Fiscal

An analysis on Brazil is available below. Feature Chart I-1Poor Performance By EM Stocks, Currencies And Commodities bca.ems_wr_2019_11_28_s1_c1 bca.ems_wr_2019_11_28_s1_c1 I had the pleasure of meeting again with a long-term BCA client Ms. Mea last week during my trip to Europe. Ms. Mea and I meet on a semi-annual basis, where she has the opportunity to query my analysis and view. In our latest meeting, she was more perplexed than usual by the global macro developments and financial market dynamics. Ms. Mea: All the seemingly positive news on the trade front is pushing up global share prices. In fact, a substantial portion -if not all -of the global equity price gains have occurred on days when there has been positive news surrounding the US-China trade negotiations. Given EM financial markets were the most damaged by the trade war, one would have thought that EM markets would outperform in a rally stemming from progress in negotiations. Yet this has not occurred. EM currencies have failed to advance (a number of currencies are in fact breaking down), EM sovereign credit spreads are widening and the relative performance of EM vs. DM share prices has relapsed (Chart I-1). What is causing this disconnect? Answer: The disconnect is due to a somewhat false narrative that the global trade and manufacturing recession as well as the EM/China slowdown were primarily caused by the US-China trade confrontation. The principal reason behind the global manufacturing and trade recession has been a deceleration in Chinese domestic demand. The latter can only partially be attributed to the US-China trade tariffs and tensions. Chart I-2 illustrates that mainland exports are not contracting while imports excluding processing trade1 are down 5% from a year ago. This implies that China’s growth slump has not been due to a contraction in its exports but rather due to weakness in its domestic demand. The principal reason behind the global manufacturing and trade recession has been a deceleration in Chinese domestic demand. The basis as to why mainland exports have held up so well is because Chinese exporters have been re-routing their shipments to the US via other countries such as Vietnam and Taiwan. Critically, the key force driving EM currencies and risk assets has been Chinese imports (Chart I-3). Mainland imports continue to shrink, with no recovery in sight. This is the reason why EM risk assets and currencies have performed so poorly, even amid the global risk-on environment. Chart I-2Chinese Imports Are Worse Than Exports Chinese Imports Are Worse Than Exports Chinese Imports Are Worse Than Exports Chart I-3China Imports Drive EM Currencies bca.ems_wr_2019_11_28_s1_c3 bca.ems_wr_2019_11_28_s1_c3   Ms. Mea: Are you implying that a ceasefire in the trade war will not help Chinese growth rebound, and in turn support EM economies? The “Phase One” agreement and possible reductions in US tariffs on imports from China may help the Middle Kingdom’s exports, but not its imports. Crucially, the Chinese authorities will likely be reluctant to augment their credit and fiscal stimulus if there is a “Phase One” deal with the US. Absent greater stimulus, China’s domestic demand is unlikely to stage a swift recovery. In the case of a “Phase One” agreement, a mild improvement in business confidence in China and worldwide is likely, but a major upswing is doubtful. The basis is that business people around the world have witnessed the struggles faced by the US and China in their negotiations. They will likely doubt the ability of both nations to reach a structural resolution – and rightly so. Investors should realize that the Chinese economy does not depend on exports to the US nearly as much as is commonly believed. Importantly, global investors are miscalculating China’s negotiating strategy and tactics. We put much greater odds than many other investors on the possibility that China will continue to drag out the negotiations without signing the “Phase One” agreement. This could easily derail the global equity rally. Investors should realize that the Chinese economy does not depend on exports to the US nearly as much as is commonly believed. China’s shipments to the US have been around 3.3% of GDP, even before the trade war began. The value-added to the economy/income generated from China’s exports to the US is less than 3% of its GDP. In contrast, capital spending accounts for the largest share (42%) of China’s GDP. In turn, investment outlays are driven by the credit cycle and fiscal spending, rather than by exports. Chart I-4China: Stimulus And Business Cycle bca.ems_wr_2019_11_28_s1_c4 bca.ems_wr_2019_11_28_s1_c4 Ms. Mea: Turning to stimulus in China, the authorities have been easing for about a year. By now, the cumulative effect of this stimulus should have begun to revive the mainland’s domestic demand. Why do you still think China’s business cycle has not reached a bottom? Answer: Indeed, our credit and fiscal spending impulse has been rising since January. Based on its historical relationship with business cycle variables – it leads those variables by roughly nine months – China’s growth should have troughed in August or September (Chart I-4). However, the time lags between the credit and fiscal spending impulse and economic cycle are not constant as can be seen in Chart I-4. On average, the lag has been nine months but has also varied from zero (at the trough in early 2009) to 18 months (at the peak in 2016-‘17). Relationships in economics – as opposed to those in hard sciences – are not constant and stable. Rather, correlations and time lags between variables vary substantially over time. In addition, the magnitude of stimulus is not the only variable that should be taken into account. The potential multiplier effect is also significant. One way to proxy the multiplier effect is via the marginal propensity to spend by households and companies. In our opinion, the prime cause behind households’ and businesses’ reluctance to spend is the weak property market. Our proxies for Chinese marginal propensity to spend by companies and households have been falling (Chart I-5). This entails that households and businesses in China remain downbeat, which caps their expenditures, in turn offsetting the positive impact of stimulus. In our opinion, the prime cause behind households’ and businesses’ reluctance to spend is the weak property market. Without rapidly rising property prices and construction volumes, boosting sentiment and growth will prove challenging. We discussed the current conditions and outlook of China’s property market in last week’s report. Construction is the single largest sector of the mainland economy, and it is in recession: floor area started and under construction are all shrinking (Chart I-6). Chart I-5China: A Weak Multiplier Effect China: A Weak Multiplier Effect China: A Weak Multiplier Effect Chart I-6China Construction Is In Recession China Construction Is In Recession China Construction Is In Recession   It is difficult to envision an improvement in manufacturing and a rebound in demand for commodities/materials and industrial goods without a recovery in construction. Notably, Chart I-6 displays the most comprehensive data on construction, as it encompasses all residential and non-residential construction by property developers and all other entities. Ms. Mea: Why are some global business cycle indicators turning up if, as you argue, the global manufacturing slowdown originated from Chinese domestic demand and the latter has not yet turned around? Answer: At any point of the business cycle, it is possible to find data that point both up and down. Our ongoing comprehensive review of global business cycle data leads us to conclude that the improvement is evident only in a few circumstances, and is not broad-based. In particular: In China and the rest of EM, there is no domestic demand recovery at the moment. China and EM ex-China capital goods imports are shrinking (Chart I-7). Chinese consumer spending is also sluggish (Chart I-8). The rise in China’s manufacturing Caixin PMI over the past several months is an aberration. Chart I-7EM/China Capex Is Very Weak EM/China Capex Is Very Weak EM/China Capex Is Very Weak Chart I-8No Recovery For Chinese Consumers No Recovery For Chinese Consumers No Recovery For Chinese Consumers     In EM ex-China, Korea and Taiwan, narrow and broad money growth are underwhelming (Chart I-9). These developments signify that EM policy rate cuts have not yet boosted money/credit and domestic demand. We elaborated on this in more detail in our recent report. The basis for such poor transmission is banking-system health in many developing countries. Banks remain saddled with non-performing loans (NPLs). The need to boost provisions and fears of more NPLs continues to make banks reluctant to lend. Besides, real (inflation-adjusted) lending rates are high, discouraging credit demand. In the US and euro area, consumption – outside of autos – as well as money and credit growth have never slowed in this cycle. The slowdown has largely been due to exports and the auto sector. The latter may be bottoming in the euro area (Chart I-10). This might be behind the improvement in some business surveys in Europe. Chart I-9EM Ex-China: Money Growth Is At Record Low EM Ex-China: Money Growth Is At Record Low EM Ex-China: Money Growth Is At Record Low Chart I-10Euro Area’s Auto Sales: Is The Worst Over? Euro Area’s Auto Sales: Is The Worst Over? Euro Area’s Auto Sales: Is The Worst Over?   European business survey data are mixed, but the weakest segment - manufacturing – remains lackluster. In particular, Germany’s IFO index for business expectations and current conditions in manufacturing have not improved (Chart I-11, top panel). Similarly, the Swiss KOF economic barometer remains downbeat (Chart I-11, top panel). The only improvement is in Belgian business confidence, and a mild pickup in the euro area manufacturing PMI (Chart I-11, bottom panel). Chart I-11European Manufacturing And Business Confidence European Manufacturing And Business Confidence European Manufacturing And Business Confidence   In the US, shipping and carload data are rather grim. They are not corroborating the marginal improvement in the US manufacturing PMI. Overall, at this point there are no signs that domestic demand is recovering in China and the rest of EM, which have been the epicenter of the slowdown. The improvement is limited to some data in the US and Europe. Consistently, US and European share prices have been surging, while EM equities have dramatically underperformed. Ms. Mea: What about lower interest rates driving multiples expansion in both DM and EM equities? Answer: Concerning multiples expansion, our general framework is as follows: So long as corporate profits do not contract, lower interest rates will likely lead to equity multiples expansion. However, when corporate earnings shrink, the latter overwhelms the positive effect of a lower discount rate on multiples, and share prices drop along with lower interest rates. DM corporate profits are flirting with contraction, but are not yet contracting meaningfully. Hence, it is sensible that US and European stocks have experienced multiples expansion. In contrast, EM corporate earnings are shrinking at a rate of 10% from a year ago as illustrated in Chart I-12. The basis for an EM profit recession is the downturn in Chinese domestic demand and consequently imports. EM per-share earnings correlate much better with Chinese imports (Chart I-13, top panel) than US ones (Chart I-13, bottom panel). Chart I-12EM Profits And Share Prices EM Profits And Share Prices EM Profits And Share Prices Chart I-13EM EPS Is Driven By China Not The US EM EPS Is Driven By China Not The US EM EPS Is Driven By China Not The US   In fact, we have documented numerous times in our reports that EM currencies and share prices correlate well with China’s business cycle/global trade/commodities prices, more so than with US bond yields. This does not mean that EM share prices are insensitive to interest rates. They are indeed sensitive to their own borrowing costs, but not to US Treasury yields. Chart I-14 demonstrates that EM share prices move in tandem with inverted EM sovereign US dollar bond yields and EM local currency bond yields. Similarly, emerging Asian share prices correlate with inverted high-yield Asian US dollar corporate bond yields (Chart I-14, bottom panel). Chart I-14EM Share Prices And EM Bond Yields EM Share Prices And EM Bond Yields EM Share Prices And EM Bond Yields Chart I-15Chinese Bond Yields Herald Relapse In EM Stocks And Currencies bca.ems_wr_2019_11_28_s1_c15 bca.ems_wr_2019_11_28_s1_c15 In short, EM share prices typically sell off when EM borrowing costs rise – regardless if it is driven by mounting US Treasury yields or widening credit spreads. Looking forward, exchange rates hold the key. A relapse in EM currencies will push up both the US dollar and local currency bond yields in many EMs. That will in turn warrant a setback in EM share prices. Ms. Mea: What about the correlation between EM performance and Chinese local rates? Answer: This is an essential relationship. Chart I-15 demonstrates that EM share prices and currencies have a strong positive correlation with local interest rates in China. The rationale is that all of them are driven by China’s business cycle. Relapsing interest rates in China are presently sending a bearish signal for EM risk assets and currencies. Ms. Mea: What does all this mean for investment strategy? A few weeks ago, you wrote that if the MSCI EM equity US dollar index breaks above 1075, you would reverse your recommended strategy. How does this square with your fundamental analysis that is still downbeat? Answer: My fundamental analysis on EM/China has not changed: I do not believe in the sustainability of this EM rebound in general, and EM outperformance versus DM in particular. The key risk to my strategy on EM stems from the US and Europe. It is possible that US and European share prices continue to rally. EM share prices typically sell off when EM borrowing costs rise – regardless if it is driven by mounting US Treasury yields or widening credit spreads. Notably, the high-beta segments of the US equity market and the overall Euro Stoxx 600 index are flirting with major breakouts (Chart I-16A and I-16B). If these breakouts transpire, the up-leg in US and European share prices will be long-lasting. This will also drag EM share prices higher in absolute terms. This is why I have placed a buy stop on the EM equity index. Chart I-16AUS High-Beta Stocks High-Beta Stocks High-Beta Stocks Chart I-16BEuropean Equities: At A Critical Juncture European Equities: At A Critical Juncture European Equities: At A Critical Juncture   That said, I have a strong conviction that EM will continue to underperform DM, even in such a scenario. Hence, I continue to recommend underweighting EM versus DM in both global equity and credit portfolios. As we have recently written in detail, the global macro backdrop and financial market dynamics in such a scenario will resemble 2012-2014, when EM currencies depreciated, commodities prices fell and EM share prices massively underperformed DM ones (Chart I-17). Further, I am not arguing that the current global trade and manufacturing downtrends will persist indefinitely. The odds are that the global business cycle, including China’s, will bottom sometime next year. The point is that EM share prices have decoupled from fundamentals – namely corporate earnings growth – since January. The point is that EM share prices have decoupled from fundamentals – namely corporate earnings growth – since January (please refer to Chart I-12 on page 8). This is an unprecedented historical gap, making EM stocks, currencies and credit markets vulnerable to continued disappointments in EM corporate profitability. Ms. Mea: What market signals give you confidence in poor EM performance going forward? Answer: Even though the S&P 500 has broken to new highs, multiple segments of EM financial markets have posted extremely disappointing performance. These include: Small-cap stocks in EM overall and emerging Asia as well as the EM equal-weighted equity index have struggled to rally (Chart I-18). Chart I-17EM Underperformed During 2012-14 Bull Market bca.ems_wr_2019_11_28_s1_c17 bca.ems_wr_2019_11_28_s1_c17 Chart I-18Various EM Equity Indexes: Failure To Rally Is A Bad Omen Various EM Equity Indexes: Failure To Rally Is A Bad Omen Various EM Equity Indexes: Failure To Rally Is A Bad Omen   Various Chinese equity indexes – onshore and offshore, small and large – have failed to advance and continue to underperform the global equity index. EM ex-China currencies and industrial commodities prices have remained subdued (please refer to Chart I-1 on page 1). Ms. Mea: Would you mind reminding me of your country allocation across various EM asset classes such as equities, credit, currencies and fixed-income? Answer: Within an EM equity portfolio, our overweights are Mexico, Russia, central Europe, Korea and Thailand. Our equity underweights are Indonesia, the Philippines, Turkey, South Africa and Colombia. We continue recommending to short an EM currency basket including ZAR, CLP, COP, IDR, MYR, PHP and KRW. Today, we add the BRL to our short list (please refer to the section below on Brazil). As to the country allocation within EM local currency bonds and sovereign credit portfolios, investors can refer to our asset allocation tables below that are published at the end of each week’s report and are available on our web site. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Brazil: Deflationary Pressures Warrant A Weaker BRL The Brazilian real is breaking below its previous support. We recommend shorting the BRL against the US dollar. The primary macro risk in Brazil is not inflation but rather mounting deflationary pressures. Inflation has fallen to very low levels, to the bottom of the central bank’s target range (Chart II-1). Deflation or low inflation is dangerous when there are high debt levels. The Brazilian government is heavily indebted. With nominal GDP growth still below government borrowing costs and a primary budget balance at -1.3% of GDP, the public debt trajectory remains unsustainable as we discussed in previous reports (Chart II-2). Chart II-1Brazil: Undershooting Inflation Target Brazil: Undershooting Inflation Target Brazil: Undershooting Inflation Target Chart II-2Public Debt Dynamics Are Still Not Sustainable Public Debt Dynamics Are Still Not Sustainable Public Debt Dynamics Are Still Not Sustainable   The cyclical profile of the economy is very weak as shown in Chart II-3. Tight fiscal policy and a drawdown of foreign exchange reserves have caused money growth to slow. That in turn entails a poor outlook for the economy, which will reinforce the deflationary trend. Accordingly, Brazil needs to reflate its economy to boost nominal GDP, which is the only scenario where the nation escapes a public debt trap. Yet, fiscal policy is straightjacketed by the spending cap rule, which stipulates that government spending can only grow at the previous year’s IPCA inflation rate. Federal government spending is set to grow only at the low nominal rate of 3.4% in 2020. Hence, monetary policy is the sole tool available for policymakers to reflate. Both bond yields and bank lending rates remain elevated in real terms. This hampers any recovery in the business cycle. Notably, the marginal propensity to spend by companies and consumers is declining, foreshadowing weaker economic activity ahead (Chart II-4). Chart II-3Brazil: The Economy Is Weak Brazil: The Economy Is Weak Brazil: The Economy Is Weak Chart II-4Brazil: Propensity To Spend Is Declining Brazil: Propensity To Spend Is Declining Brazil: Propensity To Spend Is Declining   The central bank is determined to reduce interest rates further. As such, they cannot control the exchange rate. Indeed, the Impossible Trinity thesis states that in an economy with an open capital account (like in Brazil), the authorities cannot control both interest and exchange rates simultaneously. Minister of Economy Paulo Guedes stated in recent days that tight fiscal and easy monetary policies are consistent with a lower currency value. Brazilian policymakers are open to the idea of a weaker exchange rate and will not defend the real. Their currency market interventions are intended to smooth volatility in the exchange rate but not preclude depreciation. In fact, currency depreciation is another option to boost nominal growth that the nation desperately needs. Brazilian policymakers are open to the idea of a weaker exchange rate and will not defend the real. Their currency market interventions are intended to smooth volatility in the exchange rate but not preclude depreciation. Commodities prices remain an important driver of the Brazilian real (Chart II-5). These have failed to rebound amid the risk-on regime in global financial markets. This suggests that the path of least resistance for commodities prices is down, which is bad news for the real. Brazil’s current account deficit is widening and has reached 3% of GDP (Chart II-6). Notably, not only are export prices deflating but export volumes are also shrinking (Chart II-6, bottom panel). Chart II-5BRL And Commodities Prices BRL And Commodities Prices BRL And Commodities Prices Chart II-6Widening Current Account Deficit Widening Current Account Deficit Widening Current Account Deficit   Chart II-7The BRL Is Not Cheap The BRL Is Not Cheap The BRL Is Not Cheap Meanwhile, the nation’s foreign debt obligations – the sum of short-term claims, interest payments and amortization over the next 12 months – are at $190 billion, all-time highs. As the real depreciates, foreign currency debtors (companies and banks) will rush to acquire dollars or hedge their dollar liabilities. This will reinforce the weakening trend in the currency. Finally, the Brazilian real is not cheap - it is close to fair value (Chart II-7). Hence, valuation will not prevent currency depreciation. Bottom Line: We are initiating a short BRL / long US dollar trade. Investors should remain neutral on Brazil within EM equity, local bonds and sovereign credit portfolios. Investors with long-term horizon should consider the following strategy: long the Bovespa, short the real. This is a bet that Brazil will succeed in reflating the economy at the detriment of the currency. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Andrija Vesic Research Analyst andrijav@bcaresearch.com     Footnotes 1    Processing trade includes imports of goods that undergo further processing before being re-exported.   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights Monetary policy settings should continue to sustain the expansion,… : Tight monetary policy is a precondition for a recession. Although the line separating tight from easy is a matter of judgment, current Fed policy is squarely accommodative.  … and the building blocks of GDP confirm that recession is not an imminent threat: A robust labor market and fortified household balance sheets should continue to support consumption; the fixed investment outlook is okay as long as trade tensions don’t wreck business confidence; and the fiscal taps are likely to remain open throughout 2020. Housing will not get in the way of the economy or the markets: Mortgage rates have fallen since we examined housing dynamics in a two-part Special Report this time last year, and residential investment will increasingly reflect it. We project that the beginning of the next recession is about two years away, and that the equity and credit bull markets still have room to run: We are not perma-bulls, but there’s no evidence that the long bull run is about to end. Feature We view the study of key cycles – the business cycle, the credit cycle, the monetary policy cycle and the sentiment cycle – as an essential element of investment strategy. The monetary policy cycle has been especially critical throughout the long expansion and bull market because it has held sway over the business cycle and the credit cycle since the crisis. We have also found that it exerts a powerful influence on equity returns: for six decades, stocks have done very well when policy is easy, but they have failed to generate positive real total returns when it’s tight. There is far more to investment returns than monetary policy, but a simple strategy of embracing risk during easy-policy phases of the fed funds rate cycle and limiting exposure to it when policy is tight has been a big winner over time. Although the fed funds rate cycle has been an especially valuable input in our process, it relies on an estimate. The equilibrium, or neutral, fed funds rate cannot be directly observed. We can only infer when the target fed funds rate crosses above or below it by observing actual economic performance. We continually review real-time data to gauge whether our equilibrium estimate is in the ballpark. As a formal check on that estimate, we regularly examine the building blocks of GDP for insight into where the business cycle is going. We update our review of the GDP equation in this report, and conclude that the expansion should remain on track over the next six to twelve months. We also provide an update on housing a year after our dedicated Special Reports on the topic, finding that it is unlikely to derail the expansion. The GDP Equation – Consumption As we all learned in Introductory Macroeconomics, GDP is the sum of consumption (C), investment (I), government spending (G) and net exports (X-M). As net exports are insubstantial in the comparatively closed US economy, US GDP growth reduces to the weighted sum of growth in consumption, investment and government spending, with consumption accounting for two-thirds of growth and investment and government spending accounting for one-sixth each. GDP = C + I + G Month-to-month moves in real retail sales and personal consumption expenditures (PCE) are volatile, but both series have recovered from their late-2018 softness to get back to their mean for this cycle, somewhat below the means of the previous two expansions (Chart 1). The activity supports our constructive take at the time of our initial review of the GDP equation in April,1 but the choppy series do not provide much insight into the consumption outlook. Looking forward involves examining households’ income prospects and balance sheets to project the money that will be coming in, and consumers’ ability and willingness to spend it. Chart 1Consumption Has Been Holding Up Well Consumption Has Been Holding Up Well Consumption Has Been Holding Up Well Labor market conditions drive household income, and they remain quite tight. The number of unfilled job openings continues to exceed the number of unemployed workers (Chart 2), indicating that demand for employees remains strong. An elevated quits rate indicates that employers are competing fiercely to meet that demand, even to the point of poaching employees from one another (Chart 3). Our payrolls model projects that employment growth will stay close to its pace of the last several years (Chart 4, top panel), as small businesses have ambitious hiring plans (Chart 4, second panel), temporary employment is still growing (Chart 4, third panel), and the 26-week moving average of initial unemployment claims is only slowly beginning to rise (Chart 4, bottom panel). Chart 2With More Jobs Than Workers, ... With More Jobs Than Workers, ... With More Jobs Than Workers, ... Chart 3... Employees Can Seek Out Greener Pastures ... Employees Can Seek Out Greener Pastures ... Employees Can Seek Out Greener Pastures Chart 4Payrolls Will Keep Expanding Payrolls Will Keep Expanding Payrolls Will Keep Expanding Wages are already growing around 3% year-over-year, and the tight labor-market backdrop should promote further gains. With employers forced to bid up wages to attract a shrinking pool of available workers, we expect that wage growth will peak somewhere above 3.5% before the cycle ends. Humans’ ability to see into the future does not extend beyond six to twelve months, but we are confident that more households will be working by the middle of 2020 than are working now, and that they’ll be earning more, in real terms. Households don't have to spend their income gains, but they're in a comfortable position to do so after several years of building up savings and working down debt. Households won’t necessarily spend all of their income gains. They may choose to direct them to paying down debt or increasing savings. Their balance sheets suggest they don’t have a need to do so, however, as the savings rate is back to early ‘90s levels above 8% (Chart 5, top panel), nearly all the debt as a share of GDP that they took on in the last expansion has been worked off (Chart 5, middle panel), and their aggregate debt service burden is lower now than it has been at any point in the last 40 years (Chart 5, bottom panel). Not only do households face little pressure to save their coming income gains, they have plenty of capacity to borrow to augment them. Chart 5Household Finances Are Solid Household Finances Are Solid Household Finances Are Solid The GDP Equation – Investment And Government Spending Investment accounts for just a sixth of GDP, but its volatility gives it a greater likelihood of tipping the economy into a recession than either consumption or government spending (Chart 6). Per the surveys we use to anticipate capital expenditures, the change since April is mixed. Small business capital spending plans as reported in the NFIB survey have ticked up and remain elevated (Chart 7, top panel), while capex intentions from the regional Fed manufacturing surveys have continued to slip and are only around their historical mean (Chart 7, bottom panel). We expect that the trade negotiations will exert a powerful near-term pull on corporate capex; if the US and China reach some sort of accord, capex should pick up, but if tensions worsen, corporate confidence will decline and capex may outright contract. Our base case calls for a modest détente around a Phase 1 agreement, so we do not expect that investment will break down, but it is the most vulnerable component of GDP and we are watching it closely. Chart 6Investment Is The Swing Factor Investment Is The Swing Factor Investment Is The Swing Factor Chart 7The Capex Outlook Is Only Okay, ... The Capex Outlook Is Only Okay, ... The Capex Outlook Is Only Okay, ... Government spending, on the other hand, doesn’t merit a whole lot of attention right now. It is a stable series that accounts for a modest share of GDP and for most of the postwar era, it was reliably countercyclical, shrinking when times were good and expanding when times were bad (Chart 8). The gaping divergence between the federal deficit and economic performance bodes ill for Treasuries and the dollar over the long term, but it shows that there’s no appetite for reining in federal spending ahead of the most hotly contested election campaign in recent memory. State and local spending accounts for about 60% of all government spending, and the strong labor market will boost state receipts, which come from income and sales taxes, while steady home price appreciation will support property tax receipts (Chart 9), keeping municipal coffers full. The longer-term implications of the debauched federal budget are unpleasant, but government profligacy will help sustain the expansion through the end of next year. Chart 8... But The Fiscal Party Rages On ... But The Fiscal Party Rages On ... But The Fiscal Party Rages On Chart 9Home Price Gains Will Fill Local Government Coffers Home Price Gains Will Fill Local Government Coffers Home Price Gains Will Fill Local Government Coffers Housing Residential investment finally broke out of a six-quarter string of detracting from GDP growth last quarter, though its drag in the first half of the year was modest. Residential investment may not exert the sway over the economy that it did earlier in the postwar era when the suburbs were being created from scratch, but its interest rate sensitivity makes it a good proxy for the effect of monetary policy on the economy. Housing has picked up as mortgage rates have fallen, and rates’ lagged effect suggests that more gains are in store (Chart 10). A high level of affordability should keep the momentum going (Chart 11), and new household formations continue to outstrip housing starts (Chart 12, top panel), at a time when inventories (Chart 12, middle panel) and vacancies (Chart 12, bottom panel) are historically low. Chart 10The Full Effect Of Lower Rates Is Yet To Be Felt The Full Effect Of Lower Rates Is Yet To Be Felt The Full Effect Of Lower Rates Is Yet To Be Felt Chart 11Affordability Is High, ... Affordability Is High, ... Affordability Is High, ... Chart 12... And Supply Is Tight ... And Supply Is Tight ... And Supply Is Tight We continue to believe that housing poses no threat to the expansion. New home sales should pick up as builders address the undersupply of homes for first-time and first move-up buyers. The cap on itemized deductions imposed by the December 2017 revision to the federal tax code does not appear to have had a material impact on regional sales activity, and the relationship between top marginal income tax rates2 and home price appreciation since the tax act passed is weak (Chart 13). The bottom line is that residential investment is more likely to boost fixed investment over the next year than it is to detract from it. Chart 13Post-Act Home Price Appreciation Among 20-City Case-Shiller Constituents Stay The Course Stay The Course Investment Implications The underlying elements of the GDP equation support our monetary policy-driven assessment that the expansion will keep chugging along. A robustly healthy labor market will support wage gains, and household balance sheets have firmed up enough to allow consumers to spend their increased income. Surveys indicate that fixed investment does not present a major economic headwind, and positive trade developments could turn it into a tailwind. Government spending will be well supported through 2020. It would be consistent with history if this bull market didn't end until it made one more big push higher. Recessions and bear markets coincide, so the equity bull market should persist until the next recession is in sight. Spread product should also continue to outperform Treasuries and cash, especially while lenders are desperately seeking incremental carry. We reiterate our broad recommendation to overweight equities and spread product, while underweighting Treasuries, and urge investors with more conservative mandates to remain at least equal weight equities and spread product. Excesses in the real economy or the financial markets are a recession prerequisite, and it is quite possible that the excesses that precipitate the next recession will not emerge until after stocks make another significant move higher. We want to be positioned to participate in that move, which would be consistent with bull markets’ established tendency to sprint to the finish line.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Please see the April 8, 2019 US Investment Strategy Weekly Report, “If We Were Wrong,” available at www.bcaresearch.com 2 The 2017 Act capped the amount of state and local tax payments household filers could claim as itemized deductions, severely reducing the federal government’s homeownership subsidy. Residents of states with high income tax rates lost the most from the change, but those states’ housing markets have not yet experienced disproportionately negative impacts.

Mr. X and his daughter, Ms. X, are long-time BCA clients who visit our office toward the end of each year to discuss the economic and financial market outlook for the year ahead. This report is an edited transcript of our recent conversation. Mr. X: I have been eagerly looking forward to this meeting given my many concerns about the outlook. Our portfolio has done well in the past year thanks to the surge in bond prices and the outperformance of defensive equities. However, I am deeply troubled by the amount of monetary stimulus required to support risk assets, and by how expensive bonds and equities are. Moreover, the global economy remains engulfed in deflationary risks, and policymakers are running out of ammunition. As always, there is much to talk about. Ms. X: Let me add that I am also pleased to once again be here to discuss the major risks and opportunities in the global marketplace. A year ago, I held a more positive market view than my father. Directly after our meeting, the deep market correction gave me second thoughts, but ultimately, the rebound in stock prices vindicated my view. Clearly, your assertion that markets would be turbulent proved correct. Since I joined the family firm in early 2017, I have been pushing my father to keep a higher equity exposure than he was normally comfortable with. We agreed to still favor stocks last year, albeit, with a bias toward defensive sectors, and this strategy paid off. But after the past year’s powerful rally in both bonds and stocks, we are again left wondering how to position our portfolio. Ultimately, I do not believe a recession is imminent. Yes, stocks are expensive, but bonds are even more so. Since I expect economic growth to pick up, I am inclined to tilt the portfolio further into equities and move away from our preference for defensive sectors. As usual, I am very interested to hear your views. BCA: Our core theme for 2019 was that we would face classic late-cycle turbulence. Despite this volatility, a run-up in asset prices was likely. Soon after we met, the stock market plunged, hitting a low on December 26, 2018. We anticipated the Federal Reserve to be much more hawkish than what actually transpired. Wage growth and even core inflation have remained firm in the US, but the weakness in global inflation expectations drove central banks’ reaction functions more powerfully than we anticipated. Moreover, the rapid escalation of the Sino-US trade war added a layer of uncertainty that exacerbated the economic slowdown that had started in mid-2018, forcing global central banks to ease policy as an indemnity against recession. Looking ahead, central bankers are highly unlikely to tighten monetary policy as long as inflation expectations remain below their normal range consistent with a 2% inflation target. We agree that the odds of a US recession in the coming year are still low because financial conditions are set to remain accommodative, Chinese authorities are setting policy to shore up growth, and a trade truce is likely. Global economic activity will rebound in early 2020. Instead, the most probable timeframe for a broad based recession is late 2021/early 2022. As a result, we remain positive on risk assets, especially foreign stocks. We are also underweighting bonds as they offer extremely poor absolute and relative value. Mr. X: I can see we will have a lively discussion because I do not share your or my daughter’s optimism. My list of concerns is long, I hope we have time to get through them all. But first, let’s briefly review your predictions from last year. BCA: This exercise is always interesting and often humbling, too. A year ago, our key conclusions were that: Tensions between policy and markets would be an ongoing theme in 2019. With the US unemployment rate at a 48-year low, it would take a significant slowdown for the Fed to stop hiking rates. Ultimately, the Fed would deliver more hikes in 2019 than discounted in the markets. This would push up the dollar and keep the upward trend in Treasury yields intact. The dollar would peak in mid-2019. China would also become more aggressive in stimulating its economy, which would boost global growth. However, until both of these things happened, emerging markets would remain under pressure. We favored developed market equities over their EM peers. We also preferred defensive equity sectors such as healthcare and consumer staples over cyclical sectors such as industrials and materials. Within the developed market universe, the US would outperform Europe and Japan over the next few quarters, especially in dollar terms. Stabilization in global growth would ignite a blow off rally in global equities. If the Fed was raising rates in response to falling unemployment, it would be unlikely to derail the stock market. However, once supply-side constraints began to bite fully in early 2020 and inflation began to rise well above the Fed’s target of 2%, stocks would begin to buckle. This would mean that a window would exist in 2019 for stocks to outperform bonds. We would maintain a benchmark allocation to stocks, but increase exposure if global bourses were to fall significantly from then (late 2018) current levels without a corresponding deterioration in the economic outlook. Corporate credit would underperform stocks as government bond yields rise. A major increase in credit spreads was unlikely as long as the economy remained in expansion mode, but spreads could still widen modestly. US shale companies had been the marginal producers in the global oil sector. With breakeven costs in shale close to $50/bbl, crude prices would be unlikely to rise much from current levels over the long term. However, we expected production cuts in Saudi Arabia would push prices up, with Brent crude averaging around $82/bbl in 2019. A balanced portfolio was likely to generate average returns of only 2.8% a year in real terms over the next decade. This compares to average returns of around 6.6% a year between 1982 and 2018. As already noted, our forecast for more Fed rate hikes was wrong. This meant that we were offside in our duration call. Ultimately, 10-year Treasuries have generated returns of 10.8% so far this year, and German bunds and Japanese government bonds returns of 5.8% and 1.0% in EUR and JPY terms, or 2.5% and 2.0% in USD terms, respectively (Table 1). Nonetheless, our expectation of a run-up in risk asset prices was spot on. Equities outperformed bonds, with global stocks climbing 22.2% in USD terms. We missed the initial outperformance of corporate bonds relative to Treasuries, as investment grade credit rose by 13.9%. However, our bond team took a more constructive stance on corporates as the year progressed. Table 1Market Performance OUTLOOK 2020: Heading Into The End Game OUTLOOK 2020: Heading Into The End Game Chart 12019 Was A Good Year For Stocks 2019 Was A Good Year For Stocks 2019 Was A Good Year For Stocks In terms of regional allocation recommendations, we were correct to overweight US equities which beat non-US stocks by 13.4%, partly thanks to the dollar’s appreciation. We were also right to underweight EM equities, with Asia and Latin America generating dollar returns of only 12.6% and 6.9%. Overall, it was a good year for financial markets (Chart 1). Our growth forecasts were mixed. We predicted global growth would slow in the first half of 2019 but improve thereafter. Instead, the slowdown extended and intensified into the second half of the year as the Sino-US trade war escalated more than expected, and Chinese policymakers were more reluctant to reflate than anticipated. The IMF also revised down its growth forecasts. In the October 2019 World Economic Outlook report, growth in advanced economies for the year was cut to 1.7% from 2.1% compared to 2018 forecasts, led by a downward revision to 1.5% from 2% in Europe (Table 2). They also pared down 2019 EM growth estimates to 3.9% from 4.7%. Consequently, inflation was softer than originally predicted. These trends in economic activity meant that our dollar call was partially right. The currency did not peak in the middle of the year as we foresaw, but has been flat since the spring and today trades where it was in April. Meanwhile, the weaker-than-expected growth put our oil call offside, with Brent averaging $62/bbl this year, not $82/bbl. Table 2IMF Economic Forecasts OUTLOOK 2020: Heading Into The End Game OUTLOOK 2020: Heading Into The End Game The Cycle’s End Game Mr. X: You mentioned that you remain positive on risk assets and stocks for 2020. You will not be surprised that I am extremely skeptical of this view. The Fed could only raise rates to 2.5% before all hell broke loose, and it has now cut them back to 1.75%. The European Central Bank has lowered its deposit rate to -0.5% and is resuming its asset purchase program, while the Bank of Japan is clearly out of ammunition. Yet global growth remains weak. Despite this lack of economic traction, US stocks are at a record high and are unequivocally expensive. This situation seems untenable. If global growth weakens further, there is little more policymakers can do. I think the risk of a recession is a lot more elevated than you believe, especially as we cannot count on a lasting trade détente. Meanwhile, the US presidential election makes me uncomfortable, and I cannot see how business leaders will want to deploy capital to expand capacity given the risk that the regulatory and tax environment could become hostile to the corporate sector. If I’m wrong about growth – and I hope I am – then inflationary pressures will build and central banks will have to tighten policy suddenly. As bond yields rise, stocks will be sold and yet bonds will not offer any protection since they yield so little. Also, I have not even talked about negative interest rates. $12.1 trillion of debt yields less than zero percent. This is obviously preventing creative destruction from purging the system of rot. It is also promoting capital misallocation and undue risk-taking by financial institutions who cannot meet fiduciary liabilities. Ms. X: Based on this tirade, you can easily imagine what life at the office has been like in recent months. I do share some of my father’s concerns. Negative rates cannot be a good thing, especially from a long-term perspective. If growth weakens further, I’m also concerned that central banks have few options left. However, I do not see these risks as imminent. There are nascent signs that the global economy will stabilize soon; both President Trump and President Xi have strong incentives to reach a trade truce; and central banks are nowhere near removing the proverbial punch bowl. While US stocks are expensive, other risk assets offer value if global growth rebounds. The wall of worry is high, but stocks can and will climb that wall. BCA: Your debate is similar to our own internal discussions. It is undeniable that the investing landscape looks shaky at the moment, especially with the S&P 500 currently trading at 18-times forward earnings. However, the situation you are describing is a direct consequence of one BCA’s long running macro themes: The end of the debt supercycle. While the debt supercycle is dead in advanced economies, it remains very much alive in emerging markets, and China in particular. The private debt load in advanced economies has declined by 20% of GDP since 2009 (Chart 2A). Despite the burgeoning US federal government deficit, public debt accumulation has not been strong enough to cause total debt loads to increase. Instead, aggregate indebtedness has been stuck slightly above 260% of GDP for the past 10 years. Depressed, and in some cases, negative interest rates reflect weak demand for credit. Chart 2AThe Debt Supercycle Is Dead In DM... The Debt Supercycle Is Dead In DM... The Debt Supercycle Is Dead In DM... Chart 2B...But Not In EM ...But Not In EM ...But Not In EM   The end of the debt supercycle has both a negative and positive impact. Without increasing leverage, domestic demand cannot grow faster than trend GDP. Thus, it takes much more time for inflationary pressures to build. Concurrently, in the absence of inflationary pressure, more time passes before monetary policy reaches a restrictive level causing recession. The upshot is that the business cycle can last much longer. Moreover, a world less geared to credit accumulation reduces the fragility of the financial system, at the margin. While the debt supercycle is dead in advanced economies, it remains very much alive in emerging markets, and China in particular (Chart 2B), where the demand for credit is still very sensitive to changes in monetary settings. EM countries are the major source of volatility in the global business cycle. Chinese policymakers’ management of the tradeoff between growth and leverage will determine whether the global economy can avoid deflation. If they decide to tackle debt excesses head on, EM credit growth will contract and EM final demand will suffer. In this scenario, negative rates will persist in low-growth advanced economies, and the Fed will be incapable of raising rates because global deflationary forces will be too strong. Chart 3The World Is In The Midst Of A Deflationary Episode The World Is Experiencing A Deflationary Episode... The World Is Experiencing A Deflationary Episode... The second half of 2018 and the whole of 2019 gave us a taste of these forces. When China tightened credit conditions, the EM economies slowed first. Trade and manufacturing hubs like Europe, Australia and Japan quickly followed. A deflationary wave spread around the world, as evidenced by a drop in global producer prices (Chart 3). The US is a comparatively closed economy, but it could not avoid this gravitational pull. The ISM manufacturing survey ultimately started to contract in August 2018, converging to weakness in the rest of the world. The trade war’s hit to business confidence added insult to the injury of an already weak economic environment. Looking ahead, our optimism reflects an expectation that Chinese policymakers will adopt a more pro-growth policy stance because they too are spooked by the downtrend in their economy. While the Politburo Standing Committee has not abandoned its structural reform agenda, it realizes that aggressive deleveraging is dangerous. The Chinese economy is growing at its weakest pace in nearly 30 years and deflation is once again taking hold. In response to date, policymakers have lowered China’s reserve requirement ratio by 400 basis points, cut taxes by 2.8% of GDP, increased the issuance of local government bonds to finance public infrastructure projects, and boosted capex at state-owned enterprises. EM economies will respond to these stimulative measures. The Chinese credit and fiscal impulse has stabilized (Chart 4). Meanwhile, the Fed has pushed the real fed funds rate 74.4 basis points below the Holston-Laubach-Williams estimate of the neutral rate, and coordinated global policy easing points to a rebound in the global manufacturing sector (Chart 4, bottom panel). Moreover, the global inventory purge that magnified the industrial sector’s pain is getting exhausted and the auto sector is looking up. Finally, we agree with Ms. X that both President Trump and President Xi have their own incentives to deescalate trade policy uncertainty. We are entering the end game of this business cycle and bull market. Global borrowing rates will rise, but only to a limited extent. Rightly or wrongly, major central banks are terrified by the prospect of the Japanification of their economies. Practically speaking, this means that they want inflation expectations to move back up to normal levels (Chart 5). However, after undershooting their 2% targets for 11 years, achieving this objective will require central banks to let realized inflation overshoot these targets first. Thus, central banks are unlikely to tighten policy until late next year at the earliest, which will limit how far yields can climb in 2020. Chart 4…But Do Not Bet Against Reflation ...But Do Not Bet Against Reflation ...But Do Not Bet Against Reflation Chart 5Depressed Inflation Expectations Depressed Inflation Expectations Depressed Inflation Expectations   Equities and other risk assets should perform well if global growth re-accelerates but interest rates don’t rise much at first. Some benefit of this fertile backdrop is already priced in, but many pockets of value levered to stronger global growth still exist. We are entering the end game of this already long business cycle. While the general environment favors remaining invested in risk assets in 2020, this is likely the last window of opportunity to do so. Today’s accommodative monetary policy will revive inflationary pressures in 2021, and central banks will ultimately be forced to lift rates much more aggressively. China will continue to resist excessive leverage. Neither the business cycle nor the equity bull market will withstand these final assaults. Mr. X: Your benign outlook reminds me of when we met in December 2007. Do you remember? You told me that the housing slowdown and the credit market seizure were large risks, but central banks would put a floor under global growth. How did that turn out? I agree that in advanced economies, overall debt loads have been stable. But this belies major disparities. For example, US corporate debt has never represented a larger share of GDP than it does today. This must be a major vulnerability. While household balance sheets look healthy, I do not think consumption will save the day if companies are cutting capex and employment while they clean up their balance sheets. Countries like Canada and Australia are drowning in private sector debt. How can you ignore these vulnerabilities? BCA: A comparison with 2008 actually reveals why advanced economies, particularly the US, are not the powder keg that they once were. US corporate debt is elevated when compared to GDP, but profits also represent a much larger share of GDP than they did 10 or 20 years ago, and interest rates are close to historic lows. As a result, interest coverage ratios are still adequate (Chart 6). In 2007, household debt loads were large, but interest payments also accounted for 18.1% of disposable income, the highest proportion since 1972. Additionally, US firms’ debt-to-asset ratio is in line with the post-1970 average of 22.1%. Finally, US businesses have not used rising leverage to fund capital spending, as demonstrated by the elevated age of the capital stock. Thus, the US corporate sector continues to generate positive net savings. Ahead of recessions, US businesses typically generate negative net savings. The composition of the creditors is another important difference. In 2007, an extremely large share of the spurious borrowings resided on banks’ balance sheets. Moreover, the banking system was woefully undercapitalized with a leverage ratio of 17x. Weak banks had to absorb 2.2 trillion of losses after 2008. Consequently, the money creation mechanism broke down, and money multipliers collapsed (Chart 7). Today, US banks boast relatively stronger balance sheets, and they are still judicious about extending credit despite being less exposed to the corporate sector than they were to the mortgage market in 2008. Instead, most corporate debt is held by less levered entities such as ETFs, pension plans, and insurance companies. The leveraged losses that proved so debilitating in 2008 are less likely to be a source of systemic risk in this cycle. Chart 6US Businesses Can Still Service Their Debt US Businesses Can Still Service Their Debt US Businesses Can Still Service Their Debt Chart 72008 Heralded A Destruction Of Money 2008 Heralded A Destruction Of Money 2008 Heralded A Destruction Of Money   Countries like Australia and Canada have much more worrisome private sector debt dynamics, as their servicing costs are elevated (Chart 8). However, these economies are unlikely to collapse when global rates are low, as long as the global economy can avoid a recession, which would reduce export revenue in these trade-sensitive countries. You expect a moderate rebound in global growth next year, but not a sharp acceleration because Chinese stimulus will not be that aggressive. The bottom line is that both the US corporate sector and at-risk countries like Canada should avoid a day of reckoning until interest rates rise meaningfully. As we have already mentioned, central banks are very clear that they will allow inflation to overshoot before tightening policy anew. We monitor US inflation breakeven rates to gauge the likely timing of that outcome. At 1.6%, they remain well below the 2.3% to 2.5% range, which is historically consistent with central banks durably achieving their inflation target (Chart 9). Until inflation expectations are re-anchored back up in that range, we will not worry about an imminent tightening in monetary conditions. Chart 8Canada And Australia Are Close To Their Debt Walls Canada And Australia Are Close To Their Debt Walls Canada And Australia Are Close To Their Debt Walls Chart 9The Fed Is In No Rush To Tighten The Fed Is In No Rush To Tighten The Fed Is In No Rush To Tighten   Chart 10Inflation Is A Lagging Indicator OUTLOOK 2020: Heading Into The End Game OUTLOOK 2020: Heading Into The End Game It is true that inflationary pressures are building in the US. Historical evidence points to a kink in the Phillips curve, the link between wage growth and the unemployment rate. Since the labor market is tight, we are already seeing average hourly earnings growth accelerate. Moreover, the output gap is mostly closed. However, keep in mind that inflation is also a lagging economic indicator (Chart 10). Consequently, the recent global economic slowdown is likely to keep US inflation at bay for most of 2020. The sharp fall in US capacity utilization along with the decline in imported goods and core producer price inflation corroborate this picture. Mr. X: So you believe that as long as rates stay low, the day of reckoning will be delayed. But ultimately, that it is unavoidable. BCA: Correct. No matter what, we are entering the end game of this already long business cycle. The current period of easy policy will allow cyclical spending to rise as a share of output, and debt to build up again over the coming 18 months. Because slack is clearly limited, this latest wave of policy easing will generate inflationary pressures. Ultimately, the Fed will be forced to play catch up and tighten more aggressively than expected in 2021. Paradoxically, the longer the onset of recession is delayed, the deeper it is likely to be… Mr. X: Because imbalances and vulnerabilities will only grow larger! BCA: Absolutely! Mr. X: That is something we can agree on. Ms. X: The way you complete one another’s sentences is a testament to how many years you have been talking to each other. For me, the most concerning issue is political risk. While I am more positive on the outlook for trade policy than my father, I do worry about the impact of US election risk on capital spending. Chart 11If The 2012 Election Is Any Guide, Trump Can Still Win A Second Term OUTLOOK 2020: Heading Into The End Game OUTLOOK 2020: Heading Into The End Game BCA: On the trade war, we would like to address your father’s concerns. All politicians, even unconventional ones like President Trump, seek re-election. Yet, President Trump’s overall approval rating is low (Chart 11). If the election were held today, his odds of winning would be minimal. However, US presidential elections do ultimately favor the incumbent. If the re-election of President Obama in 2012 is any guide, President Trump has enough time to boost his approval rating over the coming 12 months to secure a second term through the Electoral College. In order to achieve this outcome, he must reverse the large slowdown in wage growth currently plaguing the swing states he won by only a small margin in 2016 (Chart 12). Workers in states like Michigan, Pennsylvania and Wisconsin are suffering disproportionately from the uncertainty created by the trade tensions. President Trump will have to pause the tariffs – and even cut tariff rates – to support the economy and reassure voters. Chart 12Trump's Fear Is Coming True Trump's Fear Is Coming True Trump's Fear Is Coming True China is willing to accept a trade truce. The Chinese economy is weak and producer prices are once again deflating. President Xi doesn’t want to preside over another massive surge in leverage or a 1930’s Irving Fisher-style deflationary spiral. Reviving private sector investment sentiment via a reduction in trade policy uncertainty would help stabilize spending and avoid a disorderly economic slump. Moreover, President Xi may not trust the current White House, but the prospect of a Democratic administration that will be tough on both environmental standards and human rights would offer little solace. This brings us to the US election. The recent Bank of America Merrill Lynch positioning survey shows that the investment community shares your concerns. This risk is hard to quantify. The Democratic nomination is wide open. Former Vice President Joe Biden leads the opinion polls, and is a known quantity. Meanwhile, the rising progressive wing of the party, embodied in Senator Elizabeth Warren, is hostile to business and likely to cause concerns in boardrooms across the US, especially in the tech, energy, financial services and healthcare sectors. This could dampen animal spirits. Biden’s and Warren’s odds of beating President Trump are overstated by current polls, especially if the President softens his stance on trade to allow for a growth pick-up. Moreover, to be competitive nationally, Senator Warren will have to abandon some of her more progressive plans and pivot toward the center. The recent upbeat equity market performance of sectors like managed healthcare suggests that markets are discounting this shift. Thus, we doubt the election is currently really weighing on business intentions. The recent pick up in capital spending intentions in various Fed Manufacturing surveys fades this risk. Chart 13A Structural Tailwind Has Vanished A Structural Tailwind Has Vanished A Structural Tailwind Has Vanished What is clear though is that if the economy were to weaken further, Senator Warren’s chances would improve and CEOs would genuinely begin to worry about re-regulation, potentially unleashing a vicious cycle. Thus, the end game is an unstable equilibrium. On a structural basis, whether one looks at the rise of populism or the geopolitical rivalry between China and the US, trade tensions will remain a pesky feature of the global economy. In effect, the trade truce will not be a permanent deal. The global economy has therefore lost the tailwind of deepening global integration achieved through trade (Chart 13). This will limit global potential GDP growth. Ms. X: Thank you. I think the time is right to explore your economic outlook in more detail. The Economic Outlook Chart 14China: Modest Reflation Is Underway China: Modest Reflation Is Underway China: Modest Reflation Is Underway Mr. X: From your arguments, it seems that the outlook for China and Emerging Markets is critical, so let’s start there. My impression is that President Xi is not abandoning his structural reform agenda. Avoiding the middle-income trap will require decreasing China’s dependence on credit as a growth driver. Can economic activity really stabilize under those circumstances? BCA: You are correct: Senior Chinese administrators are reluctant to allow another major phase of debt accumulation to take hold. However, as we already highlighted, policymakers are taking steps to end the most severe economic slowdown since the first half of the 1990s. China is currently implementing a middling stimulus program. The positive impact of the lower bank reserve requirement ratio, the tax cuts and increased public infrastructure spending is being mitigated by strong regulatory constraints on the shadow banking system and small financial institutions, by efforts to limit real estate speculation, and by the cash crunch facing real estate developers. These crosscurrents make it unlikely that the credit impulse will rise as sharply as it did following the reflationary campaigns of 2009, 2012 or 2016. Nonetheless, the Chinese economy is indeed exhibiting some mildly positive signals. Our monetary indicator and state-owned enterprise capital spending point to a rebound in overall Chinese economic activity (Chart 14). Moreover, household spending is trying to bottom. If China stabilizes, then the EM slowdown will end soon. Without a deepening drag from the Chinese economy, EM countries should be able to take advantage of the easing in global financial and liquidity conditions. But the end of the Chinese drag on EM growth does not mean a massive tailwind will be forthcoming. Additionally, deflationary forces remain stronger in the emerging world than in the US. As a result, EM real rates will remain stubbornly above the level that real economic activity warrants, posing a headwind for capital and durable goods spending. Generally speaking, EM and China are moving from a headwind for the world to a mild tailwind. Treasury yields are unlikely to move significantly higher than the 2.25% to 2.5% zone. Ms. X: I’m somewhat more positive than you on global growth next year. The policy easing around the world looks very promising for economic activity. How do you factor the impact of improving global liquidity conditions into your outlook for 2020? BCA: It is undeniable that global liquidity conditions have eased massively. As we already highlighted, the majority of global central banks cutting rates is a very positive dynamic for global growth. Trends in measures of liquidity ratify this message. Foreign exchange reserves are again growing and our BCA US Financial Liquidity index has rallied sharply over the past 12 months. Historically, this indicator forecasts the trend in the BCA Global Leading Economic Indicator, commodity prices and EM export prices by 18 months (Chart 15). Moreover, money aggregates are growing faster than credit across the major advanced economies. Such developments typically foretell an acceleration in global economic activity (Chart 16). Chart 15Liquidity Dynamics: Fueling A Global Growth Recovery Liquidity Dynamics: Fueling A Global Growth Recovery Liquidity Dynamics: Fueling A Global Growth Recovery Chart 16Rising Money Supply Is A Good Thing Rising Money Supply Is A Good Thing Rising Money Supply Is A Good Thing   The duration of the current slowdown also warrants optimism. We have often highlighted that since the early 1990s, the global manufacturing sector evolves over 36-month symmetric cycles (Chart 17). The current soft patch has lasted more than 18 months. In the context of easing liquidity and depleted inventories, pent-up demand can easily translate into actual spending. The recent surge in the new orders-to-inventories ratio confirms that global manufacturing activity should soon pick up (Chart 18). The auto sector’s weakness, which was exacerbated by previous inventory buildups, changing emission standards, and rising borrowing costs, is also ebbing. Chart 17The Mid-Cycle Slowdown Is Long In The Tooth The Mid-Cycle Slowdown Is Long In The Tooth The Mid-Cycle Slowdown Is Long In The Tooth Chart 18The New Order-To-Inventory Ratio Points To A Global Rebound The New Orders-To-Inventories Ratio Points To A Global Rebound The New Orders-To-Inventories Ratio Points To A Global Rebound     Various growth indicators are sniffing out this positive inflection point. The recent trough in the global ZEW survey is revealing (Chart 19). It materialized quickly after Sino-US trade tensions began to ease. Enough positive global economic momentum exists such that a minor decline in policy uncertainty could unleash a large improvement in growth expectations. The rebound in Taiwanese equities and European luxury stocks confirms that the global economy should soon bottom. There are two things we cannot emphasis enough. First, this is the end game of the business cycle, after which a recession will ensue. Second, investors should not expect the kind of strong synchronized growth rebound witnessed in 2017. Without a Chinese and EM boom, a crucial source of demand will be wanting. Mr. X: What about US growth? The yield curve inverted this summer and deteriorating consumer and business confidence raised the specter of an imminent recession. Moreover, the fiscal stimulus that helped the economy in the first half of 2019 is now over. In fact, with a $1 trillion federal deficit despite an unemployment rate of only 3.6%, we have run out of fiscal room to support activity if and when a recession materializes. BCA: The recent yield curve inversion most likely overstated the risk of an economic contraction. First, in the mid-1990s, if the term premium had been as low as it is today, the curve would have also inverted without any recession materializing from 1995 to 2000. Second, this summer, the curve inverted up to the 5-year tenor and steepened for longer maturities. Prior to recessions, the curve inverts across all maturities. Recessions are not born out of thin air. They are caused by imbalances and tight monetary policy. The large debt buildup and other investment imbalances that have preceded prior US recessions are not yet apparent. Prior to the 1991, 2001 and 2008 recessions, the private sector debt load had increased by 20.6%, 14.6% and 25.6% of GDP in the previous five years, not the current 1.4% run rate. The Fed’s policy is now clearly accommodative. Not only is the real fed funds rate 74.4 basis points below the Fed’s favored estimate of the neutral rate of interest, but also real estate, the most interest-rate sensitive economic sector, is rebounding. In 2018, real estate activity collapsed in response to mortgage rates rising to 4.9%. Today, the NAHB Homebuilding index has retraced 79% of its losses; mortgage demand has improved; and housing starts and building permits have recovered (Chart 20). When policy is tight, real estate activity never recovers this quickly, even as yields fall. Chart 19Positive Signals For Global Growth Positive Signals For Global Growth Positive Signals For Global Growth Chart 20The Housing Market Signals That Policy Is Accommodative The Housing Market Signals That Policy Is Accommodative The Housing Market Signals That Policy Is Accommodative   Chart 21Robust Household Financial Health OUTLOOK 2020: Heading Into The End Game OUTLOOK 2020: Heading Into The End Game A counterargument is that real estate price appreciation is weak. However, tight monetary policy is not the cause. Two forces are dampening house prices. First, the Jobs and Tax Act of 2017 lowered allowable mortgage interest and state and local tax deductions. High-end properties in high-tax states such as California, New York and Massachusetts have suffered from this adjustment. Second, the US housing market has an overhang of large, pricey homes relative to strong demand for smaller, starter homes. Median home prices outpacing average ones show this divergence. We also to need to gauge if consumer spending is likely to follow the manufacturing sector lower. If it does, a recession will be unavoidable. On this front, we are hopeful because: The outlook for household income is positive. As you noted, the unemployment rate is still extraordinarily low, and more Americans will be working by the end of 2020 than today. Additionally, the rising employment-to-population ratio for prime-age workers is tightly linked to stronger wages (Chart 21). Also, the recent pick up in productivity growth points to higher real wage growth. The household savings rate is elevated and has limited upside. Households already have a large cushion insulating them from unforeseen shocks. At 8.1% of disposable income, the savings rate is in the 65th percentile of its post-1980 distribution. It is especially lofty if we take into account robust American households’ net worth (Chart 21, bottom panel). Consumer credit demand is rising, according to the Fed’s Senior Loan officer survey. Since household liquid assets are quickly expanding and the household formation rate is robust, consumption of durable goods should pick up, especially in light of the large decrease in borrowing costs. This is particularly true since the household debt-to-assets ratio is at its lowest level since 1985 and debt-servicing costs only represent 9.7% of disposable income, the lowest share for nearly 40 years. The corporate sector outlook should brighten soon. The modest rise in productivity protects margins from higher wages, an effect that will linger given that capacity expansion is consistent with further productivity gains (Chart 22). Crucially, the combined fiscal and monetary easing in China should bolster capital-spending intentions around the world, including the US (Chart 23). Rising productivity will only consolidate these trends. Chart 22Capacity Growth Provides Some Support For Productivity Capacity Growth Provides Some Support For Productivity Capacity Growth Provides Some Support For Productivity Chart 23Chinese Reflation Will Revive US Capital Spending Chinese Reflation Will Revive US Capital Spending Chinese Reflation Will Revive US Capital Spending   The most positive development for the US corporate sector is our outlook for non-US growth. If the global manufacturing sector mends itself, so will the US. Ample liquidity is a positive for the world economy, as well as for US manufacturing conditions (Chart 24). On the fiscal front, we appreciate your worries, but they are not a story for 2020. The US fiscal thrust will not be as positive as it was in 2018 or 2019, but it is set to remain a small tailwind, not a drag. Furthermore, given that 2020 is an election year it is unlikely that politicians will tighten purse strings over the coming 12 months. Fiscal risks are undoubtedly greater in the long run. However, a sudden fiscal consolidation is a remote probability because fiscal austerity has gone out of style. Instead, the federal debt burden will be a major source of long-term inflation because there is no other easy way to address this gigantic pile of liabilities. The path of least resistance will be more spending and financial repression. In other words, real rates will stay too low and excess government spending will push prices higher, conveniently eroding the real value of that high federal debt burden. This was a big story in the 20th century and it will remain so in the 21st (Chart 25), especially since an aging population and the peak in globalization will weigh on global savings. Chart 24The US Manufacturing Slowdown Has Run Its Course The US Manufacturing Slowdown Has Run Its Course The US Manufacturing Slowdown Has Run Its Course Chart 25Inflation Is About Political Decisions Inflation Is About Political Decisions Inflation Is About Political Decisions   Ms. X: Your point about demographics makes me think of Europe and Japan. Brexit has not been resolved; populism remains a concern in Italy; and the European banking system is still fragile. Japan suffers from an even worse demographic profile and the recent VAT increase was ill-timed, economically. Given these headwinds, can these regions participate in the global recovery you foresee? BCA: The short answer is yes, albeit to varying degrees. The outlook for Europe is more promising than Japan. A No-Deal Brexit is now a very low probability event, even after next month’s UK election. The conservatives’ support for Prime Minister Johnson’s Brexit plan will ensure as much. A large source of uncertainty is being lifted, which will allow European businesses to resume investment planning. The situation in the European periphery is also improving. Non-performing loans in Spain and Italy are falling (Chart 26), which is allowing for a normalization of credit origination. The narrowing Italian and peripheral spreads to German bunds will be helped by easing financial conditions in the European economies that need it most. Higher Italian bond prices improve banks’ solvency and cut borrowing costs for the private sector. Finally, populism is alive and well in Europe, rejecting fiscal austerity, but not embracing euro-skepticism. More generous fiscal spending would be a positive for Europe. European liquidity conditions are also generous. Deposit growth has strengthened and financial conditions have benefited from lower German yields and a cheap euro, which trades 15% below fair-value estimates. Our model for European banks’ return on tangible equity is rising, which is a clear indication that easy financial and liquidity conditions should deliver stronger incremental economic activity (Chart 27). Chart 26Declining Non-Performing Loans Are A Positive For The European Periphery Declining Non-Performing Loans Are A Positive For The European Periphery Declining Non-Performing Loans Are A Positive For The European Periphery Chart 27European Banks' Return On Equity Will Improve In 2020 European Banks' Return On Equity Will Improve In 2020 European Banks' Return On Equity Will Improve In 2020   The fiscal outlook is murkier. European fiscal thrust was a positive 0.4% of GDP in 2019, but it will decline to 0.1% in 2020. However, fiscal policy affects economic activity with a lag. The impact of this year’s easing has yet to be fully felt. Since European rates are so low and the economy is not operating at full capacity, the fiscal multiplier is greater than one. Therefore, Europe can still reap a substantial fiscal dividend next year. Finally, Europe remains a very pro-cyclical economy. A large share of euro area GDP is connected to manufacturing and exports. As a result, Europe will be one of the prime beneficiaries of a pickup in global growth. Already, the sharp rebound in the German and euro area ZEW survey expectation components point to a brighter outlook for the region. Japan is also a very pro-cyclical economy, which will reap a dividend from a bottom in global manufacturing activity. However, the Land of the Rising Sun is still subject to idiosyncratic constraints. Japanese financial conditions have not improved as much as those in Europe. The yen has appreciated 2.6% in trade-weighted terms this year, while Japanese yields have not melted as much as European ones (because Italian and peripheral yields fell so much in 2019). Japan will also have to reckon with the impact of the October VAT increase. Ahead of the tax hike, retail sales spiked by 9.1% on a year-on-year basis, or 7.1% compared to the previous month, a script similar to 2014. 2015 was a payback year where consumption was depressed. This scenario will play out again, even if the Abe government has implemented some fiscal offsets. Ultimately, the Japanese economy will lag Europe’s in the first half of the year but should catch up in the second half. The impact of the tax hike will dissipate. Most importantly, rebounding global growth will hurt the yen, at least on a trade-weighted basis, providing a lift to export prospects and easing Japanese financial conditions relative to the rest of the world, which will produce a growth dividend later in 2020. Ms. X: To summarize, you expect a moderate rebound in global growth next year, but not a sharp acceleration because Chinese stimulus will not be that aggressive. EM activity will also pick up but will not generate fireworks. The US will be okay but Europe will probably deliver the largest positive growth surprise as external and domestic conditions align positively. Japan will also stabilize on the back of stronger global growth, but domestic headwinds mean that a true reacceleration won’t happen until the latter part of the year. This recovery constitutes the business cycle’s end game as inflation will become a concern in 2021, forcing the Fed to tighten then. BCA: Yes, this is correct. Ms. X: Thank you! Bond Market Prospects Chart 28Global Bonds Are Extremely Overvalued Global Bonds Are Extremely Overvalued Global Bonds Are Extremely Overvalued Ms. X: I do not like US Treasuries at current yields. They do not protect me against an inflation surprise and will do nothing for me in an economic recovery. However, my bearishness is tempered by the large stock of bonds with negative yields in Europe and Japan. As long as this strange situation persists, I doubt US yields will experience much upside. US paper is too attractive to foreign asset managers right now. BCA: We share your view and are recommending an underweight to global government bonds. Global yields offer little value and are vulnerable to a rebound in economic activity or a trade détente. Our Global Bond Valuation index is flashing a clear sell signal (Chart 28). As yields rise, global yield curves are bound to steepen. We also agree that the upside for Treasury yields is limited, but we disagree with the limiting factor. Foreign investors are not the major buyers of Treasuries. Indeed, the data shows that European and Japanese investors have not been aggressive purchasers of US government securities. The US yield curve is flat and US short rates tower above European and Japanese ones, hedging currency exposure when buying Treasuries is expensive. In euro or yen terms, a hedged Treasury yields -67 basis points and -60 basis points, less than 10-year bunds or JGBs, respectively. Meanwhile, EM central banks are diversifying their FX reserves away from the US dollar into gold. Instead, our view is governed by the concept we dub the “Golden Rule of Treasury Investing.” According to this principle, the outperformance of Treasuries relative to cash is a direct function of the Fed’s ability to surprise the market. If the Fed cuts rates more than the OIS curve anticipated 12 months prior, Treasuries outperform. The opposite happens if the Fed delivers a hawkish surprise (Chart 29). Chart 29The Golden Rule Of Treasury Investing The Golden Rule Of Treasury Investing The Golden Rule Of Treasury Investing Treasury yields are unlikely to move significantly higher than the 2.25% to 2.5% zone, because the OIS curve is now only pricing in 28 basis points of rate cuts over the next year. It is not just the US OIS curve that has priced out a large amount of rate cuts; this phenomenon has materialized around the world over the past five weeks. Chart 30The Term Premium Is Too Low The Term Premium Is Too Low The Term Premium Is Too Low Any upside risk to that 2.25% to 2.5% forecast for 2020 will come from the inflation expectations and term premium components of yields. Central banks, including the Fed, have telegraphed an intention to allow inflation expectations to rise, initially, in response to stronger global growth. Moreover, declining risk aversion should also allow the exceptionally depressed term premium to normalize (Chart 30). Only in late 2020 or early 2021 will Treasury yields durably move above this 2.25-2.5% zone. Punching above these levels will require core PCE inflation to have been above target long enough to re-anchor inflation expectations back up to their 2.3% to 2.5% target zone. Only then will the Fed give the all-clear signal to the bond market to lift yields higher. Mr. X: You still have not directly addressed the question of negative yields in Europe and Japan. This story will not end well. Do you worry about these bond markets over the next year? BCA: Our answer is an emphatic yes. But we assume you will not let us leave it at that. Mr. X: You know me too well. BCA: Over the course of the past 50 years, we have learned a thing or two about you. In all seriousness, let’s start with our simple but effective valuation ranking. It compares the current level of real yields for each country to their historical averages and standard deviations. You can see that the most unattractive bond markets right now are all in Europe (Chart 31). Chart 31European Bonds Are Too Dear OUTLOOK 2020: Heading Into The End Game OUTLOOK 2020: Heading Into The End Game Chart 32Swiss Bonds Are A Lose-Lose Proposition Swiss Bonds Are A Lose-Lose Proposition Swiss Bonds Are A Lose-Lose Proposition The lower bound of interest rates is another reason to avoid these markets. This floor seems to lie around -1% in nominal terms. Because of these constraints, in recent months, Swiss, Swedish, Dutch and German 10-year bonds have failed to rally as much as their higher-yielding US, Canadian or Australian counterparts when global yields are declining. However, they also underperform when yields are rising (Chart 32). They have become a lose-lose proposition. The only pockets of value left in DM bond markets are Greece, Portugal or Italy. Despite their apparent risks, we still like them. Support for the euro in Greece and Italy is 70% and 65%, respectively. Even populist governments in these nations are reluctant to attack euro membership anymore. Moreover, the ECB remains committed to the survival of the euro area in its current form. Christine Lagarde will not change that. For 2020 or 2021, the risk of euro breakup is practically zero. The same may not be true on a 5- to 10-year investment horizon, but for the coming year, these bonds offer an attractive risk-adjusted carry. Ms. X: Unsurprisingly, my father does not like corporate bonds because of highly levered corporate balance sheets. I think this is a long-term problem, but not a risk for 2020, so I’m looking to stay overweight spread product relative to Treasuries. Where do you stand on this market? BCA: On this issue, we sit somewhere between you both. Our Corporate Health Monitor continues to deteriorate (Chart 33). The high debt load of the US business sector coupled with the decline of the return on capital worries us. Furthermore, the covenant-lite trend in recent issuance suggests that corporate borrowers, not lenders, are getting the good deals. Essentially, too much cash is still chasing too little available yield pick-up. In this environment, capital is sure to be misallocated, and money ultimately lost. We find the reward-to-risk tradeoff more attractive in Europe and Japan than in emerging markets. On a short-term basis, the spreads will not widen much. An easy Fed, recovering global growth, and the gigantic pile of negative-yielding bonds around the world will make sure of that. We advocate a neutral stance on investment grade corporates because IG bonds have high modified duration such that breakeven spread compensation versus Treasuries is near the bottom of its historical distribution across the IG credit spectrum (Chart 34). This means that credit will generate poor returns if government bond yields rise. Chart 33Dangerous Long-Term Picture For US Corporates A Precarious Long-Term Picture For US Corporates A Precarious Long-Term Picture For US Corporates Chart 34No Value Left In IG No Value Left In IG No Value Left In IG   Chart 35EMs Still Experiencing Deflation EMs Still Experiencing Deflation EMs Still Experiencing Deflation Thankfully, they are ways around this problem: emphasizing exposure to high-yield (HY) bonds and agency mortgage-backed securities (MBS) instead. HY breakeven spreads remain much more attractive than in the IG space, and option-adjusted spreads will benefit if our growth and inflation forecasts materialize. Investors reluctant to commit capital to these products should look into high quality agency MBS. After the recent wave of mortgage refinancing, these securities’ duration has collapsed to 3.0 compared to 7.9 for IG corporates. These securities therefore offer much better protection in a rising-yield environment. Ms. X: Before we move on to equities, where do you stand on EM bonds? BCA: We need to differentiate between EM local-currency bonds and EM USD-denominated bonds. We do like some EM local currency bonds. Inflation in EM countries is low and dropping. Money and credit growth is slowing, which implies that the disinflationary trend will remain in place through 2020 (Chart 35). Weaker nominal growth means that central banks in EM will continue to cut rates, providing a nice tailwind for local-currency bond prices. This comes with a caveat. Lower policy rates will boost bond prices but hurt EM currencies, especially because most EM currencies are not cheap and are already over-owned. Next year, it will be preferable to garner exposure to those countries interest rate moves via the swap market rather than the cash bond market. Chart 36The Mexican Peso Is Cheap The Mexican Peso Is Cheap The Mexican Peso Is Cheap There are some exceptions, like Mexico. The MXN is already very cheap because of fears surrounding the economic policies of President Andres Manual Lopez Obrador (AMLO) (Chart 36). However, we doubt he will turn out to be as dangerous as feared. Hence, MXN Mexican bonds are attractive to foreign investors in unhedged terms. We are currently avoiding EM USD-denominated debt, corporate and sovereign. Since emerging markets sport $5.1 trillion of dollar-denominated debt, falling EM exchange rates will increase the cost of servicing this debt, which makes it riskier. Mr. X: I think we will continue to underweight corporate and EM bonds in our fixed income portfolio. Spread levels still make no sense in terms of providing compensation for credit risk. I must admit that I find your recommendation to overweight MBS intriguing. We will need to ponder this idea further. Ms. X: And please wish me luck trying to convince my father to buy some high-yield bonds. Equity Market Outlook Mr. X: US stocks are too expensive for my taste, with the S&P 500 trading at a forward P/E ratio of 18. I’m well aware of the argument that equities may be expensive but that they are actually cheap compared to bonds, which implies that I should favor stocks over bonds. However, you know that I emphasize capital preservation. With stocks this rich already, equities offer no margin of safety. If I own stocks, I am therefore exposed to any unexpected shocks. Because I do not share your optimism on the economy, I am more worried about downside risk. Moreover, even if the economy performs better than I fear, I suspect stocks will respond poorly to higher yields. Chart 37The S&P Is Very Expensive The S&P Is Very Expensive The S&P Is Very Expensive Ms. X: I agree with my father that stocks are expensive. Nonetheless, as Keynes famously quipped, “Markets can stay irrational longer than you can stay solvent.” In today’s context, to me this means that stocks can ignore their overvaluation so long as liquidity is plentiful, rates are low, and a recession is avoided. BCA: On this question, we agree with Ms. X. We all agree that US equities are expensive. As you mentioned, their price-to-earnings ratio is 18. Only at the apex of the tech bubble and in early 2018 was the S&P 500 more expensive. Worryingly, the price-to-sales ratio is at 2.3, an even larger historical outlier than the P/E (Chart 37). Chart 38Low Yields And Plentiful Liquidity Are Still Fertile Ground For Stocks Low Bond Yields And Plentiful Liquidity Are Still Fertile Ground For Stocks Low Bond Yields And Plentiful Liquidity Are Still Fertile Ground For Stocks Ms. X is correct that we cannot look at stock valuations in isolation. Investing is about opportunity cost and the macroeconomic context. On this front, even US equities have their merit. Despite the S&P 500’s expensive multiples, our Composite Valuation Indicator is no more elevated than it was in 2013. Meanwhile, our Monetary Indicator has rarely been as supportive of stock prices as it is today, and our Speculation Indicator is in line with its January 2016 reading (Chart 38). Moreover, BCA’s Composite Sentiment indicator is still below its long-term historical average and margin debt has declined by $47.5 billion to the lowest share of US market capitalization since June 2005. These are hardly signs of irrational exuberance. Ultimately, bear markets and recessions travel together. A durable 20% drop in stock prices requires a significant and long-lasting decline in earnings. These developments happen during recessions (Chart 39). Our call is for a recession in the next 24 months or so. We must also remember that while equities perform poorly six months ahead of a recession, the end of a bull market, its last 12 to 18 months, tend to be very rewarding (Table 3). We are within this window. Chart 39Bear Markets And Recessions Travel Together Bear Markets And Recessions Travel Together Bear Markets And Recessions Travel Together Table 3The End Game Can Be Rewarding OUTLOOK 2020: Heading Into The End Game OUTLOOK 2020: Heading Into The End Game Based on our forecast for interest rates, we do not share the concerns that rising bond yields will topple stocks right away. Stock prices are an inverse function of risk-free rates, but a positive function of growth expectations. Higher yields will initially reflect stronger growth, not restrict it. But remember: the upside for yields is limited because central banks do not want to choke off the recovery. They will maintain accommodative policy. In other words, we expect real rates to lag behind growth expectations. Because long-term growth expectations, whether from sell-side analysts or extracted out of market prices using the Gordon Growth Model, are low, we are willing to make this bet (Chart 40). Equities will suffer if the global bond yield rises above 2.5%. This is more a story for 2021, and not our central scenario for 2020. It is nonetheless a reminder that we are entering the end game of the business cycle, so we are also entering the end-game of the bull market. Mr. X: I think you are playing with fire. Stocks are so expensive that if you are wrong on either the growth call or the yield call, they will suffer. I would rather miss the last melt-up in stocks than unnecessarily expose my portfolio to a meltdown. Additionally, you have not addressed the fact that S&P 500 margins have begun to soften but are still extremely elevated. Shouldn’t this dampen your optimism? BCA: Aggregate S&P 500 margins have some downside. Our Composite Margin Proxy, Operating Margins Diffusion index and Corporate Pricing Power indicator all remain weak (Chart 41). The deceleration in the crude PPI excluding food and energy and the past strength in the dollar confirm this insight, especially as the corporate wage bill climbs in a tight labor market. The biggest mitigating factor is that productivity is also on the mend, which curbs the negative impact of higher worker pay. Chart 40Growth Expectations Are Muted Profit Growth Expectations Are Muted Profit Growth Expectations Are Muted Chart 41US Margins Under Pressure US Margins Under Pressure US Margins Under Pressure   This danger must be put into perspective though. Margin expansion has been dominated by the tech sector (Chart 42). Excluding this industry, S&P 500 margins are roughly in line with their previous peak, and are not declining. The aggregate softness in margins is a reflection of the sharper decline in tech margins. Declining margins do not spell the imminent end of the bull market either. Table 4 shows that on average, the S&P 500 rises by 9.5% following the peak in margins. Equities can rise after margins crest because this is often an environment where wages are climbing, which boosts consumption. Consequently, top-line growth can accelerate and earnings can rise even if they represent a lower proportion of sales. This is the environment we foresee over 2020. Chart 42Tech Margins Have Likely Peaked Tech Margins Have Likely Peaked Tech Margins Have Likely Peaked Table 4Margin Peaks Do Not Spell S&P Doom OUTLOOK 2020: Heading Into The End Game OUTLOOK 2020: Heading Into The End Game   Chart 43Taiwanese Stocks Are Sniffing Out Better Global Growth Taiwanese Stocks Are Sniffing Out Better Global Growth Taiwanese Stocks Are Sniffing Out Better Global Growth Ms. X: You have talked about the tech sector being a drag on overall margins. How would you position a US stock portfolio? BCA: First, around the world, we prefer cyclical sectors to defensive ones. Cyclical stocks are depressed relative to defensive firms’ shares. Rebounding global growth and rising bond yields will favor cyclical sectors. Globally, the performance of cyclical equities relative to defensive ones correlates with Taiwanese equities, which are currently rallying smartly (Chart 43). This suggests that at the margin, the most cyclical asset markets are beginning to express optimism about global growth. Within the S&P 500, our favorite pair trade to express this bias is to overweight energy stocks at the expense of utilities. Utilities are bond proxies which will substantially underperform energy stocks when the rate of change of Treasury yields moves up (Chart 44). Moreover, based on our valuation indicators, energy stocks have never traded at such a deep discount to utilities, nor have they ever been as oversold. Chart 44Favor Energy Over Utilities Favor Energy Over Utilities Favor Energy Over Utilities Second, we are currently neutral on tech stocks but have put them on a downgrade alert. Tech equities are expensive, trading at a forward P/E ratio 21% above the other cyclicals. Moreover, since software spending has remained surprisingly resilient despite the global economic slowdown, it will likely lag investment in machinery and structures when industrial demand rebounds. Consequently, tech earnings will lag other traditional cyclical sectors. Tech multiples will also suffer when bond yields rise. As high-growth stocks, tech equities derive a large proportion of their intrinsic value from long-term deferred cash flows and their terminal value. Thus, tech multiples are highly sensitive to changes in the discount rate We implement this view by way of an underweight in tech and an overweight to industrials. Industrials have suffered disproportionately from the trade war. Any near term truce is unlikely to contain a grand bargain on intellectual property rights transfer that galvanizes tech exports, but it will remove some of the uncertainty weighing on industrials. Moreover, industrials are a much cheaper play on a global growth rebound. The global manufacturing slowdown has caused industrial equities to trade at their greatest discount to the tech sector since the financial crisis. Finally, the wage bill for the industrial sector is melting relative to tech, and our margin proxy is surging (Chart 45). This has created a very positive backdrop for this pair trade. We also like financials. They will be a key beneficiary of rising yields and a steepening yield curve. Additionally, household credit demand has picked up and overall credit growth should accelerate as central banks will maintain very accommodative monetary conditions. The yield impulse already points toward higher bank credit growth and companies are issuing an increasingly large stock of bonds (Chart 46). Chart 45Operating Metrics Will Boost Industrials Versus Tech Equities Operating Leverage Will Boost Industrials Versus Tech Equities Operating Leverage Will Boost Industrials Versus Tech Equities Chart 46Easing Financial Conditions Will Support Credit Creation Easing Financial Conditions Will Support Credit Creation Easing Financial Conditions Will Support Credit Creation   Ms. X: When combining valuation analysis with your fundamental sectoral slant, I am guessing that you must favor European, Japanese and EM stocks over the S&P 500? BCA: We do favor European and Japanese equities. Based on valuation alone, all the regions you mentioned offer higher expected long-term real rates of return than the US (Chart 47). Moreover, the dollar is expensive relative to advanced economies’ currencies. Hence, these markets are cheaper vehicles than the S&P 500 to bet on a global economic recovery. But valuation alone is not enough. US stocks are trading at unprecedented levels relative to global equities because of the FAANG craze (Chart 48). Looking at sector representation, our positive view on non-tech cyclicals also flatters exposure to Europe and Japan (Table 5). Chart 47Non US Equities Offer Better Value OUTLOOK 2020: Heading Into The End Game OUTLOOK 2020: Heading Into The End Game Chart 48FAANG-Driven US Outperformance FAANG-Driven US Outperformance FAANG-Driven US Outperformance   Table 5Equity Market Sector Composition OUTLOOK 2020: Heading Into The End Game OUTLOOK 2020: Heading Into The End Game Chart 49European Banks Are Cheap European Banks Are Cheap European Banks Are Cheap Europe is particularly attractive because of its large skew towards industrials and financials, which represent 32.3% of the market versus 22.3% in the US. Moreover, European financials are also a tantalizing bet because they trade at a 50% discount to US financials, according to their price-to-book ratio. Additionally, their return on tangible equity will benefit from higher German yields, easing financial conditions, declining non-performing loans in the periphery and rebounding global growth. Our RoE model for European banks already points to a resurgence in their stock prices (Chart 49). Of the major markets we track, Japan offers the highest prospective long-term real returns. Its strong cyclical slant and low share of tech stocks means it is another market investors should overweight to bet on a global recovery. The biggest problem for Japanese equities is the yen. When global yields climb higher, a weak JPY will clip some of the Nikkei’s gains for foreign investors. Finally, we are reluctant to overweight EM stocks just yet. In this space, median P/E ratios are much higher than on a market capitalization-weighted basis (Chart 50). State-owned companies explain this bifurcation, Chinese banks in particular. Since we expect Chinese banks to remain a conduit for policy, credit origination may flatter economic growth more than shareholders’ interests. Moreover, we have a negative outlook on EM currencies, and hedging this exposure is expensive. Finally, if China’s economic activity improves only modestly in 2020, the 2012 experience suggests that EM stocks can still underperform the global equity universe as global growth improves and yields rise (Chart 51). In other words, we find the reward-to-risk tradeoff more attractive in Europe and Japan than in emerging markets. Chart 50EM Stocks Are No Bargain Yet EM Stocks Are No Bargain Yet EM Stocks Are No Bargain Yet Chart 51EM Stocks Can Underperform When Global Growth Improves EM Stocks Can Underperform Even When Global Growth Improves EM Stocks Can Underperform Even When Global Growth Improves     Mr. X: Thank you. I am still not sure what share of our portfolio will be dedicated to stocks. However, I think that whatever this proportion will be, buying global equities makes more sense than US ones. Your valuation argument alone is swaying me, considering my more conservative instincts. Ms. X: I’m glad we will not have to argue on this point, but I know we will nonetheless battle on the stock/bond/gold split. Should we move on to your currency and commodity forecasts? BCA: It would be our pleasure. Currencies And Commodities Mr. X: You have often argued that the dollar is a countercyclical currency. Based on our discussion so far, you must expect the dollar to decline until we get closer to the next recession. I am not fully convinced. Specifically, I remember that in the back half of 2016 global growth was rebounding, but the dollar soared. Therefore, the growth/dollar relationship can be more complex than you argue. Meanwhile, with negative interest rates in Europe, Japan and Switzerland, why would I even consider divesting out of my positive yielding dollar assets? Chart 52The Dollar Is A Counter Cyclical Currency The Dollar Is A Counter Cyclical Currency The Dollar Is A Counter Cyclical Currency BCA: You raise interesting questions, and you are correct that we expect the dollar to depreciate if our constructive view on global growth pans out for 2020. The inverse relationship between global industrial production (excluding the US) and the trade-weighted dollar is unambiguous (Chart 52). As you also mentioned, the reality is a little bit more nuanced. To understand why, it is important to remember how currencies function. We can think of an exchange rate as an adjustment mechanism that solves for the gap in growth between any two countries. This is at the root of the dollar’s counter-cyclicality. When global growth is picking up, returns tend to be higher in cyclical markets, which are highly concentrated outside of the US. Flows then gravitate from the US to other markets and the dollar declines. After a while, the dollar becomes cheap enough that these flows reverse. In the second half of 2016, three factors drove the dollar rebound. First, US manufacturing was improving at a faster pace than that of the rest of the world. Second, the Fed resumed its interest rate hikes, so interest rate differentials suddenly flattered the dollar anew. Finally, the election of President Trump, who campaigned on large scale fiscal stimulus, elicited memories of the Reagan dollar bull market of the first half of the 1980s. These factors eventually faded as global growth rebounded. Today, the Fed’s policies are hurting the dollar. Aside from recent interest rate cuts, the Fed has been injecting liquidity into the banking system through repurchase agreements and renewed asset (T-Bills) purchases. Moreover, the rate cuts are also easing global funding conditions and promoting a re-steepening of the yield curve. This will incentivize banks to lend and boost the US money supply. As growth re-accelerates and demand for imports (machinery, commodities, and consumer goods) rises, the current account deficit will widen further. This process will increase the international supply of dollars. Historically, these dynamics usually hurt the dollar. What we have described is a tentative abatement in geopolitical risk at best – but it would be cavalier to get overly enthusiastic. Like you, we are deeply uncomfortable with negative interest rates. Thankfully, the nascent pickup in global economic activity is lifting global bond yields. So far, foreign bond markets have led this move. More specifically, countries that have suffered most from the global manufacturing slowdown are now seeing their bond yields rise the quickest (Chart 53). For example, yields in Germany, Norway, Sweden, Switzerland and Japan have risen by a lot more than those in the US since global yields troughed in September. Should the initial signals of stabilization in global growth morph into a synchronized recovery, the US yield advantage will evaporate. In a nutshell, interest rates might be negative in Europe and Switzerland, but the positive carry offered by US assets is rapidly fading. Chart 53AAre Interest Rate Differentials Flashing A Signal About Exchange Rates? Are Interest Rate Differentials Flashing A Signal About Exchange Rates? Are Interest Rate Differentials Flashing A Signal About Exchange Rates? Chart 53BAre Interest Rate Differentials Flashing A Signal About Exchange Rates? Are Interest Rate Differentials Flashing A Signal About Exchange Rates? Are Interest Rate Differentials Flashing A Signal About Exchange Rates?   Chart 54Foreigners Are Selling Treasuries Foreigners Are Selling Treasuries Foreigners Are Selling Treasuries For international investors, the currency risk inherent in owning US bonds is just too large at the current juncture. Remember, the trade-weighted dollar stands 25% above its long-term equilibrium and the US twin deficits are expanding. Markets priced in cheap currencies with some potential upside, such as Australia, Canada, Norway or even the European periphery, might be better bets. Flows highlight just how precarious the situation is for the US dollar. Since last August, overall flows into the US Treasury market have been negative. Net foreign purchases by private investors are still positive at an annualized US$180 billion, but they are clearly rolling over. Moreover, official net outflows are running at $350 billion, easily cancelling out the private sector’s inflows (Chart 54). Essentially, foreigners’ appetite for US fixed-income assets is waning exactly as interest rate differentials have started moving against the dollar. Ms. X: I share my father’s concerns, but how would you implement your negative dollar view. Which currencies should I be loading up on as we enter the business cycle’s end game? BCA: The more export-dependent economies (and currencies) should benefit the most from a rebound in global growth. Within the G-10, we particularly like the Swedish krona, the Norwegian krone and the British pound. Bond yields for these currencies are rising the fastest vis-à-vis the US. As a result, the currencies themselves should soon follow (previously mentioned Chart 53). We also expect commodity currencies to benefit, but only upon clearer signs that the resource-thirsty Chinese economy is improving. Until then, they are likely to lag the pro-cyclical European currencies, which are less directly dependent on Chinese stimulus. The euro could become the greatest beneficiary from a weaker dollar because a large headwind for European economic activity is disappearing for now. For the past ten years, European real interest rates have been too low for the most productive, competitive exporter – Germany – but too high for others such as Spain and Italy. Consequently, the euro has been caught in a tug-of-war between a rising neutral rate of interest for Germany and a very low one for the peripheral economies. Via its rate cuts, asset purchase programs, and aggressive TLTRO packages, the ECB may have now finally eased policy to the point where nearly all Eurozone countries enjoy an accommodative monetary environment. 10-year government bond yields in France, Spain, Portugal and even Italy now all sit close to the neutral rate of interest for the entire eurozone (Chart 55). Chart 55The ECB Has Eased Policy Enough The ECB Has Eased Policy Enough The ECB Has Eased Policy Enough Finally, the euro is likely to benefit from inflows into European equity markets. The euro’s drop since 2018 has eased financial conditions and made euro area businesses more competitive. This is an important tailwind for European corporate profits and thus stocks. Moreover, European equities, especially those in the periphery, remain unloved, as illustrated by their cheap valuations compared to other advanced economies. Additionally, analysts’ earnings expectations for eurozone equities are perking up relative to US stocks. If the sell-side is right, powerful inflows into the region will lift the euro in 2020. Mr. X: Thank you. I find it difficult to share your enthusiasm for the euro, a currency backed by such a flimsy edifice. While I would agree that it could rebound next year, I find currencies highly unpredictable on such a time horizon. I prefer to think about them on a long-term basis, and while the euro is cheap, its weak institutional underpinning is too concerning. Let’s move on to commodities. Following our meeting last year, we took your advice on oil and gold. Overall, these calls helped our portfolio. Going forward, these markets are extremely perplexing. There is so much risk in oil markets, such as the tensions in the Middle East and the uncertainty stemming from the trade war between the US and China. How would you recommend playing the oil market in 2020? Chart 56Inventory Drawdown Will Support Oil Inventory Drawdown Will Support Oil Inventory Drawdown Will Support Oil BCA: Your assessment of these markets is spot on. Yet, price risk is skewed to the upside because fiscal and monetary stimulus will revive commodity demand. The oil-producer coalition led by Saudi Arabia and Russia will continue to restrain production, and will probably extend its 1.2mm b/d production cut due to expire at the end of March to year-end 2020. In the US, market-imposed capital discipline will keep reducing the growth of US shale-oil supply. Additionally, US shale-oil supply growth is threatened by flaring of associated natural gas in the Bakken and Permian basins. Failure to limit the burn-off at oil-production sites could provide the environmental lobby an opening to challenge growth. Ms. X: What about the demand side of the oil markets? The fall in the growth rate of demand this year caught most participants off guard. What do you make of that? BCA: Demand data shows a lot of lingering weakness, much of which was caused by tight financial conditions last year in the US and China. But now, most global central banks are pursuing highly accommodative monetary policy and many governments are also easing fiscal policy. As a result, this demand weakness will fade next year. We think next year growth will clock in at 1.4mm b/d. Not as robust as 2017, but still respectable. This should stop the downward pressure on oil prices that has prevailed since May (Chart 56). Mr. X: You’re describing a fairly strong market for next year. What are the downside risks to your view? BCA: Global economic policy uncertainty remains elevated. Uncertainty is one of the key factors driving demand for USD, which is one of the most popular safe havens in the world (Chart 57). A strong dollar creates a headwind for commodity demand. It raises the local-currency costs of consumers in the EM economies that drive oil demand, and lowers production costs outside of the US, encouraging supply growth at the margin. Chart 57Elevated Global Economic Uncertainty Has Kept The USD Well Bid OUTLOOK 2020: Heading Into The End Game OUTLOOK 2020: Heading Into The End Game Chart 58Gold: A Valuable Portfolio Hedge OUTLOOK 2020: Heading Into The End Game OUTLOOK 2020: Heading Into The End Game Ms. X: So, pulling it all together, what is your call for 2020? BCA: The weaker 2019 demand data and the upward revisions to global oil inventories pushed our 2020 Brent Oil forecast to $67/bbl from $70/bbl. We still expect WTI to trade at a $4/bbl discount to Brent. As we mentioned earlier, the risk to our forecast is to the upside: a resolution of the US-China trade war, and lower global economic policy uncertainty could trigger a sharp rally in crude prices. Mr. X: Thank you for your insight on oil. I would like to hear your thoughts on gold. You can tell that I see little absolute value in stocks or bonds at the moment, so I have an outsized preference for the yellow metal this year. Also, how could the US dollar and gold both rally at the same time in 2019? BCA: Let’s start with your dollar/gold question. It is very rare to see gold and the dollar rally together. Normally a strong dollar hurts gold. As you know, we’ve been recommending an allocation to gold since 2017, mostly as a portfolio hedge. We like that gold strongly outperforms other safe havens in equity bear markets and can participate in the upside (even if to a limited extent) in bull markets. We think the safe-haven properties of gold and the US dollar really have come to the fore over the past couple of years (Chart 58). Economic policy uncertainty, and divisive politics globally have raised the level of uncertainty to record levels. In such an environment, the dollar and gold both provide a safe haven and a portfolio hedge. Hence, their joint popularity this past year. We should also remember that gold is a good inflation hedge, and is particularly negatively correlated with real interest rates. A Fed that is willing to let the economy overheat is a Fed that will limit how high real rates climb. Moreover, global liquidity is plentiful. Finally, EM central banks have been slowly divesting from Treasuries and diversifying into gold lately, buying most of the new supply in the process. This backdrop, along with our forecast of a weaker dollar, should support gold again in 2020. That being said, because gold is tactically overbought and could face temporary headwinds if global uncertainty recedes, we prefer silver, which is not as stretched. Furthermore, silver’s higher industrial use means that it should also benefit from a global manufacturing recovery. Geopolitics Chart 59Multipolarity Creates An Unstable Environment Multipolarity Creates An Unstable Environment Multipolarity Creates An Unstable Environment Mr. X: Let’s return to geopolitical and policy risks, both of which abound. Global economic policy uncertainty is the highest it has been since academics began measuring it. The world is fraught with populism, authoritarianism, war, immigration, technological disruption, inequality, and corruption. With so much chaos, and so little consensus, is there anything solid for an investor to grasp about the political backdrop next year? BCA: Geopolitics is the likeliest candidate to short circuit this long bull market, given that the Federal Reserve, the usual culprit, has paused its rate tightening campaign. On a secular basis, geopolitical risk is rising because the United States’ national power is declining relative to that of other world powers (Chart 59). China’s rise, in particular, is stirring conflict with the US and its allies in the western Pacific. Beijing’s technological and military advance is generating fear across the American political establishment. Russia and China continue to deepen their relationship in the face of an increasingly unpredictable United States. These strategic tensions will persist despite any tariff ceasefire with China. Chart 60Globalization Has Peaked Globalization Has Peaked Globalization Has Peaked Competition among the great powers makes for a world of contested authority. As the rules of the road have become less certain, the tailwind behind international trade and investment has weakened (Chart 60). Deglobalization is a headwind for the earnings of large cap global companies in the long run. Emerging markets, which are exposed to trade, face persistent unrest. Mr. X: Given the above, how can an investor take an optimistic view of the global economy and markets next year? BCA: We have a framework for analyzing politics: constraints over preferences. We cannot predict what the chief politicians will prefer at any given time, but we can try to identify and measure the constraints that will restrict their freedom of movement. With global growth slowing, world leaders have become more sensitive to their constraints. The Fed has reversed rate hikes; China is easing policy; President Trump has refrained from attacking Iran; and President Trump and President Xi are negotiating a ceasefire. The UK has avoided a “no deal” Brexit – not once but twice. In short, the risk of recession (or conflict) has been sufficient to alter the policy trajectory. As a result, there is a prospect for global geopolitical risks to abate somewhat in 2020. Both the American and Chinese administrations need to see growth stabilize despite their ongoing strategic conflict. Both the British and European governments need to avoid a disorderly Brexit despite their lack of clarity beyond that. Geopolitical risk is declining, albeit from an extremely elevated level. Mr. X: The US and China have already come close to a deal only to get cold feet and back away from it. The British Prime Minister is committed to leaving the EU with or without a deal. Surely you cannot believe that the Middle East, Russia, other emerging markets, or North Korea will be any bastion of stability. BCA: The US-China trade war is still the single greatest threat to the equity bull market. Brexit is not resolved and a new deadline for a trade deal looms at the end of 2020. Investors must remain vigilant and hedge their portfolios, particularly with gold. Nevertheless, one cannot ignore this year’s reaffirmation of the Fed put, the China put, and Trump’s “Art of the Deal.” The base case for next year should be constructive, albeit with vigilant attention to the major risks: President Trump, China and Iran. The other issues you mention have varying degrees of market relevance. Russia is focusing on pacifying domestic discontent. North Korea is on a diplomatic track with the United States. Emerging market unrest is particularly relevant where it can have a bearing on global stability: Iraq, Iran and Hong Kong in particular. Ms. X: If I may interject: It seems to me that the worst of the trade war has passed, that the risk of a no-deal Brexit is negligible, and that Iran is unlikely to outdo its attack against Saudi Arabia in September. Doesn’t this imply that geopolitical risk is overrated and that investors should rush to capture the risk premium in equities? BCA: What we have described is a tentative abatement in geopolitical risk at best – but it would be cavalier to get overly enthusiastic. After all, any fall in global risks will be amply made up for by the impending rise in US domestic political risk. Indeed, US politics are the chief source of global political risk in 2020. First, if President Trump becomes a “lame duck” then he could take actions that are hugely disruptive to global markets in a desperate attempt to win reelection as a “war president.” Chart 61European Political Risk Is Now Low Europe Political Risk Is Now Low Europe Political Risk Is Now Low Second, if President Trump is reelected, then his disruptive populism will have a new mandate and his “America First” foreign and trade policy will be unshackled. Third, if the opposition Democrats succeed in unseating an incumbent president, they will likely take the Senate too, removing the main hurdle to a dramatic policy change. That would mark the third 180-degree reversal in national policy in 12 years. Moreover, investors may find the country merely exchanged right-wing populism for left-wing populism, which has a more negative impact on corporate earnings prospects. Polarization and institutional erosion will continue. The election results may be razor thin; swing states may have to recount votes; and the outcome could hinge on rare or unprecedented developments in the Electoral College, the Supreme Court or cyberspace. A crisis of legitimacy could easily afflict the next administration. In short, there are few scenarios in which US political risk does not rise over the next 12-24 months. Rising American risk stands in stark contrast to Europe (Chart 61), where the will to integrate has overcome several challenges since the sovereign debt crisis. Substantial majority of voters support the euro and the European Union. Germany is on the brink of a major political succession but it is not turning its back on the European project. France is successfully pursuing structural reforms. Italy remains the weakest link, but even the populist Northern League accepts the euro. This leaves two remaining global risks: China and Iran. Chinese political risk is generally understated. President Xi Jinping, lacking President Trump’s electoral constraint, could overestimate his leverage. He could overreach in the trade talks, in his battle to prevent excessive debt growth, or in his handling of Hong Kong, Taiwan, North Korea, or Iran. The result could be a breakdown in the trade talks or a separate strategic crisis with the United States. Another cold war-style escalation in tensions could easily kill the green shoots in global growth. As for Iran, the regime is under crippling American sanctions and faces unrest both at home and within its regional sphere of influence. There is a non-negligible risk that it will lash out and cause an extended oil supply shock. Conclusions Mr. X: This is a good place to conclude our discussion. We have covered a lot of ground but I remain deeply concerned that staying invested in risk assets today is akin to picking-up pennies in front of a steamroller. I accept your opinion that a recession is unlikely in 2020, but valuations of both stocks and bonds are uncomfortably stretched for my taste. As a result, I believe stocks could suffer whether growth is good or bad next year. Finally, since so many things need to go right for the global economy to continue to defy gravity, a recession may hit faster than you envision. To me, there is simply not enough margin of safety in stocks to compensate me for the risk! Ms. X: I agree with my father that the risks are high because we are entering the end game of the cycle. But I also see pockets of value, some of which you have mentioned today. Moreover, I am sympathetic to your view that global growth will recover next year. Corporate earnings should therefore expand. Hence, I fear that being out of the market will be very painful, especially because policy is quite accommodative. While stocks may not perform as well as they did in 2019, I expect them to outperform bonds handily. I’m therefore willing to continue holding risk assets, even if I need to be more judicious in my sector and regional allocation. BCA: Your family debate mirrors our own internal discussions. There is always a trade-off between maximizing short-term returns and taking a longer-term approach. Valuations are the ultimate guidepost for long-term return prospects. Because so many assets have become more expensive this year, long-term returns are likely to be uninspiring compared to recent history. Table 6 shows our baseline calculations of what a balanced portfolio will earn over the coming decade. We estimate that such a portfolio will deliver average annual returns of 4.4% over the next ten years, or 2.4% after adjusting for inflation. That is a noticeable deterioration from our inflation-adjusted estimate of 2.8% from last year, and also still well below the 6.5% real return that a balanced portfolio earned between 1982 and 2019. Table 6Asset Market Return Projections OUTLOOK 2020: Heading Into The End Game OUTLOOK 2020: Heading Into The End Game Our outlook for next year hinges on global growth rebounding and policy uncertainty receding. Monetary policy is less of a threat to equities than it was last year because central banks have already eased considerably and have been very open about their willingness to let inflation run above target for a while before retightening the monetary screws. We propose the following list of easy-to-track milestones to monitor whether or not our central scenario for the global economy and asset markets is playing out, and how close we are to the end of the cycle: Chinese money and credit numbers. Chinese credit growth must stabilize for the economy to do so. If credit origination continues to decelerate, this will indicate that Beijing has decided to tolerate the slowdown and prioritize its reform and deleveraging agenda. In this case, the Chinese debt supercycle is over sooner and the global economy will pay the price. Our China Investment Strategy Activity Index. Global policy is accommodative and liquidity conditions have improved significantly. However, if the Chinese economy continues to deteriorate, global growth will not rebound. The China Activity Index must stabilize and even improve somewhat for our global growth view to come to fruition. Progress in the “phase one” deal. China and the US must agree to a trade détente. As long as uncertainty around immediate tariffs remain high and retaliation risks stay alive, global capital spending intentions and thus the global manufacturing sector will be hamstrung. Surveys of global growth. The Global manufacturing PMI and the global growth expectation component of the ZEW survey must both recover. If these variables cannot gain any traction, the global economy is sicker than we estimate and risk assets will suffer. Commodity prices and the dollar. In the first quarter, industrial commodity prices must rebound and the dollar must start to depreciate. These two developments will not only reflect an improvement in global growth. They will also alleviate deflationary pressures around the world, revive profits and sponsor a business spending recovery. Moreover, a weaker dollar will also ease global financial conditions by decreasing the global cost of capital. 10-year inflation breakeven rate. If US breakevens move above the 2.3% to 2.5% zone, the Fed will become more proactive about raising rates. This would provoke a quicker end to the business cycle. President Trump’s approval rating. If President Trump’s approval rating stabilizes below 42%, he could give up on the economy and instead bet on a “rally around the flag” as his best strategy for re-election. This would result in a much more hawkish and confrontational White House that would become an even greater source of uncertainty for the economy, and thus risk asset prices. Ms. X: Thank you for this comprehensive list of variables to monitor. As always, you have left us with much to think about. We look forward to these discussions every year. Before we conclude, it would be helpful to have a recap of your key views. BCA: It will be our pleasure. The key points are as follow: Global equities are entering the end game of their nearly 11-year bull market. Stocks are expensive, but bonds are even more so. As a result, if global growth can recover and the US can avoid a recession in 2020, earnings will not weaken significantly and stocks will again outperform bonds. Low rates reflect the end of the debt supercycle in the advanced economies. However, the debt supercycle is still alive in EM in general, and in China, in particular. The global economic slowdown that begun more than 18 months ago started when China tried to limit debt growth. If Beijing continues to push for more deleveraging, global growth will continue to suffer as the EM debt supercycle will end. Nonetheless, we expect China to try to mitigate domestic deflationary pressures in 2020. As a result, a small wave of Chinese reflation, coupled with the substantial easing in global monetary and liquidity conditions should promote a worldwide re-acceleration in economic activity. Policy uncertainty will recede next year. Domestic constraints are forcing China and the US toward a trade détente. The risk of a no-deal Brexit is now marginal, and President Trump is still the favorite in 2020. A decline in policy risk will foster a global economic rebound. That being said, some pockets of risk remain, such as in the Middle East. Global central banks are highly unlikely to remove the punch bowl anytime soon. Not only will it take some time before global deflationary forces recede, monetary authorities in the G10 want to avoid the Japanification of their economies. As a result, they are already announcing that they will allow inflation to overshoot their 2% target for a period of time. This will ultimately raise the need for higher rates in 2021, which will push the global economy into recession in late 2021, or early 2022. These dynamics are key to our categorization of 2020 as the end game. US growth will re-accelerate. The US consumer remains in good shape thanks to healthy balance sheets and robust employment and wage growth prospects. Meanwhile, corporate profits and capex should benefit from a decline in global uncertainty and a pick-up in global economic activity. China will continue to stimulate its economy but will not do so as aggressively as it did over the past 10 years. Consequently, EM growth will also bottom but is unlikely to boom. Europe and Japan will re-accelerate in 2020. Bond yields will grind higher in 2020. However, Treasury yields are unlikely to break above the 2.25% to 2.5% range until much later in the year. Inflationary pressures won’t resurface quickly, so the Fed is unlikely to signal its intention to raise interest rates until late 2020 or later. European bonds are particularly unattractive. Corporate bonds are a mixed offering. Investment grade credit is unattractive owing to low option-adjusted spreads and high duration, especially when corporate health is deteriorating. Agency mortgage-backed securities and high-yield bonds offer better risk-adjusted value. Global stocks will enjoy their last-gasp rally in 2020. As global growth recovers, favor the more cyclical sectors and regions which also happen to offer the best value. US stocks are the least attractive bourse; they are very expensive and loaded with defensive and tech-related exposure, two groups that could suffer from higher bond yields. We are neutral on EM equities. Investors should pare exposure to equities after inflation breakevens have moved back into their 2.3% to 2.5% normal range and the Fed funds rate has moved closer to neutral. We anticipate this to be a risk in 2021. The dollar is likely to decline because it is a countercyclical currency. Balance of payment dynamics and valuation considerations are also becoming headwinds. The pro-cyclical European currencies and the euro should be the main beneficiary of any dollar depreciation. Oil and gold will have upside next year. Crude will benefit from both supply-side discipline and a recovery in oil demand on the back of the improving growth outlook. Gold will strengthen as global central banks limit the upside to real rates by allowing inflation to run a bit hot. A weaker dollar will flatter both commodities. A balanced portfolio is likely to generate average returns of only 2.4% a year in real terms over the next decade. This compares to average returns of around 6.5% a year between 1982 and 2019. We would like to take this opportunity to wish you and all of our clients a very peaceful, healthy and prosperous New Year. The Editors November 22, 2019

Mr. X and his daughter, Ms. X, are long-time BCA clients who visit our office toward the end of each year to discuss the economic and financial market outlook for the year ahead. This report is an edited transcript of our recent conversation. Mr. X: I have been eagerly looking forward to this meeting given my many concerns about the outlook. Our portfolio has done well in the past year thanks to the surge in bond prices and the outperformance of defensive equities. However, I am deeply troubled by the amount of monetary stimulus required to support risk assets, and by how expensive bonds and equities are. Moreover, the global economy remains engulfed in deflationary risks, and policymakers are running out of ammunition. As always, there is much to talk about. Ms. X: Let me add that I am also pleased to once again be here to discuss the major risks and opportunities in the global marketplace. A year ago, I held a more positive market view than my father. Directly after our meeting, the deep market correction gave me second thoughts, but ultimately, the rebound in stock prices vindicated my view. Clearly, your assertion that markets would be turbulent proved correct. Since I joined the family firm in early 2017, I have been pushing my father to keep a higher equity exposure than he was normally comfortable with. We agreed to still favor stocks last year, albeit, with a bias toward defensive sectors, and this strategy paid off. But after the past year’s powerful rally in both bonds and stocks, we are again left wondering how to position our portfolio. Ultimately, I do not believe a recession is imminent. Yes, stocks are expensive, but bonds are even more so. Since I expect economic growth to pick up, I am inclined to tilt the portfolio further into equities and move away from our preference for defensive sectors. As usual, I am very interested to hear your views. BCA: Our core theme for 2019 was that we would face classic late-cycle turbulence. Despite this volatility, a run-up in asset prices was likely. Soon after we met, the stock market plunged, hitting a low on December 26, 2018. We anticipated the Federal Reserve to be much more hawkish than what actually transpired. Wage growth and even core inflation have remained firm in the US, but the weakness in global inflation expectations drove central banks’ reaction functions more powerfully than we anticipated. Moreover, the rapid escalation of the Sino-US trade war added a layer of uncertainty that exacerbated the economic slowdown that had started in mid-2018, forcing global central banks to ease policy as an indemnity against recession. Looking ahead, central bankers are highly unlikely to tighten monetary policy as long as inflation expectations remain below their normal range consistent with a 2% inflation target. We agree that the odds of a US recession in the coming year are still low because financial conditions are set to remain accommodative, Chinese authorities are setting policy to shore up growth, and a trade truce is likely. Global economic activity will rebound in early 2020. Instead, the most probable timeframe for a broad based recession is late 2021/early 2022. As a result, we remain positive on risk assets, especially foreign stocks. We are also underweighting bonds as they offer extremely poor absolute and relative value. Mr. X: I can see we will have a lively discussion because I do not share your or my daughter’s optimism. My list of concerns is long, I hope we have time to get through them all. But first, let’s briefly review your predictions from last year. BCA: This exercise is always interesting and often humbling, too. A year ago, our key conclusions were that: Tensions between policy and markets would be an ongoing theme in 2019. With the US unemployment rate at a 48-year low, it would take a significant slowdown for the Fed to stop hiking rates. Ultimately, the Fed would deliver more hikes in 2019 than discounted in the markets. This would push up the dollar and keep the upward trend in Treasury yields intact. The dollar would peak in mid-2019. China would also become more aggressive in stimulating its economy, which would boost global growth. However, until both of these things happened, emerging markets would remain under pressure. We favored developed market equities over their EM peers. We also preferred defensive equity sectors such as healthcare and consumer staples over cyclical sectors such as industrials and materials. Within the developed market universe, the US would outperform Europe and Japan over the next few quarters, especially in dollar terms. Stabilization in global growth would ignite a blow off rally in global equities. If the Fed was raising rates in response to falling unemployment, it would be unlikely to derail the stock market. However, once supply-side constraints began to bite fully in early 2020 and inflation began to rise well above the Fed’s target of 2%, stocks would begin to buckle. This would mean that a window would exist in 2019 for stocks to outperform bonds. We would maintain a benchmark allocation to stocks, but increase exposure if global bourses were to fall significantly from then (late 2018) current levels without a corresponding deterioration in the economic outlook. Corporate credit would underperform stocks as government bond yields rise. A major increase in credit spreads was unlikely as long as the economy remained in expansion mode, but spreads could still widen modestly. US shale companies had been the marginal producers in the global oil sector. With breakeven costs in shale close to $50/bbl, crude prices would be unlikely to rise much from current levels over the long term. However, we expected production cuts in Saudi Arabia would push prices up, with Brent crude averaging around $82/bbl in 2019. A balanced portfolio was likely to generate average returns of only 2.8% a year in real terms over the next decade. This compares to average returns of around 6.6% a year between 1982 and 2018. As already noted, our forecast for more Fed rate hikes was wrong. This meant that we were offside in our duration call. Ultimately, 10-year Treasuries have generated returns of 10.8% so far this year, and German bunds and Japanese government bonds returns of 5.8% and 1.0% in EUR and JPY terms, or 2.5% and 2.0% in USD terms, respectively (Table 1). Nonetheless, our expectation of a run-up in risk asset prices was spot on. Equities outperformed bonds, with global stocks climbing 22.2% in USD terms. We missed the initial outperformance of corporate bonds relative to Treasuries, as investment grade credit rose by 13.9%. However, our bond team took a more constructive stance on corporates as the year progressed. Table 1Market Performance OUTLOOK 2020: Heading Into The End Game OUTLOOK 2020: Heading Into The End Game Chart 12019 Was A Good Year For Stocks 2019 Was A Good Year For Stocks 2019 Was A Good Year For Stocks In terms of regional allocation recommendations, we were correct to overweight US equities which beat non-US stocks by 13.4%, partly thanks to the dollar’s appreciation. We were also right to underweight EM equities, with Asia and Latin America generating dollar returns of only 12.6% and 6.9%. Overall, it was a good year for financial markets (Chart 1). Our growth forecasts were mixed. We predicted global growth would slow in the first half of 2019 but improve thereafter. Instead, the slowdown extended and intensified into the second half of the year as the Sino-US trade war escalated more than expected, and Chinese policymakers were more reluctant to reflate than anticipated. The IMF also revised down its growth forecasts. In the October 2019 World Economic Outlook report, growth in advanced economies for the year was cut to 1.7% from 2.1% compared to 2018 forecasts, led by a downward revision to 1.5% from 2% in Europe (Table 2). They also pared down 2019 EM growth estimates to 3.9% from 4.7%. Consequently, inflation was softer than originally predicted. These trends in economic activity meant that our dollar call was partially right. The currency did not peak in the middle of the year as we foresaw, but has been flat since the spring and today trades where it was in April. Meanwhile, the weaker-than-expected growth put our oil call offside, with Brent averaging $62/bbl this year, not $82/bbl. Table 2IMF Economic Forecasts OUTLOOK 2020: Heading Into The End Game OUTLOOK 2020: Heading Into The End Game The Cycle’s End Game Mr. X: You mentioned that you remain positive on risk assets and stocks for 2020. You will not be surprised that I am extremely skeptical of this view. The Fed could only raise rates to 2.5% before all hell broke loose, and it has now cut them back to 1.75%. The European Central Bank has lowered its deposit rate to -0.5% and is resuming its asset purchase program, while the Bank of Japan is clearly out of ammunition. Yet global growth remains weak. Despite this lack of economic traction, US stocks are at a record high and are unequivocally expensive. This situation seems untenable. If global growth weakens further, there is little more policymakers can do. I think the risk of a recession is a lot more elevated than you believe, especially as we cannot count on a lasting trade détente. Meanwhile, the US presidential election makes me uncomfortable, and I cannot see how business leaders will want to deploy capital to expand capacity given the risk that the regulatory and tax environment could become hostile to the corporate sector. If I’m wrong about growth – and I hope I am – then inflationary pressures will build and central banks will have to tighten policy suddenly. As bond yields rise, stocks will be sold and yet bonds will not offer any protection since they yield so little. Also, I have not even talked about negative interest rates. $12.1 trillion of debt yields less than zero percent. This is obviously preventing creative destruction from purging the system of rot. It is also promoting capital misallocation and undue risk-taking by financial institutions who cannot meet fiduciary liabilities. Ms. X: Based on this tirade, you can easily imagine what life at the office has been like in recent months. I do share some of my father’s concerns. Negative rates cannot be a good thing, especially from a long-term perspective. If growth weakens further, I’m also concerned that central banks have few options left. However, I do not see these risks as imminent. There are nascent signs that the global economy will stabilize soon; both President Trump and President Xi have strong incentives to reach a trade truce; and central banks are nowhere near removing the proverbial punch bowl. While US stocks are expensive, other risk assets offer value if global growth rebounds. The wall of worry is high, but stocks can and will climb that wall. BCA: Your debate is similar to our own internal discussions. It is undeniable that the investing landscape looks shaky at the moment, especially with the S&P 500 currently trading at 18-times forward earnings. However, the situation you are describing is a direct consequence of one BCA’s long running macro themes: The end of the debt supercycle. While the debt supercycle is dead in advanced economies, it remains very much alive in emerging markets, and China in particular. The private debt load in advanced economies has declined by 20% of GDP since 2009 (Chart 2A). Despite the burgeoning US federal government deficit, public debt accumulation has not been strong enough to cause total debt loads to increase. Instead, aggregate indebtedness has been stuck slightly above 260% of GDP for the past 10 years. Depressed, and in some cases, negative interest rates reflect weak demand for credit. Chart 2AThe Debt Supercycle Is Dead In DM... The Debt Supercycle Is Dead In DM... The Debt Supercycle Is Dead In DM... Chart 2B...But Not In EM ...But Not In EM ...But Not In EM   The end of the debt supercycle has both a negative and positive impact. Without increasing leverage, domestic demand cannot grow faster than trend GDP. Thus, it takes much more time for inflationary pressures to build. Concurrently, in the absence of inflationary pressure, more time passes before monetary policy reaches a restrictive level causing recession. The upshot is that the business cycle can last much longer. Moreover, a world less geared to credit accumulation reduces the fragility of the financial system, at the margin. While the debt supercycle is dead in advanced economies, it remains very much alive in emerging markets, and China in particular (Chart 2B), where the demand for credit is still very sensitive to changes in monetary settings. EM countries are the major source of volatility in the global business cycle. Chinese policymakers’ management of the tradeoff between growth and leverage will determine whether the global economy can avoid deflation. If they decide to tackle debt excesses head on, EM credit growth will contract and EM final demand will suffer. In this scenario, negative rates will persist in low-growth advanced economies, and the Fed will be incapable of raising rates because global deflationary forces will be too strong. Chart 3The World Is In The Midst Of A Deflationary Episode The World Is Experiencing A Deflationary Episode... The World Is Experiencing A Deflationary Episode... The second half of 2018 and the whole of 2019 gave us a taste of these forces. When China tightened credit conditions, the EM economies slowed first. Trade and manufacturing hubs like Europe, Australia and Japan quickly followed. A deflationary wave spread around the world, as evidenced by a drop in global producer prices (Chart 3). The US is a comparatively closed economy, but it could not avoid this gravitational pull. The ISM manufacturing survey ultimately started to contract in August 2018, converging to weakness in the rest of the world. The trade war’s hit to business confidence added insult to the injury of an already weak economic environment. Looking ahead, our optimism reflects an expectation that Chinese policymakers will adopt a more pro-growth policy stance because they too are spooked by the downtrend in their economy. While the Politburo Standing Committee has not abandoned its structural reform agenda, it realizes that aggressive deleveraging is dangerous. The Chinese economy is growing at its weakest pace in nearly 30 years and deflation is once again taking hold. In response to date, policymakers have lowered China’s reserve requirement ratio by 400 basis points, cut taxes by 2.8% of GDP, increased the issuance of local government bonds to finance public infrastructure projects, and boosted capex at state-owned enterprises. EM economies will respond to these stimulative measures. The Chinese credit and fiscal impulse has stabilized (Chart 4). Meanwhile, the Fed has pushed the real fed funds rate 74.4 basis points below the Holston-Laubach-Williams estimate of the neutral rate, and coordinated global policy easing points to a rebound in the global manufacturing sector (Chart 4, bottom panel). Moreover, the global inventory purge that magnified the industrial sector’s pain is getting exhausted and the auto sector is looking up. Finally, we agree with Ms. X that both President Trump and President Xi have their own incentives to deescalate trade policy uncertainty. We are entering the end game of this business cycle and bull market. Global borrowing rates will rise, but only to a limited extent. Rightly or wrongly, major central banks are terrified by the prospect of the Japanification of their economies. Practically speaking, this means that they want inflation expectations to move back up to normal levels (Chart 5). However, after undershooting their 2% targets for 11 years, achieving this objective will require central banks to let realized inflation overshoot these targets first. Thus, central banks are unlikely to tighten policy until late next year at the earliest, which will limit how far yields can climb in 2020. Chart 4…But Do Not Bet Against Reflation ...But Do Not Bet Against Reflation ...But Do Not Bet Against Reflation Chart 5Depressed Inflation Expectations Depressed Inflation Expectations Depressed Inflation Expectations   Equities and other risk assets should perform well if global growth re-accelerates but interest rates don’t rise much at first. Some benefit of this fertile backdrop is already priced in, but many pockets of value levered to stronger global growth still exist. We are entering the end game of this already long business cycle. While the general environment favors remaining invested in risk assets in 2020, this is likely the last window of opportunity to do so. Today’s accommodative monetary policy will revive inflationary pressures in 2021, and central banks will ultimately be forced to lift rates much more aggressively. China will continue to resist excessive leverage. Neither the business cycle nor the equity bull market will withstand these final assaults. Mr. X: Your benign outlook reminds me of when we met in December 2007. Do you remember? You told me that the housing slowdown and the credit market seizure were large risks, but central banks would put a floor under global growth. How did that turn out? I agree that in advanced economies, overall debt loads have been stable. But this belies major disparities. For example, US corporate debt has never represented a larger share of GDP than it does today. This must be a major vulnerability. While household balance sheets look healthy, I do not think consumption will save the day if companies are cutting capex and employment while they clean up their balance sheets. Countries like Canada and Australia are drowning in private sector debt. How can you ignore these vulnerabilities? BCA: A comparison with 2008 actually reveals why advanced economies, particularly the US, are not the powder keg that they once were. US corporate debt is elevated when compared to GDP, but profits also represent a much larger share of GDP than they did 10 or 20 years ago, and interest rates are close to historic lows. As a result, interest coverage ratios are still adequate (Chart 6). In 2007, household debt loads were large, but interest payments also accounted for 18.1% of disposable income, the highest proportion since 1972. Additionally, US firms’ debt-to-asset ratio is in line with the post-1970 average of 22.1%. Finally, US businesses have not used rising leverage to fund capital spending, as demonstrated by the elevated age of the capital stock. Thus, the US corporate sector continues to generate positive net savings. Ahead of recessions, US businesses typically generate negative net savings. The composition of the creditors is another important difference. In 2007, an extremely large share of the spurious borrowings resided on banks’ balance sheets. Moreover, the banking system was woefully undercapitalized with a leverage ratio of 17x. Weak banks had to absorb 2.2 trillion of losses after 2008. Consequently, the money creation mechanism broke down, and money multipliers collapsed (Chart 7). Today, US banks boast relatively stronger balance sheets, and they are still judicious about extending credit despite being less exposed to the corporate sector than they were to the mortgage market in 2008. Instead, most corporate debt is held by less levered entities such as ETFs, pension plans, and insurance companies. The leveraged losses that proved so debilitating in 2008 are less likely to be a source of systemic risk in this cycle. Chart 6US Businesses Can Still Service Their Debt US Businesses Can Still Service Their Debt US Businesses Can Still Service Their Debt Chart 72008 Heralded A Destruction Of Money 2008 Heralded A Destruction Of Money 2008 Heralded A Destruction Of Money   Countries like Australia and Canada have much more worrisome private sector debt dynamics, as their servicing costs are elevated (Chart 8). However, these economies are unlikely to collapse when global rates are low, as long as the global economy can avoid a recession, which would reduce export revenue in these trade-sensitive countries. You expect a moderate rebound in global growth next year, but not a sharp acceleration because Chinese stimulus will not be that aggressive. The bottom line is that both the US corporate sector and at-risk countries like Canada should avoid a day of reckoning until interest rates rise meaningfully. As we have already mentioned, central banks are very clear that they will allow inflation to overshoot before tightening policy anew. We monitor US inflation breakeven rates to gauge the likely timing of that outcome. At 1.6%, they remain well below the 2.3% to 2.5% range, which is historically consistent with central banks durably achieving their inflation target (Chart 9). Until inflation expectations are re-anchored back up in that range, we will not worry about an imminent tightening in monetary conditions. Chart 8Canada And Australia Are Close To Their Debt Walls Canada And Australia Are Close To Their Debt Walls Canada And Australia Are Close To Their Debt Walls Chart 9The Fed Is In No Rush To Tighten The Fed Is In No Rush To Tighten The Fed Is In No Rush To Tighten   Chart 10Inflation Is A Lagging Indicator OUTLOOK 2020: Heading Into The End Game OUTLOOK 2020: Heading Into The End Game It is true that inflationary pressures are building in the US. Historical evidence points to a kink in the Phillips curve, the link between wage growth and the unemployment rate. Since the labor market is tight, we are already seeing average hourly earnings growth accelerate. Moreover, the output gap is mostly closed. However, keep in mind that inflation is also a lagging economic indicator (Chart 10). Consequently, the recent global economic slowdown is likely to keep US inflation at bay for most of 2020. The sharp fall in US capacity utilization along with the decline in imported goods and core producer price inflation corroborate this picture. Mr. X: So you believe that as long as rates stay low, the day of reckoning will be delayed. But ultimately, that it is unavoidable. BCA: Correct. No matter what, we are entering the end game of this already long business cycle. The current period of easy policy will allow cyclical spending to rise as a share of output, and debt to build up again over the coming 18 months. Because slack is clearly limited, this latest wave of policy easing will generate inflationary pressures. Ultimately, the Fed will be forced to play catch up and tighten more aggressively than expected in 2021. Paradoxically, the longer the onset of recession is delayed, the deeper it is likely to be… Mr. X: Because imbalances and vulnerabilities will only grow larger! BCA: Absolutely! Mr. X: That is something we can agree on. Ms. X: The way you complete one another’s sentences is a testament to how many years you have been talking to each other. For me, the most concerning issue is political risk. While I am more positive on the outlook for trade policy than my father, I do worry about the impact of US election risk on capital spending. Chart 11If The 2012 Election Is Any Guide, Trump Can Still Win A Second Term OUTLOOK 2020: Heading Into The End Game OUTLOOK 2020: Heading Into The End Game BCA: On the trade war, we would like to address your father’s concerns. All politicians, even unconventional ones like President Trump, seek re-election. Yet, President Trump’s overall approval rating is low (Chart 11). If the election were held today, his odds of winning would be minimal. However, US presidential elections do ultimately favor the incumbent. If the re-election of President Obama in 2012 is any guide, President Trump has enough time to boost his approval rating over the coming 12 months to secure a second term through the Electoral College. In order to achieve this outcome, he must reverse the large slowdown in wage growth currently plaguing the swing states he won by only a small margin in 2016 (Chart 12). Workers in states like Michigan, Pennsylvania and Wisconsin are suffering disproportionately from the uncertainty created by the trade tensions. President Trump will have to pause the tariffs – and even cut tariff rates – to support the economy and reassure voters. Chart 12Trump's Fear Is Coming True Trump's Fear Is Coming True Trump's Fear Is Coming True China is willing to accept a trade truce. The Chinese economy is weak and producer prices are once again deflating. President Xi doesn’t want to preside over another massive surge in leverage or a 1930’s Irving Fisher-style deflationary spiral. Reviving private sector investment sentiment via a reduction in trade policy uncertainty would help stabilize spending and avoid a disorderly economic slump. Moreover, President Xi may not trust the current White House, but the prospect of a Democratic administration that will be tough on both environmental standards and human rights would offer little solace. This brings us to the US election. The recent Bank of America Merrill Lynch positioning survey shows that the investment community shares your concerns. This risk is hard to quantify. The Democratic nomination is wide open. Former Vice President Joe Biden leads the opinion polls, and is a known quantity. Meanwhile, the rising progressive wing of the party, embodied in Senator Elizabeth Warren, is hostile to business and likely to cause concerns in boardrooms across the US, especially in the tech, energy, financial services and healthcare sectors. This could dampen animal spirits. Biden’s and Warren’s odds of beating President Trump are overstated by current polls, especially if the President softens his stance on trade to allow for a growth pick-up. Moreover, to be competitive nationally, Senator Warren will have to abandon some of her more progressive plans and pivot toward the center. The recent upbeat equity market performance of sectors like managed healthcare suggests that markets are discounting this shift. Thus, we doubt the election is currently really weighing on business intentions. The recent pick up in capital spending intentions in various Fed Manufacturing surveys fades this risk. Chart 13A Structural Tailwind Has Vanished A Structural Tailwind Has Vanished A Structural Tailwind Has Vanished What is clear though is that if the economy were to weaken further, Senator Warren’s chances would improve and CEOs would genuinely begin to worry about re-regulation, potentially unleashing a vicious cycle. Thus, the end game is an unstable equilibrium. On a structural basis, whether one looks at the rise of populism or the geopolitical rivalry between China and the US, trade tensions will remain a pesky feature of the global economy. In effect, the trade truce will not be a permanent deal. The global economy has therefore lost the tailwind of deepening global integration achieved through trade (Chart 13). This will limit global potential GDP growth. Ms. X: Thank you. I think the time is right to explore your economic outlook in more detail. The Economic Outlook Chart 14China: Modest Reflation Is Underway China: Modest Reflation Is Underway China: Modest Reflation Is Underway Mr. X: From your arguments, it seems that the outlook for China and Emerging Markets is critical, so let’s start there. My impression is that President Xi is not abandoning his structural reform agenda. Avoiding the middle-income trap will require decreasing China’s dependence on credit as a growth driver. Can economic activity really stabilize under those circumstances? BCA: You are correct: Senior Chinese administrators are reluctant to allow another major phase of debt accumulation to take hold. However, as we already highlighted, policymakers are taking steps to end the most severe economic slowdown since the first half of the 1990s. China is currently implementing a middling stimulus program. The positive impact of the lower bank reserve requirement ratio, the tax cuts and increased public infrastructure spending is being mitigated by strong regulatory constraints on the shadow banking system and small financial institutions, by efforts to limit real estate speculation, and by the cash crunch facing real estate developers. These crosscurrents make it unlikely that the credit impulse will rise as sharply as it did following the reflationary campaigns of 2009, 2012 or 2016. Nonetheless, the Chinese economy is indeed exhibiting some mildly positive signals. Our monetary indicator and state-owned enterprise capital spending point to a rebound in overall Chinese economic activity (Chart 14). Moreover, household spending is trying to bottom. If China stabilizes, then the EM slowdown will end soon. Without a deepening drag from the Chinese economy, EM countries should be able to take advantage of the easing in global financial and liquidity conditions. But the end of the Chinese drag on EM growth does not mean a massive tailwind will be forthcoming. Additionally, deflationary forces remain stronger in the emerging world than in the US. As a result, EM real rates will remain stubbornly above the level that real economic activity warrants, posing a headwind for capital and durable goods spending. Generally speaking, EM and China are moving from a headwind for the world to a mild tailwind. Treasury yields are unlikely to move significantly higher than the 2.25% to 2.5% zone. Ms. X: I’m somewhat more positive than you on global growth next year. The policy easing around the world looks very promising for economic activity. How do you factor the impact of improving global liquidity conditions into your outlook for 2020? BCA: It is undeniable that global liquidity conditions have eased massively. As we already highlighted, the majority of global central banks cutting rates is a very positive dynamic for global growth. Trends in measures of liquidity ratify this message. Foreign exchange reserves are again growing and our BCA US Financial Liquidity index has rallied sharply over the past 12 months. Historically, this indicator forecasts the trend in the BCA Global Leading Economic Indicator, commodity prices and EM export prices by 18 months (Chart 15). Moreover, money aggregates are growing faster than credit across the major advanced economies. Such developments typically foretell an acceleration in global economic activity (Chart 16). Chart 15Liquidity Dynamics: Fueling A Global Growth Recovery Liquidity Dynamics: Fueling A Global Growth Recovery Liquidity Dynamics: Fueling A Global Growth Recovery Chart 16Rising Money Supply Is A Good Thing Rising Money Supply Is A Good Thing Rising Money Supply Is A Good Thing   The duration of the current slowdown also warrants optimism. We have often highlighted that since the early 1990s, the global manufacturing sector evolves over 36-month symmetric cycles (Chart 17). The current soft patch has lasted more than 18 months. In the context of easing liquidity and depleted inventories, pent-up demand can easily translate into actual spending. The recent surge in the new orders-to-inventories ratio confirms that global manufacturing activity should soon pick up (Chart 18). The auto sector’s weakness, which was exacerbated by previous inventory buildups, changing emission standards, and rising borrowing costs, is also ebbing. Chart 17The Mid-Cycle Slowdown Is Long In The Tooth The Mid-Cycle Slowdown Is Long In The Tooth The Mid-Cycle Slowdown Is Long In The Tooth Chart 18The New Order-To-Inventory Ratio Points To A Global Rebound The New Orders-To-Inventories Ratio Points To A Global Rebound The New Orders-To-Inventories Ratio Points To A Global Rebound     Various growth indicators are sniffing out this positive inflection point. The recent trough in the global ZEW survey is revealing (Chart 19). It materialized quickly after Sino-US trade tensions began to ease. Enough positive global economic momentum exists such that a minor decline in policy uncertainty could unleash a large improvement in growth expectations. The rebound in Taiwanese equities and European luxury stocks confirms that the global economy should soon bottom. There are two things we cannot emphasis enough. First, this is the end game of the business cycle, after which a recession will ensue. Second, investors should not expect the kind of strong synchronized growth rebound witnessed in 2017. Without a Chinese and EM boom, a crucial source of demand will be wanting. Mr. X: What about US growth? The yield curve inverted this summer and deteriorating consumer and business confidence raised the specter of an imminent recession. Moreover, the fiscal stimulus that helped the economy in the first half of 2019 is now over. In fact, with a $1 trillion federal deficit despite an unemployment rate of only 3.6%, we have run out of fiscal room to support activity if and when a recession materializes. BCA: The recent yield curve inversion most likely overstated the risk of an economic contraction. First, in the mid-1990s, if the term premium had been as low as it is today, the curve would have also inverted without any recession materializing from 1995 to 2000. Second, this summer, the curve inverted up to the 5-year tenor and steepened for longer maturities. Prior to recessions, the curve inverts across all maturities. Recessions are not born out of thin air. They are caused by imbalances and tight monetary policy. The large debt buildup and other investment imbalances that have preceded prior US recessions are not yet apparent. Prior to the 1991, 2001 and 2008 recessions, the private sector debt load had increased by 20.6%, 14.6% and 25.6% of GDP in the previous five years, not the current 1.4% run rate. The Fed’s policy is now clearly accommodative. Not only is the real fed funds rate 74.4 basis points below the Fed’s favored estimate of the neutral rate of interest, but also real estate, the most interest-rate sensitive economic sector, is rebounding. In 2018, real estate activity collapsed in response to mortgage rates rising to 4.9%. Today, the NAHB Homebuilding index has retraced 79% of its losses; mortgage demand has improved; and housing starts and building permits have recovered (Chart 20). When policy is tight, real estate activity never recovers this quickly, even as yields fall. Chart 19Positive Signals For Global Growth Positive Signals For Global Growth Positive Signals For Global Growth Chart 20The Housing Market Signals That Policy Is Accommodative The Housing Market Signals That Policy Is Accommodative The Housing Market Signals That Policy Is Accommodative   Chart 21Robust Household Financial Health OUTLOOK 2020: Heading Into The End Game OUTLOOK 2020: Heading Into The End Game A counterargument is that real estate price appreciation is weak. However, tight monetary policy is not the cause. Two forces are dampening house prices. First, the Jobs and Tax Act of 2017 lowered allowable mortgage interest and state and local tax deductions. High-end properties in high-tax states such as California, New York and Massachusetts have suffered from this adjustment. Second, the US housing market has an overhang of large, pricey homes relative to strong demand for smaller, starter homes. Median home prices outpacing average ones show this divergence. We also to need to gauge if consumer spending is likely to follow the manufacturing sector lower. If it does, a recession will be unavoidable. On this front, we are hopeful because: The outlook for household income is positive. As you noted, the unemployment rate is still extraordinarily low, and more Americans will be working by the end of 2020 than today. Additionally, the rising employment-to-population ratio for prime-age workers is tightly linked to stronger wages (Chart 21). Also, the recent pick up in productivity growth points to higher real wage growth. The household savings rate is elevated and has limited upside. Households already have a large cushion insulating them from unforeseen shocks. At 8.1% of disposable income, the savings rate is in the 65th percentile of its post-1980 distribution. It is especially lofty if we take into account robust American households’ net worth (Chart 21, bottom panel). Consumer credit demand is rising, according to the Fed’s Senior Loan officer survey. Since household liquid assets are quickly expanding and the household formation rate is robust, consumption of durable goods should pick up, especially in light of the large decrease in borrowing costs. This is particularly true since the household debt-to-assets ratio is at its lowest level since 1985 and debt-servicing costs only represent 9.7% of disposable income, the lowest share for nearly 40 years. The corporate sector outlook should brighten soon. The modest rise in productivity protects margins from higher wages, an effect that will linger given that capacity expansion is consistent with further productivity gains (Chart 22). Crucially, the combined fiscal and monetary easing in China should bolster capital-spending intentions around the world, including the US (Chart 23). Rising productivity will only consolidate these trends. Chart 22Capacity Growth Provides Some Support For Productivity Capacity Growth Provides Some Support For Productivity Capacity Growth Provides Some Support For Productivity Chart 23Chinese Reflation Will Revive US Capital Spending Chinese Reflation Will Revive US Capital Spending Chinese Reflation Will Revive US Capital Spending   The most positive development for the US corporate sector is our outlook for non-US growth. If the global manufacturing sector mends itself, so will the US. Ample liquidity is a positive for the world economy, as well as for US manufacturing conditions (Chart 24). On the fiscal front, we appreciate your worries, but they are not a story for 2020. The US fiscal thrust will not be as positive as it was in 2018 or 2019, but it is set to remain a small tailwind, not a drag. Furthermore, given that 2020 is an election year it is unlikely that politicians will tighten purse strings over the coming 12 months. Fiscal risks are undoubtedly greater in the long run. However, a sudden fiscal consolidation is a remote probability because fiscal austerity has gone out of style. Instead, the federal debt burden will be a major source of long-term inflation because there is no other easy way to address this gigantic pile of liabilities. The path of least resistance will be more spending and financial repression. In other words, real rates will stay too low and excess government spending will push prices higher, conveniently eroding the real value of that high federal debt burden. This was a big story in the 20th century and it will remain so in the 21st (Chart 25), especially since an aging population and the peak in globalization will weigh on global savings. Chart 24The US Manufacturing Slowdown Has Run Its Course The US Manufacturing Slowdown Has Run Its Course The US Manufacturing Slowdown Has Run Its Course Chart 25Inflation Is About Political Decisions Inflation Is About Political Decisions Inflation Is About Political Decisions   Ms. X: Your point about demographics makes me think of Europe and Japan. Brexit has not been resolved; populism remains a concern in Italy; and the European banking system is still fragile. Japan suffers from an even worse demographic profile and the recent VAT increase was ill-timed, economically. Given these headwinds, can these regions participate in the global recovery you foresee? BCA: The short answer is yes, albeit to varying degrees. The outlook for Europe is more promising than Japan. A No-Deal Brexit is now a very low probability event, even after next month’s UK election. The conservatives’ support for Prime Minister Johnson’s Brexit plan will ensure as much. A large source of uncertainty is being lifted, which will allow European businesses to resume investment planning. The situation in the European periphery is also improving. Non-performing loans in Spain and Italy are falling (Chart 26), which is allowing for a normalization of credit origination. The narrowing Italian and peripheral spreads to German bunds will be helped by easing financial conditions in the European economies that need it most. Higher Italian bond prices improve banks’ solvency and cut borrowing costs for the private sector. Finally, populism is alive and well in Europe, rejecting fiscal austerity, but not embracing euro-skepticism. More generous fiscal spending would be a positive for Europe. European liquidity conditions are also generous. Deposit growth has strengthened and financial conditions have benefited from lower German yields and a cheap euro, which trades 15% below fair-value estimates. Our model for European banks’ return on tangible equity is rising, which is a clear indication that easy financial and liquidity conditions should deliver stronger incremental economic activity (Chart 27). Chart 26Declining Non-Performing Loans Are A Positive For The European Periphery Declining Non-Performing Loans Are A Positive For The European Periphery Declining Non-Performing Loans Are A Positive For The European Periphery Chart 27European Banks' Return On Equity Will Improve In 2020 European Banks' Return On Equity Will Improve In 2020 European Banks' Return On Equity Will Improve In 2020   The fiscal outlook is murkier. European fiscal thrust was a positive 0.4% of GDP in 2019, but it will decline to 0.1% in 2020. However, fiscal policy affects economic activity with a lag. The impact of this year’s easing has yet to be fully felt. Since European rates are so low and the economy is not operating at full capacity, the fiscal multiplier is greater than one. Therefore, Europe can still reap a substantial fiscal dividend next year. Finally, Europe remains a very pro-cyclical economy. A large share of euro area GDP is connected to manufacturing and exports. As a result, Europe will be one of the prime beneficiaries of a pickup in global growth. Already, the sharp rebound in the German and euro area ZEW survey expectation components point to a brighter outlook for the region. Japan is also a very pro-cyclical economy, which will reap a dividend from a bottom in global manufacturing activity. However, the Land of the Rising Sun is still subject to idiosyncratic constraints. Japanese financial conditions have not improved as much as those in Europe. The yen has appreciated 2.6% in trade-weighted terms this year, while Japanese yields have not melted as much as European ones (because Italian and peripheral yields fell so much in 2019). Japan will also have to reckon with the impact of the October VAT increase. Ahead of the tax hike, retail sales spiked by 9.1% on a year-on-year basis, or 7.1% compared to the previous month, a script similar to 2014. 2015 was a payback year where consumption was depressed. This scenario will play out again, even if the Abe government has implemented some fiscal offsets. Ultimately, the Japanese economy will lag Europe’s in the first half of the year but should catch up in the second half. The impact of the tax hike will dissipate. Most importantly, rebounding global growth will hurt the yen, at least on a trade-weighted basis, providing a lift to export prospects and easing Japanese financial conditions relative to the rest of the world, which will produce a growth dividend later in 2020. Ms. X: To summarize, you expect a moderate rebound in global growth next year, but not a sharp acceleration because Chinese stimulus will not be that aggressive. EM activity will also pick up but will not generate fireworks. The US will be okay but Europe will probably deliver the largest positive growth surprise as external and domestic conditions align positively. Japan will also stabilize on the back of stronger global growth, but domestic headwinds mean that a true reacceleration won’t happen until the latter part of the year. This recovery constitutes the business cycle’s end game as inflation will become a concern in 2021, forcing the Fed to tighten then. BCA: Yes, this is correct. Ms. X: Thank you! Bond Market Prospects Chart 28Global Bonds Are Extremely Overvalued Global Bonds Are Extremely Overvalued Global Bonds Are Extremely Overvalued Ms. X: I do not like US Treasuries at current yields. They do not protect me against an inflation surprise and will do nothing for me in an economic recovery. However, my bearishness is tempered by the large stock of bonds with negative yields in Europe and Japan. As long as this strange situation persists, I doubt US yields will experience much upside. US paper is too attractive to foreign asset managers right now. BCA: We share your view and are recommending an underweight to global government bonds. Global yields offer little value and are vulnerable to a rebound in economic activity or a trade détente. Our Global Bond Valuation index is flashing a clear sell signal (Chart 28). As yields rise, global yield curves are bound to steepen. We also agree that the upside for Treasury yields is limited, but we disagree with the limiting factor. Foreign investors are not the major buyers of Treasuries. Indeed, the data shows that European and Japanese investors have not been aggressive purchasers of US government securities. The US yield curve is flat and US short rates tower above European and Japanese ones, hedging currency exposure when buying Treasuries is expensive. In euro or yen terms, a hedged Treasury yields -67 basis points and -60 basis points, less than 10-year bunds or JGBs, respectively. Meanwhile, EM central banks are diversifying their FX reserves away from the US dollar into gold. Instead, our view is governed by the concept we dub the “Golden Rule of Treasury Investing.” According to this principle, the outperformance of Treasuries relative to cash is a direct function of the Fed’s ability to surprise the market. If the Fed cuts rates more than the OIS curve anticipated 12 months prior, Treasuries outperform. The opposite happens if the Fed delivers a hawkish surprise (Chart 29). Chart 29The Golden Rule Of Treasury Investing The Golden Rule Of Treasury Investing The Golden Rule Of Treasury Investing Treasury yields are unlikely to move significantly higher than the 2.25% to 2.5% zone, because the OIS curve is now only pricing in 28 basis points of rate cuts over the next year. It is not just the US OIS curve that has priced out a large amount of rate cuts; this phenomenon has materialized around the world over the past five weeks. Chart 30The Term Premium Is Too Low The Term Premium Is Too Low The Term Premium Is Too Low Any upside risk to that 2.25% to 2.5% forecast for 2020 will come from the inflation expectations and term premium components of yields. Central banks, including the Fed, have telegraphed an intention to allow inflation expectations to rise, initially, in response to stronger global growth. Moreover, declining risk aversion should also allow the exceptionally depressed term premium to normalize (Chart 30). Only in late 2020 or early 2021 will Treasury yields durably move above this 2.25-2.5% zone. Punching above these levels will require core PCE inflation to have been above target long enough to re-anchor inflation expectations back up to their 2.3% to 2.5% target zone. Only then will the Fed give the all-clear signal to the bond market to lift yields higher. Mr. X: You still have not directly addressed the question of negative yields in Europe and Japan. This story will not end well. Do you worry about these bond markets over the next year? BCA: Our answer is an emphatic yes. But we assume you will not let us leave it at that. Mr. X: You know me too well. BCA: Over the course of the past 50 years, we have learned a thing or two about you. In all seriousness, let’s start with our simple but effective valuation ranking. It compares the current level of real yields for each country to their historical averages and standard deviations. You can see that the most unattractive bond markets right now are all in Europe (Chart 31). Chart 31European Bonds Are Too Dear OUTLOOK 2020: Heading Into The End Game OUTLOOK 2020: Heading Into The End Game Chart 32Swiss Bonds Are A Lose-Lose Proposition Swiss Bonds Are A Lose-Lose Proposition Swiss Bonds Are A Lose-Lose Proposition The lower bound of interest rates is another reason to avoid these markets. This floor seems to lie around -1% in nominal terms. Because of these constraints, in recent months, Swiss, Swedish, Dutch and German 10-year bonds have failed to rally as much as their higher-yielding US, Canadian or Australian counterparts when global yields are declining. However, they also underperform when yields are rising (Chart 32). They have become a lose-lose proposition. The only pockets of value left in DM bond markets are Greece, Portugal or Italy. Despite their apparent risks, we still like them. Support for the euro in Greece and Italy is 70% and 65%, respectively. Even populist governments in these nations are reluctant to attack euro membership anymore. Moreover, the ECB remains committed to the survival of the euro area in its current form. Christine Lagarde will not change that. For 2020 or 2021, the risk of euro breakup is practically zero. The same may not be true on a 5- to 10-year investment horizon, but for the coming year, these bonds offer an attractive risk-adjusted carry. Ms. X: Unsurprisingly, my father does not like corporate bonds because of highly levered corporate balance sheets. I think this is a long-term problem, but not a risk for 2020, so I’m looking to stay overweight spread product relative to Treasuries. Where do you stand on this market? BCA: On this issue, we sit somewhere between you both. Our Corporate Health Monitor continues to deteriorate (Chart 33). The high debt load of the US business sector coupled with the decline of the return on capital worries us. Furthermore, the covenant-lite trend in recent issuance suggests that corporate borrowers, not lenders, are getting the good deals. Essentially, too much cash is still chasing too little available yield pick-up. In this environment, capital is sure to be misallocated, and money ultimately lost. We find the reward-to-risk tradeoff more attractive in Europe and Japan than in emerging markets. On a short-term basis, the spreads will not widen much. An easy Fed, recovering global growth, and the gigantic pile of negative-yielding bonds around the world will make sure of that. We advocate a neutral stance on investment grade corporates because IG bonds have high modified duration such that breakeven spread compensation versus Treasuries is near the bottom of its historical distribution across the IG credit spectrum (Chart 34). This means that credit will generate poor returns if government bond yields rise. Chart 33Dangerous Long-Term Picture For US Corporates A Precarious Long-Term Picture For US Corporates A Precarious Long-Term Picture For US Corporates Chart 34No Value Left In IG No Value Left In IG No Value Left In IG   Chart 35EMs Still Experiencing Deflation EMs Still Experiencing Deflation EMs Still Experiencing Deflation Thankfully, they are ways around this problem: emphasizing exposure to high-yield (HY) bonds and agency mortgage-backed securities (MBS) instead. HY breakeven spreads remain much more attractive than in the IG space, and option-adjusted spreads will benefit if our growth and inflation forecasts materialize. Investors reluctant to commit capital to these products should look into high quality agency MBS. After the recent wave of mortgage refinancing, these securities’ duration has collapsed to 3.0 compared to 7.9 for IG corporates. These securities therefore offer much better protection in a rising-yield environment. Ms. X: Before we move on to equities, where do you stand on EM bonds? BCA: We need to differentiate between EM local-currency bonds and EM USD-denominated bonds. We do like some EM local currency bonds. Inflation in EM countries is low and dropping. Money and credit growth is slowing, which implies that the disinflationary trend will remain in place through 2020 (Chart 35). Weaker nominal growth means that central banks in EM will continue to cut rates, providing a nice tailwind for local-currency bond prices. This comes with a caveat. Lower policy rates will boost bond prices but hurt EM currencies, especially because most EM currencies are not cheap and are already over-owned. Next year, it will be preferable to garner exposure to those countries interest rate moves via the swap market rather than the cash bond market. Chart 36The Mexican Peso Is Cheap The Mexican Peso Is Cheap The Mexican Peso Is Cheap There are some exceptions, like Mexico. The MXN is already very cheap because of fears surrounding the economic policies of President Andres Manual Lopez Obrador (AMLO) (Chart 36). However, we doubt he will turn out to be as dangerous as feared. Hence, MXN Mexican bonds are attractive to foreign investors in unhedged terms. We are currently avoiding EM USD-denominated debt, corporate and sovereign. Since emerging markets sport $5.1 trillion of dollar-denominated debt, falling EM exchange rates will increase the cost of servicing this debt, which makes it riskier. Mr. X: I think we will continue to underweight corporate and EM bonds in our fixed income portfolio. Spread levels still make no sense in terms of providing compensation for credit risk. I must admit that I find your recommendation to overweight MBS intriguing. We will need to ponder this idea further. Ms. X: And please wish me luck trying to convince my father to buy some high-yield bonds. Equity Market Outlook Mr. X: US stocks are too expensive for my taste, with the S&P 500 trading at a forward P/E ratio of 18. I’m well aware of the argument that equities may be expensive but that they are actually cheap compared to bonds, which implies that I should favor stocks over bonds. However, you know that I emphasize capital preservation. With stocks this rich already, equities offer no margin of safety. If I own stocks, I am therefore exposed to any unexpected shocks. Because I do not share your optimism on the economy, I am more worried about downside risk. Moreover, even if the economy performs better than I fear, I suspect stocks will respond poorly to higher yields. Chart 37The S&P Is Very Expensive The S&P Is Very Expensive The S&P Is Very Expensive Ms. X: I agree with my father that stocks are expensive. Nonetheless, as Keynes famously quipped, “Markets can stay irrational longer than you can stay solvent.” In today’s context, to me this means that stocks can ignore their overvaluation so long as liquidity is plentiful, rates are low, and a recession is avoided. BCA: On this question, we agree with Ms. X. We all agree that US equities are expensive. As you mentioned, their price-to-earnings ratio is 18. Only at the apex of the tech bubble and in early 2018 was the S&P 500 more expensive. Worryingly, the price-to-sales ratio is at 2.3, an even larger historical outlier than the P/E (Chart 37). Chart 38Low Yields And Plentiful Liquidity Are Still Fertile Ground For Stocks Low Bond Yields And Plentiful Liquidity Are Still Fertile Ground For Stocks Low Bond Yields And Plentiful Liquidity Are Still Fertile Ground For Stocks Ms. X is correct that we cannot look at stock valuations in isolation. Investing is about opportunity cost and the macroeconomic context. On this front, even US equities have their merit. Despite the S&P 500’s expensive multiples, our Composite Valuation Indicator is no more elevated than it was in 2013. Meanwhile, our Monetary Indicator has rarely been as supportive of stock prices as it is today, and our Speculation Indicator is in line with its January 2016 reading (Chart 38). Moreover, BCA’s Composite Sentiment indicator is still below its long-term historical average and margin debt has declined by $47.5 billion to the lowest share of US market capitalization since June 2005. These are hardly signs of irrational exuberance. Ultimately, bear markets and recessions travel together. A durable 20% drop in stock prices requires a significant and long-lasting decline in earnings. These developments happen during recessions (Chart 39). Our call is for a recession in the next 24 months or so. We must also remember that while equities perform poorly six months ahead of a recession, the end of a bull market, its last 12 to 18 months, tend to be very rewarding (Table 3). We are within this window. Chart 39Bear Markets And Recessions Travel Together Bear Markets And Recessions Travel Together Bear Markets And Recessions Travel Together Table 3The End Game Can Be Rewarding OUTLOOK 2020: Heading Into The End Game OUTLOOK 2020: Heading Into The End Game Based on our forecast for interest rates, we do not share the concerns that rising bond yields will topple stocks right away. Stock prices are an inverse function of risk-free rates, but a positive function of growth expectations. Higher yields will initially reflect stronger growth, not restrict it. But remember: the upside for yields is limited because central banks do not want to choke off the recovery. They will maintain accommodative policy. In other words, we expect real rates to lag behind growth expectations. Because long-term growth expectations, whether from sell-side analysts or extracted out of market prices using the Gordon Growth Model, are low, we are willing to make this bet (Chart 40). Equities will suffer if the global bond yield rises above 2.5%. This is more a story for 2021, and not our central scenario for 2020. It is nonetheless a reminder that we are entering the end game of the business cycle, so we are also entering the end-game of the bull market. Mr. X: I think you are playing with fire. Stocks are so expensive that if you are wrong on either the growth call or the yield call, they will suffer. I would rather miss the last melt-up in stocks than unnecessarily expose my portfolio to a meltdown. Additionally, you have not addressed the fact that S&P 500 margins have begun to soften but are still extremely elevated. Shouldn’t this dampen your optimism? BCA: Aggregate S&P 500 margins have some downside. Our Composite Margin Proxy, Operating Margins Diffusion index and Corporate Pricing Power indicator all remain weak (Chart 41). The deceleration in the crude PPI excluding food and energy and the past strength in the dollar confirm this insight, especially as the corporate wage bill climbs in a tight labor market. The biggest mitigating factor is that productivity is also on the mend, which curbs the negative impact of higher worker pay. Chart 40Growth Expectations Are Muted Profit Growth Expectations Are Muted Profit Growth Expectations Are Muted Chart 41US Margins Under Pressure US Margins Under Pressure US Margins Under Pressure   This danger must be put into perspective though. Margin expansion has been dominated by the tech sector (Chart 42). Excluding this industry, S&P 500 margins are roughly in line with their previous peak, and are not declining. The aggregate softness in margins is a reflection of the sharper decline in tech margins. Declining margins do not spell the imminent end of the bull market either. Table 4 shows that on average, the S&P 500 rises by 9.5% following the peak in margins. Equities can rise after margins crest because this is often an environment where wages are climbing, which boosts consumption. Consequently, top-line growth can accelerate and earnings can rise even if they represent a lower proportion of sales. This is the environment we foresee over 2020. Chart 42Tech Margins Have Likely Peaked Tech Margins Have Likely Peaked Tech Margins Have Likely Peaked Table 4Margin Peaks Do Not Spell S&P Doom OUTLOOK 2020: Heading Into The End Game OUTLOOK 2020: Heading Into The End Game   Chart 43Taiwanese Stocks Are Sniffing Out Better Global Growth Taiwanese Stocks Are Sniffing Out Better Global Growth Taiwanese Stocks Are Sniffing Out Better Global Growth Ms. X: You have talked about the tech sector being a drag on overall margins. How would you position a US stock portfolio? BCA: First, around the world, we prefer cyclical sectors to defensive ones. Cyclical stocks are depressed relative to defensive firms’ shares. Rebounding global growth and rising bond yields will favor cyclical sectors. Globally, the performance of cyclical equities relative to defensive ones correlates with Taiwanese equities, which are currently rallying smartly (Chart 43). This suggests that at the margin, the most cyclical asset markets are beginning to express optimism about global growth. Within the S&P 500, our favorite pair trade to express this bias is to overweight energy stocks at the expense of utilities. Utilities are bond proxies which will substantially underperform energy stocks when the rate of change of Treasury yields moves up (Chart 44). Moreover, based on our valuation indicators, energy stocks have never traded at such a deep discount to utilities, nor have they ever been as oversold. Chart 44Favor Energy Over Utilities Favor Energy Over Utilities Favor Energy Over Utilities Second, we are currently neutral on tech stocks but have put them on a downgrade alert. Tech equities are expensive, trading at a forward P/E ratio 21% above the other cyclicals. Moreover, since software spending has remained surprisingly resilient despite the global economic slowdown, it will likely lag investment in machinery and structures when industrial demand rebounds. Consequently, tech earnings will lag other traditional cyclical sectors. Tech multiples will also suffer when bond yields rise. As high-growth stocks, tech equities derive a large proportion of their intrinsic value from long-term deferred cash flows and their terminal value. Thus, tech multiples are highly sensitive to changes in the discount rate We implement this view by way of an underweight in tech and an overweight to industrials. Industrials have suffered disproportionately from the trade war. Any near term truce is unlikely to contain a grand bargain on intellectual property rights transfer that galvanizes tech exports, but it will remove some of the uncertainty weighing on industrials. Moreover, industrials are a much cheaper play on a global growth rebound. The global manufacturing slowdown has caused industrial equities to trade at their greatest discount to the tech sector since the financial crisis. Finally, the wage bill for the industrial sector is melting relative to tech, and our margin proxy is surging (Chart 45). This has created a very positive backdrop for this pair trade. We also like financials. They will be a key beneficiary of rising yields and a steepening yield curve. Additionally, household credit demand has picked up and overall credit growth should accelerate as central banks will maintain very accommodative monetary conditions. The yield impulse already points toward higher bank credit growth and companies are issuing an increasingly large stock of bonds (Chart 46). Chart 45Operating Metrics Will Boost Industrials Versus Tech Equities Operating Leverage Will Boost Industrials Versus Tech Equities Operating Leverage Will Boost Industrials Versus Tech Equities Chart 46Easing Financial Conditions Will Support Credit Creation Easing Financial Conditions Will Support Credit Creation Easing Financial Conditions Will Support Credit Creation   Ms. X: When combining valuation analysis with your fundamental sectoral slant, I am guessing that you must favor European, Japanese and EM stocks over the S&P 500? BCA: We do favor European and Japanese equities. Based on valuation alone, all the regions you mentioned offer higher expected long-term real rates of return than the US (Chart 47). Moreover, the dollar is expensive relative to advanced economies’ currencies. Hence, these markets are cheaper vehicles than the S&P 500 to bet on a global economic recovery. But valuation alone is not enough. US stocks are trading at unprecedented levels relative to global equities because of the FAANG craze (Chart 48). Looking at sector representation, our positive view on non-tech cyclicals also flatters exposure to Europe and Japan (Table 5). Chart 47Non US Equities Offer Better Value OUTLOOK 2020: Heading Into The End Game OUTLOOK 2020: Heading Into The End Game Chart 48FAANG-Driven US Outperformance FAANG-Driven US Outperformance FAANG-Driven US Outperformance   Table 5Equity Market Sector Composition OUTLOOK 2020: Heading Into The End Game OUTLOOK 2020: Heading Into The End Game Chart 49European Banks Are Cheap European Banks Are Cheap European Banks Are Cheap Europe is particularly attractive because of its large skew towards industrials and financials, which represent 32.3% of the market versus 22.3% in the US. Moreover, European financials are also a tantalizing bet because they trade at a 50% discount to US financials, according to their price-to-book ratio. Additionally, their return on tangible equity will benefit from higher German yields, easing financial conditions, declining non-performing loans in the periphery and rebounding global growth. Our RoE model for European banks already points to a resurgence in their stock prices (Chart 49). Of the major markets we track, Japan offers the highest prospective long-term real returns. Its strong cyclical slant and low share of tech stocks means it is another market investors should overweight to bet on a global recovery. The biggest problem for Japanese equities is the yen. When global yields climb higher, a weak JPY will clip some of the Nikkei’s gains for foreign investors. Finally, we are reluctant to overweight EM stocks just yet. In this space, median P/E ratios are much higher than on a market capitalization-weighted basis (Chart 50). State-owned companies explain this bifurcation, Chinese banks in particular. Since we expect Chinese banks to remain a conduit for policy, credit origination may flatter economic growth more than shareholders’ interests. Moreover, we have a negative outlook on EM currencies, and hedging this exposure is expensive. Finally, if China’s economic activity improves only modestly in 2020, the 2012 experience suggests that EM stocks can still underperform the global equity universe as global growth improves and yields rise (Chart 51). In other words, we find the reward-to-risk tradeoff more attractive in Europe and Japan than in emerging markets. Chart 50EM Stocks Are No Bargain Yet EM Stocks Are No Bargain Yet EM Stocks Are No Bargain Yet Chart 51EM Stocks Can Underperform When Global Growth Improves EM Stocks Can Underperform Even When Global Growth Improves EM Stocks Can Underperform Even When Global Growth Improves     Mr. X: Thank you. I am still not sure what share of our portfolio will be dedicated to stocks. However, I think that whatever this proportion will be, buying global equities makes more sense than US ones. Your valuation argument alone is swaying me, considering my more conservative instincts. Ms. X: I’m glad we will not have to argue on this point, but I know we will nonetheless battle on the stock/bond/gold split. Should we move on to your currency and commodity forecasts? BCA: It would be our pleasure. Currencies And Commodities Mr. X: You have often argued that the dollar is a countercyclical currency. Based on our discussion so far, you must expect the dollar to decline until we get closer to the next recession. I am not fully convinced. Specifically, I remember that in the back half of 2016 global growth was rebounding, but the dollar soared. Therefore, the growth/dollar relationship can be more complex than you argue. Meanwhile, with negative interest rates in Europe, Japan and Switzerland, why would I even consider divesting out of my positive yielding dollar assets? Chart 52The Dollar Is A Counter Cyclical Currency The Dollar Is A Counter Cyclical Currency The Dollar Is A Counter Cyclical Currency BCA: You raise interesting questions, and you are correct that we expect the dollar to depreciate if our constructive view on global growth pans out for 2020. The inverse relationship between global industrial production (excluding the US) and the trade-weighted dollar is unambiguous (Chart 52). As you also mentioned, the reality is a little bit more nuanced. To understand why, it is important to remember how currencies function. We can think of an exchange rate as an adjustment mechanism that solves for the gap in growth between any two countries. This is at the root of the dollar’s counter-cyclicality. When global growth is picking up, returns tend to be higher in cyclical markets, which are highly concentrated outside of the US. Flows then gravitate from the US to other markets and the dollar declines. After a while, the dollar becomes cheap enough that these flows reverse. In the second half of 2016, three factors drove the dollar rebound. First, US manufacturing was improving at a faster pace than that of the rest of the world. Second, the Fed resumed its interest rate hikes, so interest rate differentials suddenly flattered the dollar anew. Finally, the election of President Trump, who campaigned on large scale fiscal stimulus, elicited memories of the Reagan dollar bull market of the first half of the 1980s. These factors eventually faded as global growth rebounded. Today, the Fed’s policies are hurting the dollar. Aside from recent interest rate cuts, the Fed has been injecting liquidity into the banking system through repurchase agreements and renewed asset (T-Bills) purchases. Moreover, the rate cuts are also easing global funding conditions and promoting a re-steepening of the yield curve. This will incentivize banks to lend and boost the US money supply. As growth re-accelerates and demand for imports (machinery, commodities, and consumer goods) rises, the current account deficit will widen further. This process will increase the international supply of dollars. Historically, these dynamics usually hurt the dollar. What we have described is a tentative abatement in geopolitical risk at best – but it would be cavalier to get overly enthusiastic. Like you, we are deeply uncomfortable with negative interest rates. Thankfully, the nascent pickup in global economic activity is lifting global bond yields. So far, foreign bond markets have led this move. More specifically, countries that have suffered most from the global manufacturing slowdown are now seeing their bond yields rise the quickest (Chart 53). For example, yields in Germany, Norway, Sweden, Switzerland and Japan have risen by a lot more than those in the US since global yields troughed in September. Should the initial signals of stabilization in global growth morph into a synchronized recovery, the US yield advantage will evaporate. In a nutshell, interest rates might be negative in Europe and Switzerland, but the positive carry offered by US assets is rapidly fading. Chart 53AAre Interest Rate Differentials Flashing A Signal About Exchange Rates? Are Interest Rate Differentials Flashing A Signal About Exchange Rates? Are Interest Rate Differentials Flashing A Signal About Exchange Rates? Chart 53BAre Interest Rate Differentials Flashing A Signal About Exchange Rates? Are Interest Rate Differentials Flashing A Signal About Exchange Rates? Are Interest Rate Differentials Flashing A Signal About Exchange Rates?   Chart 54Foreigners Are Selling Treasuries Foreigners Are Selling Treasuries Foreigners Are Selling Treasuries For international investors, the currency risk inherent in owning US bonds is just too large at the current juncture. Remember, the trade-weighted dollar stands 25% above its long-term equilibrium and the US twin deficits are expanding. Markets priced in cheap currencies with some potential upside, such as Australia, Canada, Norway or even the European periphery, might be better bets. Flows highlight just how precarious the situation is for the US dollar. Since last August, overall flows into the US Treasury market have been negative. Net foreign purchases by private investors are still positive at an annualized US$180 billion, but they are clearly rolling over. Moreover, official net outflows are running at $350 billion, easily cancelling out the private sector’s inflows (Chart 54). Essentially, foreigners’ appetite for US fixed-income assets is waning exactly as interest rate differentials have started moving against the dollar. Ms. X: I share my father’s concerns, but how would you implement your negative dollar view. Which currencies should I be loading up on as we enter the business cycle’s end game? BCA: The more export-dependent economies (and currencies) should benefit the most from a rebound in global growth. Within the G-10, we particularly like the Swedish krona, the Norwegian krone and the British pound. Bond yields for these currencies are rising the fastest vis-à-vis the US. As a result, the currencies themselves should soon follow (previously mentioned Chart 53). We also expect commodity currencies to benefit, but only upon clearer signs that the resource-thirsty Chinese economy is improving. Until then, they are likely to lag the pro-cyclical European currencies, which are less directly dependent on Chinese stimulus. The euro could become the greatest beneficiary from a weaker dollar because a large headwind for European economic activity is disappearing for now. For the past ten years, European real interest rates have been too low for the most productive, competitive exporter – Germany – but too high for others such as Spain and Italy. Consequently, the euro has been caught in a tug-of-war between a rising neutral rate of interest for Germany and a very low one for the peripheral economies. Via its rate cuts, asset purchase programs, and aggressive TLTRO packages, the ECB may have now finally eased policy to the point where nearly all Eurozone countries enjoy an accommodative monetary environment. 10-year government bond yields in France, Spain, Portugal and even Italy now all sit close to the neutral rate of interest for the entire eurozone (Chart 55). Chart 55The ECB Has Eased Policy Enough The ECB Has Eased Policy Enough The ECB Has Eased Policy Enough Finally, the euro is likely to benefit from inflows into European equity markets. The euro’s drop since 2018 has eased financial conditions and made euro area businesses more competitive. This is an important tailwind for European corporate profits and thus stocks. Moreover, European equities, especially those in the periphery, remain unloved, as illustrated by their cheap valuations compared to other advanced economies. Additionally, analysts’ earnings expectations for eurozone equities are perking up relative to US stocks. If the sell-side is right, powerful inflows into the region will lift the euro in 2020. Mr. X: Thank you. I find it difficult to share your enthusiasm for the euro, a currency backed by such a flimsy edifice. While I would agree that it could rebound next year, I find currencies highly unpredictable on such a time horizon. I prefer to think about them on a long-term basis, and while the euro is cheap, its weak institutional underpinning is too concerning. Let’s move on to commodities. Following our meeting last year, we took your advice on oil and gold. Overall, these calls helped our portfolio. Going forward, these markets are extremely perplexing. There is so much risk in oil markets, such as the tensions in the Middle East and the uncertainty stemming from the trade war between the US and China. How would you recommend playing the oil market in 2020? Chart 56Inventory Drawdown Will Support Oil Inventory Drawdown Will Support Oil Inventory Drawdown Will Support Oil BCA: Your assessment of these markets is spot on. Yet, price risk is skewed to the upside because fiscal and monetary stimulus will revive commodity demand. The oil-producer coalition led by Saudi Arabia and Russia will continue to restrain production, and will probably extend its 1.2mm b/d production cut due to expire at the end of March to year-end 2020. In the US, market-imposed capital discipline will keep reducing the growth of US shale-oil supply. Additionally, US shale-oil supply growth is threatened by flaring of associated natural gas in the Bakken and Permian basins. Failure to limit the burn-off at oil-production sites could provide the environmental lobby an opening to challenge growth. Ms. X: What about the demand side of the oil markets? The fall in the growth rate of demand this year caught most participants off guard. What do you make of that? BCA: Demand data shows a lot of lingering weakness, much of which was caused by tight financial conditions last year in the US and China. But now, most global central banks are pursuing highly accommodative monetary policy and many governments are also easing fiscal policy. As a result, this demand weakness will fade next year. We think next year growth will clock in at 1.4mm b/d. Not as robust as 2017, but still respectable. This should stop the downward pressure on oil prices that has prevailed since May (Chart 56). Mr. X: You’re describing a fairly strong market for next year. What are the downside risks to your view? BCA: Global economic policy uncertainty remains elevated. Uncertainty is one of the key factors driving demand for USD, which is one of the most popular safe havens in the world (Chart 57). A strong dollar creates a headwind for commodity demand. It raises the local-currency costs of consumers in the EM economies that drive oil demand, and lowers production costs outside of the US, encouraging supply growth at the margin. Chart 57Elevated Global Economic Uncertainty Has Kept The USD Well Bid OUTLOOK 2020: Heading Into The End Game OUTLOOK 2020: Heading Into The End Game Chart 58Gold: A Valuable Portfolio Hedge OUTLOOK 2020: Heading Into The End Game OUTLOOK 2020: Heading Into The End Game Ms. X: So, pulling it all together, what is your call for 2020? BCA: The weaker 2019 demand data and the upward revisions to global oil inventories pushed our 2020 Brent Oil forecast to $67/bbl from $70/bbl. We still expect WTI to trade at a $4/bbl discount to Brent. As we mentioned earlier, the risk to our forecast is to the upside: a resolution of the US-China trade war, and lower global economic policy uncertainty could trigger a sharp rally in crude prices. Mr. X: Thank you for your insight on oil. I would like to hear your thoughts on gold. You can tell that I see little absolute value in stocks or bonds at the moment, so I have an outsized preference for the yellow metal this year. Also, how could the US dollar and gold both rally at the same time in 2019? BCA: Let’s start with your dollar/gold question. It is very rare to see gold and the dollar rally together. Normally a strong dollar hurts gold. As you know, we’ve been recommending an allocation to gold since 2017, mostly as a portfolio hedge. We like that gold strongly outperforms other safe havens in equity bear markets and can participate in the upside (even if to a limited extent) in bull markets. We think the safe-haven properties of gold and the US dollar really have come to the fore over the past couple of years (Chart 58). Economic policy uncertainty, and divisive politics globally have raised the level of uncertainty to record levels. In such an environment, the dollar and gold both provide a safe haven and a portfolio hedge. Hence, their joint popularity this past year. We should also remember that gold is a good inflation hedge, and is particularly negatively correlated with real interest rates. A Fed that is willing to let the economy overheat is a Fed that will limit how high real rates climb. Moreover, global liquidity is plentiful. Finally, EM central banks have been slowly divesting from Treasuries and diversifying into gold lately, buying most of the new supply in the process. This backdrop, along with our forecast of a weaker dollar, should support gold again in 2020. That being said, because gold is tactically overbought and could face temporary headwinds if global uncertainty recedes, we prefer silver, which is not as stretched. Furthermore, silver’s higher industrial use means that it should also benefit from a global manufacturing recovery. Geopolitics Chart 59Multipolarity Creates An Unstable Environment Multipolarity Creates An Unstable Environment Multipolarity Creates An Unstable Environment Mr. X: Let’s return to geopolitical and policy risks, both of which abound. Global economic policy uncertainty is the highest it has been since academics began measuring it. The world is fraught with populism, authoritarianism, war, immigration, technological disruption, inequality, and corruption. With so much chaos, and so little consensus, is there anything solid for an investor to grasp about the political backdrop next year? BCA: Geopolitics is the likeliest candidate to short circuit this long bull market, given that the Federal Reserve, the usual culprit, has paused its rate tightening campaign. On a secular basis, geopolitical risk is rising because the United States’ national power is declining relative to that of other world powers (Chart 59). China’s rise, in particular, is stirring conflict with the US and its allies in the western Pacific. Beijing’s technological and military advance is generating fear across the American political establishment. Russia and China continue to deepen their relationship in the face of an increasingly unpredictable United States. These strategic tensions will persist despite any tariff ceasefire with China. Chart 60Globalization Has Peaked Globalization Has Peaked Globalization Has Peaked Competition among the great powers makes for a world of contested authority. As the rules of the road have become less certain, the tailwind behind international trade and investment has weakened (Chart 60). Deglobalization is a headwind for the earnings of large cap global companies in the long run. Emerging markets, which are exposed to trade, face persistent unrest. Mr. X: Given the above, how can an investor take an optimistic view of the global economy and markets next year? BCA: We have a framework for analyzing politics: constraints over preferences. We cannot predict what the chief politicians will prefer at any given time, but we can try to identify and measure the constraints that will restrict their freedom of movement. With global growth slowing, world leaders have become more sensitive to their constraints. The Fed has reversed rate hikes; China is easing policy; President Trump has refrained from attacking Iran; and President Trump and President Xi are negotiating a ceasefire. The UK has avoided a “no deal” Brexit – not once but twice. In short, the risk of recession (or conflict) has been sufficient to alter the policy trajectory. As a result, there is a prospect for global geopolitical risks to abate somewhat in 2020. Both the American and Chinese administrations need to see growth stabilize despite their ongoing strategic conflict. Both the British and European governments need to avoid a disorderly Brexit despite their lack of clarity beyond that. Geopolitical risk is declining, albeit from an extremely elevated level. Mr. X: The US and China have already come close to a deal only to get cold feet and back away from it. The British Prime Minister is committed to leaving the EU with or without a deal. Surely you cannot believe that the Middle East, Russia, other emerging markets, or North Korea will be any bastion of stability. BCA: The US-China trade war is still the single greatest threat to the equity bull market. Brexit is not resolved and a new deadline for a trade deal looms at the end of 2020. Investors must remain vigilant and hedge their portfolios, particularly with gold. Nevertheless, one cannot ignore this year’s reaffirmation of the Fed put, the China put, and Trump’s “Art of the Deal.” The base case for next year should be constructive, albeit with vigilant attention to the major risks: President Trump, China and Iran. The other issues you mention have varying degrees of market relevance. Russia is focusing on pacifying domestic discontent. North Korea is on a diplomatic track with the United States. Emerging market unrest is particularly relevant where it can have a bearing on global stability: Iraq, Iran and Hong Kong in particular. Ms. X: If I may interject: It seems to me that the worst of the trade war has passed, that the risk of a no-deal Brexit is negligible, and that Iran is unlikely to outdo its attack against Saudi Arabia in September. Doesn’t this imply that geopolitical risk is overrated and that investors should rush to capture the risk premium in equities? BCA: What we have described is a tentative abatement in geopolitical risk at best – but it would be cavalier to get overly enthusiastic. After all, any fall in global risks will be amply made up for by the impending rise in US domestic political risk. Indeed, US politics are the chief source of global political risk in 2020. First, if President Trump becomes a “lame duck” then he could take actions that are hugely disruptive to global markets in a desperate attempt to win reelection as a “war president.” Chart 61European Political Risk Is Now Low Europe Political Risk Is Now Low Europe Political Risk Is Now Low Second, if President Trump is reelected, then his disruptive populism will have a new mandate and his “America First” foreign and trade policy will be unshackled. Third, if the opposition Democrats succeed in unseating an incumbent president, they will likely take the Senate too, removing the main hurdle to a dramatic policy change. That would mark the third 180-degree reversal in national policy in 12 years. Moreover, investors may find the country merely exchanged right-wing populism for left-wing populism, which has a more negative impact on corporate earnings prospects. Polarization and institutional erosion will continue. The election results may be razor thin; swing states may have to recount votes; and the outcome could hinge on rare or unprecedented developments in the Electoral College, the Supreme Court or cyberspace. A crisis of legitimacy could easily afflict the next administration. In short, there are few scenarios in which US political risk does not rise over the next 12-24 months. Rising American risk stands in stark contrast to Europe (Chart 61), where the will to integrate has overcome several challenges since the sovereign debt crisis. Substantial majority of voters support the euro and the European Union. Germany is on the brink of a major political succession but it is not turning its back on the European project. France is successfully pursuing structural reforms. Italy remains the weakest link, but even the populist Northern League accepts the euro. This leaves two remaining global risks: China and Iran. Chinese political risk is generally understated. President Xi Jinping, lacking President Trump’s electoral constraint, could overestimate his leverage. He could overreach in the trade talks, in his battle to prevent excessive debt growth, or in his handling of Hong Kong, Taiwan, North Korea, or Iran. The result could be a breakdown in the trade talks or a separate strategic crisis with the United States. Another cold war-style escalation in tensions could easily kill the green shoots in global growth. As for Iran, the regime is under crippling American sanctions and faces unrest both at home and within its regional sphere of influence. There is a non-negligible risk that it will lash out and cause an extended oil supply shock. Conclusions Mr. X: This is a good place to conclude our discussion. We have covered a lot of ground but I remain deeply concerned that staying invested in risk assets today is akin to picking-up pennies in front of a steamroller. I accept your opinion that a recession is unlikely in 2020, but valuations of both stocks and bonds are uncomfortably stretched for my taste. As a result, I believe stocks could suffer whether growth is good or bad next year. Finally, since so many things need to go right for the global economy to continue to defy gravity, a recession may hit faster than you envision. To me, there is simply not enough margin of safety in stocks to compensate me for the risk! Ms. X: I agree with my father that the risks are high because we are entering the end game of the cycle. But I also see pockets of value, some of which you have mentioned today. Moreover, I am sympathetic to your view that global growth will recover next year. Corporate earnings should therefore expand. Hence, I fear that being out of the market will be very painful, especially because policy is quite accommodative. While stocks may not perform as well as they did in 2019, I expect them to outperform bonds handily. I’m therefore willing to continue holding risk assets, even if I need to be more judicious in my sector and regional allocation. BCA: Your family debate mirrors our own internal discussions. There is always a trade-off between maximizing short-term returns and taking a longer-term approach. Valuations are the ultimate guidepost for long-term return prospects. Because so many assets have become more expensive this year, long-term returns are likely to be uninspiring compared to recent history. Table 6 shows our baseline calculations of what a balanced portfolio will earn over the coming decade. We estimate that such a portfolio will deliver average annual returns of 4.4% over the next ten years, or 2.4% after adjusting for inflation. That is a noticeable deterioration from our inflation-adjusted estimate of 2.8% from last year, and also still well below the 6.5% real return that a balanced portfolio earned between 1982 and 2019. Table 6Asset Market Return Projections OUTLOOK 2020: Heading Into The End Game OUTLOOK 2020: Heading Into The End Game Our outlook for next year hinges on global growth rebounding and policy uncertainty receding. Monetary policy is less of a threat to equities than it was last year because central banks have already eased considerably and have been very open about their willingness to let inflation run above target for a while before retightening the monetary screws. We propose the following list of easy-to-track milestones to monitor whether or not our central scenario for the global economy and asset markets is playing out, and how close we are to the end of the cycle: Chinese money and credit numbers. Chinese credit growth must stabilize for the economy to do so. If credit origination continues to decelerate, this will indicate that Beijing has decided to tolerate the slowdown and prioritize its reform and deleveraging agenda. In this case, the Chinese debt supercycle is over sooner and the global economy will pay the price. Our China Investment Strategy Activity Index. Global policy is accommodative and liquidity conditions have improved significantly. However, if the Chinese economy continues to deteriorate, global growth will not rebound. The China Activity Index must stabilize and even improve somewhat for our global growth view to come to fruition. Progress in the “phase one” deal. China and the US must agree to a trade détente. As long as uncertainty around immediate tariffs remain high and retaliation risks stay alive, global capital spending intentions and thus the global manufacturing sector will be hamstrung. Surveys of global growth. The Global manufacturing PMI and the global growth expectation component of the ZEW survey must both recover. If these variables cannot gain any traction, the global economy is sicker than we estimate and risk assets will suffer. Commodity prices and the dollar. In the first quarter, industrial commodity prices must rebound and the dollar must start to depreciate. These two developments will not only reflect an improvement in global growth. They will also alleviate deflationary pressures around the world, revive profits and sponsor a business spending recovery. Moreover, a weaker dollar will also ease global financial conditions by decreasing the global cost of capital. 10-year inflation breakeven rate. If US breakevens move above the 2.3% to 2.5% zone, the Fed will become more proactive about raising rates. This would provoke a quicker end to the business cycle. President Trump’s approval rating. If President Trump’s approval rating stabilizes below 42%, he could give up on the economy and instead bet on a “rally around the flag” as his best strategy for re-election. This would result in a much more hawkish and confrontational White House that would become an even greater source of uncertainty for the economy, and thus risk asset prices. Ms. X: Thank you for this comprehensive list of variables to monitor. As always, you have left us with much to think about. We look forward to these discussions every year. Before we conclude, it would be helpful to have a recap of your key views. BCA: It will be our pleasure. The key points are as follow: Global equities are entering the end game of their nearly 11-year bull market. Stocks are expensive, but bonds are even more so. As a result, if global growth can recover and the US can avoid a recession in 2020, earnings will not weaken significantly and stocks will again outperform bonds. Low rates reflect the end of the debt supercycle in the advanced economies. However, the debt supercycle is still alive in EM in general, and in China, in particular. The global economic slowdown that begun more than 18 months ago started when China tried to limit debt growth. If Beijing continues to push for more deleveraging, global growth will continue to suffer as the EM debt supercycle will end. Nonetheless, we expect China to try to mitigate domestic deflationary pressures in 2020. As a result, a small wave of Chinese reflation, coupled with the substantial easing in global monetary and liquidity conditions should promote a worldwide re-acceleration in economic activity. Policy uncertainty will recede next year. Domestic constraints are forcing China and the US toward a trade détente. The risk of a no-deal Brexit is now marginal, and President Trump is still the favorite in 2020. A decline in policy risk will foster a global economic rebound. That being said, some pockets of risk remain, such as in the Middle East. Global central banks are highly unlikely to remove the punch bowl anytime soon. Not only will it take some time before global deflationary forces recede, monetary authorities in the G10 want to avoid the Japanification of their economies. As a result, they are already announcing that they will allow inflation to overshoot their 2% target for a period of time. This will ultimately raise the need for higher rates in 2021, which will push the global economy into recession in late 2021, or early 2022. These dynamics are key to our categorization of 2020 as the end game. US growth will re-accelerate. The US consumer remains in good shape thanks to healthy balance sheets and robust employment and wage growth prospects. Meanwhile, corporate profits and capex should benefit from a decline in global uncertainty and a pick-up in global economic activity. China will continue to stimulate its economy but will not do so as aggressively as it did over the past 10 years. Consequently, EM growth will also bottom but is unlikely to boom. Europe and Japan will re-accelerate in 2020. Bond yields will grind higher in 2020. However, Treasury yields are unlikely to break above the 2.25% to 2.5% range until much later in the year. Inflationary pressures won’t resurface quickly, so the Fed is unlikely to signal its intention to raise interest rates until late 2020 or later. European bonds are particularly unattractive. Corporate bonds are a mixed offering. Investment grade credit is unattractive owing to low option-adjusted spreads and high duration, especially when corporate health is deteriorating. Agency mortgage-backed securities and high-yield bonds offer better risk-adjusted value. Global stocks will enjoy their last-gasp rally in 2020. As global growth recovers, favor the more cyclical sectors and regions which also happen to offer the best value. US stocks are the least attractive bourse; they are very expensive and loaded with defensive and tech-related exposure, two groups that could suffer from higher bond yields. We are neutral on EM equities. Investors should pare exposure to equities after inflation breakevens have moved back into their 2.3% to 2.5% normal range and the Fed funds rate has moved closer to neutral. We anticipate this to be a risk in 2021. The dollar is likely to decline because it is a countercyclical currency. Balance of payment dynamics and valuation considerations are also becoming headwinds. The pro-cyclical European currencies and the euro should be the main beneficiary of any dollar depreciation. Oil and gold will have upside next year. Crude will benefit from both supply-side discipline and a recovery in oil demand on the back of the improving growth outlook. Gold will strengthen as global central banks limit the upside to real rates by allowing inflation to run a bit hot. A weaker dollar will flatter both commodities. A balanced portfolio is likely to generate average returns of only 2.4% a year in real terms over the next decade. This compares to average returns of around 6.5% a year between 1982 and 2019. We would like to take this opportunity to wish you and all of our clients a very peaceful, healthy and prosperous New Year. The Editors November 22, 2019

Highlights Analysis on the Chinese property market is available below. In the Philippines, domestic demand is set to accelerate at the hands of the government’s fiscal boost. The current account deficit will widen and the peso and local bonds will likely sell-off. This warrants an underweight stance in this interest rate-sensitive bourse. A new trade: Pay 2-year swap rates. The outlook for China’s property market and construction activity is downbeat. Financial market plays leveraged to mainland construction activity remain at risk. The Philippines: The Cycle Is Turning The relative performance of Philippine equities against the EM benchmark is moving inversely to the direction of relative (Philippines minus EM) local bond yields (Chart I-1). When local Philippine bond yields drop versus those of other EMs, this bourse outperforms, and vice versa. Likewise, Philippine share prices in absolute terms exhibit a negative relationship with local bond yields (Chart I-2). The rationale behind this high sensitivity in share prices to local interest rates is the large presence of banks and property stocks in the Philippines' bourse. Banks account for 20% and real estate stocks another 21% of the local stock exchange. These sectors benefit in a falling interest rate environment and suffer during periods of rising rates. Chart I-1Philippines Vs. EM: Relative Stock Prices And Bond Yields Philippines Vs. EM: Relative Stock Prices And Bond Yields Philippines Vs. EM: Relative Stock Prices And Bond Yields Chart I-2Philippine Stocks Are Inversely Correlated To Domestic Bond Yields Philippine Stocks Are Inversely Correlated To Domestic Bond Yields Philippine Stocks Are Inversely Correlated To Domestic Bond Yields Our underweight position in Philippine equities has not played out because the economy has slowed much more than we had expected, which has also coincided with collapsing US Treasury bond yields. Consequently, Philippine local bond yields have plummeted, supporting the stock market’s absolute and relative performance. Chart I-3Philippine Growth Slowed Due To A Slump In Government Spending Philippine Growth Slowed Due To A Slump In Government Spending Philippine Growth Slowed Due To A Slump In Government Spending Chart I-4Negative Fiscal & Credit Impulse Stabilized The Current Account Deficit Negative Fiscal & Credit Impulse Stabilized The Current Account Deficit Negative Fiscal & Credit Impulse Stabilized The Current Account Deficit The growth rate of the Philippines has decelerated markedly due to sharp slowdowns in both government spending and bank loan growth (Chart I-3). In fact, the combined bank loan and fiscal spending impulse has plunged, leading to a major slowdown in domestic demand, which in turn has stabilized the current account (Chart I-4). The latter effect has supported the currency and allowed the central bank to cut rates. A budget deadlock on a number of items delayed the approval of the 2019 budget, causing government spending to plunge in the first half of 2019. In short, it was unintended fiscal tightening that has wrong-footed our view on the direction of the macro cycle, and consequently Philippine financial markets. Government spending has been instrumental in driving fixed capital formation since President Rodrigo Duterte came to power in May 2016. Philippine local bond yields have plummeted, supporting the stock market’s absolute and relative performance. Going forward, the macro cycle is set to reverse: Chart I-5Philippines: Signs Of A Growth Rebound Philippines: Signs Of A Growth Rebound Philippines: Signs Of A Growth Rebound Government expenditure will rise substantially – infrastructure spending in particular – lifting imports. The 2019 budget was approved back in April, and the House of Representatives has given the green light to extend the shelf-life of the current 2019 budget. Moreover, the fiscal 2020 budget, now approved by Duterte, entails 12% nominal growth in government expenditures in general and 14% growth in capital/infrastructure spending in particular. Duterte will oversee 100 flagship infrastructure projects estimated to cost 4.3 trillion Philippine pesos, or 24% of GDP. More than half of these projects are either ongoing or will commence construction in the next six to eight months. The larger infrastructure expenditure will encourage bank lending. Overall, domestic demand will revive considerably, causing the current account deficit to widen. Importantly, the expected fiscal boost will come on top of already strong consumer spending. The marginal propensity to spend among households and companies is already improving, confirming domestic growth acceleration (Chart I-5, top panel). In particular, both vehicle and machinery sales are recovering (Chart I-5, middle panel). Narrow and broad money impulses have bottomed (Chart I-5, bottom panel). Stronger imports amid still-depressed exports due to sluggish global demand will lead to a widening of the current account deficit. We expect the peso to resume its depreciation. Renewed currency weakness and a domestic demand revival will put a floor under inflation. The central bank is headed by Governor Benjamin Diokno, the former Budget Secretary and an associate of populist President Duterte. The odds are that the central bank will not hike interest rates in the face of a rising current account deficit and modestly rising inflation. This will reinforce currency depreciation. Finally, domestic bond yields are set to rise. A widening fiscal deficit has historically coincided with higher domestic bond yields (Chart I-6). Odds are it will not be different this time. Besides, Philippine banks have been relentlessly purchasing government bonds because credit demand from companies has been sluggish (Chart I-7). As private credit demand begins to recover and banks accelerate their loan origination, they will become net sellers – or will at least ease their pace of government bond purchases – pushing yields higher. Chart I-6Rising Fiscal Deficit Is Bad News For Bonds Rising Fiscal Deficit Is Bad News For Bonds Rising Fiscal Deficit Is Bad News For Bonds Chart I-7Philippine Commercial Banks Have Been Purchasing Government Bonds En Masse Philippine Commercial Banks Have Been Purchasing Government Bonds En Masse Philippine Commercial Banks Have Been Purchasing Government Bonds En Masse Bottom Line: Unintended fiscal tightening has slowed domestic demand, narrowed the current account deficit, supported the currency and induced a drop in local bond yields. This has allowed the Philippines’ interest rate-sensitive bourse to outperform the overall EM equity index. Going forward, the macro cycle is set to reverse. This cycle is about to reverse due to strong fiscal expansion: Domestic demand and imports will grow briskly, and the current account deficit will widen considerably. Widening twin deficits will lead to material currency depreciation and higher domestic bond yields. Investment Recommendations Continue shorting the Philippine peso versus the US dollar. 2-year swap rates are 48 basis points below the policy rate (Chart I-8). The market will price out rate cuts as the business cycle recovers and the currency depreciates. We recommend a new trade: pay 2-year swap rates. Dedicated EM fixed-income investors should underweight the Philippines in their EM domestic currency bonds and sovereign credit portfolios. Chart I-8The Market Is Expecting Rate Cuts The Market Is Expecting Rate Cuts The Market Is Expecting Rate Cuts Chart I-9Philippine Equity Market Is Not Cheap Philippine Equity Market Is Not Cheap Philippine Equity Market Is Not Cheap     Does an upcoming growth revival warrant an overweight stance in Philippine stocks within an EM equity portfolio? As shown in Charts I-1 and I-2, this equity market is more sensitive to interest rates than growth. The growth deceleration did not prevent this stock market from outperforming its EM peers. Hence, higher local bond yields amid renewed currency depreciation will likely lead to a period of underperformance. Finally, Philippine stocks are not cheap in absolute terms or relative to the EM benchmark (Chart I-9). Hence, they will not respond well to rising interest rates. Chart I-10Philippine Property Stocks Will Suffer As Interest Rates Rise Philippine Property Stocks Will Suffer As Interest Rates Rise Philippine Property Stocks Will Suffer As Interest Rates Rise Within this bourse, underweight/short property stocks. These stocks are the most vulnerable to rising bond yields (Chart I-10). The key risks to our strategy are lower global bond yields and continuous flows of foreign capital into EM assets in general, and local bonds in particular.   Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   China: Making Sense Of The Property Market Real estate activity in general, and property construction volumes in particular, are critical to our thesis of an ongoing growth slowdown in China. The basis is that construction volumes on the mainland have a considerable impact on industrial activity both within and outside China. On the structural front, housing demand is facing major headwinds: Genuine pent-up demand for housing has diminished. Most Chinese households already own at least one property. Based on a recent survey conducted by The Economic Daily,1 nearly 97% of households surveyed own at least one residential property. Last year’s China Household Finance Survey (CHFS), conducted by Southwestern University of Finance and Economics of China, showed about 68% of new homes sold in China’s urban areas in the first quarter of 2018 were purchased for the purpose of investment. In addition, the living area per capita in China’s urban areas has risen to 40 square meters as of the end of last year – larger than in South Korea and Japan. Other structural impediments include low affordability, slowing rural-to-urban migration, demographic changes and the promotion of the housing rental market. The government has been repeatedly stressing that China will not use the property market as a short-term economic growth-booster this time. The authorities will also continue to prevent speculative housing demand. Between late 2015 and 2017, the People's Bank of China undertook outright monetization of excess housing inventories via the Pledged Supplementary Lending (PSL) program. So far, even though the Chinese economy has already slowed considerably, the government has not injected much stimulus into the property market. On the contrary, the government has drastically reduced the number of slum-reconstruction units as well as its PSL injection this year. This year, the government has also started a new long-term project of renovating residential buildings built in 2000 or earlier. The projects involved include adding parking lots, elevators, fiber cable installments, electricity/gas line improvements, and so on. This renovation program will likely delay property purchases from those owners who were considering purchasing new properties instead of living in the older residential buildings. Chart II-1Property Sales In China: A Sustainable Recovery? Property Sales In China: A Sustainable Recovery? Property Sales In China: A Sustainable Recovery? From a cyclical perspective (6-12 months), falling home prices and relatively tight financing for property developers will likely prevent a recovery in construction activity: First, Chart II-1 shows there has recently been a pickup in residential property sales. Our research reveals that this has been the result of aggressive promotion strategies – price reductions – implemented by many real estate developers. Among the promotions being offered by many developers are “buy one property, get the second one at half price,” “buy a house and get a car for free,” or “buy a house and get free furniture and decorations.” Local governments have been “discouraging” outright property price declines. Yet, it seems they have allowed implicit price reductions to take place. In cases where outright price cuts cannot be avoided, the authorities try to limit them. Earlier this month, the government of Maanshan, a third-tier city in the Anhui province, released a rule instructing property developers not to lower prices by more than 10%. The outlook for China’s property market and construction activity is downbeat. As a result, official statistics on new housing prices do not truly reflect price pressures in the marketplace. Official statistics show new housing prices are rising at 9% since last year. Nevertheless, many 1st- and 2nd- tier cities are showing price declines in their secondhand residential property markets (Chart II-2).  Chart II-2China: Secondary Market Property Prices Are Weak China: Secondary Market Property Prices Are Weak China: Secondary Market Property Prices Are Weak Chart II-3Chinese Property Developers: Massive Pre-Sold Homes, But Lack Of Funding To Complete Construction Chinese Property Developers: Massive Pre-Sold Homes, But Lack Of Funding To Complete Construction Chinese Property Developers: Massive Pre-Sold Homes, But Lack Of Funding To Complete Construction   All in all, it seems that falling home prices have begun to spread from 1st tier cities to some 2nd- and 3rd-tier cities. The number of cities reporting declines in residential home prices is on the rise.   Second, in theory, falling property prices should discourage new starts and new construction. Falling prices signal that supply is exceeding demand, with producers typically responding by curtailing output. This holds true for any industry. However, the intricacies of property developers in China may be different. Chart II-4Building Construction Data Is A Broader Measure Than Commodity Buildings Building Construction Data Is A Broader Measure Than Commodity Buildings Building Construction Data Is A Broader Measure Than Commodity Buildings Specifically, property developers have been pre-selling aggressively since 2017 while slowing their completion process due to lack of financing (Chart II-3). Such financial constraints arose due to their rapid expansion in the past 10 years. Having already incurred enormous amounts of leverage, they have resorted to pre-sales as another source of funding. Property developers are currently under pressure to deliver those units that were pre sold about two years ago. Will they be able to secure new funding and ramp up construction? Or will they default or delay delivery of houses? It may well be different for each developer. The ones with strong balance sheets and access to financing will build and deliver. The weakest ones will default, while the average ones will likely delay delivery. Hence, it is difficult to gauge construction trends in the next six months in the residential property market. Even so, it is unlikely to be very strong given the industry is highly fragmented, and many small and medium and even some large developers are financially weak. Finally, there is a large gap between the two construction activity datasets – both published by the National Bureau of Statistics. These datasets are referred to as “commodity buildings” and “building construction” (Chart II-4). “Commodity buildings” – i.e., those developed by real estate developers (the equivalent of homebuilders in the US), are only a subset of “building construction.” The “building construction” dataset is more comprehensive. It includes not only “commodity buildings” but also buildings built by non-real estate developers. For example, companies, universities, and various organizations that can construct both residential and non-residential buildings for their own use. Both datasets include residential and non-residential buildings. From a cyclical perspective (6-12 months), falling home prices and relatively tight financing for property developers will likely prevent a recovery in construction activity. Chart II-5 illustrates that “building construction” floor area started, under construction and completed are all shrinking. They are much weaker than floor area started, under construction and completed of “commodity buildings.” Chart II-5Building Construction Is In Recession Building Construction Is In Recession Building Construction Is In Recession Chart II-6Falling Construction-Related Commodities Prices Reflect The Weakness In China Construction Activity Falling Construction-Related Commodities Prices Reflect The Weakness In China Construction Activity Falling Construction-Related Commodities Prices Reflect The Weakness In China Construction Activity The take-away from these datasets is as follows: Construction activity in China goes beyond property developers and “commodity buildings” statistics do not always paint the complete picture. Companies and organizations have dramatically curtailed their construction activity. Combined with tight financing conditions for real estate developers, this heralds a downbeat outlook for construction activity. Bottom Line: While short-term fluctuations in construction activity are impossible to gauge in China, the cyclical outlook remains negative. The current round of stimulus has avoided the property market, and real estate bubble excesses have not yet been wrung out. This is why we remain negative on China’s construction outlook and continue to recommend underweighting property developers relative to both the A-share and investable equity indexes. Falling steel, iron ore and industrial commodities prices confirm that construction activity in China remains weak (Chart II-6).   Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com     Footnotes 1    The Economic Daily, administratively managed by the Ministry of Communication, is one of the most influential and authoritative newspapers in China. It is an official outlet for the government to publicize its economic policies. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Feature We spent the past two weeks visiting and exchanging views with our clients in Asia. We presented our view that the ongoing stimulus measures are beginning to bear fruit in terms of stabilizing China’s economic activity, and that we expect the economic slowdown to bottom early next year. In addition, Chinese policymakers are signaling their willingness to accelerate stimulus on both monetary and fiscal fronts, which should mitigate the downside risks and help the economy regain traction in 2020. Interestingly, our view sparked divergent responses: clients outside of China were more upbeat about the state of the Chinese economy than clients from mainland China.  While few investors we spoke to showed concerns over an imminent “hard landing” in China’s economy or systemic risk from China’s financial system, our mainland Chinese clients remain skeptical that the ongoing stimulus will be sufficient to revive the economy. They were also worried that financial regulations may be too restrictive to generate the amount of money growth needed for the economy. Another interesting observation was that while being pessimistic about the economy, our mainland Chinese investors share our assessment that Chinese domestic stocks still have some upside in the coming year. On the other hand, global investors, who are more sanguine about China’s economic recovery, prefer to wait on the sidelines before favoring Chinese investable stocks (Chart 1). Chart 1AA Tale Of Two Markets: Onshore Outperforms Global Markets... A Tale Of Two Markets: Onshore Outperforms Global Markets A Tale Of Two Markets: Onshore Outperforms Global Markets Chart 1B...While Offshore Underperforms ...While Offshore Underperforms ...While Offshore Underperforms Below we present some of the top questions that were posed by investors during our trip, along with our answers. We recap the conclusions of our view, and draw out the investment implications of the differences between the sentiments towards China’s equity markets, in the last question of the report. Q: Recent economic data suggests a weakening Chinese economy. Why do you think the economy will reach a bottom in 2020? Historically, China’s credit formation has consistently led economic activity by about three quarters (Chart 2).  Even though credit growth this year has not been as strong as in previous expansionary cycles, a turning point in the credit impulse occurred at the start of 2019. This suggests that economic activity should turn around within the next two quarters. Chart 2Expecting A Turn In Q1 2020 Expecting A Turn In Q1 2020 Expecting A Turn In Q1 2020 Chart 3Emerging Green Shoots Emerging Green Shoots Emerging Green Shoots   Furthermore, despite weakening headline economic data, some underlying components indicate promising improvements (Chart 3): Growth in infrastructure investment has ticked up modestly in the past couple months, and is set to improve further. The State Council mandated local governments to allocate the proceeds from special-purpose bond sales to infrastructure projects by the end of October. This, combined with a frontloading of next year’s local government bonds, should lend support to infrastructure spending in the coming months. After fluctuating in and out of contraction for a year, growth in auto manufacturing production picked up in August and remained positive through October. This improvement is due to less contraction in auto sales and a faster reduction in auto inventories. Moreover, electricity output surged in October, which also indicates that growth may be gaining momentum. Chart 4Trade Should Improve Into 2020 Trade Should Improve Into 2020 Trade Should Improve Into 2020 Lastly, global financial conditions have eased significantly and credit growth has picked up worldwide, which should help support global demand. Even though Sino-US trade negotiations are ongoing, our baseline view is that a “Phase One” trade deal will be inked in the next couple months. Eased trade tensions and even some rollbacks in the existing tariffs on Chinese export goods, coupled with improved global demand, should provide some tailwinds to China’s external sector (Chart 4). Q: What is your outlook on China’s economic policy for 2020? The Chinese economic growth model remains reliant on credit formation and capital investment. Therefore, the sustainability of an economic recovery depends on whether Chinese policymakers are willing to keep the stimulus wheel turning. Chart 5A Sign Of A Policy Shift A Sign Of A Policy Shift A Sign Of A Policy Shift For investors favoring China-related assets, the good news is that there has been an increasing urgency in policymakers’ tone to support economic growth since September. Capex growth from state-owned enterprises (SOEs) has increasingly outpaced the private sector, which is significant:  A sustained rotation in the pace of SOE vis-à-vis private sector capex marked a turning point in the 2015-2016 cycle, when Chinese policymakers’ imperative to supporting growth outweighed their desire to continue with structural reforms (Chart 5).  We do not expect a 2016-style drastic rise in SOE capex growth next year, because the current economic slowdown is not as severe or prolonged as in 2015. Nonetheless, the rotation in capex growth is an important signal that Chinese policymakers may be more willing to stimulate the economy by again allowing the state sector to upstage the private sector. In the meantime, we expect that some pro-growth “policy adjustments” will be deployed in 2020: Chart 6Infrastructure Investment Likely To Rise Infrastructure Investment Likely To Rise Infrastructure Investment Likely To Rise Monetary policy will incrementally ease, with one to two 10-15bps loan prime rate (LPR) cuts in the next 3-6 months. At the same time, China’s central bank (PBoC) will keep bank liquidity ample and commercial banks’ funding costs relatively low, by continuing frequent liquidity injections to stabilize the interbank rate. A further cut in the reserve requirement ratio (RRR) is also highly likely. Keeping banks well capitalized will partially mitigate the pressure commercial banks face from falling profit margins and rising credit defaults. Accommodative monetary conditions will also support more stimulus on the fiscal front. We expect that the National People’s Congress in March 2020 will approve higher quotas on the issuing of local government bonds. Chinese state-owned commercial banks will continue to be the main buyers for local government bonds.  A portion of 2020 local government special-purpose bond issuance will be frontloaded to the remainder of 2019 and into the first months of next year. Relaxed capital requirements will likely boost local governments’ infrastructure project funding and expenditures. Our model suggests infrastructure spending should pick up from the current 3.3% year-on-year, to close to 7.5% in the second and third quarters next year (Chart 6). There are subtle signs that the government is starting to relax restrictions on the real estate sector. Land sales by local governments have increased since mid-2019, and the trend will continue into 2020 (Chart 7).  Income from land sales accounts for 70% of local government revenues, thus allowing more land sales should help fund a larger local government spending budget next year. Declining government subsidies to shantytown renovation (namely the Pledged Supplementary Lending, or PSL) have recently abated and will likely continue to improve (Chart 8). Chart 7Some Improvement To Come In The Real Estate Sector Some Improvement To Come In The Real Estate Sector Some Improvement To Come In The Real Estate Sector Chart 8Government Subsidies Will Continue Government Subsidies Will Continue Government Subsidies Will Continue   December’s Central Economic Work Conference (CEWC) will set policy priorities for the following year. We think Chinese policymakers will make economic growth a top priority for 2020. Credit growth swelled in the first quarter of 2019 following the December 2018 CEWC, and we expect a surge in early 2020 as well.Due to the unusually high credit growth in January this year and the seasonal factor next year (Chinese New Year will fall in January 2020), the surge in credit growth, on a year-over-year basis, will more likely be muted until towards the end of the first quarter and into the second quarter. Investors should overweight Chinese investable stocks in the next 6-12 months, but need to watch for more positive signs to upgrade tactical stance. Beyond the second quarter, however, the outlook gets cloudier as tension from the US election heats up and President Trump may change his trade negotiation strategies with China.1 This may have implications on China’s domestic policies. But for now, our baseline view is that Chinese policymakers will incrementally accelerate the pace of economic stimulus throughout next year. Q:  Monetary policy has been accommodative for more than a year, but capex this year has fallen below market expectations compared with past cycles. How will further stimulus help to revive investment and economic growth next year? In short, our answer is this: interest rate cuts alone will not be enough to boost economic growth in China. Capex, and growth more generally, will only revive through synchronized policy support from the Chinese authorities. In a previous report2 we discussed that the lack of response to monetary easing has been due to a less effective monetary policy transmission mechanism, a reactive and reluctant central bank, and a debt-loaded corporate sector. More importantly, the “half-measured” stimulus has been preferred by Chinese authorities in this cycle, as they prioritized financial de-risking over growth and have significantly tightened financial regulations since 2016. Given the expected policy pivot to a more pro-growth stance in the coming year, the following underlines our conviction that capex should pick up in 2020.  Modern Money Theory (MMT), with Chinese characteristics:3 local governments will ramp up debt again, and this quasi-fiscal stimulus will be a key support to the economy in 2020. During the 2015-2016 cycle, aggressive interest cuts did not result in a significant uptick in credit growth. Bank lending was not the core driver for economic recovery in 2016. The economy only bottomed following an unprecedented issuance of local government bonds after mid-2015 (Chart 9).  Chinese authorities will keep a “back door” open: even though overall tight financial regulations will remain intact, we expect the PBoC to allow a more moderate contraction in shadow banking (Chart 10). This will provide smaller banks and enterprises access to tap into bank credit. Importantly, this means the government will acquiesce to local governments in providing extra funding through shadow banking. We already see local government financing vehicles (LGFV) making a comeback in recent months. Chart 9A Chinese Version Of MMT A Chinese Version Of MMT A Chinese Version Of MMT Chart 10The "Back Door" May Open Wider The "Back Door" May Open Wider The "Back Door" May Open Wider     Small- and medium-sized enterprises (SMEs) will benefit from lowered financing costs through the new LPR system. As we pointed out in our previous report,4 the new LPR regime is not intended as much to expand bank credit as to help struggling SMEs survive economic hardships. This, along with tax cuts, should provide SMEs some relief from capital constraints. Q. CPI has been rising sharply and is above the government’s inflation target of 3%. Will inflation prevent the PBoC from maintaining an easy monetary policy? Chart 11PBoC Likely To Capitulate To Producer Deflation PBoC Likely To Capitulate To Producer Deflation PBoC Likely To Capitulate To Producer Deflation No. We think deflationary pressure in the industrial sector (measured by producer prices) poses a bigger threat to the economy, and that PBoC is more likely to loosen monetary policy than to tighten (Chart 11). Chart 12 shows that the recent surge in headline consumer prices has almost been entirely driven by soaring pork prices. There is compelling evidence from historical data that, unless core consumer price inflation also rises, climbing food prices alone will have a limited impact on PBoC policy (Chart 13). We think this approach is justified, as the necessity of “core feedthrough” is also what most central banks in the developed world look for when confronted with a detrimental supply shock. Chart 12Rising Pork Prices Have Driven Up Headline Inflation... Rising Pork Prices Have Driven Up Headline Inflation... Rising Pork Prices Have Driven Up Headline Inflation... Chart 13...But Won't Be Driving Up Interest Rates ...But Won't Be Driving Up Interest Rates ...But Won't Be Driving Up Interest Rates Chart 14A Wild Year For The RMB A Wild Year For The RMB A Wild Year For The RMB Core CPI has been trending downwards since February 2018, and there is no evidence to suggest that food prices will drive up core CPI inflation (Chart 13, bottom panel).  This, in combination with deflating producer prices, means that the probability of tighter monetary policy over the coming 6-9 months is extremely low. In fact, we expect, with high conviction, that the PBOC will guide the LPR lower in the coming months. Q: What is your view on the RMB for 2020? The RMB depreciated by 5% against the US dollar from its peak in February this year, mostly driven by market expectations of US tariffs imposed on Chinese export goods. Interest rate differentials, short-term capital flows, and economic fundamentals all have played much smaller roles in the RMB’s value changes (Chart 14). The depreciation in the CNY/USD this year has pushed the RMB close to two sigma below its long-term trend (Chart 15). As we expect a “Phase One” trade deal to be signed and trade tensions abating at least in the near term, the RMB will face upward pressure through the first half of 2020. The appreciation will also be supported by, although to a lesser extent, China’s improved domestic economy, rising demand for RMB-denominated assets, and a weakening US dollar (Chart 16). According to our model, the USD/CNY exchange rate can return to a 6.8-7.0 range, if a significant portion of the existing tariffs is rolled back (Chart 17).  This range seems to be within the “fair value” of the RMB, justifiable by the current China-US interest rate differential (Chart 14, bottom panel). Chart 15Has The RMB Gone Too Far? Has The RMB Gone Too Far? Has The RMB Gone Too Far? Chart 16Demand For RMB Assets On The Rise, Despite The Trade War Demand For RMB Assets On The Rise, Despite The Trade War Demand For RMB Assets On The Rise, Despite The Trade War However, it would not be in the PBoC’s best interests to let the RMB appreciate too rapidly, because an appreciating Chinese currency would act as a deflationary force on China’s export and manufacturing sectors.  The large differential in the China-US interest rates would allow PBoC to cut interest and/or RRR rates, to ease upward pressure on the RMB.   Chart 17Tariff Rollbacks Will Push Up RMB Tariff Rollbacks Will Push Up RMB Tariff Rollbacks Will Push Up RMB   Q: How should equity investors position themselves towards China over the coming year? We are bullish on Chinese investable stocks in the next 6 to 12 months, based on our view that the Chinese economy will bottom in the first quarter next year, policy will be incrementally more supportive, and a “Phase One” trade deal will be signed soon. In the very near term, however, we think downside risks to Chinese equities are not trivial. We remain a neutral tactical stance, but will continue to watch for the following signs before upgrading our tactical call from neutral to overweight.5 Chart 18A (top panel) shows that cyclical stocks remain very depressed relative to defensives, underscoring investors’ lack of confidence in the Chinese economy and trade negotiations. A breakout in cyclicals versus defensives would signify a major improvement in investor sentiment towards Chinese economic growth. An uptick in the relative performance of industrials and consumer staples (Chart 18A, bottom panel). The negative sensitivity of industrials and positive sensitivity of consumer staples to monetary policy suggests that the relative performance between the two sectors may be a reflationary barometer for China’s economy. The relative performance trend remains off its recent low, which suggests that China’s existing policy stance has not yet turned more reflationary. A technical breakdown in the relative performance of healthcare and utility stocks (Chart 18B) would also be a bullish sign. Investable health care and utilities stocks have historically led China’s economic activity, core inflation and stock prices by 1-3 months. A technical breakdown in the relative performance of these sectors would signify that market participants anticipate a bottom in China’s economy. As we mentioned at the outset, we observed an interesting divergence in sentiment among our domestic versus global investors. This divergence is reflected in both the onshore and offshore stock markets; year to date, onshore A shares have outperformed global benchmarks by 5.6% (Chart 1, on page 1 of the report). Chart 18AWaiting For A Telltale Sign... Waiting For A Telltale Sign... Waiting For A Telltale Sign... Chart 18B...Before A Tactical Upgrade ...Before A Tactical Upgrade ...Before A Tactical Upgrade However, all of the outperformance in A shares occurred before end April, when the trade talks broke down and domestic credit expansion significantly slowed from the first quarter. Since May, the relative performance of A shares in US dollar terms has been mostly flat, reflecting the fact the markets were not expecting a significant stimulus forthcoming.  Chinese investable stocks, on the other hand, have been trading heavily on the day-to-day news surrounding the trade negotiations and have significantly underperformed both domestic A shares and global benchmarks. Therefore, our base case view of a trade truce coupled with an improved Chinese economy and more supportive policy near year, warrant a cyclical overweight stance favoring Chinese investable stocks over their domestic peers. Earnings from both onshore and offshore markets will benefit from a modest improvement in economic activity, but we think the investable market will benefit more from the trade truce and more upside growth potential. Stay tuned.   Jing Sima China Strategist jings@bcaresearch.com Footnotes 1Please see Geopolitical Strategy Special Report, "Is China Afraid Of The Big Bad Warren?" dated October 25, 2019, available at gps.bcaresearch.com 2Please see China Investment Strategy Weekly Report, " Threading A Stimulus Needle (Part 1): A Reluctant PBoC," dated July 10 2019, available at cis.bcaresearch.com 3We call it a “MMT” because China’s state-owned commercial banks own approximately 80% of local government bonds. The commercial banks are essentially backed by China’s central bank, which has a fiat currency system and can make independent monetary policy decisions. 4Please see China Investment Strategy Weekly Report, "Mild Deflation Means Timid Easing," dated October 9, 2019, available at cis.bcaresearch.com 5Please see China Investment Strategy Special Report, "A Guide To Chinese Investable Equity Sector Performance," dated October 30, 2019, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Highlights Maintaining an adequate level of aggregate demand has proven to be one of the biggest macroeconomic challenges of the modern era. Yet, in principle, it should not be difficult to increase demand. After all, people like to consume. If households are not spending enough, governments can just give them money or increase spending directly on public infrastructure and other worthwhile endeavors.  Various explanations have been proposed for why these solutions either won’t work or are bad ideas even if they do work. These include Ricardian Equivalence-type arguments; claims that periods of high unemployment may be necessary to cleanse financial and economic imbalances; and concerns about excessive levels of government debt. None of these explanations are particularly persuasive, which suggests that politics, rather than economics, may be at the heart of the demand-side secular stagnation problem. Bondholders benefit from low inflation, which has often led them to oppose meaningful fiscal stimulus. Looking out, the influence of bondholders is likely to wane as populism proliferates. Investors should favor “real assets” such as equities, real estate, and commodities over “nominal assets” such as bonds and cash. A Rather Peculiar Problem Some problems are hard to solve. Curing cancer is hard. Reconciling quantum mechanics with general relativity is hard. But why should getting people to spend more be so difficult? After all, people like to consume. It is getting them to save that should be challenging. And yet, the most pressing macroeconomic problem in many countries over the past decade (and much longer in Japan) has been generating enough spending to achieve full employment, which is a precondition for allowing central banks to move away from extreme measures such as quantitative easing and negative rates. It would be one thing if secular stagnation were primarily a problem of inadequate supply. Increasing supply is difficult. While some economists such as Robert Gordon have focused on the poor prospects for potential GDP growth in developed economies (sluggish productivity and labor force growth being among the key culprits), the Larry Summers characterization of secular stagnation is first and foremost about inadequate demand. If people are not spending enough, why can’t the government simply increase transfers to households or spend money directly on public infrastructure, scientific exploration, or other worthwhile endeavors? Three arguments have been advanced as to why this strategy either will not work or is a bad idea even if it does work: 1) Ricardian Equivalence-type theories claiming that the private sector will increase savings by enough to counter larger budget deficits, thus leaving overall demand unchanged; 2) claims that periods of high unemployment are both necessary and desirable for shifting resources to more productive uses; and 3) concerns that higher government debt levels stemming from larger budget deficits will impose long-term costs that swamp the short-term growth benefits of fiscal stimulus. As we discuss below, none of these arguments are particularly persuasive. This suggests that politics, rather than economics, explains why there has been so much reluctance towards fiscal easing. Ricardian Equivalence Ricardian Equivalence stipulates that the lifetime present value of after-tax income determines household consumption. This implies that if a government issues each person a check for $1 million, everybody will just save the money in anticipation of higher taxes down the road. If that sounds a tad implausible, this is because the theory assumes, among other things, that everyone is perfectly rational, can borrow as much as they want, and lives forever (or at least values their heirs’ or beneficiaries’ welfare as much as their own).  The theory is even less convincing when applied to government spending. Only in the extreme scenario where the government permanently increases spending would rational, infinitely-lived households cut their spending by exactly enough to offset the rise in government expenditures. If the increase in government spending were perceived to be temporary, aggregate demand would still rise, even if everyone is completely rational. To see this, consider a case where the government increases spending by $1 billion per year for three years. The “rational” response would be for households to cut their own expenditures by the annual carrying cost of the additional $3 billion in debt. Assuming an interest rate of 2%, this would amount to a reduction in annual consumption of about $60 million, leaving a net annual fiscal boost of $940 billion. The example above almost certainly overstates the negative impact on consumption in situations where the economy is operating below potential. This is because raising government spending in a depressed economy will boost output, thus increasing the present value of lifetime incomes. The expectation of higher income will lift consumption. The bottom line is that Ricardian Equivalence applies only in a very narrow range of circumstances, none of which are relevant in the real world. Indeed, as Box 1 discusses, the empirical evidence clearly suggests that fiscal multipliers are positive, especially in economies grappling with high unemployment. The Urge To Purge One popular view, often associated with the Austrian School of economics, is that recessions cleanse the economy and the financial system of excesses, paving the way for faster growth. The main problem with this view is that it assumes that resources will only shift to more worthwhile uses if many people are unemployed. In practice, this is not the case. In any given month, about five million US workers will either quit or lose their job, while a slightly higher number will find new work (Chart 1). Chart 1Labor Market Churn Tends To Increase As Unemployment Falls Labor Market Churn Tends To Increase As Unemployment Falls Labor Market Churn Tends To Increase As Unemployment Falls Chart 2Residential Construction Accounted For Only 20% Of The Job Losses During The Great Recession Secular Stagnation: The Easiest Problem In The World? Secular Stagnation: The Easiest Problem In The World?   The small difference between gross inflows and outflows is the net change in employment. This is the number investors focus on every month when the payroll report is released; it is usually less than 5% of gross flows. Strikingly, gross separations usually rise when the unemployment rate falls, implying that labor market churn increases when the economy strengthens. This occurs because more people tend to quit their jobs when the labor market is tight and job openings are plentiful. The pro-cyclicality of the quits rate dominates the counter-cyclicality of the discharge rate. The Great Recession demonstrated that most of the job losses during severe downturns are gratuitous in the sense that they impose needless suffering on workers without making the economy more productive. Chart 2 shows that only 20% of US job losses between 2007 and 2009 took place in the residential building sector and related financial activities where excesses were plainly evident. The rest of the losses were in parts of the economy that had little to do with the housing bubble.   Too Much Debt? Opponents of loose fiscal policy often point to rising government debt levels as an unwelcome side effect of larger budget deficits. Worries about high debt levels are certainly justified for countries that do not print their own currencies. When a country lacks a buyer of last resort for its debt, a self-fulfilling crisis can develop where rising bond yields make it more difficult for the government to service its obligations, leading to even higher bond yields (Chart 3). Chart 3Multiple Equilibria In Debt Markets Are Possible Without A Lender Of Last Resort Secular Stagnation: The Easiest Problem In The World? Secular Stagnation: The Easiest Problem In The World? In contrast, central banks in countries that are able to issue debt in their own currencies can always purchase their own government’s bonds with newly issued cash. They can also set short-term interest rates at whatever level they want, thus ensuring that the government has a reliable source of financing. The “golden rule” for debt sustainability says that a country’s debt-to-GDP ratio will stabilize as long as the interest rate the government pays on its debt is less than the growth rate of the economy. This is true regardless of how big a primary budget deficit the government runs (Chart 4).1 Chart 4Debt Dynamics When r Is Less Than g Secular Stagnation: The Easiest Problem In The World? Secular Stagnation: The Easiest Problem In The World? In fact, the higher the debt-to-GDP ratio is, the larger the sustainable level of the budget deficit that the government can achieve. For example, if nominal GDP growth is 4% and the target debt-to-GDP ratio is 50%, the government can run a budget deficit of 2% of GDP in perpetuity; in contrast, if the target debt-to-GDP ratio is 250%, the government can run a budget deficit of 10% of GDP. The catch is that this magic only works if the interest rate stays below the growth rate of the economy. When there is a lot of spare capacity, this is not a major issue since interest rates can be kept low without the worry that inflation will accelerate. Things get trickier once the economy reaches full employment. At that point, if the budget deficit remains high, inflation could rise as aggregate demand begins to outstrip the economy’s productive capacity. This may cause the central bank to raise interest rates, which could be a vexing problem for a highly indebted government. One might argue that the government could preempt the central bank from having to raise rates simply by tightening fiscal policy once the economy begins to overheat. In many cases, this would indeed be the correct response. However, there may be some occasions where tightening fiscal policy is politically impossible. In such cases, the preferred political response may be to allow inflation to rise. Higher inflation would push up nominal income, thus putting downward pressure on the debt-to-GDP ratio. Once the real value of the debt has been inflated away, the central bank could raise rates in order to cool the economy. Would such an inflationary strategy be preferable to not running a large budget deficit to begin with? It depends on who you ask! If you ask bondholders, they would certainly say no. If anything, bondholders might prefer a deflationary environment since falling prices would increase the purchasing power of their bonds. In contrast, workers and businesses may prefer more stimulus. For them, higher inflation down the road is a price worth paying if it means continued low unemployment and rising profits. How do these competing interests balance out? In most cases, the economy would be better off following the bigger budget deficit/higher inflation strategy. This is partly because deflation is generally a greater risk to the financial system and the broader economy than inflation. It is also because the capital stock is likely to grow more quickly in an economy that is able to stay close to full employment than one that suffers from deficient demand (firms generally invest more when unemployment is low). Hence, not only can fiscal stimulus provide short-term support to employment and consumption during the period when demand is depressed, it can even generate longer-term gains in the form of higher labor productivity and lower structural unemployment compared to what would have happened in the absence of any fiscal easing. The Political Economy Of Debt And Inflation The discussion above suggests that political forces, rather than economic logic, explain why some countries fail to take the necessary steps to solve what should be an elementary problem: increasing demand. In particular, demand-side secular stagnation is likely to be a bigger threat in countries where the preferences of bondholders and others who benefit from very low inflation hold sway. The appreciation of this fact helps explain some key developments in economic history, while shedding light on what the future may hold. Chart 5Universal Suffrage Made Inflation Politically More Palatable Than Deflation Universal Suffrage Made Inflation Politically More Palatable Than Deflation Universal Suffrage Made Inflation Politically More Palatable Than Deflation The introduction of universal suffrage in the first few decades of the twentieth century made inflation politically more palatable (Chart 5). A poor farmer did not need to worry quite as much about losing his land to the bank, since he could vote for someone who would ensure that crop prices increased rather than decreased. In William Jennings Bryan's colorful words, the rich and powerful would no longer “crucify mankind upon a cross of gold." Today, populism is on the rise again. Whether it is rightwing populism or leftwing populism, the result is usually the same: bigger budget deficits and higher inflation. Retirees may not welcome higher inflation, but given the choice between rising prices and cuts to pensions and health care programs, they are likely to opt for the former. For their part, today’s youth has become increasingly enamored with socialism. According to a recent YouGov poll, 70% of Millennials would be somewhat or extremely likely to vote for a socialist candidate (Chart 6). More than one-third of Millennials view communism favorably, while about 20% think the Communist Manifesto “better guarantees freedom and equality” than the Declaration of Independence. No wonder the Democrats are talking about introducing Universal Basic Income, Medicare For All, and a Green New Deal. Chart 6Woke Millennials Cozying Up To Socialism Secular Stagnation: The Easiest Problem In The World? Secular Stagnation: The Easiest Problem In The World? Contrary to conventional wisdom, an individual’s political attitudes are fairly stable over their lifespan.2 This suggests that the average political orientation of US voters will continue to move leftward as older voters pass away. Meanwhile, globalization – a historically deflationary force – has peaked (Chart 7). And despite all the hype about game-changing technological innovation, productivity growth in advanced economies continues to underwhelm (Chart 8). Chart 7Globalization Has Peaked Globalization Has Peaked Globalization Has Peaked   In a world of excess savings, inflation could be held at bay. However, the ratio of workers-to-consumers has now begun to decline as ever more baby boomers leave the labor force (Chart 9). As more people stop working, aggregate savings will fall. The shortage of savings will put upward pressure on the neutral rate. If central banks drag their feet in raising policy rates in response to an increase in the neutral rate, monetary policy will end up being too stimulative. As economies overheat, inflation will pick up. Chart 8Productivity Growth In Advanced Economies Has Decelerated Materially Productivity Growth In Advanced Economies Has Decelerated Materially Productivity Growth In Advanced Economies Has Decelerated Materially Chart 9The Worker-To-Consumer Ratio Has Peaked Globally The Worker-To-Consumer Ratio Has Peaked Globally The Worker-To-Consumer Ratio Has Peaked Globally   Investment Conclusions Few people are worried about rising inflation these days, as evidenced by the weakness in long-term market-based inflation expectations (Chart 10). For now, most of our leading inflation indicators remain contained (Chart 11). However, we suspect this will change in the next few years as the unemployment rate – which is already at a generational low in the G7 – continues to fall (Chart 12). Chart 10Long-Term Inflation Expectations Are Muted Long-Term Inflation Expectations Are Muted Long-Term Inflation Expectations Are Muted Chart 11An Inflation Breakout Is Not Imminent An Inflation Breakout Is Not Imminent An Inflation Breakout Is Not Imminent   Chart 12Falling Unemployment Rate Across Developed Markets Falling Unemployment Rate Across Developed Markets Falling Unemployment Rate Across Developed Markets Chart 13Prices And Wages In Japan Have Been Rising Since 2014... Albeit At A Sluggish Pace Prices And Wages In Japan Have Been Rising Since 2014... Albeit At A Sluggish Pace Prices And Wages In Japan Have Been Rising Since 2014... Albeit At A Sluggish Pace   Chart 14Japan: Labor Market Tightening May Eventually Spur Higher Inflation Japan: Labor Market Tightening May Eventually Spur Higher Inflation Japan: Labor Market Tightening May Eventually Spur Higher Inflation As we discussed two weeks ago in our analysis of whether negative rates will spread out across the world, both the theoretical and empirical evidence suggest that the Phillips curve is kinked.3 This means that a decline in the unemployment rate may not have a significant effect on inflation until unemployment reaches a threshold that is low enough to trigger a price-wage spiral. The US will probably be the first major economy to reach the kink, but others will follow. This includes the mother of all recent deflationary economies: Japan. Chart 13 shows that Japanese prices are rising again, albeit still at a slower pace than the BoJ’s target. Japanese inflation will accelerate if the labor market continues to tighten. Already, the ratio of job openings-to-applicants is near a 45-year high (Chart 14). All this suggests that investors should favor “real assets” such as equities, real estate, and commodities over “nominal assets” such as bonds and cash. To the extent that investors need to maintain exposure to fixed income, we would recommend a short-duration stance and above-benchmark exposure to inflation-linked securities. Box 1 Fiscal Multipliers: How Large? Secular Stagnation: The Easiest Problem In The World? Secular Stagnation: The Easiest Problem In The World? Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1Please see Global Investment Strategy Weekly Report, “Is There Really Too Much Government Debt In The World?” dated February 22, 2019, for a fuller discussion of this debt sustainability equation. 2Johnathan Peterson, Kevin Smith, and John Hibbing, “Do People Really Become More Conservative as They Age? ” The Journal of Politics, (2018). 3Please see Global Investment Strategy Special Report, “Is The Entire World Heading For Negative Rates?” dated October 25, 2019.   Strategy & Market Trends MacroQuant Model And Current Subjective Scores Secular Stagnation: The Easiest Problem In The World? Secular Stagnation: The Easiest Problem In The World? Strategic Recommendations Closed Trades

Martin Barnes and I spent last week visiting clients in Hong Kong and Singapore in celebration of BCA’s 70th anniversary. Martin has been with BCA Research for 32 years and has been a keen observer of market trends for much longer than that. It is always fascinating to hear his thoughts on the state of world affairs. I have spent this week visiting clients in Sydney and Melbourne. I made the case that global growth will accelerate next year. Stronger growth will pull down the U.S. dollar, while pushing up bond yields, equities, and commodity prices. EM and European stocks will begin to outperform their global benchmark. Cyclical equity sectors (including financials) will outperform defensives. What follows are my answers to some of the most common questions I have been receiving. Best regards, Peter Berezin, Chief Global Strategist Feature Q: What makes you confident that global growth will rebound? A: Three things. First, global financial conditions have eased significantly thanks largely to the dovish pivot of most central banks. Reflecting this development, credit growth has picked up. This should support economic activity in the months ahead (Chart 1). Second, the manufacturing downturn seems to be running its course, as excess inventories continue to be liquidated (Box 1). As we have noted before, manufacturing cycles tend to last about three years, with 18 months of weaker growth followed by 18 months of stronger growth (Chart 2). Given that the current downturn began in the first half of 2018, we are probably approaching a bottom in growth. Chart 1Lower Rates Should Help Spur Growth Lower Rates Should Help Spur Growth Lower Rates Should Help Spur Growth Chart 2A Fairly Regular Three-Year Manufacturing Cycle A Fairly Regular Three-Year Manufacturing Cycle A Fairly Regular Three-Year Manufacturing Cycle Third, while there will be plenty of bumps along the road, trade tensions are likely to continue easing. As a self-described master negotiator, President Trump has to produce a “tremendous” deal for the American people. Had he negotiated an agreement with China a year or two ago, he would currently be on the hook for showing that it resulted in a smaller trade deficit. But with the presidential election only a year away, he can semi-credibly claim that the trade balance will only improve after he is re-elected. For their part, the Chinese would rather grapple with Trump now than risk either having to negotiate with him during his second term (when he will be unconstrained by re-election pressures) or having to negotiate with Elizabeth Warren (who may insist on including stringent environmental and human rights provisions in any trade deal). Better the devil you know than the devil you don’t, as they say. Q: Will a ceasefire between the U.S. and China really be enough to boost business confidence? Don’t we need to see an outright rollback of tariffs? A: We do not know if any tariffs will be rolled back as part of the “phase 1” deal that is currently being negotiated. Right now, the U.S. has only agreed to cancel the previously announced October 15th tariff hike on $250 billion of Chinese imports. A Reuters news story earlier this week indicated that China is also asking the U.S. scrap its plan to levy tariffs on $156 billion of Chinese imports on December 15th and to abolish the 15% tariffs on $125 billion in imports which were imposed on September 1st.1 Chart 3China Is No Longer As Dependent On Trade With The U.S. As It Once Was China Is No Longer As Dependent On Trade With The U.S. As It Once Was China Is No Longer As Dependent On Trade With The U.S. As It Once Was While the removal of some tariffs would be a positive development, it is not a necessary condition for a global growth revival. Remember that U.S. exports to China account for only 0.5% of GDP while Chinese exports to the U.S. account for 3.4% of GDP (Chart 3). The numbers are even smaller when measured in value-added terms. That does not mean that the trade war is irrelevant. An out-of-control trade war could cause the global supply chain to break down, leading to significant economic disruptions. To the extent that a détente greatly reduces the odds of such an outcome, it justifies a meaningful upgrade to the probability-weighted economic outlook. Q: What’s your read on the Chinese economy right now? A: China’s growth data have been mixed. The Caixin manufacturing purchasing managers’ index rose to 51.7 in October, the best reading since December 2016. The new orders subcomponent reached the highest level since September 2013. Export orders rose back above 50, registering the largest month-on-month increase of any of the subcomponents. In contrast, the “official” National Bureau of Statistics (NBS) manufacturing PMI, which mainly samples larger, state-owned companies, remained below 50 and sank to the lowest level since February. The NBS nonmanufacturing PMI also weakened. It is worth noting that unlike most of the industries tracked by the NBS, the construction sector PMI moved back above 60 in October. This is consistent with industry data showing that sales of reinforced steel bars, a good proxy for property construction, have accelerated. Electricity consumption has also picked up, which often bodes well for industrial output (Chart 4). Policy has generally remained supportive: Bank reserve requirements have been cut. Benchmark interest rates should come down over the coming months. Credit growth surprised on the upside in September. While the acceleration in credit formation has been more muted this past year than in 2015-16, the credit impulse has nevertheless moved off its late-2018 lows. The Chinese credit impulse leads global growth by about nine months (Chart 5). Chart 4A Positive Sign For Chinese Growth Momentum A Positive Sign For Chinese Growth Momentum A Positive Sign For Chinese Growth Momentum Chart 5The Chinese Credit Cycle Should Support Global Growth The Chinese Credit Cycle Should Support Global Growth The Chinese Credit Cycle Should Support Global Growth   Chart 6China Stepped Up Fiscal Stimulus In 2019 China Stepped Up Fiscal Stimulus In 2019 China Stepped Up Fiscal Stimulus In 2019 Less noticed is the fact that fiscal policy has been eased significantly. According to the IMF, the augmented budget deficit – which includes spending through local government financing vehicles and other off-balance sheet expenditures – is on track to reach nearly 13% of GDP in 2019, a bigger deficit than during the depth of the Great Recession (Chart 6).  Looking out, we expect Chinese growth to rebound next year as the global manufacturing downturn ends and trade war tensions subside. Q: How much of a growth rebound can we expect in Europe? A: The slowdown in the euro area has been concentrated in Italy and Germany. In contrast, growth in Spain and France has held up relatively well (Chart 7). Looking out, Italian growth should rebound thanks to the 270 bps decline in 10-year bond yields that has taken place since October 2018 (Chart 8). German growth should also recover on an improvement in world trade and a stabilization in global auto production and demand. Chart 7Euro Area Growth: The Good, The Bad, And The Ugly Euro Area Growth: The Good, The Bad, And The Ugly Euro Area Growth: The Good, The Bad, And The Ugly Chart 8Lower Yields Should Lift Italian Growth Lower Yields Should Lift Italian Growth Lower Yields Should Lift Italian Growth     Q: Will we see fiscal stimulus in Europe? A: Yes. Fiscal policy remains quite tight in the euro area, but it is starting to loosen at the margin. The fiscal thrust should reach 0.4% of GDP this year, the highest level since 2010 (Chart 9). We expect further modest fiscal easing in 2020, even against a backdrop of stronger domestic economic growth.   Chart 9Euro Area Fiscal Stimulus Will Also Boost Growth Euro Area Fiscal Stimulus Will Also Boost Growth Euro Area Fiscal Stimulus Will Also Boost Growth Chart 10Germany's Competitive Advantage Against The Rest Of The Euro Area Is Deteriorating Germany's Competitive Advantage Against The Rest Of The Euro Area Is Deteriorating Germany's Competitive Advantage Against The Rest Of The Euro Area Is Deteriorating       Germany has been reluctant to increase its own budget deficit in the past. However, there are at least two reasons why this attitude may slowly change. First, there are growing calls within Germany for more spending on public infrastructure, including on ”green” measures to mitigate climate change. The fact that Germany can issue debt at negative rates only incentivizes fiscal easing. If you can get paid to issue debt, why not do it? Second, relatively fast wage growth has caused Germany to become less competitive against its neighbors over the past eight years. As a result, Germany’s trade surplus with the rest of the euro area has fallen in half (Chart 10). A shrinking trade surplus will require a bigger budget deficit to compensate for the loss of aggregate demand.   Q: Is A “No Deal” Brexit still a risk? A: No. Westminster and the British Supreme Court have both rebuked Prime Minister Boris Johnson’s threat of a “no deal” Brexit. This means that the only outcome that would unsettle markets – a disorderly U.K. exit from the EU – is practically off the table. Two options remain: An orderly Brexit in which an eventual trade deal minimizes tariffs, or another referendum. There is no appetite for a no-deal exit. Furthermore, if another referendum on EU membership were held today, the remain side would probably win (Chart 11). Chart 11Brexit Angst: A Case Of Bremorse Brexit Angst: A Case Of Bremorse Brexit Angst: A Case Of Bremorse Q: Is the Fed done cutting rates? A: Yes. The FOMC statement removed the promise to “act as appropriate to sustain the expansion” and replaced it with a more neutral pledge to “monitor the implications of incoming information for the economic outlook”. If there were any ambiguity left about what this meant, Chair Powell squelched it by noting in his press conference that “monetary policy is in a good place” and “the current stance of policy [is] likely to remain appropriate.” This week’s “insurance cut” brings the total for this year to 75 bps. This is exactly the same amount of easing the Fed delivered in 1995/96 and 1998 — two episodes that are widely seen as successful mid-cycle course corrections. Today’s strong employment report and uptick in the ISM manufacturing index provide further evidence that the U.S. economy is on the right track. If U.S. and global growth continue to pick up as we expect, there will not be any need to cut rates further. Q: When can we expect the Fed to start hiking rates again? Chart 12Inflation Expectations Are Too Low Inflation Expectations Are Too Low Inflation Expectations Are Too Low A: Probably not until December 2020 at the earliest. This is partly because the Fed will want to stay out of the political fray leading up to the presidential election (perhaps wishful thinking). Arguably more important, the Fed, along with most market participants, has convinced itself that the neutral rate of interest is very low. If that is truly the case, raising rates is a risky strategy because it could cause growth to weaken at a time when inflation expectations are still below the Fed’s comfort zone (Chart 12). In his recent press conference, Powell seemed to go out of his way to stress that he would not make the same mistake he did last October when he said rates were “a long way from neutral”. Most notably, he said this week that the FOMC “would need to see a really significant move up in inflation that is persistent before we even consider raising rates to address inflation concerns.” Q: How worried should equity investors be about the prospect of President Warren? A: While Elizabeth Warren would not be a welcome treat for shareholders, she probably would not be a disaster either. Right now she is trying to elbow Bernie Sanders out of the race in order to lock up the “progressive” vote. Thus, it is not surprising that she has dialed up the far-left rhetoric. If Warren succeeds in securing the Democratic Party nomination, she will pivot to the centre. Remember this is the same person who said last year she was “a capitalist” and “I love what markets can do… They are what make us rich, they are what create opportunity.”2 Considering that financial sector reform has been the focus of Warren’s academic and legislative career, bank shareholders are understandably worried about what a Warren presidency would entail. They probably shouldn’t be. Banks today operate more like staid utilities than the reckless casinos they were prior to the financial crisis. A lot of the rules and regulations that Warren champions have already been implemented in one guise or another. In fact, it would not be a stretch to say that had these rules been in place 15 years ago, the share prices of many financial institutions would be a lot higher today (especially the ones that went under!). Lastly, one should keep in mind that the U.S. political system has numerous checks and balances. Even if Elizabeth Warren did want to pursue a radical agenda, she would be stymied by moderate Democrats and a Senate which, more likely than not, will remain in Republican control. Q: Taking everything you said on board, how should investors position themselves over the next 12 months? A: Despite the risks facing the global economy, investors should continue to overweight stocks relative to bonds in a balanced portfolio. A rebound in global growth next year will give corporate earnings a lift. As a countercyclical currency, the U.S. dollar is likely to weaken in an environment of improving global growth (Chart 13). The combination of stronger growth and a weaker dollar will boost commodity prices (Chart 14). Chart 13The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency Chart 14Dollar Weakness Is A Boon For Commodities Dollar Weakness Is A Boon For Commodities Dollar Weakness Is A Boon For Commodities Cyclical equity sectors normally outperform defensive sectors when the global economy is strengthening and the dollar is weakening (Chart 15).     Chart15ACyclical Stocks Will Outperform If The Dollar Weakens Cyclical Stocks Will Outperform If The Dollar Weakens Cyclical Stocks Will Outperform If The Dollar Weakens Chart 15BCyclical Stocks Are More Attractive Than Defensives Cyclical Stocks Are More Attractive Than Defensives Cyclical Stocks Are More Attractive Than Defensives       We would include financials in our definition of cyclical sectors. As global growth improves, long-term bond yields will increase at the margin. Since central banks are in no hurry to raise rates, yield curves will steepen. This will boost bank net interest margins, flattering profits and share prices (Chart 16). Emerging market and European stocks have more exposure to cyclical sectors than U.S. stocks. Thus, it stands to reason that EM and European equities will outperform their U.S. peers over the next 12 months (Chart 17). Chart 16Steeper Yield Curves Will Benefit Financials Steeper Yield Curves Will Benefit Financials Steeper Yield Curves Will Benefit Financials Chart 17EM And Euro Area Equities Usually Outperform When Global Growth Improves EM And Euro Area Equities Usually Outperform When Global Growth Improves EM And Euro Area Equities Usually Outperform When Global Growth Improves   Non-U.S. stocks also have the advantage of being cheaper, even if adjusted for differences in sector weights. U.S. equities currently trade at a forward PE ratio of 18, compared to 13 for non-U.S. stocks. Since interest rates are generally lower outside the U.S., the equity risk premium is especially wide for non-U.S. stocks (Chart 18). Chart 18Equity Risk Premia Remain Quite High Equity Risk Premia Remain Quite High Equity Risk Premia Remain Quite High Box 1 Evidence of Inventory Liquidation In The Manufacturing Sector   U.S. (October 2019): “Finally, despite a renewed rise in input buying, the stronger increase in new business meant firms increasingly dipped into stocks to ensure new orders were fulfilled in a timely manner. Therefore, pre-production inventories fell at the quickest rate for three months and stocks of finished goods decreased slightly.” Markit “The [inventory] index contracted for the fifth straight month, but at a slower rate. Improvements in new orders and stocking for the fourth quarter both contributed positively to the index compared to September” ISM (Institute for Supply Management) Germany (October 2019): “However, weighing on the index were faster decreases in employment and stocks of purchases, alongside a more marked improvement in supplier delivery times.” Markit U.K. (October 2019): “A number of firms revisited their Brexit preparations during October, leading to higher levels of input purchasing and a build-up of safety stocks. Growth in inventories of finished goods and purchases were at six-month highs, but remained below the survey-record rates reached during the first quarter.” Markit Japan (October 2019): “A reluctance to hold items in stocks was also signalled by simultaneous draw-downs to pre- and post-production inventories during the latest survey period. In fact, rates of depletion in both cases accelerated during the month, with stocks of finished goods falling at the fastest rate since survey data were first collected 18 years ago.” Markit Canada (October 2019): “Latest data signalled a marginal accumulation of preproduction inventories across the manufacturing sector. In contrast, stocks of finished goods were depleted for the first time in three months. A number of survey respondents commented on efforts to boost cash flow by streamlining their post-production inventories.” Markit China (October 2019): “Improved client demand led firms to expand their purchasing activity, with the rate of growth the quickest since February 2018. This contributed to a further rise in stocks of inputs, albeit marginal. Inventories of finished goods meanwhile declined amid reports of the greater use of stocks to fulfil orders.” Markit Taiwan (October 2019): “Stocks of both pre- and postproduction goods contracted at accelerated rates, with the latter falling solidly overall.” Markit Korea (October 2019): “Elsewhere, latest survey data highlighted a strong drive towards cost cutting, with firms clearing their existing stocks of both inputs and finished goods at accelerated rates.” Markit India (October 2019): “Both pre- and post-production inventories decreased in October. The fall in the latter was sharper and the quickest in 16 months.” Markit Russia (October 2019): “Finally, firms reduced their purchasing activity further as they supplemented production through the use of preproduction inventories. Stocks of finished goods also fell amid lower client demand and efforts to run down stores.” Markit Turkey (October 2019): “A muted easing of purchasing activity was recorded in October, while stocks of both purchases and finished goods were scaled back.” Markit Brazil (October 2019): “As a result, stocks of purchases fell at the quickest rate in 16 months. Post-production inventories likewise decreased to the greatest extent since mid-2018 during October. According to panel members, the fall was due to sales growth.” Markit   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1Please see David Lawder, and Andrea Shalal, “U.S., China say they are 'close to finalizing' part of a Phase One trade deal,” Reuters (October 25, 2019); and Alexandra Alper, and Doina Chiacu,"Trump: 'ahead of schedule' on China trade deal," Reuters (October 28, 2019). 2Please see John Harwood, “Democratic Sen. Elizabeth Warren: ‘I am a capitalist’ – but markets need to work for more than just the rich,” CNBC (July 24, 2018).   Strategy & Market Trends MacroQuant Model And Current Subjective Scores Questions From The Road: The Pacific Rim Edition Questions From The Road: The Pacific Rim Edition   Strategic Recommendations Closed Trades