Financials

Dear Client, I have been on the road visiting clients in St. Louis, Minneapolis, and Chicago this week. Instead of our regular Weekly Report, we are sending you a Special Report on European bank stocks written by my colleague Xiaoli Tang from our Global Asset Allocation service. In advance of the holiday season, we will be publishing next week’s report summarizing our key views for 2019 on Tuesday morning. Best regards, Peter Berezin, Chief Global Strategist   Highlights Euro area bank profits are driven more by economic growth than monetary factors. This growth link explains the close correlation between the relative performance of banks within the euro area and the relative performance between euro area and U.S. equities. It also highlights the importance of euro area banks to global asset allocators. Euro area banks now have attractive valuations, which are offset however by a lackluster profit outlook. Long-term investors should avoid banks in the region. Investors with a more tactical mandate and much nimbler style could use our valuation indicators to “time” their entry and exit into banks as a short-term trade. Feature Banks in the euro area have underperformed the region’s broader market by about 50% since March 2009, when global equities reached their financial crisis lows. In the same period, the overall euro area equity index also underperformed U.S. equities by about 50% in common-currency terms. In fact, the relative performance of euro area banks to the euro area broad market has been joined at the hip with the relative performance of euro area equities vs. U.S. equities over the past decade (Chart 1, panel 1). Getting the bank view right in the euro area is therefore an important input into our country allocation decision between U.S. and euro area equities. Chart 1Is It Time To Buy Euro Area Banks? Is It Time To Buy Euro Area Banks? Is It Time To Buy Euro Area Banks? With a more than 50% discount to the broad market in terms of price-to-book (P/B), banks are now looking very cheap. However, banks in the euro area have always traded at a discount to the broader market on an absolute basis. Currently the relative P/B reading of 0.45 is only slightly lower than the 3-year average of 0.47 – still higher than the lower band of the valuation range (Chart 1, panel 2). The relative dividend yield also gives similar information (Chart 1, panel 3). Historically, when the relative P/B discount hits the lower band and the relative dividend yield hits the upper band, a rebound in relative return performance could be expected. In order to support sustainable outperformance, however, banks need to have sustained profitability. In this Special Report, we delve into the fundamental factors that affect a bank’s profit outlook such as capital position, loan growth and non-performing loan situation to determine if banks in the euro area are cheap for a reason, or are about to embark on a period of sustainable outperformance. What Drives Bank Share Performance? According to research published in BCA’s Global Asset Allocation Special Report on July 27, 2017,1 it is clear that return on equity (ROE) has historically been closely correlated with the performance of bank shares, especially on a relative-to-the-broad-market basis (Chart 2, panel 1). Chart 2Euro Area Bank Performance Drivers Euro Area Bank Performance Drivers Euro Area Bank Performance Drivers The recovery of ROE has so far been tepid. This is largely a result of deleveraging in the banking system and very low asset utilization, because both return on assets and net profit margins have recovered strongly (Chart 2, panels 2 and 3). Since the Global Financial Crisis (GFC), euro area banks have steadily reduced leverage to a multi-decade low, while asset utilization has been in a downtrend since the 1990s – even though this ratio seems to have been stabilizing over the past few years. Profit margins reached a historical high of 12.7% in Q4/2006, then collapsed during the GFC and reached a low of 0.34% in Q3/2009. The subsequent rebound in profit margins was short-circuited by the euro debt crisis, causing net profit margins to plummet into negative territory, reaching a historical low of -7.6% in Q3/2012. They have recovered strongly since, reaching 9.8% in Q3/2018, not far from the 2006 peak margin level. As such, banks have to increase their leverage and asset utilization in order to generate higher ROE. This also means they need to increase their asset base and take on more risk. Do banks in the euro area have the ability to do so? Capital Adequacy Vs. Deleveraging The capital adequacy ratio (CAR), the ratio of a bank’s regulatory capital to its risk-weighted assets, measures a bank’s ability to absorb shocks. As shown in Chart 3, banks in all countries have steadily increased this ratio since the GFC. Banks in Ireland, the Netherlands and Finland have the highest CAR values, but they have all come down from their respective peak levels. On the other hand, Spanish, Italian and Portuguese banks have the lowest CAR readings, though they are still improving. French banks stand out because their capital adequacy ratio has been in a steady uptrend with the least volatility. Chart 3Improving Capital Position, But... Improving Capital Position, But... Improving Capital Position, But... Looking at CAR alone, however, could be misleading when trying to gauge a bank’s capital situation. In fact, the generally rising capital adequacy ratio has mainly been achieved through the reduction of risk-weighted assets in all countries except France (Chart 4). Chart 4...With Massive Leverage ...With Massive Leverage ...With Massive Leverage French banks’ risk-weighted assets have been more or less stable since 2006, with a small decline into 2015 and a gradual increase since. Belgian banks have also experienced similar asset growth as French banks over the past few years, though that is after massive deleveraging occurred between 2007 and 2014 (Chart 4, panel 1). Both Spanish and Italian banks tried to grow assets in 2014 after several years of deleveraging, but the attempt was short-lived as both resumed asset reduction, starting in 2015 (Chart 4, panel 2). Dutch banks seem to have stabilized their asset base since 2014, while Irish banks, which cut half their asset base between 2010 and 2014, have continued to deleverage, albeit at a much slower pace (Chart 4, panel 3). The deleveraging process in Portuguese and Finish banks has been ongoing since 2010, and it seems that the painful deleveraging process may have come to a stage of stabilization (Chart 4, panel 4). In terms of regulatory capital, the numerator of the capital adequacy ratio, French banks again stand out with a steadily increasing regulatory capital base, while Dutch banks have also grown their regulatory capital base at a similar pace. The regulatory capital bases in Spanish, Italian and Belgian banks, however, have been oscillating over the past decade, while Portuguese and Irish banks’ regulatory capitals have declined significantly (Chart 5). Chart 5Regulatory Capital Growth: No Synchronization Regulatory Capital Growth: No Synchronization Regulatory Capital Growth: No Synchronization Another indicator of bank resilience, the ratio of non-performing-loans (NPLs) net of provision relative to capital, measures if a bank can write off all of its bad loans and remain solvent. How do all the banks measure up in this aspect? Even though banks in all countries now have good readings (less than 100%), both Italy and Portugal were under severe stress until only a few years ago. Despite significant improvement since, banks in these two countries still have high levels of bad loans relative to capital compared to banks in other countries in the region (Chart 6). Chart 6Bad Loans Are Well Provisioned Bad Loans Are Well Provisioned Bad Loans Are Well Provisioned Loan Quality Vs. Quantity The ratio of NPLs-to-gross loans provides potentially useful insights into the quality of assets. NPL ratios in France, Germany, Belgium, Austria, and Finland are all less than 5%, while those in Italy, Portugal and Ireland are higher than 10%, and Spain is in between (Chart 7). Since the peak around 2015, the NPL ratios in all countries other than Finland have come down. Compared to levels before 2006, however, bad loan ratios are still high. Chart 7NPL Ratio NPL Ratio NPL Ratio In addition, despite the improvement in asset quality, banks have not aggressively grown their loan books. Only banks in France and Finland have been consistently lending to their respective private sectors – along with German banks, albeit at a lesser pace. Lending to the private sector in Spain, Portugal and Ireland has in fact contracted by 40%-50% since 2008, while loan growth from banks in Italy, Austria and the Netherlands has basically been flat since the GFC, as shown in Chart 8. Chart 8Bank Loans To Private Sector Bank Loans To Private Sector Bank Loans To Private Sector Exposure To Emerging Markets Banks in the euro area are known to have a strong presence in the emerging markets. As shown in panel 1 of Chart 9, Spanish banks have more than doubled their lending to emerging markets (EM) since 2006; even after a reduction over the past two years, loans to EM still account for over 16% of total lending. This stands in stark contrast to their domestic lending, which has contracted sharply since peaking in early 2009 (Chart 8, panel 3). Portuguese banks share similar patterns to Spanish banks in terms of loan growth to EM and domestically, however, their absolute amounts have been much smaller (Chart 8, panel 3 and Chart 9, panel 2). Dutch banks shrank their loan books to EM right after the GFC but have been gradually building them back up since 2011, while Austrian banks have been steadily reducing the pace of their lending to EM (Chart 9, panels 3 and 4). Chart 9Bank Exposure To EM Bank Exposure To EM Bank Exposure To EM After the turbulence earlier this year in Turkey and Argentina, BCA’s Global Investment Strategy and Foreign Exchange Strategy services identified six countries (Argentina, Turkey, Colombia, Brazil, Mexico, and Chile) as the most vulnerable to catching the “Turkish Flu,” based on the following factors: current account balance, net international investment position, external debt, external debt-service obligation, external funding requirements, private-sector savings/investment, private-sector debt, government budget balance, government debt, foreign ownership of local-currency bonds, and inflation2 (Table 1). Chart The vulnerability of Latin America highlights the poor performance of Spanish banks, given their heavy exposure to the region. For example, Banco Santander, the largest Spanish bank and also the largest component in the euro area bank index, has aggressively expanded into Latin America to beef up asset utilization and return on assets. However, loan quality from Latin America has been much lower, as evidenced by the much-higher percentage of bad loan provisions from the region compared to its share of loans. Currently, loans to Latin America account for about 18% of total lending, yet bad loan provisions account for about 42% of total provisions (Chart 10). Chart 10Banco Santander: More Like An EM Bank Banco Santander: More Like An EM Bank Banco Santander: More Like An EM Bank Exposure To Italian Government Debt The fiscal budget saga in Italy has been a negative factor impacting euro area assets, especially Italian banks. Italian banks have been large buyers of Italian government debt securities, reaching over 400 billion euros at the peak and accounting for about a quarter of total debt securities. Following the European Central Bank’s quantitative easing program (QE) that started in March 2015, Italian banks’ share of government debt holdings subsequently dropped to about 18% by the end of 2017. In 2018, however, Italian banks purchased more government bonds to a level of 393.8 billion euros as of September 2018, or about 20% of the overall debt securities outstanding – only a tad lower than the peak level before the QE program (Chart 11). Chart 11Italian Debt By Type Of Investor Italian Debt By Type Of Investor Italian Debt By Type Of Investor Now the ECB’s QE program is expected to come to an end soon. With government debt securities holdings accounting for 24% of tier 1 capital in Italian banks, (Chart 12), investors should pay close attention to the “Doom Loop,” i.e. when weakening government bonds threaten to topple the banks that own those bonds, the banks are forced to unload the bond holdings, which in turn pushes the government into additional fiscal stress. Chart 12The Doom Loop The Doom Loop The Doom Loop Moreover, Italian banks are not the only banks in the euro area which are exposed to Italian government debt. According to the European Banking Authority’s 2017 Transparency Exercise, French and Spanish banks held 44 billion euros and 29 billion euros of Italian debt, respectively. For example, the largest French bank, BNP Paribas (BNP), which is the second-largest component by market cap in the euro area bank index, has gradually added more Italian government debt securities since 2015 (when the ECB started buying Italian bonds) following a large reduction in 2011 (Chart 13). Chart 13 Investment Implications The euro area banks and diversified financial sector indices are currently mostly dominated by Spain (30%), France (25%) and Italy (15%), which all have grown at the expense of the German banks over the past two decades (Chart 14). Chart 14Euro Area Bank Index: High Concentration Euro Area Bank Index: High Concentration Euro Area Bank Index: High Concentration From a fundamental perspective, only French banks have both good-quality assets with decent and steady loan growth; the largest weight – Spanish banks – has experienced negative loan growth domestically while expanding aggressively to emerging markets up until 2017. Some may argue that exposure to Italian debt and emerging markets may have already been fully priced in, given the massive underperformance of the banks. This may well be true, and there could be a short-term bounce in bank stocks, given the attractive valuation metrics. For long-term investors, however, such a bounce may not be captured easily. We suggest long-term investors stay away from euro area banks, in line with our regional equity view of favoring the U.S. over the euro area. Why? Because cheap valuations are offset by lackluster profit outlook at a time when growth is slowing and monetary policy is becoming less accommodative (Charts 15A and 15B). Relative earnings growth for both banks and diversified financials are closely tied to the euro area PMI, the leading indicator for economic growth (Charts 15A and 15B, panel 2). This growth link explains why the banks’ relative performance in the euro area has such a close correlation with the performance of euro area equities relative to their U.S. peers. Chart 15APoor Profit Outlook For Banks Poor Profit Outlook For Banks Poor Profit Outlook For Banks Chart 15BPoor Profit Outlook For Diversified Financials Poor Profit Outlook For Diversified Financials Poor Profit Outlook For Diversified Financials For investors with a more tactical mandate and much nimbler style, however, Chart 1 could be used as a guide to “time” an entry and exit to the industry: go overweight when the relative price-to-book reaches the lower band and relative dividend yield reaches the upper band, and vice versa.   Xiaoli Tang, Associate Vice President xiaoliT@bcaresearch.com Appendix 1 Euro Area Bank Indexes Different index providers have different classifications and compositions for banks, based on their different respective index methodologies.3, 4 GAA uses the MSCI All Country Equity index as its global equity benchmark. As such, whenever possible, we use the MSCI indexes in our research work. When data is not available from MSCI, however, we also use the Datastream Thomson Reuters (Datastream) index. In this Special Report, we have combined the MSCI “Bank Index” and “Diversified Financials Index” into one Aggregate Bank Index for one reason: MSCI reclassified Deutsche Bank as a “diversified financial” from a “bank” in 2003. Appendix Table 1 and Appendix Table 2 show the comparisons between the Datastream Bank Index and the MSCI Aggregate Bank Index. Even though Datastream includes 16 countries and MSCI includes only eight countries, both indexes are quite concentrated in Spain, France, Italy and the Netherlands. These four countries account for 77.4% of the Datastream Bank Index with 34 stocks, while they account for 78.8% of the MSCI aggregate bank index with 19 stocks. What’s more, the top five stocks are the same in both indexes, but they account for half of the MSCI Aggregate Bank Index and only 42% of the Datastream Bank Index. Image   Image Consequently, while the two indexes are quite similar, users should be aware of the differences. For example, since March 2009, the MSCI Aggregate Bank index has underperformed the broader index by 48%, but Datastream banks have underperformed the broad index by 55%, as shown in Appendix Chart 1. Image Footnotes   1 Please see Global Asset Allocation Special Report, “What Drives Bank Share Performance?” dated July 27, 2017 available at gaa.bcaresearch.com. 2 Please see Global Investment Strategy Weekly Report, “Hot Dollar, Cold Turkey,” dated August 17, 2018, available at gis.bcaresearch.com. 3 Please see https://www.msci.com/eqb/methodology/meth_docs/MSCI_GIMIMethodology_Nov2018.pdf 4 Please see http://www.datastream.jp/wp/wp-content/uploads/2017/02/DatastreamGlobalEquityIndicesUGissue05.pdf  

Highlights On the bright side, Malaysia’s structural backdrop is improving notably, especially in the semiconductors segment. Yet the cyclical growth outlook remains downbeat. While we are maintaining a market-weight allocation to Malaysian equities within an EM equity portfolio, we are putting this bourse on our upgrade watch list. As a play on the ameliorating structural outlook, we recommend an overweight position in Malaysian small-cap stocks relative to the EM universe – both the small-cap and overall equity benchmarks. Feature Malaysian stocks have performed quite poorly in recent years: the equity index, in U.S. dollars, is close to its 2016 lows in absolute terms, and relative to the emerging markets (EM) benchmark, it is not far from the lows of last decade (Chart I-1). Chart I-1Malaysian Stocks & Commodities Prices: Tight Relationship Malaysian Stocks & Commodities Prices: Tight Relationship Malaysian Stocks & Commodities Prices: Tight Relationship Odds are that a structural bottom in this bourse’s relative performance versus the EM index may have been reached. Hence, we are putting Malaysian equities on our upgrade watch list while maintaining a market-weight allocation due to tactical considerations. On the negative side, the past credit excesses have not been recognized and provisioned for by Malaysian commercial banks. The latter account for a notable 34% of the MSCI Malaysia index, and they will be a drag on this bourse's performance. Absolute performance also still hinges on global growth, commodities prices and the overall direction of Asian/EM markets. We are still negative on these parameters. Critically, there are various signs indicating an ameliorating structural backdrop in Malaysia. The country is undergoing notable improvements in the semiconductor sector, thereby reducing its dependence on commodities and increasing its exposure to a high-value industry. To capitalize on this theme of an improving structural backdrop, we are recommending an overweight position in Malaysian small-cap stocks relative to the EM universe – both the small-cap and overall equity benchmarks. Shifting Away From Commodities And Toward Electronics Parting Ways With Commodities Malaysia and its financial markets have been very exposed to commodities prices over the past 15 years or so (Chart I-1, top panel). Nevertheless, the country seems to be shifting away from its considerable reliance on the resource sector and moving into other value-added segments: in particular, semiconductors and technology. Such a structural shift – if successful – would be an extremely positive development as it would lead to rising productivity gains and higher per capita income growth. In short, the country would be able to achieve higher rates of sustainable non-inflationary growth, feeding into a sustainable bull market in Malaysian equities. Several points are noteworthy in this regard: The real output of crude and petroleum products as well as palm oil are declining sharply relative to the economy’s real total output (Chart I-2). Chart I-2Malaysia's Commodities Output Is Falling In Importance Malaysia's Commodities Output Is Falling In Importance Malaysia's Commodities Output Is Falling In Importance Exports volumes of palm oil, crude oil and natural gas have all been falling relative to Malaysia’s total overseas shipment volumes (Chart I-3). Chart I-3Commodities Export Volumes Are Declining In Relative Terms Commodities Export Volumes Are Declining In Relative Terms Commodities Export Volumes Are Declining In Relative Terms Crude oil, gas, and palm oil now account for 4%, 5%, and 7% of total exports in value terms, respectively. Crucially, not only is the importance of commodities in the overall Malaysian economy diminishing in volume terms, it is also falling in nominal terms due to low resource prices. For instance, net export revenues from fuel (i.e. crude oil, petroleum and natural gas) have fallen from US$18 billion in 2013 to US$5 billion today (Chart I-4, top panel). Chart I-4Commodities' Net Export Revenues Are Also Diminishing Commodities' Net Export Revenues Are Also Diminishing Commodities' Net Export Revenues Are Also Diminishing Meanwhile, net exports of palm oil (and other plant-based fats) have dropped from US$20 billion to US$10 billion (Chart I-4, bottom panel). Improvement In High-Value-Added Manufacturing There are also some positive structural signs taking place in the Malaysian economy that are signaling an improvement in productivity and competitiveness: Malaysian export volumes of machinery and transport equipment are expanding in absolute terms as well as relative to overall export volumes (Chart I-5, top and middle panels). Chart I-5Malaysia's Machinery Exports Are Rocking Malaysia's Machinery Exports Are Rocking Malaysia's Machinery Exports Are Rocking Remarkably, Malaysian aggregate export volumes are quickly regaining lost global market share (Chart I-5, bottom panel). Further, the ratio of exports to imports has hit a structural bottom and is slowly picking up in volume terms (Chart I-6). Chart I-6Malaysian Overall Exports Are Regaining Lost Market Share Malaysian Overall Exports Are Regaining Lost Market Share Malaysian Overall Exports Are Regaining Lost Market Share This suggests some improvements in the competitiveness of domestic industries is slowly underway. Meanwhile, Malaysian high-skill and technology intensive exports as a share of global high-tech exports seem to have made a major bottom in U.S. dollar terms and will begin to rise (Chart I-7). Chart I-7Bottom In Malaysia's High-Tech Global Share? Bottom In Malaysia's High-Tech Global Share? Bottom In Malaysia's High-Tech Global Share? Advanced education enrollment is high and improving – and is only outpaced by Korea and China in emerging Asia (Chart I-8). Importantly, Malaysia has among the best demographics of mainstream developing countries. The working age population as a share of the total population will continue to be high all the way to 2040. Chart I-8Malaysians Like Going To School Malaysians Like Going To School Malaysians Like Going To School Malaysian expenditures on R&D have also been on the rise, outpacing a lot of other countries in the region (Chart I-9, top panel). R&D expenditures in Malaysia could also be catching up to Singapore’s (Chart I-9, bottom panel). Chart I-9Malaysia's Expenditure On R&D Is Rising Malaysia's Expenditure On R&D Is Rising Malaysia's Expenditure On R&D Is Rising In line with these positives, net FDIs into Malaysia have been rising briskly (Chart I-10). Importantly, these investments have been driven by European companies, meaning the latter are transferring valuable technological know-how to Malaysia. Chart I-10Net FDIs Are Rising Net FDIs Are Rising Net FDIs Are Rising The Malaysian ringgit is cheap (Chart I-11) and has reached almost two-decade lows against many Asian currencies. This makes Malaysia increasingly more competitive. Chart I-11The Ringgit Is Cheap The Ringgit Is Cheap The Ringgit Is Cheap Finally, our colleagues from the Geopolitical Strategy team believe that the recently elected Pakatan Harapan government will improve governance and transparency, which had significantly deteriorated under Najib Razak’s rule. A Marriage To Electronics Malaysia is attempting to reestablish itself as a major semiconductor hub in the region. Remarkably, after declining for 15 years, semiconductor exports are finally rising as a share of GDP (Chart I-12) and Malaysian semiconductor exports are outperforming those of its neighbors. Chart I-12Malaysian Semiconductor Exports Are Booming Malaysian Semiconductor Exports Are Booming Malaysian Semiconductor Exports Are Booming The Malaysian government since 2010, has identified the semiconductor sector as a key area for development and prosperity. In turn, it has been introducing programs and setting up institutions to support the industry. The 2019 budget reinforces the government’s priority to develop the sector. Several anecdotal observations confirm that Malaysia is moving up the value chain in the semiconductor industry, and is going beyond simple testing and assembly: Growing the semiconductor cluster: The Malaysian Institute of Microelectronic Systems (MIMOS) has established a shared services platform for advanced analytical services in the semiconductor industry to provide support to Malaysian semiconductor companies. The Economic Industrial Design Centre (EIDC) is also providing support to SMEs in order to enhance their efficiency. Similarly, the Semiconductor Fabrication Association of Malaysia (SFAM) has been partnering with local universities to enhance their engineering programs and offer training, internships and research opportunities for students. Developing home-grown semiconductors: In 2015, Malaysian public institutions in partnership with private companies developed the Green Motion Controller (GMS), an integrated circuit that reduces energy consumption. This semiconductor is an energy efficient controller that carries applications in hybrid cars and air conditioners, among other things. Nanotechnology: NanoMalaysia – a nanotechnology commercialization agency – is providing services to SMEs and start-ups to help increase their competitiveness by enabling them to upgrade to more efficient production methods. Light-emitting Diode (LED) manufacturing: Malaysia is becoming a hub for the manufacturing of energy efficient LED chips. This is the result of OSRAM’s – a German light manufacturer – large investment in a high-tech production facility. There are early signs already that the above developments are beginning to bear results. Chart I-13 shows that the difference between exports and imports of semiconductors (in U.S. dollars) have been surging. This shows Malaysia is able to add greater value to the semiconductors it imports and then re-exports. Chart I-13Malaysia Adds Value To The Semis It Imports Malaysia Adds Value To The Semis It Imports Malaysia Adds Value To The Semis It Imports Bottom Line: Commodities are declining in importance to the Malaysian economy. Meanwhile, Malaysia’s structural backdrop is improving as the semiconductor and hardware technology segments are rising in prominence. Cyclical Weakness Despite the positive structural backdrop, Malaysia’s cyclical outlook remains challenging. Our view on commodities and global trade continues to be negative. Not only are commodities prices deflating but semiconductor prices are also falling, and their global shipments are weakening (Chart I-14). Chart I-14Cyclical Weakness In Global Semiconductor Cycle Cyclical Weakness In Global Semiconductor Cycle Cyclical Weakness In Global Semiconductor Cycle The epicenter of the global trade slowdown, however, will be in Chinese construction activity. Consequently, industrial resources prices are more vulnerable than electronics in this global growth downturn. The above deflationary forces would negatively shock Asia’s growth outlook, and consequently Malaysian growth as well: The top panel of Chart I-15 shows that Malaysian narrow money growth has already rolled over decisively and is foreshadowing weaker bank loan growth. Chart I-15Malaysian Domestic Growth Set To Weaken Malaysian Domestic Growth Set To Weaken Malaysian Domestic Growth Set To Weaken Slower bank loan growth will weaken purchasing power and impact domestic consumption. The middle panel of Chart I-15 shows that car sales – having surged this summer because of the abolishment of the GST – are weakening anew. Malaysian companies and banks have among the largest foreign currency debt loads (Table I-1). We expect more currency depreciation in Malaysia, as we do in EM overall. This will make foreign currency debt more expensive to service, and consequently dampen companies’ and banks’ appetites for expansion. Table I-1Malaysia's External Debt Breakdown Malaysia: Structural Improvements Despite Cyclical Weaknesses Malaysia: Structural Improvements Despite Cyclical Weaknesses Finally, the real estate sector remains depressed. Property volume sales are contracting and have dropped to 2008 levels, and housing construction approvals are slumping (Chart I-16). Chart I-16Malaysia's Property Sector Is Depressed Malaysia's Property Sector Is Depressed Malaysia's Property Sector Is Depressed While this means that cleansing has been taking place in the property sector, the banking sector has not recognized NPLs and remains the weakest link in the Malaysian economy. Specifically, the top panel of Chart I-17 illustrates that the NPLs in the banking system still stand at a mere 1.5%. This is in spite of the fact that since 2009, non-financial private sector credit to GDP has risen significantly. Therefore, the true level of NPLs is probably considerably higher. Chart I-17Malaysian Banks Are Under-Provisioned Malaysian Banks Are Under-Provisioned Malaysian Banks Are Under-Provisioned Further, Malaysian banks have been lowering provisions to boost profits (Chart I-17, bottom panel). This is unsustainable. As growth weakens, Malaysian banks will see their NPLs rise and will need to raise provisions. Chart I-18 demonstrates that if provisions rise by 20%, bank operating earnings will contract and bank share prices would fall. Chart I-18Malaysian Banks' Share Prices Will Fall Malaysian Banks' Share Prices Will Fall Malaysian Banks' Share Prices Will Fall Bottom Line: Malaysia’s cyclical growth outlook is still feeble, with the banking system being the weakest link. Banks’ large weight in the equity index makes this bourse still vulnerable in the coming months. Optimal Macro Policy Mix Fiscal Consolidation… Fiscal policy is set to be tighter as per the Malaysian government budget announced on November 2 and its preference to pursue fiscal consolidation to reduce the deficit. The budget projects only a slight increase in expenditures in 2019, which means it will likely slowdown from 8% currently (Chart I-19). Chart I-19Government Expenditure Growth Will Soften Government Expenditure Growth Will Soften Government Expenditure Growth Will Soften The government will also recognize public-sector liabilities not presently shown on its balance sheet and strengthen both transparency and administrative efficiency. Critically, the budget also includes strategies to support the entrepreneurial part of the economy. Overall, this budget bodes very well for the structural outlook. Yet it will not support growth cyclically. …To Be Offset By Easy Monetary Policy Despite continued currency weakness, the Malaysian monetary authorities will not be in a hurry to raise interest rates to defend the ringgit. This is in contrast with other central banks in the region like Indonesia and the Philippines. This is presently an optimal policy mix for Malaysia and is positive for the stock market’s relative performance versus its counterparts in many other EMs. Malaysia’s structural inflation is low: core inflation hovers around zero. Therefore, the central bank will neither raise interest rates nor sell its foreign exchange reserves to defend the currency. Both currency depreciation and low interest rates are needed to mitigate the downturn in exports as well as offset fiscal consolidation. In the meantime, the ringgit is unlikely to depreciate in a sudden and vicious manner but rather will likely fall gradually. First, the current account will remain in surplus, even as global trade contracts. The basis is that if Malaysian exports fall, imports will simultaneously follow. The country imports a lot of intermediate goods to then process and re-export. Second, Malaysia is unlikely to witness pronounced capital flight as occurred in 2015. The new government has increased confidence in the economy among both locals and foreigners. In addition, net portfolio investments have been negative for a while. This means that a large amount of foreign capital has exited already, reducing the risk of further outflows. What’s more, foreign ownership of local currency bonds has fallen from 33% in June 2016 to 24% today. Moreover, at 28% of market cap, foreign ownership of equities is among the lowest in EM. These also limit potential foreign selling. Bottom Line: Policymakers are adopting a wise policy mix for the economy at the current juncture: tight fiscal and easy monetary policies. This is structurally positive, even if it does not preclude cyclical weakness. Investment Conclusions Weighing structural positives versus the cyclical growth weakness and the unhealthy banking system, we are maintaining a market-weight allocation to Malaysian stocks within the EM universe, but are placing this bourse on our upgrade watch list. We need to see a selloff in bank stocks before we upgrade it to overweight. Within Malaysian equities, we recommend shorting/underweighting banks and going long/overweighting small cap stocks. To capitalize on Malaysia’s improving structural growth outlook, we recommend buying Malaysian small caps, but hedging positions by shorting the EM aggregate or small-cap indexes. The ringgit is poised to depreciate further versus the U.S. dollar along with other EM/Asian currencies. We continue to short the ringgit versus the greenback. With respect to sovereign credit and local government bonds, dedicated portfolios should currently have a market-weight allocation. The negative cyclical growth outlook is offset by the right macro policy mix and improving growth potential.   Ayman Kawtharani, Associate Editor ayman@bcaresearch.com​​​​​​​ Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Downside risks to EM assets remain substantial. Stay put. EM stocks, credit and currencies will underperform their DM counterparts in the first half of 2019. The key and necessary condition for a new secular EM bull market to emerge is the end of abundant financing. The latter is imperative to compel corporate restructuring, bank recapitalization as well as structural reforms. The cyclical EM outlook hinges on China’s business cycle. The slowdown in China is broad-based and will deepen. The slowdown in China/EM will likely lead to global trade contraction. The latter is negative for global cyclicals yet bullish for the U.S. dollar. Feature As we head into 2019, the past decade is shaping up to be a lost one for emerging markets (EM) assets. In particular: EM stocks have underperformed DM markets substantially since the end of 2010 (Chart I-1). In absolute terms, EM share prices are at the same level as they were in early 2010. Chart I-1EM Equities Have Been Underperforming DM For Eight Years EM Equities Have Been Underperforming DM For Eight Years EM Equities Have Been Underperforming DM For Eight Years EM currencies have depreciated substantially since 2011, and the EM local currency bond index (GBI-EM) on a total-return basis has produced zero return in U.S. dollar terms since 2010 (Chart I-2). Chart I-2A Lost Decade For Investors In EM Local Currency Bonds? A Lost Decade For Investors In EM Local Currency Bonds? A Lost Decade For Investors In EM Local Currency Bonds? Finally, EM sovereign and corporate high-yield bonds have not outperformed U.S. high-yield corporate bonds on an excess-return basis. Will 2019 witness a major reversal of such dismal EM performance? And if so, will it be a structural or cyclical bottom? The roots underneath this lost decade for EM stem neither from trade wars nor from Federal Reserve tightening. Therefore, a structural bottom in EM financial markets is contingent neither on the end of Fed tightening nor the resolution of current trade tussles. We address the issues of Fed tightening and trade wars below. A Lost Decade: Causes And Remedies What led to a lost decade for EM was cheap and plentiful financing. When the price of money is low and financing is abundant, companies and households typically rush to borrow and spend unwisely. Capital is misallocated and, consequently, productivity and real income growth disappoint – and debtors’ ability to service their debts worsens. This is exactly what has happened in EM, as easy money splashed all over developing economies since early 2009. There have been three major sources of financing for EM: Source 1: Chinese Banks Chinese banks have expanded their balance sheets by RMB 198 trillion to RMB 262 trillion (or the equivalent of $28.8 trillion) over the past 10 years (Chart I-3, top panel). When commercial banks expand their balance sheets by lending to or buying an asset from non-banks, they create deposits (money). Consistently, the broad money supply has expanded by RMB 175 trillion to RMB 234 trillion (or the equivalent of $25.5 trillion). Chart I-3Enormous Boom In Chinese Banks' Assets And Money Supply Enormous Boom In Chinese Banks' Assets And Money Supply Enormous Boom In Chinese Banks' Assets And Money Supply Notably, the People’s Bank of China (PBoC) has increased commercial banks’ excess reserves by RMB 1.5 trillion to RMB 2.8 trillion (or the equivalent of $0.22 trillion) (Chart I-3, bottom panel). Hence, the meaningful portion of money supply expansion has been due to the money multiplier – money created by mainland banks – not a provision of excess reserves by the PBoC (Chart I-4). Chart I-4Attribution Of Rise In Money Supply To Excess Reserves And Money Multiplier Attribution Of Rise In Money Supply To Excess Reserves And Money Multiplier Attribution Of Rise In Money Supply To Excess Reserves And Money Multiplier Not only has such enormous money creation by commercial banks generated purchasing power domestically, but it has also boosted Chinese companies’ and households’ purchases of foreign goods and services. The Middle Kingdom’s imports of goods and services have grown to $2.5 trillion compared with $3.2 trillion for the U.S. (Chart I-5). China’s spending has boosted growth considerably in many Asian, Latin American, African, Middle Eastern, and even select advanced economies. Chart I-5Imports Of Goods And Services: China And The U.S. Imports Of Goods And Services: China And The U.S. Imports Of Goods And Services: China And The U.S. Source 2: DM Central Banks’ QE By conducting quantitative easing, the central banks of several advanced economies have crowded out investors from fixed-income markets, incentivizing them to search for yield in EM. The Fed, the Bank of England, the European Central Bank and the Bank of Japan have in aggregate expanded their balance sheets by $10 trillion (Chart I-6). Chart I-6Quantitative Easing In DM Quantitative Easing In DM Quantitative Easing In DM This has led to massive inflows of foreign portfolio capital into EM, and reflated asset prices well beyond what was warranted by their fundamentals. Specifically, since January 2009, foreign investors have poured $1.5 trillion on a net basis into the largest 15 developing countries excluding China, Taiwan and Korea (Chart I-7, top panel). For China, net foreign portfolio inflows amounted to $560 billion since January 2009 (Chart I-7, bottom panel). Chart I-7Cumulative Foreign Portfolio Inflows Into EM And China Cumulative Foreign Portfolio Inflows Into EM And China Cumulative Foreign Portfolio Inflows Into EM And China Source 3: EM Ex-China Banks EM ex-China began expanding their balance sheets aggressively in early 2009, originating new money (local currency) and thereby creating purchasing power. This was especially the case between 2009 and 2011. Since that time, money creation by EM ex-China banks has decelerated substantially due to periodic capital outflows triggering currency weakness and higher borrowing costs. Out of these three sources, China’s money/credit cycles remain the primary driver of EM. The mainland’s imports from developing economies serves as the main nexus between China and the rest of EM. Essentially, Chinese money and credit drive imports, influencing growth and corporate profits in the EM universe (Chart I-8). Chart I-8China's Credit Cycle Leads Its Imports China's Credit Cycle Leads Its Imports China's Credit Cycle Leads Its Imports In turn, EM business cycle upturns attract international capital. Meanwhile, credit creation by local banks in EM ex-China – primarily in economies with high inflation or current account deficits – is a residual factor. In these countries, domestic credit creation is contingent on a healthy balance of payments and a stable exchange rate. The latter two, in turn, transpire when exports to China and international portfolio capital inflows are improving. The outcome of easy financing is over-borrowing and capital misallocation. The upshot of the latter is usually lower efficiency and productivity growth. Not surprisingly, productivity growth in both China and EM ex-China has decelerated considerably since 2009 (Chart I-9). EM return on assets has dropped a lot in the past 10 years and is now on par with levels last seen during the 2008 global recession (Chart I-10). Chart I-9Falling Productivity Growth In EM And China =... Falling Productivity Growth In EM And China =... Falling Productivity Growth In EM And China =... Chart I-10... = Low Profit Margins And Low Return On Capital ... = Low Profit Margins And Low Return On Capital ... = Low Profit Margins And Low Return On Capital Accordingly, the ability to service debt by EM companies has deteriorated considerably in the past decade – the ratios of cash flows from operations to both interest expenses and net debt have dropped (Chart I-11). Chart I-11EM: Deteriorating Ability To Service Debt EM: Deteriorating Ability To Service Debt EM: Deteriorating Ability To Service Debt These observations offer unambiguous confirmation that money has been spent inefficiently – i.e., misallocated. Credit booms and capital misallocations warrant a period of corporate restructuring and banking sector recapitalization. Without this, a new cycle cannot emerge. A secular bull market in equities and exchange rates arises when productivity growth and hence income-per-capita growth accelerates, and return on capital begins to climb. This is not yet the case for most developing economies. The end of cheap and abundant financing is imperative to compel corporate restructuring, bank recapitalization as well as structural reforms. These are necessary conditions to create the foundation for a new secular bull market. Ironically, the best remedy for an addiction to easy money is a period of tight money. For example, U.S. share prices would not be as high as they currently are if the U.S. did not go through the Lehman crisis. This 10-year bull market in U.S. equities was born from the ashes of the Lehman crisis. Vanished financing and the private sector’s tight budgets in 2008-‘09 compelled corporate restructuring as well as a focus on efficiency and return on equity. Has EM financing become scarce and tight? Cyclically, China’s money creation and credit flows have slowed, pointing to a cyclical downturn in EM share prices and commodities (please see below for a more detailed discussion). International portfolio flows to EM have also subsided since early this year. There has been selective corporate restructuring post the 2015 commodities downturn, including in the global/EM mining and energy sectors, China steel and coal industries as well as among Russian and Brazilian companies. However, there are many economies and industries where corporate restructuring, bank recapitalization and structural reforms have not been undertaken. Yet from a structural perspective, China’s money and credit growth remain elevated and excesses have not been purged. Besides, international portfolio flows to EM have had periodic “stop-and-gos” but have not yet retrenched meaningfully (refer to Chart I-7 on page 4). Consequently, structural overhauls and corporate restructuring in China/EM have by and large not yet occurred – in turn negating the start of a new secular bull market. Bottom Line: Conditions for a structural bull market in EM/China are not yet present. EM/China: A Cyclical Bottom Is Not In Place From a cyclical perspective, China is an important driving force for the majority of EM economies, and its deepening growth slowdown will continue to weigh on EM growth and global trade. In fact, odds are that global trade will contract in the first half of 2019: In China, tightening of both monetary policy as well as bank and non-bank regulation from late 2016 has led to a deceleration in money and credit growth. The latter has, with a time, lag depressed growth since early this year. Policymakers have undertaken some stimulus since the middle of this year, but it has so far been limited. Stimulus also works with a time lag. Besides, even though the broad money impulse has improved, the credit and fiscal spending impulse remains in a downtrend (Chart I-12). Therefore, there are presently mixed signals from money and credit. Chart I-12China's Stimulus Leads EM And Commodities China's Stimulus Leads EM And Commodities China's Stimulus Leads EM And Commodities As illustrated in Chart I-12, the bottoms in the money and combined credit and fiscal spending impulses, in July 2015, preceded the bottom in EM and commodities by six months and their peak led the top in financial markets by about 15 months in January 2018. Besides, in 2012-‘13, the rise in the money and credit impulses did not do much to help EM stocks or industrial commodities prices. Hence, even if the money as well as credit and fiscal impulses bottom today, it could take several more months before the selloff in EM financial markets and commodities prices abates. Additionally, the ongoing regulatory tightening of banks and non-bank financial institutions will hinder these institutions' willingness and ability to extend credit, despite lower interest rates. We discussed in a recent report that both the effectiveness of the monetary transmission mechanism and the time lag between policy easing and a bottom in the business cycle are contingent on the money multiplier (creditors' willingness to lend, and borrowers' readiness to borrow) and the velocity of money (the marginal propensity to spend among households and companies). Growth in capital spending in general and construction in particular have ground to a halt (Chart I-13). Chart I-13China: Weak Capital Spending China: Weak Capital Spending China: Weak Capital Spending Not only has capital spending decelerated but household consumption has also slowed since early this year, as demonstrated in the top panel of Chart I-14. Chart I-14China: A Broad-Based Slowdown China: A Broad-Based Slowdown China: A Broad-Based Slowdown Finally, mainland imports are the main channel in terms of how China’s growth slowdown transmits to the rest of the world. Not surprisingly, EM share prices and industrial metals prices correlate extremely well with the import component of Chinese manufacturing PMI (Chart I-15). Chart I-15China's Imports And EM And Commodities China's Imports And EM And Commodities China's Imports And EM And Commodities Bottom Line: The slowdown in China is broad-based, and our proxies for marginal propensity to spend by households and companies both point to further weakness (Chart I-14, middle and bottom panels). Constraints And Chinese Policymakers’ Dilemma Given the ongoing slowdown in the economy, why are Chinese policymakers not rushing to the rescue with another round of massive stimulus? First, policymakers in China realize that the stimulus measures of 2009-‘10, 2012-‘13 and 2015-‘16 led to massive misallocations of capital and fostered both inefficiencies and speculative excesses in many parts of the economy – the property markets being among the main culprits. Indeed, policymakers recognize that easy money does not foster productivity growth, which is critical to the long-term prosperity of any nation. For China to grow and prosper in the long run, the economy’s addiction to easy financing should be curtailed. Second, policymakers are currently facing a dilemma. The real economy is saddled with enormous debt and is slowing. This warrants lower interest rates – probably justifying bringing down short-term rates close to zero. Yet, despite enforcing capital controls, it seems the exchange rate has been correlated with China’s interest rate differential with the U.S. since early 2010 (Chart I-16). Given the ongoing growth slowdown and declining return on capital in China, there are rising pressures for capital to exit the country. Notably, the PBoC’s foreign exchange reserves of $3 trillion are only equivalent to 10-14% of broad money supply (i.e., all deposits in the banking system) (Chart I-17). Chart I-16Chinese Currency And Interest Rates Chinese Currency And Interest Rates Chinese Currency And Interest Rates Chart I-17China: Foreign Currency Reserves Are Very Low Compared To Money Supply/Deposits China: Foreign Currency Reserves Are Very Low Compared To Money Supply/Deposits China: Foreign Currency Reserves Are Very Low Compared To Money Supply/Deposits The current interest rate differential is only 33 basis points. If the PBoC guides short-term rates lower and the Fed stays on hold or hikes a few more times, the spread will drop to zero or turn negative. Based on the past nine-year correlation, the narrowing interest rate spread suggests yuan depreciation. This will weigh on EM and probably even global risk assets. In a scenario where policymakers prioritize defending the yuan’s value, they may not be able to reduce borrowing costs and assist indebted companies and households. As a result, the downtrend in the real economy would likely worsen. Consequently, EM and global growth-sensitive assets will drop further. Given the constraints Chinese policymakers are facing, reducing interest rates and allowing the yuan to depreciate further is the least-bad outcome. Yet this will rattle Asian and EM currencies and risk assets. What About The Fed And Trade Wars? The Fed and EM: Fed policy and U.S. interest rates are relevant to EM, but they are of secondary importance. The primary driver of EM economies are their own domestic fundamentals as well as global trade – not just U.S. growth. Historically, the correlation between EM risk assets and the fed funds rate has been mixed, albeit more positive than negative (Chart I-18). On this chart, we have shaded the five periods over the past 38 years when EM stocks rallied despite a rising fed funds rate. Chart I-18The Fed And EM Share Prices: A Historical Perspective The Fed And EM Share Prices: A Historical Perspective The Fed And EM Share Prices: A Historical Perspective There were only two episodes when EMs crashed amid rising U.S. interest rates: the 1982 Latin American debt crisis and the 1994 Mexican Tequila crisis. Yet it is vital to emphasize that these crises occurred because of poor EM fundamentals – elevated foreign currency debt levels, negative terms-of-trade shocks, large current account deficits and pegged exchange rates. Dire EM fundamentals also prevailed before the Asian/EM crises of 1997-1998. However, these late-1990s crises occurred without much in the way of Fed tightening or rising U.S. bond yields. Trade Wars: China’s current growth slowdown has not originated from a decline in its exports. In fact, Chinese aggregate exports and those to the U.S. have been growing at a double-digit pace, largely due to the front running ahead of U.S. import tariffs. More importantly, China’s exports to the U.S. and EU account for 3.8% and 3.2% of its GDP, respectively (Chart I-19). Total exports amount to 20% of GDP, with almost two-thirds of that being shipments to developing economies. This compares with capital spending that makes up 42% of GDP and household consumption of 38% of GDP. Hence, capital expenditures and household spending are significantly larger than shipments to the U.S. Chart I-19Structure Of Chinese Economy Structure Of Chinese Economy Structure Of Chinese Economy There is little doubt that the U.S.-China confrontation has affected consumer and business sentiment in China. Nevertheless, the slowdown in China has - until recently - stemmed from domestic demand, not exports. Investment Recommendations It is difficult to forecast whether the current EM down leg will end with a bang or a whimper. Whatever it is, the near-term path of least resistance for EM is to the downside. “A bang” scenario – where financial conditions tighten substantially and for an extended period – would likely compel corporate and bank restructuring as well as structural reforms. Therefore, it is more likely to mark a structural bottom in EM financial markets. “A whimper” scenario would probably entail only moderate tightening in financial conditions. Thereby, it would not foster meaningful corporate restructuring and structural reforms. Hence, such a scenario might not mark a secular bottom in EM stocks and currencies. In turn, the EM cyclical outlook hinges on China’s business cycle. If and when Chinese policymakers reflate aggressively, the mainland business cycle will revive, producing a cyclical rally in EM risk assets. At the moment, Chinese policymakers are behind the curve. With respect to investment strategy, we continue to recommend: Downside risks to EM assets remain substantial. Stay put. EM stocks, credit and currencies will underperform their DM counterparts in the first half of 2019. The slowdown in China/EM will likely lead to global trade contraction. The latter is negative for global cyclicals yet bullish for the U.S. dollar. For dedicated EM equity portfolios, our overweights are: Brazil, Mexico, Chile, Colombia, Russia, central Europe, Korea and Thailand. Our underweights are: South Africa, Peru, Indonesia, India, the Philippines and Hong Kong stocks. We are neutral on the remaining bourses. In the currency space, we continue to recommend shorting a basket of the following EM currencies versus the U.S. dollar: ZAR, CLP, IDR, MYR and KRW. The latter is a play on RMB depreciation. The full list of our recommendation across EM equity, fixed-income, currency and credit markets is available on pages 14-15. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights The Reserve Bank of Australia (RBA) may consider a rate hike in 2019 if additional tightening of labor markets leads to higher wage inflation, which would help lift core inflation back to the midpoint of the RBA’s 2-3% target band.  Reflation in China could also embolden the RBA to tighten monetary policy – though the odds of a more aggressive stimulus package will decline as long as China’s overall economy remains stable and the U.S. maintains its tariff ceasefire. The Labor Party is favored to win the federal election, which is most likely to occur in May. This is a low-conviction view, as polls are tight and economic improvement will help the ruling Liberal-National Coalition. Feature 2018 has been a challenging year for global financial markets, as investors have had to deal with greater economic uncertainty, less dovish central banks and more volatile asset prices. One country that has bucked the trend to some degree is Australia. The nation has famously avoided a recession since 1991 and last saw a tightening of monetary policy in 2010. While the recession streak is unlikely to be broken in 2019, there are growing risks that the era of interest rate tranquility will soon end. In this Special Report, jointly published with our colleagues at BCA Geopolitical Strategy, we update our views on Australia for 2019 – a year when the investment backdrop has the potential to become far more interesting, and volatile, due to election year uncertainty and a potential shift to a more hawkish bias for monetary policy. The Bond Outlook: What To Watch To Turn Bearish BCA Global Fixed Income Strategy has maintained an overweight stance on Australian government bonds since the end of 2017. That high-conviction view stemmed from our expectation that the Reserve Bank of Australia (RBA) would keep policy rates on hold for longer due to sluggish economic growth and underwhelming inflation. This recommendation has performed well, with Australian government bonds returning 2.4% (currency-hedged into U.S. dollars) in 2018 year-to-date, beating the Bloomberg Barclays Global Treasury index by 190bps. The benchmark 10-year Australian government is now yielding 36bps below the equivalent 10-year U.S. Treasury yield, the tightest spread since 1980 (Chart 1). Chart 1Australian Bonds Have Outperformed Australian Bonds Have Outperformed Australian Bonds Have Outperformed Looking ahead, we still have a positive opinion on Australian debt relative to its global peers over the next six months. The RBA is unlikely to make any adjustments to the Cash Rate - which remains at a highly-accommodative level of 1.5% - without seeing some signs of accelerating inflation in both the Q4 2018 and Q1 2019 CPI reports. This is especially true given the political uncertainty with another federal election due by May 18,1 which could change the outlook for fiscal policy (as we discuss later in this report) and impact the RBA’s economic projections. In our view, the RBA will only be able to seriously consider an interest rate hike, warranting a downgrade of our recommended overweight stance, if all three of the following conditions occur: Australia’s underemployment rate falls below 8% China’s economy shows convincing evidence of reacceleration, especially in commodity-intensive industries like construction Core CPI inflation rises back to at least the midpoint of the RBA’s 2-3% target band We will now discuss each of these in turn. Underemployment Australia is a fairly open economy with a large export sector, but consumer spending is still the largest share of GDP (60%) so it matters most for growth. On that front, real consumption has grown in a narrow and uninspiring range between 2-3% over the past five years. Anemic wages and disposable incomes have been the problem, with the growth of both (in nominal terms) struggling to grow faster than low realized inflation, which now sits below the RBA’s inflation target range of 2-3% (Chart 2). Households have been forced to deploy a greater share of that modest income growth just to maintain spending, with the savings rate plunging from 8% at the end of 2014 to 1% this year and consumer debt piling up. Chart 2An Income-Fueled Pickup In Consumer Spending An Income-Fueled Pickup In Consumer Spending An Income-Fueled Pickup In Consumer Spending The dynamics may be changing in a more positive direction, however. Growth rates of nominal wage (+2.3%) and disposable income (+3.1%) have accelerated this year to a pace faster than inflation. With real incomes perking up, the year-over-year growth rate of real consumer spending growth accelerated to 3% in Q3/2018, driving real GDP growth to similar levels. A sustained pickup in wage growth is necessary before the RBA would even contemplate a rate hike. For that to occur, there must be decisive evidence of a tightening Australian labor market and increased resource utilization. While the headline unemployment rate of 5.0% is below the OECD’s estimate of the full employment NAIRU for Australia (5.3%), broader measures of labor market slack are still at elevated levels. Specifically, the “underemployment” rate, which includes workers who are working fewer hours than they would like or at jobs below their skill levels, is still at an elevated 8.3% (Chart 3). That is down from the peak of just below 9% seen in early 2017, but well above the 2012 trough near 7% (when wage growth was close to 4%).  Chart 3UNDERemployment Rate Matters More For Australian Wages UNDERemployment Rate Matters More For Australian Wages UNDERemployment Rate Matters More For Australian Wages Australian wage growth tends to correlate more with the underemployment rate than the traditional unemployment rate (middle panel). This suggests that the recent blip higher in wage growth could be the beginning of a new trend, given that it has occurred alongside the recent drop in underemployment. Already, underemployment is back below the levels that prevailed when the RBA did its last interest rate cut back in 2016 (bottom panel).  A further dip lower in the underemployment rate to below the 8% threshold would likely confirm that wage growth has more upside. That outcome would give the RBA greater confidence that consumer spending will gain more strength even with a low savings rate, and that CPI inflation will return back into the target range – both outcomes that would justify some removal of the RBA’s highly stimulative monetary accommodation. China Stimulus The main connection from China’s economy to Australia is through Chinese demand for Australian exports. There is also an indirect, but very important, link between Chinese demand boosting industrial commodity prices. The latter boosts Australian growth through positive terms-of-trade effects and increased capital spending in commodity-related sectors like mining. Iron ore is the most important of those commodities, representing 18% of total Australian goods exports, with 85% of those iron ore exports going to China. Australian export growth has decelerated during 2018 from the very robust 15% year-over-year pace to a still solid 10% rate. This has mirrored the trends seen in many other economies, where exports have slowed alongside diminished demand from China. If Chinese authorities change their current policy trajectory, and embrace more aggressive fiscal and credit stimulus, then they will reaccelerate the country’s flagging demand, which should benefit Australian exporters. If the increase in spending occurs in commodity-intensive parts of China’s economy, like construction, then Australia can also benefit from a terms-of-trade impact if commodity prices rise. However, BCA’s Geopolitical Strategy and China Investment Strategy remain skeptical that China will launch a major economic stimulus package along the lines of what occurred in 2015-16. That surge not only boosted Chinese GDP and import demand but also triggered a boost to global industrial commodity prices that benefitted many commodity exporters, including Australia. In recent months, there has been a pickup in overall Chinese import growth, as well as some acceleration of higher frequency growth indicators like the Li Keqiang index (Chart 4). Australian exports to China have not picked up though, and Chinese iron ore imports are contracting. Part of that is due to the elevated levels of Chinese iron ore inventories. More likely, there is little demand for additional iron ore given China’s reform agenda and the struggles of its construction sector (which accounts for roughly 35% of Chinese steel demand). Chart 4China Stimulus Not Helping Australia...Yet? China Stimulus Not Helping Australia...Yet? China Stimulus Not Helping Australia...Yet? Our colleagues at BCA China Investment Strategy2 have noted that both weakening sales and tighter funding sources for real estate developers point to declining growth in property starts and construction. This will be negative for construction-related commodity markets and construction-related machinery. This is coming at a time when the Chinese government is trying specifically to address over-indebted industries like construction. As for the U.S.-China trade truce, a permanent de-escalation of tensions – which has not yet occurred – could provide a boost to Australian export demand, as with other export-focused countries. But the negative impact of bilateral U.S.-China tariffs on the global economy is much smaller than that of China’s attempt to limit indebtedness. Moreover, a trade truce will remove China’s primary incentive to adopt more aggressive stimulus. Nevertheless, from the RBA’s perspective, any boost to China’s construction-related activity would have a big impact on Australia’s economy and would strengthen the case for a rate hike in 2019.  Core Inflation Australia’s headline CPI inflation has struggled to hit even the bottom end of the RBA’s 2-3% target band since 2015, reaching only 1.9% in Q3 of this year (Chart 5). The story is even worse for inflation excluding food and energy, with core CPI inflation now only at 1.2% after having drifted lower in two consecutive quarters. Both market-based and survey-based measures of inflation expectations are also hovering near 2%. Chart 5Australian Inflation Well Below RBA Target Australian Inflation Well Below RBA Target Australian Inflation Well Below RBA Target When breaking down the CPI into tradeables (i.e. more globally-focused) and non-tradeables (i.e. more domestically-focused), the two types of inflation have not been accelerating at the same time since the 2009-11 period. Since then, faster tradeables inflation has occurred alongside slowing non-tradeables inflation, and vice versa.  While volatility on the tradeables side should be expected given the correlation to swings in commodity prices and the Australian dollar, the weakness in non-tradeables is more directly related to the spare capacity in the domestic economy. Therefore, if wage growth continues to pick up as the labor market tightens, then non-tradeables inflation should follow suit and boost Australian CPI inflation back towards the RBA target range. The implication for the RBA is that a move in core CPI inflation back towards 2.5% (the midpoint of the RBA band), occurring after an acceleration in wage growth as described above, would give the central bank confidence that a higher Cash Rate is required. Bottom Line: The RBA has kept interest rates on hold for over two years, but may consider a rate hike in 2019 if additional tightening of labor markets leads to higher wage inflation, which would help lift core inflation back to the midpoint of the RBA’s 2-3% target band. A more aggressive fiscal and monetary stimulus package in China, while not our base case, would also embolden the RBA to tighten monetary policy. Risks From Australian Banks? Throughout 2018, the Australian financial industry has had to endure the slings and arrows of a government inquiry into its questionable business practices and misconduct. Revelations of bribery, fraud, the charging of fees for no service and from the accounts of deceased people, as well as board-level deception of regulators, have roiled Australia's financial sector since the explosive inquiry began in February. The final report of the Australian Financial Services Royal Commission will be published in February, but the impact is already being felt throughout the industry. Bank CEOs have been publically shamed, while other senior financial sector executives have been forced from their jobs. The chairman of National Australia Bank stated before the inquiry that customers’ trust in lenders had been “pretty well eroded to zero”, and that it could take as long as a decade to successfully overhaul the culture within the banks. The biggest impacts from the Commission will come through hits to banks’ earnings and funding costs, as well as the potential impact on lending standards for new loans. Australian banks will be less profitable because of fines, customer refunds, setting aside provisions for potential misconduct penalties and the government wanting increased competition. If banks also choose to be more conservative with the marking of loans, then higher loan-loss provisions could be an additional drag on bank earnings. Already, Australian bank stocks have severely underperformed the overall domestic market, and there has been some slowing of domestic credit growth (Chart 6). There are also signs of bank funding stresses from contracting bank deposit growth (second panel) and wider offshore funding costs like relatively elevated LIBOR-OIS spreads (bottom panel). Considering how heavily Australian banks rely on offshore funding, any squeeze in those markets could severely influence the availability of credit within the Australian economy. Chart 6Australian Banks Under Some Stress... Australian Banks Under Some Stress... Australian Banks Under Some Stress... Looking ahead, if banks do tighten up their lending standards in response to the criticism and findings of the Commission, that will be from a starting point of very accommodative levels. In other words, getting a loan will likely still be “easy”, rather than “incredibly easy”. The reason is that Australian bank balance sheets remain in excellent condition. Credit crunches begin when banks are undercapitalized and are forced to retrench new loan activity as losses on existing loans pile up. That is not the case in Australia, where the major banks have Tier 1 capital ratios in the 10-12% range and non-performing loans are a tiny share of total lending. In our view, a true credit crunch would likely only occur after the Australian housing bubble bursts and the economy enters a severe downturn. That outcome would most likely be triggered by monetary policy tightening via multiple RBA rate hikes. Importantly, some of the steam has already been taken out of Australian house prices thanks to changes in regulations on new lending (Chart 7), potentially reducing some of the immediate risks to growth from a sharp plunge in home values.  Chart 7...But No Credit Crunch Expected ...But No Credit Crunch Expected ...But No Credit Crunch Expected Bottom Line: In 2019, the Australian government and its key financial regulators will have to work together to enforce responsible lending without triggering a catastrophic property market unwind. RBA policymakers are less likely to hike rates given their desire to maintain financial stability in the aftermath of the Commission – or at least until the inflation story forces their hand, as outlined in this report. The Federal Election: Polling Slightly Favors Labor Scandals in the financial sector are of utmost importance to the other major factor that could make 2019 a year of significant change in Australia: the federal election that looms most likely in the spring. Parliament is balanced on a knife’s edge, with the Australian Liberal Party’s loss of former Prime Minister Malcolm Turnbull’s parliamentary seat in a Sydney by-election on October 20. The ruling Liberal-National Coalition no longer has a majority and must rely on independent MPs to survive any no-confidence vote. This precarious situation suggests that the election could come even sooner than May and that the slightest twist in the campaign could deliver at least a small majority to either of the top two parties. Indeed, at this early stage, a high-conviction view on the election outcome is not warranted. After all, the 2016 election was decided in the Coalition’s favor only after a shift in opinion in the final month! Chart 8Labor Party Narrowly Leads All-Party Opinion Polls A Year Of Change In Australia? A Year Of Change In Australia? Nevertheless, with all due caveats, our baseline case is for a Labor majority in 2019, however slim it may be.3 Labor is slightly ahead of the Coalition in the primary opinion polling, which includes all parties (Chart 8). In two-party preference polling, Labor has gradually widened its general lead since the July 2016 election and now holds a 10% advantage in the federal polls – albeit only a 6% lead when a moving average is taken (Chart 9). Labor is also winning or tied in every major state. Chart 9Labor Has Large Lead In Two-Party Preference Polls A Year Of Change In Australia? A Year Of Change In Australia? The dramatic shift in polling since August is significant because that is when the knives came out and the Coalition ousted Turnbull in favor of the current Prime Minister Scott Morrison. The purpose of this move was to give the party a facelift ahead of the election. It is true that public opinion views Morrison as the preferred prime minister to Labor’s Bill Shorten. Shorten has a negative net approval rating and has never been viewed as an inspiring politician, while Morrison is just barely net positive. This perception works against Labor’s lead in the party polling – which is very competitive anyway – and suggests the election will be close. Critically, the Liberal-National Coalition’s polling as a whole has not benefited from the change in leadership. And in fact the data does not support the two major Australian parties’ abiding belief that a leadership coup will boost their popularity: Australia has seen four of these coups since 2010, two from Labor and two from the Coalition, and the party in question lost an average of 8% of the popular vote and 14 seats in parliament in the succeeding election (Table 1). Table 1Intra-Party Coups Don’t Win Votes A Year Of Change In Australia? A Year Of Change In Australia? Turnbull’s ouster also calls attention to another detrimental factor for the Coalition: the challenge on the right flank from minor and anti-establishment parties. Pauline Hanson’s One Nation has a relatively low support rate both historically and in today’s race, currently at 8%, but anti-establishment feeling may have forced the Coalition into an error. Judging by the party’s weak polling since August, the negative response to Turnbull’s ouster has been more detrimental than the nomination of Morrison, an immigration hardliner and social conservative, has been beneficial. Meanwhile, Labor’s momentum has been corroborated by a string of surprise victories in by-elections and a sweeping win in the Victoria state elections on November 24. In the latter case, the party not only defended its hold on government, as one might expect in this progressive state, but exceeded expectations to win 56 seats out of 88 in the lower House, while the Coalition lost nearly half of its seats, falling from 37 to 21. Still, Labor’s lead is by no means decisive. In the average of the various primary polls its edge over the Coalition is within the margin of error. Moreover, the Coalition holds more “safe” (uncompetitive) seats than Labor.4 The bottom line is that a small swing in either party’s favor can produce a thin majority. The Coalition’s best case is the economy. But as concerns about unemployment and job creation recede, voters will make other demands. The top issues in recent polling are the cost of living, health care, housing affordability, and wages. Some polls also emphasize social mobility and climate change and renewable energy. Will Shorten’s Labor Party be able to capture the median voter? It is highly significant that the party has taken a rightward turn on immigration and taxes even as it holds out a more left-wing agenda on health, education, regulation, and social benefits. Immigration has played a major role in Australian politics and Labor is currently positioned near the political center – in other words, if Morrison hardens his line to guard against populists, he risks over-hardening and moving away from the median voter (Chart 10). Shorten has proposed a large bipartisan task force to determine the proper limits to immigration and how to deal with congestion and infrastructure pressures. Shorten’s platform also calls attention to abuse of temporary visas by foreign workers. Chart 10Labor Is Not Too Soft On Immigration A Year Of Change In Australia? A Year Of Change In Australia? On taxes, Shorten has attempted to separate small and big companies, again in a bid for the political center. When Prime Minister Morrison sought to establish his anti-tax credentials (Chart 11), Shorten met him halfway and proposed relief for middle class families and small and medium-sized enterprises. Yet he doubled down on higher taxes for multinational corporations and high-income earners. Chart 11Liberal-National Coalition Cutting Corporate Tax Rates A Year Of Change In Australia? A Year Of Change In Australia? Critically, the latter redistributive stances are more in line with the median voter than the Liberal Party’s more conservative, supply-side, tax cut agenda. All of Australia’s parties, including the increasingly popular “minority parties,” have a more favorable attitude toward redistribution than the Coalition, which is the outlier (Chart 12). Indeed, the National Party is closer in line with the others than the Liberals, highlighting the divisions within the Coalition that have been jeopardizing votes. As for tax cuts on middle income earners and small businesses, Labor’s acceptance of them speaks to voter concerns about living costs, jobs, and wages. Chart 12The Coalition Is Out Of Synch On Taxes A Year Of Change In Australia? A Year Of Change In Australia? Labor is also closer to the median voter on the aforementioned financial sector scandals. The Coalition stands to suffer because it has developed a reputation for being too cozy with the banks (Chart 13). This is one of the biggest perceived differences between the two major parties – in addition to the negative perception of intra-Coalition betrayal – and it is possibly one of the most salient issues in the election. This presents a serious danger for the Coalition. Chart 13Banks: The Coalition’s Ball And Chain A Year Of Change In Australia? A Year Of Change In Australia? What would a Labor government bring? The market will be jittery about Shorten’s attempts to increase tax revenue, which threatens a non-negligible tightening of fiscal policy. Shorten wants to raise taxes on high income earners; remove or lower deductions and discounts (such as on capital gains); crack down on tax evasion; and tighten control over a range of tax practices specific to Australia (limiting “negative gearing” and cutting cash refunds for “franking credits”). He is also taking a tough position on banks and the energy sector. At the same time, it is clear from Labor’s proposals in 2016 (Chart 14) that there will be a hefty amount of new spending coming down the pike if a Labor government is formed – primarily on education, health, infrastructure and job training. The tax cuts that Shorten does support will go to those with a higher propensity to consume, as well as to SMEs that are responsible for job creation. Chart 14Labor’s Spending Plans Unlikely To Change Much A Year Of Change In Australia? A Year Of Change In Australia? Ultimately, Australia’s recent history, taken in consideration with the global business cycle, does not suggest that the Labor Party is all that much more fiscally profligate than the Coalition – but the current budget balance does suggest that there is substantial room to increase deficits, which is convenient for a government that is predisposed to give voters more services (Chart 15). Hence fiscal easing is the path of least resistance - one that could make the RBA even more comfortable in raising interest rates if the conditions laid out earlier in this report come to pass. Chart 15Australia's Next Government Will Have Room To Spend! Australia's Next Government Will Have Room To Spend! Australia's Next Government Will Have Room To Spend! Bottom Line: The Australian Labor Party is slightly favored to win the next Australian election. This is a low-conviction call given the tight competition in public opinion polling and other mixed indicators. Broadly speaking, Labor’s shift to the political center on immigration and some tax issues makes the party more electable relative to the Coalition; meanwhile its promise of more government services fits with voter demands. We do not accept the narrative that Shorten’s Labor Party will engage in substantial fiscal tightening. The path of least resistance is for tax cuts as well as revenue collection, and for greater government spending. On the other hand, if the Coalition capitalizes on the incumbent advantage and stays in power, larger tax cuts will be in store. Hence we expect Australia to see marginally larger-than-expected budget deficits and fiscal thrust as the one reliable takeaway of next year’s election. Fixed Income Investment Implications We continue to recommend an overweight stance on Australian government bonds in currency-hedged global bond portfolios. While we have laid out the conditions that would make us change that view in this report, it is still too soon to position for such a move. Our RBA Monitor, which measures the cyclical pressures on the central bank to change monetary policy settings, is modestly below the zero line (Chart 16). This indicates a need for easier policy, although the indicator is starting to rise driven by the inflation components in the Monitor (bottom panel). In terms of market pricing, there are only 15bps of rate hikes over the next year discounted in the Australian Overnight Index Swap (OIS) curve, so markets are exposed to any shift to a more hawkish bias by the RBA as 2019 progresses. Chart 16Our RBA Monitor Starting To Turn Less Dovish Our RBA Monitor Starting To Turn Less Dovish Our RBA Monitor Starting To Turn Less Dovish Looking purely at Australian government bond yields, the forward curves are priced for very little change in yields over the next year (Chart 17). This suggests that outright duration trades in Australia look uninteresting from a carry perspective of betting against the forwards. We continue to prefer Australian bonds on a relative basis to global developed market peers until there is more decisive evidence pointing to convergence of Australian growth and inflation to the other major economies (bottom panel). Chart 17Stay Overweight Australian Government Bonds Stay Overweight Australian Government Bonds Stay Overweight Australian Government Bonds Over the past year, Global Fixed Income Strategy has recommended tactical trades in Australian money market futures to fade the pricing of RBA hikes that we did not expect to materialize. Specifically, we entered a long position in December 2018 Australian 90-Day Bank Bill futures on October 17, 2017, then switched to a long October 2019 90-Day Bank Bill futures position on May 29, 2017. The latter contract is now trading at implied interest rate levels just above the RBA’s 1.5% Cash Rate (Chart 18), suggesting that there is no more value in this trade.  Chart 18Taking Profits On Our Long Bank Bill Futures Trade Taking Profits On Our Long Bank Bill Futures Trade Taking Profits On Our Long Bank Bill Futures Trade We therefore take a profit of 21bps on the Bank Bill futures trade, while awaiting evidence from the “RBA Hike Checklist” introduced in this report before considering trades that will benefit from a more hawkish central bank.   Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Ray Park, CFA, Research Analyst ray@bcaresearch.com Footnotes 1      Technically the House of Representatives election could occur as late as November 2, while the half Senate election is due May 18, but the norm is to hold the election simultaneously. The 2016 election was a “double dissolution” involving the election of the entire Senate and House of Representatives.  2      Please see BCA China Investment Strategy Special Report, “China’s Property Market: Where Will It Go From Here?” dated September 13, 2018, available at cis.bcareserach.com. 3      We would slightly favor Labor leading a slim majority in the Senate as well as in the House. In the Senate, the half of the seats that are up for grabs are evenly split and the polling at this early stage favors Labor over the Coalition. The poor performance of the Greens, in recent polling and in the Victoria state election, suggests a positive development for Labor on the margin, whereas One Nation, whose polls are improving, poses a threat to the Coalition. 4      Labor is fighting for 15 “marginal” (hotly contested) seats and 28 “fairly safe” seats, while the Coalition is only fighting for 12 marginal seats and 14 fairly safe seats.  

Highlights On a 6-month horizon, go long a combination of banks and high quality 10-year bonds. The recommended combination is 25 cents in the banks and 75 cents in the bonds. The preferred banks are European or euro area and the preferred bonds are U.S. T-bonds. Stay short oil and gas versus financials. During December, use any sharp sell-offs in sterling to buy the pound… …and to downgrade the FTSE100 to underweight. Feature Chart of the WeekBanks And Bond Yields Were Connected At The Hip... Until This Year Banks And Bond Yields Were Connected At The Hip... Until This Year Banks And Bond Yields Were Connected At The Hip... Until This Year Back in June, in Oddities In The 1st Half, Opportunities In The 2nd Half we pointed out two striking oddities in financial market behaviour. One oddity was the sharp decoupling of crude oil from industrial commodity prices (Chart I-2). It is highly unusual for crude oil to outperform copper by 50 percent in the space of just six months. We argued that such an extreme deviation would have to correct one way or another. Which of course it did… Chart I-2Crude Oil Abruptly Decoupled From Industrial Commodities... Then Abruptly Recoupled Crude Oil Abruptly Decoupled From Industrial Commodities... Then Abruptly Recoupled Crude Oil Abruptly Decoupled From Industrial Commodities... Then Abruptly Recoupled The other oddity was the abrupt decoupling of bank equity performance from bond yields (Chart I-3 and Chart of the Week). Bank equity prices and bond yields are usually connected at the hip. The tight connection exists because higher bond yields tend to signal stronger economic growth, either real or nominal. Stronger growth should be good for banks as it is associated with both accelerating credit growth and lower provisions for non-performing loans. Chart I-3Banks Decoupled From Bond Yields... But Will Recouple Banks Decoupled From Bond Yields... But Will Recouple Banks Decoupled From Bond Yields... But Will Recouple On the back of these two striking oddities, we recommended a compelling trade: short oil and gas versus financials. This trade is now in profit and has further to run, but today we want to introduce a new trade: go long a combination of banks and bonds. Explaining The Oddities Of 2018 The underperformance of banks from February through September was entirely consistent with similar underperformances in the other classically growth-sensitive sectors – industrials, and basic materials as well as the decline in industrial commodity prices (Chart I-4). Furthermore, these underperformances started well before any inkling of a trade war. This suggests that the cyclical sector underperformances were correctly reflecting a common or garden down-oscillation in global growth. Chart I-4Oil And Gas Was The Odd Man Out Oil And Gas Was The Odd Man Out Oil And Gas Was The Odd Man Out Oil was a striking oddity because its supply dynamics, rather than its demand dynamics, were dominating its price action, at one point lifting its year-on-year inflation rate to 70 percent for Brent and 80 percent for WTI. Part of this surge in year-on-year inflation was also to do with the ‘base effect’, the dip in the oil price to $45 in the summer of 2017. The base effect shouldn’t really bother markets. After all, most people do not consciously compare a price today with the price precisely a year ago. The problem is that central banks do compare a price today with the price precisely a year ago in their inflation targets. Clearly, when oil price inflation was running at 80 percent, it was underpinning headline CPI inflation, central bank reaction functions, and thereby bond yields. Hence, the two striking oddities – oil abruptly decoupling from industrial commodities (Chart I-5) and bond yields abruptly decoupling from banks – are two sides of the same coin. From February through September, bond yields were taking their cue, at least partly, from the rising price of oil, given its major impact on headline inflation and on central bank reaction functions. Whereas banks, industrials, and industrial commodity prices were taking their cue from fading global growth and industrial activity. Chart I-5It Is Highly Unusual For Oil To Outperform Copper By 50% In Six Months It Is Highly Unusual For Oil To Outperform Copper By 50% In Six Months It Is Highly Unusual For Oil To Outperform Copper By 50% In Six Months A Banks Plus Bonds Combination Could Be A Win-Win The oddities of 2018 are now correcting. With the oil price sharply lower, its year-on-year inflation rate has plunged to -10 percent (Chart I-6). Furthermore, as we have pointed out in recent reports, the sharp deceleration in global credit growth from February through September has clearly arrested and even reversed. The upshot is that banks and bond yields will recouple, one way or the other. Chart I-6Oil Inflation Down from 70% To -10% Oil Inflation Down from 70% To -10% Oil Inflation Down from 70% To -10% Most likely, global growth will rebound somewhat and the beaten-down bank equity prices have considerable scope for recovery (Chart I-7), while the restraint on headline CPI inflation will keep bond yields in check. Indeed, as President Trump recently tweeted: Chart I-7Global Growth Will Rebound, So Will Banks Global Growth Will Rebound, So Will Banks Global Growth Will Rebound, So Will Banks “Inflation down, are you listening Fed!” But if we are wrong and growth disappoints, bank equities are already beaten-down while a further downdraft in inflation will pull down bond yields. Either way, on a six month horizon a combination of banks and high quality 10-year bonds should be a win-win strategy. Given the different betas of the two investments, the recommended combination is 25 cents in the banks and 75 cents in the bonds. The preferred banks are European or euro area and the preferred bonds are U.S. T-bonds. Focus On Sectors And Currencies The remainder of this report is a reminder that successful macro investing requires the application of the Pareto Principle, also known as 80:20 rule. In macro investing, the vast majority of performance outcomes, ‘the 80’, are explained by a very small number of drivers, ‘the 20’. We find that the vast majority of a region’s or a country’s stock market relative performance is explained just by its distinguishing sector fingerprint combined with its currency (Chart I-8 - Chart I-12). Chart I-8Euro Stoxx 600 Vs. MSCI Emerging Markets = Global Healthcare In Euros Vs. Global Technology In Dollars Euro Stoxx 600 Vs. MSCI Emerging Markets = Global Healthcare In Euros Vs. Global Technology In Dollars Euro Stoxx 600 Vs. MSCI Emerging Markets = Global Healthcare In Euros Vs. Global Technology In Dollars Chart I-9Euro Stoxx 50 Vs. S&P 500 = Global Banks In Euros Vs. Global Technology In Dollars Euro Stoxx 50 Vs. S&P 500 = Global Banks In Euros Vs. Global Technology In Dollars Euro Stoxx 50 Vs. S&P 500 = Global Banks In Euros Vs. Global Technology In Dollars Chart I-10FTSE 100 Vs. S&P 500 = Global Oil And Gas In Pounds Vs. Global Technology In Dollars FTSE 100 Vs. S&P 500 = Global Oil And Gas In Pounds Vs. Global Technology In Dollars FTSE 100 Vs. S&P 500 = Global Oil And Gas In Pounds Vs. Global Technology In Dollars Chart I-11FTSE 100 Vs. Nikkei 225 = Global Oil And Gas In Pounds Vs. Global Industrials In Yen FTSE 100 Vs. Nikkei 225 = Global Oil And Gas In Pounds Vs. Global Industrials In Yen FTSE 100 Vs. Nikkei 225 = Global Oil And Gas In Pounds Vs. Global Industrials In Yen Chart I-12FTSE 100 Vs. Euro Stoxx 50 = Global Oil And Gas In Pounds Vs. Global Banks In Euros FTSE 100 Vs. Euro Stoxx 50 = Global Oil And Gas In Pounds Vs. Global Banks In Euros FTSE 100 Vs. Euro Stoxx 50 = Global Oil And Gas In Pounds Vs. Global Banks In Euros Major stock markets comprise of multinational companies whose sales and profits are internationally diversified. But each major stock market has a distinguishing ‘long’ sector in which it contains up to a quarter of its total market capitalisation, as well as a distinguishing ‘short’ sector in which it has a significant under-representation. The combination of this long sector and short sector gives each equity index its distinguishing fingerprint (Table I-1): FTSE100 = long energy, short technology. Eurostoxx50 = long banks, short technology. Nikkei225 = long industrials, short banks and energy. S&P500 = long technology, short materials. MSCI Emerging Markets = long technology, short healthcare. Table I-1Each Major Stock Market Has A Distinguishing Fingerprint Oil, Banks, And Bonds: The Oddities Of 2018 Oil, Banks, And Bonds: The Oddities Of 2018 The other important factor is the currency. The FTSE100 oil and gas stock, BP, receives its revenue and incurs its costs in multiple major currencies, such as euros and dollars. In other words, BP’s global business is currency neutral. But BP’s stock price is quoted in London in pounds. Hence, if the pound strengthens, the company’s multi-currency profits will decline relative to the stock price and weigh it down. Conversely, if the pound weakens, it will lift the BP stock price. This means that the domestic economy can impact its stock market through the currency channel. Albeit it is a counterintuitive relationship: a strong economy via a strong currency hinders the stock market; a weak economy via a weak currency helps the stock market. What does all of this mean for our European country allocation right now? From a sector perspective, a stance that is short oil and gas versus financials penalises the FTSE100 versus the Eurostoxx50, given the FTSE100’s oil and gas fingerprint and the Eurostoxx50’s banks fingerprint. Against this, a weakening pound would support the FTSE100. Given that Theresa May’s Brexit agreement will meet stiff resistance when it comes to Parliament in the second week of December, the point of maximum risk for the pound is still ahead of us. But as we argued last week, we ultimately expect relief for the pound as: either the Article 50 process is extended, or the U.K. moves into a transition period within a negotiated Brexit.1 Hence, during December, use any sharp sell-offs in sterling to buy the pound, and to downgrade the FTSE100 to underweight.   Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading Model* This week we note that this year’s sell-off in Italian equities is technically very stretched. Therefore, in a continued de-escalation of the budget spat between Italy and the EU, Italian equities would be ripe for a strong countertrend burst of outperformance. On this basis, our recommended trade is long MIB versus the Eurostoxx with a profit target of 5% and a symmetrical stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-13 Long MIB Vs. Euro Stoxx Long MIB Vs. Euro Stoxx The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com Footnote 1 Please see the European Investment Strategy Weekly Report “DM Versus EM, And Two European Psychodramas”, November 22, 2018 available at eis.bcaresearch.com. Fractal Trading Model Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights Turkish commercial banks have been ramping up purchases of local currency government bonds. Given that commercial banks create new money “out of thin air” when they buy assets from non-bank entities, should investors interpret this phenomenon positively or negatively? Under the backdrop of a severe recession, we view this phenomenon as a stabilizing factor that can provide moderate relief - a painkiller rather than a poison. Meanwhile, record-wide net interest rate spreads as well as rising purchases of government bonds yielding around 20% are positive for banks’ earnings amid an otherwise dismal economic outlook. To express a selective positive bias toward this depressed and still fundamentally challenged market versus other EMs, we recommend a relative equity trade: long Turkish banks / short EM banks, currency unhedged. Feature On August 15, 2018, we upgraded our stance on Turkish markets from underweight to neutral and closed our shorts in the currency and bank stocks after having been bearish/underweight for several years.1 Our rationale was that Turkish equity and currency valuations had become cheap, and its financial markets oversold. Yet we stated that the adjustment in interest rates and ensuing economic slowdown were still pending – preventing us from going overweight. Are Turkish interest rates now sufficiently high to put a floor under the currency? In other words, is monetary demagoguery – relentless bank lending promoted by the authorities amid high inflation – a thing of the past?2 At first glimpse, the answer appears to be no. Turkish banks have been aggressively buying local currency government bonds – at a time when foreigners have been selling their holdings (Chart I-1). Chart I-1Turkish Banks Have Been Buying Local Government Bonds Turkish Banks Have Been Buying Local Government Bonds Turkish Banks Have Been Buying Local Government Bonds As we demonstrate in Box I-1 on page 9, commercial banks in all countries create new money when they purchase any asset, including any security, from non-bank entities. One can argue that the Turkish banks’ creation of money “out of thin air” holds the potential to trigger renewed currency depreciation. Furthermore, banks’ financing of the government depresses government bond yields, bringing down market-determined local currency interest rates. On the other hand, there is also evidence that banks have drastically curtailed financing to the real economy, which is causing a severe collapse in domestic demand. This has already squeezed imports and has started to narrow the current account deficit - a necessary condition for macro and exchange rate stabilization (Chart I-2). As such, it seems Turkey’s necessary macro adjustment is already under way. Chart I-2Turkey: Current Account Deficit Is Narrowing Turkey: Current Account Deficit Is Narrowing Turkey: Current Account Deficit Is Narrowing These two dynamics – (1) banks financing the government by creating money “out of thin air” and (2) banks inhibiting financing to households and companies – are conflicting. While many economists refer to this phenomenon as a crowding out of the private sector by the government, we disagree with this analytical framework. Please refer to Box I-1 on page 9 for a more detailed discussion. Our assessment of these dynamics is as follows: In the current context of rapidly shrinking domestic demand, banks’ financing of the government is a mitigating factor in the ongoing macro adjustment. Commercial banks’ financing of the public sector via bond purchases caps market-determined interest rates and allows the government to spend, therefore diminishing the blow to the real economy. Consequently, the expansion of Turkish banks’ purchases of government bonds is a silver lining in an otherwise harsh macro adjustment. So long as this phenomenon is not prolonged indefinitely and does not cause the currency to plunge anew, it is an acceptable strategy for both banks and the government. In fact, it could form a fertile ground for Turkish banks’ stock prices to start rising from the ashes, at least relative to other emerging markets. Fiscal Deficit Financing By Banks: Poison Or Painkiller? Diagnosing a patient in critical condition and prescribing the right medicine is a complex task. Assessing monetary conditions in a financial crisis-stricken economy and determining the correct policy mix is no different. While monetary tightening may be the right medicine for some parts of the economy, monetary easing can be appropriate for others parts. In fact, this is what is currently happening in Turkey. There is a dichotomy occurring between monetary easing for the government (in the local currency bond market) and monetary tightening for companies and households. Chart 3 demonstrates that local currency broad money growth now slightly exceeds bank loan growth. One of the reasons for this is that banks are literally creating money by purchasing government securities. With a low likelihood of default and a yield of 20%, government securities are currently attractive for Turkish banks. On the surface, government deficit financing via money creation by banks might seem like a recipe for higher inflation. Yet, we have to put this phenomenon in the context of current cyclical economic conditions in Turkey. The economy is on the precipice of a major recession which will likely produce a major deflationary shockwave. Money and credit growth in real terms is negative (Chart I-3, bottom panel). In addition, government expenditures in real terms are now contracting, suggesting that fiscal policy is tight (Chart I-4). Furthermore, government debt levels are low – total public debt stands at 31% of GDP. This means that fiscal expansion is a lever that authorities can and should be using. Chart I-3Turkey: Money And Loan Growth Are Negative In Real Terms Turkey: Money And Loan Growth Are Negative In Real Terms Turkey: Money And Loan Growth Are Negative In Real Terms Chart I-4Turkey: Fiscal Policy Is Tight Turkey: Fiscal Policy Is Tight Turkey: Fiscal Policy Is Tight Hence, we infer that banks’ financing of government expenditures are not excessive from a macro perspective; particularly when considering the currently heightened recessionary crosscurrents. Bottom Line: The expansion of Turkish banks’ purchases of government bonds are capping local bond yields and, on the margin, allowing the government to support the economy. Given the backdrop of a severe recession, we view this as a stabilizing factor – a painkiller rather than a poison. Monetary Tightening In The Real Economy Commercial banks have substantially tightened financing to companies and households. Interest rates on bank loans to businesses and consumers have risen much more than the central bank’s policy rate. The former are now 850 basis points higher than the latter (Chart I-5, top panel). Chart I-5Turkey: Tight Monetary Conditions In The Real Economy Turkey: Tight Monetary Conditions In The Real Economy Turkey: Tight Monetary Conditions In The Real Economy In real terms (deflated by core CPI), commercial bank loan interest rates are now 8% (Chart I-5, bottom panel). High real bank loan rates charged to households and companies will cause domestic demand to collapse – despite a real policy rate at zero. Provided economic activity is already shrinking, it will be difficult for debtors to achieve a hurdle real rate of 8%. This is already producing a collapse in loan demand and a material retrenchment in consumer and business spending. A statistical regression of economic activity variables on the change in borrowing costs demonstrates that the Turkish economy is in for a severe recession across all sectors, with capital expenditures being the hardest hit (Chart I-6). Chart I-6Turkey: The Recession Will Be Severe Turkey: The Recession Will Be Severe Turkey: The Recession Will Be Severe A cheapened currency and high borrowing costs are the correct medicine for the nation’s deep economic imbalances – i.e. its large and persistent current account deficits. In fact, the real economy has already been adjusting: the current account excluding oil is starting to narrow (refer to Chart I-2 on page 2). This together with cheap valuations may help put a floor under the lira (Chart I-7). Chart I-7The Turkish Lira Is Cheap The Turkish Lira Is Cheap The Turkish Lira Is Cheap Bottom Line: Interest rates on bank loans have increased much more than the central bank policy rate and are sufficiently high in real terms, foreshadowing a severe, but necessary, domestic demand contraction. Go Long Turkish Banks / Short EM Banks There appears to be a relative tactical opportunity to go long Turkish banks while shorting EM banks. Relative share prices in dollar terms between Turkish and EM banks are at an all-time low (Chart I-8). Odds are that Turkish banks will outperform for the time being. Chart I-8Long Turkish Banks / Short EM Banks Long Turkish Banks / Short EM Banks Long Turkish Banks / Short EM Banks Not only are Turkish banks charging a large spread on loans relative to the policy rate, they are also enjoying a wide net interest rate spread – lending rates minus deposit rates. In fact, Turkish banks’ net interest rate spread is presently the highest in recorded history (Chart I-9, top panel). This is very positive for banks’ net interest margins (NIM) – net interest income as percent of loans - and earnings (Chart I-9, bottom panel). Chart I-9Turkish Banks' Margins Are Widening Turkish Banks' Margins Are Widening Turkish Banks' Margins Are Widening In addition, banks’ purchases of government bonds allows them to expand their balance sheets and earn a yield that is around 20%. Given the government’s low credit risk, this is also positive for banks’ profits. On the negative side, non-performing loans (NPLs) are set to surge. Therefore, any investment consideration should take into account banks’ equity erosion due to surging NPLs. Turkish banks are presently extremely under-provisioned, as illustrated in Chart I-10. Yet their share prices have already plunged substantially, discounting a higher level of NPLs than banks have acknowledged and provisioned for. Chart I-10Turkey: NPLs Are Set To Surge Turkey: NPLs Are Set To Surge Turkey: NPLs Are Set To Surge We have performed a credit stress test for the Turkish banking system. The scenario analysis shown in Table I-1 illustrates that banks’ share prices are already pricing in a significant amount of bad news regarding the NPL cycle. For example, in a scenario where the non-performing credit assets (NPCA) ratio rises to 20% from its current 3.5% level, bank stocks would be fairly valued at current levels. Table I-1Credit Stress Test For Turkish Banks Turkish Monetary Demagoguery: A Thing Of The Past? Turkish Monetary Demagoguery: A Thing Of The Past? Considering that the NPL-to-total-loan ratio reached 18% after the 2001 currency crisis, we believe 20% is a reasonable estimate. The key difference between now and the 2001 crisis is that woes in 2001 were related to unsustainable government debt, while Turkey’s present problems stem from excessive private debt. This valuation part of the stress test assumes that the fair value for the price-to-book value (PBV) ratio adjusted for all credit losses is 1.3 - the average PBV ratio for EM banks since 2011. In short, banks’ stock prices are currently trading close to their fair value assuming 20% NPCA (Table I-1). In all scenarios, we assume a recovery rate of 40%. In terms of structural valuations, using our model for the cyclically-adjusted P/E (CAPE) ratio, Turkish banks are currently trading at two standard deviations below their fair value in absolute terms, and two-and-half standard deviations relative to the other EM banks (Chart I-11). Chart I-11Turkish Bank Stocks Are Cheap Turkish Bank Stocks Are Cheap Turkish Bank Stocks Are Cheap Given that we expect an additional selloff in EM risk assets, Turkish bank stocks will likely relapse in absolute terms. This is why we recommend a market-neutral bet. In short, we expect more downside in the share price of EM banks than in Turkish ones for now. Investment Conclusions Given our overarching negative view on emerging markets as a whole, we are reluctant to be bullish on Turkish risk assets in absolute terms. The basis behind why we are not upgrading our stance on Turkey’s overall stock index is as follows: Non-financials companies are about to experience severe profit shrinkage as the recession deepens. Conversely, contraction in banks’ earnings will be mitigated by a very wide NIM and an increased financing of the government at yields above 20%. In addition, we expect EM currencies and high-yielding local bonds to resume their selloff, and corporate and sovereign credit spreads to widen. Given Turkey has historically been a high-beta market, it is difficult to bet on its financial markets outperforming EM peers in a bear market. Finally, the recent rebound in Turkish markets was from quite oversold levels and is currently facing its first technical resistance (Chart I-12). Chart I-12The Lira And Local Government Bonds Are Facing Their First Technical Resistance The Lira And Local Government Bonds Are Facing Their First Technical Resistance The Lira And Local Government Bonds Are Facing Their First Technical Resistance Overall, we continue to recommend a neutral allocation to Turkey for EM dedicated equity investors, as well as local currency bond and credit portfolios. Nevertheless, to express a selective positive bias toward this depressed market versus other EMs, we recommend a relative equity trade: Long Turkish banks / short EM banks, currency unhedged. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Box 1 How Banks Create Money By Purchasing Assets From A Non-Bank Entity We demonstrate, in a stylized example, how a commercial bank (Bank 1) creates a new deposit in the banking system – which consists of two banks (Bank 1 and Bank 2) - when it purchases a bond from an investor (Investor A) that is a non-bank. For simplicity, we presume that this is the only transaction in the banking system on that day. All numbers we cite here are local currency values and all transactions take place in local currency. We assume at the beginning of Day 1 that both Bank 1 and Bank 2 each have excess reserves (ERs) of 1000 and existing deposits of 1000 (Figure I-1). Hence, the overall banking system ERs amount to 2000 and total deposits are equal to 2000. Figure I-1Begining Of Day 1 Balance Sheet & Transactions Turkish Monetary Demagoguery: A Thing Of The Past? Turkish Monetary Demagoguery: A Thing Of The Past? As Bank 1 purchases a bond at the price of 300 from Investor A, the following balance sheet accounting entries take place (these entries are shown in red in Figure I-1): Bank 1 acquires a bond and its assets now include a bond valued at 300. Investor A has an account at Bank 2, so to pay for this purchase Bank 1 transfers 300 from its ERs to Bank 2’s ERs account at the central bank. Bank 1 ERs decline by 300. Hence, its assets and liabilities have not changed – it has just swapped 300 in ERs with 300 in bond (Figure I-1). Bank 2 credits Investor A’s deposit account by 300. Hence, Investor A received a deposit valued at 300 that it previously did not have. This is a new deposit for the whole banking system that was created “out of thin air”. Bank 2’s ERs and hence its total assets have risen by 300. This rise in Bank 2’s assets is balanced by the increase of its deposit by 300 (Figure I-2). In brief, this deposit is nothing more than an accounting entry to balance Bank 2’s assets and liabilities. Yet, deposits represent money and give their holders purchasing power. Figure I-2End Of Day 1 Balance Sheet Turkish Monetary Demagoguery: A Thing Of The Past? Turkish Monetary Demagoguery: A Thing Of The Past? Assuming that during the day there was no other transaction in this banking system, the latter’s ERs have remained unchanged at 2000 yet its total deposits have risen from 2000 to 2300. A new deposit worth 300 was created without the central bank providing any funding (new ERs) to the banking system. Money supply is the sum of all deposits in the banking system and commercial banks create deposits “out of thin air” when they lend to non-banks or purchase assets from non-banks. As such, banks do not need to reduce private sector lending to fund the government. In other words, no “crowding out” of the private sector needs to take place for banks to buy government bonds.   Footnotes 1      Please see Emerging Markets Strategy Special Alert "Turkey: Booking Profits On Shorts," dated August 15, 2018, the link available on page 14. 2      Please see Emerging Markets Strategy Special Report "Turkey's Monetary Demagoguery," dated June 1, 2016, available at ems.bcaresearch.com   Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights The relative performance of developed market (DM) versus emerging market (EM) equities just corresponds to the relative performance of healthcare versus financials. On a six month horizon, DM will underperform EM. Within Europe, overweight Poland, Hungary and Czech Republic, but steer clear of energy-heavy Russia. Wait for the 10-year BTP yield to move closer to 3 percent before buying Italian assets, either in absolute or relative terms. Buy the pound on any sharp sell-offs during the Brexit psychodrama. Our medium-term expected value of pound/euro equals 1.18. Chart of the WeekDeveloped Vs. Emerging Markets = Healthcare Vs. Financials Developed Vs. Emerging Markets = Healthcare Vs. Financials Developed Vs. Emerging Markets = Healthcare Vs. Financials Feature They say that to capture the Zeitgeist at any moment, all you need to do is name the top five companies in the world. So here are the top five companies in the developed equity markets (DM): Apple, Microsoft, Google, Amazon, and Facebook (Table I-1). Table I-1Developed Markets: Top 5 Companies DM Versus EM, And Two European Psychodramas DM Versus EM, And Two European Psychodramas These five names do perfectly capture the spirit of our time and should not surprise you. Now look at the top five companies in the emerging equity markets (EM): Tencent, Taiwan Semiconductor, Samsung Electronics, Alibaba, and Naspers (Table I-2). Table I-2Emerging Markets: Top 5 Companies DM Versus EM, And Two European Psychodramas DM Versus EM, And Two European Psychodramas What may surprise you is that technology titans dominate in EM markets too. In fact, the technology sector's weighting in EM, at 25 percent, is even larger than in DM, at 19 percent. If technology looms even larger in EM than in DM, what is the defining sector difference between the two regions? The answer is that emerging markets have almost no healthcare stocks, and an offsetting substantial overweighting to financials (Table I-3). Table I-3Developed Markets Versus Emerging Markets: Sector Weights DM Versus EM, And Two European Psychodramas DM Versus EM, And Two European Psychodramas Developed Vs. Emerging Markets = Healthcare Vs. Financials The following is a very different way of looking at the DM versus EM investment decision and, as such, may differ from the BCA house view. As we have demonstrated time and time again on these pages, an equity market's dominant sector skew is of critical importance to investors (Chart I-2). This is because equity sector skews almost always drive regional and country relative performance. Crucially, this fundamental truth applies at the highest level too: the relative performance of DM versus EM. The Chart of the Week should leave you in absolutely no doubt that the relative performance of DM versus EM just corresponds to the relative performance of healthcare versus financials. Chart I-2Developed Versus Emerging Markets: Sector Weight Differences DM Versus EM, And Two European Psychodramas DM Versus EM, And Two European Psychodramas Nevertheless, this striking observation raises a fascinating question: what is the direction of causality? Does healthcare versus financials drive DM versus EM, or in fact does DM versus EM drive healthcare versus financials? The answer is sometimes the former, and at other times the latter. For example, a major slump in emerging economies would undoubtedly drag down global equities. In the ensuing synchronized bear market, the more defensive healthcare sector would almost certainly outperform the financials, and under these circumstances the direction of causality would clearly be from DM versus EM to global sector performance. On the other hand, absent a major bear market, if a reappraisal of sector relative valuations and growth prospects caused a rotation in sector leadership, the causality would run in the other direction: from global sector performance to DM versus EM. Such a reappraisal of sector relative valuations and growth prospects appears to be underway at the moment, and is likely to persist for the next few months. This is because the very sharp down-oscillation in global credit growth which occurred from February through September has now clearly flipped into an up-oscillation. For investors, these oscillations in global credit growth provide excellent tactical opportunities because the oscillations are very regular and therefore predictable; and the cyclical versus defensive sector performance closely tracks the oscillations. So after healthcare's strong outperformance versus financials from February through September, sector relative performance has now flipped into a reverse configuration (Chart I-3). Chart I-3An Up-Oscillation In Global Credit Growth Technically Favours Financials An Up-Oscillation In Global Credit Growth Technically Favours Financials An Up-Oscillation In Global Credit Growth Technically Favours Financials To be clear, this is likely a tactical opportunity lasting no more than six months or so. Nevertheless, from a DM versus EM perspective, it would imply a countertrend move within a structural trend - in which the outperformance of DM versus EM temporarily ends, or even flips into an underperformance (Chart I-4). Chart I-4An Up-Oscillation In Global Credit Growth Technically Favours EM An Up-Oscillation In Global Credit Growth Technically Favours EM An Up-Oscillation In Global Credit Growth Technically Favours EM For European equity investors, the important implication is that developed Europe versus emerging Europe closely tracks broad DM versus broad EM (Chart I-5). Of course, 'emerging Europe' is a misnomer because Poland, Hungary, Czech Republic, and even Russia are developed economies and markets. Nevertheless, as they fall within the MSCI EM index, they tend to move with EM. Chart I-5Developed Europe Vs. Emerging Europe = Developed Markets Vs. Emerging Markets Developed Europe Vs. Emerging Europe = Developed Markets Vs. Emerging Markets Developed Europe Vs. Emerging Europe = Developed Markets Vs. Emerging Markets The upshot is that on a tactical horizon, emerging Europe is likely to outperform developed Europe. However, given our high conviction view that non-energy commodities will continue to outperform energy, focus on Poland, Hungary and Czech Republic and steer clear of energy-heavy Russia. European Psychodrama 1: Italy Vs. The EU In the low-level game of chicken between Italy and the EU Commission over Italy's 2019 budget, the bond market will determine who swerves first. If the 10-year BTP yield rises and stays well above 4 percent, the weakened capital position of Italian banks from lower bond prices combined with deteriorating funding conditions will weigh on bank lending and economic growth. This will put pressure on the Italian government to swerve first and concede ground to the EU's demands. That said, it is hard to know the exact level of yields at which the government would reach its pain threshold. On the other hand, if the 10-year BTP yield falls and stays well below 3 percent, the bond market's insouciance would embolden the Italian government. Moreover, this apparent vote of confidence would be based on sound economics. Italy likely has a very high fiscal multiplier, meaning that a modest increase in its budget deficit to 2.4 percent would more than pay for itself through higher economic growth. Under these circumstances the EU would be under pressure to swerve first and give Italy some room for manoeuvre. The long-term investment opportunity is the Italy versus Spain sovereign 10-year yield spread. At 200 bps, the spread is at its all-time widest, and incongruous with the vanishing gap between the non-performing loans ratios in Italy and Spain. Nevertheless, our recommendation is to wait for the 10-year BTP yield to move closer to 3 percent before buying Italian assets, either in absolute or relative terms (Chart I-6). Chart I-6Remain Neutral Italian Assets Until The 10-Year BTP Yield Moves Closer To 3 Percent Remain Neutral Italian Assets Until The 10-Year BTP Yield Moves Closer To 3 Percent Remain Neutral Italian Assets Until The 10-Year BTP Yield Moves Closer To 3 Percent European Psychodrama 2: Brexit In the psychodrama called Brexit, every new plot twist and turn has the potential to move the pound up or down by a few cents in a day. The next such major twist is the passage of the withdrawal bill through the U.K. parliament in early December. The ultra Brexiteer Conservative MPs and Northern Ireland Unionists will almost certainly vote against the agreement that Theresa May has forged with Brussels. This is because the agreement conjures up the Brexiteers' worst nightmare: a potentially indefinite customs union with the EU27, making it impossible for the U.K. to strike free trade deals with the rest of the world. Hence, for Theresa May to get her agreement through parliament, she will require the support of a substantial number of Labour MPs. But the substantial numbers just aren't there. The upshot is that she is likely to lose the vote, at which point the pound will tumble. For medium-term investors, this would be the moment to buy the pound, and we now explain why. On a six month horizon, the crucial question is: what will happen when the Article 50 process for the U.K. to leave the EU expires at 11pm on March 29, 2019? There are only three possibilities: 1. The U.K. doesn't leave the EU. At this advanced stage on the timeline, not leaving the EU on March 29 2019 effectively means an extension of the Article 50 process. This would require the U.K. to apply for an extension, and for the EU27 to agree to it. But realistically, the EU27 would only agree to it to facilitate a general election and/or a second referendum which could reverse Brexit. Probability = 45%. With the parliamentary arithmetic pointing to a rejection of May's Brexit deal as it stands, an amendment to the withdrawal bill forcing a second referendum, or a lost vote of no confidence in the government could lead to this outcome. Pound/euro = 1.20, because of the realistic prospect of reversing Brexit (Chart I-7). Chart I-7British Public Opinion On Brexit Is Shifting Long Emerging Markets Vs. Developed Markets Long Emerging Markets Vs. Developed Markets 2. The U.K. enters a transition period to leave the EU with a negotiated agreement. Theresa May's proposed withdrawal deal, or a variation of it, is approved by the U.K parliament (and the EU27) Probability = 45%. Appropriate amendments to the withdrawal agreement might sufficiently reduce the parliamentary rebellion. Pound/euro = 1.20 because the removal of the 'no deal' outcome would liberate the BoE to hike interest rates. 3. The U.K. crashes out of the EU with 'no deal'. Probability = 10%. This outcome would be the result of a gridlock in the U.K. parliament, with no majority formed for any Brexit strategy. Unlikely, but not impossible. Pound/euro = 1.00 because the U.K. economy would face months of severe disruption and uncertainty. Based on these three possible outcomes on March 29 2019, our expected value of pound/euro equals 1.18. Meaning that any sharp sell-off during the ongoing psychodrama constitutes a medium-term buying opportunity. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading Model* Supporting the thesis in the main body of this report, the 130-day fractal dimension of EM versus DM recently hit its lower bound, suggesting an oversold extreme and a likely countertrend move. For a short-term trade, position for a 2.5% profit with a symmetrical stop-loss. In other trades, long Portugal / short Hungary hit its stop-loss and is closed, leaving four open trades. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-8 Long Emerging Markets Vs. Developed Markets Long Emerging Markets Vs. Developed Markets The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights Bond yields have trapped equities, and equities have trapped bond yields. The double-digit investment opportunities are within asset-classes. From a tactical perspective: Banks will outperform the broad market. EM will outperform DM. The Eurostoxx50 will briefly outperform the S&P500. Raw industrial commodities will outperform crude oil. Feature What has been the biggest driver of financial markets this year? Trade wars and the emerging market slowdown? The budget spat between Italy and the EU Commission? The U.S. mid-term elections? Or perhaps, central bank policy normalization? These are all sensible answers, and each one has generated endless output of commentary and analysis. But none of these tells the biggest story of 2018. Chart of the WeekIn 2018, Bond Yields Have Trapped Equities, And Equities Have Trapped Bond Yields In 2018, Bond Yields Have Trapped Equities, And Equities Have Trapped Bond Yields In 2018, Bond Yields Have Trapped Equities, And Equities Have Trapped Bond Yields The Biggest Story Is Not Economics Or Politics... It Is Mathematics This year, the two largest five-day plunges in the global stock market - 6 percent in February and 7 percent in mid-October - resulted directly from the two largest five-day spikes in the global bond yield (Chart I-2 and Chart I-3). This simple observation reveals the biggest story in the financial markets this year: the hypersensitivity of the stock market to rising bond yields, and especially when the global 10-year yield approaches 2 percent - or equivalently 'the rule of 4': when the sum of the 10-year U.S. T-bond, German bund and Japanese government bond approaches 4 percent (Chart of the Week).1 Chart I-2Equities Plunged In February After A Spike In Bond Yields Equities Plunged In February After A Spike In Bond Yields Equities Plunged In February After A Spike In Bond Yields Chart I-3Equities Plunged In October After A Spike In Bond Yields Equities Plunged In October After A Spike In Bond Yields Equities Plunged In October After A Spike In Bond Yields With the global stock market now flat year-to-date, it follows that excluding these two five-day plunges, global equities would be comfortably higher even with the emerging market slowdown, trade war quarrels, and political spats. Meaning that this year's market action is not explained by economics or by politics. It is explained by mathematics, and specifically the great misunderstanding of investment risk. Previous reports have focused on this great misunderstanding, most recently Risk: The Great Misunderstanding Of Finance, to which we refer our readers. Here, we will just summarize:2 An investment's risk depends on the negative asymmetry of its short-term returns. At very low bond yields, bond returns develop the same negative asymmetry as equity returns. This means that equities lose their excess riskiness versus bonds, requiring equity valuations to experience a phase transition sharply higher. But when bond yields normalize, equities regain their excess riskiness versus bonds - and their valuations must suffer a phase transition sharply lower. This phase transition to sharply lower equity valuations is most pronounced when the global 10-year bond yield rises to 2 percent. This dynamic has proved to be the biggest driver of financial markets in 2018, and is likely to be the biggest driver in 2019 too. Essentially, higher bond yields can suddenly and viciously undermine the valuation support of equities, limiting the upside in the stock market (Chart I-4). In turn, a plunge in the stock market and other risk-assets threatens a disinflationary impulse, limiting the sustainable upside in bond yields. Chart I-4Equities Remain Richly Valued Equities Remain Richly Valued Equities Remain Richly Valued In effect, bond yields have trapped equities, and equities have trapped bond yields (Chart I-5). The result is that in 2018 the global asset-classes: equities, bonds, commodities, and cash have all ended up going nowhere. Indeed, the global 30-year bond yield has been trapped since early 2017!3 Chart I-5The Global 30-Year Bond Yield Has Been Trapped For Two Years The Global 30-Year Bond Yield Has Been Trapped For Two Years The Global 30-Year Bond Yield Has Been Trapped For Two Years The Double-Digit Investment Opportunities Are Within Asset-Classes Although the global asset-classes have ended up going nowhere this year (Chart I-6), 2018 has still provided double-digit investment opportunities. But to find these double-digit opportunities, you have to look below the main asset allocation decision to within the asset-classes, in sector, region and country allocation. Chart I-6In 2018, Global Asset-Classes Have Ended Up Going Nowhere In 2018, Global Asset-Classes Have Ended Up Going Nowhere In 2018, Global Asset-Classes Have Ended Up Going Nowhere For example, until very recently: banks had underperformed the broad equity market by 10 percent globally and 25 percent in Europe; emerging market equities had underperformed developed market equities by 15 percent; the Eurostoxx50 had underperformed the S&P500 by 13 percent; and raw industrial commodities had underperformed crude oil by 30 percent. But in the last month or so, these strong trends have exhausted and even started to reverse: banks have started to outperform the market; the Eurostoxx50 has eked ahead of the S&P500; emerging market equities have retraced versus developed market equities; and raw industrial commodities have made up much lost ground on crude oil (Charts I-7 - Chart I-10). One important reason is that the sharp down-oscillation in global credit growth which was responsible for many of this year's intra asset-class trends has now clearly rebounded into an up-oscillation. Chart I-7Banks Have Started To Outperform Banks Have Started To Outperform Banks Have Started To Outperform Chart I-8The Eurostoxx50 Is Starting To Outperform The S&P500 The Eurostoxx50 Is Starting To Outperform The S&P500 The Eurostoxx50 Is Starting To Outperform The S&P500 Chart I-9EM Has Started To Outperform DM EM Has Started To Outperform DM EM Has Started To Outperform DM Chart I-10Industrial Commodities Are Starting To Outperform Crude Oil Industrial Commodities Are Starting To Outperform Crude Oil Industrial Commodities Are Starting To Outperform Crude Oil Hence, we expect these trend reversals to continue in the coming months. From a tactical perspective only, this means: 1. Banks will outperform the broad market. 2. EM will outperform DM. 3. The Eurostoxx50 will briefly outperform the S&P500. 4. Raw industrial commodities will outperform crude oil. Such an inflection point can leave investors scratching their heads in confusion, because sector performances seem to conflict with the economic data releases. But the conflict is easily resolved. Though we are now in mid-November, the economic data releases - for example, German exports - are a lagging indicator, referring to a time in the past, September, when global credit growth might still have been in a down-oscillation. Whereas the financial markets - for example, bank equities' relative performance - are a contemporaneous indicator, sensing credit growth's switch to an up-oscillation in real-time. Always remember that market prices move on the marginal change in information and expectations. To be absolutely clear, we are not referring to the business cycle. We are referring to predictable oscillations in credit growth that occur within the business cycle, but which nevertheless create double-digit investment opportunities - such as bank equities' relative performance. The Importance Of 6-Month Credit Growth Still, several clients have asked about our choice of 6-month credit growth, as it appears to be an arbitrary period plucked out of thin air or, more cynically, 'data-mined'. In fact, our choice of 6-month growth has a rock-solid foundation in economic theory.4 For any item, if supply lags demand by a period t, then economic theory proves that both the quantity of the item and its price will experience oscillations with half-cycle length t. Clearly, bank credit is such an item whose supply does lag demand. For example, a mortgage is only allocated and released after a time-consuming process of checking collateral and creditworthiness. For bank credit in aggregate, the lag between demand and supply, and specifically final spending of the funds, averages six to eight months. Once you accept this fundamental truth, it follows that credit growth must also experience oscillations whose half-cycles last six to eight months. So we end with a very important investment lesson. If you only look at the conventionally examined year-on-year credit growth data, you will not see the predictable oscillations in 6-month credit growth. And if you do not look at 6-month credit growth, you will miss the double-digit investment opportunities that are always on offer (Chart I-11). Chart I-11A Sharp Down-Oscillation In Global Credit Growth Has Rebounded Into An Up-Oscillation A Sharp Down-Oscillation In Global Credit Growth Has Rebounded Into An Up-Oscillation A Sharp Down-Oscillation In Global Credit Growth Has Rebounded Into An Up-Oscillation The choice is yours. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 We use the MSCI All Country World Index in local currency terms to capture the global stock market. 2 Negative asymmetry of returns means the possibility of larger short-term losses than short-term gains. Please see the European Investment Strategy Weekly Report, "Risk: The Great Misunderstanding Of Finance", October 25, 2018 available at eis.bcaresearch.com. 3 Please see the European Investment Strategy Weekly Report, "Trapped: Have Equities Trapped Bonds?", September 13, 2018 available at eis.bcaresearch.com. 4 Please see the European Investment Strategy Special Report, "The Cobweb Theory And Market Cycles", January 11, 2018 available at eis.bcaresearch.com. Fractal Trading Model* Palladium has outperformed nickel by 50% in the past three months, but this strong trend is nearing exhaustion according to its 65-day fractal dimension. Hence, this week's trade recommendation is long nickel/short palladium setting a profit target of 14% with a symmetrical stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-12 Long Platinum / Short Nickel Long Platinum / Short Nickel The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations