Consumer

Highlights Fed: Fed policymakers are sending a unified message that they want to keep rates on hold until they see a significant increase in inflation. However, our reading of their recent remarks suggests that they will be reluctant to actually cut rates unless GDP growth falls to below its estimated potential. Economy: If we strip out the volatile net exports, government and inventory components of growth, we see that economic activity slowed to below potential in the first quarter. However, the timeliest data on consumer spending, nonresidential investment and residential investment all suggest that Q1 will be the trough for the year. All in all, economic growth should be comfortably above potential in 2019, keeping rate cuts at bay. Investment Strategy: Investors should keep portfolio duration low, avoiding the 5-year/7-year part of the Treasury curve. Investors should also overweight spread product versus Treasuries, with a focus on Baa and junk rated corporate bonds. Feature Since January, Federal Reserve policymakers have sent a strikingly unified message: Policy should remain “patient” in an effort to re-anchor inflation expectations and demonstrate the symmetry of the Fed’s 2 percent inflation target. Take for example, two excerpts from recent speeches by Boston Fed President Eric Rosengren and Chicago Fed President Charles Evans. Rosengren:1 My own preference is for the Federal Reserve to adopt an inflation range that explicitly recognizes the challenge of the effective lower bound. We might be forced to accept below-2-percent inflation during recessions, but we would commit to achieving above-2-percent inflation in good times, so as to provide more policy space to counteract the next recession. Evans:2 I think the Fed must be willing to embrace inflation modestly above 2 percent 50 percent of the time. Indeed, I would communicate comfort with core inflation rates of 2-1/2 percent, as long as there is no obvious upward momentum and the path back toward 2 percent can be well managed. The consensus appears to be not only that higher inflation is necessary before the Fed lifts rates again, but also that the Fed should explicitly target an overshoot of its 2 percent target. With trailing 12-month core PCE inflation running at only 1.55% as of March, it will undoubtedly take some time before these inflation goals are met. We think the Fed’s commitment to keeping rates steady could waver if financial conditions ease sufficiently.3 But for now, with the market priced for 36 basis points of rate cuts over the next 12 months, the more pertinent question is: What will it take for the Fed to lower rates from current levels? Expecting A Rate Cut? Don’t Hold Your Breath Our Fed Monitor has an excellent track record calling turning points in monetary policy, and at present it is very close to zero, consistent with the Fed’s “on hold” stance (Chart 1). The Monitor is comprised of 44 indicators of economic growth, inflation and financial conditions. In other words, for the Monitor to recommend rate cuts going forward we will need to see some further deterioration in either economic growth, inflation or financial markets (Chart 2). This is roughly consistent with how Chicago Fed President Evans described his reaction function in his speech from two weeks ago: Chart 1"On Hold" Stance Justified "On Hold" Stance Justified "On Hold" Stance Justified Chart 2Fed Monitor Components Fed Monitor Components Fed Monitor Components If growth runs close to or somewhat above its potential and inflation builds momentum, then some further rate increases may be appropriate over time… In contrast, if activity softens more than expected or if inflation and inflation expectations run too low, then policy may have to be left on hold – or perhaps even loosened – to provide the appropriate accommodation to obtain our objectives. Our interpretation of the Fed’s reaction function is that it wants to maintain an accommodative monetary policy to ensure that inflation and inflation expectations move higher over time. However, it will consider monetary policy to be accommodative as long as GDP growth stays close to, or above, estimates of its potential rate. In other words, while the Fed is in no rush to tighten, we probably need to see a significant period of below-potential GDP growth before rate cuts are on the table. In his speech, Evans indicates that his personal estimate of potential GDP growth is 1.75%. The March Summary of Economic Projections shows that the central tendency of FOMC participant estimates is 1.8% - 2%. Our view is that U.S. growth will easily surpass this threshold in 2019, keeping rate cuts at bay. Tracking U.S. Growth Markets were caught off guard last week when we learned that real GDP grew 3.17% in the first quarter, above consensus estimates and well above the 1.8% - 2% potential growth threshold. However, the headline Q1 figure was flattered by significant gains in a few volatile GDP components. Chart 3Underlying Growth Slowdown Underlying Growth Slowdown Underlying Growth Slowdown Much like how core measures of inflation strip out volatile food and energy prices to give us a better sense of the underlying trend, we can also look at Real Final Sales To Domestic Purchasers (FSDP) to get a better sense of the underlying trend in economic growth. FSDP includes only consumer spending, nonresidential investment and residential investment. That is, it removes government spending, net exports and inventory investment from the overall number. Viewed this way, we see that the U.S. economy did experience a significant growth slowdown in the first quarter. Real FSDP grew only 1.45% in Q1, below the 1.8% - 2% potential growth threshold (Chart 3). Net Exports & Inventories Chart 4Net Exports & Inventories Net Exports & Inventories Net Exports & Inventories First quarter GDP was boosted by a +1.03% contribution from net exports and a +0.65% contribution from inventory investment, neither of which is likely to be repeated in Q2 (Chart 4). The top panel of Chart 4 shows just how unusual it is to see such a large contribution from net exports, an event that becomes even less likely when you factor in the dollar’s recent appreciation (Chart 4, panel 2). Turning to inventories, a significant build was long overdue given the backlog of orders seen during the past two years. But the ISM Manufacturing Index’s backlog of orders component has now fallen back to a neutral level (Chart 4, bottom panel). This suggests that firms are comfortable with their current inventory stockpiles, and that no aggressive inventory increases are likely during the next few quarters. Interestingly, while net exports and inventories will almost certainly pressure GDP growth lower in Q2, back toward the growth rate in FSDP, the latter has probably already troughed for the year. Recent data on consumer spending, nonresidential investment and residential investment all appear to have turned a corner. Consumer Spending Consumer spending added a meager +0.8% to GDP in Q1, but core retail sales growth has recovered sharply after having plunged near the end of last year (Chart 5). What’s more, with consumer sentiment close to one standard deviation above its historical mean – whether we look at expectations or current conditions surveys – consumers don’t seem inclined to retrench in the months ahead (Chart 6). Chart 5Consumer Spending Consumer Spending Consumer Spending Chart 6Buoyant Consumer Sentiment Buoyant Consumer Sentiment Buoyant Consumer Sentiment Nonresidential Investment Chart 7Nonresidential Investment Nonresidential Investment Nonresidential Investment We expected business investment to weaken in Q1, and its +0.4% growth contribution is low compared to recent readings. The decline was anticipated due to last year’s significant deterioration in global growth. Slower global growth necessarily causes firms to downgrade their profit expectations. Faced with lower expected profits, companies are much more inclined to curtail investment. However, considering the outlook heading into mid-year, we have already noticed signs of improvement in leading global growth indicators.4 More recently, we have even seen that improvement translate into stronger U.S. investment data. Core durable goods new orders grew +17% (annualized) in March, dragging the year-over-year rate up to +5.3% (Chart 7). Further, our BCA Composite New Orders Indicator – a weighted combination of ISM New Orders and NFIB Capital Spending Plans – has bounced during the past few months, returning close to its historical mean (Chart 7, panel 3). An average of Capital Spending Intentions from regional Fed surveys also remains close to one standard deviation above its historical average (Chart 7, bottom panel). Residential Investment Residential investment (aka Housing) has exerted a meaningful drag on GDP growth in each of the past five quarters, and it lowered GDP by -0.1% in Q1 (Chart 8). However, much like with consumer spending and nonresidential investment, the timely economic data suggest a turnaround is in the offing. Much like with consumer spending and nonresidential investment, the timely economic data suggest a turnaround is in the offing. Optimism has returned to housing since mortgage rates fell earlier this year. New home sales and mortgage purchase applications have jumped, and single-family housing starts are the only important housing-related data that haven’t yet rebounded. We expect that rebound to occur soon, as do homebuilders whose confidence has risen during the past few months. Homebuilder optimism surveys remain close to one standard deviation above their historical averages (Chart 9). Chart 8Residential Investment Residential Investment Residential Investment Chart 9Buoyant Homebuilder Confidence Buoyant Homebuilder Confidence Buoyant Homebuilder Confidence Bottom Line: Fed policymakers are sending a unified message that they want to keep rates on hold until they see a significant increase in inflation. However, our reading of their recent remarks suggests that they will be reluctant to actually cut rates unless GDP growth falls to below its estimated potential. Potential GDP growth is estimated to be in the 1.8% to 2% range. If we strip out the volatile net exports, government and inventory components of growth, we see that economic activity slowed to below potential in the first quarter. However, the timeliest data on consumer spending, nonresidential investment and residential investment all suggest that Q1 will be the trough for the year. All in all, economic growth should be comfortably above potential in 2019, keeping rate cuts at bay. Investment Implications To translate the above views on the economy and the Fed’s reaction function into a portfolio strategy, we first return to our Golden Rule of Bond Investing.5The Golden Rule states that if the Fed delivers more (fewer) rate hikes than are currently discounted in the market over the next 12 months, then the Treasury index will earn negative (positive) excess returns versus cash during that investment horizon (Chart 10). At present, this means that investors should only expect positive excess returns from taking duration risk in the event that the Fed cuts rates by more than 36 basis points during the next 12 months. Given our view that rate cuts are unlikely, investors should maintain below-benchmark portfolio duration. Chart 10The Golden Rule's Track Record The Golden Rule's Track Record The Golden Rule's Track Record If we further assume that market expectations will shift to price-in fewer rate cuts, or even possibly some rate hikes, then we would expect 5-year and 7-year yields to rise the most (Chart 11). Investors should avoid those maturities and focus their Treasury exposure on the short and long ends of the curve. These barbell over bullet trades have the advantage of being positive carry, so they will earn money even if rate hike expectations are unchanged.6  Chart 11Avoid The 5- And 7-Year Maturities Avoid The 5- And 7-Year Maturities Avoid The 5- And 7-Year Maturities Chart 12Investment Grade Spread Targets Investment Grade Spread Targets Investment Grade Spread Targets Finally, the combination of above-potential GDP growth and a patient Fed is positive for spread product. Investors should remain overweight spread product versus Treasuries in bond portfolios, focusing on Baa and junk rated corporate bonds. Spreads for those credit tiers remain wide compared to historical median levels for this phase of the cycle (Charts 12 &13).7 Chart 13High-Yield Spread Targets High-Yield Spread Targets High-Yield Spread Targets Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Footnotes 1 https://www.bostonfed.org/news-and-events/speeches/2019/monetary-policymaking-in-todays-environment.aspx 2 https://www.chicagofed.org/publications/speeches/2019/risk-management-and-the-credibility-of-monetary-policy 3 Please see U.S. Bond Strategy Weekly Report, “The New Battleground For Monetary Policy”, dated March 26, 2019, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, “Bond Kitchen”, dated April 9, 2019, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, “Paid To Wait”, dated February 26, 2019, available at usbs.bcaresearch.com 7 For further details on how we calculate these spread targets please see U.S. Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights We remain constructive on the U.S. economy, …: It was another uneven week, but conditions remain broadly favorable for the U.S., and the expansion is intact. … and things seem to be perking up in the rest of the world, in line with BCA’s house view, …: China’s PMI data gave global markets a boost and European PMIs hinted at the potential for green shoots on the continent. … but money managers get paid to worry for their clients, and we get paid to worry for the managers, …: We would be remiss if we didn’t explore alternative scenarios, especially around an unobservable variable like the equilibrium fed funds rate. … so we’re always looking for the ways that we could be getting it wrong: This week’s report explores how the landscape would look from the perspective of consumption, investment, and government spending if a recession were at hand. Feature Chart 1Selloff, What Selloff? Selloff, What Selloff? Selloff, What Selloff?   Last week’s data were mixed, but there is no doubt, as we’ve acknowledged throughout 2019, that the U.S. economy is decelerating. The deceleration has fanned recession fears, and the yield curve’s fleeting inversion two weeks ago added fuel to the fire.1 The sell-off in financial markets in the fourth quarter seemed largely to have been animated by concerns that the Fed was pushing the fed funds rate into restrictive territory. The sharp decline in equities, and the sharp rise in corporate bond yields, amounted to a material tightening in financial conditions that threatened to become a self-fulfilling prophecy. What a difference a quarter makes. The potent first-quarter rally has reversed much of the fourth quarter’s tightening of financial conditions (Chart 1), while the FOMC’s March meeting indicated that the Fed has pivoted from defending against inflation overshoots to trying to correct its extended post-crisis undershoot. The threat that the Fed would follow the typical path of tightening into a recession has now receded, at least for the rest of 2019. As long as inflation doesn’t suddenly flare up, the expansion should remain intact, provided that the Fed hasn’t already lifted short rates into restrictive territory. We have contended that it hasn’t, as the fed funds rate is comfortably below our current estimate of the equilibrium rate, and is even further below our year-end equilibrium projection. We are well aware that the equilibrium rate cannot be directly observed, and that our estimate may be off the mark. We therefore devote this week’s report to considering what the building blocks of GDP might look like if a recession were about to begin. We particularly focus on consumption, which accounts for the lion’s share of U.S. activity, and indirectly affects both investment and government spending.2 Is Consumption On A Recession Path? Retail sales contracted month-over-month in February, though upward revisions to the January data made the release something of a wash. Year to date, though, retail sales growth has not been strong enough to erase the disappointment from December’s lousy print. From a longer-term perspective, real retail sales don’t suggest anything definitive about the business cycle: although they’re in a mini downtrend, previous pre-recession slides have been steeper and/or longer (Chart 2, top panel). Growth in real personal consumption expenditures (PCE), the consumption input to GDP, has been trendless for the last three years, but is not in the extended slide that preceded other recessions, nor has it yet become stretched in this cycle (Chart 2, bottom panel). Chart 2Neither Here Nor There Neither Here Nor There Neither Here Nor There   Chart 3Steady As She Goes Steady As She Goes Steady As She Goes We find that consumption fundamentals are sending a clearer message than the retail sales or PCE series themselves. We segment the fundamentals into three components: ongoing demand for workers, the prospects for wage increases, and households’ capacity to borrow to support spending. The labor market is currently quite strong and net payroll growth has been remarkably steady for the last four years (Chart 3). Our payrolls model, which incorporates initial unemployment claims, temporary workers and NFIB small business hiring plans, projects no more than modest slowing (Chart 4). Chart 4No More Than Mild Deceleration Ahead No More Than Mild Deceleration Ahead No More Than Mild Deceleration Ahead     Prices rise when demand outpaces supply, and the excess of job openings over unemployed workers (Chart 5) bodes well for wage growth. The elevated rate of employees quitting their jobs is also a positive sign (Chart 6). A worker doesn’t quit one job unless s/he has a higher-paying one lined up. We therefore read the elevated quits rate as an indication that the competition to attract employees is fierce, and that workers have regained some measure of bargaining power. Chart 5More Jobs Than Candidates ... More Jobs Than Candidates ... More Jobs Than Candidates ... Chart 6... Makes For A Johnny Paycheck Labor Market ... ... Makes For A Johnny Paycheck Labor Market ... ... Makes For A Johnny Paycheck Labor Market ...   The combination of rising household income and a light debt-servicing burden augurs well for consumption. A negative unemployment gap (an unemployment rate below the estimated natural rate of unemployment) also tends to be good for compensation growth. Over the last 30 years, annualized average hourly earnings (AHE) have grown one-and-a-half times faster when the unemployment gap is negative than when it is positive, and the earnings growth rates have been remarkably consistent (Chart 7). Household income will have a solid tailwind behind it if AHE gains can catch up to the nearly 4% level consistent with negative gaps in the late ‘80s, late ‘90s and mid-aughts. Chart 7... Where Employers Have To Keep Employees Happy ... Where Employers Have To Keep Employees Happy ... Where Employers Have To Keep Employees Happy Employment and wage gains suggest that rising household incomes will support spending, but the support would be undermined if households chose to use the income gains to pay down debt. Households have been shoring up their balance sheets ever since the crisis, more than tripling the savings rate from its summer 2005 low (Chart 8, top panel), and have now unwound nearly all of the debt (as a share of GDP) they took on in the ’01-’07 expansion (Chart 8, second panel). They may not yet be done, but the pace at which they’ve been deleveraging has slowed considerably over the last few years. With today’s still-low interest rates, servicing households’ debt burden is easier than it has been at any time in the last 40 years (Chart 8, bottom panel). Households are positioned to take on more debt if they so choose. Chart 8Low Rates Make For A Light Burden Low Rates Make For A Light Burden Low Rates Make For A Light Burden Bottom Line: Prospects for continued payroll expansion and wage gains are good, and households have the capacity to borrow to augment spending. We therefore expect that consumption is not on a recessionary path. The fundamentals underlying the U.S. economy’s largest pillar are solid. Could Investment Tip The Economy Into A Recession? Consumption is clearly the 800-pound gorilla of the U.S. economy. It accounted for close to 70% of GDP in the fourth quarter, and when it sneezes, the overall economy catches a cold. It has been a relatively stable series over time, however, and its infrequent contractions tend to be pretty modest. The story is quite different for private domestic investment, which routinely makes wild swings, and tends to seize up during recessions (Chart 9). Even though investment and government spending each account for just a quarter of consumption’s weight, it’s statistically easiest for investment to negate 2% growth in the rest of the economy (Table 1). Chart 9Consumption May Be Larger, But Investment Punches Harder Consumption May Be Larger, But Investment Punches Harder Consumption May Be Larger, But Investment Punches Harder Table 1The Road To Recession If We Were Wrong If We Were Wrong We have previously demonstrated that consumption leads capex. It turns out that fixed investment is the opposite of the if-you-build-it-they-will-come “Field of Dreams” mantra; corporations will only build if the customers have already come (Chart 10). Consumption is gently slowing right now, which suggests that corporate investment is not about to boom. To induce a recession, though, fixed private investment would have to crater, and nothing in consumption’s current trend, the employment outlook, the compensation outlook, or households’ borrowing capacity suggests that consumption is at risk of plunging. Chart 10Consumption Drives Capex Consumption Drives Capex Consumption Drives Capex Surveys asking corporations about their investment plans have been decent coincident indicators of corporate fixed investment. The dip in capital spending plans from the NFIB survey suggests that demand for non-defense capital goods is headed lower (Chart 11, top panel), as does the decline in capex plans in the regional Fed surveys (Chart 11, bottom panel). Neither implies the sharp decline that would be required to offset trend growth in the rest of the economy, however. The corporate tax cut does not appear to have inflated 2018 capex, so 2019 investment should not be at risk of suddenly unwinding. Chart 11Capex May Soften, But It's Not About To Melt Capex May Soften, But It's Not About To Melt Capex May Soften, But It's Not About To Melt Residential investment accounts for around a fifth of private domestic investment. We have written about housing at length over the last several months and will not rehash the discussion here, other than to note that permits and starts remain in a broad uptrend (Chart 12, top panel), as do new and existing home sales (Chart 12, middle panel). Affordability has revived with the decline in mortgage rates, and is once again above its pre-crisis peaks. The inventory of homes for sale is also at multi-year lows (Chart 12, bottom panel). With the Fed sidelined for an extended period, housing demand appears as if it will hold up, and there’s nothing to worry about from a supply perspective. Chart 12The Housing Market Is Fine The Housing Market Is Fine The Housing Market Is Fine Bottom Line: The investment component of GDP does not appear as if it is about to contract in a significant way. It is unlikely to be the source of a cyclical inflection. Government Spending By virtue of its modest size and muted volatility relative to consumption and investment, government spending is the least likely component of GDP to extinguish the expansion. The prospects for a negative-two-standard-deviation event that could trigger a recession look especially slim. With employment and household incomes rising, and home values still appreciating, state and local tax receipts should be well supported. Pro-cyclical federal fiscal policy is an anomaly (Chart 13), but we see no signs that the current administration will reverse course with a presidential election on the horizon. Although defense has accounted for a shrinking share of federal spending ever since the end of the Cold War, it still accounts for 60% of federal spending (Chart 14, bottom panel), and a quarter of aggregate government spending. Consistent with CBO projections, we expect defense spending will continue to expand through 2020, as it remains a Republican priority. Federal entitlements were a sacred cow in the 2016 Trump campaign and will remain so in the 2020 campaign, given their importance to the administration’s aging rural base. Chart 13Fiscal Policy Has Turned Pro-Cyclical Fiscal Policy Has Turned Pro-Cyclical Fiscal Policy Has Turned Pro-Cyclical   State and local spending account for the majority of aggregate government spending (Chart 14, top panel). Healthcare and education are the biggest line items in state budgets, and healthcare reforms have the potential to alter budget composition, but aggregate spending moves in lockstep with aggregate revenues, as many states are constitutionally mandated to maintain balanced budgets. The main sources of state revenues are income taxes and sales taxes. Municipalities rely heavily on property taxes. Chart 14State Spending Matters ... State Spending Matters ... State Spending Matters ... State income tax receipts are clearly a function of employment, though the link has come and gone this cycle as the expansion has matured (Chart 15, top panel). Sales tax receipts move with employment as well, because consumption is tied to income (Chart 15, second panel). Property taxes are a function of appraised property values, for which home prices are a solid proxy (Chart 15, third panel). If demand for labor remains robust, wages face upward pressure, and home prices don’t contract, state and local government spending is unlikely to dry up anytime soon. Chart 15... And It's Tied To Income, Consumption, And Property Prices ... And It's Tied To Income, Consumption, And Property Prices ... And It's Tied To Income, Consumption, And Property Prices   As long as the expansion remains intact (and valuations don’t get silly), risk-friendly positioning remains appropriate. Bottom Line: Nothing points to a sudden decline in government expenditures on the order of the negative-two-standard-deviation move which would be required to induce a recession. Weakness in employment and wage growth would hurt state tax revenues, reinforcing a slowdown in consumption, but that is not our base-case scenario for 2019. Investment Implications Investors should stay the course and remain overweight equities, given that a recession is not imminent. Although we think the Fed’s largesse will ultimately be reversed in potentially heavy-handed fashion, its implicit pledge to remain on the sidelines into the second half of this year extends the runway for risk asset outperformance. We are not in love with the S&P 500 at current levels, and will be surprised if it continues to appreciate at its current pace, but the policy climate – monetary and fiscal – is conducive to outperforming cash and high-quality fixed income. We would hold some capital in reserve to deploy in the event of a pullback, but continue to advocate a risk-friendly portfolio tilt.   Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com   Jennifer Lacombe Senior Analyst, Global ETF Strategy jenniferl@bcaresearch.com Footnotes 1 With the yield curve clawing its way back to positive territory by March 29’s close, it actually has yet to invert on a monthly basis. We have heard its downbeat growth message loud and clear, however, and are on alert for further potential weakness. 2 We leave net exports out of our analysis, as they’re not consequential to the comparatively closed U.S. economy.

Highlights Odds are that the recent improvement in Chinese manufacturing PMIs could be due to inventory re-stocking rather than a decisive turnaround in final demand. “Hard” data have not shown meaningful improvements in China’s final demand. Weighing the pros and cons, we are instituting a stop-buy on our EM strategy: We will turn tactically positive on EM risk assets if the MSCI EM equity index breaks above 1125, which is 4% above its current level. Keep Malaysia on an upgrade watch list. Downgrade Brazil to underweight. Feature The strong Chinese PMI prints released this week have challenged our negative view on EM assets and China plays. This week we take a deeper look at the underlying reasons behind the recent improvement in China’s PMI data. In addition, we elaborate on what it would take for us to alter our current strategy on EM risk assets. A Manufacturing Upturn The upturn in China’s manufacturing PMIs in March has been validated by improvement in Taiwanese PMI’s export orders (Chart I-1, top panel). The latter’s amelioration has been broad-based across all sectors: electronics and optical, electrical machinery and equipment, basic materials, and chemical/biological/medical (Chart I-1, bottom panel). China accounts for 30% of Taiwanese exports, making Taiwan’s manufacturing sector heavily exposed to China’s business cycle. Does this improvement in manufacturing PMIs reflect a final demand revival in China? Looking For Final Demand Revival China’s domestic and overseas orders remain weak, as exhibited in Chart I-2. These indicators give us the primary trajectory of the Chinese business cycle, while the PMI indexes exhibit considerable short-term volatility. Chart I-1One-Month Surge In China's And Taiwan's PMIs One-Month Surge In China's And Taiwan's PMIs One-Month Surge In China's And Taiwan's PMIs Chart I-2Noise And Business Cycle Trajectory Noise And Business Cycle Trajectory Noise And Business Cycle Trajectory   The domestic demand and overseas orders reflect quarterly data from 5,000 enterprises. The latest datapoints are from Q1 2019 and were released on March 22. To be sure, we are not suggesting an absence of bright spots, but at the moment “hard” data do not corroborate broad-based improvement in final demand. Consumer spending: There has been no improvement in households’ propensity to spend. Our proxy for households’ marginal propensity to spend has not turned up (Chart I-3). Consistently, China’s smartphone sales and passenger car sales are contracting at double-digit rates, while the growth rate in online sales of services has not improved (Chart I-4, top three panels). Chart I-3Chinese Consumers' Propensity To Spend Chinese Consumers' Propensity To Spend Chinese Consumers' Propensity To Spend Chart I-4China: No Improvement In "Hard" Data China: No Improvement In "Hard" Data China: No Improvement In "Hard" Data   The bottom panel of Chart I-4 demonstrates the retail sales of consumer goods during the Chinese New Year compared with the previous year’s spring festival. It is evident that as of mid-February, when this year’s spring festival took place, there was no improvement in Chinese consumer demand. Business spending / investment: Our proxy for enterprises’ propensity to spend continues to decline (Chart I-5). Companies’ propensity to spend has historically led the cyclical trajectory in industrial metals prices. Crucially, this has not corroborated the rebound in base metals prices over the past three months. Besides, China’s imports of capital goods, its total imports from Korea and its machinery and machine tool imports from Japan are all still contracting at a double-digit rate (Chart I-6). Chart I-5China: Enterprises' Propensity To Spend And Metals China: Enterprises' Propensity To Spend And Metals China: Enterprises' Propensity To Spend And Metals Chart I-6Contracting At A Double Digit Rate Contracting At A Double Digit Rate Contracting At A Double Digit Rate   China’s fixed asset investment in infrastructure has picked up of late and will continue to improve. However, this may not be sufficient to revive the mainland’s economy. China’s growth decelerated in 2014-2015 and industrial commodities prices dwindled, despite robust growth in infrastructure investment at the time (Chart I-7). The culprit was the decline in property construction in 2014-2015. As to the property market, the People’s Bank of China’s (PBoC) Pledged Supplementary Lending (PSL) financing points to further weakness in property demand in the coming months (Chart I-8). Chart I-7China's Infrastructure Investment And Base Metals Prices China's Infrastructure Investment And Base Metals Prices China's Infrastructure Investment And Base Metals Prices Chart I-8China: The Outlook For Residential Property Demand China: The Outlook For Residential Property Demand China: The Outlook For Residential Property Demand   Moreover, property starts have been surging, yet their completions have been tumbling. This suggests a ballooning amount of work-in-progress on real estate developers’ balance sheets. To be sure, we are not suggesting an absence of bright spots, but at the moment “hard” data do not corroborate broad-based improvement in final demand. It may well be that property developers do not have financing to complete work or that they are reluctant to bring new units to the market amid tame demand. Whatever the case, the mediocre pace of construction activity is negative for suppliers to the construction industry. Government spending: Aggregate government spending in China – including central and local government as well as government-managed funds (GMF) – has been very robust in the past year (Chart I-9). Hence, government spending has not been the reason behind the economic slowdown. Chart I-9China's Aggregate Fiscal Spending China's Aggregate Fiscal Spending China's Aggregate Fiscal Spending For 2019, overall government spending is projected to expand by 11% in nominal terms from a year ago, down from 17% in 2018. The key fiscal risk is shrinking land sales, which account for 86% of GMF revenues. The latter have substantially increased in size and now makeup 27% of aggregate fiscal spending. Local and central government expenditures account for 62% and 11% of aggregate fiscal spending, respectively. If land revenues undershoot, GMF and local governments will not be able to meet their expenditure targets without Beijing altering the former’s borrowing quotas. In brief, fiscal policy may be involuntarily tightened due to a shortfall in land sales revenues before the central government permits local governments to borrow more. Exports: Chinese shipments to the U.S. will recover as China and the U.S. finalize their trade deal. The media is extremely focused on the trade negotiations, and markets have been trading off the headlines. Nevertheless, it is essential to realize that China’s exports to the U.S. make up only 3.6% of the country’s total GDP (Chart I-10). This contrasts with capital spending that accounts for 42% of the mainland’s GDP.  Consequently, we believe the credit cycle that drives construction and capital spending is more important to China’s growth than its shipments to the U.S. Global ex-China Demand: The areas of global final demand that weighed on global growth last year remain depressed. Global semiconductors and auto sales have been shrinking at a rapid pace and have so far not experienced a reversal (Chart I-11). Chart I-10China Is Not Reliant On Exports To The U.S. China Is Not Reliant On Exports To The U.S. China Is Not Reliant On Exports To The U.S. Chart I-11Global "Hard" Data Are Still Bad Global "Hard" Data Are Still Bad Global "Hard" Data Are Still Bad   Bottom Line: There is a lack of pertinent “hard” business cycle data in China that have improved. What Does It All Mean Having reviewed final demand conditions in China, it is reasonable to argue that the improvement in the Chinese and Taiwanese manufacturing PMIs could be due to inventory re-stocking. Unfortunately, in China, there is limited reliable data that quantifies inventory levels well in various industries. Having reviewed final demand conditions in China, it is reasonable to argue that the improvement in the Chinese and Taiwanese manufacturing PMIs could be due to inventory re-stocking. The consensus view in the investment community is that China’s credit stimulus has boosted the economy since the beginning of this year. Business conditions have certainly improved. The rally in Chinese stocks has in turn mirrored this improvement. Yet it is not clear that this revival in the business cycle is due to the credit stimulus. Chart I-12 plots the credit impulse, including local government general and special bonds issuance, with the three typical business cycle variables: manufacturing PMI and nominal manufacturing production growth. Chart I-12China: Credit Impulse Leads "Hard" Data China: Credit Impulse Leads "Hard" Data China: Credit Impulse Leads "Hard" Data As can be seen from the chart, the manufacturing PMI is very volatile. In the short term, there is little correlation between it and the credit impulse (Chart I-12, top panel). Meanwhile, the credit impulse leads nominal manufacturing output growth by nine months (Chart I-12, bottom panel). Based on the past time lag relationships, the mainland’s business cycle should not have bottomed until the third quarter of this year. Hence, the bottom in the manufacturing PMIs in January does not fit the historical pattern of the relationship between the credit impulse and the mainland’s business cycle. Bottom Line: Presently, it is hard to make a definite conclusion on the reasons behind the pick-up in Chinese manufacturing. That said, business cycles do not always evolve in a common-sense manner that can be both rationalized and forecast by indicators. Therefore, it is essential for investors, to have confirmation signals from financial markets on the direction of the business cycle. Financial Markets As A Litmus Test We continuously monitor numerous financial markets that are sensitive to both the global and Chinese business cycles. These financial market-based indicators are often coincident with EM asset prices. Hence, they can be used to confirm or refute EM market direction. Our Risk-On-to-Safe-Haven (ROSH) currency ratio has recently softened, flashing a warning signal for EM share prices (Chart I-13). Chart I-13Currency Markets Are Flashing Amber For EM Stocks bca.ems_wr_2019_04_04_s1_c13 bca.ems_wr_2019_04_04_s1_c13 The ROSH ratio is the relative total return (including carry) of six commodities currencies (AUD, NZD, CAD, CLP, BRL and ZAR) versus two safe-haven currencies: the yen and Swiss franc. Hence, this currency ratio is agnostic to U.S. dollar trends, making its signals especially valuable. Our Reflation Confirming Indicator has retreated, also signaling a pullback in the EM equity index (Chart I-14). This indicator is composed of an equal-weighted average of industrial metals prices (a play on Chinese growth), platinum prices (a play on global reflation) and U.S. lumber prices (a proxy play on U.S. growth). Chart I-14Commodities Markets Are Flashing Amber For EM Stocks Commodities Markets Are Flashing Amber For EM Stocks Commodities Markets Are Flashing Amber For EM Stocks Within EM credit markets, corporate investment-grade spreads have begun narrowing versus high-yield spreads (Chart I-15). This typically coincides with lower EM share prices. Finally, EM share prices have been underperforming DM since late December. Relative performance of EM ex-China stocks against the global equity index has been even more underwhelming. In short, these markets are at a critical juncture. A decisive breakout will entail a lasting rally, while a failure to break out will signal imminent downside risk. Bottom Line: These financial market signals are not consistent with a durable China-led recovery in the global business cycle. Investment Strategy A number of financial markets are currently at a critical juncture. These markets will either break out or break down, with subsequently significant moves. The broad U.S. trade-weighted dollar has been flattish in the past nine months despite falling interest rate expectations in the U.S. and the risk-on market environment. We read this as a sign of underlying strength. The trade-weighted dollar is presently sitting on its 200-day moving average (Chart I-16). Consistent with a flattish trend in the greenback, the U.S. dollar volatility has dropped to very low levels. Exchange rates usually do not trade sideways much longer than that. Hence, the dollar is about to break out or break down and any move will be lasting and large. Chart I-15A Message From EM Corporate Credit Market A Message From EM Corporate Credit Market A Message From EM Corporate Credit Market Chart I-16The U.S. Dollar Is About To Make A Big Move The U.S. Dollar Is About To Make A Big Move The U.S. Dollar Is About To Make A Big Move   The Korean won has been forming a tapering wedge pattern from both short-term and long-term perspectives (Chart I-17, top and middle panels). Its volatility has also plunged to a record low (Chart I-17, bottom panel). Chart I-17The Korean Won Is At Crossroads The Korean Won Is At Crossroads The Korean Won Is At Crossroads Chart I-18A Stop-Buy On EM Stocks A Stop-Buy On EM Stocks A Stop-Buy On EM Stocks Finally, emerging Asian equities’ relative performance to global stocks is facing an important technical resistance as are copper and oil prices. In short, these markets are at a critical juncture. A decisive breakout will entail a lasting rally, while a failure to break out will signal imminent downside risk. Consistently, China’s “soft” data that has improved markedly yet there is no “hard” data confirmation. Moreover, there is some evidence to suggest that the pickup in the soft data may simply reflect inventory building.   Weighing the pros and cons, we are instituting a stop-buy on our EM strategy: We will turn tactically positive on EM risk assets if the MSCI EM equity index in U.S. dollar terms breaks above 1125, which is 4% above its current level (Chart I-18). Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Malaysia: Keep On Upgrade Watch List Malaysian equities have been underperforming their EM counterparts since 2013 and are now resting around their 2017 lows (Chart II-1). The odds are high that this market’s underperformance is late. Chart II-1Malaysian Stocks Relative to EM Malaysian Stocks Relative to EM Malaysian Stocks Relative to EM Investors should keep Malaysian equities on an upgrade watch list. We upgraded the Malaysian bourse from underweight to neutral in December 2018. In a Special Report published at that time, we argued that the structural outlook for Malaysia had improved, yet the cyclical downturn would persist. The latter did not warrant moving the bourse to overweight. This view is still at play. Economic Slowdown Is Advanced The Malaysian economy has been digesting credit and property market excesses. Property sector: Property sales have declined by 37% since 2010, and prices for some property segments are beginning to deflate (Chart II-2). Similarly, housing construction approvals have slumped severely since 2012. Consumers: Passenger vehicle sales have been falling since 2012 along with households' declining marginal propensity to consume, and retail trade has been very weak (Chart II-3). Chart II-2Property Sector Is Depressed Property Sector Is Depressed Property Sector Is Depressed Chart II-3Consumer Sector Is Weak Consumer Sector Is Weak Consumer Sector Is Weak   An ongoing purge of excesses by companies entails lower wage growth and weaker employment, resulting in subdued household income growth. The latter could extend the consumer slump. Business sector: Capital spending growth in real terms has decelerated and may contract. Both profit margins and return-on-equity (ROE) for non-financial publicly listed companies have slumped and are currently resting below their 2008 levels (Chart II-4). This warrants cost-cutting and reduced corporate spending/capital expenditures for now. Chart II-4Corporate Restructuring On The Way? Corporate Restructuring On The Way? Corporate Restructuring On The Way? Reduced employment and weak wage growth are negative dynamics for households but positive for companies’ profit margins. Commercial Banks: Malaysian banks remain unhealthy. At 1.5%, their NPLs remain low relative to the credit boom that occurred over the past decade. Moreover, Malaysian banks have been lowering their provisions levels to boost profits. This is an unsustainable strategy. Provided economic growth will remain weak, both NPLs and provisions will rise, hurting banks’ profits and share prices. Banks hold a very large market-cap weighting in this bourse, and the negative outlook for banks’ profits deters us from upgrading this equity market. Purging Excesses: Implications For The Exchange Rate Purging of economic excesses is painful in the short- and medium-term, as it instills deflation. A currency often depreciates during this phase to mitigate the deflationary forces in the economy. However, purging excesses, deleveraging and corporate restructuring are ultimately structurally bullish for a currency. First, corporate restructuring and improved capital allocation lift productivity growth in the long run. The Malaysian economy has been digesting credit and property market excesses. Second, low inflation or outright deflation allow the currency to depreciate in real terms. The Malaysian ringgit is already cheap based on the real effective exchange rate (Chart II-5). Finally, amid deflation and in the absence of widespread bailout of debtors funded by bank loans or excessive government borrowing, cash becomes “king”. Hence, deleveraging is ultimately currency positive. In contrast, pervasive bailouts funded by money creation – i.e., mushrooming money growth – usually undermine residents’ and foreigners’ willingness to hold the currency. A capital flight ensues and the currency plunges. Malaysia in 2015 was the latter case, with the ringgit plummeting as residents converted their ringgits to U.S. dollars (Chart II-6, top panel). Chart II-5The Ringgit Is Cheap The Ringgit Is Cheap The Ringgit Is Cheap Chart II-6Malaysia: 2015 Vs. Now Malaysia: 2015 Vs. Now Malaysia: 2015 Vs. Now   Presently, the opposite dynamics are at play. The central bank is reducing commercial banks’ excess reserves, domestic private credit growth is weak and residents are not fleeing the ringgit (Chart II-6). In addition, the structural reorientation of the economy from commodities to semiconductors/technology is beginning to bear fruit. As a result, overall trade balance has significantly improved, despite weak commodities prices. This is also positive for the currency. Finally, a more stable (i.e., modestly weaker) exchange rate amid both a global and domestic downturn will allow Malaysia’s central bank to reduce interest rates and smooth the growth slump. This is in contrast to 2015 when capital outflows and the plunging currency did not allow the central bank to reduce borrowing costs. Investment Conclusions We recommend keeping Malaysian stocks on an upgrade watch list for now. We recommend upgrading Malaysian sovereign credit and local currency government bonds from underweight to neutral relative to their respective EM benchmarks A relatively stable ringgit will benefit Malaysia’s local and U.S. dollar bonds. Furthermore, foreign ownership of local bonds has fallen meaningfully, diminishing the risk of future outflows. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Downgrading Brazil: The Honeymoon Is Over In our October 9 report, we upgraded Brazil following the outcome of the first round of presidential elections. We, like the market, gave a benefit of the doubt to the new president. However, the honeymoon is over for President Bolsonaro. The markets are becoming increasingly pessimistic because of the lack of progress on the social security reforms front. It is no secret that Brazil needs bold pension reform to make its public debt sustainable. As things stand now, the public debt dynamic in Brazil is precarious. Two prerequisites for public debt sustainability are (1) for interest rates to be below nominal GDP growth or (2) continuous robust primary fiscal surpluses. Hence, a government can stabilize its debt-to-GDP ratio by either having nominal GDP above its borrowing costs, or by running persistent and sizable primary fiscal surpluses. Neither of these two stipulations are presently satisfied in Brazil. The gap between government local currency bond yields and nominal GDP growth is still very wide (Chart III-1). Meanwhile, the primary fiscal deficit is 1.5% of GDP (Chart III-2). Chart III-1Brazil: An Unsustainable Gap Brazil: An Unsustainable Gap Brazil: An Unsustainable Gap Chart III-2Brazil: Public Debt Dynamics Are Precarious Brazil: Public Debt Dynamics Are Precarious Brazil: Public Debt Dynamics Are Precarious     In the early 2000s, the government stabilized its public debt dynamics by running persistent primary surpluses of about 4% of GDP (Chart III-2, top panel). Will Brazil achieve primary fiscal surpluses in the coming years assuming some form of the pension reform is adopted? It is doubtful. According to the government’s own forecasts, the submitted draft of social security reforms, including the one for the army, will save only BRL190 billion in next four years or 0.7% of GDP per year. The current primary deficit is 1.5% of GDP (Chart III-2). Unless nominal GDP growth and government revenue growth shoot up, the primary deficit will not be eliminated or the primary surplus will be very small. Overall, it seems unlikely that the government’s proposed pension reforms will be sufficient to turn around Brazil’s public debt dynamics in the next several years - barring very strong economic growth that will fill in government coffers. Bottom Line: We are downgrading Brazil from overweight to underweight within EM equity, local currency bonds and sovereign credit benchmarks. Andrija Vesic, Research Analyst andrijav@bcaresearch.com Footnotes Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Dear Client, I will be meeting clients in Europe next week. Instead of our usual weekly bulletin, I will be sending you a Special Report discussing how “The Most Important Trend In The World” – a trend that has been around for thousands of years and accounts for all of the economic growth the world has ever experienced – has recently reversed, and what this means for your investment decisions. This is one report you will not want to miss. Best regards, Peter Berezin, Chief Global Strategist Highlights China’s debt problem is a symptom of a deeper ailment: The country’s excessively high saving rate. While the authorities are taking steps to boost consumption, this is likely to be a drawn-out process. In the meantime, the economy will have to continue recycling savings into fixed-asset investment. Now that credit growth has fallen close to nominal GDP growth, the need to further suppress credit growth has abated. The 6-month credit impulse is already moving higher, and the 12-month impulse should follow suit by the middle of the year. As Chinese growth bottoms out this summer, global growth will start to reaccelerate. This will help boost global cyclical stocks as well as EM shares. Feature Global Growth Worries Weigh On Risk Sentiment Global growth is clearly slowing (Chart 1). Our tactical MacroQuant model, which did an exemplary job of flagging the Q4 selloff in stocks, is flashing amber again, after having turned more constructive in late December (Chart 2). Chart 1Growth Is Slowing Growth Is Slowing Growth Is Slowing   Chart 2 As we discussed last week, the world economy should stabilize by mid-year, paving the way for global equities to rise further from current levels.1 Until then, volatility will remain elevated. Many factors will influence the trajectory of global growth over next 12 months, but perhaps none more important than what happens to China. In this week’s report, we focus on one of the most critical problems facing the Chinese economy – a problem that surprisingly gets very little attention from market participants. China’s Savings Problem Saving is usually considered a virtue. At the individual level, that is certainly true. However, at the economy-wide level, saving can be a vice if it leads to a shortfall of spending, resulting in higher unemployment. This is precisely the problem that China confronts today. Simply put, the country consumes too little of what it produces. The result is a national saving rate of 45% of GDP, higher than any other major economy in the world (Chart 3). Chart 3China Saves A Lot China Saves A Lot China Saves A Lot The reasons for China’s high saving rate are long and varied. Just as the Great Depression instilled a sense of thrift among Americans who came of age in the 1930s, memories of the abject poverty that many older Chinese citizens endured during the Cultural Revolution have restrained the desire to spend needlessly. While the younger generation is more willing to live it up, it also faces severe constraints to spending more. The labor market remains challenging, even for those with a university degree. Sky-high property prices require young people to save a large fraction of their incomes in order to have any hope of owning a home. Looking out, there is little reason to expect China’s saving rate to fall rapidly. While the number of people entering retirement is steadily increasing, the share of the population in their prime savings years – ages 30-to-59 – has yet to peak (Chart 4). Chart 4China: Share Of Population In Its High Savings Years Has Yet To Peak China: Share Of Population In Its High Savings Years Has Yet To Peak China: Share Of Population In Its High Savings Years Has Yet To Peak In addition, an increasingly skewed male-female sex ratio has created an "arms race" of sorts among Chinese bachelors hoping to accumulate enough wealth to find a bride. One academic study concluded that this factor accounts for half of the increase in the household saving rate since the late-1970s.2 Unfortunately, China’s gender imbalance is only likely to worsen, given that the ratio of men between the ages of 25-and-39 and women between the ages of 20-and-34 – a proxy for gender imbalances in the marriage market – is projected to rise from 1.06 in 2011 to 1.34 by the middle of the next decade (Chart 5). Chart 5Not Enough Chinese Brides Not Enough Chinese Brides Not Enough Chinese Brides What To Do With Excess Savings? By definition, a country’s savings are either recycled into domestic investment or exported abroad via a current account surplus. The latter strategy served China well in the years leading up to the Great Recession, when the country’s current account surplus reached a whopping 10% of GDP (Chart 6). Just like Germany today, China was able to export its excess production with the help of a highly undervalued currency. Chart 6China: No Longer Exporting Savings Abroad China: No Longer Exporting Savings Abroad China: No Longer Exporting Savings Abroad Unfortunately for China, as its economy has grown in relation to the rest of the world, running massive trade surpluses has become more difficult. This is especially true today, when the country is being singled out by the Trump administration and much of the international community for alleged unfair trade practices. As China’s ability to churn out large current account surpluses declined, the government moved to Plan B: propping up growth by recycling the country’s copious savings into fixed-asset investment (see Box 1). This process saw households park their savings in banks and other financial institutions which, in turn, lent the money out to companies and local governments in order to finance various investment projects. Not surprisingly, debt levels exploded (Chart 7). Chart 7China: From Exporting Savings To Investing Domestically (And Building Up Debt) China: From Exporting Savings To Investing Domestically (And Building Up Debt) China: From Exporting Savings To Investing Domestically (And Building Up Debt) This strategy was feasible when China did not have a lot of debt and needed more factories, housing, and public infrastructure. But those days are long gone. The rate of return on assets among state-owned enterprises has now fallen below their borrowing costs (Chart 8). Our EM team estimates that 15%-to-20% of apartments in China are sitting vacant.3 Chart 8Rate Of Return On Assets Below Borrowing Costs For Chinese SOEs Rate Of Return On Assets Below Borrowing Costs For Chinese SOEs Rate Of Return On Assets Below Borrowing Costs For Chinese SOEs How To Boost Consumption There is only one long-term solution to China’s excess savings problem: Tackle it head-on by taking steps to increase consumption. The good news is that there is some scope to do so. The Chinese income tax structure is fairly regressive. Poor households face an effective income tax rate exceeding 40%. This is well above OECD norms (Chart 9). A more progressive tax system would boost spending among poorer households. It would also curb inequality, which has increased sharply since the 1980s (Chart 10). The saving rate among the richest 10% of Chinese earners is close to 50%. Policies that shift income from the rich to the poor would reduce overall household savings. Chart 9 Chart 10China: Inequality Has Risen In The Past Two Decades China: Inequality Has Risen In The Past Two Decades China: Inequality Has Risen In The Past Two Decades As a share of GDP, public-sector spending in China on education, health care, and pensions is close to half of the OECD average (Chart 11). If the government were to finance the increase in social spending by running larger budget deficits, this would help reduce overall national savings both by increasing the budget deficit and by discouraging precautionary household savings. Unlike in most countries, the poor in China are net savers, largely because they cannot rely on a publicly-funded social safety net (Chart 12). Chart 11 Chart 12 Recent tax changes, including an increase in the threshold at which income begins to be taxed and an expansion of deductions for childhood education, medical costs, and home loan interest and rent, are steps in the right direction. More Financial Repression? Over a longer-term horizon, the Chinese authorities are also likely to step up efforts to discourage savings by driving down real interest rates into negative territory. Since nominal interest rates are already low in China, the only way to reduce real rates is to raise inflation. The added benefit of higher inflation is that it would boost nominal GDP growth, thus putting downward pressure on the debt-to-GDP ratio. The catch is that negative real rates could destabilize the currency, fueling capital outflows. Negative real rates could also inflate asset bubbles, especially in the property market. The only way to square the circle is to tighten administrative controls, such as those relating to property speculation and capital flows, in order to preserve the benefits of negative real rates, while attenuating the costs. This suggests that hopes that the RMB will become an international reserve currency anytime soon are likely to be dashed. China Will Continue To Back Off From Its Deleveraging Campaign Realistically, the measures to boost consumption listed above will take time to implement. In the meantime, China’s economy continues to slow. Not only does a weaker economy endanger domestic stability, it also puts the Chinese government in a weaker negotiating position with the Trump administration over trade matters. This suggests that the government will continue to ease off its deleveraging campaign at least until growth recovers. Granted, one could have said the same thing last year. That is correct, but here is the thing: last year, credit growth was running at a much faster pace than today. Total social financing increased by only 11% year-over-year in December, not much higher than trend nominal GDP growth. On all three occasions over the past ten years when credit growth has fallen back towards nominal GDP growth, the government has allowed credit growth to accelerate (Chart 13). Chart 13China: Credit Growth Versus GDP Growth China: Credit Growth Versus GDP Growth China: Credit Growth Versus GDP Growth We do not expect growth to surge this time around. However, if monthly credit growth simply stabilizes at current levels, the credit impulse, which is just the change in credit growth, will turn positive. Chart 14 shows that the 6-month impulse is already moving higher. The 12-month impulse is still trending down, but if credit growth remains constant at its current pace, it will start hooking up this summer (Chart 15). Chart 14Rebound In Chinese 6-Month Credit Impulse Bodes Well For Metals Rebound In Chinese 6-Month Credit Impulse Bodes Well For Metals Rebound In Chinese 6-Month Credit Impulse Bodes Well For Metals   Chart 15The 12-Month Credit Impulse Will Turn Up If Monthly Credit Growth Even Merely Stabilizes The 12-Month Credit Impulse Will Turn Up If Monthly Credit Growth Even Merely Stabilizes The 12-Month Credit Impulse Will Turn Up If Monthly Credit Growth Even Merely Stabilizes Importantly, the Li Keqiang index, a broad real-time measure of economic growth in China, is highly correlated with the 12-month credit impulse. As Chinese growth bottoms out this summer, global growth will start to reaccelerate. This will help boost global cyclical stocks as well as EM shares. My colleague, Arthur Budaghyan, BCA’s chief emerging markets strategist, remains bearish on EM equities in both relative and absolute terms. While this publication does not have a strong view on the relative performance of EM versus DM shares, we do expect EM stocks to rise in absolute terms over the remainder of the year. Accordingly, we sold our March-2019 EEM put on January 3rd for a gain of 104%, and are now outright long the ETF as one of our recommended trades. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com   BOX 1 Do Banks Create Money Out Of “Thin Air”? Strictly speaking, banks can create deposits by issuing new loans without the need for economic savings (which economists define as the difference between what an economy produces and consumes). In that sense, banks can create money out of “thin air.” However, this does not mean, as is sometimes claimed, that economic savings are irrelevant to credit creation or that there is no effective limit on the volume of loans that banks can originate. Even if one ignores the presence of legal capital requirements, the public must still be willing to hold whatever deposits banks create. Just like the number of apples a society wishes to consume is simultaneously determined by the number of apples farmers wish to produce and the number of apples people wish to eat (with the price of apples equilibrating supply and demand), the answer to the question of whether loans create deposits or deposits create loans is always “both.” The aggregate volume of deposits that people wish to hold depends, among other things, on the level and distribution of net worth across society, as well as the rate of return that bank deposits offer compared to competing financial instruments (including cash, which pays nothing). A country’s net worth tends to be closely correlated with the value of its capital stock. Both are mainly determined by accumulated economic savings. Real interest rates are also largely determined by economic savings, especially at the global level, where rates adjust to ensure that world savings equals investment. The distribution of savings also matters. When some people wish to spend more than they earn, while others wish to do the opposite, debt levels will rise. The same is true for individual sectors of the economy. If there are some sectors that save a lot (such as households in China) and other sectors that borrow a lot (Chinese state-owned companies and local governments), debt levels will go up. Debt levels will also rise when people purchase assets using credit. Fresh economic savings are not necessary to finance the purchase of existing assets, but with the exception of undeveloped land and natural resources, economic savings are needed to create those assets (such as when a home is constructed or a factory is built). In China, a perfect trifecta of sky-high property prices, a high and uneven distribution of savings throughout the economy, and a financial sector that has been willing to intermediate savings without much regard for credit quality, have all contributed to the elevated debt levels we see today. Footnotes 1      Please see Global Investment Strategy Weekly Report, "Patient Jay," dated January 18, 2019. 2      Shang-Jin Wei and Xiao Zhang, "The Competitive Saving Motive: Evidence From Rising Sex Ratios And Savings Rates In China," Journal of Political Economy, Vol. 119, No. 3, 2011. 3      Please see Emerging Markets Strategy Special Report, “China Real Estate: A Never-Bursting Bubble?” dated April 6, 2018. Strategy & Market Trends MacroQuant Model And Current Subjective Scores Chart 16 Tactical Trades Strategic Recommendations Closed Trades

Highlights Differences of opinion are what make a market, and we’ve got a big one when it comes to the Fed: The money market says the fed funds rate goes no higher than 2.75%; BCA says 3.5% by the end of 2019, and possibly 4% sometime in 2020. We are confident in our assessment of the economy’s underlying strength, … : Fiscal stimulus will keep the economy growing above trend in 2019, and the unemployment rate will almost certainly continue to grind lower. ... even if many commentators are accentuating the negative: The experts quoted in Barron’s found abundant fault with the November employment situation report, and the yield curve is out-trending all of the Kardashians combined. Amidst all the uncertainty, we’re sticking with an investment strategy that is more cautious than our outlook: The monetary backdrop is still too accommodative to spell the end of the equity bull market, but we are waiting for a better entry point to put our cash overweight to work. Feature Dear Client, This is our last report of 2018. Our regular publishing schedule will resume on Monday, January 7th. We wish you a happy, healthy and prosperous new year. Best regards, Doug Peta, Senior Vice President U.S. Investment Strategy   We have often remarked how we feel that we are watching a different game than the money market when it comes to the gap in our respective terminal fed funds rate expectations. Both we and the market expect a 25-basis-point (“bps”) hike to 2.5% at the conclusion of the FOMC’s two-day meeting on Wednesday, but from there our paths diverge sharply. The market grudgingly allows that one more hike, to 2.75%, is possible, though it is by no means certain. It sees about a 60% chance that the Fed will make that additional rate hike toward the end of 2019, but then proceeds to price that hike out by the end of 2020 (Chart 1). Chart 1Mind The Gap Mind The Gap Mind The Gap The terminal rate’s ultimate destination, and the path it follows along the way, is not just an academic matter. Once the fed funds rate crosses above the equilibrium fed funds rate (r-star, in economics-speak), monetary policy will become restrictive for the first time since the crisis began to break. We expect the shift to a restrictive policy setting will herald the end of the expansion. Most importantly for investors, it will mark the point when asset allocation should become considerably more defensive. Getting the Fed right, then, is of the utmost importance, and we need to get to the bottom of our differences with the market. We suspect they come down to disparate assessments of the state of the economy and the state of policy. The money market seems to believe that the economy is weaker than we perceive, and that the fed funds rate is currently much closer to equilibrium than we realize. In both cases, we are vulnerable if it is later in the cycle than we think, because we are not positioned for an imminent inflection. Is The Business Cycle Closer To Ending Than We Think? Real GDP growth will slow in 2019, just as one would expect when 60 bps of fiscal thrust is taken away from an economy that was already operating at its full 2-2.25% capacity (Chart 2). Per the IMF’s fiscal estimates, 2020 shapes up as the real challenge for the economy, especially once the Fed crosses the equilibrium-rate Rubicon. In October and November, however, financial markets acted as if they feared the beginning of the recession was considerably nearer (Chart 3). Our clients’ concerns seemed to coalesce around the implications of a slowdown in housing. Chart 2Lessened Thrust, Lessened Growth Lessened Thrust, Lessened Growth Lessened Thrust, Lessened Growth   Chart 3Growth Scare Growth Scare Growth Scare We do not worry about residential investment pulling down the economy,1 but we do pay close attention to nonfarm payrolls. Employment may be a coincident indicator, but it is powerfully self-reinforcing, and the sub-NAIRU2 unemployment rate looms large in the Fed’s policy calculus. Payrolls growth is robust, and our model projects that it will continue to be over the near term (Chart 4, top panel), as all of its components are in fine fettle, especially initial jobless claims (Chart 4, second panel), and small businesses’ hiring intentions (Chart 4, bottom panel). Chart 4Payrolls Should Keep Growing, ... Payrolls Should Keep Growing, ... Payrolls Should Keep Growing, ... As we have noted before, it only takes about 110,000 net new jobs every month to keep unemployment at a steady state. Even if our model turns out to be overly optimistic, the unemployment rate appears to be several months away from bottoming, unless the participation rate rises enough to materially increase the size of the labor force. Demographics argue against that, as the baby boomers, ages 54 to 72, exit the work world in a nearly interminable conga line. The participation rate has done well to stabilize in the face of the boomer headwind (Chart 5), but there’s a limit to how much more it can close the gap when businesses are already lamenting the difficulty of finding qualified workers (Chart 6). Chart 5... But The Part Rate Probably Won't ... But The Part Rate Probably Won't ... But The Part Rate Probably Won't   Chart 6Good Help Is Hard To Find Good Help Is Hard To Find Good Help Is Hard To Find A robust labor market suggests that households in the aggregate will have the means to support consumption. Now that payrolls have expanded for a record 98 straight months, the lowest-income households are finally in line to capture some of the benefits. Those households have the highest marginal propensity to consume, which may provide spending with an additional fillip. With the savings rate now back to its late-‘90s levels, better-heeled households are also in a position to do their part to keep consumption humming (Chart 7). Chart 7Plenty Of Dry Powder For Spending Plenty Of Dry Powder For Spending Plenty Of Dry Powder For Spending The near-term consumption outlook is additionally supported by the expectations component of the Conference Board’s consumer confidence survey, which has been a reliable coincident indicator throughout its entire history (Chart 8). The unusual divergence between the two series suggests that consumers may have more of an appetite to spend than they’ve demonstrated so far. Employment gains and real consumption also have a well-established history of traveling together (Chart 9). Chart 8Consumers' Optimism Points To More Spending ... Consumers' Optimism Points To More Spending ... Consumers' Optimism Points To More Spending ... \   Chart 9... And So Do Solid Employment Gains ... And So Do Solid Employment Gains ... And So Do Solid Employment Gains Bottom Line: We find it hard to believe the economy is set to weaken in a worrisome way when the labor market still has plenty of momentum, and consumption is well supported on multiple fronts. Is The Fed Funds Rate Cycle Further Along Than We Realize? The Real Economy Our equilibrium fed funds rate model continues to suggest that the target fed funds rate is well below its equilibrium level and will not exceed it until late next year.3 Equilibrium is only a concept, however, so we actively seek out objective data that may confirm or disprove our assessment. Our approach is to trust our modeled estimate of a concept, but verify it with as much real-time evidence as we can muster. Based on the current level of activity, housing seems to be the only major segment that is experiencing some indigestion from higher rates. Corporate investment may not have lived up to the most optimistic post-tax-cut estimates, but there is no evidence that corporations are holding back because of higher rates. A back-of-the-envelope proxy, calculating the difference between the S&P 500’s return on capital and the after-tax interest rate on BBB-rated corporate bonds, suggests that prospective returns to borrowing are near their best level in 30 years, even with the reduction in the debt tax shield4 (Chart 10). Through December 14th, the Atlanta Fed’s GDPNow model was projecting an increase of 3.8% in fourth-quarter final domestic demand, forcefully pushing back against the notion that r-star is at hand. Chart 10Higher Rates Aren't Biting Yet Higher Rates Aren't Biting Yet Higher Rates Aren't Biting Yet The ongoing application of fiscal thrust to an economy already operating at capacity argues for a higher equilibrium rate than would otherwise apply. The equilibrium rate is also higher because the unemployment rate is well below NAIRU (4.5%, per the dots), suggesting that the Fed will have to push harder against the economy than it otherwise would to keep it from overheating. Tepid post-crisis investment, mixed with unnecessary fiscal stimulus, and combined with a red-hot labor market, is a recipe for inflation pressures that can only be neutralized by a higher r-star. Financial Conditions As last week’s Google Trends chart of yield-curve searches made clear, investors have developed something of an obsession with an inverted yield curve. The yield curve’s ability to flag overly tight monetary policy in real time has made it a reliable leading indicator of recessions, and it is a key input into our simple recession indicator. The curve has flattened over the last five-plus weeks as the 10-year Treasury yield has melted, stoking recession fears. Before they get too worked up, however, investors should bear in mind that the depressed term premium has the potential to distort its signal in this cycle. The term premium is the yield differential between a Treasury note or bond, and a strip of T-bills, laddered to match the note or bond’s maturity. In line with its name, the term premium is typically positive, as investors have typically demanded compensation for bearing the increased interest-rate volatility embedded in longer-maturity instruments. That volatility may well have been restrained by the Fed’s large-scale asset purchase program, along with long yields themselves, though the entire matter of QE’s impact is subject to spirited debate. Whatever the mechanism, the term premium is considerably lower than it has been across the five decades that the yield curve has had a nearly perfect record of calling recessions (Chart 11). If the term premium were in line with its historical mean value, the yield curve would be nowhere near inverting. We continue to trust in the yield curve’s propensity to sense danger, but concede that the anomalously low term premium may render it somewhat less timely now. Given the preponderance of evidence to the contrary, we are not concerned that it is signaling that r-star is materially closer than our equilibrium fed funds rate model estimates. Chart 11The Bar For Inversion Is A Lot Lower In This Cycle The Bar For Inversion Is A Lot Lower In This Cycle The Bar For Inversion Is A Lot Lower In This Cycle QE raises one more issue for our equilibrium fed funds rate model, which does not account for any tightening of monetary conditions occasioned by the unwinding of the Fed’s balance sheet. We assume that such tightening occurs only at the margin, but it could delay our recognition that policy has shifted from accommodative to restrictive. Attempting to isolate the impact of balance sheet reduction on monetary conditions would be more trouble than it’s worth, however, and we simply assume that it will cause the confidence interval around our equilibrium estimate to widen a little. Bottom Line: Our equilibrium fed funds rate model projects that policy is not nearing restrictive territory, and our interpretation of the whole of the real-time data supports that view. We think that the Fed is still several hikes away from reaching r-star. Investment Implications As we noted in last week’s 2019 outlook, the view that the economy is strong enough to overheat undergirds all of our recommendations. The potential for overheating is what will impel the Fed to hike aggressively through 2019 and possibly beyond. Investors should therefore underweight Treasuries in balanced portfolios, while maintaining below-benchmark duration. The idea that the economy will gather more momentum on its way to overheating keeps us constructive on equities. We do not believe the bull market is over, and are therefore keeping an eye out for an opportunity to overweight the S&P 500 before it makes new highs. We are confident that the unemployment rate will continue to decline, but must concede that the key outcome for Fed policy – higher wages – has been slow to materialize. Several investors have become impatient with waiting for the Phillips Curve to assert itself, and we cannot blame them. Shorn of its fancy trappings, though, the Phillips Curve is just a supply-and-demand story, and we have always found it hard to argue against supply-and-demand stories’ plain logic. The action in the 10-year Treasury nonetheless has us reviewing our call closely in search of anything that we may be missing. It appears that the decline in yields is better explained by the unwinding of lopsided positioning and sentiment (Chart 12), than by anything connected to economic growth. We are acutely conscious of how a worsening of U.S.-China trade tensions could impair global growth and subvert our constructive take on risk assets. U.S. equities may shine on a relative basis in the worst-case scenario, but absolute losses would be assured. We remain in wait-and-see mode, open to deploying our cash overweight if the opportunity presents itself, but happy to have it for ballast and insurance in the meantime. Chart 12Stretched Rubber Bands Snap Back Stretched Rubber Bands Snap Back Stretched Rubber Bands Snap Back   Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com   Footnotes 1 Please see the U.S. Investment Strategy Special Reports, “Housing: Past, Present And (Near) Future,” and “Housing Seminar,” published November 19 and December 3, 2018, respectively, at usis.bcaresearch.com. 2 NAIRU, the non-accelerating-inflation rate of unemployment (also known as the natural rate of unemployment), is the unemployment rate that can be sustained over time without causing the economy to overheat. 3 Our model estimates that equilibrium fed funds is currently around 3%, will be around 3.25% by the middle of 2019, and will settle near 3⅜% at year end. 4 Before the 2017 tax reform act, corporations faced a top marginal rate of 35%, and could deduct interest expense without limit. After-tax interest expense for large corporations amounted to (1-.35), or 65% of the pre-tax expense. Now that the top marginal rate is 21%, after-tax interest expense is (1-.21), or 79% of pre-tax expense.

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