Real Estate

Highlights The CAD and AUD have tactical upside; however, this may well prove to be the last hurrah before some serious declines play out. This time domestic – not global – factors will drive the CAD and AUD lower. Canada and Australia are hitting the end game for their respective debt supercycles as rising U.S. rates will lift the global cost of capital. Canadian and Australian house prices and debt loads are too elevated; a reversal of these excesses is likely to push these two countries toward liquidity traps. These liquidity traps will cause the R-star in Canada and Australia to fall, lagging well behind the U.S. Canada and Australia are uncompetitive, suggesting external demand will not come to their respective rescue, at least not until after the CAD and AUD have fallen significantly. The CAD may fall first, but the AUD has more downside ultimately; not only is Australia even less competitive than Canada, but the Aussie is also more expensive than the Loonie. Feature The Canadian and Australian dollars are in the process of rebounding. This is not surprising. By the end of 2018, both these currencies were deeply oversold, and the recent easing in global financial conditions, helped by the Federal Reserve’s pause, is fueling their rebound (Chart 1). Moreover, pessimism toward China has hit an extreme, yet Sino-U.S. trade relations seem on the cusp of improving and Chinese policymakers are increasingly trying to manage the downside in the Chinese economy. This setup is normally supportive for the Canadian and Australian dollars (Chart 2). Chart 1Financial Conditions Point To A Tactical Rebound In The AUD And The CAD... Financial Conditions Point To A Tactical Rebound In The AUD And The CAD... Financial Conditions Point To A Tactical Rebound In The AUD And The CAD...   Chart 2...So Does Chinese Reflation ...So Does Chinese Reflation ...So Does Chinese Reflation While we have been recommending that our more tactically minded clients play this rally,1  the longer-term outlook for the CAD and AUD remains poor. These countries are getting closer to the end of their respective debt supercycles. Consequently, the CAD and AUD need to trade at much larger discounts to fair value in order to be attractive. Way Too Much Debt Canada and Australia have become victims of their own success. Canada and Australia have seen real estate prices rise for more than two decades. At first, rising prices reflected solid valuations, growing populations and rising prosperity. However, things changed around the Great Financial Crisis. During this traumatic event, the Bank of Canada and the Reserve Bank of Australia both dropped interest rates by 4.25%. Since both countries’ banking sectors escaped the crisis unscathed, and households did not experience similar losses of wealth as those in the U.S., Ireland or Spain, credit growth remained strong. A real estate bubble became the natural consequence of this easy monetary policy. Banks pushed credit to households, and households – impressed by the solid performance of real estate prices, attracted by low interest rates, and enamored with the dream of easy riches – willingly took on mortgages and piled into the property market. A feedback loop ensued, whereby rising collateral values made credit even easier to access, fomenting further house price gains and even-easier credit conditions. Today, we stand at the end of this process. Vancouver and Toronto in Canada, and Sydney and Melbourne in Australia are some of the most expensive real estate markets in world in terms of price-to-income ratios, when one controls for population density (Chart 3). This has created major systemic risks for both countries. Chart 3 Few would care about the systemic risk created by elevated house prices if debt loads were small. However, in both countries, household indebtedness makes Americans circa 2007 look like a frugal bunch. In Canada, household debt has now reached 176% of disposable income, or 100% of GDP, while in Australia, the same ratios are 189% and 121%, respectively. This is well above the levels that prevailed in the U.S. in 2007 (Chart 4). Mortgage debt alone represents 108% and 140% of disposable income in Canada and Australia, respectively. Moreover, Canadian and Australian households also spend 14.5% and 15.6% of their incomes servicing debt, which also compares unfavorably with the U.S. in 2007. Chart 4ACanadians And Australians Make Americans Look Frugal Canadians And Australians Make Americans Look Frugal (1) Canadians And Australians Make Americans Look Frugal (1) Chart 4BCanadians And Australians Make Americans Look Frugal Canadians And Australians Make Americans Look Frugal (2) Canadians And Australians Make Americans Look Frugal (2) Canadian and Australian households thus seem close to having reached their maximum debt loads. Moreover, measures taken in Canada and Australia to limit foreign money inflows and constrain bank lending are beginning to bite. In both countries, real estate transactions are slowing, with property sales declining by 20% and 8% in Canada and Australia, respectively. House prices too are being hit. House prices in Vancouver and Toronto peaked by 2018, and in Sydney and Melbourne in 2017. Residential construction is likely to be the first victim. Real estate inventories in both these countries have been rising, courtesy of the frenetic pace of housing starts going on for decades. Today, residential investment represents 7% of GDP in Canada and 5% of GDP in Australia (Chart 5). Thus, slowing real estate activity could curtail Canadian and Australian GDP by 2% if we move back to the real estate environment that prevailed in the mid-1990s. This would also imply large hits to employment as construction, real estate and finance have created 336-thousand and 250-thousand jobs in Canada and Australia since 2009, respectively. Chart 5AA Decline In Construction Activity Would Be A Vicious Hit To Canada And Australia (1) A Decline In Construction Activity Would Be A Vicious Hit To Canada And Australia (1) A Decline In Construction Activity Would Be A Vicious Hit To Canada And Australia (1) Chart 5BA Decline In Construction Activity Would Be A Vicious Hit To Canada And Australia (2) A Decline In Construction Activity Would Be A Vicious Hit To Canada And Australia (2) A Decline In Construction Activity Would Be A Vicious Hit To Canada And Australia (2) Consumption too is likely to suffer. Without a growing wealth effect and with declining equity in their houses, Canadian and Australian households are likely to curtail consumption – consumption that has contributed 60% and 30% of Canada’s and Australia’s cumulative GDP growth since 2009. Already, we are seeing slowing Canadian and Australian retail sales – right behind drops in housing activity. The biggest and most dangerous risk is that Canada and Australia teeter on the verge of falling into a liquidity trap, like the U.S. after 2007. As Chart 6 illustrates, propelled by households binging on cheap money in the form of mortgages, Canadian and Australian banks have managed to maintain higher levels of return on equity after the financial crisis. This robust profitability will decline if non-performing loans, which so far remain low, grow in response to weakening house prices and fragile household financial health (Chart 7). Chart 6Canadian And Australian Banks Remain Profitable... Canadian And Australian Banks Remain Profitable... Canadian And Australian Banks Remain Profitable... Chart 7...As Long As NPLs Do Not Rise ...As Long As NPLs Do Not Rise ...As Long As NPLs Do Not Rise Rising NPLs and declining RoEs tend to limit the willingness of banks to lend. Just as crucially, the poor health of households and falling real estate prices is likely to also limit demand for credit. This combination was behind the sharp decline in the U.S. money multiplier in 2008. No matter how much reserves the Federal Reserve would inject in commercial banks via QE programs, broader money would not respond. A similar fate is likely to ensue in Canada and Australia (Chart 8). The velocity of money is also likely to fall if households are not willing to take on debt anymore and instead focus on rebuilding their financial buffers. Chart 8Canada And Australia Have Avoided A Liquidity Trap... So Far Canada And Australia Have Avoided A Liquidity Trap... So Far Canada And Australia Have Avoided A Liquidity Trap... So Far The consequence of this monetary constipation will be much lower interest rates. When an economy enters a liquidity trap, as was the case in the U.S. after 2007, in Japan since the 1990s, or in Europe after 2010, the neutral real rate of interest, the so-called R-star, falls to zero or even lower. Essentially, no matter how low interest rates fall, they cannot equilibrate the demand and supply for savings. Everyone wants to save, no one wants to borrow, and banks are unwilling to lend. This fate looks increasingly likely for both Canada and Australia over the coming two years. Bottom Line: The Canadian and Australian real estate markets have enjoyed incredible runs for more than two decades. Now, not only are real estate prices in these two nations very expensive, households have been left with prodigious debt loads. As real estate activity slows, residential construction will suffer, but most importantly, these two countries are likely to teeter toward becoming liquidity traps as banks curtail lending and households curtail borrowing. This will result in structurally lagging interest rates. Why Now? Betting on the end of the Canadian and Australian housing bubbles has so far been mugs games. Why is the situation different now? Because the U.S. economy is stronger. Until now, very low global interest rates have kept the Canadian and Australian housing bubbles afloat, but rising U.S. interest rates are now putting upward pressure on mortgage rates in both Canada and Australia (Chart 9). This simply reflects the fact that U.S. rates represent the ultimate opportunity cost of investing outside the international reserve currency, the U.S. dollar. After years of household deleveraging, the U.S. seems to be able to handle higher rates. However, because Canadian and Australian balance sheets are much weaker, their tolerance for higher rates is substantially lower. Chart 9Higher U.S. Rates Threaten Canadian And Australian Households Higher U.S. Rates Threaten Canadian And Australian Households Higher U.S. Rates Threaten Canadian And Australian Households BCA sees further upside for U.S. rates and thus for the global cost of capital. In other words, we do not anticipate the Fed’s pause to last beyond June. The following reasons underpin this view: The U.S. labor market is increasingly inflationary. The employment-to-population ratio for prime-age workers continues to rise, which historically has boosted labor costs (Chart 10). The New York City Fed Underlying Inflation Gauge points toward higher core inflation (Chart 11). Moreover, Ryan Swift argues in BCA’s U.S. Bond Strategy that an unfavorable base effect will dissipate after February, further reinforcing the upside risk to inflation.2  Being the only component of our Fed Monitor moving toward “easy money required” territory, the tightening in U.S. financial conditions last year was the lynchpin behind the Fed’s pause. The other components of the Fed Monitor have not deteriorated significantly, and they still argue in favor of further rate hikes (Chart 12). Thus, if the recent easing in financial conditions can persist, the Fed will hike again this year. Chart 10   Chart 11Budding U.S. Inflationary Pressures Budding U.S. Inflationary Pressures Budding U.S. Inflationary Pressures   Chart 12The Fed Is Pausing Because Of Tightening Financial Conditions, Not The Economy The Fed Is Pausing Because Of Tightening Financial Conditions, Not The Economy The Fed Is Pausing Because Of Tightening Financial Conditions, Not The Economy Finally, U.S. productivity is set to pick up over the coming two years. Since a rising capital stock boosts productivity, the recent strength in capex augurs well (Chart 13). Moreover, the demand deficit created by the deleveraging of U.S. households has weighed on productivity. As U.S. credit growth picks up, so will productivity. This is important as rising productivity lifts the neutral rate, and thus creates more room for the Fed to lift interest rates. Chart 13Upside For U.S. Productivity Equals Upside For U.S. Rates Upside For U.S. Productivity Equals Upside For U.S. Rates Upside For U.S. Productivity Equals Upside For U.S. Rates Ultimately, all these factors point to higher U.S. rates. As such, it suggests that Canadian mortgage rates, and to a lesser extent Australian ones as well, will experience upward pressure – exactly at the time when households in these two countries are most vulnerable to higher rates. Bottom Line: Higher U.S. rates are the main reason why we expect the Canadian and Australian housing markets and economies to buckle now, finally heeding the call of doomsayers. Higher U.S. rates lift the global cost of capital. While U.S. households are in robust shape and therefore better able to handle higher rates, the same cannot be said about Canadian and Australian households. Can the External Sector Come To The Rescue? This is unlikely. After years of commodity booms and strong domestic demand supported by rising household wealth, the Canadian and Australian manufacturing sectors have been greatly diminished. Much capacity has vanished, and it will be difficult to replace the lost output from falling domestic demand by exports of manufactured goods. The Australian and especially the Canadian corporate sectors are also already heavily indebted, and thus, it could take quite some time before capacity is expanded. Complicating the situation, Canada and Australia are not competitive exporters anymore. As the top panel of Chart 14 shows, since 1980, U.S. unit labor costs have risen by 156%, but they have risen by 183% in Canada and by a stunning 282% in Australia. Productivity trends paint a similar, albeit less dramatic picture. Since 1980, U.S. labor productivity has risen 22% versus its trading partners; in Canada it has declined by 20%, and in Australia, by 5%. Consequently, both Canadian and Australia labor will have to cheapen. Historically, the mechanism through which labor costs decline is higher unemployment, which forces a painful adjustment in wages. These adjustments are likely to force both interest rates and currencies lower. Chart 14Canada And Australia Are Uncompetitive Canada And Australia Are Uncompetitive Canada And Australia Are Uncompetitive Could China come to the rescue? Via higher commodity prices, both Canada and Australia have been major beneficiaries of the Chinese economic boom. However, while China today is trying to contain its economic deceleration, Chinese policymakers remain fixated on controlling credit growth. This means that China is unlikely to go on another debt binge similar to what transpired in 2009 or in 2015-‘16. As a result, the recent uptick in commodity prices is unlikely to last long. More fundamentally, China is not only trying to move away from its debt-led growth model: It is also trying to move away from its investment-led growth model. This means that the commodity intensiveness of the Chinese economy is likely to decline. China’s emphasis on controlling air pollution will strengthen this trend. As Chart 15 illustrates, when the share of Capex as a percentage of Chinese GDP declines, so does the labor participation rate of Canada and Australia relative to the U.S. This decline in relative participation rates is associated with falling CAD and AUD values versus the U.S. dollar, a consequence of falling growth potential and interest rates. Chart 15AChanging Chinese Growth Model Points To Falling Canadian And Australian Participation Rates (1) Changing Chinese Growth Model Points To Falling Canadian And Australian Participation Rates (1) Changing Chinese Growth Model Points To Falling Canadian And Australian Participation Rates (1) Chart 15BChanging Chinese Growth Model Points To Falling Canadian And Australian Participation Rates (2) Changing Chinese Growth Model Points To Falling Canadian And Australian Participation Rates (2) Changing Chinese Growth Model Points To Falling Canadian And Australian Participation Rates (2) Bottom Line: Canada’s and Australia’s lack of manufacturing capacity, poor competitiveness, and China moving away from its investment-led growth model suggest that a deflationary environment will ultimately develop in these two nations, at least relative to the U.S. Moreover, the structurally negative outlook on consumption, debt growth and employment suggests that Canadian and Australian neutral rates are likely to fall relative to the U.S. These economic forces point to deeper lows this cycle in the CAD and AUD against the USD. Investment Implications Based on this economic backdrop, both the Canadian and Australian dollar could suffer significant downside in the coming years as their fair value is likely to fall, dragged by interest rates that will lag those in the U.S. However, if an asset is cheap enough, it may nonetheless be an attractive buy. The CAD and AUD do not fall into that camp. Today, the CAD trades in line with our long-term fair-value model, implying that if its fair value falls, the CAD provides zero insulation and will therefore also have to decline. The AUD is in an even worst spot as it currently trades above its fair value (Chart 16). Additionally, the Australian current account deficit is larger than Canada’s. Chart 16The CAD And AUD Are Not Cheap Enough To Compensate For Secular Risks The CAD And AUD Are Not Cheap Enough To Compensate For Secular Risks The CAD And AUD Are Not Cheap Enough To Compensate For Secular Risks In terms of timing, the Loonie could start weakening before the Aussie. The Canadian housing bubble is likely to collapse first as Canadian mortgage rates are more tightly linked to U.S. ones than Australian rates are. Moreover, the Canadian economy seems even more levered to rising real estate prices than that of Australia. However, a collapse in Vancouver and Toronto housing prices will promptly catalyze similar weaknesses in Sydney and Melbourne. Thus, while the CAD may be the first to take the great plunge, the AUD will not be far behind. Ultimately, the AUD will suffer the greatest decline. Obviously, the more onerous pricing of the AUD contributes to this assessment, but so does the greater lack of competitiveness in Australia than in Canada. Australia is likely to endure deeper deflationary pressures as its labor costs need greater adjustments. Furthermore, Australia already suffers from a larger degree of underutilized labor than Canada. Since the currency – not wages – is likely to withstand the bulk of the competiveness adjustment, this implies that the AUD has more work to do than the CAD. The more expensive valuations of Australian assets also handicap the Aussie versus the Loonie. Australian real estate is pricier than Canadian property, and Australian stocks are more expensive (Chart 17). This means that Australians could end up with deeper holes in their balance sheets than Canadians, and that Australia has scope to witness greater outflows of capital than Canada. Chart 17Canadian Financial Assets Are Cheaper Than Australian Ones... Canadian Financial Assets Are Cheaper Than Australian Ones... Canadian Financial Assets Are Cheaper Than Australian Ones... Where Australia shines relative to Canada is in terms of the ability of fiscal authorities to respond to an economic slowdown. Canadian public debt stands at 90% of GDP versus 41% of GDP in Australia. Canada’s cyclically-adjusted primary deficit is already deteriorating, while Australia’s is improving (Chart 18). This means that the Australian governments have deeper pockets and a greater capacity to support domestic demand than Canada’s. This could cushion the deflationary impact in Australia relative to Canada. That being said, the Japanese, Spanish or U.S. experiences argue that once a real estate bubble bursts, fiscal spending can cushion some of the pain, but it cannot eradicate the problem – at least not until banks are recapitalized and the private sector is once again ready to borrow, something that takes years of balance-sheet rebuilding. Chart 18...But Australia Has More Fiscal Space ...But Australia Has More Fiscal Space ...But Australia Has More Fiscal Space Bottom Line: Both the CAD and AUD are likely to experience substantial downside over the coming years. The CAD and AUD are not cheap enough to compensate for a BoC and RBA that will greatly lag the Fed. While the CAD may weaken first, the AUD will suffer more long-term downside. The Aussie is more expensive, Australia is less competitive than Canada, and it could suffer greater outflows of capital. Continue to underweight Australian and Canadian assets in global portfolios as the AUD and CAD will drag their performance down. Remain short AUD/CAD on a structural basis.   Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Weekly Report, titled “Global Liquidity Trends Support The Dollar, But…”, dated January 25, 2019, 2018, available at fes.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, “Buy Corporate Credit”, dated January 15, 2019, available at usbs.bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Duration: The U.S. economic data show few signs of restrictive monetary policy, despite the fact that the market is now priced for an end to the Fed’s rate hike cycle. Investors should position for further rate hikes this year. Practically, this means keeping portfolio duration low and avoiding the 5-year/7-year part of the Treasury curve. Corporate Spreads: Corporate breakeven spreads are too wide for this phase of the cycle, especially for the Baa and junk credit tiers. Our default-adjusted spread shows that high-yield bonds offer adequate compensation for default losses, in line with the historical average. Corporate Defaults: A simple model using gross nonfinancial corporate leverage pegs fair value for the 12-month speculative grade default rate at 4.1%. This fair value estimate should decline slightly in the months ahead, as long as pre-tax profit growth stays above 7%, the approximate rate of debt growth. Feature Fed rate hikes have been completely priced out of the curve. As of last Friday’s close, the overnight index swap market was priced for 2 basis points of rate hikes during the next 12 months and 9 bps of cuts during the next 24 months (Chart 1). The sharp drop in rate hike expectations is an overreaction, and investors should position for a near-term rise in rate expectations. The Fed’s rate hike cycle still has room to run before interest rates peak. Chart 1Market Says "No More Hikes" Market Says "No More Hikes" Market Says "No More Hikes" In this week’s report we survey the recent economic data, searching for any signal that interest rates are high enough to choke off the recovery. We conclude that monetary conditions remain accommodative, and that the Fed’s rate hike cycle will re-start in the second half of this year. Searching For Signs Of Tight Money Policymakers frequently talk about the concept of the neutral (or equilibrium) fed funds rate. In essence, the neutral rate is the interest rate that is consistent with trend economic growth and stable inflation. If the fed funds rate is set above neutral, then we should expect growth to slow and inflation to fall. Conversely, if the fed funds rate is set below neutral, we should expect growth to accelerate and inflation to rise. The slope of the yield curve can help distill this concept for bond investors. An inverted yield curve signals that the market is priced for interest rate cuts in the future. This is what we would expect to see in an environment where the fed funds rate is above neutral and monetary conditions are restrictive. Conversely, a very steep yield curve means that investors expect rate hikes in the future. This is usually consistent with accommodative monetary policy and an interest rate well below neutral. We find the neutral rate to be a useful concept, though like Fed Chairman Powell we think it is unwise to place too much stock in point estimates of its level.1 Such estimates are very difficult to make in real time, and tend to be heavily revised with hindsight.2 For investors, a wiser strategy is to look for signs in the economic data that interest rates are too high, and to use those signs to decide when interest rates have peaked for the cycle. We review a few of those potential signs below. Nominal GDP Growth One simple signal of restrictive monetary policy is when interest rates rise above the year-over-year growth rate in nominal GDP. In the last cycle, Treasury returns versus cash didn’t move materially higher until after year-over-year nominal GDP growth was below both the 10-year Treasury yield and the 3-month T-bill rate (Chart 2). At present, year-over-year nominal GDP growth is running at 5.5%. Though it is very likely to slow during the next few quarters, it still has a long way to go before it falls below 2.76%, the current 10-year Treasury yield. Chart 2GDP Growth Suggests That Monetary Policy Remains Accommodative GDP Growth Suggests That Monetary Policy Remains Accommodative GDP Growth Suggests That Monetary Policy Remains Accommodative Verdict: An assessment of nominal GDP growth shows that monetary policy remains accommodative. The Housing Market Given that the mortgage market provides the most direct link between interest rates and real economic activity, it makes sense that signs of tight money might show up first in the housing data. Empirical investigation backs up this claim. As was observed by Edward Leamer in his 2007 paper, of the ten post-WWII U.S. recessions, eight were preceded by a significant slowdown in residential investment.3 Our own reading of the data is consistent with this message. Downtrends in the 12-month moving averages of both single-family housing starts and new home sales preceded inflection points higher in excess Treasury returns in each of the past two cycles (Chart 3). Chart 3No Signal From Housing No Signal From Housing No Signal From Housing While these housing metrics certainly deteriorated during the past nine months, it appears that the worst is now behind us. The recent moderation in mortgage rates has already led to a significant bounce in mortgage purchase applications and a pop in homebuilder confidence (Chart 4). This will translate into increased housing starts and new home sales during the next few months. Chart 4Housing Rebound Underway Housing Rebound Underway Housing Rebound Underway Verdict: The housing data are most likely consistent with still-accommodative monetary policy. However, if single-family housing starts and new home sales do not respond as expected to the recent drop in the mortgage rate, then we will be forced to re-visit this view. The Labor Market Of all the available labor market statistics, initial unemployment claims tend to be the most leading and have historically provided the best signal of tight monetary conditions. In each of the past two cycles a significant increase in jobless claims has coincided with the inflection point higher in Treasury excess returns (Chart 5). While there was some concern toward the end of last year that claims were trending up, this has now been dashed and claims actually fell below 200k last week. Notice in Chart 5 that the 13-week change in claims remains negative. In prior cycles it rose above zero around the same time that Treasury returns started to improve.. Chart 5No Signal From Labor Market No Signal From Labor Market No Signal From Labor Market Verdict: The labor market data remain consistent with accommodative monetary policy. Bottom Line: It seems very likely that U.S. monetary policy remains accommodative. Nominal GDP growth and the labor market both strongly support this claim. The housing data have been weaker, but are already showing signs of rebounding. The implication for bond investors is that the Fed is not done lifting interest rates, even though the market is priced for exactly that outcome. Investors should maintain below-benchmark portfolio duration on the view that rate hikes will re-start in the second half of this year. The 5-year/7-year part of the Treasury curve is especially vulnerable to an increase in rate hike expectations. Investors should avoid this part of the curve, focusing on the very long and short maturities.4 The Weakness Is Global The analysis in the above section begs the question: If the economic data do not suggest that monetary policy is restrictive, then why is the market priced for an end to the Fed’s rate hike cycle? The answer is that everything is not rosy in the economic outlook. Specifically, we have already seen a significant slowdown in non-U.S. economic growth that weighed significantly on financial markets near the end of last year and is starting to impact the most externally-exposed segments of the U.S. economy. Chart 6 shows that a slowdown in the Global ex. U.S. Leading Economic Indicator (LEI) is now dragging the U.S. LEI down with it. Chart 6Global Weakness Infects U.S. Global Weakness Infects U.S. Global Weakness Infects U.S. Not surprisingly, the components of the U.S. LEI that have weakened are those related to financial markets and the corporate sector. Given that corporate profits are determined globally, a slowdown in global growth often shows up first in downward revisions to investors’ corporate profit expectations. This weighs on equity prices and causes business owners to re-assess their future investment plans. Consistent with this narrative, we have seen significant downward moves in ISM New Orders and NFIB Capital Spending Plans, shown averaged together in the top panel of Chart 7. Capital spending plans as reported in regional Fed surveys have also moderated (Chart 7, panel 2), and CEO confidence has plunged (Chart 7, bottom panel). All of these indicators suggest that weaker global growth will weigh on the nonresidential investment component of U.S. GDP during the next few quarters. Chart 7Weaker Nonresidential Investment... Weaker Nonresidential Investment... Weaker Nonresidential Investment... But while corporate investment is poised to weaken, the U.S. consumer is in rude health (Chart 8). Core retail sales are growing strongly, though the most recent data only extend through November. For more timely data we can look at the Johnson Redbook measure of same-store sales which has accelerated into the New Year (Chart 8, top panel). The University of Michigan survey of consumers shows that expectations dipped last month (Chart 8, panel 2), but also that consumers still view current conditions as extremely positive (Chart 8, bottom panel). Chart 8...And Resilient Consumer Spending ...And Resilient Consumer Spending ...And Resilient Consumer Spending The overall picture is reminiscent of 2015/16. The U.S. consumer and labor market are in good shape, but slowing foreign growth and a strong U.S. dollar are weighing on the corporate profit outlook and U.S. corporate investment spending. As in 2016, the solution is for the Fed to temporarily pause its rate hike cycle. This will allow the dollar’s uptrend to moderate and will take some pressure off the corporate profit and investment outlooks. With a Fed pause discounted in the market, the conditions are already in place for renewed optimism on the corporate sector. It is for this reason that we upgraded our recommended allocation to corporate bonds two weeks ago.5 We expect this optimism will cause financial conditions to ease during the next few months, allowing the Fed to resume its rate hike cycle in the second half of this year. Corporate Bond Valuation Update As mentioned above, we increased our recommended exposure to corporate credit (both investment grade and junk) two weeks ago, partly due to valuations that had become too attractive to pass up. The Breakeven Spread One of our preferred valuation techniques is to look at 12-month breakeven spreads for each corporate credit tier as a percentile rank versus history.6 We like this method for three reasons: First, focusing on each individual credit tier controls for the fact that the average credit rating of bond indexes can change over time. Second, using the breakeven spread instead of the average index option-adjusted spread allows us to control for the changing average duration of the bond indexes. Finally, we find that the percentile rank is often a better representation of credit spreads than the spread itself. This is because credit spreads often tighten to very low levels and then remain tight for an extended period of time. By showing us the percentage of time that a given spread has been tighter than its current level, the percentile rank gives a better sense of this pattern than the actual spread. At present, Baa-rated debt and all junk credit tiers have 12-month breakeven spreads at or above their historical medians. Aa and A rated bonds have breakeven spreads that rank near the 40th percentile, and Aaa-rated debt remains expensive with a 12-month breakeven spread below the 10th percentile since 1989. To appreciate how cheap these spreads are, especially for Baa-rated and junk credits, consider that the current 12-month breakeven spread for a Baa-rated corporate bond is 24 bps (Chart 9). In our analysis of the different phases of the economic cycle, we determined that in an environment where the slope of the 3/10 Treasury curve is between 0 bps and 50 bps (it is 18 bps today), the 12-month Baa-rated breakeven spread averages 18 bps.7 Chart 9Attractive Baa Valuation Attractive Baa Valuation Attractive Baa Valuation Given current index duration, if the 12-month Baa-rated breakeven spread returned to the 18 bps level that is typical for this stage of the cycle, it would imply a tightening in the option-adjusted spread from 169 bps to 129 bps – a 40 bps tightening! Default-Adjusted Spread Another valuation measure to consider is our high-yield default-adjusted spread. This is the excess spread available in the high-yield index after subtracting expected default losses. To determine expected default losses we use Moody’s baseline forecast for the 12-month default rate and our own forecast for the 12-month recovery rate. At present, this gives us a default-adjusted spread of 237 bps, right in line with the historical average (Chart 10). In other words, if default losses during the next 12 months match those embedded in our calculation, then investors should expect an excess return that is in line with the historical average, assuming also no capital gains/losses from spread tightening/widening. Chart 10In Line With Historical Average In Line With Historical Average In Line With Historical Average But how likely is it that default losses fall in line with that expectation? In its last Monthly Default Report, Moody’s revised its baseline 12-month default rate forecast up to 3.4%, from 2.6% previously. The new 3.4% forecast seems reasonable to us. A simple model of the 12-month trailing default rate based only on our measure of gross leverage for the nonfinancial corporate sector puts fair value for the 12-month default rate at 4.1% (Chart 11). Our measure of gross leverage is simply total debt divided by pre-tax profits. This measure fell during the past year because pre-tax profits grew by 17% and total debt grew by only 7%. Chart 11Default Expectations Default Expectations Default Expectations Going forward, profit growth will almost certainly moderate during the next 12 months, driven by the combination of weaker global growth and rising wage pressures. However, it needs to fall a long way, to below 7%, before our measure of leverage starts to rise. In other words, a further slight decline in our measure of gross leverage is a reasonable expectation at the current juncture, which would bring the fair value from our simple default rate model close to the current Moody’s projection. All in all, our default-adjusted spread tells us that high-yield bonds offer historically average compensation given reasonable default expectations. Bottom Line: Corporate breakeven spreads are too wide for this phase of the cycle, especially for the Baa and junk credit tiers. Our default-adjusted spread shows that high-yield valuation is in line with the historical average, given a reasonable expectation for default losses. Overall, we conclude that corporate spreads are attractive at current levels and we recommend an overweight allocation to both investment grade and high-yield corporate debt in a U.S. bond portfolio.   Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy Weekly Report, “The Powell Doctrine Emerges”, dated September 4, 2018, available at usbs.bcaresearch.com 2 Chairman Powell cites a few examples of this in his Jackson Hole address from last fall. https://www.federalreserve.gov/newsevents/speech/powell20180824a.htm 3 http://www.nber.org/papers/w13428  4 Please see U.S. Bond Strategy Weekly Report, “Don’t Position For Curve Inversion”, dated January 22, 2019, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, “Buy Corporate Credit”, dated January 15, 2019, available at usbs.bcaresearch.com 6 The 12-month breakeven spread is the spread widening required on a 12-month investment horizon for a corporate bond to break even with a duration-matched position in Treasury securities. It can be quickly approximated by dividing the bond’s option-adjusted spread by its duration. 7 For a more complete analysis of the economic cycle based on the slope of the yield curve please see U.S. Bond Strategy Special Report, “2019 Key Views: Implications For U.S. Fixed Income”, dated December 11, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Feature Conditions are falling into place in Brazil that will facilitate a recovery in physical property prices as well as the outperformance of real estate stocks. With the overall Brazilian equity index having rallied considerably, investors are now wondering which sectors of the market presently offer the most upside with the least risk. Our bias is that the risk-reward of property stocks is currently attractive both relative to the overall equity index as well as in absolute terms (Chart I-1). Chart I-1Good Risk-Or-Reward In Property Sector Good Risk-Or-Reward In Property Sector Good Risk-Or-Reward In Property Sector As such, we recommend investors begin accumulating Brazilian real estate stocks on weakness and other proxies that stand to benefit from a revival in both residential and commercial property markets. The Macro Case For Real Estate Following years of severe depression, fertile ground for strong growth in Brazilian real estate and related assets is finally developing: Interest rates are falling, employment and incomes are rising, and credit availability is improving amid substantial pent-up demand for properties. Barring an outright failure by the government to adopt pension reforms, which would cause major financial market turbulence, the economy will continue on a recovery path (Chart I-2). Please see page 7 for more details. Chart I-2Domestic Demand Bottoming... Domestic Demand Bottoming... Domestic Demand Bottoming... We upgraded our recommended allocation in Brazil from underweight to overweight across equity, fixed-income, currency and credit markets right after the October elections.1 We argued that the presidential election victory by pro-business candidate Jair Bolsonaro was set to revive sentiment and “animal spirits” among businesses, unleashing pent-up demand for capital expenditures and hiring. On the whole, the Brazilian economy is recovering from the most severe economic depression of the past several decades (Chart I-3). Consequently, there is a lot of pent-up demand for discretionary spending in general and properties in particular. Chart I-3...After The Worst Recession In Decades ...After The Worst Recession In Decades ...After The Worst Recession In Decades Our view remains negative on Chinese growth and commodities. Historically, Brazilian financial markets have never sustainably diverged from commodities prices, as illustrated in Chart I-4. Nevertheless, going forward the odds that Brazilian domestic plays could decouple from commodities prices are non-trivial. Chart I-4Can Brazilian Financial Markets Decouple From Commodities? Can Brazilian Financial Markets Decouple From Commodities? Can Brazilian Financial Markets Decouple From Commodities? Importantly, aggregate exports make up only 13% of Brazilian GDP (Chart I-5). This indicates that Brazil’s exposure to global demand in general and commodities in particular is not substantial. Besides, Brazil’s commodities exports are very diversified – overseas shipments of each commodity accounts for only a small portion of Brazilian exports and GDP (Table I-1). Chart I-5Brazil Is A Closed Economy! Brazil Is A Closed Economy! Brazil Is A Closed Economy! Chart I- In Brazil, the property market is one of the few sectors that is least exposed to global growth and most leveraged to local interest rates and household income growth. Hence, this sector stands to outperform in a scenario where global cyclicals and commodities fare poorly while domestic income and spending recover. Notably, real estate is the most leveraged play on falling real interest rates. The rationale for why real estate is more sensitive to real rather than nominal rates is as follows: Property prices benefit from higher inflation – higher inflation lifts nominal household income, which improves affordability for buyers and renters. In addition, investors often buy properties as an inflation hedge. Provided property prices positively correlate with inflation but negatively correlate with nominal interest rates, it follows that they are very strongly inversely correlated with real (inflation-adjusted) interest rates. Confirming this, relative performance of property stocks to the overall market tracks real interest rate trends very closely (Chart I-6) Chart I-6Lower Real Rates Warrant Real Estate Stocks Outperformance Lower Real Rates Warrant Real Estate Stocks Outperformance Lower Real Rates Warrant Real Estate Stocks Outperformance Yields on inflation-indexed bonds – real rates – have recently broken down (Chart I-7). If Congress adopts social security reforms in the coming months, real interest rates could drop further. Chart I-7Real Rates Have Fallen To All-Time Lows Real Rates Have Fallen To All-Time Lows Real Rates Have Fallen To All-Time Lows In short, falling real rates will greatly benefit real estate prices and volumes. Some commentators might argue that Brazil’s low national savings rate will preclude real rates from falling. We discussed why a low national savings rate is not an impediment to a decline in real interest rates in our March 22, 2018 Special Report (please click on the link to access the report). Property Market: Post Depression… The majority of excesses have been wrung out of the physical property markets in Brazil over the past 5-6 years, and real estate prices and volumes are finally showing signs of recovery. Residential property prices have been flat in nominal terms over the past 5 years. Yet in real (inflation-adjusted) terms they have declined by 20%, and in U.S. dollar terms they are down 40% from their 2014 peak (Chart I-8). Chart I-8Apartment Prices Have Been Beaten Down Nationwide Apartment Prices Have Been Beaten Down Nationwide Apartment Prices Have Been Beaten Down Nationwide Property sales and prices in São Paulo have already begun rising, but not in Rio de Janeiro (Chart I-9). Typically, bull markets begin in financial and business centers and then spread to other cities and regions. Chart I-9Brazil: Apartment Prices Brazil: Apartment Prices Brazil: Apartment Prices Over the past two days, during our visit to clients in São Paulo, we witnessed very few cranes. Even in this financial and business center, property construction/supply remains extremely subdued. Vacancy rates in office spaces, residential property inventories, and the average sales time are all starting to fall (Chart I-10). These are all early signposts of revival. Chart I-10Signs Of Life Signs Of Life Signs Of Life Notably, the consumer debt-servicing ratio has fallen due to lower interest rates (Chart I-11). Mortgage rates remain high relative to the (SELIC) policy rate. However, odds are that this spread will narrow as confidence and appetite for mortgage lending among banks improves. Chart I-11Diminishing Household Debt Stress Diminishing Household Debt Stress Diminishing Household Debt Stress Bottom Line: Overall residential property prices across Brazil’s 11 largest metropolitan areas are slowly starting to rise in nominal but not in real terms yet (Chart I-12). The recovery is only beginning to take shape. Chart I-12Property Price Deflation Is Ending Property Price Deflation Is Ending Property Price Deflation Is Ending Pension Reforms Hold The Key At the moment, we believe pension reforms – not commodities prices – are the key to sustaining the positive momentum behind Brazil’s financial markets and economy. If Bolsonaro introduces pension legislation immediately, while his political capital is still high, then it will be a market-positive development. However, it is difficult to determine the odds of the passage of the social security reform bill, and the form in which it will be adopted. On one hand, the Brazilian Congress is as fragmented as ever. Bolsonaro’s PSL party holds only 52 seats, or 10% of the total. This means that the president has to convince 256 congressmen outside his party to vote for pension reforms in order to get the 308 votes required to pass this constitutional amendment (Chart I-13). His attempt to find a new way to form a coalition may backfire, at least initially, and he will also face obstructionist voting behavior from minor parties. Chart I-13 On the other hand, Brazilian presidents eventually tend to succeed in forming coalitions that comprise a majority of seats. On paper, right-leaning parties have slightly more seats than the three-fifths majority needed for constitutional changes in the Chamber of Deputies. Moreover, many congressmen are new faces in politics and represent small parties. They have little political experience and may not go against a popular president at the very early stages of their congressional terms. It is reasonable to assume that they could side with the president and vote for the pension reforms, for several reasons: (1) distancing themselves from Bolsonaro may not help their own popularity; and (2) voters may well be focused on issues other than unpalatable pension reforms four years from now if the economy is doing well. Hence, voting for the pension reforms early in their term may be a reasonable political strategy for them. Importantly, it seems these reforms have the initial backing of both the military and the police establishments, even though their pensions will be negatively impacted by the changes. Specifically, Vice President and retired general Hamilton Mourão has hinted at the army’s and police’s support of the upcoming social security reforms proposal. In brief, the adoption of pension reforms will create positive tailwinds for investor and business sentiment and in turn support the economic recovery. Investment Recommendation Brazilian stocks have lately exhibited a low correlation with the EM overall equity index. This gives us comfort in arguing that even if our negative view on EM risk assets plays out, Brazilian domestic equity plays will likely have only moderate downside in absolute terms, and certainly outperform the EM equity benchmark on a relative basis. Therefore, we recommend investors begin accumulating Brazilian real estate stocks on weakness. Even though their valuations are not cheap, rising revenue and cash flow will improve their valuation metrics and boost their share prices. With respect to sector composition, the Brazilian real estate sector is comprised of 27 listed firms: 15 listed homebuilders, 7 mall operators, 3 commercial properties and 2 brokers.2 Their total market cap relative to the Bovespa is now around 1.2% – down from 2.4% in 2012 (Chart I-14). We recommend buying a mix of these companies to gain exposure to various parts of the Brazilian property market. Chart I-14More Upside In Real Estate Stocks bca.ems_sr_2019_01_24_s1_c14 bca.ems_sr_2019_01_24_s1_c14   Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Andrija Vesic, Research Analyst andrijav@bcaresearch.com Footnotes 1      Please see Emerging Markets Strategy Special Alert "Brazil: A Regime Shift?" dated October 9, 2018, available on page 12. 2      We used the BM&FBOVESPA Real Estate Index (IMOB) in Chart 14. The Real Estate Index (IMOB) is compiled as a weighted average of 13 stocks. For more detail, please refer to: http://www.b3.com.br/en_us/market-data-and-indices/indices/indices-de-segmentos-e-setoriais/real-estate-index-imob.htm Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Our leading indicator for China’s old economy continues to point to slower growth over the coming months, which is consistent with the bearish message from China’s housing market and forward-looking export indicators. We would caution investors against interpreting the recent relative outperformance of Chinese stocks as a basis to become cyclically bullish, as it has largely reflected a “catchup” selloff in global stocks. We remain tactically overweight, in recognition of the fact that investors may bid up Chinese stocks on positive signs that a trade deal may be in sight. Onshore corporate bond spreads remain wide relative to pre-2017 levels, suggesting that it is too early to expect easier liquidity conditions to significantly improve domestic economic conditions. Feature Tables 1 and 2 on pages 2 and 3 highlight key developments in China’s economy and its financial markets over the past month. On the growth front, the primary trend for China’s old economy remains down, although measures of freight remain supported by trade front-running activity (which will wane over the coming months). Our Li Keqiang leading indicator continues to suggest that economic activity will slow from current levels, a conclusion that is reinforced by recent developments in the housing market and December’s PMI release. Table 1The Trend In Domestic Demand, And The Outlook For Trade, Remains Negative Monitoring The (Weak) Pulse Of The Data Monitoring The (Weak) Pulse Of The Data   Table 2Financial Market Performance Summary Monitoring The (Weak) Pulse Of The Data Monitoring The (Weak) Pulse Of The Data From an investment strategy perspective, we remain tactically overweight Chinese investable stocks versus the global benchmark in recognition of the fact that investors may bid up Chinese stocks on positive signs that a trade deal may be in sight. However, China’s recent outperformance has been passive in nature (i.e. reflecting declining global stocks), suggesting that Chinese stocks have simply been the winner of an “ugly contest” over the past few months. This is hardly a basis to be cyclically long, and we continue to recommend that investors remain neutral for now. In reference to Tables 1 and 2, we provide several detailed observations concerning developments in China’s macro and financial market data below: Bloomberg’s measure of the Li Keqiang index (LKI) fell in November for the third month in a row, although our Alternative LKI has risen due to a pickup in freight transport turnover. We showed in our December 5 Weekly Report that trade front-running has clearly boosted economic activity since Q1 of 2018,1 implying that freight volume growth is set to decelerate in the months ahead. Our Li Keqiang leading indicator ticked lower in December, after having risen non-trivially in the third quarter of 2018 (Chart 1). The December decline was caused by a pullback in the monetary conditions components of the indicator, which in turn was caused by the recent rise in CNY-USD. This echoes a point that we have made in previous reports, that the improvement in our leading indicator last year was not broad-based and that it does not yet herald a positive turning point for China’s old economy. Chart 1The Q3 Rise In Our Leading Indicator Was Not Broad-Based The Q3 Rise In Our Leading Indicator Was Not Broad-Based The Q3 Rise In Our Leading Indicator Was Not Broad-Based The October housing market slowdown that we highlighted in our November 21 Weekly Report continued into December,2 with floor space started and sold decelerating further (Chart 2). The latter, which typically leads the former, has returned to negative territory which, in conjunction with weaker Pledged Supplementary Lending from the PBOC, does not bode well for housing over the coming few months. House price appreciation remains strong outside of tier 1 cities, but a peak in our price diffusion indexes signals slower price gains are likely over the coming months. Chart 2China's Housing Market Activity Continues To Weaken China's Housing Market Activity Continues To Weaken China's Housing Market Activity Continues To Weaken On the trade front, nominal Chinese US$ import and export growth is now trending lower, confirming the negative signal provided by China’s manufacturing PMIs over the past few months. Notably, the new export orders components of both the official and Caixin PMIs declined in December, despite the tariff ceasefire that emerged during the G20 meeting at the end of November, suggesting that export growth is set to slow further in the first quarter of 2019. In relative US$ terms, Chinese investable stocks rose nearly 10% versus the global benchmark from mid-October until the end of 2018. However, as Chart 3 shows, this outperformance was entirely passive in nature, as Chinese stocks have not been trending higher in absolute terms. Chart 3Recent Equity Outperformance Has Been Passive, Not Active Recent Equity Outperformance Has Been Passive, Not Active Recent Equity Outperformance Has Been Passive, Not Active We remain tactically overweight Chinese investable stocks; the Chinese market remains deeply oversold in absolute terms, and signs of a potential trade deal over the coming few weeks may significantly improve global investor sentiment towards the country’s bourse. However, we would caution investors against interpreting the recent relative outperformance as a basis to become cyclically bullish, as it has largely reflected a “catchup” selloff in global stocks. The underperformance of Chinese health care stocks over the past two months has been stunning, with investable health care having fallen nearly 30% in relative terms since mid-November (Chart 4). However, this decline appears to have been caused by a sector-specific event (a massive profit margin squeeze due to a new government generic drug procurement program), and does not seem to imply anything about the outlook for Chinese consumers. Chart 4A Stunning, Idiosyncratic, Collapse In Health Care Stocks A Stunning, Idiosyncratic, Collapse In Health Care Stocks A Stunning, Idiosyncratic, Collapse In Health Care Stocks Despite the recent collapse in the health care sector, Chinese consumer discretionary (CD) stocks remain the largest losers within the investable universe, having declined over 40% in US$ terms over the past 12 months. The next twelve months may look quite different for CD, especially if China’s efforts to stimulate consumer spending succeed. The recent changes to the global industrial classification system (GICS) mean that Alibaba (China’s largest e-commerce retailer) is now included in the sector with a significant weight, overwhelming the heavy influence that auto producers used to wield. Auto stocks have struggled in the past due to China’s pollution controls, weak auto sales, and pledges to open up the auto sector (which would be negative for the market share of domestic firms). We will be watching over the coming several months for a pickup in retail goods spending combined with a technical breakout in relative performance as a sign to overweight Chinese consumer discretionary stocks relative to the investable index. Chinese interbank rates have fallen substantially over the past month (Chart 5), in response to additional efforts by the PBOC to boost liquidity in the financial system. Whether the additional liquidity (and lower borrowing rates) will feed into materially stronger credit growth remains to be seen, as we have presented evidence in past reports showing that China’s monetary policy transmission mechanism is impaired.2 Chart 5More Liquidity Has Lowered Interbank Rates More Liquidity Has Lowered Interbank Rates More Liquidity Has Lowered Interbank Rates Chinese onshore corporate bond spreads have creeped modestly higher since early-November, although by a small magnitude. While we remain optimistic that onshore defaults over the coming year will be less intense than many investors believe, onshore corporate bond spreads have been one of the more successful leading indicators of economic growth in China over the past two years, and remain wide by historical standards. This suggests that it is too early to expect easier liquidity conditions to significantly improve domestic economic conditions. While it is too early to call a durable bottom, the gap between CNY-USD and its 200-day moving average is steadily closing (Chart 6). The recent (modest) uptrend has been caused by two factors: 1) cautious optimism about the possibility of a durable trade deal with the U.S., and 2) retreating U.S. interest rate expectations. We would expect further weakness if the trade ceasefire collapses and President Trump moves forward with the previously-announced tariffs, but also a sizeable rally if a deal is negotiated. Chart 6A Tentative, But Noteworthy Improvement A Tentative, But Noteworthy Improvement A Tentative, But Noteworthy Improvement   Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com Footnotes 1      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. 2      Please see China Investment Strategy Weekly Report “Trade Is Not China's Only Problem”, dated November 21, 2018, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights The often-quoted 60% urbanization rate understates the extent of China’s industrialization. China is much more industrialized than generally perceived: the country’s industrialization rate is currently 82.5% – i.e., over 80% of jobs in China are already in non-agricultural sectors. This entails a slower rate of industrialization and urbanization going forward. Both rural-to-urban labor migration and expansion of existing cities will slow significantly over the next decade. Transforming rural areas into urban without migration will become the major form of urbanization over the next decade. Investment themes: Demand for urban property will slow considerably, while agricultural machinery sales may have sustainable growth ahead. Feature The scale of urbanization in China over the past two decades has been unprecedented in human history. China’s urban population has increased by 460 million from 1995 to 2017, outnumbering the total population of the U.S. and Japan combined. The extraordinary urbanization process, fundamentally driven by the country’s rapid and widespread industrialization process, had led to a massive migration of laborers from rural to urban areas, and in turn significant expansion of cities and a huge boom in the Chinese real estate market. Where is China now in terms of its industrialization and urbanization path? Will further urbanization be able to continue to support very high productivity growth as well as demand for its already bubbly property market? This report takes a closer look at the country’s progress of industrialization and urbanization. Industrialization Versus Urbanization Urbanization commonly refers to the increase in the proportion of people living in urban areas. For China, the National Bureau of Statistics (NBS) has two sets of data measuring the country’s urbanization rate – one uses the number of people who have resided in an urban area1 for at least six months within the period of one year, and the other uses the number of people who have only registered non-agricultural hukou.2 However, neither measure reflects the country’s industrialization level. Industrialization is defined as the transformation of an agrarian economy into an industrial one. One way to measure it is the share of employment in non-agricultural3 sectors of total employment. Based on this measure, China’s industrialization process is already reasonably advanced. Chart 1 shows that while only about 60% of the population lives in an urban area, as defined by the NBS (this is the often-cited measure by economists and strategists), World Bank data show that China’s industrialization rate is currently 82.5% – i.e., over 80% of jobs in China are already in non-agricultural sectors. This underscores that China’s development path is more advanced than is generally perceived by investors. Chart 1China: More Industrialized Than Perceived China: More Industrialized Than Perceived China: More Industrialized Than Perceived China’s urbanization rate cannot capture the fact that there are many non-agricultural jobs held by people living and working in areas administratively classified as rural. Therefore, the 60% urbanization rate understates the extent of China’s industrialization, and overestimates potential upside in future growth. The nation is already reasonably advanced in terms of moving labor from agriculture to non-agriculture industries. This conclusion is reinforced by comparing China with developed economies (the U.S., Japan and South Korea) based on standard urbanization rates and based on our measure of industrialization: The latter points to a much smaller gap between China and advanced countries than the former (Charts 2 and 3). Chart 2China Vs. Advanced Economies: A Much Smaller Gap In Industrialization Measure... China Vs. Advanced Economies: A Much Smaller Gap In Industrialization Measure... China Vs. Advanced Economies: A Much Smaller Gap In Industrialization Measure... Chart 3…Than In Standard Urbanization Measure ...Than In Standard Urbanization Measure ...Than In Standard Urbanization Measure China’s industrialization rate at 82.5% is similar to South Korea in the early-1990s (Chart 4, top panel). If in next 10 years China’s industrialization progresses in line with the South Korean experience during 1991-2001, this will mean China’s industrialization pace – defined as an annual increase in the industrialization rate – will slow materially to 0.6 percentage points per year over the next decade, from 1.4 percentage points per year over the past decade (Chart 4, bottom panel). Chart 5 demonstrates the close correlation between the pace of industrialization and real per capita GDP growth in both China and South Korea. What is clear from the chart is that as the pace of industrialization decelerates, per capita real income growth will slow further.   Chart 4Korean's Roadmap: Falling China's Industrialization Pace Ahead Korean's Roadmap: Falling China's Industrialization Pace Ahead Korean's Roadmap: Falling China's Industrialization Pace Ahead Chart 5Industrialization Pace Vs. Real Per Capita GDP Growth: Closely Correlated Industrialization Pace Vs. Real Per Capita GDP Growth: Closely Correlated Industrialization Pace Vs. Real Per Capita GDP Growth: Closely Correlated Indeed, industrialization has allowed massive rural-to-urban labor migration as well as enormous expansion of existing cities. Due to the high base, the pace of industrialization has already been slowing, and will continue to do so. Consequently, China’s industrialization-driven urbanization will also continue to lose steam, with ramifications for the economy and its various sectors. We discuss below each of the specific factors that are likely to contribute to China’s future urbanization path, and then conclude the report with the attendant implications for Chinese real estate and agricultural machinery sales. Falling Rural-To-Urban Migration Industrialization generally leads to urbanization by establishing manufacturing factories and generating job opportunities, which in turn induces the movement of agriculture labor to cities. Hence, rural-to-urban migration, triggered by industrialization, is typically the main driver of rising urbanization. Currently, rural-to-urban migration is falling, which is a negative signal for the pace of future urbanization. In China, the rural-to-urban migration process is indeed slowing – i.e., the number of new migrant workers moving from rural areas to cities has already decreased nearly by half, from an average of 9.3 million per year over 2009-2012 to 4.8 million per year over 2013-2017. If we exclude migrant workers aged 50 and above, the number of migrant workers (a stock variable) actually contracted last year (Chart 6). Chart 6The Number Of Young Migrant Workers: Actually Contracted In 2017 The Number Of Young Migrant Workers: Actually Contracted In 2017 The Number Of Young Migrant Workers: Actually Contracted In 2017 Several points suggest that the rural-to-urban migration process will likely progress at an even slower pace going forward: Declining industrial employment: Employment in industrial sectors has contracted across the board, implying less demand for migrant workers (Chart 7). Employment has contracted in all 30 industrial subsectors that the NBS monitors, and 29 of them currently have fewer employees than five years ago. Higher automation in factories, the government’s de-capacity reforms in some industries with excessive capacity (i.e., coal, steel, aluminum, cement and so on), and some labor-intensive industries (i.e. textiles) shifting to other low-labor-cost countries (i.e. Vietnam, Pakistan, Bangladesh, etc.) are all factors that have contributed to the reduction in industrial employment. Chart 7Declining Industrial Employment Declining Industrial Employment Declining Industrial Employment Aging migrant workers: The average age of migrant workers has already risen from 34 in 2008 to 39.7 last year, with 21.3% of total migrant workers now aged 50 and above. As they continue to age over the next five to 10 years, our sense is that a considerable proportion of these older migrant workers will likely move back out of urban areas because of the existence of a family support network in their villages/rural townships. Shrinking youth population in rural areas: China’s rural population has declined by 33% from its peak of about 860 million in 1995 to 577 million in 2017 (Chart 8, top panel). All else equal, the lower rural population base alone will result in smaller rural-to-city migration compared to the previous two decades. More importantly, as substantial numbers of the working-age population left their rural homes for cities, the proportion of elders in the rural population has significantly increased, while the proportion of young people has drastically decreased. The current 19-and-under cohort will be the major source of future rural-to-urban migration over next five to 10 years. Based on the NBS data, in rural areas the share of the population aged 50 and over rose to 33% in 2017, much higher than the 25% of the population aged 19 and younger. This contrasts with 18% and 36%, respectively, back in 1997. The increasing proportion of elders and the declining proportion of the young population segment in rural areas implies smaller rural-to-city migration scale going forward. Chart 8Rural-To-Urban Migration Will Continue To Decline Rural-To-Urban Migration Will Continue To Decline Rural-To-Urban Migration Will Continue To Decline Changing preferences of the rural population: In recent years, the agricultural hukou has become much more valuable than in the past. In China, the government always assigns a piece of land for farming to a person with an agricultural hukou when he or she is born. This does not apply to a person with a non-agricultural hukou. As the central government’s policy focuses more on rural development, more non-farming job opportunities will likely be created in the rural areas. Services that in the past could only be enjoyed in urban areas are now spreading into rural areas as well, suggesting farmers who have either kids or elder parents to take care of will be more willing to stay in rural areas. If we use the annual change in the rural population as an indicator to predict the scale of rural-to-urban migration, the migration started in 1996 and peaked in 2010, and will decline going forward (Chart 8, bottom panel). Bottom Line: The scale of rural-to-urban migration will likely continue to diminish in the next five to 10 years. Slower City Area Expansion China’s industrialization-driven urbanization is not only driven by rural-to-urban labor migration, but also by the process of expanding and developing existing urban areas. In Western parlance, this factor would be described as the intense development of the territories surrounding the core of a “metropolitan area.” By establishing manufacturing factories, developing public facilities (roads, highways, subways, schools, hospitals, recreation centers, etc.), and constructing residential/commercial buildings to accommodate massive influxes of migrant workers in the rural areas surrounding cities, these territories have quickly expanded and have been transformed into urban areas4 over the past two decades. Statistics show that the “city area” in China has expanded 150% since 2000, almost twice the 77% rate of growth in the urban population during the same period (Chart 9, top panel). Chart 9Overdevelopment Of City Area Expansion Overdevelopment Of City Area Expansion Overdevelopment Of City Area Expansion In these now formerly rural areas, local governments often bought land from local farmers and then either sold the land to real estate developers to construct new residential properties or commercial buildings or used the land to develop public facilities. As a result, living conditions and economic development in these rural areas have become “urban-like.” Looking forward, over the next five to 10 years, we believe city area expansion will slow considerably (Chart 9, bottom panel). First, local governments have already taken on massive debt to fund city area expansion over the past two decades, as part of an attempt to demonstrate the success of their economic development plans to the central government (which is usually measured by GDP). However, circumstances have changed. China’s central government now expects local governments to generate “high-quality” and environmentally-sustainable economic growth – and they are unlikely to measure the performance of local government officials simply based on GDP. In addition, containing debt/leverage (including that of SOEs and local governments) is a priority for the central government, implying that debt-fueled city area expansion is unlikely to continue. Moreover, Beijing has already shifted its policy focus from city-area expansion to rural-in-situ urbanization (discussed below). Bottom Line: Past overdevelopment and constraints on local governments suggest that city-area expansion in China will slow considerably in the next five to 10 years, constraining the country’s urbanization pace. Rising Rural-In-Situ Urbanization Going forward, the major driver of urbanization in China will be greatly different from the previous 30 years. Over the next five to 10 years, China’s urban population growth will be driven more by the rural-in-situ urbanization (urbanization without people migration) by transforming rural areas into urban. This is in contrast to urbanization through rural-to-urban labor migration and city-area expansion. The rural-in-situ urbanization – transforming townships/villages directly into towns – has become a policy focus of the central government. The Chinese central government released its first national urbanization plan in March 2014 and announced the “Rural Revitalization Strategic Plan 2018-2022” in September. Both strategic blueprints emphasize the goal of “rural-in-situ urbanization” over the next five to 10 years, to be achieved by building up villages directly into towns. There are currently about 7,000 specialty towns planned or under construction, and it seems more are on the way. However, given already high local government debt and lack of funds for a sizeable proportion of Chinese local governments, we believe a considerable portion of the development of these specialty towns will miss their initial expectations. We expect the rural-in-situ urbanization to be the major force of further urbanization in China (Chart 10). As noted above, the shifting demographic structure of China’s rural areas and the changing preferences of the rural population will also facilitate the rural-in-situ urbanization. Meanwhile, with the government’s policy support, disposable income per capita in rural areas will likely continue to grow faster than in urban areas, which may also help induce rural farmers to remain in rural areas (Chart 11). Chart 10Rising Rural-In-Situ Urbanization Rising Rural-In-Situ Urbanization Rising Rural-In-Situ Urbanization Chart 11Rural Vs. Urban: Higher Disposable Income Per Capita Growth Rural Vs. Urban: Higher Disposable Income Per Capita Growth Rural Vs. Urban: Higher Disposable Income Per Capita Growth Bottom Line: Over the next decade, China’s urbanization will be driven more by the rural-in-situ urbanization (without people migration) by transforming rural areas into urban. Rising “Organic” Urban Population Growth As a final point, “organic” urban population growth (births minus deaths) will likely account for a larger share of China’s rising urban population in the future. A larger urban population base, improving birth rate due to the end of the one-child policy and longer life expectancy (76.3 in 2016 vs. 74 in 2005) will result in a rising urban population going forward (Chart 12). Chart 12Rising "Organic" Urban Population Growth Rising "Organic" Urban Population Growth Rising "Organic" Urban Population Growth However, unaffordable housing and rising household debt levels (Chart 13) are generating pressure on new families, suggesting the demographic dividend of removing the one-child policy may be smaller than hoped. As a result, a rising urban-area population is unlikely to offset the slowing urbanization factors noted above. Chart 13Household Leverage: China And U.S. Structural Headwinds For Chinese Household Consumption Growth Growing Reluctance To Have More Kids Household Leverage: China And U.S. Structural Headwinds For Chinese Household Consumption Growth Growing Reluctance To Have More Kids Household Leverage: China And U.S. Structural Headwinds For Chinese Household Consumption Growth Growing Reluctance To Have More Kids Bottom Line: We believe China’s urban population growth will drift below 2.5%, the lowest in the past 30 years (Chart 14). Chart 14China's Urban Population Growth Will Drift Lower China's Urban Population Growth Will Drift Lower China's Urban Population Growth Will Drift Lower Investment Implications A declining pace of industrialization and changing forms of urbanization will have the following ramifications: Falling rural-to-urban labor migration points to diminishing property demand from migrant workers. This is structurally bearish for the Chinese residential real estate market, given that most residential construction has occurred in urban areas (Chart 15). Investors holding housing units in urban areas in expectations of rampant price appreciation due to continuous large-scale rural-to-urban migration will be disappointed in the long run. Chart 15Chinese Property Demand: Gloomy Outlook Chinese Property Demand: Gloomy Outlook Chinese Property Demand: Gloomy Outlook An emphasis on rural-in-situ urbanization suggests the government is aiming to improve the living conditions of rural households to enable them to live more similar to urban households. For income per capita in rural areas to rise faster, their productivity growth should grow more rapidly. To raise productivity in the agricultural sector, the government is aiming to implement farmland reforms as proposed by the “Rural Revitalization Strategic Plan 2018-2022.” The objective is to enable either the private sector or public sector to collate many small pieces of farmland into large ones. Large tracts of farmland will in turn allow for an improvement in productivity by applying modern agricultural techniques and machinery. Hence, we believe agricultural machinery sales may have sustainable growth ahead. The aging population and rising number of newborns suggest growth in healthcare, childcare and eldercare will outperform the real estate and raw materials sectors over the long run. Ellen JingYuan He, Associate Vice President Emerging Markets Strategy EllenJ@bcaresearch.com   Footnotes 1      The definition of urban area and rural area in China is based on the country’s administrative divisions defined by the government. In China, cities and towns are recognized as urban areas while townships and villages are considered to be rural areas. 2      The Hukou system is a governmental household registration process to define residence in mainland China. It determines a person’s access to housing, education, medical treatment, and social welfare in a city. 3      All sectors other than the agricultural sector (farming, fishery, forestry and animal husbandry). 4      There is no clear definition or standards for the transformation of rural areas to urban areas. In general, a rural area, where has become more developed in terms of economic development, more connected to the city or town in terms of transportation and public facility access, and the residents’ living condition is more like the urban residents, is more likely to be re-defined as urban area by the local government. CYCLICAL INVESTMENT STANCE

Highlights Our Special Report on housing betrayed little concern, … : We noted the softness in housing, and its drag on U.S. growth, in our November 19 Special Report, but we concluded that it was not sending a more worrisome message about the U.S. economic outlook. ... which didn’t mesh with several of our clients’ assessments, … : Our conclusion was apparently out of step with a fair proportion of investors. The clients who contacted us are not convinced that the softness so far isn’t just the tip of the iceberg. … so we’ve been discussing it a lot, … : Some BCA strategists are also more uneasy about housing and what it may be saying about the fate of the expansion. The topic continues to be bandied about in our daily meetings, and it probably hasn’t been exhausted yet. … and we’re sharing the conversations with everyone now: Publicly airing our one-on-one discussions gives all clients a chance to listen in and also gives us a chance to expand upon our views. Though we stand by our original conclusion, engaging in dialogue has enhanced our understanding of the issues. Feature The stock market still feels a little shaky, but the S&P 500 bounced smartly off of 2,640 once again, the abbreviated day-after-Thanksgiving session aside. Our Global Investment Strategy colleagues’ MacroQuant model sees more near-term downside, but neither of our teams believes that the bull market is over. The economy is strong; monetary policy remains accommodative; and fiscal stimulus will continue to support growth in 2019, albeit to a lesser degree. We do not see the good times ending for risk assets or the expansion until the Fed intervenes to bring the curtain down. We will discuss our outlook for the coming year, and the way we expect the key cycles will evolve, next week. For now, we turn to the wave of client questions that followed our Special Report on housing two weeks ago. The general view seems to be that we are not taking the potential implications of disappointing housing data seriously enough. The highlights of our follow-up discussions appear below, but we continue to believe that the housing slowdown does not portend larger immediate problems. Q: What about the effect of the new $10,000 cap on the deductibility of state and local taxes in high-tax states? The $10,000 cap on state and local tax (SALT) deductions will hurt housing demand at the margin, as will lower limits on mortgage interest deductibility. People respond to incentives, and several households may choose to rent instead of buy now that homeownership subsidies have been dialed back. The 1986 Tax Reform Act provides a ready antecedent. The mortal wound it dealt real estate tax shelters set the stage for the commercial real estate downturn of the late ‘80s and early ‘90s, and it also contributed to the nearly decade-long stagnation in nominal home prices (Chart 1) that was quite nasty in inflation-adjusted terms (Chart 2). Chart 1The Last Tax-Code Revamp Squeezed Home Values... The Last Tax-Code Revamp Squeezed Home Values... The Last Tax-Code Revamp Squeezed Home Values...   Chart 2...Especially On An Inflation-Adjusted Basis ...Especially On An Inflation-Adjusted Basis ...Especially On An Inflation-Adjusted Basis The regional disparities in home sales do not suggest that the tax changes have been a primary driver of the softness. Households in states with high income-tax burdens are most likely to go from itemizing their deductions (the mechanism for claiming housing subsidies) to taking the standard deduction. If the SALT rule change were squeezing home sales, one would expect that the states with the highest income-tax rates would be experiencing the biggest declines. We tested that proposition by comparing population-weighted tax rates with the share of home sales in each region. Although the South has the lowest top marginal income tax rate by a mile (Table 1), it has lost nearly two percentage points, or 4%, of its national market share since this year’s peak in home sales (Table 2). The high-tax Northeast, on the other hand, picked up nearly one percentage point, or 9%, of market share. The onerously-taxed West has lost the same proportional share as the South, but its homes are also the least affordable – a family earning the median income barely qualifies for a standard mortgage to buy the median-priced house in that region (Chart 3, bottom panel). Table 1Regional Income Tax Rates Housing Seminar Housing Seminar   Table 2Regional Share Of National Home Sales Housing Seminar Housing Seminar   Chart 3Only The West Is A Stretch Only The West Is A Stretch Only The West Is A Stretch Bottom Line: Income tax changes reducing homeowner subsidies will surely dampen marginal demand for homes, but they have not yet had an observable effect on the regional data. Q: The decline in activity has been modest so far, but what if it’s the start of something bigger? How do you know it’s not 2006? Housing is an important part of the economy, and residential investment could become a problem if it weakens further. We did not mean to imply that investors can ignore what’s going on in the industry. Residential activity puts a lot of people to work, directly and indirectly, and drives big-ticket consumption of home improvements, appliances and home furnishings. Its status as a rate-sensitive pillar helps provide insight into the effect of monetary policy, a particular flash point right now. From the narrow perspective of whether or not housing is likely to tip the economy into a recession, however, the arithmetic is clear. According to the IMF’s latest projections, fiscal stimulus will add 40 basis points to real GDP in 2019. Merely offsetting the effect of next year’s fiscal thrust would require residential investment, which accounts for 3.3% of GDP, to contract by 12% on an annualized basis. Residential construction would have to grind to a halt to wipe out projected growth of 2.5%. Even following October’s new home sales dud, the housing market is nowhere near oversupplied (Chart 4). The supply/demand balance is night-and-day different from what it was ahead of the crisis. Back then, there was also a decade of excessive mortgage issuance that needed to be unwound. Housing remains an important component of the economy, but it has shrunk to the point that it is not in a position to overwhelm the preponderance of positive macro data. Chart 4Supply Is Tight Supply Is Tight Supply Is Tight Bottom Line: We are watching housing, as BCA always has, but the market’s aggregate undersupply gives us confidence that residential activity is not about to fall off of a cliff. Q: The value of the housing stock is so large that it wouldn’t take a bust to have major economic implications. Consumption would immediately be at risk, and the economy with it. It is true that homes account for a sizable portion of household net worth, but the widely-repeated notion that homes are the biggest asset on the aggregate household balance sheet is misleading. When considered in terms of homeowner equity (home value net of mortgage obligations), homes currently account for about 14% of aggregate household net worth. Pension entitlements and equity and mutual fund holdings each account for about a quarter of net worth, and cash and equity in non-corporate businesses each account for about an eighth (Chart 5). Homeowner equity’s share of household net worth has rebounded nicely from its crisis lows, but it is a full third below its 1980s and 2006 peaks. Chart 5Home Values Matter, But They're Far From The Whole Story Home Values Matter, But They're Far From The Whole Story Home Values Matter, But They're Far From The Whole Story The point is that a generalized decline in home prices might affect consumption less than investors fear. The wealth effect is real, but fluctuations in home values are not evident to homeowners in real time. While we estimate that consumption falls five cents for every dollar decline in home values, the two series do not always march in lockstep, as in the ‘90s and the initial post-crisis years, when consumption grew even as home prices shrank (Chart 6, bottom panel). With the market in a state of undersupply, we don’t see a reason to expect that home prices are at much risk. Chart 6Consumption And Home Price Appreciation Are Linked Consumption And Home Price Appreciation Are Linked Consumption And Home Price Appreciation Are Linked Bottom Line: Absent overbuilding, foolhardy lending, or a harmful structural change on the order of the imposition of the passive activity rules, there is no clear catalyst for severe home-price declines. The economy should be able to handle a modest home-price correction without too much ado. Q: Not so fast. The crisis demonstrated that there’s a direct link between housing and credit conditions. It doesn’t take a perma-bear to see how a decline in home prices could cause the banking system to seize up. Our BCA colleagues are quite familiar with our view that homes are the collateral for the U.S. banking system. That view is a broad generalization, but the crisis bore it out. Banks are vastly better capitalized than they were in 2007, however, and it is difficult to see a path to major declines in home prices. Busts follow booms because they’re a necessary cure for unsustainable excesses, but nothing extreme has occurred this time on either the supply or the price fronts. Although we are hardly card-carrying Austrians, we have a lot of sympathy for the view that ZIRP, NIRP and QE programs subjected financial markets to distortions. They abetted a search for yield that allowed questionable credits to attract capital and promoted a widespread relaxation of debt covenants. They additionally seem to have lit a fire under property values in jurisdictions where home prices have become detached from standard value metrics. In the main, however, those jurisdictions are not in the U.S. (Chart 7). Chart 7U.S. Housing Isn't The Problem U.S. Housing Isn't The Problem U.S. Housing Isn't The Problem In talking through the bank exposure issue with a client, we arrived at a simple rule: property markets that haven’t already received their comeuppance are the property markets that threaten wealth, confidence and banking systems. The U.S. got its comeuppance in the crisis: property values plunged, loans went bad en masse, banks and specialty lenders failed, the survivors were chastened, and new regulations were put in place to protect the bankers from themselves and the economy from banks. As the Fed continues on its slow march to remove monetary accommodation, it is entirely reasonable for a macro-minded investor to be on the lookout for wobbly property markets. S/he would be best served by studying the rest of the dollar bloc: Canada, Australia and New Zealand are all vulnerable; the United States is not. Q: The Kansas City market is bifurcated by price. Supply is constrained at lower price points, although the formerly red-hot move-up segment has slowed considerably since mortgage rates spiked. High-end homes are being discounted sharply, and the baby boomers’ 4,000-6,000-square-foot suburban behemoths, untouched since the ‘80s, cost as much as brand-new high-end construction once you factor in the work they’d need to make them appeal to today’s buyers. Meanwhile, the limited supply of homes for first-time buyers has multi-family apartments popping up on every block. A market based on location, location, location is inherently heterogeneous, but a lot of what is happening in Kansas City appears to be playing out nationally. The rapid rise in mortgage rates has dented demand across the board. We’ve been hearing rumblings about easy multi-family credit for a while, most memorably from a Texas client who told us in 2014 that a blueprint was all it took for an apartment developer to get a bank loan. There is no investment idea so good that it can’t be destroyed by too much capital, and it’s entirely possible that some developers, commercial real estate lenders, commercial mortgage-backed securities holders and apartment REITs could be vulnerable if entry-level supply surges. There is no sign right now that it will, however. According to the Harvard Joint Center for Housing Studies, “virtually all” of the nation’s metropolitan areas “had more homes for sale in the top third of the market by price than in the bottom third.” A limited supply of available land and rising construction costs push developers to migrate to higher price points. The trend toward more expensive homes has been in place across the entire 30-year history of the Harvard center’s annual survey: the share of smaller homes (1,800 square feet or less) has slid from 50 percent in 1988 to 36 percent in 2000 and 22 percent in 2017.1 The fate of the boomers’ homes touches on what may be the most compelling long-term issue: to whom will the baby boomers pass the baton? Will the millennials accumulate enough wealth to be able to take it? Will they want to, after living through the formative experience of the financial crisis? Will suburban and exurban homes go vacant as preferences shift to the density and walkability of town and city centers? Are wide swaths of the existing housing stock destined for obsolescence? We are not inclined to think so. Even if homeownership is suppressed by a lessened desire to own, or delays in starting a career in the wake of the crisis, millennials and their families will still need a roof over their heads. We expect that purchase and rental prices will correct for changes in location and decorating preferences; homebuyers will put up with dark cabinets, loud tile patterns and wall-to-wall shag carpeting if the price is right. Lower prices might be what’s needed to help solve a potentially thorny problem raised by a client in the antipodes: the transfer of wealth across generations. He sees barriers to homeownership for the middle class as a social and political powder keg. A transfer of wealth from older generations to younger generations, accomplished by property markdowns instead of punitive income and property taxes, could be far less disruptive for markets and may even help to ease inequality strains. Furthermore, buyers who get a deal on a property have more money available for other consumption, while those who pay up retain less dry powder to help keep the economy humming. Investment Implications Investors are well served to be alert for excesses that cannot be sustained, and it is a near certainty that a 10-year expansion nourished on extreme monetary accommodation would have bred more than a few. From our perspective, however, all of the worst ones exist beyond the borders of the United States. Virtually all of the post-crisis increase in private-sector leverage has been contained in the emerging markets. The wild residential party has been raging in the developed world’s other former British colonies: Canada, Australia and New Zealand face inevitably sharp declines in construction activity and home prices. We are neither congenital Pollyannas nor market cheerleaders. We are bent on sniffing out market and economic inflection points as adroitly as possible, but we’re convinced that investors who are looking for them in U.S. housing are barking up the wrong tree. The Fed is moving steadily toward inducing an inflection point, but it is not yet upon us, and when it arrives, the attendant distress is not going to be centered on the United States, which already underwent its trial by fire ten years ago. We remain vigilant, but we are constructive on the U.S. economy and risk assets, especially in relation to the rest of the world.   Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com   Footnotes 1The State of the Nation’s Housing 2018, Joint Center for Housing Studies of Harvard University, p.6.

Mr. X and his daughter, Ms. X, are long-time BCA clients who visit our office toward the end of each year to discuss the economic and financial market outlook. This report is an edited transcript of our recent conversation. Mr. X: I have been eagerly looking forward to this meeting given the recent turbulence in financial markets. Our investments have done poorly in the past year and, with hindsight, I wish I had followed my instincts to significantly cut our equity exposure at the end of 2017, although we did follow your advice to move to a neutral stance in mid-2018. I remain greatly troubled by economic and political developments in many countries. I have long believed in open and free markets and healthy political discourse, and this all seems under challenge. As always, there is much to talk about. Ms. X: Let me add that I also am pleased to have this opportunity to talk through the key issues that will influence our investment strategy over the coming year. As I am sure you remember, I was more optimistic than my father about the outlook when we met a year ago but things have not worked out as well as I had hoped. In retrospect, I should have paid more attention to your view that markets and policy were on a collision course as that turned out to be a very accurate prediction. When I joined the family firm in early 2017, I persuaded my father that we should have a relatively high equity exposure and that was the correct stance. However, this success led us to maintain too much equity exposure in 2018, and my father has done well to resist the temptation to say “I told you so.” So, we are left with a debate similar to last year: Should we move now to an underweight in risk assets or hold off on the hope that prices will reach new highs in the coming year? I am still not convinced that we have seen the peak in risk asset prices as there is no recession on the horizon and equity valuations are much improved, following recent price declines. I will be very interested to hear your views. BCA: Our central theme for 2018 that markets and policy would collide did turn out to be appropriate and, importantly, the story has yet to fully play out. The monetary policy tightening cycle is still at a relatively early stage in the U.S. and has not even begun in many other regions. Yet, although it was a tough year for most equity markets, the conditions for a major bear market are not yet in place. One important change to our view, compared to a year ago, is that we have pushed back the timing of the next U.S. recession. This leaves a window for risk assets to show renewed strength. It remains to be seen whether prices will reach new peaks, but we believe it would be premature to shift to an underweight stance on equities. For the moment, we are sticking with our neutral weighting for risk assets, but may well recommend boosting exposure if prices suffer further near-term weakness. We will need more clarity about the timing of a recession before we consider aggressively cutting exposure. Mr. X: I can see we will have a lively discussion because I do not share your optimism. My list of concerns is long and I hope we have time to get through them all. But first, let’s briefly review your predictions from last year. BCA: That is always interesting to do, although sometimes rather humbling. A year ago, our key conclusions were that: The environment of easy money, low inflation and healthy profit growth that has been so bullish for risk assets will start to change during the coming year. Financial conditions, especially in the U.S., will gradually tighten as decent growth leads to building inflationary pressures, encouraging central banks to withdraw stimulus. With U.S. equities at an overvalued extreme and investor sentiment overly optimistic, this will set the scene for an eventual collision between policy and the markets.  The conditions underpinning the bull market will erode only slowly which means that risk asset prices should continue to rise for at least the next six months. However, long-run investors should start shifting to a neutral exposure. Given our economic and policy views, there is a good chance that we will move to an underweight position in risk assets during the second half of 2018. The U.S. economy is already operating above potential and thus does not need any boost from easier fiscal policy. Any major tax cuts risk overheating the economy, encouraging the Federal Reserve to hike interest rates and boosting the probability of a recession in 2019. This is at odds with the popular view that tax cuts will be good for the equity market. A U.S. move to scrap NAFTA would add to downside risks. For the second year in a row, the IMF forecasts of economic growth for the coming year are likely to prove too pessimistic. The end of fiscal austerity has allowed the Euro Area economy to gather steam and this should be sustained in 2018. However, the slow progress in negotiating a Brexit deal with the EU poses a threat to the U.K. economy. China’s economy is saddled with excessive debt and excess capacity in a number of areas. Any other economy would have collapsed by now, but the government has enough control over banking and other sectors to prevent a crisis. Growth should hold above 6% in the next year or two, although much will depend on how aggressively President Xi pursues painful reforms. The market is too optimistic in assuming that the Fed will not raise interest rates by as much as indicated in their “dots” projections. There is a good chance that the U.S. yield curve will become flat or inverted by late 2018. Bonds are not an attractive investment at current yields. Only Greece and Portugal have real 10-year government bond yields above their historical average. Corporate bonds should outperform governments, but a tightening in financial conditions will put these at risk in the second half of 2018. The Euro Area and Japanese equity markets should outperform the U.S. over the next year reflecting their better valuations and more favorable financial conditions. Developed markets should outperform the emerging market index. Historically, the U.S. equity market has led recessions by between 3 and 12 months. If, as we fear, a U.S. recession starts in the second half of 2019, then the stock market would be at risk from the middle of 2018. The improving trend in capital spending should favor industrial stocks. Our other two overweight sectors are energy and financials. The oil price will be well supported by strong demand and output restraint by OPEC and Russia. The Brent price should average $65 a barrel over the coming year, with risks to the upside. We expect base metals prices to trade broadly sideways but will remain highly dependent on developments in China. Modest positions in gold are warranted. Relative economic and policy trends will favor a firm dollar in 2018. Unlike at the start of 2017, investors are significantly short the dollar which is bullish from a contrary perspective. Sterling is quite cheap but Brexit poses downside risks. The key market-relevant geopolitical events to monitor will be fiscal policy and mid-term elections in the U.S., and reform policies in China. With the former, the Democrats have a good chance of winning back control of the House of Representatives, creating a scenario of complete policy gridlock. A balanced portfolio is likely to generate average returns of only 3.3% a year in nominal terms over the next decade. This compares to average returns of around 10% a year between 1982 and 2017. As already noted, the broad theme that policy tightening – especially in the U.S. – would become a problem for asset markets during the year was supported by events. However, the exact timing was hard to predict. The indexes for non-U.S. developed equity markets and emerging markets peaked in late-January 2018, and have since dropped by around 18% and 24%, respectively (Chart 1). On the other hand, the U.S. market, after an early 2018 sell-off, hit a new peak in September, before falling anew in the past couple of months. The MSCI All-Country World index currently is about 6% below end-2017 levels in local-currency terms. Chart 1Our 'Collision Course' Theme For 2018 Played Out Our 'Collision Course' Theme For 2018 Played Out Our 'Collision Course' Theme For 2018 Played Out We started the year recommending an overweight in developed equity markets but, as you noted, shifted that to a neutral position mid-year. A year ago, we thought we might move to an underweight stance in the second half of 2018 but decided against this because U.S. fiscal stimulus boosted corporate earnings and extended the economic cycle. Our call that emerging markets would underperform was on target. Although it was U.S. financial conditions that tightened the most, Wall Street was supported by the large cut in the corporate tax rate while the combination of higher bond yields and dollar strength was a major problem for many indebted emerging markets. Overall, it was not a good year for financial markets (Table 1). Table 1Market Performance OUTLOOK 2019: Late-Cycle Turbulence OUTLOOK 2019: Late-Cycle Turbulence As far as the overall macro environment was concerned, we were correct in predicting that the IMF was too pessimistic on economic growth. A year ago, the IMF forecast that the advanced economies would expand by 2% in 2018 and that has since been revised up to 2.4% (Table 2). This offset a slight downgrading to the performance of emerging economies. The U.S., Europe and Japan all grew faster than previously expected. Not surprisingly, inflation also was higher than forecast, although in the G7, it has remained close to the 2% level targeted by most central banks. Table 2IMF Economic Forecasts OUTLOOK 2019: Late-Cycle Turbulence OUTLOOK 2019: Late-Cycle Turbulence Despite widespread fears to the contrary, the data have supported our view that Chinese growth would hold above a 6% pace in 2018. Nevertheless, a slowdown currently is underway and downside risks remain very much in place in terms of excessive credit and trade pressures. Another difficult year lies ahead for the Chinese authorities and we will no doubt return to this topic later. As far as our other key forecasts are concerned, we were correct in our views that oil prices and the U.S. dollar would rise and that the market would be forced to revise up its predictions of Fed rate hikes. Of course, oil has recently given back its earlier gains, but we assume that is a temporary setback. On the sector front, our macro views led us to favor industrials, financials and energy, but that did not work out well as concerns about trade took a toll on cyclical sectors. Overall, there were no major macro surprises in 2018, and it seems clear that we have yet to resolve the key questions and issues that we discussed a year ago. At that time, we were concerned about the development of late-cycle pressures that ultimately would undermine asset prices. That story has yet to fully play out. It is hard to put precise timing on when the U.S. economy will peak and, thus, when asset prices will be at maximum risk. Nevertheless, our base case is that there likely will be a renewed and probably final run-up in asset prices before the next recession. Late-Cycle Challenges Mr. X: This seems like déjà-vu all over again. Since we last met, the cycle is one year older and, as you just said, the underlying challenges facing economies and markets have not really changed. If anything, things are even worse: Global debt levels are higher, inflation pressures more evident, Fed policy is moving closer to restrictive territory and protectionist policies have ratcheted up. If it was right to be cautious six months ago, then surely we should be even more cautious now. Ms. X: Oh dear, it does seem like a repeat of last year’s discussion because, once again, I am more optimistic than my father. Obviously, there are structural problems in a number of countries and, at some point, the global economy will suffer another recession. But timing is everything, and I attach very low odds to a downturn in the coming year. Meanwhile, I see many pockets of value in the equity market. Rather than cut equity positions, I am inclined to look for buying opportunities. BCA: We sympathize with your different perspectives because the outlook is complex and we also have lively debates about the view. The global equity index currently is a little below where it was when we met last year, but there has been tremendous intra-period volatility. That pattern seems likely to be repeated in 2019. In other words, it will be important to be flexible about your investment strategy. You both make good points. It is true that there are several worrying problems regarding the economic outlook, including excessive debt, protectionism and building inflation risks. At the same time, the classic conditions for an equity bear market are not yet in place, and may not be for some time. This leaves us in the rather uncomfortable position of sitting on the fence with regard to risk asset exposure. We are very open to raising exposure should markets weaken further in the months ahead, but also are keeping careful watch for signs that the economic cycle is close to peaking. In other words, it would be a mistake to lock in a 12-month strategy right now. Mr. X: I would like to challenge the consensus view, shared by my daughter, that the next recession will not occur before 2020, and might even be much later. The main rationale seems to be that the policy environment remains accommodative and there are none of the usual imbalances that occur ahead of recessions. Of course, U.S. fiscal policy has given a big boost to growth in the past year, but I assume the effects will wear off sharply in 2019. More importantly, there is huge uncertainty about the level of interest rates that will trigger economic problems. It certainly has not taken much in the way of Fed rate hikes to rattle financial markets. Thus, monetary policy may become restrictive much sooner than generally believed. I also strongly dispute the idea that there are no major financial imbalances. If running U.S. federal deficits of $1 trillion in the midst of an economic boom is not an imbalance, then I don’t know what is! At the same time, the U.S. corporate sector has issued large amounts of low-quality debt, and high-risk products such as junk-bond collateralized debt obligations have made an unwelcome reappearance. It seems that the memories of 2007-09 have faded. It is totally normal for long periods of extremely easy money to be accompanied by growing leverage and increasingly speculative financial activities, and I don’t see why this period should be any different. And often, the objects of speculation are not discovered until financial conditions become restrictive. Finally, there are huge risks associated with rising protectionism, the Chinese economy appears to be struggling, Italy’s banks are a mess, and the Brexit fiasco poses a threat to the U.K. economy. Starting with the U.S., please go ahead and convince me why a recession is more than a year away. BCA: It is natural for you to worry that a recession is right around the corner. The current U.S. economic expansion will become the longest on record if it makes it to July 2019, at which point it will surpass the 1990s expansion. Economists have a long and sad history of failing to forecast recessions. Therefore, a great deal of humility is warranted when it comes to predicting the evolution of the business cycle. The Great Recession was one of the deepest downturns on record and the recovery has been fairly sluggish by historic standards. Thus, it has taken much longer than usual for the U.S. economy to return to full employment. Looking out, there are many possible risks that could trip up the U.S. economy but, for the moment, we see no signs of recession on the horizon (Chart 2). For example, the leading economic indicator is still in an uptrend, the yield curve has not inverted and our monetary indicators are not contracting. Our proprietary recession indicator also suggests that the risk is currently low, although recent stock market weakness implies some deterioration. Chart 2Few U.S Recession 'Red Flags' Few U.S Recession 'Red Flags' Few U.S Recession 'Red Flags' The buildup in corporate debt is a cause for concern and we are not buyers of corporate bonds at current yields. However, the impact of rising yields on the economy is likely to be manageable. The interest coverage ratio for the economy as a whole – defined as the profits corporations generate for every dollar of interest paid – is still above its historic average (Chart 3). Corporate bonds are also generally held by non-leveraged investors such as pension funds, insurance companies, and ETFs. The impact of defaults on the economy tends to be more severe when leveraged institutions are the ones that suffer the greatest losses. Chart 3Interest Costs Not Yet A Headwind Interest Costs Not Yet A Headwind Interest Costs Not Yet A Headwind We share your worries about the long-term fiscal outlook. However, large budget deficits do not currently imperil the economy. The U.S. private sector is running a financial surplus, meaning that it earns more than it spends (Chart 4). Not only does this make the economy more resilient, it also provides the government with additional savings with which to finance its budget deficit. If anything, the highly accommodative stance of fiscal policy has pushed up the neutral rate of interest, giving the Fed greater scope to raise rates before monetary policy enters restrictive territory. The impetus of fiscal policy on the economy will be smaller in 2019 than it was in 2018, but it will still be positive (Chart 5). Chart 4The U.S. Private Sector Is Helping To Finance The Fiscal Deficit The U.S. Private Sector Is Helping To Finance The Fiscal Deficit The U.S. Private Sector Is Helping To Finance The Fiscal Deficit Chart 5U.S. Fiscal Policy Still Stimulative In 2019 U.S. Fiscal Policy Still Stimulative In 2019 U.S. Fiscal Policy Still Stimulative In 2019 The risks to growth are more daunting outside the U.S. As you point out, Italy is struggling to contain borrowing costs, a dark cloud hangs over the Brexit negotiations, and China and most other emerging markets have seen growth slow meaningfully. The U.S., however, is a relatively closed economy – it is not as dependent on trade as most other countries. Its financial system is reasonably resilient thanks to the capital its banks have raised over the past decade. In addition, Dodd-Frank and other legislation have made it more difficult for financial institutions to engage in reckless risk-taking. Mr. X: I would never take a benign view of the ability and willingness of financial institutions to engage in reckless behavior, but maybe I am too cynical. Even if you are right that debt does not pose an immediate threat to the market, surely it will become a huge problem in the next downturn. If the U.S. federal deficit is $1 trillion when the economy is strong, it is bound to reach unimaginable levels in a recession. And, to make matters worse, the Federal Reserve may not have much scope to lower interest rates if they peak at a historically low level in the next year or so. What options will policymakers have to respond to the next cyclical downturn? Is there a limit to how much quantitative easing central banks can do? BCA: The Fed is aware of the challenges it faces if the next recession begins when interest rates are still quite low. Raising rates rapidly in order to have more “ammunition” for counteracting the downturn would hardly be the best course of action as this would only bring forward the onset of the recession. A better strategy is to let the economy overheat a bit so that inflation rises. This would allow the Fed to push real rates further into negative territory if the recession turns out to be severe. There is no real limit on how much quantitative easing the Fed can undertake. The FOMC will undoubtedly turn to asset purchases and forward guidance again during the next economic downturn. Now that the Fed has crossed the Rubicon into unorthodox monetary policy without generating high inflation, policymakers are likely to try even more exotic policies, such as price-level targeting. The private sector tends to try to save more during recessions. Thus, even though the fiscal deficit would widen during the next downturn, there should be plenty of buyers for government debt. However, once the next recovery begins, the Fed may feel increasing political pressure to keep rates low in order to allow the government to maintain its desired level of spending and taxes. The Fed guards its independence fiercely, but in a world of increasingly political populism, that independence may begin to erode. This will not happen quickly, but to the extent that it does occur, higher inflation is likely to be the outcome. Ms. X: I would like to explore the U.S.-China dynamic a bit more because I see that as one of the main challenges to my more optimistic view. I worry that President Trump will continue to take a hard line on China trade because it plays well with his base and has broad support in Congress. And I equally worry that President Xi will not want to be seen giving in to U.S. bullying. How do you see this playing out? BCA: Investors hoping that U.S. President Donald Trump and his Chinese counterpart Xi Jinping will reach a deal to end the trade war on the sidelines of the forthcoming G20 leaders' summit in Buenos Aires are likely to be disappointed. President Trump's fiscal policy is completely inconsistent with his trade agenda. Fiscal stimulus in a full-employment economy will suck in imports. It also forces the Fed to raise rates more aggressively than it otherwise would, leading to a stronger dollar. The result will be a larger U.S. trade deficit. Trump will not be able to blame Canada or Mexico for a deteriorating trade position because he just signed a trade agreement with them. The new USMCA agreement is remarkably similar to NAFTA, with the notable exception that it contains a clause barring Canada and Mexico from negotiating bilateral trade deals with China. This means Trump needs a patsy who will take the blame for America's burgeoning trade deficit and China will fill that role. For his part, President Xi knows full well that he will still be China’s leader when Trump is long gone. Giving in to Trump’s demands would hurt him politically. All this means that the trade war will persist. Mr. X: I see a trade war as a major threat to the economy, but it is not the only thing that could derail the economic expansion. Let’s explore that issue in more detail. The Economic Outlook Mr. X: You have shown in previous research that housing is often a very good leading indicator of the U.S. economy, largely because it is very sensitive to changes in the monetary environment. Are you not concerned about the marked deterioration in recent U.S. housing data? BCA: Recent trends in housing have indeed been disappointing, with residential investment acting as a drag on growth for three consecutive quarters. The weakness has been broad-based with sales, the rate of price appreciation of home prices, and builder confidence all declining (Chart 6). Even though the level of housing affordability is decent by historical standards, there has been a fall in the percentage of those who believe that it is a good time to buy a home. Chart 6Recent Softness In U.S. Housing Recent Softness In U.S. Housing Recent Softness In U.S. Housing There are a few possible explanations for the weakness. First, the 2007-09 housing implosion likely had a profound and lasting impact on the perceived attractiveness of home ownership. The homeownership rate for people under 45 has remained extremely low by historical standards. Secondly, increased oversight and tighter regulations have curbed mortgage supply. Finally, the interest rate sensitivity of the sector may have increased with the result that even modest increases in the mortgage rate have outsized effects. That, in turn, could be partly explained by recent tax changes that capped the deduction on state and local property taxes, while lowering the limit on the tax deductibility of mortgage interest. The trend in housing is definitely a concern, but the odds of a further major contraction seem low. Unlike in 2006, the home vacancy rate stands near record levels and the same is true for the inventory of homes. The pace of housebuilding is below the level implied by demographic trends and consumer fundamentals are reasonably healthy. The key to the U.S. economy lies with business investment and consumer spending and these areas are well supported for the moment. Consumers are benefiting from continued strong growth in employment and a long overdue pickup in wages. Meanwhile, the ratio of net worth-to-income has surpased the previous peak and the ratio of debt servicing-to-income is low (Chart 7). Last year, we expressed some concern that the depressed saving rate might dampen spending, but the rate has since been revised substantially higher. Based on its historical relationship with U.S. household net worth, there is room for the saving rate to fall, fueling more spending. Real consumer spending has grown by 3% over the past year and there is a good chance of maintaining that pace during most of 2019. Chart 7U.S. Consumer Fundamentals Are Healthy U.S. Consumer Fundamentals Are Healthy U.S. Consumer Fundamentals Are Healthy Turning to capital spending, the cut in corporate taxes was obviously good for cash flow, and surveys show a high level of business confidence. Moreover, many years of business caution toward spending has pushed up the average age of the nonresidential capital stock to the highest level since 1963 (Chart 8). Higher wages should also incentivize firms to invest in more machinery. Absent some new shock to confidence, business investment should stay firm during the next year. Chart 8An Aging Capital Stock An Aging Capital Stock An Aging Capital Stock Overall, we expect the pace of U.S. economic growth to slow from its recent strong level, but it should hold above trend, currently estimated to be around 2%. As discussed earlier, that means capacity pressures will intensify, causing inflation to move higher. Ms. X: I share the view that the U.S. economy will continue to grow at a healthy pace, but I am less sure about the rest of the world. BCA: You are right to be concerned. We expected U.S. and global growth to diverge in 2018, but not by as much as occurred. Several factors have weighed on CEO confidence outside of the U.S., including trade wars, a strong dollar, higher oil prices, emerging market turbulence, the return of Italian debt woes, and a slowdown in the Chinese economy. The stress has shown up in the global manufacturing PMI, although the latter is still at a reasonably high level (Chart 9). Global export growth is moderating and the weakness appears to be concentrated in capex. Capital goods imports for the major economies, business investment, and the production of investment-related goods have all decelerated this year. Chart 9Global Manufacturing Slowdown Global Manufacturing Slowdown Global Manufacturing Slowdown Our favorite global leading indicators are also flashing yellow (Chart 10). BCA’s global leading economic indicator has broken below the boom/bust line and its diffusion index suggests further downside. The global ZEW composite and the BCA boom/bust indicator are both holding below zero. Chart 10Global Growth Leading Indicators Global Growth Leading Indicators Global Growth Leading Indicators Current trends in the leading indicators shown in Chart 11 imply that the growth divergence between the U.S. and the rest of the world will remain a key theme well into 2019. Among the advanced economies, Europe and Japan are quite vulnerable to the global soft patch in trade and capital spending. Chart 11Global Economic Divergence Will Continue Global Economic Divergence Will Continue Global Economic Divergence Will Continue The loss of momentum in the Euro Area economy, while expected, has been quite pronounced. Part of this is due to the dissipation of the 2016/17 economic boost related to improved health in parts of the European banking system that sparked a temporary surge in credit growth. The tightening in Italian financial conditions following the government’s budget standoff with the EU has weighed on overall Euro Area growth. Softer Chinese demand for European exports, uncertainties related to U.S. trade policy and the torturous Brexit negotiations, have not helped the situation. Real GDP growth decelerated to close to a trend pace by the third quarter of 2018. The manufacturing PMI has fallen from a peak of 60.6 in December 2017 to 51.5, mirroring a 1% decline in the OECD’s leading economic indicator for the region. Not all the economic news has been bleak. Both consumer and industrial confidence remain at elevated levels according to the European Commission (EC) surveys, consistent with a resumption of above-trend growth. Even though exports have weakened substantially from the booming pace in 2017, the EC survey on firms’ export order books remains at robust levels (Chart 12). Importantly for the Euro Area, the bank credit impulse has moved higher.The German economy should also benefit from a rebound in vehicle production which plunged earlier this year following the introduction of new emission standards. Chart 12Europe: Slowing, But No Disaster Europe: Slowing, But No Disaster Europe: Slowing, But No Disaster We interpret the 2018 Euro Area slowdown as a reversion-to-the-mean rather than the start of an extended period of sub-trend growth. Real GDP growth should fluctuate slightly above trend pace through 2019. Given that the Euro Area’s output gap is almost closed, the ECB will not deviate from its plan to end its asset purchase program by year end. Gradual rate hikes should begin late in 2019, assuming that inflation is closer to target by then. In contrast, the Bank of Japan (BoJ) is unlikely to change policy anytime soon. The good news is that wages have finally begun to grow at about a 2% pace, although it required extreme labor shortages. Yet, core inflation is barely positive and long-term inflation expectations are a long way from the 2% target. The inflation situation will have to improve significantly before the BoJ can consider adjusting or removing the Yield Curve Control policy. This is especially the case since the economy has hit a bit of an air pocket and the government intends to raise the VAT in 2019. Japan’s industrial production has stalled and we expect the export picture to get worse before it gets better. We do not anticipate any significant economic slack to develop, but even a sustained growth slowdown could partially reverse the gains that have been made on the inflation front. Ms. X: We can’t talk about the global economy without discussing China. You have noted in the past how the authorities are walking a tightrope between trying to unwind the credit bubble and restructure the economy on the one hand, and prevent a destabilizing economic and financial crisis on the other. Thus far, they have not fallen off the tightrope, but there has been limited progress in resolving the country’s imbalances. And now the authorities appear to be stimulating growth again, risking an even bigger buildup of credit. Can it all hold together for another year? BCA: That’s a very good question. Thus far, there is not much evidence that stimulus efforts are working. Credit growth is still weak and leading economic indicators have not turned around (Chart 13). There is thus a case for more aggressive reflation, but the authorities also remain keen to wean the economy off its addiction to debt. Chart 13China: No Sign Of Reacceleration China: Credit Impulse Remains Weak China: Credit Impulse Remains Weak Waves of stimulus have caused total debt to soar from 140% of GDP in 2008 to about 260% of GDP at present (Chart 14). As is usually the case, rapid increases in leverage have been associated with a misallocation of capital. Since most of the new credit has been used to finance fixed-asset investment, the result has been overcapacity in a number of areas. For example, the fact that 15%-to-20% of apartments are sitting vacant is a reflection of overbuilding. Meanwhile, the rate of return on assets in the state-owned corporate sector has fallen below borrowing costs. Chart 14China: Debt Still Rising China: Debt Still Rising China: Debt Still Rising Chinese exports are holding up well so far, but this might only represent front-running ahead of the implementation of higher tariffs. Judging from the steep drop in the export component of both the official and private-sector Chinese manufacturing PMI, exports are likely to come under increasing pressure over the next few quarters as the headwinds from higher tariffs fully manifest themselves (Chart 15). Chart 15Chinese Exports About To Suffer Chinese Exports About To Suffer Chinese Exports About To Suffer The most likely outcome is that the authorities will adjust the policy dials just enough to stabilize growth sometime in the first half of 2019. The bottoming in China’s broad money impulse offers a ray of hope (Chart 16). Still, it is a tentative signal at best and it will take some time before this recent easing in monetary policy shows up in our credit impulse measure and, later, economic growth. A modest firming in Chinese growth in the second half of 2019 would provide a somewhat stronger demand backdrop for commodities and emerging economies that sell goods to China. Chart 16A Ray Of Hope From Broad Money bca.bca_mp_2018_12_01_c16 bca.bca_mp_2018_12_01_c16 Ms. X: If you are correct about a stabilization in the Chinese economy next year, this presumably would be good news for emerging economies, especially if the Fed goes on hold. EM assets have been terribly beaten down and I am looking for an opportunity to buy. BCA: Fed rate hikes might have been the catalyst for the past year’s pain in EM assets, but it is not the underlying problem. As we highlighted at last year’s meeting, the troubles for emerging markets run much deeper. Our long-held caution on emerging economies and markets is rooted in concern about deteriorating fundamentals. Excessive debt is a ticking time bomb for many of these countries; EM dollar-denominated debt is now as high as it was in the late 1990s as a share of both GDP and exports (Chart 17). Moreover, the declining long-term growth potential for emerging economies as a group makes it more difficult for them to service the debt. The structural downtrend in EM labor force and productivity growth underscores that trend GDP growth has collapsed over the past three decades (Chart 17, bottom panel). Chart 17EM Debt A Problem Given Slowing Supply-Side... EM Debt A Problem Given Slowing Supply-Side... EM Debt A Problem Given Slowing Supply-Side... Decelerating global growth has exposed these poor fundamentals. EM sovereign spreads have moved wider in conjunction with falling PMIs and slowing industrial production and export growth. And it certainly does not help that the Fed is tightening dollar-based liquidity conditions. EM equities usually fall when U.S. financial conditions tighten (Chart 18). Chart 18...And Tightening Financial Conditions ...And Tightening Financial Conditions ...And Tightening Financial Conditions Chart 19 highlights the most vulnerable economies in terms of foreign currency funding requirements, and foreign debt-servicing obligations relative to total exports. Turkey stands out as the most vulnerable, along with Argentina, Brazil, Indonesia, Chile, and Colombia. In contrast, Emerging Asia appears to be in better shape relative to the crisis period of the late 1990s. Chart 19Spot The Outliers OUTLOOK 2019: Late-Cycle Turbulence OUTLOOK 2019: Late-Cycle Turbulence The backdrop for EM assets is likely to get worse in the near term, given our view that the Fed will continue to tighten and China will be cautious about stimulating more aggressively. Our base case outlook sees some relief in the second half of 2019, but it is more of a “muddle-through” scenario than a V-shaped economic recovery. Mr. X: Perhaps EM assets could enjoy a bounce next year if the Chinese economy stabilizes, but the poor macro fundamentals you mentioned suggest that it would be a trade rather than a buy-and-hold proposition. I am inclined to avoid the whole asset class in 2019. Bond Market Prospects Ms. X: Let’s turn to fixed income now. I was bearish on bonds in 2018, but yields have risen quite a bit, at least in the United States. The Fed has lifted the fed funds rate by 100 basis points over the past year and I don’t see a lot of upside for inflation. So perhaps yields have peaked and will move sideways in 2019, which would be good for stocks in my view. BCA: Higher yields have indeed improved bond value recently. Nonetheless, they are not cheap enough to buy at this point (Chart 20). The real 10-year Treasury yield, at close to 1%, is still depressed by pre-Lehman standards. Long-term real yields in Germany and Japan remain in negative territory at close to the lowest levels ever recorded. Chart 20Real Yields Still Very Depressed Real Yields Still Very Depressed Real Yields Still Very Depressed We called the bottom in global nominal bond yields in 2016. Our research at the time showed that the cyclical and structural factors that had depressed yields were at an inflection point, and were shifting in a less bond-bullish direction. Perhaps most important among the structural factors, population aging and a downward trend in underlying productivity growth resulted in lower equilibrium bond yields over the past couple of decades. Looking ahead, productivity growth could stage a mild rebound in line with the upturn in the growth rate of the capital stock (Chart 21). As for demographics, the age structure of the world population is transitioning from a period in which aging added to the global pool of savings to one in which aging is beginning to drain that pool as people retire and begin to consume their nest eggs (Chart 22). The household saving rates in the major advanced economies should trend lower in the coming years, placing upward pressure on equilibrium global bond yields. Chart 21Productivity Still Has Some Upside Productivity Still Has Some Upside Productivity Still Has Some Upside Chart 22Demographics Past The Inflection Point Demographics Past The Inflection Point Demographics Past The Inflection Point Cyclical factors are also turning against bonds. U.S. inflation has returned to target and the Fed is normalizing short-term interest rates. The market currently is priced for only one more rate hike after December 2018 in this cycle, but we see rates rising more than that. Treasury yields will follow as market expectations adjust. Long-term inflation expectations are still too low in the U.S. and most of the other major economies to be consistent with central banks’ meeting their inflation targets over the medium term. As actual inflation edges higher, long-term expectations built into bond yields will move up. The term premium portion of long-term bond yields is also too low. This is the premium that investors demand to hold longer-term bonds. Our estimates suggest that the term premium is still negative in the advanced economies outside of the U.S., which is not sustainable over the medium term (Chart 23). Chart 23Term Premia Are Too Low Term Premia Are Too Low Term Premia Are Too Low We expect term premia to rise for two main reasons. First, investors have viewed government bonds as a good hedge for their equity holdings because bond prices have tended to rise when stock prices fell. Investors have been willing to pay a premium to hold long-term bonds to benefit from this hedging effect. But the correlation is now beginning to change as inflation and inflation expectations gradually adjust higher and output gaps close. As the hedging benefit wanes, the term premium should rise back into positive territory. Second, central bank bond purchases and forward guidance have depressed yields as well as interest-rate volatility. The latter helped to depress term premia in the bond market. This effect, too, is beginning to unwind. The Fed is letting its balance sheet shrink by about $50 billion per month. The Bank of England has kept its holdings of gilts and corporate bonds constant for over a year, while the ECB is about to end asset purchases. The Bank of Japan continues to buy assets, but at a much reduced pace. All this means that the private sector is being forced to absorb a net increase in government bonds for the first time since 2014 (Chart 24). Chart 25 shows that bond yields in the major countries will continue to trend higher as the rapid expansion of central bank balance sheets becomes a thing of the past. Chart 24Private Sector To Absorb More Bonds OUTLOOK 2019: Late-Cycle Turbulence OUTLOOK 2019: Late-Cycle Turbulence Chart 25QE Unwind Will Weigh On Bond Prices QE Unwind Will Weigh On Bond Prices QE Unwind Will Weigh On Bond Prices Ms. X: I’m not a fan of bonds at these levels, but that sounds overly bearish to me, especially given the recent plunge in oil prices. BCA: Lower oil prices will indeed help to hold down core inflation to the extent that energy prices leak into non-energy prices in the near term. Nonetheless, in the U.S., this effect will be overwhelmed by an overheated economy. From a long-term perspective, we believe that investors still have an overly benign view of the outlook for yields. The market expects that the 10-year Treasury yield in ten years will only be slightly above today’s spot yield, which itself is still very depressed by historical standards (Chart 26). And that also is the case in the other major bond markets. Chart 26Forward Yields Are Too Low Forward Yields Are Too Low Forward Yields Are Too Low Of course, it will not be a straight line up for yields – there will be plenty of volatility. We expect the 10-year Treasury yield to peak sometime in 2019 or early 2020 in the 3.5%-to-4% range, before the next recession sends yields temporarily lower. Duration should be kept short at least until the middle of 2019, with an emphasis on TIPS relative to conventional Treasury bonds. We will likely downgrade TIPS versus conventionals once long-term inflation expectations move into our target range, which should occur sometime during 2019. The ECB and Japan will not be in a position to raise interest rates for some time, but the bear phase in U.S. Treasurys will drag up European and Japanese bond yields (at the very long end of the curve for the latter). Total returns are likely to be negative in all of the major bond markets in 2019. Real 10-year yields in all of the advanced economies are still well below their long-term average, except for Greece, Italy and Portugal (Chart 27). Chart 27Valuation Ranking Of Developed Bond Markets OUTLOOK 2019: Late-Cycle Turbulence OUTLOOK 2019: Late-Cycle Turbulence Within global bond portfolios, we recommend being underweight bond markets where central banks are in a position to raise short-term interest rates (the U.S. and Canada), and overweight those that are not (Japan and Australia). The first ECB rate hike is unlikely before the end of 2019. However, the imminent end of the asset purchase program argues for no more than a benchmark allocation to core European bond markets within global fixed-income portfolios, especially since real 10-year yields in parts of continental Europe are the furthest below their long-term average. We are overweight gilts at the moment, but foresee shifting to underweight in 2019, depending on how Brexit plays out. Ms. X: What about corporate bonds? I know that total returns for corporates will be poor if government bond yields are rising. But you recommended overweighting corporate bonds relative to Treasurys last year. Given your view that the next U.S. recession is more than a year away, it seems reasonable to assume they will outperform government bonds. BCA: We were overweight corporates in the first half of 2018, but took profits in June and shifted to neutral at the same time that we downgraded our equity allocation. Spreads had tightened to levels that did not compensate investors for the risks. Recent spread widening has returned some value to U.S. corporates. The 12-month breakeven spreads for A-rated and Baa-rated corporate bonds are almost back up to their 50th percentile relative to history (Chart 28). Still, these levels are not attractive enough to justify buying based on valuation alone. As for high-yield, any rise in the default rate would quickly overwhelm the yield pickup in this space. Chart 28Corporate Bond Yields Still Have Upside Corporate Bond Yields Still Have Upside Corporate Bond Yields Still Have Upside It is possible that some of the spread widening observed in October and November will reverse, but corporates offer a poor risk/reward tradeoff, even if the default rate stays low. Corporate profit growth is bound to decelerate in 2019. This would not be a disaster for equities, but slowing profit growth is more dangerous for corporate bond excess returns because the starting point for leverage is already elevated. As discussed above, at a macro level, the aggregate interest coverage ratio for the U.S. corporate sector is decent by historical standards. However, this includes mega-cap companies that have little debt and a lot of cash. Our bottom-up research suggests that interest coverage ratios for firms in the Bloomberg Barclays corporate bond index will likely drop close to multi-decade lows during the next recession, sparking a wave of downgrade activity and fallen angels. Seeing this coming, investors may require more yield padding to compensate for these risks as profit growth slows. Our next move will likely be to downgrade corporate bonds to underweight. We are watching the yield curve, bank lending standards, profit growth, and monetary indicators for signs to further trim exposure. You should already be moving up in quality within your corporate bond allocation. Mr. X: We have already shifted to underweight corporate bonds in our fixed income portfolio. Even considering the cheapening that has occurred over the past couple of months, spread levels still make no sense in terms of providing compensation for credit risk. Equity Market Outlook Ms. X: While we all seem to agree that corporate bonds are not very attractive, I believe that enough value has been restored to equities that we should upgrade our allocation, especially if the next recession is two years away. And I know that stocks sometimes have a powerful blow-off phase before the end of a bull market. Mr. X: This is where I vehemently disagree with my daughter. The recent sell-off resembles a bloodbath in parts of the global market. It has confirmed my worst fears, especially related to the high-flying tech stocks that I believe were in a bubble. Hopes for a blow-off phase are wishful thinking. I’m wondering if the sell-off represents the beginning of an extended bear market. BCA: Some value has indeed been restored. However, the U.S. market is far from cheap relative to corporate fundamentals. The trailing and 12-month forward price-earnings ratios (PER) of 20 and 16, respectively, are still far above their historical averages, especially if one leaves out the tech bubble period of the late 1990s. And the same is true for other metrics such as price-to-sales and price-to-book value (Chart 29). BCA’s composite valuation indicator, based on 8 different valuation measures, is only a little below the threshold of overvaluation at +1 standard deviation because low interest rates still favor equities on a relative yield basis. Chart 29U.S. Equities Are Not Cheap U.S. Equities Are Not Cheap U.S. Equities Are Not Cheap It is true that equities can reward investors handsomely in the final stage of a bull market. Chart 30 presents cumulative returns to the S&P 500 in the last nine bull markets. The returns are broken down by quintile. The greatest returns, unsurprisingly, generally occur in the first part of the bull market (quintile 1). But total returns in the last 20% of the bull phase (quintile 5) have been solid and have beaten the middle quartiles. Chart 30Late-Cycle Blow-Offs Can Be Rewarding OUTLOOK 2019: Late-Cycle Turbulence OUTLOOK 2019: Late-Cycle Turbulence Of course, the tricky part is determining where we are in the bull market. We have long viewed financial markets through the lens of money and credit. This includes a framework that involves the Fed policy cycle. The historical track record for risk assets is very clear; they tend to perform well when the fed funds rate is below neutral, whether rates are rising or falling. Risk assets tend to underperform cash when the fed funds rate is above neutral (Table 3). Table 3Stocks Do Well When The Fed Funds Rate Is Below Neutral OUTLOOK 2019: Late-Cycle Turbulence OUTLOOK 2019: Late-Cycle Turbulence We believe the fed funds rate is still in easy territory. This suggests that it is too early to shift to underweight on risk assets. We may even want to upgrade to overweight if stocks become cheap enough, as long as Fed policy is not restrictive. That said, there is huge uncertainty about the exact level of rates that constitutes “neutral” (or R-star in the Fed’s lingo). Even the Fed is unsure. This means that we must watch for signs that the fed funds rate has crossed the line into restrictive territory as the FOMC tightens over the coming year. An inversion of the 3-month T-bill/10-year yield curve slope would be a powerful signal that policy has become tight, although the lead time of an inverted curve and declining risk asset prices has been quite variable historically. Finally, it is also important to watch U.S. profit margins. Some of our research over the past couple of years focused on the late-cycle dynamics of previous long expansions, such as the 1960s, 1980s and 1990s. We found that risk assets came under pressure once U.S. profit margins peaked. Returns were often negative from the peak in margins to the subsequent recession. Mr. X: U.S. profit margins must be close to peak levels. I’ve seen all sorts of anecdotal examples of rising cost pressures, not only in the labor market. BCA: We expected to see some margin pressure to appear by now. S&P 500 EPS growth will likely top out in the next couple of quarters, if only because the third quarter’s 26% year-over-year pace is simply not sustainable. But it is impressive that our margin proxies are not yet flagging an imminent margin squeeze, despite the pickup in wage growth (Chart 31). Chart 31U.S. Margin Indicators Still Upbeat U.S. Margin Indicators Still Upbeat U.S. Margin Indicators Still Upbeat Margins according to the National Accounts (NIPA) data peaked in 2014 and have since diverged sharply with S&P 500 operating margins. It is difficult to fully explain the divergence. The NIPA margin is considered to be a better measure of underlying U.S. corporate profitability because it includes all companies (not just 500), and it is less subject to accounting trickery. That said, even the NIPA measure of margins firmed a little in 2018, along with the proxies we follow that correlate with the S&P 500 measure. The bottom line is that the macro variables that feed into our top-down U.S. EPS model point to a continuing high level of margins and fairly robust top-line growth, at least for the near term. For 2019, we assumed slower GDP growth and incorporated some decline in margins into our projection just to err on the conservative side. Nonetheless, our EPS model still projects a respectable 8% growth rate at the end of 2019 (Chart 32). The dollar will only be a minor headwind to earnings growth unless it surges by another 10% or more. Chart 32EPS Growth Forecasts EPS Growth Forecasts EPS Growth Forecasts The risks to EPS growth probably are to the downside relative to our forecast, but the point is that U.S. earnings will likely remain supportive for the market unless economic growth is much weaker than we expect. None of this means that investors should be aggressively overweight stocks now. We trimmed our equity recommendation to benchmark in mid-2018 for several reasons. At the time, value was quite poor and bottom-up earnings expectations were too high, especially on a five-year horizon. Also, sentiment measures suggested that investors were overly complacent. As you know, we are always reluctant to chase markets into highly overvalued territory, especially when a lot of good news has been discounted. As we have noted, we are open to temporarily shifting back to overweight in equities and other risk assets. The extension of the economic expansion gives more time for earnings to grow. The risks facing the market have not eased much but, given our base-case macro view, we would be inclined to upgrade equities if there is another meaningful correction. Of course, our profit, monetary and economic indicators would have to remain supportive to justify an upgrade. Mr. X: But you are bearish on bonds. We saw in October that the equity market is vulnerable to higher yields. BCA: It certainly won’t be smooth sailing through 2019 as interest rates normalize. Until recently, higher bond yields reflected stronger growth without any associated fears that inflation was a growing problem. The ‘Fed Put’ was seen as a key backstop for the equity bull market. But now that the U.S. labor market is showing signs of overheating, the bond sell-off has become less benign for stocks because the Fed will be less inclined to ease up at the first sign of trouble in the equity market. How stocks react in 2019 to the upward trend in yields depends a lot on the evolution of actual inflation and long-term inflation expectations. If core PCE inflation hovers close to or just above 2% for a while, then the Fed Put should still be in place. However, it would get ugly for both bonds and stocks if inflation moves beyond 2.5%. Our base case is that this negative dynamic won’t occur until early 2020, but obviously the timing is uncertain. One key indicator to watch is long-term inflation expectations, such as the 10-year TIPS breakeven inflation rate (Chart 33). It is close to 2% at the moment. If it shifts up into the 2.3%-2.5% range, it would confirm that inflation expectations have returned to a level that is consistent with the Fed meeting its 2% inflation target on a sustained basis. This would be a signal to the Fed that it is must become more aggressive in calming growth, with obvious negative consequences for risk assets. Chart 33Watch For A Return To 2.3%-2.5% Range Watch For A Return To 2.3%-2.5% Range Watch For A Return To 2.3%-2.5% Range Mr. X: I am skeptical that the U.S. corporate sector can pull off an 8% earnings gain in 2019. What about the other major markets? Won’t they get hit hard if global growth continues to slow as you suggest? BCA: Yes, that is correct. It is not surprising that EPS growth has already peaked in the Euro Area and Japan. The profit situation is going to deteriorate quickly in the coming quarters. Industrial production growth in both economies has already dropped close to zero, and we use this as a proxy for top-line growth in our EPS models. Nominal GDP growth has decelerated sharply in both economies in absolute terms and relative to the aggregate wage bill. These trends suggest that profit margins are coming under significant downward pressure. Even when we build in a modest growth pickup and slight rebound in margins in 2019, EPS growth falls close to zero by year-end according to our models. Both the Euro Area and Japanese equity markets are cheap relative to the U.S., based on our composite valuation indicators (Chart 34). However, neither is above the threshold of undervaluation (+1 standard deviation) that would justify overweight positions on valuation alone. We think the U.S. market will outperform the other two at least in the first half of 2019 in local and, especially, common-currency terms. Chart 34Valuation Of Nonfinancial Equity Markets Relative To The U.S. OUTLOOK 2019: Late-Cycle Turbulence OUTLOOK 2019: Late-Cycle Turbulence Ms. X: It makes sense that U.S. profit growth will outperform the other major developed countries in 2019. I would like to circle back to emerging market assets. I understand that many emerging economies have deep structural problems. But you admitted that the Chinese authorities will eventually stimulate enough to stabilize growth, providing a bounce in EM growth and asset prices next year. These assets seem cheap enough to me to warrant buying now in anticipation of that rally. As we all know, reversals from oversold levels can happen in a blink of an eye and I don’t want to miss it. BCA: We are looking for an opportunity to buy as well, but are wary of getting in too early. First, valuation has improved but is not good enough on its own to justify buying now. EM stocks are only moderately undervalued based on our EM composite valuation indicator and the cyclically-adjusted P/E ratio (Chart 35). EM currencies are not particularly cheap either, outside of Argentina, Turkey and Mexico (Charts 36A and 36B). Valuation should only play a role in investment strategy when it is at an extreme, and this is not the case for most EM countries. Chart 35EM Stocks Are Not At Capitulation Levels... bca.bca_mp_2018_12_01_c35 bca.bca_mp_2018_12_01_c35   Chart 36A…And Neither Are EM Currencies ...And Neither Are EM Currencies ...And Neither Are EM Currencies Chart 36B…And Neither Are EM Currencies ...And Neither Are EM Currencies ...And Neither Are EM Currencies Second, corporate earnings growth has plenty of downside potential in the near term. Annual growth in EM nonfinancial EBITDA, currently near 10%, is likely to turn negative next year, based on our China credit and fiscal impulse indicator (Chart 37). And, as we emphasized earlier, China is not yet pressing hard on the gas pedal. Chart 37EM Earnings Growth: Lots Of Downside EM Earnings Growth: Lots Of Downside EM Earnings Growth: Lots Of Downside Third, it will take time for more aggressive Chinese policy stimulus, if it does occur, to show up in EM stocks and commodity prices. Trend changes in money growth and our credit and fiscal impulse preceded the trough in EM stocks and commodity prices in 2015, and again at the top in stocks and commodities in 2017 (Chart 38). However, even if these two indicators bottom today, it could take several months before the sell-off in EM financial markets and commodity prices abates. Chart 38Chinese Money And Credit Leads EM And Commodities Chinese Money And Credit Leads EM And Commodities Chinese Money And Credit Leads EM And Commodities Finally, if Chinese stimulus comes largely via easier monetary policy rather than fiscal stimulus, then the outcome will be a weaker RMB. We expect the RMB to drift lower in any event, because rate differentials vis-à-vis the U.S. will move against the Chinese currency next year. A weaker RMB would add to the near-term headwinds facing EM assets. The bottom line is that the downside risks remain high enough that you should resist the temptation to bottom-fish until there are concrete signs that the Chinese authorities are getting serious about boosting the economy. We are also watching for signs outside of China that the global growth slowdown is ending. This includes our global leading economic indicator and data that are highly sensitive to global growth, such as German manufacturing foreign orders. Mr. X: Emerging market assets would have to become a lot cheaper for me to consider buying. Debt levels are just too high to be sustained, and stronger Chinese growth would only provide a short-term boost. I’m not sure I would even want to buy developed market risk assets based solely on some Chinese policy stimulus. BCA: Yes, we agree with your assessment that buying EM in 2019 would be a trade rather than a buy-and-hold strategy. Still, the combination of continued solid U.S. growth and a modest upturn in the Chinese economy would alleviate a lot of investors’ global growth concerns. The result could be a meaningful rally in pro-cyclical assets that you should not miss. We are defensively positioned at the moment, but we could see becoming more aggressive in 2019 on signs that China is stimulating more firmly and/or our global leading indicators begin to show some signs of life. Besides upgrading our overall equity allocation back to overweight, we would dip our toes in the EM space again. At the same time, we will likely upgrade the more cyclical DM equity markets, such as the Euro Area and Japan, while downgrading the defensive U.S. equity market to underweight. We are currently defensively positioned in terms of equity sectors, but it would make sense to shift cyclicals to overweight at the same time. Exact timing is always difficult, but we expect to become more aggressive around the middle of 2019. We also think the time is approaching to favor long-suffering value stocks over growth stocks. The relative performance of growth-over-value according to standard measures has become a sector call over the past decade: tech or financials. The sector skew complicates this issue, especially since tech stocks have already cracked. But we have found that stocks that are cheap within equity sectors tend to outperform expensive (or growth) stocks once the fed funds rate moves into restrictive territory. This is likely to occur in the latter half of 2019. Value should then have its day in the sun. Currencies: Mr. X: We don’t usually hedge our international equity exposure, so the direction of the dollar matters a lot to us. As you predicted a year ago, the U.S. dollar reigned supreme in 2018. Your economic views suggest another good year in 2019, but won’t this become a problem for the economy? President Trump’s desire to lower the U.S. trade deficit suggests that the Administration would like the dollar to drop and we could get some anti-dollar rhetoric from the White House. Also, it seems that the consensus is strongly bullish on the dollar which is always a concern. BCA: The outlook for the dollar is much trickier than it was at the end of 2017. As you highlighted, traders are already very long the dollar, implying that the hurdle for the greenback to surprise positively is much higher now. However, a key driver for the dollar is the global growth backdrop. If the latter is poor in the first half of 2019 as we expect, it will keep a bid under the greenback. Interest rates should also remain supportive for the dollar. As we argued earlier, current market expectations – only one more Fed hike after the December meeting – are too sanguine. If the Fed increases rates by more than currently discounted, the dollar’s fair value will rise, especially if global growth continues to lag that of the U.S. Since the dollar’s 2018 rally was largely a correction of its previous undervaluation, the currency has upside potential in the first half of the year (Chart 39). Chart 39U.S. Dollar Not Yet Overvalued U.S. Dollar Not Yet Overvalued U.S. Dollar Not Yet Overvalued A stronger dollar will dampen foreign demand for U.S.-produced goods and will boost U.S. imports. However, do not forget that a rising dollar benefits U.S. consumers via its impact on import prices. Since the consumer sector represents 68% of GDP, and that 69% of household consumption is geared toward the (largely domestic) service sector, a strong dollar will not be as negative for aggregate demand and employment as many commentators fear, unless it were to surge by at least another 10%. In the end, the dollar will be more important for the distribution of U.S. growth than its overall level. Where the strong dollar is likely to cause tremors is in the political arena. You are correct to point out that there is a large inconsistency between the White House’s desires to shore up growth, while simultaneously curtailing the trade deficit, especially if the dollar appreciates further. As long as the Fed focuses on its dual mandate and tries to contain inflationary pressures, the executive branch of the U.S. government can do little to push the dollar down. Currency intervention cannot have a permanent effect unless it is accompanied by shifts in relative macro fundamentals. For example, foreign exchange intervention by the Japanese Ministry of Finance in the late 1990s merely had a temporary impact on the yen. The yen only weakened on a sustained basis once interest rate differentials moved against Japan. This problem underpins our view that the Sino-U.S. relationship is unlikely to improve meaningfully next year. China will remain an easy target to blame for the U.S.’s large trade deficit. What ultimately will signal a top in the dollar is better global growth, which is unlikely until the second half of 2019. At that point, expected returns outside the U.S. will improve, causing money to leave the U.S., pushing the dollar down. Mr. X: While 2017 was a stellar year for the euro, 2018 proved a much more challenging environment. Will 2019 be more like 2017 or 2018? BCA: We often think of the euro as the anti-dollar; buying EUR/USD is the simplest, most liquid vehicle for betting against the dollar, and vice versa. Our bullish dollar stance is therefore synonymous with a negative take on the euro. Also, the activity gap between the U.S. and the Euro Area continues to move in a euro-bearish fashion (Chart 40). Finally, since the Great Financial Crisis, EUR/USD has lagged the differential between European and U.S. core inflation by roughly six months. Today, this inflation spread still points toward a weaker euro. Chart 40Relative LEI's Moving Against Euro Relative LEI's Moving Against Euro Relative LEI's Moving Against Euro It is important to remember that when Chinese economic activity weakens, European growth deteriorates relative to the U.S. Thus, our view that global growth will continue to sputter in the first half of 2019 implies that the monetary policy divergence between the Fed and the ECB has not yet reached a climax. Consequently, we expect EUR/USD to trade below 1.1 in the first half of 2019. By that point, the common currency will be trading at a meaningful discount to its fair value, which will allow it to find a floor (Chart 41). Chart 41Euro Heading Below Fair Value Before Bottoming Euro Heading Below Fair Value Before Bottoming Euro Heading Below Fair Value Before Bottoming Mr. X: The Bank of Japan has debased the yen, with a balance sheet larger than Japan’s GDP. This cannot end well. I am very bearish on the currency. BCA: The BoJ’s monetary policy is definitely a challenge for the yen. The Japanese central bank rightfully understands that Japan’s inability to generate any meaningful inflation – despite an economy that is at full employment – is the consequence of a well-established deflationary mindset. The BoJ wants to shock inflation expectations upward by keeping real rates at very accommodative levels well after growth has picked up. This means that the BoJ will remain a laggard as global central banks move away from accommodative policies. The yen will continue to depreciate versus the dollar as U.S. yields rise on a cyclical horizon. That being said, the yen still has a place within investors’ portfolios. First, the yen is unlikely to collapse despite the BoJ’s heavy debt monetization. The JPY is one of the cheapest currencies in the world, with its real effective exchange rate hovering at a three-decade low (Chart 42). Additionally, Japan still sports a current account surplus of 3.7% of GDP, hardly the sign of an overstimulated and inflationary economy where demand is running amok. Instead, thanks to decades of current account surpluses, Japan has accumulated a positive net international investment position of 60% of GDP. This means that Japan runs a constant and large positive income balance, a feature historically associated with strong currencies. Chart 42The Yen Is Very Cheap The Yen Is Very Cheap The Yen Is Very Cheap Japan’s large net international investment position also contributes to the yen’s defensive behavior as Japanese investors pull money back to safety at home when global growth deteriorates. Hence, the yen could rebound, especially against the euro, the commodity currencies, and EM currencies if there is a further global growth scare in the near term. Owning some yen can therefore stabilize portfolio returns during tough times. As we discussed earlier, we would avoid the EM asset class, including currency exposure, until global growth firms. Commodities: Ms. X: Once again, you made a good call on the energy price outlook a year ago, with prices moving higher for most of the year. But the recent weakness in oil seemed to come out of nowhere, and I must admit to being confused about where we go next. What are your latest thoughts on oil prices for the coming year? BCA: The fundamentals lined up in a very straightforward way at the end of 2017. The coalition we have dubbed OPEC 2.0 – the OPEC and non-OPEC producer group led by the Kingdom of Saudi Arabia (KSA) and Russia – outlined a clear strategy to reduce the global oil inventory overhang. The producers that had the capacity to increase supply maintained strict production discipline which, to some analysts, was still surprising even after the cohesiveness shown by the group in 2017. Outside that core group output continued to fall, especially in Venezuela, which remains a high-risk producing province. The oil market was balanced and prices were slowly moving higher as we entered the second quarter of this year, when President Trump announced the U.S. would re-impose oil export sanctions against Iran beginning early November. The oft-repeated goal of the sanctions was to reduce Iranian exports to zero. To compensate for the lost Iranian exports, President Trump pressured OPEC, led by KSA, to significantly increase production, which they did. However, as we approached the November deadline, the Trump Administration granted the eight largest importers of Iranian oil 180-day waivers on the sanctions. This restored much of the oil that would have been lost. Suddenly, the market found itself oversupplied and prices fell. As we move toward the December 6 meeting of OPEC 2.0 in Vienna, we are expecting a production cut from the coalition of as much as 1.4mm b/d to offset these waivers. The coalition wishes to keep global oil inventories from once again over-filling and dragging prices even lower in 2019. On the demand side, consumption continues to hold up both in the developed and emerging world, although we have somewhat lowered our expectations for growth next year. We are mindful of persistent concerns over the strength of demand – particularly in EM – in 2019. Thus, on the supply side and the demand side, the level of uncertainty in the oil markets is higher than it was at the start of 2018. Nonetheless, our base-case outlook is on the optimistic side for oil prices in 2019, with Brent crude oil averaging around $82/bbl, and WTI trading $6/bbl below that level (Chart 43). Chart 43Oil Prices To Rebound In 2019 Oil Prices To Rebound In 2019 Oil Prices To Rebound In 2019 Ms. X: I am skeptical that oil prices will rebound as much as you expect. First, oil demand is likely to falter if your view that global growth will continue slowing into early 2019 proves correct. Second, U.S. shale production is rising briskly, with pipeline bottlenecks finally starting to ease. Third, President Trump seems to have gone from taking credit for high equity prices to taking credit for low oil prices. Trump has taken a lot flack for supporting Saudi Arabia following the killing of The Washington Post journalist in Turkey. Would the Saudis really be willing to lose Trump’s support by cutting production at this politically sensitive time? BCA: Faltering demand growth remains a concern. However, note that in our forecasts we do expect global oil consumption growth to slow down to 1.46mm b/d next year, somewhat lower than the 1.6mm b/d growth we expect this year.  In terms of the U.S. shale sector, production levels over the short term can be somewhat insensitive to changes in spot and forward prices, given the hedging activity of producers. Over the medium to longer term, however, lower spot and forward prices will disincentivize drilling by all but the most efficient producers with the best, lowest-cost acreage. If another price collapse were to occur – and were to persist, as the earlier price collapse did – we would expect a production loss of between 5% and 10% from the U.S. shales.  Regarding KSA, the Kingdom needs close to $83/bbl to balance its budget this year and next, according to the IMF’s most recent estimates. If prices remain lower for longer, KSA’s official reserves will continue to fall, as its sovereign wealth fund continues to be tapped to fill budget gaps. President Trump’s insistence on higher production from KSA and the rest of OPEC is a non-starter – it would doom those economies to recession, and stifle further investment going forward. The U.S. would also suffer down the road, as the lack of investment significantly tightens global supply. So, net, if production cuts are not forthcoming from OPEC at its Vienna meeting we – and the market – will be downgrading our oil forecast. Ms. X: Does your optimism regarding energy extend to other commodities? The combination of a strong dollar and a China slowdown did a lot of damage to industrial commodities in 2018. Given your view that China’s economy should stabilize in 2019, are we close to a bottom in base metals? BCA: It is too soon to begin building positions in base metals because the trade war is going to get worse before it gets better. Exposure to base metals should be near benchmark at best entering 2019, although we will be looking to upgrade along with other risk assets if Chinese policy stimulus ramps up. Over the medium term, the outlook for base metals hinges on how successfully China pulls off its pivot toward consumer- and services-led growth, away from heavy industrial-led development. China accounts for roughly half of global demand for these base metals. Commodity demand from businesses providing consumer goods and services is lower than that of heavy industrial export-oriented firms. But demand for commodities used in consumer products – e.g., copper, zinc and nickel, which go into stainless-steel consumer appliances such as washers and dryers – will remain steady, and could increase if the transition away from heavy industrial-led growth is successful. Gasoline and jet fuel demand will also benefit, as EM consumers’ demand for leisure activities such as tourism increases with rising incomes. China is also going to be a large producer and consumer of electric vehicles, as it attempts to reduce its dependence on imported oil. Although timing the production ramp-up is difficult, in the long term these trends will be supportive for nickel and copper. Mr. X: You know I can’t let you get away without asking about gold. The price of bullion is down about 5% since the end of 2017, but that is no worse than the global equity market and it did provide a hedge against economic, financial or political shocks. The world seems just as risky as it did a year ago, so I am inclined to hold on to our gold positions, currently close to 10% of our portfolio. That is above your recommended level, but keeping a solid position in gold is one area where my daughter and I have close agreement regarding investment strategy. BCA: Gold did perform well during the risk asset corrections we had in 2018, and during the political crises as well. The price is not too far away from where we recommended going long gold as a portfolio hedge at the end of 2017 ($1230.3/oz). We continue to expect gold to perform well as a hedge. When other risk assets are trading lower, gold holds value relative to equities and tends to outperform bonds (Chart 44). Likewise, when other risk assets are rising, gold participates, but does not do as well as equities. It is this convexity – outperforming on the downside but participating on the upside with other risk assets – that continues to support our belief that gold has a role as a portfolio hedge. However, having 10% of your portfolio in gold is more than we would recommend – we favor an allocation of around 5%. Chart 44Hold Some Gold As A Hedge OUTLOOK 2019: Late-Cycle Turbulence OUTLOOK 2019: Late-Cycle Turbulence Geopolitics Ms. X: I’m glad that the three of us agree at least on one thing – hold some gold! Let’s return to the geopolitical situation for a moment. Last year, you correctly forecast that divergent domestic policies in the U.S. and China – stimulus in the former and lack thereof in the latter – would be the most investment-relevant geopolitical issue. At the time, I found this an odd thing to highlight, given the risks of protectionism, populism, and North Korea. Do you still think that domestic policies will dominate in 2019? BCA: Yes, policy divergence between the U.S. and China will also dominate in 2019, especially if it continues to buoy the U.S. economy at the expense of the rest of the world. Of course, Beijing may decide to do more stimulus to offset its weakening economy and the impact of the trade tariffs. A headline rate cut, cuts to bank reserve requirements, and a boost to local government infrastructure spending are all in play. In the context of faltering housing and capex figures in the U.S., the narrative over the next quarter or two could be that the policy divergence is over, that Chinese policymakers have “blinked.” We are pushing back against this narrative on a structural basis. We have already broadly outlined our view that China will not be pressing hard to boost demand growth. Many of its recent policy efforts have focused on rebalancing the economy away from debt-driven investment (Chart 45). The problem for the rest of the world is that raw materials and capital goods comprise 85% of Chinese imports. As such, efforts to boost domestic consumption will have limited impact on the rest of the world, especially as emerging markets are highly leveraged to “old China.” Chart 45Rebalancing Of The Chinese Economy Rebalancing Of The Chinese Economy Rebalancing Of The Chinese Economy Meanwhile, the Trump-Democrat gridlock could yield surprising results in 2019. President Trump is becoming singularly focused on winning re-election in 2020. As such, he fears the “stimulus cliff” looming over the election year. Democrats, eager to show that they are not merely the party of “the Resistance,” have already signaled that an infrastructure deal is their top priority. With fiscal conservatives in the House all but neutered by the midterm elections, a coalition between Trump and likely House Speaker Nancy Pelosi could emerge by late 2019, ushering in even more fiscal stimulus. While the net new federal spending will not be as grandiose as the headline figures, it will be something. There will also be regular spending increases in the wake of this year’s bipartisan removal of spending caps. We place solid odds that the current policy divergence narrative continues well into 2019, with bullish consequences for the U.S. dollar and bearish outcomes for EM assets, at least in the first half of the year. Mr. X: Your geopolitical team has consistently been alarmist on the U.S.-China trade war, a view that bore out throughout 2018. You already stated that you think trade tensions will persist in 2019. Where is this heading? BCA: Nowhere good. Rising geopolitical tensions in the Sino-American relationship has been our premier geopolitical risk since 2012. The Trump administration has begun tying geopolitical and strategic matters in with the trade talks. No longer is the White House merely asking for a narrowing of the trade deficit, improved intellectual property protections, and the removal of non-tariff barriers to trade. Now, everything from surface-to-air missiles in the South China Sea to Beijing’s “Belt and Road” project are on the list of U.S. demands. Trade negotiations are a “two-level game,” whereby policymakers negotiate in parallel with their foreign counterparts and domestic constituents. While Chinese economic agents may accept U.S. economic demands, it is not clear to us that its military and intelligence apparatus will accept U.S. geopolitical demands. And Xi Jinping himself is highly attuned to China’s geopolitical position, calling for national rejuvenation above all. We would therefore downplay any optimistic news from the G20 summit between Presidents Trump and Xi. President Trump could freeze tariffs at current rates and allow for a more serious negotiating round throughout 2019. But unless China is willing to kowtow to America, a fundamental deal will remain elusive in the end. For Trump, a failure to agree is still a win domestically, as the median American voter is not asking for a resolution of the trade war with China (Chart 46). Chart 46Americans Favor Being Tough On China OUTLOOK 2019: Late-Cycle Turbulence OUTLOOK 2019: Late-Cycle Turbulence Ms. X: Could trade tensions spill into rising military friction? BCA: Absolutely. Minor military skirmishes will likely continue and could even escalate. We believe that there is a structural bull market in “war.” Investors should position themselves by being long global defense stocks. Mr. X: That is not encouraging. What about North Korea and Iran? Could they become geopolitical risks in 2019? BCA: Our answer to the North Korea question remains the same as 12 months ago: we have seen the peak in the U.S.’ display of a “credible military threat.” But Iran could re-emerge as a risk mid-year. We argued in last year’s discussion that President Trump was more interested in playing domestic politics than actually ratcheting up tensions with Iran. However, in early 2018 we raised our alarm level, particularly when staffing decisions in the White House involved several noted Iran hawks joining the foreign policy team. This was a mistake. Our initial call was correct, as President Trump ultimately offered six-month exemptions to eight importers of Iranian crude. That said, those exemptions will expire in the spring. The White House may, at that point, ratchet up tensions with Iran. This time, we will believe it when we see it. Intensifying tensions with Iran ahead of the U.S. summer vacation season, and at a time when crude oil markets are likely to be finely balanced, seems like folly, especially with primary elections a mere 6-to-8 months away. What does President Trump want more: to win re-election or to punish Iran? We think the answer is obvious, especially given that very few voters seem to view Iran as the country’s greatest threat (Chart 47). Chart 47Americans Don’t See Iran As A Major Threat OUTLOOK 2019: Late-Cycle Turbulence OUTLOOK 2019: Late-Cycle Turbulence Ms. X: Let’s turn to Europe. You have tended to dismiss Euroskeptics as a minor threat, which has largely been correct. But don’t you think that, with Brexit upon us and Chancellor Angela Merkel in the twilight, populism in continental Europe will finally have its day? BCA: Let’s first wait to see how Brexit turns out! The next few months will be critical. Uncertainty is high, with considerable risks remaining. We do not think that Prime Minister May has the votes in the House of Commons to push through any version of soft Brexit that she has envisioned thus far. If the vote on the U.K.-EU exit deal falls through, a new election could be possible. This will require an extension of the exit process under Article 50 and a prolonged period of uncertainty. The probability of a no-deal Brexit is lower than 10%. It is simply not in the interest of anyone involved, save for a smattering of the hardest of hard Brexit adherents in the U.K. Conservative Party. Put simply, if the EU-U.K. deal falls through in the House of Commons, or even if PM May is replaced by a hard-Brexit Tory, the most likely outcome is an extension of the negotiation process. This can be easily done and we suspect that all EU member states would be in favor of such an extension given the cost to business sentiment and trade that would result from a no-deal Brexit. It is not clear that Brexit has emboldened Euroskeptics. In fact, most populist parties in the EU have chosen to tone down their Euroskepticism and emphasize their anti-immigrant agenda since the Brexit referendum. In part, this decision has to do with how messy the Brexit process has become. If the U.K. is struggling to unravel the sinews that tie it to Europe, how is any other country going to fare any better? The problem for Euroskeptic populists is that establishment parties are wise to the preferences of the European median voter. For example, we now have Friedrich Merz, a German candidate for the head of the Christian Democratic Union – essentially Merkel’s successor – who is both an ardent Europhile and a hardliner on immigration. This is not revolutionary. Merz simply read the polls correctly and realized that, with 83% of Germans supporting the euro, the rise of the anti-establishment Alternative for Germany (AfD) is more about immigration than about the EU. As such, we continue to stress that populism in Europe is overstated. In fact, we expect that Germany and France will redouble their efforts to reform European institutions in 2019. The European parliamentary elections in May will elicit much handwringing by the media due to a likely solid showing by Euroskeptics, even though the election is meaningless. Afterwards, we expect to see significant efforts to complete the banking union, reform the European Stability Mechanism, and even introduce a nascent Euro Area budget. But these reforms will not be for everyone. Euroskeptics in Central and Eastern Europe will be left on the outside looking in. Brussels may also be emboldened to take a hard line on Italy if institutional reforms convince the markets that the core Euro Area is sheltered from contagion. In other words, the fruits of integration will be reserved for those who play by the Franco-German rules. And that could, ironically, set the stage for the unraveling of the European Union as we know it. Over the long haul, a much tighter, more integrated, core could emerge centered on the Euro Area, with the rest of the EU becoming stillborn. The year 2019 will be a vital one for Europe. We are sensing an urgency in Berlin and Paris that has not existed throughout the crisis, largely due to Merkel’s own failings as a leader. We remain optimistic that the Euro Area will survive. However, there will be fireworks. Finally, a word about Japan. The coming year will see the peak of Prime Minister Shinzo Abe’s career. He is promoting the first-ever revision to Japan’s post-war constitution in order to countenance the armed forces. If he succeeds, he will have a big national security success to couple with his largely effective “Abenomics” economic agenda – after that, it will all be downhill. If he fails, he will become a lame duck. This means that political uncertainty will rise in 2019, after six years of unusual tranquility. Conclusions Mr. X: This is a good place to conclude our discussion. We have covered a lot of ground and your views have reinforced my belief that 2019 could be even more turbulent for financial markets than the past has been. I accept your opinion that a major global economic downturn is not around the corner, but with valuations still stretched, I feel that it makes good sense to focus on capital preservation. I may lose out on the proverbial “blow-off” rally, but so be it – I have been in this business long enough to know that it is much better to leave the party while the music is still playing! Ms. X: I agree with my father that the risks surrounding the outlook have risen as we have entered the late stages of this business-cycle expansion. Yet, if global growth does temporarily stabilize and corporate earnings continue to expand, I fear that being out of the market will be very painful. The era of hyper-easy money may be ending, but interest rates globally are still nowhere near restrictive territory. This tells me that the final stages of this bull market could be very rewarding. A turbulent market is not only one where prices go down – they can also go up a lot! BCA: The debate you are having is one we ourselves have had on numerous occasions. There is always a trade-off between maximizing short-term returns and taking a longer-term approach. Valuations are the ultimate guidepost for long-term returns. While most assets have cheapened over the past year, prices are still fairly elevated. Table 4 shows our baseline calculations of what a balanced portfolio will earn over the coming decade. We estimate that such a portfolio will deliver average annual returns of 4.9% over the next ten years, or 2.8% after adjusting for inflation. That is an improvement over our inflation-adjusted estimate of 1.3% from last year, but still well below the 6.6% real return that a balanced portfolio earned between 1982 and 2018. Table 410-Year Asset Return Projections OUTLOOK 2019: Late-Cycle Turbulence OUTLOOK 2019: Late-Cycle Turbulence Our return calculations for equities assume that profit margins decline modestly over the period and that multiples mean revert to their historical average. These assumptions may turn out to be too pessimistic if underlying changes in the economy keep corporate profits elevated as a share of GDP. Structurally lower real interest rates may also justify higher P/E multiples, although this would be largely offset by the prospect of slower economic growth, which will translate into slower earnings growth. In terms of the outlook for the coming year, a lot hinges on our view that monetary policy in the main economies stays accommodative. This seems like a safe assumption in the Euro Area and Japan, where rates are near historic lows, as well as in China, where the government is actively loosening monetary conditions. It is not such a straightforward conclusion for the U.S., where the Fed is on track to keep raising rates. If it turns out that the neutral interest rate is not far above where rates are already, we could see a broad-based slowdown of the U.S. economy that ripples through to the rest of the world. And even if U.S. monetary policy does remain accommodative, many things could still upset the apple cart, including a full-out trade war, debt crises in Italy or China, or a debilitating spike in oil prices. As the title of our outlook implies, 2019 is likely to be a year of increased turbulence. Ms. X: As always, you have left us with much to think about. My father has looked forward to these discussions every year and now that I am able to join him, I understand why. Before we conclude, it would be helpful to have a recap of your key views. BCA: That would be our pleasure. The key points are as follows: The collision between policy and markets that we discussed last year finally came to a head in October. Rather than falling as they normally do when stocks plunge, U.S. bond yields rose as investors reassessed the willingness of the Fed to pause hiking rates even in the face of softer growth. Likewise, hopes that China would move swiftly to stimulate its economy were dashed as it became increasingly clear that the authorities were placing a high emphasis on their reform agenda of deleveraging and capacity reduction. The ongoing Brexit saga and the stalemate between the populist Italian government and the EU have increased uncertainty in Europe at a time when the region was already beginning to slow. We expect the tensions between policy and markets to be an ongoing theme in 2019. With the U.S. unemployment rate at a 48-year low, it will take a significant slowdown for the Fed to stop hiking rates. Despite the deterioration in economic data over the past month, real final domestic demand is still tracking to expand by 3% in the fourth quarter, well above estimates of the sustainable pace of economic growth. Ultimately, the Fed will deliver more hikes next year than discounted in the markets. This will push up the dollar and keep the upward trend in Treasury yields intact. The dollar should peak midway next year. China will also become more aggressive in stimulating its economy, which will boost global growth. However, until both of these things happen, emerging markets will remain under pressure. For the time being, we continue to favor developed market equities over their EM peers. We also prefer defensive equity sectors such as health care and consumer staples over cyclical sectors such as industrials and materials. Within the developed market universe, the U.S. will outperform Europe and Japan for the next few quarters, especially in dollar terms. A stabilization in global growth could ignite a blow-off rally in global equities. If the Fed is raising rates in response to falling unemployment, this is unlikely to derail the stock market. However, once supply-side constraints begin to fully bite in early 2020 and inflation rises well above the Fed’s target of 2%, stocks will begin to buckle. This means that a window exists next year where stocks will outperform bonds. We would maintain a benchmark allocation to stocks for now, but increase exposure if global bourses were to fall significantly from current levels without a corresponding deteriorating in the economic outlook. Corporate credit will underperform stocks as government bond yields rise. A major increase in spreads is unlikely as long as the economy is still expanding, but spreads could still widen modestly given their low starting point. U.S. shale companies have been the marginal producers in the global oil sector. With breakeven costs in shale close to $50/bbl, crude prices are unlikely to rise much from current levels over the long term. However, over the next 12 months, we expect production cuts in Saudi Arabia will push prices up, with Brent crude averaging around $82/bbl in 2019. A balanced portfolio is likely to generate average returns of only 2.8% a year in real terms over the next decade. This compares to average returns of around 6.6% a year between 1982 and 2018. We would like to take this opportunity to wish you and all of our clients a very peaceful, healthy and prosperous New Year. The Editors November 26, 2018 ​​​​​​