Consumer

Highlights Even as a net oil importer, China loses more than it gains when oil prices collapse. An oil price collapse generates a formidable deflationary force, which will further depress China’s industrial pricing power and profit growth in Q2. There are early signs that demand in some sectors is gaining traction in the first three weeks of April. A full removal of travel restrictions in late May in China should help speed up the return of domestic business activities. We maintain our view that China’s economic recovery will pick up momentum in H2, underpinning our cyclical overweight stance on Chinese risk assets. Feature The nosedive in oil futures last week was a rude awakening of the enormous and unpredictable impact the pandemic has on the global economy and financial markets. WTI futures for May 2020 delivery fell to -$40.40 per barrel on April 20, an unprecedented event.  The collapse in oil prices since March will generate substantial deflationary headwinds to China’s economy in the months ahead (Chart 1). Producer prices are already in contraction. An imported deflation from low oil prices will weaken industrial pricing power even more, pushing up real rates. China’s industrial profit growth also moves in lockstep with producer prices. A deepening in PPI contraction means industrial profit growth will remain underwater, underscoring our view that the near-term outlook for Chinese stocks is yet to turn sanguine (Chart 2). Chart 1Falling Oil Prices: A Substantial Deflationary Force Chart 2Deflation Weakens Industrial Profit Growth   Oil prices will likely rebound in Q3 when the global economy re-opens, oil supply cuts take hold and the US dollar peaks. Our Commodity and Energy strategist estimates that WTI spot prices will reach $38/barrel by end-2020.1 A modest recovery in oil prices alone will not be enough to lift Chinese producer prices back to positive. The substantial reflationary efforts from China’s policymakers since Q1 should start to have an impact on the real economy in H2. The exponential credit growth should effectively prop up investment and consumption growth, and reduce inventory overhang in the industrial sector. We expect industrial producer prices and profits to turn slightly positive in Q3/Q4, underpinning our constructive view on Chinese stocks in the next 6- to 12-months. Oil Price Collapse: A Bane, Not A Boon China, as a net oil importer, stands to lose more than gain in an oil price war. This is contrary to commonly held economic theory that net oil importing countries are winners from cheaper oil. In theory falling oil prices reduces import prices, improves net oil importers’ term of trade, and in turn contributes positively to their GDP growth. In reality oil prices rarely fall in isolation. A precipitous fall in oil prices is almost always triggered by a sharp decline in global demand, accompanied with a spike in the US dollar, and results in a turmoil in the global financial markets (Chart 3). Therefore, depending on where an economy is positioned in the global value chain, a net oil importer may lose even more than a net oil exporter when oil prices collapse. Chart 3Global Trade Remains Under Pressure Until Dollar Peaks Chart 4China Loses More From Falling Trade Than Gains From Falling Oil Prices At only 14% of world oil consumption, China’s demand for oil alone is not enough to support a price recovery. But as a global manufacturing powerhouse, the benefits China has gained from cheaper oil in the past cycles were often more than offset by the economic and financial shocks from an oil price collapse (Chart 4). The small positive contribution to China’s GDP growth via savings on oil import bills is further discounted by losses from China’s own oil and oil-product exports (Chart 4, middle panel). China’s oil and gas sector does not necessarily benefit from collapsing oil prices. The country’s domestic oil exploration becomes deeply unprofitable when international oil prices collapse. Falling domestic demand for finished oil products and rising competition in the industry when prices are low squeeze out any extra profits for oil refineries (Chart 5). Chart 5China’s Energy Sector Suffers Too In An Oil Bear Market Chart 6Energy Costs: A Small Part Of Chinese CPI Chart 7US Consumers Benefit Much More From An Oil Price Decline Than Chinese Consumers Furthermore, unlike the US, Chinese household consumption does not get a boost from cheaper oil. Food prices, rather than energy, drive the overall consumer price inflation in China (Chart 6). In addition, China’s domestic petrol market is heavily regulated and retail prices for energy are set by the Chinese government. China does not pass on the entire benefit of an energy price decline to its consumers, a rigid policy that has not been changed since 2016.2 As such, the current reduction in oil prices will not have the same “tax cut” benefit as it does for US consumers (Chart 7). Bottom Line: Low oil prices, accompanied by a strong dollar and depressed global trade, create a self-feeding deflationary feedback loop to China’s industrial sector, reducing the effects of the existing reflationary measures on its economy. Budding Signs Of Reflation A modest recovery in oil prices in Q3 will not be enough to return China's PPI to positive territory. Even when the global economy re-opens, the initial recovery in business activities and demand will likely be gradual, a situation China has experienced in the past two months (Chart 8). Thus, China’s domestic demand will bear most of the brunt to shore up inflation in produced goods, by propping up investment and consumption growth. We expect China’s substantial reflationary measures to start filtering into the real economy in H2. China’s industrial sector should get a boost from an acceleration in infrastructure investment and producer prices should turn moderately positive later in Q3 (Chart 9). Chart 8China’s Export Growth Set To Decline Further In Q2 Chart 9Huge Credit Wave Should Start Lifting Industrial Profits In H2 High-frequency data point to some early signs of a rebound in China’s domestic demand. The annual growth in the transaction volume of rebar steel rebounded from an 8% decline in March to 4% growth in the first three weeks in April.3 The contraction in passenger car sales also narrowed from -38% in March to -7.3% so far in April.4 China is ramping up its COVID-19 antibody testing to prevent a second-wave outbreak and is preparing for the National People’s Congress (NPC), which may take place in mid-May. Inter-provincial travel restrictions have limited the speed of recovery in business operations, but we expect such cautionary measures to be fully lifted in late May. The removal of logistic restrictions will help to accelerate a return to normal in both domestic production and demand. As we noted in our last week’s report,5 the April 17 Politburo meeting confirmed a policy shift to maximum reflation. President Xi’s new slogan, “The Six Stabilities and The Six Guarantees,” sets the tone that the government will increase investments to ensure that China’s post-pandemic economic growth is strong enough to stabilize employment. Bottom Line: Chinese business activities continue to inch up.  The recovery in domestic demand should pick up momentum in H2 to offset imported deflationary pressures on China’s industrial profits.  Investment Conclusions In the near term, a strong US dollar is a key risk to the recovery of China’s industrial profits.  The greenback not only generates downward pressure on oil prices and global trade, but also puts the RMB in a poor position of depreciating against the dollar but at the same time appreciating against China’s export competitors (Chart 10). All are creating headwinds to China’s economic recovery. We recommend that investors stay on the sidelines in the near term until the dollar peaks and oil prices rebound, probably in Q3.  However, on a cyclical time horizon, as the global economy re-opens and demands slowly recovers in H2, the flood of stimulus including China's own reflation efforts should help to restore investors’ risk appetite and lift the prices of risk assets. Although Chinese stocks have passively outperformed global stocks this year, the strong rebound in the SPX in recent weeks has made Chinese stocks slightly less overbought in relative terms (Chart 11). Chart 10A Tough Combination For The RMB Chart 11Chinese Stocks: Slightly Less Overbought In Past Weeks We expect China’s corporate profit growth to outpace global earnings growth this year, even as other economies re-open and start to recover. This warrants an overweight stance on Chinese stocks after near-term risks and market gyrations subside.   Jing Sima China Strategist jings@bcaresearch.com     Footnotes 1Please see Commodity & Energy Strategy Weekly Report "USD Strength Restrains Commodity Recovery," dated April 23, 2020, available at ces.bcaresearch.com 2The floor for retail fuel prices is set at $40 a barrel to limit losses at China’s state-owned oil companies, which generally have average production costs in the range of $40-$50 per barrel. http://english.www.gov.cn/news/top_news/2016/01/13/content_281475271410529.htm 3Based on daily data from MySteel. 4Based on weekly data from China Passenger Car Association. 5Please see China Investment Strategy Weekly Report "Three Questions Following The Coronacrisis," dated April 23, 2020, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Special Report

Highlights Since 2004, Sweden’s private sector leverage trend can be explained using a simple Taylor rule approach. The approach clearly highlights three distinct monetary policy phases, and underscores the singular role of inflation (not systemic risk from rising indebtedness) as a driving factor for Riksbank policy. Since 2015, the Riksbank has maintained interest rates well below what a Taylor rule approach would suggest, owing to the desire to raise inflation expectations and Sweden’s high trade exposure to the euro area. This highlights strong similarities between the experience of Sweden and Canada: both countries are in the orbit of a major neighboring central bank, which has created serious distortions in both economies. Given the extent of the spread of the SARS-CoV-2 virus, especially in Europe, our assessment of the Riksbank’s reaction function suggests the odds appear to be high that the repo rate will move back into negative territory at some point this year (despite their reluctance to do so). Over the near-term, Swedish policy easing suggests that investors should avoid the krona versus both the US dollar and euro. Over a medium-term time horizon, one implication of a return to negative interest rates is that Swedish house price appreciation is likely to trend higher once the economic impact of the COVID-19 pandemic ends, potentially to the benefit of Swedish consumer durable and apparel stocks. Finally, over the long-term, Sweden is very likely to face a period of domestic economic stagnation stemming from the extraordinary rise in private sector debt that has built up over the past two decades. The co-ordinated global response to the pandemic suggests that this is not the end of Sweden’s debt supercycle, but timing the transition from reflation to stagnation will be of crucial importance for investors exposed to the domestic Swedish economy over the coming few years. Feature One of the worrying legacies of the global financial crisis has been a substantial buildup in private sector debt in many economies around the world. This has most famously occurred in China, but private indebtedness is also very high in many developed economies. Among advanced countries, Sweden stands out as being particularly exposed to elevated private sector debt. Chart I-1 highlights that Sweden’s private sector debt-to-GDP ratio has ballooned to a massive 250% of GDP over the past 15 years, from a starting point of roughly average indebtedness. Chart I-1Sweden's Extremely Indebted Private Sector In this report we explore why Sweden has seen an explosion in private sector debt-to-GDP, and highlight that Sweden’s experience can be compared closely with that of Canada – both countries are in the orbit of a major neighboring central bank, which has created distortions in each economy. We also summarize what this implies for Riksbank policy, and what investment recommendations can be drawn from our analysis. We conclude that while the Riksbank is clearly reluctant to cut the repo rate after having just existed its negative interest rate position last year, it appears likely that they will forced to do so unless the negative economic impact from the COVID-19 pandemic abates very soon. Over the short-term, this suggests that investors should avoid the Swedish krona, versus either the US dollar or the euro. Why has Sweden seen such an explosion in private-sector debt? Over the medium-term, easy Riksbank policy and the probable absence of any additional macroprudential measures is likely to spur a renewed increase in Swedish house prices and household debt, which will likely benefit consumer durables and apparel stocks relative to the broad Swedish equity market.  But this will reinforce Sweden’s existing credit bubble, and similar to Canada will set the stage for domestic economic stagnation over the very long-term. Riksbank Policy and Sweden’s Private Sector Debt: A Tale Of Three Phases Much of the investor attention on Sweden's extremely high private sector debt load has occurred following the global financial crisis. But Chart I-1 clearly highlights that the process of private sector leveraging began in 2004, arguing that the Riksbank’s easy monetary policy stance following the global financial crisis is not the only cause of Sweden’s extremely elevated private debt-to-GDP ratio. In a previous Special Report for our Global Investment Strategy service,1 we investigated a similar experience in Canada and used a simple Taylor rule approach to show that the Bank of Canada’s decision to maintain interest rates below equilibrium levels for nearly two decades has contributed to a substantial buildup in private sector leverage. A similar approach for Sweden highlights similar conclusions, albeit with some complications: Chart I-2 shows our Taylor rule estimate for Sweden alongside the policy rate, and shows the deviation from the rule in the second panel. Chart I-2Since 2000, Sweden Has Had Three Distinct Monetary Policy Phases Compared with Canada’s experience, which has maintained too-low interest rates consistently for the past 20 years, Chart I-2 shows that the stance of Sweden’s monetary policy since 2000 falls into three distinct phases: Persistently easy policy from 2000 to 2008 A period of less easy and then relatively tight policy from 2009 to early-2014 A period of extremely easy policy from 2015 until today. The first phase noted above closely resembles the experience of Canada: policymakers in both countries simply kept interest rates too low during the last global economic expansion. In the second phase, the stance of monetary policy in Sweden became progressively less easy: the Taylor rule collapsed in 2009/2010, and trended lower again during the euro area sovereign debt crisis as well as its aftermath. In fact, Chart I-2 suggests that Sweden’s monetary policy stance was outrightly tight from 2012-2014, and in early-2014 the Taylor rule recommended negative policy rates while the actual policy rate was above 1%. In the third phase, the Riksbank appears to have overcompensated for the second phase of relatively less easy and eventually tight monetary policy. The Riksbank pushed policy rates into negative territory in late-2014, as had been recommended by the Taylor rule a year before, at a time when the rule was rising sharply. Roughly 2/3rds of the rise in the rule from early-2014 to late-2018 occurred due to the significant rise in Swedish inflation, with the rest due to a rise in Sweden’s output gap – which turned positive in late-2016 according to the OECD (Chart I-3). It is this third phase, featuring a massive and glaring gap between Swedish policy rates and a monetary policy rule that correctly recommended easy policy from 2010 – 2014, that has attracted global investor attention over the past few years. But Chart I-4 presents Sweden’s Taylor rule gap alongside its private sector debt-to-GDP ratio, and highlights that over 80% of the rise in the latter since 2000 actually occurred in the first phase described above – a period of persistently easy monetary policy as defined by our Taylor rule approach. The behavior of Sweden’s private sector debt-to-GDP ratio in the second and third phases also seems to validate our approach, as gearing essentially stopped during the second phase and restarted in the third phase. Chart I-3Since 2014, Sweden’s Rising Taylor Rule Has Been Driven Mostly By Inflation Chart I-4Sweden’s Monetary Policy Phases Explain Its Private Sector Leveraging The Riksbank: “Talk To Us About Inflation, Not Debt” Chart I-5During Phase 2, Households Clearly Took Advantage Of Low Mortgage Rates It is crucial to understand the motivations of Sweden’s central bank during each of these phases in order to be able to forecast the likelihood of a return to negative interest rates this year, as well as the Riksbank’s likely policy response once the COVID-19 pandemic subsides. In the first monetary policy phase that we have described, Sweden was not the only country to maintain persistently easy monetary policy. Given the relative scarcity of private sector deleveraging events in the post-war era, most policy makers, academic economists, and market participants were regrettably unconcerned about rising private sector indebtedness during this period, and only came to understand the consequences during the crisis and its aftermath. Most advanced economies leveraged during the first of Sweden’s monetary policy phases, and Sweden really only stands out as a major outlier from 2007 – 2009 when nearly 60% of the country’s total 2000-2019 private sector leveraging occurred (most of which, in turn, occurred before the collapse of Lehman Brothers in September 2008). In essence, by the time that Swedish policymakers were given a vivid and painful demonstration of the dangers of elevated private sector debt, it was too late to prevent most of the increase in debt-to-GDP that is facing the country today. In the second phase of Sweden's modern monetary policy, our Taylor rule framework highlights that the Riksbank largely acted as appropriate. One complication, however, is the difference in the leverage trend between Sweden's nonfinancial corporate and household sectors. Chart I-5 clearly highlights that Sweden's household sector took advantage of low interest rates during the country’s second monetary policy phase. Household sector leveraging began to rise again starting in late-2011, whereas it was completely absent for the corporate sector during the period. A crucial reason why the Riksbank ignored this renewed household sector leveraging is also part of the reason that it has maintained extremely low policy rates in the third phase noted above. The Riksbank’s monetary policy strategy, which is published in every monetary policy report, includes the following: “According to the Sveriges Riksbank Act, the Riksbank’s tasks also include promoting a safe and efficient payment system. Risks linked to developments in the financial markets are taken into account in the monetary decisions. With regard to preventing an unbalanced development of asset prices and indebtedness however, well-functioning regulation and effective supervision play a central role. Monetary policy only acts as a compliment to these.” In other words, the Riksbank has been very clear that preventing excessive leveraging is not its responsibility, and that the job ultimately falls to the Swedish government. But if the Taylor rule was recommending meaningfully higher interest rates during phase 3, then why did the Riksbank continue to lower interest rates into negative territory until last year? In our view, their behavior can be explained by the confluence of three factors: 1. Sweden’s deflation scare in 2014: Sweden’s underlying inflation rate had been trending lower for four years by the time that it dipped briefly into negative territory in March 2014. By this point, the Riksbank appears to have become increasingly concerned about inflation expectations rather than the trend in actual inflation. Chart I-6 presents Sweden’s underlying inflation rate and an adaptive-expectations based estimate of inflation expectations alongside the repo rate, and shows that inflection points in the repo rate match inflection points in expectations. Specifically, the repo rate continued to fall until inflation expectations stabilized in early-2016, and the Riksbank did not raise the repo rate until expectations crossed above 1.5%, a level that was reasonably close to the central bank’s 2% target. Chart I-6During Phase 3, The Riksbank Focused On Low Inflation Expectations 2. Sweden’s high trade sensitivity: Chart I-7 highlights that Sweden’s economy, like Canada and other Scandinavian countries, is highly exposed to exports to top trading partners. The euro area accounts for a large portion of Sweden’s exports, and Chart I-8 highlights that nominal euro area imports from Sweden remained very weak from 2012-2016. In addition, Sweden’s import sensitivity is also very high, with total imports of goods and services accounting for over 40% of Sweden’s GDP. By our calculations, roughly 2/3rds of Swedish imports are for domestic consumption,2 and Chart I-9 highlights how closely (inversely) correlated imported consumer and capital goods prices are to Sweden’s trade-weighted currency index. By pushing the repo rate into negative territory, the Riksbank reinforced rising inflation expectations by supporting exports and importing inflation from its trading partners via a weaker krona. Chart I-7Sweden, Like Other Small DM Countries, Are Highly Exposed To Trade Chart I-8Euro Area Demand For Swedish Goods Remained Weak For Several Years Chart I-9To 'Import' Inflation, The Riksbank Had To Weaken The Krona 3. The euro area’s persistently weak inflation and extremely easy monetary policy: While this is related to Sweden's overall trade sensitivity, the fact that the euro area had to combat persistently weak inflation with negative interest rates and asset purchases from late-2014 to late-2018 has had a particularly strong impact on Riksbank policy given the latter’s goal of boosting Swedish inflation via higher import prices. Chart I-10 highlights the strong link between the SEK-EUR exchange rate and the real interest rate differential between the two countries, and in particular shows that the Riksbank had to lower the differential into negative territory in order to bring the krona below “normal” levels (defined here as the average of the past global economic expansion). When faced with a real euro area policy rate of roughly -1.5% during the period (Chart I-11), the only way to achieve a negative real rate differential was to maintain the repo rate at an extremely low level as Swedish inflation rose. Chart I-10To Weaken The ##br##Krona... Chart I-11…Deeply Negative Real Policy Rates Were Required Where Next For The Repo Rate? In February 2019 the Riksbank was forecasting that the repo rate would return into positive territory by the end of this year, and would rise as high as 80 basis points by mid-2022. They downgraded this assessment in April, and again in October, highlighting that they expected a 0% repo rate for essentially the entire three-year forecast period. In other words, the Riksbank had been moving in a dovish direction even before the COVID-19 pandemic began. Prior to the outbreak, we would have been inclined to argue that the Riksbank’s forecast of a 0% repo rate beyond 2020 was suspect, given the budding recovery in global growth. Chart I-12 highlights that the global PMI had been improving for several months prior to the outbreak, and the Swedish PMI and consumer confidence index had recently rebounded sharply. A negative repo rate was essential to “import” inflation. But, given the extent of the spread of the SARS-CoV-2 virus, especially in Europe, and our description of the Riksbank mandate and reaction function, the odds appear to be high that the repo rate will move back into negative territory at some point this year. Besides the very negative direct impact to global trade from the pandemic, Chart I-13 highlights that Swedish inflation is now falling, and that our measure of inflation expectations has now peaked. Chart I-12Swedish Economic Momentum Was Building Prior To The Pandemic... Char I-13...But Inflation Is Falling And The Unemployment Rate Is Rising In addition, the Swedish unemployment rate has been trending higher since early-2018 (Chart I-13, second panel), in response to several factors: a shock to household wealth in late-2015/early-2016 due to sharply falling equity prices, a meaningful decline in house prices driven by newly introduced macroprudential policies, and a sharp albeit seemingly one-off decline in the contribution to Swedish economic growth from government expenditure (Chart I-14). These trends would have likely reversed at some point this year given the building economic momentum that was evident in January and early-February, but it is now clear that the pandemic will more than offset the budding improvement in economic activity. Chart I-14Swedish Policymakers Will Have To Reverse The Factors That Caused The Pre-Pandemic Slowdow Over the past week the Riksbank has announced two policies: it will provide cheap loans to the country’s banks (500 billion SEK) to bolster credit supply to Swedish small & medium-sized enterprises, and it will increase its asset purchase program by 300 billion SEK. The Riksbank is clearly reluctant to cut the repo rate after having just existed its negative interest rate position last year, and has argued that strong liquidity support and stepped up asset purchases are more likely to be effective measures in the current environment. However, Charts I-10 & I-11 underscored the link between real interest rate differentials and the currency, and the Riksbank will risk having the krona appreciate versus the euro and other currencies if inflation continues to fall and the policy rate is kept unchanged. Chart I-15 shows that market participants have already begun to price in cuts to the repo rate, and our sense is that the Riksbank will be forced to act in a way that is consistent with the market’s view. Chart I-15The Market Expects The Riksbank To Return To Negative Interest Rates. We Agree. Investment Conclusions Over a cyclical (i.e. 6-12 month) time horizon, the Swedish krona is the asset with the clearest link to our discussion of Riksbank policy, and investors should recognize that the krona call is now a binary one based on the evolution of the COVID-19 pandemic. It is one of the cheapest currencies in the G10 space, but foreign exchange markets have recently ignored fundamentals such as interest rate differentials and valuation. This is particularly true in the face of a spike in US dollar cross-currency basis swaps, which have started to send the dollar higher even against the safe haven currencies. In such an a environment, selling pressure could continue to push SEK lower, especially if the Riksbank is pushed to reduce the repo rate sooner rather than later. The SEK is one of the most procyclical currencies in the FX space, suggesting that investors should stand aside until markets stabilize (Chart I-16). Right now, the Swedish krona is the clearest play on Riksbank policy. As for the EUR/SEK cross, any renewed ECB stimulus suggests that Sweden will act accordingly to prevent the SEK from appreciating too far, too fast. EUR/SEK will top out after global growth is in an eventual upswing, and the Riskbank has eased policy further. Over the medium-term time horizon, one implication of a return to negative interest rates is that Swedish house price appreciation is likely to trend higher once the economic impact of the COVID-19 pandemic ends. House prices will likely decelerate in the near term given the shock to household wealth from falling equity prices, but we showed in Chart I-5 that Sweden’s household sector ultimately took advantage of low interest rates during Sweden’s second monetary policy phase. We expect a similar dynamic to unfold beyond the coming 6-9 months, and Chart I-17 highlights that overweighting Swedish consumer durable and apparel stocks within the overall Swedish equity market is likely the best way to eventually play a resumption of household leveraging and rising house prices. Chart I-16Avoid Krona Exposure ##br##For Now Chart I-17Swedish Consumer Durables & Apparel Stocks Linked To Domestic, Not Global, Demand With the exception of a selloff in 2013, the relative performance of the industry group has closely correlated with house price appreciation, and is now deeply oversold. The companies included the industry group earn a significant portion of their revenue from global sales, but the close correlation of relative performance with Swedish house prices and limited correlation with the global PMI suggests that domestic economic performance matter in driving returns for these stocks (Chart I-17, bottom panel). We are not yet prepared to recommend a long relative position favoring this industry group, but we are likely to view signs of policy traction and a relative performance breakout as a good entry point. Finally, the key long-term implication of our research is that Sweden will at some point likely face a period of stagnation stemming from the extraordinary rise in private sector debt that has built up over the past two decades. While regulators had begun to combat excessive debt with macroprudential measures, further measures to restrict household sector debt are extremely unlikely to occur until after another substantial reacceleration in Swedish house prices and another nontrivial rise in household sector leverage. This will be cyclically positive for Sweden coming out of the pandemic, but will ultimately make Sweden’s underlying debt problem meaningfully worse. Macroprudential control of rising nonfinancial corporate debt has not and is not likely to occur, and no regulatory control measure will be able to significantly ease the existing debt burden facing the private sector. Chart I-18 highlights that while Sweden’s private sector debt service ratio (DSR) is not the highest in the world, is it extremely elevated compared to other important DM countries such as the US, UK, Japan, and core euro area. Several other countries with higher private sector DSRs, such as Canada and Hong Kong, are also at serious risk of long-term stagnation. Chart I-18Swedish Domestic Economic Stagnation Is A 'When', Not An 'If' We have not yet identified a specific list of assets that will be negatively impacted by Swedish domestic economic stagnation over the longer term. Our European Investment Strategy service recently argued that Swedish stocks are attractive over the very long term versus Swedish bonds, based on valuations and the fact that the Swedish equity market as a whole is heavily driven by the global business cycle. We plan on revisiting the question of which equity sectors are most vulnerable to domestic stagnation in a future report, as the onset of stagnation draws nearer. As we noted in our report on Canada,3 it is difficult to identify precisely when Sweden’s high debt load will meaningfully and sustainably impact Swedish economic activity and related equity sectors. The acute shock to global activity from the COVID-19 pandemic is an obvious potential trigger, but the fact that policymakers around the world are responding forcefully to the pandemic suggests that this is not the end of Sweden’s debt supercycle. In this regard, the prospect of globally co-ordinated fiscal spending is especially significant. Our best guess is that Sweden’s true reckoning will come once US and global activity contracts for conventional reasons, instigated by tight monetary policy to control rising and above-target inflation. This may mean that Sweden will avoid a balance sheet recession for some time, but investors exposed to domestically-linked Swedish financial assets should take heed that the eventual consequences of such an event are likely to grow in magnitude the longer it takes to arrive. In short, beyond the acute nearer-term impact of the pandemic, Sweden is likely to experience short-term gain for long-term pain. The short- to medium-term focus of investors should be on the former, but with full recognition that the latter will eventually occur. Timing the transition between these two states will be of crucial importance for investors exposed to the domestic Swedish economy over the coming few years. Stay tuned!   Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com Footnotes 1 Please see Global Investment Strategy Special Report "Canada: A (Probably) Happy Moment In An Otherwise Sad Story," dated July 14, 2017, available at uses.bcaresearch.com 2 We assume that all services imports are consumed domestically. Among goods exports, we assume domestic consumption of all imports of food & live animals, beverages & tobacco, mineral fuels, lubricants, and related materials, miscellaneous manufactured articles, road vehicles, and other goods. 3 Please see Global Investment Strategy Special Report "Canada: A (Probably) Happy Moment In An Otherwise Sad Story," dated July 14, 2017, available at uses.bcaresearch.com

Highlights Financial markets have experienced two weeks of wild swings: Following the negative 5-standard-deviation weekly move in the S&P 500 two weeks ago, the index moved at least 2.8% in each of last week’s first four sessions. 10- and 30-year Treasury yields made one all-time low after another. The coronavirus has arrived in the United States: It would appear inevitable that the coronavirus is going to spread across the US; the unknowns are how long it will spread, how deadly it will be, and how much it will impact the economy. Confronted with these unknowns, markets shot first and left asking questions for later. The selling may have gone a little far. The Fed and the Democratic candidates for president were in the news last week, … : The Fed made its first intra-meeting rate cut since the financial crisis was raging, cutting the fed funds rate by 50 basis points instead of waiting for its regularly scheduled March 17-18 gathering. Super Tuesday upended the chase for the Democratic presidential nomination, as our geopolitical strategists foresaw. … and we offer our quick read on their market impact: We expect that the Fed’s rate cut will be modestly positive for markets and the economy, while Joe Biden’s move to the head of the Democratic pack greatly diminished a risk that would otherwise have troubled investors all the way to November 3rd. Feature US equities have endured a rollercoaster ride over the last two-and-a-half weeks. From its all-time intraday high of 3,393.52 on February 19th, to the February 28th intraday low of 2,855.84, the S&P 500 corrected by 15.8% in just seven sessions. The brunt of the decline occurred two weeks ago, when the index lost 11.5% in its fourth worst week in the last six decades. The decline amounted to more than a negative 5-standard-deviation event, and took its place among what we now consider to be landmark episodes in US stock market history (Table 1). Table 1Socialism + Pandemic = History (But Not The Good Kind) The epic rout followed a weekend of distressing news. First, the coronavirus (COVID-19) slipped its Asian bonds, popping up fully formed in Italy and Iran in a sobering demonstration of its global reach. Second, Bernie Sanders had seemingly solidified his grip on the Democratic presidential nomination by trouncing the rest of the crowded field in the Nevada caucuses with nearly twice the share of the vote that he captured in his Iowa and New Hampshire wins. We therefore characterize the February 28th intraday low as the coronavirus/Sanders bottom. The former is still running around freely, but the latter has been largely contained. COVID-19 will surely be with us for a while longer, and may yet push the S&P 500 below its February 28th low, but it will have to do so without help from Bernie Sanders. Joe Biden reclaimed front-runner status following his tremendous Super Tuesday performance, and support for him coalesced with remarkable speed, relieving investors’ acute concern about a Sanders presidency. The primary campaign is still in its early stages, and the gaffe-prone Biden is capable of multiple stumbles between now and the nominating convention, but a general election without a self-declared socialist bent on ending health insurance as we know it will provoke considerably less market anxiety. The Rate Cut Equities had been pining for a rate cut, beginning last week’s surge upon the news that central bankers would be joining the G-7 Finance Ministers on their hastily arranged Tuesday morning conference call. After an immediate 2.5% pop upon the announcement of the intra-meeting cut, however, the S&P 500 sagged and wound up ending Tuesday’s session nearly 2% lower than its pre-cut level. The dismal market reception, and Powell’s own halting, tepid responses to questions at the press conference to discuss the rationale for the move left investors wondering if the Fed had made a mistake. We neither know nor care if it will turn out to be good policy, but we expect that the rate cut will lend support to risk assets over our 12-month investment horizon. Why would the Fed use monetary policy to try to combat a public health crisis, or any supply shock? Monetary policy tools were not made to fight public health crises. They will not speed the development of an antidote, make medical care more widely available, or make up for a lack of preparedness at the public health agencies leading the effort to blunt COVID-19’s spread. They also are not particularly well-suited to combat supply shocks. They cannot resolve global supply bottlenecks, put more people back to work in China, South Korea and Italy, or create and distribute all the test kits and protective clothing that medical professionals sorely need. It is within the Fed’s power, however, to try to keep COVID-19’s second-order economic consequences from taking root. Negative headlines, deserted shopping districts and runs on products like hand sanitizer and face masks can drag down business and consumer confidence. Falling confidence can weigh on consumption and investment, hobbling output, stifling employment growth, and raising the specter of a negatively self-reinforcing dynamic in which layoffs lead to less consumption, which feeds more layoffs, and less investment, etcetera. If the Fed can bolster the spirits of consumers and businesses, it can help to contain COVID-19’s adverse economic impact. Won’t this move leave the Fed with less ammunition down the road? Yes, it surely will, especially if the Fed would prefer to stick to conventional policy tools to combat the next recession. Last week’s cut may postpone the start date of that recession, however, affording the Fed a chance to execute a series of rate hikes before it arrives. For an investor with a timeframe that doesn’t exceed twelve months, it may not matter, provided the increased accommodation successfully reduces near-term recession risk. Do you think this move will be effective? At the margin, yes, we think it will. First of all, it will contribute to the mortgage-refinancing wave that has been building since the beginning of the year (Chart 1). With an average 3.45% 30-year fixed-rate mortgage rate, data provider Black Knight estimates 11 million borrowers could save at least 75 basis points by refinancing their existing loans.1 If the average rate were to fall to 3%, as it would if the spread between mortgage rates and Treasury yields simply eases back to the 2% neighborhood (Chart 2), the pool of potential refinancers would expand to 19 million. Reduced mortgage payments put more money in homeowners’ pockets and will help support consumption at the margin. Chart 1Mortgage Refis Were Already Ramping Up, ... Chart 2... And There Will Be Even More Activity Once Mortgage Spreads Normalize Lower rates will also increase demand for new-home purchases, which have positive multiplier effects, and other big-ticket consumer goods. They will also support investment at the margin, as hurdle rates fall, and more opportunities are projected to generate a positive net present value. Potential homebuyers may be less prone to attend open houses or conduct home searches if COVID-19 spreads, and skittish managers may be less prone to invest, but easier monetary conditions do promote economic activity. Finally, a Fed that is demonstrably committed to easing monetary conditions to mitigate COVID-19’s potential negative impacts may help shore up business and consumer confidence. It will take confidence to keep gloomy virus headlines from becoming a self-fulfilling recession prophecy. As Figure 1 illustrates, the Fed does have the means to boost demand in financial markets and the real economy. Figure 1Monetary Policy And The Economy What will it mean for markets? It may encourage investors to pay more for each dollar of a corporation’s earnings, helping to cushion equities from falling earnings projections (the Confidence/Risk Taking channel in Figure 1), though we think a surer outcome is that it will keep the search for yield at a fever pitch. Life insurers, pension funds and endowments can no longer rely on highly-rated sovereign bonds to deliver the income to meet their fixed obligations, but have very little leeway to allocate away from fixed income. They have therefore been forced to venture further and further out the risk curve (Figure 1’s Portfolio Balance Effect), which has had the effect of providing an ample supply of funds for less-than-pristine borrowers. Under zero- and negative-interest-rate policy (ZIRP and NIRP, respectively) just about any borrower aside from brick-and-mortar retailers and thinly capitalized oil drillers can attract a line of would-be lenders out the door and around the corner simply by offering an incremental 50-75 bps of yield. Since no borrower defaults, or goes bankrupt, as long as there is a lender willing to roll over its maturing obligations, extraordinarily accommodative monetary policy has had the effect of limiting default rates. We expect that the Fed’s move back in the direction of ZIRP will continue to squeeze spreads and ease financial conditions. That’s far from an ideal fundamental basis for owning spread product, and it won’t keep credit outperforming forever, but we expect it will allow spread product to continue to generate positive excess returns over Treasuries and cash over the next twelve months. Recession Prospects There is no doubt that the probability of a recession is rising. COVID-19 is already exerting intense pressure on the airline and hotel industries, and strapped small businesses will find themselves in its crosshairs soon. It is certainly possible that a recession could sneak up on us while we focus on our assessment of the monetary policy backdrop. But just as COVID-19 survival rates are heavily influenced by a patient’s intrinsic condition, the economy’s prognosis may be a function of its pre-outbreak status. To assess the economy’s vital signs, we begin with housing, the major economic segment with the greatest interest-rate sensitivity. If monetary policy is less accommodative than we’ve estimated, the housing market might be gasping for air, but it appears to be as fit as a fiddle. Permits and starts turned sharply higher in the middle of last year (Chart 3, top panel), following the sales component of the NAHB survey (Chart 3, bottom panel) and purchase mortgage applications (Chart 3, middle panel). Homes are already quite affordable, relative to history (Chart 4, top panel), and they’re bound to get even more affordable as mortgage rates fall. Chart 3Housing Charts Are Up And To The Right Across The Board Chart 4Homes Are Amply Affordable Nothing in the available data indicates that housing is running too hot. Residential investment’s contribution to GDP has flipped from barely negative to modestly positive (Chart 5), and there are no signs that its current course is unsustainable. Unsold inventories and the share of vacant homes are at 25-year lows (Chart 6), and starts and permits are only just catching up with the multi-year average of household formations, suggesting that the market has been undersupplied since the crisis excesses were worked off. The overall takeaway is that the housing market is in the early days of an overdue recovery that has plenty of room to run. Chart 5Residential Investment's Current Pace Is Easily Sustainable, ... Chart 6... And The Housing Market Still Looks Undersupplied Chart 7The Labor Market Is Strong Table 2No Sign Of Recession Here February’s employment situation report, ignored by markets in the throes of Friday's selloff, suggests that the labor market, and by extension the economy, was in fighting trim before COVID-19 took root in American soil (Chart 7). February’s net job additions far surpassed consensus estimates, and the figures for January and December were revised appreciably higher (Table 2). With the three-month moving average of net additions coming in one-third higher than expected, the report was nothing short of tremendous. The March release is sure to be worse, and the all-time record streak of expanding monthly payrolls may well come to an end, but the patient was in an awfully robust state before it encountered the virus, and that bodes well for its immediate future. The Democratic Primaries Super Tuesday turned out to be super for US financial markets. With all of the Democratic party’s machinery now at the service of Joe Biden, the probability that frightening left-tail outcomes might emerge from the general election has been dramatically reduced. Markets can live with a Biden-Trump contest no matter how it turns out. Although we thought that markets were exaggerating the potentially negative conditions that would ensue under President Sanders, they would have been subject to rolling bouts of angst every time his general election prospects rose. Though our geopolitical strategists unwaveringly saw the former vice president as the Democratic frontrunner, theirs was a decidedly minority view. Following the Nevada caucus, Sanders was viewed far and wide as the presumptive nominee. Although a Biden administration would presumably be less market-friendly than the current administration, he himself is a card-carrying member of the establishment and wouldn’t do anything that would upset the apple cart. From an investment perspective, Biden is the candidate that would Make America Predictable Again, and even if re-election is markets’ preferred outcome, the prospect of a Biden presidency is hardly frightening. Investment Implications Although our conviction level has fallen in the face of COVID-19 uncertainties, we hold to our view that a soft patch is more likely than a recession, and a correction is more likely than a bear market. We remain constructive on risk assets because we think the selling has gotten overdone. There may well be more of it, and the S&P 500 could reach its 2,708.92 bear-market level before we can publish again next Monday, but we will be buying it in our own account all the way there. We think the most plausible worst-case scenario is a sharp but short recession, produced by a nasty supply shock that frightens households and businesses enough that they cease to consume or invest. The demand strike would imperil indebted businesses that suffered the biggest revenue declines: airlines, hotels, restaurants, retailers, thinly capitalized oil producers and a range of small businesses. They would shrink their workforces and many would default on their loans. That would be bad, as all recessions are bad, but it wouldn’t be a replay of the crisis. Credit extended to the sorts of borrowers listed above, ex-small businesses, is well-dispersed throughout the economy via corporate bonds and securitizations. The exposures the SIFI banks and their large- and mid-cap regional bank cousins have retained will be easily absorbed by the layers of additional capital mandated by Dodd-Frank and Basel 3. It seems to us that markets are pricing in a significant probability of something much worse than a run-of-the-mill recession, and we think that sets up an attractive risk-reward profile for investors in risk assets. We reiterate our risk-friendly recommendations, though we now recommend that fixed-income investors maintain benchmark duration positioning. We failed to appreciate the potential scope for a decline in long yields and are correcting course now.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Boston, Claire and Raimonde, Olivia, “A 30-Year Mortgage Below 3%? Treasury Rally Offers Bargain Loans,” Bloomberg, March 5, 2020.

Highlights The coronavirus is a wild card that may have a significant impact on the global economy, … : The COVID-19 outbreak is unfolding in real time, half a world away, and its ultimate course is uncertain. For now, our China strategists think the worst-case scenarios are unlikely, but we will not remain constructive if the virus outlook materially worsens. … but as long as there is not a significantly negative exogenous event, the US economy will be just fine, … : From a domestic perspective, the US expansion is in very good shape. Easy monetary conditions will support a range of activities, and a potent labor market will give increasing numbers of households the confidence and wherewithal to ramp up consumption. … and if there’s no recession, there will not be a bear market: Recessions and equity bear markets coincide, with stocks typically peaking six months ahead of the onset of a recession. If the next recession doesn’t come before late 2021/early 2022, the bull market should remain intact at least through the end of this year. What We Do US Investment Strategy’s stated mission is to analyze the US economy and its future direction for the purpose of helping clients make asset-allocation and portfolio-management decisions. As important as the economic backdrop is, however, we never forget that we are investment strategists, not economic forecasters. We don’t belabor the state of every facet of the economy because neither we nor our clients care about 10- to 20-basis-point wiggles in real GDP growth in themselves. They do want us to keep them apprised of the general trend, though, and we are always trying to assess it. Ultimately, macro analysis benefits investors by providing them with timely recognition of the approach or emergence of an inflection point in the cycles that matter most for financial assets. We view investment strategy as the practical application of the study of cycles, and we are continuously monitoring the business cycle, the credit cycle, the monetary policy cycle and the squishy and only sporadically relevant sentiment cycle. This week, we turn our attention to the business cycle, and the ongoing viability of the expansion, which is already the longest on record at 128 months and counting. If it remains intact, risk assets are likely to continue to generate returns in excess of returns on Treasuries and cash. The Message From Our Simple Recession Indicator We have previously described our simple recession indicator.1 It has just three components, and all three of them have to be sounding the alarm to conclude that a recession is imminent. Our first input is the slope of the yield curve, measured by the difference between the yield on the 10-year Treasury bond and the 3-month T-bill.2 The yield curve inverts when the 3-month bill yield exceeds the 10-year bond yield, and a recession has followed all but one yield curve inversion over the last 50 years (Chart 1). The yield curve inverted from May through September last year, and the coronavirus outbreak (COVID-19) has driven it to invert again, but the unprecedentedly negative term premium (Chart 2) has made the curve much more prone to set off a false alarm. Chart 1An Inverted Curve May Not Be What It Used To Be ... Chart 2... When A Negative Term Premium Is Holding Down Long Yields The indicator’s second input is the year-over-year change in the leading economic index (“LEI”). When the LEI contracts on a year-over-year basis, a recession typically ensues. As with the inverted yield curve, year-over-year contractions in the LEI have successfully called all of the recessions in the last 50 years with just one false positive (Chart 3). The LEI bounced off the zero line thanks to January’s strong reading, and the year-ago comparisons are much easier than they were last year, but we are mindful that it is flirting with sending a recession warning. Chart 3Leading Indicators Are Wobbly, ... It takes more than tight monetary conditions to make a recession, but you can't have one without them. To confirm the signal from the yield curve and the LEI and make it more robust, we also consider the monetary policy backdrop. Over the nearly 60 years for which BCA’s model calculates an equilibrium rate, every recession has occurred when the fed funds rate has exceeded our estimate of equilibrium (Chart 4). Tight monetary policy isn’t a sufficient condition for a recession – expansions continued for six more years despite tight policy in the mid-‘80s and mid-'90s – but it is a necessary one. Our indicator will not definitively signal an approaching recession until monetary conditions turn restrictive. Chart 4... But The Fed Is Nowhere Near Inducing A Recession Bottom Line: In our view, the yield curve and the LEI both represent yellow lights, though the LEI has a greater likelihood of turning red, especially in the wake of COVID-19. Monetary policy is unambiguously green, however, and we will not conclude that a recession is imminent until the Fed deliberately attempts to rein in the economy. Bolstering Theory With Observation A potential shortcoming of our recession indicator is its reliance on a theoretical concept. The equilibrium (or natural) rate of interest cannot be directly observed, so our judgment of whether monetary policy is easy or tight turns on an estimate. To bolster our assessment of whether or not the expansion can continue, we have been tracking the drivers of the main components of US output. Going back to the GDP equation from Introductory Macroeconomics, GDP = C + I + G + (X - M), we look at the forces supporting Consumption (C), Investment (I) and Government Spending (G). (Because the US is a comparatively closed economy in which trade plays a minor role, we ignore net exports (X-M).) Consumption is by far the largest component, accounting for two-thirds of overall output, while investment and government spending each contribute a sixth. As critical as consumption is for the US economy, it is not the whole story; smaller but considerably more volatile investment is capable of plunging the economy into a recession on its own. The Near-Term Outlook For Consumption Chart 5Labor Market Slack Has Been Absorbed Consumption depends on household income, the condition of household balance sheets, and households’ willingness to spend. The labor market remains extremely tight, with the unemployment rate at a 50-year low, and “hidden” unemployment dwindling as the supply of discouraged (Chart 5, top panel) and involuntary part-time workers (Chart 5, bottom panel) has withered. The prime-age employment-to-population ratio trails only the peak reached during the dot-com era (Chart 6), which bodes well for household income. The historical correlation between the prime-age non-employment-to-population ratio and wage gains has been quite robust, and compensation growth has plenty of room to run before it catches up with the best-fit line (Chart 7). Chart 6Prime-Age Employment Has Surged, ... Chart 7... And Wages Will Eventually Follow Suit Chart 8No Pressing Need To Save, Or Pay Down Debt Households can use additional income to increase savings or pay down debt instead of spending it, but it doesn’t look like they will. The savings rate is already quite elevated, having returned to its mid-‘90s levels (Chart 8, top panel); households have already run debt down to its post-dot-com bust levels (Chart 8, middle panel); and debt service is less demanding than it has been at any point in the last 40 years (Chart 8, bottom panel). The health of household balance sheets, and the recent pickup in the expectations component of the consumer confidence surveys, suggest that households have the ability and the willingness to keep consumption growing at or above trend.   Household balance sheets are healthy enough to support spending income gains; there's even room to borrow to augment them.           The Near-Term Outlook For Investment Table 1GDP Equation Recession Probabilities Chart 9A Budding Turnaround We previously identified investment as the individual component most likely to decline enough to zero out trend growth from the other two components (Table 1), and it was a drag in 2019, declining in each of the last three quarters to end the year more than 3% below its peak. We expect it will hold up better this year, however, as the capital spending intentions components of the NFIB survey of smaller businesses (Chart 9, top panel) and the regional Fed manufacturing surveys (Chart 9, bottom panel) have both pulled out of declines. The trade tensions with China weighed heavily on business confidence in 2019, but the signing of the Phase 1 trade agreement lifted that cloud, and we expect that capex will revive in line with confidence once COVID-19 has been subdued. Government Spending In An Election Year Chart 10State And Local Revenues Are Well Supported Heading into the most hotly contested election in many years, we confidently assert that federal spending is not going to go away. Regardless of party affiliation, everyone in Congress sees the appeal of distributing pork to their constituents. Spending by state and local governments, which accounts for 60% of aggregate government spending, should also hold up well, as a robust labor market will support state income tax (Chart 10, top panel) and sales tax (Chart 10, middle panel) receipts. Healthy trailing home price gains will support property tax assessments, keeping municipal coffers full (Chart 10, bottom panel). Coronavirus Uncertainties The coronavirus epidemic (COVID-19) is unfolding in real time, generating daily updates on new infections, deaths and recoveries. Any opinion we offer on the economy’s future is conditioned on the virus' ongoing course. If it takes a sharp turn for the worse, with more severe consequences than we had previously expected, it is likely that we will downgrade our outlook. For now, we are operating under the projection that the virus will cause China’s first quarter output to contract sharply enough to zero out global growth in the first quarter. Our base-case scenario, following from the work of our China Investment Strategy service, is fairly benign from there. For now, we are expecting that the worst of the effects will be confined to the first quarter, and that the Chinese economy and the global economy will bounce back vigorously in the second quarter and beyond, powered by pent-up demand that will go unfilled until the outbreak begins to recede. Our China strategists continue to be heartened by Chinese officials' aggressive (albeit belated) measures to stem the outbreak, revealed in the apparent slowing of the rate of new infections in Hubei province, the epicenter of the outbreak (Chart 11, top panel), and in the rest of China (Chart 11, bottom panel). They also expect a determined policy response to offset the drag from the epidemic (Charts 12 and 13), as officials pursue the imperative of meeting their goal to double the size of the economy between 2010 and 2020. Chart 11Stringent Quarantine Measures May Be Gaining Traction Chart 12The PBOC Is Doing Its Part, ... Chart 13... By Easing Monetary Conditions If the economy is expanding, investors' bar for de-risking should be high. Bottom Line: Our China strategists’ COVID-19 view remains fairly optimistic, though it is subject to unfolding developments. Our US view is contingent on BCA’s evolving COVID-19 views. Investment Implications As we noted at the outset, we are not interested in the economy for the economy’s sake; we are only interested in its impact on financial markets. The key business-cycle takeaway for markets is that bear markets and recessions typically coincide, as it is difficult to get a 20% decline at the index level without a meaningful decline in earnings, and earnings only decline meaningfully during recessions. No recession means no bear market, and it also means no meaningful pickup in loan delinquencies and defaults. The bottom line is that it is premature to de-risk while the expansion remains intact. We reiterate our recommendation that investors should remain at least equal weight equities in balanced portfolios, and at least equal weight spread product within fixed income allocations, though we may turn more cautious as we learn more about the progression of COVID-19.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Please see the August 13, 2018 US Investment Strategy Special Report, "How Much Longer Can The Bull Market Last?" available at usis.bcaresearch.com. 2 We use the 3-month/10-year segment instead of the more common 2-year/10-year because the 3-month bill is a cleaner proxy for short rates than the 2-year note, which incorporates estimates of the Fed’s future actions.

Highlights Bulk commodity markets – chiefly iron ore and steel – could see sharp rallies once Chinese authorities give the all-clear on COVID-19 (the WHO’s official name for the coronavirus). These markets rallied sharply Tuesday, as President Xi vowed China would achieve its growth targets this year, which, all else equal, likely will require additional monetary and fiscal stimulus. China accounts for ~ 70% of the global trade in iron ore, and ~ 50% of global steel supply and demand. COVID-19-induced losses have hit Chinese demand for steel hard, forcing blast furnaces to sharply reduce output. However, this partly is being countered by transitory weather- and COVID-19-related disruptions that are reducing iron ore exports from Brazil and delaying Australian shipments. Iron ore inventories could be drawn hard in 2Q and 2H20 to meet demand as steelmakers rebuild stocks and construction and infrastructure projects restart (Chart of the Week). The Chinese Communist Party celebrates its 100th anniversary next year. To offset the COVID-19-induced drag on domestic growth this year, which could take GDP growth below 5%, and a weak GDP performance next year additional stimulus is an all-but-foregone conclusion. Feature When policymakers really want to jumpstart GDP growth, their playbook typically turns to the real economy via policies that encourage construction, infrastructure development and manufacturing. There is a compelling case a strong rally in iron ore and steel will accompany the containment of COVID-19, reversing the 14% and 4% declines in both since the start of the year (Chart 2). Chief among the drivers of the rally will be the increase in fiscal and monetary stimulus required to restore Chinese GDP growth disrupted by the COVID-19 outbreak, which could reduce annual growth closer to 5% than the ~ 6% rate policymakers were targeting. Chart of the WeekLow Iron Ore Stocks Setting Up A Rally Chart 2Policy Stimulus Will Reverse Declines In Iron Ore And Steel Prices There are a number of reasons for expecting this. 2020 marks the terminus of the decade-long policy evolution that was supposed to end with the realization of the “Chinese Dream.” Chief among the goals that were to be realized by the end of this year – which will usher in the 100th anniversary of the founding of the Chinese Communist Party in 2021 – are a doubling of per capita income and of GDP.1 The Communist Party in China has numerous policy levers it can pull to respond to worse-than-expected growth and economic shocks. These policies consume a lot of bulk commodities and base metals. When policymakers really want to jump-start GDP growth, their playbook typically turns to the real economy via policies that encourage construction, infrastructure development and manufacturing. This was clearly seen following the Global Financial Crisis (GFC) in 2008-09 (Chart 3). Even before the COVID-19 outbreak, policymakers made it clear they wanted to stabilize growth following the Sino-US trade war at the conclusion of the Central Economic Work Conference (CEWC) in December. Nominal wages and per capita income growth had been falling since 3Q18, imperilling one of the principal goals of the “Chinese Dream.” Chart 3Policy Stimulus Will Lift GDP And Iron Ore And Steel Prices Policymakers will aim for annualized quarterly growth of ~ 6.5% in 2Q- 4Q20 if their goal is simply to achieve 6% p.a. growth this year. Following that CEWC meeting, our colleagues at BCA’s China Investment Strategy (CIS) anticipated policymakers would announce growth targets at the National People’s Congress (NPC) meeting next month in the range of 5.8 and 6.2% p.a. growth, noting, “the Chinese economy needs to increase by 6% in 2020 to double its size from the 2010 level in real terms.”2 The growth rate required to put the economy on track to deliver on the “Chinese Dream” is now much higher following the COVID-19 outbreak, which could shave ~1% or more off China’s growth this year alone. This suggests policymakers will aim for annualized quarterly growth of ~ 6.5% in 2Q-4Q20 if their goal is simply to achieve 6% p.a. growth this year. This predisposes us to expect significant monetary and fiscal stimulus this year after the all-clear is sounded and the economy can return to its day-to-day activities. In addition – and by no means least of the concerns driving policymakers’ decisions – the 100th anniversary of the founding of the CCP will be celebrated next year, something policymakers at all levels have been looking forward to showcase the success of their revolution. A Boon For Bulks As monetary policy eases, the construction growth trajectory should pick up smartly. China accounts for ~ 70% of the global trade in iron ore. It is expected to import ~ 1.1 billion MT this year and next, based on estimates published by the Australian government’s Department of Industry, Innovation and Science in its December 2019 quarterly assessment (Chart 4). China will account for ~ 50% of global steel supply and demand, or roughly 900mm MT/yr in 2020 and 2021. The COVID-19 outbreak reduced utilization rates at the close to 250 steel mills monitored by Mysteel Global in China to 78%, a drop of 2.3pp.3 Platts estimates refined steel production could fall by 43mm MT by the end of February.4 Most of China’s steel output goes into commercial and residential construction (~ 35%), infrastructure (~20%), machinery (~ 20%), and automobile production (~ 7%), based on S&P Global Platts estimates.5 Residential construction began to recover last year, and residential housing inventories were declining relative to sales (Chart 5). In our view, once the COVID-19 infection rate falls outside Hubei Province – the epicenter of the outbreak – markets will begin pricing in a revival of commercial and residential construction in China. As monetary policy eases, the construction growth trajectory should pick up smartly (Chart 6). Chart 4China Dominates Iron Ore, Steel Markets   Chart 5Resumption Of Construction Will Lift Demand For Bulks Chart 6Easier Money And Credit Policy Will Revive Construction Infrastructure spending already was on track to increase prior to the COVID-19 outbreak, based on our CIS colleagues’ reading of the CEWC statement issued in December, which “suggests fiscal support to the economy will mainly focus on infrastructure, and listed transportation, urban and rural development, and the 5G networks to be the government’s main investment projects next year.”6 This fiscal push will be supported by additional spending at the local government level, and by the issuance of special-purpose bonds by these governments with proceeds earmarked for infrastructure development (Chart 7). “A bigger fiscal push by the central government, coupled with a frontloading of 2020 local government special-purpose bond issuance, will likely boost infrastructure spending to around 10% in the first two quarters, doubling the growth in the first eleven months of 2019,” according to our CIS colleagues. Chart 7Pump Priming Will Boost Infrastructure Spending Bottom Line: Infrastructure fixed asset investment will be supported by easier credit and fiscal policy in China. Whether it rises at double-digit growth rates remains to be seen, however. Expect Chinese Consumers To Come Out Spending Infrastructure fixed asset investment will be supported by easier credit and fiscal policy in China. Prior to the outbreak of COVID-19, consumer confidence was running high (Chart 8), and employment prospects have bottomed and turned higher, although they still indicate contraction. (Chart 9). This boded well for consumer-spending expectations, particularly for autos (Chart 10). Chart 8Consumer Confidence Was High Prior to COVID-19 Outbreak ... Chart 9... And Job Prospects Were Improving ... At ~ 7%, China’s automobile production remains a marginal contributor to overall steel consumption. Nonetheless, a meaningful pickup in automobile production following the depressed growth rate of the past 15 months would move steel demand upward. China’s share of world auto sales is ~30% (Chart 11). Chart 10... Thus Lifting Prospects For Chinese Auto Sales   Chart 11Policy Stimulus Will Revive Chinese Auto Sector Accommodative monetary and fiscal policies in China point toward higher growth for the auto sector. However, it is important to note the revival in auto production needs to be driven by consumer demand – if it is led simply by restocking, the rebound will not be sustainable. The recovery we are expecting will support steel and metal consumption at the margin, but the outlook for infrastructure and construction remains key due to their higher weight in total steel consumption. Bottom Line: Auto consumption and production were recovering in late 2019; however, the strength of the recovery did not match previous stimulus programs (2009 and 2016). The recovery we are expecting this year will support steel and metal consumption at the margin, but the outlook for infrastructure and construction remains key due to their higher weight in total steel consumption. If these other sectors remain constructive for metal demand (or at least are not contracting or slowing drastically), the boost from the auto sector will meaningfully contribute to higher iron ore and steel prices.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Associate Editor Commodity & Energy Strategy HugoB@bcaresearch.com     Commodities Round-Up Energy: Overweight Oil prices halted their decline and rose 1% on Tuesday as the number of daily confirmed cases of the Wuhan coronavirus decelerated in China. As of Tuesday, the daily growth in cases dropped to 5%, down from 6% the previous day. Investors will closely monitor this number for any sign of a durable slowdown in daily confirmed cases. Separately, the US Energy Information Administration revised down its global demand growth estimates for 2020 to 1.0mm b/d from 1.3mm b/d last month, reflecting the effects of the coronavirus and warmer-than-expected January temperatures in the northern hemisphere. We will be updating our global oil balances next week. Base Metals: Neutral Iron ore prices fell 14% since the COVID-2019 outbreak in January. Investors are assessing how the iron ore market will balance weaker demand expectations in China amid lower supply – largely a result of falling Brazilian ore exports. Brazil’s total iron ore exports fell ~19% y/y in January due to heavy rainfall and lower production at Brazilian miner Vale. The company’s output never fully recovered from the 2019 dam incident and remains a risk to iron ore supply in 1Q20. Vale lowered its March sales guidance by 2mm MT. Low Chinese port inventories raise prices’ vulnerability to supply disruptions (Chart 12). Precious Metals: Neutral Gold remains well bid despite a strong US dollar, fueled by safe-haven demand. The yellow metal’s price fell slightly on Tuesday as investors’ concerns over the coronavirus eased. Based on our fair-value model, prices averaged $55/oz above our estimate in January. Investors – i.e. global ETF holders and net speculative positions reported by the US CFTC – have been important contributors to the latest gold rally. Investors’ total holding of gold reached a record high 113mm oz last week. Nonetheless, we believe there is still opportunity for this group to further support prices: the share of gold allocation vs. world equity-market capitalization is still low at 0.24%, vs. its peak of 0.42% in 2012 (Chart 13). Ags/Softs:  Underweight March wheat futures were down 1.8% at Tuesday’s close, settling at the lowest level of the year after the USDA called for ‘stable supplies’ of the grain for the 2019/2020 U.S. marketing year. For corn, ending stocks were unchanged relative to the January projection, while world production was revised slightly upwards. March corn futures finished 2¢ lower at $3.7975/bu. The USDA also estimated higher soybean exports on the back of increased sales to China. However, soybean price gains were limited by higher production and ending stocks abroad. Chart 12Low Iron Ore Inventory Raises Exposure To Supply Disruptions Chart 13A Higher Share Of Gold Holdings Could Support Prices Further   Footnotes 1     The “Chinese Dream” is a phrase coined by President Xi Jinping, following the 18th Party Congress of the Chinese Communist Party in 2012, when the overarching goal of transforming China into a “moderately well-off society” was memorialized in writing. These goals were crystalized in terms of progress expected in per capita income and GDP, both of which were to be doubled in the decade ending this year. Please see Why 2020 Is a Make-or-Break Year for China published by thediplomat.com February 13, 2015. 2     Please see A Year-End Tactical Upgrade, published by BCA Research’s China Investment Strategy December 18, 2019, for an in-depth analysis of policy guidance coming out of the Economic Work Conference last December. It is available at cis.bcaresearch.com. 3    Please see WEEKLY: China’s blast furnace capacity use drops to 78% published by Mysteel Global February 10, 2020. 4    Please see China steel consumption to plunge by up to 43 mil mt in February due to coronavirus published February 6, 2020, by S&P Global Platts. 5    Please see China Macro & Metals: Steel output falls, but property creates bright spots published by S&P Global Platts December 6, 2019. 6    Please see footnote 2 above. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q4 Commodity Prices and Plays Reference Table Trades Closed in 2020 Summary of Closed Trades

Highlights The SARS episode of 2003 suggests that the panic over the coronavirus will only subside when the number of new cases peaks. Although the latest data is somewhat encouraging, it is far from clear that we have reached that point. Provided the outbreak is contained, global equities should move higher over the course of the year. US companies remain net buyers of shares, implying that households and other holders have been net sellers. But against a backdrop of rising incomes, high savings, and improving confidence, households have also wanted to own more equities. How can households be net sellers of stocks while simultaneously increasing their equity exposure? There is only one answer: Share prices need to rise. The process will only stop once households decide they own enough stocks. In the US, while household equity holdings are on the high side as a share of household wealth, this is counterbalanced by the fact that the earnings yield on stocks is well above the yields on competing assets. Outside the US, household ownership of equities is quite low while the equity risk premium is still high. Going Viral We upgraded global equities after markets plunged in late 2018 and have remained overweight stocks on a 12-month horizon to this day. However, we indicated three weeks ago that equities had become technically overbought and would likely need to consolidate their gains. Thus, while we kept our 12-month views unchanged, we downgraded our tactical 3-month view on global stocks from overweight to neutral, while also advising clients with short horizons to boost exposure to cash and government bonds at the expense of riskier credit (our entire set of views can be found in the Global Investment Strategy View Matrix at the back of this report). Since then, the outbreak of the coronavirus has added another headwind to the near-term outlook for stocks. Many commentators have drawn comparisons between today’s outbreak and the SARS epidemic in 2003. The SARS episode imposed a significant but short-lived economic toll on the affected countries. While Chinese GDP growth fell to 3.4% in Q2 of 2003, it surged back to 15.7% in Q3, leaving the overall level of GDP down about 1% for the year as a whole relative to what would have transpired if the virus had never emerged.1 The broader Asia-Pacific region experienced a hit to growth of around 0.5%. In contrast, growth in developed economies was barely affected. Even in Canada, where 44 people died from SARS, the outbreak shaved only around 0.1% from the level of GDP in 2003, according to the Bank of Canada.2   The outbreak of the coronavirus has added another headwind to the near-term outlook for stocks. The obvious problem with the SARS analogy is that it is based on a sample of one. We do not know how this new strain of the virus compares to SARS or, for that matter, the Spanish flu, which killed 50-to-100 million people (3%-to-5% of the world’s population at the time). We do not even know if the full scope of the SARS outbreak was as fleeting as what we remember, since in a cosmic multiverse there will be a tendency to recall life-or-death outcomes more favorably than they actually were (I will have more to say about the financial implications of this in a future special report). Chart 1The Coronavirus Is Spreading Faster Than SARS Did What we do know is that, to date, the coronavirus has spread more quickly than SARS (Chart 1). It is not clear if that is because of faster, more accurate reporting methods or because the virus is more communicable. The Chinese Minister of Health has said that this new virus, unlike SARS, can be transmitted while people are still asymptomatic. While others have cast doubt on this claim, if it turns out to be correct, the coronavirus may be much more difficult to control. Viruses often become less lethal as they mutate because a virus that kills its host is also a virus that kills itself. Unfortunately, in a world of mass travel, a virus can spread across the globe before it has time to lose potency. The typical seasonal flu kills less than 0.1% of those who contract it. Most estimates suggest that SARS killed 10%-15% of infected patients. The Spanish flu killed a similar percentage. The death rate from the coronavirus is currently tracking at 2%-to-3%. However, it is possible that this estimate will rise. The vast majority of the people who have contracted the coronavirus are still sick. In fact, more people have died from it than have fully recovered (Chart 2). Thus, an honest assessment would simply admit that we do not know how bad this potential pandemic will get. Chart 2How Will This End: Outbreak, Epidemic, Or Pandemic? Chart 3Markets Bottomed As The SARS Infection Rate Was Peaking What should investors do? The SARS experience suggests that risk assets will only bottom when the number of new cases peaks (Chart 3). It is not clear that we have reached this point yet. While the number of new cases reported by China’s National Health Commission has stabilized over the past two days, this could just be a temporary respite (Chart 4). Until the rate at which new cases are diagnosed begins a clear downward trend, a somewhat cautious stance towards risk assets is warranted. Global Growth Should Recover Provided the outbreak is contained during the coming weeks, global equities should move higher over the course of the year. This is partly because global growth should pick up thanks to the lagged effects of last year’s decline in bond yields, an improvement in the global manufacturing inventory cycle, and diminished Brexit and trade war risks. Continued fiscal/credit stimulus out of China should also help. China spends less on health care than almost all other countries (Chart 5). It is likely that the past few weeks will prompt the government to increase social spending.   Chart 4The Number Of New Cases Has Stagnated Over The Past Two Days Chart 5China: Public Spending On Health Care Has Room To Catch Up Higher Equity Prices: Just A Matter Of Arithmetic? Chart 6There Is A Structural Decline In Listed Companies In The US Chart 7The Supply Of US Stocks Has Been Drying Up In addition to stronger global growth, there is another factor supporting stocks which receives insufficient attention and is worth highlighting in this week’s report: corporate buybacks. US companies have repurchased about 3% of their shares every year for the past decade. On the flipside, only 110 companies went public last year, less than a third of the number of new listings in 1996-99. In fact, the number of publicly traded domestic companies has fallen by over 40% since 1996 (Chart 6). The combination of copious buybacks and dearth of IPOs has caused the S&P divisor – a broad measure of the total number of split-adjusted shares outstanding – to decline by a cumulative 9% since 2011. Between 1990 and 2004, the divisor increased by 40% (Chart 7). If companies are net buyers of stocks, then households and other holders must be net sellers of stock. But this raises an obvious question: What if households also want to be net buyers of stocks? Chart 8Households Are Bullish Chart 9High Equity Ownership By Households Translates Into Poor Long-Term Returns This question is highly relevant in today’s environment, where unemployment is low, wage growth is accelerating, the household savings rate is high, consumer confidence is strong, and a higher-than-average percentage of people expect stocks to increase in the coming months (Chart 8). Arithmetically, there is only one way that households can be net sellers of stocks while simultaneously increasing their equity exposure: Share prices need to rise. At what point will share prices stop rising? That depends on two things: 1) How much stock market wealth households hold relative to other assets; and 2) The risk-adjusted rate of return that households expect from stocks compared to other assets. Stock returns are highest when equity holdings are low, but sentiment towards stocks is improving. Conversely, returns are lowest when equity holdings are high, but stock market sentiment is deteriorating (Chart 9 and Table 1).   Table 1Equity Returns Tend To Suffer When Bulls Are Losing Conviction The latter typically occurs during economic downturns when earnings are falling and risk aversion is rising. Thus, it is no surprise that recessions and equity bear markets tend to overlap (Chart 10). Chart 10Recessions And Bear Markets Tend To Overlap Where Things Stand Today In the US, household equity holdings are on the high side. According to Fed data and our own estimates, households currently hold 33% of their financial assets in stocks (Chart 11). This is higher than in 2007, but still below the dotcom peak of 39%. Similarly, the monthly asset allocation survey conducted by the American Association of Individual Investors shows a somewhat elevated allocation to equities, although one that is still broadly on par with the 2003-2007 and post-2014 averages (Chart 12). Chart 11US Household Equity Holdings Are On The High Side (I) Chart 12US Household Equity Holdings Are On The High Side (II) Chart 13Relative Valuations Favor Stocks   One major difference with prior occasions when US equity allocations were elevated is that the earnings yield on stocks at present is still quite a bit higher than the yield on competing assets such as cash and bonds (Chart 13). While this is mainly because interest rates are so low, it does suggest that households may seek to further increase their equity allocations provided that the economy continues to perform well. Foreign companies have been less aggressive re-purchasers of their own shares than their US peers. That said, household equity ownership is significantly lower outside the US (Chart 14). The spread between equity earnings yields and bond yields is also higher abroad, reflecting the fact that both PE multiples and interest rates are generally lower outside the US. Given that investors tend to favor companies listed in their home country, efforts by non-US investors to increase their equity allocations will primarily benefit stock markets outside the US. In addition, stronger global growth tends to favor EM and European equities, largely because stock markets in those regions have more of a cyclical bent (Chart 15). Thus, on balance, we recommend that investors overweight non-US stocks this year. Chart 14Equity Ownership By Households Is Lower Outside The US Chart 15Stronger Global Growth Tends To Favor A Cyclical Bias In Equity Allocation Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1   Jong-Wha Lee and Warwick J. McKibbin, “Globalization and Disease: The Case of SARS,” Brookings Institution, dated February 2004. 2   Please see Monetary Policy Report, Bank of Canada, October 2003. Global Investment Strategy View Matrix MacroQuant Model And Current Subjective Scores Strategic Recommendations Closed Trades

Highlights Global growth is poised to accelerate this year, although the spread of the coronavirus could dampen spending in the very short term. History suggests that the likelihood of a recession rises when unemployment falls to very low levels. Three channels have been proposed to explain why that is: 1) Low unemployment can prompt households and businesses to overextend themselves, making the economy more fragile; 2) Faster wage growth stemming from a tight labor market can compress profit margins, leading to less capital spending and hiring; 3) Shrinking spare capacity can fuel inflation, forcing central banks to raise rates. The first channel is highly relevant for some smaller, developed economies where housing bubbles have formed and household debt has reached very high levels. However, it is not an immediate concern in the US, Japan, and most of the euro area. We would downplay the importance of the second channel, as faster wage growth is also likely to raise aggregate demand and incentivize firms to increase capital spending on labor-saving technologies. The third channel poses the greatest long-term risk, but is unlikely to be market-relevant this year. Investors should remain bullish on global equities over the next 12-to-18 months. A more prudent stance will be warranted starting in the second half of 2021. Global Equities: Sticking With Bullish Global equities are vulnerable to a short-term correction after having gained 16% since their August lows. Nevertheless, we continue to maintain a positive outlook on stocks for the next 12 months due to our expectation that global growth will gather steam over the course of the year. The latest data on global manufacturing activity has generally been supportive of our constructive thesis. The New York Fed Manufacturing PMI beat expectations, while the Philly Fed PMI jumped nearly 15 points to the highest level in eight months. The business outlook (six months ahead) component of the Philly Fed index rose to its best level since May 2018. European manufacturing should also improve this year. Growth expectations for Germany in the ZEW index surged in January, rising to the highest level since July 2015 (Chart 1). The Sentix and IFO indices have also moved higher. Encouragingly, euro area car registrations rose by 22% year-over-year in December. In the UK, business confidence in the CBI survey of manufacturers surged from -44 in Q3 of 2019 to +23 in Q4, the largest increase in the 62-year history of the survey. Fiscal stimulus and diminished risk of a disorderly Brexit should also bolster growth this year. Chart 1Some Green Shoots Emerging In The Euro Area Chart 2EM Asia Is Rebounding The manufacturing and trade data in Asia have been improving. Following last week’s better Chinese trade data, Korean exports recovered on a rate-of-change basis for a fourth month in a row. Japanese exports to China increased for the first time since last February. In Taiwan, industrial production increased by more than expected in December, as did export orders. Our EM Asia Economic Diffusion Index has risen to the highest level since October 2018 (Chart 2). Coronavirus: Nothing To Sneeze At? The outbreak of the coronavirus represents a potential short-term threat to the budding global economic recovery. Conceptually, outbreaks can affect the economy in two ways. One, they can reduce demand by curtailing spending on travel, entertainment, restaurants, or anything that requires close proximity to others. Two, they can reduce supply by causing people to avoid going to work. In practice, the first effect usually dominates the second. As a result, such outbreaks tend to have a deflationary impact. The Brookings Institution estimates that the 2003 SARS epidemic shaved about one percentage point from Chinese growth that year.1 The fact that this outbreak is happening during the Chinese New Year celebrations, when over 400 million people will be on the move, has the potential to exacerbate the transmission of the virus, and in the process, amplify the economic damage. That said, while it is from the same class of zoonotic viruses, early indications suggest that this particular strain is less lethal than SARS. In addition, the Chinese authorities have moved faster to address the risks than they did during the SARS outbreak. The government has effectively quarantined Wuhan, a city of 11 million people, where the virus appears to have originated. They have also sequenced the virus and shared the information with the global medical community. This has allowed the US Centers for Disease Control (CDC) to develop a test for the virus, which is likely to become available over the coming weeks. The Dark Side Of Low Unemployment Provided the coronavirus outbreak is contained, stronger global growth should continue to soak up lingering labor market slack. This raises the question of whether, at some point, declining unemployment could become counterproductive. The outbreak of the coronavirus represents a potential short-term threat to the budding global economic recovery. The unemployment rate in the OECD currently stands at 5.1%, below the low of 5.5% set in 2007 (Chart 3). In the US, the unemployment rate has dropped to a 50-year low. Chart 3Unemployment Rates Are Below Their Pre-Crisis Lows In Most Economies No one would deny that the decline in unemployment since the financial crisis has been a welcome development. However, it does carry one major risk: Historically, the likelihood of a recession has risen when unemployment has fallen to very low levels (Chart 4). Chart 4Recessions Become More Likely When The Labor Market Begins To Overheat Three channels have been proposed to explain this positive correlation: 1) Low unemployment can prompt households and businesses to overextend themselves, making the economy more fragile; 2) Faster wage growth stemming from a tight labor market can compress profit margins, leading to less capital spending and hiring; 3) Shrinking spare capacity can fuel inflation.  This can force central banks to raise rates, choking off growth. Let’s examine each in turn. Unemployment And Irrational Exuberance Chart 5Growing Housing Imbalances In Some Economies A strong economy promotes risk-taking. While some risk-taking is essential for capitalism, an excessive amount can lead to the buildup of imbalances, thereby setting the stage for an eventual downturn. In Australia, New Zealand, Canada, and the Scandinavian economies, the combination of low interest rates and strong economic growth has stoked debt-fueled housing bubbles (Chart 5, panel 3). As we discussed last week, higher interest rates in those economies could sow the seeds for economic distress.2 In most other countries, financial imbalances are not severe enough to trigger recessions. Chart 6 shows that the private-sector financial balance – the difference between what the private sector earns and spends – still stands at a healthy surplus of 3.4% of GDP in advanced economies. In 2007, the private-sector financial balance fell to 0.4% in advanced economies, reaching a deficit of 2% in the US. The private-sector balance also deteriorated sharply in the lead-up to the 2001 recession (Chart 7). Chart 6The Private Sector Spends Less Than It Earns In Most Economies Chart 7The Private-Sector Surplus Is Larger Than It Was Before The End Of Previous Expansions   In the US, the personal savings rate has risen to nearly 8%, much higher than one would expect based on the level of household net worth (Chart 8). Despite growing at around 2.5% in 2018/19, real personal consumption has increased at a slower pace than predicted by the level of consumer confidence. This suggests that households have maintained a fairly prudent disposition. Consistent with this, the ratio of household debt-to-disposable income has declined by 32 percentage points since 2008. Chart 8Households Are Saving More Than One Would Expect Granted, some credit categories have seen large increases (Chart 9). Student debt has risen to 9% of disposable income. Auto loans have moved back to their pre-recession highs. We would not worry too much about the former, as the vast majority of student debt is guaranteed by the government. Auto loans are more of a concern. However, it is important to keep in mind that the auto loan market is less than one-sixth as large as the mortgage market. Moreover, after loosening lending standards for vehicle loans between 2011 and 2016, banks have since tightened them. This adjustment appears to be largely complete. Lending standards did not tighten any further in the latest Senior Loan Officer Survey, while demand for auto loans rose at the fastest pace in two years. The share of auto loans falling into delinquency has been trending lower, which suggests that delinquency rates are peaking (Chart 10). Chart 9US Household Debt Levels Have Fallen, Despite Increases in Student And Auto Loans Chart 10Auto Loans: Monitoring Trends In Credit Standards And Delinquency Rates Lastly, we would point out that despite all the hoopla over the state of the auto market, auto loan asset-backed securities have performed well (Chart 11). While default rates have risen, lenders have generally set interest rates high enough to absorb incoming losses. Chart 11Securitized Auto Loans Have Performed Well Will Falling Profit Margins Derail The Expansion? Profit margins usually peak a few years before the onset of a recessions (Chart 12, top panel). This has led some to speculate that falling margins could usher in a recession by curbing companies’ willingness to hire workers and invest in new capacity. Chart 12A Peak In Profit Margins: An Ominous Sign? While it is an interesting theory, it does not stand up to closer scrutiny. Surveys of business sentiment clearly show that capital spending intentions are positively correlated with plans to raise wages (Chart 13, left panel). Far from cutting capital expenditures in response to rising wages, firms are more likely to boost capex if they are also planning to increase labor compensation.  Chart 13AFaster Wage Growth, Increased Hiring, And More Capex Go Hand In Hand (I) Chart 13BFaster Wage Growth, Increased Hiring, And More Capex Go Hand In Hand (II) One reason for this is that rising wages make automation more attractive. By definition, automation requires more capital spending. However, that is not the entire story because firms also tend to hire more workers during periods when wage growth is rising (Chart 13, right panel). This implies that a third factor – strong economic growth – is responsible for both accelerating wages and rising hiring intentions. The fact that real business sales are strongly correlated with both employment growth and nonresidential investment is evidence for this claim (Chart 12, bottom panel). Falling Margins: A Symptom Of A Problem The discussion above suggests that faster wage growth is unlikely to dissuade firms from either hiring more workers or boosting capital spending. Indeed, the opposite is probably true: Since workers normally spend more of every dollar of income than firms do, an increase in the share of national income flowing to workers will lift aggregate demand. So why do profit margins usually peak before recessions? The answer is that declining labor market slack tends to push up unit labor costs, forcing central banks to hike interest rates in an effort to stave off rising inflation. Thus, falling margins are just a symptom of an underlying problem: economic overheating. Don’t blame lower margins for recessions. Blame central banks. Inflation Is Not A Threat... Yet For now, unit labor cost inflation remains reasonably well contained in the major economies (Chart 14). However, there is little evidence to suggest that the historic relationship between labor market slack and wage growth has broken down (Chart 15). Barring a major surge in productivity growth, inflation is likely to accelerate eventually as companies try to pass on higher labor costs to their customers. Chart 14AUnit Labor Costs Are Well Behaved For Now (I) Chart 14BUnit Labor Costs Are Well Behaved For Now (II)       Chart 15Correlation Between Labor Market Slack And Wage Growth Remains Intact We do not know exactly when such a price-wage spiral will emerge. Inflation is a notoriously lagging indicator (Chart 16). Our best guess is that inflation could become a serious risk for investors in late 2021 or 2022. Thus, investors should remain overweight global equities for the next 12-to-18 months, but be prepared to turn more cautious in the second half of 2021.  Chart 16Inflation Is A Lagging Indicator   Peter Berezin Chief Global Strategist peterb@bcaresearch.com   Footnotes 1   Jong-Wha Lee and Warwick J. McKibbin, “Globalization and Disease: The Case of SARS,” Brookings Institution, dated February 2004. 2  Please see Global Investment Strategy Weekly Report, “Bond Yields: How High Is Too High?” dated January 17, 2020.   Global Investment Strategy View Matrix MacroQuant Model And Current Subjective Scores Strategic Recommendations Closed Trades

Special Report

Highlights Economy & Inflation: The macro backdrop in Japan remains bond friendly for JGBs; growth momentum is only starting to bottom out, but will lag the recovery heralded by improving global leading economic indicators, while inflation remains closer to 0% than the BoJ's 2% target. BoJ Options: The BoJ has limited policy choices available to provide more stimulus, with negative policy rates crushing Japanese bank profitability and the central bank already owning massive amounts of JGBs and ETFs. 2020 Japan Bond Strategy: Dedicated bond investors should overweight Japan in global government bond portfolios over the next year, as a complement to an overall below-benchmark duration exposure. Expect some mild yield curve steepening pressure if the BoJ attempts to use its limited remaining policy tools, like targeting shorter maturities for its asset purchases, to try and alleviate the pressure on banks from negative rates and a flat yield curve. Feature Chart 1The Role Of Japan In Global Bond Investing Is Complex In a year where the majority of global bond markets have delivered stellar returns, Japanese fixed income performance has predictably languished in 2019 compared to the other developed economies. Despite a cyclically weak economy with very low inflation, Japanese government bond (JGB) yields have been locked in narrow ranges at or below 0% throughout the year. Monetary policy is a big reason for that, as the Bank of Japan (BoJ) has run of out of fresh stimulus options to try and push JGB yields even lower. In this Special Report, we make the case for owning JGBs as a low-beta, defensive asset in global fixed income portfolios over the next 6-12 months – a period when improving growth is expected to exert upward pressure on global bond yields, but where JGB yields are expected to remain anchored with Japan likely to lag the global upturn (Chart 1). The Japanese Growth & Inflation Backdrop Is No Threat To JGBs Japan’s economy has suffered alongside the global industrial downturn in 2019, with the Japanese manufacturing PMI struggling below 50 for seven consecutive months. Both business investment and exports have been contracting, in response to the slump in global and trade and increase in uncertainty related to the US-China tariff war. The underlying trend in consumer spending – the largest component of Japan’s economy – is more difficult to interpret, however, because of the volatility surrounding the October hike in the consumption tax. On October 1st, Japanese Prime Minister Abe’s government finally passed its long-desired hike in the consumption tax rate from 8% to 10%, in a bid to begin chipping away at Japan’s massive fiscal debt burden. The timing of the move, which had been twice delayed previously, appears ill-advised given the overall weakness in the economy. That can be seen in the response of consumer demand to the tax increase. Japanese consumers, quite rationally, front-loaded purchases in September in advance of the tax hike, but that surge was followed by a collapse in nominal retail sales in October of -14% on a month-over-month basis (Chart 2). This was much larger than the decreases seen after the previous consumption tax increases in 1997 and 2014. This may seem surprising given that the Japanese unemployment rate is a stunningly low 2.4%, suggesting a tight labor market that should be boosting wage growth and consumer confidence. Quite the opposite is happening, however, as consumer confidence is depressed and wage growth is contracting in real terms (bottom panel). Even more unusual is that real disposable income growth for Japanese households is now up to 5% (year-over-year), after stagnating for much of the previous decade. The acceleration is due to more people, especially women and senior citizens, having joined the labor force and found work – on a “per worker” basis, income growth is much less impressive and is more in line with stagnant wage growth. Therefore, unless there is clear acceleration of wages, a sustainable improvement in aggregate consumption is not expected. In the absence of an unlikely consumer boom, a pickup in global trade and manufacturing activity is a necessary requirement to stabilize the Japanese economy where the manufacturing sector is relatively larger than that of other major developed countries (20% of GDP).1 On that front, the news is getting better with the recent improvement seen in the global manufacturing PMI, global ZEW and our own global leading economic indicator (LEI). Looking at the overall conditions in Japan's manufacturing sector, however, there are still mixed signals indicating that a true bottom has been reached (Chart 3): Chart 2Challenging Times For Japanese Consumers Chart 3A Trough In Japanese Manufacturing the Markit manufacturing PMI did rise modestly in November, but remains at only 48.9 (top panel); the most recent Tankan survey from the BoJ showed that both large and small firms in the manufacturing sector expect business conditions to worsen (second panel); real capital spending growth did perk up in the third quarter in the GDP accounts, but additional gains are unlikely given the still moderate reading on manufacturing business confidence (third panel); machine tool orders continue to contract on a year-over-year basis, although the growth in domestic orders may be stabilizing; foreign orders remain depressed due to weakening Chinese demand for automotive and electronic equipment (bottom panel). Chart 4Japan"s Non-Manufacturing Sector Is Struggling Turning to the services sector, which accounts for around 80% of the Japanese economy, the data also show only moderate growth. This is mainly because demand for services is less influenced by global economic conditions, and more related to the tight labor market and rising household income growth. Even given that better fundamental backdrop, however, it is still not clear that services can drive growth in the Japanese economy in 2020 (Chart 4): Chart 5Past The Worst For Japanese Exports while the Tankan survey of large non-manufacturing firms has stayed at the same high level seen since 2014, the data for smaller firms has weakened steadily throughout 2019; the Markit services PMI index has remain solidly above the 50 boom/bust line all year long, yet overall sales for non-manufacturers contracted by -3.1% on a year-over-year basis in the third quarter of the year according to Japan’s Ministry of Finance. One potential ray of hope for Japanese growth comes from exports. While growth in total nominal exports is still contracting by –9.2% on a year-over-year basis, the recent pickup in our global LEI is heralding a potential bottoming in export momentum (Chart 5). In particular, the emerging market sub-component of our global LEI is signaling a potentially sharp pickup in demand for Japanese exports to Asia (middle panel). A similar optimistic message is given regarding Chinese demand, based on the modest improvement in the OECD China LEI (bottom panel). Yet these developments are still in the early stages and could be derailed by a breakdown of the US-China trade negotiations (not the base case scenario of BCA’s geopolitical strategists). Summing it all up, the Japanese economy remains in a fragile state after absorbing multiple blows from trade uncertainty, contracting global manufacturing activity and, more recently, an ill-timed hike in the consumption tax. While some data is showing signs of bottoming, the momentum is unlikely to be strong enough in 2020 to generate much upward pressure on Japanese bond yields. Japanese Inflation Remains A No-Show Japan remains the poster child for the global low inflation backdrop of the post-crisis decade. Even an economy with an unemployment rate near record lows can still not generate inflation sustainably above 0%. Headline CPI inflation is now at only 0.2%, while and core CPI inflation is slightly higher at 0.7% (Chart 6). The former is being dragged down by the lagged impact of lower oil prices and the stubbornly firm Japanese yen. More worrisome, however, is that services CPI inflation dipped slightly below 0% in November (middle panel), in line with the contraction seen in the domestic corporate goods prices and import prices indices (bottom panel). Chart 6Inflation Remains WELL Below The BoJ"s Target Chart 7Not A Consistent Story From Japanese Inflation Expectations Market-based inflation expectations, measured using either CPI swap rates or breakevens from inflation-linked bonds, are also hovering close to 0% (Chart 7). In a bit of a surprise, survey-based measures of inflation expectations produced by the BoJ are closer to the 2-3% range, even though realized inflation only reached that range once, on an annual calendar year basis, since 1991 – in 2014, unsurprisingly another year with a consumption tax increase. The market-based inflation indicators are more important for bond investors, however. It will take a sustained increase in realized inflation before the JGB market begins to worry about inflation again. Perhaps that can begin to happen in 2020 if Japanese and global growth improves, coming alongside some yen weakness. More likely, next year will be another year of mushy inflation readings from Japan as the economy tries to emerge from the slowdown seen in 2019 and the unnecessary tightening of fiscal policy coming from the consumption tax hike (which is likely to cause a temporary, but not sustained, blip in realized inflation rates in 2020). Bottom Line: The macro backdrop in Japan remains bond friendly for JGBs; growth momentum is only starting to bottom out, but will lag the recovery heralded by improving global leading economic indicators, while inflation remains closer to 0% than the BoJ's 2% target. There’s Not Much New The BoJ Can Do The BoJ remains in a bind with regards to future monetary policy decisions. Inflation remains far below its target, while the economy is struggling to generate above-potential growth. Yet unemployment remains exceptionally low and, by the BoJ’s own estimates, Japan’s economy is operating with no spare capacity (i.e. the output gap is a positive number). For a traditional central bank that believes in the tradeoff between spare capacity/unemployment and inflation, like the BoJ, the data is sending a very confusing message about the next policy move. Can A Weaker Yen Solve Japan’s Low Inflation Problem? Chart 8The Balance Of Payments Remains Yen-Supportive The BoJ’s job in setting the right policy to get Japanese inflation higher would be made a lot easier if the yen were not so stubbornly firm. On a trade-weighted basis, the yen is 10.1% above the low seen in 2018 and 22.9% above the 2015 low (Chart 8). This has happened despite the disappointing performance of the Japanese economy and the negative interest rates that have typically made the yen a good funding currency for global carry trades. While there has been likely been some safe-haven demand for the yen given the global growth uncertainties and sharp decline in non-Japanese bond yields in 2019, the root cause for the yen strength is more fundamental. Our colleagues at BCA Research Foreign Exchange Strategy published a Special Report last week, reviewing the balance of payments of the major global currencies.2 Going through the components for Japan, the current account balance remains firmly positive at 3.4% of GDP, despite the fact that the trade balance is now negative. The main reason for that is the steady 4% of GDP in the investment income balance – an inevitable result given Japan’s massive net foreign asset position. On the capital account side, there has been a steady increase in net foreign direct investment (FDI) outflows over the past several years, as more Japanese companies have moved productive capacity offshore (and fewer foreign companies invest in Japan). In addition, portfolio outflows have been gaining momentum with Japanese investors ramping up their purchases of foreign long term assets. Add it all up and Japan's basic balance (the current account plus net FDI) is now negative for the first time since 2015 (bottom panel). Thus, Japan’s balance of payments may now finally be in a position to generate some yen weakness that can help boost domestic inflation – if some of the uncertainties over global growth and the US-China trade negotiations begin to dissipate, as we expect in 2020. So what can the BoJ do? The BoJ has maintained a negative policy interest rate for 45 months since cutting rates below zero in February 2016. Yet according to our BoJ Monitor, there is still a need for additional monetary policy easing to combat weak growth and inflation (Chart 9). Chart 9The BoJ"s Policy Options Are Limited Interest rate markets do not expect the BoJ to do much with short-term interest rates in 2020, with only -5bps of cuts discounted in the Japanese overnight index swap (OIS) curve. BoJ officials have not outright dismissed the possibility that another rate cut could happen, but policymakers have learned that negative rates are lethal for the profits of the banking system. That can be seen in Japan, where bank profits have contracted -19.4% over the past year as negative borrowing rates have become more deeply entrenched. Other parts of the Japanese financial system, like insurance companies and pension funds that need income to meet payouts and liabilities, also suffer from negative interest rates on domestic fixed income assets. Therefore, the BoJ cutting policy rates deeper into negative territory is a very unlikely outcome, even if the economy and inflation continue to struggle, as the risks to the financial system would be worsened. So what else can the BoJ do to provide further monetary stimulus, if necessary? The choices are limited. The BoJ could alter its forward guidance to signal to the market that rates will remain low for a very long time, but that would have a limited effect with rate levels already so low. The central bank could also ramp up its pace of asset purchases, but that will also prove difficult as it owns nearly 50% of outstanding JGBS and nearly 80% of outstanding ETFs. Buying more assets would likely not generate any easier financial conditions, and would simply further disrupt the liquidity of Japan’s financial markets. A March 2019 academic study found that the impact on Nikkei 225 stock returns from the BoJ ETF buying has grown smaller over time despite the increased purchase amounts.3 Chart 10More Room For The BoJ To Buy Shorter Maturity Bonds The BoJ could lower its “Yield Curve Control” target yield for 10-year JGBs to below 0%, but that would also prove difficult as the BoJ already owns a whopping 75% of all outstanding 10-year JGBs (Chart 10) – a figure that would likely need to increase if global bond yields continue to drift higher in 2020, as we expect, forcing the BoJ to buy more 10-year JGBs to ensure that yields do not rise. A unique option might be for the BoJ to purchase foreign bonds. This would potentially help further weaken the yen, which would help increase exports and inflation. Although given the current global backdrop of populism and trade protectionism, a policy specifically designed to weaken the yen would likely not be greeted warmly by other countries. In our view, there is only one plausible option that the BoJ could consider to ease policy further in 2020 to fight low inflation – choosing a different maturity point for its Yield Curve Target. For example, instead of targeting a 10-year JGB near 0%, the BoJ could target a 5-year JGB near 0%. The BoJ owns a lower share of outstanding bonds in that part of the curve (around 45%, by our calculations). The net result could be a steeper JGB curve, which could help ease the drag on profits of the Japanese banks from negative longer-term yields and a flat curve (Chart 11). One thing is for certain: none of the conditions that we have long believed would be necessary before the BoJ would consider abandoning its yield curve target and letting yields rise – a USD/JPY exchange rate between 115 and 120; core CPI inflation and nominal wage inflation both above 1.5%; and clear signs of JGB overvaluation - are currently in place (Chart 12). The BoJ has to continue to stay accommodative, even if other central banks turn less dovish as global growth improves in 2020. Chart 11Shifting BoJ Purchases Could Generate A Steeper JGB Curve Chart 12These Must ALL Happen Before The BoJ Lifts Its JGB Yield Target   Bottom Line: The BoJ has limited policy choices available to provide more stimulus, with negative policy rates crushing Japanese bank profitability and the central bank already owning massive amounts of JGBs and ETFs. Overweight Low-Beta JGBs In Global Bond Portfolios In 2020 Chart 13Overweight Low-Beta JGBs In 2020 As we have discussed in previous reports, yield betas of developed market sovereign bonds to changes in the “global” bond yield are a good tool to use when considering fixed income country allocation decisions when yields are rising everywhere.4 We are currently recommending overweight allocations to government bonds in countries with more dovish central banks and/or where yields are low in relative terms – namely, Germany, Japan and Australia. Not by coincidence, those are also countries whose government bonds have the lowest yield betas among the major developed economies. The rolling 52-week yield betas for JGB yields to the “global” yield (defined as the yield-to-maturity of the Bloomberg Barclays Global Treasury index) is shown in Chart 13. We show the betas for different maturity “buckets” across the yield curve, and we also present the same betas for US Treasuries and German government bonds for comparison. The betas for JGBs are consistent but positive across the entire yield curve, around 0.5 or less. German yields have a similar beta at shorter maturities but a beta close to 1.0 at the longer-end of the curve. US Treasuries, to no surprise, are the highest beta market, with yield betas of 1.5 or more across the entire yield curve. The positive low beta for JGBs means that Japanese bond yields will still move in the same direction as global yields, but with far less volatility. Thus, during the period when global government bonds are rallying, low-beta markets like Japan underperform versus global benchmarks. That has been the story in 2019, when much of the world needed to ease monetary policy but Japan was already at very accommodative policy settings. When global yields are rising, however, lower beta markets should see smaller yield increases and better relative performance. That will be the story for JGBs in 2020, given the strong likelihood that Japan will lag the global economic rebound that we expect next year and the BoJ will be forced to, once again, be the most dovish central bank among the major economies. Bottom Line: Dedicated bond investors should overweight Japan in global government bond portfolios over the next year, as a complement to an overall below-benchmark duration exposure. Expect some mild yield curve steepening pressure if the BoJ attempts to use its limited remaining policy tools, like targeting shorter maturities for its asset purchases, to try and alleviate the pressure on banks from negative rates and a flat yield curve.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Ray Park, CFA Research Analyst ray@bcaresearch.com Footnotes 1 Based on the value added from manufacturing as % of GDP. Other countries, by comparison: China: 29%; Germany: 21%; World: 16%; US: 11%. Source: United Nations and World Bank. 2 Please see BCA Research Foreign Exchange Strategy Special Report, “Updating Our Balance Of Payments Monitor” dated November 29, 2019, available at fes.bcaresearch.com. 3 Kimie Harada and Tatsuyoshi Okimoto, "The BOJ’s ETF Purchases and Its Effects on Nikkei 225 Stocks", RIETI Discussion Paper Series 19-E-014, March 2019. 4 Please see BCA Research Global Fixed Income Strategy Weekly Report, " Cracks Are Forming In The Bond-Bullish Narrative", dated October 23, 2019, available at gfis.bcaresearch.com.

An analysis on Brazil is available below. Feature Chart I-1Poor Performance By EM Stocks, Currencies And Commodities I had the pleasure of meeting again with a long-term BCA client Ms. Mea last week during my trip to Europe. Ms. Mea and I meet on a semi-annual basis, where she has the opportunity to query my analysis and view. In our latest meeting, she was more perplexed than usual by the global macro developments and financial market dynamics. Ms. Mea: All the seemingly positive news on the trade front is pushing up global share prices. In fact, a substantial portion -if not all -of the global equity price gains have occurred on days when there has been positive news surrounding the US-China trade negotiations. Given EM financial markets were the most damaged by the trade war, one would have thought that EM markets would outperform in a rally stemming from progress in negotiations. Yet this has not occurred. EM currencies have failed to advance (a number of currencies are in fact breaking down), EM sovereign credit spreads are widening and the relative performance of EM vs. DM share prices has relapsed (Chart I-1). What is causing this disconnect? Answer: The disconnect is due to a somewhat false narrative that the global trade and manufacturing recession as well as the EM/China slowdown were primarily caused by the US-China trade confrontation. The principal reason behind the global manufacturing and trade recession has been a deceleration in Chinese domestic demand. The latter can only partially be attributed to the US-China trade tariffs and tensions. Chart I-2 illustrates that mainland exports are not contracting while imports excluding processing trade1 are down 5% from a year ago. This implies that China’s growth slump has not been due to a contraction in its exports but rather due to weakness in its domestic demand. The principal reason behind the global manufacturing and trade recession has been a deceleration in Chinese domestic demand. The basis as to why mainland exports have held up so well is because Chinese exporters have been re-routing their shipments to the US via other countries such as Vietnam and Taiwan. Critically, the key force driving EM currencies and risk assets has been Chinese imports (Chart I-3). Mainland imports continue to shrink, with no recovery in sight. This is the reason why EM risk assets and currencies have performed so poorly, even amid the global risk-on environment. Chart I-2Chinese Imports Are Worse Than Exports Chart I-3China Imports Drive EM Currencies   Ms. Mea: Are you implying that a ceasefire in the trade war will not help Chinese growth rebound, and in turn support EM economies? The “Phase One” agreement and possible reductions in US tariffs on imports from China may help the Middle Kingdom’s exports, but not its imports. Crucially, the Chinese authorities will likely be reluctant to augment their credit and fiscal stimulus if there is a “Phase One” deal with the US. Absent greater stimulus, China’s domestic demand is unlikely to stage a swift recovery. In the case of a “Phase One” agreement, a mild improvement in business confidence in China and worldwide is likely, but a major upswing is doubtful. The basis is that business people around the world have witnessed the struggles faced by the US and China in their negotiations. They will likely doubt the ability of both nations to reach a structural resolution – and rightly so. Investors should realize that the Chinese economy does not depend on exports to the US nearly as much as is commonly believed. Importantly, global investors are miscalculating China’s negotiating strategy and tactics. We put much greater odds than many other investors on the possibility that China will continue to drag out the negotiations without signing the “Phase One” agreement. This could easily derail the global equity rally. Investors should realize that the Chinese economy does not depend on exports to the US nearly as much as is commonly believed. China’s shipments to the US have been around 3.3% of GDP, even before the trade war began. The value-added to the economy/income generated from China’s exports to the US is less than 3% of its GDP. In contrast, capital spending accounts for the largest share (42%) of China’s GDP. In turn, investment outlays are driven by the credit cycle and fiscal spending, rather than by exports. Chart I-4China: Stimulus And Business Cycle Ms. Mea: Turning to stimulus in China, the authorities have been easing for about a year. By now, the cumulative effect of this stimulus should have begun to revive the mainland’s domestic demand. Why do you still think China’s business cycle has not reached a bottom? Answer: Indeed, our credit and fiscal spending impulse has been rising since January. Based on its historical relationship with business cycle variables – it leads those variables by roughly nine months – China’s growth should have troughed in August or September (Chart I-4). However, the time lags between the credit and fiscal spending impulse and economic cycle are not constant as can be seen in Chart I-4. On average, the lag has been nine months but has also varied from zero (at the trough in early 2009) to 18 months (at the peak in 2016-‘17). Relationships in economics – as opposed to those in hard sciences – are not constant and stable. Rather, correlations and time lags between variables vary substantially over time. In addition, the magnitude of stimulus is not the only variable that should be taken into account. The potential multiplier effect is also significant. One way to proxy the multiplier effect is via the marginal propensity to spend by households and companies. In our opinion, the prime cause behind households’ and businesses’ reluctance to spend is the weak property market. Our proxies for Chinese marginal propensity to spend by companies and households have been falling (Chart I-5). This entails that households and businesses in China remain downbeat, which caps their expenditures, in turn offsetting the positive impact of stimulus. In our opinion, the prime cause behind households’ and businesses’ reluctance to spend is the weak property market. Without rapidly rising property prices and construction volumes, boosting sentiment and growth will prove challenging. We discussed the current conditions and outlook of China’s property market in last week’s report. Construction is the single largest sector of the mainland economy, and it is in recession: floor area started and under construction are all shrinking (Chart I-6). Chart I-5China: A Weak Multiplier Effect Chart I-6China Construction Is In Recession   It is difficult to envision an improvement in manufacturing and a rebound in demand for commodities/materials and industrial goods without a recovery in construction. Notably, Chart I-6 displays the most comprehensive data on construction, as it encompasses all residential and non-residential construction by property developers and all other entities. Ms. Mea: Why are some global business cycle indicators turning up if, as you argue, the global manufacturing slowdown originated from Chinese domestic demand and the latter has not yet turned around? Answer: At any point of the business cycle, it is possible to find data that point both up and down. Our ongoing comprehensive review of global business cycle data leads us to conclude that the improvement is evident only in a few circumstances, and is not broad-based. In particular: In China and the rest of EM, there is no domestic demand recovery at the moment. China and EM ex-China capital goods imports are shrinking (Chart I-7). Chinese consumer spending is also sluggish (Chart I-8). The rise in China’s manufacturing Caixin PMI over the past several months is an aberration. Chart I-7EM/China Capex Is Very Weak Chart I-8No Recovery For Chinese Consumers     In EM ex-China, Korea and Taiwan, narrow and broad money growth are underwhelming (Chart I-9). These developments signify that EM policy rate cuts have not yet boosted money/credit and domestic demand. We elaborated on this in more detail in our recent report. The basis for such poor transmission is banking-system health in many developing countries. Banks remain saddled with non-performing loans (NPLs). The need to boost provisions and fears of more NPLs continues to make banks reluctant to lend. Besides, real (inflation-adjusted) lending rates are high, discouraging credit demand. In the US and euro area, consumption – outside of autos – as well as money and credit growth have never slowed in this cycle. The slowdown has largely been due to exports and the auto sector. The latter may be bottoming in the euro area (Chart I-10). This might be behind the improvement in some business surveys in Europe. Chart I-9EM Ex-China: Money Growth Is At Record Low Chart I-10Euro Area’s Auto Sales: Is The Worst Over?   European business survey data are mixed, but the weakest segment - manufacturing – remains lackluster. In particular, Germany’s IFO index for business expectations and current conditions in manufacturing have not improved (Chart I-11, top panel). Similarly, the Swiss KOF economic barometer remains downbeat (Chart I-11, top panel). The only improvement is in Belgian business confidence, and a mild pickup in the euro area manufacturing PMI (Chart I-11, bottom panel). Chart I-11European Manufacturing And Business Confidence   In the US, shipping and carload data are rather grim. They are not corroborating the marginal improvement in the US manufacturing PMI. Overall, at this point there are no signs that domestic demand is recovering in China and the rest of EM, which have been the epicenter of the slowdown. The improvement is limited to some data in the US and Europe. Consistently, US and European share prices have been surging, while EM equities have dramatically underperformed. Ms. Mea: What about lower interest rates driving multiples expansion in both DM and EM equities? Answer: Concerning multiples expansion, our general framework is as follows: So long as corporate profits do not contract, lower interest rates will likely lead to equity multiples expansion. However, when corporate earnings shrink, the latter overwhelms the positive effect of a lower discount rate on multiples, and share prices drop along with lower interest rates. DM corporate profits are flirting with contraction, but are not yet contracting meaningfully. Hence, it is sensible that US and European stocks have experienced multiples expansion. In contrast, EM corporate earnings are shrinking at a rate of 10% from a year ago as illustrated in Chart I-12. The basis for an EM profit recession is the downturn in Chinese domestic demand and consequently imports. EM per-share earnings correlate much better with Chinese imports (Chart I-13, top panel) than US ones (Chart I-13, bottom panel). Chart I-12EM Profits And Share Prices Chart I-13EM EPS Is Driven By China Not The US   In fact, we have documented numerous times in our reports that EM currencies and share prices correlate well with China’s business cycle/global trade/commodities prices, more so than with US bond yields. This does not mean that EM share prices are insensitive to interest rates. They are indeed sensitive to their own borrowing costs, but not to US Treasury yields. Chart I-14 demonstrates that EM share prices move in tandem with inverted EM sovereign US dollar bond yields and EM local currency bond yields. Similarly, emerging Asian share prices correlate with inverted high-yield Asian US dollar corporate bond yields (Chart I-14, bottom panel). Chart I-14EM Share Prices And EM Bond Yields Chart I-15Chinese Bond Yields Herald Relapse In EM Stocks And Currencies In short, EM share prices typically sell off when EM borrowing costs rise – regardless if it is driven by mounting US Treasury yields or widening credit spreads. Looking forward, exchange rates hold the key. A relapse in EM currencies will push up both the US dollar and local currency bond yields in many EMs. That will in turn warrant a setback in EM share prices. Ms. Mea: What about the correlation between EM performance and Chinese local rates? Answer: This is an essential relationship. Chart I-15 demonstrates that EM share prices and currencies have a strong positive correlation with local interest rates in China. The rationale is that all of them are driven by China’s business cycle. Relapsing interest rates in China are presently sending a bearish signal for EM risk assets and currencies. Ms. Mea: What does all this mean for investment strategy? A few weeks ago, you wrote that if the MSCI EM equity US dollar index breaks above 1075, you would reverse your recommended strategy. How does this square with your fundamental analysis that is still downbeat? Answer: My fundamental analysis on EM/China has not changed: I do not believe in the sustainability of this EM rebound in general, and EM outperformance versus DM in particular. The key risk to my strategy on EM stems from the US and Europe. It is possible that US and European share prices continue to rally. EM share prices typically sell off when EM borrowing costs rise – regardless if it is driven by mounting US Treasury yields or widening credit spreads. Notably, the high-beta segments of the US equity market and the overall Euro Stoxx 600 index are flirting with major breakouts (Chart I-16A and I-16B). If these breakouts transpire, the up-leg in US and European share prices will be long-lasting. This will also drag EM share prices higher in absolute terms. This is why I have placed a buy stop on the EM equity index. Chart I-16AUS High-Beta Stocks Chart I-16BEuropean Equities: At A Critical Juncture   That said, I have a strong conviction that EM will continue to underperform DM, even in such a scenario. Hence, I continue to recommend underweighting EM versus DM in both global equity and credit portfolios. As we have recently written in detail, the global macro backdrop and financial market dynamics in such a scenario will resemble 2012-2014, when EM currencies depreciated, commodities prices fell and EM share prices massively underperformed DM ones (Chart I-17). Further, I am not arguing that the current global trade and manufacturing downtrends will persist indefinitely. The odds are that the global business cycle, including China’s, will bottom sometime next year. The point is that EM share prices have decoupled from fundamentals – namely corporate earnings growth – since January. The point is that EM share prices have decoupled from fundamentals – namely corporate earnings growth – since January (please refer to Chart I-12 on page 8). This is an unprecedented historical gap, making EM stocks, currencies and credit markets vulnerable to continued disappointments in EM corporate profitability. Ms. Mea: What market signals give you confidence in poor EM performance going forward? Answer: Even though the S&P 500 has broken to new highs, multiple segments of EM financial markets have posted extremely disappointing performance. These include: Small-cap stocks in EM overall and emerging Asia as well as the EM equal-weighted equity index have struggled to rally (Chart I-18). Chart I-17EM Underperformed During 2012-14 Bull Market Chart I-18Various EM Equity Indexes: Failure To Rally Is A Bad Omen   Various Chinese equity indexes – onshore and offshore, small and large – have failed to advance and continue to underperform the global equity index. EM ex-China currencies and industrial commodities prices have remained subdued (please refer to Chart I-1 on page 1). Ms. Mea: Would you mind reminding me of your country allocation across various EM asset classes such as equities, credit, currencies and fixed-income? Answer: Within an EM equity portfolio, our overweights are Mexico, Russia, central Europe, Korea and Thailand. Our equity underweights are Indonesia, the Philippines, Turkey, South Africa and Colombia. We continue recommending to short an EM currency basket including ZAR, CLP, COP, IDR, MYR, PHP and KRW. Today, we add the BRL to our short list (please refer to the section below on Brazil). As to the country allocation within EM local currency bonds and sovereign credit portfolios, investors can refer to our asset allocation tables below that are published at the end of each week’s report and are available on our web site. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Brazil: Deflationary Pressures Warrant A Weaker BRL The Brazilian real is breaking below its previous support. We recommend shorting the BRL against the US dollar. The primary macro risk in Brazil is not inflation but rather mounting deflationary pressures. Inflation has fallen to very low levels, to the bottom of the central bank’s target range (Chart II-1). Deflation or low inflation is dangerous when there are high debt levels. The Brazilian government is heavily indebted. With nominal GDP growth still below government borrowing costs and a primary budget balance at -1.3% of GDP, the public debt trajectory remains unsustainable as we discussed in previous reports (Chart II-2). Chart II-1Brazil: Undershooting Inflation Target Chart II-2Public Debt Dynamics Are Still Not Sustainable   The cyclical profile of the economy is very weak as shown in Chart II-3. Tight fiscal policy and a drawdown of foreign exchange reserves have caused money growth to slow. That in turn entails a poor outlook for the economy, which will reinforce the deflationary trend. Accordingly, Brazil needs to reflate its economy to boost nominal GDP, which is the only scenario where the nation escapes a public debt trap. Yet, fiscal policy is straightjacketed by the spending cap rule, which stipulates that government spending can only grow at the previous year’s IPCA inflation rate. Federal government spending is set to grow only at the low nominal rate of 3.4% in 2020. Hence, monetary policy is the sole tool available for policymakers to reflate. Both bond yields and bank lending rates remain elevated in real terms. This hampers any recovery in the business cycle. Notably, the marginal propensity to spend by companies and consumers is declining, foreshadowing weaker economic activity ahead (Chart II-4). Chart II-3Brazil: The Economy Is Weak Chart II-4Brazil: Propensity To Spend Is Declining   The central bank is determined to reduce interest rates further. As such, they cannot control the exchange rate. Indeed, the Impossible Trinity thesis states that in an economy with an open capital account (like in Brazil), the authorities cannot control both interest and exchange rates simultaneously. Minister of Economy Paulo Guedes stated in recent days that tight fiscal and easy monetary policies are consistent with a lower currency value. Brazilian policymakers are open to the idea of a weaker exchange rate and will not defend the real. Their currency market interventions are intended to smooth volatility in the exchange rate but not preclude depreciation. In fact, currency depreciation is another option to boost nominal growth that the nation desperately needs. Brazilian policymakers are open to the idea of a weaker exchange rate and will not defend the real. Their currency market interventions are intended to smooth volatility in the exchange rate but not preclude depreciation. Commodities prices remain an important driver of the Brazilian real (Chart II-5). These have failed to rebound amid the risk-on regime in global financial markets. This suggests that the path of least resistance for commodities prices is down, which is bad news for the real. Brazil’s current account deficit is widening and has reached 3% of GDP (Chart II-6). Notably, not only are export prices deflating but export volumes are also shrinking (Chart II-6, bottom panel). Chart II-5BRL And Commodities Prices Chart II-6Widening Current Account Deficit   Chart II-7The BRL Is Not Cheap Meanwhile, the nation’s foreign debt obligations – the sum of short-term claims, interest payments and amortization over the next 12 months – are at $190 billion, all-time highs. As the real depreciates, foreign currency debtors (companies and banks) will rush to acquire dollars or hedge their dollar liabilities. This will reinforce the weakening trend in the currency. Finally, the Brazilian real is not cheap - it is close to fair value (Chart II-7). Hence, valuation will not prevent currency depreciation. Bottom Line: We are initiating a short BRL / long US dollar trade. Investors should remain neutral on Brazil within EM equity, local bonds and sovereign credit portfolios. Investors with long-term horizon should consider the following strategy: long the Bovespa, short the real. This is a bet that Brazil will succeed in reflating the economy at the detriment of the currency. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Andrija Vesic Research Analyst andrijav@bcaresearch.com     Footnotes 1    Processing trade includes imports of goods that undergo further processing before being re-exported.   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations