Demographics

Highlights Abenomics was working – prior to trade war and COVID-19 – and it will remain Japan’s economic policy setting, albeit in a new guise. This is true even if a dark horse candidate wins the Liberal Democratic Party’s leadership race. Japan’s strategic alliance with the United States is based on a shared interest to balance China’s rise and will not change regardless of the 2020 and 2021 elections. Abe failed to make peace with Russia, but Russo-Japanese relations remain the bellwether of a revolution in Russian policy toward China. We are far from that now. Stay long JPY-USD. The yen’s safe haven properties will buoy it during the coming three-to-six months of extreme political risk. The dollar is set to fall in the medium term due to US debt monetization, twin deficits, and global growth recovery. Feature Japanese equities have rallied despite trailing their American and global counterparts (Chart 1). Yet the good news for markets is now coinciding with the emergence of political uncertainty, as Prime Minister Shinzo Abe, now the longest-serving in Japan’s history, announced he will step down due to illness. Abe’s departure marks the end of a chapter in the country’s modern history and raises questions about the future of “Abenomics,” the eponymous economic policy consisting of ultra-dovish monetary policy, accommodative fiscal policy, and neoliberal structural reforms aimed at lifting productivity and growth. Chart 1Japan's Rally Trails Global Counterparts Japan's Rally Trails Global Counterparts Japan's Rally Trails Global Counterparts Chart 2… As Longest-Serving Prime Minister Steps Down Abenomics Will Smell As Sweet By Any Other Name Abenomics Will Smell As Sweet By Any Other Name Japanese leaders rarely last as long as Abe so the market will likely have to familiarize itself with more churn in top-level government policies going forward (Chart 2). But will the churn change the secular direction? No. Abenomics: A Concise Post-Mortem Chart 3Population And Workforce Decline Population And Workforce Decline Population And Workforce Decline The driver of Abenomics was not Abe, or his central bank Governor Haruhiko Kuroda, or even the long-dominant Liberal Democratic Party. It was geopolitics – an accumulation of social, political, economic, and strategic pressures demanding that the ruling elite shake up decades-long policies in pursuit of the national interest. Everyone knows that Japan’s population is aging and shrinking, but the key to understanding the Abe era is the recognition that the 2008 global financial crisis coincided almost exactly with the peak in Japan’s total population. This came 18 years after the working age population’s peak in the very year of Japan’s own financial crisis (Chart 3). The first crisis triggered Japan’s slide into price deflation; the second crisis threatened the permanent entrenchment of deflation along with a series of existential threats to the wellbeing of the nation. The driver of Abenomics was geopolitics, not Abe. First came global recession in 2008. Next the institutional ruling party – Liberal Democrats – fell from power for the first substantial period of time in modern memory in 2009. Then China fully emerged as a great power, brandishing its new foreign policy assertiveness and igniting a maritime-territorial clash and minor trade war from 2010 (Chart 4). Japan’s decline reached its nadir with a literal nuclear meltdown, following the devastating Tohoku earthquake and tsunami in 2011. The country’s strategic import dependency combined its ongoing financial instability, as shuttered nuclear plants required a surge in high-priced energy imports that wiped away Japan’s all-important current account surplus (Chart 5). Chart 4Geopolitical Status Anxiety Geopolitical Status Anxiety Geopolitical Status Anxiety Chart 5Nuclear Meltdown And Resource Anxiety Nuclear Meltdown And Resource Anxiety Nuclear Meltdown And Resource Anxiety The Liberal Democrats returned to power in a sweeping election victory after this ill-fated experiment with opposition rule. Party leader Shinzo Abe was relatively popular and willing to oversee a drastic overhaul of stale policies. Abenomics was never going to solve all of Japan’s deep structural challenges – population decline, massive debt, overregulation, lifetime employment. But its critics failed to recognize that the country had hit rock-bottom and policymakers had no choice but to stimulate, reform, and open up the economy. Otherwise they would go straight back into the political wilderness at the next election.1 Abenomics was about as successful as an overhyped political policy program can be: The economic boom drew in workers from all parts of society, particularly women, whose participation rate soared (Chart 6). Abe flung open the doors to immigration in a traditionally xenophobic country, attracting Chinese, Vietnamese, and Filipinos to live and work in Japan (Chart 7). Chart 6Abe Got People To Work Abe Got People To Work Abe Got People To Work Chart 7Abe Broke The Taboo On Immigration Abenomics Will Smell As Sweet By Any Other Name Abenomics Will Smell As Sweet By Any Other Name Kuroda at the Bank of Japan flew into action with aggressive asset purchases, triggering a sharp devaluation of the yen (Chart 8). Nominal GDP growth and core CPI trends both improved, critical to easing debt burdens, lowering real rates, stimulating economic activity, and shaking off the deflationary mindset (Chart 9). Chart 8Abe Kicked The BoJ Into Action Abe Kicked The BoJ Into Action Abe Kicked The BoJ Into Action Chart 9Abe Combatted Deflation Abe Combatted Deflation Abe Combatted Deflation Stagnant wages finally started to grow, with an extremely tight labor market (Chart 10). This was all the more remarkable due to the simultaneous surge in foreign workers. Corporate investment stabilized and turned upward, finally overcoming the long decline since 1990 (Chart 11). Chart 10Wage Growth Improved (Until Trade War, Pandemic) Wage Growth Improved (Until Trade War, Pandemic) Wage Growth Improved (Until Trade War, Pandemic) Chart 11Abe Revived Corporate Investment Abe Revived Corporate Investment Abe Revived Corporate Investment Abe also opened the door to foreign trade, taking on powerful vested interests, including his own party’s base, to join the Trans-Pacific Partnership (TPP) along with the United States in a bid to create an advanced new trade framework that sidestepped China. Chart 12Abe Opened The Doors, A Bonus With Or Without Trade War Abenomics Will Smell As Sweet By Any Other Name Abenomics Will Smell As Sweet By Any Other Name When US President Donald Trump pulled out of the bloc in accordance with his protectionist campaign promises, Abe led the charge in preserving it. Japan stands to benefit from opening up these markets whether the US-China trade war continues or not (Chart 12). This was generally effective leadership, but none of it happened by sheer force of personality. It happened because Japan glimpsed the specter of national failure in 2011 under the combined weight of internal malaise and external domination. Economic revival was as much about shoring up Japan’s national security as it was about improving Japanese lives and livelihoods. Abenomics was the economic component of a broader national revival. The goal was to become a “normal” nation, capable of self-defense and independent policy, and a pro-active world power at that. China’s rise and a distracted US will pressure Japan to maintain Abe’s policies. The drivers of Japan’s political earthquake in 2011 are not spent. COVID-19 dashed many of Abe’s gains in the fight against deflation. China’s rise is a greater challenge than ever before. The US is even more divided and distracted. The next prime minister would not be able to change course even if he wanted to do so. Suganomics, Kishidanomics … Ishibanomics? Chart 13Still No Alternative To Institutional Ruling Party Still No Alternative To Institutional Ruling Party Still No Alternative To Institutional Ruling Party The Liberal Democrats and their longtime coalition partners, New Komeito, have not only lost about 5% of popular support since their triumphant comeback in 2012, standing at 40% support today – and with some improvement since 2017. More importantly, their nearest rivals all poll under 5% of the popular vote (Chart 13). There is no political competition as yet. The ruling party will choose a new leader with little fanfare. Abe’s Chief Cabinet Secretary and chosen successor Yoshihide Suga is the frontrunner as we go to press. Political uncertainty, such as it is in Japan, will emerge ahead of the September 2021 election. Abe’s retirement and the aftermath of the global recession create an opening for disgruntled factions and opposition parties to challenge the ruling party. It will not succeed but it will portend a less predictable period in the absence of a unifying figure like Abe. In fact, Abe’s influence peaked in July 2019 when he lost a single-party super-majority in the House of Councillors, the upper house of parliament (Chart 14). The 2021 election now raises the prospect of additional erosion of support. Chart 14US-Japan Alliance Versus China Will Persist Abenomics Will Smell As Sweet By Any Other Name Abenomics Will Smell As Sweet By Any Other Name Opposition is particularly likely if Suga attempts to achieve Abe’s major unfinished task: the revision of Article Nine of the constitution to countenance Japan’s de facto armed forces and right to self-defense. At very least Suga will mark the return of the “revolving door,” in which weak prime ministers come and go in rapid succession. The top candidates for the leadership race lack differentiation: the leading contenders are dovish on monetary and fiscal policy, hawkish on national security and foreign policy, just like Shinzo Abe (Table 1). The exception is former Defense Minister Shigeru Ishiba, but a close examination of his statements and actions suggests that he does not pose a real risk to the policy status quo (Box 1 at bottom). Should Ishiba rise to power, now or later, we would be buyers of any risk premium in financial markets on his account. Table 1The Return Of The Revolving Door Abenomics Will Smell As Sweet By Any Other Name Abenomics Will Smell As Sweet By Any Other Name The prime minister over the 2021-22 period will have the occasion to appoint up to four members of the Bank of Japan’s Policy Board (Table 2). Theoretically, the appointment of neutral or less dovish candidates could lead to a 5-4 majority on the board by 2023. But this is very unlikely. Table 2Dovish BoJ Is Here To Stay Abenomics Will Smell As Sweet By Any Other Name Abenomics Will Smell As Sweet By Any Other Name First, it would require all vacant seats to be filled with members who hold hawkish views, which would mark a sharp departure from the current thinking both within the BoJ and the LDP. Second, Kuroda is still governor and could hold that post until 2028. Third, Japan’s economic demands will still require easy monetary policy, as the population will still be shrinking and the country’s vast debt pile will remain a burden. Fiscal austerity is impossible. There is no reason to expect Abe’s successors to be fiscal hawks either. Abe proved to be more of a hawk than expected, by going forward with statutory increases to the consumption tax rate. These are now complete, at 10%, with no future tax hikes scheduled. If Abe managed to create small positive surprises in fiscal thrust throughout his term despite this effort at fiscal consolidation, then his successor should be able to do so in the wake of COVID-19 without any consolidation as yet on the books (Chart 15). Chart 15Despite Mistakes, Fiscal Thrust Surprised To Upside Abenomics Will Smell As Sweet By Any Other Name Abenomics Will Smell As Sweet By Any Other Name Chart 16Fiscal Austerity Impossible Abenomics Will Smell As Sweet By Any Other Name Abenomics Will Smell As Sweet By Any Other Name Fiscal austerity is impossible as nearly 60% of the budget is dedicated to social spending for the graying and shrinking society as well as interest payments on the national debt – leaders will continue to avail themselves of the ancient imperial practice of tokusei, or debt forgiveness, rather than draconian spending cuts or tax increases that would drag down the economy and hence increase the debt even faster (Chart 16). Of course, the major failure of Abenomics will still dog Abe’s successors over the long run: the inability to lift Japanese productivity. Despite Abe’s attempts to shake up the labor market, spark corporate investment, reform corporate governance, and open up the economy to foreign trade, productivity has still declined, underperforming both the EU and the UK (Chart 17). Japan will continue to depend heavily on foreign demand, especially Chinese demand. In the short term this is positive, since China’s deleveraging campaign and the COVID-19 shock are giving way to another major bout of Chinese fiscal and credit stimulus. China will be forced to keep stimulating to cope with its secular slowdown and manufacturing dislocation. Japan is still a cyclical economy and stands to benefit (Chart 18). Chart 17No Quick Fix For Poor Productivity No Quick Fix For Poor Productivity No Quick Fix For Poor Productivity Chart 18Chinese Stimulus Will Be Steady Chinese Stimulus Will Be Steady Chinese Stimulus Will Be Steady In the long run, however, Japan’s future darkens considerably when its own demographic decline and deflationary tendencies are coupled with China’s inheritance of these same trends. The Communist Party is doubling down on import substitution and foreign policy assertiveness, ensuring that trade and strategic conflict with the US will escalate over time. Japan will remain allied with the United States, out of its own strategic interest, but will pay the price in periodic headwinds to growth. Its ability to relocate manufacturing to Japan is limited in all but the most sophisticated of industries. It will have to embrace ever more unorthodox monetary and fiscal policy while investing heavily in new technologies and emerging markets ex-China in search of growth. Geopolitically speaking, Shinzo Abe helped the United States formulate its new strategic plan of promoting a “free and open Indo-Pacific” and the spirit of this policy will outlive Abe and President Trump. The US’s “pivot to Asia” began under the Democratic Party, which will rejoin the Trans-Pacific Partnership, with a few tweaks, if it returns to power. The US and Japan are both interested in forming a grand coalition of nations surrounding China to contain its ambitions, whether military, political, or technological. China would be naïve not to see the quadrilateral security dialogue between these countries and India and Australia as the blueprint of a naval alliance designed to contain it. The Taiwan Strait, the South and East China Seas, Vietnam, the Philippines, and the Korean Peninsula will become the sites of “proxy battles” as the US and Japan strive to contain China. Japan will retain its safe haven status – in both the geopolitical and financial sense – while other countries will see a higher geopolitical risk premium. Japanese and Korean trade tensions will persist, unless the US takes a leadership role in strengthening the trilateral relationship. Russia has chosen to throw in its lot with China, which will not change anytime soon. But if Abe’s successor is able to get peace negotiations back on track, in pursuit of another of Abe’s major unfinished initiatives, then this would serve as an important bellwether of Russia’s own fear of China’s growing power. Investment Takeaways Chart 19Japanese Stocks Look Attractive... Japanese Stocks Look Attractive... Japanese Stocks Look Attractive... Japanese equities are exceedingly cheap and hence attractive over the long run, given that a new global business cycle is beginning and governments around the world are committed to providing as much support as they are able. At a dividend yield of less than 2.5%, the real return on Japanese stocks over the next ten years could be 20% (Chart 19). However, over the next three-to-six months, the world faces extreme uncertainty over the US election and rapidly deteriorating US-China relations. The Japanese economy is slowing and monetary policy, at the zero lower bound, will play a marginal role. The yen is set to appreciate as a safe-haven in this environment (Chart 20), and until there is a total divergence of the inverse correlation of the yen and Japanese equities, the latter will struggle to outperform those of other developed markets on a sustained basis. Chart 20... But Yen Rally Will Continue ... But Yen Rally Will Continue ... But Yen Rally Will Continue Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Box 1: Ishiba Is Not A Real Risk To The Policy Status Quo Shigeru Ishiba, while not favored to succeed Abe in the short run, is a compelling Japanese politician and one of the few Liberal Democratic leadership candidates who would mark a change with Abe, as Table 1 above indicates. If Ishiba looks to become prime minister, now or later, he would create some financial market jitters primarily because he would not symbolize seamless policy continuity. He is a major rival of Abe and has publicly criticized Abenomics, including in his 2018 book.2 He is reputed to be a hawk on monetary and fiscal policy. However, a close look at his record shows that he is not ideological and would not revolutionize Japanese national policy once in office. Ishiba is a careful and rational thinker and an institutional and establishment LDP politician. Both Ishiba and his father (Jiro Ishiba) were scions of the Tanaka/Takeshita factions whose base was agriculture, construction industry, defense industry, and the postal service.3 His is not the background of a radical fiscal hawk. One of Ishiba’s major concerns is generating growth outside of the major cities, but he does not take a slash and burn approach to the central government budget. For example, at a forum on Abenomics, the director of the Japanese Civilization Institute spoke with Ishiba in his capacity as Minister of Regional Revitalization. The moderator gave Ishiba the opportunity to denounce excess government spending and promote central spending cuts, saying, “Maybe you must arrange fiscal discipline more appropriately. Then, you can supply that money to regional areas.” Ishiba responded drily, “But I think regional areas must make their own money too.” The yen could rally on a bout of political uncertainty if Ishiba at any time looks likely to become LDP leader and he criticizes excessively easy economic policies. But, as we noted above in the report above, the BoJ Policy Board, not the prime minister’s office, will set monetary policy – and Ishiba would struggle to stack the board with hawks due to institutional resistance. Moreover in the wake of a global recession, the next prime minister will not have much ability to drive parliament into budget cuts or tax hikes. Ishiba would more likely seek to pursue deregulation. If he insisted on austerity, the economy would slump and his premiership would be ruined. Chances are he would listen to his advisers. The one policy that concerns Ishiba above all is national defense and security. Ishiba previously served as defense minister and was known for his hawkish tone, particularly over disputes in the East China Sea and domestic protests against the country’s new security law. More recently he differed with Abe’s constitutional revision – not over the need to normalize Japan’s self-defense forces, but because Abe tried to avoid an explicit mention of Japan’s right to maintain armed forces. If anything, Ishiba would be inclined to increase military spending. Yet his foreign policy is not a risk to the markets, beyond rhetoric, as he is also more willing to engage China than some other LDP leaders. Footnotes 1 In truth, something of a national awakening had already begun in the early 2000s under Prime Minister Junichiro Koizumi. This is reflected in the improvement of the fertility rate from 2005. But it fell to Abe to pick up where Koizumi had left off, fighting deflation and strengthening Japan’s international position. 2 See "Abe’s rival to declare bid to become Japan’s next leader," Nikkei, July 13, 2018, asia.nikkei.com. See a campaign synopsis at ishiba.com. 3 See Jojin V. John, "Developments in Japanese Politics: LDP Presidential Election and the Future of Prime Minister Shinzo Abe," Indian Council of World Affairs, August 29, 2018, icwa.in

Highlights China faces unprecedented socioeconomic challenges but its political response is rigid rather than flexible. The twin political goals of centralization and self-sufficiency bode ill for productivity. Communist Party elites have become more ideological and provincial, less cosmopolitan and technocratic. A global protectionist backlash adds to China’s woes. Over the long run, favor cyclical and commodity plays that benefit from China’s reflation but are distanced from its large and persistent political and geopolitical risks. Feature In ancient times Chinese emperors ruled with the “mandate of heaven.” As long as they could keep famine, rebellion, invasion, and plague from ravaging the nation, they were perceived as having divine sanction. Their dynasty would retain power and the people would be kept in awe (Table 1). Table 1Disease And The Fall Of Chinese Dynasties Is Xi Jinping Losing The Mandate Of Heaven? Is Xi Jinping Losing The Mandate Of Heaven? The COVID-19 pandemic and recession are highly unlikely to cause the downfall of General Secretary Xi Jinping and the Communist Party “dynasty.” But it is part of a string of recent challenges to the regime that are secular and structural in nature. The regime’s response, thus far, has been rigidity rather than flexibility – a warning sign that things may get worse before they get better. Investors should not view China as “fundamentally stable,” as has largely been the case for the past 20-30 years. Instead they should view it as fundamentally unstable and therefore a source of understated risk to the Chinese currency, equities, and corporate bonds. This is especially true relative to markets that benefit from Chinese reflation yet are distanced from its political and geopolitical risks. Political risks are more likely to manifest in China’s periphery in the short run. Mainland Chinese political risks are more likely to manifest over the long run. A Massive Reflationary Kick China convenes the National People’s Congress on May 21, after a two-month delay due to the extraordinary COVID-19 pandemic. The annual legislative session typically drives reflationary sentiment in the global economy and financial markets, especially in years of crisis such as 2009 and 2016. This year should be another such year, particularly viewed from a long-term perspective. Investors can count on massive Chinese stimulus because the spike in unemployment poses a threat to social stability. Chinese authorities are wheeling out the big guns for this crisis. The fiscal measures announced thus far should reach 10% of gross domestic product. The “quasi-fiscal” function of Chinese banks could push the total well above that when all is said and done. Investors can count on massive stimulus because the spike in unemployment poses a threat to social stability. The economy is contracting for the first time since the Cultural Revolution (Chart 1). Chart 1China's Rapid Growth, A Pillar Of Stability, Is Officially Gone China's Rapid Growth, A Pillar Of Stability, Is Officially Gone China's Rapid Growth, A Pillar Of Stability, Is Officially Gone Table 2The Great Chinese Boom, 1980-2020 Is Xi Jinping Losing The Mandate Of Heaven? Is Xi Jinping Losing The Mandate Of Heaven? Ever since that chaotic period, the Communist Party has based its legitimacy on economic growth and rising incomes. The results of China’s economic boom of 1980-2020 are well known. China’s share of global GDP has risen from 2% to 16%; its share of global capital stock from 3% to 21%; exports 1% to 13%; and military spending 1% to 14% (Table 2). In the future, with this economic pillar cracked, Beijing will have to devote even more attention to “stability maintenance” at home. Reflation Doesn’t Solve Structural Problems Household consumption is China’s only hope for developing sustainable economic growth in the wake of a boom driven by investment in export-manufacturing and construction. Cyclically, the virus threatens consumption by discouraging consumers from going anywhere other than work. However, China’s suppression of the virus is enabling consumers to resume activity gradually. Elsewhere, including Europe, economic expectations are also perking up, corroborating China’s data that consumers are increasingly willing to venture out of their homes (Chart 2). Still, China is vulnerable to subsequent outbreaks and is already instituting new lockdowns in the northeast. Structurally, China’s economy is susceptible to a series of historic shifts that were already taking place and that the pandemic has accelerated. The working-age share of the population is now declining rapidly. This coincides with a drop in the national savings rate (Chart 3) and a rapid rise in the dependency ratio – faster even than in Germany or Japan over the past two decades. Consumption will rise relative to investment. But if households are precautionary savers, as in Japan, then consumption will not grow fast enough to sustain overall GDP growth, forcing the government to spend more to shore up overall demand. Chart 2Chinese And Global Sentiment Recovering Chinese And Global Sentiment Recovering Chinese And Global Sentiment Recovering Chart 3China's Demographic Changes Portend Higher Cost Of Capital China's Demographic Changes Portend Higher Cost Of Capital China's Demographic Changes Portend Higher Cost Of Capital China no longer primarily channels its savings into export manufacturing. Instead it invests them at home. China’s total debt – public and private – has surpassed that of many developed nations despite the country’s lower level of development and wealth (Chart 4). China can manage this debt, given that it prints its own currency, keeps a closed capital account, and has shifted to a primarily domestic-oriented economy. But the debt is less manageable than before the crisis. Nominal growth has fallen beneath interest rates, implying that, in the midst of the crisis, debt cannot be serviced for the economy as a whole (Chart 5). Growth will revive, but it will likely run at lower rates than prior to the crisis. Debt servicing will be a recurrent problem for small or inefficient businesses. Chart 4China’s Indebtedness Will Continue To Surge Is Xi Jinping Losing The Mandate Of Heaven? Is Xi Jinping Losing The Mandate Of Heaven? Chart 5China Needs Growth To Service Debt China Needs Growth To Service Debt China Needs Growth To Service Debt Chart 6China Struggling To Avoid 'Twin Deficits' China Struggling To Avoid 'Twin Deficits' China Struggling To Avoid 'Twin Deficits' The whole problem is illustrated by China’s verging on “twin deficits” – an ever-widening budget deficit combined with a recent tendency to slip into current account deficit (Chart 6). Anglo-Saxon economies often run large twin deficits. But China is more comparable to Japan, which has never let itself run persistent current account deficits, since it would then become reliant on foreign sources of financing. Since China will run large budget deficits for the foreseeable future, it will either have to make its corporate sector more efficient (e.g. by depressing wages), or it will see downward pressure on the currency as a result of a weakening current account balance. The pandemic and recession will pass, thanks to massive stimulus. What will remain is China’s voyage into new territory. Prior to COVID-19 the concern was that China would grow old before it grows rich – that the transition to a low-growth consumer economy would occur at a much lower level of GDP per capita than it did with economies like Taiwan, Japan, and South Korea. Now, with a sudden downward shift in growth rates, it is possible that China will grow old without growing rich. This would be a huge risk to the regime in the long run. The Communist Party Returns To Its Roots Risk of economic stagnation – the so-called middle-income trap – is why policymakers at the National People’s Congress this weekend will lay so much emphasis on “reform and opening up,” even as they are forced by the pandemic to do the opposite for now and stimulate the economy via debt-financed fixed investment. China has pledged sweeping structural reforms, liberalization, and internationalization so many times now that it is common for western policymakers to complain of “promise fatigue.” The lack of verification is one reason foreign governments are increasingly willing to consider punitive measures in dealing with China. Today’s macro and geopolitical context do not favor liberal reforms, such as occurred in China in the late 1990s, but the changing characteristics of China’s elite political leaders reveal a more specific reason why policy has grown more statist, more “communist,” and less liberal, over the past decade. Members of the Politburo Standing Committee (PSC), the most powerful decision-making body, have become more ideological, more authoritarian, less cosmopolitan, and less technocratic over the years (Chart 7). They are far less likely to have studied the hard sciences or engineering than their predecessors, who orchestrated China’s westernizing, capitalist reforms from the 1980s to early 2000s. Chart 7China’s Leadership Increasingly Provincial And Inward-Looking Is Xi Jinping Losing The Mandate Of Heaven? Is Xi Jinping Losing The Mandate Of Heaven? They lack experience running state-owned enterprises, which might seem like a plus, except that the alternative is being a career politician – a ruler of a province – and never having run any business at all. Leaders increasingly hail from rural provinces, as opposed to the wealthy, internationally savvy coasts. Chart 8China Will Miss Some Centennial Income Targets China Will Miss Some Centennial Income Targets China Will Miss Some Centennial Income Targets Essentially, the grassroots interior of the country – the base of the Communist Party – has been reclaiming the party from the corrupt, liberal, westernizing technocrats. And the party is about to grow even more reactionary. First, it is now officially failing to meet its own development goals. For several years the administration has talked of abandoning annual GDP growth targets as part of its push to prioritize quality rather than quantity of economic growth, but has not done so. Now it is not only the annual growth target that will be missed in 2020, but the party’s decade goals will have to be fudged (Chart 8). Moreover, if the economy does not recover as quickly as hoped then the highly symbolic 2021 centennial of the Communist Party will be marred. Replacing hard numerical targets is reasonable but will not change the party’s constant need to emphasize development goals to keep the people looking forward. And it will not remove the local-level incentive structures that cause economic distortions to meet central government goals. The takeaway is that massive stimulus is assured as the party cannot afford to suffer instability over this period of political milestones. Second, the administration’s difficulties open up at least some possibility of factional struggle within the party. Remember that Xi Jinping was supposed to step down in 2022 at the twentieth National Party Congress. This would have marked the end of his ten-year rule according to the rules that his two predecessors tried to establish. Xi altered this pattern in 2017 to pave the way to rule until 2035 or beyond. Thus while the market can look forward to stimulus this year and next to ensure the economy has stabilized by 2022 (Chart 9), there is potential for surprising political events to rattle China’s appearance of political stability and unity. Chart 9Xi Jinping Was Originally Slated To Step Down In 2022 Xi Jinping Was Originally Slated To Step Down In 2022 Xi Jinping Was Originally Slated To Step Down In 2022 Granted, Xi has shifted the party’s governance model from single-party rule to single-person rule. The most likely political shocks will come from Xi cracking down on his opponents to re-consolidate power, as he did in 2012-13 and 2017. Factional struggles could cause minor risk-off episodes in financial markets but they will say something more important, which is that the unity of the ruling party is a façade and stability cannot be assumed forever. Economic Targets: Centralization And Autarky In the coming years, Xi Jinping’s government will continue to centralize control over society and the economy as it has done throughout his term. This is the opposite of “reform” in the sense of former leader Deng Xiaoping, which meant decentralizing power and letting local governments and private business innovate. The Xi administration’s “reform” push was to cut industrial overcapacity and deleverage the corporate sector, as we highlighted in a series of reports from 2016-18. We argued then that these reforms would be abandoned as soon as major downside risks to growth returned – which is what occurred due to the trade war and now COVID-19. Thus the net effect of the Xi administration thus far has been to centralize the economy and pursue self-sufficiency. Centralization can be shown in the resurgence of the Communist Party, the central government in Beijing, and state-owned enterprises. Government debt has grown at the expense of private leverage (Chart 10), which faced a crackdown, while the state-owned share of corporate debt has grown from one-half to two-thirds since 2013. Xi formally pledged in 2017 to make state companies stronger, better, and bigger. His term has witnessed a major bull market in SOE equities relative to the broad market – and each phase of power consolidation adds a new rally to this trend (Chart 11). Chart 10Public Sector Encroaching On Private Sector … Before COVID-19 Is Xi Jinping Losing The Mandate Of Heaven? Is Xi Jinping Losing The Mandate Of Heaven? Chart 11SOE Bull Market Under Xi Jinping SOE Bull Market Under Xi Jinping SOE Bull Market Under Xi Jinping As for international trade, China has become far less reliant on foreign parts and components for its manufacturing sector over recent decades (Chart 12). It has also increasingly used state resources to pursue strategic self-sufficiency through technological acquisition, import substitution, and state-backed “indigenous innovation.” The attempt to make a new Great Leap Forward in advanced manufacturing and high-tech services has led to a direct clash with the US government, which is now actively expanding export controls. In the upcoming fourteenth Five Year Plan for the years 2021-25, Beijing is highly likely to double down on technological self-reliance. Chart 12China Closes Its Doors Is Xi Jinping Losing The Mandate Of Heaven? Is Xi Jinping Losing The Mandate Of Heaven? Chart 13Centralization And Closed Economy Harm Productivity Is Xi Jinping Losing The Mandate Of Heaven? Is Xi Jinping Losing The Mandate Of Heaven? Centralization and import substitution have harmed productivity, especially total factor productivity (Chart 13). Centralization is not necessarily bad for productivity – state-directed research and development can galvanize major improvements. But in China centralization is excessive and constricts the flow of information and ideas in civil society and academia, which discourages innovation and privileges quantity over quality of output. Closure to the outside world reinforces this point – particularly as a global protectionist backlash comes to affect China’s acquisition of tech and talent – and exacerbates the misallocation of capital at home. Social Unrest Will Grow China’s falling potential growth will generate social unrest over time, despite the appearance of perfect control in this authoritarian society. Table 3 shows our COVID-19 Social Unrest Index. Countries are ranked from best to worst, top to bottom. Obviously a high rank does not suggest a country is immune to unrest – all emerging markets are vulnerable. A poor score under “household grievances” – i.e., income inequality combined with the “misery index” of high inflation and unemployment – can engender unrest even in relatively well-governed states, as is happening in Chile. Table 3China Looks Stable On Paper: Our COVID-19 Social Unrest Index Is Xi Jinping Losing The Mandate Of Heaven? Is Xi Jinping Losing The Mandate Of Heaven? China ranks fourth overall, with poor governance indicators dragging down the total. However, household grievances will rise as the unemployment rate rises (and perhaps food and fuel inflation). Unemployment is much higher in China than officially reported. The government is also unfamiliar with how to deal with large surges in unemployment, having long utilized policy to minimize the unemployment rate at any cost (Chart 14). Chart 14AUnemployment Spike A Threat To Chinese Stability Unemployment Spike A Threat To Chinese Stability Unemployment Spike A Threat To Chinese Stability Chart 14BUnemployment Spike A Threat To Chinese Stability Unemployment Spike A Threat To Chinese Stability Unemployment Spike A Threat To Chinese Stability Chart 15Income Inequality In China Is Xi Jinping Losing The Mandate Of Heaven? Is Xi Jinping Losing The Mandate Of Heaven? Inequality is at extreme levels and will worsen as a result of COVID-19. Our China Investment Strategist shows that the bifurcation in wealth between the top 10% and the bottom 50% will widen as job losses hit low-skilled and labor-intensive sectors (Chart 15). The rural-urban disparity – an obsession of policymakers in recent years – will also grow amid the crisis (Chart 16). Two factors are aggravating these trends. First, the decline of the manufacturing sector alluded to above. China’s manufacturing sector was too large and it has been rapidly converging to the level of developed economies, meaning that as many as 10% of workers’ jobs are at risk in the coming years. A maturing economy and mercantilist geopolitical trends are accelerating this process (Chart 17). Beijing will have to confiscate wealth from the coastal provinces and power centers to reduce inequality and social grievances. Chart 16Regional Inequality In China Is Xi Jinping Losing The Mandate Of Heaven? Is Xi Jinping Losing The Mandate Of Heaven? Chart 17Large Manufacturing Sector Getting Purged Large Manufacturing Sector Getting Purged Large Manufacturing Sector Getting Purged Second, migrant workers are drifting home amid the COVID-19 crisis, just as in 2008. 51 million migrants vanished from employment rolls in the first quarter (Chart 18). The government’s model of household registration reform has focused not on making it easier for migrants to integrate into wealthy coastal provinces but rather on subsidizing activity in interior provinces and foisting workers back into their home provinces. This is a trigger of unrest. Will social unrest end up being politically significant? In most cases no. Beijing is prepared to quell protests and dissent – it has devoted massive resources to domestic security, even compared to its rapid military modernization (Chart 19). Chart 18Migrant Workers Cast Adrift Amid COVID-19 Is Xi Jinping Losing The Mandate Of Heaven? Is Xi Jinping Losing The Mandate Of Heaven? Chart 19‘Stability Maintenance’ Is A State Priority Is Xi Jinping Losing The Mandate Of Heaven? Is Xi Jinping Losing The Mandate Of Heaven? The Communist Party began prioritizing “social stability maintenance” across all dimensions of society in the wake of the global financial crisis in 2008. The abortive “Jasmine Revolution” in 2011, at the height of the Arab Spring, was literally swept away by street-cleaning trucks. The Wukan riots that same year were more persistent, flaring up again in 2016, but the siege was ultimately confined to a single city in the generally more restive south. Various shows of defiance in Wuhan and Hubei in the wake of COVID-19 have been snuffed out. Social unrest will not always be politically significant. State repression and mismanagement could turn any minor incident of unrest into a major incident. But as long as disturbances remain local, they will have limited political consequences. The risk for China is its pursuit of innovation and technological modernization. Greater connectivity will increase the potential for cross-border coordination. The running assumption is that China is an authoritarian state with sufficient police force to silence any discontent. But political activism does not have to be liberal – it could be nationalist, or simply based on quality of life issues that cannot easily be demonized. At any rate, the dislocation of the manufacturing sector and labor market in the context of a secular growth slowdown is a long-term tailwind for social and political challenges to the state. Political risk will grow, not fall, from here. Diversions From Domestic Unrest Beijing’s attempt to re-centralize power and reassert Communist Party control has sparked resistance in the Chinese periphery. Both Taiwan and Hong Kong have seen protest movements – consisting of middle class workers as well as youth – since 2013. These movements have not spread to the mainland – if anything they are a diversion from the mainland’s own problems. But they have prompted Beijing to crack down on the periphery, further polarizing opinion. While unrest in Hong Kong will heat up as Beijing attempts to impose even more direct control, ultimately Hong Kong has no alternative. Taiwan, on the other hand, is an island that already largely conceives of itself as an autonomous unit. The sense of Taiwanese identity – as opposed to Chinese – has exploded upward in recent years (Chart 20). There is a very high bar for war in the Taiwan Strait. And yet Chinese military hawks and strategists have begun to discuss it more openly. China’s military drills around the island are a measured but intimidating response to the rise of the popular, nominally pro-independence government since 2016. The US is making active but measured moves to shore up the diplomatic and military relationship with Taiwan. Given Washington’s renewed focus on China’s drive to achieve dominance in semiconductors, and America’s desire to secure supply chains that run through Taiwan and the mainland, we remain fully committed to our view that Taiwan is a major underrated geopolitical risk. Given the high bar for outright war on Taiwan, it should be no surprise that disputes over sovereignty and military positioning in the South China Sea should revive (Chart 21). This is a convenient outlet for Chinese nationalism. The sea is of vital strategic importance to all the major East Asian economies – not because of resources but because of supply security. Military actions in the sea have a direct bearing on cross-strait relations as well as Sino-Japanese relations, which are also liable to flare up during periods of economic distress. Chart 20Tensions In Chinese Periphery Set To Increase Is Xi Jinping Losing The Mandate Of Heaven? Is Xi Jinping Losing The Mandate Of Heaven? Chart 21South China Sea: Not Just A Distraction Is Xi Jinping Losing The Mandate Of Heaven? Is Xi Jinping Losing The Mandate Of Heaven? The US is pushing back in the seas as well, increasing the odds of a skirmish or incident. Recent reports that China will seek to establish an air defense identification zone (ADIZ) in the South China Sea have been dismissed by Taiwanese authorities, but an ADIZ is just one of many plausible scenarios that could escalate tensions overnight. Will The US Sabotage China? The US election has the potential to exacerbate China’s economic and political insecurities in the near term. The major constraint on US-China economic decoupling is well known: US allies, such as Europe and Japan, can and will continue to trade with China. Thus the US would suffer the most if it insisted on an outright blockade of trade or tech. The implication, however, is that President Trump will change strategy in any second term. There is a substantial risk to European industry that he could attempt a trade war with the EU as well as China. But the major constraint – that the US cannot take on China alone – means that his advisers across all parties and agencies will urge him to change his position. Whether he will listen is anybody’s guess. Meanwhile a Democratic victory will ensure a multilateral strategy is adopted, as was the case from 2008-16. The real political risk comes when Xi Jinping attempts to step down and pass the baton to a successor. In this regard it is essential to recognize that China’s progress up the manufacturing value chain is a threat to US allies independently of the United States (Chart 22). Chart 22China’s Manufacturing Rivals Advanced Nations Is Xi Jinping Losing The Mandate Of Heaven? Is Xi Jinping Losing The Mandate Of Heaven? Judging by China’s fastest growing export categories, Germany, South Korea, Taiwan, Japan, and Singapore have nearly as much to lose as the United States if China’s state-backed trade practices are not constrained (Chart 23). These include illegal tech transfer, hacking, and increasingly Russian-style disinformation campaigns. Chart 23US Not Alone In Concern Over China’s Manufacturing Machine Is Xi Jinping Losing The Mandate Of Heaven? Is Xi Jinping Losing The Mandate Of Heaven? Chart 24China's Rise Comes At Expense Of US Allies, Not Necessarily US China's Rise Comes At Expense Of US Allies, Not Necessarily US China's Rise Comes At Expense Of US Allies, Not Necessarily US In terms of overall geopolitical power, China’s rise has occurred at the expense of Japan and the EU as well as the United States, even though Europe is less threatened militarily (Chart 24). The implication is that if the US should make a concerted diplomatic effort to form a united front against China demanding verifiable reform and opening, it will eventually be able to bring its allies over to the cause. Xi Jinping’s Succession Crisis How would China respond to this external pressure, which threatens to pile onto its new domestic woes? China will resist US unilateral pressure tactics, so confrontation with a re-elected Trump could be very destabilizing. A “grand alliance” of the West that leaves open the path to economic cooperation could force China to capitulate and offer real concessions. But we are far from there today. Faced with outright confrontation or multilateral encirclement, China will double down on self-sufficiency. Thus geopolitics reinforces China’s internal political evolution and the macro backdrop outlined above. Centralization, Maoism, protectionism, and confrontation with the United States suggest that China faces serious trouble over the long run, especially when today’s massive stimulus wears off. Chart 25Markets Want Chinese Reforms And A Trade Deal Markets Want Chinese Reforms And A Trade Deal Markets Want Chinese Reforms And A Trade Deal Will the challenges be so great as to deprive Xi Jinping of the mandate of heaven? Not anytime soon. He sits at the helm of a wealthy authoritarian state and has the distinct advantage of having consolidated power, from 2012-17, prior to the onslaught of internal and external pressure. He enjoys popular support, despite the seeds of unrest identified in this report. The real political risk for the Communist Party comes when Xi Jinping attempts to step down and pass the baton to a successor. It was the succession after Chairman Mao Zedong’s death that occasioned the power struggles of the late 1970s. And it was Deng Xiaoping’s various attempts to set up a successor that led to unrest and party divisions in the 1980s, culminating at Tiananmen Square. The implication is that systemic regime instability is a long way off – yet still discernible. Chinese equities trade at a high risk premium. However, it may persist for some time. Political and geopolitical trends are not positive for China’s growth, productivity, private sector, or trade over the long run. Equity returns in USD terms over the course of the just-finished bull market compare very unfavorably to the previous bull market (Chart 25). On a 12-month and beyond investment horizon, we recommend investors seek cyclical and commodity plays that benefit from Chinese reflation yet are removed from its governance and geopolitical risks. These include industrial metals, Southeast Asian assets, and Japanese and European equities.   Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com

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

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

Highlights No, it’s not: We expect negative rates to remain the exception rather than the rule. A growing body of evidence suggests that negative rates may be doing more harm than good. Stronger global growth is likely to lift inflation over the next few years, thus making the debate around negative rates increasingly irrelevant. Contrary to conventional wisdom, there is scant evidence that structural forces related to globalization, automation, weak trade unions, and demographics are holding back inflation. Asset allocators should overweight global equities during the next 12-to-24 months, while maintaining a short duration bias in fixed-income portfolios.  A more defensive stance towards equities may be necessary starting in 2022. Just A Matter Of Time? Chart 1A Spike In Negative-Yielding Debt Is The Entire World Heading For Negative Rates? Is The Entire World Heading For Negative Rates? There is nearly $14 trillion of negative-yielding debt outstanding today (Chart 1). While most of this debt has been issued in the euro area and Japan, many investment professionals believe that negative yields will eventually become the norm in the U.S. and other developed economies. The rationale for this belief is easy to understand: The current expansion, like all past expansions, will inevitably end (in many investors’ minds, it already has). Once a recession is afoot, central banks will try to ease monetary policy even more than they already have. The Fed has cut rates by more than five percentage points on average during past recessions (Chart 2). Even a mild recession could see U.S. rates fall to zero. Once rates reach zero, pushing them into negative territory could become the logical next step. Chart 2Will The U.S. Join The Negative Rate Club After The Next Recession? Will The U.S. Join The Negative Rate Club After The Next Recession? Will The U.S. Join The Negative Rate Club After The Next Recession? It is a compelling argument. However, it rests on two assumptions. The first is that negative rates are an effective tool against an economic downturn. That is far from clear. Second, the argument presupposes that the forces which have pushed some countries to adopt negative rates will endure until the next recession. To those who see the current expansion as very “late stage” and regard the persistence of low interest rates as largely structural in nature, this is a perfectly plausible assumption. However, as we discuss later on, it is probably flawed. The Merits (Or Lack Thereof) Of Negative Rates In theory, negative rates could incentivize banks to loan out excess funds in order to avoid paying interest on reserves. It could also boost demand for credit. In practice, banks have been reluctant to force depositors to pay interest on their savings. Instead, they have absorbed the cost of negative rates through lower net interest margins. At a time when some banks are still struggling to shore up their balance sheets, the introduction of negative rates may have perversely resulted in less lending. Labor market slack has diminished significantly around the world. Some policymakers have slowly come around to the conclusion that negative rates may be doing more harm than good. Most senior Fed officials have rejected negative rates as an effective policy tool. Japanese and European officials have been more supportive of negative rates. The ECB even cut rates further into negative territory in September. However, ECB officials have acknowledged the harm done to the banking system by introducing a tiering system that shields a portion of excess bank reserves from negative deposit rates. The Swedish Riksbank, an early pioneer of negative rates, has even gone as far as to warn that “if negative nominal interest rates are perceived as a more permanent state, the behavior of agents may change and negative effects may arise.” Groundhog Day Judging by today’s low level of bond yields, it is easy to conclude that deflationary forces are just as powerful as they were a decade ago. There are, however, at least two important differences between now and then. First, the deleveraging cycle has ended in most developed economies. As a share of GDP, U.S. nonfinancial private-sector debt has risen over the past four years. Even in Japan, private debt levels have moved off their lows. The ratio of private debt-to-GDP has been broadly flat in the euro area, with rising debt levels in France offsetting falling leverage in Italy and Spain (Chart 3). Second, labor market slack has diminished significantly around the world. The unemployment rate in the G7 has fallen from a peak of 8.4% in 2009 to 4.2%. It is currently a full percentage point below its pre-recession low of 5.2% set in 2007 (Chart 4). Chart 3Deleveraging Has Ended In Most Developed Markets Deleveraging Has Ended In Most Developed Markets Deleveraging Has Ended In Most Developed Markets Chart 4Falling Unemployment Rate Across Developed Markets Falling Unemployment Rate Across Developed Markets Falling Unemployment Rate Across Developed Markets Some have argued that disguised joblessness is distorting the official unemployment statistics. While this was a major problem earlier in the recovery, it is much less of a concern today. In the U.S., the share of the working-age population that wants a job, but is not actively looking for one, is smaller than in 2007 (Chart 5). Whither The Phillips Curve? Falling unemployment has pushed up wage growth. Indeed, for all the talk about how the Phillips curve is dead, the “wage version” of the curve – which is how William Phillips originally formulated the concept – is very much alive and well (Chart 6). Chart 5U.S. Labor Market Slack Has Diminished U.S. Labor Market Slack Has Diminished U.S. Labor Market Slack Has Diminished Chart 6Falling Unemployment Has Pushed Up Wage Growth Falling Unemployment Has Pushed Up Wage Growth Falling Unemployment Has Pushed Up Wage Growth Chart 7Rising Labor Share Of Income Occurring Alongside Labor Market Tightening Rising Labor Share Of Income Occurring Alongside Labor Market Tightening Rising Labor Share Of Income Occurring Alongside Labor Market Tightening What is true is that the “price version” of the Phillips curve – the one that compares unemployment with price inflation – still looks very flat in most countries. This is another way of saying that rising nominal wages have mainly translated into higher real wages, with an accompanying increase in labor’s share of income (Chart 7). Workers tend to spend more of their incomes than companies. If the share of national income flowing to workers continues to rise, aggregate demand will increase. Unless supply expands in tandem, shortages of goods and services will arise, leading to higher inflation. Getting Close To The Kink There is considerable theoretical and econometric evidence suggesting that the Phillips curve is kinked.1  When slack is plentiful, modest declines in spare capacity have little effect on inflation. When slack disappears altogether, however, inflation can surge. This was certainly what happened during the 1960s. Chart 8 shows that U.S. core inflation was remarkably stable at around 1.5% in the first half of the decade. It was only in 1966 that inflation took off, rising to nearly 4% in less than two years. Core inflation proceeded to make its way to over 6% in 1970, a full three years before the first oil shock. The U.S. unemployment rate was two percentage points below NAIRU in 1966. By most estimates, the unemployment rate today is still a bit less than a point below its full employment level. Thus, an inflationary breakout is not imminent. This is confirmed by a wide variety of leading indicators for inflation (Chart 9). Chart 8Inflation Took Off In The 1960s Amid An Overheated Economy Inflation Took Off In The 1960s Amid An Overheated Economy Inflation Took Off In The 1960s Amid An Overheated Economy Chart 9An Inflation Breakout Is Not Imminent... An Inflation Breakout Is Not Imminent... An Inflation Breakout Is Not Imminent... Nevertheless, U.S. inflation has begun to firm at the margin (Chart 10). Trimmed mean inflation, which according to one Fed study does a better job of tracking underlying inflationary trends than more conventional measures, has been running at over 2% for much of the past 12 months.2  The median item in the CPI basket is rising by about 3%. Inflation has been slower to accelerate outside the U.S., partly because there is still more slack abroad. Nonetheless, embryonic signs of inflation are emerging. The deflationary pressures which plagued countries such as Spain have receded (Chart 11). Prices in Japan have been rising since 2014, albeit at a slower pace than the Bank of Japan is targeting (Chart 12). Chart 10... But Inflation Is Firming At The Margin ... But Inflation Is Firming At The Margin ... But Inflation Is Firming At The Margin Chart 11Deflationary Pressures Have Receded in Spain Deflationary Pressures Have Receded in Spain Deflationary Pressures Have Receded in Spain Chart 12Prices In Japan Have Been Rising Since 2014... Albeit At A Slower Pace Than The BoJ's Target Prices In Japan Have Been Rising Since 2014... Albeit At A Slower Pace Than The BoJ's Target Prices In Japan Have Been Rising Since 2014... Albeit At A Slower Pace Than The BoJ's Target The Myth Of Structurally Low Inflation Will structural forces contain the extent to which inflation rises even if unemployment continues to decline? Perhaps, but we would not bet on it. While globalization, automation, weak trade unions, and demographics are often cited as structural deflationary forces, the importance of these factors is greatly exaggerated. Globalization Conceptually, the disinflationary force stemming from globalization should be a function of the degree to which globalization is increasing. Yet, as Chart 13 illustrates, the ratio of global trade-to-GDP has been flat for over a decade. Correspondingly, the share of U.S. imports from emerging markets has stabilized at below 25%. Chart 13AGlobalization Has Peaked Globalization Has Peaked Globalization Has Peaked Chart 13BGlobalization Has Peaked Globalization Has Peaked Globalization Has Peaked A variety of studies have concluded that slack abroad has only a minimal effect on U.S. inflation.3 This is not surprising. The lion’s share of GDP consists of services, which are not easily tradeable. Imports account for only 14.8% of U.S. GDP. Many imported goods also have U.S. substitutes, which means that a large appreciation in the dollar is often necessary to induce Americans to shift purchases abroad.  Automation The belief that faster productivity growth is necessarily deflationary involves a fallacy of composition. Yes, above-average productivity gains in one sector of the economy will cause prices in that sector to decline relative to other prices. But falling prices will also boost real incomes, leading to more spending. Rising spending will lift prices elsewhere in the economy. Chart 14Globally, Productivity Growth Has Been Falling For Over A Decade Globally, Productivity Growth Has Been Falling For Over A Decade Globally, Productivity Growth Has Been Falling For Over A Decade Chart 15Steadier Prices For Computer Hardware And Software In Recent Years Steadier Prices For Computer Hardware And Software In Recent Years Steadier Prices For Computer Hardware And Software In Recent Years In any case, the whole narrative about how faster productivity growth is deflationary seems rather antiquated considering that productivity growth has been quite weak in most of the world for over a decade (Chart 14). Consistent with this, the price deflator for electronic goods has been falling a lot less rapidly in recent years than it has in the past (Chart 15). Chart 16Retail Sector Profit Margins Are Strong Retail Sector Profit Margins Are Strong Retail Sector Profit Margins Are Strong What about the so-called Amazon effect? The problem with the claim that online shopping is undermining corporate pricing power is that outside of department stores, profit margins in the retail sector remain quite high (Chart 16). In fact, recent productivity growth in the U.S. distribution sector has actually been slower than in the 1990s, a decade which produced large productivity gains stemming from the displacement of “mom and pop” stores with “big box” retailers such as Walmart and Costco. Trade Unions The declining influence of trade unions is often cited as a reason for why inflation will remain subdued. There are a number of problems with this argument. First, unionization rates in the U.S. peaked in the mid-1950s, more than a decade before inflation began to accelerate. Second, while the unionization rate continued to decline in the U.S. during the 1980s and 1990s, it remained elevated in Canada. Yet, this did not prevent Canadian inflation from falling as rapidly as it did in the United States (Chart 17). Chart 17Inflation Fell In Canada, Despite A High Unionization Rate Inflation Fell In Canada, Despite A High Unionization Rate Inflation Fell In Canada, Despite A High Unionization Rate Chart 18Higher Inflation Led To More Inflation-Indexed Wage Contracts, Not The Other Way Around Higher Inflation Led To More Inflation-Indexed Wage Contracts, Not The Other Way Around Higher Inflation Led To More Inflation-Indexed Wage Contracts, Not The Other Way Around The widespread use of inflation-linked wage contracts in the 1970s also appears to have been a consequence of rising inflation rather than the cause of it (Chart 18).   Demographics Demographics has undoubtedly been a deflationary force for most of the past 40 years. Slower population growth reduced spending on everything from houses to refrigerators, thus sapping demand from the economy. The influx of women into the labor force also boosted the available supply of goods and services, while the increase in the share of the population in their prime earning years – ages 30-to-50 – raised savings. Chart 19The Worker-To-Consumer Ratio Has Peaked Globally The Worker-To-Consumer Ratio Has Peaked Globally The Worker-To-Consumer Ratio Has Peaked Globally Now that baby boomers are starting to retire, however, they are transitioning from being savers to dissavers. Chart 19 shows that the ratio of workers-to-consumers has begun to decline globally as the post-war generation leaves the labor force. As more people stop working, aggregate savings will fall. The shortage of savings will put upward pressure on the neutral rate. If central banks drag their feet in raising policy rates in response to an increase in the neutral rate, monetary policy will end up being too stimulative. As economies overheat, inflation will pick up. It Shouldn’t Be Hard There are many hard problems in the world. Finding a cure for cancer is hard. Reconciling general relativity with quantum mechanics is hard. In contrast, getting people to spend money should not be hard. People like to consume! Just give them money and they will spend it. If they don’t spend enough of the money that they receive, just give them some more. So why has raising demand proven to be so difficult in many countries? The answer is that central banks have been asked to do too much. Fiscal policy should have been a lot more stimulative. If there is one potential benefit of negative rates, it is that they could incentivize governments to loosen fiscal policy by cutting taxes and/or raising spending. After all, if you can get paid to issue debt, why not do it? In an age of brewing political populism, the temptation to run larger budget deficits will grow. Central banks will indulge governments by keeping rates low. The path to higher rates is lined with lower rates. As economies eventually overheat, inflation will rise, thus allowing central banks to finally move away from negative rates. Real rates will stay low, but nominal rates will increase in line with higher inflation. Of course, if inflation eventually gets too high, central banks will be forced to step on the brakes. We do not see that happening in the next two years, but it could occur later on. Thus, asset allocators should overweight equities during the next 12-to-24 months, while maintaining a short duration bias in fixed-income portfolios. A more defensive stance towards equities may be necessary starting in 2022.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com   Footnotes 1 Jeremy Nalewaik, “Non-Linear Phillips Curves with Inflation Regime-Switching,” Federal Reserve Board (Divisions of Research & Statistics and Monetary Affairs) (August 2016); and Anil Kumar and Pia Orrenius, “A Closer Look at the Phillips Curve Using State Level Data,” Federal Reserve Bank of Dallas, Working paper No. 1409 (May 2015). 2 Jim Dolmas and Evan F. Koenig, “Two Measures Of Core Inflation: A Comparison,” Federal Reserve Bank Of Dallas, Working Paper No. 1903 (February 25, 2019). 3 Please Jane Ihrig, Steven B. Kamin, Deborah Lindner, and Jaime Marquez, “Some Simple Tests of the Globalization and Inflation Hypothesis,” Board of Governors of the Federal Reserve System (International Finance Discussion Papers No. 891) (April 2007); Janet. L. Yellen, 'Panel discussion of William R. White “Globalisation and the Determinants of Domestic Inflation”,' Presentation to the Banque de France International Symposium on Globalisation, Inflation and Monetary Policy (March 2008); and Fabio Milani, “Global Slack And Domestic Inflation Rates: A Structural Investigation For G-7 Countries,”Journal of Macroeconomics, (32:4) (2010). Strategy & Market Trends MacroQuant Model And Current Subjective Scores Is The Entire World Heading For Negative Rates? Is The Entire World Heading For Negative Rates? Tactical Trades Strategic Recommendations Closed Trades

Highlights The currency market is bifurcated in terms of shorter-term expectations versus longer-term factors. The Swedish krona, Norwegian krone, and British pound are solid long-term buys, but could remain very volatile in the short term. We continue to focus on the crosses rather than outright dollar bets. Remain long SEK/NZD, GBP/JPY, and NOK/SEK. Tighten stops on long GBP/JPY to protect profits. EUR/SEK should top out once global growth improves. Sell the gold/silver ratio at 90, as recommended in last week’s report.1 Feature Chart I-1One Way Street Since 2018 One Way Street Since 2018 One Way Street Since 2018 Of all the G10 currencies we follow, the Swedish krona is probably the one that is the most perplexing. The Riksbank is one of the few central banks to have raised rates this year, but the krona remains the weakest G10 currency. Admittedly, the performance of the Swedish manufacturing sector has been dismal, and was especially so in September, but this has not been a story specific to Sweden alone. The euro area, which is also experiencing a deep manufacturing recession, has seen better currency performance despite a more dovish European Central Bank (ECB). The underperformance of the krona begs the question of whether it signals a much prolonged global manufacturing recession, or is indicative of something more endogenous to Sweden. Put another way, has the driver of USD/SEK (and even USD/NOK) strength been an appreciating dollar, or more domestic factors (Chart I-1)? And if it is the latter, what are the important signposts to look out for should a turnaround be around the corner? The Soft Versus Hard Data Debate The big question for Sweden is whether the manufacturing sector is just in a volatile bottoming process, or about to contract much further. Industrial production is currently growing at 4% year-over-year, but the signal from the soft data is that it should be contracting in the double digits (Chart I-2, top panel). As such there is either a big disconnect between the perception of investors and reality, or we are on the verge of a much deeper manufacturing slump. Exchange rates tend to be extremely fluid in discounting a wide swath of economic data, and in the case of Sweden, in discounting the outcome for global growth. However, with EUR/SEK at 10.8 and USD/SEK at 9.7 – the latter well above its 2008 highs – it is fair to assume that anything other than a deep recession will justify a stronger SEK.  One of the more consistent ratios in calling a bottom in the Swedish manufacturing sector in particular (and that of the Eurozone in general) is the manufacturing new orders-to-inventories ratio (Chart I-2, bottom panel). The tick down in September was disconcerting. However, unlike the manufacturing PMI, this ratio is not hitting new lows, tentative evidence that we might be in a volatile bottoming process rather than a protracted slump. The last time we encountered such a divergence was in 2011/2012, at the height of the European debt crisis; in that instance, Swedish hard data ended up sending the right signal for the overall economy. The deterioration in the manufacturing sector has yet to hit domestic consumption in general or the labor market in particular.  The deterioration in the manufacturing sector has yet to hit domestic consumption in general or the labor market in particular. The import component of the PMI index remains well above that of exports. Meanwhile, the employment component of the PMI index began to stabilize around the middle of this year, meaning employment growth should bottom at around 1% or so (Chart I-3). Swedish exports are higher up the manufacturing food chain than in most other developed economies, and autos are quite important. But so far, the Swedish economy has weathered the auto slowdown quite well, with production still clocking in at 7% per year. Chart I-2Soft Data Is Much Worse Soft Data Is Much Worse Soft Data Is Much Worse Chart I-3Domestic Demand Is Holding Up Well Domestic Demand Is Holding Up Well Domestic Demand Is Holding Up Well The tick up in the Swedish unemployment rate is problematic, but we do not believe it constitutes a major change in labor market dynamics. Sweden has a long history of higher openness toward asylum seekers and refugees than many other European countries. The Syrian crisis a couple of years ago led to an exceptional surge, where the number of asylum seekers skyrocketed to over 150,000 or almost 1.5% of the total population (Chart I-4). Historically, immigration has provided a big labor dividend to Sweden, allowing growth to outpace both the U.S. and the euro area. But this has also been a source of frictional unemployment, as new migrants integrate into the labor force. Chart I-4A New Pool Of Labor That Has To Be Integrated A New Pool Of Labor That Has To Be Integrated A New Pool Of Labor That Has To Be Integrated Foreign-born workers now constitute about 20% of the total population, a big portion of which need to learn a new language and adopt new skills (Chart I-5A). This growth dividend will be reaped for many years to come. Integration is a politically contentious issue, and so the highly restrictive asylum and reunification law adopted in mid-2016 probably means the immigration boom is behind us. The rise of the anti-immigration Sweden Democrats in the September 2018 elections is a case in point. However, the pivot of the democratic population towards the right has been a global phenomenon, and so is not as negative for Sweden on a relative basis. All that to say, compared to most developed nations, Sweden still enjoys a relatively positive demographic outlook (Chart I-5B). Chart I-5AA Huge Labor Dividend A Huge Labor Dividend A Huge Labor Dividend Chart I-5BNo Apparent Demographic Cliff No Apparent Demographic Cliff No Apparent Demographic Cliff The inflow of migrants has a mixed impact on inflation. While there is downward pressure on wages, due to an increase in the share of employment that pays lower wages, there is still upward pressure on housing and consumption in response to the increased number of workers. This comes on top of a fiscal boost as the government spends more on social services. Meanwhile, the unemployment rate among foreign-born people is around 15%. This means that the Phillips curve is flat for the first few years, before it starts to steepen. But as the new labor force is finally absorbed into the economy, it should start to generate meaningful wage pressures. The Riksbank clearly understands these dynamics, which is why over the prior years, its stance has been dovish even when the Swedish economy has been holding up well. Interest rates were cut to negative territory in 2015 and held at -0.5% (lower than the ECB policy rate) all through the global recovery in 2016 and 2017. Quantitative easing has also been extended up until 2020, well ahead of the ECB’s renewed asset purchase program announcement. Both have tremendously eased monetary conditions in Sweden, including via a weaker currency. Going forward, there are a few key reasons to believe  the path of least resistance for the krona is now up: A weak krona has typically helped the manufacturing sector with a lag of twelve months.  A weak krona has typically helped the manufacturing sector with a lag of twelve months. Negative divergences only tend to happen ahead of deep recessions. Unless we are in that particular situation now, better demand for relatively cheaper Swedish goods (think Volvo versus BMW) should lead to a stronger krona (Chart I-6). Yes, the Riskbank has been conducting QE, but the pace of expansion in its balance sheet has been slowing in recent quarters. USD/SEK has tended to track relative balance sheet trends between the Riksbank and the Fed, but a gaping wedge has opened up in favor of the krona (Chart I-7). Meanwhile, with the Fed about to re-expand its balance sheet, this should also favor a stronger SEK versus the USD. Chart I-6Swedish Krona And Manufacturing Swedish Krona And Manufacturing Swedish Krona And Manufacturing Chart I-7USD/SEK And Relative Balance Sheets USD/SEK And Relative Balance Sheets USD/SEK And Relative Balance Sheets The Swedish housing market is becoming a thorn in the Riksbank’s side. When negative rates were introduced in 2015, growth in house prices exploded to the tune of 15% year-on-year (Chart I-8). More recently, a curb on migration has allowed a cooling of sorts, but Swedish household leverage remains very elevated. With the memory of the 1990s housing crisis still fresh in their minds, this is making the Riksbank quite uncomfortable with its current policy stance. The carry cost is lower from being short NZD compared to being short the U.S. dollar. Our bias is that though Governor Stefan Ingves prefers to renormalize policy as quickly as possible, given that he is managing a small-open economy with trade a whopping 45% of GDP, but is held hostage to external conditions. The SEK is the cheapest currency in the G10 universe, and could bounce sharply on even the softest evidence indicating global growth has bottomed. Furthermore, rising global growth will tighten resource utilization, which should begin to boost underlying inflationary pressures in Sweden (Chart I-9) Chart I-8House Prices In Sweden##br## Are Bubbly House Prices In Sweden Are Bubbly House Prices In Sweden Are Bubbly Chart I-9Resource Utilization And Inflation In Sweden Resource Utilization And Inflation In Sweden Resource Utilization And Inflation In Sweden In terms of SEK trading strategy, USD/SEK and NZD/SEK tend to be highly correlated; since the SEK has a higher beta to global growth than the kiwi (Sweden exports 45% of its GDP versus 27% for New Zealand). On a relative basis, the Swedish economy appears to have bottomed relative to that of the U.S., making the SEK/NZD an attractive way to play USD/SEK downside. Meanwhile, the carry cost is lower from being short NZD compared to being short the U.S. dollar (Chart I-10). As for EUR/SEK, the cross could consolidate at current levels before heading lower but will ultimately peak once global growth reaccelerates. Chart I-10Remain Long SEK/NZD Remain Long SEK/NZD Remain Long SEK/NZD Bottom Line: We remain long the SEK/NZD as a relative value play, but the true upside lies in the SEK/USD cross. Our bias is that SEK weakness has been driven by the market’s focus on disappointing soft data, while hard data remains relatively resilient. Once it becomes clearer that the global growth environment is not as precarious as the surveys suggest, the krona could bounce sharply. Housekeeping Our long GBP/JPY position hit 5% this week. We are tightening stops to 138 in order to protect profits. We were also stopped out of short EUR/NOK for a 2% loss. We are standing aside for now. EUR/NOK is now trading above 2008 recession levels, which is only justifiable by a prolonged growth recession, but risk management warrants patience for now. Stay tuned.   Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Weekly Report, titled “On Money Velocity, EUR/USD And Silver,” dated October 11, 2019, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data in the U.S. have been soft: Retail sales contracted by 0.3% month-on-month in September. Industrial production fell by 0.4% month-on-month. Both export and import prices fell by 1.6% year-on-year in September. Michigan Consumer Sentiment Index grew to 96 in October, up from 93.2 in the previous month. NY Empire State Manufacturing Index increased to 4 in October, up from 2 in September. Building permits and housing starts both fell by 2.7% and 9.4% month-on-month in September, but the housing recovery remains intact. Initial jobless claims increased to 214K for the week ended Oct 11th. The DXY index depreciated by 0.7% this week. The latest Beige Book summarized that the U.S. economy expanded at a slight-to-modest pace. The slowdown in the manufacturing sector remains the biggest risk to the economy, while trade tensions continue to weigh on business sentiment and capex intensions. The most recent “entente” in trade discussions might represent a pivotal shift from heightened uncertainty that has prevailed throughout the summer. Report Links: On Money Velocity, EUR/USD And Silver - October 11, 2019 Preserving Capital During Riot Points - September 6, 2019 Has The Currency Landscape Shifted? - August 16, 2019 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data in the euro area remain subdued: Headline inflation fell to 0.8% year-on-year in September, the slowest in nearly three years. Core inflation however, increased to 1% year-on-year. Industrial production in the euro area continued to contract, by 2.8% year-on-year in August. The ZEW sentiment in the euro area fell further to -23.5 in October, however this is well above expectations of -33. The ZEW sentiment for Germany also fell to -22.8 in October. It is worth noting that expectations continue to improve relative to the current situation. The trade balance in the euro area improved to €20.3 billion in August, up from the downward-revised €17.5 billion in July. However, this is mostly due to a contraction in imports. EUR/USD rose by 0.9% this week, in part helped by broad dollar weakness. The trade dynamics in the euro area remain worrisome: exports fell by 2.2% year-on-year in August, while imports plunged by 4.1% year-on-year. Notably, year-to-date, the EU’s trade surplus with U.S. grew to €103 billion, up from €91 billion a year earlier, while the trade deficit with China widened further to €127 billion from €116 billion. Report Links: On Money Velocity, EUR/USD And Silver - October 11, 2019 A Few Trade Ideas - Sept. 27, 2019 Battle Of The Central Banks - June 21, 2019 Japanese Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan continue to disappoint: Industrial production fell by 4.7% year-on-year in August. Capacity utilization decreased by 2.9% month-on-month in August. The Japanese yen fell by 0.8% against the U.S. dollar this week. Kuroda has again emphasized that the BoJ will not hesitate to act if economic developments continue to deteriorate. On the other hand, while the Fed and the ECB are both on course to expand their balance sheets through asset purchases, it is an open question as to how much more the BoJ can do, beyond yield curve control. We remain long the yen in anticipation that it will require a “Lehman moment” for the BoJ to act aggressively. Report Links: A Few Trade Ideas - Sept. 27, 2019 Has The Currency Landscape Shifted? - August 16, 2019 Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the U.K. have been mostly negative: The ILO unemployment rate slightly increased to 3.9% in August. Average earnings quarterly growth slowed to 3.8%, however this was above expectations of 3.7%. The Retail price index grew by 2.4% year-on-year in September, a slowdown from 2.6% in the previous month. Headline inflation was unchanged at 1.7% year-on-year in September, while core inflation jumped to 1.7% from 1.5%. Retail sales grew by 3.1% year-on-year in September, up from 2.6% in the previous month. GBP/USD surged by 3.3% this week on optimism towards the European Council Summit on Brexit. From a valuation perspective, the pound is trading at a large discount to its fair value. Should positive Brexit news continue to hit the headlines, the pound could continue to soar. We are long GBP/JPY, which is above 5% in the money. Tighten stop to 138. Report Links: A Few Trade Ideas - Sept. 27, 2019 United Kingdon: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Battle Of The Central Banks - June 21, 2019 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data in Australia have been modest: NAB business confidence fell further to -2, while conditions improved to 1 in Q3. On the labor market front, the unemployment rate fell further to 5.2% in September. 14.7K jobs were created, consisting of 26.2K full-time jobs and a loss of 11.4K part-time jobs. AUD/USD increased by 0.4% this week. RBA minutes were released earlier this week. Interestingly, it presents a sharp debate about the effects of low rates. On the one hand, lower rates have been theoretically justified to achieve full employment and the inflation target. On the other hand, some RBA members fear that low rates could fuel already inflated house prices. The probability for another rate cut has thus decreased post RBA minutes. Report Links: A Contrarian View On The Australian Dollar - May 24, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Not Out Of The Woods Yet - April 5, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand have been negative: Visitor arrivals increased by 1.8% year-on-year in August, slightly down from 2% in the previous month. Headline inflation slowed to 1.5% year-on-year in Q3. NZD/USD has been more or less flat this week. Closely tied to global growth, the New Zealand dollar has been fluctuating with the ebb and flow of the U.S.-China trade headlines. The two countries have agreed on a partial deal last week, however the details remain vague. While the kiwi is a high beta currency, it should unerperform at the crosses. We continue to play the kiwi weakness through the Aussie dollar and the Swedish Krona. Report Links: USD/CNY And Market Turbulence - August 9, 2019 Where To Next For The U.S. Dollar? - June 7, 2019 Not Out Of The Woods Yet - April 5, 2019 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data in Canada have been relatively strong: The unemployment rate decreased further to 5.5% in September. Moreover, average hourly wages continued to grow by 4.3% year-on-year, up from 3.8% in the previous month. Lastly, 53.7K jobs were created in September, well above expectations of 10K. Both headline and core inflation were unchanged at 1.9% year-on-year in September. The Canadian dollar has appreciated by 1% against the U.S. dollar, on the back of the positive employment data last Friday. All eyes are on the federal election this month, which could be crucial for the future of the Canadian energy sector and environment policies.  Report Links: Preserving Capital During Riot Points - September 6, 2019 Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 On Gold, Oil And Cryptocurrencies - June 28, 2019 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland have been positive: The trade surplus (excluding precious metals) widened sharply to CHF 2.88 billion in September. Notably, Swiss exports grew by 8.2% month-on-month to CHF 20.3 billion, led by higher sales of chemical and pharmaceutical products. Swiss imports slightly dropped by 1.4% month-on-month to CHF 17.4 billion. Producer and import prices continued to fall by 2% year-on-year in September. USD/CHF fell by 1% this week. The Swiss franc will continue to fight a tug-of-war between being a defensive currency, but a tool of manipulation by the SNB. Our guestimate is that EUR/CHF 1.06 is an ultimate stress point.  Global portfolios should hold the Swiss franc as insurance, for the simple reason that the currency is a structural outperformer. Report Links: Notes On The SNB - October 4, 2019 What To Do About The Swiss Franc? - May 17, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway have been depressed: The trade balance shifted to a deficit of NOK 1.2 billion in September. That’s a decrease of NOK 24 billion year-on-year. The Norwegian krone has depreciated by nearly 1% against the U.S. dollar this week. Energy prices remain subdued over the past few weeks. Moreover, the Norwegian trade balance has shifted to a deficit for the first time since November 2017. Exports plunged by 19.5% year-on-year, due to lower sales of energy products, while imports jumped by 12.9% year-on-year. The message is clear – Norway continues to hold up well domestically, but dependence on petroleum exports is introducing volatility into any growth forecasts. BCA has lowered its oil price projections for 2019, which has dampened the appeal of the Norwegian Krone. Stay tuned. Report Links: A Few Trade Ideas - Sept. 27, 2019 Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 On Gold, Oil And Cryptocurrencies - June 28, 2019 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Recent data in Sweden have been neutral: The unemployment rate was unchanged at 7.1% in September. USD/SEK fell by 1.1% this week. As the worst performing G-10 currency this year, the Swedish krona is now trading at a large discount to its fair value. Please refer to our front section this week which presents an in-depth analysis on the Swedish economy and the krona. Report Links: Where To Next For The U.S. Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 201 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Feature Introduction Chart 1Japanese Equities: ##br##Buying Opportunity Or Value Trap? Japanese Equities: Buying Opportunity Or Value Trap? Japanese Equities: Buying Opportunity Or Value Trap? Clients have recently been asking us a lot about Japan. The reason seems clear. With the consistent outperformance of U.S. equities over the past decade, and their rather high valuations now, asset allocators are looking for an alternative. Emerging Markets and the euro zone have major structural concerns which suggest they are unlikely to outperform over any prolonged period (even if they might have a short-lived cyclical pop). Maybe Japan – whose own structural problems are well known and so surely priced in by now – could be a candidate for outperformance and a structural rerating over the next three to five years. Indeed, since the Global Financial Crisis (GFC), Japanese equities have not performed as badly as you might have imagined: they have performed in line with all their global peers – except for the U.S. (Chart 1). In this Special Report, we answer the most common questions that clients have asked us about the long-term (three to five year) outlook for Japan, and try to address the key issue: Are Japanese equities now a buying opportunity, or still a value trap? Our conclusions are as follows: The Japanese economy is still weighed down by structural problems – stubborn disinflation, and a shrinking and aging population – which means consumption growth will remain weak over the coming years. Japan’s structural problems will not easily be solved, and will continue to dampen the economy’s growth. We think it is unlikely, therefore, that Japanese equities will outperform in the long run. In that sense, Japan probably is a value trap, not a buying opportunity. In the past, Japanese equities benefited from bouts of Chinese reflationary stimulus – which we expect will be ramped up in the coming months – but the effect was usually short-lived and muted. The clash between accommodative monetary policy and contractionary fiscal policy, particularly October’s tax hike, is likely to dampen any revival in the Japanese economy. Global Asset Allocation downgraded Japanese equities to underweight over a six-to-12 month investment horizon in our most recent Quarterly Outlook.1 We find it hard to make a strong “rerating” case for Japan, and so, do not expect Japanese equities to outperform other major developed markets in the long run. Why Isn’t Inflation Rising? Chart 2Domestic Drivers Muted Japanese Inflation Domestic Drivers Muted Japanese Inflation Domestic Drivers Muted Japanese Inflation The market clearly does not believe that Bank of Japan (BoJ) Governor Haruhiko Kuroda can raise inflation to the BoJ’s target of 2%, despite negative interest rates and massive quantitative easing. The 5-year/5-year forward CPI swap rate, a proxy for inflation expectations, is currently at 0.1% (Chart 2, panel 1). Japan’s ultra-accommodative monetary policy has failed to push recorded inflation higher, with the core and core core measures2 both at 0.6% as of June (Chart 2, panel 2). In its recent outlook, the BoJ revised down its inflation forecasts in fiscal years 2019, 2020, and 2021 to 1.0%, 1.3%, and 1.6% respectively, implying that it does not expect to get even close to 2% over the forecast horizon.3  Prior to the bursting of Japan’s bubble in 1990, a big percentage of Japanese inflation came from domestic factors: housing, culture and recreation, and health care. By contrast, prices of items manufactured overseas, mainly in China, and imported goods – especially furniture and clothing – did not rise much. The same was true for other developed economies such as the U.S. and the euro area. However, since the 1990s, domestically-produced items in Japan have failed to rise in price, unlike the situation in the U.S. This kept a lid on Japanese inflation. Housing in particular, which represents about 20% of the inflation basket, now contributes only 0.02% to Japanese core core inflation (Chart 2, panels 3 & 4). Chart 3Deregulation = Low Inflation Deregulation = Low Inflation Deregulation = Low Inflation There are three main reasons for this difference: Stagnant wages Unfavorable demographics Deregulation The first two causes are discussed in detail below. Gradual deregulation of various industries has also been disinflationary. In the 1980s, Japan remained a highly regulated economy, with the government fixing many prices and limiting entry into many sectors. Although change has been slow, deregulation and the introduction of competition have caused structural downward pressure on prices in a number of industries, notably telecommunications and utilities. For example, deregulation of electric power companies in 2016 allowed increased competition and new entrants into the market.4 As a result, electricity prices in Japan dropped from an average of 11.4 JPY/Kwh prior to full deregulation to 9.3 JPY/Kwh (Chart 3). But there are still many industries which are more tightly regulated in Japan than in other advanced economies (the near-ban on car-sharing services such as Uber, and tight restrictions on AirBnB are just the most newsworthy examples). This suggests that structural disinflationary pressures are likely to persist on any further deregulation. Why Is Wage Growth Stagnant, Despite A Tight Labor Market? Chart 4Wages Have Been Beaten Down... bca.gaa_sr_2019_08_09_c4 bca.gaa_sr_2019_08_09_c4 Japan’s labor market appears very tight. The unemployment rate is 2.3%, the lowest since the early 1990s, and the jobs-to-applications ratio is 1.61, the highest since the 1970s. And yet wage growth has remained stagnant, averaging only 0.5% over the past five years. (Chart 4).5  There are a number of structural reasons why wages have failed to respond to the tight labor market situation. One major contributory factor is the social norm of “lifetime employment,” whereby many employees, especially at large companies, tend to stay with their initial employer through their careers, being rotated from one department to another, without becoming specialists in any particular field. This means they have little pricing power – and few transferable skills – when it comes to seeking a mid-career change. This social norm is also reflected in Japan’s typical salary schemes, which are based on employment length (Chart 5, panel 1). Wages tend to rise with age, while in other developed economies they peak around the age of 50. Another factor is the big increase in recent years in part-time and temporary positions, which typically pay lower wages than full-time positions. Because employment law makes it hard (if not impossible) to fire workers, companies have tended to prefer hiring non-permanent staff, who are easier to replace. Part-time workers have increased by 11 million over the past three decades, compared to an increase of two million in full-time workers (Chart 5, panel 2). A substantial part of this increase in part-time employment came from both the elderly and women joining the labor market – groups that have little wage bargaining power (Chart 5, panel 3). Part-time wage growth has also turned negative this year (Chart 5, panel 4). Bonuses are a significant portion of wages, and tend to be rather volatile, moving in line with corporate profits, which have weakened this year (Chart 5, panel 5). Japan’s structural problems will not easily be solved, and will continue to dampen the economy’s growth. Nonetheless, there are some tentative signs of a change in this social norm. The number of employees changing jobs has been rising over the past few years. This is mostly evident among employees aged over 45, signaling the need for experienced personnel (Chart 6, panel 1). The percentage of unemployed who had voluntarily quit their jobs, rather than being let go, has also reached an all-time high (Chart 6, panel 2). This evidence suggests that employees are increasingly willing to leave their jobs in search of a more interesting or a better-paid one. Given such a tight labor market, it seems only a matter of time before there is some pressure on employers to increase salaries in order to attract talent. Chart 5...Mainy Due To Part-Time Employment ...Mainy Due To Part-Time Employment ...Mainy Due To Part-Time Employment Chart 6Changing The Norm Changing The Norm Changing The Norm   Is There An Answer To Japan’s Demographic Problem? Chart 7Japanese Population: Shrinking And Aging Japanese Population: Shrinking And Aging Japanese Population: Shrinking And Aging Deteriorating demographics is a key reason why inflation has remained subdued. The Japanese population peaked in 2009 and, over the past eight years, has shrunk on average by 0.2%, or 220,000 people, a year. Furthermore, the working-age population (25-64) has shrunk by 6 million, or 10%, since its peak in 2005. With marital rates continuing to fall, and fertility rates doing no more than stabilizing, there is no sign of a quick turnaround in this situation (Chart 7, panels 1 & 2). Prime Minister Abe has eased immigration laws to try to put a stop to the population decline. Late last year, the Diet passed a law that will allow more foreign workers into the country. The law will provide long-term work visas for immigrants in various blue-collar sectors, whereas the previous regulation allowed in only highly skilled workers. It will also enable foreign workers to upgrade to a higher-tier visa category, giving them a path to permanent residency, and allowing them to bring their families along.6  However, Japan’s closed culture raises the question of how successful Prime Minister Abe’s immigration reforms will be. The number of foreign residents has risen over the past few years, reaching a cumulative 2.73 million people, but this has been insufficient to reverse the decline in the population. In addition, without implementing effective measures to integrate new immigrants and support their efforts to become long-term residents, these reforms are likely to be minor in their impact (Chart 7, panel 3). Chart 8Aging Population = Slowing Productivity Aging Population = Slowing Productivity Aging Population = Slowing Productivity Japan’s population is not just shrinking but also aging. People aged 65 and older comprise 28% of the total population (Chart 7, panel 4). That figure is projected to reach 40% within the next 40 years. The dependency ratio – those younger than 15 years and older than 64, as a ratio of the working-age population – continues to rise rapidly (Chart 7, panel 5). Moreover, older people tend to be less productive. Because of this, Japan’s productivity may continue to decline from its current level, which is already low compared to other developed countries (Chart 8). The combination of a shrinking working-age population and poor productivity growth means that Japan’s trend real GDP growth over the next decade – absent an increase in capital expenditure or improvement in technology – is unlikely to be above zero.7   Some argue that Japan’s aging population could be the trigger to overcoming its disinflation problem. They argue that, as the share of the elderly-to-total-population increases, public expenditure on health care will balloon. The United Nations projects the median age in Japan to be 53 years, 10 and 5 years older than in the U.S. and China, respectively, by 2060 (Chart 9). This implies that the Japanese government, which currently pays about 80% of total health care expenditure, will face an increasing burden from medical spending, elderly care, and public pension payments. These expenditures are projected to increase from 19% to 25% of GDP (Chart 9, panel 2). The government, therefore, may have no alternative but to resort to monetizing its debt to pay these bills, which would ultimately prove to be inflationary. Chart 9Aging Population = Higher Fiscal Burden Aging Population = Higher Fiscal Burden Aging Population = Higher Fiscal Burden Chart 10 In some countries, BCA has argued, an aging population is inflationary because retirees’ incomes fall almost to zero after retirement, but expenditure rises, particularly towards at the end of life as they spend more on health care.8 The resulting dissaving, and disparity between the demand and supply of goods, should have inflationary effects. But this rationale does not hold for Japanese households. Older people in Japan tend to maintain their level of savings (Chart 10). This phenomenon might change as a new generation, keener on leisure activities and less culturally attuned to maximizing savings, retires. But to date, at least, Japan’s aging process has been disinflationary. It is likely, then, that a combination of subdued wage growth, decreased spending by the elderly, low demand for housing, and the ineffectiveness of an ultra-accommodative monetary policy is likely to keep inflation low. Moreover, to reduce the burden on its budget, the government will continue its efforts to keep down health care costs, which have a 5% weight in the core core inflation measure. We find it unlikely, therefore, that the BoJ will achieve its 2% inflation target over the next few years. So, What Else Could The BoJ Do? Chart 11The BoJ's Ammunition Is Running Out The BoJ's Ammunition Is Running Out The BoJ's Ammunition Is Running Out Over the past six years, since Kuroda became governor in 2013, the Bank of Japan has rolled out aggressive monetary easing. It has cut rates to -0.1% and introduced a policy of “yield curve control,” which aims to keep the yield on 10-year JGBs at 0%, plus or minus 20 basis points. As a result, it now holds JPY479 trillion of JGBs, or 46% of the total outstanding amount (and equivalent to 89% of Japan’s GDP). It has also bought an average of JPY6 trillion of equity ETFs a year over the past three years (Chart 11, panels 1 & 2), to bring its total equity ETF holdings to JPY28 trillion, almost 5% of Japan's equity market cap. However, as noted above, these policies have had little impact on inflation, or on inflation expectations. BCA’s Central Bank Monitor indicates that Japan needs to ease monetary conditions further (Chart 11, panel 3). What alternative tools could the BoJ use to spur inflation? The BoJ could cut rates further, and indeed the futures market is discounting a 10 basis points cut over the next 12 months (Chart 11, panel 4). In its July Monetary Policy Committee meeting, the bank committed to keeping policy easy “at least through around spring 2020.” But it seems reluctant to cut rates, given that this would further damage the profitability of Japan’s banks, particularly the rather fragile regional banks. Indeed, one can argue that a small rate cut would be unlikely to have much effect, given the impotence of previous such moves. The BoJ might be inclined to emulate the ECB and extend its asset purchase program. It owns only JPY3 trillion of corporate bonds, and has bought almost no new ones since 2013 (Chart 11, panel 5), although the small size of the Japanese corporate bond market would give it limited scope to increase these purchases. It could also increase its purchases of REITs, of which it currently owns JPY26 trillion. It could even consider buying foreign assets (as does the Swiss National Bank), though this would annoy the U.S. authorities, who would consider it currency manipulation. Some economists argue in favor of a Japanese equivalent of the ECB’s Targeted Long-Term Refinancing Operations (TLTRO). In other words, the BoJ should provide funds to banks at rates significantly below zero, provided they use the proceeds to give out loans to households and corporations.9 This would not only increase credit in the economy, but also bolster banks’ declining profitability. Some academics consider Japan, which appears stuck in a liquidity trap, as the perfect setting to try out Modern Monetary Theory (MMT).10,11 However, the Ministry of Finance remains fixated on reducing Japan’s excessive pile of outstanding government debt, which is currently 238% of GDP. When MMT was debated in the Japanese Diet this June, Finance Minister Taro Aso dismissed it, saying “I’m not sure I should even call it a theory, it’s a line of argument,” and insisted that tax hikes are necessary to secure Japan’s welfare system. The Ministry’s current plan is to close the primary budget deficit by 2027.  Moreover, the Bank of Japan Law bans the central bank from underwriting government debt, due to the abuses of this in the 1930s, when it funded Japan’s militarist expansion12 – though there are no limits on how much the BoJ can buy in the secondary market.  Our conclusion is that negative rates and quantitative easing have reached the limit of their effectiveness. Even if the BoJ ramps up the measures it has taken up until now, this will have little impact on inflation. It will be only when the government finally understands that a combination of easy fiscal and monetary policy is single effective tool left that the situation can change. There is little sign of this happening soon. It will probably take a crisis before this mindset shifts. Are There Any Signs Of Improvement In Japan’s Banking Sector? Japan’s financial sector is also one of its longstanding problems. After Japan’s 1980s bubble burst, the BoJ aggressively cut rates from 6% to 0.5% over the span of eight years. Long-term rates also fell. Falling interest rates reduced Japanese banks’ net interest margins. The banks spent the 1990s cleaning up their balance sheets and recapitalizing themselves. In the end, the banks’ cumulative losses (including write-offs and increased provisioning) during the 1992-2004 period reached the equivalent of 20% of Japanese GDP.13 Japanese bank stocks have consistently underperformed the aggregate index since the late 1980s (with the exception of a short period in the mid-2000s) – and by 75% since 1995 (Chart 12, panel 1). It now seems like banks' relative performance is bound by the policy rate. It is likely, then, that a combination of subdued wage growth, decreased spending by the elderly, low demand for housing, and the ineffectiveness of an ultra-accommodative monetary policy is likely to keep inflation low. Bank loan growth throughout the period of 1995-2006 was weak or negative, as banks became more risk averse and borrowers focused on repairing their balance sheets (Chart 12, panel 2). It has picked up a little over the past decade, but remains low at around 2%-4%. This has been a drag on economic activity since both Japan’s corporate and household sectors rely much more heavily on banks for funding compared to the U.S. or the euro area (Chart 12, panels 3 & 4). As a result of stagnant loan growth at home, Japanese banks have in recent years expanded their activities overseas, particularly in south-east Asia. Foreign lending for Japan’s three largest banks comprises 29.7% of total loans, 33% of which is to Asia.14 This represents a risk for future stability since these assets could easily become non-performing in the event of an Emerging Markets crisis in the next recession. Chart 12Bank Stocks Have Consistently Underperformed... Bank Stocks Have Consistently Underperformed... Bank Stocks Have Consistently Underperformed... Chart 13...Because Of Weak Loan Growth ##br##And Poor Profits ...Because Of Weak Loan Growth And Poor Profits ...Because Of Weak Loan Growth And Poor Profits By the mid-2000s, Japanese banks had finished cleaning up from the 1980s bubble and the non-performing loan ratio is now low. But measures of profitability such as return on assets and net interest margin remain poor by international standards (Chart 13). Japanese financial institutions’ capital adequacy ratios have also deteriorated moderately over the past five years, according to the BoJ’s Financial System Report, as risk-weighted assets have increased more quickly than profits. The core capital adequacy ratio of just above 10% is significantly lower than in other major developed economies.15 How Should Investors Be Positioned In The Short-Term? There are two factors that will determine how Japanese equities perform over the next 12 months: Chinese stimulus, and the impact of the consumption tax hike in October. Can Chinese Reflation Help Boost Japanese Economic Activity? Chart 14Chinese Stimulus Boosts Japan's Activity... Chinese Stimulus Boosts Japan's Activity... Chinese Stimulus Boosts Japan's Activity... Chart 15...Yet Its Impact Is Short-Lived And Muted ...Yet Its Impact Is Short-Lived And Muted ...Yet Its Impact Is Short-Lived And Muted While Japan is not a particularly open economy – exports represent only 15% of GDP – its manufacturing sector is very exposed to global trade, and the swings in this sector (which is a lofty 20% of GDP) have a disproportionately large marginal impact on the overall economy. China accounts for 20% of Japan’s exports, roughly 3% of Japan’s GDP (Chart 14). China’s economic slowdown since 2017 has clearly weighed heavily on Japanese exports and the manufacturing sector. Japanese machine tool orders have contracted for nine months, in June reaching the lowest growth since the GFC, -38% year-on-year. Vehicle production growth has also been weak, rising only 1.8% year-to-date compared to 2018, and overall industrial production growth has turned negative, falling by 4.1% YoY in June. It seems that global growth data has not yet bottomed. The German manufacturing PMI remains well below the boom/bust line at 43.2. Korean export growth is also contracting at a double-digit rate. Nevertheless, we expect the global manufacturing downturn – which typically lasts about 18 months from peak-to-trough – to bottom towards the end of this year.16 This will be supported by the Chinese authorities accelerating their monetary and fiscal stimulus, although the magnitude of this might not be as big as it was in 2012 and 2015.17 Japanese economic activity has historically been closely correlated with Chinese credit growth, with a lag of six-to-nine months (Chart 15). What Will Be The Impact Of The Consumption Tax Hike? Japanese consumer demand has been sluggish for some time, mainly as a result of low wage growth. The planned rise in the consumption tax from 8% to 10% in October is likely to dampen consumption further. With the economy currently so weak, there seems little justification for a tax rise. But, having postponed it twice, it seems highly unlikely that Prime Minister Abe will do so again, particularly after his victory in last month’s Upper House election, which was a de facto referendum on the tax hike. Chart 16Previous Tax Hikes Hurt Sales Badly Previous Tax Hikes Hurt Sales Badly Previous Tax Hikes Hurt Sales Badly The OECD, based on Japanese government data, estimates the impact on households of the tax hike will be 5.7 trillion yen (about 1% of GDP).18 Consumers did not take previous tax rate hikes well. Spending was brought forward to the two to three months immediately before the hike. However, following the hike, not only did sales fall back, they also trended down for some time (Chart 16). The risk to the economy is that the same happens again.  The government, however, is planning several measures to mitigate the tax burden (Table 1). It will not apply the tax increase to food and beverages, which will stay at 8%. The government will implement a fiscal package including free early childhood education, support for low-income earners, and tax breaks on certain consumer durable goods, such as automobiles and housing. It will also introduce a rebate program, to encourage consumer spending at small retailers using non-cash payments (partly to reduce tax avoidance by these businesses).19 Based on the government’s estimates, these measures will be enough to fully offset the impact of the tax hike. However, the IMF’s Fiscal Monitor sees fiscal policy tightening due to the tax rate hike, although by less than in 2014. Its estimate is a drag of 0.6% of potential GDP in 2020 (Chart 17). Table 1Easing The Tax Hike Burden Japan: Frequently Asked Questions Japan: Frequently Asked Questions Chart 17Clash Of Policies: Fiscal Vs. Monetary Clash Of Policies: Fiscal Vs. Monetary Clash Of Policies: Fiscal Vs. Monetary   Previous sales tax hikes caused a short-lived jump in inflation, which trended lower afterwards. Assuming a full pass-through rate of price increases to consumers, the BoJ expects the hike to raise core inflation by +0.2% and +0.1% in fiscal years 2019 and 2020 respectively.20 Consumers did not take previous tax rate hikes well. As such, over the next 12 months, Global Asset Allocation recommends an underweight on Japanese equities. While a bottoming of the global manufacturing cycle and the impact of Chinese stimulus are positive factors, there are better markets in which to play this, given the risks surrounding Japanese consumption caused by the consumption tax rise. Are Improvements In Corporate Governance Enough To Make Japanese Equities A Long-Term Buy? Chart 18Corporate Governance Not Improving Enough Corporate Governance Not Improving Enough Corporate Governance Not Improving Enough Many investors believe that improved corporate governance could be the catalyst the stock market needs to outperform. It is true that there have been some improvements in recent years. Japanese companies have increased the share of independent directors on their boards, although this remains low by international standards (Chart 18, panel 1). Share buybacks have increased, and are on track to hit all-time high this year (Chart 18, panel 2). However, the improvements are still somewhat superficial. Cash holdings of Japanese companies are about 50% of GDP and 100% of market capitalization. The dividend payout ratio, at 30%, is significantly lower than in other developed markets, for example 40% in the U.S. and 50% in the euro area (Chart 18, panels 3 & 4). Why haven’t Japanese corporations returned their excess cash to shareholders? The answer is that many companies simply do not believe that they hold excess cash (Chart 19). The lack of a vibrant market for corporate control, and the general failure of activist foreign investment funds in Japan, means there is also less pressure on companies to use cash efficiently, and to raise leverage to improve their return on equity. The growing presence of the BoJ in the stock market is also a concern. The BoJ now holds over 70% of outstanding ETF equity assets, and is on track to become the single largest owner of Japanese stocks within a couple of years. With the BoJ not taking an active role as a shareholder, this risks undermining corporate governance reforms.21 It also suggests that, without the BoJ’s equity purchases over the past few years, Japanese equities might have performed even worse. Foreign investors have been the main buyers of Japanese equities over the past two decades, offsetting net selling by domestic households and most types of financial institutions. But foreign purchases have recently started to roll over, a trend that could be another catalyst for downward pressures on the stock market, if it were to continue (Chart 20). Chart 19 Chart 20Who Will Buy If Foreigners Don't? Who Will Buy If Foreigners Don't? Who Will Buy If Foreigners Don't?   We conclude, therefore, that signs of improvement in corporate governance are still sporadic and not sufficient to justify a major rerating of the Japanese corporate sector.   Bottom Line GAA recommends an underweight on Japan over a 12-month time horizon, since the drag on consumption from the tax hike will override any positive impact from a rebound in global growth caused by Chinese stimulus. In the longer term, a stubborn refusal to use fiscal policy as well as monetary easing, the limited improvement in corporate governance, and Japan’s intractable structural problems such as demographics, mean it is hard to make a strong rerating case for Japanese equities.   Amr Hanafy, Research Associate amrh@bcaresearch.com Footnotes 1      Please see Global Asset Allocation Quarterly Portfolio Outlook, “Precautionary Dovishness – Or Looming Recession?” dated July 1, 2019, available on gaa.bcaresearch.com. 2      The BoJ calculates core inflation as headline inflation less fresh food, and core core inflation as headline inflation less fresh food and energy. 3      Please see “Outlook for Economic Activity and Prices (July 2019),” Bank Of Japan, July 2019. 4      Please see “Energy transition Japan: 'We have to disrupt ourselves,' says TEPCO,” Engerati, April 24, 2017.   5      Wage growth is total cash earnings, which includes regular/scheduled earnings plus overtime pay plus special earnings/bonuses. 6      Menju Toshihiro, “Japan’s Historic Immigration Reform: A Work in Progress,” nippon.com, February 6,2019. 7      Please see Global Asset Allocation Special Report, “Return Assumptions – Refreshed And Refined,” dated June 25, 2019, available at gaa.bcaresearch.com. 8      Please see Global Asset Allocation Special Report, “Investor’s Guide To Inflation Hedging: How To Invest When Inflation Rises,” dated May 22, 2019 available at gaa.bcaresearch.com. 9      Takuji Okubo, “Japan’s dormant central bank may have to rouse itself once more,” Financial Times, May 27, 2019. 10     The core idea of MMT is that, since governments can print as much of their own currency as they require, they do not need to raise money in order to spend money. Japan could increase its fiscal spending and, as long as the BoJ bought the increased bond issuance, this would not raise interest rates. 11     Please see Global Investment Strategy Special Report, “MMT And Me,” dated May 31 2019, available at gis.bcaresearch.com. 12     Please see Global Asset Allocation Special Report, “The Emperor’s Act Of Grace,” dated 8 June 2016, available at gaa.bcaresearch.com. 13     Mariko Fujii and Masahiro Kawai, “Lessons from Japan’s Banking Crisis 1991-2005,” ADB Institute Working Paper, No. 222, June 2010. 14     Mizuho, Mitsubishi UFJ and Sumitomo Mitsui. Data from March 2019 annual reports. 15     Please see “Financial System Report,” Bank of Japan, April 2019. 16       Please see Global Investment Strategy Weekly Report, “Three Cycles,” dated July 26, 2019, available at gis.bcaresearch.com. 17       Please see GAA’s latest Monthly Portfolio Update, “Manufacturing Recession, Consumer Resilience, Dovish Central Banks,” dated 1 August 2019, available at gaa.bcaresearch.com. 18     Please see “OECD Economic Surveys: Japan,” OECDiLibrary, April 15, 2019. 19     Please see “Government plans 5% rebates for some cashless payments after 2019 tax hike,”The Japan Times, November 22, 2018. 20     Please see “Outlook For Economic Activity And Price (July 2019),” Bank Of Japan, July 30, 2019. 21     Andrew Whiffin, “BoJ’s dominance over ETFs raises concern on distorting influence,” Financial Times, March 31, 2019.

Image Highlights Fed policy is likely to proceed in two stages: An initial stage characterized by a highly accommodative monetary policy, followed by a second stage where the Fed is raising rates aggressively in response to galloping inflation. The first stage, which will end in late 2021, will be heaven for risk assets. The subsequent stage, which will feature a global recession, will be hell. In the end, we expect the fed funds rate to reach 4.75%, representing thirteen more 25-basis point hikes than implied by current market pricing. For the time being, investors should maintain a pro-risk stance: Overweight global equities and high-yield credit relative to government bonds and cash. Regardless of what happens to the trade negotiations, China is stimulating its economy, which will benefit global growth. As a countercyclical currency, the dollar will weaken over the next 12 months. Cyclical stocks will outperform defensives. We expect to upgrade European and EM stocks this summer. Feature Dear Client, In lieu of next week’s report, I will be hosting a webcast on Wednesday, July 3rd at 10:00 AM EDT, where I will be discussing the major investment themes and views I see playing out for the rest of the year and beyond. Best regards, Peter Berezin, Chief Global Strategist Macro Outlook Right On Stocks, Wrong On Bonds We turned structurally bullish on global equities following December’s sell-off, having temporarily moved to the sidelines last June. This view has generally played out well. In contrast, our view that bond yields would rise this year as stocks recovered has been one gigantic flop. What went wrong with the bond view? The answer is that central banks are reacting to incoming news and data differently than in the past. As we discuss below, this has monumental implications for investment strategy. A Not So Recessionary Environment If one had been told at the start of the year that investors would be expecting the fed funds rate to fall to 1.5% by mid-2020 – with a 93% chance that the Fed would cut rates at least twice and a 62% chance it will cut rates three times in 2019 – one would probably have assumed that the U.S. had teetered into recession and that the stock market would be down on the year (Chart 1). Chart 1 Instead, the S&P 500 is near an all-time high, while credit spreads have narrowed by 145 bps since the start of the year. Outside the manufacturing sector, the economy continues to grow at an above-trend pace and the unemployment rate is below most estimates of full employment. According to the Atlanta Fed, real final domestic demand is set to increase by 2.8% in Q2, up from 1.6% in Q1. Real personal consumption expenditures are tracking to rise at a 3.7% annualized pace (Chart 2). Chart 2 So why is the Fed telegraphing rate cuts when real interest rates are barely above zero? A few reasons stand out: Global growth has slowed (Chart 3). The trade war has heated up again following President Trump’s decision to further increase tariffs on Chinese goods. Inflation expectations have fallen in the U.S. as well as around the world (Chart 4). Chart 3Global Growth Has Slowed Global Growth Has Slowed Global Growth Has Slowed Chart 4Inflation Expectations Have Fallen Around The World Inflation Expectations Have Fallen Around The World Inflation Expectations Have Fallen Around The World   There’s More To The Story As important as they are, these three factors, even taken together, would not be enough to justify rate cuts were it not for an additional consideration: The Fed, like most other major central banks, has become increasingly worried that the neutral rate of interest – the rate consistent with full employment and stable inflation – is extremely low. This has resulted in a major shift in its reaction function. Nobody really knows exactly where the neutral rate is. According to the widely-cited Laubach Williams (L-W) model, the nominal neutral rate stands at 2.2% in the United States. This is close to current policy rates (Chart 5). The range for the longer-term interest rate dot in the Summary of Economic Projections is between 2.4% and 3.3%, which is higher than the L-W estimate. However, the range has trended lower since it was introduced in 2014 (Chart 6). Chart 5The Fed Thinks Rates Are Close To Neutral The Fed Thinks Rates Are Close To Neutral The Fed Thinks Rates Are Close To Neutral Chart 6 A Fundamental Asymmetry Given that inflation expectations are quite low and there is considerable uncertainty over the level of the neutral rate, it does make some sense for policymakers to err on the side of being too dovish rather than too hawkish. This is because there is an asymmetry in monetary policy in the current environment. If the neutral rate turns out to be higher than expected and inflation starts to accelerate, central banks can always raise rates. In contrast, if the neutral rate turns out to be very low, the decision to hike rates could plunge the economy into a downward spiral. Historically, the Fed has cut rates by over five percentage points during recessions (Chart 7). At the present rate of inflation, the zero-lower bound on interest rates would be quickly reached, at which point monetary policy would become largely impotent. Chart 7The Fed Is Worried About The Zero Bound The Fed Is Worried About The Zero Bound The Fed Is Worried About The Zero Bound The asymmetry described above argues in favor of letting the economy run hot in order to allow inflation to rise. A higher inflation rate going into a recession would let a central bank push real rates deeper into negative territory before the zero bound is reached. In addition, a higher inflation rate would facilitate wage adjustments in response to economic shocks. Firms typically try to reduce costs when demand for their products and services declines, but employers are often wary of cutting nominal wages. Even though it is not fully rational, workers get more upset when they are told that their wages will fall by 2% when inflation is 1% than when they are told their wages will rise by 1% when inflation is 3%. More controversially, a modestly higher inflation rate could improve financial stability. In a low-inflation, low-nominal-rate environment, risky borrowers are likely to be able to roll over loans for an extended period of time. This could lead to the proliferation of bad debt. Chart 8Higher Underlying Inflation Can Cushion Nominal Asset Price Declines Higher Underlying Inflation Can Cushion Nominal Asset Price Declines Higher Underlying Inflation Can Cushion Nominal Asset Price Declines Higher inflation can also cushion the blow from a burst asset bubble. For example, the Case-Shiller 20-City Composite Index fell by 34% between 2006 and 2012, or 41% in real terms. If inflation had averaged 4% over this period and real home prices had fallen by the same amount, nominal home prices would have declined by only 26%, resulting in fewer underwater mortgages (Chart 8). A New Reaction Function It is usually a mistake to base market views on an opinion about what policymakers should do rather than what they will do. On rare occasions, however, the opposite is true. And, where our Fed call is concerned, this seems to be the case. Where we fumbled earlier this year was in assuming the Fed would follow a more traditional, Taylor Rule-based monetary framework, which calls for raising rates as the output gap shrinks. Instead, the Fed has adopted a risk-based approach of the sort described above, reminiscent in many ways of the optimal control framework that Janet Yellen set out in 2012. The New Normal Becomes The New Consensus Chart 9 If one is going to conduct monetary policy in a way that errs on the side of letting the economy overheat, one should not be too surprised if the economy does overheat. Yet, the implied rate path from the futures curve suggests that investors are not taking this risk seriously. Chart 9 shows that investors are assigning a mere 5% chance that U.S. short-term rates will be above 3.5% in mid-2022. Why isn’t the market assigning more of a risk to an inflation overshoot? We suspect that most investors have bought into the consensus view that the real neutral rate is zero. According to this view, U.S. monetary policy had already turned restrictive last year when the 10-year Treasury yield climbed above 3%. If this view is correct, the recent decline in yields may stave off a recession, but it will not be enough to cause the economy to overheat. Many of the same investors also believe that deep-seated structural forces ranging from globalization, automation, demographics, to the waning power of trade unions, will all prevent inflation from rising much over the coming years even if the unemployment rate continues to fall. In other words, the Phillips curve is broken and destined to stay that way. But are these views correct? We think not.  Where Is Neutral? There is a big difference between arguing that the neutral rate may be low – and taking preemptive steps to remedy it – and arguing that it definitely is low. We subscribe to the former view, but not the latter. Our guess is that in the end, we will discover that the neutral rate is lower than in the past, but not nearly as low as investors currently think. Probably closer to 1.5% in real terms than 0%. As we discussed in detail two weeks ago, while a deceleration in trend growth has pushed down the neutral rate, other forces have pushed it up.1 These include looser fiscal policy (especially in the U.S.), a modest revival in private-sector credit demand, and dwindling labor market slack.  Since the neutral rate cannot be observed directly, the best we can do is monitor the more interest rate-sensitive sectors of the economy to see if they are cooling in a way that would be expected if monetary policy had become restrictive. For example, housing is a long-lived asset that is usually financed through debt. Hence, it is highly sensitive to changes in mortgage rates. History suggests that the recent decline in mortgage rates will spur a rebound in home sales and construction later this year (Chart 10). The fact that homebuilder confidence has bounced back this year and purchase mortgage applications have reached a cycle high is encouraging in that regard. The same goes for the fact that the vacancy rate is near an all-time low, housing starts have been running well below the rate of household formation, and the quality of mortgage lending has been quite strong (Chart 11). Chart 10Declining Yields Bode Well For Housing Declining Yields Bode Well For Housing Declining Yields Bode Well For Housing Chart 11U.S. Housing: No Oversupply Problem, While Demand Is Firm U.S. Housing: No Oversupply Problem, While Demand Is Firm U.S. Housing: No Oversupply Problem, While Demand Is Firm     Nevertheless, if the rebound in housing activity fails to materialize, it would provide evidence that other factors, such as job security concerns among potential homebuyers, are overwhelming the palliative effects of lower mortgage rates.  Have Financial Markets “Trapped” Central Banks? An often-heard argument is that central banks can ill-afford to raise rates for fear of unsettling financial markets. Proponents of this argument often mention that the value of all equities, corporate bonds, real estate and other risk assets around the world exceeds $400 trillion, five times greater than global GDP. There are at least two things wrong with this argument. First, an increase in financial wealth should translate into more spending, and hence a higher neutral rate of interest. Second, as we discussed earlier this year, the feedback loop between asset prices and economic activity tends to kick in only when monetary policy has already become restrictive.2  When policy rates are close to or above neutral, further rate hikes threaten to push the economy into recession. Corporate profits inevitably contract during recessions, which hurts risk asset prices. A vicious spiral can develop where falling asset prices lead to less spending throughout the economy, leading to lower profits and even weaker asset prices. In contrast, when interest rates are below their neutral level, as we believe is the case today in the major economies, an increase in policy rates will simply reduce the odds that the economy will overheat, which is ultimately a desirable outcome. U.S. Imbalances Are Modest Chart 12U.S. Corporate Debt (I): No Cause For Alarm U.S. Corporate Debt (I): No Cause For Alarm U.S. Corporate Debt (I): No Cause For Alarm Recessions usually occur when rising rates expose some serious imbalances in the economy. In the U.S. at least, the imbalances are fairly modest. As noted above, housing is on solid ground, which means that mortgage rates would need to rise substantially before the sector crumbles. Equities are pricey, but far from bubble territory. Moreover, unlike in the late 1990s, the run-up in stock prices over the past five years has not led to a massive capex overhang. Corporate debt is the weakest link in the financial system, but we should keep things in perspective. Even after the recent run-up, net corporate debt is only modestly higher than it was in the late 1980s, a period where the fed funds rate averaged nearly 10% (Chart 12). Thanks to low interest rates and rapid asset accumulation, the economy-wide interest coverage ratio is above its long-term average, while the ratio of debt-to-assets is below its long-term average (Chart 13). The corporate sector financial balance – the difference between what businesses earn and spend – is still in surplus. Every recession during the past 50 years has begun when the corporate sector financial balance was in deficit (Chart 14). Chart 13U.S. Corporate Debt (II): No Cause For Alarm U.S. Corporate Debt (II): No Cause For Alarm U.S. Corporate Debt (II): No Cause For Alarm Chart 14U.S. Corporate Debt (III): No Cause For Alarm U.S. Corporate Debt (III): No Cause For Alarm U.S. Corporate Debt (III): No Cause For Alarm     The Dollar, The Neutral Rate, and Global Growth In a globalized economy, capital flows can equalize, at least partially, neutral rates across countries. If any one central bank tries to raise rates – while others are standing pat or even cutting rates – the currency of the economy where rates are rising will shoot up, causing net exports to shrink and growth to slow.  In the case of the U.S. dollar, there is an additional issue to worry about, which is that there is about $12 trillion in overseas dollar-denominated debt. A stronger greenback would make it difficult for external borrowers to service their debts, leading to increased bankruptcies and defaults. Since financial and economic imbalances are arguably larger outside the U.S., a rising dollar would probably pose more of a problem for the rest of the world than for the United States. Although this is a serious risk, it is unlikely to materialize over the next 12-to-18 months, given our assumption that the dollar will weaken over this period. The U.S. dollar trades as a countercyclical currency, which is another way of saying that it tends to weaken whenever global growth strengthens (Chart 15). While the U.S. benefits from faster global growth, the rest of the world benefits even more. This stems from the fact that the U.S. has a smaller manufacturing base and a larger service sector than most other economies, which makes the U.S. a “low beta” economy. Hence, stronger global growth tends to cause capital to flow from the U.S. to the rest of the world, putting downward pressure on the greenback. Right now, China is stimulating its economy. The stimulus is a reaction to both slowing domestic growth, as well as worries about the potential repercussions of a trade war. It also reflects the fact that Chinese credit growth had sunk to a level only modestly above nominal GDP growth late last year. With the ratio of credit-to-GDP no longer rising quickly, the authorities had the luxury of suspending the deleveraging campaign (Chart 16). Chart 15The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency Chart 16Chinese Deleveraging Campaign Has Now Been Put On The Backburner Chinese Deleveraging Campaign Has Now Been Put On The Backburner Chinese Deleveraging Campaign Has Now Been Put On The Backburner   The combination of Chinese stimulus, the lagged effects from lower bond yields, and a turn in the global manufacturing cycle should all lift global growth in the back half of this year. This should cause the dollar to weaken. Trade War Worries Needless to say, this rosy outlook is predicated on the assumption that the trade war does not get out of hand. Our baseline envisions a “muddle through” scenario, where some sort of deal is hatched that allows the U.S. to bring down existing tariffs over time in exchange for a binding agreement by the Chinese to improve market access for U.S. companies and better secure intellectual property rights. The specifics of the deal are less important than there being a deal – any deal – that avoids a major escalation. Ultimately, the distinction between a “small” trade war and a “moderate” trade war is a function of how high tariffs end up being. Tariffs are taxes, and while no one likes to pay taxes, they are a familiar part of the global capitalist system. Chart 17 What is less familiar, and much more dangerous to global finance, are nontariff barriers that effectively bar countries from accessing critical inputs and technologies. Most global trade is in the form of intermediate goods (Chart 17). If a company cannot access the global supply chain, there is a good chance it may not be able to function at all. The current travails of Huawei is a perfect example of this. A full-blown trade war would create a lot of stranded capital. The stock market represents a claim on the existing capital stock, not the capital stock that would emerge after a trade war has been fought. Stocks would plunge in this scenario, with the U.S. and most other economies succumbing to a recession. Enough voters would blame Donald Trump that he would lose the election. While such an outcome cannot be entirely dismissed, it is precisely its severity that makes it highly unlikely. Inflation: Waiting For Godot? Global monetary policy is highly accommodative at present, and will only become more so if the Fed and some other central banks cut rates. Provided that the trade war does not boil over, global growth should accelerate, putting downward pressure on the U.S. dollar. A weaker dollar will further ease global financial conditions. In such a setting, global growth is likely to remain above trend, leading to a further erosion of labor market slack. Among the major economies, the U.S. is the closest to exhausting all remaining spare capacity (Chart 18). The unemployment rate has fallen to 3.6%, the lowest level since 1969. The number of people outside the labor force who want a job as a share of the working-age population is below the level last seen in 2000. The quits and job opening rates remain near record highs. Given the erosion in slack, why has inflation not taken off? To some extent, the answer is that the Phillips curve is “kinked.” A decline in the unemployment rate from say, 8% to 5%, does little to boost inflation because even at 5%, there are enough jobless workers keen to accept what employment offers they get. It is only once the unemployment rate falls well below NAIRU that inflation starts to kick in. In the 1960s, it was not before the unemployment rate fell two percentage points below NAIRU that inflation broke out (Chart 19). Chart 18U.S. Is Back To Full Employment U.S. Is Back To Full Employment U.S. Is Back To Full Employment Chart 19Inflation Took Off In The 1960s Amid An Overheated Economy Inflation Took Off In The 1960s Amid An Overheated Economy Inflation Took Off In The 1960s Amid An Overheated Economy   Wage growth has picked up. However, productivity growth has risen as well. As a result, unit labor costs – the ratio of wages-to-productivity – have actually decelerated over the past 18 months. Unit labor cost inflation tends to lead core inflation by up to one year (Chart 20).  Chart 20No Imminent Threat Of A Wage-Price Inflationary Spiral No Imminent Threat Of A Wage-Price Inflationary Spiral No Imminent Threat Of A Wage-Price Inflationary Spiral As the unemployment rate continues to drop, wage growth is likely to begin outstripping productivity gains. A wage-price spiral could develop. This is not a major risk for the next 12 months, but could become an issue thereafter. Could structural forces related to globalization, automation, demographics, and waning union power prevent inflation from rising even if labor markets tighten significantly further? We think that is unlikely. Globalization Regardless of what happens to the trade war, the period of hyperglobalization, ushered in by the fall of the Berlin Wall and China’s entry into the WTO, is over. As a share of global GDP, trade has been flat for more than ten years (Chart 21).  Chart 21Globalization Has Peaked Globalization Has Peaked Globalization Has Peaked Granted, it is not just the change in globalization that matters for inflation. The level matters too. In a highly globalized world, excess demand in one economy can be satiated with increased imports from another economy. However, this is only true if other economies have enough spare capacity. Even outside the United States, the unemployment rate in the G7 economies is approaching a record low (Chart 22). Chart 22The Unemployment Rate In The U.S. And Elsewhere Is Near Record Lows The Unemployment Rate In The U.S. And Elsewhere Is Near Record Lows The Unemployment Rate In The U.S. And Elsewhere Is Near Record Lows In any case, for a fairly closed economy such as the U.S., where imports account for only 15% of GDP, relative prices would need to shift a lot in order to incentivize households and firms to purchase substantially more goods from abroad. In the absence of dollar appreciation, this would require that the prices of U.S. goods increase in relation to the prices of foreign goods. In other words, U.S. inflation would still have to rise above that of the rest of the world. Automation Everyone likes to think that they are living in a special age of technological innovation. Yet, according to the productivity statistics, U.S. productivity has grown at a slower pace over the last decade than during the 1970s (Chart 23). As we argued in a past report, this is unlikely to be the result of measurement error.3  Perhaps the recent pickup in productivity growth will mark the start of a new structural trend. Maybe, but it could also just reflect a temporary cyclical revival. As labor has become less plentiful, companies have started to invest in more capital. Chart 24 shows that productivity growth and capital spending are highly correlated over the business cycle. Chart 23 Chart 24U.S. Productivity Growth And Capex Move In Lock-Step U.S. Productivity Growth And Capex Move In Lock-Step U.S. Productivity Growth And Capex Move In Lock-Step   It is less clear whether total factor productivity (TFP) growth — which reflects such things as technological know-how and business practices – has turned the corner. Over the past two centuries, TFP growth has accounted for over two-thirds of overall productivity growth. Recent data suggests TFP growth in the U.S. and around the world has remained sluggish (Chart 25). Chart 25ATotal Factor Productivity Remains Muted Across Developed Markets Total Factor Productivity Remains Muted Across Developed Markets Total Factor Productivity Remains Muted Across Developed Markets Chart 25BTotal Factor Productivity Remains Muted Across Developed Markets Total Factor Productivity Remains Muted Across Developed Markets Total Factor Productivity Remains Muted Across Developed Markets     Even if TFP growth does accelerate, it is not obvious that this will end up being deflationary. Increased productivity means more income, but more income means more potential spending. To the extent that stronger productivity growth expands aggregate supply, it also has the potential to raise aggregate demand. Thus, while faster productivity growth in one sector will cause relative prices in that sector to fall, this will not necessarily reduce the overall price level. Chart 26Rising Labor Share Of Income Occurring Alongside Labor Market Tightening Rising Labor Share Of Income Occurring Alongside Labor Market Tightening Rising Labor Share Of Income Occurring Alongside Labor Market Tightening Chart 27 True, faster productivity growth has the ability to shift income from poor workers to rich capitalists. Since the former spend more of their income than the latter, this could slow aggregate demand growth. However, the recent trend has been in the other direction, as a tighter labor market has pushed up labor’s share of income (Chart 26). Among workers, wage growth is now higher at the bottom end of the income distribution than at the top (Chart 27). Demographics For several decades, slower population growth has reduced the incentive for firms to expand capacity. Population aging has also shifted more people into their prime saving years. The combination of lower investment demand and higher desired savings pushed down the neutral rate on interest. Chart 28The Worker-To-Consumer Ratio Has Peaked Globally The Worker-To-Consumer Ratio Has Peaked Globally The Worker-To-Consumer Ratio Has Peaked Globally Now that baby boomers are starting to retire, they are moving from being savers to dissavers. Chart 28 shows that ratio of workers-to-consumers globally has begun to decline as the post-war generation leaves the labor force. As more people stop working, aggregate savings will fall. The shortage of savings will put upward pressure on the neutral rate. If central banks drag their feet in raising policy rates in response to an increase in the neutral rate, monetary policy will end up being too stimulative. As economies overheat, inflation will pick up. The Waning Power Of Unions The declining influence of trade unions is often cited as a reason for why inflation will remain subdued. There are a number of problems with this argument. First, unionization rates in the U.S. peaked in the mid-1950s, more than a decade before inflation began to accelerate. Second, while the unionization rate continued to decline in the U.S. during the 1980s and 1990s, it remained elevated in Canada. Yet, this did not prevent Canadian inflation from falling as rapidly as it did in the United States (Chart 29). The widespread use of inflation-linked wage contracts in the 1970s appears mainly to have been a consequence of rising inflation rather than the cause of it (Chart 30). Chart 29Inflation Fell In Canada, Despite A High Unionization Rate Inflation Fell In Canada, Despite A High Unionization Rate Inflation Fell In Canada, Despite A High Unionization Rate Chart 30Higher Inflation Led To More Inflation-Indexed Wage Contracts, Not The Other Way Around Higher Inflation Led To More Inflation-Indexed Wage Contracts, Not The Other Way Around Higher Inflation Led To More Inflation-Indexed Wage Contracts, Not The Other Way Around   Ultimately, the price level cannot increase on a sustained basis independent of other things such as the level of the money supply. Unions have influence over wages, but in the long run, central banks play the decisive role. Alt-Right Or Ctrl-Left, The Result Is Usually Inflation In a speech to the Council on Foreign Relations this week, Jay Powell noted that “The Fed is insulated from short-term political pressures – what is often referred to as our ‘independence’.”4 The operative words in his remarks were “short-term”. Powell knows full well that the Fed’s independence is not cast in stone. Even if Trump cannot legally fire or demote him, the President can choose who to nominate to the Fed’s Board of Governors. Early on in his tenure, Trump showed little interest in the workings of the Federal Reserve. He even went so far as to nominate Marvin Goodfriend – definitely no good friend of easy money – to the Fed board. Trump’s last two candidates, Stephen Moore and Herman Cain, were both political flunkies, happy to ditch their previous commitments to hard money in favor of Trump’s desire to see lower interest rates. Neither made it as far as the Senate confirmation process. Recent media reports have suggested that Trump will nominate Judy Shelton, a previously unknown economist whose main claim to fame is the promulgation of a bizarre theory about why the Fed should not pay interest on excess reserves (which, conveniently, would imply that overnight rates would need to fall to zero immediately).5  It is not clear whether Trump’s attempt to stack the Fed with lackeys will succeed. But one thing is clear: Countries with independent central banks tend to end up with lower inflation rates than countries where central banks are not independent (Chart 31). Chart 31 Whether it be Trump-style right-wing populism or left-wing populism (don’t forget, MMT is a product of the left, not the right), the result is usually the same: higher inflation. Investment Recommendations Overall Strategy The discussion above suggests the Fed will proceed along a two-stage path: An initial stage characterized by a highly accommodative monetary policy, followed by a second stage where the Fed is raising rates aggressively in response to galloping inflation. The first stage will be heaven for risk assets. The subsequent stage will be hell. The big question is when the transition from stage one to stage two will occur. Inflation is a highly lagging indicator. It usually does not peak until a recession has begun and does not bottom until a recovery is well under way (Chart 32). Chart 32 While some measures of U.S. core inflation such as the Dallas Fed’s “trimmed mean” have moved back up to 2%, this follows a prolonged period of sub-target inflation. For now, the Fed wants both actual inflation and inflation expectations to increase. Thus, we doubt that inflation will move above the Fed’s comfort zone before 2021, and it will probably not be until 2022 that monetary policy turns contractionary. It will take even longer for inflation to rise meaningfully in the euro area and Japan. Recessions rarely happen if monetary policy is expansionary. Sustained equity bear markets in stocks, in turn, almost never happen outside of recessionary periods (Chart 33). As such, a pro-risk asset allocation, favoring global equities and high-yield credit over safe government bonds and cash, is warranted at least for the next 12 months. Chart 33Recessions And Equity Bear Markets Usually Overlap Recessions And Equity Bear Markets Usually Overlap Recessions And Equity Bear Markets Usually Overlap The key market forecast charts on the first page of this report graphically lay out our baseline forecasts for equities, bonds, currencies, and commodities. Broadly speaking, we expect a risk-on environment to prevail until the end of 2021, followed by a major sell-off in equities and credit. Equities Stocks tend to peak about six months before the onset of a recession. In the 13-to-24 month period prior to the recession, returns tend to be substantially higher than during the rest of the expansion (Table 1). We are approaching that party phase. Table 1Too Soon To Get Out Third Quarter 2019 Strategy Outlook: The Long Hurrah Third Quarter 2019 Strategy Outlook: The Long Hurrah Global equities currently trade at 15-times forward earnings. Unlike last year, earning growth estimates are reasonably conservative (Chart 34). Chart 34Global Stocks Are Not That Expensive Global Stocks Are Not That Expensive Global Stocks Are Not That Expensive Outside the U.S., stocks trade at a respectable 13-times forward earnings. Considering that bond yields are negative in real terms in most economies – and negative in nominal terms in Japan and many parts of Europe – this implies a sizable equity risk premium.  We have yet to upgrade EM and European stocks to overweight, but expect to do so some time this summer, once we see some evidence that global growth is accelerating. International stocks should do especially well in common-currency terms over the next 12 months, if the dollar continues to trend lower, as we expect will be the case.  We are less enthusiastic about Japanese equities. First, there is still the risk that the Japanese government will needlessly raise the consumption tax in October. Second, as a risk-off currency, the yen is likely to struggle in an environment of strengthening global growth. Investors looking for exposure to Japanese stocks should favor the larger multinational exporters. At the global sector level, cyclicals should outperform defensives in an environment of stronger global growth, a weaker dollar, and ongoing Chinese stimulus. We particularly like industrials and energy. Financials should catch a bid in the second half of this year. According to the forwards, the U.S. yield curve will steepen by 38 bps over the next six months (Chart 35). Worries about an inverted yield curve will taper off. Curves will also likely steepen outside the U.S. as growth prospects improve. A steeper yield curve is manna from heaven for banks. Euro area banks trade at an average dividend yield of 6.4% (Chart 36). We are buying them as part of a tactical trade recommendation. Chart 35 Chart 36Euro Area Banks Are A Buy Euro Area Banks Are A Buy Euro Area Banks Are A Buy     Fixed Income The path to higher rates is lined with lower rates. The longer a central bank keeps rates below their neutral level, the more economies will overheat, and the larger the eventual inflation overshoot will be. The Fed’s dovish turn means that rates will stay lower for longer, but will ultimately go higher than we had originally envisioned. As a result, we are increasing our estimate of the terminal fed funds rate for this cycle by 50 bps to 4.75% and initiating a new trade going short the March 2022 Eurodollar futures contract. Our terminal fed funds rate projection assumes a neutral real rate of 1.5% and a peak inflation rate of 2.75%. Rates will rise roughly 50 basis points above neutral in the first half of 2022, enough to generate a recession later that year. The 10-year Treasury yield will peak at 4% this cycle. While the bulk of the increase will happen in 2021/22, yields will still rise over the next 12 months, as U.S. growth surprises on the upside. Thus, a short duration stance is warranted even in the near-to-medium term. The German 10-year yield will peak at 1.5% in 2022. We expect the U.S.-German spread to narrow modestly through to end-2021 and then widen somewhat as U.S. inflation accelerates relative to German inflation. The spread between Italian and German yields will decline in the lead-up to the global recession in 2022 and widen thereafter. U.K. gilt yields are likely to track global bond yields, although Brexit remains a source of downside risk for yields. Our base case is either no Brexit or a very soft Brexit, given that popular opinion has turned away from leaving the EU (Chart 37). Chart 37U.K.: In The Case Of A Do-Over, The Remain Side Would Likely Win U.K.: In The Case Of A Do-Over, The Remain Side Would Likely Win U.K.: In The Case Of A Do-Over, The Remain Side Would Likely Win Chart 38U.S. Default Losses Will Remain In Check U.S. Default Losses Will Remain In Check U.S. Default Losses Will Remain In Check   We expect only a very modest increase in Japanese yields over the next five years. Japanese long-term inflation expectations are much lower than in the other major economies, which will require an extended period of near-zero rates to rectify. We expect corporate credit to outperform government bonds over the next 12 months. While spreads are not likely to narrow much from present levels, the current yield pickup is high enough to compensate for expected bankruptcy risk. Our U.S. fixed-income strategists expect default losses on the Bloomberg Barclays High-Yield index on the order of 1.25%-1.5% over the next 12 months (Chart 38). In that scenario, the junk index offers 224 bps – 249 bps of excess spread, a solid positive return that is only slightly below the historical average of 250 bps.  Currencies And Commodities The two-stage Fed cycle described above will govern the trajectory of the dollar over the next few years. In the initial stage, where global growth is accelerating and the Fed is falling ever further behind the curve in normalizing monetary policy, the dollar will depreciate. Dollar weakness will be especially pronounced against the euro and EM currencies. Commodities and commodity currencies will see solid gains. Our commodity strategists are particularly bullish on oil, as they expect crude prices to benefit from both stronger global demand and increasingly tight supply conditions. The Chinese yuan will start strengthening again if a detente is reached in the trade talks. Even if a truce fails to materialize, the Chinese authorities will likely step up the pace of credit stimulus, rather than trying to engineer a significant, and possibly disorderly, devaluation.   In the second stage, where the Fed is desperately hiking rates to prevent inflation expectations from becoming unmoored, the dollar will soar. The combination of higher U.S. rates and a stronger dollar will cause global equities to crash and credit spreads to widen. The resulting tightening in financial conditions will lead to slower global growth, which will further turbocharge the dollar. Only once the Fed starts cutting rates again in late 2022 will the dollar weaken anew. Gold should do well in the first stage of the Fed cycle and at least part of the second stage. In the first stage, gold will benefit from a weaker dollar. In the initial part of the second stage, gold prices will continue to rise as inflation fears escalate. Gold will probably weaken temporarily once real interest rates reach restrictive territory and a recession becomes all but inevitable. We recommended buying gold on April 17, 2019. The trade is up 10.8% since then. Stick with it.   Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Footnotes 1      Please see Global Investment Strategy Weekly Report, “A Two-Stage Fed Cycle,” dated June 14, 2019. 2      Please see Global Investment Strategy Weekly Report, “Low Odds Of An FCI Doom Loop,” dated January 4, 2019. 3      Please see Global Investment Strategy Special Report, "Weak Productivity Growth: Don't Blame The Statisticians," dated March 26, 2016. 4      Please see “Powell Emphasizes Fed’s Independence,” The New York Times, June 25, 2019. 5      Heather Long, “Trump’s potential Fed pick Judy Shelton wants to see ‘lower rates as fast as possible’,” The Washington Post, June 19, 2019.   Strategy & Market Trends MacroQuant Model And Current Subjective Scores Chart 39 Tactical Trades Strategic Recommendations Closed Trades

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

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