said for Hong Kong: the US did not pass a Hong Kong Human Rights and Democracy Act in 2014, during the first round of mass protests, which prompted Beijing to take heavy-handed legal, legislative, and censorship actions. It passed the bill in 2019, after the climate in Washington had changed. Why does this matter for investors? There are two general risks that come with a greater public engagement in foreign policy. First, the “phase one” trade deal between China and the US could fall victim to domestic politics. This deal envisions a large step up in Sino-American economic cooperation. But if China is to import around $200 billion of additional US goods and services over the next two years – an almost inconceivable figure – the US and China will have to tamp down on public vitriol. This is notably the case if the Democratic Party takes over the White House, given its likely greater focus on liberal concerns such as human rights. And yet the latest bills became law under President Trump and a Republican Senate, and we fully expect a second Trump term to involve a re-escalation of trade tensions to ensure compliance with phase one and to try to gain greater structural concessions in phase two. Second, mounting nationalist sentiment will make it more difficult for US and Chinese policymakers to reduce tensions following a potential future military skirmish, accidental or otherwise. While our scenario of a military conflict in 2013 was cogent, the public backlash in the United States was probably manageable.1 Today we can no longer guarantee that this is the case. The “phase one” trade deal risks falling victim to domestic politics due to greater public engagement in foreign policy. China has greater control over the domestic narrative and public discourse, but the rise of the middle class and the government’s efforts to rebuild support for the single-party regime have combined to create an increase in nationalism. Thus it is also more difficult for Chinese policymakers to contain the popular backlash if conflict erupts. In short, the probability of a quick tamping down of public enmity is actively being reduced as American public vilification of China is closing the gap with China’s burgeoning nationalism at an alarming pace. Another of our black swan risks – Taiwan island – is inextricably bound up in this dangerous US-China dynamic. To be clear, Washington will tread carefully, as a conflict over Taiwan could become a major war. Nevertheless Taiwan’s election, as we expected, has injected new vitality into this already underrated geopolitical risk. It is not only that a high-turnout election (Chart II-12) gave President Tsai Ing-wen a greater mandate (Chart II-13), or that her Democratic Progressive Party retained its legislative majority (Chart II-14). It is not only that the trigger for this resounding victory was the revolt in Hong Kong and the Taiwanese people’s rejection of the “one country, two systems” formula for Taiwan. It is also that Tsai followed up with a repudiation of the mainland by declaring, “We don’t have a need to declare ourselves an independent state. We are an independent country already and we call ourselves the Republic of China, Taiwan.” Chart II-12Tsai Ing-Wen Enjoys A Greater Mandate On Higher Turnout… Chart II-13…Popular Support… Chart II-14…And A Legislative Majority This statement is not a minor rhetorical flourish but will be received as a major provocation in Beijing: the crystallization of a long-brewing clash between Beijing and Taipei. Additional punitive economic measures against Taiwan are now guaranteed. Saber-rattling could easily ignite in the coming year and beyond. Taiwan is the epicenter of the US-China strategic conflict. First, Beijing cannot compromise on its security or its political legitimacy and considers the “one China principle” to be inviolable. Second, the US maintains defense relations with Taiwan (and is in the process of delivering on a relatively large new package of arms). Third, the US’s true willingness to fight a war on Taiwan’s behalf is in doubt, which means that deterrence has eroded and there is greater room for miscalculation. Bottom Line: A US-China military skirmish has been our biggest black swan risk since we began writing the BCA Geopolitical Strategy. The difference between then and now, however, is that the American public is actually paying attention. Political ideology – the question of democracy and human rights – is clearly merging with trade, security, and other differences to provoke Americans of all stripes. This makes any skirmish more than just a temporary risk-off event, as it could lead to a string of incidents or even protracted military conflict. Black Swan 3: Social Unrest Erupts In America There are numerous lessons that one can learn from the ongoing unrest in Hong Kong, but perhaps the most cogent one is that Millennials and Generation Z are not as docile and feckless as their elders think. Images of university students and even teenagers throwing flying kicks and Molotov cocktails while clad in black body armor have shocked the world. Perhaps all those violent video games did have a lasting impact on the youth! What is surprising is that so few commentators have made the cognitive leap from the ultra-first world streets of Hong Kong to other developed economies. Perhaps what is clouding analysts’ minds is the idiosyncratic nature of the dispute in Hong Kong, the “one China” angle. However, Hong Kong youth are confronted with similar socio-economic challenges that their peers in other advanced economies face: overpriced real estate and a bifurcated service-sector labor market with few mid-tier jobs that pay a decent wage. There is a risk of rebellion from Trump’s most ardent supporters if he loses the White House. In the US, Millennials and Gen Z are also facing challenges unique to the US. First, their debt burden is much more toxic than that of the older cohorts, given that it is made up of student loans and credit card debt (Chart II-15). Second, they find themselves at odds – demographically and ideologically – with the older cohorts (Chart II-16). Chart II-15Younger American Cohorts Plagued By Toxic Debt Chart II-16Younger And Older Cohorts At Odds Demographically Chart II-17Massive Turnout To The 2016 Referendum On Trump The adage that the youth are apolitical and do not turn out to vote may have ended thanks to President Trump. The 2018 midterm election, which the Democratic Party successfully turned into a referendum on the president, saw the youth (18-29) turnout nearly double from 20% to 36% (the 30-44 year-old cohort also saw a jump in turnout from 35.6% to 48.8%). The election saw one of the highest turnouts in recent memory, with a 53.4% figure, just two points off the 2016 general election figure (Chart II-17). Despite the high turnout in 2018, the-most-definitely-not-Millennial Vice President Joe Biden continues to lead the Democratic Party in the polls. His probability of winning the nomination is not overwhelming, but it is the highest of any contender. In recent polls, Biden comes third place in Millennial/Gen-Z vote preferences (Chart II-18). Yet he is hardly out of contention, especially for the 30-44 year-old cohort. The view that “Uncle Joe” does not fit the Democratic Party zeitgeist has become so entrenched in the Democratic Party narrative that it became conventional wisdom last year, pulling oddsmakers and betting markets away from the clear frontrunner (Chart II-19). Chart II-18Biden Unpopular Among Young American Voters Chart II-19Bookies Pulled Down 'Uncle Joe’s' Odds, Capturing Democratic Party Zeitgeist     As such, a Biden victory at the Democratic National Convention in Milwaukee, Wisconsin on July 13-16 may come as an affront to the left-wing activists who will surely descend on the convention. This will particularly be the case if Biden wins despite the progressive candidates amassing a majority of overall delegates, which is possible judging by the combined progressive vote share in current polling (Chart II-20). He would arrive in Milwaukee without clearing the 1990 delegate count required to win on the first ballot. On the second ballot, his presidency would then receive a boost from “superdelegates” and those progressives who are unwilling to “rock the boat,” i.e. unify against an establishment candidate with the largest share of votes. This is also how Mayor Michael Bloomberg could pull off a surprise win. Chart II-20Progressives Come Closest To Victory Such a “brokered” – or contested – convention has not occurred since 1952. However, several Democratic Party conventions came close, including 1968, 1972, and 1984. The 1968 one in Chicago was notable for considerable violence and unrest. Even if the Milwaukee Democratic Party convention does not produce unrest, it could sow the seeds for unrest later in the year. First, a breakout Biden performance in the primaries is unlikely. As such, he will likely need to pledge a shift to the left at the convention, including by accepting a progressive vice-presidential candidate. Second, an actual progressive may win the primary. Chart II-21Zealots In Both Parties Perceive Each Other As A National Threat It is likely that either of the two options would be seen as an existential threat to many of Trump’s loyal supporters across the United States. President Trump’s rhetoric often paints the scenario of a Democratic takeover of the White House in apocalyptic terms. And data suggests that the zealots in both parties perceive each other as a “threat to the nation’s wellbeing” (Chart II-21). The American Civil War in the nineteenth century began with the election of a president. This is not just because Abraham Lincoln was a particularly reviled figure in the South, but because the states that ultimately formed the Confederacy saw in his election the demographic writing-on-the-wall. The election was an expression of a general will that, from that point onwards, was irreversible. Given demographic trends in the US today, it is possible that many would see in Trump’s loss a similar fait accompli. If one perceives progressive Democrats as an existential threat to the US constitution, rebellion is the obvious and rational response. Bottom Line: Year 2020 may be a particularly violent one for the US. First, left wing activists may be shocked and angered to learn that Joe Biden (or Bloomberg) is the nominee of the Democratic Party come July. With so much hype behind the progressive candidates throughout the campaign, Biden’s nomination could be seen as an affront to what was supposed to be “the big year” for left-wing candidates. Second, investors have to start thinking about what happens if Biden – or a progressive candidate – goes on to defeat President Trump in the general election. While liberal America took Trump’s election badly, it has demographics – and thus time – on its side. Trump’s most ardent supporters may conclude that his defeat means the end of America as they know it. Black Swan 4: Europe’s Migration Crisis Restarts It is a testament to Europe’s resilience that we do not have a Black Swan scenario based on an election or a political crisis set on the continent in 2020. Support for the common currency and the EU as a whole has rebounded to its highest since 2013. Even early elections in Germany and Italy are unlikely to produce geopolitical risk. The populists in the former are in no danger of outperforming whereas the populists in the latter barely deserve the designation. But what if one of the reasons for the surge in populism – unchecked illegal immigration – were to return in 2020? Chart II-22Decline In Illegal Immigration Dampened European Populism The data suggests that the risk of migrant flows has massively subsided. From its peak of over a million arrivals in 2015, the data shows that only 125,472 migrants crossed into Europe via land and sea routes in the Mediterranean last year (Chart II-22). Why? There are five reasons that we believe have checked the flow of migrants: Supply: The civil wars in Syria, Iraq, and Libya have largely subsided. Heterogenous regions, cities, and neighborhoods have been ethnically cleansed and internal boundaries have largely ossified. It is unlikely that any future conflict will produce massive outflows of refugees as the displacement has already taken place. These countries are now largely divided into armed, ethnically homogenous, camps. Enforcement: The EU has stepped up border enforcement since 2015, pouring resources into the land border with Turkey and naval patrols across the Mediterranean. Individual member states – particularly Italy and Hungary – have also stepped up border enforcement policy. While most EU member states have publicly chided both for “draconian” policies, there is no impetus to force Rome and Budapest to change policy. Libyan Imbroglio: Conflict in Libya has flared up in 2019 with military warlord Khalifa Haftar looking to wrest control from the UN-backed Government of National Accord led by Fayez al-Serraj. The Islamic State has regrouped in the country as well. Ironically, the conflict is helping stem the flow of migrants as African migrants from sub-Saharan countries dare not cross into Libya as they did in 2015 when there was a brief lull in fighting. Turkish benevolence: Ankara is quick to point out that it is the only thing standing between Europe and a massive deluge of migrants. Turkey is said to host somewhere between two and four million refugees from various conflicts in the Middle East. Fear of the crossing: If crossing the Mediterranean was easy, Europe would have experienced a massive influx of migrants throughout the twentieth century. Not only is it not easy, it is costly and quite deadly, with thousands lost each year. Furthermore, most migrants are not welcomed when they arrive to Europe, many are held in terrible conditions in holding camps in Italy and Greece. Over time, migrants who made it into Europe have reported these dangers and conditions, reducing the overall demand for illegal migration. We do not foresee these five factors changing, at least not all at once. However, there are several reasons to worry about the flow of migrants in 2020. US-Iran tensions have sparked outright military action, while unrest is flaring up across Iran’s sphere of influence. Going forward, Iran could destabilize Iraq or fuel Shia unrest against US-backed regimes. Second, Afghanistan has been the source of most migrants to Europe via sea and land Mediterranean routes – 19.2%. The conflict in the country continues and may flare up with President Trump’s decision to formally withdraw most US troops from the country in 2020. Third, a break in fighting in Libya may encourage sub-Saharan migrants to revisit routes to Europe. Migrants from Guinea, Cote d’Ivoire, and the Democratic Republic of Congo make up over 10% of migrants to Europe. Finally, Turkish relationship with the West could break up further in 2020, causing Ankara to ship migrants northward. We highly doubt that President Erdogan will risk such a break, given that 50% of Turkish exports go to Europe. A European embargo on Turkish exports – which would be a highly likely response to such an act – would crush the already decimated Turkish economy. Bottom Line: While we do not see a return to the 2015 level of migration in 2020, we flag this risk because it would fundamentally undermine political stability in Europe. Black Swan 5: Russia Faces A “Peasant Revolt” Our fifth and final black swan risk for the year stems from Russia. This risk may seem obvious, since the US election creates a dynamic that revives the inherent conflict in US-Russian relations. Russia could seek to accomplish foreign policy objectives – interfering in US elections, punishing regional adversaries. The Trump administration may be friendly toward Russia but Trump is unlikely to veto any sanctions passed by the House and Senate in an election year, should an occasion for new sanctions arise. Conversely Russia could anticipate greater US pressure if the Democrats win in November. Yet it is Russia’s domestic affairs that represent the real underrated risk. Putin’s fourth term as president has been characterized by increased focus on domestic political control and stability as opposed to foreign adventurism. The creation of a special National Guard in 2016, reporting directly to Putin and responsible for quelling domestic unrest, symbolizes the shift in focus. So too does Russia’s adherence to the OPEC 2.0 regime of production control to keep oil prices above their budget breakeven level. Meanwhile Putin’s courting of Europe for the Nordstream II pipeline, and his slight peacemaking efforts with Ukraine, has suggested a slightly more restrained international posture. Strategically it makes little sense for Russia to court negative attention at a time when the US and Europe are at odds over trade and the Middle East, the US is preoccupied with China and Iran, and Russia itself faces mounting domestic problems. The domestic problems are long in coming. The central bank has maintained a stringent monetary policy for the better part of the decade. Despite cutting interest rates recently, monetary and credit conditions are still tight, hurting domestic demand. Moscow has also imposed fiscal austerity, namely by cutting back on state pensions and hiking the value added tax. Real wage growth is weak (Chart II-23), retail sales are falling, and domestic demand looks to weaken further, as Andrija Vesic of BCA Emerging Markets Strategy observes in a recent Special Report. The effect of Russia’s policy austerity has been a drop in public approval of the administration (Chart II-24). Protests erupted in 2019 but were largely drowned out by the larger and more globally significant protests in Hong Kong. These were met by police suppression that has not removed their underlying cause. Putin’s first major decision of the new year was to reshuffle the government, entailing Prime Minister Dmitri Medvedev’s transfer to a new post and the appointment of a new cabinet. This move reveals the need to show some accountability to reduce popular pressure. While Moscow now has room to cut interest rates and ease fiscal policy, it is behind the curve and the weak economy will add fuel to domestic unrest. Chart II-23Sluggish Wage Growth Threatens Russian Stability Chart II-24Austerity Weighed On The Administration's Popularity In Russia   Meanwhile Putin’s efforts to alter the Russian constitution so he can stay in power beyond current term limits, effectively becoming emperor for life, like Xi Jinping, should not be dismissed merely because they are expected. They reflect a need to take advantage of Putin’s popular standing to consolidate domestic political power at a time when the ruling United Russia party and the federal government face discontent. They also ensure that strategic conflict with the United States will take on an ideological dimension. Russia's recent cabinet shakeup is positive from the point of view of economic reform. And the country's monetary and fiscal room provide a basis for remaining overweight equities within EM, as our Emerging Markets Strategy recommends. However, Russian equities have rallied hard and the political risk is understated. Chart II-25Russian Political Risk Is Unsustainably Low Bottom Line: It is never easy predicting Putin’s next international move. Our market-based indicators of Russian political risk have hit multi-year lows, but both the domestic and international context suggest that these lows will not be sustained (Chart II-25). A new bout of risk can emanate from Putin, or from changes in Washington, or from the Russian people themselves. What would take the world by surprise would be domestic unrest on a larger scale than Russia can easily suppress through the police force. Housekeeping We are closing our long European Union / short Chinese equities strategic trade with a 1.61% loss since inception on May 10, 2019. Dhaval Joshi of BCA’s European Investment Strategy downgraded the Eurostoxx 50 to underweight versus the S&P 500 and the Nikkei 225 this week. He makes the point that the Euro Area bond yield 6-month impulse hit 100 bps – a critical technical level – and will be a strong headwind to growth. We will look to reopen this trade at a later date when the euphoria over the “phase one” trade deal subsides, as we still favor European equities and DM bourses over EM. We will reinstitute our long Brent crude H2 2020 versus H2 2021 tactical position, which was stopped out on January 9, 2020. We remain bullish on oil fundamentals and expect Middle East instability to add a political risk premium. China's stimulus and the oil view also give reason for us to reinitiate our long Malaysian equities relative to EM as a tactical position. The Malaysian ringgit will benefit as oil prices move higher, helping Malaysian companies make payments on their large pile of dollar-denominated debt and improving household purchasing power. Higher oil prices also correlate with higher equity prices, while China's stimulus and the US trade ceasefire will push the US dollar lower and help trade revive in the region. Marko Papic Chief Strategist, Clocktower Group Matt Gertken Geopolitical Strategist Footnotes 1 Observe how little attention the public paid to US-China saber-rattling around China’s announcement of an Air Defense Identification Zone in the East China Sea that year.

Highlights The liquidity-driven rally will soon be followed by an acceleration in global growth. The economic recovery will bump up expectations of long-term profit growth. The dollar has downside, but the euro will not benefit much. Overweight stocks relative to bonds and bet on traditional cyclical sectors and commodities. The potential for outperformance of value relative to growth favors European equities. The probability of a tech mania is escalating: how should investors factor an expanding bubble into their portfolios? Feature Chart I-1A Bull Market In Stocks And Volatility? Despite all odds, the nCoV-2019 outbreak is barely denting the S&P 500’s frenetic rally. Plentiful liquidity, thawing Sino-US trade relations and improving economic activity in Asia, all have created ideal conditions for risk assets to appreciate on a cyclical basis. Stocks may look increasingly expensive and are primed to correct, but the bubble will expand further. After lifting asset valuations, monetary policy easing will soon boost worldwide economic activity. Consequently, earnings in the US and Europe will improve. As long as central bankers remain unconcerned about inflation, investors will bid up stocks. Investors should remember we are in the final innings of a bull market. Stocks can deliver outsized returns during this period, but often at the cost of elevated volatility, and the options market is not pricing in this uncertainty (Chart I-1). Moreover, timing the ultimate end of the bubble is extremely difficult. Hence, we prefer to look for assets that can still benefit from easy monetary conditions and rebounding growth, but are not as expensive as equities. Industrial commodities fit that description, especially after their recent selloff. The dollar remains a crucial asset to gauge the path of least resistance for assets. If it refuses to swoon, then it will indicate that global growth is in a weaker state than we foresaw. The good news is that the broad trade-weighted dollar seems to have peaked. Accommodative Monetary Conditions Are Here To Stay Easy liquidity has been the lifeblood of the S&P 500’s rally. The surge in the index coincided with the lagged impact of the rise in our US Financial Liquidity Index (Chart I-2). Low rates have allowed stocks to climb higher, yet earnings expectations remain muted. For example, since November 26, 2018, the forward P/E ratio for the S&P 500 has increased from 15.2 to 18.7, while 10-year Treasury yields have collapsed from 3.1% to 1.6%. Meanwhile, expectations for long-term earnings annual growth extracted from equity multiples using a discounted cash flow model have dropped from 2.4% to 1.2%. Historically, easier monetary policy pushes asset prices higher before it lifts economic activity. Historically, easier monetary policy pushes asset prices higher before it lifts economic activity. Yet, stocks and risk assets normally continue to climb when the economy recovers. Even without any additional monetary easing, as long as policy remains accommodative, risk assets will generate positive returns. Expectations for stronger cash flow growth become the force driving asset prices higher. Policy will likely remain accommodative around the world. Within this framework, peak monetary easing is probably behind us, even though liquidity conditions remain extremely accommodative. Nominal interest rates remain very low, and real bond yields are still falling. Unlike in 2018 and 2019, dropping TIPs yields reflect rising inflation expectations (Chart I-3). Those factors together indicate that policy is reflationary, which is confirmed by the gold rally. Chart I-2A Liquidity Driven Rally Chart I-3Today, Lower TIPS Yields Are Reflationary   Chart I-4Economic Activity To Respond To Liquidity Based on the historical lags between monetary easing and manufacturing activity, the global industrial sector is set to mend (Chart I-4). Moreover, the liquidity-driven surge in stock prices, combined with low yields and compressed credit spreads, has eased financial conditions, which creates the catalyst for an industrial recovery. Where will the growth come from? First, worldwide inventory levels have collapsed after making negative contributions to growth since mid-2018 (Chart I-5). Thus, there is room for an inventory restocking. Secondly, auto sales in Europe and China have rebounded to 18.5% from -23% and to -0.1% from -16.4%, respectively. Thirdly, China’s credit and fiscal impulse has improved. The uptick in Chinese iron ore imports indicates that the pass-through from domestic reflation to global economic activity will materialize soon (Chart I-6). Finally, following the Phase One Sino-US trade deal, global business confidence is bottoming, as exemplified by Belgium’s business confidence, Switzerland KOF LEI, Korea's manufacturing business survey, or US CFO and CEO confidence measures. The increase in EM earnings revisions shows that US capex intentions should soon re-accelerate, which bodes well for investment both in the US and globally (Chart I-7). Chart I-5Room For Inventory Restocking Chart I-6China Points To Stronger Global Growth   Construction activity, a gauge of the monetary stance, is looking up across the advanced economies. In the US, housing starts – a leading indicator of domestic demand – have hit a 13-year high. A pullback in this volatile data series is likely, but it should be limited. Vacancies remain at a paltry 1.4%, household formation is solid and affordability is not demanding (Chart I-8). In Europe, construction activity has been relatively stable through the economic slowdown. Even in Canada and Australia, housing transactions have gathered steam quickly following declines in mortgage rates (Chart I-9). Chart I-7Capex Is Set To Recover Chart I-8US Housing Is Robust Chart I-9Even The Canadian And Australian Housing Markets Are Stabilizing Consumers will remain a source of strength for the global economy. The dichotomy between weak manufacturing PMIs and the stable service sector reflects a healthy consumer spending. December retail sales in Europe and the US corroborate this assessment. The stabilization in US business confidence suggests that household incomes are not in as much jeopardy as three months ago. As household net worth and credit growth improve further, a stable outlook for household income will underwrite greater gains in consumption. Policy will likely remain accommodative around the world. For the time being, US inflationary pressures are muted. The New York Fed’s Underlying Inflation Gauge has rolled over, hourly earnings growth has moved back below 3%, our pipeline inflation indicator derived from the ISM is weak, and core producer prices are flagging (Chart I-10). This trend is not US-specific. In the OECD, core consumer price inflation is set to decelerate due to the lagged impact of the manufacturing slowdown. Central banks are also constrained to remain dovish by their own rhetoric. The Fed's statement this week was a testament to this reality. Central banks are increasingly looking to set symmetrical inflation targets. After a decade of missing their targets, a symmetric target would imply keeping policy easier for longer, even if realized inflation moves back above 2%. A rebound in global growth and weak inflation should create a poisonous environment for the US dollar. Finally, fiscal policy will make a small positive contribution to growth in most major advanced economies in 2020, particularly in Germany and the UK (Table I-1). Chart I-10Limited Inflation Will Allow The Fed To Remain Easy Table I-1Modest Fiscal Easing In 2020   The Dollar And The Sino-US Phase One Deal At first glance, a rebound in global growth and weak inflation should create a poisonous environment for the US dollar (Chart I-11). As we have often argued, the dollar’s defining characteristic is its pronounced counter-cyclicality. Chart I-11A Painful Backdrop For The Greenback Deteriorating dollar fundamentals make this risk particularly relevant. US interest rates are well above those in the rest of the G10, but the gap in short rates has significantly narrowed. Historically, the direction of rates differentials and not their levels has determined the trend in the USD (Chart I-12). Moreover, real differentials at the long end of the curve support the notion that the maximum tailwinds for the dollar are behind us (Chart I-12, bottom panel). Furthermore, now that the US Treasury has replenished its accounts at the Federal Reserve, the Fed’s addition of excess reserves in the system will likely become increasingly negative for the dollar, especially against EM currencies. Likewise, relative money supply trends between the US, Europe, Japan and China already predict a decline in the dollar (Chart I-13). Chart I-12Interest Rate Differentials Do Not Favor The Dollar... Chart I-13...Neither Do Money Supply Trends   Chart I-14The Phase One Deal Is Ambitious The recent Sino-US trade agreement obscures what appears to be a straightforward picture. According to the Phase One deal signed mid-January, China will increase its US imports by $200 billion in the next two years vis-à-vis the high-water mark of $186 billion reached in 2017. This is an extremely ambitious goal (Chart I-14). Politically, it is positive that China has committed to buy manufactured goods and services in addition to commodities. However, the scale of the increase in imports of US manufactured goods is large, at $77 billion. China cannot fulfill this obligation if domestic growth merely stabilizes or picks up just a little, especially now that the domestic economy is in the midst of a spreading illness. It will have to substitute some of its European and Japanese imports with US goods. A consequence of this trade deal is that the euro’s gains will probably lag those recorded in normal business cycle upswings. Historically, European growth outperforms the US when China’s monetary conditions are easing and its marginal propensity to consume is rising (Chart I-15). However, given the potential for China to substitute European goods in favor of US ones, China’s economic reacceleration probably will not benefit Europe as much as it normally does. China may not ultimately follow through with as big of US purchases as it has promised, but it is likely, at least initially, to show good faith in the agreement. The euro’s gains will probably lag those recorded in normal business cycle upswings. While the trade agreement is a headwind for the euro, it is a positive for the Chinese yuan. The US output gap stands at 0.1% of potential GDP and the US labor market is near full employment. The US industrial sector does not possess the required spare capacity to fulfill additional Chinese demand. To equilibrate the market for US goods, prices will have to adjust to become more favorable for Chinese purchasers. The simplest mechanism to achieve this outcome is for the RMB to appreciate. Meanwhile, the euro is trading 16% below its equilibrium, which will allow European producers to fulfill US domestic demand. A widening US trade deficit with Europe would undo improvements in the trade balance with China. The probability that US equities correct further in the short-term is elevated. The implication for the dollar is that the broad trade-weighted USD will likely outperform the Dollar Index (DXY). The euro represents 18.9% of the broad trade-weighted dollar versus 57.6% of the DXY. Asian currencies, EM currencies at large, the AUD and the NZD, all should benefit from their close correlation with the RMB (Chart I-16). Chart I-15Europe Normally Wins When China Recovers Chart I-16EM, Asian, And Antipodean Exchange Rates Love A Strong RMB   Obviously, before the RMB and the assets linked to it can appreciate further, the panic surrounding the coronavirus will have to dissipate. However, the economic damage created by SARS was short lived. This respiratory syndrome resulted in a 2.4% contraction Hong-Kong’s GDP in the second quarter of 2003. The economy of Hong Kong recovered that loss quickly afterward. Investment Forecasts BCA continues to forecast upside in safe-haven yields. Global interest rates remain well below equilibrium and a global economic recovery bodes poorly for bond prices (Chart I-17). However, inflation expectations and not real yields will drive nominal yield changes. The dovish slant of global central banks and the growing likelihood that symmetric inflation targets will become the norm is creating long-term upside risks for inflation. Moreover, if symmetric inflation targets imply lower real short rates in the future, then they also imply lower real long rates today. Investors should begin switching their risk assets into industrial commodity plays, especially after their recent selloff. Easy monetary conditions, decreased real rates and an improvement in economic activity are also consistent with an outperformance of assets with higher yields. High-yield bonds, which offer attractive breakeven spreads, will benefit from this backdrop (Chart I-18). Furthermore, carry trades will likely continue to perform well. In addition to low interest rates across most of the G10, the low currency volatility caused by an extended period of easy policy will continue to encourage carry-seeking strategies. Chart I-17Bonds Are Still Expensive Chart I-18Where Is The Value In Credit?   An environment in which growth is accelerating and monetary policy is accommodative argues in favor of stocks. Our profit growth model for the S&P 500 has finally moved back into positive territory. As earnings improve, investors will likely re-rate depressed long-term growth expectations for cash flows (Chart I-19). The flip side is that equity risk premia are elevated, especially outside the US (Chart I-19). Hence, as long as accelerating growth (but not tighter policy) drives up yields, equities should withstand rising borrowing costs. The use of passive investing and the prevalence of “closet indexers” accentuates the risk that a tech mania could blossom. The 400 point surge in the S&P 500 since early October complicates the picture. The probability that US equities correct further in the short-term is elevated, based on their short-term momentum and sentiment measures, such as the put/call ratio (Chart I-20). Foreign equities will continue to correct along US ones, even if they are cheaper. Chart I-19Elevated Stock Multiples Reflect Low Yields, Not Growth Exuberance Chart I-20Tactical Risks For Stocks   Chart I-21Buy Commodities/Sell Stocks? The coronavirus panic seems to be the catalyst for such a correction. When a market is overextended, any shock can cause a pullback in prices. Moreover, as of writing, medical professionals still have to ascertain the virus’s severity and potential mutations. Therefore, risk assets must embed a significant risk premium for such uncertainty, even if ultimately the infection turns out to be mild. However, that risk premium will likely prove to be short lived. During the SARS crisis in 2003, stocks bottomed when the number of reported new cases peaked. The tech sector has plentiful downside if the correction gathers strength. As indicated in BCA’s US Equity Sector Strategy, Apple, Microsoft, Google, Amazon and Facebook account for 18% of the US market capitalization, which is the highest market concentration since the late 1990s tech bubble. Investors should begin switching their risk assets into industrial commodity plays, especially after their recent selloff. Commodity prices are trading at a large discount to US equities. Moreover, the momentum of natural resource prices relative to stocks has begun to form a positive divergence with the price ratio of these two assets (Chart I-21). Technical divergences such as the one visible in the ratio of commodities to equities are often positive signals. Low real rates, an ample liquidity backdrop, a global economic recovery, a weak broad trade-weighted dollar and a strong RMB, all benefit commodities over equities. Tech stocks underperform commodities when the dollar weakens and growth strengthens. Moreover, our positive stance on the RMB justifies stronger prices for copper, oil and EM equities (Chart I-22). Chart I-22The Winners From A CNY Rebound Our US Equity Strategy Service has also reiterated its preference for industrials and energy stocks, and it recently upgraded materials stocks to neutral.1 All three sectors trade at significant valuation discounts to the broad market and to tech stocks in particular. They are also oversold in relative terms. Finally, their operating metrics are improving, a trend which will be magnified if global growth re-accelerates. Do not make these bets aggressively. A weakening broad trade-weighted dollar would allow for a rotation into foreign equities and an outperformance of value relative to growth stocks. The share of US equities in the MSCI All-Country World Index is a direct function of the broad trade-weighted dollar (Chart I-23). Moreover, since 1971, the dollar and the relative performance of growth stocks versus value stocks have exhibited a positive correlation (Chart I-24). Thus, the dollar’s recent strength has been a key component behind the run enjoyed by tech stocks. Chart I-23Global Stocks Love A Soft Dollar Chart I-24Value Stocks Needs A Weaker Dollar To Outperform Growth Stocks Despite the risks to the euro discussed in the previous section, European equities could still outperform US equities. Such a move would be consistent with value stocks beating growth equities (Chart I-24, bottom panel). This correlation exists because the euro area has a combined 17.7% weighting to tech and healthcare stocks compared with a 37.1% allocation in US benchmarks. Moreover, a cheap euro should allow European industrials and materials to outperform their US counterparts. Finally, the recent uptick in the European credit impulse indicates that an acceleration in European profit growth is imminent, a view that is in line with our preference for European financials (Chart I-25).2 Chart I-25Euro Area Profits Should Improve Bottom Line: The current environment remains favorable for risk assets on a 12-month investment horizon. As such, we expect stocks and bond yields to continue to rise in 2020. Moreover, a pick-up in global growth, along with a fall in the broad trade-weighted dollar, should weigh on tech and growth stocks, and boost the attractiveness of commodity plays, industrial, energy and materials stocks, as well as European and EM equities. Forecast Meets Strategy Liquidity-driven rallies, such as the current one, can carry on regardless of the fundamentals. As Keynes noted 90 years ago: “Markets can remain irrational longer than you can stay solvent.” The gap between forecast and strategy can be great. The use of passive investing and the prevalence of “closet indexers” accentuates the risk that a tech mania could blossom. We assign a substantial 30% probability to the risk of another tech mania. Outflows from equity ETFs and mutual funds have been large. Investors will be tempted to move back into those vehicles if stocks continue to rally on the back of plentiful liquidity and improving global growth (Chart I-26). In the process, the new inflows will prop up the over-represented, over-valued, and over-extended tech behemoths. Chart I-26Depressed Equity Flows Should Pick Up The current tech bubble can easily run a lot further. Based on current valuations, the NASDAQ trades at a P/E ratio of 31 compared with 68 in March 2000 (Chart I-27). Moreover, momentum is becoming increasingly favorable for the NASDAQ and other high-flying tech stocks. The NASDAQ is outperforming high-dividend stocks and after a period of consolidation, its relative performance is breaking out. Momentum often performs very well in liquidity-driven rallies. Chart I-27Where Is The Bubble? Chart I-28Debt Loads Are Already High Everywhere A full-fledged tech mania would make our overweight equities / underweight bonds a profitable call, but it would invalidate our sector and regional recommendations. Moreover, with a few exceptions in China and Taiwan, the major tech bellwethers are listed in the US. A tech bubble would most likely push our bearish dollar stance to the offside. Bubbles are dangerous: participating on the upside is easy, but cashing out is not. Moreover, financial bubbles tend to exacerbate the economic pain that follows the bust. During manic phases, capital is poorly invested and the economy becomes geared to the sectors that benefit from the financial excesses. These assets lose their value when the bubble deflates. Moreover, bubbles often result in growing private-sector indebtedness. Writing off or paying back this debt saps the economy’s vitality. Making matters worse, today overall indebtedness is unprecedented and central banks have little room to reflate the global economy once the bubble bursts (Chart I-28). Finally, US/Iran tensions will create additional risk in the years ahead. Matt Gertken, BCA’s Geopolitical Strategist, warns that the ratcheting down of tensions following Iran’s retaliation to General Soleimani’s assassination is temporary.3 As a result, the oil market remains a source of left-handed tail-risk. Section II discusses other potential black swans lurking in the geopolitical sphere. We continue to recommend that investors overweight industrials and energy, upgrade materials to neutral, Europe to overweight, and curtail their USD exposure as long as US inflation remains well behaved and the US inflation breakeven rate stays below the 2.3% to 2.5% range. However, do not make these bets aggressively. Moreover, some downside protection is merited. Due to our very negative view on bonds, we prefer garnering these hedges via a 15% allocation to gold and the yen. The yen is especially attractive because it is one of the few cheap, safe-haven plays (Chart I-29). Chart I-29The Yen Offers Cheap Portfolio Protection Mathieu Savary Vice President The Bank Credit Analyst January 30, 2020 Next Report: February 27, 2020   II. Five Black Swans In 2020 Our top five geopolitical “Black Swans” are risks that the market is seriously underpricing. With the “phase one” trade deal signed, Chinese policy could become less accommodative, resulting in a negative economic surprise. The trade deal may fall victim to domestic politics, raising the risk of a US-China military skirmish. A Biden victory at the Democratic National Convention or a Democratic takeover of the White House could trigger social unrest and violence in the US. A pickup in the flow of migrants to Europe would fundamentally undermine political stability there. Russia’s weak economy will add fuel to domestic unrest, risking an escalation beyond the point of containment. Over the past four years, BCA’s Geopolitical Strategy service has started off each year with their top five geopolitical “Black Swans.” These are low-probability events whose market impact would be significant enough to matter for global investors. Unlike the great Byron Wien’s perennial list of market surprises, we do not assign these events a “better than 50% likelihood of happening.” We offer risks that the market is seriously underpricing by assigning them only single-digit probabilities when we think the reality is closer to 10%-15%, a level at which a risk premium ought to be assigned. Some of our risks below are so obscure that it is not clear how exactly to price them. We exclude issues that are fairly probable, such as flare-ups in Indo-Pakistani conflict. The two major risks of the year – discussed in our Geopolitical Strategy’s annual outlook – are that either US President Donald Trump or Chinese President Xi Jinping overreaches in a major way. But what would truly surprise the market would be a policy-induced relapse in Chinese growth or a direct military clash between the two great powers. That is how we begin. Other risks stem from domestic affairs in the US, Europe, and Russia. Black Swan 1: China’s Financial Crisis Begins Chart II-1A Crackdown On Financial Risk Could Cause China's Economy To Derail The risk of Xi Jinping’s concentration of power in his own person is that individuals can easily make mistakes, especially if unchecked by advisors or institutions. Lower officials will fear correcting or admonishing an all-powerful leader. Inconvenient information may not be relayed up the hierarchy. Such behavior was rampant in Chairman Mao Zedong’s time, leading to famine among other ills. Insofar as President Xi’s cult of personality successfully imitates Mao’s, it will be subject to similar errors. If President Xi overreaches and makes a policy mistake this year, it could occur in economic policy or other policies. We begin with economic policy, as we have charted the risks of Xi’s crackdown on the financial system since early 2017 (Chart II-1). This year is supposed to be the third and final year of Xi Jinping’s “three battles” against systemic risk, pollution, and poverty. The first battle actually focuses on financial risk, i.e. China’s money and credit bubble. The regime has compromised on this goal since mid-2018, allowing monetary easing to stabilize the economy amid the trade war. But with a “phase one” trade deal having been signed, there is an underrated risk that economic policy will return to its prior setting, i.e. become less accommodative (Chart II-2). When Xi launched the “deleveraging campaign” in 2017, we posited that the authorities would be willing to tolerate an annual GDP growth rate below 6%. This would not only cull excesses in the economy but also demonstrate that the administration means business when it says that China must prioritize quality rather than quantity of growth. While Chinese authorities are most likely targeting “around 6%” in 2020, it is entirely possible that the authorities will allow an undershoot in the 5.5%-5.9% range. They will argue that the GDP target for 2020 has already been met on a compound growth rate basis (Chart II-3), as astute clients have pointed out. They may see less need for stimulus than the market expects. Chart II-2Easing Of Trade Tensions May Re-Incentivize Tighter Policy Chart II-3Chinese Authorities Might Tolerate A Growth Undershoot In 2020   Similarly, while urban disposable income is ostensibly lagging its target of doubling 2010 levels by 2020, China’s 13th Five Year Plan, which concludes in 2020, conspicuously avoided treating urban and rural income targets separately. If the authorities focus only on general disposable income, then they are on track to meet their target (Chart II-4). This would reduce the impetus for greater economic support. The Xi administration may aim only for stability, not acceleration, in the economy. There are already tentative signs that Chinese authorities are “satisfied” with the amount of stimulus they have injected: some indicators of money and credit have already peaked (Chart II-5). The crackdown on shadow banking has eased, but informal lending is still contracting. The regime is still pushing reforms that shake up state-owned enterprises. Chart II-4Lower Impetus For Economic Support Due To Improvements In National Income? Chart II-5Has China's Stimulus Peaked?   An added headwind for the Chinese economy stems from the currency. The currency should track interest rate differentials. Beijing’s incremental monetary stimulus, in the form of cuts to bank reserve requirement ratios (RRRs), should also push the renminbi down over time (Chart II-6). However, an essential aspect of any trade deal with the Trump administration is the need to demonstrate that China is not competitively devaluing. Hence the CNY-USD could overshoot in the first half of the year. This is positive for global exports to China, but it tightens Chinese financial conditions at home. A stronger than otherwise justified renminbi would add to any negative economic surprises from less accommodative monetary and fiscal policy. Conventional wisdom says China will stimulate the economy ahead of two major political events: the centenary of the Communist Party in 2021 and the twentieth National Party Congress in 2022. The former is a highly symbolic anniversary, as Xi has reasserted the supremacy of the party in all things, while the latter is more significant for policy, as it is a leadership reshuffle that will usher in the sixth generation of China’s political elite. But conventional wisdom may be wrong – the Xi administration may aim only for stability, not acceleration, in the economy. It would make sense to save dry powder for the next US or global recession. The obvious implication is that China’s economic rebound may lose steam as early as H2 – but the black swan risk is that negative surprises could cause a vicious spiral inside of China. This is a country with massive financial and economic imbalances, a declining potential growth profile, and persistent political obstacles to growth both at home and abroad. Corporate defaults have spiked sharply. While the default rate is lower than elsewhere, the market may be sniffing out a bigger problem as it charges a much higher premium for onshore Chinese bonds (Chart II-7). Chart II-6CNY/USD Overshoot Would Tighten Chinese Financial Conditions Chart II-7Is China's Bond Market Sniffing Out A Problem?   Bottom Line: Our view is that China’s authorities will remain accommodative in 2020 in order to ensure that growth bottoms and the labor market continues to improve. But Beijing has compromised its domestic economic discipline since 2018 in order to fight trade war. The risk now, with a “phase one” deal in hand, is that Xi Jinping returns to his three-year battle plan and underestimates the downward pressures on the economy. The result would be a huge negative surprise for the Chinese and global economy in 2020. Black Swan 2: The US And China Go To War In 2013, we predicted that US-China conflict was “more likely than you think.” This was not just an argument for trade conflict or general enmity that raises the temperature in the Asia-Pacific region – we included military conflict. At the time, the notion that a Sino-American armed conflict was the world’s greatest geopolitical threat seemed ludicrous to many of our clients. We published this analysis in October of that year, months after the Islamic State “Soldier’s Harvest” offensive into Iraq. Trying to direct investors to the budding rivalry between American and Chinese naval forces in the South China Sea amidst the Islamic State hysteria was challenging, to say the least. Chart II-8Americans’ Attitudes Toward China Plunged… The suggestion that an accidental skirmish between the US and China could descend into a full-blown conflict involved a stretch of the imagination because China was not yet perceived by the American public as a major threat. In 2014, only 19%of the US public saw China as the “greatest threat to the US in the future.” This came between Russia, at 23%, and Iran, at 16%. Today, China and Russia share the top spot with 24%. Furthermore, the share of Americans with an unfavorable view of China has increased from 52% to 60% in the six intervening years (Chart II-8). The level of enmity expressed by the US public toward China is still lower than that toward the Soviet Union at the onset of the Cold War in the 1950s (Chart II-9). However, the trajectory of distrust is clearly mounting. We expect this trend to continue: anti-China sentiment is one of the few sources of bipartisan agreement remaining in Washington, DC (Chart II-10). Chinese sentiment toward the United States has also darkened dramatically. The geopolitical rivalry is deepening for structural reasons: as China advances in size and sophistication, it seeks to alter the regional status quo in its favor, while the US grows fearful and seeks to contain China. Chart II-9…But Not Yet To War-Inducing Levels Chart II-10Distrust Of China Is Bipartisan   Chart II-11Newfound American Concern For China’s Repression One example of rising enmity is the US public’s newfound concern for China’s domestic policies and human rights, specifically Beijing’s treatment of its Uyghur minority in Xinjiang. A Google Trends analysis of the term “Uyghur” or “Uyghur camps” shows a dramatic rise in mentions since Q2 of 2018, around the same time the trade war ramped up in a major way (Chart II-11). While startling revelations of re-education camps in Xinjiang emerged in recent years, the reality is that Beijing has used heavy-handed tactics against both militant groups and the wider Uyghur minority since at least 2008 – and much earlier than that. As such, the surge of interest by the general American public and legislators – culminating in the Uyghur Human Rights Policy Act of 2019 – is a product of the renewed strategic tension between the two countries. The same can be said for Hong Kong: the US did not pass a Hong Kong Human Rights and Democracy Act in 2014, during the first round of mass protests, which prompted Beijing to take heavy-handed legal, legislative, and censorship actions. It passed the bill in 2019, after the climate in Washington had changed. Why does this matter for investors? There are two general risks that come with a greater public engagement in foreign policy. First, the “phase one” trade deal between China and the US could fall victim to domestic politics. This deal envisions a large step up in Sino-American economic cooperation. But if China is to import around $200 billion of additional US goods and services over the next two years – an almost inconceivable figure – the US and China will have to tamp down on public vitriol. This is notably the case if the Democratic Party takes over the White House, given its likely greater focus on liberal concerns such as human rights. And yet the latest bills became law under President Trump and a Republican Senate, and we fully expect a second Trump term to involve a re-escalation of trade tensions to ensure compliance with phase one and to try to gain greater structural concessions in phase two. Second, mounting nationalist sentiment will make it more difficult for US and Chinese policymakers to reduce tensions following a potential future military skirmish, accidental or otherwise. While our scenario of a military conflict in 2013 was cogent, the public backlash in the United States was probably manageable.3 Today we can no longer guarantee that this is the case. The “phase one” trade deal risks falling victim to domestic politics due to greater public engagement in foreign policy. China has greater control over the domestic narrative and public discourse, but the rise of the middle class and the government’s efforts to rebuild support for the single-party regime have combined to create an increase in nationalism. Thus it is also more difficult for Chinese policymakers to contain the popular backlash if conflict erupts. In short, the probability of a quick tamping down of public enmity is actively being reduced as American public vilification of China is closing the gap with China’s burgeoning nationalism at an alarming pace. Another of our black swan risks – Taiwan island – is inextricably bound up in this dangerous US-China dynamic. To be clear, Washington will tread carefully, as a conflict over Taiwan could become a major war. Nevertheless Taiwan’s election, as we expected, has injected new vitality into this already underrated geopolitical risk. It is not only that a high-turnout election (Chart II-12) gave President Tsai Ing-wen a greater mandate (Chart II-13), or that her Democratic Progressive Party retained its legislative majority (Chart II-14). It is not only that the trigger for this resounding victory was the revolt in Hong Kong and the Taiwanese people’s rejection of the “one country, two systems” formula for Taiwan. It is also that Tsai followed up with a repudiation of the mainland by declaring, “We don’t have a need to declare ourselves an independent state. We are an independent country already and we call ourselves the Republic of China, Taiwan.” Chart II-12Tsai Ing-Wen Enjoys A Greater Mandate On Higher Turnout… Chart II-13…Popular Support… Chart II-14…And A Legislative Majority This statement is not a minor rhetorical flourish but will be received as a major provocation in Beijing: the crystallization of a long-brewing clash between Beijing and Taipei. Additional punitive economic measures against Taiwan are now guaranteed. Saber-rattling could easily ignite in the coming year and beyond. Taiwan is the epicenter of the US-China strategic conflict. First, Beijing cannot compromise on its security or its political legitimacy and considers the “one China principle” to be inviolable. Second, the US maintains defense relations with Taiwan (and is in the process of delivering on a relatively large new package of arms). Third, the US’s true willingness to fight a war on Taiwan’s behalf is in doubt, which means that deterrence has eroded and there is greater room for miscalculation. Bottom Line: A US-China military skirmish has been our biggest black swan risk since we began writing the BCA Geopolitical Strategy. The difference between then and now, however, is that the American public is actually paying attention. Political ideology – the question of democracy and human rights – is clearly merging with trade, security, and other differences to provoke Americans of all stripes. This makes any skirmish more than just a temporary risk-off event, as it could lead to a string of incidents or even protracted military conflict. Black Swan 3: Social Unrest Erupts In America There are numerous lessons that one can learn from the ongoing unrest in Hong Kong, but perhaps the most cogent one is that Millennials and Generation Z are not as docile and feckless as their elders think. Images of university students and even teenagers throwing flying kicks and Molotov cocktails while clad in black body armor have shocked the world. Perhaps all those violent video games did have a lasting impact on the youth! What is surprising is that so few commentators have made the cognitive leap from the ultra-first world streets of Hong Kong to other developed economies. Perhaps what is clouding analysts’ minds is the idiosyncratic nature of the dispute in Hong Kong, the “one China” angle. However, Hong Kong youth are confronted with similar socio-economic challenges that their peers in other advanced economies face: overpriced real estate and a bifurcated service-sector labor market with few mid-tier jobs that pay a decent wage. There is a risk of rebellion from Trump’s most ardent supporters if he loses the White House. In the US, Millennials and Gen Z are also facing challenges unique to the US. First, their debt burden is much more toxic than that of the older cohorts, given that it is made up of student loans and credit card debt (Chart II-15). Second, they find themselves at odds – demographically and ideologically – with the older cohorts (Chart II-16). Chart II-15Younger American Cohorts Plagued By Toxic Debt Chart II-16Younger And Older Cohorts At Odds Demographically   Chart II-17Massive Turnout To The 2016 Referendum On Trump The adage that the youth are apolitical and do not turn out to vote may have ended thanks to President Trump. The 2018 midterm election, which the Democratic Party successfully turned into a referendum on the president, saw the youth (18-29) turnout nearly double from 20% to 36% (the 30-44 year-old cohort also saw a jump in turnout from 35.6% to 48.8%). The election saw one of the highest turnouts in recent memory, with a 53.4% figure, just two points off the 2016 general election figure (Chart II-17). Despite the high turnout in 2018, the-most-definitely-not-Millennial Vice President Joe Biden continues to lead the Democratic Party in the polls. His probability of winning the nomination is not overwhelming, but it is the highest of any contender. In recent polls, Biden comes third place in Millennial/Gen-Z vote preferences (Chart II-18). Yet he is hardly out of contention, especially for the 30-44 year-old cohort. The view that “Uncle Joe” does not fit the Democratic Party zeitgeist has become so entrenched in the Democratic Party narrative that it became conventional wisdom last year, pulling oddsmakers and betting markets away from the clear frontrunner (Chart II-19). Chart II-18Biden Unpopular Among Young American Voters Chart II-19Bookies Pulled Down 'Uncle Joe’s' Odds, Capturing Democratic Party Zeitgeist     As such, a Biden victory at the Democratic National Convention in Milwaukee, Wisconsin on July 13-16 may come as an affront to the left-wing activists who will surely descend on the convention. This will particularly be the case if Biden wins despite the progressive candidates amassing a majority of overall delegates, which is possible judging by the combined progressive vote share in current polling (Chart II-20). He would arrive in Milwaukee without clearing the 1990 delegate count required to win on the first ballot. On the second ballot, his presidency would then receive a boost from “superdelegates” and those progressives who are unwilling to “rock the boat,” i.e. unify against an establishment candidate with the largest share of votes. This is also how Mayor Michael Bloomberg could pull off a surprise win. Chart II-20Progressives Come Closest To Victory Such a “brokered” – or contested – convention has not occurred since 1952. However, several Democratic Party conventions came close, including 1968, 1972, and 1984. The 1968 one in Chicago was notable for considerable violence and unrest. Even if the Milwaukee Democratic Party convention does not produce unrest, it could sow the seeds for unrest later in the year. First, a breakout Biden performance in the primaries is unlikely. As such, he will likely need to pledge a shift to the left at the convention, including by accepting a progressive vice-presidential candidate. Second, an actual progressive may win the primary. Chart II-21Zealots In Both Parties Perceive Each Other As A National Threat It is likely that either of the two options would be seen as an existential threat to many of Trump’s loyal supporters across the United States. President Trump’s rhetoric often paints the scenario of a Democratic takeover of the White House in apocalyptic terms. And data suggests that the zealots in both parties perceive each other as a “threat to the nation’s wellbeing” (Chart II-21). The American Civil War in the nineteenth century began with the election of a president. This is not just because Abraham Lincoln was a particularly reviled figure in the South, but because the states that ultimately formed the Confederacy saw in his election the demographic writing-on-the-wall. The election was an expression of a general will that, from that point onwards, was irreversible. Given demographic trends in the US today, it is possible that many would see in Trump’s loss a similar fait accompli. If one perceives progressive Democrats as an existential threat to the US constitution, rebellion is the obvious and rational response. Bottom Line: Year 2020 may be a particularly violent one for the US. First, left wing activists may be shocked and angered to learn that Joe Biden (or Bloomberg) is the nominee of the Democratic Party come July. With so much hype behind the progressive candidates throughout the campaign, Biden’s nomination could be seen as an affront to what was supposed to be “the big year” for left-wing candidates. Second, investors have to start thinking about what happens if Biden – or a progressive candidate – goes on to defeat President Trump in the general election. While liberal America took Trump’s election badly, it has demographics – and thus time – on its side. Trump’s most ardent supporters may conclude that his defeat means the end of America as they know it. Black Swan 4: Europe’s Migration Crisis Restarts It is a testament to Europe’s resilience that we do not have a Black Swan scenario based on an election or a political crisis set on the continent in 2020. Support for the common currency and the EU as a whole has rebounded to its highest since 2013. Even early elections in Germany and Italy are unlikely to produce geopolitical risk. The populists in the former are in no danger of outperforming whereas the populists in the latter barely deserve the designation. But what if one of the reasons for the surge in populism – unchecked illegal immigration – were to return in 2020? Chart II-22Decline In Illegal Immigration Dampened European Populism The data suggests that the risk of migrant flows has massively subsided. From its peak of over a million arrivals in 2015, the data shows that only 125,472 migrants crossed into Europe via land and sea routes in the Mediterranean last year (Chart II-22). Why? There are five reasons that we believe have checked the flow of migrants: Supply: The civil wars in Syria, Iraq, and Libya have largely subsided. Heterogenous regions, cities, and neighborhoods have been ethnically cleansed and internal boundaries have largely ossified. It is unlikely that any future conflict will produce massive outflows of refugees as the displacement has already taken place. These countries are now largely divided into armed, ethnically homogenous, camps. Enforcement: The EU has stepped up border enforcement since 2015, pouring resources into the land border with Turkey and naval patrols across the Mediterranean. Individual member states – particularly Italy and Hungary – have also stepped up border enforcement policy. While most EU member states have publicly chided both for “draconian” policies, there is no impetus to force Rome and Budapest to change policy. Libyan Imbroglio: Conflict in Libya has flared up in 2019 with military warlord Khalifa Haftar looking to wrest control from the UN-backed Government of National Accord led by Fayez al-Serraj. The Islamic State has regrouped in the country as well. Ironically, the conflict is helping stem the flow of migrants as African migrants from sub-Saharan countries dare not cross into Libya as they did in 2015 when there was a brief lull in fighting. Turkish benevolence: Ankara is quick to point out that it is the only thing standing between Europe and a massive deluge of migrants. Turkey is said to host somewhere between two and four million refugees from various conflicts in the Middle East. Fear of the crossing: If crossing the Mediterranean was easy, Europe would have experienced a massive influx of migrants throughout the twentieth century. Not only is it not easy, it is costly and quite deadly, with thousands lost each year. Furthermore, most migrants are not welcomed when they arrive to Europe, many are held in terrible conditions in holding camps in Italy and Greece. Over time, migrants who made it into Europe have reported these dangers and conditions, reducing the overall demand for illegal migration. We do not foresee these five factors changing, at least not all at once. However, there are several reasons to worry about the flow of migrants in 2020. US-Iran tensions have sparked outright military action, while unrest is flaring up across Iran’s sphere of influence. Going forward, Iran could destabilize Iraq or fuel Shia unrest against US-backed regimes. Second, Afghanistan has been the source of most migrants to Europe via sea and land Mediterranean routes – 19.2%. The conflict in the country continues and may flare up with President Trump’s decision to formally withdraw most US troops from the country in 2020. Third, a break in fighting in Libya may encourage sub-Saharan migrants to revisit routes to Europe. Migrants from Guinea, Cote d’Ivoire, and the Democratic Republic of Congo make up over 10% of migrants to Europe. Finally, Turkish relationship with the West could break up further in 2020, causing Ankara to ship migrants northward. We highly doubt that President Erdogan will risk such a break, given that 50% of Turkish exports go to Europe. A European embargo on Turkish exports – which would be a highly likely response to such an act – would crush the already decimated Turkish economy. Bottom Line: While we do not see a return to the 2015 level of migration in 2020, we flag this risk because it would fundamentally undermine political stability in Europe. Black Swan 5: Russia Faces A “Peasant Revolt” Our fifth and final black swan risk for the year stems from Russia. This risk may seem obvious, since the US election creates a dynamic that revives the inherent conflict in US-Russian relations. Russia could seek to accomplish foreign policy objectives – interfering in US elections, punishing regional adversaries. The Trump administration may be friendly toward Russia but Trump is unlikely to veto any sanctions passed by the House and Senate in an election year, should an occasion for new sanctions arise. Conversely Russia could anticipate greater US pressure if the Democrats win in November. Yet it is Russia’s domestic affairs that represent the real underrated risk. Putin’s fourth term as president has been characterized by increased focus on domestic political control and stability as opposed to foreign adventurism. The creation of a special National Guard in 2016, reporting directly to Putin and responsible for quelling domestic unrest, symbolizes the shift in focus. So too does Russia’s adherence to the OPEC 2.0 regime of production control to keep oil prices above their budget breakeven level. Meanwhile Putin’s courting of Europe for the Nordstream II pipeline, and his slight peacemaking efforts with Ukraine, has suggested a slightly more restrained international posture. Strategically it makes little sense for Russia to court negative attention at a time when the US and Europe are at odds over trade and the Middle East, the US is preoccupied with China and Iran, and Russia itself faces mounting domestic problems. The domestic problems are long in coming. The central bank has maintained a stringent monetary policy for the better part of the decade. Despite cutting interest rates recently, monetary and credit conditions are still tight, hurting domestic demand. Moscow has also imposed fiscal austerity, namely by cutting back on state pensions and hiking the value added tax. Real wage growth is weak (Chart II-23), retail sales are falling, and domestic demand looks to weaken further, as Andrija Vesic of BCA Emerging Markets Strategy observes in a recent Special Report. The effect of Russia’s policy austerity has been a drop in public approval of the administration (Chart II-24). Protests erupted in 2019 but were largely drowned out by the larger and more globally significant protests in Hong Kong. These were met by police suppression that has not removed their underlying cause. Putin’s first major decision of the new year was to reshuffle the government, entailing Prime Minister Dmitri Medvedev’s transfer to a new post and the appointment of a new cabinet. This move reveals the need to show some accountability to reduce popular pressure. While Moscow now has room to cut interest rates and ease fiscal policy, it is behind the curve and the weak economy will add fuel to domestic unrest. Chart II-23Sluggish Wage Growth Threatens Russian Stability Chart II-24Austerity Weighed On The Administration's Popularity In Russia   Meanwhile Putin’s efforts to alter the Russian constitution so he can stay in power beyond current term limits, effectively becoming emperor for life, like Xi Jinping, should not be dismissed merely because they are expected. They reflect a need to take advantage of Putin’s popular standing to consolidate domestic political power at a time when the ruling United Russia party and the federal government face discontent. They also ensure that strategic conflict with the United States will take on an ideological dimension. Russia's recent cabinet shakeup is positive from the point of view of economic reform. And the country's monetary and fiscal room provide a basis for remaining overweight equities within EM, as our Emerging Markets Strategy recommends. However, Russian equities have rallied hard and the political risk is understated. Chart II-25Russian Political Risk Is Unsustainably Low Bottom Line: It is never easy predicting Putin’s next international move. Our market-based indicators of Russian political risk have hit multi-year lows, but both the domestic and international context suggest that these lows will not be sustained (Chart II-25). A new bout of risk can emanate from Putin, or from changes in Washington, or from the Russian people themselves. What would take the world by surprise would be domestic unrest on a larger scale than Russia can easily suppress through the police force. Housekeeping We are closing our long European Union / short Chinese equities strategic trade with a 1.61% loss since inception on May 10, 2019. Dhaval Joshi of BCA’s European Investment Strategy downgraded the Eurostoxx 50 to underweight versus the S&P 500 and the Nikkei 225 this week. He makes the point that the Euro Area bond yield 6-month impulse hit 100 bps – a critical technical level – and will be a strong headwind to growth. We will look to reopen this trade at a later date when the euphoria over the “phase one” trade deal subsides, as we still favor European equities and DM bourses over EM. We will reinstitute our long Brent crude H2 2020 versus H2 2021 tactical position, which was stopped out on January 9, 2020. We remain bullish on oil fundamentals and expect Middle East instability to add a political risk premium. China's stimulus and the oil view also give reason for us to reinitiate our long Malaysian equities relative to EM as a tactical position. The Malaysian ringgit will benefit as oil prices move higher, helping Malaysian companies make payments on their large pile of dollar-denominated debt and improving household purchasing power. Higher oil prices also correlate with higher equity prices, while China's stimulus and the US trade ceasefire will push the US dollar lower and help trade revive in the region. Marko Papic Chief Strategist, Clocktower Group Matt Gertken Geopolitical Strategist   III. Indicators And Reference Charts The S&P 500 rally looks increasingly vulnerable from a tactical perspective. The US benchmark is overbought, and the percentage of NYSE stocks above their 30-week and 10-week moving averages is rolling over at elevated levels. Additionally, the number of NYSE new highs minus new lows has moved in a parabolic fashion and has hit levels that in previous years have warned of an imminent correction. The spread of nCoV-2019 is likely to be the catalyst to a pullback that could cause the S&P 500 to retest its October 2019 breakout. An improving outlook for global growth, limited inflationary pressures and global central banks who maintain an accommodative monetary stance bode well for stocks. Therefore, the anticipated equity correction will not morph into a bear market. For now, our Monetary Indicator remains at extremely elevated levels. Furthermore, our Composite Technical Indicator has strengthened. Additionally, our BCA Composite Valuation index suggests that stocks are expensive, but not so much as to cancel out the supportive monetary and technical backdrop. Finally, our Speculation Indicator is elevated, but is not so high as to warn of an imminent market top. This somewhat muted level of speculation is congruent with the expectation of low long-term growth rates for profits embedded in equity prices. In contrast to our Revealed Preference Indicator, our Willingness-to-Pay (WTP) is moving in accordance with our constructive cyclical stance for stocks. Indeed, the WTP for the US, Japan and Europe continues to improve. The WTP indicator tracks flows, and thus provides information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. This broad-based improvement therefore bodes well for equities. Meanwhile, net earnings revisions appear to be forming a trough. 10-year Treasury yields remain extremely expensive. Moreover, according to our Composite Technical Indicator, T-Note prices are losing momentum. The fear surrounding the spread of the new coronavirus has cause bonds to rally again, but this is likely to be the last hurrah for the Treasury markets before a major reversal takes hold. The rising risk premia linked to the coronavirus is also helping the dollar right now, but signs that global growth is bottoming, such as the stabilization in the global PMIs, the pick-up in the German ZEW and Belgium’s Business Confidence surveys, or the improvement in Asia’s export growth, point to a worsening outlook for the counter-cyclical US dollar. Moreover, the dollar trades at a large premium of 24.5% relative to its purchasing-power parity equilibrium. Additionally, the negative divergence between the dollar and our Composite Momentum Indicator suggests that the dollar is technically vulnerable. In fact, the very modest pick-up in the dollar in response to the severe fears created by the spreading illness in China argues that dollar buying might have become exhausted. Finally, commodity prices have corrected meaningfully in response to the stronger dollar and the growth fears created by the spread of the coronavirus. However, they have not pulled back below the levels where they traded when they broke out in late 2019. Moreover, the advance/decline line of the Continuous Commodity Index remains at an elevated level, indicating underlying strength in the commodity complex. Natural resources prices will likely become the key beneficiaries of both the eventual pullback in virus-related fears and the weaker dollar.   EQUITIES: Chart III-1US Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Chart III-5US Stock Market Valuation Chart III-6US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance   FIXED INCOME: Chart III-9US Treasurys And Valuations Chart III-10Yield Curve Slopes Chart III-11Selected US Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets   CURRENCIES: Chart III-16US Dollar And PPP Chart III-17US Dollar And Indicator Chart III-18US Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning   ECONOMY: Chart III-28US And Global Macro Backdrop Chart III-29US Macro Snapshot Chart III-30US Growth Outlook Chart III-31US Cyclical Spending Chart III-32US Labor Market Chart III-33US Consumption Chart III-34US Housing Chart III-35US Debt And Deleveraging   Chart III-36US Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China   Mathieu Savary Vice President The Bank Credit Analyst   Footnotes 1 Please see US Equity Strategy Weekly Report "Three EPS Scenarios," dated January 13, 2020, available at uses.bcaresearch.com; US Equity Strategy Insight Report "Bombed Out Energy," dated January 8, 2020, available at uses.bcaresearch.com; US Equity Strategy Special Report "Industrials: Start Your Engines," dated January 21, 2020, available at uses.bcaresearch.com 2  Please see The Bank Credit Analyst Monthly Report "January 2020," dated December 20, 2019 available at bca.bcaresearch.com; The Bank Credit Analyst Monthly Report "OUTLOOK 2020: Heading Into The End Game," dated November 22, 2019 available at bca.bcaresearch.com 3 Please see Geopolitical Strategy "A Reprieve Amid The Bull Market In Iran Tensions," dated January 8, 2020, available at gps.bcaresearch.com 4 Observe how little attention the public paid to US-China saber-rattling around China’s announcement of an Air Defense Identification Zone in the East China Sea that year.

Highlights Portfolio Strategy There are high odds that China’s real GDP deceleration will continue for the next decade, casting a shadow over the profit prospects of the S&P 1500 metals & mining index. A structural below benchmark allocation is warranted. Rising total mutual fund assets under management, improved trading revenue prospects, rising investor confidence along with a revival in IPO and M&A activity, all signal that it still pays to be overweight the S&P capital markets index. Recent Changes There are no changes in our portfolio this week. Table 1 Feature “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” - Charles Owen "Chuck" Prince III (ex-CEO of Citigroup) The SPX remains near all time highs and the invincible tech sector continues to lead the pack. Two weeks ago we showed that the market capitalization concentration of the top five stocks in the S&P 500 surpassed the late-1990s parallel (Chart 1), and Table 2 shows that late in the cycle a handful of stocks explain a sizable part of the broad market’s return.1 However, in terms of valuation overshoot the current forward P/E of these top five stocks is roughly half the late-1990s parabolic episode (Chart 2). Chart 1Vertigo Warning Chart 2Unlike The Late-1990s While the overall market does not fully resemble the excesses of the dot.com bubble era, at least not yet, there are elements that are eerily reminiscent of the late-1990s. Table 2Contribution To Late Cycle Rallies In The SPX Chart 3Correlation Breakdown Contrary to popular belief, during manias historical correlations break down and the forward multiple becomes positively correlated with the discount rate. So in the late 1990s, the fed funds rate and the 10-year yield jumped 200bps in a short time span and the SPX forward P/E soared 40% from roughly 18x to 25x (Chart 3) before collapsing to 14x soon thereafter. Simultaneously, the US dollar was roaring as real interest rates were 4%, but the NASDAQ 100 outperformed the emerging markets, another break in historical correlations. As Chuck Prince mused in 2007, there is a narrative in the equity market today that, “as long as the music is playing, you’ve got to get up and dance”. While the overall market does not fully resemble the excesses of the dot.com bubble era, at least not yet, there are elements that are eerily reminiscent of the late-1990s. We filtered for large cap stocks that are at all-time highs and have increased in value at a minimum 10x since 2010. Among the stocks that met these criteria, five really stand out, Apple, Tesla, Lam Research, Amd & Salesforce, and comprise our “ATLAS” index; the mania in these stocks will likely end in tears (Chart 4). Even their forward P/E ratio has gone exponential, hitting a 60 handle last year similar to top five SPX stocks in the late-1990s. Chart 4ATLAS: Holding The World On His Shoulders Currently, SPX profits are barely growing and the sole reason equities are higher is the massive injection of liquidity via the drubbing in interest rates and the restart of QE. From peak-to-trough the 10-year yield fell 175bps in nine months, and the Fed commenced expanding its balance sheet by $60bn/month since last September; yet profits have barely budged. Ultimately, profits have to show up and the news on this front remains grim. The current non-inflationary trend-growth backdrop is a “goldilocks” scenario especially for tech stocks that thrive during disinflationary periods. While stocks can go higher defying weak EPS fundamentals as they have yet to reach a fully euphoric state according to our Complacency-Anxiety Indicator (Chart 5), a sell-off in the bond market will likely cause some consternation in equities in general and tech stocks in particular similar to early- and late-2018. Chart 5Not Max Complacent Yet Other catalysts that can suddenly cause “the music to stop” are either the recent coronavirus becoming an epidemic or a geopolitical event that would result in a risk off backdrop. Ultimately, profits have to show up and the news on this front remains grim. Our mid-January “Three EPS Scenarios” analysis still suggests that the SPX is 9% overvalued.2 This week we are updating our capital markets view and adding a sixth long-term theme and a related investment implication to our mid-December 2019, Special Report titled, “Top US Sector Investment Ideas For The Next Decade”.3 Sixth Big Theme For The Decade And Investment Implications China’s ascendancy on the world scene was a mega driver of equity markets in the 2000s following its inclusion in the WTO. The commodity super-cycle captured investors’ imaginations and China’s insatiable appetite for commodities caused a massive bubble in the commodity complex in general and commodity-related equities in particular. Nevertheless, the Great Recession posed a severe threat to China and the authorities injected an extraordinary amount of stimulus into the economy (15% of GDP over two years). This succeeded in doubling real GDP growth, but only temporarily. The unintended consequence was an enormous debt binge fueled by cheap money. Moreover, this debt burden along with falling labor force growth and productivity forced the government to re-think its policies as they caused a steady down drift in real output growth. The sixth big theme for the 2020s is a sustained deceleration of Chinese real GDP growth to a range of 4% to 2% (Chart 6). Not only is the debt overhang weighing on real output growth, but Chinese leaders are adamant about transitioning the economy to developed market status, which is synonymous with higher consumption expenditures at the expense of gross fixed capital formation. Chart 6From Boom… Chart 7…To Bust In other words, China remains committed to weaning its economy off of investment and reconfiguring it toward consumption (Chart 7). This is a strategic plan but it is possible that the Chinese economy can achieve this transition in due time. While this will not happen overnight, the implication is steadily lower real GDP growth as is common among large, mature, developed market economies. China will remain one of the top commodity consumers in the world, as urbanization is ongoing, but the intensity of commodity consumption will continue to decelerate (Chart 8). At the margin, this change in consumption behavior will have knock on effects on the broad basic resources sector in general and the S&P 1500 metals & mining index in particular. Were this Chinese backdrop to pan out in the coming decade as we expect, it would sustain the relative underperformance of metals & mining equities as Chart 6 & 7 depict. Chart 8Commodity Consumption Deceleration Will… Chart 9…Continue To Weigh On Metals & Mining Profits Importantly, these commodity producers will have to adjust their still bloated cost structures to lower run rates which is de facto negative both for relative sales and profit growth (Chart 9). Tack on the large negative footprint mining extraction has on the environment, and if ESG investing (our fifth big theme for the decade4) also takes off, investors should avoid the S&P 1500 metals & mining index on a secular basis. Bottom Line: There are high odds that China’s real GDP deceleration will continue for the next decade, casting a shadow over the profit prospects of the S&P 1500 metals & mining index. A structural below benchmark allocation is warranted. The ticker symbols for the stocks in this index are: BLBG S15METL – NEM, FCX, NUE, RS, RGLD, STLD, CMC, ATI, CRS, CLF, CMP, X, KALU, WOR, MTRN, HCC, AKS, SXC, HAYN, CENX, TMST, ZEUS. Capital Markets Update Capital markets stocks have come out of hibernation recently and are on the cusp of breaking out – in a bullish fashion – of their 18-month trading range. A number of the indicators we track signal that an earnings-led outperformance period is in the cards for this financials sub-group and we reiterate our overweight stance. Sloshing liquidity has pushed investors out the risk spectrum and high yield bond option adjusted spreads are flirting with multi-year lows. Such a tame junk bond market backdrop coupled with easy financial conditions are conducive to rising M&A activity (Chart 10). Importantly, the Fed’s Senior Loan Officer Survey paints an improving profit backdrop for investment banks. Not only are bankers willing extenders of credit, but demand for credit for the majority of loan categories that the Fed tracks is squarely in positive territory (top panel, Chart 11). Chart 10Subsiding Risks Are A Boon To Capital Markets Chart 11Positive Profit Catalysts This is likely a consequence of last year’s drubbing in the price of credit. M&A activity usually goes hand in hand with loan growth, underscoring that business combinations are on track to accelerate (third panel, Chart 10). This will revive a lucrative business line for capital markets firms. Total mutual fund assets are expanding at a brisk rate and hitting fresh all-time highs, signaling an uptick in risk appetite (third panel, Chart 11). Rising investor confidence will facilitate both new and secondary share issuance, an important source of fee generation for capital markets firms. Moreover, equity trading volumes have sprang back to life in recent weeks underscoring that the recent impressive Q4 earnings results will likely continue into Q1/2020 (bottom panel, Chart 10). Meanwhile, the three Fed rate cuts last year should work through the economy and at least stem further losses in the ISM manufacturing survey. The US/China trade détente will also lead to a stabilization in global growth. In fact, the V-shaped recovery in the global ZEW survey suggests that capital markets profits will likely outpace the broad market this year (second & bottom panels, Chart 11). Finally, the recent surge in the stock-to-bond ratio reflects a massive psychological shift, from last year’s recessionary fears to growing investor confidence that tail risks are abating (Chart 12). Still depressed valuations neither reflect the firming capital markets profit outlook nor the rising industry ROE (bottom panel, Chart 12). Adding it all up, accelerating total mutual fund assets under management, improved trading revenue prospects, rising investor confidence and a revival in IPO and M&A activity, all signal that it still pays to be overweight the S&P capital markets index.  Bottom Line: Stay overweight the S&P capital markets index. The ticker symbols for the stocks in this index are: BLBG S5CAPM – GS, CME, SPGI, MS, BLK, SCHW, ICE, MCO, BK, TROW, STT, MSCI, NTRS, AMP, MKTX, CBOE, NDAQ, RJF, ETFC, BEN, IVZ. Chart 12Valuation Re-Rating Looms     Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com     1     Please see BCA US Equity Strategy Weekly Report, “Three EPS Scenarios” dated January 13, 2020, available at uses.bcaresearch.com. 2     Ibid. 3     Please see BCA US Equity Strategy Special Report, “Top US Sector Investment Ideas For the Next Decade” dated December 16, 2019, available at uses.bcaresearch.com. 4     Ibid.   Current Recommendations Current Trades Size And Style Views Stay neutral cyclicals over defensives (downgrade alert) Favor value over growth Favor large over small caps (Stop 10%)

Highlights Our top five geopolitical “Black Swans” are risks that the market is seriously underpricing. With the “phase one” trade deal signed, Chinese policy could become less accommodative, resulting in a negative economic surprise. The trade deal may fall victim to domestic politics, raising the risk of a US-China military skirmish. A Biden victory at the Democratic National Convention or a Democratic takeover of the White House could trigger social unrest and violence in the US. A pickup in the flow of migrants to Europe would fundamentally undermine political stability there. Russia’s weak economy will add fuel to domestic unrest, risking an escalation beyond the point of containment. Feature Over the past four years, we have started off the year with our top five geopolitical “Black Swans.” These are low-probability events whose market impact would be significant enough to matter for global investors. Unlike the great Byron Wien’s perennial list of market surprises, we do not assign these events a “better than 50% likelihood of happening.” We offer risks that the market is seriously underpricing by assigning them only single-digit probabilities when we think the reality is closer to 10%-15%, a level at which a risk premium ought to be assigned. Some of our risks below are so obscure that it is not clear how exactly to price them. We exclude issues that are fairly probable, such as flare-ups in Indo-Pakistani conflict. The two major risks of the year – discussed in our annual outlook – are that either US President Donald Trump or Chinese President Xi Jinping overreaches in a major way. But what would truly surprise the market would be a policy-induced relapse in Chinese growth or a direct military clash between the two great powers. That is how we begin. Other risks stem from domestic affairs in the US, Europe, and Russia. Black Swan 1: China’s Financial Crisis Begins The risk of Xi Jinping’s concentration of power in his own person is that individuals can easily make mistakes, especially if unchecked by advisors or institutions. Lower officials will fear correcting or admonishing an all-powerful leader. Inconvenient information may not be relayed up the hierarchy. Such behavior was rampant in Chairman Mao Zedong’s time, leading to famine among other ills. Insofar as President Xi’s cult of personality successfully imitates Mao’s, it will be subject to similar errors. If President Xi overreaches and makes a policy mistake this year, it could occur in economic policy or other policies. We begin with economic policy, as we have charted the risks of Xi’s crackdown on the financial system since early 2017 (Chart 1). Chart 1A Crackdown On Financial Risk Could Cause China's Economy To Derail Chart 2Easing Of Trade Tensions May Re-Incentivize Tighter Policy This year is supposed to be the third and final year of Xi Jinping’s “three battles” against systemic risk, pollution, and poverty. The first battle actually focuses on financial risk, i.e. China’s money and credit bubble. The regime has compromised on this goal since mid-2018, allowing monetary easing to stabilize the economy amid the trade war. But with a “phase one” trade deal having been signed, there is an underrated risk that economic policy will return to its prior setting, i.e. become less accommodative (Chart 2). When Xi launched the “deleveraging campaign” in 2017, we posited that the authorities would be willing to tolerate an annual GDP growth rate below 6%. This would not only cull excesses in the economy but also demonstrate that the administration means business when it says that China must prioritize quality rather than quantity of growth. While Chinese authorities are most likely targeting “around 6%” in 2020, it is entirely possible that the authorities will allow an undershoot in the 5.5%-5.9% range. They will argue that the GDP target for 2020 has already been met on a compound growth rate basis (Chart 3), as astute clients have pointed out. They may see less need for stimulus than the market expects. Chart 3Chinese Authorities Might Tolerate A Growth Undershoot In 2020 Similarly, while urban disposable income is ostensibly lagging its target of doubling 2010 levels by 2020, China’s 13th Five Year Plan, which concludes in 2020, conspicuously avoided treating urban and rural income targets separately. Chart 4Lower Impetus For Economic Support Due To Improvements In National Income? Chart 5Has China's Stimulus Peaked? If the authorities focus only on general disposable income, then they are on track to meet their target (Chart 4). This would reduce the impetus for greater economic support. There are already tentative signs that Chinese authorities are “satisfied” with the amount of stimulus they have injected: some indicators of money and credit have already peaked (Chart 5). The crackdown on shadow banking has eased, but informal lending is still contracting. The regime is still pushing reforms that shake up state-owned enterprises. The Xi administration may aim only for stability, not acceleration, in the economy. An added headwind for the Chinese economy stems from the currency. The currency should track interest rate differentials. Beijing’s incremental monetary stimulus, in the form of cuts to bank reserve requirement ratios (RRRs), should also push the renminbi down over time (Chart 6). However, an essential aspect of any trade deal with the Trump administration is the need to demonstrate that China is not competitively devaluing. Hence the CNY-USD could overshoot in the first half of the year. This is positive for global exports to China, but it tightens Chinese financial conditions at home. A stronger than otherwise justified renminbi would add to any negative economic surprises from less accommodative monetary and fiscal policy. Conventional wisdom says China will stimulate the economy ahead of two major political events: the centenary of the Communist Party in 2021 and the twentieth National Party Congress in 2022. The former is a highly symbolic anniversary, as Xi has reasserted the supremacy of the party in all things, while the latter is more significant for policy, as it is a leadership reshuffle that will usher in the sixth generation of China’s political elite. But conventional wisdom may be wrong – the Xi administration may aim only for stability, not acceleration, in the economy. It would make sense to save dry powder for the next US or global recession. The obvious implication is that China’s economic rebound may lose steam as early as H2 – but the black swan risk is that negative surprises could cause a vicious spiral inside of China. This is a country with massive financial and economic imbalances, a declining potential growth profile, and persistent political obstacles to growth both at home and abroad. Corporate defaults have spiked sharply. While the default rate is lower than elsewhere, the market may be sniffing out a bigger problem as it charges a much higher premium for onshore Chinese bonds (Chart 7). Chart 6CNY-USD Overshoot Would Tighten Chinese Financial Conditions Chart 7Is China's Bond Market Sniffing Out A Problem? Bottom Line: Our view is that China’s authorities will remain accommodative in 2020 in order to ensure that growth bottoms and the labor market continues to improve. But Beijing has compromised its domestic economic discipline since 2018 in order to fight trade war. The risk now, with a “phase one” deal in hand, is that Xi Jinping returns to his three-year battle plan and underestimates the downward pressures on the economy. The result would be a huge negative surprise for the Chinese and global economy in 2020. Black Swan 2: The US And China Go To War In 2013, we predicted that US-China conflict was “more likely than you think.” This was not just an argument for trade conflict or general enmity that raises the temperature in the Asia-Pacific region – we included military conflict. Chart 8Americans' Attitudes Toward China Plunged … At the time, the notion that a Sino-American armed conflict was the world’s greatest geopolitical threat seemed ludicrous to many of our clients. We published this analysis in October of that year, months after the Islamic State “Soldier’s Harvest” offensive into Iraq. Trying to direct investors to the budding rivalry between American and Chinese naval forces in the South China Sea amidst the Islamic State hysteria was challenging, to say the least. The suggestion that an accidental skirmish between the US and China could descend into a full-blown conflict involved a stretch of the imagination because China was not yet perceived by the American public as a major threat. In 2014, only 19%of the US public saw China as the “greatest threat to the US in the future.” This came between Russia, at 23%, and Iran, at 16%. Today, China and Russia share the top spot with 24%. Furthermore, the share of Americans with an unfavorable view of China has increased from 52% to 60% in the six intervening years (Chart 8). The level of enmity expressed by the US public toward China is still lower than that toward the Soviet Union at the onset of the Cold War in the 1950s (Chart 9). However, the trajectory of distrust is clearly mounting. We expect this trend to continue: anti-China sentiment is one of the few sources of bipartisan agreement remaining in Washington, DC (Chart 10). Chinese sentiment toward the United States has also darkened dramatically. The geopolitical rivalry is deepening for structural reasons: as China advances in size and sophistication, it seeks to alter the regional status quo in its favor, while the US grows fearful and seeks to contain China. Chart 9… But Not Yet To War-Inducing Levels Chart 10Distrust Of China Is Bipartisan Chart 11Newfound American Concern For China’s Repression One example of rising enmity is the US public’s newfound concern for China’s domestic policies and human rights, specifically Beijing’s treatment of its Uyghur minority in Xinjiang. A Google Trends analysis of the term “Uyghur” or “Uyghur camps” shows a dramatic rise in mentions since Q2 of 2018, around the same time the trade war ramped up in a major way (Chart 11). While startling revelations of re-education camps in Xinjiang emerged in recent years, the reality is that Beijing has used heavy-handed tactics against both militant groups and the wider Uyghur minority since at least 2008 – and much earlier than that. As such, the surge of interest by the general American public and legislators – culminating in the Uyghur Human Rights Policy Act of 2019 – is a product of the renewed strategic tension between the two countries. The “phase one” trade deal risks falling victim to domestic politics due to greater public engagement in foreign policy. The same can be said for Hong Kong: the US did not pass a Hong Kong Human Rights and Democracy Act in 2014, during the first round of mass protests, which prompted Beijing to take heavy-handed legal, legislative, and censorship actions. It passed the bill in 2019, after the climate in Washington had changed. Why does this matter for investors? There are two general risks that come with a greater public engagement in foreign policy. First, the “phase one” trade deal between China and the US could fall victim to domestic politics. This deal envisions a large step up in Sino-American economic cooperation. But if China is to import around $200 billion of additional US goods and services over the next two years – an almost inconceivable figure – the US and China will have to tamp down on public vitriol. This is notably the case if the Democratic Party takes over the White House, given its likely greater focus on liberal concerns such as human rights. And yet the latest bills became law under President Trump and a Republican Senate, and we fully expect a second Trump term to involve a re-escalation of trade tensions to ensure compliance with phase one and to try to gain greater structural concessions in phase two. Second, mounting nationalist sentiment will make it more difficult for US and Chinese policymakers to reduce tensions following a potential future military skirmish, accidental or otherwise. While our scenario of a military conflict in 2013 was cogent, the public backlash in the United States was probably manageable.1 Today we can no longer guarantee that this is the case. China has greater control over the domestic narrative and public discourse, but the rise of the middle class and the government’s efforts to rebuild support for the single-party regime have combined to create an increase in nationalism. Thus it is also more difficult for Chinese policymakers to contain the popular backlash if conflict erupts. In short, the probability of a quick tamping down of public enmity is actively being reduced as American public vilification of China is closing the gap with China’s burgeoning nationalism at an alarming pace. Chart 12Tsai Ing-Wen Enjoys A Greater Mandate On Higher Turnout … Another of our black swan risks – Taiwan island – is inextricably bound up in this dangerous US-China dynamic. To be clear, Washington will tread carefully, as a conflict over Taiwan could become a major war. Nevertheless Taiwan’s election, as we expected, has injected new vitality into this already underrated geopolitical risk. It is not only that a high-turnout election (Chart 12) gave President Tsai Ing-wen a greater mandate (Chart 13), or that her Democratic Progressive Party retained its legislative majority (Chart 14). It is not only that the trigger for this resounding victory was the revolt in Hong Kong and the Taiwanese people’s rejection of the “one country, two systems” formula for Taiwan. It is also that Tsai followed up with a repudiation of the mainland by declaring, “We don’t have a need to declare ourselves an independent state. We are an independent country already and we call ourselves the Republic of China, Taiwan.” Chart 13… Popular Support … Chart 14… And A Legislative Majority This statement is not a minor rhetorical flourish but will be received as a major provocation in Beijing: the crystallization of a long-brewing clash between Beijing and Taipei. Additional punitive economic measures against Taiwan are now guaranteed. Saber-rattling could easily ignite in the coming year and beyond. Taiwan is the epicenter of the US-China strategic conflict. First, Beijing cannot compromise on its security or its political legitimacy and considers the “one China principle” to be inviolable. Second, the US maintains defense relations with Taiwan (and is in the process of delivering on a relatively large new package of arms). Third, the US’s true willingness to fight a war on Taiwan’s behalf is in doubt, which means that deterrence has eroded and there is greater room for miscalculation. Bottom Line: A US-China military skirmish has been our biggest black swan risk since we began writing the BCA Geopolitical Strategy. The difference between then and now, however, is that the American public is actually paying attention. Political ideology – the question of democracy and human rights – is clearly merging with trade, security, and other differences to provoke Americans of all stripes. This makes any skirmish more than just a temporary risk-off event, as it could lead to a string of incidents or even protracted military conflict. Black Swan 3: Social Unrest Erupts In America There are numerous lessons that one can learn from the ongoing unrest in Hong Kong, but perhaps the most cogent one is that Millennials and Generation Z are not as docile and feckless as their elders think. Images of university students and even teenagers throwing flying kicks and Molotov cocktails while clad in black body armor have shocked the world. Perhaps all those violent video games did have a lasting impact on the youth! What is surprising is that so few commentators have made the cognitive leap from the ultra-first world streets of Hong Kong to other developed economies. Perhaps what is clouding analysts’ minds is the idiosyncratic nature of the dispute in Hong Kong, the “one China” angle. However, Hong Kong youth are confronted with similar socio-economic challenges that their peers in other advanced economies face: overpriced real estate and a bifurcated service-sector labor market with few mid-tier jobs that pay a decent wage. In the US, Millennials and Gen Z are also facing challenges unique to the US. First, their debt burden is much more toxic than that of the older cohorts, given that it is made up of student loans and credit card debt (Chart 15). Second, they find themselves at odds – demographically and ideologically – with the older cohorts (Chart 16). Chart 15Younger American Cohorts Plagued By Toxic Debt Chart 16Younger And Older Cohorts At Odds Demographically The adage that the youth are apolitical and do not turn out to vote may have ended thanks to President Trump. The 2018 midterm election, which the Democratic Party successfully turned into a referendum on the president, saw the youth (18-29) turnout nearly double from 20% to 36% (the 30-44 year-old cohort also saw a jump in turnout from 35.6% to 48.8%). The election saw one of the highest turnouts in recent memory, with a 53.4% figure, just two points off the 2016 general election figure (Chart 17). Chart 17Massive Turnout To The 2016 Referendum On Trump Despite the high turnout in 2018, the-most-definitely-not-Millennial Vice President Joe Biden continues to lead the Democratic Party in the polls. Chart 18Biden Unpopular Among Young American Voters Chart 19Bookies Pulled Down "Uncle Joe's" Odds, Capturing Democratic Party Zeitgeist His probability of winning the nomination is not overwhelming, but it is the highest of any contender. In recent polls, Biden comes third place in Millennial/Gen-Z vote preferences (Chart 18). Yet he is hardly out of contention, especially for the 30-44 year-old cohort. The view that “Uncle Joe” does not fit the Democratic Party zeitgeist has become so entrenched in the Democratic Party narrative that it became conventional wisdom last year, pulling oddsmakers and betting markets away from the clear frontrunner (Chart 19). As such, a Biden victory at the Democratic National Convention in Milwaukee, Wisconsin on July 13-16 may come as an affront to the left-wing activists who will surely descend on the convention. This will particularly be the case if Biden wins despite the progressive candidates amassing a majority of overall delegates, which is possible judging by the combined progressive vote share in current polling (Chart 20). He would arrive in Milwaukee without clearing the 1990 delegate count required to win on the first ballot. On the second ballot, his presidency would then receive a boost from “superdelegates” and those progressives who are unwilling to “rock the boat,” i.e. unify against an establishment candidate with the largest share of votes. This is also how Mayor Michael Bloomberg could pull off a surprise win. Chart 20Progressives Come Closest To Victory Such a “brokered” – or contested – convention has not occurred since 1952. However, several Democratic Party conventions came close, including 1968, 1972, and 1984. The 1968 one in Chicago was notable for considerable violence and unrest. Even if the Milwaukee Democratic Party convention does not produce unrest, it could sow the seeds for unrest later in the year. First, a breakout Biden performance in the primaries is unlikely. As such, he will likely need to pledge a shift to the left at the convention, including by accepting a progressive vice-presidential candidate. Second, an actual progressive may win the primary. Chart 21Zealots In Both Parties Perceive Each Other As A National Threat It is likely that either of the two options would be seen as an existential threat to many of Trump’s loyal supporters across the United States. President Trump’s rhetoric often paints the scenario of a Democratic takeover of the White House in apocalyptic terms. And data suggests that the zealots in both parties perceive each other as a “threat to the nation’s wellbeing” (Chart 21). The American Civil War in the nineteenth century began with the election of a president. This is not just because Abraham Lincoln was a particularly reviled figure in the South, but because the states that ultimately formed the Confederacy saw in his election the demographic writing-on-the-wall. The election was an expression of a general will that, from that point onwards, was irreversible. Given demographic trends in the US today, it is possible that many would see in Trump’s loss a similar fait accompli. If one perceives progressive Democrats as an existential threat to the US constitution, rebellion is the obvious and rational response. There is a risk of rebellion from Trump’s most ardent supporters if he loses the White House. Bottom Line: Year 2020 may be a particularly violent one for the US. First, left wing activists may be shocked and angered to learn that Joe Biden (or Bloomberg) is the nominee of the Democratic Party come July. With so much hype behind the progressive candidates throughout the campaign, Biden’s nomination could be seen as an affront to what was supposed to be “the big year” for left-wing candidates. Second, investors have to start thinking about what happens if Biden – or a progressive candidate – goes on to defeat President Trump in the general election. While liberal America took Trump’s election badly, it has demographics – and thus time – on its side. Trump’s most ardent supporters may conclude that his defeat means the end of America as they know it. Black Swan 4: Europe’s Migration Crisis Restarts Chart 22Decline In Illegal Immigration Dampened European Populism It is a testament to Europe’s resilience that we do not have a Black Swan scenario based on an election or a political crisis set on the continent in 2020. Support for the common currency and the EU as a whole has rebounded to its highest since 2013. Even early elections in Germany and Italy are unlikely to produce geopolitical risk. The populists in the former are in no danger of outperforming whereas the populists in the latter barely deserve the designation. But what if one of the reasons for the surge in populism – unchecked illegal immigration – were to return in 2020? The data suggests that the risk of migrant flows has massively subsided. From its peak of over a million arrivals in 2015, the data shows that only 125,472 migrants crossed into Europe via land and sea routes in the Mediterranean last year (Chart 22). Why? There are five reasons that we believe have checked the flow of migrants: Supply: The civil wars in Syria, Iraq, and Libya have largely subsided. Heterogenous regions, cities, and neighborhoods have been ethnically cleansed and internal boundaries have largely ossified. It is unlikely that any future conflict will produce massive outflows of refugees as the displacement has already taken place. These countries are now largely divided into armed, ethnically homogenous, camps. Enforcement: The EU has stepped up border enforcement since 2015, pouring resources into the land border with Turkey and naval patrols across the Mediterranean. Individual member states – particularly Italy and Hungary – have also stepped up border enforcement policy. While most EU member states have publicly chided both for “draconian” policies, there is no impetus to force Rome and Budapest to change policy. Libyan Imbroglio: Conflict in Libya has flared up in 2019 with military warlord Khalifa Haftar looking to wrest control from the UN-backed Government of National Accord led by Fayez al-Serraj. The Islamic State has regrouped in the country as well. Ironically, the conflict is helping stem the flow of migrants as African migrants from sub-Saharan countries dare not cross into Libya as they did in 2015 when there was a brief lull in fighting. Turkish benevolence: Ankara is quick to point out that it is the only thing standing between Europe and a massive deluge of migrants. Turkey is said to host somewhere between two and four million refugees from various conflicts in the Middle East. Fear of the crossing: If crossing the Mediterranean was easy, Europe would have experienced a massive influx of migrants throughout the twentieth century. Not only is it not easy, it is costly and quite deadly, with thousands lost each year. Furthermore, most migrants are not welcomed when they arrive to Europe, many are held in terrible conditions in holding camps in Italy and Greece. Over time, migrants who made it into Europe have reported these dangers and conditions, reducing the overall demand for illegal migration. We do not foresee these five factors changing, at least not all at once. However, there are several reasons to worry about the flow of migrants in 2020. US-Iran tensions have sparked outright military action, while unrest is flaring up across Iran’s sphere of influence. Going forward, Iran could destabilize Iraq or fuel Shia unrest against US-backed regimes. Second, Afghanistan has been the source of most migrants to Europe via sea and land Mediterranean routes – 19.2%. The conflict in the country continues and may flare up with President Trump’s decision to formally withdraw most US troops from the country in 2020. Third, a break in fighting in Libya may encourage sub-Saharan migrants to revisit routes to Europe. Migrants from Guinea, Cote d’Ivoire, and the Democratic Republic of Congo make up over 10% of migrants to Europe. Finally, Turkish relationship with the West could break up further in 2020, causing Ankara to ship migrants northward. We highly doubt that President Erdogan will risk such a break, given that 50% of Turkish exports go to Europe. A European embargo on Turkish exports – which would be a highly likely response to such an act – would crush the already decimated Turkish economy. Bottom Line: While we do not see a return to the 2015 level of migration in 2020, we flag this risk because it would fundamentally undermine political stability in Europe. Black Swan 5: Russia Faces A “Peasant Revolt” Our fifth and final black swan risk for the year stems from Russia. This risk may seem obvious, since the US election creates a dynamic that revives the inherent conflict in US-Russian relations. Russia could seek to accomplish foreign policy objectives – interfering in US elections, punishing regional adversaries. The Trump administration may be friendly toward Russia but Trump is unlikely to veto any sanctions passed by the House and Senate in an election year, should an occasion for new sanctions arise. Conversely Russia could anticipate greater US pressure if the Democrats win in November. Yet it is Russia’s domestic affairs that represent the real underrated risk. Putin’s fourth term as president has been characterized by increased focus on domestic political control and stability as opposed to foreign adventurism. The creation of a special National Guard in 2016, reporting directly to Putin and responsible for quelling domestic unrest, symbolizes the shift in focus. So too does Russia’s adherence to the OPEC 2.0 regime of production control to keep oil prices above their budget breakeven level. Meanwhile Putin’s courting of Europe for the Nordstream II pipeline, and his slight peacemaking efforts with Ukraine, has suggested a slightly more restrained international posture. Chart 23Sluggish Wage Growth Threatens Russian Stability Strategically it makes little sense for Russia to court negative attention at a time when the US and Europe are at odds over trade and the Middle East, the US is preoccupied with China and Iran, and Russia itself faces mounting domestic problems. The domestic problems are long in coming. The central bank has maintained a stringent monetary policy for the better part of the decade. Despite cutting interest rates recently, monetary and credit conditions are still tight, hurting domestic demand. Moscow has also imposed fiscal austerity, namely by cutting back on state pensions and hiking the value added tax. Real wage growth is weak (Chart 23), retail sales are falling, and domestic demand looks to weaken further, as Andrija Vesic of BCA Emerging Markets Strategy observes in a recent Special Report. The effect of Russia’s policy austerity has been a drop in public approval of the administration (Chart 24). Protests erupted in 2019 but were largely drowned out by the larger and more globally significant protests in Hong Kong. These were met by police suppression that has not removed their underlying cause. Putin’s first major decision of the new year was to reshuffle the government, entailing Prime Minister Dmitri Medvedev’s transfer to a new post and the appointment of a new cabinet. This move reveals the need to show some accountability to reduce popular pressure. While Moscow now has room to cut interest rates and ease fiscal policy, it is behind the curve and the weak economy will add fuel to domestic unrest. Meanwhile Putin’s efforts to alter the Russian constitution so he can stay in power beyond current term limits, effectively becoming emperor for life, like Xi Jinping, should not be dismissed merely because they are expected. They reflect a need to take advantage of Putin’s popular standing to consolidate domestic political power at a time when the ruling United Russia party and the federal government face discontent. They also ensure that strategic conflict with the United States will take on an ideological dimension. Chart 24Austerity Weighed On The Administration's Popularity In Russia Chart 25Russian Political Risk Is Unsustainably Low Russia's recent cabinet shakeup is positive from the point of view of economic reform. And the country's monetary and fiscal room provide a basis for remaining overweight equities within EM, as our Emerging Markets Strategy recommends. However, Russian equities have rallied hard and the political risk is understated. Bottom Line: It is never easy predicting Putin’s next international move. Our market-based indicators of Russian political risk have hit multi-year lows, but both the domestic and international context suggest that these lows will not be sustained (Chart 25). A new bout of risk can emanate from Putin, or from changes in Washington, or from the Russian people themselves. What would take the world by surprise would be domestic unrest on a larger scale than Russia can easily suppress through the police force. Housekeeping We are closing our long European Union / short Chinese equities strategic trade with a 1.61% loss since inception on May 10, 2019. Dhaval Joshi of BCA’s European Investment Strategy downgraded the Eurostoxx 50 to underweight versus the S&P 500 and the Nikkei 225 this week. He makes the point that the Euro Area bond yield 6-month impulse hit 100 bps – a critical technical level – and will be a strong headwind to growth. We will look to reopen this trade at a later date when the euphoria over the “phase one” trade deal subsides, as we still favor European equities and DM bourses over EM. We will reinstitute our long Brent crude H2 2020 versus H2 2021 tactical position, which was stopped out on January 9, 2020. We remain bullish on oil fundamentals and expect Middle East instability to add a political risk premium. China's stimulus and the oil view also give reason for us to reinitiate our long Malaysian equities relative to EM as a tactical position. The Malaysian ringgit will benefit as oil prices move higher, helping Malaysian companies make payments on their large pile of dollar-denominated debt and improving household purchasing power. Higher oil prices also correlate with higher equity prices, while China's stimulus and the US trade ceasefire will push the US dollar lower and help trade revive in the region. Marko Papic Consulting Editor marko@bcaresearch.com Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com   Footnotes 1 Observe how little attention the public paid to US-China saber-rattling around China’s announcement of an Air Defense Identification Zone in the East China Sea that year.

Feature Chart I-1Lebanese Bond Yields Have Surged To Precarious Levels In a May 2018 Special Report, we warned that a devaluation and government default were only a matter of time in Lebanon. The country's sovereign US dollar bond yields have now reached a whopping 21% and local currency interest rates stand at 18% (Chart I-1). On the black market, the Lebanese pound is already trading 12% below its official rate. A public run on banks and bank deposit moratorium, as well as public debt default and a massive currency devaluation are now unavoidable. A Classic Case Of EM Bank Run And Currency Devaluation… The current state of Lebanon’s balance of  payments (BoP) is disastrous: The current account (CA) deficit has oscillated between 10% and 20% of GDP in the past 10 years (Chart I-2). This wide CA deficit has been funded by speculative portfolio flows into local currency government bonds, sovereign bonds and bank deposits. However, since the middle of 2018 these inflows have dried up. In turn, to defend the currency peg to the US dollar and avoid a currency depreciation in the face of the BoP deficit, the Central Bank of Lebanon (BDL) has been depleting its foreign exchange (fx) reserves, i.e., the central bank has been financing the BoP deficit (Chart I-3). Chart I-2Lebanon's Chronic Current Account Deficit   Chart I-3Lebanon: The BoP Has Been Deteriorating Substantially   BDL’s gross fx reserves – including gold – have dropped from $48 billion in 2018 to its current level of $43 billion. We estimate that BDL’s net foreign exchange reserves excluding commercial banks’ US dollar deposits at BDL are at just $26 billion. This amount is insufficient in light of the panic-induced outflows the country and the banking system are experiencing.1  As a result of the two-week long bank shutdown amid massive protests, confidence in the banking system is quickly collapsing and capital is leaving Lebanon. Chart I-4Depositors’ Are Heading For The Exit Worryingly, as a result of the two-week long bank shutdown amid massive protests, confidence in the banking system is quickly collapsing and capital is leaving Lebanon.2   Moreover, after opening their doors, Lebanese commercial banks are now imposing unofficial capital controls – they are paying US dollar deposits in local currency only and are no longer providing dollar-denominated credit lines to businesses and importers. This will only intensify the panic among depositors. Chart I-4 illustrates that local currency deposits have already been declining while US dollar deposits have been slowing, and will likely begin contracting soon. In short, capital outflows will intensify in the coming weeks as people and businesses quickly realize that banks cannot meet their demand for deposits. Critically, we suspect Lebanese commercial banks are short on US dollars to meet people’s demand for the hard currency. Commercial banks’ net foreign currency assets stand at negative $70 billion or 127% of GDP. They hold, roughly, somewhere around $20 billion worth of US dollars in the form of liquid and readily available deposits (in banks abroad and deposits in the central bank) versus $124 billion worth of dollar deposits. Over the years, Lebanese commercial banks have been an attractive place for investors and residents to park their US dollars given the high interest rate paid by the banks. In turn, Lebanese commercial banks have been converting these US dollar deposits into local currency in order to buy government bonds. With domestic bonds yielding well above the rates on US dollar deposits - and given the exchange rate peg to the dollar - commercial banks have been de facto playing the carry trade. In addition, commercial banks also lent some of these dollars directly to the private sector. With the economy collapsing and the widening dollar shortage, banks will not be able to either collect their dollar loans or purchase dollars in the market.   Without new dollar funding – which is very likely to persist – banks will fail to meet the demand for dollars. As a result, a bank run is imminent. At this point, the sole option is for the central bank to keep pushing local interest rates higher to discourage capital flight and a run on the banks. Yet, at 18% and surging, interest rates will suffocate the Lebanese economy and the property market. This will dampen sentiment further and cause a bank run. Bottom Line: A bank run is brewing and bank moratorium as well as currency devaluation are inevitable. …As Well As Public Debt Default Lebanese commercial banks are not only being squeezed by capital outflows and deposit withdrawals, they are also about to face a public debt default. Chart I-5Public Debt Dynamics Are Toxic Lebanese commercial banks are not only being squeezed by capital outflows and deposit withdrawals, they are also about to face a public debt default. Commercial banks own 37% of outstanding government debt. This will come on top of skyrocketing private-sector non-performing loans and will push banks into outright bankruptcy. Lebanon’s fiscal and public debt dynamics have reached untenable levels. The fiscal deficit stands at 10% of GDP and total public debt stands at 150% of GDP (Chart I-5). Surging government borrowing costs will push interest payments as a share of government aggregate expenditures to extremely high levels. These are unsustainable fiscal and debt arithmetics (Chart I-6). Meanwhile, government revenues will decline as growth falters (Chart I-6, bottom panel). The pillars of the Lebanese economy – private credit growth and construction activity – have been already collapsing (Chart I-7). Chart I-6Surging Interest Rates Will Make Public Debt Servicing Impossible Chart I-7Lebanon: Domestic Economy Has Been Collapsing Bottom Line: The Lebanese government will be forced to default on both local currency and dollar debt. This will be the final nail in the coffin of the Lebanese banking system.    Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com   Footnotes 1    BDL does not publish its holding of net foreign exchange reserves. However, other estimates of BDL’s net fx reserves  are even lower. Please refer to the following paper: Financial Crisis In Lebanon, by Toufic Gaspard and the following article: Lebanon Warned on Default and Recession as Its Reserves Decline. 2   Banks shut down allegedly as a result of the ongoing civil disobedience that was sparked by the government’s reckless decision to tax WhatsApp's call service. The protests quickly escalated to a country-wide uprising, causing the government to resign on October 29.

Special Report

Highlights Mutual Funds & ETFs: The liquidity mismatch between easily tradeable mutual fund shares and the less liquid underlying corporate bonds makes it possible for negative feedback loops to emerge between fund flows and corporate bond spreads. The growing presence of open-ended mutual funds and ETFs in the corporate bond market should be seen as a risk that could exacerbate future periods of spread widening, leading to worse economic outcomes. BBB Securities: The large amount of outstanding BBB debt could lead to fire sales from corporate bond holders with investment grade-only mandates when the debt is downgraded to junk. However, in contrast to the negative feedback loop that can be generated by mutual fund flows, the evidence shows that the negative price pressure from fallen angel fire sales is fleeting. Leveraged Loans: The rapid surge in leveraged loans has been partially offset by reduced high-yield issuance, helping mitigate a potentially destabilizing rise in all riskier corporate debt. At the same time, bank exposure is focused on the safest CLO tranches, limiting the potential systemic risks from bank losses. Feature In April, we published a Special Report that investigated whether corporate debt poses a risk to the U.S. economy.1 That report focused on what economic theory and empirical evidence say about the relationship between corporate debt and future economic growth. We arrived at the following conclusions: The empirical evidence decisively shows that private (household + business) debt helps predict future economic outcomes. Some evidence shows that household debt is more important than corporate debt in this regard. In contrast to mainstream economic theory, the level of private debt-to-GDP does not help predict future economic outcomes. Rather, it is rapid private debt growth that is linked to more severe economic downturns. Ebullient credit market sentiment is also shown to predict weak economic growth. Tight credit spreads should be viewed as a warning sign, similar to rapid private debt growth. In this follow-up Special Report, we consider three credit market developments that are unique to this cycle: The large ownership stake of open-ended mutual funds and ETFs in the U.S. corporate bond market. The elevated amount of BBB-rated debt outstanding relative to other credit tiers. The rapid issuance of leveraged loans. All three of these developments could mediate the relationship between corporate debt and economic growth, potentially increasing risks to the economy. We consider each factor in turn. 1. Fund Flows One unique feature of the current cycle is that open-ended mutual funds and ETFs own a much larger share of outstanding corporate bonds than in the past. Back in 1990, insurance companies and pension funds were the largest holders of corporate debt, controlling 54% of the market. Meanwhile, open-ended funds owned a paltry 3%. Since then, fund ownership has surged to 16%, mostly at the expense of financial institutions, insurance companies and pensions. Foreign holdings of U.S. corporate bonds have also increased during this period, from 13% of the market to 28% (Charts 1 & 2). Chart 2Mutual Funds Now An Important Market Player Why Does Fund Ownership Matter? We focus on fund ownership of corporate bonds because it has been theorized that flows into and out of open-ended mutual funds can have a similar impact on market prices as leverage, amplifying price moves in either direction. As described in a 2014 paper by Feroli, Kashyap, Shoenholtz, and Shin:2 [W]hen asset flows for certain fixed income securities are high, prices persistently rise and a feedback loop emerges. High flows lead to rising prices, which attract more flows, which further raises prices. Obviously, the proposed feedback loop also works in reverse: Outflows cause prices to decline, and lower prices lead to further outflows. This sort of feedback loop is unique to mutual funds. Insurance companies and pension funds, for example, do not experience investor capital flight in response to a near-term price drop. This makes the larger presence of mutual funds in the corporate bond market potentially destabilizing. Fund ownership has surged to 16%, from a paltry 3% back in 1990. Why Do Fund Flows Behave This Way? Mutual fund shares are much more liquid than the corporate debt securities they hold. As described in a 2017 paper by Goldstein, Jiang and Ng:3 When [mutual] fund investors redeem their shares, they get the net asset value as of the day of redemption. The fund then has to conduct costly liquidation that hurts the value of the shares for investors who keep their money in the fund. Hence, the expected redemption by some investors increases the incentives for others to redeem. In other words, during times of stress, mutual fund investors have an incentive to withdraw their money before other fund shareholders get the chance. Otherwise, they could be stuck holding a basket of illiquid corporate bonds. This bank-run like behavior is well documented for corporate and municipal bond funds, though it appears not to exist for funds that traffic in more liquid instruments, such as Treasuries and equities. In fact, when Goldstein et al looked at how flows into and out of individual corporate bond and equity funds respond to past fund performance, they found that the Flow-Performance curve for an individual corporate bond fund exhibits a pronounced concave shape. Meanwhile, the same curve for an individual equity fund is convex (Chart 3). This means that corporate bond mutual fund shareholders are quick to redeem their shares in response to poor fund performance, while equity fund shareholders are more inclined to stand pat. On the flipside, positive fund performance leads to large equity fund inflows, but doesn’t attract capital to corporate bond funds to the same extent. The above results apply to individual funds, but Goldstein et al also performed the same analysis for corporate bond funds in the aggregate. That is, rather than measuring whether investors sold a particular corporate bond mutual fund in response to its poor performance, they measured whether investors exited the corporate bond mutual fund space altogether in response to poor corporate bond performance. Interestingly, they found a very similar result (Chart 4). Investors are inclined to exit the corporate bond space entirely following periods of poor performance. Meanwhile, they found no relationship between aggregate equity fund flows and performance. Investors might switch between different equity funds in response to recent performance trends, but they don’t exit the asset class altogether.   These results provide a clear indication for why the large presence of corporate bond mutual funds might be destabilizing. Corporate bond fund investors are quick to flee the space during periods of poor performance. For more liquid securities, such as equities and Treasuries, a large mutual fund presence in the market is not a concern, since flows do not respond as aggressively to price shocks. Empirical Evidence For The Flow-Performance Feedback Loop The evidence presented above shows that fund flows respond to performance, but for the theorized feedback loop between fund flows and corporate bond prices to exist, we also need evidence that fund flows impact corporate bond performance. In that regard, a 2019 Banque de France working paper examines the impact of aggregate flows into French corporate bond funds on the yields of the underlying securities.4 It finds that not only do flows impact yields contemporaneously, but also that outflows have a larger influence on yields than inflows. Using a different methodology, a 2015 paper by Hoseinzade finds no material impact of fund flows on underlying corporate bond yields, but for an interesting reason.5 The paper confirms that corporate bond fund shareholders demonstrate bank-run like behavior in response to poor performance, but also argues that “bond fund managers hold a significant level of liquid assets, allowing them to manage redemptions without excessively liquidating corporate bonds.” Chart 5Funds Deploy Cash Before Selling Bonds It’s true that corporate bond mutual funds often hold significant allocations to cash and U.S. Treasuries, and Hoseinzade shows that fund managers tend to discharge their most liquid holdings first, before attempting to sell corporate bonds. This result lines up with our casual observation. Chart 5 shows the aggregate liquid asset (cash and Treasury) holdings of corporate bond mutual funds. It is apparent that they tend to fall during periods of spread widening. We also note that corporate bond mutual funds, in aggregate, currently hold about 6% of their assets in liquid securities. This buffer can probably withstand a sizeable shock, but liquid assets fell from similar levels into negative territory during each of the past two recessions. One other factor that could help break the feedback loop between fund flows and prices is the institutional ownership of corporate bond mutual funds. Goldstein et al find that mutual funds mostly owned by institutional investors exhibit less of a feedback loop between flows and performance. That is, large institutional investors are less likely to redeem their shares in response to a bout of poor performance. While we don’t have data on corporate bond mutual fund ownership specifically, Federal Reserve data reveal that insurance companies and pension funds own a significantly larger proportion of outstanding mutual fund shares than in the 1990s, though less than they did in the mid-2000s (Chart 6). Note that Chart 6 shows data for all mutual funds, including equity funds, Treasury funds, etc… Chart 6Institutional Ownership Of Mutual Funds We conclude that there is enough evidence of a feedback loop between fund flows and corporate bond prices that we should be wary of the growing presence of open-ended mutual funds and ETFs in the corporate bond space. Cash holdings and institutional ownership can help mitigate negative flow/performance feedback loops to some extent, but probably shouldn’t be counted on in the event of a severe shock. What’s The Economic Impact? In our corporate debt Special Report from April, we postulated that changes in corporate bond spreads might, themselves, cause an economic downturn, rather than simply reflect one. The mechanism is summarized nicely by Lopez-Salido, Stein and Zakrajsek (2016):6 [a] sentiment-driven widening of credit spreads amounts to a reduction in the supply of credit, especially to lower credit-quality firms. It is this reduction in credit supply that exerts a negative influence on economic activity. With that in mind, in the current environment it seems very possible that an initially sentiment-driven credit spread widening could be exacerbated by outflows from corporate bond mutual funds. A larger shock to credit spreads leads to a larger reduction in credit supply and a more severe economic impact. Aggregate liquid asset holdings of corporate bond mutual funds tend to fall during periods of spread widening. Bottom Line: The liquidity mismatch between easily tradeable mutual fund shares and the less liquid underlying corporate bonds makes it possible for negative feedback loops to emerge between fund flows and corporate bond spreads. The growing presence of open-ended mutual funds and ETFs in the corporate bond market should be seen as a risk that could exacerbate future periods of spread widening, leading to worse economic outcomes. 2: BBB Debt Outstanding Chart 7The Large Amount Of BBB Debt It has been widely reported that an unusually large amount of outstanding corporate bonds are rated BBB, the lowest credit rating that is still considered investment grade. In fact, the par value of BBB-rated securities now makes up 50% of the Bloomberg Barclays Investment Grade index, up from 21% in 1990 (Chart 7). The amount of outstanding BBB securities is more than double the par value of the Bloomberg Barclays High-Yield index, and BBBs represent 41% of the total combined par value of the investment grade and high-yield indexes. The reason to be wary about the large amount of outstanding BBB debt is that when the credit cycle turns and ratings downgrades start to occur, a larger than normal amount of debt will be downgraded from investment grade into high-yield. When that happens, any investors with an investment grade-only mandate will be forced to sell. The concern is that such forced selling could set off a negative feedback loop very similar to the one discussed in the first section. An added layer of risk comes from the fact that in addition to investment grade-only mutual funds, insurance companies and pension funds – who still control 35% of the corporate bond market (see Chart 2 on page 3) – are often burdened with larger capital costs for high-yield debt. This means that a very large pool of investors could be impacted by a spate of BBB downgrades. In terms of the potential market impact, a 2010 paper by Ellul, Jotikasthira and Lundblad investigated fire sales of downgraded corporate bonds induced by regulatory constraints.7 The authors found that insurance companies often engage in the forced selling of bonds that have been recently downgraded into high-yield. Further, the downgraded bonds experience negative near-term price pressure from the fire sale, but that pressure tends to reverse after a few months. The finding that the negative price pressure is fleeting is important. In contrast to the negative feedback loop that can be generated by mutual fund flows, BBB securities can only be downgraded to high-yield once. In other words, once the initial fire sale of fallen angel debt takes place, there is no mechanism to force the downward price pressure to continue.8 Bottom Line: The large amount of outstanding BBB debt could lead to fire sales from corporate bond holders with investment grade-only mandates when the debt is downgraded to junk. However, in contrast to the negative feedback loop that can be generated by mutual fund flows, the evidence shows that the negative price pressure from fallen angel fire sales is fleeting. 3. Leveraged Loans The rapid growth of leveraged loans – lending made to below investment-grade borrowers - over the past couple of years has caught the attention of global central banks and financial regulators. That concern is understandable, as it would be a dereliction of duty for any policymaker or regulator who lived through the 2008 financial crisis to not consider the potential risks to financial stability and future economic growth from a surge in lower quality lending. This is especially true given the increase in the number of securitized instruments linked to leveraged loans – collateralized loan obligations, or CLOs – which evokes memories of the toxic subprime mortgage products that helped trigger the 2008 crisis. Although as the Fed’s Vice Chair for Supervision, Randal Quarles, recently noted, the financial media has been overplaying the leveraged loan story in such a way that it felt like “the Earth must be getting hit by an asteroid.” The BoE estimates that the CLOs would have to suffer a loss more than twice as severe as seen during the 2008 financial crisis for the AAA-rated piece of CLOs issued in 2018 to incur losses. The leveraged loan and CLO markets can be opaque. However, based on the information we do have from credible sources like central banks, the IMF and the BIS, some conclusions can be made about the potential economic risks from the rapid build-up of U.S. leveraged loans: Leveraged loan expansion has been partially offset by high-yield contraction. Chart 8More Leveraged Loans, Less Junk Bonds Based on estimates from the BIS and IMF, there are around $1.4 trillion in U.S. leveraged loans outstanding, which is greater than the $1.2 trillion U.S. high-yield bond market (Chart 8). That is an all-time high in the dollar amount of leveraged loans, as well as for the share of all lower-rated corporate debt accounted for by loans. The annual growth rate of U.S. leveraged loans is now a whopping 29% - the fastest pace seen since 2007. Yet the growth of the total amount of leveraged loans plus high-yield bonds is a much lower 12%. While that is still a large number, it is below the peak growth rates seen during the past fifteen years. This is because the amount of high-yield bonds outstanding has been modestly contracting since 2015. Much of that run-up in leveraged loan growth has been to satiate the demand for loans created by private equity funds and, more importantly, CLOs. The strong risk appetite from investors resulted in a notable deterioration in lending standards, with loans coming out at higher leverage multiples (debt/EBITDA) and with reduced investor covenant protection. Yet since lower-rated companies were not ramping up high-yield bond issuance at the same time, the economic stability risks from a rapid run-up in total riskier borrowing are lower, on the margin. The ownership structure of leveraged loans (and CLOs) is diverse enough to not create systemic problems. To date, the Bank of England (BoE) has compiled the most detailed estimates of the ownership breakdown of both leveraged loans and CLOs.9 In Chart 9, we have recreated a chart from the BoE’s July 2019 Financial Stability Report, which colorfully shows the ownership of global leveraged loans and CLOs. The way to read the chart is that each square represents a 1% share of the estimated $3.2 trillion of global leveraged loans and CLOs. The split in the chart is 75% loans and 25% CLOs (CLO ownership is shown on the right side of the thick dotted line). The biggest category of leveraged loan investor is what the BoE titled “U.S. and other global banks”, a group that represents 38% of total loans and CLOs. European banks own 12%, U.K. banks own 3% and Japanese banks own 3% (entirely through CLOs), thus bringing the global bank exposure to 56% of all leveraged loan instruments. While that sounds like a large number, the majority of that is in the form of revolving credit facilities – effectively, overdraft facilities to lower-rated borrowers. Revolving credit facilities are typically less risky than leveraged loans, because credit facilities have greater covenant protection and even more seniority in terms of creditor claims on borrower assets. The BoE estimates that 40% of all global leveraged loans and CLOs are owned by non-bank investors. This includes pension funds, insurance companies and investment funds (mutual funds and ETFs). Chart 9 shows how much more diverse the investor base is for CLOs than for other leveraged loans. It suggests that any future potential losses from CLOs will be distributed more evenly within the financial system, rather than being concentrated in the banks. Chart 10Leveraged Loan Losses Are Typically Lowered Compared To Junk Even within the bank holdings of CLOs, the systemic risks are lessened. The BoE noted that the increased amount of subordination (i.e. lower-rated tranches) of more recent CLO deals helps protect the senior tranches from losses. According to the BoE, the AAA-rated piece of a representative sample of CLOs issued in 2018 was 63%; this compares to 70% for CLOs issued in 2006.10 Furthermore, the central bank estimates that the CLOs would have to suffer a loss more than twice as severe as seen during the 2008 financial crisis for the AAA-rated piece of CLOs issued in 2018 to incur losses. That would be an extraordinary outcome, given how 2008 generated losses on leveraged loans that were over twice as bad as the previous worst year in 2002 (Chart 10). Potential losses from AAA tranches are important from a financial stability perspective. The BoE estimates that 40% of all CLOs are owned by global banks (including a large 13% share from yield-chasing Japanese banks). These banks tend to focus on safer AAA-rated CLO tranches. The demand for leveraged loan products is volatile, but that might actually be a good thing for economic stability. The surge in leveraged loans over the past two years has not only been related to demand from private equity funds and CLOs. U.S. retail investors have also been big buyers of mutual funds and ETFs linked to the leveraged loan market, as a way to seek out higher credit returns against a backdrop of Fed rate hikes. Chart 11Fed Rate Expectations Drive The Demand For Loans Vs Bonds Leveraged loans are floating rate instruments. Thus, they are more desirable than fixed-rate high-yield corporate debt when short-term interest rates are rising. This is seen in Chart 11, where we show net flows into the largest U.S. junk bond and leveraged loan ETFs. These flows are plotted with the JP Morgan survey of bond investor duration positioning (top panel) and our Fed Funds Discounter that measures the market-implied expected change in the fed funds rate over the next year (bottom panel). The conclusion is obvious – there was very strong retail demand for floating-rate leveraged loans over fixed-rate junk bonds during 2016-18 when expected rate hikes justified defensive duration positioning. In 2019, the tables have turned. The Fed is more dovish, rate cuts are now expected, investors have been adding duration exposure, and demand for leveraged loan funds has plunged while high-yield bond funds have been seeing inflows. The exodus from all leveraged loan funds has been historically large, with Lipper reporting that there were 33 straight weeks of outflows to July 3, 2019, for a total of $32 billion.11 Already, that reduced demand for leveraged loans has translated into sharply reduced issuance of new U.S. CLOs, which was 73% lower in the first half of 2019 versus the same period in 2018 (Chart 12). At the same time, high-yield bond issuance was up 20% in the first six months of 2019 versus 2018. The reduced demand for leveraged loans has also shifted the balance of power back to lenders, as the share of U.S. leveraged loans that have been issued with limited covenant protection (“cov-lite”) has plunged from 72% in 2018 to around 40% (Chart 13). Chart 12Lower-Rated Issuance Is "Self-Regulating" Chart 13Reduced Covenant-Lite Issuance So Far In 2019     This is a critical point on the potential stability risks from leveraged loans – the market for those loans is “self-regulating”, based on final demand from investors who “toggle” between floating rate and fixed rate credit instruments. This helps limit the growth in overall corporate indebtedness, helping to put off the date when credit booms turn into future credit busts. Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Robert Robis, CFA, Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1      Please see U.S. Bond Strategy / Global Fixed Income Strategy Special Report, “The Risk From U.S. Corporate Debt: Theory And Evidence”, dated April 23, 2019, available at usbs.bcaresearch.com 2     https://www.nowpublishers.com/article/DownloadEBook/9781680834864?format=pdf 3     http://finance.wharton.upenn.edu/~itayg/Files/bondfunds-published.pdf 4     https://ideas.repec.org/p/bfr/banfra/706.html 5     https://pdfs.semanticscholar.org/5a60feab84a7d10de084abfce414b5888d5586e2.pdf 6     https://www.nber.org/papers/w21879 7     https://pdfs.semanticscholar.org/55a4/8602b17bc7e7f8428695ab6a3ef2c87756ab.pdf 8      Corporate bonds that are downgraded from investment grade to high-yield are called fallen angels. 9      The Financial Stability Board, the international body that monitors and makes recommendations on the global financial system, is due to publish a comprehensive analysis of the ownership structure of the leveraged loan market in the autumn of 2019. 10     For a more detailed description of this analysis, see pages 28 & 29 of the Bank of England’s July 2019 Financial Stability report, which can be found here: https://www.bankofengland.co.uk/financial-stability-report/2019/july-20… 11     https://www.spglobal.com/marketintelligence/en/news-insights/latest-news-headlines/leveraged-loan-news/leveraged-loan-fund-withdrawal-streak-hits-record-33-weeks-totaling-32b