Developed Countries

Overweight A number of macro factors have fallen into place that have warmed us to the S&P movies & entertainment index. Consumer confidence remains glued to multi-decade highs and there are high odds that the big gulf that has opened up between confidence and relative share prices will narrow via a rise in the latter (top panel). Moreover, a vibrant labor market with payrolls expanding at a healthy clip (second panel), the unemployment rate and unemployment insurance claims at generational lows, all signal that consumers will keep their purse strings loose, especially given rising wages (third panel). More dollars spent on recreation is synonymous with a margin expansion in the S&P movies & entertainment index (bottom panel). This consumer spending backdrop is also conducive to a rise in relative profitability, the opposite of what the sell-side currently expects. Bottom Line: We lifted the S&P movies & entertainment index to overweight on Monday; please see our Weekly Report for more details. The ticker symbols for the stocks in this index are: BLBG: S5MOVI – DIS, NFLX, VIAb.

Special Report

Highlights Corporate Debt In Theory: Conventional theory holds that high levels of corporate debt pose a risk to the economy because they make the corporate sector more vulnerable to exogenous economic shocks. Corporate Debt In Practice: The conventional theory is contradicted by empirical evidence that links rapid private debt growth to negative economic outcomes, but shows no relationship between high debt levels and slow economic growth. The empirical evidence also links measures of credit market sentiment – such as corporate bond spreads – to future economic outcomes. We present an alternative theory of the corporate credit cycle that better aligns with the observed empirical results. The Current Risk: At present, the corporate debt measures that have historically been linked to weaker economic growth paint a fairly benign picture. We see no immediate risk to the U.S. economy from elevated corporate debt. Feature In our interactions with clients we are often asked whether corporate debt poses a risk to the U.S. economy. It’s easy to see why, U.S. nonfinancial corporate debt as a percent of GDP is higher than at any time since 1936 (Chart 1). Chart 1U.S. Corporate Debt: Highest Since 1936! This Special Report investigates the issue by looking at what recent academic theory and empirical evidence have to say about the relationship between corporate debt and economic growth. We then apply that evidence to today’s corporate debt situation to assess the economy’s current level of risk. We should note that this report focuses on potential risks stemming from the amount of outstanding debt, how quickly it is growing and how it is valued in financial markets. In a follow-up report, we will consider whether the ownership structure of the corporate bond market imparts additional risks to the economy and financial system. The Risk From Corporate Debt In Theory Conventional economic theory tells us that we should be concerned about elevated private sector debt because high debt makes the economy more vulnerable in the face of future shocks. Case in point, here is how the Federal Reserve’s Financial Stability Report describes the mechanism through which private sector debt impacts the economy: Excessive borrowing by businesses and households leaves them more vulnerable to distress if their incomes decline or the assets they own fall in value. In the event of such shocks, businesses and households with high debt burdens may need to cut back spending sharply, affecting the overall level of economic activity.1 This theory raises a few issues that we will consider in the remainder of this report: The theory suggests that the absolute amount of private sector debt matters more than its rate of growth. The theory suggests that elevated debt leads to a more severe economic downturn, but doesn’t necessarily cause the downturn. In other words, high debt simply makes the economy more vulnerable to exogenous shocks. The theory suggests that household debt and corporate debt are equally important. The Empirical Record Level Versus Growth While conventional theory implies that the crucial variable to monitor is the level of private sector debt, recent empirical evidence challenges this view. For example, a 2017 Bank of England paper considered a sample of 130 recessions across 26 countries and found that the rate of private debt growth matters much more.2 Please note that in the remainder of this report we define “debt growth” as the 3-year change in the debt-to-GDP ratio. Specifically, the researchers found a statistically and economically significant link between the severity of the recession – defined as the drawdown in per capita GDP – and the 3-year change in private debt-to-GDP that immediately preceded the downturn. They found no similar relationship using the level of private debt-to-GDP. In fact, the researchers found that the level of private debt to GDP only helped explain the severity of the recession when it was interacted with the rate of private debt growth. To quote from the paper: It appears that the level of credit before a recession matters for the severity of the downturn only when it is accompanied by a credit boom. By contrast, periods of fast credit growth appear to be associated with more severe recessions whether or not the level of credit is elevated.3 These findings suggest that the conventional theory presented above – that high debt levels make the private sector more vulnerable to exogenous shocks – is not the principle mechanism at work. We need an alternative theory to explain why the rate of debt growth is the more important variable to monitor. We discuss a possible alternative theory in the section titled “Toward A Better Theory” below. But for now, let’s consider the current state of the U.S. economy in light of the Bank of England’s findings. Chart 2 shows that the level of U.S. private sector debt-to-GDP is elevated compared to history. In fact, using data beginning in 1955, it was only higher in the run-up to the 2008 financial crisis. However, the second panel of Chart 2 shows that private sector debt growth is only 2.5%, a far cry from what was seen prior to the last three recessions. Chart 2Recession Watch: Private Debt Growth And Inflation We don’t mean to imply that a recession cannot occur with low private debt growth, but the track record of post-WWII U.S. recessions shows that every single one was preceded either by elevated private debt growth – 8% or above – or high inflation. At present, the U.S. economy shows very little risk on either front. Household Debt Versus Corporate Debt So far we’ve looked at private sector debt in total, i.e. we have combined household debt and nonfinancial corporate debt. This arguably masks the true instability in the U.S. economy, which is concentrated in the corporate sector. Chart 3 shows that low overall private sector debt growth of 2.5% is split between relatively quick corporate debt growth of 4.2% and household debt that is contracting at a rate of 1.8%. If we ignore the household sector’s persistent deleveraging, we see that current corporate debt growth of 4.2% is not that far below the peaks of 6.9%, 7.9% and 8% seen prior to each of the last three recessions. Chart 3U.S. Private Debt Growth Is Driven By Corporate Sector This raises two interesting questions. First, are corporate debt and household debt equally de-stabilizing for the economy? And relatedly, when tracking the U.S. economy should we focus on overall private sector debt, or should we monitor household and corporate sector debt individually? The track record of post-WWII U.S. recessions shows that every single one was preceded either by elevated private debt growth or high inflation. On the first question, we can turn back to the Bank of England paper. That paper presented the results from several regressions where the researchers looked at household debt growth and corporate debt growth individually. The results showed that elevated household debt growth and elevated corporate debt growth were both associated with more severe recessions, and with roughly equal coefficients. In the words of the researchers: Rapid credit growth continues to be an important predictor of the severity of a recession whether we look at lending to non-financial companies or to households, suggesting that the role of lending to businesses should not be ignored. Interestingly, this result stands in contrast to some other recent empirical work. Most notably, a 2016 paper by Atif Mian, Amir Sufi and Emil Verner (MSV). That paper looked at a panel of 30 countries between 1960 and 2012 and found that while higher household debt growth is associated with lower subsequent GDP growth, no such correlation is found with corporate debt.4 MSV summarize their basic result as follows: There is a significant negative correlation between changes in private debt and future output growth. Moreover, this negative correlation is entirely driven by the growth in household debt. The magnitude of the negative correlation is large, with a one standard deviation increase in the change in household debt to GDP ratio (6.2 percentage points) associated with a 2.1 percentage point lower growth rate during the subsequent three years. The main difference between the MSV methodology and that used by the Bank of England is that the MSV paper looks at GDP growth unconditional on whether there is a recession. In contrast, the Bank of England paper looks only at recessionary periods. A look back at past U.S. recessions makes us reluctant to ignore corporate debt growth completely. Table 1 lists every post-WWII U.S. recession, showing the peak-to-trough drawdown in GDP as a measure of the recession’s severity along with prior peaks in private debt growth, household debt growth, corporate debt growth and inflation. Table 1A History Of Post-WWII U.S. Recessions Table 1 confirms what we already stated above, that every post-WWII U.S. recession has been preceded by either rapid private sector debt growth or high inflation. If we dig deeper and look at the breakdown between household debt growth and corporate debt growth we find that there have only been two recessions where peak corporate debt growth exceeded peak household debt growth. Current corporate debt growth of 4.2% is not that far below the peaks of 6.9%, 7.9% and 8% seen prior to each of the last three recessions. The first such recession occurred in 1973-75, but that recession was clearly driven by high inflation. Both household and corporate debt growth were quite low during that period. The second example is the 2001 recession. Private debt growth was elevated prior to the 2001 recession, and more heavily concentrated in the corporate sector. However, it’s important to note that the 2001 recession was also the mildest post-WWII U.S. recession. Main Takeaways We draw several conclusions from our review of the empirical research: First, we should pay attention to the rate of growth in private debt-to-GDP and downplay the level of private debt-to-GDP. The latter has very little predictive power on its own. Second, a U.S. recession is unlikely to occur in the absence of elevated private sector debt growth (above ~8%) or high inflation. At the moment, neither factor suggests that the U.S. economy is on the cusp of a downturn. Third, we should not ignore corporate debt growth. However, the MSV research suggests it might be less economically important than household debt growth. Further, the Bank of England paper shows that the severity of any future downturn is equally sensitive to both household and corporate debt, suggesting that it is reasonable to combine the two and use overall private sector debt growth as our key metric when assessing risks to the economy. Finally, the empirical research suggests that the theory of how corporate debt relates to the economy that was presented in the first section of this report is at best incomplete. That theory cannot explain why the rate of debt growth is associated with weaker economic activity, but the level of debt is not. Fortunately, some recent research proposes a few alternative theories that better align with the empirical results. These theories also suggest a few other measures of corporate credit risk that are important for investors to monitor. Looking Beyond Debt Growth So far we have focused on the difference between the level of corporate debt and the rate of corporate debt growth, but recent empirical research has also linked several other measures of ebullient credit market sentiment to future slow-downs in economic activity. Assessing Credit Market Sentiment For example, a 2016 paper by David Lopez-Salido, Jeremy Stein and Egon Zakrajsek (LSZ) shows, using U.S. data from 1929 to 2013, that “when corporate bond spreads are narrow relative to their historical norms and when the share of high-yield bond issuance in total corporate bond issuance is elevated, this forecasts a substantial slowing of growth in real GDP, business investment, and employment over the subsequent few years. Thus buoyant credit-market sentiment today is associated with a significant weakening of real economic outcomes over a medium-term horizon.”5 Before getting into the possible reason for this finding, let’s quickly look at how the U.S. economy stacks up with regard to credit market sentiment. First, the spread between Baa-rated corporate bonds and the 10-year U.S. Treasury yield – the spread measure used in the LSZ paper – is slightly above its historical average, and does not look stretched compared to history (Chart 4). Chart 4U.S. Credit Spreads Aren't Stretched Second, even a more conventional spread measure like the average option-adjusted spread from the Bloomberg Barclays Investment Grade Corporate Bond index remains fairly wide (Chart 5). Chart 5Junk Share Of New Issuance Is Falling Third, the high-yield share of new corporate bond issuance was elevated early in the recovery, especially compared to last cycle, but has declined in recent years (Chart 5, panel 2). Relatedly, the par value of outstanding junk debt as a proportion of the total par value of corporate debt has been falling since 2015 (Chart 5, bottom panel). Does Elevated Credit Market Sentiment Cause Slower Economic Growth? Of course, the empirical finding that tight credit spreads predict slower economic growth could simply reflect the fact that credit spreads respond to swings in the economic data. If our goal is to forecast economic growth, then this would suggest that we don’t need to pay much attention to credit spreads, because they are simply reflecting swings in the economy rather than causing them. However, the empirical evidence increasingly suggests that there is a causal mechanism at play. To test this, the LSZ paper employs a two-step regression procedure. In the first step, researchers model the future change in credit spreads based on the lagged level of credit spreads and the junk share of new issuance. In the second step, they use the fitted value from the first regression to predict changes in economic activity. The fact that the fitted value is significantly related to changes in economic activity implies that there is some predictable mean reversion in credit market sentiment, unrelated to economic fundamentals, that actually exerts an influence on future economic growth. LSZ suggest the following causal mechanism: Heightened levels of sentiment in credit markets today portend bad news for future economic activity. This is because mean reversion implies that when sentiment is unusually positive today, it is likely to deteriorate in the future. Moreover, a sentiment-driven widening of credit spreads amounts to a reduction in the supply of credit, especially to lower credit-quality firms. It is this reduction in credit supply that exerts a negative influence on economic activity. It follows from this analysis that if we could show that corporate bond spreads are tight relative to their “economic fair value”, then the economy would be at even greater risk from a mean reversion in credit market sentiment. While it’s difficult to identify a true “fair value” for credit spreads, Simon Gilchrist and Egon Zakrajsek (GZ) have calculated an Excess Bond Premium that measures the excess spread available in a sample of corporate bonds after removing a bottom-up estimate of expected default losses.6 Expected default losses are estimated using the Merton model and each firm’s market value of equity and face value of debt.7 Using this new measure, GZ find that “over the past four decades, the predictive power of credit spreads for economic downturns is due entirely to the Excess Bond Premium”. This stunning result is the most compelling evidence yet that swings in credit market sentiment actually cause shifts in economic activity, rather than simply reflect them. Looking at the GZ Excess Bond Premium today, we see that while it had been negative for most of the current cycle, it recently ticked above zero and has yet to recover (Chart 6). For the time being, there is no evidence of excessively optimistic credit market sentiment. Chart 6U.S. Credit Spreads Are High Relative To Fundamentals Toward A Better Theory So far we’ve seen that rapid debt growth is a better predictor of future economic weakness than high debt levels. We’ve also seen evidence that optimistic credit market sentiment (tight credit spreads, especially relative to fundamentals, and an elevated junk share of new issuance) forecasts, and likely causes, future economic weakness. Clearly, we need a better theory for why corporate debt matters for the economy than the one provided by the Federal Reserve in the first section of this report. In our view, the theory that most closely aligns with the empirical data is Nicola Gennaioli and Andrei Shleifer’s theory of Diagnostic Expectations, as detailed in their 2018 book A Crisis Of Beliefs.8 In the book, the author’s demonstrate how investors systematically overreact to new economic information. A tendency that makes forecast errors highly predictable. For example, Chart 7 shows that forecasts for what the Baa/Treasury spread will be in one year’s time are tightly linked with today’s actual spread. This means that investors inevitably expect too much future spread widening when spreads are high, and too much future tightening when spreads are low. Chart 7Forecast Errors Are Predictable Gennaioli and Shleifer integrate this systematic behavioral bias into a model that, from our perspective, better aligns with the empirical data on the relationship between corporate debt and the real economy. According to Gennaioli and Shleifer: Good economic news […] makes right-tail outcomes representative. This leads investors to both overestimate average future conditions and to neglect the unrepresentative downside risk, causing overexpansion of both leverage and real investment. When good news stops coming, investors revise their expectations down, even without adverse shocks. These revisions cause credit spreads to revert, the lenders to perform poorly, and economic and financial conditions to deteriorate, leading to deleveraging and cuts in real investment. A severe crisis occurs if arriving news is sufficiently bad as to render left-tail outcomes representative and hence overstated. This theory would seem to explain all of the key empirical findings. Investors form their expectations based on an overreaction to recent news. During an economic recovery this causes credit spreads to tighten and debt to grow rapidly. Eventually, investors realize that expectations have become unrealistically optimistic, credit spreads mean-revert and debt growth plunges. Crucially, in this model a severe economic shock is not required for credit spreads to mean-revert, only a lack of further good news to confirm investor over-optimism. Based on this theory, if we are concerned about the impact of corporate debt on the real economy we should predominantly track measures of credit market sentiment and the rate of debt growth. The theory helps reveal why the level of corporate debt has little informational value. Concluding Thoughts Conventional theory tells us that high corporate debt levels could pose a risk to the economy because they make the corporate sector more vulnerable in the face of exogenous economic shocks. However, empirical evidence suggests that this theory is of little practical value. A better theory is one where investors and corporate managers overreact to positive economic news, leading to overvaluation in credit markets and rapid debt growth. Then, when sentiment is revealed to be overly optimistic, it leads to a mean-reversion in credit spreads and a tightening of credit supply that actually causes a period of weaker economic growth. Investors inevitably expect too much future spread widening when spreads are high, and too much future tightening when spreads are low. It follows from this theory that if we are concerned about the impact of corporate debt on the real economy we should predominantly track debt growth and measures of credit market sentiment such as credit spreads and the junk share of new issuance. The U.S. economy currently looks quite stable by these measures. Overall private sector debt growth is only 2.5%. Historically, it has been above 8% prior to recessions that weren’t caused by high inflation. The GZ Excess Bond Premium also shows that credit market sentiment is not currently stretched relative to fundamentals. Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com   Footnotes 1      https://www.federalreserve.gov/publications/files/financial-stability-report-201811.pdf 2      https://www.bankofengland.co.uk/working-paper/2017/down-in-the-slumps-t… 3      Please note that the Bank of England paper uses the term “credit” in place of “debt”. In this report we use both terms interchangeably. 4      https://chicagounbound.uchicago.edu/cgi/viewcontent.cgi?article=1050&co… 5      https://www.nber.org/papers/w21879 6      https://www.federalreserve.gov/econresdata/notes/feds-notes/2016/recession-risk-and-the-excess-bond-premium-20160408.html 7      Merton, Robert C., “On The Pricing Of Corporate Debt: The Risk Structure of Interest Rates”, The Journal of Finance, Vol. 29, No. 2, May 1974. 8      Nicola Gennaioli and Andrei Shleifer, A Crisis Of Beliefs: Investor Psychology And Financial Fragility, Princeton University Press, 2018.

Highlights Portfolio Strategy Disney’s recent streaming pricing disclosure and a favorable macro backdrop for recreation PCE argue that more gains are in store for the S&P movies & entertainment index. The price of credit, credit quality and credit growth along with equity buybacks all suggest that bank profits will continue to overwhelm. Recent Changes Upgrade the S&P movies & entertainment index to overweight today. Table 1   Feature Equities continued to defy gravity last week as the earnings season warmed up and did not reveal any “skeletons in the closet”. Lower interest rates single-handedly explain the recent stock market exuberance (Treasury yield shown inverted, Chart 1). In more detail, the Fed’s complete pivot has suppressed the 10-year Treasury yield and last year’s forward multiple drubbing – to the tune of a 30% drawdown – has reversed. Chart 1Lower Yield = Higher Multiple Chart 2 shows that, year-to-date, the forward multiple has done all the heavy lifting in the SPX and then some, as EPS have actually subtracted from the broad market’s return. In theory, a lower discount rate should boost the multiple and vice versa. Nevertheless, there are good odds that the 10-year Treasury yield has troughed, and BCA’s fixed income strategists continue to expect a selloff in the bond market for the rest of the year. The implication is that equities are becoming fully priced and if profits fail to pick up the baton from the multiple expansion phase, the risk/reward tradeoff is to the downside on a tactical horizon. Meanwhile, there are a number of indicators we track that are still firing warning shots for the overall equity market. Margin debt has stalled and remains 13% below the all-time peak hit last year. Historically, this has been a coincident equity market indicator and a lack of confirmation is troublesome for the overall equity market (bottom panel, Chart 3). Chart 2SPX Return Explained Chart 3M&A Lull... M&A activity has taken a step back, with the total number of deals down 25% from the 2018 zenith (top panel, Chart 3). Similar to margin debt uptake, this is a coincident indicator and the latest weak reading is cause for concern, as it signals that animal spirits are low. With regard to frail sentiment, CEO confidence has taken a beating of late on all fronts. The most recent Business Roundtable and Conference Board CEO surveys reveal that chief executives are a worried bunch. Their views on the overall economic outlook, all industries (including services manufacturing, durable and non-durable), capital outlays, employment, and revenues all remain downbeat, and likely explain the recent M&A lull (Chart 4). On the profit front, last year’s once in a lifetime equity retirement will not repeat this year, warning that artificial EPS growth will weigh on overall profit growth in 2019. Beyond this grim reading on “soft data”, select financial market leading indicators are also not corroborating the euphoric equity market. J.P. Morgan’s EM FX index has petered out recently and both EM and Chinese investable stocks (in U.S. dollar terms) remain well below their early-2018 peaks. Similarly, China-levered U.S. semi equipment stocks are a far cry from their cyclical highs set last year and suggest that some caution is still warranted in the broad equity market (Chart 5). Chart 4...Drop In CEO Confidence... Chart 5...And Financial Indicators Still Flashing Red Finally, on the profit front, last year’s once in a lifetime equity retirement will not repeat this year, warning that artificial EPS growth will weigh on overall profit growth in 2019. In addition, Charts 6A & 6B show that buybacks are already concentrated in a few sectors. Our sense is that this concentration theme will continue this year and likely center around financials as banks will flex their equity retirement muscle.   This week we delve deeper into banks and upgrade a communication services subsector. “A Kind Of Magic” Factors have fallen into place to boost the recently rejigged S&P movies & entertainment index to an above benchmark allocation today. DIS and NFLX dominate this index now comprising roughly 97% of the market cap weight and VIAb is merely the third wheel. The dust has settled from the global media industry M&A frenzy of the past two years, but the push to the cloud via online streaming services suggests that it is only a temporary break. We would not rule out another round of inter- and intra-industry M&A, as content is king once again (Chart 7). Chart 7Rejigged Recent pricing news of Disney’s streaming service, expected later this year, sent reverberations across the media space as Disney priced it at such a low point in order to grab market share and likely pave the way for future price hikes. While streaming services have been mushrooming, there is space for a number of competitors, signaling that Netflix’s global streaming domination will not come crumbling down all of a sudden. While the index’s 12-month forward EPS took a hit with the NFLX addition in October, 2018 and the forward P/E jumped to the historical mean, this niche communication services subgroup is now clearly a growth index and will continue to command a premium valuation to the broad market (bottom panel, Chart 8). From a macro perspective there are also compelling reasons to warm up to the S&P movies & entertainment index. Consumer confidence remains glued to multi-decade highs and there are high odds that the big gulf that has opened up between confidence and relative share prices will narrow via a rise in the latter (top panel, Chart 8). Moreover, a vibrant labor market with payrolls expanding at a healthy clip (top panel, Chart 9), the unemployment rate and unemployment insurance claims at generational lows, all signal that consumers will keep their purse strings loose, especially given rising wages (third panel, Chart 9). Chart 8Positive Macro... Chart 9...Drivers... Tack on the confidence consumers have in residential real estate with house prices expanding both on a year-over-year and on a shorter-term basis (second panel, Chart 9), and the ingredients are in place for an increase in consumer recreation outlays. Disney’s streaming pricing disclosure, a favorable macro backdrop on recreation PCE and sell-side analyst extreme profit pessimism argue that more gains are in store for the S&P movies & entertainment index. Lift to overweight today. One final macro variable that is also on the side of the S&P movies & entertainment index is the ISM non-manufacturing index. Historically, real outlays on recreation activities has moved in lockstep with the ISM services survey and the current message is positive for PCE on recreation (bottom panel, Chart 9). More dollars spent on recreation is synonymous with a margin expansion in the S&P movies & entertainment index (third panel, Chart 8). This consumer spending backdrop is also conducive to a rise in relative profitability, the opposite of what the sell-side currently expects (middle panel, Chart 10). Chart 10...But Analysts Are Not Buying It Not only are industry EPS slated to trail the SPX by 300bps in the coming year, but also analysts have been vigorously downgrading their EPS estimates weighing on the sector’s net earnings revisions ratio (bottom panel, Chart 10). This is contrarily positive and we would lean against such analyst pessimism. Netting it all out, Disney’s streaming pricing disclosure, a favorable macro backdrop for recreation PCE and sell-side analyst extreme profit pessimism argue that more gains are in store for the S&P movies & entertainment index. Bottom Line: Lift the S&P movies & entertainment index to overweight today. The ticker symbols for the stocks in this index are: BLBG: S5MOVI – DIS, NFLX, VIAb. Bank Update: Primed For A Re-rating By the end of last week most banks reported profits that exceeded expectations and investors breathed a sigh of relief, despite the early-December yield curve inversion and the more recent broadening of the inversion from the 5/3 all the way out to the 10/fed funds rate slope. What partially explains the sector’s EPS resilience is net interest margins (NIMs) that just entered their fifth straight year of widening. While this may seem counterintuitive given the inverted/flattening yield curve, banks are repressing depositors by not passing on higher interest rates on deposits, thus guaranteeing extremely cheap funding. The bottom panel of Chart 11 shows that the 2-year Treasury yield/1-year CD rate slope is steep and it has historically moved in lockstep with bank NIMs. As a reminder, BCA’s bond strategists expect a selloff in the bond market and remain short duration, signaling that bank NIMs will not suffer a setback for the remainder of the year. Beyond the prospects for a further increase in the price of credit, another key source of bank EPS support is equity retirement. Citi explicitly mentioned it this earnings season, and the S&P financials sector buybacks, largely driven by banks, corroborate this anecdote (Chart 12). Chart 11Deciphering Bank Profit Resilience Chart 12New Buyback Kings In fact, there is a wide gap between this artificial EPS lift and relative share prices that will likely narrow in the coming months via a catch up phase in the latter, particularly if banks pass the Fed’s stringent stress test anew as we expect later this summer. On the credit quality front, bank NPLs remain anchored near cycle lows and tight labor markets suggest that a flare up in delinquencies is a low probability event in the coming year, especially given BCA’s view of no recession (bottom panel, Chart 13). Chargeoffs and souring loans are almost non-existent in all the categories that the Federal Reserve tracks, with the slight exception of credit card loans that are ticking higher, but from an extremely low base (we provide more details below in the risk section, second & third panels, Chart 13). Finally, loan growth has held up very well despite the stock market collapse in Q4/2018 and the massive tightening in financial conditions. While our overall loans & leases and C&I loan models are decelerating, they remain squarely in expansion mode and should continue to underpin bank profitability (second and bottom panel, Chart 14). Chart 13Pristine Credit Quality Chart 14Credit Growth Rests On A Solid Foundation  Consumer confidence remains sky-high and house prices are also rising at a healthy pace, signaling that mortgage (top panel, Chart 11) and consumer loan origination will remain upbeat (third panel, Chart 14). The price of credit, credit quality, credit growth along with buybacks all suggest that bank profits will continue to overwhelm. Stay overweight the S&P banks index. All of this positive news is already reflected in banks’ return on equity that vaulted higher recently signaling that a re-rating in still-extremely depressed valuations is looming in the coming quarters (Chart 15). Nevertheless, there are two risks to our sanguine S&P banks view that we are closely monitoring. First, our Economic Impulse Indicator remains near the zero line and, coupled with the still downbeat Citi Economic Surprise Index, warn that demand for loans may start softening at the margin (top panel, Chart 16). Chart 15Follow The ROE Chart 16Two Risks To Monitor Second, while the top 100 largest commercial banks are not showing a deterioration on the credit card delinquency front, the rest of the banks are waving a red flag as delinquencies are already at recessionary levels. This explains why the overall credit card delinquency rate is ticking higher (bottom panel, Chart 16). Netting it all out, the price of credit, credit quality, credit growth along with buybacks all suggest that bank profits will continue to overwhelm. Bottom Line: Stay overweight the S&P banks index. The ticker symbols for the stocks in this index are: BLBG: S5BANKX – JPM, BAC, WFC, C, USB, PNC, BBT, STI, MTB, FITB, FRC, KEY, CFG, RF, HBAN, SIVB, CMA, ZION, PBCT.   Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com   Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Special Report

Highlights Actively managed U.S. equity mutual funds have been hemorrhaging assets under management (AUM), with the lost AUM flowing directly to ETFs and index mutual funds. Chatter about the adverse consequences of too much passive investing is intensifying, and BCA clients are increasingly asking if a bubble is inflating in passive investing or ETFs more generally. We view passive investing as the surest cure for passive investing and do not worry that index tracking is undermining price discovery or distorting equity markets. Temporary distortions are manna from heaven for professional investors and we would like to have more of them. Active mutual fund management may not be all it’s cracked up to be, in any event. The Active Share metric, which measures the portion of a portfolio that differs from its benchmark, has been in steady decline for the last 30 years, indicating that active management practices have undergone a sea change. We have faith in ETFs’ underlying architecture and continue to recommend investing in them. They are an efficient, inexpensive and liquid way to gain market exposure and investors need not worry about getting stuck when the music stops. Feature Dear Client, The market impact of passive investing continues to be a hot topic among investors, sell-side researchers and the financial media. To contribute our view to the discussion, we are sending you a lightly edited update of a review of passive investing’s implications first published under our Global ETF Strategy banner in September 2017. We met with clients in China last week, and will be taking some time off this week, so we will not be publishing on April 29th. We will resume publication on Monday, May 6th. Best regards, Doug Peta   Over the last few years, we have received a thin but steady stream of questions from clients asking about a potential ETF bubble. We note that ETFs do not exhibit any of the characteristics delineated by economic historian Charles Kindleberger in Manias, Panics and Crashes. There is a difference between the increasingly widespread adoption of a useful innovation and a febrile spell of mass exuberance or suspension of disbelief. We have duly expressed the view in one-on-one communications with clients that ETFs shouldn’t inspire any particular worry. The related chatter about a passive investment bubble only seems to intensify, however, and we focus on it in this Special Report. We ultimately fail to see the justification for the most extreme warnings about the dangers of passive investing. Perhaps the emergence and bursting of two bubbles in rapid succession has sparked a mini-bubble in searching for bubbles among academics, investors and reporters. We do not think that the popularity of ETFs is distorting pricing mechanisms, though we would welcome a good distortion to break up the logjam of full-but-not-extreme valuations that portend tepid intermediate- and long-term balanced portfolio returns. The Active Management Exodus The causes and consequences may be a matter of debate, but the facts are clear: actively managed U.S. equity mutual funds have been losing ground to index mutual funds for two-and-a-half decades (Chart 1). Before ETFs began to boom ahead of the crisis, active equity mutual funds still managed to attract annual net inflows despite their share losses, but they have now suffered net outflows in every one of the last 12 years. Index ETF and index mutual fund inflows have amounted to nearly 90% of the active mutual funds’ outflows, with index ETFs drawing more than twice the AUM as their mutual fund counterparts (Chart 2). Chart 2Mirror Image Given the near symmetry of active mutual fund outflows and index fund inflows, it appears that an extended active-to-passive migration is well under way. The move is rational, and has helped investors at the expense of asset managers, as index funds cost considerably less than actively managed funds. (In 2017, the asset-weighted average expense ratio for actively managed and index equity mutual funds was 0.78% and 0.09%, respectively.) If mutual fund managers tend to be wealthier than their clients, the fee savings give the economy a modest boost by shifting wealth to households with a higher marginal propensity to consume. The Spoilsport Chorus What’s not to like about lower fees for the same, or better, returns?1 Plenty, as it turns out. The myriad objections to passive investing’s increasing sway boil down to three major arguments: passive investing undermines price discovery; passive investing undermines capital allocation; and passive investing is potentially anti-competitive. Price insensitivity carries the seeds of its own demise. An index-tracking investor is a price-insensitive investor, and a surfeit of passive investment could undermine equity markets’ price-discovery function. Index-trackers are free riders, living off of the active investors whose trading decisions set prices. Just as a parasite cannot live without a host, naive passive investors need price-setters to keep them safe. The passive investing naysayers’ heads are filled with images of lemmings rushing over the edge of a cliff after active investors are routed, but we are not so sure. It’s important to remember that the price an investor pays for a security2 is the major determinant of his/her long-run return, and a price-insensitive investor is all but certain to underperform a price-aware investor over time, perhaps by a material margin. Thus the cure for passive investment is passive investment; the fewer active investors participating in the markets, the greater the prospective returns accruing to active investment. Greater prospective returns will draw an increasing proportion of assets until active management is no longer likely to outperform. Then the pendulum will swing back to index investing – lather, rinse, repeat – but skilled security analysts will have a field day while their talents are underappreciated. Passive investing’s impact on markets’ capital allocation function is indirect at best. Only primary market transactions channel capital to, or from, ideas and enterprises. Secondary market transactions merely involve exchanges of capital between incumbents and new owners, and index tracking is a secondary-market function. The sell-siders that found passive investing wanting in comparison with central planning would seem to have been trying too hard to be provocative.3 The late John Bogle may have been a bit of a scold, but we’d take him over Karl Marx any day. The notion that high concentrations of ownership among passive holders could be anti-competitive strikes us as especially strained. An article published in The Atlantic a year and a half ago bore the provocative headline, “Are Index Funds Evil?” and sub-header, “A growing chorus of experts argue that they’re strangling the economy – and must be stopped.4” The article highlighted a working paper from a team of newly-minted PhDs that argued that high common ownership in the airline industry has been associated with decreased route competition and increased fares. If the same entities hold significant stakes in all of the companies in a particular industry, those entities may have an incentive to collude to restrain competition within the industry and thereby increase the size of the pie for the industry as a whole. This may be so at the airline-industry level, but as passive owners of the entire market, Vanguard, BlackRock and State Street own considerable stakes in every other industry as well, so increasing the profitability of a single portfolio segment at the expense of other portfolio segments would seem to be self-defeating, not to mention personally risky, given stiff antitrust penalties. What Makes A Bubble? Bubbles differ in their specifics, but they share several common empirical characteristics. Kindleberger homes in on the easy availability of credit and its role in enabling the euphoria that fuels temporarily self-reinforcing, albeit ultimately unsustainable, price gains. The gains generated by the headlong pursuit of short-term capital gains are the key to keeping the bubble going, but the upward price movement is halted in its tracks when credit availability slows, and prices plunge like Wile E. Coyote once it’s cut off. Neither ingredient has been a part of the ETF boom. Index ETFs are the opposite of a get-rich-quick scheme; they’re what investors buy when they decide to stop chasing after buried treasure. The easy and inexpensive availability of credit has surely contributed to elevated equity multiples (Chart 3) and narrow bond spreads (Chart 4). The instruments ETFs hold are somewhat pricey and will be vulnerable when the next recession comes, but they are not discounting euphoric expectations that cannot realistically be met. ETF sponsors do not rely on debt; launching an ETF is such a capital-light process that the field is full to bursting with several funds that amount to unfinished experiments. Without the burden of servicing debt, sponsors are free to throw their ideas up against a wall and see what sticks. Chart 3Equity Multiples Are Elevated... Chart 4... And Spreads Are Tight ETFs are not being bought on margin in any significant degree; they are not the apple of frenzied gain-chasers’ eyes. Aside from leveraged ETFs that provide a designated multiple of daily returns, pooled investment vehicles that amalgamate the performance of several securities are the antithesis of an ideal speculative instrument. Index ETFs allow an investor to obtain benchmark returns at low cost and with a minimum of fuss, and are a sane alternative to speculation. As Benjamin Graham put it, the dumb money ceases to be dumb when it acknowledges its limitations, and index investing is an explicit acknowledgement of one’s limitations. ETF Flows Are Not Coming Out Of Thin Air To the notion that “so much money is flowing into ETFs that it’s distorting prices across the board,” we say not necessarily. If the money to buy ETFs were materializing out of thin air (as it is in Tokyo and Zurich thanks to the efforts of the BoJ and the SNB), one could argue that ETF inflows are inflating multiples and narrowing spreads. But the money to purchase U.S.-listed ETFs comes almost entirely from sales of actively managed mutual funds. ETF purchases are a reallocation of existing investment capital, not new marginal investment with the potential to move markets. Just How Active Are The “Active” Outflows? Chart 5Indexing Hasn't Hijacked Equity Correlations On the subject of changes at the margin, if the capital to purchase index ETFs comes from mutual funds that are active in name only, they simply shift cash from one passive pocket to another, and don’t amount to any change at all. The professor-investors who created the Active Share metric to measure how much a portfolio deviates from its benchmark5 describe a mutual fund industry that has steadily migrated away from stock picking. By their reckoning, the share of mutual fund assets managed by closet indexers rose from 1% in 1980 to nearly 33% in 2009.6 Using the Active Share calculator at https://activeshare.info/, we find that one-third of AUM in actively-managed U.S. equity mutual funds with AUM of at least $1 billion are held by closet-indexing mutual funds (funds with Active Share of 60% or less). Our large-fund sample suggests that two-thirds of active fund AUM is truly active. The loss of even that amount of actively managed assets does not appear to have been enough to hijack internal market dynamics. If everyone became an index tracker, and all trades were trades of the entire market, correlations at the stock and sector level would go to 1. Despite ETFs’ growing muscle, and their capture of share from stock-picking funds, correlations have not consistently risen over the 2015-17 period that has witnessed a stampede from active to indexed equity funds (Chart 5). Investment Implications We do not believe that the steadily expanding investment in passive vehicles poses a threat to markets or investors. Passive vehicles offer investors the most cost-effective way to obtain market exposure and the actively managed funds they’re exchanging for index trackers have become increasingly less active as benchmark indexes have become more prominent. If the passive trend continues, and a rising share of capital is invested without regard for distinctions between companies, the ex-ante returns to active strategies will increase and investors will return to them in droves. In the meantime, if passive investing’s share reaches the tipping point, wherever it may be, fundamentally-focused investors will feast on excess returns. Active investors will clean up if passive investing ever crosses the tipping point. We do not worry that passive investing will weigh on the economy by hindering the efficient allocation of capital to the ideas with the most merit. Index tracking is confined to the secondary markets and will not consign the U.S. economy to a Soviet fate. We view the suggestion that index tracking may lead to collusion among operating companies as unfounded conjecture. Investors need not worry that ETFs are in a bubble, or that investing in passive strategies will be a drag on economic output.   Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com   Footnotes 1 In a typical year, a majority of mutual funds underperform their benchmarks. 2 Price is defined as starting real yield for bonds, and cyclically-adjusted P/E for equities. 3 “The Silent Road to Serfdom: Why Passive Investing Is Worse Than Marxism,” August 23, 2016, Sanford C. Bernstein & Co., LLC. 4    Partnoy, Frank, “Are Index Funds Evil?” The Atlantic, September 2017. 5 Cremers, K.J. Martijn and Petajisto, Antti. “How Active Is Your Fund Manager? A New Measure That Predicts Performance,” Review of Financial Studies, September 2009. 6 Petajisto, Antti. “Active Share and Mutual Fund Performance,” Financial Analysts Journal, July/August 2013.

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

Highlights Chinese credit origination surpassed expectations in March. Credit growth is now clearly trending higher, and the latest data suggest that economic activity is rebounding. This bodes well for global growth. The conventional wisdom is that China’s releveraging efforts represent “short-term gain for long-term pain.” We disagree. For the most part, Chinese releveraging is inevitable, desirable, and sustainable. Credit growth is inevitable because rising debt is necessary for transforming the country’s copious savings into fixed-asset investment. It is desirable for ensuring that GDP growth stays close to trend. It is broadly sustainable because the interest rate at which the government and much of the private sector are able to borrow is well below the economy’s growth rate. In fact, under a plausible set of assumptions, faster credit growth in China could lead to a lower debt-to-GDP ratio. Stronger global growth later this year should weaken the U.S. dollar. We are closing our long DXY trade for a carry-adjusted gain of 16.4% and exiting our long USD/CNY trade for a loss of 3.1%. We are also taking profits on our short AUD/CAD, short EUR/CAD, and short EUR/RUB trades of 1.6%, 3.9%, and 8.6%, respectively, and initiating two new currency trades: short USD/RUB and long EUR/JPY. The combination of a weaker dollar and faster Chinese growth should benefit EM and European stocks. Gold hit our limit buy order of $1275/ounce and we are now long the yellow metal. Feature A Blockbuster Month For Chinese Credit Growth After turning cautious for about six months, we moved back to being bullish on global equities in late December. We also sold our put on the EEM ETF on January 3rd for a gain of 104% in anticipation of a wave of Chinese credit stimulus. Credit growth blew past expectations in January, but surprised on the downside in February. This made the March release particularly important. In the end, the March data did not disappoint those who were hoping for a solid reading. New CNY loans rose by RMB 1690 billion, above Bloomberg consensus estimates of RMB 1250 billion. Our adjusted aggregate financing measure, which excludes a number of items such as equity financing but includes local government bond issuance, rose by 12.3% year-over-year, up from 11.6% in February (Chart 1). China’s credit impulse leads the import component of its manufacturing PMI (Chart 2). The credit impulse bottomed in November 2018, which should feed into higher imports over the coming months. This week’s release of better-than-expected data on industrial production, retail sales, and housing activity all suggest that the rebound in Chinese growth is already afoot. Chart 1Chinese Credit Growth Is Rebounding... Chart 2...Which Should Bode Well For Global Exports To China   Short-Term Gain For Long-Term Pain? At times like these, the bears are always ready with their standby argument: Sure, China may be stimulating, but all that credit growth will just make the debt bubble even bigger. Once the bubble bursts, there will be hell to pay. Long-term investors should steer clear of any growth-sensitive assets. It is a seductive argument. But it is wrong. Chinese releveraging is: 1) inevitable; 2) desirable; and 3) sustainable. The fundamental macroeconomic problem that China faces is that it consumes too little of what it produces. 1. Chinese Debt Growth Is Inevitable The fundamental macroeconomic problem that China faces is that it consumes too little of what it produces. The result is a national savings rate of 45%, by far the highest of any major economy (Chart 3). Chart 3China Still Saving A Lot Chart 4From Exporting Savings To Investing Domestically And Building Up Debt   There was a time when China was able to export a large part of its excess production. Its current account surplus reached nearly 10% of GDP in 2007. As its economy has grown in relation to the rest of the world, running massive trade surpluses has become more difficult. This is especially true today, when the country is being targeted by the Trump administration and much of the international community for alleged unfair trade practices. As China’s ability to churn out large current account surpluses declined, the government moved to Plan B: propping up growth by recycling the country’s copious savings into fixed-asset investment. This process saw households park their savings in banks and other financial institutions which, in turn, lent the money out to companies and local governments in order to finance various investment projects. Not surprisingly, debt levels exploded higher (Chart 4). As China’s population ages and more workers leave the labor force, savings will decline. However, this is likely to be a slow process. In the meantime, further debt growth is inevitable. 2. Chinese Debt Growth Is Desirable In an ideal world, Chinese households would consume more of their incomes, leaving only enough savings to finance high-quality private and public investment projects. That is not the world we are living in. In a far-from-ideal world, we need to think about second-best solutions. Yes, a sizable share of Chinese investment spending goes towards projects of dubious value. Yet, the same could have been said about Japan’s fabled “bridges to nowhere.” One may regard the construction of a seldom-used bridge as a misallocation of capital. But what is the counterfactual? If the bridge had not been built, would the workers have found productive work? If not, then there also would have been a misallocation of capital – human capital – which is arguably a much more serious problem. In any case, keep in mind that the rate of return on private investment depends on the state of the economy. If an economy is suffering from chronic lack of demand, only the most worthwhile projects will be undertaken. As the economic outlook improves, the set of viable projects will expand. It is only when all excess private-sector savings have been depleted, and interest rates are rising, that public spending starts to crowd out private investment. 3. Chinese Debt Growth Is Sustainable Even if one accepts the proposition that China needs continued debt growth to maintain full employment, is it still possible that all this additional debt will push the economy into a full-blown debt crisis? Most self-professed “serious-minded” observers would say yes. But then again, many of these same observers were predicting that Japan was heading for a debt crisis when government debt reached 100% of GDP in the late 1990s. Today, Japan’s government debt-to-GDP ratio stands at about 240% of GDP, and yet interest rates remain at rock-bottom levels. China will avoid a debt crisis for the same reason Japan has been able to avoid one. Much of China’s debt stock is composed of state-owned enterprise, local government, and other forms of quasi-public sector debt. Credit policy in China is often indistinguishable from fiscal policy. Given the abundant supply of savings in the economy, most of this debt can be internally financed at fairly low interest rates. The standard equation for government debt dynamics says that the change in the debt-to-GDP ratio, D/Y, can be expressed as:1 G - T is the primary budget deficit, r  is the borrowing rate, and g is the growth rate of the economy (it is irrelevant whether r and g are defined in nominal or real terms, as long as they are both expressed the same way). China will avoid a debt crisis for the same reason Japan has been able to avoid one. The Chinese 10-year government bond yield is currently four percentage points below projected GDP growth over the next decade, which is one of the biggest gaps among the major economies (Chart 5). Arithmetically, this means that China can have as large a primary fiscal deficit as it wants. As long as r remains below g, the debt-to-GDP ratio will converge to a stable level. Chart 6 shows this point analytically. In fact, it is possible that a permanently larger budget deficit could lead to a decline in the equilibrium debt-to-GDP ratio. How could that be? The answer is revealed by the equation above. If the debt-to-GDP ratio is fairly high to begin with and an increase in the primary budget deficit leads to higher inflation (and hence, lower real rates and/or faster nominal GDP growth), this could more than fully counteract the increase in the deficit. Chart 7Stronger Growth Coincided With Accelerating Inflation And Lower Real Rates This is not just a theoretical curiosity. Historically, Chinese inflation has risen while real rates have fallen whenever GDP growth has accelerated (Chart 7). Given China’s high debt levels, even a modest amount of additional inflation could put significant downward pressure on the debt-to-GDP ratio.2  Of course, all this is predicated on the assumption that faster credit growth will not cause interest rates to rise above the growth rate of the economy. For the portion of China’s debt stock that is either directly or indirectly backstopped by the central government, this seems like a safe assumption. After all, if credit/fiscal stimulus is simply being undertaken in response to inadequate demand, there is no need for policymakers to hike rates. Things get trickier when we look at private debt. In the past, the government has encouraged state-owned banks to roll over souring loans for fear that a wave of defaults would undermine the economy and endanger social stability. More recently, however, policymakers have been backing away from this strategy due to the well-founded view that it encourages moral hazard. Faster growth in China in the second half of this year will lift Chinese imports. This will be welcome news for the rest of the world. We expect the authorities to continue taking steps to instill market discipline by allowing failing firms to, well, fail. Realistically, however, the transition to a full market-based economy will take quite a bit of time. In the interim, the government will keep cutting taxes and increasing on-budget spending in order to ensure that any decline in employment among failing firms is offset by employment growth elsewhere. In such an environment, neither a debt crisis nor a deep economic slowdown appear likely. Investment Conclusions Faster growth in China in the second half of this year will lift Chinese imports. This will be welcome news for the rest of the world. Chart 9Germany Welcomes The Upturn In Chinese Credit Growth While the U.S. will benefit from a revival in Chinese growth, Europe will gain even more (Chart 8). Germany, in particular, should see a pronounced acceleration in growth. China’s credit impulse leads Chinese automobile spending which, in turn, reliably leads euro area automobile exports, as well as overall exports (Chart 9). The recent rebound in the expectations component of the German ZEW index, as well as in the manufacturing output component of the April flash PMI, suggests that green shoots are starting to sprout (Chart 10). Italy should also benefit from the steep drop in bond yields since last October (Chart 11). Italian industrial production strongly surprised to the upside in February, suggesting that the euro area’s third biggest economy may have finally turned the corner. Chart 10Tentative Green Shoots Out Of Germany Chart 11Italy: The Drop In Bond Yields Should Boost The EconomyThe ECB will not hike rates this year even if growth shifts into higher gear, but the market will probably price in a bit more monetary tightening in 2020 and 2021. This should help lift the euro. We recommend that investors position themselves for this by going long EUR/JPY. Relatedly, we are closing our short EUR/CAD trade for a gain of 3.9%.   The U.S. dollar tends to be a countercyclical currency, meaning that it moves in the opposite direction of the global business cycle (Chart 12). This countercyclicality stems from the fact that the U.S. is more geared towards services than manufacturing compared with most other economies (Chart 13). As such, when global growth accelerates, capital tends to flow from the U.S. to the rest of the world, translating into more demand for foreign currency and less demand for dollars. Chart 12The Dollar Is A Countercyclical Currency Chart 13The U.S. Is A Low-Beta Play On Global Growth A “patient” Fed and the prospect of stronger global growth in the second half of this year are bearish for the dollar. As such, we are closing our long DXY trade for a carry-adjusted gain of 16.4% and exiting our long USD/CNY trade for a loss of 3.1%. We are also closing our short AUD/CAD trade for a gain of 1.6%. Faster Chinese growth will boost metal prices, which is bullish for the Aussie dollar. Lastly, we are switching our short EUR/RUB trade (which is currently up 8.6%) into a short USD/RUB trade. A weaker greenback and stronger global growth will be manna from heaven for international stocks, especially when priced in U.S. dollars. Investors should prepare to move European and EM equities to overweight within a global equity portfolio during the coming weeks. A “patient” Fed and the prospect of stronger global growth in the second half of this year are bearish for the dollar. We are less keen on upgrading Japanese equities. While Japanese exporters will benefit from stronger Chinese growth, the domestic economy will be weighed down by the upcoming hike in the sales tax, which is slated to take place in October. Moreover, the yen is likely to experience headwinds as global bond yields rise in relation to JGB yields. Investors contemplating buying Japanese stocks should hedge any currency risk. Finally, the price of gold fell to $1275/ounce earlier this week, triggering our buy order. With the Fed on pause, the U.S. economy starting to overheat, and the dollar likely to trend lower, bullion could shine over the coming months.   Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Footnotes 1      Please see Global Investment Strategy Weekly Report, “Is There Really Too Much Government Debt In The World?” dated February 22, 2019, for a fuller discussion of this debt sustainability equation. 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