Japan

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

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

Highlights Solid credit growth numbers from China last week suggest an emerging window for pro-cylical currency trades. However, since 2009, these currency pairs have tended to work in real time rather than with a lag. Continued muted currency action over the next few weeks will be cause for concern. Our favorite currency pairs to play U.S. dollar downside for now are the SEK, NOK and GBP. With the Aussie dollar close to the epicenter of Chinese stimulus, data down under is increasingly stabilizing. Place a limit buy on AUD/USD at 0.70. Improving global growth will eventually put downward pressure on the broad trade-weighted U.S. dollar. Meanwhile, the risk-reward profile for safe-haven currencies has been greatly augmented in this low-volatility environment. Rising net short positioning on the yen and swiss franc is making them attractive from a contrarian standpoint. Feature The unambiguous message from incoming data is that we are entering a reflationary window. Our report last week highlighted the fact that the Chinese economy is in a bottoming process.1 Since then, data out of China has come out much stronger than expected. Export growth in March surged from -21% to 14%, new yuan-denominated loans came in at 1.7 trillion RMB versus 886 billion RMB the previous month, and industrial production in March grew at 8.5% on an annual basis – the strongest print since July 2014. Retail sales were also stronger and house prices are re-inflating, suggesting construction activity will pick up steam. Historically, March data is a cleaner print compared to prior months since it evades nuances from the Chinese lunar new year. As such, these numbers are consistent with a re-acceleration in domestic demand in the Chinese economy in the coming months. As we embrace confirmation that the Chinese economy has bottomed, it will be important to monitor if this cycle plays out like those in the past. Since 2009, the evolution of the Chinese credit cycle has been an important driver of pro-cyclical currency trades. However, in recent years there appears to have been diminishing returns to these trades. Continued lack of more pronounced strength in the Australian, New Zealand, and Canadian dollar exchange rates in light of solid hard data out of China will be genuine reason for concern. Our general assessment is that while the credit impulse in China has clearly bottomed, the magnitude of the rise is unlikely to be what we saw in 2015-2016. Given this backdrop, not all pro-cyclical currency pairs are going to benefit equally. We are long the SEK, NOK, and GBP and recommend adding AUD to the list of pro-cyclical favorites. Paradoxically, the risk-reward profile for safe-haven currencies has also been greatly augmented in this low-volatility environment, but it is still too early to begin putting on currency hedges. Pro-Cyclical Trades Need Broad Dollar Weakness Chart I-1 highlights the fact that pro-cyclical currencies have had diverging performances over the evolution of the business cycle since 2009. Chart I-1 The aftermath of the global financial crisis was most bullish for commodity currencies, with the AUD, CAD, NOK, and NZD rising around 20%-30% versus the U.S. dollar. The DXY index was roughly flat during this period, but the broad trade-weighted dollar did weaken. The biggest driver back then was rising commodity prices, driven by Chinese demand and a revaluation of these currency pairs from deeply oversold levels. The weakest currencies were the euro and yen. Chart I-2New Lows In Currency Volatility New Lows In Currency Volatility New Lows In Currency Volatility The second phase of the business cycle upswing occurred from July 2012 to February 2014, using the global Purchasing Managers’ Index from J.P. Morgan. During this phase, the best-performing currency pairs were the euro and swiss franc, and the worst was the Japanese yen. Commodity currencies fared poorly back then. The driver then was monetary policy, with European Central Bank Governor Mario Draghi’s “whatever it takes” put and the launch of “Abenomics.” Notably, the 4% weakness in the DXY did not help pro-cyclical currencies much, given commodity prices had peaked. From February 2016 to December 2017, the upswing was driven again by Chinese stimulus. Commodity prices rallied and the dollar did weaken significantly, which helped pro-cyclical currencies. However, the returns were modest compared to 2009-2010 episode. The yen was flat during the period. Finally, NOK, SEK and NZD have been winners throughout all three business cycle upswings. This time around, more evidence will need to emerge that the broad trade-weighted U.S. dollar has peaked for pro-cyclical currencies to outperform. For now, the calm in developed currency markets seems very eerie, given the flow of incoming economic data. We have highlighted in recent bulletins that most currency pairs have been narrowly trading towards the apex of very tight wedge formations, which has severely dampened volatility (Chart I-2). In the post-Bretton Woods world, it has been very rare for periods of extended currency stability to persist. We eventually expect the U.S. dollar to weaken, but we will need to closely monitor the forces that have so far been keeping a bid under it.  Liquidity, Global Growth And The Dollar Most measures of relative trends still favor the dollar. The April Markit manufacturing PMI releases this week showed that while both Japan and the euro area remain in contraction territory, the U.S. reading of 52.4 puts it solidly above the rest of the world. It is true that the momentum of this leadership has been rolling over recently, but historically such growth divergences between the U.S. and the rest of the world have generated anywhere from 10%-15% rallies in the greenback over a period of six months (Chart I-3). So far, the DXY dollar index is up 1% for the year. Repatriation flows have had a non-neglible influence on the broad trade-weighted dollar. Meanwhile, even though the Federal Reserve has paused hiking interest rates, relative policy trends still favor the greenback. The interest rate gap between the U.S. and the rest of the world pins the broad trade-weighted dollar index at 128, or 7% above current levels (Chart I-4). And even today, unless the Fed moves toward outright rate cuts, the dovish shift by other central banks around the world remains an immediate tailwind for the U.S. dollar. It will be important for yield curves to steepen globally as confirmation that other central banks are getting ahead of the curve, which should be a headwind for the dollar. Chart I-3U.S. Growth Leadership ##br##Is Rolling Over U.S. Growth Leadership Is Rolling Over U.S. Growth Leadership Is Rolling Over Chart I-4Interest Rate Differentials Still Favor The Dollar Interest Rate Differentials Still Favor The Dollar Interest Rate Differentials Still Favor The Dollar Internationally, dollar liquidity will need to increase significantly for the greenback to meaningfully weaken. The Fed’s tapering of asset purchases has been a net drain on dollar liquidity, despite a widening U.S. current account deficit. This is expected to end by September, but has already triggered a severe contraction in the U.S. monetary base. Our preferred measure of international liquidity is foreign central bank reserves deposited at the Fed, and this is still contracting at its worst pace in over 40 years (Chart I-5). At a minimum, an end to the balance sheet runoff will steer growth in the U.S. monetary base from deeply negative to zero. A rising external profit environment will be needed for an increase in foreign central bank reserves. Finally, data from the U.S. Treasury International Capital (TIC) system show that on a rolling 12-month basis, the U.S. continues to repatriate back a net of about $400 billion in assets, or close to 2% of GDP. Repatriation flows have had a non-neglible influence on the broad trade-weighted dollar (Chart I-6). Unless these flows roll over and begin to weaken, it will make it very difficult for the greenback to depreciate. Chart I-5International Dollar Liquidity Remains Tight International Dollar Liquidity Remains Tight International Dollar Liquidity Remains Tight Chart I-6Repatriation Flows Still Favor The Dollar Repatriation Flows Still Favor The Dollar Repatriation Flows Still Favor The Dollar Chart I-7Watch The Gold-To-Bond Ratio Watch The Gold-To-Bond Ratio Watch The Gold-To-Bond Ratio The bottom line is that pro-cyclical currencies will need broad dollar weakness to outperform. Our favorite indicator for gauging ultimate downside in the dollar is the gold-to-bond ratio (Chart I-7). Any sign that the balance of forces are moving away from the U.S. dollar will favor a breakout in the gold-to-bond ratio. For now, our favorite currency pairs to play U.S. dollar downside are the SEK, NOK, and GBP. What About Safe Havens? During bull markets, countries that have negative interest rates are subject to powerful outflows from carry trades. The impact of these outflows are difficult to measure, but it is fair to assume that periods of low hedging costs (which tend to correspond to periods of lower volatility) can be powerful catalysts. As markets get volatile and these trades get unwound, unhedged trades become victim to short-covering flows. Chart I-8 With many yield curves around the world flattening, the danger is that the frequency of this short-covering implicitly rises, since long bond returns are falling short of spot rates. One winner as volatility starts to rise is the yen (Chart I-8). Investors should consider initiating small short USD/JPY and USD/CHF positions in the coming weeks as a portfolio hedge. Back in late 2016, global growth was soft, the yen was very cheap and everyone was short the currency on the back of a dovish shift by the Bank of Japan. Having recently introduced yield curve control (YCC), the market was grappling with the dovish implications for the currency, arguably the most significant change in monetary policy by any central bank at the time in several years. Given that backdrop, the yen strengthened by circa 10% from December 2016 to mid-2017, even as equity markets remained resilient. When the equity market drawdown finally arrived in early 2018, it carried the final legs of the yen rally. Dollar weakness was a significant reason for yen strength given global growth was accelerating, a negative for the counter-cyclical dollar. But with a net international investment position of almost 60% of GDP, and yearly income receipts of almost 4% of GDP, any volatility in markets could lead to powerful repatriation flows back to Japan. Chart I-9The Consumption Tax Hike Will Hurt Japanese Growth The Consumption Tax Hike Will Hurt Japanese Growth The Consumption Tax Hike Will Hurt Japanese Growth We expect the BoJ to remain on hold at next week’s policy meeting, but the incentive for the central bank to act preemptively this time around is getting stronger. The starting point is that the consumption tax hike, scheduled for October this year, will be disastrous for the economy. Since the late 1990s, every time the consumption tax has been hiked, the economy has slumped by an average of over 1.3% in subsequent quarters. For an economy with a potential growth rate of just 0.5-1%, this is a highly unpalatable outcome (Chart I-9). More importantly, similar to past episodes, the consumption tax is being hiked at a time when the economy is slowing. This week’s data show that exports continued to contract for the month of March. Machine tool orders, a good proxy for Japanese machinery sales, are still falling by almost 30% year-on-year. The Japanese PMI remains below the 50 boom/bust line, even though it has ticked marginally higher in April. Both household and business confidence are falling. The Economy Watcher’s Survey is currently at 44.8, well below the 50 boom/bust line and the lowest reading since 2016. In its April regional outlook, the BoJ downgraded most of the prefectures in Japan, with only Hokkaido receiving an upgrade in the aftermath of the earthquake. As domestic deflationary pressures intensify, this should nudge the BoJ towards more stimulus. This also raises the probability that the government defers the consumption tax hike. However, the yen could benefit from any short-covering rallies in the interim. We expect the BoJ to remain on hold at next week’s policy meeting, but the incentive for the central bank to act preemptively this time around is getting stronger. Bottom Line: The risk-reward profile for safe-haven currencies has been greatly augmented in this low-volatility environment. The rise in net short positioning on the yen and Swiss franc is becoming attractive from a contrarian standpoint. Investors should consider initiating short USD/JPY and short USD/CHF positions in the coming weeks as a hedge. Place A Limit-Buy On AUD/USD At 0.70 Data out of Australia are showing tentative signs of a bottom. This week’s important jobs report showed that the economy added 25,700 jobs, more than double the consensus forecast. Importantly, this was driven by full-time jobs, with a net gain of 48,300. And despite the participation rate ticking higher, unemployment stayed near a six-year low at 5%. Admittedly, the most recent Reserve Bank of Australia minutes showed there was discussion about rate cuts, but this could change if the economy begins to benefit from an acceleration in Chinese growth. Outright short AUD bets are at risk from either upside surprises in global growth or simply the forces of mean reversion. For more than two decades, the Australian dollar has tended to be mostly driven by external conditions, especially the commodity cycle. But for the first time in several years, domestic factors have joined in to exert powerful downward pressure on the currency. The Australian Prudential Regulation Authority (APRA) succeeded in its mission to deflate the overvalued housing market, and with house prices deflating by over 5% year-on-year, Australia may already be far along its adjustment path, especially vis-à-vis its antipodean counterpart (Chart I-10). In terms of currency performance, a lot of the bad news already appears priced in to the Australian dollar, which is down 12% from its 2018 peak and 35% from its 2011 peak. This suggests outright short AUD bets are at risk from either upside surprises in global growth or simply the forces of mean reversion (Chart I-11). We are already long the Aussie dollar versus the kiwi and suggest placing a limit-buy on AUD/USD at 0.7. Chart I-10The Aussie Housing Market Has Already Adjusted The Aussie Housing Market Has Already Adjusted The Aussie Housing Market Has Already Adjusted Chart I-11Chinese Growth Will Benefit The Aussie Dollar Chinese Growth Will Benefit The Aussie Dollar Chinese Growth Will Benefit The Aussie Dollar Chart I-12LNG Exports Will Benefit The Aussie Dollar LNG Exports Will Benefit The Aussie Dollar LNG Exports Will Benefit The Aussie Dollar Finally, the AUD/USD cross will benefit from rising terms-of-trade. Iron ore prices are already surging, reflecting supply-related issues but also rising demand in China. Meanwhile, Beijing’s clear environmental push has lifted the share of liquefied natural gas in Australia’s export mix (Chart I-12). Given that eliminating pollution is a strategic goal in China, this will be a multi-year tailwind. As the market becomes more liberalized and long-term contracts are revised to reflect higher spot prices, the Aussie dollar will get a boost.   Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Weekly Report, titled “Reading The Tea Leaves From China,” dated April 12, 2019, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data in the U.S. suggest a slower pace of growth: The preliminary U. of Mich. consumer sentiment index fell to 96.9 in April. The NY empire state manufacturing index surprised to the upside, coming in at 10.1 in April. Industrial production contracted by 0.1% month-on-month in March. Trade balance came in at a lower-than-expected deficit of $49.4B in February. Retail sales increased by 1.6% month-on-month in March. Preliminary April Markit composite PMI fell to 52.8; manufacturing component and services component fell to 52.4 and 52.9, respectively. DXY index edged up by 0.35% this week. The Fed’s Beige Book was released on Wednesday, summarizing that economic activity expanded at a slight-to-moderate pace in March and early April, with some states showing more signs of relative strength. The Book suggests that going forward, a similarly muted pace of growth should be anticipated for the coming months. Report Links: Not Out Of The Woods Yet - April 5, 2019 Tug OF War, With Gold As Umpire - March 29, 2019 Into A Transition Phase - March 8, 2019 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data in the euro area remain soft: Industrial production came in at -0.3% year-on-year in February, outperforming expectations. April ZEW economic sentiment index improved to 4.5 in euro area. The German ZEW current conditions component fell to 5.5, while sentiment improved to 3.1 nonetheless. The current account balance fell to €26.8B, while trade balance increased to €19.5B in February. March headline inflation and core inflation were unchanged at 1.4% and 0.8% year-on-year, respectively. The euro area April composite PMI fell to 51.3; the services component fell to 52.5; the manufacturing component increased to 47.5. German composite PMI increased to 52.1; manufacturing and services components increased to 44.5 and 55.6, respectively. French composite PMI increased to 50; manufacturing component fell to 49.6; services component increased to 50.5. EUR/USD fell by 0.34% this week. As the Chinese economy bottoms, this should benefit European exports and the euro. Report Links: Reading The Tea Leaves From China - April 12, 2019 Into A Transition Phase - March 8, 2019 A Contrarian Bet On The Euro - March 1, 2019 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan have been neutral: The adjusted trade balance decreased, coming in at a ¥177.8 billion deficit in March. Exports contracted by 2.4% year-on-year, while imports grew by 1.1% year-on-year. Industrial production fell by 1.1% year-on-year in February. The preliminary Nikkei manufacturing PMI improved to 49.5 in April. USD/JPY has been trading flat this week. During the most recent IMF meeting, global finance chiefs have warned that global growth uncertainties remain at a high level. With currency volatility at record lows, any flight to safety could support safe-haven currencies like the yen. Report Links: Tug OF War, With Gold As Umpire - March 29, 2019 A Trader’s Guide To The Yen - March 15, 2019 Balance Of Payments Across The G10 - February 15, 2019 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the U.K. have been mostly positive: Rightmove house price index slightly improved to -0.1% year-on-year in April.  On the labor market front, 179K jobs were created in February; ILO unemployment rate was unchanged at 3.9%; average weekly earnings came in line at 3.5% year-on-year.  On the inflation front, headline inflation and core inflation were unchanged at 1.9% and 1.8% year-on-year, respectively, underperforming expectations. Retail sales came in at 6.7% year-on-year in March, surprising to the upside. GBP/USD fell by 0.5% this week. With Brexit being kicked down the road, the volatility of sterling has dropped, and attention is moving towards U.K. fundamentals. Economic surprises in the U.K. relative to both the U.S. and euro area are soaring. This will put a bid under sterling. Report Links: Not Out Of The Woods Yet - April 5, 2019 A Trader’s Guide To The Yen - March 15, 2019 Balance Of Payments Across The G10 - February 15, 2019 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 The labor market in Australia remains robust: Westpac leading index increased by 0.19% month-on-month in March. 25.7K jobs were created in total in March, with 48.3K new full-time jobs and a loss of 22.6K part-time jobs. The participation rate increased to 65.7% in March, slightly higher than expected which nudged the unemployment rate to 5%, in line with expectations. AUD/USD appreciated by 0.7% this week, now approaching 0.72. The RBA published its meeting minutes on Tuesday. The minutes stated that the Australian dollar is still near its recent lower end. However, the strength in commodity prices and improving trade terms are supporting the currency. Report Links: Not Out Of The Woods Yet - April 5, 2019 Into A Transition Phase - March 8, 2019 Balance Of Payments Across The G10 - February 15, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1   Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2   Recent data in New Zealand are slowing: Q1 inflation fell to 1.5% year-on-year, underperforming expectations. NZD/USD fell by 0.8% this week. The relative underperformance of New Zealand growth could further weaken the Kiwi on a cyclical basis. Our long AUD/NZD position is now 1.6% in the money. Report Links: Not Out Of The Woods Yet - April 5, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data in Canada have been mostly positive: The Teranet/National Bank HPI fell to 1.5% year-on-year in March. Existing home sales in March grew by 0.9% month-on-month, higher than the previous reading of -9.1% while still lower than the expected 2%. Trade balance came in at a smaller deficit of 2.9 billion CAD. Headline inflation and core inflation climbed to 1.9% and 1.6% year-on-year respectively. The ADP number of new jobs created fell to 13.2K in March. Retail sales increased by 0.8% month-on-month in February, outperforming expectations. USD/CAD fell by 0.3% this week. The spring 2019 BoC Business Outlook Survey was released on Monday. It’s worth mentioning that the Business Outlook Survey Indicator fell from a strongly positive level in the winter survey to slightly negative, implying the softening in recent business sentiment. Report Links: A Shifting Landscape For Petrocurrencies - March 22, 2019 Into A Transition Phase - March 8, 2019 Balance Of Payments Across The G10 - February 15, 2019 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland have been positive: Producer and import prices came in at -0.2% year-on-year in March, higher than the previous reading of -0.7%. Trade balance increased to a surplus of 3.2 billion CHF in March. Exports increased to 21 billion CHF, and imports increased to 17.9 billion CHF. Swiss watch exports increased by 4.4% year-on-year in March. USD/CHF rose by 1% this week. The global growth stabilization and improving sentiment in the euro area are offsetting the attractiveness of the safe-haven franc. We are long EUR/CHF for a 1% profit. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Waiting For A Real Deal - December 7, 2018 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 There is little data from Norway this week: Trade balance in March fell to 13.9 billion NOK. USD/NOK fell after the spike overnight, returning flat this week. The Norwegian krone is still trading at around one sigma band below its fair value, while the economic activity is improving with rising oil prices. Our long NOK/SEK position is now at a 3.6% profit. Report Links: A Shifting Landscape For Petrocurrencies - March 22, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Recent data in Sweden have been negative: The unemployment rate increased to 6.7% in March. USD/SEK appreciated by 0.2% this week. Like the Norwegian krone, the Swedish krona is undervalued, trading at a large discount to its fair value. We remain overweight the SEK, which will benefit from a bottoming in global growth. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Global Liquidity Trends Support The Dollar, But... - January 25, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Feature For a decade, mainstream economics has prescribed remedies for sluggish growth in the euro area on the basis of three articles of blind faith. First, that the ailment arises from structural impediments to growth; second, that in response to an ailing economy, ultra-loose monetary policy is always and everywhere effective; and third, that ‘Keynesian’ government stimuluses are at best a necessary evil and at worst a recipe for disaster. As a result, European policymakers have expended much time and energy attempting structural reforms, experimenting with ultra-loose monetary policy, while shirking government borrowing and spending. But have policymakers misdiagnosed the ailment? Chart of the WeekItaly’s Private Sector Is Paying Back Debt Italy's Private Sector Is Paying Back Debt Italy's Private Sector Is Paying Back Debt Why The Focus On Public Deficits And Debt Might Be Misplaced We frown upon government deficits. They are associated with crowding out and misallocation of resources. But when the private sector is running a financial surplus, the exact opposite is true. Government borrowing and spending causes no crowding out because the government is simply utilising the private sector’s surplus savings and debt repayments. And importantly, this deficit spending prevents a deflationary shrinkage of the broad money supply. Most people are aware of the size of government deficits. Few people are aware of the size of private sector surpluses; and the leakage from the national income stream that they create. By not making this connection, people might believe that government deficits are profligate. But if the private sector as a whole has a financial surplus, it makes sense for the government to borrow to support economic growth. In a similar vein, an economy’s debt sustainability depends on its total indebtedness, not on its public indebtedness or its private indebtedness in isolation. Debt becomes unsustainable when the marginal extra euro of debt results in misallocation of resources and mal-investment. At this point, the extra debt adds nothing to growth or, worse, it subtracts from growth. This is also the point at which lenders tend to be unwilling to provide the marginal loan. Therefore, debt reaches its sustainable limit when the economy has exhausted all productive uses for it. Deficit spending can prevent a deflationary shrinkage of the broad money supply. It does not matter whether these productive uses are funded with private debt or with public debt. For example, successful economies require investment in high-quality healthcare and education. Some economies fund this with private debt, while others fund it with public debt. This means that if productive private indebtedness is low, there is more scope for productive public indebtedness. Many people believe that Italy has one of the world’s most indebted economies. But this belief is wrong. Although Italy’s public indebtedness is high, Italy’s private indebtedness is one of the lowest in the world, making Italy’s total indebtedness less than that of France and the U.K., and broadly equal to that of the U.S. (Chart I-2-I-5). Crucially, Italy’s extremely low private indebtedness means that it could afford relatively high public indebtedness before reaching the limit of debt sustainability. Chart I-2Italy: Total Debt = 250% Of GDP Italy: Total Debt = 250% Of GDP Italy: Total Debt = 250% Of GDP Chart I-3France: Total Debt = 315% Of GDP France: Total Debt = 315% Of GDP France: Total Debt = 315% Of GDP Chart I-4U.K.: Total Debt = 280% Of GDP U.K.: Total Debt = 280% Of GDP U.K.: Total Debt = 280% Of GDP Chart I-5U.S: Total Debt = 250% Of GDP U.S: Total Debt = 250% Of GDP U.S: Total Debt = 250% Of GDP   Italy And Japan: Compare And Contrast In a normal world, the task of ensuring that private sector savings are borrowed and spent falls on the banks, which take in the savings and debt repayments and lend them out to others in the private sector who can make the best use of the funds. But if a dysfunctional banking system fails this task, the savings generated by the private sector will find no borrowers. The unrecycled funds become a leakage from the national income stream generating a persistent deflationary headwind for the economy. Welcome to Italy! Since 2008, the stock of loans to Italian households and firms has been stagnant while in real terms it has fallen (Chart of the Week). The upshot is that the real money supply has shrunk despite low private sector indebtedness, low interest rates and massive injections of ECB liquidity into the banking system. Japan’s public sector levering has been counterbalancing its private sector de-levering. After the 2008 global financial crisis Italian banks’ balance sheets were left unrepaired and undercapitalized. For an individual bank whose solvency is impaired, the right thing to do is shrink its loan book relative to its equity capital. But when the entire banking system is doing this simultaneously, the economy falls into a massive fallacy of composition: what is right for an individual bank becomes very deflationary when all banks are doing it together. Under these circumstances, an agent outside the fallacy of composition – namely, the government – must counter this deflationary headwind by borrowing and spending the un-recycled private sector savings. Welcome to Japan! The Japanese government has been doing precisely this for the past 25 years. Many people fret about the Japanese government’s persistent deficits and its ballooning public debt. What these people do not realise is that these persistent deficits are simply counterbalancing private sector de-levering. Hence, Japan’s all-important total (public plus private) indebtedness as a share of GDP has not been rising (Chart I-6). In Italy, the banking system has been dysfunctional for over a decade, preventing the private sector from borrowing (Chart I-7). Under these circumstances, the Italian government could borrow the private sector’s excess savings and debt repayments and put them to highly productive use, just like in Japan. Chart I-6Japan’s Persistent Deficits Have Been Counterbalancing Private Sector De-levering Japan's Persistent Deficits Have Been Counterbalancing Private Sector De-levering Japan's Persistent Deficits Have Been Counterbalancing Private Sector De-levering Chart I-7The Italian Banking System Has Been Dysfunctional The Italian Banking System Has Been Dysfunctional The Italian Banking System Has Been Dysfunctional Japan and Italy have quite similar demographics, but there is also a big difference. Despite the Japanese government’s persistent deficit and ballooning debt, the 10-year Japanese government bond seems not the slightest bit concerned and is yielding zero. Whereas in Italy, where the government finances are close to structural balance, the merest hint of a Keynesian stimulus sent the 10-year BTP yield rocketing towards 4 percent. Why? The answer is that Italy does not have its own central bank. The Japanese government bond yield is a direct function of the BoJ’s expected monetary policy. But the Italian BTP yield has two components: the ECB’s expected monetary policy plus a risk-premium for currency redenomination in the event that Italy left the euro. Italy’s problem is that even if modest deficit spending was the right policy, it would take time to prove. Meanwhile, bond vigilantes shoot first and ask questions later. The euro debt crisis was essentially a fear of currency redenomination which resulted from bond vigilantes running amok. When bond markets refuse to lend to sovereigns at a rational interest rate, maturing debt has to be refinanced at a penalising interest rate, causing an undeserved deterioration in the government’s finances. Thereby, the fear of redenomination could become a self-fulfilling prophecy. In Italy, the banking system has been dysfunctional for over a decade. The bottom line is that every economy has its own ‘tipping-point’ interest rate, at which its debt financing can flip from stability to instability. But we believe this interest rate is low everywhere. Modern Monetary Theory Simplified Modern Monetary Theory (MMT) is a hot topic of the moment. Our view is that its breakthrough is to establish the ‘appropriate’ public sector deficits in the context of private sector surpluses, and it simplifies to this question: In highly indebted economies, what is the interest rate needed to keep total (public plus private) indebtedness as a share of GDP stable, and prevent a deflationary shrinkage of the broad money supply? The answer differs slightly from economy to economy because private sector indebtedness is modestly rising in some places, stable in a few, while declining in others (Chart I-8).  But crucially, at a global level, total indebtedness is stabilising with the global bond yield within a historically depressed sideways channel (Chart I-9). Chart I-8Private Sector Indebtedness Is Not Rising As A Whole Private Sector Indebtedness Is Not Rising As A Whole Private Sector Indebtedness Is Not Rising As A Whole Chart I-9The Global Long Bond Yield Has Been In A Sideways Channel The Global Long Bond Yield Has Been In A Sideways Channel The Global Long Bond Yield Has Been In A Sideways Channel Admittedly, the global bond yield is now at the bottom of this channel. This means that from a tactical perspective, we can expect 10-year yields to go up about 50 bps before hitting the top of the channel. However, from a structural perspective, the interest rate needed to stabilise total indebtedness as a share of GDP now appears to be extremely low. And this means that structurally low bond yields are here to stay. Finally, I am excited to report that two of the main commentators on MMT – Richard Koo and Stephanie Kelton – are keynote speakers at our annual conference on September 26-27 in New York City. Suffice to say it will be an event not to be missed! Fractal Trading System* There are no new trades this week, leaving five open positions. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 Short the 10-Year OAT Short the 10-Year OAT The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. *  For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com Dhaval Joshi, Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields   Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations