Equities
Mr. X is a long-time BCA client who visits our offices toward the end of each year to discuss the economic and financial market outlook. This year, Mr. X introduced us to his daughter, who we shall identify as Ms. X. She has many years of experience as a portfolio manager, initially in a wealth management firm, and subsequently in two major hedge funds. In 2017, she joined her father to help him run the family office portfolio. She took an active role in our recent discussion and this report is an edited transcript of our conversation. Mr. X: As always, it is a great pleasure to sit down with you to discuss the economic and investment outlook. And I am thrilled to bring my daughter to the meeting. She and I do not always agree on the market outlook and appropriate investment strategy, but even in her first year working with me she has added tremendous value to our decisions and performance. As you know, I have a very conservative bias in my approach and this means I sometimes miss out on opportunities. My daughter is more willing than me to take risks, so we make a good team. I am happy that our investment portfolio has performed well over the past year, but am puzzled by the high level of investor complacency. I can't understand why investors do not share my concerns about by sky-high valuations, a volatile geopolitical environment and the considerable potential for financial instability. Over the years, you have made me appreciate the power of easy money to create financial bubbles and also that market overshoots can last for a surprisingly long time. Thus, I am fully aware that we could easily have another year of strong gains, but were that to happen, I would worry about the potential for a sudden 1987-style crash. I remember that event well and it was an unpleasant experience. My inclination is to move right now to an underweight equity position. Ms. X: Let me add that I am delighted to finally attend the annual BCA meeting with my father. Over the years, he has talked to me at length about your discussions, making me very jealous that I was not there. He and I do frequently disagree about the outlook so it will be good to have BCA's independent and objective perspective. As my father noted, I do not always share his cautious bias. When I joined the family firm in early 2017, I persuaded him to raise our equity exposure and that was the right decision. I have been in the business long enough to know that it is dangerous to get more bullish as the market rises and I agree there probably is too much complacency. However, I do not see an early end to the conditions that are driving the bull market and I am inclined to stay overweight equities for a while longer. Thus, the big debate between us is whether or not we should now book profits from the past year's strong performance and move to an underweight stance in risk assets. Hopefully, this meeting will help us make the right decision. Chart 1An Impressive Bull Market BCA: First of all, we are delighted to see you both and look forward to getting to know Ms. X in the years to come. It is not a surprise that you are debating whether to cut exposure to risk assets because that question is on the mind of many of our clients. We share your surprise about complacency - investors have been seduced by the relentless upward drift of prices since early 2016. The global equity index has not suffered any setback above 2% during the past year, and that has to be close to a record (Chart 1). The conditions that have underpinned this remarkable performance are indeed still in place but we expect that to change during the coming year. Thus, if equity prices continue to rise, it would make sense to reduce exposure to risk assets to a neutral position over the next few months. A blow-off phase with a final spike in prices cannot be ruled out, but trying to catch those moves is a very high-risk strategy. We are not yet recommending underweight positions in risk assets, but if our economic and policy views pan out, we likely will shift in that direction in the second half of 2018. Ms. X: It seems that you are siding with my father in terms of wanting to scale back exposure to risk assets. That would be premature in my view and I look forward to discussing this in more detail. But first, I would be interested in reviewing your forecasts from last year. BCA: Of course. A year ago, our key conclusions were that: A number of important regime shifts will impact the economic and investment outlook over the next few years. These include the end of the era of falling inflation and interest rates, a move away from fiscal conservatism, a policy pushback against globalization, and a rise in the labor share of income at the expense of profit margins. Together with an earlier regime shift when the Debt Supercycle ended, these trends are consistent with very modest returns from financial assets over the next decade. The failure of low interest rates to trigger a vigorous rebound in private credit growth is consistent with our end-of-Debt Supercycle thesis. The end point for dealing with high debt levels may ultimately be sharply higher inflation, but only after the next downturn triggers a new deflationary scare. The potential for trade restrictions by the incoming U.S. administration poses a threat to the outlook, but the odds of a global trade war are low. Time lags in implementing policy mean that the fiscal plans of President-elect Trump will boost U.S. growth in 2018 more than 2017. This raises the risk of an overheated economy in 2018 leading to a monetary squeeze and recession in 2019. The key issue will be whether the supply side of the economy expands alongside increased demand and it will be critical to monitor business capital spending. Lingering structural problems will prevent any growth acceleration outside the U.S. The euro area and emerging economies are still in the midst of a deleveraging cycle and demographics remain a headwind for Japan. Not many countries will follow the U.S. example of fiscal stimulus. Nevertheless, for the first time since the recovery began, global growth forecasts are likely avoid a downgrade over the next couple of years. China remains an unbalanced and fragile economy but the authorities have enough policy flexibility to avoid a hard landing, at least over the year or two. The longer-run outlook is more bearish unless the government moves away from its stop-go policy approach and pursues more supply-side reforms. Inflation has bottomed in the U.S., but the upturn will be gradual in 2017 and it will stay subdued in the euro area and Japan. Divergences in monetary policy between the U.S. and other developed economies will continue to build in 2017 as the Fed tightens and other central banks stay on hold. Unlike a year ago, the Fed's rate expectations look reasonable. Bond yields in the U.S. may fall in the near run after their recent sharp rise, but the cyclical trend is up against a backdrop of monetary tightening, fiscal stimulus and rising inflation. Yields in the euro area will be held down by ongoing QE, while the 10-year yield will stay capped at zero in Japan. The secular bull market in bonds is over although yields could retest their recent lows in the next downturn. The search for yield will remain an important investment theme, but rich valuations dictate only a neutral weighting in investment-grade corporate bonds and a modest underweight in high-yielders. The U.S. equity market is modestly overvalued but the conditions are ripe for an overshoot in 2017 given optimism about a boost to profits from the new administration's policies. Earnings expectations are far too high and ignore the likelihood that rising labor costs will squeeze margins. Nevertheless, that need not preclude equity prices moving higher. There is a good chance of a sell-off in early 2017 and that would be a buying opportunity. Valuations are better in Japan and several European markets than in the U.S. and relative monetary conditions also favor these markets. We expect the U.S. to underperform in 2017. We expect emerging markets to underperform developed markets. The oil price should average around $55 a barrel over the next one or two years, with some risk to the upside. Although shale production should increase, the cutbacks in oil industry capital spending and planned production cuts by OPEC and some other producers will ensure that inventories will have to be drawn down in the second half of 2017. Non-oil commodity prices will stay in a trading range after healthy gains in 2016, but the long-run outlook is still bearish. The dollar bull market should stay intact over the coming year with the trade-weighted index rising by around 5%. Relative policy stances and economic trends should all stay supportive of the dollar. The outlook for the yen is especially gloomy. A stabilization in resource prices will keep commodity prices in a range. We remain bearish on EM currencies. The biggest geopolitical risks relate to U.S.-China relations, especially given President-elect Trump's inclination to engage in China-bashing. Meanwhile, the defeat of ISIS could create a power vacuum in the Middle East that could draw Turkey into a disastrous conflict with the Kurds and Iran/Russia. The coming year is important for elections in Europe but we do not expect any serious threat to the EU or single currency to emerge. The most important prediction that we got right was our view that conditions were ripe for an overshoot in equity prices. The MSCI all-country index has delivered an impressive total return of around 20% in dollar terms since the end of 2016, one of the best calendar year performances of the current cycle (Table 1). So it was good that your daughter persuaded you to keep a healthy equity exposure. It is all the more impressive that the market powered ahead in the face of all the concerns that you noted earlier. Our preference for European markets over the U.S. worked out well in common currency terms, but only because the dollar declined. Emerging markets did much better than we expected, with significant outperformance relative to their developed counterparts. Table 1Market Performance With regard to the overall economic environment, we were correct in forecasting a modest improvement in 2017 global economic activity and that growth would not fall short of the IMF's predictions for the first time in the current expansion. However, one big surprise, not only for us, but also for policymakers, was that inflation drifted lower in the major economies. Latest data show the core inflation rate for the G7 economies is running at only 1.4%, down from 1.6% at the end of 2016. We will return to this critical issue later as the trend in inflation outlook will be a key determinant of the market outlook for the coming year and beyond. Regionally, the Euro area and Japanese economies registered the biggest upside surprises relative to our forecast and those of the IMF (Table 2). That goes a long way to explaining why the U.S. dollar was weaker than we expected. In addition, the dollar was not helped by a market downgrading of the scale and timing of U.S. fiscal stimulus. Nonetheless, it is worth noting that the dollar has merely unwound the 2016 Trump rally and recently has shown some renewed strength. Table 2IMF Economic Forecasts A year ago, there were major concerns about potential political turmoil from important elections in Europe, the risk of U.S.-led trade wars and a credit bust-up in China. We downplayed these issues as near-term threats to the markets and that turned out to be appropriate. Nevertheless, there are many lingering risks to the outlook and market complacency is a much bigger concern now than it was a year ago. Mr. X: As you just noted, a key theme of your Outlook last year was "Shifting Regimes" such as the end of disinflation and fiscal conservatism, a retreat from globalization, and the start of a rebalancing in income shares away from profits toward labor. And of course, you talked about the End of the Debt Supercycle a few years ago. Do you still have confidence that these regime shifts are underway? BCA: Absolutely! These are all trends that we expect to play out over a number of years and thus can't be judged by short-term developments. There have been particularly important shifts in the policy environment. The 2007-09 economic and financial meltdown led central banks to fight deflation rather than inflation and we would not bet against them in this battle. Inflation has been lower than expected, but there has been a clear turning point. On fiscal policy, governments have largely given up on austerity against a background of a disappointingly slow economic recovery in recent years and rising populist pressures (Chart 2). The U.S. budget deficit could rise particularly sharply over the next few years. In the U.S., the relative income shares going to profits and labor have started to shift direction, but there is a long way to go. Finally, the same forces driving government to loosen fiscal purse strings have also undermined support for globalization with the U.S. even threatening to abandon NAFTA. The ratio of global trade to output has trended sideways for several years and is unlikely to turn higher any time soon. All these trends are part of our Regime Shift thesis. Chart 2Regime Shifts The remarkable macro backdrop of low inflation, easy money and healthy profits has been incredibly positive for financial markets in recent years. You would have to be an extreme optimist to believe that such an environment will persist. Our big concern for the coming year is that we are setting up for a collision between the markets and looming changes in economic policy. The Coming Collision Between Policy And The Markets BCA: As you mentioned earlier, we attach enormous importance to the role of easy money in supporting asset prices and it is hard to imagine that we could have had a more stimulative monetary environment than has existed in recent years. Central banks have been in panic mode since the 2007-09 downturn with an unprecedented period of negative real interest rates in the advanced economies, coupled with an extraordinary expansion of central bank balance sheets (Chart 3). Initially, the fear was for another Great Depression and as that threat receded, the focus switched to getting inflation back to the 2% target favored by most developed countries. In a post-Debt Supercycle world, negative real rates have failed to trigger the typical rebound in credit demand that was so characteristic of the pre-downturn era. Central banks have expanded base money in the form of bank reserves, but this has not translated into markedly faster growth in broad money or nominal GDP. This is highlighted by the collapse in money multipliers (the ratio of broad to base money) and in velocity (the ratio of GDP to broad money). This has been a double whammy: there is less broad money generated for each dollar of base money and less GDP for every dollar of broad money (Chart 4). Chart 3An Extraordinary Period Of Easy Money Chart 4Monetary Policy: Pushing On A String Historically, monetary policy acted primarily through the credit channel with lower rates making households and companies more willing to borrow, and lenders more willing to supply funds. In the post-Debt Supercycle world, the credit channel has become partly blocked, forcing policymakers to rely more on the other channels of monetary transmission, the main one being boosting asset prices. However, there is a limit to how far this can go because the end result is massively overvalued assets and building financial excesses. The Fed and many other central banks now realize that this strategy cannot be pushed much further. The economic recovery in the U.S. and other developed economies has been the weakest of the post-WWII period. But potential growth rates also have slowed which means that spare capacity has gradually been absorbed. According to the IMF, the U.S. output gap closed in 2015 having been as high as 2% of potential GDP in 2013. The IMF estimates that the economy was operating slightly above potential in 2017 with a further rise forecast in 2018 (Chart 5). According to IMF estimates, the median output gap for 20 advanced economies will shift from -0.1% in 2017 to +0.3% in 2018 (i.e. they will be operating above potential). This makes it hard to justify the maintenance of hyper-stimulative monetary policies. Chart 5No More Output Gaps The low U.S. inflation rate is giving the Fed the luxury of moving cautiously and that is keeping the markets buoyant. Indeed, the markets don't even believe the Fed will be able to raise rates as much they expect. The most recent FOMC projections show a median federal funds rate of 2.1% by the end of 2018 but the markets are discounting a move to only 1.8%. The markets probably have this wrong because inflation is likely to wake up from its slumber in the second half of the year. Ms. X: This is another area where my father and I disagree. I view the world as essentially deflationary. We all know that technological innovations have opened up competition in a lot of markets, driving down prices. Two obvious examples are Uber and Airbnb, but these are just the tip of the iceberg. Amazon's purchase of Whole Foods is another example of how increased competitive pressures will continue to sweep through previously relatively stable industries. And such changes have an important impact on employee psychology and thus bargaining power. These days, people are glad to just keep their jobs and this means companies hold the upper hand when it comes to wage negotiations. So I don't see a pickup in inflation being a threat to the markets any time soon. Mr. X: I have a different perspective. First of all, I do not even believe the official inflation data because most of the things I buy have risen a lot in price over the past couple of years. Secondly, given the extremely stimulative stance of monetary policy in recent years, a pickup in inflation would not surprise me at all. So I am sympathetic to the BCA view. But, even if the data is correct, why have inflation forecasts proved so wrong and what underpins your view that it will increase in the coming year? BCA: There is an interesting disconnect between the official data and the inflation views of many consumers and economic/statistics experts. According to the Conference Board, U.S. consumers' one-year ahead inflation expectations have persistently exceeded the published data and the latest reading is close to 5% (Chart 6). That ties in with your perception. Consumer surveys by the New York Fed and University of Michigan have year-ahead inflation expectations at a more reasonable 2.5%. At the same time, many "experts" believe the official data is overstated because it fails to take enough account of technological changes and new lower-priced goods and services. The markets also have a moderately optimistic view with the five-year CPI swap rate at 2%. This is optimistic because it is consistent with inflation below the Fed's 2% target, if one allows for an inflation risk premium built in to the swap price. We are prepared to take the inflation data broadly at face value. Low inflation is consistent with an ongoing tough competitive environment in most sectors, boosted by the disruptive impact of technological changes that Ms. X described. The inflation rate for core goods (ex-food and energy) has been in negative territory for several years while that for services ex-shelter is at the low end of its historical range (Chart 7). Chart 6Differing Perspectives Of Inflation Chart 7Not Much Inflation Here There is no simple explanation of why inflation has fallen short of forecasts. Economic theory assumes that price pressures build as an economy moves closer to full employment and the U.S. is at that point. This raises several possibilities: There is more slack in the economy than suggested by the low unemployment rate. The lags are unusually long in the current cycle. Technological disruption is having a greater impact than expected. The link between economic slack and inflationary pressures is typically captured by the Phillips Curve which shows the relationship between the unemployment rate and inflation. In the U.S., the current unemployment rate of 4.1% is believed to be very close to a full-employment level. Yet, inflation recently has trended lower and while wage growth is in an uptrend, it has remained softer than expected (Chart 8). Chart 8Inflationary Pressures Are Turning We agree with Ms. X that employee bargaining power has been undermined over the years by globalization and technological change and by the impact of the 2007-09 economic downturn. That would certainly explain a weakened relationship between the unemployment rate and wage growth, but does not completely negate the theory. The historical evidence still suggests that once the labor market becomes tight, inflation eventually does accelerate. A broad range of data indicates that the U.S. labor market is indeed tight and the Atlanta Fed's wage tracker is in an uptrend, albeit modestly. Two other factors consistent with an end to disinflation are the lagged effects of dollar weakness and a firming in oil prices. Non-oil prices have now moved decisively out of deflationary territory while oil prices in 2017 have averaged more than 20% above year-ago levels. As far as the impact of technology is concerned, there is no doubt that innovations like Uber and Airbnb are deflationary. However, our analysis suggests that the growth in online spending has not had a major impact on the inflation numbers. E-commerce still represents a small fraction of total U.S. consumer spending, depressing overall consumer inflation by only 0.1 to 0.2 percentage points. The deceleration of inflation since the global financial crisis has been in areas largely unaffected by online sales, such as energy and rent. Moreover, today's creative destruction in the retail sector is no more deflationary than the earlier shift to 'big box' stores. We are not looking for a dramatic acceleration in either wage growth or inflation - just enough to convince the Fed that it needs to carry on with its plan to raise interest rates. And the pressure to do this will increase if the Administration is able to deliver on its planned tax cuts. Ms. X: You make it sound as if cutting taxes would be a bad thing. Surely the U.S. would benefit from the Administration's tax plan? A reduction in the corporate tax rate would be very bullish for equities. BCA: The U.S. tax system is desperately in need of reform via eliminating loopholes and distortions and using the savings to lower marginal rates. That would make it more efficient and hopefully boost the supply side of the economy without undermining revenues. However, the economy does not need stimulus from net tax giveaways given that it is operating close to potential. That would simply boost demand relative to supply, create overheating, and give the Fed more reason to get aggressive. The Republican's initial tax plan has some good elements of reform such as cutting back the personal mortgage interest deduction, eliminating some other deductions and making it less attractive for companies to shift operations overseas. However, many of these proposals are unlikely to survive the lobbying efforts of special interest groups. The net result probably will be tax giveaways without much actual reform. Importantly, there is not a strong case for personal tax cuts given that a married worker on the average wage and with two children paid an average income tax rate of only 14% in 2016, according to OECD calculations. There inevitably will be contentious negotiations in Congress but we assume that the Republicans will eventually come together to pass some tax cuts by early next year. The combination of easier fiscal policy and Fed rate hikes will be bullish for the dollar and this will contribute to tighter overall financial conditions. That is why we see a coming collision between economic policy and the markets. The narrative for the so-called Trump rally in markets was based on the assumption that the Administration's platform of increased spending, tax cuts and reduced regulations would be bullish for the economy and thus risk assets. That was always a misplaced notion. The perfect environment for markets has been moderate economic growth, low inflation and easy money. The Trump agenda would be appropriate for an economy that had a lot of spare capacity and needed a big boost in demand. It is less suited for an economy with little spare capacity. Reduced regulations and lower corporate tax rates are good for the supply side of the economy and could boost the potential growth rate. However, if a key move is large personal tax cuts then the boost to demand will dominate. Mr. X: It seems that you are making the case for a serious policy error in the U.S. in the coming year - both on fiscal and monetary policy. I can't argue against that because everything that has happened over the past few years tells me that policymakers don't have a good grip on either the economy or the implications of their actions. I never believed that printing money and creating financial bubbles was a sensible approach to an over-indebted economy. I always expected it to end badly. BCA: Major tightening cycles frequently end in recession because monetary policy is a very blunt tool. Central banks would like to raise rates by just enough to cool things down but that is hard to achieve. The problem with fiscal policy is that implementation lags mean that it often is pro-cyclical. In other words, there is pressure for fiscal stimulus in a downturn, but by the time legislation is passed, the economy typically has already recovered and does not really need a big fiscal boost. And that certainly applies to the current environment. The other area of potential policy error is on trade. Having already pulled the U.S. out of the Trans-Pacific Partnership, the Trump Administration is taking a hardline attitude toward a renegotiation of NAFTA. This could even end up with the deal being scrapped and that would add another element of risk to the North American economies. Ms. X: Your scenario assumes that the Fed will be quite hawkish. However, everything I have read about Jerome Powell, the new Fed chair, suggests that he will err on the side of caution when it comes to raising rates. So monetary policy may not collide with markets at all over the coming year. BCA: It is certainly true that Powell does not have any particular bias when it comes to the conduct of monetary policy. That would not have been the case if either John Taylor or Kevin Warsh had been given the job - they both have a hawkish bias. Powell is not an economist so will likely follow a middle path and be heavily influenced by the Fed's staff forecasts and by the opinions of other FOMC members. There are still several vacancies on the Fed's Board so much will depend on who is appointed to those positions. The latest FOMC forecasts are for growth and inflation of only 2% in 2018 and these numbers seem too low. Meanwhile, the prediction that unemployment will still be at 4.1% at end-2018 is too high. We expect projections of growth and inflation to be revised up and unemployment to be revised down. That will embolden the Fed to keep raising rates. So, even with Powell at the helm, monetary policy is set to get tighter than the market currently expects. Ms. X: So far, we have talked mainly about the U.S. What about other central banks? I can't believe that inflation will be much of a problem in the euro area or in Japan any time soon. Does that not mean that the overall global monetary environment will stay favorable for risk assets? BCA: The Fed is at the leading edge of the shift away from extreme monetary ease by hiking interest rates and starting the process of balance sheet reduction. But the Bank of Canada also has raised rates and the ECB has announced that it will cut its asset purchases in half beginning January 2018, as a first step in normalizing policy. Even the Bank of England has raised rates despite Brexit-related downside risks for the economy. The BoJ will keep an accommodative stance for the foreseeable future. You are correct that financial conditions will be tightening more in the U.S. than in other developed economies. Moreover, equity valuations are more stretched in the U.S. than elsewhere leaving that market especially vulnerable. Yet, market correlations are such that any sell-off in U.S. risk assets is likely to become a global affair. Another key issue relates to the potential for financial shocks. Long periods of extreme monetary ease always fuel excesses and sometimes these remain hidden until they blow up. We know that companies have taken on a lot of debt, largely to fund financial transactions such as share buybacks and merger and acquisitions activity. That is unlikely to be the direct cause of a financial accident but might well become a problem in the next downturn. It typically is increased leverage within the financial sector itself that poses the greatest risk and that is very opaque. The banking system is much better capitalized than before the 2007-09 downturn so the risks lie elsewhere. As would be expected, margin debt has climbed higher with the equity market, and is at a historically high level relative to market capitalization (Chart 9). We don't have good data on the degree of leverage among non-bank financial institutions such as hedge funds but that is where leverage surprises are likely to occur. And the level of interest rates that causes financial stress is almost certainly to be a lot lower than in the past. Chart 9Financial Leverage Has Risen Mr. X: That is the perfect lead-in to my perennial concern - the high level of debt in the major economies. I realize high debt levels are not a problem when interest rates are close to zero, but that will change if your view on the Fed is correct. Ms. X: I would just add that this is one area where I share my father's concerns, but with an important caveat. I wholeheartedly agree that high debt levels pose a threat to economic and financial stability, but I see this as a long-term issue. Even with rising interest rates, debt servicing costs will stay low for at least the next year. It seems to me that rates will have to rise a lot before debt levels in the major economies pose a serious threat to the system. Even if the Fed tightens policy in line with its plans, real short rates will still stay low by historical standards. This will not only keep debt financing manageable but will also sustain the search for yield and support equity prices. BCA: We would be disappointed if you both had not raised the issue of debt. Debt levels do indeed remain very elevated among advanced and emerging economies (Chart 10). The growth in private debt remains far below pre-crisis levels in the advanced countries, but this has been offset by the continued high level of government borrowing. As a result, the total debt-to-GDP ratio has stayed close to a peak. And both private and public debt ratios have climbed to new highs in the emerging economies, with China leading the charge. Chart 10ADebt Levels Remain Elevated Chart 10BDebt Levels Remain Elevated As we have discussed in the past, there is not an inconsistency between our End of Debt Supercycle thesis and the continued high levels of debt in most countries. As noted earlier, record-low interest rates have not triggered the kind of private credit resurgence that occurred in the pre-crisis period. For example, household borrowing has remained far below historical levels as a percent of income in the U.S., despite low borrowing costs (Chart 11). At the same time, it is not a surprise that debt-to-income ratios are high given the modest growth in nominal incomes in most countries. Chart 11Low Rates Have Not Triggered ##br##A Borrowing Surge In U.S. Debt growth is not benign everywhere. In the developed world, Canada's debt growth is worryingly high, both in the household and corporate sectors. As is also the case with Australia, Canada's overheated housing market has fueled rapid growth in mortgage debt. These are accidents waiting to happen when borrowing costs increase. In the emerging word, China has yet to see the end of its Debt Supercycle. Fortunately, with most banks under state control, the authorities should be able to contain any systemic risks, at least in the near run. With regard to timing, we agree that debt levels are not likely to pose an economic or financial problem in next year. It is right to point out that debt-servicing costs are very low by historical standards and it will take time for rising rates to have an impact given that a lot of debt is locked in at low rates. For example, in the U.S., the ratio of household debt-servicing to income and the non-financial business sector's ratio of interest payments to EBITD are at relatively benign levels (Chart 12). However, changes occur at the margin and the example of the Bernanke taper tantrum highlighted investor sensitivity to even modest changes in the monetary environment. You may well be right Ms. X that risk assets will continue to climb higher in the face of a tighter financial conditions. But given elevated valuations, we lean toward a cautious rather than aggressive approach to strategy. We would rather leave some money on the table than risk being caught in a sudden downdraft. Other investors, including yourself, might prefer to wait for clearer signals that a turning point is imminent. Returning to the issue of indebtedness, the end-game for high debt levels continues to be a topic of intense interest. There really are only three options: to grow out of it, to write it off, or to try and inflate it away. The first option obviously would be best - to have fast enough growth in real incomes that allowed debtors to start paying down their debt. Unfortunately, that is the least likely prospect given adverse demographic trends throughout the developed world and disappointing productivity growth (Chart 13). Chart 12Borrowing Costs Are Benign Chart 13It's Hard To Grow Out Of Debt ##br##With These Structural Headwinds Writing the debt off - i.e. defaulting - is a desperate measure that would be the very last resort after all other approaches had failed. In this case, we are talking mainly about government debt, because private debt always has to be written off when borrowers become bankrupt. Japan is the one developed country where government debt probably will be written off eventually. Given that the Bank of Japan owns around 45% of outstanding government debt, those holdings can be neutralized by converting them to perpetuals - securities that are never redeemed. If the first two options are not viable, then inflation becomes the preferred solution to over-indebtedness. To make a big impact, inflation would need to rise far above the 2% level currently favored by central banks, and it would have to stay elevated for quite some time. Central banks are not yet ready to allow such an environment, but that could change after the next economic downturn. Central banks have made it clear that they are prepared to pursue radical policies in order to prevent deflation. This sets the scene for increasingly aggressive actions after the next recession and the end result could be a period of significantly higher inflation. Mr. X: I don't disagree with that view which is why I always like to hold some physical gold in my portfolio. It is interesting that you are worried about a looming setback for risk assets because you are positive on the near-run economic outlook. That is contrary to the typical view that sees a decent economy as supporting higher equity prices. Let's spend a bit more time on your view of the economic outlook. Ms. X: Before we do that, I would just emphasize that it is far too early to worry about debt end games and the potential for sharply rising inflation. I don't disagree that monetary policy could be forced to embrace massive reflation during the next downturn and perhaps that will make me change my view of the inflation outlook. But the sequencing is important because we would first have to deal with a recession that could be a very deflationary episode. And before the next recession we could have period of continued decent growth, which would be positive for risk assets. So I agree that the near-term view of the economic outlook is important. The Economic Outlook BCA: This recovery cycle has been characterized by a series of shocks and headwinds that constrained growth in various regions. In no particular order, these included fiscal austerity, the euro crisis, a brief U.S. government shutdown, the Japanese earthquake, and a spike in oil prices above $100. As we discussed a year ago, in the absence of any new shocks, we expected global growth to improve and that is what occurred in 2017. A broad range of indicators shows that activity has picked up steam in most areas. Purchasing managers' indexes are in an uptrend, business and consumer confidence are at cyclical highs and leading indicators have turned up (Chart 14). This is hardly a surprise given easy monetary conditions and a more relaxed fiscal stance almost everywhere. Chart 14Global Activity On An Uptrend The outlook for 2018 is positive and the IMF's projections for growth is probably too low (see Table 2). So, for the second year in a row, the next set of updates due in the spring are likely to be revised up. Ms. X: Let's talk about the U.S. economy. You are concerned that tax cuts could contribute to overheating, tighter monetary policy and an eventual collision with the markets. But there are two alternative scenarios, both quite optimistic for risk assets. On the one hand, a cut in the corporate tax rate could trigger a further improvement in business confidence and thus acceleration in capital spending. This would boost the supply side of the economy and mean that faster growth need not lead to higher inflation. It would be the perfect world of a low inflation boom. At the other extreme, if political gridlock prevents any meaningful tax cuts, we will be left with the status quo of moderate growth and low inflation that has been very positive for markets during the past several years. Mr. X: You can always rely on my daughter to emphasize the potential for optimistic outcomes. I would suggest another entirely different scenario. The cycle is very mature and I fear it would not take much to tip the economy into recession, even if we get some tax relief. So I am more concerned with near-term downside risks to the U.S. economy. A recession in the coming year would be catastrophic for the stock market in my view. BCA: Before we get to the outlook, let's agree on where we are right now. As we already noted, the U.S. economy currently is operating very close to its potential level. The Congressional Budget Office estimates potential growth to be only 1.6% a year at present, which explains why the unemployment rate has dropped even though growth has averaged a modest 2% pace in recent years. The consumer sector has generally been a source of stability with real spending growing at a 2¾% pace over the past several years (Chart 15). And, encouragingly, business investment has recently picked up from its earlier disappointing level. On the negative side, the recovery in housing has lost steam and government spending has been a source of drag. Looking ahead, the pattern of growth may change a bit. With regard to consumer spending, the pace of employment growth is more likely to slow than accelerate given the tight market and growing lack of available skilled employees. According to the National Federation of Independent Business survey, 88% of small companies hiring or trying to hire reported "few or no qualified applicants for the positions they were trying to fill". Companies in manufacturing and construction say that the difficulty in finding qualified workers is their single biggest problem, beating taxes and regulations. In addition, we should not assume that the personal saving rate will keep falling given that it has hit a recovery low of 3.1% (Chart 16). On the other hand, wage growth should continue to firm and there is the prospect of tax cuts. Overall, this suggests that consumer spending should continue to grow by at least a 2% pace in 2018. Chart 15Trends In U.S. Growth Chart 16Personal Saving At A Recovery Low Survey data suggests that business investment spending should remain strong in the coming year, even without any additional boost from corporate tax cuts. Meanwhile, rebuilding and renovations in the wake of Hurricanes Harvey and Irma should provide a short-term boost to housing investment and a more lasting improvement will occur if the millennial generation finally moves out of their parents' basements. On that note, it is encouraging that the 10-year slide in the homeownership rate appears to have run its course (Chart 17). And although housing affordability is down from its peak, it remains at an attractive level from a historical perspective. Chart 17A Weak Housing Recovery Last, but not least, government spending will face countervailing forces. The Administration plans to increase spending on defense and infrastructure but there could be some offsetting cutbacks in other areas. Overall, government spending should make a positive contribution to 2018 after being a drag in 2017. Putting all this together, the U.S. economy should manage to sustain a growth rate of around 2.5% in 2018, putting GDP further above its potential level. And it could rise above that if tax cuts are at the higher end of the range. You suggested three alternative scenarios to our base case: a supply-side boom, continued moderate growth and a near-term recession. A supply-side revival that leads to strong growth and continued low inflation would be extremely bullish, but we are skeptical about that possibility. The revival in capital spending is good news, but this will take time to feed into faster productivity growth. Overall, any tax cuts will have a greater impact on demand than supply, putting even greater pressure on an already tight labor market. The second scenario of a continuation of the recent status quo is more possible, especially if we end up with a very watered-down tax package. However, growth would actually have to drop below 2% in order to prevent GDP from rising above potential. We will closely monitor leading indicators for signs that growth is about to lose momentum. The bearish scenario of a near-term recession cannot be completely discounted, but there currently is no compelling evidence of such a development. Recessions can arrive with little warning if there is an unanticipated shock, but that is rare. Historically, a flat or inverted yield curve has provided a warning sign ahead of most recessions and the curve currently is still positively sloped (Chart 18). Another leading indicator is when cyclical spending1 falls as a share of GDP, reflecting the increased sensitivity of those items to changes in financial conditions. Cyclical spending is still at a historically low level relative to GDP and we expect this to rise rather than fall over the coming quarters. While a near-term recession does not seem likely, the odds will change during the course of 2018. By late year, there is a good chance that the yield curve will be flat or inverted, giving a warning signal for a recession in 2019. Our base case view is for a U.S. recession to start in the second half of 2019, making the current expansion the longest on record. At this stage, it is too early to predict whether it would be a mild recession along the lines of 1990-91 and 2000-01 or a deeper downturn. Chart 18No Recession Signals For The U.S. ...Yet Mr. X: I hope that you are right that a U.S. recession is more than a year away. I am not entirely convinced but will keep an open mind, and my daughter will no doubt keep me fully informed of any positive trends. Ms. X: You can be sure of that. Although I lean toward the optimistic side on the U.S. economy, I have been rather surprised at how well the euro area economy has done in the past year. Latest data show that the euro area's real GDP increased by 2.5% in the year to 2017 Q3 compared to 2.3% for the U.S. Can that be sustained? BCA: The relative performance of the euro area economy has been even better if you allow for the fact that the region's population growth is 0.5% a year below that of the U.S. So the economic growth gap is even greater on a per capita basis. The euro area economy performed poorly during their sovereign debt crisis years of 2011-13, but the subsequent improvement has meant that the region's real per capita GDP has matched that of the U.S. over the past four years. And even Japan's GDP has not lagged much behind on a per capita basis (Chart 19). Chart 19No Clear Winner On Growth The recovery in the euro area has been broadly based but the big change was the end of a fiscal squeeze in the periphery countries. Between 2010 and 2013, fiscal drag (the change in the structural primary deficit) was equivalent to around 10% of GDP in Greece and Portugal and 7% of GDP in Ireland and Spain. There was little fiscal tightening in the subsequent three years, allowing those economies to recover lost ground. Meanwhile, Germany's economy has continued to power ahead, benefiting from much easier financial conditions than the economy has warranted. That has been the inevitable consequence of a one size fits all monetary policy that has had to accommodate the weakest members of the region. The French and Italian economies have disappointed, but there are hopes that the new French government will pursue pro-growth policies. And Italy should also pick up given signs that it is finally starting to deal with its fragile banking system. Both Spain and Italy faced a sharp rise in non-performing bank loans during the great recession, but Italy lagged Spain in dealing with the problem (Chart 20). That goes a long way to explaining why the Italian economic recovery has been so poor relative to Spain. With Italian banks raising capital and writing off non-performing loans more aggressively, the Italian economy should start to improve, finally catching up with the rest of the region. Overall, the euro area economy should manage to sustain growth above the 2.1% forecast by the IMF for 2018. Overall financial conditions are likely to stay favorable for at least another year and we do not anticipate any major changes in fiscal policy. If, as we fear, the U.S. moves into recession in 2019, there will be negative fallout for Europe, largely via the impact on financial markets. However, in relative terms, the euro area should outperform the U.S. during the next downturn. Mr. X: A year ago, you said that Brexit posed downside risks for the U.K. economy. For a while, that seemed too pessimistic as the economy performed quite well, but recent data show things have taken a turn for the worse. How do you see things playing out with this issue? BCA: It was apparent a year ago that the U.K. government had no concrete plans to deal with Brexit and little has changed since then. The negotiations with the EU are not going particularly well and the odds of a "hard" exit have risen. This means withdrawing from the EU without any agreement on a new regime for trade, labor movements or financial transactions. A growing number of firms are taking the precaution of shifting some operations from the U.K. to other EU countries. As you noted, there are signs that Brexit is starting to undermine the U.K. economy. For example, London house prices have turned down and the leading economic index has softened (Chart 21). The poor performance of U.K. consumer service and real estate equities relative to those of Germany suggest investors are becoming more wary of the U.K. outlook. Of course, a lot will depend on the nature of any deal between the U.K. and the EU and that remains a source of great uncertainty. Chart 20A Turning Point For Italian Banks? Chart 21U.K. Consumer Services Equities Are ##br##Underperforming Brexit Effects Show Up At the moment, there are no real grounds for optimism. The U.K. holds few cards in the bargaining process and the country's strong antipathy toward the free movement of people within the EU will be a big obstacle to an amicable separation agreement. Ms. X: I think the U.K. made the right decision to leave the EU and am more optimistic than you about the outlook. There may be some short-term disruption but the long-term outlook for the U.K. will be good once the country is freed from the stifling bureaucratic constraints of EU membership. The U.K. has a more dynamic economy than most EU members and it will be able to attract plenty of overseas capital if the government pursues appropriate policies toward taxes and regulations. It will take a few years to find out who is correct about this. In the meantime, given the uncertainties, I am inclined to have limited exposure to sterling and the U.K. equity market. Let's now talk about China, another country facing complex challenges. This is a topic where my father and I again have a lot of debates. As you might guess, I have been on the more optimistic side while he has sided with those who have feared a hard landing. And I know that similar debates have occurred in BCA. BCA: It is not a surprise that there are lots of debates about the China outlook. The country's impressive economic growth has been accompanied by an unprecedented build-up of debt and supply excesses in several sectors. The large imbalances would have led to a collapse by now in any other economy. However, China has benefited from the heavy state involvement in the economy and, in particular, the banking sector. The big question is whether the government has enough control over economic developments to avoid an economic and financial crisis. The good news is that China's government debt is relatively low, giving them the fiscal flexibility to write-off bad debts from zombie state-owned enterprises (SOEs). The problems of excessive leverage and over-capacity are particularly acute in SOEs that still comprise a large share of economic activity. The government is well aware of the need to reform SOEs and various measures have been announced, but progress has been relatively limited thus far. The IMF projects that the ratio of total non-financial debt to GDP will remain in an uptrend over the next several years, rising from 236% in 2016 to 298% by 2022 (Chart 22). Yet, growth is expected to slow only modestly over the period. Of course, one would not expect the IMF to build a crisis into their forecast. Some investors have been concerned that a peak in China's mini-cycle of the past two years may herald a return to the economic conditions that prevailed in 2015, when the industrial sector grew at a slower pace than during the acute phase of the global financial crisis. These conditions occurred due to the combination of excessively tight monetary conditions and weak global growth. While China's export growth may slow over the coming year, monetary policy remains accommodative. Monetary conditions appear to have peaked early this year but are still considerably easier than in mid-2015. Shifts in the monetary conditions index have done a good job of leading economic activity and they paint a reasonably positive picture (Chart 23). The industrial sector has finally moved out of deflation, with producer prices rising 6.9% in the year ended October. This has been accompanied by a solid revival in profits. Chart 22China: Debt-Fueled Growth To Continue Chart 23China Leaves Deflation Behind On balance, we assume that the Chinese economy will be able to muddle through for the foreseeable future. President Xi Jinping has strengthened his grip on power and he will go to great lengths to ensure that his reign is not sullied with an economic crisis. The longer-term outlook will depend on how far the government goes with reforms and deleveraging and we are keeping an open mind at this point. In sum, for the moment, we are siding with Ms. X on this issue. Mr. X: I have been too bearish on China for the past several years, but I still worry about the downside risks given the massive imbalances and excesses. I can't think of any example of a country achieving a soft landing after such a massive rise in debt. I will give you and my daughter the benefit of the doubt, but am not totally convinced that you will be right. BCA has been cautious on emerging economies in general: has that changed? BCA: The emerging world went through a tough time in 2015-16 with median growth of only 2.6% for the 23 constituent countries of the MSCI EM index (Chart 24). This recovered to 3% in 2017 according to IMF estimates, but that is still far below the average 5% pace of the period 2000-07. Chart 24Emerging Economy Growth: ##br##The Boom Years Are Over It is always dangerous to generalize about the emerging world because the group comprises economies with very different characteristics and growth drivers. Two of the largest countries - Brazil and Russia - went through particularly bad downturns in the past couple of years and those economies are now in a modest recovery. In contrast, India has continued to grow at a healthy albeit slowing pace, while Korea and the ASEAN region have not suffered much of a slowdown. If, as seems likely, Chinese growth holds above a 6% pace over the next year, then those countries with strong links to China should do fine. And it also points to reasonably steady commodity prices, supporting resource-dependent economies. Longer-run, there are reasons to be cautious about many emerging economies, particularly if the U.S. goes into recession 2019, as we fear. That would be associated with renewed weakness in commodity prices, and capital flight from those economies with high external debt such as Turkey and South Africa. As we stated a year ago, the heady days of emerging economy growth are in the past. Mr. X: It seems that both my daughter and I can find some areas of agreement with your views about the economic outlook. You share her expectation that the global growth outlook will stay healthy over the coming year, but you worry about a U.S.-led recession in 2019, something that I certainly sympathize with. But we differ on timing: I fear the downturn could occur even sooner and I know my daughter believes in a longer-lasting upturn. Let's now move onto what this all means for financial markets, starting with bonds. Bond Market Prospects Ms. X: I expect this to be a short discussion as I can see little attraction in bonds at current yields. Even though I expect inflation to stay muted, bonds offer no prospect of capital gains in the year ahead and even the running yield offers little advantage over the equity dividend yield. BCA: As you know, we have believed for some time that the secular bull market in bonds has ended. We expect yields to be under upward pressure in most major markets during 2018 and thus share your view that equities offer better return prospects. By late 2018, it might well be appropriate to switch back into bonds against a backdrop of higher yields and a likely bear market in equities. For the moment, we recommend underweight bond exposure. It is hard to like government bonds when the yield on 10-year U.S. Treasuries is less than 50 basis points above the dividend yield of the S&P 500 while the euro area bond yield is 260 basis points below divided yields (Chart 25). Real yields, using the 10-year CPI swap rate as a measure of inflation expectations, are less than 20 basis points in the U.S. and a negative 113 basis points in the euro area. Even if we did not expect inflation to rise, it would be difficult to recommend an overweight position in any developed country government bonds. One measure of valuation is to compare the level of real yields to their historical average, adjusted by the standard deviation of the gap. On this basis, the most overvalued markets are the core euro area countries, where real yields are 1.5 to 2 standard deviations below their historical average (Chart 26). There are only two developed bond markets where real 10-year government yields currently are above their historical average: Greece and Portugal. This is warranted in Greece where there needs to be a risk premium in case the country is forced to leave the single currency at some point. This is less of a risk for Portugal, making it a more interesting market. Real yields in New Zealand are broadly in line with their historical average, also making it one of the more attractive markets. Chart 25Bonds Yields Offer Little Appeal Chart 26Valuation Ranking Of Developed Bond Markets Mr. X: Given your expectation of higher inflation, would you recommend inflation-protected Treasuries? BCA: Yes, in the sense that they should outperform conventional Treasuries. The 10-year TIPS are discounting average inflation of 1.85% and we would expect this to be revised up during the coming year. However, the caveat is that absolute returns will still be mediocre. Ms. X: You showed earlier that corporate bonds had a reasonable year in 2017, albeit falling far short of the returns from equities. A year ago, you recommended only neutral weighting in investment-grade bonds and an underweight in high yield. But you became more optimistic toward both early in 2017, shifting to an overweight position. Are you thinking of scaling back exposure once again, given the tight level of spreads? BCA: Yes, we were cautious on U.S. corporates a year ago because valuation was insufficient to compensate for the deterioration in corporate balance sheet health. Nonetheless, value improved enough early in 2017 to warrant an upgrade to overweight given our constructive macro and default rate outlook. The cyclical sweet spot for carry trades should continue to support spread product for a while longer. Moreover, value is better than it appears at first glance. The dotted line in Chart 27 shows the expected 12-month option-adjusted spread for U.S. junk bonds after adjusting for our base case forecast for net default losses. At 260 basis points, this excess spread is in line with the historical average. In the absence of any further spread narrowing, speculative-grade bonds would return 230 basis points more than Treasurys in 2018. If high-yield spreads were to tighten by another 150 basis points, then valuations would be at a historical extreme, and that seems unwarranted. An optimistic scenario would have another 100 basis point spread tightening, delivering excess returns of 5%. Of course, if spreads widen, then corporates will underperform. If financial conditions tighten in 2018 as we expect then it will be appropriate to lower exposure to corporates. In the meantime, you should favor U.S. and U.K. corporate bonds to issues in the Eurozone because ECB tapering is likely to spark some spread widening in that market. Mr. X: What about EM hard-currency bonds? BCA: The global economic background is indeed positive for EM assets. However, EM debt is expensive relative to DM investment-grade bonds which, historically, has heralded a period of underperformance (Chart 28). We expect that relative growth dynamics will be more supportive of U.S. corporates because EM growth will lag. Any commodity price weakness and/or a stronger U.S. dollar would also weigh on EM bonds and currencies. Chart 27Not Much Value In U.S. Corporates Chart 28Emerging Market Bonds Are Expensive Mr. X: We have not been excited about the bond market outlook for some time and nothing you have said changes my mind. I am inclined to keep our bond exposure to the bare minimum. Ms. X: I agree. So let's talk about the stock market which is much more interesting. As I mentioned before, I am inclined to remain fully invested in equities for a while longer, while my father wants to start cutting exposure. Equity Market Outlook BCA: This is one of those times when it is important to draw a distinction between one's forecast of where markets are likely to go and the appropriate investment strategy. We fully agree that the conditions that have driven this impressive equity bull market are likely to stay in place for much of the next year. Interest rates in the U.S. and some other countries are headed higher, but they will remain at historically low levels for some time. Meanwhile, in the absence of recession, corporate earnings still have upside, albeit not as much as analysts project. However, we have a conservative streak at BCA that makes us reluctant to chase markets into the stratosphere. For long-term investors, our recommended strategy is to gradually lower equity exposure to neutral. However, those who are trying to maximize short-term returns should stay overweight and wait for clearer signs that tighter financial conditions are starting to bite on economic activity. Chart 29Reasons For Caution On U.S. Stocks Getting down to specifics, here are the trends that give us cause for concern and they are all highlighted in Chart 29. Valuation: Relative to both earnings and book value, the U.S. equity market is more expensive than at any time since the late 1990s tech bubble. The price-earnings ratio (PER) for the S&P 500 is around 30% above its 60-year average on the basis of both trailing operating earnings and a 10-year average of earnings. The market is not expensive on a relative yield basis because interest rates are so low, but that will change as rates inevitably move higher. Other developed markets are not as overvalued as the U.S., but neither are they cheap. Earnings expectations: The performance of corporate earnings throughout this cycle - particularly in the U.S. - has been extremely impressive give the weaker-than-normal pace of economic growth. However, current expectations are ridiculously high. According to IBES data, analysts expect long-run earnings growth of around 14% a year in both the U.S. and Europe. Even allowing for analysts' normal optimistic bias, the sharp upward revision to growth expectations over the past year makes no sense and is bound to be disappointed. Investor complacency: We all know that the VIX index is at a historical low, indicating that investors see little need to protect themselves against market turmoil. Our composite sentiment indicator for the U.S. is at a high extreme, further evidence of investor complacency. These are classic contrarian signs of a vulnerable market. Most bear markets are associated with recessions, with the stock market typically leading the economy by 6 to 12 months (Chart 30). The lead in 2007 was an unusually short three months. As discussed earlier, we do not anticipate a U.S. recession before 2019. If a recession were to start in mid-2019, it would imply the U.S. market would be at risk from the middle of 2018, but the rally could persist all year. Of course, the timing of a recession and market is uncertain. So it boils down to potential upside gains over the next year versus the downside risks, plus your confidence in being able to time the top. Chart 30Bear Markets And Recessions Usually Overlap We are not yet ready to recommend that you shift to an underweight position in equities. A prudent course of action would be to move to a broadly neutral position over the next few months, but we realize that Ms. X has a higher risk tolerance than Mr. X so we will leave you to fight over that decision. The timing of when we move to an underweight will depend on our various economic, monetary and market indicators and our assessment of the risks. It could well happen in the second half of the year. Mr. X: My daughter was more right than me regarding our equity strategy during the past year, so maybe I should give her the benefit of the doubt and wait for clearer signs of a market top. Thus far, you have focused on the U.S. market. Last year you preferred developed markets outside the U.S. on the grounds of relative valuations and relative monetary conditions. Is that still your stance? BCA: Yes it is. The economic cycle and thus the monetary cycle is far less advanced in Europe and Japan than in the U.S. This will provide extra support to these markets. At the same time, profit margins are less vulnerable outside the U.S. and, as you noted, valuations are less of a problem. In Chart 31, we show a valuation ranking of developed equity markets, based on the deviation of cyclically-adjusted PERs from their historical averages. The chart is not meant to measure the extent to which Portugal is cheap relative to the U.S., but it indicates that Portugal is trading at a PER far below its historical average while that of the U.S. is above. You can see that the "cheaper" markets tend to be outside the U.S. Japan's reading is flattered by the fact that its historical valuation was extremely high during the bubble years of the 1980s, but it still is a relatively attractive market. Chart 31Valuation Ranking Of Developed Equity Markets From a cyclical standpoint, we are still recommending overweight positions in European and Japanese stocks relative to the U.S., on a currency-hedged basis. Nevertheless, market correlations are such that a sell-off in the U.S. will be transmitted around the world (Chart 32). Chart 32When the U.S. Market Sneezes, The World Catches A Cold Ms. X: I would like to turn the focus to emerging equity markets. You have been cautious on these for several years and that worked out extremely well until 2017. I note from your regular EM reports that you have not changed your stance. Why are you staying bearish given that you see an improvement in global growth and further potential upside in developed equity prices? BCA: The emerging world did extremely well over many years when global trade was expanding rapidly, China was booming, commodity prices were in a powerful bull market and capital inflows were strong. Those trends fostered a rapid expansion in credit-fueled growth across the EM universe and meant that there was little pressure to pursue structural reforms. However, the 2007-09 economic and financial crisis marked a major turning point in the supports to EM outperformance. As we noted earlier, the era of rapid globalization has ended, marking an important regime shift. Meanwhile, China's growth rate has moderated and the secular bull market in commodities ended several years ago. We do not view the past year's rebound in commodities as the start of a major new uptrend. Many emerging equity markets remain highly leveraged to the Chinese economy and to commodity prices (Chart 33). Although we expect the Chinese economy to hold up, growth is becoming less commodity intensive. Finally, the rise in U.S. interest rates is a problem for those countries that have taken on a marked increase in foreign currency debt. This will be made even worse if the dollar appreciates. Obviously, the very term "emerging" implies that this group of countries has a lot of upside potential. However, the key to success is pursuing market-friendly reforms, rooting out corruption and investing in productive assets. Many countries pay only lip service to these issues. India is a case in point where there is growing skepticism about the Modi government's ability to deliver on major reforms. The overall EM index does not appear expensive, with the PER trading broadly in line with its historical average (Chart 34). However, as we have noted in the past, the picture is less compelling when the PER is calculated using equally-weighted sectors. The financials and materials components are trading at historically low multiples, dragging down the overall index PER. Emerging market equities will continue to rise as long as the bull market in developed markets persists, but we expect them to underperform on a relative basis. Chart 33Drivers Of EM Performance Chart 34Emerging Markets Fundamentals Mr. X: One last question on equities from me: do you have any high conviction calls on sectors? BCA: A key theme of our sector view is that cyclical stocks should outperform defensives given the mature stage of the economic cycle. We are seeing the typical late-cycle improvement in capital spending and that will benefit industrials, and we recommend an overweight stance in that sector. Technology also is a beneficiary of higher capex but of course those stocks have already risen a lot, pushing valuations to extreme levels. Thus, that sector warrants only a neutral weighting. Our two other overweights are financials and energy. The former should benefit from rising rates and a steeper yield curve while the latter will benefit from firm oil prices. If, as we fear, a recession takes hold in 2019, then obviously that would warrant a major shift back into defensive stocks. For the moment, the positive growth outlook will dominate sector performance. Ms. X: I agree that the bull market in equities, particularly in the U.S., is very mature and there are worrying signs of complacency. However, the final stages of a market cycle can sometimes be very rewarding and I would hate to miss out on what could be an exciting blow-off phase in 2018. As I mentioned earlier, my inclination is to stay heavily invested in equities for a while longer and I have confidence that BCA will give me enough of a warning when risks become unacceptably high. Of course, I will have to persuade my father and that may not be easy. Mr. X: You can say that again, but we won't bother our BCA friends with that conversation now. It's time to shift the focus to commodities and currencies and I would start by commending you on your oil call. You were far out of consensus a year ago when you said the risks to crude prices were in the upside and you stuck to your guns even as the market weakened in the first half. We made a lot of money following your energy recommendations. What is your latest thinking? Commodities And Currencies BCA: We had a lot of conviction in our analysis that the oil market would tighten during 2017 against a backdrop of rising demand and OPEC production cuts, and that view turned out to be correct. As we entered the year, the big reason to be bearish on oil prices was the bloated level of inventories. We forecast that inventories would drop to their five-year average by late 2017, and although that turned out to be a bit too optimistic, the market tightened by enough to push prices higher (Chart 35). Chart 35Oil Market Trends The forces that have pushed prices up will remain in force over the next year. Specifically, our economic view implies that demand will continue to expand, and we expect OPEC 2.0 - the producer coalition of OPEC and non-OPEC states, led by Saudi Arabia and Russia - to extend its 1.8 million b/d production cuts to at least end-June. On that basis, OECD inventories should fall below their five-year average by the end of 2018. We recently raised our 2018 oil price target to an average of $65 in 2018. Of course, the spot market is already close to that level, but the futures curve is backwardated and that is likely to change. We continue to see upside risks to prices, not least because of potential production shortfalls from Venezuela, Nigeria, Iraq and Libya. Mr. X: The big disruptor in the oil market in recent years was the dramatic expansion in U.S. shale production. Given the rise in prices, could we not see a rapid rebound in shale output that, once again, undermines prices? BCA: Our modeling indicates that U.S. shale output will increase from 5.1 mb/d to 6.0 mb/d over the next year, in response to higher prices. This is significant, but will not be enough to materially change the global oil demand/supply balance. Longer run, the expansion of U.S. shale output will certainly be enough to prevent any sustained price rise, assuming no large-scale production losses elsewhere. A recent report by the International Energy Agency projected that the U.S. is destined to become the global leader in oil and gas production for decades to come, accounting for 80% of the rise in global oil and gas supply between 2010 and 2025. Ms. X: You have suggested that China's economic growth is becoming less commodity intensive. Also, you have shown in the past that real commodity prices tend to fall over time, largely because of technological innovations. What does all this imply for base metals prices over the coming year? BCA: The base metals story will continue to be highly dependent on developments in China. While the government is attempting to engineer a shift toward less commodity-intensive growth, it also wants to reduce excess capacity in commodity-producing sectors such as coal and steel. Base metals are likely to move sideways until we get a clearer reading on the nature and speed of economic reforms. We model base metals as a function of China's PMIs and this supports our broadly neutral stance on these commodities (Chart 36). Chart 36China Drives Metals Prices Mr. X: As usual, I must end our commodity discussion by asking about gold. Last year, you agreed that an uncertain geopolitical environment coupled with continued low interest rates should support bullion prices, and that was the case with a respectable 12% gain since the end of 2016. You also suggested that I should not have more than 5% of my portfolio in gold which is less than I am inclined to own. It still looks like a gold-friendly environment to me. Ms. X: Let me just add that this is one area where my father and I agree. I do not consider myself to be a gold bug, but I think bullion does provide a good hedge against shocks in a very uncertain economic and political world. I would also be inclined to hold more than 5% of our portfolio in gold. BCA: There will be opposing forces on gold during the coming year. On the positive side, it is safe to assume that geopolitical uncertainties will persist and may even intensify, and there also is the potential for an increase in inflation expectations that would support bullion. On the negative side, rising interest rates are not normally good for gold and there likely will be an added headwind from a firmer U.S. dollar. Gold appears to be at an important point from a technical perspective (Chart 37). It currently is perched just above its 200-day average and a key trend line. A decisive drop below these levels would be bearish. At the same time, there is overhead resistance at around 1350-1360 and prices would have to break above that level to indicate a bullish breakout. Traders' sentiment is at a broadly neutral level, consistent with no clear conviction about which way prices will break. There is no science behind our recommendation of keeping gold exposure below 5%. That just seems appropriate for an asset that delivers no income and where the risk/reward balance is fairly balanced. Ms. X: You referred to the likelihood of a firmer dollar as a depressant on the gold price. You also were bullish on the dollar a year ago, but that did not work out too well. How confident are you that your forecast will fare better in 2018? BCA: We did anticipate that the dollar would experience a correction at the beginning of 2017, but we underestimated how profound this move would be. A combination of factors explains this miscalculation. Chart 37Gold At A Key Level It first began with positioning. We should have paid more attention to that fact that investors were massively bullish and long the dollar at the end of 2016, making the market vulnerable to disappointments. And disappointment did come with U.S. inflation weakening and accelerating in the euro area. Additionally, there were positive political surprises in Europe, especially the presidential victory of Emmanuel Macron in France. In the U.S., the government's failure to repeal Obamacare forced investors to lower expectations about fiscal stimulus. As a result, while investors were able to price in an earlier first hike by the ECB, they cut down the number of rate hikes they anticipated out of the Fed over the next 24 months. In terms of the current environment, positioning could not be more different because investors are aggressively shorting the dollar (Chart 38). The hurdle for the dollar to deliver positive surprises is thus much lower than a year ago. Also, we remain confident that tax cuts will be passed in the U.S. by early 2018. As we discussed earlier, U.S. GDP will remain above potential, causing inflation pressures to build. This will give the Fed the leeway to implement its planned rate hikes, and thus beat what is currently priced in the market. This development should support the dollar in 2018. Ms. X: A bullish view on the U.S. dollar necessarily implies a negative view on the euro. However, the European economy seems to have a lot of momentum, and inflation has picked up, while U.S. prices have been decelerating. To me, this suggests that the ECB also could surprise by being more hawkish than anticipated, arguing against any major weakness in the euro. BCA: The European economy has indeed done better than generally expected in the past year. Also, geopolitical risks were overstated by market participants at the beginning of 2017, leaving less reason to hide in the dollar. However, the good news in Europe is now well known and largely discounted in the market. Investors are very long the euro, by both buying EUR/USD and shorting the dollar index (Chart 39). In that sense, the euro today is where the dollar stood at the end of 2016. Chart 38Too Much Pessimism On The Dollar Chart 39Positioning Risk In EUR/USD Valuations show a similar picture. The euro might appear cheap on a long-term basis, but not so much so that its purchasing power parity estimate - which only works at extremes and over long-time periods - screams a buy. Moreover, the euro has moved out of line with historical interest rate parity relationships, warning that the currency is at risk if the economy disappoints. Overall, we expect EUR/USD to trade around 1.10 in 2018. Long-run, the picture is different because a U.S. recession in 2019 would trigger renewed broad-based weakness in the dollar. Mr. X: I have been perplexed by the yen's firmness in the past year, with the currency still above its end-2016 level versus the dollar. I expected a lot more weakness with the central bank capping bond yields at zero and more or less monetizing the government deficit. A year ago you also predicted a weak yen. Will it finally drop in 2018? BCA: We were not completely wrong on the yen as it has weakened over the past year on a trade-weighted basis and currently is about 2% below its end-2016 level. But it has risen slightly against the U.S. dollar. In the past couple of years, the yen/dollar rate has been highly correlated with real bond yield differentials (Chart 40). These did not move against the yen as much as we expected because U.S. yields drifted lower and there was no major change in relative inflation expectations. Chart 40Bond Yield Differentials Drive The Yen The real yield gap is likely to move in the dollar's favor over the next year, putting some downward pressure on the yen. Meanwhile, the Bank of Japan will continue to pursue a hyper-easy monetary stance, in contrast to the Fed's normalization policy. However, it is not all negative: the yen is cheap on a long-term basis, and Japan is an international net creditor to the tune of more than 60% of GDP. Investors are also quite short the yen as it remains a key funding currency for carry trades. Thus, it will continue to benefit each time global markets are gripped with bouts of volatility. It remains a good portfolio hedge. Ms. X: Are any other currency views worth noting? BCA: The outlook for sterling obviously will be tied to the Brexit negotiations. Having fallen sharply after the Brexit vote, sterling looks cheap relative to its history. This has allowed it to hold in a broad trading range over the past 18 months, even though the negotiations with the EU have not been going well. At this stage, it is hard to know what kind of deal, if any, will emerge regarding Brexit so we would hedge exposure to sterling. Our optimism toward the oil price is consistent with a firm Canadian dollar, but developments in the NAFTA negotiations represent a significant risk. At the moment, we are overweight the Canadian dollar, but that could change if the NAFTA talks end badly. We still can't get enthusiastic about emerging market currencies even though some now offer reasonable value after falling sharply over the past few years. Mr. X: We can't leave currencies without talking about Bitcoin and cryptocurrencies in general. I like the idea of a currency that cannot be printed at will by governments. There are too many examples of currency debasement under a fiat money system and the actions of central banks in recent years have only served to increase my mistrust of the current monetary system. But I can't profess to fully understand how these cryptocurrencies work and that makes me nervous about investing in them. What are your thoughts? BCA: You are right to be nervous. There have been numerous cases of hackers stealing Bitcoins and other cryptocurrencies. Also, while there is a limit to the number of Bitcoins that can be issued, there is no constraint on the number of possible cryptocurrencies that can be created. Thus, currency debasement is still possible if developers continue creating currencies that are only cosmetically different from the ones already in existence. Moreover, we doubt that governments will sit idly by and allow these upstart digital currencies to become increasingly prevalent. The U.S. Treasury derives $70 billion a year in seigniorage revenue from its ability to issue currency which it can then redeem for goods and services. At some point, governments could simply criminalize the use of cryptocurrencies. This does not mean that Bitcoin prices cannot rise further, but the price trend is following the path of other manias making it a highly speculative play (Chart 41). If you want more detail about our thoughts on this complex topic then you can read the report we published last September.2 Chart 41Bitcoin Looks Like Other Bubbles Ms. X: I don't fear bubbles and manias as much as my father and have made a lot of money during such episodes in the past. But I am inclined to agree that Bitcoin is best avoided. The topic of manic events presents a nice segue into the geopolitical environment which seems as volatile as ever. Geopolitics Ms. X: Which geopolitical events do you think will have the biggest impact on the markets over the coming year? BCA: Domestic politics in the U.S. and China will be very much in focus in 2018. In the U.S., as we discussed, the Republicans will pass tax cuts but it is unclear whether this will help the GOP in the November midterm elections. At this point, all of our data and modeling suggests that Democrats have a good chance of picking up the House of Representatives, setting a stage for epic battles with President Trump about everything under the sun. In China, we are watching carefully for any sign that Beijing is willing to stomach economic pain in the pursuit of economic reforms. The two reforms that would matter the most are increased financial regulation and more aggressive purging of excess capacity in the industrial sector. The 19th Party Congress marked a serious reduction in political constraints impeding President Xi's domestic agenda. This means he could launch ambitious reforms, akin to what President Jiang Zemin did in the late 1990s. While this is a low-conviction view, and requires constant monitoring of the news and data flow out of China, it would be a considerable risk to global growth. Reforms would be good for China's long-term outlook, but could put a significant damper on short-term growth. The jury is out, but the next several months will be crucial. Three other issues that could become market-relevant are the ongoing North Korean nuclear crisis, trade protectionism, and tensions between the Trump administration and Iran. The first two are connected because a calming of tensions with North Korea would give the U.S. greater maneuvering room against China. The ongoing economic détente between the U.S. and China is merely a function of President Trump needing President Xi's cooperation on pressuring North Korea. But if President Trump no longer needs China's help with Kim Jong-Un, he may be encouraged to go after China on trade. As for Iran, it is not yet clear if the administration is serious about ratcheting up tensions or whether it is playing domestic politics. We suspect it is the latter implying that the market impact of any brinkmanship will be minor. But our conviction view is low. Mr. X: We seem to be getting mixed messages regarding populist pressures in Europe. The far right did not do as well as expected in the Netherlands or France, but did well in Austria. Also, Merkel is under some pressure in Germany. BCA: We don't see much in the way of mixed messages, at least when it comes to support for European integration. In Austria, the populists learned a valuable lesson from the defeats of their peers in the Netherlands and France: stay clear of the euro. Thus the Freedom Party committed itself to calling a referendum on Austria's EU membership if Turkey was invited to join the bloc. As the probability of that is literally zero, the right-wing in Austria signaled to the wider public that it was not anti-establishment on the issue of European integration. In Germany, the Alternative for Germany only gained 12.6%, but it too focused on an anti-immigration platform. The bottom line for investors is that the European anti-establishment right is falling over itself to de-emphasize its Euroskepticism and focus instead on anti-immigration policies. For investors, the former is far more relevant than the latter, meaning that the market relevance of European politics has declined. One potential risk in 2018 is the Italian election, likely to be held by the end of the first quarter. However, as with Austria, the anti-establishment parties have all moved away from overt Euroskepticism. At some point over the next five years, Italy will be a source of market risk, but in this electoral cycle and not with economic growth improving. Ms. X: The tensions between the U.S. and North Korea, fueled by two unpredictable leaders, have me very concerned. I worry that name-calling may slide into something more serious. How serious is the threat? BCA: The U.S.-Iran nuclear negotiations are a good analog for the North Korean crisis. The U.S. had to establish a "credible threat" of war in order to move Iran towards negotiations. As such, the Obama administration ramped up the war rhetoric - using Israel as a proxy - in 2011-2012. The negotiations with Iran did not end until mid-2015, almost four years later. We likely have seen the peak in "credible threat" display this summer between the U.S. and North Korea. The next two-to-three months could revisit those highs as North Korea responds to President Trump's visit to the region, as well as to the deployment of the three U.S. aircraft carriers off the coast of the Korean Peninsula. However, we believe that we have entered the period of "negotiations." It is too early to tell how the North Korean crisis will end. We do not see a full out war between either of the main actors. We also do not see North Korea ever giving up its nuclear arsenal, although limiting its ballistic technology and toning down its "fire and brimstone' rhetoric is a must. The bottom line is that this issue will remain a source of concern and uncertainty for a while longer. Conclusions Mr. X: This seems a good place to end our discussion. We have covered a lot of ground and your views have reinforced my belief that it would make good sense to start lowering the risk in our portfolio. I know that such a policy could leave money on the table as there is a reasonable chance that equity prices may rise further. But that is a risk I am prepared to take. Ms. X: I foresee some interesting discussions with my father when we get back to our office. At the risk of sounding reckless, I remain inclined to stay overweight equities for a while longer. I am sympathetic to the view that the era of hyper-easy money is ending and at some point that may cause a problem for risk assets. However, timing is important because, in my experience, the final stages of a bull market can deliver strong gains. BCA: Good luck with those discussions! We have similar debates within BCA between those who want to maximize short-run returns and those who take a longer-term view. Historically, BCA has had a conservative bias toward investment strategy and the bulk of evidence suggests that this is one of these times when long-run investors should focus on preservation of capital rather than stretching for gains. Our thinking also is influenced by our view that long-run returns will be very poor from current market levels. Our estimates indicate that a balanced portfolio will deliver average returns of only 3.3% a year over the coming decade, or 1.3% after inflation (Table 3). That is down from the 4% and 1.9% nominal and real annual returns that we estimated a year ago, reflecting the current more adverse starting point for valuations. There is a negligible equity risk premium on offer, implying that stock prices have to fall at some point to establish higher prospective returns. Table 310-Year Asset Return Projections The return calculations for equities assume profit margins decline modestly over the period and that multiples mean revert to their historical average. These assumptions may turn out to be too pessimistic if there is no redistribution of income shares from the corporate sector back to labor and/or PERs stay at historically high levels. In that case, equities obviously would do better than our estimates. In terms of the outlook for the coming year, a lot will depend on the pace of economic growth. We are assuming that growth is strong enough to encourage central banks to keep moving away from hyper-easy policies, setting up for a collision with markets. If growth slows enough that recession fears spike, then that also would be bad for risk assets. Sustaining the bull market requires a goldilocks growth outcome of not too hot and not too cold. That is possible, but we would not make it our base case scenario. Ms. X: You have left us with much to think about and I am so glad to have finally attended one of these meetings. My father has always looked forward to these discussions every year and I am very happy to be joining him. Many thanks for taking the time to talk to us. Before we go, it would be helpful to have a recap of your key views. BCA: That will be our pleasure. The key points are as follows: The environment of easy money, low inflation and healthy profit growth that has been so bullish for risk assets will start to change during the coming year. Financial conditions, especially in the U.S., will gradually tighten as decent growth leads to building inflation pressures, encouraging central banks to withdraw stimulus. With U.S. equities at an overvalued extreme and investor sentiment overly optimistic, this will set the scene for an eventual collision between policy and the markets. The conditions underpinning the bull market will erode only slowly which means that risk asset prices should continue to rise for at least the next six months. However, long-run investors should start shifting to a neutral exposure. Given our economic and policy views, there is a good chance that we will move to an underweight position in risk assets during the second half of 2018. The U.S. economy is already operating above potential and thus does not need any boost from easier fiscal policy. Any major tax cuts risk overheating the economy, encouraging the Federal Reserve to hike interest rates and boosting the odds of a recession in 2019. This is at odds with the popular view that tax cuts will be good for the equity market. A U.S. move to scrap NAFTA would add to downside risks. For the second year in a row, the IMF forecasts of economic growth for the coming year are likely to prove too pessimistic. The end of fiscal austerity has allowed the euro area economy to gather steam and this should be sustained in 2018. However, the slow progress in negotiating a Brexit deal with the EU poses a threat to the U.K. economy. China's economy is saddled with excessive debt and excess capacity in a number of areas. Any other economy would have collapsed by now, but the government has enough control over banking and other sectors to prevent a crisis. Growth should hold above 6% in the next year or two, although much will depend on how aggressively President Xi pursues painful reforms. The market is too optimistic in assuming that the Fed will not raise interest rates by as much as indicated in their "dots" projections. There is a good chance that the U.S. yield curve will become flat or inverted by late 2018. Bonds are not an attractive investment at current yields. Only Greece and Portugal currently have 10-year government bond real yields above their historical average. Corporate bonds should outperform governments, but a tightening in financial conditions will put these at risk in the second half of 2018. The euro area and Japanese equity markets should outperform the U.S. over the next year reflecting their better valuations and more favorable financial conditions. Developed markets should outperform the emerging market index. Historically, the U.S. equity market has led recessions by between 3 and 12 months. If, as we fear, a U.S. recession starts in the second half of 2019, then the stock market would be at risk from the middle of 2018. The improving trend in capital spending should favor industrial stocks. Our other two overweight sectors are energy and financials. The oil price will be well supported by strong demand and output restraint by OPEC and Russia. The Brent price should average $65 a barrel over the coming year, with risks to the upside. We expect base metals prices to trade broadly sideways but will remain highly dependent on developments in China. Modest positions in gold are warranted. Relative economic and policy trends will favor a firm dollar in 2018. Unlike at the start of 2017, investors are significantly short the dollar which is bullish from a contrary perspective. Sterling is quite cheap but Brexit poses downside risks. The key market-relevant geopolitical events to monitor will be fiscal policy and mid-term elections in the U.S., and reform policies in China. With the former, the Democrats have a good chance of winning back control of the House of Representatives, creating a scenario of complete policy gridlock. A balanced portfolio is likely to generate average returns of only 3.3% a year in nominal terms over the next decade. This compares to average returns of around 10% a year between 1982 and 2017. Let us take this opportunity to wish you and all of our clients a very peaceful, healthy and prosperous New Year. The Editors November 20, 2017 1 This comprises consumer spending on durables, housing and business investment in equipment and software. 2 Please see 'Bitcoin's Macro Impact', BCA Global Investment Strategy Special Report, September 15, 2017.
Highlights The cyclical bull market in stocks will last until the end of next year. That said, global equities have become increasingly vulnerable to a correction, so fast-money investors should consider putting on a tactical hedge spanning the next few weeks. The passage of tax legislation in the U.S. will face many hurdles, and this is likely to ruffle markets in the near term. We ultimately expect Congress to pass a bill early next year. While lower corporate tax rates will be a boon for Wall Street, the gains to Main Street will be a lot more muted. A higher after-tax rate of return on equity will encourage capital inflows into the U.S. This will bid up the value of the dollar, depressing exports in the process. Over the long haul, a larger budget deficit will soak up private-sector savings that could otherwise have been used to finance investment spending. This will lead to less capital accumulation, and eventually a lower standard of living. Feature Rising Odds Of A Stock Market Correction We remain cyclically bullish on global equities based on the expectation that global growth will stay strong over the next 12 months, which should support corporate earnings. Nevertheless, the recent price action in credit markets is disconcerting. Yesterday's relief rally notwithstanding, junk bonds have been selling off in recent weeks, as have EM credit and currencies (Chart 1). We have found that credit trends generally lead the stock market. This raises the risk of an equity correction. The fact that the bull/bear ratio has reached a 30-year high in the weekly Investors Intelligence Sentiment survey (Chart 2), and that the most recent BofA Merrill Lynch Survey shows that a record share of fund managers are overweight risk assets, only add to our worries. Chart 1Junk Bond Selloff Raises ##br##Risks Of An Equity Correction Chart 2Equity Bullish Sentiment:##br## Getting Stretched Doubts about the ability of Republicans in Congress to push through tax cuts further muddle the picture. We continue to expect a tax bill to be signed into law early next year, but the intention of President Trump and Senator Majority Leader Mitch McConnell to include a provision in the bill to rescind the individual mandate to purchase health insurance could greatly complicate this task. Moreover, as we discuss in greater detail below, the economic benefits of the tax legislation are likely to be muted, even if equity prices do rise on the back of lower corporate tax rates. This will make selling the merits of the tax plan to the American people all the more difficult. With all this in mind, we are putting on a short S&P 500 trade recommendation. We are targeting a gain of 5% and putting in a stop-loss of 2%. We will close this trade before the end of the year, so this should be seen as a purely tactical decision appropriate for fast-money investors only. Fiscal Policy Was Tightened Too Early ... Global bond yields plummeted during the Great Recession, but then quickly recovered. The U.S. 10-year Treasury yield hit 3.95% in June 2009, while the German bund yield reached 3.72% that same month. Today, output gaps are much smaller globally than they were seven years ago, yet bond yields are substantially lower (Chart 3). Chart 3ASmaller Output Gaps... Chart 3B...But Lower Bond Yields Many theories have been offered to account for this seemingly paradoxical turn of events. Was it QE? Maybe the Phillips curve broke down? Perhaps investors have steadily revised down their estimate of the neutral rate of interest? One can make compelling arguments in support of all these explanations. However, there is one reason that has received relatively little attention: fiscal policy. Chart 4 shows that fiscal policy was tightened by an average of 4.1% of GDP in the G20 economies between 2010 and 2015. This happened despite the fact that unemployment was still quite high. One could make a half-plausible case that fiscal austerity was necessary in southern Europe, where one country after another was being attacked by the bond vigilantes (although even there, the failure of the ECB to act as a lender of last resort to European sovereigns greatly exacerbated the problem). It is harder to justify the shift towards austerity in countries such as the U.S. and the U.K. which were able to issue debt in their own currencies; or to explain why Germany felt the need to tighten fiscal policy when its structural primary balance was already in surplus. In Japan's case, the 2.9% of GDP in fiscal tightening that occurred between 2013 and the 2015 was a key reason why Abenomics failed to push the country out of deflation. Faced with the reality of what was happening on the fiscal front, central banks had no choice but to step in. They did so by slashing interest rates, in some cases pushing them into negative territory. They also engaged in massive asset purchases. The tsunami of easy money helped to keep economies afloat. But in many countries, slower government debt growth was replaced by faster private-sector debt growth (Chart 5). Debt continued to rise. It just did so in a different form. Chart 4Fiscal Belt-Tightening##br## In 2010-2015 Chart 5Private Debt Growth Picked Up##br## Amid Slowing Government Debt Growth ... And Is Now Being Eased Too Late The good news is that governments are abandoning their obsession with fiscal austerity. The bad news is that they are doing it at a time when fiscal easing is no longer warranted. Standard economic theory suggests that governments should run budget deficits when unemployment is high, and surpluses when it is low. In the U.S., the unemployment rate stands at 4.1%, 0.6 percentage points below the Fed's estimate of NAIRU. And yet, President Trump and the Republicans in Congress are pushing for massive tax cuts which, according to the CBO, would add $1.7 trillion to federal debt over the next ten years, while pushing up the debt-to-GDP ratio by an extra six percentage points to 97% (Chart 6). Limited Supply-Side Benefits Proponents of the legislation argue that lower tax rates will spur growth by so much that they will pay for themselves. This is highly unlikely. Chart 7 shows that major tax cuts in the past have always led to a rising debt-to-GDP ratio, whereas tax hikes have led to a deceleration, or even outright decline, in the debt ratio. Even the much lauded 1981 Reagan tax cuts had to be partially rolled back in 1982 after the budget deficit widened sharply. Chart 6More Red Ink Chart 7Do Tax Cuts Pay For Themselves? The growth-enhancing effects of lower tax rates are likely to be smaller at present than they were in the early 1980s. The Reagan tax cuts were introduced when the economy was in the doldrums and government debt levels were much lower than they are today. Cross-border ownership of foreign assets has also increased tremendously since the Reagan era. Foreigners now own more than $10 trillion of U.S. equities, or close to 35% of the total, up from 10% in the early 1980s (Chart 8). This implies that a corporate tax cut would not only represent a massive windfall for foreigners - a bizarre outcome for a self-professed nationalist president - but would mean that a smaller share of capital gains taxes will make their way into the coffers of the U.S. Treasury. Personal income tax cuts are also likely to generate much less bang for the buck. Most empirical studies suggest that lower personal tax rates increase labor supply largely by boosting female labor participation.1 The prime-age female labor participation rate in the U.S. today is 11 points higher than it was in 1980, which limits the scope for further gains. Moreover, when Ronald Reagan cut taxes in 1981, the top personal tax rate stood at 70% (Chart 9). At such a high rate, a one percentage-point cut in the top rate increases take-home pay by 3.3% (1/30). Today, the top rate stands at 39.6%, so a one-point cut would raise after-tax income by only 1.6% (1/60.4). Thus, the incentive effect from cutting the top marginal tax rate is only half of what it was back then. And, of course, the lower the tax rate, the less incremental revenue the government gets from every additional dollar of income. A reasonable estimate is that the revenue offset from tax cuts today would be only one-quarter of whatever modest amount it was in the early 1980s. Chart 8Growing Share Of U.S. Equities##br## Is Held By Foreigners Chart 9Lower Bang For The Buck From##br## Cutting Individual Tax Rates Tax Cuts Versus Tax Reform This is not to say that tax reform is undesirable. Statutory corporate tax rates in the U.S. are quite high, but effective rates are very low, given the myriad deductions and tax-sheltering strategies (Chart 10). The combination of base-broadening and lower statutory rates would make the economy more efficient. In this respect, the set of reforms unveiled by Paul Ryan earlier this year actually had a lot going for it. Unfortunately, the half-measures in both the House and Senate bills run the risk of making the current system even worse. For example, the proposed transition from the current system where U.S. companies are taxed on their worldwide profits to one where they are taxed only on the profits they earn in the U.S. is likely to increase the incentive to use accounting gimmicks to shift more taxable income to low-tax jurisdictions abroad.2 The new "pass through" tax rate of 25% would also provide passive business owners, who are currently subject to the top marginal tax rate, with a massive tax break. Chart 10Statutory Vs. Effective Corporate Tax Rates: Please Mind The Gap In theory, full business investment expensing is a good idea, but the economic impact is likely to be modest. Companies pay less tax upfront when they can write off the value of capital expenditures immediately, but incur higher taxes in the future due to the absence of any further depreciation expenses. When interest rates are low, as they are today, the present value gain from shifting tax liabilities around in this way is bound to be small. This, along with the fact that companies can already write off a large share of capital purchases under current law in the first few years after they are made, will limit the benefits of the proposal. The full expensing of capital purchases also expires after five years under the Republican plan. This could cause companies to pull forward capital spending simply to game the tax code. Such a policy could be justified if the economy were depressed, but that is not the case today. The Tax Foundation, a free-market think tank that a number of left-leaning economists have accused of overstating the benefits of tax cuts, estimates that temporary expensing would raise the level of real GDP by only 0.18% after a decade, compared to 1.6% in the case of permanent expensing.3 From Populism To Pluto-Populism Chart 11This Is Not Populism Martin Wolf has aptly referred to Donald Trump as a "pluto-populist" - someone who talks like a champion of the poor and middle class to his adoring supporters, but actually pushes for policies that mainly benefit the wealthiest Americans.4 Many of the proposals in the Republican tax bills - including the abolition of the Alternative Minimum Tax, the phase-out of the estate tax, and the aforementioned reduction in the business pass-through tax - would further skew the distribution of income towards the rich (Chart 11). Indeed, the benefits for the wealthy grow over time under the proposed plans, even as those for the middle class dissipate, eventually reaching the point where the average middle-class household ends up paying more taxes under the House plan than they do now (Chart 12).5 And no, one cannot say that this outcome is simply the inevitable consequence of the fact that the rich pay most of the taxes. Once regressive taxes such as the payroll tax and state and local taxes are included in the tally, the rich pay about the same share of their income in taxes as the middle class (Chart 13). To make matters worse, the Republican tax bill would trigger $25 billion in Medicare cuts and $111 billion in cuts to other government programs under current PAYGO rules. More pain for middle-class voters. Donald Trump was quick to throw Ed Gillespie under the bus after he failed to win the governor's race in Virginia, tweeting that Gillespie "did not embrace me or what I stand for." But the truth is Trump has not embraced Trumpism either. We were widely scorned in the early days of the primary season for saying that Trump would secure the Republican nomination, and mocked again in 2016 for predicting that he would win the presidential election. At this point, however, the odds are high that the Republicans will lose the House next November and Trump will fail to get re-elected in 2020. Chart 12Middle-Class Tax Cuts Will Morph Into Tax Hikes Chart 13U.S. Taxation Not Very Progressive Investment Conclusions U.S. equities are overbought and ripe for a correction. As is almost always the case, lower stock prices in the U.S. will negatively impact global bourses. Fortunately, the selloff is likely to be short-lived, with strong global growth and rising earnings powering stocks into 2018. The passage of tax legislation in the U.S. will face many hurdles, and this is likely to ruffle markets in the near term. Nevertheless, we expect Congress to pass a bill early next year. While lower corporate tax rates will be a boon for Wall Street, the gains to Main Street will be a lot more muted. A higher after-tax rate of return on equity will encourage capital inflows into the U.S. This will bid up the value of the dollar, depressing exports in the process. Over the long haul, a wider budget deficit will soak up private-sector savings that could otherwise have been used to finance investment spending. This will lead to less capital accumulation, and eventually a lower standard of living. Chart 14Inflation Higher In Countries Lacking Independent Central Banks Higher government debt levels will also increase the temptation to inflate away debt. As we discussed a few weeks ago, rising political polarization is affecting every facet of society, with the NFL just being the latest example.6 It is hard to believe that the Fed will remain above the fray. History suggests that the loss of central bank independence is often associated with higher inflation (Chart 14). Such may be America's fate as well. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Robert K. Triest, "The Effect Of Income Taxation On Labor Supply In The United States," The Journal of Human Resources, Special Issue on Taxation and Labor Supply in Industrial Countries, 25:3 (Summer 1990); and Costas Meghir and David Phillips, "Labour Supply And Taxes," IZA Discussion Paper No. 3405 (March 2008). 2 Both the House and Senate versions of the tax bill have a number of provisions to limit the ability of corporations to shift profits abroad, but at present, it is unclear how effective these measures will be. 3 Please see "Economic and Budgetary Impact of Temporary Expensing," Tax Foundation, dated October 4, 2017. 4 Martin Wolf, "Donald Trump Embodies How Great Republics Meet Their End," Financial Times, March 1, 2016. 5 This mainly occurs because the "Family Flexibility Credit" expires after 2022. The expanded Child Tax Credit is also not indexed to inflation under the House plan, implying that its value to tax filers will go down over time. In addition, the repeal of the individual mandate would cause fewer lower-income earners to buy health insurance, leading them to forego the tax subsidies that they would otherwise receive. 6 Please see , "Three Demographic Megatrends," dated October 27, 2017. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights Broad Chinese equity market performance since last month's Party Congress is consistent with our view that the pace of reforms over the coming year will not cause a meaningful deceleration in China's industrial sector. Stay overweight Chinese stocks. After accounting for idiosyncrasy, divergent sector performance is largely consistent with the stated intentions of Chinese policymakers. Our new China Reform Monitor, which is based on sector performance, should help investors identify whether the pace of reforms is moving too rapidly to be consistent with a benign growth outlook. We are adding two new reform-themed trades this week, and closing one existing position (with a healthy profit). Feature BCA's China Investment Strategy service has presented a relatively benign view of the economic impact of stepped up reform efforts in China over the coming 6-12 months. As we noted in last week's report, while a "status quo" scenario of no significant reforms is highly unlikely over the coming year, the pace of reforms will be structured at a level of intensity that will be sufficient to avoid an outsized deceleration in China's industrial sector. We also highlighted that monitoring reform progress would be an important theme to revisit, and in this week's report we review the response of investors to the Party Congress, both at the broad market and sector level, to judge whether it is consistent with our outlook and positioning. We also introduce two new reform-themed trades, and recommend booking profits on an existing position. Broad Market Performance Post-Congress Before gauging the market's view of the likely impact of refocused reform efforts on the Chinese economy over the coming year, it is worth revisiting what kind of market performance would be consistent with our view. To recap the view of our Geopolitical Strategy service,1 President Xi's reform agenda is likely to intensify over the next 12 months, suggesting that Chinese policymakers will make meaningful efforts to: Pare back heavy-polluting industry Hasten the transition of China's economy to "consumer-led" growth2 Deleverage the financial sector Continue to crack down on corruption and graft From the perspective of BCA's China Investment Strategy service, a rapid and intense pace of these reforms would likely be a net negative for Chinese equities, as well as for emerging markets (EM) and other plays on China's industrial sector. For example, in terms of the impact on Chinese stock prices, we highlighted in last week's report that MSCI China ex-tech earnings have been closely correlated with the Li Keqiang index, which would likely decline non-trivially in the face of a very pressing reform push. In addition, the potential for a policy mistake would presumably raise the risk premium on Chinese equities, which would reverse at least some of their meaningful re-rating vs the global benchmark since late-2015. As such, to be consistent with our view, broad market performance (relative to emerging market or global stocks) should have been largely unaffected in the immediate aftermath of the Party Congress, but somewhat divergent at the sector level, given the likely creation of at least some industry "winners" and "losers" from renewed reforms. For the overall market, Chart 1 shows that this is exactly what has occurred over the past month. The chart presents the relative performance of Chinese equities versus the emerging market (EM) and global benchmarks, both in US$ terms and rebased to 100 on the day of President Xi's speech at the Party Congress. The initial reaction to the speech was modestly negative, with Chinese stocks falling a little over 2% in relative terms versus their global peers. But this loss disappeared less than three weeks following the speech, underscoring that market participants agree with our assessment that a rebooted reform effort will not threaten the economy as a whole. Investors should stay overweight Chinese stocks relative to their benchmark. Chart 1No Sign That Stepped Up Reforms Will Be A Net Negative For Chinese Economic Growth The Sector Implications Of Renewed Reforms Chart 2 shows that the sector effects of President Xi's speech have indeed been more divergent, which is also in line with our perspective of view-consistent performance. The chart shows that the past month's performance of the 11 level 1 GICS sectors relative to the broad market can be grouped into three distinct categories: Chart 2China's Reforms Will Create Some Winners##br## And Losers Clear outperformers, which include health care, energy, information technology, and consumer staples, Neutral to modest underperformers, which include utilities, telecom services, and financials, and Clear underperformers, which include industrials, real estate, consumer discretionary, and materials Several of these results are not surprising, as they clearly resonate with the stated intensions of Chinese policymakers. In particular, the outperformance of health care, technology, and consumer staples stocks and the underperformance of capital-goods intensive industrials straightforwardly reflects the goal of re-orienting "old China" towards a new, consumer-focused economy. While energy stocks are viewed as a traditionally cyclically-sensitive carbon-intensive sector, oil prices have risen over the past month and China's share of global energy consumption is much smaller than that of base metals. However, the relative return profiles of a few sectors mentioned above are at least somewhat counterintuitive. On this front, several observations are noteworthy: At first blush, the significant underperformance of Chinese consumer discretionary stocks is counterintuitive if policymakers are aiming to reduce the country's reliance on investment and increase the share of private consumption. However, as Table 1 shows, Chinese consumer discretionary stocks have likely sold off due to the automobile & components industry group, which is potentially at risk of being negatively impacted by the environmental mandate of President Xi's proposed reforms. The table shows that the automobiles & components industry group accounts for a full 1/3rd of Chinese consumer discretionary market capitalization, which is non-trivially larger than in the case of the global benchmark. Table 1 also highlights that China's retailing industry group is as large as that of automobiles & components, which in theory should have provided an offset to the latter's weakness. However, in market capitalization terms, retailers in the MSCI China index are dominated by two large players, one of which is active in providing corporate travel management services. The continuation and expansion of China's anti-corruption campaign was a key message from the Party Congress, and it would appear that investors are concerned about the potential for anti-graft efforts to negatively impact the demand for goods & services that could be potentially linked to corruption or largesse. The underperformance of the materials sector is seemingly reform-consistent, although here too the details of China's investible indexes matter. Table 2 presents a sub-industry breakdown of the MSCI China materials index, as well as an indication whether rebooted reform efforts are a clear negative for the sub-industry. The table highlights that the likely impact of a renewed reform push is mixed: construction materials firms and copper producers (at least in terms of output) are like to suffer, but there are no obvious negative implications for aluminum,3 gold, and paper products producers. The impact on commodity chemicals producers is ambiguous, given that packaging for consumer goods is a significant end market for the petrochemical industry. Table 1Autos Make Up A Significant Share Of ##br##China's Consumer Discretionary Sector Table 2Impact Of Renewed Reforms ##br##On The Materials Sector Is Mixed Finally, there appears to be at least somewhat of a discrepancy between the benign performance of Chinese financials and the underperformance of the real estate sector. Attempts to curb "excessive" financial risks and debt could certainly hurt the real estate sector, but this would also negatively impact banks via a slowdown in credit growth. For now, the significant valuation gap between Chinese financials and real estate appears to be the only explanation for this divergent performance post Party Congress, but we will continue to watch these sectors for signs of a wider market implication. Sector idiosyncrasies aside, the broad conclusion from China's equity market performance over the past month is that investors acknowledge that there are likely to be winners and losers from a rebooted reform mandate, but that overall economic growth in China is not likely to significantly decelerate. This is consistent with our view that the pace of reform efforts over the coming year will not be so intense as to trigger a meaningful decline in the growth rate of China's industrial sector. But the potential for an aggressive pace of reforms is a clear risk to our view that the ongoing slowdown in China's economy is likely to be benign and controlled. Chart 3 introduces our China Reform Monitor as one way to monitor this risk, which is calculated as an equally-weighted average of the four "winner" sectors highlighted above relative to an equally-weighted average of the remaining seven sectors. Significant underperformance of "loser" sectors could become a headwind for broad MSCI China outperformance (especially ex-tech), and we will be watching closely for signs that our monitor is rising largely due to outright declines in the denominator. Chart 3Our China Reform Monitor Will Help Us Track The Impact Of A Renewed Reform Push Two New Reform-Themed Trade Ideas, And One Trade Closure We have new two trade ideas for investors given the performance of Chinese equities in the wake of the Party Congress: Long investable consumer staples / short investable consumer discretionary Long investable environmental, social and governance (ESG) leaders / short investable benchmark The basis for the first trade stems from our earlier discussion of the current limitations of China's investable consumer discretionary index as a clear-cut play on retail-oriented consumer spending. In addition, while consumer staples stocks are reliably low-beta, they have recently been rising vs consumer discretionary in relative terms despite a rise in the broad investable market (Chart 4). The odds favor a continuation of this trend if a renewed reform push continues to appear likely (i.e., we are banking that this trade will be driven by alpha rather than beta). Chart 4Staples Are A Better Consumer Play Chart 5ESG Leaders Should Fare Quite Well In A Reform Environment The basis for the second trade is to overweight stocks that are best positioned to deliver "sustainable" growth. Our proxy for this trade is the MSCI ESG Leaders index, which favors firms with the highest MSCI ESG ratings in each sector (using a proprietary ranking scheme). The index maintains similar sector weights as the investable benchmark, which limits the beta risk of the trade. Chart 5 highlights that MSCI's ESG Leaders index has outperformed the broad market by almost 7% per year since 2010, with current valuation levels that are broadly similar to the benchmark. To us, this trade represents an attractive risk-reward profile even if the pace of China's reforms are not aggressive over the coming year. Chart 6Close Our China / DM Materials Trade Finally, we recommend closing our long MSCI China investable materials sector / short developed markets materials trade. A scenario where China continues to shrink the domestic production capacity of metals without significantly curtailing its overall import volume may be modestly positive for global base metals prices, but it would appear that DM materials producers would benefit more from this outcome than Chinese producers (owing to the impact of production constraints on the volume of product sold). While the Chinese material sector remains grossly undervalued versus its DM peer, the bottom line is that the outlook for this trade is cloudier than before at a time when it is correcting sharply from previously overbought conditions (Chart 6). We suggest that investors close the trade for now, booking a healthy profit of 11%. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Please see BCA Special Report, "China: Party Congress Ends ... So What?" dated November 2, 2016, available at bca.bcaresearch.com. 2 Investors should note that BCA's China Investment Strategy service has long been skeptical of calls to shift China's economy to a consumption-driven growth model, because it significantly raises the odds that the country will not be able to escape the middle-income trap. For example, please see Please see China Investment Strategy Special Report, "On A Higher Note", dated October 5, 2017, available at cis.bcaresearch.com 3 In our view, the use of aluminum in transportation is consistent with an environmental protection mandate, given that its light-weight properties allow for reduced energy consumption. For example, in the U.S. in 2014/2015, Ford Motor Company switched the production of the F150 from a steel to an aluminum frame, resulting in a significant improvement in fuel economy. Cyclical Investment Stance Equity Sector Recommendations
Highlights There are a number of cracks emerging in global risk assets. Not only have U.S. junk bond prices recently posted sharp declines, but a number of economic and financial market developments within EM also warrant investors' close attention. In particular: Feature The EM manufacturing PMI has rolled over at relatively low levels, despite continued strength in advanced economies' manufacturing PMI (Chart 1). Importantly, the trend in relative manufacturing PMIs heralds EM equity underperformance against DM bourses (Chart 2). Chart 1EM Manufacturing: Rolling Over Chart 2EM Stocks To Underperform DM Stocks The Shanghai Container Freight Index has relapsed in recent months. This index has been a good indicator for EM/Asian export volumes (Chart 3, top panel). That said, DRAM semiconductor prices continue to surge (Chart 3, bottom panel). DRAM prices have jumped five-fold in less than two years, justifying the massive rally in semiconductors' stock prices. It is hard to know how long and how far the ascent in DRAM prices will continue. Nevertheless, our hunch is that non-technology exports in Asia will slow down, regardless of what happens in the global technology sector. Consistently, we expect EM non-technology stocks to relapse sooner than later, even as tech stocks remain a wild card. Global and EM tech stocks rallied exponentially and appear to be in a mania phase that could make any reasonable assessment and investment strategy off-mark. Weighing the pros and cons, we continue to recommend overweighting the tech sector within the EM universe, even as the outlook for their absolute performance remains highly uncertain. Within EM tech, we favor semi stocks (Samsung and TSMC) versus internet and social media stocks. The sheer magnitude of the EM equity rally has been driven by a few names such as Tencent, Alibaba, Baidu, Samsung and TSMC. Their combined market cap as a share of the overall MSCI EM equity index has risen to 19%. Remarkably, the equal-weighted MSCI EM stock index has massively underperformed the market cap-weighted MSCI EM equity index (Chart 4, top panel). In contrast, the same measure for DM equities has held up much better (Chart 4, bottom panel). Chart 3Asian/EM Exports At Risk Chart 4A Perspective On Internal Equity Dynamics: EM And DM EM stock prices have been firm so far despite the rebound in the broad trade-weighted U.S. dollar (Chart 5). As the greenback continues to advance, odds are that EM share prices will dive, as occurred in 2014 and 2015. In China, the effects of triple tightening - the liquidity squeeze by the central bank, the regulatory clampdown on banks and shadow banking by the Banking Regulatory Commission, and the anti-corruption drive that is targeting the financial industry - are gaining momentum. Onshore corporate bond yields and credit spreads over government bonds have risen further since the end of the most recent Party Congress. One of the reasons why policymakers are tightening is to rein in the enormous excesses prevalent in the credit, money and property markets that have developed in recent years. Given that advanced economies have now recovered, the Chinese authorities feel more confident to tighten domestically. Finally, while less recognized by the investment community, inflationary pressures have been rising in China. Although still at 2.25%, core consumer price inflation is clearly trending up, warranting a policy response (Chart 6, top panel). This is especially true given that real deposit rates - deflated by core consumer price inflation - have plummeted into negative territory (Chart 6, bottom panel). Chart 5U.S. Dollar Rebound = EM Pullback Chart 6China: Beware Of Rising Inflation Consistent with tightening, China's official broad money growth has decelerated to an all-time low (Chart 7, top panel). In the meantime, narrow money (M1) growth is falling rapidly. Remarkably, M1 growth has been correlated with Chinese H-share prices (Chart 7, bottom panel). We have extensively documented in past reports1 that China's money and credit impulses are good leading indicators of the mainland's business cycle. The current readings of these indicators signal considerable growth deceleration. In addition, general (central and local) government spending growth has already slowed a lot (Chart 8). Chart 7China: Broad Money Growth Is At Record Low Chart 8China: Aggregate Fiscal Spending Growth Is Also Weak The fundamentally weakest EM currencies such as the South African rand and the Turkish lira have already broken down. Some others have so far been only marginally weak. A chain, however, typically cracks at its weakest link. Hence, it makes sense that the selloff has begun with the fundamentally weakest currencies. We expect other EM currencies to follow. Currency depreciation in EM will undermine returns for foreign investors, and the latter will become marginal sellers in both EM equity markets and local currency bonds. Meanwhile, EM currency depreciation and potentially falling commodities prices will trigger credit spread widening in EM sovereign and corporate bonds. Investment Positioning Global equity portfolios should continue underweighting EM versus DM. The risk-reward profile for EM stocks' absolute performance is extremely unfavorable. We continue to recommend underweighting EM credit markets relative to U.S. investment grade bonds. Our strongest conviction shorts are a basket of the following currencies: ZAR, TRY, BRL, IDR and MYR. We are also shorting the COP and CLP. For traders who prefer a market neutral currency portfolio, our recommended longs are TWD, THB, SGD, ARS, RUB, PLN and CZK. INR and CNH will also outperform other EM currencies. Unlike in 2014-2015, EM currencies will depreciate not only versus the U.S. dollar but also the euro. This will erode EM returns for European investors, and temporarily halt or reverse capital inflows into EM. Among local currency bond markets, the most vulnerable are Turkey, South Africa, Indonesia and Malaysia. The least vulnerable are Korea, Russia, India, Argentina2 and Central Europe. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Weekly Report, titled "Questions From The Road", dated September 20, 2017. 2 Please refer to the Emerging Markets Strategy Special Report, titled "Argentina: A Genuine Bull Market", dated October 25, 2017. Equity Recommendations Fixed-Income, Credit And Currency Recommendations