Banks

Highlights In Indonesia, investors are ignoring the weakness in global growth, which is an important driver of the country’s financial markets. The Indonesian currency, equities and local currency bonds all remain vulnerable. We continue to recommend underweighting Indonesian assets for now. In Turkey, additional adjustments in the exchange rate and interest rates are unavoidable. Stay put/underweight Turkish financial markets. In the UAE, the economy is set to improve marginally this year. We recommend overweighting UAE equities and corporate spreads within their respective EM portfolios. Feature Indonesia: The Currency And Bank Stocks Are At Risk  Indonesian financial assets have benefited from the Federal Reserve’s dovish turn and corresponding fall in U.S. bond yields (Chart I-1, top panel). Moreover, the market is cheering President Joko Widodo’s lead in the presidential vote tally. Yet investors are ignoring the budding weakness in industrial metals prices, which has historically been an important driver of Indonesia’s exchange rate (Chart I-1, middle panel). Going forward, the Indonesian currency, equities and local currency bonds all remain vulnerable: Falling global growth in general and Chinese imports in particular will intensify Indonesia’s exports contraction and worsen the country’s already wide current account deficit. In turn, the latter will induce currency depreciation, which will then lead to higher interbank rates (Chart I-2). Chart I-1Global Growth Matters For Indonesian Markets Global Growth Matters For Indonesian Markets Global Growth Matters For Indonesian Markets Chart I-2Falling Current Account Deficit = Higher Local Rates Falling Current Account Deficit = Higher Local Rates Falling Current Account Deficit = Higher Local Rates Upward pressure on local interbank rates will cause a slowdown in domestic private loan growth.   The Indonesian central bank – Bank Indonesia (BI) – has been attempting to lower interbank rates, which have been hovering above the central bank's policy rate (Chart I-3). To achieve this, the central bank has substantially increased excess reserves in the banking system (Chart I-4). It has done so by purchasing central bank certificates from commercial banks, conducting foreign exchange swaps and providing repo lending. Chart I-3A Sign Of Liquidity Strains A Sign Of Liquidity Strains A Sign Of Liquidity Strains Chart I-4Bank Indonesia Is Injecting Liquidity Bank Indonesia Is Injecting Liquidity Bank Indonesia Is Injecting Liquidity   Yet by expanding banking system liquidity so aggressively, BI risks renewed currency depreciation. Like any central bank in a country with an open capital account, BI cannot expect to have full control over the exchange rate while simultaneously targeting local interest rates. The Impossibly Trinity dilemma dictates that a central bank needs to choose between controlling the two. Yet investors are ignoring the budding weakness in industrial metals prices, which has historically been an important driver of Indonesia’s exchange rate. Therefore, if BI continues to inject local currency liquidity to cap or bring down interest rates (interbank rates), the resulting excess liquidity could encourage and facilitate speculation against the rupiah. Scratching below the surface, the recent strong outperformance of Indonesian equities has been entirely due to the surge in the country’s bank share prices (Chart I-5, top panel). Remarkably, the performance of Indonesian non-financial as well as small-cap stocks has been especially dismal (Chart I-5, middle and bottom panels). This is an upshot of poor profitability among Indonesia’s non-financial listed companies (Chart I-6). Chart I-5Indonesian Bank Stocks Are The Only Outperformers Indonesian Bank Stocks Are The Only Outperformers Indonesian Bank Stocks Are The Only Outperformers Chart I-6Falling Non-Financial Corporate Profitability Falling Non-Financial Corporate Profitability Falling Non-Financial Corporate Profitability Furthermore, deteriorating financial health of non-financial corporates, especially small companies, will lead to higher NPLs on banks’ books. Notably, Indonesian banks are more heavily exposed to businesses than to households. As NPLs rise anew, Indonesian commercial banks will need to lift their bad-loan provisioning levels, generating a major profit relapse (Chart I-7). Importantly, Indonesian commercial banks have been boosting their profits by reducing NPL provisions since early 2018. Reversing this will materially affect their earnings. Chart I-7Indonesian Bank Share Prices Are Vulnerable Indonesian Bank Share Prices Are Vulnerable Indonesian Bank Share Prices Are Vulnerable Additionally, bank stocks are vulnerable due to falling net interest income margins. Moreover, their share prices are overbought and not cheap. To be clear, we are not negative on Indonesia’s structural outlook. The above-mentioned alarms are more near-to-medium terms issues. Still, foreign ownership of local currency bonds and stocks – at 38% each – are high, and could be a major source of potential outflows if the rupiah depreciates. This would cause Indonesian stocks and local currency bonds to sell off severely. Bottom Line: The global growth slowdown/commodities downturn and the U.S. dollar upturn are not yet over. Consequently, foreign flows into EM will diminish, which will be particularly negative for Indonesian financial markets. We recommend investors continue underweighting Indonesian equities and avoid Indonesian local currency bonds for now. We continue to recommend a short position in the IDR versus USD. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com Turkey’s Foreign Debt Bubble: The Worst Is Not Yet Behind Us Turkish financial assets, and the currency especially, will remain under selling pressure in the coming months. Additional adjustments in the exchange rate and interest rates - as well as in the real economy and current account balance - appear unavoidable. The key imbalance remains the gap between foreign debt obligations (FDOs) and the availability of foreign currency to meet these debt obligations. Turkey’s FDOs in 2019 are equivalent to $180 billion (Chart II-1). FDOs measure the sum of short-term claims, interest payments and amortization over the next 12 months. This consists of $15 billion in interest payments, $65 billion in debt amortization and $100 billion in maturing short-term (under one year) claims. In theory, these debt obligations can either be rolled over, or the nation should generate current account and capital account surpluses and use these surpluses to pay down FDOs. Even though the current account deficit is shrinking, it is still in a deficit of $18 billion. Net FDI inflows remain weak at US$10 billion. Hence, it appears that Turkey’s only options are either to roll over maturing foreign currency debt or to lure foreign investors into local currency assets and use the surplus in net portfolio inflows to meet these FDOs. The central bank’s foreign currency reserves excluding both commercial banks’ deposits at the Central Bank of Turkey and FX swaps now stand at $13 billion. However, due to a lack of credibility in the Turkish government’s macro policies - in addition to the ongoing deep economic recession and heightened financial market volatility - external creditors will be unwilling to roll over the debt. In fact, net portfolio flows into government debt and equities have tumbled for the same reason. Typically, when foreign funding dries up temporarily, a country can use its foreign exchange reserves to meet its FDOs. However, Turkey’s foreign exchange reserves have already plummeted to extremely low levels (Chart II-2). The central bank’s foreign currency reserves excluding both commercial banks’ deposits at the Central Bank of Turkey and FX swaps now stand at $13 billion. This is negligible compared with the $180 billion FDO figure due in 2019. Chart II-1Turkey: A Large Foreign Debt Servicing Burden Turkey: A Large Foreign Debt Servicing Burden Turkey: A Large Foreign Debt Servicing Burden Chart II-2Foreign Exchange Reserves Are Too Small Foreign Exchange Reserves Are Too Small Foreign Exchange Reserves Are Too Small   The recent plunge in the central bank’s net foreign exchange reserves excluding swaps (i.e. net international reserves) has put many pertinent metrics at record lows. In particular, net international reserves are at a precarious level relative to both total imports and external debt (Chart II-3). Finally, the net international reserves-to-broad money supply ratio has fallen to 7% (from 15% in 2014) despite the fact that the massive lira depreciation reduced the U.S. dollar measure of broad money supply (Chart II-4). Chart II-3FX Reserves Do Not Cover Imports Or External Debt FX Reserves Do Not Cover Imports Or External Debt FX Reserves Do Not Cover Imports Or External Debt Chart II-4Low Coverage Of Broad Money By International Reserves Low Coverage Of Broad Money By International Reserves Low Coverage Of Broad Money By International Reserves The currency will have to depreciate further and interest rates will have to move higher to shrink domestic demand/imports more. This is needed to generate a current account surplus that could be used to service FDOs, or that otherwise entices foreign creditors to be willing to roll over foreign debt or invest in Turkey. Finally, while the adjustment in the real economy is advanced, it is unlikely to be over, due to the large foreign debt bubble. Importantly, with large foreign and local currency debt obligations coming due for both companies and households - in addition to the deterioration in economic activity and higher interest rates - NPLs are bound to rise (Chart II-5). This is especially likely to occur because a lot of borrowing has been used in the property market both for construction and purchases. Notably, real estate volumes are shrinking, and prices are deflating in real terms (Chart II-6). Chart II-5NPLs Will Rise A Lot NPLs Will Rise A Lot NPLs Will Rise A Lot Chart II-6Turkey: Real Estate Is In Free Fall Turkey: Real Estate Is In Free Fall Turkey: Real Estate Is In Free Fall     Bottom Line: The macro adjustment in Turkey is not yet complete. The country still lacks foreign currency supply to service its enormous 2019 FDOs. Further currency depreciation and higher interest rates are required to depress domestic demand/imports and push the current account into surplus. Stay put / underweight Turkish financial markets. The authorities are becoming desperate, and the odds of capital control enforcement are not negligible. While such an outcome is not possible to forecast with any certainty or time frame, investors should consider this very real risk. Andrija Vesic, Research Analyst andrijav@bcaresearch.com Overweight UAE Equities And Corporate Bonds Over the next six to nine months, we believe both UAE equities and corporate spreads will outperform their respective emerging market (EM) benchmarks. The UAE economy is set to improve marginally this year (Chart III-1). It will benefit from expansionary fiscal policy, rising oil output, a buoyant tourism sector, a resilient banking sector and less of a drag from the real estate sector. First, sizable fiscal spending will lead to rising non-oil economic growth. The UAE’s federal budget spending for 2019 will increase by 17.3% from a year ago, much higher than the 5.5% year-on-year growth in 2018. Second, UAE oil output could increase by 15% later this year from current levels (Chart III-2). The U.S. announced on April 22 that all Iran sanction waivers will not be extended beyond the early-May expiration date. The U.S. administration also stated that it has secured pledges from Saudi Arabia and the UAE to increase their oil production in order to offset disrupted supply from Iran. Rising oil output will mitigate the negative impact of potentially lower oil prices on the UAE’s economy. Chart III-1Improving UAE Economy Improving UAE Economy Improving UAE Economy Chart III-2Rising Oil Output Rising Oil Output Rising Oil Output   Third, the outlook for the tourism sector is also positive. The number of tourists is set to rise as Expo 2020 approaches. The government is targeting 20 million visitors in 2020, 26% higher than last year’s levels. The UAE is building theme parks, museums, hotels and infrastructure to attract more tourists. The UAE economy is set to improve marginally this year. Fourth, the UAE’s banking sector will enjoy rising credit growth, robust profitability and improved asset quality this year. The banking system has been in consolidation mode since January 2016, with a 15% reduction in branches and a 14% drop in the number of employees. This has improved the banking sector’s profitability by cutting operating costs and increasing efficiency. The improving growth outlook will lift credit growth. The central bank’s most recent Credit Sentiment Survey suggests banks’ lending standards for both business and personal loans are loosening (Chart III-3). In addition, UAE banks enjoy large capital buffers. Despite rising non-performing loans (Chart III-4), UAE banks still reported a Tier-1 capital adequacy ratio of 17% as of December 2018. Chart III-3Credit Growth Is Likely To Increase Credit Growth Is Likely To Increase Credit Growth Is Likely To Increase Chart III-4Rising NPLs, But Still Large Capital Buffers Rising NPLs, But Still Large Capital Buffers Rising NPLs, But Still Large Capital Buffers   Lastly, the real estate markets in both Dubai and Abu Dhabi have suffered from oversupply (from both mushrooming supply and weaker demand) over the past several years. Property prices have already fallen over 20% in both Dubai and Abu Dhabi from their 2014 peaks (Chart III-5). Odds are high that the most dangerous phase of the property market downturn is behind us. Chart III-5Real Estate Adjustment Is Advanced Real Estate Adjustment Is Advanced Real Estate Adjustment Is Advanced In addition, the government’s efforts to attract people to stay in the country longer will somewhat offset the ongoing exodus of expatriates. Last May, the UAE introduced a new visa system that will allow investors, innovators and talented specialists in the medical, scientific, research and technical fields to stay in the country for up to 10 years. Overall, a potential bottom in property demand and restrained supply will likely make the real estate sector less of a drag on this bourse this year. Finally, the authorities are also more open to increasing the foreign ownership cap in the banking sector, albeit not up to 100%. For example, in early April, the largest UAE lender – First Abu Dhabi Bank – obtained regulatory approval to increase its foreign ownership limit to 40% from 25%. This has boosted foreign equity purchases and has supported the equity index. Bottom Line: We recommend an overweight position in UAE equities within an EM portfolio this year (Chart III-6). For fixed income investors, we recommend overweighting UAE corporate credit in an EM corporate credit portfolio. UAE corporate credit is a lower beta market and will outperform as EM corporate spreads widen (Chart III-7). Most UAE-dollar corporate bonds have been issued by banks. Banks in the UAE do not suffer from structural overhangs, and the cyclical downturn in the property market is well advanced. This is why they have been, and will remain, a lower beta sector within an EM corporate credit portfolio. Chart III-6Overweight UAE Equities Within An EM Portfolio Overweight UAE Equities Within An EM Portfolio Overweight UAE Equities Within An EM Portfolio Chart III-7UAE Corporate Credit Will Likely Outperform EM Benchmark UAE Corporate Credit Will Likely Outperform EM Benchmark UAE Corporate Credit Will Likely Outperform EM Benchmark   Ellen JingYuan He, Associate Vice President ellenj@bcaresearch.com Footnotes Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights The U.S. dollar will ultimately reach fresh cycle highs, but not before going through a weak phase starting this summer that could last 12 months. We closed our long DXY trade for a carry-adjusted return of 16.4% last week. We will go tactically short the index if it breaches 101 (about 3% above current levels). As a countercyclical currency, the dollar is likely to stumble in the second half of this year as global growth accelerates. Positioning and sentiment are currently very dollar bullish, which is likely to exacerbate any sell-off in the greenback. The dollar should begin to rally again late next year, as global growth decelerates while the Fed is forced to turn more hawkish in the face of rising inflation. Go long European banks as a tactical trade. Feature Moving To The Sidelines On The Dollar We closed our long DXY trade recommendation for a carry-adjusted gain of 16.4% at last Thursday’s close – too early it turns out, as the DXY has gained another 0.7% since then. The dollar is a high-momentum currency (Chart 1). The trend is the dollar’s friend at the moment, which makes betting against the greenback risky. Nevertheless, we would not chase the dollar higher at these levels. Long dollar positioning is highly stretched and sentiment is overly bullish (Chart 2). This makes a price reversal increasingly probable. Chart 1 Perhaps more importantly, the macro fundamentals, which have worked in favor of the dollar since early 2018, will likely start working against it as the summer months approach. Chart 2There Are A Lot Of Dollar Bulls Out There There Are A Lot Of Dollar Bulls Out There There Are A Lot Of Dollar Bulls Out There   Stronger Global Growth Will Hurt The Greenback The dollar is a countercyclical currency, meaning that it tends to move in the opposite direction of global growth (Chart 3). Global growth has been decelerating since early 2018, and that has helped boost the dollar’s value. The dollar is a countercyclical currency, meaning that it tends to move in the opposite direction of global growth. Chart 3The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency If anything, the growth divergence between the U.S. and the rest of the developed world has increased over the past few months. Goldman’s Current Activity Indicator (CAI) for the U.S. has been rising since January, while the European and Japanese CAIs have continued to fall (Chart 4). Looking out, the rest of the world is likely to catch up to the United States. The Chinese CAI has already moved sharply higher thanks in part to an acceleration in Chinese credit growth. Chart 4Growth Is Recovering In The U.S. And China Growth Is Recovering In The U.S. And China Growth Is Recovering In The U.S. And China Chart 5China: Credit Is Growing At A Moderately Faster Pace Than GDP China: Credit Is Growing At A Moderately Faster Pace Than GDP China: Credit Is Growing At A Moderately Faster Pace Than GDP We would downplay recent market speculation that the Chinese authorities are preparing to restart their deleveraging campaign. Credit growth is now running only modestly above nominal GDP growth (Chart 5). With the ratio of debt-to-GDP broadly stable, there is no need to further clamp down on credit formation. The Chinese government also wants to keep the economy buoyant in order to gain negotiating leverage in trade talks with the Trump administration.   Better Chinese Data Will Benefit The Rest Of The World Fluctuations in Chinese growth usually affect Europe with a lag of around six months (Chart 6). This suggests that European exports should strengthen starting this summer. Meanwhile, European domestic demand should benefit from an easing of fiscal policy of around 0.5% of GDP. Chart 6Europe Will Benefit From Improving Chinese Growth Europe Will Benefit From Improving Chinese Growth Europe Will Benefit From Improving Chinese Growth Chart 7Swings In Interest Rate Differentials Explain Some Currency Moves Swings In Interest Rate Differentials Explain Some Currency Moves Swings In Interest Rate Differentials Explain Some Currency Moves   Faster growth in the U.S. in relation to the euro area has caused the spread in expected interest rates to widen between the two regions. The spread in one-month, five-year forward OIS rates now stands at 202 bps, similar to the highs seen in late-2016 (Chart 7). If euro area growth recovers this summer, the market will price in a bit of tightening from the ECB starting late next year. This will cause the spread to narrow, leading to a stronger euro. A revival in Chinese growth should also help EM and commodity currencies. The market is currently pricing in 44 basis points of rate cuts in Australia, 33 bps of cuts in New Zealand, and 21 bps of cuts in Canada over the next 12 months. While domestic concerns around high household debt levels and overvalued real estate markets will keep central banks on guard in all three economies, a more robust global growth backdrop should allow some of the expected easing to be priced out. Japan remains a bit of a wildcard due to the government’s stated intention to raise the sales tax this October. We see little justification for increasing the sales tax given that inflation expectations are still nowhere close to the BOJ’s target. Japan needs easier, not tighter, fiscal policy. There is still an outside chance that the tax hike will be postponed, but even if it is, rising bond yields in the rest of the world will still hurt the yen. The BOJ has no intention of abandoning its yield curve targeting system anytime soon. In fact, it introduced new forward guidance at this week’s monetary policy meeting promising not to raise rates at least until the spring of 2020. Investors looking to trade the yen should consider going long EUR/JPY or AUD/JPY. We recommend going long European banks outright for a tactical trade. Bottom Line: If global growth accelerates later this year, the dollar will probably weaken. Accordingly, investors should use this week’s rally in the dollar to scale back exposure to the currency. We are also putting in a limit order to go short the DXY index if it reaches 101 (about 3% above its current level). Looking Further Out… Chart 8Low Odds Of An Imminent Major Inflationary Upswing In The U.S. Low Odds Of An Imminent Major Inflationary Upswing In The U.S. Low Odds Of An Imminent Major Inflationary Upswing In The U.S. Mini-cycles within the broader global business cycle tend to last around 12-to-18 months. If this pattern continues to hold, global growth will probably falter again in the second half of next year. At that point, the dollar is likely to strengthen again. By how much can the dollar rise? That depends on what the Fed does. A stronger dollar would entail a tightening in financial conditions. Normally that would cause the Fed to turn more dovish, limiting the upside for the greenback. The risk is that rising inflation prevents the Fed from turning more accommodative. Inflation is not much of a concern now. Leading indicators of inflation such as core intermediate goods prices and the prices paid component of the ISM remain well contained (Chart 8). Wage growth has picked up, but productivity growth has risen even more. As a result, unit labor costs, which tend to lead core inflation, have been decelerating since the middle of last year. If the U.S. economy continues to grow above trend, however, inflation could begin to break out late next year. That would force the Fed to start raising rates more aggressively than it would like, even in the face of slower growth. Such a stagflationary outcome will be awful for equities and other risk assets. As U.S. financial conditions tighten, global growth will slow, giving the dollar a further boost. The upshot is that the dollar could see a meaningful rally starting late next year. Stay Bullish On Stocks For Now… Until that fateful day arrives, we are inclined to maintain our bullish equity bias. We upgraded global stocks to overweight in December after having moved to the sidelines in June. Despite the run-up in stock prices, the forward P/E ratio on the MSCI All-Country World Index is still 7% below where it was at the start of 2018 and 3% below its long-term (30-year) average (Chart 9). Earnings estimates are also finally starting to increase (Chart 10). Accelerating global economic growth will ensure that profits continue to rise into year-end. Chart 9Global Stocks Are Not That Expensive Global Stocks Are Not That Expensive Global Stocks Are Not That Expensive Chart 10Earnings Estimates Have Turned The Corner Earnings Estimates Have Turned The Corner Earnings Estimates Have Turned The Corner     … And Buy Some European Banks For A Tactical Trade European banks are trading at distressed valuations (Chart 11). One can debate the long-term prospects for the European banking sector, but in the near term, one thing is clear: If European growth begins to surprise on the upside, bond yields in core European markets will rise, which should help European bank stock prices (Chart 12). Stronger economic growth will also translate into more credit demand and lower non-performing loans. This will boost bank earnings (Chart 13). With all this in mind, we recommend going long European banks outright for a tactical trade. Chart 11European Banks: A Good Value Play European Banks: A Good Value Play European Banks: A Good Value Play Chart 12Euro Area: Higher Bond Yields Bode Well For Bank Stocks Euro Area: Higher Bond Yields Bode Well For Bank Stocks Euro Area: Higher Bond Yields Bode Well For Bank Stocks Chart 13More Credit, Fatter Bank Earnings More Credit, Fatter Bank Earnings More Credit, Fatter Bank Earnings   Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com   Strategy & Market Trends MacroQuant Model And Current Subjective Scores Chart 14 Tactical Trades Strategic Recommendations Closed Trades

Highlights An aging population, a banking sector in poor health, and a private sector focused on building up savings are the key factors undermining euro area growth on a structural basis. A large manufacturing sector makes the euro area vulnerable to EM competition. Unlike the U.S., the region’s tech sector is held back by regulatory burdens, taxes and heavy dependence on bank funding. The euro area growth faces decades of low growth and inflation. Euro area rates will stay depressed, but paradoxically, the euro can still experience structural appreciation. Euro area equities are cheap for a good reason, and banks will continue to weigh on performance. Feature Over the past 10 years, the euro area has gone through a sovereign debt crisis, a double-dip recession, persistent below-target inflation, and most recently, yet another major growth slowdown. Moreover, this economic malaise materialized despite highly stimulative monetary policy, including negative interest rates. The ongoing economic weakness has raised the specter that the euro area is the new Japan. Nearly three decades after the bursting of the Nikkei bubble, the Land of the Rising Sun remains mired in low growth and mild but persistent deflation. Consequently, charts showing that European policy rates or bond yields are tracking Japanese developments with a 17-year lag (Chart II-1) have not only become commonplace, they elicit fears that European growth, interest rates and asset valuations will lag the rest of the world for decades to come. Chart II-1Europe Is Following The Japanese Example Europe Is Following The Japanese Example Europe Is Following The Japanese Example In this piece, we discuss the various forces that explain why the euro area economy has been so weak this decade, and why such low interest rates have had so little impact on growth. We also study what sets the U.S. and euro area apart, and whether or not Europe will follow the trail blazed by Japan nearly 30 years ago. The Three Headwinds Three ills have kept European growth particularly depressed this cycle and are likely to remain significant headwinds into the foreseeable future: demographics, the banking sector’s poor health, and nonfinancial private sector balance sheet cleansing. 1)   Demographics This is the most well understood and acknowledged problem impacting Europe today. Since 2008, the European population has grown by 2%, or only 0.2% a year, with the working age population having peaked around that year. Going forward, the picture will only deteriorate: The UN expects Europe’s population to contract by 12% over the next 27 years, and the working age population to fall by 15%. This also means that the dependency ratio – the number of individuals aged less than 15 and above 65 per 100 working-age people – will approximately double over the coming 40 years. This is a clear parallel with Japan. As Chart II-2 illustrates, Europe’s population, the number of working-age individuals and the dependency ratio are all tracking Japan with a 17-year lag. Like Japan, Europe’s trend growth will thus only deteriorate further. Not only will Europe not be able to add as many workers as the U.S. to its total, but it will need to build even fewer schools, malls, office buildings or units of housing. Consequently, both the supply and demand sides of the economy will lag due to this factor alone. 2)   Banking Sector Health The poor health of the euro area banking sector is well known. BCA’s Global Asset Allocation service published an in-depth analysis of the European banking sector last December.4 The piece demonstrated that European banks have been much slower to recognize non-performing loans, curtail credit and rebuild capital than their U.S. counterparts. U.S. bank loans to the private sector fell by 13% in the two years during the crisis, while in Europe, these same loans have only fallen by 2% since 2008. Euro area banks generally remain burdened with significant non-performing loans as a percentage of regulatory capital. Moreover, net interest margins are also dismal, implying that the income cushion against bad loans is thin. Consequently, outside of France, Finland and Germany, European banks have either not grown their loan books to the private sector or, as is the case with Spain, Portugal, and Ireland, these books are continuously shrinking (Chart II-3). Chart II-2Same Demography In Europe Now Than In Japan Then Same Demography In Europe Now Than In Japan Then Same Demography In Europe Now Than In Japan Then Chart II-3Peripheral Banks Continue To Curtail Credit Peripheral Banks Continue To Curtail Credit Peripheral Banks Continue To Curtail Credit   The poor health of the European banking system is now constraining the supply of new credit to the rest of the economy. This is a much bigger problem than is the case in the U.S. given that in Europe, 72% of corporate funding comes from the banking system while 88% of household liabilities are also funded this way. In the U.S., the share of bank funding for these sectors is 32% and 29%, respectively (Chart II-4). A weak euro area banking system prevents the nonfinancial private sector from growing as robustly as it could. Chart II-4 3)   Nonfinancial Private Sector Balance Sheet Cleanse Another major drag on European growth has been the continued efforts of the European private sector to rebuild its balance sheet. To use the terminology developed by our upcoming conference speaker Richard Koo, the euro area has been in the thralls of a powerful balance sheet recession. Households in the euro area, Japan and the U.S. are all accumulating more financial assets than liabilities. However, only in the U.S. is the nonfinancial corporate sector building more liabilities than it is accumulating assets (Chart II-5). In Japan and Europe, the nonfinancial corporate sector is also a source of savings for the economy. Moreover, in Europe, the government runs a much smaller financial deficit. The current account balance tells this story vividly. A country’s current account is equal to the private sector’s savings minus investment and minus government deficits. As Italy, Spain, and other peripheral economies increased their aggregate savings after 2008, their large current account deficits vanished. Meanwhile, the governments of countries like Germany or the Netherlands, which sported healthy public finances, did not increase their spending in a commensurate way. This adjustment transformed an overall euro area current account deficit of 1.5% in 2008 into a surplus of 3.0% of GDP today, sending some of Europe’s excess savings abroad. This mimics the post-1990 Japanese experience. In the U.S., where the private sector savings did not rise as durably as in Europe, the current account stopped improving meaningfully in 2010 (Chart II-6). Chart II-5European Businesses Are Savers, Like In Japan European Businesses Are Savers, Like In Japan European Businesses Are Savers, Like In Japan Chart II-6The Current Account Dynamics Epitomise The Savings Dynamics The Current Account Dynamics Epitomise The Savings Dynamics The Current Account Dynamics Epitomise The Savings Dynamics   A private sector squarely focused on rebuilding its balance sheet liquidity can lead to a liquidity trap. In this state, monetary policy can become ineffective as spending does not respond to lower interest rates. This is where Europe is currently stuck, explaining why the European Central Bank is finding that inflation and growth are not experiencing much lift, despite seemingly incredibly accommodative monetary conditions. Why Such An Urge To Save? The fact that the household sector is a net saver is not surprising, as this is a normal state of affairs across most economies. But why is the European nonfinancial corporate sector still trying to improve its balance sheet liquidity by accumulating more assets than liabilities? Like Japanese businesses 30 years ago, European firms have large debt loads. Another problem is the lack of capex opportunities in Europe. Why do we make this assertion? The return on assets in Europe has been at rock-bottom levels ever since the introduction of the euro (Chart II-7). In the decade from 1998 to 2008, this was a non-issue. Strong global growth flattered European sales, and easy access to credit meant that via rising leverage euro area-listed nonfinancial corporations were able to generate returns on equity comparable to U.S. firms (Chart II-8, top panel). Once European banks got cold feet and European nonfinancial businesses began focusing on deleveraging, the low level of return on assets became more apparent. Part of the problem is that European profit margins are much closer to Japanese than U.S. levels (Chart II-8, middle panel). Even more damning, asset turnover – how much sales are generated by a unit of assets – has been structurally lower in Europe than in both Japan and the U.S. for multiple decades (Chart II-8, bottom panel). Chart II-7Europe Suffers From A Lower RoA Europe Suffers From A Lower RoA Europe Suffers From A Lower RoA Chart II-8DuPont's Decomposition Shows Why The Euro Area RoA Is Poor DuPont's Decomposition Shows Why The Euro Area RoA Is Poor DuPont's Decomposition Shows Why The Euro Area RoA Is Poor   The first factor weighing on the level of asset utilization and returns in Europe is the elevated level of capital stock. As Chart II-9 illustrates, the capital stock as a share of output in Italy, Spain and France dwarfs that of Japan, China or the U.S. Even Germany’s capital stock, which stands well below that of other large euro area economies, is nearly 100 percentage points of GDP larger than the U.S’s. Europe has too large a pool of assets to make any additional investments profitable, especially in light of its poor demographic profile. Chart II-9 The second factor weighing on European asset utilization and returns is the poorer level of labor productivity. From the 1950s to the early 1980s, European GDP per worker rose relative to the U.S., albeit peaking at 92% of the levels across the Atlantic. Due to falling working hours in Europe relative to the U.S. since the 1980s, relative output per hour continued to rise until the mid-1990s, peaking at 105% of the U.S. level. However, since their respective zeniths, both relative productivity measures have collapsed (Chart II-10, top panel). Chart II-10Another Symptom Of Europe's Misallocation Of Capital In The 2000s Another Symptom Of Europe's Misallocation Of Capital In The 2000s Another Symptom Of Europe's Misallocation Of Capital In The 2000s These collapses are in fact worse than Japan’s performance since its lost decades began. As the second panel of the chart shows, since the early 1990s, Japan’s relative output per hour and per worker have flattened – not declined – at around 65% and 72%, respectively, of U.S. levels. Instead, relative European productivity levels are currently converging toward Japanese levels (Chart II-10, third and fourth panels). The particularly poor level of European asset utilization and productivity principally reflects the duality between the peripheral as well as French economies on one side, and Germany as well as the Netherlands on the other side. The exceptionally large capital stock outside of Germany is a legacy of the years directly after the euro’s introduction. Back then, the ECB kept rates low to help Germany, the then-sick man of Europe. These rates were too low for the rest of Europe, encouraging large capital stock build-ups. Moreover, this capital was misallocated, as demonstrated by the tepid growth of output per hour and output per capita in Europe post 2000. Since funds were poorly allocated, the output-to-capital ratio in the periphery collapsed. In other words, the peripheral capital-stock-to-GDP ratios continued rising because the denominator, GDP, lagged. An additional problem for Europe’s asset utilization has been its large manufacturing sector. Even after declining, 20% of Europe’s GDP still comes from the secondary sector versus less than 12% in the U.S. (Chart II-11). This has two consequences for Europe’s asset utilization relative to the U.S. First, a large manufacturing sector requires a much larger asset base than a large service or tech sector. Second, the manufacturing sector is more exposed to competition from emerging markets than the tech sector, or than the domestically-focused service sector. Chart II-11Europe Is Left Exposed To EM Competition Europe Is Left Exposed To EM Competition Europe Is Left Exposed To EM Competition In other words, not only has the U.S. experienced less capital misallocation than a large swath of the European economy, it has also re-aligned its economy to make it more robust in the face of competition from emerging economies, while Europe mostly has not. Consequently, hurt by foreign competition and unable or unwilling to re-invent itself, Europe has been left with dwindling relative productivity levels and poor degrees of asset utilization and returns. Why Did The U.S. Economy Transition Better than Europe To A Globalized World? There are many reasons why the U.S. has maintained higher RoAs and has been more successful at transitioning away from a manufacturing-led economy than the euro area. First, the level of product and service market regulation in Europe is highly punitive. As Chart II-12 illustrates, like Japan, most euro area countries fare poorly in the World Bank’s Ease of Doing Business survey. In fact, Italy scores even lower than China! Meanwhile, the U.S. ranks near the top, not far from Singapore. This means that starting new businesses, competing, and so on is easier in the U.S. than in Europe, helping foster a greater level of entrepreneurialism. Consequently, established businesses have been able to maintain the status quo longer in Europe than in the U.S., preventing creative destruction from purging the system of bad assets. Chart II-12 Second, most large euro area economies are burdened by heavy taxes. As Chart II-13 shows, while the U.S. public sector extracts taxes equal to 27.1% of GDP, German, Italian and French taxes equal 37.5%, 42.4% and 46.2% of GDP, respectively, well above the OECD average of 34.2%. Such high levels of taxation disincentivize risk-taking. Lower levels of risk taking by individuals further prevented the degree of creative destruction necessary for Europe to better use its capital stock. Chart II-13 Third, and linked to the previous point, government spending equals 34.9% of GDP in the U.S., compared to 48.2% and 56.0% in Italy or France, respectively. A large government has historically stifled innovation and favored the status quo. By no means does this implies that the U.S. system is free of imbalances, but it highlights that compared to two of the three largest European economies, the U.S. public sector has had a less deleterious impact on growth conditions and entrepreneurialism. Moreover, Italy and France have been in deep need of structural reforms that have been lacking. On this front, while the outlook is improving in France under Macron’s presidency, Italy remains mired in immobilism. Europe has too large a pool of assets to make any additional investments profitable, especially in light of its poor demographic profile. Fourth, the financing structure in the U.S. favors investing in new businesses and industries, especially when compared to the euro area. Equities represent 78% of the capital structure of nonfinancial corporations in the U.S. while they represent only 61% in the euro area. Moreover, within debt-financing, capital markets account for 68% of sourced funds in the U.S. compared to 28% in the euro area. In fact, junk bond market capitalization only accounts for 2.2% of GDP in Europe compared to 6.0% in the U.S. This suggests that financing risky ventures – and entrepreneurialism is inherently risky – is tougher in Europe than in the U.S. In fact, as a share of GDP, the European venture capital business is less than a sixth the size of the U.S.’s (Chart II-14), a gap that has existed for more than 30 years. Chart II-14U.S. Financing Allows For Greater Risk Taking U.S. Financing Allows For Greater Risk Taking U.S. Financing Allows For Greater Risk Taking With all these hurdles, it is unsurprising that Europe has taken more time to make its economy more dynamic in the globalized economy of the 21st century. It also explains why Europe might be suffering more from EM competition than the U.S. Interestingly, this last point may be changing as U.S. voters seem to want to move back toward a larger manufacturing sector. This transition is unlikely to happen without more protectionism. This is a topic for another report. Is Europe Doomed To Japanification… Or Worse? It is easy to see why Europe cannot hope to grow as fast as the U.S., and therefore why the ECB will not be able to lift rates as high as the Fed and why bund yields are likely to lag Treasurys for years to come. Europe has a much more dire demographic profile than the U.S. It needs to purge its capital stock and invigorate its economy through reforms, a smaller public sector, and more diversified financing channels. But can the euro area fare better than Japan has over the past 30 years? On three fronts, the euro area looks better than Japan. First, as Chart II-15 shows, the overall European nonfinancial private sector entered its crisis in 2008 with lower leverage than Japan’s in the early 1990s. Additionally, European stocks were much cheaper in 2007 than the Nikkei was in 1989 (Chart II-16, top panel). Even Spanish real estate was more reasonably valued in 2007 than Japanese real estate in the early 1990s (Chart II-16, bottom panel). This combination means that now that the acute part of the crisis is over, the hole in the European private sector’s balance sheet is much smaller than the one Japan needed to plug 30 years ago. Thus, from a balance-sheet perspective, the need to rebuild savings is lower in Europe than Japan, and we could expect the current period of elevated savings to be shorter in the euro area than it has been in Japan. Chart II-15 Chart II-16...And European Assets Were Not As Expensive As Japanese Ones At The Onset Of The Crisis ...And European Assets Were Not As Expensive As Japanese Ones At The Onset Of The Crisis ...And European Assets Were Not As Expensive As Japanese Ones At The Onset Of The Crisis   Second, despite former ECB President Jean-Claude Trichet’s policy mistake of raising interest rates in 2011, the ECB was much quicker to implement extreme easing policy measures than the Bank of Japan was in its day. It took 10 years for the BoJ to cut rates to zero after the Nikkei peaked in December 1989. It took one year for the ECB to do so after stock prices peaked in 2007. It took nine years for the BoJ to expand its balance sheet aggressively, but it took less than two years for the ECB to do so. One of the key benefits of this greater European proactivity has been to keep European inflation expectations much higher than in Japan, curtailing real interest rates in the process. Third, Europe purged economic excesses much more quickly than Japan. The Japanese unemployment rate increased from 2% to 6% between 1990 and 2010. In peripheral Europe, where the worst pre-crisis excesses existed, unemployment rose from 7.5% in 2008 to 18% in 2013 (Chart II-17, top panel). Meanwhile, real wages never adjusted in Japan, but fell 27.0% at their worst in Spain and 32.5% in Greece (Chart II-17, bottom panel). Moreover, the Rajoy reforms in Spain and the Macron reforms in France show that outside of Italy, European governments have been reforming their economies faster than Japan did after the bubble burst in 1990. Chart II-17Bigger Labor Market Purge In Europe Than Japan Bigger Labor Market Purge In Europe Than Japan Bigger Labor Market Purge In Europe Than Japan However, on three fronts Europe is faring worse than Japan. First, up until the last 10 years, Japan benefited from a robust global economy where trade grew strongly. Europe is entering its second decade of low growth in an environment where global economic activity is much weaker, as potential U.S. GDP growth has slowed and China is not growing at a double-digit pace anymore. Moreover, budding protectionism in the U.S. is creating another hurdle for European economic output. Second, the excess capital stock in the European periphery is in fact greater than was the case in Japan in 1990. This suggests that the periphery needs to curtail investments by a greater margin than Japan did. Consequently, peripheral growth will continue to exert downward pressure on aggregate European activity for an extended period. Third, the European fiscal response will not match Japan’s. Investors often decry Japan’s large government debt of 238.2% of GDP as a sign of profligacy. It is not. It is mainly a mirror image of the private sector’s savings surplus. The Japanese government’s ability to run large deficits has prevented a larger fall in output – one that would have equaled the annual savings of the private sector. Without the government’s dissaving, the Japanese private sector would have found its debt load even more onerous to service, and the need to curtail spending would have been even greater as economy-wide cash flows would have been even smaller. Europe does not have a unified fiscal authority that can run such large-scale deficits. Instead, each nation’s government has a limited capacity to accumulate debt as investors worry that overly-indebted governments may very well redenominate what they have borrowed in much weaker currencies than the euro. This risk is made even greater by the fact that there is no euro-area wide deposit insurance scheme. Since Italian and Spanish banks hold large amounts of BTPs and Bonos, respectively, a so-called doom-loop exists that links the health of banks in those countries to the health of their governments, further limiting the public sector’s ability to act as a spender of last resort. This makes the efforts of the private sector in Italy, France, and Spain to increase its savings and bring down its excess capital stock more difficult, and thus, likely to last longer. Even if 10 years after the crisis first emerged, Europe has done more to purge its economy from its pre-crisis excesses than Japan had after its first lost decade, a lack of unified fiscal lever in Europe nullifies this positive. Thus, so long as the European integration efforts remain on the backburner, euro area growth, inflation, and interest rates will continue to look more like Japan’s have over the past 30 years than the U.S. This is likely to cause a big problem once the next recession emerges. Europe will enter that slowdown without any ammunition to reflate growth. Therefore, the next recession is likely to prove very deflationary and test the recent improvement in support for the euro seen across all euro area nations (Chart II-18). If the euro area survives this crisis, and we suspect it will, the probability of a fiscal union will only grow.2 After all, it has been through various crises that Europe has moved closer together, and the rise of a multipolar geopolitical environment dominated by large countries makes this imperative ever more vital. Chart II-18Support For The Euro Is Resilient Support For The Euro Is Resilient Support For The Euro Is Resilient Bottom Line: We expect European growth and inflation to continue to lag well behind the U.S. for years to come if not a full decade. Ultimately, bringing down the expensive capital stock in the European periphery will be a slow process, especially if governments remain tight fisted. Investment Implications First, core euro area interest rates are likely to remain well below U.S. levels. As long as the European private sector pares back investments in order to normalize its capital stock-to-GDP ratio - a phenomenon that will be most pronounced in the periphery and France - European growth and inflation will lag behind the U.S. This also means that as long as European governments remain shy spenders and do not compensate for the lack of spending from the private sector, in the euro area periphery, European banks will suffer from depressed net interest margins and be structural underperformers. Second, the euro is likely to experience a structural upward drift. The euro is trading at a 10.5% discount to its purchasing power parity. Moreover, high private sector savings not only weigh on inflation, they will also push Europe’s net international investment position higher via an accumulated current account surplus. Both these factors are long-term bullish for the euro. Moreover, the fact that the euro area will soon become a net creditor nation, along with a lack of room to stimulate growth via monetary easing in times of recessions, means that the euro could increasingly become a counter-cyclical currency like the yen. So long as the European integration efforts remain on the backburner, euro area growth, inflation, and interest rates will continue to look more like Japan’s have over the past 30 years than the U.S. Third, European equities are trading at a discount to U.S. equities, but we do not think this guarantees long-term outperformance. European equities are cheap because European growth prospects are poor. If Japan is any guide, European stocks may be set to continue underperforming. This is especially true as financials are over-represented in European equity benchmarks, and banks stand at the epicenter of the European economic malaise. Fourth, European stocks will remain slaves to the global business cycle. Since the crisis, European growth has become hypersensitive to global growth, making European equities very responsive to the global business cycle. The same phenomenon happened in post-1990 Japan. In other words, the beta of European stocks is likely to continue to rise. This phenomenon could be exacerbated if the euro indeed does become a counter-cyclical currency, in which case the euro and European equities would become negatively correlated, like the yen and the Nikkei. Finally, the period from 1999 to 2005 showed how ECB policy targeted at supporting Germany resulted in imbalances that boosted real estate and equity returns in the periphery – in Spain and Ireland in particular. Today, the periphery is the worst offender when it comes to poor bank health and private sector balance sheet rebuilding. This means that the ECB is likely to keep monetary conditions too accommodative for Germany, where balance sheets are more robust and where the capital stock is not as excessive. As a result, financial market plays linked to German real estate are likely to continue outperforming other European domestic plays. They therefore warrant an overweight within European portfolios. Mathieu Savary Vice President The Bank Credit Analyst   Footnotes 1 Please see Global Asset Allocation Special Report "Euro Area Banks: Value Play Or Value Trap?" dated December 14, 2018, available at gaa.bcaresearch.com 2 The European Commission Eurobarometer Surveys show that Europeans overwhelmingly see Europe as a peace project and as a way to maintain a voice in a world dominated by huge players like the U.S., China, or Russia, a world where France, Germany, or Italy individually are marginal players. In 2016, the U.K. population did not share this opinion. Moreover, even after what amounts to a depression, the support for the euro continues to rise in Greece, showing the growing commitment of Europeans to the euro, and the resilience of this commitment to economic shocks.

Highlights The recent dovish shift in tone from central banks around the world is here to stay this year, providing support for global growth. As a result, stock prices will benefit from a combination of easy policy and rebounding activity, while safe-haven yields will grind higher. The recent deterioration in profit margins is not due to rising costs but reflects weaknesses in pricing power. Pricing power is pro-cyclical: If global growth improves and the dollar weakens, margins should recover. Overweight financials and energy. We are upgrading European equities to neutral, and placing them on a further upgrade watch. Feature Easy Does It The global monetary environment has eased over the past four months. Some major central banks like the Federal Reserve and the Bank of Canada have backed away from tightening. Others, like the Bank of Japan, the Reserve Bank of Australia, the Reserve Bank of New Zealand and the Swedish Riksbank have provided very dovish forward guidance. And one major policy setting institution – the European Central Bank – has even eased policy outright by announcing a large-scale injection of liquidity in the banking sector through its TLTRO-III operation that will begin in September. This phenomenon is not limited to advanced economies. Important EM central banks are also targeting easier liquidity conditions. The Reserve Bank of India has cut interest rates by 50 basis points; the Monetary Authority of Singapore is now targeting a flat exchange rate; and the Bank of Korea has issued a somewhat dovish forward guidance. Most importantly, Chinese policymakers are once again forcing debt through the system, with total social financing flows amounting to RMB 2.9 trillion last quarter, more than the RMB 2.4 trillion pumped through the economy in the first quarter of 2016. These reflationary efforts will bear fruit. Policy easing, especially when it relies as largely on forward guidance as the current wave does, should result in lower forward interest rates. And as Chart I-1 illustrates, when a large proportion of global forward rates are falling, a rebound in global economic activity typically follows. This time will not be different. Chart I-1Monetary Guardians Are Coming To The Rescue Monetary Guardians Are Coming To The Rescue Monetary Guardians Are Coming To The Rescue The S&P 500 and global equities have already rebounded by 18.9% and 17.2%, respectively since late December. Have markets already fully discounted the growth improvement that lies ahead, leaving them vulnerable to disappointments? Or do global stocks have more upside? While a rest may prove necessary, BCA anticipates that global equity prices have more upside over the coming 12 months. Are Central Banks About To Abandon Their Newfound Dovish Bias? We sincerely doubt it. Reversing the recent tone change soon would only hurt the battered credibility that central banks are fighting so hard to maintain. In the case of the U.S., the most recent FOMC minutes were clear: The Fed does not intend to tighten policy soon, even if growth remains decent. The minutes confirmed the idea we espoused last month, that FOMC members are focused on avoiding a Japan-like outcome for the U.S. where low expected inflation begets low realized inflation. Such an outcome would greatly increase the probability that an entrenched deflationary mindset develops in the U.S. in the next recession. As a result, we anticipate that the Fed will refrain from tightening policy until inflation expectations move back up toward their historical range (Chart I-2). Further justifying the Fed’s new stance, a small rebound in productivity is keeping unit labor costs at bay, despite a pick-up in wages. This is likely to put a lid on core inflation for now (Chart I-3). Chart I-2Inflation Expectations: Too Low For The FOMC's Comfort Inflation Expectations: Too Low For The FOMC's Comfort Inflation Expectations: Too Low For The FOMC's Comfort Chart I-3A Whiff Of Disinflation A Whiff Of Disinflation A Whiff Of Disinflation There is little reason for the ECB to adopt a more hawkish stance either. The euro area PMIs have stabilized but are still flirting with the boom/bust line. Realized core inflation is a paltry 0.8% and the ECB’s own forecast is inconsistent with its definition of price stability, which dictates that the inflation rate should be “below but close to 2% over the medium term.” Our ECB Monitor captures these dynamics, remaining in the neutral zone (Chart I-4).   In China, the case for quickly removing credit accommodation is weak. Property developer stocks have rebounded 41% from their October lows, but sales of residential floor space remain soft, keeping real estate speculation in check. Meanwhile, our proxy for the marginal propensity to consume of Chinese households – based on the ratio of demand deposits to time deposits – continues to deteriorate (Chart I-5). The recent pick up in credit growth should put a floor under those trends, but it will take some time before these variables overheat enough to call for policy tightening. Chart I-4Our ECB Monitor Supports An ECB Standing Still Our ECB Monitor Supports An ECB Standing Still Our ECB Monitor Supports An ECB Standing Still Chart I-5Key Domestic Variables Argue Against Tightening Policy In China Key Domestic Variables Argue Against Tightening Policy In China Key Domestic Variables Argue Against Tightening Policy In China   Bottom Line: The three most important policymakers in the world are not set to suddenly slam on the brake pedal. As a result, the global policy backdrop will remain accommodative for at least two to three quarters. The few economic green shoots observed around the world should therefore blossom into a full-fledge global growth pick-up. From Green Shoots To Green Gardens If central banks adopt an easier bias but global growth is slowing sharply without any end in sight, stock prices are unlikely to find a floor. After all, stock prices represent the discounted value of future cash flows. If those cash flows are expected to decline at a faster pace than the risk-free rate, then stock prices can fall – even if policy is becoming more accommodative. However, if economic activity is stabilizing, easier policy should generate substantial equity gains. Stimulative financial conditions will result in an improvement in global activity indicators, including emerging economies (Chart I-6, top panel). This is very important as emerging markets were at the epicenter of the slowdown in global trade, and because they historically lead global industrial activity (Chart I-6, bottom panel). The few economic green shoots observed around the world should therefore blossom into a full-fledge global growth pick-up. Policy easing in China is of particular significance. Our Chinese activity indicator is still slowing, but BCA’s Li-Keqiang Leading Indicator, which mostly tracks developments in the credit sector, has stabilized (Chart I-7, top panel). The rebound in the credit impulse also points to an acceleration in Chinese nominal manufacturing output (Chart I-7, bottom panel). This should lift Chinese imports, resulting in a positive growth impulse for the rest of the world. Chart I-6The Dance Of FCI And Activity The Dance Of FCI And Activity The Dance Of FCI And Activity Chart I-7Chinese Industrial Activity Will Rebound Soon Chinese Industrial Activity Will Rebound Soon Chinese Industrial Activity Will Rebound Soon   At the moment, the euro area remains weak, but it will become a key beneficiary of improving growth. As the top panel of Chart I-8 illustrates, the Eurozone’s exports to China tend to follow the trend in the Chinese Adjusted Total Social Financing impulse. Moreover, European exports to the rest of the world are set to enjoy a recovery, as highlighted by the upturn in the diffusion index of our Global Leading Economic Indicator (Chart I-8, bottom panel). This external-sector improvement is happening as the euro area domestic credit impulse is rebounding, and as the region’s fiscal thrust increases from roughly zero to 0.4% of GDP. In the U.S., it is unlikely that 2019 growth will top that of 2018, but activity should nonetheless rebound from a lukewarm first quarter. Importantly, the fed funds rate is holding below its equilibrium (Chart I-9). Additionally, household fundamentals remain solid. A tight labor market means that wages have upside and household debt levels and debt servicing costs are all well behaved relative to disposable income (Chart I-10). Moreover, housing dynamics are generally stronger than reported by the press, as mortgage applications for purchases are making cyclical highs and the NAHB Homebuilder confidence index is rebounding (Chart I-11). Offsetting some of these positives, capex intentions – a robust forecaster of actual corporate investments – have rolled over from their heady mid-2018 levels. Even so, they remain consistent with positive capex growth. Also, U.S. fiscal policy is becoming increasingly less growth-friendly starting in mid-2019. Netting it all out, U.S. growth should remain above-trend, at about 2.5%. Chart I-8Europe Will Benefit From Stabilizing Growth Elsewhere Europe Will Benefit From Stabilizing Growth Elsewhere Europe Will Benefit From Stabilizing Growth Elsewhere Chart I-9U.S. Policy Remains Accommodative U.S. Policy Remains Accommodative U.S. Policy Remains Accommodative   Chart I-10U.S. Households Are Doing Alright U.S. Households Are Doing Alright U.S. Households Are Doing Alright Chart I-11Forward-Looking Housing Indicators Point To A Pick-Up Forward-Looking Housing Indicators Point To A Pick-Up Forward-Looking Housing Indicators Point To A Pick-Up Bottom Line: While U.S. growth may be weaker than in 2018, it should not fall below trend. Meanwhile, Chinese credit trends suggest that growth there should clearly pick up in the coming months, which should also lead to stronger activity in Europe. In other words, exactly as central banks have removed policy constraints, global growth is set to re-accelerate. This is a positive backdrop for risk assets over the coming 12 months.   What Does It Mean For Asset Prices? Simply put, a dovish shift in policy along with a tentative stabilization in growth should result in both higher stock prices and rising safe-haven bond yields. First, a rebound in global economic activity means that depressed profit growth expectations could easily be bested (Chart I-12, top panel). Bottom-up estimates point to EPS growth of 3.4% in the U.S. and 5.3% in the rest of the world in 2019, using MSCI data. However, profits are extremely pro-cyclical, and a combination of easy financial conditions and improving growth conditions in the second half of the year should result in better-than-expected earnings. Chart I-12Profit Expectations Are Low Profit Expectations Are Low Profit Expectations Are Low Second, the Fed is extending its pause, as other global central banks are also adopting more accommodative policies. This implies that global real interest rates, both at the short- and long-end of the curve, will remain below equilibrium for longer than would have been the case if policy had remained on its previous path. Consequently, not only do lower real rates decrease the discount factor for stocks, they also imply a longer business cycle expansion. This should result in narrower risk premia for stocks and higher multiples. Since they offer cheaper valuations than those in the U.S., international equities may stand to benefit more from policy-led multiple expansion (Chart I-12, bottom panel). Third, the global duration indicator developed by BCA’s Global Fixed Income Strategy service is forming a bottom.1 This gauge – levered to global growth variables like the Global ZEW growth expectations survey, our Global Leading Economic Indicator and the Global LEI’s diffusion index – has perked up in response to green shoots around the globe. An upturn in global safe-haven yields is imminent (Chart I-13). Additionally, the global Policy Uncertainty Index is currently recording very high readings, congruent with depressed yields (Chart I-14). A benign resolution to the Sino-U.S. trade tensions along with the low likelihood of the implementation of a No-Deal Brexit should push this indicator down, lifting yields in the process. Chart I-13Global Dynamics Argue For Fading The Bond Rally Global Dynamics Argue For Fading The Bond Rally Global Dynamics Argue For Fading The Bond Rally Chart I-14Policy Uncertanity Is At An Apex: Look The Other Way Policy Uncertanity Is At An Apex: Look The Other Way Policy Uncertanity Is At An Apex: Look The Other Way   Fourth, while we expect the Fed to stay on pause for the remainder of 2019 and probably through the lion’s share of 2020 as well, this is a more hawkish forecast than what the market is currently pricing in (Chart I-15). As we argued last month, a fed funds rate that turns out to be higher over the next year than what is currently discounted often results in the underperformance of Treasurys relative to cash. Finally, a rebound in global growth, even if the Fed proves more hawkish than the market anticipates, generally pushes the dollar lower (Chart I-16). Since speculators currently hold large net short bets on the euro, the AUD, the CAD, and so on, the probability is high that this historical pattern will assert itself. The recent period of dollar strength is unlikely to last more than a couple of weeks. A weak dollar, easy policy and rebounding growth should boost commodity prices, especially metals and oil. The latter should benefit most from this set up as the end of the waivers of U.S. sanctions on Iran will constrain the availability of crude in international markets. Chart I-15 Chart I-16The Dollar Last Hurrah Will End Very Soon The Dollar Last Hurrah Will End Very Soon The Dollar Last Hurrah Will End Very Soon   Rebounding global growth should also allow equity prices to be resilient in the face of rising bond yields, up to a point. When yields and inflation expectations are low, multiples and equity prices tend to move in tandem. This is because in an environment where central banks are frightened by deflationary risks, monetary authorities do not lift rates as quickly as nominal activity would warrant. Thus, improving nominal growth lifts the growth component of equity multiples more than it raises yields. In other words, we expect yields and stocks to rise together because low but rising inflation expectations, but not surging real rates, will drive the upside in bond yields. Obviously, this cannot last forever. Once the Fed starts suggesting that rates will rise again, and the entire yield curve moves closer to neutral, higher yields will curtail equity advances. This is a constructive cyclical setup; but the tactical environment is murkier. The problem is that equity prices have already moved up significantly over the past four months. With volatility across asset classes having once again plunged toward historical lows, risk assets display a high degree of vulnerability to disappointing economic data. This means that unless growth rebounds strongly and quickly, stocks could experience a short-term correction in the coming months. While staying overweight equities, it is nonetheless prudent to buy some protection. Investors should also wait on the sidelines to deploy any excess cash. Rebounding global growth should also allow equity prices to be resilient in the face of rising bond yields, up to a point. Bottom Line: The current environment is favorable for risk assets on a cyclical basis. Low real rates will not only continue to nurture the nascent improvement in the global economy. They also imply lower discount rates. Meanwhile, improving economic activity and a decline in policy uncertainty will push safe-haven yields higher. Consequently, it remains sensible to be long stocks and underweight bonds for the remainder of the year, even if the risk of a short-term stock correction has risen. Within fixed-income portfolios, a below-benchmark duration makes sense, especially as oil prices are rising, Sino-U.S. trade negotiations should end in a benign outcome, and a No-Deal Brexit remains unlikely. Margins Are The Greatest Risk At the current juncture, the biggest risk for stocks is that profits fall short of depressed analysts’ estimates for 2019 – not because revenue growth disappoints, but because profit margins contract. Our U.S. Equity Sector Strategy service has recently highlighted that the S&P 500 operating earnings margin stands at 10.1% after having peaked at 12% in Q3 2018 (Chart I-17).2 Despite this decline, margins remain both elevated by historical standards and above their long-term upward-sloping trend. As Chart I-18 illustrates, the decline in margins is not an S&P 500-only phenomenon: It is an economy wide one as well, as the pattern is repeated using national accounts data. Chart I-17Will This Margin Deterioration Continue? Will This Margin Deterioration Continue? Will This Margin Deterioration Continue? Chart I-18Margins: All About Labor Costs Versus Selling Prices Margins: All About Labor Costs Versus Selling Prices Margins: All About Labor Costs Versus Selling Prices   At first glance, the Fed’s current pause may undermine profit margins. As Chart I-19 shows, when the unemployment rate stands below NAIRU, on average, wages grow faster than when the labor market is not at full employment. Since the unemployment gap stands as -0.8% today, we are likely to see continued wage pressures in the U.S. economy. Chart I-19Wages Have Upside Wages Have Upside Wages Have Upside The problem with this story is that productivity has been accelerating – from a -0.3% annual rate in the second quarter of 2016 to 1.8% in the fourth quarter of 2018. Because wage inflation did not experience as large a change, unit labor cost inflation is still growing at 1% annually, as they did in Q2 2016. In fact, real unit labor costs are currently contracting at a 0.4% pace. The pick-up in capex over the past three years suggests that productivity can continue to improve over the coming quarters. Consequently, as has been the case over the past two years, rising wages will only have a limited negative impact on margins. The key source of variance in profit margins has been, and will likely remain over the next year or so, corporate pricing power, which today stands at its lowest level since the deflationary episode of 2015-2016 (Chart I-20). As was the case back then, the slowdown in global growth has played a role, since it has resulted in falling global export prices. Not only do they affect foreign revenues for U.S. businesses, they also impact the price of goods sold at home, and thus have a broad impact on aggregate pricing power. Chart I-20Pricing Power Follows The Global Business Cycle Pricing Power Follows The Global Business Cycle Pricing Power Follows The Global Business Cycle Last year’s dollar strength amplified those headwinds. A strengthening dollar affects profitability through four channels. First, it negatively impacts global growth by tightening financial conditions for foreign borrowers who fund themselves in USD. They are thus more financially constrained when the dollar appreciates. Second, a strong dollar hurts commodity prices and industrial goods prices. Third, a strong dollar negatively impacts the competitiveness of U.S. firms, forcing them to cut their prices to stay competitive. Finally, a strong dollar hurts the translation of overseas earnings back into USDs. As a result, a strong dollar weighs on earnings estimates (Chart I-21).   Chart I-21The Dollar Amplified Margins Problems The Dollar Amplified Margins Problems The Dollar Amplified Margins Problems Since we anticipate global growth to improve and the greenback to buckle, the current pricing power problem faced by corporate America should fade and profit margins should rebound in the second half of 2019. This suggests that for now, declining profit margins remain a risk that needs to be monitored – not a base case to embrace. Our U.S. Equity Sector Strategy service has highlighted that the tech sector has the poorest earnings outlook within the S&P 500. An economic upswing could counteract some of the recent declines in tech margins, but the much more pronounced rise in labor costs in Silicon Valley than in other sectors suggests that tech profits could lag behind other heavyweights like financials and energy. Consequently, BCA recommends a neutral allocation to tech stocks. We instead recommend overweighting financials and the energy sector. Financials will benefit from an easy monetary policy setting that should help credit growth. Moreover, net interest margins are at cycle highs of 3.5%, as banks have prevented interest costs on deposits from rising in line with short rates. Finally, buybacks by financial services firms are rising and will likely battle the tech sector’s buybacks for the pole position this year (Chart I-22).3 Chart I-22Why Are We Neutral On Tech? Why Are We Neutral On Tech? Why Are We Neutral On Tech? Our positive stance on energy stems from undue pessimism surrounding the sector. Bottom-up analysts currently pencil in such a large contraction in earnings for this group that, according to their forecasts, energy will curtail 2019 S&P 500 earnings by 18%. With WTI prices back above $65/bbl, rising per-well productivity and easing financing costs, the hurdle to beat is already low. Moreover, the end of U.S. waivers on Iranian sanctions further supports oil prices. In this context, if global growth rebounds and the dollar depreciates, energy stocks could catch fire. Bottom Line: The biggest risk to our positive stance on equities is that earnings are dragged down by declining margins. While the recent softness in margins is concerning, it does not reflect an increase in labor costs. Instead, it is a consequence of eroding pricing power. Falling pricing power is itself a symptom of the slowdown in global growth and a stronger dollar. As both these ills pass, margins should recover in the second half of 2019. Within equities, we prefer financials and energy, as their earnings prospects outshine tech stocks. Upgrading European Equities To Neutral, And Looking For More For equity investors competing against a global benchmark, there is a simple way to express the view that global growth will rebound, safe-haven yields have upside, the dollar will weaken, and that profit margins are a risk to monitor. It is to abandon underweight allocations to European equities and overweight positions to U.S. stocks. This month, we are upgrading European equities to neutral and downgrading U.S. stocks to neutral. Even after this upgrade, we are putting European equities on a further upgrade watch. First, the euro area is much more sensitive than the U.S. to Chinese growth. This also has implication for equities. As Chart I-23 shows, when the ratio of M1 to M2 money supply in China perks up, as it is currently doing, European stocks end up outperforming their U.S. counterparts. This is because the M1-to-M2 ratio ultimately reflects the growth of demand deposits relative to savings deposits in the Chinese banking sector. It therefore informs how spending is likely to evolve. Currently, China’s reflationary efforts point toward a pickup in spending that should lift European exports, and European profits as well. Chart I-23Monetary Dynamics In China Favor Fading Euro Area Bearishness Monetary Dynamics In China Favor Fading Euro Area Bearishness Monetary Dynamics In China Favor Fading Euro Area Bearishness Second, European exports have upside, and unsurprisingly, the bottoming in the BCA Boom/Bust indicator – which captures global growth dynamics beyond just China – is also flagging the end of European equity underperformance (Chart I-24, top panel). Moreover, if the global reflationary period is sustained, the decline in forward interest rates will reverse. This too is consistent with a period of outperformance for European equities (Chart I-24, bottom panel). Third, our overweight stance on financials relative to tech equates to European equities beating their U.S. counterparts. This simply reflects the fact that financials constitute 17.9% of the MSCI euro area index, while tech stocks account for 9.2%. The same sectors represent 12.9% and 26.8% of the U.S. market, respectively. Not only are European banks trading at 0.6-times book value compared to 1.2-times for U.S. lenders, but European banks stand to benefit more than U.S. banks from rising bond yields as they garner a larger share of their income from lending activity. Fourth, European profit margins are toward the bottom third of their distribution relative to U.S. profit margins. As Chart I-25 shows, European profit margins tend to rise when euro area unit labor costs lag U.S. ones. Since the euro area output gap is not as positive as that of the U.S., it is unlikely that European wages will outpace U.S. wages this year. Also, since European stocks are more heavily weighted toward industrials, materials and energy, the sectors that suffered the greatest loss of pricing power during the global economic slowdown, pricing power in Europe could rebound more strongly than in the U.S. This too should flatter European profit margins relative to the U.S. Chart I-24European Equities To Benefit From Rebounding Global Growth European Equities To Benefit From Rebounding Global Growth European Equities To Benefit From Rebounding Global Growth Chart I-25European Profit Margins Can Experience A Further Cyclical Lift European Profit Margins Can Experience A Further Cyclical Lift European Profit Margins Can Experience A Further Cyclical Lift   Finally, even after adjusting for sectoral composition, European equities trade at a discount to U.S. stocks. On an equal-sector basis, the 12-month forward P/E ratio is 14.2, and the price-to-book ratio is 2.0. For the U.S., the same multiples stand at 20.7 and 4.0, respectively. This means that European stocks are not yet pricing in an improving outlook. Be warned: The positive outlook for European equities relative to the U.S. is a cyclical story. As Section II of this report argues, poor demographics and an excessively large capital stock suggest that European rates of return will continue to lag the U.S. As a result, the return from investing in European stocks is unlikely to beat that of the U.S. beyond 12 to 18 months. Bottom Line: Within a global equity portfolio, we are upgrading the euro area from underweight to neutral at the expense of the U.S., which moves to neutral. We are also putting European equities on a further upgrade watch. Mathieu Savary Vice President The Bank Credit Analyst April 25, 2019 Next Report: May 30, 2019 II. Europe: Here I Am, Stuck In A Liquidity Trap An aging population, a banking sector in poor health, and a private sector focused on building up savings are the key factors undermining euro area growth on a structural basis. A large manufacturing sector makes the euro area vulnerable to EM competition. Unlike the U.S., the region’s tech sector is held back by regulatory burdens, taxes and heavy dependence on bank funding. The euro area growth faces decades of low growth and inflation. Euro area rates will stay depressed, but paradoxically, the euro can still experience structural appreciation. Euro area equities are cheap for a good reason, and banks will continue to weigh on performance. Over the past 10 years, the euro area has gone through a sovereign debt crisis, a double-dip recession, persistent below-target inflation, and most recently, yet another major growth slowdown. Moreover, this economic malaise materialized despite highly stimulative monetary policy, including negative interest rates. The ongoing economic weakness has raised the specter that the euro area is the new Japan. Nearly three decades after the bursting of the Nikkei bubble, the Land of the Rising Sun remains mired in low growth and mild but persistent deflation. Consequently, charts showing that European policy rates or bond yields are tracking Japanese developments with a 17-year lag (Chart II-1) have not only become commonplace, they elicit fears that European growth, interest rates and asset valuations will lag the rest of the world for decades to come. Chart II-1Europe Is Following The Japanese Example Europe Is Following The Japanese Example Europe Is Following The Japanese Example In this piece, we discuss the various forces that explain why the euro area economy has been so weak this decade, and why such low interest rates have had so little impact on growth. We also study what sets the U.S. and euro area apart, and whether or not Europe will follow the trail blazed by Japan nearly 30 years ago. The Three Headwinds Three ills have kept European growth particularly depressed this cycle and are likely to remain significant headwinds into the foreseeable future: demographics, the banking sector’s poor health, and nonfinancial private sector balance sheet cleansing. 1)   Demographics This is the most well understood and acknowledged problem impacting Europe today. Since 2008, the European population has grown by 2%, or only 0.2% a year, with the working age population having peaked around that year. Going forward, the picture will only deteriorate: The UN expects Europe’s population to contract by 12% over the next 27 years, and the working age population to fall by 15%. This also means that the dependency ratio – the number of individuals aged less than 15 and above 65 per 100 working-age people – will approximately double over the coming 40 years. This is a clear parallel with Japan. As Chart II-2 illustrates, Europe’s population, the number of working-age individuals and the dependency ratio are all tracking Japan with a 17-year lag. Like Japan, Europe’s trend growth will thus only deteriorate further. Not only will Europe not be able to add as many workers as the U.S. to its total, but it will need to build even fewer schools, malls, office buildings or units of housing. Consequently, both the supply and demand sides of the economy will lag due to this factor alone. 2)   Banking Sector Health The poor health of the euro area banking sector is well known. BCA’s Global Asset Allocation service published an in-depth analysis of the European banking sector last December.4 The piece demonstrated that European banks have been much slower to recognize non-performing loans, curtail credit and rebuild capital than their U.S. counterparts. U.S. bank loans to the private sector fell by 13% in the two years during the crisis, while in Europe, these same loans have only fallen by 2% since 2008. Euro area banks generally remain burdened with significant non-performing loans as a percentage of regulatory capital. Moreover, net interest margins are also dismal, implying that the income cushion against bad loans is thin. Consequently, outside of France, Finland and Germany, European banks have either not grown their loan books to the private sector or, as is the case with Spain, Portugal, and Ireland, these books are continuously shrinking (Chart II-3). Chart II-2Same Demography In Europe Now Than In Japan Then Same Demography In Europe Now Than In Japan Then Same Demography In Europe Now Than In Japan Then Chart II-3Peripheral Banks Continue To Curtail Credit Peripheral Banks Continue To Curtail Credit Peripheral Banks Continue To Curtail Credit   The poor health of the European banking system is now constraining the supply of new credit to the rest of the economy. This is a much bigger problem than is the case in the U.S. given that in Europe, 72% of corporate funding comes from the banking system while 88% of household liabilities are also funded this way. In the U.S., the share of bank funding for these sectors is 32% and 29%, respectively (Chart II-4). A weak euro area banking system prevents the nonfinancial private sector from growing as robustly as it could. Chart II-4 3)   Nonfinancial Private Sector Balance Sheet Cleanse Another major drag on European growth has been the continued efforts of the European private sector to rebuild its balance sheet. To use the terminology developed by our upcoming conference speaker Richard Koo, the euro area has been in the thralls of a powerful balance sheet recession. Households in the euro area, Japan and the U.S. are all accumulating more financial assets than liabilities. However, only in the U.S. is the nonfinancial corporate sector building more liabilities than it is accumulating assets (Chart II-5). In Japan and Europe, the nonfinancial corporate sector is also a source of savings for the economy. Moreover, in Europe, the government runs a much smaller financial deficit. The current account balance tells this story vividly. A country’s current account is equal to the private sector’s savings minus investment and minus government deficits. As Italy, Spain, and other peripheral economies increased their aggregate savings after 2008, their large current account deficits vanished. Meanwhile, the governments of countries like Germany or the Netherlands, which sported healthy public finances, did not increase their spending in a commensurate way. This adjustment transformed an overall euro area current account deficit of 1.5% in 2008 into a surplus of 3.0% of GDP today, sending some of Europe’s excess savings abroad. This mimics the post-1990 Japanese experience. In the U.S., where the private sector savings did not rise as durably as in Europe, the current account stopped improving meaningfully in 2010 (Chart II-6). Chart II-5European Businesses Are Savers, Like In Japan European Businesses Are Savers, Like In Japan European Businesses Are Savers, Like In Japan Chart II-6The Current Account Dynamics Epitomise The Savings Dynamics The Current Account Dynamics Epitomise The Savings Dynamics The Current Account Dynamics Epitomise The Savings Dynamics   A private sector squarely focused on rebuilding its balance sheet liquidity can lead to a liquidity trap. In this state, monetary policy can become ineffective as spending does not respond to lower interest rates. This is where Europe is currently stuck, explaining why the European Central Bank is finding that inflation and growth are not experiencing much lift, despite seemingly incredibly accommodative monetary conditions. Why Such An Urge To Save? The fact that the household sector is a net saver is not surprising, as this is a normal state of affairs across most economies. But why is the European nonfinancial corporate sector still trying to improve its balance sheet liquidity by accumulating more assets than liabilities? Like Japanese businesses 30 years ago, European firms have large debt loads. Another problem is the lack of capex opportunities in Europe. Why do we make this assertion? The return on assets in Europe has been at rock-bottom levels ever since the introduction of the euro (Chart II-7). In the decade from 1998 to 2008, this was a non-issue. Strong global growth flattered European sales, and easy access to credit meant that via rising leverage euro area-listed nonfinancial corporations were able to generate returns on equity comparable to U.S. firms (Chart II-8, top panel). Once European banks got cold feet and European nonfinancial businesses began focusing on deleveraging, the low level of return on assets became more apparent. Part of the problem is that European profit margins are much closer to Japanese than U.S. levels (Chart II-8, middle panel). Even more damning, asset turnover – how much sales are generated by a unit of assets – has been structurally lower in Europe than in both Japan and the U.S. for multiple decades (Chart II-8, bottom panel). Chart II-7Europe Suffers From A Lower RoA Europe Suffers From A Lower RoA Europe Suffers From A Lower RoA Chart II-8DuPont's Decomposition Shows Why The Euro Area RoA Is Poor DuPont's Decomposition Shows Why The Euro Area RoA Is Poor DuPont's Decomposition Shows Why The Euro Area RoA Is Poor   The first factor weighing on the level of asset utilization and returns in Europe is the elevated level of capital stock. As Chart II-9 illustrates, the capital stock as a share of output in Italy, Spain and France dwarfs that of Japan, China or the U.S. Even Germany’s capital stock, which stands well below that of other large euro area economies, is nearly 100 percentage points of GDP larger than the U.S’s. Europe has too large a pool of assets to make any additional investments profitable, especially in light of its poor demographic profile. Chart II-9 The second factor weighing on European asset utilization and returns is the poorer level of labor productivity. From the 1950s to the early 1980s, European GDP per worker rose relative to the U.S., albeit peaking at 92% of the levels across the Atlantic. Due to falling working hours in Europe relative to the U.S. since the 1980s, relative output per hour continued to rise until the mid-1990s, peaking at 105% of the U.S. level. However, since their respective zeniths, both relative productivity measures have collapsed (Chart II-10, top panel). Chart II-10Another Symptom Of Europe's Misallocation Of Capital In The 2000s Another Symptom Of Europe's Misallocation Of Capital In The 2000s Another Symptom Of Europe's Misallocation Of Capital In The 2000s These collapses are in fact worse than Japan’s performance since its lost decades began. As the second panel of the chart shows, since the early 1990s, Japan’s relative output per hour and per worker have flattened – not declined – at around 65% and 72%, respectively, of U.S. levels. Instead, relative European productivity levels are currently converging toward Japanese levels (Chart II-10, third and fourth panels). The particularly poor level of European asset utilization and productivity principally reflects the duality between the peripheral as well as French economies on one side, and Germany as well as the Netherlands on the other side. The exceptionally large capital stock outside of Germany is a legacy of the years directly after the euro’s introduction. Back then, the ECB kept rates low to help Germany, the then-sick man of Europe. These rates were too low for the rest of Europe, encouraging large capital stock build-ups. Moreover, this capital was misallocated, as demonstrated by the tepid growth of output per hour and output per capita in Europe post 2000. Since funds were poorly allocated, the output-to-capital ratio in the periphery collapsed. In other words, the peripheral capital-stock-to-GDP ratios continued rising because the denominator, GDP, lagged. An additional problem for Europe’s asset utilization has been its large manufacturing sector. Even after declining, 20% of Europe’s GDP still comes from the secondary sector versus less than 12% in the U.S. (Chart II-11). This has two consequences for Europe’s asset utilization relative to the U.S. First, a large manufacturing sector requires a much larger asset base than a large service or tech sector. Second, the manufacturing sector is more exposed to competition from emerging markets than the tech sector, or than the domestically-focused service sector. Chart II-11Europe Is Left Exposed To EM Competition Europe Is Left Exposed To EM Competition Europe Is Left Exposed To EM Competition In other words, not only has the U.S. experienced less capital misallocation than a large swath of the European economy, it has also re-aligned its economy to make it more robust in the face of competition from emerging economies, while Europe mostly has not. Consequently, hurt by foreign competition and unable or unwilling to re-invent itself, Europe has been left with dwindling relative productivity levels and poor degrees of asset utilization and returns. Why Did The U.S. Economy Transition Better than Europe To A Globalized World? There are many reasons why the U.S. has maintained higher RoAs and has been more successful at transitioning away from a manufacturing-led economy than the euro area. Europe has too large a pool of assets to make any additional investments profitable, especially in light of its poor demographic profile. First, the level of product and service market regulation in Europe is highly punitive. As Chart II-12 illustrates, like Japan, most euro area countries fare poorly in the World Bank’s Ease of Doing Business survey. In fact, Italy scores even lower than China! Meanwhile, the U.S. ranks near the top, not far from Singapore. This means that starting new businesses, competing, and so on is easier in the U.S. than in Europe, helping foster a greater level of entrepreneurialism. Consequently, established businesses have been able to maintain the status quo longer in Europe than in the U.S., preventing creative destruction from purging the system of bad assets. Chart II-12 Second, most large euro area economies are burdened by heavy taxes. As Chart II-13 shows, while the U.S. public sector extracts taxes equal to 27.1% of GDP, German, Italian and French taxes equal 37.5%, 42.4% and 46.2% of GDP, respectively, well above the OECD average of 34.2%. Such high levels of taxation disincentivize risk-taking. Lower levels of risk taking by individuals further prevented the degree of creative destruction necessary for Europe to better use its capital stock. Chart II-13 Third, and linked to the previous point, government spending equals 34.9% of GDP in the U.S., compared to 48.2% and 56.0% in Italy or France, respectively. A large government has historically stifled innovation and favored the status quo. By no means does this implies that the U.S. system is free of imbalances, but it highlights that compared to two of the three largest European economies, the U.S. public sector has had a less deleterious impact on growth conditions and entrepreneurialism. Moreover, Italy and France have been in deep need of structural reforms that have been lacking. On this front, while the outlook is improving in France under Macron’s presidency, Italy remains mired in immobilism. Fourth, the financing structure in the U.S. favors investing in new businesses and industries, especially when compared to the euro area. Equities represent 78% of the capital structure of nonfinancial corporations in the U.S. while they represent only 61% in the euro area. Moreover, within debt-financing, capital markets account for 68% of sourced funds in the U.S. compared to 28% in the euro area. In fact, junk bond market capitalization only accounts for 2.2% of GDP in Europe compared to 6.0% in the U.S. This suggests that financing risky ventures – and entrepreneurialism is inherently risky – is tougher in Europe than in the U.S. In fact, as a share of GDP, the European venture capital business is less than a sixth the size of the U.S.’s (Chart II-14), a gap that has existed for more than 30 years. Chart II-14U.S. Financing Allows For Greater Risk Taking U.S. Financing Allows For Greater Risk Taking U.S. Financing Allows For Greater Risk Taking With all these hurdles, it is unsurprising that Europe has taken more time to make its economy more dynamic in the globalized economy of the 21st century. It also explains why Europe might be suffering more from EM competition than the U.S. Interestingly, this last point may be changing as U.S. voters seem to want to move back toward a larger manufacturing sector. This transition is unlikely to happen without more protectionism. This is a topic for another report. Is Europe Doomed To Japanification… Or Worse? It is easy to see why Europe cannot hope to grow as fast as the U.S., and therefore why the ECB will not be able to lift rates as high as the Fed and why bund yields are likely to lag Treasurys for years to come. Europe has a much more dire demographic profile than the U.S. It needs to purge its capital stock and invigorate its economy through reforms, a smaller public sector, and more diversified financing channels. But can the euro area fare better than Japan has over the past 30 years? On three fronts, the euro area looks better than Japan. First, as Chart II-15 shows, the overall European nonfinancial private sector entered its crisis in 2008 with lower leverage than Japan’s in the early 1990s. Additionally, European stocks were much cheaper in 2007 than the Nikkei was in 1989 (Chart II-16, top panel). Even Spanish real estate was more reasonably valued in 2007 than Japanese real estate in the early 1990s (Chart II-16, bottom panel). This combination means that now that the acute part of the crisis is over, the hole in the European private sector’s balance sheet is much smaller than the one Japan needed to plug 30 years ago. Thus, from a balance-sheet perspective, the need to rebuild savings is lower in Europe than Japan, and we could expect the current period of elevated savings to be shorter in the euro area than it has been in Japan. Chart II-15 Chart II-16...And European Assets Were Not As Expensive As Japanese Ones At The Onset Of The Crisis ...And European Assets Were Not As Expensive As Japanese Ones At The Onset Of The Crisis ...And European Assets Were Not As Expensive As Japanese Ones At The Onset Of The Crisis   Second, despite former ECB President Jean-Claude Trichet’s policy mistake of raising interest rates in 2011, the ECB was much quicker to implement extreme easing policy measures than the Bank of Japan was in its day. It took 10 years for the BoJ to cut rates to zero after the Nikkei peaked in December 1989. It took one year for the ECB to do so after stock prices peaked in 2007. It took nine years for the BoJ to expand its balance sheet aggressively, but it took less than two years for the ECB to do so. One of the key benefits of this greater European proactivity has been to keep European inflation expectations much higher than in Japan, curtailing real interest rates in the process. Third, Europe purged economic excesses much more quickly than Japan. The Japanese unemployment rate increased from 2% to 6% between 1990 and 2010. In peripheral Europe, where the worst pre-crisis excesses existed, unemployment rose from 7.5% in 2008 to 18% in 2013 (Chart II-17, top panel). Meanwhile, real wages never adjusted in Japan, but fell 27.0% at their worst in Spain and 32.5% in Greece (Chart II-17, bottom panel). Moreover, the Rajoy reforms in Spain and the Macron reforms in France show that outside of Italy, European governments have been reforming their economies faster than Japan did after the bubble burst in 1990. Chart II-17Bigger Labor Market Purge In Europe Than Japan Bigger Labor Market Purge In Europe Than Japan Bigger Labor Market Purge In Europe Than Japan However, on three fronts Europe is faring worse than Japan. First, up until the last 10 years, Japan benefited from a robust global economy where trade grew strongly. Europe is entering its second decade of low growth in an environment where global economic activity is much weaker, as potential U.S. GDP growth has slowed and China is not growing at a double-digit pace anymore. Moreover, budding protectionism in the U.S. is creating another hurdle for European economic output. Second, the excess capital stock in the European periphery is in fact greater than was the case in Japan in 1990. This suggests that the periphery needs to curtail investments by a greater margin than Japan did. Consequently, peripheral growth will continue to exert downward pressure on aggregate European activity for an extended period. Third, the European fiscal response will not match Japan’s. Investors often decry Japan’s large government debt of 238.2% of GDP as a sign of profligacy. It is not. It is mainly a mirror image of the private sector’s savings surplus. The Japanese government’s ability to run large deficits has prevented a larger fall in output – one that would have equaled the annual savings of the private sector. Without the government’s dissaving, the Japanese private sector would have found its debt load even more onerous to service, and the need to curtail spending would have been even greater as economy-wide cash flows would have been even smaller. Europe does not have a unified fiscal authority that can run such large-scale deficits. Instead, each nation’s government has a limited capacity to accumulate debt as investors worry that overly-indebted governments may very well redenominate what they have borrowed in much weaker currencies than the euro. This risk is made even greater by the fact that there is no euro-area wide deposit insurance scheme. Since Italian and Spanish banks hold large amounts of BTPs and Bonos, respectively, a so-called doom-loop exists that links the health of banks in those countries to the health of their governments, further limiting the public sector’s ability to act as a spender of last resort. This makes the efforts of the private sector in Italy, France, and Spain to increase its savings and bring down its excess capital stock more difficult, and thus, likely to last longer. Even if 10 years after the crisis first emerged, Europe has done more to purge its economy from its pre-crisis excesses than Japan had after its first lost decade, a lack of unified fiscal lever in Europe nullifies this positive. Thus, so long as the European integration efforts remain on the backburner, euro area growth, inflation, and interest rates will continue to look more like Japan’s have over the past 30 years than the U.S. This is likely to cause a big problem once the next recession emerges. Europe will enter that slowdown without any ammunition to reflate growth. Therefore, the next recession is likely to prove very deflationary and test the recent improvement in support for the euro seen across all euro area nations (Chart II-18). If the euro area survives this crisis, and we suspect it will, the probability of a fiscal union will only grow.2 After all, it has been through various crises that Europe has moved closer together, and the rise of a multipolar geopolitical environment dominated by large countries makes this imperative ever more vital. Chart II-18Support For The Euro Is Resilient Support For The Euro Is Resilient Support For The Euro Is Resilient Bottom Line: We expect European growth and inflation to continue to lag well behind the U.S. for years to come if not a full decade. Ultimately, bringing down the expensive capital stock in the European periphery will be a slow process, especially if governments remain tight fisted. Investment Implications First, core euro area interest rates are likely to remain well below U.S. levels. As long as the European private sector pares back investments in order to normalize its capital stock-to-GDP ratio - a phenomenon that will be most pronounced in the periphery and France - European growth and inflation will lag behind the U.S. This also means that as long as European governments remain shy spenders and do not compensate for the lack of spending from the private sector, in the euro area periphery, European banks will suffer from depressed net interest margins and be structural underperformers. Second, the euro is likely to experience a structural upward drift. The euro is trading at a 10.5% discount to its purchasing power parity. Moreover, high private sector savings not only weigh on inflation, they will also push Europe’s net international investment position higher via an accumulated current account surplus. Both these factors are long-term bullish for the euro. Moreover, the fact that the euro area will soon become a net creditor nation, along with a lack of room to stimulate growth via monetary easing in times of recessions, means that the euro could increasingly become a counter-cyclical currency like the yen. So long as the European integration efforts remain on the backburner, euro area growth, inflation, and interest rates will continue to look more like Japan’s have over the past 30 years than the U.S. Third, European equities are trading at a discount to U.S. equities, but we do not think this guarantees long-term outperformance. European equities are cheap because European growth prospects are poor. If Japan is any guide, European stocks may be set to continue underperforming. This is especially true as financials are over-represented in European equity benchmarks, and banks stand at the epicenter of the European economic malaise. Fourth, European stocks will remain slaves to the global business cycle. Since the crisis, European growth has become hypersensitive to global growth, making European equities very responsive to the global business cycle. The same phenomenon happened in post-1990 Japan. In other words, the beta of European stocks is likely to continue to rise. This phenomenon could be exacerbated if the euro indeed does become a counter-cyclical currency, in which case the euro and European equities would become negatively correlated, like the yen and the Nikkei. Finally, the period from 1999 to 2005 showed how ECB policy targeted at supporting Germany resulted in imbalances that boosted real estate and equity returns in the periphery – in Spain and Ireland in particular. Today, the periphery is the worst offender when it comes to poor bank health and private sector balance sheet rebuilding. This means that the ECB is likely to keep monetary conditions too accommodative for Germany, where balance sheets are more robust and where the capital stock is not as excessive. As a result, financial market plays linked to German real estate are likely to continue outperforming other European domestic plays. They therefore warrant an overweight within European portfolios. Mathieu Savary Vice President The Bank Credit Analyst III. Indicators And Reference Charts The S&P 500 is retesting its all-time high made last fall. While our indicators suggest that U.S. equity have additional upside, the violence of the rally since December argues that a period of digestion may first be needed. Our Willingness-to-Pay (WTP) indicator for the U.S. and Japan continues to improve, while for the euro area, it is flat-lining after a tentative rebound. The WTP indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. The current readings in major advanced economies thus suggest that investors are still inclined to add to their stock holdings. Our Revealed Preference Indicator (RPI) is not echoing this message. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. The pick-up in global growth remains too feeble for the RPI to validate the advance in stocks. This is why we worry that a correction is likely until economic activity around the globe confirms the rally in stocks. According to BCA’s composite valuation indicator, an amalgamation of 11 measures, the U.S. stock market remains slightly overvalued from a long-term perspective. Nonetheless, the S&P 500 is not at nosebleed valuation levels anymore. Hence, we are betting that once global growth picks up, stocks will be able to move even higher and any correction will prove temporary. Moreover, our Monetary Indicator remains into stimulative territory. The Fed has reiterated its dovish message and global central banks have all engaged in dovish talks, thus monetary conditions should stay supportive. As a result, our speculation indicator has also now fully moved out of the “speculative activity” zone. Our Composite Technical indicator for stocks had broken down in December, but it has now moved back above its 9-month moving average. This positive cyclical signal reinforces our confidence that any correction in stocks should prove tactical in nature, and that on a nine- to twelve-month basis equities have upside. According to our model, 10-year Treasurys are slightly expensive. However, we should not read too much into this. Essentially, yields are currently within their neutral range. Moreover, our technical indicator flags a similar picture. That being said, since BCA expects that over the next 24 months, the Fed will lift rates more than the OIS curve anticipates, and since the term premium is incredibly low, once green shoots for global growth fully bloom, bonds could suffer a violent selloff. Since our duration indicator has begun to deteriorate, it is probably a good time to begin moving out of safe-haven bonds. On a PPP basis, the U.S. dollar has only gotten more expensive. Additionally, our Composite Technical Indicator is becoming increasingly overbought. This combination suggests that the greenback could experience further downside this year. However, this downside will only materialize once global growth shows greater signs of strength. EQUITIES: Chart III-1U.S. Equity Indicators U.S. Equity Indicators U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation U.S. Stock Market Valuation U.S. Stock Market Valuation Chart III-6U.S. Earnings U.S. Earnings U.S. Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance   FIXED INCOME: Chart III-9U.S. Treasurys And Valuations U.S. Treasurys And Valuations U.S. Treasurys And Valuations Chart III-10Yield Curve Slopes Yield Curve Slopes Yield Curve Slopes Chart III-11Selected U.S. Bond Yields Selected U.S. Bond Yields Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets   CURRENCIES: Chart III-16U.S. Dollar And PPP U.S. Dollar And PPP U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator U.S. Dollar And Indicator U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals U.S. Dollar Fundamentals U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning   ECONOMY: Chart III-28U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot U.S. Macro Snapshot U.S. Macro Snapshot Chart III-30U.S. Growth Outlook U.S. Growth Outlook U.S. Growth Outlook Chart III-31U.S. Cyclical Spending U.S. Cyclical Spending U.S. Cyclical Spending Chart III-32U.S. Labor Market U.S. Labor Market U.S. Labor Market Chart III-33U.S. Consumption U.S. Consumption U.S. Consumption Chart III-34U.S. Housing U.S. Housing U.S. Housing Chart III-35U.S. Debt And Deleveraging U.S. Debt And Deleveraging U.S. Debt And Deleveraging   Chart III-36U.S. Financial Conditions U.S. Financial Conditions U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China   Mathieu Savary Vice President The Bank Credit Analyst Footnotes 1       Please see Global Fixed Income Strategy Weekly Report, “A Sustainable Bottom In Global Bond Yields,” dated April 9, 2019, available at gfis.bcaresearch.com 2       Please see U.S. Equity Strategy Weekly Report, “Have SPX Margins Peaked?” dated March 25, 2019, available at uses.bcaresearch.com 3       Please see U.S. Equity Strategy Weekly Report, “Mixed Signals,” dated April 22, 2019, available at uses.bcaresearch.com 4       Please see Global Asset Allocation Special Report "Euro Area Banks: Value Play Or Value Trap?" dated December 14, 2018, available at gaa.bcaresearch.com 5       The European Commission Eurobarometer Surveys show that Europeans overwhelmingly see Europe as a peace project and as a way to maintain a voice in a world dominated by huge players like the U.S., China, or Russia, a world where France, Germany, or Italy individually are marginal players. In 2016, the U.K. population did not share this opinion. Moreover, even after what amounts to a depression, the support for the euro continues to rise in Greece, showing the growing commitment of Europeans to the euro, and the resilience of this commitment to economic shocks. EQUITIES:FIXED INCOME:CURRENCIES:COMMODITIES:ECONOMY:

Highlights Portfolio Strategy Disney’s recent streaming pricing disclosure and a favorable macro backdrop for recreation PCE argue that more gains are in store for the S&P movies & entertainment index. The price of credit, credit quality and credit growth along with equity buybacks all suggest that bank profits will continue to overwhelm. Recent Changes Upgrade the S&P movies & entertainment index to overweight today. Table 1 Mixed Signals Mixed Signals   Feature Equities continued to defy gravity last week as the earnings season warmed up and did not reveal any “skeletons in the closet”. Lower interest rates single-handedly explain the recent stock market exuberance (Treasury yield shown inverted, Chart 1). In more detail, the Fed’s complete pivot has suppressed the 10-year Treasury yield and last year’s forward multiple drubbing – to the tune of a 30% drawdown – has reversed. Chart 1Lower Yield = Higher Multiple Lower Yield = Higher Multiple Lower Yield = Higher Multiple Chart 2 shows that, year-to-date, the forward multiple has done all the heavy lifting in the SPX and then some, as EPS have actually subtracted from the broad market’s return. In theory, a lower discount rate should boost the multiple and vice versa. Nevertheless, there are good odds that the 10-year Treasury yield has troughed, and BCA’s fixed income strategists continue to expect a selloff in the bond market for the rest of the year. The implication is that equities are becoming fully priced and if profits fail to pick up the baton from the multiple expansion phase, the risk/reward tradeoff is to the downside on a tactical horizon. Meanwhile, there are a number of indicators we track that are still firing warning shots for the overall equity market. Margin debt has stalled and remains 13% below the all-time peak hit last year. Historically, this has been a coincident equity market indicator and a lack of confirmation is troublesome for the overall equity market (bottom panel, Chart 3). Chart 2SPX Return Explained SPX Return Explained SPX Return Explained Chart 3M&A Lull... M&A Lull... M&A Lull... M&A activity has taken a step back, with the total number of deals down 25% from the 2018 zenith (top panel, Chart 3). Similar to margin debt uptake, this is a coincident indicator and the latest weak reading is cause for concern, as it signals that animal spirits are low. With regard to frail sentiment, CEO confidence has taken a beating of late on all fronts. The most recent Business Roundtable and Conference Board CEO surveys reveal that chief executives are a worried bunch. Their views on the overall economic outlook, all industries (including services manufacturing, durable and non-durable), capital outlays, employment, and revenues all remain downbeat, and likely explain the recent M&A lull (Chart 4). On the profit front, last year’s once in a lifetime equity retirement will not repeat this year, warning that artificial EPS growth will weigh on overall profit growth in 2019. Beyond this grim reading on “soft data”, select financial market leading indicators are also not corroborating the euphoric equity market. J.P. Morgan’s EM FX index has petered out recently and both EM and Chinese investable stocks (in U.S. dollar terms) remain well below their early-2018 peaks. Similarly, China-levered U.S. semi equipment stocks are a far cry from their cyclical highs set last year and suggest that some caution is still warranted in the broad equity market (Chart 5). Chart 4...Drop In CEO Confidence... ...Drop In CEO Confidence... ...Drop In CEO Confidence... Chart 5...And Financial Indicators Still Flashing Red ...And Financial Indicators Still Flashing Red ...And Financial Indicators Still Flashing Red Finally, on the profit front, last year’s once in a lifetime equity retirement will not repeat this year, warning that artificial EPS growth will weigh on overall profit growth in 2019. In addition, Charts 6A & 6B show that buybacks are already concentrated in a few sectors. Our sense is that this concentration theme will continue this year and likely center around financials as banks will flex their equity retirement muscle. Chart 6 Chart 6   This week we delve deeper into banks and upgrade a communication services subsector. “A Kind Of Magic” Factors have fallen into place to boost the recently rejigged S&P movies & entertainment index to an above benchmark allocation today. DIS and NFLX dominate this index now comprising roughly 97% of the market cap weight and VIAb is merely the third wheel. The dust has settled from the global media industry M&A frenzy of the past two years, but the push to the cloud via online streaming services suggests that it is only a temporary break. We would not rule out another round of inter- and intra-industry M&A, as content is king once again (Chart 7). Chart 7Rejigged Rejigged Rejigged Recent pricing news of Disney’s streaming service, expected later this year, sent reverberations across the media space as Disney priced it at such a low point in order to grab market share and likely pave the way for future price hikes. While streaming services have been mushrooming, there is space for a number of competitors, signaling that Netflix’s global streaming domination will not come crumbling down all of a sudden. While the index’s 12-month forward EPS took a hit with the NFLX addition in October, 2018 and the forward P/E jumped to the historical mean, this niche communication services subgroup is now clearly a growth index and will continue to command a premium valuation to the broad market (bottom panel, Chart 8). From a macro perspective there are also compelling reasons to warm up to the S&P movies & entertainment index. Consumer confidence remains glued to multi-decade highs and there are high odds that the big gulf that has opened up between confidence and relative share prices will narrow via a rise in the latter (top panel, Chart 8). Moreover, a vibrant labor market with payrolls expanding at a healthy clip (top panel, Chart 9), the unemployment rate and unemployment insurance claims at generational lows, all signal that consumers will keep their purse strings loose, especially given rising wages (third panel, Chart 9). Chart 8Positive Macro... Positive Macro... Positive Macro... Chart 9...Drivers... ...Drivers... ...Drivers... Tack on the confidence consumers have in residential real estate with house prices expanding both on a year-over-year and on a shorter-term basis (second panel, Chart 9), and the ingredients are in place for an increase in consumer recreation outlays. Disney’s streaming pricing disclosure, a favorable macro backdrop on recreation PCE and sell-side analyst extreme profit pessimism argue that more gains are in store for the S&P movies & entertainment index. Lift to overweight today. One final macro variable that is also on the side of the S&P movies & entertainment index is the ISM non-manufacturing index. Historically, real outlays on recreation activities has moved in lockstep with the ISM services survey and the current message is positive for PCE on recreation (bottom panel, Chart 9). More dollars spent on recreation is synonymous with a margin expansion in the S&P movies & entertainment index (third panel, Chart 8). This consumer spending backdrop is also conducive to a rise in relative profitability, the opposite of what the sell-side currently expects (middle panel, Chart 10). Chart 10...But Analysts Are Not Buying It ...But Analysts Are Not Buying It ...But Analysts Are Not Buying It Not only are industry EPS slated to trail the SPX by 300bps in the coming year, but also analysts have been vigorously downgrading their EPS estimates weighing on the sector’s net earnings revisions ratio (bottom panel, Chart 10). This is contrarily positive and we would lean against such analyst pessimism. Netting it all out, Disney’s streaming pricing disclosure, a favorable macro backdrop for recreation PCE and sell-side analyst extreme profit pessimism argue that more gains are in store for the S&P movies & entertainment index. Bottom Line: Lift the S&P movies & entertainment index to overweight today. The ticker symbols for the stocks in this index are: BLBG: S5MOVI – DIS, NFLX, VIAb. Bank Update: Primed For A Re-rating By the end of last week most banks reported profits that exceeded expectations and investors breathed a sigh of relief, despite the early-December yield curve inversion and the more recent broadening of the inversion from the 5/3 all the way out to the 10/fed funds rate slope. What partially explains the sector’s EPS resilience is net interest margins (NIMs) that just entered their fifth straight year of widening. While this may seem counterintuitive given the inverted/flattening yield curve, banks are repressing depositors by not passing on higher interest rates on deposits, thus guaranteeing extremely cheap funding. The bottom panel of Chart 11 shows that the 2-year Treasury yield/1-year CD rate slope is steep and it has historically moved in lockstep with bank NIMs. As a reminder, BCA’s bond strategists expect a selloff in the bond market and remain short duration, signaling that bank NIMs will not suffer a setback for the remainder of the year. Beyond the prospects for a further increase in the price of credit, another key source of bank EPS support is equity retirement. Citi explicitly mentioned it this earnings season, and the S&P financials sector buybacks, largely driven by banks, corroborate this anecdote (Chart 12). Chart 11Deciphering Bank Profit Resilience Deciphering Bank Profit Resilience Deciphering Bank Profit Resilience Chart 12New Buyback Kings New Buyback Kings New Buyback Kings In fact, there is a wide gap between this artificial EPS lift and relative share prices that will likely narrow in the coming months via a catch up phase in the latter, particularly if banks pass the Fed’s stringent stress test anew as we expect later this summer. On the credit quality front, bank NPLs remain anchored near cycle lows and tight labor markets suggest that a flare up in delinquencies is a low probability event in the coming year, especially given BCA’s view of no recession (bottom panel, Chart 13). Chargeoffs and souring loans are almost non-existent in all the categories that the Federal Reserve tracks, with the slight exception of credit card loans that are ticking higher, but from an extremely low base (we provide more details below in the risk section, second & third panels, Chart 13). Finally, loan growth has held up very well despite the stock market collapse in Q4/2018 and the massive tightening in financial conditions. While our overall loans & leases and C&I loan models are decelerating, they remain squarely in expansion mode and should continue to underpin bank profitability (second and bottom panel, Chart 14). Chart 13Pristine Credit Quality Pristine Credit Quality Pristine Credit Quality Chart 14Credit Growth Rests On A Solid Foundation  Credit Growth Rests On A Solid Foundation  Credit Growth Rests On A Solid Foundation  Consumer confidence remains sky-high and house prices are also rising at a healthy pace, signaling that mortgage (top panel, Chart 11) and consumer loan origination will remain upbeat (third panel, Chart 14). The price of credit, credit quality, credit growth along with buybacks all suggest that bank profits will continue to overwhelm. Stay overweight the S&P banks index. All of this positive news is already reflected in banks’ return on equity that vaulted higher recently signaling that a re-rating in still-extremely depressed valuations is looming in the coming quarters (Chart 15). Nevertheless, there are two risks to our sanguine S&P banks view that we are closely monitoring. First, our Economic Impulse Indicator remains near the zero line and, coupled with the still downbeat Citi Economic Surprise Index, warn that demand for loans may start softening at the margin (top panel, Chart 16). Chart 15Follow The ROE Follow The ROE Follow The ROE Chart 16Two Risks To Monitor Two Risks To Monitor Two Risks To Monitor Second, while the top 100 largest commercial banks are not showing a deterioration on the credit card delinquency front, the rest of the banks are waving a red flag as delinquencies are already at recessionary levels. This explains why the overall credit card delinquency rate is ticking higher (bottom panel, Chart 16). Netting it all out, the price of credit, credit quality, credit growth along with buybacks all suggest that bank profits will continue to overwhelm. Bottom Line: Stay overweight the S&P banks index. The ticker symbols for the stocks in this index are: BLBG: S5BANKX – JPM, BAC, WFC, C, USB, PNC, BBT, STI, MTB, FITB, FRC, KEY, CFG, RF, HBAN, SIVB, CMA, ZION, PBCT.   Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com   Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Highlights In China, “helicopter” money and the socialist put are positive for growth in the medium term but will prove harmful for the economy over the long run. In the socialist put scenario, a buy-and-hold strategy is inappropriate for Chinese stocks. The enormous amount of money supply in China is “the sword of Damocles” on the yuan’s exchange rate. A new equity trade: Short Chinese banks / long U.S. banks. Take profits on our short Chinese property developers / long U.S. homebuilders equity position. Feature Last week’s China credit and money data affirmed that Chinese banks have engaged in another round of massive credit and money injection into the economy. In the first quarter alone, aggregate credit rose by RMB 8.5 trillion (US$1.3 trillion). Aggregate credit growth accelerated to 11.6%, well above first-quarter nominal GDP growth of 8% (Chart I-1). This is in spite of numerous pledges by many of China’s top policymakers that they have no plans to resort to “floodgate irrigation” style stimulus, and that credit/money growth will be kept on par with nominal GDP growth. Our credit and fiscal spending impulse has spiked up, pointing to a potential improvement in economic data in the months ahead (Chart I-2). Chart I-1China: No Deleveraging At All China: No Deleveraging At All China: No Deleveraging At All What’s more, there is anecdotal evidence of a revival of housing demand in March, and that property developers have once again commenced bidding up land prices in certain parts of the country. Chart I-2China: Leading Economic Indicators China: Leading Economic Indicators China: Leading Economic Indicators   Regarding investment strategy, two weeks ago we put a stop-buy limit on the MSCI EM stock index at 1125. If this index breaks above this level we will turn tactically positive on EM risk assets. There is anecdotal evidence of a revival of housing demand in March, and that property developers have once again commenced bidding up land prices in certain parts of the country. Below are the pros and cons of upgrading the EM outlook at the current juncture. Pros The credit impulse in China leads both the mainland’s business cycle and the global manufacturing cycle by an average of nine months. Given its bottom was in December 2018, the trough in the mainland business and global industrial cycles should have been around August 2019 (Chart I-3). Chart I-3Global Manufacturing PMI Has Not Led Global Stocks Global Manufacturing PMI Has Not Led Global Stocks Global Manufacturing PMI Has Not Led Global Stocks Our assessment has been that the bottom in EM equities that occurred in late December 2018 was too early. Our basis has been that the Chinese and global manufacturing cycles were not likely to bottom before August 2019, according to their previous relationship with China’s credit and fiscal spending impulse. Consequently, we have been expecting China-related plays in financial markets to experience a setback before a more sustainable buying opportunity emerged. However, as China’s credit recovery is now gaining momentum and infrastructure spending financed by local government special bonds is accelerating, the window of downside risk for share prices is narrowing. There have been no recent major stimulus measures directed at China’s property market, but it appears banks have substantially boosted mortgage loan origination and their financing of property developers by loosening lending standards. Easy financing for both homebuyers and property developers makes a revival in real estate more likely. The property market and construction activity are critical to the mainland’s business cycle. If green shoots in the property market multiply, the odds of an overall growth recovery will rise substantially. Finally, if the EM equity index breaks above our stop-buy limit, it would clear an important technical resistance level, confirming the sustainability of this rally (Chart I-4). Cons EM corporate profit growth is contracting in U.S. dollar terms, and the pace of contraction will deepen into the end of this year. This assessment is based on the previous decline in China’s credit impulse. The latter suggests a bottom in EM EPS in December 2019 (Chart I-5). It is still unclear whether EM share prices can ignore this profit contraction and advance through the entire year without major bumps. Chart I-4EM Stocks Are Facing Technical Resistance EM Stocks Are Facing Technical Resistance EM Stocks Are Facing Technical Resistance Chart I-5EM Profits Will Continue Contracting EM Profits Will Continue Contracting EM Profits Will Continue Contracting   As of March, Chinese domestic smartphone sales (Chart I-6), as well as Korean, Japanese, Singaporean and Taiwanese exports to the mainland, are all still shrinking at double-digit rates from a year ago (Chart I-7). Chart I-6China: Consumer Spending In March Was Still Weak China: Consumer Spending In March Was Still Weak China: Consumer Spending In March Was Still Weak Chart I-7Exports To China Contracted At A Double-Digit Rate In March Exports To China Contracted At A Double-Digit Rate In March Exports To China Contracted At A Double-Digit Rate In March   Our indicators for marginal propensity to consume for Chinese households and companies remain in a downtrend as of March (Chart I-8). An upturn in these indicators is needed to validate that the fiscal and credit stimulus is accompanied by a greater multiplier effect. Chart I-8China: Marginal Propensity To Spend By Consumers And Enterprises China: Marginal Propensity To Spend By Consumers And Enterprises China: Marginal Propensity To Spend By Consumers And Enterprises Chart I-9Low Vol Precedes A ##br##Regime Shift Low Vol Precedes A Regime Shift Low Vol Precedes A Regime Shift Finally, financial markets’ aggregate volatility is extremely low (Chart I-9). This is especially true for the currency markets (Chart I-10, top panel). Typically, this is a sign of both complacency and a forthcoming major regime shift in financial markets. Chart I-10The Dollar Is Poised To Break Out Or Break Down The Dollar Is Poised To Break Out Or Break Down The Dollar Is Poised To Break Out Or Break Down We would be much more comfortable upgrading the EM outlook if the broad trade-weighted U.S. dollar broke down, corroborating the improvement in global/EM growth. So far, the greenback has been moving sideways along its 200-day moving average (Chart I-10, bottom panel). If the dollar breaks out, it would confirm the negative outlook for EM. Investors should closely watch foreign exchange markets and adjust their investment strategy accordingly. “Helicopter” Money Forever = A Socialist Put China’s forthcoming recovery is good news for financial markets. Nonetheless, the long-term outlook for the Chinese economy is deteriorating because the credit and money, as well as property bubbles, will keep expanding. First, China holds the world record with respect to corporate sector leverage (Chart I-11). Second, households in China are more leveraged than those in the U.S. (Chart I-12). Given that borrowing costs for households are higher in China than in the U.S., interest payments take up a larger share of Chinese households’ disposable income. Chart I-11Corporate Sector Leverage: China Holds The World Record Corporate Sector Leverage: China Holds The World Record Corporate Sector Leverage: China Holds The World Record Chart I-12Chinese Households Are More Leveraged Than Americans Chinese Households Are More Leveraged Than Americans Chinese Households Are More Leveraged Than Americans   Third, contrary to popular belief, banks do not channel savings/deposits into credit. They create deposits/money supply when they lend to or buy assets from non-banks. Money supply is the sum of deposits and cash in circulation. Financial markets’ aggregate volatility is extremely low. This is especially true for the currency markets. In a nutshell, credit and money excesses in China are not natural outcomes of the nation’s high savings rate but are the result of reckless credit origination by China’s commercial banks. We have elaborated on this point in a series of reports we have written on credit, money and savings.1 When commercial banks originate a loan, they create new money and new purchasing power “out of thin air.” Nobody needs to save for a bank to make a loan or buy assets. Consequently, new purchasing power for goods and services boosts demand in the real economy and inflates asset prices. Chinese banks have literally been dropping “helicopter” money over the past 10 years. Since January 2009 – the onset of the country’s massive credit binge – banks have created 165 trillion yuan ($25 trillion) of new broad money, based on our measure of M3 broad money. This is triple of the $8.3 trillion broad money supply created in the U.S., the euro area and Japan combined during the same period (Chart I-13, top panel). Chart I-13Helicopter Money In China Helicopter Money In China Helicopter Money In China China’s broad (M3) money supply now stands at 220 trillion yuan, equivalent to $32.5 trillion. What’s astonishing is that Chinese broad money is larger than the sum of broad money in both the U.S. and the euro area (i.e. all outstanding U.S. dollars and euros in the world combined) (Chart I-13, bottom panel). Yet China’s nominal GDP is only 38% of U.S. and euro area’s GDP combined. Credit and money excesses in China are not natural outcomes of the nation’s high savings rate but are the result of reckless credit origination by China’s commercial banks. In a market-based economy, the constraints on banks doing “helicopter” money are bank shareholders, regulators and central banks. Bank shareholders are the primary and largest losers from credit booms because they are highly exposed to non-performing loans. That is why they should be the first to cut credit flows to the economy when they sense non-payments on loans could rise. In China, neither bank shareholders nor bank regulators or the People’s Bank of China have prevented banks from expanding credit/money. Moreover, the authorities have not forced banks to acknowledge non-performing loans. This scenario – whereby banks expand credit without taking responsibility for collecting the loans – only occurs in a socialist system. This is the ultimate socialist put. China’s Potential Growth Roadmaps We have been arguing for several years that China is facing a historic choice between: (1) Moving toward a more market-based economic system that entails making creditors and borrowers take responsibility for their lending/borrowing and investment decisions. If lenders and borrowers are made explicitly accountable for their business/financial decisions, then credit flows will decelerate considerably, bankruptcies will mushroom and a period of deleveraging will be inevitable. However, the quality of capital allocation will improve, enhancing the country’s productivity and potential growth in the long run (Chart I-14). Chart I-14 This is a scenario of medium-term pain, long-term gain. The recent ramp-up in credit growth does not suggest the authorities are willing to embrace this option. Chart I-15China: Structural Growth Tailwinds Have Dissipated China: Structural Growth Tailwinds Have Dissipated China: Structural Growth Tailwinds Have Dissipated (2) “Helicopter money” and a socialist put scenario entails lower potential GDP growth and rising inflation. If China continues opting to keep the socialist put in place, its potential growth rate – which is equivalent to the sum of growth rates in productivity and the labor force – will drop significantly. In the long run, this socialist put discourages innovation and breeds capital misallocation, reducing productivity growth. In fact, the industrialization ratio is 85% – not 60% as many contend(Chart I-15, top panel). Further, China’s labor force growth has stalled and will be mildly negative in the years to come (Chart I-15, bottom panel). Together, these circumstances point to a slower potential growth rate. Meanwhile, recurring stimulus via “helicopter” money will create mini-cycles around a falling potential growth rate (Chart I-16). Below we discuss the investment strategy this scenario entails. Chart I-16 Implications Of The Socialist Put For The Currency… Slowing productivity and rampant money/purchasing power creation ultimately lead to rising inflation. Higher inflation and low interest rates - required to sustain an ever-rising debt burden - are a recipe for currency depreciation. Chinese households and businesses are eager to diversify their copious and mushrooming renminbi deposits into foreign currencies and assets. The PBoC’s foreign exchange reserves of $3 trillion are equal to only 10% of the amount of yuan deposits and cash in circulation. Foreign exchange reserves’ coverage of local currency money supply is much higher in many other EM countries, including Brazil and Russia (Chart I-17). Chart I-17China's FX Reserves Cover Less Local Currency Deposits Than Peers China's FX Reserves Cover Less Local Currency Deposits Than Peers China's FX Reserves Cover Less Local Currency Deposits Than Peers The enormous amount of money supply/deposits in China is “the sword of Damocles” on the yuan’s exchange rate in the long run. It is therefore inconceivable that China can fully open its capital account in the foreseeable future. On the contrary, capital account restrictions will be further tightened. Plus, the current account will become much more regulated so that there is no leakage of capital via trade transactions – such as over-invoicing of imports or under-invoicing of exports. The inability to repatriate capital when needed and structural RMB depreciation are the key risks to long-term investors in China’s onshore capital markets. …And Chinese Stocks In the socialist put scenario, a buy-and-hold strategy is inappropriate for Chinese stocks: Investors should attempt to play the resultant mini-cycles (Chart I-16). In reality, however, economic and especially financial market mini-cycles are not symmetric, and investors can make money only if they time them properly. In fact, this decade Chinese share prices – both in absolute terms and relative to global stocks – have experience wild swings (Chart I-18). Chart I-18Chinese Stocks Are Following Mini-Cycles Chinese Stocks Are Following Mini-Cycles Chinese Stocks Are Following Mini-Cycles Concerning the current outlook for Chinese investable stocks, our take is as follows: On absolute performance, we will turn positive on Chinese share prices if our stop-buy on EM equities is triggered, as per our discussion above. As for their relative performance within EM and global equity portfolios, simply because the stimulus originates in China does not warrant an overweight position in Chinese stocks. The primary losers from credit bubbles are banks and other financial companies. The basis is that they will carry the burden of potential rising non-performing loans unless the government bails them out by purchasing bad assets at par. The latter has not been the case so far this decade. Hence, an underweight position in Chinese banks/financials is currently warranted. Furthermore, the large debtors in the non-financial corporate sector should also be underweighted. When a company increases its debt but its new investments produce little net new cash flow, its equity value declines. It is difficult to find so many high-return investment projects, especially in a slowing economy. Therefore, another round of considerable capital misallocation is currently underway, and shareholders of the companies that are undertaking these investments will end up losing. In a socialist system, shareholders typically do not make money. They lose money. This is the rationale to underweight Chinese stocks within both EM and global equity portfolios. Yet, there is a caveat: This framework may not be pertinent to the two largest companies in the Chinese investable equity index Ali-Baba and Tencent - each of which accounts for 13% of the index. These two companies score well on the above issues but face different non-macro hazards including regulatory, business model and other risks. Weighing the pros and cons, we recommend maintaining a market weight allocation in Chinese equities within an EM equity portfolio. This is the view of BCA’s Emerging Markets Strategy team, which differs from the recommendations of other BCA services that are currently advocating an overweight position in Chinese stocks within a global equity portfolio. A New Trade: Short Chinese Bank / Long U.S. Bank Stocks Chinese banks’ equity value will erode as they once again expand their balance sheets aggressively, as per our discussion above. Chinese banks’ EPS have been and will continue to be diluted by the need to raise more capital. U.S. banks are better capitalized, and their asset quality is much better. Since the 2007-08 credit crisis, they have been much more prudent in expanding their balance sheets. U.S. bank stocks have underperformed the S&P 500 index since August 2018 because of falling U.S. interest rate expectations. The odds are high that U.S. bond yields are bottoming and will rise considerably – because the drag from China’s slowdown on the global economy is diminishing. This will help U.S. bank stocks. Although Chinese bank stocks optically appear undervalued, they are “cheap” for a reason. The fact that they have been “cheap” since 2011 and have failed to re-rate confirms that they suffer from chronic problems that have not been addressed yet (Chart I-19). Finally, their relative performance is facing a major resistance level, and will likely relapse (Chart I-20). Chart I-19Chinese Banks Are Cheap##br## For A Reason Chinese Banks Are Cheap For A Reason Chinese Banks Are Cheap For A Reason Chart I-20A New Trade: Short Chinese Banks / Long U.S. Banks A New Trade: Short Chinese Banks / Long U.S. Banks A New Trade: Short Chinese Banks / Long U.S. Banks   Take Profits On Short Chinese Property Developers / Long U.S. Homebuilders Position “Helicopter” money might be temporary positive for mainland property developers. In the meantime, share prices of U.S. homebuilders will be hurt due to rising U.S. bond yields. We are closing this position to protect profits. This recommendation has produced a 90% gain since its initiation on March 6, 2012. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes 1      Please see Emerging Markets Strategy Special Report "Misconceptions About China's Credit Excesses," dated October 26, 2016 and Emerging Markets Strategy Special Report "The True Meaning Of China's Great 'Savings' Wall," dated December 20, 2017, available at ems.bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Overweight This week and last have witnessed the cavalcade of U.S. banks reporting earnings. A headwind in this earnings season has been the transitory impacts of volatility, which was suppressed in Q1, on fixed income and equity trading earnings that have torqued earnings up and down. While each firm has its own idiosyncrasies and exposure to trading gains or losses, a common theme has been the expansion of net interest margins (NIMs), the measure of profit from the core lending activity, despite the 10-year yield falling throughout the first quarter. In fact, this theme is not new as NIMs have been expanding since bottoming in early-2015, regardless of the ebbs and flows of rates. One key reason for wide NIMs is that banks have not been passing higher rates on to the consumer, despite the Fed’s tightening cycle, thus cementing cheap deposit funding. In the past, NIMs have been reliable indicators of banks’ relative performance but the GFC changed that. The radioactive nature of the sector post-GFC meant that banks did not respond to the recovery of NIMs to pre-crisis levels. However, times have changed; U.S. banks are exceptionally well capitalized and the current divergence between resilient and rising NIMs and flat bank relative performance has opened an exceptional buying opportunity. Bottom Line: Stay overweight banks (and remove the downgrade alert) and stay tuned for our April 22nd Weekly Report where we will be offering a more fulsome update on the sector. Net Interest Margins Are Exceptionally Resilient Net Interest Margins Are Exceptionally Resilient

Highlights For the Eurostoxx50 to outperform the S&P500, the big euro area banks have to outperform the big U.S. tech stocks. Tactically overweight Eurostoxx50 versus S&P500 as well as other pro-cyclical positions such as overweight EM versus DM… …but prepare to take profits in the summer months. In the medium term, the euro area versus U.S. long-bond yield spread has plenty of scope to compress from its current -180 bps… …and EUR/USD has the scope to head higher. Feature Without a shadow of a doubt, the chart that causes the greatest stir among our clients is the Chart of the Week. It shows that one of the biggest investment decisions, the choice between the euro area and U.S. equity markets, reduces to the choice between the three large euro area banks – Santander, BNP Paribas, and ING – and the three U.S. tech behemoths – Apple, Microsoft, and Google.  Chart of the WeekEurostoxx50 Vs. S&P500 Is Just 3 Banks Vs. 3 Tech Stocks! Eurostoxx50 Vs. S&P500 Is Just 3 Banks Vs. 3 Tech Stocks! Eurostoxx50 Vs. S&P500 Is Just 3 Banks Vs. 3 Tech Stocks! Clients are simultaneously amazed and unsettled by this manifestation of the Pareto Principle, which states that the vast majority of an effect is explained by a tiny minority of causes. Financials feature large in the Eurostoxx50 while tech giants dominate the S&P500. But the amazing thing is that almost all of the relative performance can be explained by just three stocks in each market. The vast majority of an effect is explained by a tiny minority of causes.  The chart creates a cognitive dissonance. What about the things that are supposed to matter for stock market selection: relative economic growth, profits growth, margins, valuations and geopolitics? The answer is that all of these are interesting areas of study, but they are mere details in the big picture. For the Eurostoxx50 to outperform the S&P500, the big euro area banks have to outperform the big U.S. tech stocks (Chart I-2). Period.  Chart 2For The Eurostoxx50 To Outperform The S&P500, Euro Area Banks Have To Outperform U.S. Tech For The Eurostoxx50 To Outperform The S&P500, Euro Area Banks Have To Outperform U.S. Tech For The Eurostoxx50 To Outperform The S&P500, Euro Area Banks Have To Outperform U.S. Tech Our view is that in the immediate future this is certainly possible, but that over the long haul it will prove to be a very tall order. When The Mean Is Meaningless The structural performances of vastly different equity sectors can diverge for a very long time. How long? Japanese banks have underperformed U.S. tech for thirty years and counting! In this situation, mean-reversion and ‘standard deviations’ from the mean become meaningless concepts (Chart I-3). Chart I-3Japanese Banks Have Underperformed U.S. Tech For Thirty Years And Counting! Japanese Banks Have Underperformed U.S. Tech For Thirty Years And Counting! Japanese Banks Have Underperformed U.S. Tech For Thirty Years And Counting! The statistical concept of a standard deviation is only meaningful if the underlying data is stationary, which is to say mean-reverting. If it isn’t, then it is impossible to say that a sector price or valuation is stretched either versus another sector, or versus its own history.  One problem is that sector performances and valuations undergo phase-shifts when they enter a different economic climate. The structural outlook for bank profits experiences a phase-shift when a debt super-cycle ends. Therefore, comparing a bank valuation after a debt super-cycle with the valuation during a debt super-cycle is as meaningless as comparing your height as an adult to your height when you were a child! Sector performances and valuations undergo phase-shifts when they enter a different economic climate. To which, a frequent riposte is: within the same sector, euro area companies appear cheaper than their counterparts elsewhere in the world. But again, this apparent value is deceptive because it is simply an adjustment for the so-called ‘currency translation effect’ and the anticipated long-term moves in exchange rates. If investors anticipate the euro ultimately to strengthen – because they see that it is trading well below purchasing power parity – then a multinational company listed on a euro area bourse will suffer a future headwind to its mixed-currency denominated profits when they are translated back to a stronger euro. To discount this anticipated headwind, the euro area multinational must trade cheaper compared with a peer in, say, the U.S. But the cheapness is a false impression. Pulling together these complexities of sector effects, phase-shifts in sector valuations and currency effects, making the big call between Europe and America on the basis of performance or valuation mean-reversion is dangerous. Instead, we come back to the basic question: should you tilt towards euro area financials or towards U.S. tech? Own Banks For The Short Term Only Japanese financial sector profits peaked in 1990 and stand at less than half that level today. Euro area financial sector profits peaked in 2007, and are tracking the Japanese experience with a 17-year lag. If euro area financial profits continue to follow in Japan’s footsteps, expect no sustained growth through the next 17 years (Chart I-4). Chart I-4Euro Area Financial Profits Are Following Japanese Footsteps Euro Area Financial Profits Are Following Japanese Footsteps Euro Area Financial Profits Are Following Japanese Footsteps In a post credit boom era, banks lose the lifeblood of their business: credit creation. This loss becomes a multi-decade headwind to financial sector profit growth and share price performance. Bank profits are dependent on two other drivers. One is operational leverage – the amount of equity held against the balance sheet. More stringent European regulation is making this a headwind too. Banks have to hold more equity capital against assets, diluting their profitability. The other driver is the net interest margin – the difference between rates received on loans and rates paid on deposits. In this regard, both fintech and the blockchain are likely to create a further headwind to bank profitability. Japan’s experience suggests that euro area financials will struggle to outperform structurally. Admittedly, U.S. tech may also face its own headwinds or phase-shift, most obviously antitrust lawsuits to counter its near-monopoly status. But even allowing for this, Japan’s experience suggests that euro area financials will struggle to outperform structurally. Rather, financials is a sector to play for outperformance phases lasting no more than a few quarters. Last autumn, we noted that short-term credit impulses in the major economies were flipping from a sharp down-oscillation into an up-oscillation phase (Chart I-5). On that basis, we recommended a tactical overweight to Eurostoxx50 versus S&P500 as well as other pro-cyclical positions such as overweight EM versus DM. Those pro-cyclical sector positions have broadly succeeded, but they are still appropriate given that up-oscillation phases very reliably last around nine months. Chart I-5Short-Term Credit Impulses Have Flipped To Up-Oscillations Short-Term Credit Impulses Have Flipped To Up-Oscillations Short-Term Credit Impulses Have Flipped To Up-Oscillations The caveat is: prepare to take profits in the summer months. The Fed Is Now At ‘Neutral’, But Where Is The ECB? Last week, the Federal Reserve confirmed that “the Federal funds rate (at 2.5 percent) is now in the broad range of estimates of neutral – the rate that tends neither to stimulate nor to restrain the economy.”  This begs the question: where is the ECB policy rate (now at 0 percent) relative to its neutral? Our very high conviction view is that the ECB policy rate is well below neutral. Financials is a sector to play for outperformance phases lasting no more than a few quarters. The twenty year life of the euro captures multiple manias and crises, some centred in Europe, some in the U.S. Through these twenty years, the euro area versus U.S. long bond yield spread has averaged -50 bps1 (Chart I-6). Over this same period, the euro area versus U.S. annual inflation differential has also averaged -50 bps (Chart I-7). Ergo, the real interest rate differential has averaged zero. Meaning, the ex-post neutral real interest rates in the euro area and the U.S. have been exactly the same. Chart I-6The Euro Area Vs. U.S. Yield Spread Has Averaged -50 Bps... The Euro Area Vs. U.S. Yield Spread Has Averaged -50 Bps... The Euro Area Vs. U.S. Yield Spread Has Averaged -50 Bps... Chart I-7...The Euro Area Vs. U.S. Inflation Spread Has Also Averaged -50 Bps ...The Euro Area Vs. U.S. Inflation Spread Has Also Averaged -50 Bps ...The Euro Area Vs. U.S. Inflation Spread Has Also Averaged -50 Bps With little difference in the neutral real rates over the past two decades, is there a valid reason to expect a difference in the future? An obvious response is the fragility of the euro area’s banking system will require the ECB to persist with its zero interest rate policy for years. In Germany and France, bank lending is healthy, and could easily weather modestly tighter monetary policy. In fact, the evidence suggests that this fear is exaggerated. In Germany and France, bank lending is healthy, and could easily weather modestly tighter monetary policy (Chart I-8). The problem has been localised in Italy, where bank lending relapsed once again in 2018. Chart I-8Bank Lending Is Healthy In Germany And France Bank Lending Is Healthy In Germany And France Bank Lending Is Healthy In Germany And France However, on closer examination this was a direct result of political tensions. Recently, Italian bank lending has been a very tight (inverse) function of the Italian bond yield. The BTP yield spiked last year when Rome escalated its budget spat with Brussels, and bank lending took a hard hit. But now that the Italian bond yield has retraced, lending should recover (Chart I-9). Chart I-9Italian Bank Lending Should Recover Now That The Bond Yield Has Come Down Italian Bank Lending Should Recover Now That The Bond Yield Has Come Down Italian Bank Lending Should Recover Now That The Bond Yield Has Come Down The central issue is can the U.S. policy rate – which is at neutral – and the ECB policy – which is below neutral – diverge much from here? Our high conviction answer is no. Therefore, in the medium term, the euro area versus U.S. long-bond yield spread has plenty of scope to compress from its current -180 bps, one way or the other (Chart I-10). Chart I-10Can Interest Rate Expectations Diverge Much From Here? Can Interest Rate Expectations Diverge Much From Here? Can Interest Rate Expectations Diverge Much From Here? It also implies that after remaining range-bound in the immediate future, EUR/USD has the scope to head higher. Dhaval Joshi, Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System This week’s recommended trade is to go long SEK/NOK, as it is close to the limit of tight liquidity that has signaled many previous technical reversals in this currency cross. Set a profit target of 1.5 percent with a symmetrical stop-loss. In other trades, the on-going rally in government bonds caused the short position in 30-year T-bonds to hit its stop-loss. This leaves us with five open positions. Long SEK/NOK. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-11 Long SEK/NOK Long SEK/NOK The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com Footnotes 1 Calculated from the over 10-year government bond yield: euro area average, weighted by sovereign issue size, less U.S. Fractal Trading System Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations