Money/Credit/Debt

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 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 Chart I-3France: Total Debt = 315% Of GDP Chart I-4U.K.: Total Debt = 280% Of GDP Chart I-5U.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 Chart I-7The 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 Chart I-9The 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 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 Chart II-2Indicators To Watch - Bond Yields   Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Special Report

Feature This week, instead of our regular Weekly Report, we will answer clients’ most frequently asked questions (FAQs) from our recent marketing trip to the old continent. Table 1 lists these questions and below we will attempt to weave a cohesive piece and answer all of these interesting questions. Clients inquiring about “how is everyone else positioned” or the related “what is the general investor sentiment like” is by far the most FAQ we always get from the road and we purposefully omit it from Table 1. Table 1Most FAQs From The Road During our last three developed markets (DM) trips, while we cannot comment on the positioning question, with regard to general investor sentiment, Australia and New Zealand are off the charts bullish. On the opposite end of the spectrum, Europe is extremely bearish, especially continental Europe. The U.S. is somewhere in the middle. Chart 1Fed’s Pivot On Display With that out of the way, the recent broadening out of the U.S. yield curve inversion to the 10/fed funds rate took center stage in our client interactions, especially the implications of the inversion for sector positioning and the duration of the business cycle. To set the record straight, a yield curve inversion does not forecast recession. Instead, it explicitly signals that the market expects the Fed’s next move to be an interest rate cut (top panel, Chart 1). In that context, the yield curve has never had a false-positive reading. Even in May 1998, it accurately forecast that the Fed would decrease the fed funds rate as it actually did in the fallout of the LTCM meltdown later that year (bottom panel, Chart 1). As equity investors, what consumes us is the SPX’s performance following the yield curve inversion. On that front, mid-December last year we showed the results of our research and made a simple observation that the yield curve inversion almost always takes place prior to the S&P peak (Table 2, Charts 2 & 3). Table 2Yield Curve Inversions And S&P 500 Peaks Chart 3…And Then The SPX Peaks In addition, today we show the S&P 500’s return and the sector returns from the time the 10/2 yield curve slope inverts until the S&P peaks, and we summarize the results in Table 3. Table 3Sector Returns From Y/C Inversion To SPX Peak While every cycle is different, clearly it pays to have energy exposure more often than not. In contrast, high-yielding defensive sectors like utilities and telecom services fare poorly in these late-cycle iterations. Meanwhile, Table 4 highlights sector performance from the SPX peak until the U.S. recession hits. We first showed these results on May 22, 2018, and we are on track to publish a Special Report on May 5 on how to position portfolios at the onset of a Fed easing cycle, so stay tuned. Table 4Defensive Stocks Beat Late Investors remain infatuated with the recession signal that the yield curve inversion emits. Moreover, recent news of an onslaught of Unicorn IPOs that would bring stock supply to the equity market, near the $100bn mark on an annualized basis according to some estimates, have also brought forward recession fears, as smart money is cashing in on their investments. Chart 4 shows that $100bn per annum in IPOs has coincided with the SPX peak in the previous two cycles. Our long-held view remains that either a mega M&A deal in the tech or biotech space or Uber’s IPO at a stratospheric valuation could serve as the anecdote that confirms the current cycle’s peak. On the yield curve front specifically, the top panel of Chart 5 shows that the most important yield curve, the 10/2, has not yet inverted. Moreover, the 30/10 and the 30/5 slopes are steepening. True, we are late cycle, but we need all the slopes to invert to get a confirmation that the recession is a foregone conclusion. Chart 4Mind The Excess Supply Chart 510/2 Y/C Has Yet To Invert The Fed’s tightening cycle has not only inverted most parts of the yield curve starting early last December, but has inflicted some damage on profit margins. Following up from our recent profit margin work highlighting nil corporate pricing power at a time when wage costs are perking up, BCA’s Monetary Indicator signals more SPX margin pain in the coming months (Chart 6). In fact, sell-side estimates call for another three consecutive quarters of a year-over-year contraction in profit margins. Chart 6Margin Trouble In more detail, the earnings deceleration that commenced in Q4 2018 and is gaining steam is disconcerting. As a reminder, Q4 included the lower corporate tax rate and the Q/Q deceleration is not solely due to the tech sector profit warnings. Eight out of the 11 GICS1 sectors sharply decelerated, two modestly accelerated and only industrials steeply accelerated to a cyclical EPS peak growth rate (Table 5). This EPS breadth deterioration is eerily reminiscent of early-2015 (Chart 7) and is disquieting. Short-term caution is also warranted given the increase in investor complacency. The one sided positioning in the VIX futures market is worrisome. As a reminder, net speculative positions are now at a lower low than the February 2018 level when the VIX snapped to over 50 and caused a massive tremor in the equity market (net speculative positions shown inverted, Chart 8). Table 5Historical/Current/Future Earnings Growth Rates Chart 7Bad Breadth Chart 8Too Complacent But, before getting overly bearish there are some growth green shoots that suggest that Q2-to-Q3 will likely mark the trough in EPS/EBITDA growth and margins (Chart 9). Beyond these positive leading profit indicators, a resolution to the U.S./China trade tussle and China’s trifecta of policy easing measures will also aid in turning profit growth around and really power up U.S. cyclicals’ EPS growth rates. Following up from the January Fed meeting, on February 4 we penned a report titled “Don’t Fight The PBoC” and it is now clear with the recent manufacturing PMI release that China’s easing on all three fronts – credit (Chart 10), monetary (Chart 11) and fiscal (Chart 12) – is starting to pay some dividends. In that light, the U.S. cyclicals vs. U.S. defensives recent outperformance has more room to run. Chart 9Growth Green Shoots Chart 10Chineasing… Chart 11...On All… Chart 12…Fronts   Deep cyclicals have another major advantage this cycle compared with defensives. While at this stage of the business cycle one would expect capital intensive businesses to become debt saddled, cyclicals are still de-levering from the depths of the late-2015/early-2016 manufacturing recession, i.e. paying down debt and increasing cash flow. Defensives, however, are doing the exact opposite with relative cash flow growth problems and piling on debt. Thus, on a relative basis Chart 13 shows that the indebtedness profile clearly favors deep cyclicals vs. defensives. From a bigger picture perspective, while the U.S. has not really purged any debt and it has just shifted it around from the financial and household sectors to the non-financial business and government sectors (Chart 14), the near all-time high in non-financial business sector credit as a share of GDP is disconcerting (top panel, Chart 14). Clearly the excesses are in this segment of U.S. debt and it is unsurprising that debt saddled stocks have been underperforming equities with pristine balance sheets since the 2016 presidential elections (top panel, Chart 15). Such outperformance has staying power, especially given that we are late in the cycle and the Fed has raised interest rates to the point where parts of the yield curve are inverted and a default cycle looms large (bottom panel, Chart 15). Chart 13Cyclicals Have The Upper Hand Chart 14U.S. Debt Profile Breakdown One sub-sector that epitomizes the current cycle’s excesses is commercial real estate (CRE). CRE prices have overshot the historical time trend by almost two standard deviations and it has already been three and a half years since they surpassed the previous all-time high (Chart 16). The recent pullback in the 10-year Treasury yield has pushed cap rates even lower and the bubble in CRE is further inflated. Looking back at the late-1980s pricking of that CRE bubble is instructive and when this cycle ends a big deflationary impulse will likely deal a blow to the CRE market.       Chart 15Hide In Pristine Balance Sheets Chart 16CRE Excesses Are A Yellow Flag Speaking of bubbles, the biggest bubble we currently see is not in equities, but in bonds. Table 6 shows that red is taking over and is reminiscent of mid-year 2016 when the 10-year U.S. Treasury yield troughed a hair above 1.3%. Globally, negative yielding debt is near all-time highs (Chart 17) and the excesses are even larger in the EM sovereign space and in select DM corporates. Mexico raising century debt in U.S. dollars, in cable and in euros is perplexing, as Mexico was at the epicenter of the 1982 LatAm crisis and again in 1994 with the Tequila crisis. Argentina also raising century debt recently in hard currency speaks to the magnitude of the current bond bubble. On the corporate side, Sanofi and LVMH placing negative yielding debt is beyond our understanding, or Total issuing a perpetual bond with a 1.75% coupon. Table 6Red Takes Over   Chart 17Bonds Are In A Bubble All of this is likely linked to the unintended consequences of global QE where fixed income investors are pushed out the risk spectrum and are forced into buying riskier credit. When this bond bubble gets pricked it will end in tears as it always does and the catalyst will likely be the next U.S. recession that will cause a global recession. While our cyclical 9-to-12 month equity market view is constructive and we believe the U.S. will avoid recession, our structural 1-to-3 year view is negative. Nevertheless, we constantly challenge our thesis and the biggest pushback to the negative structural view is the following: What if the Fed can engineer a soft landing in the U.S. as it did twice in the mid-1990s, and the business cycle runs hot for another 5 years (Chart 18)? What if the starting point of low interest rates with the real fed funds rates still close to zero is very stimulative for the U.S. economy as no recession has ever started with a fed funds rate perched near zero (Chart 19)? Finally, what if the late-2015/early-2016 manufacturing recession was actually an economic recession despite the fact that the NBER did not designate it as such and the business cycle got reignited, especially with President Trump’s election that lifted animal spirits? As a reminder, while S&P profits have contracted outside of an economic recession twice before, SPX sales had never achieved that feat, until late-2015/early-2016 (Chart 20). In other words, the revenue recession we had was unprecedented and felt like an economic recession. Chart 18The Fed Has Engineered A Soft Landing Chart 19Stimulative Real Rates Chart 20There Is Always A First Time If that were the case and the cycle were to extend into the 2020s, then the risk is that SPX EPS vault to $200 and valuations overshoot, i.e. the forward P/E multiple spikes to a 20 handle and the SPX catapults to 4,000. In that case, we would leave 1,000 points on the table and our SPX 3,000 view would be way offside. While this is a risk to our negative structural view, there are two sectors we really like for the long-term as we deem them secular growth plays and should do exceptionally well on a 10-year horizon: software and defense stocks. Three key drivers underpin our bullish view on software: galloping higher private and public sector software outlays, a structurally enticing software demand backdrop and ongoing industry M&A (Chart 21). Most importantly, the move to cloud computing and SaaS, the proliferation of AI, machine learning and augmented reality are not fads but enjoy a secular growth profile, and signal that capital outlays on software are in a structural uptrend. With regard to defense stocks, the three key pillars we highlighted in our “Brothers In Arms” Special Report on October 31, 2016 remain intact: the global rearmament is still gaining steam, a space race with manned missions to the moon now includes the U.S., China and India, and cybersecurity is a real threat for governments around the world (Chart 22). On all three fronts, defense stocks stand to benefit as they have beefed up their offerings to provide governments with a one-stop shop solution covering most of these needs. Chart 21Buy The Software Breakout Chart 22Defense Stocks Remain A Long-term Buy     Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com

Highlights As long as Chinese policymakers remain committed to their anti-pollution campaign, we believe high-grade iron ore prices will remain supported by demand from newer steelmaking technologies. A continuation of the much-needed consolidation in steelmaking capacity in China – wherein larger, more efficient operators force their less competitive rivals from the market – will reinforce this trend (Chart of the Week). Chart of the WeekChina's Steel Sector Will Continue Consolidating Over time, the iron ore market will resemble other developed markets – e.g., crude oil – where higher- and lower-grades of the commodity are regularly traded against each other (Chart 2). As this develops, hedgers and investors will be able to fine tune exposures with greater precision, and prices from these markets will better reflect supply-demand fundamentals. The central and local governments also will have a valuable window on how policy is affecting fundamentals as they pursue their “blue skies” policies. We are initiating tactical spread, getting long spot high-grade 65% Fe vs. short spot 62% Fe at today’s Custeel Seaborne Iron Ore Price Index levels, consistent with our view.1 Chart 2Iron Ore Spread Markets Will Continue To Develop Highlights Energy: Overweight. The Trump administration is reviving the Monroe Doctrine with its demand Russia remove its troops and advisors from Venezuela immediately, based on comments by the U.S. National Security Advisor John Bolton. In addition, a “senior administration official” said waivers for eight of Iran’s largest crude oil importers could be allowed to expire May 4, and that the administration is considering additional sanctions against Iran.2 Brian Hook, the special U.S. envoy for Iran, this week said three of eight countries granted waivers to U.S. sanctions agreed to take oil imports to zero.3 In a related development, OPEC crude oil output fell to a four-year low of 30.4mm b/d in March, according to a Reuters’s survey, as Venezuelan output falls and Saudi Arabia continues to over-deliver on its production cuts. Base Metals: Neutral. Codelco’s mined copper ore output fell to 1.8mm MT last year, down 1.6% vs. 2017 levels. This took refined output down almost 3% to 1.7mm MT, according to Metal Bulletin. The Chilean state-owned company cited reduced ore content in its mined production as a reason for the decline. MB’s copper treatment and refining charges index for the Asia Pacific region is at its lowest level since March 26, 2018, reflecting the lower concentrate supplies. We remain long spot copper on the back of low inventories, and an expected recovery in demand. Precious Metals: Neutral. Strength in equities has taken some of the luster off gold’s rally in the near term as investors move to increase stock exposures, but we continue to favor gold as a portfolio hedge and remain long. Agriculture: Underweight. USDA’s corn planting intentions report released last week came in much stronger than earlier estimates. Corn and soybeans traded lower following the release of the report, but recovered some this week on the back of positive news from Sino - U.S. trade talks. The USDA estimated farmers intended to plant 92mm acres of corn, and 85mm acres of soybeans this year. Ahead of the report, a Farm Bureau survey estimated corn and soybean acreage would average 91.3mm acres of corn and 86.2mm acres of beans. Trade Recommendations: Our 1Q19 trade recommendations were up an average of 41% at end-March (Quarterly Performance Table below). Including recommendations that were open at the beginning of 1Q19, the average was 31%. Feature China’s push to reduce pollution in its steelmaking sector will continue to support demand for Brazil’s high-grade ores – i.e., ores with iron (Fe) content higher than 65%. Transitory Brazilian iron ore supply losses notwithstanding, China’s push to reduce pollution in its steelmaking sector will continue to support demand for Brazil’s high-grade ores – i.e., ores with iron (Fe) content higher than 65%. This will allow the continued development of an active spread market, not unlike spread markets in commodities like oil, which will expand hedging and trading opportunities for producers, consumers and investors (Chart 2). Older, more polluting steelmaking technology in China will continue to be replaced by plants that favor Brazil’s high-grade ores, then Australia’s benchmark-type grades (62% Fe), then, as a last resort, the lower quality domestic ores. In a steelmaking market still suffering significant overcapacity, we expect policymakers will, at some point, discover the benefit of letting markets forces do the work of forcing older technology offline, as happened with the country’s domestically produced lower-quality iron ore, which has lower iron content and higher impurities than Brazilian and Aussie imports.4 We believe growth in China’s steel and steel products demand – hence iron ore demand – likely has peaked and is in the process of flattening or declining slightly, which will alter the composition of iron ore imports and tilt them in favor of high-grade Fe imports from Brazil over the next 3 - 5 years (Chart 3). This leveling off in steel demand growth will put a premium on more efficient technology to meet future demand, particularly with the pollution constraints that will, we believe, be an enduring feature of this market.5 Chart 3China's Steel Demand Growth Likely Has Peaked Impurities found in lower-grade iron ore raise steelmaking costs by increasing unwanted mineral build-ups in blast furnaces, increase pollution and lower mills’ efficiency.  With inventories re-building following the winter steelmaking hiatus in China, imports will continue to grow market share at the expense of indigenous lower-quality ores (Chart 4). Imports from Australia, which mostly price to the 62% Fe benchmark, will continue to grow, but we strongly believe that in China’s post-anti-pollution-campaign market, Brazilian imports will see growth increasing (i.e., the 2nd derivative) at a higher rate (Chart 5). Chart 4Chinese Iron Ore Inventories Fall Relative To Steel Production Chart 5China's Brazil, Australia Import Growth Will Recover These imports are lower in cost, and higher in quality than the domestic iron ore. This is particularly important when it comes to keeping costs under control – impurities found in lower-grade iron ore raise steelmaking costs by increasing unwanted mineral build-ups in blast furnaces, increase pollution and lower mills’ efficiency. Extended Output Cuts Favor High-Grade Ores The biggest reason supporting our view high-grade iron ores will continue to grow market share at the expense of lower-quality domestic supply and benchmark 62% Fe material is the recent behavior of the central government and local governments vis-a-vis pollution. Both have shown they are not averse to extending operating restrictions on high-polluting industrial plants, even in provinces where steelmaking is a large employer. Last year, major steel producing regions– Hebei, Jiangsu, Shandong, Liaoning – increased production during the winter months, likely driven by higher margins at the steelmakers (Chart 6). This indicates compliance with anti-pollution regulations fell significantly (Chart 7). In turn, this led to higher pollution, according to the latest available data from China’s National Environmental Monitoring Centre, which shows concentrations of particulate matter 2.5 micrometers or less in diameter (i.e., PM2.5) rose again this year (Chart 8). Chart 6Higher Margins, Higher Output Consequently, Chinese authorities decided to tighten anti-pollution measures by extending production cuts beyond the heating season into 3Q and 4Q19.6 Furthermore, the top producing city, Tangshan, in the province of Hebei extended its most elevated level of smog alert on March 1 and deepened production cuts to 70% from 40%, with reported cases of complete operations being halted. Chart 8China's Pollution Is Increasing; Steelmaking Curbs Will Persist Last month, Chinese Communist Party (CCP) officials in Hebei announced plans to cut steel production by 14mm MT this year and next. Going forward, China’s environment ministry said winter restrictions will be extended for a third year during the 2019-2020 winter period. As we argued last year, winter curbs likely will become a permanent feature of China’s steelmaking landscape. Combined with China’s steel de-capacity reforms, iron ore and steel markets will continue to evolve to a less-polluting presence in the country.7 As a consequence, IO grade and form differentials are now crucial input in our analysis.8 We believe a wider than usual premium will remain until new high-grades and pellets supplies come on line in the next few years. Credit Stimulus Vs. Battle For Blue Skies The reversal in China’s credit cycle and in the Fed’s monetary policy stance will be supportive of steel and iron ore prices going forward. In fact, our credit cycle proxy suggests global industrial activity will increase in the next few months (Chart 9).9 Additionally, our geopolitical strategists’ base case suggests a resolution of the Sino-U.S. trade war likely will occur this year. This will support EM income growth, which will stimulate commodity demand generally at the margin. Chart 9Upturn in China's Credit Cycle Will Support Iron Ore Prices We believe China’s credit cycle bottomed in 1Q19 and that Chinese authorities will modestly increase stimulus in 2H19.10 As discussed previously, we do not expect this new round of stimulus to be as large as previous rounds; China’s economy is in better shape now than it was at the start of previous expansionary credit cycles, hence the magnitude of the stimulus needed to revive the economy is lower. Nonetheless, this stimulus will be sufficient to strengthen China’s and EM’s steel-intensive activities in the coming months. As long as China maintains its anti-pollution drive, high-grade iron ore will continue to grow market share. Historically, these sectors correlated positively with the 62% Fe content benchmark (Chart 10). However, the expected stimulus works against Beijing’s critically important battle for blue skies. A revival of China’s industrial activity would increase PM2.5 concentrations above targets. Chart 10China's Stimulus Will Stoke Iron Ore Demand These constraints, we believe, mean China’s policymakers will have to incentivize steelmakers to favor lower-polluting high-grade iron ore (Fe > 65%), in order to maximize steel output subject to their emissions target. This will widen the form and grade premiums ahead of next year’s winter period. Bottom Line: As long as China maintains its anti-pollution drive, high-grade iron ore will continue to grow market share, as steelmakers upgrade their technology and inefficient mills are shuttered. This will favor Brazilian exports going forward, and we expect the rate of growth in these imports to increase. In line with our view, we are opening a long 65% Fe spot vs. a short 62% Fe spot position at tonight’s close. This is a tactical position, but could easily become a strategic recommendation.   Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com   Footnotes 1      This index is published by Beijing Custeel E-Commerce Co., Ltd. 2      We flagged this risk in our February 21, 2019, report entitled “The New Political Economy of Oil.” We noted the odds of a U.S. – Russia military confrontation are low, and that “the U.S. would revive the Roosevelt Corollary to the Monroe Doctrine, and that Russia and China most likely would concede Venezuela is within the U.S.’s sphere of influence, as neither intends to project the force and maintain the supply lines … a confrontation would require.” That said, there is always the risk such a confrontation could go kinetic, or that either or both sides could lunch a cyberattack to disable its adversary. The Roosevelt Corollary refers to U.S. President Theodore Roosevelt’s extension of the Monroe Doctrine at the beginning of the 20th century, which has been used by the U.S. to justify the use of military power in the Western Hemisphere. Our February 21 report is available at ces.bcaresearch.com, as is a Special Report on Venezuela published November 22, 2018, entitled “Venezuela: What Cannot Go On Forever Will Stop,” which discusses Venezuela’s debts to China and Russia, et al. See also “Exclusive: Trump eyeing stepped-up Venezuela sanctions for foreign companies – Bolton” and “Oil hits 2019 high on OPEC cuts, concerns over demand ease,” published by reuters.com March 29 and April 2, 2019, respectively. 3      Please see “Three importers cut Iran oil shipments to zero - U.S. envoy” published April 2, 2019, by reuters.com. 4      According to Platts, “at least half of China’s previous 300 million mt plus iron ore mining capacity has left the market for good.” Please see “China’s quest for cleaner skies drives change in iron ore market,” published January 30, 2019, by S&P Global Platts. CRU estimates average iron content in China’s ores is 30%, which means they must undergo costly upgrading to be useful to steelmakers. 5      Australian miners are expected to bring on significant volumes of high-grade iron ore beginning in 2022 - 23, with Fe content as high as 70%, according to the Department of Industry, Innovation and Science’s March 2019 Resources and Energy Quarterly. 6      Please see “Tangshan mulls output curbs for 2nd, 3rd quarters of 2019” published January 22, 2019, by metal.com. 7      Please see China to extend winter anti-smog measures for another year published March 6, 2019, by reuters.com. 8      Grade premium: The chemistry of iron ore supply varies widely in terms of Fe content. Higher Fe content reduces production cost and pollution per unit of steel output. The higher the quality, the higher the volume of steel produced relative to energy consumed. The current global benchmark iron ore is 62% Fe, but China’s evolution to a less-polluting steelmaking sector will raise the importance of higher-grade markets. Form premium: A steelmaker’s blast furnace typically consumes iron ore in pellets, fines or lumps combined with coking coal. Fines are the most common form of iron ore, and account for ~ 75% of total seaborn IO market. This form cannot be directly fed in the blast furnace and requires an extra sintering step. Sintering is highly polluting and coal-intensive process that compresses fines into a more useable form. This process is usually conducted on-site at steel mills. On the other hand, lumps and pellets are direct feedstock and therefore completely avoid the highly polluting sintering step. Both types of premium are primarily affected by environmental policies in consuming countries, coke prices and steelmills’ profitability. 9      Modeling historical iron ore prices remains difficult because of the short sample available for spot iron prices – i.e., the benchmark 62% Fe. Before 2009, iron ore prices were determined using a producer pricing system. Once a year, prices were negotiated by miners and steelmakers and would be fixed for the remaining of the year. Given that iron ore supply was plentiful relative to demand, prices were fairly stable and this mechanism was used for over four decades. The rapid rise of emerging economies – mainly China – during the 2000s forced the pricing system to adjust toward a spot-market pricing system. The short spot-price time series available for analysis increases the distortion of policy-driven exogenous shocks like China’s de-capacity and winter restriction policies. This makes it difficult to identify the underlying relationships between its price and potential explanatory variables, and forces us to rely on theory and analogous experience in other markets like crude oil. 10     Please see BCA Commodity and Energy Strategy Weekly Report titled “Bottoming Of China’s Credit Cycle Bullish For Copper Over Near Term,” published March 14, 2019. It is available at ces.bcaresearch.com Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade Recommendation Performance In 2019 Q1 Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades

Highlights Maintain a pro-cyclical stance for the time being – overweight equities versus bonds, long commodities, overweight industrial equities, and underweight healthcare equities. But be warned, absent a continued decline in the bond yield and/or oil price, short-term positive impulses on the economy will fade and even turn negative later in the year. Hence in the summer months, look for opportunities to take profits in these pro-cyclical positions. U.K. economy plays can outperform once a cross-party parliamentary majority is found for a course of action that leads to an orderly Brexit (or no Brexit). Feature At the end of last year, we made a bold prediction: economies and financial markets would follow the opposite path in 2019 compared to 2018. Specifically we pointed out that “through most of 2018, global growth was decelerating while inflation was accelerating. Now this configuration is flipping: global growth is rebounding while inflation is set to collapse… 2019 will present investors a mirror-image pattern to 2018” (Chart of the Week). Chart of the WeekWhy 2019 Is The Opposite Of 2018 Four months on, we are delighted to report that the mirror-image pattern is unfolding exactly as predicted. This year, stock markets are up sharply; bond markets have rallied; metal prices have made double-digit gains, growth-sensitive industrial shares are outperforming; while defensive healthcare shares are underperforming. All of these are the precise opposite of what happened in early 2018 (Chart 1-2 - Chart I-6). Chart I-2Equities: 2019 Is The Opposite Of 2018 Chart I-3Bonds: 2019 Is The Opposite Of 2018   Chart I-4Commodities: 2019 Is The Opposite Of 2018 Chart I-5Cyclicals: 2019 Is The Opposite Of 2018   Chart I-6Defensives: 2019 Is The Opposite Of 2018 Why 2019 Is The Opposite Of 2018 The basis for our bold prediction was twofold. We noted that China’s 6-month credit impulse “had gone vertical” (Chart I-7). Indeed, the rebound from the trough amounted to $500 billion (and still counting), equivalent to a near 1 percent shot in the arm for global GDP. Chart I-7China's 6-Month Credit Impulse Has Gone Vertical We also argued back then that “a racing certainty for early 2019 is that headline inflation will collapse. This is because the plunge in the crude oil price is about to feed through into headline consumer price indexes. Inevitably, it will seep through into core inflation too, via the impact on energy dependent prices such as transport costs.” “Coming at a time that central banks have professed a much greater reliance on incoming data, we can deduce that central banks will find it hard to tighten policy in the face of weaker headline and core inflation prints. Crucially though, the ECB and BoJ were not planning on tightening policy anyway, so the plunge in reported inflation will be much more impactful on the Federal Reserve.” Lo and behold. China’s PMI has rebounded sharply, and the Fed has stopped hiking rates. Still, central banks’ enhanced ‘data-dependency’ carries perils. The high-profile hard data – such as CPI inflation and GDP growth prints – on which monetary policy ‘depends’ is a record of what happened in the past, sometimes the distant past. This year’s market moves are the precise opposite of what happened in early 2018. Hence, enhanced data-dependency means that central banks are now ‘driving by looking through the rear-view mirror’ rather than looking at the current terrain. In turn, monetary policy expectations are driving bond and equity market valuations. By contrast, equity market growth expectations are based on the here and now; they move in synch with economic activity in real-time, leading even the survey-based PMIs. This also solves the puzzle as to why bonds and equities can sometimes give conflicting messages. Last year, the configuration of accelerating inflation with decelerating global growth hit equities and with a lose-lose: heavy pressure on both valuations and growth expectations. Furthermore, when interest rates rise from low levels they undermine the support for elevated risk-asset valuations in a viciously non-linear way. Chart I-8In 2018, Higher Bond Yields Pressured Equity Valuations At low interest rates, bond prices develop the same unattractive negative asymmetry as equities. Therefore, an extended period of ultra-low interest rates removes the need for an equity risk premium, and justifies sharply higher valuations for equities and other risk-assets. But in early 2018, as hawkish central banks pushed up 10-year global bond yield towards 2 percent, this process reversed viciously: bond prices lost their negative asymmetry, re-requiring an equity risk premium and sharply lower valuations for risk-assets at a time that growth expectations were also sliding (Chart I-8).1 By contrast, the early 2019 configuration of dovish central banks and accelerating short-term credit impulses has provided equities a ‘mirror-image’ win-win: a boost to both valuations and to growth expectations.  What Happens Next In 2019? Chart I-9Headline Inflation Will Soon Tick Up Understand that the all-important impulses to an economy do not come from the level of the bond yield, oil price, net exports, inventories, and so on. The impulse always comes from the change in these metrics. And as the metrics cannot decline (or rise) incessantly, impulses always fade and then reverse. The oil price has rebounded 30 percent from its recent lows. Necessarily, this means that headline inflation prints will soon stabilise or even tick up (Chart I-9). Furthermore, central banks’ abrupt pivot to dovish has already happened. It would be hard to repeat or continue such a move. As central banks react to the inevitably backward-looking hard data prints, our expectation is that bond yields will stabilise or even tick up. Will equity markets also react positively to the better economic data prints? Not necessarily. To repeat, equity markets’ growth expectations move in synch with economic activity in real-time, leading even the survey-based PMIs. Equity markets never wait for the backward-looking data prints. China plays are tracking its short-term credit impulse which has gone vertical (Chart I-10). Hence, in 2019 to date, U.K. mining stocks are already up 25 percent; the Shenzhen Composite is already up 40 percent! Chart I-10China Plays Have Already Surged Still, the current win-win configuration can continue for a little while longer, given that a typical upswing in short-term credit impulses lasts around eight months. But be warned, absent a continued decline in the bond yield and/or oil price, short-term impulses will fade and even turn negative later in the year. The early 2019 configuration of dovish central banks and accelerating short-term credit impulses has provided equities a win-win. Hence, maintain a pro-cyclical stance for the time being – overweight equities versus bonds, long commodities, overweight industrial equities, and underweight healthcare equities. But our strong advice is: in the summer months, look for opportunities to take profits in all of these positions. When Will Brexit’s Groundhog Day End? We really would prefer not to talk about Brexit. It is not just that every day is Groundhog Day, every day is a shambolic Groundhog Day. Still, on a positive note this means that our investment strategy for Brexit has also remained a constant (Chart I-11). Chart I-11For Investors, Brexit Simplifies To A Binary Outcome It is not sufficient for the U.K. parliament to express what it is against (a no-deal Brexit); parliament must express what course of action it is for, leading to an orderly Brexit, or no Brexit, and that this course of action must also be acceptable to the EU27. At that point, irrespective of the exact course of action – a customs union, Common Market 2.0, or a confirmatory referendum in which ‘remain’ is an option – buy the pound, the FTSE250, and U.K. homebuilder shares. Theresa May’s overture to engage in a national unity strategy with the Labour Party is a step in the right direction. In this regard, Theresa May’s overture to engage in a national unity strategy with the Labour Party is a step in the right direction, because it finally puts national interest above party interest. To be clear, Brexit has been trapped in Groundhog Day because there is insufficient support among Conservative and DUP MPs for a relationship with the EU27 that would: Protect the cross-border supply chains which are vital to so many U.K. businesses. Avoid a hard customs border on the island of Ireland or between Ireland and Britain. Deliver on the narrow 52:48 vote to leave the EU, which was driven by a desire to control migration and the supremacy of the European Court of Justice; rather than a desire to strike independent trade deals, which is irrelevant for a majority of voters. The ray of light is that there is potentially a broader cross-party parliamentary majority for a course of action that would meet the above three conditions. Once it is found, U.K. economy plays can look forward to the “sunlit uplands”. Fractal Trading System* In line with the main body of this report, we continue to see evidence that the recent rally in bonds is technically extended. Accordingly, this week’s recommended trade is to short the 10-year OAT. The profit target is 1.3 percent with a symmetrical stop-loss. In other trades, short INR/PKR hit its 3 percent stop-loss and is now closed, 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-12 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 Footnotes 1 Please see the European Investment Strategy Weekly Report “Risk: The Great Misunderstanding Of Finance”, October 25, 2018 available at eis.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 Chart II-2Indicators To Watch - Bond Yields   Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Highlights The meaningful improvement in the March manufacturing PMIs (both Caixin and official) all but confirms that a rebound in Chinese economic activity is forthcoming. The odds that investors will look through any near-term economic and/or earnings weakness are directly related to the likely magnitude of the expansion in credit over the coming year, and our research points to the need for the recent pace of credit growth to be sustained in order to stabilize the outlook for earnings. Barring a substantial breakdown in trade talks between China and the U.S., a strong March total social financing release would likely tip the scales in favor of a recommendation to increase Chinese investable stock exposure within a global equity portfolio to overweight. Feature Tables 1 and 2 highlight key developments in China’s economy and its financial markets over the past month. On the growth front, coincident economic activity has sharply converged with our leading indicator for China’s economy, which we highlighted was likely to occur. Looking forward, while we await the March total social financing release later this month for a better sense of the likely magnitude in credit growth over the coming year, the meaningful improvement in the March manufacturing PMIs (both Caixin and official) all but confirms that a rebound in Chinese economic activity is forthcoming. Table 1China Macro Data Summary Table 2China Financial Market Performance Summary​​​​​​​ The likely magnitude of the uptrend in credit is important from an investment strategy perspective, as we have highlighted that weak coincident activity raises the risk of a lagged but meaningful further decline in Chinese earnings per share over the coming few months. The odds that investors will look through any near-term economic and/or earnings weakness are directly related to the ultimate size of the expansion in credit, and our research points to the need for the recent pace of credit growth to be sustained in order to stabilize the outlook for earnings. But the bottom line for investors is that we recently placed Chinese investable stocks (i.e. the MSCI China Index) on upgrade watch, and the March PMI is a step in the direction of a recommendation to increase equity allocation to overweight within a global stock portfolio. Investors should closely watch the March total social financing data (due to be released in mid-April); a strong release, barring a substantial breakdown in trade talks between China and the U.S., would likely tip the scales in favor of a move to overweight. In reference to Tables 1 and 2, we provide several detailed observations concerning developments in China’s macro and financial market data below: Chart 1 shows that coincident economic activity sharply converged in January and February with our leading indicator for China’s economy, as we had argued many times over the past several months was likely to occur. In our view, most if not all of the previously beneficial tariff front-running effect has probably washed out of the data, implying that future changes in activity measures are now more likely to reflect actual changes in underlying economic circumstances. Chart 1A Convergence That We Predicted The components of our LKI leading indicator continue to point to divergent outcomes for the Chinese economy (Chart 2). Monetary conditions have weakened somewhat over the past few months, but remain quite easy relative to history. The credit components bounced in January but are still weak relative to their history, whereas money growth is extremely weak and has shown no sign of improvement. Barring a major rise in the RMB, a continuation in the recent pace of credit growth would likely be enough to cause our leading indicator to trend higher, particularly if money growth begins to pick up. Chart 2An Uptrend In Credit Growth Will Push Our Leading Indicator Higher We noted in our March 13 Weekly Report that growth in residential floor space started was unsustainably strong,1 and the January/February data update confirmed this view. Growth in starts has decelerated by 10 percentage points from December to February, highlighting that housing construction cannot permanently decouple from sales volume and that a further deceleration is possible unless sales growth (which is currently negative) begins to pick up. The PMI rebound in March registers as one of the most important macro developments since the release of the January total social financing data. Both the Caixin and official manufacturing PMI data came in solidly positive for March, rising relative to their February values and surprising consensus expectations to the upside. Chart 3 highlights that the March Caixin data has pushed the series above its post-2010 median, whereas the official PMI has risen to its 40th percentile from essentially its lowest point in the past decade. In our view, the PMI rebound registers as one of the most important macro developments since the release of the January total social financing data, in that it all but confirms that a rebound in (still depressed) Chinese economic activity is forthcoming. Chart 3A Very Sharp Rebound In Both Manufacturing PMIs Despite having rallied significantly from their low, Chinese stocks (both investable and domestic) remain approximately 20% below their early-2018 high in US$ terms. This is in contrast to global stocks, which are only 7% shy of their 2018 high. If Chinese equities can avoid a major earnings recession, this discrepancy underscores that there is further upside for stock prices in relative terms over the coming 6-12 months. For the A-share market, however, Chart 4 highlights a potential near-term roadblock for continued outperformance versus global stocks. The chart highlights that the relative performance trend is now bumping up against the upper end of a declining trend channel that has been in place for almost 4 years, a bearish pattern that is in stark contrast to that of the investable market. Conversely, a break outside of this channel would warrant attention, as it could signal a secular change in trend for the domestic equity market. Chart 4Is The Four Year Downtrend In A-Share Relative Performance Over? Chart 5 highlights that the strange combination of consumer staples and real estate stocks have been the clear sector winners over the past month, both in the investable and domestic markets. Signs of stabilization in consumer spending explains staples outperformance, but the rally in real estate stocks is more difficult to explain given the weakness in housing fundamentals referenced above. For now, our bias is to believe that real estate stocks are benefitting as a value play, given their deep discount relative to both their respective broad markets and their global peers. Chart 5A Sharp Rebound In Staples And Real Estate Stocks China’s 7-day interbank repo rate has increased somewhat over the past month, raising speculation that the PBOC may soon proceed with a generalized cut to the reserve requirement ratio. In our view, the trend in the 3-month interbank repo rate has been more important over the past few years, as it has closely correlated since late-2016 with average interest rates in the economy and sharp declines in the rate last year preceded the pickup in credit growth observed in January. Still, additional easing from the PBOC could be significant for market participants, as it would likely be greeted positively by investors and could further stoke the belief that Chinese credit growth may overshoot to the upside over the coming 6-12 months. A stronger RMB versus the euro will be welcome news for European exporters. In contrast to a significant improvement in domestic equity prices and investor sentiment, Chinese onshore corporate bond spreads have actually inched higher over the past month. While the rise has been comparatively small (8 basis points), spreads now stand at roughly a third of their 12-month range. A rising trend in onshore corporate bond spreads is not consistent with a slower pace of defaults over the coming 6-12 months, suggesting that at least some headwinds facing the Chinese economy will remain over the coming year if the recent trend in spreads continues. While CNY-USD has been largely flat over the past month, CNY-EUR has continued to rise and is now within striking distance of its 2018 high (Chart 6). This is not likely welcome news for Chinese exporters with close ties to Europe, but it may help provide a much-needed trade boost to the European economy over the coming year, whose manufacturing PMI has recently fallen to a six-year low. Chart 6A Stronger CNY-EUR Cross Will Help Boost Chinese Imports From Europe   Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com Footnotes 1 Please see China Investment Strategy Weekly Report, “China Macro And Market Review”, dated March 13, 2019, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Special Report

Dear Client, Instead of our regular Weekly Report, this week we are sending you a Special Report written on February 20 by our Geopolitical Strategy service colleagues that discusses China’s recent stimulating efforts. We have only made a few minor revisions to account for the past month’s events. We trust that you will find this Special Report useful and insightful. Best regards, Anastasios Avgeriou, U.S. Equity Strategist   Highlights So What? China’s January-February credit data suggest that stimulus is here. Why? China’s early-year credit and fiscal policies suggest that stimulus risks are to the upside. January-February credit was a blowout number and fiscal spending is up. Equity bourses in South Korea and Russia are the most likely to benefit from Chinese stimulus. Industrial metals such as copper will also benefit – with a delay. Feature New credit data for China in January-February improves the chances that Beijing’s stimulus measures will overshoot this year, causing China’s economy to bottom in 2019 and jumpstart global growth. In our annual outlook for this year we argued that while China was stimulating the economy, the magnitude of stimulus would be the decisive factor for the global macro environment in 2019. We argued that the type of stimulus would remain primarily fiscal – tax cuts for households and small and medium-sized enterprises – and hence that it would be modest as fiscal easing would merely offset relatively weak credit growth. This view stemmed from our assessment of the Xi Jinping administration, highlighted in April 2017, as an “elitist” (not populist) administration. Its policy priorities are to discipline the Chinese economy, and in particular to contain systemic financial risk, which President Xi has cited as a national security threat. This view is not wrong, but the latest data clearly show that Xi has decided to pause these painful efforts at limiting leverage and rebalancing China’s economy. Witness January-February’s decisive uptick in both total social financing (total private credit) and local government bond issuance (Chart 1). Chart 1Higher Risk Of An Overshoot A massive spike in new credit is the single most important criterion in our “Checklist For A Stimulus Overshoot.” Thus, from a policy perspective, we are now at higher risk of an overshoot (Table 1). Not only credit as a whole but also informal lending saw a surge in January-February, implying that the government is relenting in its crackdown on the shadow banks. The approval of local government bond issuance for early in the year – and the People’s Bank of China’s announcement of a “Central Bank Bills Swap” program – reinforce this policy shift.1 Table 1Checklist For A Chinese Stimulus Overshoot In 2019   A stimulus overshoot is positive for Chinese demand in the short run but negative for potential GDP in the long run. A “traditional” credit surge of this nature cannot be surgically targeted at SMEs or households. It will go to state-owned enterprises, privileged corporations, property developers, and the like, which have always had the advantage in China’s financial system. SOEs have taken a much larger share of new loans than private companies in recent years,2 and the only silver lining of this trend was the possibility that tighter credit controls would discipline the SOEs. That silver lining is now fading, barring some new and surprising development on the reform front. China needs to create 26 trillion renminbi in new credit over the course of the year to avoid a corporate earnings contraction. These January-February numbers put China on track to do just that (Chart 2), assuming that President Xi and U.S. President Donald Trump agree to a short-term, framework trade deal this year. Chart 2On Track To Avoid An Earnings Contraction Of course, a few caveats are in order. First, January-February’s credit number is only one data point and credit growth is always abnormally strong in the first month of the year. Early in the year, banks seek to expand their assets rapidly in a bid to get as much market share as possible before administrative credit quotas kick in. Because of Chinese New Year, it is best to combine January and February data to get a sense of the rate of credit expansion in the first part of the year. This year’s January-February numbers are very strong relative to previous years (Chart 3) and the context is more accommodative than the 2017 January-February credit surge, when authorities were beginning to tighten rather than ease macroprudential policy. Still a rapid rate of credit expansion will have to be sustained in the coming months in order to meet the 26 trillion RMB requirement highlighted above. Second, there is some risk that China’s households and private businesses will not respond as positively today as in the past. The intensification of Communist Party control over the society and economy, President Xi’s cancellation of term limits, and the strategic confrontation with the United States have created a bearish sentiment in the private sector. Our Emerging Markets Strategy would point out that if the propensity to consume, and money velocity,3 do not accelerate, then a surge in new credit may fail to ignite a reacceleration in China (Chart 4). Chart 4Chinese Are Holding On To Their Money Still, what we now know is that Xi Jinping and his top economic adviser, Vice Premier Liu He, are not initiating the “assault phase of reform” that their predecessors initiated in the late 1990s in order to cleanse China’s economy of bad loans and zombie companies. Instead, they are likely reestablishing the “Socialist Put” in order to reverse the current deceleration, demonstrate China’s continued economic might and face down the United States’ threat of tariffs. Bottom Line: China’s stimulus measures are increasingly likely to overshoot, with positive implications for both Chinese and global growth. China is still facing a corporate earnings recession, but the odds of averting it are increasing. Trade Deadline More Likely To Be Extended What of the trade war? First, we would warn clients that China’s annual credit origination is a much bigger factor for the global economy than China’s exports to the United States (Chart 5). The trade war can escalate from here and yet, if China’s stimulus works as it has in the past, the results will be manageable for China’s economy save for Chinese companies expressly exposed to the U.S. economy through exports. In reality, both the U.S. and China are now effectively stimulating their economies and in this sense global trade as a whole will benefit regardless of bilateral tariffs. Chart 5Watch China Credit, Not So Much The Trade War But it is possible that just as global equity markets ignored China’s economic slowdown and only sold off when the tariffs were levied (Chart 6), they may not continue to rally much on China’s credit data. Given the already considerable rally in global risk assets since October, markets may not be satisfied merely with one or two months of solid credit data out of China without a clear resolution to the trade conflict. After all, if a collapse in U.S.-China trade talks portends a new Cold War, then institutional investors may be justified in taking a wait-and-see approach despite China’s credit cycle upswing. Chart 6Will Equities Ignore China Data (Again)? In the past, we have highlighted that the U.S. and China are not economically prohibited from engaging in a trade war – the export exposure is too small – and China’s new stimulus reinforces this point. However, President Trump is concerned about causing a sell-off in the tech sector and hence the broad equity market which could translate into a bear market and raise the probability of a recession occurring prior to November 2020. Meanwhile, in China, given Beijing’s reported trade concessions, there is apparently a desire to pacify the relationship and discourage U.S. unilateral tariffs and sanctions that could become seriously destabilizing for the Chinese economy and society. The need to have a happy 2021 centenary celebration for the Communist Party may factor into policymakers’ thinking. The latest news flow is mildly positive for the odds of getting a framework deal sometime this year. President Trump visited the Chinese negotiators in Washington, D.C. while President Xi reciprocated with the American negotiators in Beijing. A new round of two-week shuttle diplomacy is beginning. Trump has extended the tariff ceasefire and the two sides reportedly have arrived at an agreement on currency and are drafting written agreements on other areas of dispute. China’s National People’s Congress has passed a new Foreign Investment Law that ostensibly guarantees many of the American demands on forced tech transfer, intellectual property theft, and discriminatory treatment of U.S. companies (Table 2). Table 2New Foreign Investment Law Would Be A Positive For U.S.-China Negotiations However, Presidents Trump and Xi have yet to schedule a new summit, which is probably necessary for a final deal. And there are murmurs from the press suggesting that China’s new law and other concessions are not going to satisfy the U.S. negotiators on the critical point of “structural changes” and a verification process. This leaves us inclined to change our trade war probabilities to increase the odds of an extension (Table 3). The improvement in U.S. financial conditions and China’s stimulus, if anything, make it more likely that negotiations will be extended, as both sides feel their economic and financial constraints less acutely. Table 3Updated Trade War Probabilities Bottom Line: Global and Chinese risk assets should rally on China’s credit uptick, but the lack of resolution of the trade war could continue to inhibit animal spirits – and the odds of a March 1 resolution are declining. Who Are The Equity Winners Of China’s Stimulus? China’s strong January-February credit number is supportive of global equity markets. That much is obvious. But which equity markets will benefit the most? In what follows we examine the relationship between Chinese credit and MSCI equity returns of various countries. We find that Malaysian, Australian, South Korean, and Indonesian equities are the most highly correlated with Chinese credit growth and are thus most likely to benefit from the recent upturn (Chart 7). On the other hand, France and Italy stand out as countries whose bourses are more insulated. Out of the markets that are positively correlated, South Korea and Russia stand out as relatively cheap (Chart 8). Thus we expect these equities to do especially well. By contrast, while Indonesia and the Philippines are highly leveraged to China, these markets are currently relatively expensive. BCA’s Emerging Markets Strategy is currently overweight Korean and Russian equities within the EM space, neutral Turkey (although recently upgraded from underweight), and underweight Indonesia and the Philippines. In addition to credit stimulus, we expect Chinese household consumption to also gain support going forward. This will likely be driven by policy stimulus targeting the consumer specifically and is best exemplified by the recently announced tax cuts (Chart 9), which we expect to trickle down to greater consumer demand and growth in retail sales. Our base case calls for 8%-10% growth in household consumption over the coming 12 months, up from the current 3.5%. However, consumer sentiment in China is weak. BCA’s Emerging Markets Strategy’s proxy for household marginal propensity to spend ticked up recently, after falling since early last year (see Chart 4 above). A resumption in the decline would highlight that households are increasingly unwilling to spend, which would translate into weaker retail sales despite policy efforts to boost consumption. Such a scenario – in which credit growth accelerates without a substantial uptick in consumer spending – is plausible, given that it occurred between mid-2015 and mid-2016 (Chart 10). In any case, whether Chinese stimulus comes in the form of the traditional credit channel, or instead in the form of fiscal stimulus to household consumption, the same equity markets will generally benefit the most (Chart 11). Chart 10...But Flattish Retail Sales Are Also A Possibility Indeed, global equity markets react the same way regardless of the type of stimulus implemented. For instance, MSCI returns for the Philippines, Sweden, Malaysia, Indonesia, and Turkey are more closely correlated to both Chinese credit growth and retail sales growth compared to Italy, Japan, and France. The same conclusion is reached when we look at the correlations between Chinese credit growth or consumption growth and individual MSCI sectors such as industrials and consumer discretionary (Chart 12). The relatively stronger correlation between Chinese credit growth and equity returns – as opposed to Chinese retail sales and equity returns – can be put down to the nature of Chinese imports. While industrial goods account for the bulk of China’s purchases of foreign goods, consumer goods excluding autos make up only 15% of China’s imports (Table 4). However, as Chart 12 illustrates, the relationship between China’s retail sales growth and global equities is much tighter in the case of the consumer discretionary sector, whether the latter is compared to global industrials sectors or the overall MSCI index. Table 4Import Composition Of Chinese Imports Equity market exposure to China is not always in line with the extent of each country’s trade exposure to China (Chart 13). There are some clear exceptions – most notably Mexico, which has the highest correlation coefficient with Chinese credit and consumption variables since 2010. However, this is likely due to idiosyncratic factors.4 Correlation does not imply causation, and we cannot conclude with certainty that Mexican equities will outperform amid China’s new round of stimulus. Nevertheless, given that Mexico is a very deeply liquid market that benefits amid EM bull markets, this may not be entirely coincidental. The correlations between global equity markets and Chinese credit peak two months after the stimulus measures are first implemented (Chart 14). This is more or less in line with adjusted total social financing’s correlation versus industrial metals. However, BCA’s Commodity & Energy Strategy has shown that copper’s correlations versus other measures of Chinese money and credit peak after roughly three quarters (Chart 15).5 This is evident in both the 2012 and 2015-16 stimulus episodes in which the bottom in copper prices lagged the bottom in China’s credit growth. Thus we may witness a rebound in equity markets on the back of China’s credit splurge before we see an improvement in annual returns on copper prices. Chart 15Copper Rallies Lag China Credit Stimulus Bottom Line: South Korean and Russian equities are best positioned to benefit from the positive surprise in China’s credit data. France and Italy are the worst positioned. Copper prices will rebound with a delay.  Investment Implications BCA’s Geopolitical Strategy recommends that investors stay long Chinese equities ex-tech relative to the emerging market benchmark. This is a tactical call initiated in August 2018 that is now becoming a cyclical call on the basis of the credit upswing. We also remain long the “China Play Index,” a basket of China-sensitive assets. A rebound in China’s credit data and stronger global growth will support copper demand. Prices are still 15% below the mid-2018 peak and are poised to benefit in this environment, especially given that global inventories are already falling. BCA’s Geopolitical Strategy recommends that investors go long copper. Meanwhile, BCA’s China Investment Strategy recommends (for now) staying only tactically overweight Chinese equities relative to the global benchmark, pending higher conviction that the pace of credit growth will be strong enough to overwhelm the negative ramifications of a continued deceleration in actual activity over the coming few months on sentiment and 12-month forward earnings expectations. Over the long run, Geopolitical Strategy would look to underweight Chinese equities, as we are not optimistic about China’s productivity and potential GDP. This is because of the negative structural consequences of continuing the Socialist Put (i.e., bad loans, zombie companies, trade protectionism). We would expect CNY/USD to remain relatively buoyant in the context of both trade negotiations with the U.S. and fiscal-and-credit stimulus. The trade talks can hardly succeed if CNY/USD is falling. Depending on whether and how soon China’s stimulus results in a durable economic bottom, global growth could stabilize and the USD could see a substantial countertrend selloff.   Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Roukaya Ibrahim, Editor/Strategist roukayai@bcaresearch.com   Footnotes 1          Please see Emerging Markets Strategy Special Report titled “China: Prepping A Bazooka?” dated February 14, 2019 available at ems.bcaresearch.com 2      Please see Nicholas Lardy, “The State Strikes Back: The End Of Economic Reform In China?” Peterson Institute For International Economics, January 29, 2019, available at piie.com. 3          Please see Emerging Markets Strategy Weekly Report titled “Dissecting China’s Stimulus,” dated January 17, 2019 available at ems.bcaresearch.com 4       The 2012 election of President Enrique Peña Nieto caused Mexican equities to outperform their EM counterparts. Similarly in 2015-16, U.S. outperformance relative to EM also supported Mexico relative to EM because Mexico’s economy is highly leveraged to its northern neighbor. In both periods Mexico’s outperformance was not caused by – but instead coincided with – Chinese credit stimulus. These idiosyncratic events biased the correlation between Mexico’s equity markets and Chinese credit growth to the upside. 5      Please see Commodity & Energy Strategy Weekly Report titled “Trade Wars, China Credit Policy Will Roil Global Copper Markets,” dated June 21, 2018, available at ces.bcaresearch.com.                  

Special Report

Highlights Currency markets continue to fight a tug-of-war between deteriorating global growth and easing global financial conditions. Meanwhile, history suggests that the trade-weighted dollar should have been 10-15% higher, based on portfolio flows and interest rate differentials. The more-muted bounce is a cause for concern. As the battle unfolds, likely winners in the interim will be safe-haven currencies such as the yen. Watch the gold-to-bond ratio for cues on where the balance of forces are shifting, with a rising ratio negative for the dollar. We expect a day of reckoning to eventually arrive for the U.S. dollar, once investors shift their focus towards the rising twin deficits, de-dollarization of the global economy and low expected returns for U.S. assets. Feature The recent calm in developed currency markets seems very eerie, given the storm that has gripped global financial markets over the past week. Dismal manufacturing PMI readings from Europe and Japan last week sent equity markets into a tailspin. The closely watched U.S. 10-year versus 3-month spread inverted, triggering panic selling among investors who favor this spread as their most reliable recession indicator. Equity markets in Asia are off the year’s highs, while regional bond yields are holding close to trading lows. Outside of oil, commodity markets have also been soft. Despite these moves, the trade-weighted dollar has been relatively stable. Over the last few months, most currency pairs have been narrowly trading towards the apex of very tight wedge formations. This has severely dampened volatility (Chart 1). Over the longer term, the stability of these crosses relative to gold has spooky echoes of a fixed exchange rate regime a la Bretton Woods (Chart 2). Chart 1An Eerie Calm In Currency Markets Chart 2Fixed Exchange Rates Versus Gold?   In physics, centripetal systems tend to stay in equilibrium, while centrifugal forces can explode in spectacular fashion. In the post-Bretton Woods world, it has been very rare for periods of extended currency stability to persist. This means constantly monitoring both the trend and magnitude of imbalances between economies to gauge where the pressure points are, and in what direction the corresponding exchange rates might eventually give way. The balance of forces driving the dollar outlook seems like a natural starting point for this exercise.  Global Liquidity And The Dollar Judging by most measures of relative trends, the dollar should be soaring right now. The March Markit manufacturing PMI releases last week showed that while both Japan and the euro area remain in contraction territory, the U.S. reading of 52.5 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 large 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 3). So far, the DXY dollar index is up 1.9% since October. Every time this measure has severely contracted in the past, the shortage of dollars has triggered a blowup somewhere. Until the U.S. Federal Reserve’s recent volte-face on monetary policy, relative yields also favored the greenback. The 2-year swap differential between the U.S. and the rest of the world pinned the DXY dollar index at 105, or 8% above current levels (Chart 4). Meanwhile, relative policy rates also suggest the broad trade-weighted dollar should be 6% higher. And even today, unless the Fed moves towards outright rate cuts, the dovish shift by other central banks around the world remains an immediate tailwind for the U.S. dollar. Chart 3USD Should Be Higher Based On Growth Divergences   Chart 4USD Should Be Higher Based On Swap Differentials   Internationally, the Fed’s tapering of asset purchases has been a net drain on dollar liquidity, despite a widening U.S. current account deficit. The Fed’s balance sheet peaked a nudge above US$4.5 trillion in early 2015 and has been falling ever since. This has triggered a severe contraction in the U.S. monetary base (Chart 5), and severely curtailed commercial banks’ excess reserves, which are now contracting by over 20% on a year-on-year basis. One of BCA’s favorite key measures of international liquidity is foreign central bank reserves deposited at the Fed. This is contracting at its worst pace in over 40 years. Every time this measure has severely contracted in the past, the shortage of dollars has triggered a blowup somewhere, typically among countries running twin deficits. Chart 5A Liquidity Squeeze Of Dollars To cap it off, last year’s change in the U.S. tax code to allow for repatriation of offshore cash helped the dollar, but not to the extent that might have been expected. On a rolling 12-month basis, the U.S. has repatriated back a net of about $US400 billion in assets, or close to 2% of GDP. Historically, this is a very huge sum that would have had the potential to set the greenback on fire – circa 10% higher (Chart 6). Chart 6USD Should Be Higher On Repatriation Flows Dollar liquidity shortages tend to be vicious due to their ability to trigger negative feedback loops. As the velocity of international U.S. dollars rises, offshore dollar rates begin to rise, lifting the cost of capital for borrowing countries. Debt repayment replaces capital spending and consumption once this reaches a critical threshold. The drop in output, prices, or a combination of the two, only exacerbates the debt-deflation problem.  The bottom line is that looking at historical trends, the dollar should be much higher than current levels. Practical investors recognize the need to pay heed to correlation shifts. Either our favorite liquidity indicators have stopped working outright or more realistically other forces are at play, explaining the relative stability in the greenback. A Counter-Cyclical Currency The first possibility is that the recent stability in the U.S. dollar has been in anticipation of better economic data in the second half of this year. We have shown many times in the past that the greenback is a countercyclical currency that tends to do poorly when global economic momentum picks up. Many investors are now fixated on China – specifically, whether the latest credit injection will be sufficient to turn around the Chinese economy, let alone the rest of the world. Meanwhile, as the U.S.-China trade talks progress, it will likely include a currency clause to prevent depreciation of the RMB versus the dollar. In reality, there is still scant evidence to support a bottoming in global growth, making it difficult to loop this back to dollar stability.  In reality, there is still scant evidence to support a bottoming in global growth, making it difficult to loop this back to dollar stability. Typical reflation indicators such as commodity prices, emerging market currencies and industrial share prices are off their lows but rolling over. March export data remained weak globally, even though compositionally there were some green shoots. Exports to China from Singapore jumped by 34% year-on-year, and those to emerging markets by 22% year-on-year. Japanese machine tool orders from China also showed some stabilization. Historically, these are necessary but not sufficient conditions to gauge whether we are entering a bottoming process (Chart 7). Another contradiction is at play: If the dollar rally is being held back by prospects of improvement in global growth, then gold should fare poorly and most currencies should be outperforming both gold and the greenback. Until yesterday’s sell off in gold, this was not the case. Suggesting some other explanation might be tempering the U.S. dollar’s rise. Chart 7Tentative Green Shoots In Global Trade?   Regime Shift? While U.S. residents have been repatriating capital domestically, foreign investors have been fleeing U.S. capital markets at among the fastest pace in recent years. On a rolling 12-month total basis, the U.S. saw an exodus of about US$200 billion in equity from foreigners, the largest on record (Chart 8). In aggregate, both foreign official and private long-term portfolio investment into the U.S. has been rolling over, with investor interest limited only to agency and corporate bonds. Foreigners are still net buyers of about $450 billion in U.S. securities, but the downtrend in purchases in recent years is evident. Interestingly, gold has also outperformed Treasurys over this period. The U.S. dollar remains the reserve currency of the world today, but that exorbitant privilege is clearly fraying on the edges. Vis-à-vis official flows, China has risen within the ranks to be the number one contributor to the U.S. trade deficit. At the same time, Beijing has been destocking its holding of Treasurys, if only as retaliation against past U.S. policies, or perhaps to make room for the internationalization of the RMB (Chart 9). In a broader sense, the fall in dollar deposits at the Fed might just represent an underlying shift in the global economy away from dollars and towards a more diversified basket of currencies. This makes sense, given a growing proportion of trading – be it in crude, natural gas, bulk commodities or even softs – is being done outside U.S. exchanges. Chart 8Foreigners Are Dumping U.S. Equities   Chart 9China Has Stopped Recycling Surpluses Into Treasurys   Data from the International Monetary Fund (IMF) shows that the global allocation of foreign exchange reserves towards the U.S. dollar peaked at about 72% in the early 2000s and has been in a downtrend since. Meanwhile, allocation to other currencies, notably the British pound, Swiss franc and the yen have been surging (Chart 10). At the same time, foreign central banks have been amassing tremendous gold reserves, notably Russia and China, almost to the tune of the total annual output of the yellow metal (Chart 11). This further helps explain why the dollar may not be as strong as it should be. It also explains the stability of these currency pairs relative to the price of gold. Chart 10The World Is Diversifying Away From Dollars Chart 11Central Banks Are Absorbing Most Gold Production The U.S. dollar remains the reserve currency of the world today, but that exorbitant privilege is clearly fraying on the edges as the balance-of-payments dynamics are heading in the wrong direction. Over the next five years, the U.S. Congressional Budget Office (CBO) estimates that the U.S. budget deficit will swell to 4.5% of GDP. Assuming the current account deficit widens a bit then stabilizes, this will pin the twin deficits at 8.1% of GDP. This assumes no recession, which would have the potential to swell the deficit even further (Chart 12). Chart 12A Twin Deficit Cliff For The Dollar The U.S. saw its twin deficits swell to almost 13% of GDP following the financial crisis, but the difference then was that in the wake of the commodity boom the dollar was cheap (and commodity currencies overvalued). The subsequent shale revolution also greatly cushioned the U.S. trade deficit. Shale productivity remains robust and U.S. output will continue to rise, but the low-hanging fruit has already been plucked. For one reason or another, foreign central banks are diversifying out of dollars. If due to the changing landscape in trade, this is set to continue. If it is an excuse to shy away from the rapidly rising U.S. twin deficits, this will continue as well. And if the U.S. dollar cannot sufficiently rally on “good news,” expect it to sink when the bad news eventually starts rolling in. That said, the timing remains uncertain.   Private Capital Flows Foreign official flows might have been fleeing the U.S. dollar because it has lost some luster as a reserve currency, but private capital will begin stampeding toward the exits when the return on invested capital (ROIC) for U.S. assets falls below their cost of capital. For investors with a long horizon, this may already be happening. Take 10-year government bonds for example. For the Japanese or German investor, borrowing in local currency and investing in the U.S. might seem like the logical course of action given negative domestic rates and a 10-year Treasury yield of 2.4%. However, this positive carry suddenly evaporates when one factors in hedging costs (Chart 13). Chart 13JGBs More Attractive Than Hedged Treasuries During bull markets, countries that have negative interest rates are subject to powerful outflows from carry trades. The impact of these 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. With many yield curves around the world inverting, 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. Investors should consider initiating short USD/JPY positions today as a hedge. Outside the fixed-income space, what matters is that relative ROICs are higher than the cost of capital. Both are difficult to measure for many emerging or even developed economies across asset classes. However, for the equity market, a good starting point has always been valuations as exchange rates tend to move to equalize returns across countries. The forward P/E on the MSCI U.S., Europe and Japan indexes is 16.5x, 12.6x and 12.3x. The skew towards the U.S. is because market participants expect U.S. profits to keep outperforming, the U.S. currency to keep appreciating, or a combination of the two. However, empirically, current U.S. valuations suggest future earning streams have already been fully capitalized today (Chart 14). Chart 14AReturn On Capital Could Be Lowest In The U.S. (1) Chart 14BReturn On Capital Could Be Lowest In The U.S. (2) Chart 14CReturn On Capital Could Be Lowest In The U.S. (3) The expected 10-year annualized return for MSCI U.S. is 3.1%, versus 5.5% for MSCI Europe and 9.6% for MSCI Japan. If we assume the U.S. dollar is overvalued, as some models suggest, this will further erode future U.S. returns. Net equity portfolio flows into the U.S. are already negative, as shown in a previous chart. This means the day of reckoning for the U.S. dollar may not be far off when current tailwinds eventually fade.   Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights The odds of a continued earnings contraction have not yet fallen to the point that would warrant an overweight stance towards Chinese versus global stocks over the coming 6-12 months. While we maintain Chinese stocks on upgrade watch and may recommend increasing exposure soon, the bottom line for investors is that it is still too early for us to confidently project a sustained uptrend. While most investors attribute the chronic discount of Chinese stocks relative to the global average as being due to a sizeable equity risk premium, our analysis suggests that China’s low payout ratio and mediocre earnings growth are the true causes. This implies that China’s re-rating potential is capped barring a major structural improvement in earnings growth. Investors should pay close attention to the details of a U.S./China currency stability pact that will reportedly be included in any trade deal between the two countries. Such a pact may set up an important natural experiment for CNY/USD, and could be a revelatory event for China’s exchange rate regime. Feature Last week’s FOMC meeting dominated the headlines of the financial press, and for good reason. The Fed surprised investors with a material downgrade to their expected path of the federal funds rate over the next three years, a shift that largely reflected concerns about global growth. The subsequent inversion of the U.S. 10-year / 3-month yield curve in response to the very disappointing euro area flash manufacturing PMI for March confirms that many investors remain convinced that Fed policy is too tight and that easing is likely over the coming year.1 On the positive side, investor concerns that reflationary policy is needed in the U.S. and euro area are likely overblown: the plunge in the euro area PMI at least in part reflects the near-term uncertainty over the possibility of a hard Brexit (which will probably be avoided), whereas the Fed is pausing at a level of real interest rates that is well below real GDP growth, which means that monetary policy is still stimulative for the U.S. economy (Chart 1). Chart 1U.S. Monetary Policy Is Still Stimulative But Chart 2 highlights that a generalized slowdown in global growth is responsible for at least part of the sharp weakness in Chinese export growth over the past few months, which we had been mostly attributing to a catch-up phase following a (perversely and ironically) beneficial tariff front-running effect that had temporarily boosted trade growth last year. Chart 2Global Weakness At Least Partly Responsible For A Sharp Export Slowdown Ongoing weakness in the global economy, were it to persist, would imply that China’s external demand outlook is even less encouraging than we had previously assumed. This would raise the stakes for a trade deal with the U.S. to be agreed upon soon, as well as a continued uptrend in the pace of Chinese credit growth. Investors should closely watch the new export orders component of the March NBS manufacturing PMI later this week for signs that exporter sentiment is improving, as well as the overall Caixin PMI to confirm that smaller firms continue to benefit from the PBOC’s targeted easing efforts. When Should Investors Upgrade Chinese Stocks On A Cyclical Basis? In our view, most global investors have been focused on the wrong risk factor for Chinese stocks for the better part of the past year. In the wake of the near-vertical February rise in Chinese domestic stocks, the most common question we have received from clients is whether they should be increasing their cyclical exposure to Chinese stocks in general, and A-shares in particular. In response to the January surge in credit we placed Chinese stocks on upgrade watch in our February 27 Weekly Report,2 but we are not yet ready to recommend an outright cyclical overweight. Investors should be at the ready and aiming, but should not yet fire. In our view, most global investors have been focused on the wrong risk factor for Chinese stocks for the better part of the past year. We have noted in several previous reports that investors have focused nearly exclusively on the U.S.-China trade war since the beginning of 2018, and have largely ignored a slowing domestic economy (Chart 3). Given this, it is not surprising that a sharp improvement in the odds of a deal (which occurred at the beginning of November) has led to a material rally over the past few months versus global stocks. Chart 3The Prospect Of A Trade Deal Has Been The Primary Driver Of China-Related Assets In fact, we predicted in our December 5 Weekly Report that positive sentiment about a deal would boost the relative performance of Chinese stocks over the coming few months, and recommended a tactical overweight stance at that time.3 A cyclical (i.e. 6-12 month) overweight, however, is a different story. Sentiment alone rarely drives financial markets over a 1-year time horizon, meaning that investors need to have some degree of confidence that domestic demand will meaningfully improve over the next 12 months to justify a cyclical upgrade. Certainly, we acknowledge that there have been several positive developments pointing to such an outcome. Chinese monetary conditions have become extremely easy, credit is no longer contracting and surged in January, the Caixin PMI rose notably in February, and some form of a trade deal remains the most likely outcome of the ongoing talks. In addition, Chinese stocks still remain significantly below their 2018 peak (Chart 4), meaning that there is still material potential upside if Chinese earnings do not contract. Chart 4Chinese Stocks Still Have Room To Rise If The Earnings Outlook Stabilizes A moderate credit expansion appears to be underway, but coincident activity continues to weaken and earnings appear to have more downside. However, there are also several reasons to be cautious cyclically: Chart 5The Past Three Months Imply A Moderate Credit Uptrend Chart 6Chinese Coincident Economic Activity Continues To Weaken Chinese and U.S. policymakers have not only failed to set a date for an agreement to be signed by President’s Xi and Trump, but recent new reports suggest that momentum may be slowing and that a meeting may be postponed until June or later.4 Even if the deal does not fall through, material further delays could cause investors to get anxious and vote with their feet. Such a selloff could be violent, given the extremely sharp rise in domestic stock prices over the past six weeks. The evidence so far points to a moderate expansion in credit (Chart 5), reflecting the fact that policymakers are still somewhat concerned about financial stability and the need to prevent significant further leveraging of the private sector. This means that the odds are not yet in favor of a credit “overshoot” like what occurred in 2015/2016, implying that the pickup in growth is likely to be comparatively weaker this time around. Since 2010, monetary conditions and money & credit growth appear to be the best predictors of investment-relevant Chinese economic activity.5 While a moderate credit expansion appears to be underway, there has been no discernable pickup in money growth.6 This discrepancy likely means that the recent improvement in credit has occurred due to non-bank financial institutions, further suggesting that this economic recovery will probably be less powerful and less broad-based than during past cycles. While a moderate expansion in credit does suggest that China’s economy will bottom at some point in the coming months, coincident economic activity continues to decelerate (Chart 6). A continuation of this trend, particularly if coupled with an investor “crisis of faith” in the trade talks, could lead to a very significant retracement in Chinese equity prices before durably bottoming for the year. Trailing EPS growth is decelerating, but it has yet to contract on a year-over-year basis as would be implied by the net earnings revisions ratio (Chart 7) and the coincident activity indicators shown in Chart 6. Chinese investable EPS fell 30% during the 2015/2016 episode (20% for domestic stocks), implying meaningful further downside even if economic activity does not weaken as significantly over the coming months. Chart 7Net Earnings Revisions Point To More Downside For Earnings Chart 8 presents a helpful way for investors to make a net assessment of all of the factors highlighted above. The chart shows our earnings recession model for the MSCI China Index, and shows what is likely to occur if a trade deal causes a full recovery in Chinese exporter sentiment, China’s export-weighted RMB stays roughly at current levels, and the very recent pace of credit growth (Dec-Feb) continues along its trend. Chart 8A Trade Deal And A Moderate Credit Expansion Will Likely Stabilize The Earnings Outlook This scenario, were it to occur, would reduce the odds of a continued earnings contraction to the point that we would be comfortable recommending an overweight stance towards Chinese versus global stocks over the coming 6-12 months. While such a recommendation could come as soon as mid-April, the bottom line for investors is that it is still too early for us to confidently project this outcome. Should Chinese Stocks Be Priced At A Premium Or A Discount To Global Stocks? Most investors attribute the discount applied to Chinese stocks to a high equity risk premium (ERP), but our work paints a different picture. Besides questions about the appropriate cyclical allocation to Chinese stocks, the recent spike in interest among global investors towards A-shares has also led to a renewed focus about the degree to which Chinese stocks are cheap versus the global average. In a world where many financial assets are chronically expensive and Chinese policymakers appear to be responding to weaker economic activity, some investors question whether Chinese stocks deserve to be priced at a discount (Chart 9). Our sense is that most investors attribute the discount to a high equity risk premium (ERP) stemming from the enormous rise in Chinese non-financial corporate debt over the past decade, but our research paints a different picture. Chart 9The Chinese Equity Discount: A High ERP, Or Something More Sinister? One way of analyzing the risk premium of an equity market is to use the well-known constant Gordon growth model. Equation 1 below presents the theoretically justified 12-month trailing P/E ratio as a function of the payout ratio, the risk-free rate, the ERP, and the long-term dividend growth rate (which is equal to the long-term earnings growth rate given a constant payout ratio). Equations 2 and 3 re-arrange equation 1 to express the ERP and long-term growth rate, respectively, on the left-hand side of the equation. Equation 1: P0/E0 = (D1/E0)/(rf + ERP – g) Equation 2: ERP = [(D1/E0)/(P0/E0)] + g - rf Equation 3: g = rf + ERP-[(D1/E0)/(P0/E0)] To illustrate the approach, Chart 10 applies equation 2 to the U.S. equity market and compares it with the annual dividend discount model equity risk premium published by Professor Aswath Damodaran from New York University’s Stern School of Business,7 a well-known expert in the theory and practice of asset valuation. While there are some differences in the level of the series owing to slightly different methodologies, the overall profile of the two series is generally similar. Chart 10Our DDM Methodology For The U.S. Generates Results Similar To Other Important Estimates Proxying the market’s long-term growth expectations in a large, mature economy such as the U.S. is materially easier than is the case in an emerging market such as China. As such, instead of solving for the equity risk premium directly when judging whether China’s discount is “deserved”, we use equation 3 to solve for the implied long-term growth rate given an assumed (and very conservative) ERP range of 2-3%, using the global P/E ratio. In other words, we ask the following question: what kind of earnings growth do Chinese stocks need to achieve over the long run in order to justify the same earnings multiple as the global average, given an equity risk premium of 2-3%? Chart 11 presents the answer to this question, for both the domestic and the investable market. We use domestic 10-year bond yields as the risk-free rate in the case of the A-share market, and U.S. 10-year bond yields in the case of the MSCI China index as a proxy for the global risk-free rate. Finally, in each panel, the dashed horizontal lines denote the actual compound annual growth rate in earnings per share for each market, since the year noted next to each line. Chart 11A Low But Still Difficult L/T Earnings Hurdle Rate To Be Priced In Line With Global Stocks Two important points are apparent from the chart: The required growth rate for both markets to be priced in line with global stocks are quite low, well below Chinese nominal GDP growth. At first blush, this might suggest that the valuation discount applied to China reflects a sizeable equity risk premium that could shrink over the coming 6-12 months (i.e. a beneficial re-rating of Chinese stocks). Since 2010 or 2011, actual growth rates in EPS are materially above the required growth range in both markets. However, over more recent time horizons, particularly 2013 and later, actual earnings growth has not only been below the range but has also been extremely poor in absolute terms. This is particularly true for the investable market, which has actually recorded negative growth in 12-month trailing EPS since 2014 or 2015. A dividend discount model approach suggests that the Chinese equity market discount is justified, barring a major structural improvement in earnings growth. Chart 12 highlights the problem with China’s stock market in a nutshell. For both the investable and domestic equity markets, the dividend payout ratio is well below the global average. This is a normal circumstance for small companies with high growth potential; firms re-invest a high portion of their earnings back into the company in order to build out their asset base and deliver even higher earnings in the future. Chart 12The Chinese Discount Visualized: A Low Payout Ratio, And Mediocre Earnings Growth But panel 2 of Chart 12 shows that relative earnings for Chinese stocks versus the global average have not trended higher over the past decade, meaning that a higher earnings retention ratio among Chinese stocks has not led to a superior earnings profile. In response, global investors have rightly discounted Chinese stocks versus their global peers, a circumstance that is likely to continue unless Chinese earnings growth materially and sustainably improves. Our analysis implies that there is a natural limit to how far Chinese equities can ultimately be re-rated barring a major structural improvement in the economy, a factor that we may eventually have to contend with were we to recommend a cyclical overweight stance. Capped re-rating potential is unlikely to prevent Chinese stocks from trending higher in relative terms if economic fundamentals warrant an uptrend, but it may suggest that the duration or magnitude of the rise may be shorter than many investors hope. A Sino-U.S. Trade Deal: A Natural Currency Experiment In The Making? What explains the link between CNY-USD and the interest rate differential between the two countries? Finally, a brief note on the RMB. Since June 2018, changes in CNY-USD appear to have been closely aligned with the magnitude of proposed tariffs as a share of Chinese exports to the U.S., as would be implied in a simple open economy model with flexible exchange rates. Chart 13shows the levels implied by this framework in a variety of tariff scenarios, calculated based on the percent decline from the peak in the exchange rate in 1H 2018. As noted in our March 13 Weekly Report,8 CNY-USD today is consistent with the current tariff regime, implying potential upside if a trade deal with the U.S. rolls back some of the tariffs that have been imposed. Chart 13A Simple Equilibrium Framework Suggests CNY-USD May Rise Materially Further If Tariffs Are Rolled Back However, Chart 14 shows that CNY-USD has been closely correlated with the interest rate differential between the two countries for several years, with the relationship having recently become a leading one. Chart 14 highlights that CNY-USD has moved higher than the rate differential would imply (painting the opposite picture as that shown in Chart 13), suggesting that the currency is more likely to depreciate than appreciate over the coming 6-12 months barring tighter monetary policy in China or outright rate cuts in the U.S. Chart 14Will Policymakers Or Rate Differentials Drive CNY-USD Over The Coming Year? The relationship shown in Chart 14 is surprising, and we have struggled to understand the exact dynamics at play. As we highlighted in a September report,9 many global investors take the relationship for granted, given the strong historical link between interest rate differentials and exchange rates in developed countries. However, a major problem that arises in explaining Chart 14 is the fact that uncovered interest rate arbitrage (or the “carry trade”) cannot easily occur or cannot occur at all when one or both countries involved maintains capital controls. It is an important conundrum, and one that we have not been able to solve. From our perspective, there are only two scenarios that explain the close relationship between the exchange rate and interest rate differentials between the two countries: The relationship is causal, implying that capital flows in and out of the country are sufficiently large to enable a carry trade. The two series are correlated because of a third factor related in some way to the other two. In our view, scenario 1 is not likely. Capital is flowing out of China, but at a much slower rate than before,10 and the relationship shown in Chart 14 did not break down following China’s capital crackdown in 2015/2016. Ruling out scenario 1 necessarily implies that scenario 2 is correct. Our best guess concerning the missing third factor is that Chinese policymakers are looking to the rate differential as a guide to set the exchange rate, in order to mimic a market-based exchange rate in support of China’s goals to progressively liberalize (and internationalize) the currency. If true, this implies that China has full control of their exchange rate regardless of the prevailing interest rate differential, but that they are often choosing to follow what the differential implies. This is significant, because if Chinese and U.S. negotiators do agree to a “yuan stability pact” as has been reported in the press, a trade deal may set up an important natural experiment for the currency. In our view, a major upward move in the rate differential is unlikely over the coming year, implying that CNY-USD will persistently deviate from the relationship shown in Chart 14 if President Trump is not inclined to tolerate any real weakness in the RMB over the coming year. While the details of the currency agreement and the trade agreement more generally could allow for some decline in CNY-USD if coupled with an offsetting benefit for the U.S. (such as materially higher U.S. exports to China for some period), our bias is to believe that President Trump does not want to see a stronger dollar over the coming year in the lead-up to the 2020 election. If true, investors should pay close attention to the behavior of CNY-USD, as it is stands to be a revelatory event for China’s exchange rate regime.   Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com   1 Please see U.S. Bond Strategy and Global Fixed Income Strategy Weekly Reports “The New Battleground For Monetary Policy” and “Forward Guidance On Steroids”, dated March 26, 2019, for a detailed update on our view for Fed rate hikes and how investors should interpret the recent inversion in the yield curve. 2 Please see China Investment Strategy Weekly Report, “Dealing With A (Largely) False Narrative”, dated February 27, 2019, available at cis.bcaresearch.com 3 Please see China Investment Strategy Weekly Report, “2019 Key Views: Four Themes For China In The Coming Year”, dated December 5, 2018, available at cis.bcaresearch.com 4 Please see “Some U.S. Officials Said To See China Walking Back Trade Pledges”, Bloomberg News, dated March 19, 2019, and “Donald Trump-Xi Jinping meeting to end US-China trade war may be pushed back to June, sources say”, South China Morning Post. 5 Please see China Investment Strategy Special Report, “The Data Lab: Testing The Predictability Of China’s Business Cycle”, dated November 30, 2017, available at cis.bcaresearch.com 6 Please see Emerging Markets Strategy Weekly Report, “EM: A Sustainable Rally Or A False Start?”, dated March 7, 2019, available at ems.bcaresearch.com 7 Please see Professor Damodoran’s website for more information on his estimates of the equity risk premium. 8 Please see China Investment Strategy Weekly Report, “China Macro And Market Review”, dated March 13, 2019, available at cis.bcaresearch.com 9 Please see China Investment Strategy Weekly Report, “Moderate Releveraging And Currency Stability: An Impossible Dream?”, dated September 5, 2018, available at cis.bcaresearch.com 10 Please see China Investment Strategy Special Report, “Monitoring Chinese Capital Outflows”, dated March 20, 2019, available at cis.bcaresearch.com   Cyclical Investment Stance Equity Sector Recommendations