Consumer

Highlights U.S. growth will soon rebound thanks to robust drivers of domestic activity, and strengthening money and credit trends. The U.S. Federal Reserve will maintain an easing bias and will expand its balance sheet again. A growing Fed balance sheet will catalyze an underlying improvement in global liquidity conditions and boost the global economy. Brexit, China and Iran are key risks. The dollar will depreciate, bond yields will rise further and silver will outperform gold. Equities will surpass bonds on both cyclical and structural investment horizons. Financials and energy are more attractive than tech and healthcare. Thus, Europe is becoming increasingly appealing relative to the U.S. Feature Global equities are only 5% below their January 2018 all-time highs and the S&P 500 is close to breaking out above its July 2019 record. Meanwhile, yields are rebounding and value stocks are crushing momentum plays. Are these trends durable? Global growth is the key. If economic activity around the world can stabilize and ultimately improve, then stocks will break out and bond prices will suffer in the coming year. Otherwise, these recent financial market developments will undo themselves. Even if current activity remains weak, the outlook for global growth is looking up, despite trade wars, Brexit, Middle East tensions and problems in the interbank market. Therefore, we continue to favor stocks over bonds, because the backup in yields has further to go. If the dollar weakens, our pro-risk stance will only strengthen. U.S. Growth Drivers Are Healthy Chart I-1Recession Indicators Are Flashing A Yellow Flag The U.S. is near the end of a potent mid-cycle slowdown, but a recession will be avoided. Current conditions support an improvement in U.S. activity next year, even if key recessionary indicators, such as the yield curve and the annual rate of change of the Leading Economic Indicator, are still sending muddy signals (Chart I-1). U.S. growth will intensify because of five fundamental factors that will ultimately push the LEI higher and force the yield curve to re-steepen: A budding housing rebound, robust household spending, a stabilizing manufacturing sector, limited inflationary pressures, and a pick-up in money and credit trends. Housing The housing market has stabilized, buoyed by strong household formation, decent affordability, passing of the shock created by the cap in state and local tax deductions, and a 110-basis point collapse in mortgage yields since November 2018. Housing market indicators are finally catching up with leading variables, such as mortgage applications. In the past nine months, the NAHB housing market index has recovered nearly two-thirds of its decline since December 2018. Building permits and housing starts are at their highest levels since 2007, despite a significant fall last year. Even existing home sales have increased by 11% since December and are tracking the stimulation offered by lower borrowing costs (Chart I-2). Chart I-2The Housing Recovery Is Real Residential investment should soon boost economic activity after curtailing the level of GDP by 1% over the past six quarters. Moreover, rebounding housing activity implies that policy is not constraining growth. The real estate sector is historically the most sensitive to monetary conditions. Households Are Still Doing Well Core U.S. real retail sales continue to grow at a more than 4% annual pace and the Atlanta Fed GDPNow model forecasts a healthy 3.1% annual rise in consumer spending in the third quarter. This resilience is particularly impressive in the face of economic uncertainty and an ISM Manufacturing index below the 50 boom-bust line. Strong balance sheets are crucial to households. After 12-years of deleveraging, household debt has contracted by 37 percentage points to 99% of disposable income. Consequently, debt-servicing costs only represent 10% of disposable income, the lowest level in more than 45 years. Moreover, the household savings rate is a healthy 7.9% of after-tax income, which is particularly high in the context of the highest net worth ever and the lowest debt-to-asset ratio since 1985. Household income creates an additional support to consumption. Real disposable income is expanding at a 3% annual rate, despite slowing job creation. A tight labor market explains this apparent paradox. The employment-to-population ratio for prime-age workers is our favorite measure of labor market slack, and it has escalated to 79.7%, a level consistent with the 2.9% pace of annual growth in wages and salary (Chart I-3). The UAW strike at GM, the quits-rate at an 18-year high, and the difficulties small firms face to find qualified workers, all suggest that wages (and thus, consumption) will remain well underpinned (Chart I-3, bottom panel). Improving Manufacturing Outlook Manufacturing activity is set to rebound, despite the weakness in the ISM Manufacturing index. Recent industrial production numbers have already improved. Monthly IP expanded at a 0.6% monthly pace in August, but as recently as April, it was shrinking at a -0.6% rate. U.S. monetary conditions will continue to support asset prices and worldwide economic activity for the coming 18 months or so. The car sector will soon bottom. Weak auto production has been a primary diver of the recent global manufacturing slowdown. The automotive component of GDP contracted at a stunning 29.1% annual rate in the second quarter. However, U.S. light-vehicle sales are essentially flat. This dichotomy implies that the automobile sector’s inventories are contracting briskly (Chart I-4). Chart I-3A Tight Labor Market Supports Consumption Chart I-4Will Auto Production Rebound Soon?   Capex should also recover. Last quarter, investment in structures and equipment subtracted from GDP growth. Before this, capex intentions had fallen significantly, now, the Philly Fed’s capital expenditure component is trying to stabilize. Capex must stop falling if global manufacturing is to strengthen. Limited Inflationary Pressures Inflationary pressures remain muted in the U.S., which supports growth in two ways. First, muted inflation allows the Fed to maintain accommodative monetary conditions. In the absence of crippling debt-servicing costs, easy policy guarantees a continued expansion. Secondly, low inflation keeps real income growth higher and increases the welfare of households. At 2.4%, core CPI is perky, but will soon roll over. Core goods prices have been driving fluctuations in aggregate core prices in the past three years, while service sector inflation has been stable at 2.7% during this period. Goods inflation will soon weaken for the following reasons: Chart I-5The Trade War Is Masking The Economy's Deflationary Tendencies Soft global economic activity will drive down global inflation. Inflation lags real activity and proxies for the global economy, such as Singapore’s GDP, point to weaker core CPI in the OECD (Chart I-5). This weakness will act as a drag on U.S. inflation because U.S. goods prices have a large international component. U.S. import prices peaked 15 months ago and they normally lead goods inflation by roughly a year and a half. The strength in the broad trade-weighted dollar, which has climbed by nearly 15% in the past 18 months to an all-time high, will hurt goods prices. U.S. capacity utilization declined through 2019 and remains well below the 80% level that historically causes core goods prices to overheat. The White House’s tariffs on China are boosting inflation but this effect will prove transitory. The tariffs are pushing up inflation for goods touched by the levies, while unaffected goods are experiencing deflation (Chart I-5, bottom panel). Given that tariffs have a one-off impact and that inflation expectations are hovering near record lows, inflation for tariffed-goods will converge toward the underlying trend in non-tariffed goods. Stronger Money And Credit Trends Money and credit trends indicate that the recent slump will not translate into a recession. Moreover, improving U.S. private-sector liquidity conditions argues that the mid-cycle slowdown is ending. Chart I-6Liquidity Indicators Point To A Growth Rebound U.S. broad money is recovering. After falling to 0.9% last November, U.S. real M2 growth is expanding at a 3% annual rate, a pace in keeping with the end of mid-cycle slowdowns. Moreover, money is also accelerating relative to credit issuance, which historically has pointed to quicker industrial activity. Similarly, our U.S. financial liquidity index is rapidly escalating, a development that normally precedes turning points in the ISM manufacturing (Chart I-6) index. Credit activity is also picking up. Corporate bond issuance is firming and, according to the Fed’s Senior Loan Officer Survey, demand for loans is rebounding across the board. The yield collapse is boosting credit growth across the G-10. Gold is outperforming bonds, which confirms that a mid-cycle slowdown occurred. If inflation is not a problem, then the yellow metal always underperforms bonds ahead of recessions. However, before mid-cycle slumps, gold consistently outperforms bonds (Chart I-7). Chart I-7Bonds Outperform Gold Ahead Of Recession More Fed Easing Imminent U.S. monetary conditions will continue to support asset prices and worldwide economic activity for the coming 18 months or so. The Fed will ease policy further and is a long way from tightening. Last week, the Federal Open Market Committee (FOMC) curtailed the fed funds target rate by 25 basis points to 2%. Additionally, while the median projection shows that Fed members expect no more rate cuts for at least the next 18 months, the reality is more subtle. Among 17 FOMC members, 7 expect to cut the fed funds rate by another 25 basis points by year end, and 8 foresee a lower policy rate in late 2020. The greenback is very expensive and will decline as global liquidity conditions improve. We are still on track for three 25-basis-point rate cuts this year. The Fed remains highly data dependent and is particularly sensitive to depressed inflation expectations. This means the Fed is acutely aware of the danger created by a sudden tightening in financial conditions. If by year-end the market has not moved away from discounting another cut in 2019, the FOMC will likely deliver this easing. Otherwise, financial conditions could suddenly tighten, which would hurt inflation expectations and the economic outlook. If global growth does not recover in early 2020, the Fed would probably cut rates an additional time in the first quarter, which would validate the current 12-month pricing in the OIS curve. Chart I-8Not Enough Excess Reserves The Fed will again increase the size of its balance sheet. Interbank markets have boxed the FOMC into adding welcomed stimulus to the global economy. Allowing commercial bank excess reserves to grow anew will have a greater positive impact for global growth compared with rate cuts alone. Last month, we highlighted the risks to the repo market created by the combination of the dwindling of excess reserves, the bloated securities inventory of primary dealers financed via repo transactions, and the growth in the issuance of Treasurys.1 These risks materialized last week, when the Secured Overnight Financing Rate (SOFR) suddenly spiked above 5% (Chart I-8). To calm the market, the Fed injected $75 billion each day last week starting Tuesday to bring repo rates closer to the Interest Rate on Excess Reserves (IOER). But this is not a long-term solution. Chart I-9Higher Excess Reserves Will Hurt The Dollar And Boost Global Growth Paradoxically, the crystallization of the repo market tensions is good news for the global economy because it will force the Fed to again expand its balance sheet as soon as next month. The supply of funds to the repo market needs to increase permanently, which means that banks’ excess reserves must re-expand. As we showed last month, higher excess reserves will hurt the U.S. dollar, lift EM exchange rates and boost global PMIs (Chart I-9). Higher excess reserves ease global liquidity conditions. The money injected will find its way to the rest of the world. The dollar trades 25% above its long-term, fair-value estimate of purchasing power parity. Therefore, a growing fiscal deficit indirectly financed by a larger Fed balance sheet will lead to a larger U.S. current account deficit, which in turn, will lift global FX reserves. As a result, the Fed’s custodial holdings of securities on behalf of other central banks will rise. Thus, global dollar-based liquidity will stop contracting relative to the stock of U.S. dollar-denominated foreign currency debt it supports (Chart I-10). Higher excess reserves will also ease global financial conditions. By boosting dollar-based liquidity, a larger Fed balance sheet will dampen offshore dollar interest rates. Moreover, rising excess reserves depreciate the greenback, which further cuts the cost of credit for foreign entities borrowing in U.S. dollars. This phenomenon is especially significant for EM. Therefore, we should see an easing of EM financial conditions, which are heavily dependent on EM exchange rates. Historically, looser EM financial conditions lead to stronger global growth (Chart I-11). Chart I-10High-Powered Liquidity Set To Improve Chart I-11Easier EM FCI Should Lead To Faster Growth   Risks: The U.K., China And Iran While the outlook generally points to a rebound in global growth, which will create a positive environment for risk assets, the situations in the U.K., China, and Iran should be closely monitored. The U.K. Brexit remains a potential danger for the world even though our base case calls for a benign outcome. U.K. Prime Minister Boris Johnson’s gambit to push for a No-Deal Brexit to force the EU to make concessions could result in a miscalculation. Such a turn of events would plunge a European economy – already damaged by weak global trade – into recession. The dollar would strengthen and global financial conditions would tighten. Global growth would take another hit. Chart I-12U.K.: No Clear Winner Ahead Of A Potential Election Following this week’s Supreme Court unanimous ruling against Johnson’s decision to prorogue Parliament, No-Deal carries a less than 10% probability. Johnson lacks a majority in a Parliament staunchly against a hard Brexit and he is unable to call an election prior to the October 31st deadline to leave the EU. Therefore, a delay is the most likely outcome, which will allow the EU and the U.K. to reach a deal on the Irish backstop that Parliament can then ratify. Ultimately, the U.K. needs another election to break the current logjam, which could materialize in November or December. However, the Remain vote is split between Labour, Lib Dems, and the SNP, but the Brexit vote is not nearly as divided. (Chart I-12). Hence, Brexit will remain a risk lurking in the background even if it does not morph into a full-blown assault on global growth. China Chart I-13Chinese Stimulus Remains Too Tepid To Move The Needle China’s economic activity continues to soften. In August, industrial production and fixed-asset investment decelerated to 4.4% and 5.5%, respectively. Moreover, total social financing growth slowed on an annual basis and overall Chinese credit flows decreased as a share of GDP (Chart I-13). Chinese policy reflation remains too tepid to undo the drag created by trade uncertainty and the weakness in the marginal propensity to spend (Chart I-13, bottom panel). Sino-U.S. trade tensions have significantly decreased in recent months, but they will remain an important source of uncertainty for China and the world. China and the U.S. will again hold high-level talks next month, U.S. President Donald Trump has again postponed some of the tariff increases, and China is again buying mid-Western soybeans and pork. But last Friday’s cancelation of U.S. farm visits by Chinese officials reminds us that the situation is very fluid. Ultimately, China and the U.S. are long-term geopolitical rivals. Trump may be constrained by the 2020 election, but China could still drive a hard bargain. Hence, it is prudent to expect a stop-and-go pattern in the negotiations. Chart I-14Deflation Unleashes A Vicious Circle Of Higher Real Borrowing Costs A weak China will sow the seeds of its own recovery. In addition to the negative effect on capex intentions and credit demand of trade uncertainty, Beijing faces deteriorating employment and producer price inflation of -0.8% (Chart I-14, top panel). As PPI inflation becomes more negative, heavily indebted corporate borrowers face rising real interest rates (Chart I-14, bottom panel). This higher cost of debt weakens an already vulnerable economy, unleashing a vicious circle. Chinese policymakers are unlikely to tolerate this situation for much longer. The cumulative 400-basis point cuts in the reserve requirement ratio since April 2018 are steps in the right direction, but are not yet enough. The dovish change to the Politburo’s and State Council’s language indicates that greater stimulus is forthcoming. Thus, credit expansion, local government special bonds issuance and fiscal stimulus will become even more prevalent in the final quarter of 2019. This policy should noticeably goose economic activity in 2020, which will help global growth accelerate. Iran Tensions are re-flaring and a spike in oil prices would threaten the fragile global economy. However, this remains a risk, not a central case. In the July issue of The Bank Credit Analyst, we warned that tensions with Iran were the greatest visible risk to global growth and risk assets.2 This danger came into focus last week with the drone attacks on the Khurais oil field and Abqaiq oil processing facility in Saudi Arabia, which curtailed global oil supply by an unprecedented 5.7 million bbl/day, or 5.5% of global demand. Unsurprisingly, Brent prices quickly surged by 12% to $68/bbl. Chart I-15Higher Energy Efficiency Makes The World More Robust A durable spike in oil prices would push the global economy into a recession, especially while the global economy is already on weak footing. Chief U.S. Equity Strategist Anastasios Avgeriou reminded his clients3 that according to a seminal 2011 paper by Prof. James D. Hamilton, a doubling of oil prices preceded all but one of the post-war recessions.4 However, an oil-induced recession would likely be shallow because the oil intensity of the global economy has significantly declined in the past 30 years (Chart I-15). Moreover, global fiscal authorities would respond forcefully to an economic contraction, which would also limit the impact of the shock. There is a low likelihood that oil will double by year-end. It would require Brent prices to surge to $100/bbl. Saudi Arabia has already stated that production will return to pre-crisis levels in the coming days and not a single shipment will be missed. This promise implies further inventory drawdowns. Aramco also expects to achieve maximum output by late November. Moreover, higher oil prices will encourage further activity in the U.S. shale patch. Consequently, oil prices are unlikely to surge by another $35/bbl in the next three months. However, Brent prices could climb to $75/bbl next year, because while oil demand is set to recover, investors must also embed a greater risk premium against Saudi supply disruptions. A military conflict with Iran is a tail risk, but if it were to materialize, crude prices would surge by $35/bbl or more in an instant. According to Matt Gertken, BCA’s Chief Geopolitical strategist, the appetite for such a conflict is low in the U.S.5 President Trump has isolationist instincts and does not want to be mired in another conflict. Investment Implications The Dollar The dollar has significant downside. The greenback is very expensive and will decline as global liquidity conditions improve (Chart I-16). These dynamics reflect the countercyclical nature of the dollar and also lead to strong greenback momentum, both on the way up and down. The dollar would weaken in response to improving global growth and liquidity conditions, the lower dollar would ease global financial conditions, further stimulating the global economy. A virtuous circle could then emerge. Chart I-16Increasing Financial Liquidity Will Hurt The Greenback Repatriation flows will also move from a tailwind to a headwind for the greenback. Prompted by both rising risk aversion and the Trump tax cuts, U.S. economic agents have repatriated $461 billion in the past 18 months. This has created powerful support for the USD (Chart I-17). The effect of the tax cut is vanishing and rising global growth will incentivize U.S. households and firms to buy foreign assets more levered to the global business cycle. In the process, they will sell the dollar. Chart I-17Repatriation Will Not Support The Dollar For Much Longer The euro will continue to behave as the anti-dollar, a consequence of the pair’s plentiful market liquidity. Moreover, the euro trades at a 17% discount to its purchasing power parity equilibrium. After last week’s rate cut and QE announcement, the European Central Bank has no more room to ease. Instead, the recent fall in peripheral bond spreads is loosening European financial conditions, which is boosting European growth prospects. This makes the euro more attractive. Bonds And Precious Metals Safe-haven yields will have significant upside in the coming 12 to 18 months. As we highlighted last month, bonds are so expensive, overbought and over-owned that they suffer from an extremely elevated probability of negative cyclical returns (Chart I-18, left and right panels). Moreover, excess reserves will once again grow when the Fed re-starts to expand its balance sheet. Higher excess reserves lead to a steeper yield curve slope (Chart I-19). Short rates have limited downside, therefore, the curve can only steepen via higher 10-year yields. Chart I-18AValuation And Technicals Point Toward Higher Yields In 12 Months (I) Chart I-18BValuation And Technicals Point Toward Higher Yields In 12 Months (II)   Chart I-19Fed Purchases Will Steepen The Curve Short-term dynamics are more complex. Treasury yields have climbed by 21 basis points since their September 3rd low, mostly on the back of decreasing trade tensions. In previous mid-cycle slowdowns, bond price tops only emerged after the ISM bottomed. We are not there yet. We expect substantial short-term volatility in yields in view of the unpredictable Sino-U.S. negotiations and the current lack of pick-up in global growth. During this transition process, cyclical investors should use bond rallies such as the current one to build below-benchmark duration positions in their fixed-income portfolios. Within precious metals, we continue to prefer silver to gold. We have favored precious metals since late June,6 but higher bond yields are negative for gold. However, central banks are maintaining a dovish bias aimed at lifting inflation breakevens back to their historical norm of 2.3% to 2.5%. This process increases the chance that the economy will overheat late next year. For the next 12 months, rising inflation expectations, not higher real rates, will push up bond yields. Combined with a weaker dollar, this configuration is mildly bullish for gold. Silver has a higher beta and more industrial uses than gold, which will allow for a period of outperformance if global growth increases. In this context, the silver-to-gold ratio, which stands at its 6th percentile since 1970, is an attractive mean-reversion play (Chart I-20). Chart I-20The Silver-Gold Ratio Is A Bargain Equities Investors should continue to favor stocks relative to bonds in the next year. Equities perform well up to six months before a recession starts (Table I-1). Moreover, our monetary and technical indicators are upbeat (see Section III). Additionally, sentiment surveys do not show rampant investor complacency (see Section III), which limits risks from a contrarian perspective. Meanwhile, yields have upside, which implies an outperformance of stocks versus bonds. Table I-1The S&P 500 Doesn’t Peak Until Six Months Before A Recession The short-term picture is more complex. P/E ratio expansion powered 90% of the S&P 500’s gains since it bottomed in December 24, 2018, and according to our model, U.S. operating earnings will contract for at least eight more months (Chart I-21). Thus, if yields mount through the rest of the year, multiples will likely contract. The S&P 500 is set to continue to churn over that time frame. Chart I-21U.S. Profits Still Have Downside In this context, strategy dictates investors focus on internal stock market dynamics. Namely, investors should favor financials and energy at the expense of tech and healthcare for the following reasons: Rising bond yields lift financials’ net interest margins. They also hurt multiples for tech stocks, which carry a large percentage of their intrinsic value in long-term cash flows and their terminal value. Thus, rising yields correlate with an outperformance of financials relative to tech (Chart I-22). Moreover, financials’ valuations and technicals are very depressed relative to tech, while comparative earnings estimates are equally morose (Chart I-23). Finally, our U.S. Equity Strategy team expects buybacks by financials to increase significantly.7 Chart I-22If Yields Rise, Financials Will Beat Tech Chart I-23Valuations, Technicals And Sentiment Favor Financials Over Tech     Rising yields also hurts healthcare stocks. Additionally, the rising popularity of Democratic progressives like Senator Elizabeth Warren requires investors embed a risk premium in the price of healthcare stocks (Chart I-24). The progressives want to nationalize healthcare insurance and compress healthcare profit margins, from drugs to hospitals. Chart I-24The Rise Of The Progressives Requires A Risk Premium In Health Care Stocks We have used energy stocks as a hedge against rising tensions in the Middle East. Now, our U.S. Equity Strategy colleagues have become more positive on this sector. Energy valuations and technicals are very attractive relative to the S&P 500 (Chart I-25).8 Energy stocks will outperform if global growth recovers and lifts global bond yields These sectoral recommendations argue investors should soon begin to favor European relative to U.S. stocks. Financials and energy are overrepresented in European equities while tech and healthcare are large overweight’s in the U.S. (Table I-2). Moreover, European activity is more sensitive to global economic momentum than the U.S. Thus, when global yields rally and the world economy stabilizes, European stocks will outperform their U.S. counterparts (Chart I-26). Additionally, European banks trade at 0.6-times book value which makes them the ultimate value play, one highly geared to easier European financial conditions and higher yields. Chart I-25Energy Is A Compelling Buy Table I-2Overweighting Europe Is Consistent With Our Sectoral RecommendationsChart I-26Europe Will Soon Outperform The U.S. Chart I-27Long-Term Investors Should Favor Stocks Over Bonds These sectoral biases are also consistent with value stocks outperforming growth equities. However, as Xiaoli Tang from BCA’s Global Asset Allocation service argues in Section II, the value-versus-growth question is a complex one that needs to be differentiated across geographies and equity size. Finally, long-term investors should also favor stocks over bonds. According to BCA Chief Global Strategist Peter Berezin, global stocks at their current valuations offer an expected 10-year real return of 4.2%. By historical standards, these are not elevated returns, but they are still much more generous than government bonds. Based on their dividend yields, U.S., Japanese and European equities need to fall by 18%, 28% and 40% before underperforming bonds on a 10-year basis, respectively.9 This is a large margin of safety (Chart I-27). We prefer foreign stocks with their more attractive valuations and local-currency expected returns. Additionally, the dollar is expensive and will weaken in a 5- to 10-year investment horizon. Mathieu Savary Vice President The Bank Credit Analyst September 26, 2019 Next Report: October 31, 2019   II. Value? Growth? It Really Depends! Investors should pay particular attention to definition and methodology when evaluating value versus growth strategies, both academically and in practice. Value investors should focus on non-U.S. markets, especially the emerging market small-cap universe. Growth investors should focus on large caps, especially the U.S. large-cap universe. Small-cap investors should focus on value. Large- and mid-cap investors should not be making bets between value and growth strategically. Tactical style rotation should be done only when valuation spreads reach extreme levels.  GAA remains neutral on value versus growth, but prefers to use sector positioning (cyclicals versus defensives, financials versus tech and health care) and country positioning (euro area versus U.S.) to implement style tilts. Investing by way of style is as old as investing itself. Value versus growth has been one of the most frequently asked questions among our clients of late, particularly given the sharp style reversal in recent weeks. In this report, we attempt to answer some of the most often-asked questions on value versus growth. We have arranged these questions into five separate sections: First, we look at 93 years of history of the Fama-French value and growth portfolios to see how value, growth, and size have interacted over time, because academics have mostly used the Fama-French framework. Second, we look at how comparable U.S. style indices are, including the S&P, the Russell and the MSCI, since practitioners mostly use these commercial indices as their benchmarks. Third, we investigate if international markets share the same value-growth performance cycles as the U.S., using the MSCI suite of value-growth indices (since MSCI is the only index provider that produces value-growth indices for each market under its global coverage). Fourth, we investigate if pure exposure to value and growth can actually improve the value-growth performance spread by comparing the pure style indices from the S&P and the Russell to their standard counterparts. Finally, we present the GAA approach to style tilts in a section on our investment conclusions. 1. Is It True That Value Outperforms Growth In The Long Run? There has been overwhelming academic evidence supporting the existence of the value premium.10 Academically, the “value premium”, also known as the HML (high minus low) factor premium, or the value outperformance, is defined as the return differential between the cheapest stocks and the most expensive. Even though Fama and French used book-to-price as the sole valuation criterion,11 many researchers have combined book-to-price with other valuation measures such as earnings-to-price, sales-to-price, dividend yield,12 and so on.  There is also academic evidence suggesting that “value outperformance is almost non-existent among large-cap stocks.”13 What is more, in 2014 Fama and French caused a huge stir by publishing “A Five-Factor Asset Pricing Model” working paper demonstrating that “HML is a redundant factor” because “the average HML return is captured by the exposure of the HML to other factors” (such as size, profitability, and investment pattern) based on U.S. data from 1963 to 2013.14 Asset owners and allocators should pay special attention when selecting benchmarks for value and growth. For non-quant practitioners, especially the long-only investors, value and growth are two separate investment styles, even though the style classification shares the same principle as the academic “value factor.” Their definitions vary, as evidenced by how S&P Dow Jones, FTSE Russell, and MSCI define their value and growth indexes (see next section on page 7). In general, value stocks are cheap, with lower-than-average earnings growth potential, while growth stocks have higher-than-average earnings growth potential but are very expensive. The indices published by commercial index providers do not have very long histories, however. Fortunately, Fama and French also provide value-growth-size portfolios on their publicly available website.15 Table II-1 shows that for 93 years, from July 1926 to June 2019, U.S. value portfolios in both large-cap and small-cap buckets based on the well-known Fama-French approach have returned more than their growth counterparts, no matter whether the portfolios are equal-weighted or market-cap-weighted. Most strikingly, equal-weighted small-cap value outperformed its growth counterpart by over 10% a year in absolute terms, and has more than doubled the risk-adjusted return compared to its growth counterpart. Table II-1Fama-French Value-Growth-Size Portfolio Performance* Some media reports have claimed that value stocks are “less volatile” because they are on average “larger and better-established companies.”16 This may be true for some specific time periods. For the 93 years covered by Fama and French, however, this common belief is not supported. In fact, value portfolios in both the large- and small-cap universes have consistently had higher volatility than growth portfolios, no matter how the components are weighted. The excess returns, however, have more than offset the higher volatilities in three out of four pairs, with the exception being market cap-weighted large-cap growth, which has a slightly higher risk-adjusted return due to much lower volatility than its value counterpart. From a very long-term perspective, the value outperformance does come from taking higher risk. Further investigation shows that the superior long-run outperformance of value relative to growth came mostly in the first 80 years of Fama and French’s 93-year sample. In more recent years since 2007, however, value has underperformed growth significantly in three out of the four Fama-French value-growth pairs, with the equal-weighted small-cap value-growth pair being the sole exception, as shown in Table II-2. Even though the equal-weighted small-cap value has still outperformed its growth counterpart in the most recent period, the hit ratio drops to 54% compared to 76% in the first 80 years, while the magnitude of average calendar-year outperformance drops to a meager 1.3%, compared to 12.5% in the first 80 years. Table II-2The Fight Between Value And Growth* Statistical analysis is sensitive to the time period chosen. How have value and growth been performing over time? Chart II-1 shows the long-term dynamics among value, growth, and size. The following conclusions are clear: Chart II-1Fama-French Value-Growth-Size Peformance Dynamics* Value investors should favor small caps over large caps, while growth investors should do the opposite, favoring large caps over small caps, albeit with much less potential success (Chart II-1, panel 1). Small-cap investors should favor value stocks over growth stocks (panel 2). Value outperformance in the large-cap space (panel 3) is much weaker than in the small-cap space (panel 2). Fama and French define small and large caps based on the median market cap of all NYSE stocks on CRSP (Center for Research In Security Prices), then use the NYSE median size to split NYSE, AMEX and NASDAQ (after 1972) into a small-cap group and a large-cap group. The value and growth split is based on book-to-price, with stocks in the lowest 30% classified as growth, and the highest 30% as value. Interestingly, small-cap value and small-cap growth account for only a very small portion of the entire universe, as shown in Charts II-2A and II-2B. Value stocks’ average market cap is about half of that of growth stocks, in both the large- and small-cap universes (panel 3 in Charts II-2A and II-2B). Again, this does not support some media claims that value stocks are larger and better-established companies. However, it does add further support to the claim that all investors should favor small-cap value stocks. Unfortunately, “small-cap value” is a very small universe. As of June 2019, the CRSP total U.S. equity market cap was $26.2 trillion, with small-cap value accounting for only 1.5% (about $383 billion); even large-cap value comprises only a relatively small weight, 13% (US$3.5 trillion). Chart II-2ASmall-Cap Value-Growth Portfolios* Chart II-2BLarge-Cap Value-Growth Portfolios*   The U.S. market is dominated by large-cap growth stocks with a heavy weight of 56% (US$14.7 trillion, as of June 2019). This is encouraging because academic research does show that the value premium among large caps is weak. But the large-cap value weakness mostly started from 2007, after 80 years of strength relative to large-cap growth (Chart II-1, panel 3). The Fama-French approach is widely used in academic research, partly due to its long history from 1926. For non-quant practitioners, especially long-only investors, however, commercial indexes from FTSE Russell, S&P Dow Jones, and MSCI are more often used as performance benchmarks. In this report, we study a series of commercial value-growth indexes in the U.S. and globally to shed light on value-growth dynamics, and how asset allocators can incorporate them into their decision-making processes. 2. Not All U.S. Style Indexes Are Created Equal Three major index providers have style indices. They are FTSE Russell (which launched the industry’s first set of value-growth indexes in 1987), S&P Dow Jones, and MSCI. MSCI is the only provider that has a full suite of value-growth indices for all individual markets under coverage. While all three provide “standard” style indices that include the full component of the parent index, the FTSE Russell and the S&P Dow Jones also provide “pure” style indices. There are two major differences between “standard” and “pure” style indices: 1) the standard indices are market-cap weighted, while the “pure” indices are weighted based on style score. 2) Standard value and standard growth have overlapping components, while pure value and pure growth do not share any common components. We prefer to use sector and country positioning to implement style tilts tactically. Other than book-to-price, the value variable used by the Fama-French approach, the three providers have added different variables in the determination of value and growth, as shown in Table II-3. This also reflects the evolution of the industry’s understanding on value and growth. For example, when MSCI first launched its style index in 1997, it used only book-to-price, but changed its approach in May 2003 to the current “multi-factor two-dimension” framework. Table II-3Value-Growth Index Criteria Because of the differences in index construction methodology, value-growth indices for the U.S. have behaved differently. The S&P 500, the Russell 1000, and the MSCI standard (large and mid-cap) indices are widely followed institutional benchmarks, with back-tested history dating to the 1970s. Chart II-3 shows the relative value/growth performance dynamics from the three index providers, together with that from Fama and French (market value-weighted, to be consistent with the approach from the index providers). One can observe the following: Chart II-3Which Value/Growth? None of the three pairs looks exactly like Fama-French’s market-cap value-weighted value/growth. This raises the question of how historical analysis based on the long history of Fama-French value/growth portfolios can be applied to the commercial indices. In the first cycle from 1975 to February 2000, all three index pairs made a round trip, with flat performance between value and growth. Also, even though the S&P 500 and Russell 1000 were more closely correlated with one another than with the MSCI, the three were quite similar. In the current cycle that began in February 2000, however, Russell value/growth has rebounded much more strongly than the other two. But in the down period that started in 2007, the three indices performed in line with each other, as shown in Table II-4. Table II-4U.S. Style Index Performance* In addition, the difference between S&P and Russell does not just lie between the S&P 500 and the Russell 1000. It actually exists in every market-cap segment, as shown in Chart II-4. Unfortunately, MSCI does not provide history from 1975 for the detailed cap segments. In the current cycle since February 2000, S&P value rebounded the least between 2000 and 2006. Why? Chart II-4Know Your Benchmark Further investigation reveals some interesting observations, as shown in Chart II-5. Chart II-5Value/Growth: Russell Vs. S&P At the aggregate level, the S&P 1500, the Russell 3000 and their respective style indices have performed largely in line with one another in the most recent cycle starting from February 2000 (Chart II-5, panel 4), reflecting the industry trend of index convergence. In different market cap segments, however, the divergence is still prominent, especially in the small-cap space (panel 1). The S&P 600 has consistently outperformed the Russell 2000 in both the value and growth categories. In addition to different style factors, this consistency also reflects different universes, size distribution, and sector exposure, as explained in an earlier GAA Special Report on small caps.17 Managers with Russell 2000 as their performance benchmark could simply beat it by doing a total-return-performance swap between the Russell 2000 and the S&P 600. Bottom Line: Asset owners and allocators should pay special attention when selecting benchmarks for value and growth.  3. How Have Value And Growth Performed Globally? MSCI is the only index provider that also produces value-growth indices for each equity market under its global coverage, using the same methodology. Unfortunately, only the “standard” (i.e., large- and mid-cap) universe has a long history, dating from December 1974. Charts II-6A and II-6B show the value/growth dynamics in major DM and EM markets. The relative performance of MSCI DM value versus growth shares a similar pattern to that of the U.S. in the latest cycle since 2000, but looks very different in the period before 2000 (Chart II-6A). The ratio of EM large- and mid-cap value versus growth did not peak until February 2012, about five years after the peak of its DM peer (Chart II-6B, panel 1). On the other hand, EM small-cap value has resumed its outperformance versus growth since early 2016 after having peaked around the same time as its large-cap counterpart. Chart II-6AIs Value Dead In DM? Chart II-6BIs Value Dead In EM?   The global value/growth dynamics also show that the “value outperforming growth” effect is more prominent in the small-cap space. But why has small value also underperformed small growth in most DM markets? Our explanation is that the EM universe is much less efficient than the DM universe because there are not many quant funds dedicated to the EM small-cap space – in addition to the fact that, in general, EM small caps are much smaller than those in DM markets. This is also in line with our finding that, in general, factor premia are more prominent in the EM universe.18 Bottom Line: Value premium is more prominent in non-U.S. markets, especially the EM small-cap universe. 4. Do Pure Style Indices Improve Performance? Both S&P Dow Jones and FTSE Russell provide pure-value and pure-growth indices. Unlike the standard value-growth indices, which target about 50% of the parent market cap, the pure-style indices include only stocks with the strongest value and growth characteristics. There is no overlap between the two. In theory, the pure-style indices should outperform the standard-style indices because of their concentrated exposure to style factors. How do they do in reality? Table II-5 shows that in terms of absolute return, this is indeed the case for 14 out of the 18 pairs of indices from S&P and Russell for the period between 1998 and 2019. However, the higher returns from greater exposure to style factors have largely come from much higher volatility in 17 out of the 18 pairs. Pure style has higher volatility than standard style in general, the only exception being the Russell mid-cap value space. As such, on a risk-adjusted basis, pure style is not necessarily better. Table II-5Purer Is Not Necessarily Better Charts II-7A and II-7B show the different performance dynamics for the S&P and Russell families of style indices. For the S&P indices, pure growth has outperformed standard growth for the entire period in all three market-cap segments, but only the S&P 500 pure value outperformed its standard counterpart. Therefore, more concentrated exposure to style characteristics has improved the value-growth spread only in the large-cap space, but it has actually worsened the value-growth spread in the mid- and small-cap universes (Chart II-7A). Chart II-7AS&P Pure Styles* Chart II-7BRussell Pure Styles*   For the Russell indices, it’s clear that there were a lot more tech stocks in its pure-growth indices leading up to the 2000 tech bubble, because pure growth shot up significantly more than the standard growth before the bubble burst, and also crashed more severely following it. Overall, only in the small-cap space did the value-growth spread improve by the more concentrated exposure to style factors. However, this improvement was not because of the outperformance of the pure-style relative to the standard indices. In fact, both pure value and pure growth in the small-cap universe underperformed their standard counterparts, but pure growth performed even worse (Chart II-7B and Table II-5). 5. Investment Conclusions Value and growth can mean very different things and behave very differently. Investors should pay special attention to the definitions and methodologies when evaluating style indices or strategies, both academically and in practice. Depending on an investor’s mandate, the following is recommended: Value investors should focus on non-U.S. markets, especially the emerging market small-cap universe. Growth investors should focus on large caps, especially the U.S. large-cap space. Small-cap investors should focus on value. Large-and mid-cap investors should not make bets between value and growth strategically. Tactical style rotation should be done only when valuation spreads reach extreme levels. Price-to-book is the only common variable used in the determination of value and growth by academics and practitioners. Its track record as a systematic return predictor has been poor, as shown in panel 2 of Charts II-8A and II-8B. Another factor we have a long history for is dividend yield. Its predictive power is even worse than that of price-to-book (panel 3). Chart II-8AValuation Is A Poor Timing Tool In The U.S. Chart II-8BValuation Is A Poor Timing Tool Globally   Many factors have been used in conjunction with price-to-book by both academics and practitioners to time the rotation between value and growth. However, the results have been mixed. Regression models that correctly predicted in the past may not work in the future. For example, a regression model based on valuation spread and earnings-growth spread using data from January 1982 to October 1999 successfully predicted the rebound of value outperformance starting in early 2000,19 but the universal suffering of value funds over the past several years implies that this model may have given many false signals. Chart II-9 demonstrates how difficult it is to use regression models as a timing tool for value and growth rotation. A simple regression is conducted between value and growth return differentials (subsequent 60-month returns) and relative price-to-book. For data from December 1974 to July 2019, the r-squared for the MSCI world is 0.38 and for the U.S. it is 0.09. In hindsight, both models predicted the value outperformance starting in early 2000. However, the gaps between actual value and fitted value started to open, long before 2000. By late 1998, the gaps were already wider than the previous cycle lows, yet they continued to widen as value continued to underperform growth until February 2000. Chart II-9How Good Is The Fit? What should investors currently do, based on these models? The gaps are large, but not as large as in early 2000. At which point should investors start to shift into value given its more than 12 years of underperformance? We have often written that we prefer to use sector and country positioning to implement style tilts.20, 21  This preference has not changed. Value and growth indices have sector tilts that change over time. Currently, the S&P Dow Jones large- and mid-cap value indices have a clear overweight in financials but an underweight in tech and health care compared to their growth counterparts (Table II-6). Table II-6Sector Bets In Value And Growth Indices* Chart II-10Prefer Sector And Country Positioning To Style We have been neutral on value and growth, but would likely change this view if we change our country equity allocation between the U.S. and the euro area, and our equity sector allocation between cyclicals and defensives as well as between financials and information technology (Chart II-10). Xiaoli Tang Associate Vice President Global Asset Allocation III. Indicators And Reference Charts The S&P 500 will continue to churn this year. U.S. stocks have rebounded sharply through the month of September, yet, sentiment is neutral. Nonetheless, for now, stocks are likely to find it hard to meaningfully break above their July highs. Short-term momentum oscillators are overbought and U.S. profits still have downside. Because this year’s equity rally has been nearly entirely driven by multiples, this leaves equities vulnerable to any back-up in yields. As yields have not priced in any pick-up in growth, potential positive economic surprises are more likely to lift yields than stock prices. However, if growth disappoints, weak rates will cushion to blow to expected earnings. In line with this picture, our Revealed Preference Indicator (RPI) continues to shun stocks. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive readings from the policy and valuation measures. Conversely, if strong market momentum is not supported by valuations and policy, investors should lean against the market trend. Global growth remains the biggest problem for stocks. Until the global economy finds a floor, the outlook for profits will be poor and our RPI will argue against buying equities. The outlook for next year remains constructive for stocks. Our Willingness-to-Pay (WTP) indicator for the U.S. and Japan is markedly improving. However, it continues to deteriorate in Europe. The WTP indicator tracks flows, and thus provides information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. Global yields remain very depressed at highly stimulatory levels. Moreover, money growth has picked up around the world, and global central banks are cutting rates and expanding their balance sheets again. As a result, our Monetary Indicator remains at its most accommodative level since early 2015. Furthermore, our Composite Technical Indicator might not be improving anymore but it is still very much in constructive territory. Therefore, unlike four years ago, equities are more likely to avoid the headwind created by their overvaluation, especially as our BCA Composite Valuation index continues to improve.  10-year Treasurys may have cheapened a bit since last month, but they remain very expensive. Moreover, when current overvaluation levels are met by our technical indicator being as massively overbought as it is today, safe-haven bonds experience significant price declines over the following 12 months. That being said, the timing of a backup in yields is uncertain. If previous mid-cycle slowdowns are any guide, yields might need to wait for a bottom in the global manufacturing PMIs before rising freely. Nonetheless, the current setup argues against adding to long-duration bets. On a PPP basis, the U.S. dollar is only growing more expensive and the U.S. current account is deteriorating anew. For now, weak global manufacturing activity has helped the dollar stay well bid. However, our Composite Technical Indicator has lost momentum and has formed a negative divergence with the Greenback’s level. This means that the dollar is highly vulnerable to any stabilization in growth. In fact, we would argue that the USD might prove to be the best variable to evaluate whether global growth is forming a durable bottom or not.   EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation Chart III-6U.S. Earnings   Chart III-7Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance   FIXED INCOME: Chart III-9U.S. Treasurys And Valuations Chart III-10Yield Curve Slopes Chart III-11Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets   CURRENCIES: Chart III-16U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning   ECONOMY: Chart III-28U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot Chart III-30U.S. Growth Outlook Chart III-31U.S. Cyclical Spending Chart III-32U.S. Labor Market Chart III-33U.S. Consumption Chart III-34U.S. Housing Chart III-35U.S. Debt And Deleveraging   Chart III-36U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China   Mathieu Savary Vice President The Bank Credit Analyst Footnotes 1       Please see The Bank Credit Analyst Section I, “September 2019,” dated August 29, 2019, available at bca.bcaresearch.com 2       Please see The Bank Credit Analyst Section I, “July 2019,” dated June 27, 2019, available at bca.bcaresearch.com 3       Please see U.S. Equity Strategy Weekly Report, “The Oil Factor,” dated September 23, 2019, available at uses.bcaresearch.com 4              J. D. Hamilton, "Historical Oil Shocks," NBER Working Paper No. 16790. 5       Please see Geopolitical Strategy Special Report "Policy Risk, Uncertainty Cloud Oil Price Forecast," dated September 19, 2019, available at gps.bcaresearch.com 6       Please see The Bank Credit Analyst Section I, “July 2019,” dated June 27, 2019, available at bca.bcaresearch.com 7       Please see U.S. Equity Strategy Weekly Report, “The Great Rotation,” dated September 16, 2019, available at uses.bcaresearch.com 8       Please see U.S. Equity Strategy Weekly Report, “The Oil Factor,” dated September 23, 2019, available at uses.bcaresearch.com 9       Please see Global Investment Strategy Special Report, “TINA To The Rescue?,” dated August 23, 2019, available at gis.bcaresearch.com 10     Antti Ilmanen, Ronen Israel, Tobias J. Moskowitz, Ashwin Thapar, Franklin Wang, “Factor Premia and Factor Timing: A Century of Evidence,” AQR Working Paper, July 2, 2019. 11     Eugene F. Fama and Kenneth R. French, “Common risk factors in the return on stocks and bonds,” Journal of Financial Economics, 33 (1993). 12     Clifford Asness, Andrea Frazzini, Ronen Israel and Tobias Moskowitz, “Fact, Fiction, and Value Investing,” The Journal of Portfolio Management, Vol. 42 No.1, Fall 2015. 13     Ronen Israel and Tobias J. Moskowitz, “The Role of Shorting, Firm Size and Time on Market Anomalies,” Journal of Financial Economics, Vol 108, Issue 2, May 2013 14      Eugene F. Fama and Kenneth R. French, “A Five-Factor Asset Pricing Model,” Working Paper, University of Chicago, September 2014. 15             Fama-French value-growth-size portfolios. 16     Mark P. Cussen, “Value or growth Stocks: Which are Better?” Investopedia, Jun 25, 2019. 17     Please see Global Asset Allocation Special Report titled “Small Cap Outperformance: Fact or Myth?” dated April 7, 2017, available at gaa.bcaresearch.com. 18     Please see Global Asset Allocation Special Report titled, “Is Smart Beta A Useful Tool In Global Asset Allocation?” dated July 8, 2016, available at gaa.bcaresearch.com. 19    Clifford S. Asness, Jacques A Friedman, Robert J. Krail and John M Liew, “Style Timing: Value versus Growth,” The Journal of Portfolio Management, Spring 2000. 20     Please see Global Asset Allocation Quarterly Portfolio Outlook, “Quarterly - March 2016,” dated March 31, 2016, and available at gaa. bcaresearch.com. 21     Please see Global Asset Allocation Quarterly Portfolio Outlook, “Quarterly - April 2019,” dated April 1, 2019 available at gaa.bcaresearch.com.

Special Report

Highlights The attack on Saudi Arabian energy facilities brought oil price shocks back onto investors’ radar screens: Benchmark crude prices in Europe and the U.S. blasted higher following the September 14th attacks on Saudi oil installations. Although the initial price spike largely unwound, the incident demonstrated that oil infrastructure is vulnerable: Saudi officials say output will be restored sooner than markets initially feared, but oil production is now in play for bad actors. The probability of supply-driven price shocks has increased. How vulnerable is the U.S. economy to an oil price shock?: A whole heck of a lot less than it was at the time of the 1973-74 oil embargo. The U.S. is the world’s largest oil producer, and is on its way to becoming a net exporter. Higher oil prices now amount to much more than a tax on U.S. households and corporations. Feature On Saturday, September 14th, Saudi Arabia’s Abqaiq crude-oil processing facility and its Khurais oil field were struck by air attacks that caused multiple explosions. Yemeni forces claimed responsibility, in retaliation for Saudi Arabia’s involvement in its protracted civil war, though the Saudi and U.S. governments asserted that Iran was to blame. As our Commodity & Energy and Geopolitical Strategy colleagues have written, Iran’s involvement makes the situation more ticklish.1 It is unclear where escalating rounds of provocations between the U.S. and Iran might end up, but the geopolitical, energy and economic impacts could be quite serious. There are a lot of moving parts, and we will not rehash our colleagues’ analysis here. From the U.S. Investment Strategy perspective, the biggest takeaway is that Middle Eastern oil infrastructure is more vulnerable to malign state and non-state actors than markets previously realized. It is remarkable that the world’s single most important oil processing facility could be so easily and precisely targeted, though anyone who began flying after September 11th would likely be amazed to learn that passengers once boarded planes without anyone giving the contents of their baggage a second thought. Regardless of how quickly Abqaiq operations are fully restored, Middle East oil infrastructure has been exposed as a soft target. The net economic impact of higher oil prices is the sum total of a broad range of gross subsidiary impacts. The global oil market is therefore more vulnerable to shocks from unplanned supply outages than previously assumed, and should begin to price in a terrorism premium. Any given economy’s exposure to oil price shocks is a more important consideration than it was before the attack on Aramco operations. In this Special Report, we examine the U.S. economy’s susceptibility to an oil price shock. The good news is that we find the U.S. to be considerably less vulnerable to an oil price shock than it was at the time of the Arab oil embargo; the net “tax” from higher oil prices is a good bit lower than it was then, and it is no longer exclusively paid to foreign entities. Six Channels Of Economic Impact We count six primary channels through which oil prices impact the U.S. economy: consumption, capital expenditures, corporate profits, the trade balance, employment and financial conditions (Figure 1). Higher oil prices are unequivocally bad for consumption, because they reduce households’ discretionary income. They should be a net positive for capital expenditures, because oil exploration and production is a capital-intensive pursuit that would likely outweigh incremental cutbacks in investment by businesses in the rest of the economy. They directly increase input costs for the wide range of goods that incorporate petroleum, and the goods and services that use oil as fuel, though other businesses’ reduced profits will be offset somewhat by domestic oil producers’ increased profits. As long as the U.S. remains a net oil importer, they will act to widen the trade deficit; once it becomes a net exporter, possibly within the next few years, they will narrow it. Their net impact on employment and financial conditions is mixed. Figure 1Oil Prices And The Economy Consumption Consumption is the linchpin of the oil-shock/recession narrative, as typified by the 1973-74 oil embargo. During the October 1973 war between Israel and a coalition of Arab states, OPEC members angered by American support for Israel ceased exporting oil to the U.S. and sharply reduced production. Although the embargo lasted just six months, oil prices tripled. Inflation surged, consumer confidence suffered mightily amid ubiquitous images of gasoline lines, and a sharp recession and punishing equity bear market laid siege to the U.S. economy. Chart 1The '70s Oil Shocks ... The overthrow of Iran’s pro-western monarch in 1979 generated a second oil price shock (Chart 1). The U.S. soon entered the first phase of the Volcker double-dip recession, and the notion that oil price shocks cause recessions became entrenched in the introductory macroeconomics curriculum. Filling up the tank consumes a much smaller share of household budgets today than it did in the ‘70s, however, so household spending is nowhere near as vulnerable as it was then (Chart 2). Energy is no more expensive relative to the PCE basket than it was at the end of the ‘70s (Chart 3), allowing fuel efficiency gains to translate directly to increased discretionary income (Chart 4). The household savings rate is lower, as well (Chart 5), clearing the way for consumers to spend more of their discretionary income.2 Chart 2... Took A Big Bite Out Of Consumers' Wallets Chart 3Relative To Other Consumer Prices, Oil Costs What It Did After The Second Shock Chart 4New-Model Mileage Has Doubled Chart 5Consumers Are More Willing To Spend Than They Were In The '70s ... Bottom Line: Consumption will be undermined by higher oil prices, but not nearly to the degree it was in the 1970s, when fuel costs ate up a greater share of discretionary income. Corporate Profits Higher input costs stoked the wage-price cycle in the ‘70s, but low inflation expectations and supine unions have all but stamped out cost-push inflation pressures today. Chart 6... And Economic Output Is Far Less Dependent On Oil Higher oil prices’ negative impact on input costs is as clear-cut as their impact on consumption. Higher input costs helped trigger the ‘70s and ‘80s recessions, dragging down corporate profits and exacerbating cost-push inflation pressures as employees demanded higher wages to keep up with rising prices. That dynamic still applies, but its force is considerably attenuated, as tepid inflation expectations and the decline of unions’ collective bargaining power have all but wiped out cost-push inflation pressures. The continuing shift from manufacturing to services also limits the impact of higher input costs; the oil intensity of the U.S. economy is little more than a third of what it was at the time of the embargo (Chart 6). Growing energy self-sufficiency keeps some of the increased input costs from escaping the domestic economy. It is still valid to think of higher energy prices as a tax on businesses and consumers, but at least some of the tax revenue now accrues to U.S. parties. Shale drillers, pipeline companies, vendors and workers, and the states and localities where they reside, all share in the benefits. That limits the drag on domestic corporate profits, and the second-order drags on fixed investment, employment, consumption and creditworthiness. Capital Expenditures And The Other Channels Energy production’s increasing role within the U.S. economy came to the fore when crude prices collapsed from $107 to $26/barrel between June 2014 and February 2016. Per the ‘70s foreign-oil-dependency template, households would have gotten a huge discretionary income boost, while corporate margins would have surged. Employment and investment would likely have followed, and the consequent increase in consumption would have fed back into even more investment. Improved U.S. terms of trade would have improved living standards, and the trade balance would have narrowed. The U.S. economy no longer has a simple one-way relationship with oil price moves. Those happy growth outcomes did not materialize in the latest oil bust. Consumption growth was robust for the six quarters through 2Q16, but nonresidential fixed investment staggered across 2015 and into 2016 (Chart 7), failing to surpass its 4Q14 level (in real terms) for good until 3Q16. Swooning oil prices had no apparent effect on the trade deficit, which continued to grow at a steady pace (Chart 8). Chart 7Consumption Growth Surged During The Oil Bust, But Capex Growth Crashed Chart 8The Oil Bust Didn't Affect The Trade Deficit, ... Financial conditions tightened as high-yield credit spreads blew out, driven by bankruptcies and defaults in the oil patch (Chart 9, top panel). Oil patch capex evaporated as lenders and equity investors deserted the sector. That would happen in any oil bust, but it spread to the broader economy because shale plays had come to account for a close to a sixth of high-yield bond issuance (Chart 9, bottom panel). The net result was to reduce the supply of loanable funds for non-oil entities, while increasing their cost, bringing about a sharp tightening of financial conditions. Chart 9... But It Tightened Financial Conditions Employment suffered at the margin, as five years of steady oil and gas job gains from 2010-14 were wiped out in 2016 alone. Oil-related employment doesn’t account for a meaningful share of overall employment, but it has been a critical driver of new manufacturing employment since the crisis (Chart 10). The bottom line is that the economy’s failure to respond more positively to 2014-16’s long and steep oil price decline showed that it no longer has a one-way relationship with oil prices. Where sharply lower oil prices would previously have been an unmitigated boon for the economy, they now produce a range of offsetting effects. Chart 10Help Wanted In The Shale Patch Investment Implications Modeling the quantitative impact of a given rise in oil prices on any one factor is beyond the scope of this report, and there is no lack of published studies which have attempted to do so. Research recently cited by Dallas Fed President Kaplan suggests that a 10 percent increase in the real price of oil from a supply-driven oil price shock would lead to a roughly 10- to 30-basis-point decline in real GDP growth.3 In a general sense, we agree with both the direction and the magnitude of those studies’ conclusion. Higher oil prices would be a drag on the U.S. economy, but an increasingly modest one as domestic oil production rises and the country approaches true energy independence. Figure 1 shows that the modest negative net impact on the economy is the aggregation of several individual gross impacts, implying that the key investment takeaways are some layers below the broad macro level. When the arrows conflict within any of the individual channels in the figure, there may be an opportunity for investors to pair exposures. The need to protect vital oil infrastructure could bolster defense stocks, which have long been a favorite of our U.S. Equity Strategy and Geopolitical Strategy services. U.S. airlines, which (with one exception) scorn the idea of hedging their fuel costs, could be an attractive short/underweight candidate to pair with a defense overweight. From a macro perspective, the increased potential for oil price shocks enhances the appeal of TIPS relative to nominal Treasuries. As long as an oil supply shock would act as a headwind for U.S. growth, investors seeking to add some inflation protection to their portfolios should focus on shorter-maturity TIPS. A supply shock pushes inflation higher in the short term, but weighs on it in the long term, as investors revise their long-run inflation expectations lower upon factoring in its long-run growth-dampening effect.   Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com Footnotes 1 Please see the September 16, 2019 and September 19, 2019 Commodity & Energy Strategy and Geopolitical Strategy Special Reports, “Attacks On Critical Infrastructure In KSA Raise Questions About U.S. Response,” and “Policy Risk, Uncertainty Cloud Oil Price Forecast,” available at www.bcaresearch.com. 2 Disposable income is after-tax income. Discretionary income is what’s left of disposable income after the costs of necessities, like food, rent, clothing, gasoline and utilities, are backed out. 3 Kaplan, Robert S., “A Perspective on Oil,” June 19, 2018. Downloaded September 16, 2019 from https://www.dallasfed.org/-/media/Documents/news/speeches/kaplan/2018/rsk180619.pdf.

Highlights The U.K. economy has been holding up fairly well, despite the overhang of political uncertainty. However, even before the actual withdrawal of the U.K. from the E.U. has occurred, Brexit has left a lasting mark on the U.K. economy through elevated uncertainty, severe weakness in business investment spending, and anemic productivity. The net result is an economy with lower trend growth, a structurally weaker exchange rate, and relatively high domestic inflation. Brexit will be delayed beyond October 31. No-deal Brexit is an overstated risk unless an early election strengthens Boris Johnson’s hand. That is unlikely. The investment outlook for the British pound and U.K. gilts is highly binary: a “smooth” Brexit is bullish for the pound and bearish for gilts, while no-deal Brexit would push both the pound and gilt yields even lower. Feature Ever since the United Kingdom voted in 2016 to exit the European Union, the outlook for the economy and financial assets has been tied to the binary outcome of whether or not an exit would be orderly. This has been a tremendous source of uncertainty, putting the Bank of England (BoE) in one of the most inconvenient positions ever faced by a central bank. In this week’s report, we look to address a few high-level questions. First, has the slowdown in the U.K. economy been run of the mill, given the global manufacturing recession? Or has it been unduly protracted given heightened political uncertainty? If the latter, what are the prospects of a rebound should anything other than a “no-deal” Brexit prevail? Finally, has there been irreparable damage already done to the economy because of delayed investment, with longer-term ramifications irrespective of the relationship outcome with the E.U.? An Employment Boom The U.K. is currently experiencing the best jobs recovery since the Second World War. 4.2 million new jobs have been created over the past decade, nudging the employment-to-population ratio to the highest level in almost 50 years. What is remarkable is that this recovery looks even more impressive than that of the U.S., where labor market conditions have been very robust. For example, in the U.S., the employment rate stands at 60.9%, just a nudge below the U.K. but still nearly four percentage points below its pre-crisis peak (Chart 1). Compared to the eurozone, the outperformance of the U.K. labor market has been very evident. Despite this recovery, the pickup in wages has been the most tepid since the Boer War. The quality of jobs has also been stellar – full-time job creation has outpaced part-time and female participation rates are soaring. The jobs bonanza has also been broad across regions and industries. Yes, the manufacturing sector has seen some measure of volatility, but aside from the East Midland region, unemployment rates continue to converge downward across the United Kingdom (Chart 2) Chart 1An Employment Boom Chart 2Recovery Is Broad-Based     Despite this recovery, the pickup in wages has been the most tepid since the Boer War. In a July speech, the BoE’s chief economist, Andy Haldane, rightly noted that the lost decade of pay has been an equal-opportunity disaster across the major U.K. regions. From the 1950s until the Great Recession, real pay in the U.K. grew by about 2% per annum. Since the Great Recession, real pay has stagnated at a rate of -0.4% per year (Chart 3).1 Chart 3Wages Stagnated Until Recently There have been a few reasons for this. First, there has been strong growth in self-employment, zero-hours contracts and agency work. So even though the share of full-time work has been rising during the post-crisis period, it remains well below its pre-crisis highs. This has increased the fluidity of the labor market, lowering the cost of doing business in the process. Compensation of self-employed or zero-hours contract workers lies significantly below their permanent counterparts. The silver lining is that this phenomenon is not specific to the U.K., but is happening worldwide, especially in Europe where structural reform has disentangled rigidities in the labor market. The key question going forward is whether the nascent rise in wages will continue. Over a cyclical horizon, our contention is that should positive employment trends continue, the U.K. could begin to experience significantly stronger wage pressures. There are four fundamental reasons for this: Job offers continue to outpace the number of seekers. Depending on the measure used, there are 20%-40% more jobs than there are applicants (Chart 4). This impasse cannot easily be resolved by a higher employment rate (it is at a secular high) or lower unemployment. The BoE estimates NAIRU in the U.K. is at 4.4%, which means that the unemployment rate is firmly below its structural level. Business surveys continue to suggest that a shortage of skilled labor is among the top problems firms are facing. The Phillips curve in the U.K. has flattened in the last few years, but wage growth has started to inflect higher of late. Like many other countries, the Phillips curve in the U.K. is kinked, whereby the convexity of wage growth increases as the unemployment gap closes.  The velocity of circulation in the jobs market, also known as the job-to-job flow, has picked up. This has historically been positive for wage growth (Chart 5). This is also mirrored by the quits rate, which has been accelerating since 2012. Chart 4Wage Pressures Should Mount Chart 5Velocity Of U.K. Employment Rising At the moment, the transmission mechanism from a tight labor market to higher wages is being impeded by political uncertainty, which will continue to cast a near-term shadow on longer-term hiring plans. For example, for all the talk of the U.K. being a financial center, attrition in banking and insurance employment remains entrenched (Chart 6). The U.K. continues to attract a significant amount of financial business, especially in the foreign exchange market, but there was a clear hit to volumes in 2016, the year the Brexit referendum was held (Chart 7). Meanwhile, for the manufacturing sector, it will take a while to rekindle animal spirits and re-attract foreign direct investment. Chart 6Attrition In Manufacturing And Finance Employment Chart 7The U.K. Is An Important Financial Center That said, the U.K. economy remains mostly driven by services, meaning wages will still face some measure of upward pressure. Service sector wage growth has been robust and unless the manufacturing recession grows deeper and starts to infect other sectors of the U.K. economy, the path of least resistance for wages remains up. Bottom Line: The U.K. economy has been holding up fairly well, despite the overhang of political uncertainty. Virtuous Circle Of Spending While the U.K. income pie could grow, a lack of confidence is nonetheless constraining spending. Chart 8 shows that U.K. consumer confidence has negatively diverged from trends in both the U.S. and the euro area. There have been a few offsetting factors at play suggesting that once the clouds of Brexit uncertainty lift, spending could re-accelerate higher. The transmission mechanism from a tight labor market to higher wages is being impeded by political uncertainty, which will continue to cast a near-term shadow. A big driver for retail sales in the U.K. is tourist arrivals and the weaker pound is likely to keep attracting an influx of visitors (Chart 9). Chart 8Confidence Will Be Key For ##br##Any Recovery Chart 9The Cheap Pound Will Encourage ##br##Foreign Shoppers The U.K. commands many of the world’s leading brands that will benefit from a cheap currency. The household deleveraging process is well advanced, and the tentative recovery in borrowing and mortgage applications is helping to cushion the fall in U.K. house prices. This is underpinned by the fact that mortgage-borrowing costs in the U.K. have collapsed along with yields (Chart 10). That said, any rise is borrowing will be mitigated by the fact that household debt-to-GDP in the U.K. remains higher than in many other developed economies. Chart 10Low Rates Should Help Housing Chart 11Cost-Push Inflation Inflation expectations are blasting upward, partly in response to the weaker currency. What is remarkable is that the pound has plummeted by a lot more than is warranted on a fundamental PPP basis. This will bring about imported inflation (Chart 11). Bottom Line: The big risk to the U.K. economy is that it enters into stagflation. A BoE survey pins the loss to output in the event of a no-deal Brexit at around 3% of GDP, but these are estimates since the bulk of the economic adjustment might occur through the exchange rate. The range of estimates for the economic impact of a no-deal (Table 1), perhaps not coincidentally, mirrors the range of Britain’s recessions in the 20th century (Chart 12). This puts the BoE in a particularly uncomfortable “wait and see” mode. For example, if a hard exit leads to a fall in the pound and a rise in inflation expectations, it is not clear the BoE’s Monetary Policy Committee would cut rates if it were to meet its inflation mandate. Table 1Wide Range Of Estimates For Impact ##br##Of No-Deal Brexit Chart 12Past British Recessions Offer Guidelines ##br##For No-Deal Impact Brexit Uncertainty Has Already Caused Lasting Damage To U.K. Growth A major drag on U.K. economic growth over the past three years has been the collapse in business confidence and associated contraction in capital spending (Chart 13). Since the 2016 Brexit vote, business investment has been substantially weaker than at similar points in previous U.K. business cycles – by a cumulative 26%, according to the BoE (Chart 14). While some of the softness seen in 2019 can also be attributable to slowing global economic growth and uncertainty related to the U.S.-China trade war, U.K. capital spending has been far weaker than that of other advanced economies (Chart 15). Since the 2016 Brexit vote, business investment has been substantially weaker than at similar points in previous U.K. business cycles – by a cumulative 26%. This is a critical point to consider when judging the long-run damage that has already been inflicted on the U.K. economy just from the uncertainty of Brexit. The best way to evaluate this damage is through the lens of capital spending, the growth of which is highly correlated to changes in productivity and potential economic growth (Chart 16). Chart 13Gloomy U.K. Businesses Have Stopped Investing Chart 14Massive Underperformance Of U.K. Capex Compared To History ... Chart 15...And Compared To ##br##Global Peers Chart 16A Lasting Hit To The U.K. Economy From Brexit Uncertainty     An important research paper published by the BoE last month – co-authored by two current members of the BoE Monetary Policy Committee, Ben Broadbent and Silvana Tenreyro – discusses the linkages between Brexit uncertainty, capital spending and U.K. productivity.2 The authors concluded that the economic effects of the Brexit referendum result can be categorized as a response to an anticipated, persistent decline in productivity growth for the tradeable sectors of the U.K. economy. In that framework, the following chain of events would occur after the “news” of weaker expected productivity (i.e. the Brexit referendum result) is announced: Chart 17A Misallocation of Resources An immediate and permanent fall in the relative price of non-tradeable output relative to tradeable output, i.e. the real exchange rate. Resources shift to the tradeable sector to take advantage of the higher relative price, leading to an increase in output and a rise in exports. Productivity growth in the tradeable sector then falls, as heralded by the “news” of the Brexit vote, leading to a shift in economic resources back towards the higher productivity non-tradeable sectors. U.K. interest rates fall relative to the world, as financial markets discount the expected relatively slower path of U.K. productivity. Aggregate business investment growth slows, but overall employment growth remains resilient. This is exactly how the U.K. economy has evolved since the 2016 Brexit vote: The BoE’s trade-weighted index for the pound has fallen in both nominal and real terms. The export share of U.K. real GDP rose from 27% to 30%, while the investment share of real GDP declined from 10% to 9% (Chart 17, top panel). Annual employment growth in U.K. services (non-tradeable) fell from 2.1% to zero by the end of 2018, but has since begun to recover; manufacturing (tradeable) employment growth initially increased from 0.5% to 2.7% within a year of the Brexit vote, before slowing back to 0% in 2018, and is also starting to move higher (Chart 17, third panel). Productivity growth has declined from 1.9% to nil, even as wage growth has accelerated due to the steady pace of labor demand at a time of low unemployment (Chart 17, bottom panel). On a sectoral level, the worst growth rates of realized productivity growth are occurring in tradeable industries like metal products and financial services, while the highest productivity growth is seen in non-tradeable industries like professional services and retail (Chart 18).3 Chart 18Latest U.K. Productivity Growth Rates, By Industry Summing it all up, according to the analytic framework of the BoE research paper, the Brexit referendum result essentially created a signal, manifested by the plunge in the British pound, for the misallocation of U.K. resources away from higher-productivity non-tradeable industries to lower productivity tradeable sectors. If true, we would also expect to see the following: Chart 19Inflationary Consequences of Brexit Uncertainty Much higher inflation rates in more domestically-focused measures like services and wages. Faster growth in unit labor cost as a result of the gap between accelerating wages and stagnant productivity. Structurally higher inflation expectations. Lower real interest rates in the U.K. than in other advanced economies. Prolonged weakness in the exchange rate. Again, all of this has come to fruition in the U.K. (Chart 19): Services CPI inflation is now at 2.2%, compared to only 1.7% for overall CPI inflation. Unit labor costs growth has accelerated from below zero before the Brexit referendum to a 2%-3% range since the end of 2016. The real 10-year gilt yield (deflated by the 10-year CPI swap rate) is now -3.1%, compared to a 0% real yield on 10-year U.S. Treasurys. The trade-weighted British pound remains close to its post-Brexit referendum lows. It is clear that the Brexit uncertainty has resulted in a structurally weaker, and more inflationary, U.K. economy – an outcome that may not be quickly reversed in the event a no-deal Brexit is avoided. This has important implications for the future monetary policy decisions of the BoE and the investment outlook for the pound and U.K. gilts. Bottom Line: Even before the actual withdrawal of the U.K. from the E.U. has occurred, Brexit has left a lasting mark on the U.K. economy through elevated uncertainty, severe weakness in business investment spending and anemic productivity. The net result is an economy with lower trend growth, a structurally weak exchange rate, and relatively high domestic inflation. Political Uncertainty Prevails Chart 20Public Opposes No-Deal Brexit Even after considering the cyclical and structural state of the U.K. economy, as we have done in this report, the near-term outlook is still entirely dependent on the Brexit outcome. The state of Brexit is more uncertain than ever due to the Supreme Court case against the government’s suspension of Parliament and Prime Minister Boris Johnson’s refusal to obey an order by Parliament to seek an extension to the October 31 exit deadline. What is not in doubt is that parliament opposes a disorderly, no-deal Brexit. And the best polling suggests that public opinion opposes a no-deal Brexit as well (Chart 20). Members soundly rejected Prime Minister Boris Johnson’s negotiation strategy in September – they prohibited both a no-deal Brexit and voted against holding an early election on two separate occasions (Chart 21). Johnson lost his coalition majority and yet cannot go to new elections, leaving him hamstrung until Parliament returns. What is likely regardless of the outcome is a substantial increase in fiscal spending, The United Kingdom is not a seventeenth-century Stuart monarchy – Parliament is the supreme political body in the constitution and its decrees cannot be permanently ignored or disobeyed. Whenever Parliament reconvenes, likely October 14, it will have the ability to ensure that the Brexit deadline is extended. The E.U. is likely to grant an extension because it is in the E.U.’s interest to delay or cancel Brexit and demonstrate to all members that leaving the bloc is neither desirable nor practical. The result will then be an election. Chart 21Boris Johnson’s Negotiation Strategy Failed Chart 22A Hung Parliament Is The Likely Outcome Election polls show the Conservative Party breaking out, the Liberal Democrats overtaking Labour, and the Brexit Party maintaining an edge (Chart 22). Translating these polls to parliamentary seats is not straightforward because the first-past-the-post electoral system means that a smaller party can steal crucial votes from the most popular party leaving the second- or third-most popular party to win the seat. The key point is that the Brexit Party is a single-issue party and the Tories under Johnson are now monopolizing that same issue. If this dynamic persists, the Lib Dems pose a greater threat of splitting Labour’s votes than the Brexit Party does of splitting Conservative votes. The result is that it is still possible for the Conservatives to gain a majority, even though it seems unlikely given that they need 325-plus seats and have fallen to 288 seats after purging unruly members and losing leadership in Scotland. A hung Parliament is a more likely outcome. A hung Parliament will prolong the indecision and uncertainty – but will also be likely to remain united against a no-deal Brexit. An opposition coalition government will prevent a no-deal Brexit. Even a single-party Tory majority is not a disastrous outcome, as it would increase Johnson’s leverage with the E.U. and increase the likelihood that the E.U. would offer some concessions to get a withdrawal agreement passed, resulting in a Brexit deal and an orderly exit (Specifically, a Northern Irish limitation to the backstop, or a sunset clause or withdrawal mechanism for the same). Such a deal is in Johnson’s best interests so that he does not preside over a recession from the moment he returns to office. All of these outcomes point toward either an exit deal or a new chapter in which parliament seeks a new referendum. Chart 23Expect An Increase In Fiscal Spending The worst outcome for the markets would be a weak Tory coalition majority that cannot agree on Ireland or pass an exit deal, as this could lead to paralysis, as it did with Theresa May, at a time when the prime minister is committed to delivering an exit come hell or high water. This is the scenario in which no-deal once again becomes a genuine risk. Subjectively we have estimated that the risk of no-deal is around 30%, but this is currently falling, not rising, as a result of parliament’s strong majorities against that outcome in September – and only an election can change that. It is fruitless trying to predict the U.K.’s future political landscape without knowing the conclusion of the Brexit saga. What is likely regardless of the outcome is a substantial increase in fiscal spending, reversing the “austerity” of the aftermath of the Great Recession. This trend is already apparent from Johnson’s current attempt to present a generous social spending package at the Tory party conference this fall – which would, if vindicated by a new election, represent a turnaround in Conservative fiscal policy (Chart 23). More fiscal spending will be needed to counteract the negative impact of a disorderly Brexit, or to placate the middle class once it becomes clear that leaving the E.U. is not a panacea for the UK’s problems, or to fulfill the agenda of an opposition government when it comes to power. In the event that a no-deal Brexit occurs, the U.K. will not only face a tumultuous economic aftermath, but the constitutional struggles among the three kingdoms will reignite due to the negative impact in Northern Ireland and the likely revival of Scottish independence efforts. Bottom Line: The U.K. is not a dictatorship and the prime minister cannot refuse to obey Parliament’s will. Parliament has voted clearly to delay a no-deal Brexit and will continue to do so. A disorderly exit remains a risk because an eventual election could return the Tories to power. But in this case, the E.U. will be more likely to offer a concession that enables Parliament to pass a withdrawal bill. The odds of no deal are no higher than 30%. The structural takeaway, regardless of the outcome, is that fiscal spending will rise. Investment Conclusions The episodes surrounding the collapse of the pound in 1992 carry important lessons for today.4  Crucially, most of the adjustment in the pound happened quickly, but a key difference from today is that an exit from the European Exchange Rate Mechanism was unanticipated, unlike Brexit. Foreign exchange markets are extremely fluid and adjust to expectations quite quickly. Peak to trough, cable has already fallen by circa 30% suggesting the bulk of the downward adjustment is done. Chart 24A Binary Brexit Outcome for Gilts The British currency is free floating, meaning there are less “hidden sins” compared to the fixed exchange rate period. That said, the fair value of the pound has structurally weakened. Our bias is that if there is a hard Brexit, the pound could easily drop to the 1.10-1.15 zone. Part of this move will be an undershoot. In the case of a soft Brexit (or no Brexit), the pound should converge toward the mid-point of its historical real effective exchange rate range, which would pin it 15%-20% higher, or at around 1.50. From a risk-reward perspective, this looks attractive. For U.K. gilts, the direction of yields is also dependent on the Brexit outcome, as there is essentially no change in policy rates discounted in the U.K. Overnight Index Swap (OIS) curve (Chart 24).  A “smooth” Brexit would allow the BoE to return its focus to fighting elevated U.K. inflation expectations. That would likely result in both higher gilt yields and a flattening of the gilt yield curve, as the market prices in future BoE rate hikes, and lower longer-term inflation expectations. A rising cable will also temper inflation expectations. Neither gilts nor U.K. inflation-linked bonds would perform well in this scenario.. A “no deal” Brexit, on the other hand, would prompt the BoE to cut interest rates in order to offset the potential hit to business and consumer confidence. This could occur even if inflation expectations remain high or rise further on pound weakness. That would mean lower gilt yields and a steepening of the gilt curve. Going overweight gilts but also long inflation-linked bonds would be the best way to position for this outcome. The scenarios for fiscal easing outlined earlier would also influence the shape of the gilt curve, resulting in some degree of bearish steepening as the gilt curve prices in both larger deficits and higher future inflation, all else equal. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Matt Gertken, Geopolitical Strategist mattg@bcaresearch.com Ray Park, CFA, Research Analyst ray@bcaresearch.com Footnotes 1 Andrew G Haldane, “Climbing the Jobs Ladder,” Bank of England, July 23, 2019 2 Bank of England External MPC Unit Discussion Paper No. 51, “The Brexit vote, productivity growth and macroeconomic adjustments in the United Kingdom”, August 2019 3  London’s role as a major global financial center makes the U.K. financial services industry a “tradeable” sector, in that a significant share of its output is “traded” to non-U.K. users. 4 Mathias Zurlinden, “The Vulnerability of Pegged Exchange Rates: The British Pound in the ERM,” Economic Research, Vol. 75, No. 5 (September/October 1993). Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights The fundamental backdrop continues to be mixed, but last week’s key data releases were encouraging on balance: While the U.S. manufacturing ISM survey entered contraction territory, and European manufacturing PMIs remained moribund, the services surveys were quite strong, and services contribute much more to developed economies’ total output. The U.S. economy should be able to grow at trend for the next six to twelve months: Consumption is underpinned by a robust labor market, federal government spending will not flag ahead of the 2020 elections, and state and local revenues are well supported. Investment is unlikely to sabotage the other two pillars of the U.S. economy. The view that inflation is deader than New York Mayor de Blasio’s presidential ambitions is widespread and entrenched: Participating on a panel at an inflation-themed conference last week, we were struck by the conviction that inflation is going nowhere over the next few years. The risk-reward of taking the other side of that debate may be quite attractive. Feature Another week, another mixed set of data releases. Last Tuesday, the bears’ most cherished fantasies seemed to be within reach as the ISM Manufacturing Index slid below the boom-bust line in a print that fell well short of consensus expectations. The S&P 500, which had probed around August’s 2,945 resistance level in the final pre-Labor Day session, quickly shed more than a percentage point in response. The U.S. data confirmed the message from the previous day’s European manufacturing PMIs: global manufacturing remains in a deep funk, and a turnaround is not yet at hand. It’s hard to get a recession without tight monetary policy, and it’s hard to get a bear market without a recession, ... Wednesday’s European services PMI releases gave the bulls a lift. Though manufacturing activity truly stinks (Chart 1), it shows no signs of contaminating the services sector, which is still expanding at a solid clip (Chart 2). The U.S. ISM Non-Manufacturing Index surged in August, beating consensus expectations by the same two-point margin by which manufacturing fell short. U.S. equities were already trading higher on the back of an imminent resumption of U.S.-China negotiations when the series was released Thursday morning, and the combination helped the S&P 500 decisively break through the level that had held it in check for a month (Chart 3). Chart 1Global Manufacturing ##br##Is Ailing ... Chart 2... But The Service Sector Is Expected To Expand Chart 3Breakout Taking a step back from the consistently mixed data, recessions don’t occur when monetary conditions are easy. Equity bear markets rarely occur outside of recessions, so our default position is to remain at least equal weight equities in a balanced portfolio. We estimate that the equilibrium fed funds rate is somewhere in the neighborhood of 3 to 3.25%, so the monetary backdrop remains comfortably accommodative with fed funds at 2.25% and seemingly heading to 2% or lower in the coming months. Our estimate of equilibrium is no more than an estimate, however, so we are reprising our analysis of where consumption, investment and government spending are headed over the next six to twelve months. We remain constructive on the basis of that analysis. The GDP Equation GDP is the sum of consumption, investment, government spending and net exports. Rendered as an equation, GDP = C + I + G + (X-M). Net exports are not terribly meaningful for the comparatively closed U.S. economy, and we take a small fixed trade deficit as a given, so we reduce the equation to GDP = C + I + G. Ex-trade, consumption accounts for two-thirds of output, and fixed investment and government spending for one-sixth each. At four times each of the other components’ weight, consumption is the dominant driver of U.S. activity. Investment is considerably more variable, however, making it more likely to wipe out trend growth from the other drivers (Chart 4). As we showed the first time we performed the (C+I+G) analysis, investment would only have to fall to 0.83 standard deviations below its long-run mean to zero out 2% growth in consumption and government spending.1 Chart 4Investment Is The Wild Card In a normal distribution, events 0.83 or more standard deviations below the mean are expected to occur randomly about 20% of the time. It would take a -1.31-sigma consumption event (probability ≈ 10%) to zero out 2% growth in the rest of the economy. An expansion-killing decline in government spending would be a -1.86-sigma event (probability ≈ 3%). Investment is most likely to be the swing factor tilting the economy in the direction of a recession. Consumption Both retail sales and personal consumption expenditures have accelerated since early April (Chart 5). A robust labor market should continue to support consumption spending, as our payroll model projects a pickup in hiring (Chart 6, top panel), thanks to more ambitious NFIB hiring plans (Chart 6, second panel) and falling initial unemployment claims (Chart 6, bottom panel). Job openings are at their highest level in the 19-year history of the series, indicating that demand for new employees is high, and an elevated quits rate indicates that employers are paying up to poach workers from each other to satisfy that demand. We reiterate that more Americans will be working at the end of 2019 than at the end of 2018, and that all of them will be getting paid more, on average. A robust labor market will give household incomes a boost, and solid balance sheets will give them leave to spend it. Households don’t have to spend income gains, however. If they choose instead to save them, or divert them to paying down debt, consumption won’t get much of a near-term boost. The state of household balance sheets is also a driver of consumption’s direction, and they’ve improved at the margin since our last review. The savings rate moved sharply higher in the interim (Chart 7, top panel) and household debt as a share of GDP ticked lower (Chart 7, second panel), while the burden of servicing existing debt remains light (Chart 7, bottom panel). Chart 5Consumption Is Healthy Chart 6Hiring Is Poised To ##br##Tick Higher, ... Chart 7... And Households Are In A Position To Spend Bottom Line: Consumption remains well supported and will likely continue to be over a six- to twelve-month horizon. Investment Despite hopes that the reduction in corporate income tax rates and immediate expensing of qualified investments would promote capital expenditures, growth in nonresidential fixed investment has been uninspiring. Looking ahead, surveys of corporate investment intentions are decent coincident indicators of capex, and their monthly releases provide some leading insights into quarterly GDP investment. Capital spending plans in the NFIB small business survey have bounced since early April (Chart 8, top panel), but capex plans in the regional Fed surveys have weakened (Chart 8, bottom panel). Although both surveys have turned down, they remain at fairly elevated levels, suggesting that an investment plunge capable of negating trend growth in consumption and government spending is unlikely. Chart 8Neither Here Nor There Residential investment is less than a quarter of nonresidential investment and therefore typically only has a marginal impact on investment. It remains in a slump, with momentum in starts and permits sputtering (Chart 9, top panel); existing home sales running in place (Chart 9, middle panel); and inventories of homes for sale up since April, albeit still at low levels relative to history (Chart 9, bottom panel). Despite a sharp decline in mortgage rates since the end of last year, housing activity has failed to revive. Conversations with various market participants lead us to believe that zoning restrictions, sparse quantities of affordable land, difficulty in assembling construction crews, and a general idling of smaller developers in the wake of the crisis have all contributed to insufficient supplies of the entry-level and first-move-up homes for which there is ample demand. Chart 9Housing Is Weaker Than It Should Be, But It Doesn't Mean The Economy Is In Trouble Bottom Line: Neither nonresidential nor residential investment appears vulnerable enough to spark a decline in investment that could cause the economy to stall out. Government Spending All systems are go from a fiscal perspective. The federal spending taps will surely be open in a hotly contested presidential election year. State income and sales tax revenues have improved since our last review in April (Chart 10, top two panels), and should be well supported by a strong labor market. Solid home price appreciation will nudge the appraisals underpinning property taxes higher (Chart 10, third panel), supporting municipal tax receipts. Government spending will continue to hold up its end. Chart 10State And Local Revenues Will Hold Up Is Inflation Dead? Chart 11Another Upleg Is Coming We participated in a panel discussion last week at an inflation-linked products conference. The panel included Fed researchers and a veteran inflation-products trader turned investment manager. After a wide-ranging discussion that touched on U.S. economic prospects, the message from the yield curve, the impact of trade tensions and the continuing relevance of the Phillips Curve, each panelist was asked if inflation has already peaked for the cycle. The response was a resounding unanimous yes until we got our turn. The other panelists were not laypeople, traders, bottom-up analysts, or anyone else with only a passing interest in macroeconomics. They were experts, and we were struck by the conviction with which they dismissed the possibility that inflation could yet break out in the current cycle. Judging by the shrinking scale of the annual conference (this year’s edition was half the size of the previous two years’), the idea that inflation is dead for the foreseeable future has found a wide following. We do not think that inflation, and bond yields, will go anywhere in the immediate future, but it is far from assured that they will remain moribund for the rest of the expansion (Chart 11). Taking the other side looks attractive to us, given the preponderance of inflation-is-dead opinions. It is not terribly surprising that wide output gaps opened following an especially job-destructive downturn. With economic capacity considerably ahead of aggregate demand across the major economies, inflation had little chance of taking hold at an economy-wide level. The picture is changing, however, with the IMF estimating that the U.S. output gap closed in 2017 and in the advanced economies as a whole sometime last year (Chart 12). Goods inflation is primarily a global phenomenon, and with the IMF estimating that output gaps persist in Australia, Canada, Japan and the U.K., international slack can still mitigate domestic price pressures, though new tariff barriers would bind inflation more closely to domestic conditions. Services inflation, which is much more domestically driven, could begin to perk up now that unemployment is below NAIRU in the Eurozone as well as the U.S. (Chart 13). Finally, while central banks are hardly omnipotent, Milton Friedman’s always-and-everywhere admonition leaves little doubt that the monetary authorities can boost inflation expectations if they really want to. Chart 12Demand Has Caught Up To Capacity Chart 13Mind The Gap Investment Implications The investing backdrop is hardly ideal. Spreads are tight, stocks aren’t cheap, the two largest standalone economies are trying to inflect pain on each other, the U.K. can’t agree on how to get divorced from the EU, and the fate of the longest U.S. expansion on record is in doubt. The risks are well known, however, and save-haven assets have gotten pretty crowded. While the danger that shaky confidence could become self-fulfilling is real, our base case is that the expansion will trundle along, allowing stocks to rise as the worst-case scenarios fail to come to pass. It is at least possible that rumors of inflation’s demise have been greatly exaggerated. We continue to recommend that investors remain at least equal weight equities in balanced portfolios and at least equal weight spread product within bond allocations. We enthusiastically endorse our bond colleagues’ overweight TIPS recommendation. When nearly everyone agrees that a particular outcome cannot happen, it is often worth carving out some space in a portfolio in the event it actually does.   Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com   Footnotes 1 Please see Table 1 of the April 8, 2019 U.S. Investment Strategy Weekly Report, “If We Were Wrong,” available at usis.bcaresearch.com

Special Report

Highlights It will be impossible for China to undertake even mild deleveraging and simultaneously accelerate household income growth. All deposits in the banking system have been created by banks “out of thin air” and have not been engendered by household savings. Contrary to widespread beliefs, mainland households are highly leveraged. Cyclically, high equity valuations, crowded investor positioning and the delayed cyclical recovery in the Chinese economy pose downside risks to consumer stocks. Structurally, real income growth per capita is contingent on productivity growth. The latter will slow in China but remain relatively elevated. Overall, investors should consider buying Chinese consumer plays on weakness. Feature Deliberations about China’s successful rebalancing often boils down to whether one believes that consumers will be able to offset the slowdown in investment and exports and keep overall real GDP growth close to current levels. The narrative typically presumes that Chinese households are not spending enough and can boost their spending counteracting the ongoing slowdowns in capital spending as well as in exports. This conjecture is fallible. Chart I-1The Myth Of Deficient Consumer Demand In China Consumer spending in China has in fact been booming over the past 20 years – it has been growing at a compounded annual growth rate (CAGR) of 10% in real terms since 1998 (Chart I-1, top panel). Hence, the imbalance in China has not been sluggish consumer spending. Rather, capital expenditure has been too strong for too long (Chart I-1, bottom panel). Healthy rebalancing entails a slowdown in investment spending – not an acceleration in household demand. Hence, the market relevant question is: Can the growth rate of household expenditure accelerate above 10% CAGR in real terms as capital spending and exports decelerate? Our hunch is that this is unlikely. As the authorities attempt to contain credit and investment excesses and trade war-induced relocation of manufacturers out of China gathers steam, the pertinent question is whether the slowdown in household expenditures in real terms will be mild (from the current 10% pace to 7.5-9% CAGR), medium (6-7.5%) or material (below 6%). In our opinion, the medium scenario has the highest odds of playing out. There are many positives about the vitality of Chinese consumers and we do not mean to downplay them. Nevertheless, many of these positives are well known, and the objective of our report is to reveal misconceptions about this segment.  Deleveraging And Consumers If and when deleveraging does transpire in China, the household income growth rate will decelerate, resulting in weaker spending growth. It will be impossible for the mainland economy to undertake even mild deleveraging and simultaneously accelerate household income growth. Chart I-2Capital Spending Is Much More Important Than Exports Our focus for this report is on a slowdown in credit and capital spending rather than exports. The basis is that the latter in general, and shipments to the U.S. in particular, have a much smaller impact than investment expenditures (Chart I-2). In turn, capital spending is mostly financed by credit. It is crucial to understand the significance of credit in driving national and household income growth in China since 2008. Currently, 2.5 yuan of new credit is needed to generate one yuan of GDP growth. This certifies that the mainland economy has become addicted to credit. As we have argued in depth in past reports, commercial banks do not intermediate savings into credit, but rather create new money/credit “out of thin air” when they lend to or buy securities from non-banks. This entails that output and income growth would have been much weaker had banks not provided credit equal to RMB 19 trillion over the past 12 months. For instance, a company affiliated with the provincial government has borrowed money from banks to build three bridges over the past 10 years, accumulating a lot of debt in the process. Ostensibly, operating these bridges does not generate enough cash flow to service its debt – a common occurrence in China. With the three bridges completed, the company would then apply for a new loan to build a fourth bridge. Should banks lend additional money to construct it? Notwithstanding this hypothetical company’s low creditworthiness, if banks provide additional financing, the credit bubble will become larger, and the issue of overcapacity will intensify. On the other hand, household income and spending growth will remain robust. If banks do not finance the construction of the fourth bridge, labor income growth in the province – employees of this company and its suppliers – will slump. Thus, if for whatever reason banks are unable or unwilling to extend as much in new credit as last year, output and income growth in this province will decelerate, all else equal. Given credit has been playing an enormous role in driving China’s economic growth over the past 10 years, it will be almost impossible to slow down credit without a downshift in household income growth. This example and analysis is not meant to suggest that bank credit origination is the sole growth driver in China. Theoretically, GDP can expand even with bank credit/money contracting. According to the quantity theory of money: Nominal GDP = Money Supply x Velocity of Money This means nominal GDP can grow even when the supply of money/credit is shrinking. For this to happen, the velocity of money should rise faster than the pace of decline in the supply of money/credit. From a practical perspective, this requires enterprises and consumers to increase the turnover (velocity) of their bank deposits and cash on hand (money supply). We have deliberated in past reports that the velocity of money and the savings rate are inversely related: A rising velocity of money entails a declining savings rate, and vice versa. Going back to our example of bridge construction, the relevant question is: Will companies and households in that province increase their spending (i.e., reduce their savings rate) if banks do not finance the construction of the fourth bridge? The realistic answer is not likely. If the fourth bridge does not receive financing, weaker income growth in that province – due to employment redundancies among construction companies and their suppliers – would lead to slower spending growth. Faced with slowing demand growth, other enterprises and households would likely turn cautious and increase their savings rates – i.e., reduce the velocity of money supply. In short, reduced credit origination will mostly likely generate slower household income growth and, consequently, spending. Chart I-3China: No Deleveraging So Far Broadly speaking, household income growth has not yet downshifted because deleveraging in China has not started. Chart I-3 illustrates that aggregate domestic credit – including public sector, enterprises and households – continues to grow above 10% and well above nominal GDP growth. In fact, credit growth has exceeded nominal GDP growth since 2008. This is local currency credit and does not include foreign currency debt, but the latter is small at 14.5% of GDP (or about US$ 2 trillion). To us, deleveraging implies credit growth that is no greater than nominal GDP growth – i.e., a flat or declining credit-to-GDP ratio for at least several years. If China is serious about deleveraging and curbing its money/credit bubble, the pace of credit expansion should decline to or below nominal GDP growth – which is presently 8%. If and when this occurs it will dampen household income and spending growth. Bottom Line: Chinese household income and spending will inevitably slow if money/credit growth slumps, given the Chinese economy’s excessive reliance on new credit origination over the past 10 years. Do Households Have A Savings Or Debt Glut? What about households’ enormous savings in China? Why wouldn’t households reduce their savings and boost spending? When referring to household savings, most allude to bank deposits. But in conventional economic theory – and according to the way household savings are statistically calculated at a national level – savings actually have no relation to bank deposits. Chart I-4No Empirical Evidence That Deposits = Savings Chart I-4 illustrates that in China, the annual change in household deposits is not equal to household savings (Chart I-4, top panel). Similarly, the annual rise in all deposits (based on central bank data) is vastly different from annual national savings (as defined by conventional macroeconomics and calculated by the National Bureau of Statistics) (Chart I-4, bottom panel). Bank deposits are a monetary concept that we will refer to as “money savings.” Deposits are created by banks “out of thin air,” as illustrated in our past reports.Meanwhile, the term “savings” in conventional macroeconomics denotes goods and services that are produced but not consumed, which is a real economic (not monetary) variable. Not surprisingly, there is no relationship between these “real savings” and “money savings,” as illustrated in Chart I-4. To illustrate that household “savings” (as defined by conventional macroeconomics) are not related to money supply/deposits, let us go back to the example of the company building bridges in China. When the company wire transfers a salary of RMB 1,000 to an employee, the amount of money supply in the banking system does not change. Suppose this employee decides to save 100% of her income this month. Will the supply of money increase or decrease? The answer is that it will not change: the deposit will remain at her bank account. Alternatively, if she decides to spend all RMB 1,000 (100% of her income), the supply of money also will not change – deposits will be transferred to other banks where her suppliers have their accounts.  If she cashes out her deposit and puts it under her mattress, the amount of bank deposits will decline, but cash in circulation will rise by the same amount. Provided money supply is equal to the sum of all bank deposits and cash in circulation, the amount of money supply will not change. The only way the supply of money will decline is if she pays down her loan to a bank. Conversely, the supply of money only rises when banks originate loans or buy assets from non-banks. In short, saving/not spending does not alter the amount of money supply. Rather, broad money supply is equal to the cumulative net money creation “out of thin air” primarily by commercial banks and less so by the central bank over the course of their history. This has nothing to do with household and national “savings.” The latter stand for goods and services produced but not consumed. We have discussed what “savings” mean in conventional economics in past reports. Chart I-5Chinese Households Are More Leveraged Than U.S. Ones Critically, Chinese households presently carry more debt as a share of their disposable income than American households (Chart I-5). This chart compares household debt to disposable income using official data from both China and the U.S. In the case of China, we add Peer-to-Peer (P2P) credit to consumer credit data published by the People’s Bank of China to calculate household debt. The argument by many commentators that consumers in China are not highly leveraged is grounded on the comparison of their debt to GDP. However, in all countries, household debt is assessed versus disposable income – not GDP. The income available to households to service their debt is their disposable income – not GDP. It is correct that Chinese households’ assets have surged in the past two decades as they have purchased significant amounts of real estate, and property prices have skyrocketed. A survey by China Economic Trend Institute holds that property accounts for 66% of household assets in China. To assess creditworthiness, investors should not rely on debtors’ asset values. If debtors are en masse forced to sell their assets to service debt, equity prices would tumble well beforehand. Rather, creditworthiness should be assessed based on recurring cash flow (income) available to debtors to service their debt. One should not be surprised as to why real estate prices are very high in China. Money and credit have been surging – have grown four-fold – over the past 10 years (Chart I-6) and are still expanding at close to a 10% pace. In particular, household debt is still growing at a whopping 15.5% annually (Chart I-7). If and as money/credit growth downshifts, property prices will deflate. Chart I-6Helicopter Money In China Chart I-7Household Credit Is Expanding Twice As Fast As Income Growth Importantly, housing affordability is low and households’ ability to service their mortgages is troubling. Chart I-8 exhibits the nationwide house price-to-income ratio for China and the U.S. In the Middle Kingdom, it is currently about 7.2, while in the U.S. the ratio has never been above 4. It only approached 4  at the peak of the housing bubble in 2006. Chart I-8House Prices Are Very Expensive In China   In turn, Table I-1 illustrates mortgage interest-only payments as a share of household disposable income. The national average is 25.5%. These are very high ratios, suggesting an average new home buyer will have to allocate about a quarter of her or his household income just to pay the interest on a mortgage. These averages do not divulge enormous variations among households. High-income and rich households probably do not have much debt, and debt sustainability is not an issue for them. This also implies that there are many low-income households for whom the interest payments on mortgages absorb more than 25% of their disposable income.  Bottom Line: All deposits in the banking system have been created by banks “out of thin air” and have not been engendered by household savings. Contrary to widespread beliefs, mainland households have a lot of debt, and the latter is still expanding faster than nominal disposable income growth (Chart I-7 above). Positives And The Cyclical Outlook This section lists some positives for household incomes and spending, while also highlighting inherent risks: In the long run, per-capita real income growth in any country is equal to productivity growth. Productivity in China is still booming, justifying high real income growth. The question is whether such buoyant productivity growth can be sustained at a high level to justify robust real-income per-capita growth. Typically, easy money breeds complacency, misallocation of capital and ultimately lower productivity growth. Can China sustain productivity growth of 6% to assure a similar growth rate in real income per capita if the nation continues to experience easy money and a misallocation of capital? Forecasting productivity is not easy; only time will tell. Chart I-9Nominal Household Income, Wages And Salaries Per capita aggregate income as well as both wages and salaries are still expanding briskly – by about 8.5% in nominal terms from a year ago (Chart I-9). This is a formidable growth rate and entails vigorous spending power. The cyclical and long-term concern is whether the current rate of income growth is sustainable. So far there has been few redundancies, despite the fact that corporate revenue and profits have slumped. There is anecdotal evidence that the authorities are actively discouraging dismissals among both state-owned and private enterprises. If layoffs are avoided in this cycle, it will imply that the full pain of the slowdown is absorbed by shareholders. As a result, wages and salaries will rise as a share of GDP, causing a profit margin squeeze for companies. Will private shareholders be willing to invest in the future? Over the past year,  authorities have targeted the stimulus at consumers by cutting personal income taxes. However, this has not boosted consumption: First, the individual taxpayers’ base was very small; only one quarter of total employment (or 16% of the population) was paying personal income taxes before the most recent cut. Second, personal income tax savings have amounted to less than 2% of disposable income.   Finally, the savings from tax cuts are unevenly distributed across households. High-income families will probably get higher tax savings than lower-income ones, whereas the propensity to spend is higher for the latter than the former. Household deposit expansion has accelerated at the expense of enterprises (Chart I-10). This confirms that companies have not slowed the payments to employees (wage bill). Consequently, households have firepower which can be unleashed at any time.  However, there are presently no signs of a growing appetite to spend. Quite the contrary, our proxy for household marginal propensity to spend is falling (Chart I-11). Chart I-10Households Are Hoarding Money, Not Spending Chart I-11Household Marginal Propensity To Spend Is Still Falling Non-discretionary consumer spending has remained very robust. In contrast, discretionary spending has been extremely weak and shows no signs of recovery (Chart I-12). Finally, the impulses of non-government credit, broad money and household credit are weak (Chart I-13). Without these improving substantially and households’ marginal propensity to spend rising, it is difficult to expect a meaningful recovery in consumption. Chart I-12Discretionary Spending Is Sluggish Chart I-13Credit/Money Impulses Are Much Weaker Than In Previous Stimulus Bottom Line: A cyclical recovery in consumer spending hinges on another round of major credit and fiscal stimulus as well as improvement in households’ willingness to spend. Structurally, real income growth is contingent on China’s ability to sustain high productivity growth. Investment Implications If and as capital spending and exports growth slow further, the pace of expansion in consumer expenditure will also moderate. In such a scenario, overall economic growth in China will inevitably downshift. Structurally, Chinese consumer spending will slow from the torrid pace of 10% CAGR of the past 10 years to around 6-7.5% CAGR in real terms. This is a formidable growth rate, and warrants a bullish stance on the consumer sector. We identified Chinese consumers as a major investment theme for the current decade in our 2010 report titled How To Play EM This Decade? 1 In that report, we recommended selling commodities and sectors exposed to Chinese construction and instead favoring consumer plays, especially in the health care and tech sectors. This structural theme has played out well and has further to go. Chinese household spending on health care, education and other high-value services will rise as income per capita expands, albeit at a slower rate than before. Chart I-14 demonstrates that Chinese imports of medical and pharmaceutical products are surging, even though overall imports are currently contracting. Domestically, profit margins are expanding within the medical and pharmaceuticals industries but stagnating for the overall industrial sector (Chart I-15). Chart I-14Surging Demand For Medical Products/Goods Chart I-15Continue Favoring Companies In Health Care/Medical Space All that said, a bullish growth story does not always translate into strong equity returns. Charts I-16A and I-16B reveal that share prices of Chinese investible consumer sub-sectors have had mixed performance. With the exception of Alibaba and Tencent, a few of consumer equity sub-sectors have generated strong equity returns. Chart I-16AChinese Consumer Stocks: Mixed Performance Chart I-16BChinese Consumer Stocks: Mixed Performance Such poor equity performance given strong headline consumption growth has often been due to bottom-up problems such as profit margins squeeze, overexpansion, over-indebtedness, equity dilution, quality of management and other issues. Apart from company specific risks, investors should also consider valuations. Buying good companies in great industries at very high equity multiples will probably produce meager returns. Table I-2 shows the trailing P/E ratio for various consumer sub-sectors. The majority of them trade at a trailing P/E ratio of above 20 and in some cases above 30. Besides, China’s consumer story has been well known for some time, and many portfolios are overweight China consumer plays. Consequently, investor positioning adds to near-term risks. Cyclically, high equity valuations, crowded investor positioning and the delayed cyclical recovery in the Chinese economy pose downside risks to consumer stocks as well. However, such a selloff will create conditions for selectively investing in reasonably valued high quality companies.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Lin Xiang, Research Analyst linx@bcaresearch.com   Footnotes 1      Please see Emerging Markets Strategy Special Report, “How To Play Emerging Market Growth In The Coming Decade”, dated June 10, 2010, available at ems.bcaresearch.com Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights Markets expressed disappointment over last week’s FOMC meeting, … : Equities sold off, Treasury yields slid, and the curve flattened. … but we didn’t think there was all that much to get excited about, … : Data dependence remains the Fed’s mantra, and it was never likely that the FOMC would signal that policy through September has been pre-programmed. … though the specter of escalating trade tensions was a bummer: We have followed our repeated exogenous-shock caveat with an acknowledgement of the gravity of trade barriers. Our geopolitical strategists don’t expect a resolution any time soon, though, and White House tweets are here to stay. Marginally easier monetary policy is not likely to have all that much of an effect on the economy: A reduction in the fed funds rate from 2.5% to 2% isn’t likely to turbo-charge housing or corporate investment, but we do expect that the major central banks’ easing bias will support risk assets. Feature The FOMC delivered the result we expected at the conclusion of its meeting last week: a 25-basis-point cut and a dovish adjustment to its balance sheet runoff plans. Markets acted as if they’d been blindsided. Apparently it really isn’t what you say, it’s how you say it. Or maybe, as our colleague Martin Barnes has long contended, press conferences and all the other assorted communications strategies do more harm than good. We have nearly reached the point of Fed fatigue ourselves, but there’s no ignoring the elephant in the room. The Fed is squarely in the center of every investor’s mind and may well remain there for the rest of what was shaping up as a slow-news month before the latest tariff move. American and Chinese negotiators have called it quits until September; lawmakers have left the building in London and Brussels; the ECB’s Governing Council will be idle until mid-September; and the winnowing of the Democratic field is so far off that even Bill de Blasio remains a presidential candidate. We devote this week’s report to an examination of increased accommodation’s implications for financial markets and the U.S. economy. What did the FOMC do on Wednesday? Chart 1An Adjustment, Not A New Direction The FOMC cut the fed funds rate by 25 basis points, to a range of 2-2.25%, and terminated its modest balance sheet reduction effort two months ahead of time. It studiously kept its options open with regard to future policy rate adjustments, with Chair Powell describing the cut as a “mid-cycle adjustment,” rather than a transition to full-on policy easing. The mid-cycle reference kiboshed hopes that the cut was meant to bring the curtain down on the tightening cycle that began at the end of 2015 (Chart 1). The hawkish surprise concerning the future direction of the fed funds rate overwhelmed the modestly dovish news that the Fed is immediately ending small-scale quantitative tightening. How did markets take the developments? Not so well, especially over the two hours of Wednesday afternoon trading following the decision. The S&P 500 sold off by close to 2% during the press conference, the dollar surged against the euro, and the yield curve flattened as long-dated Treasuries surged while the 2-year note sold off sharply. Equities recovered their losses in Thursday morning’s trading, though bonds and the dollar held much of their gains, before the latest salvo in the U.S.-China dispute sent investors in all markets scurrying for cover. Overall, financial markets were disappointed that they didn’t get a clearer signal that additional accommodation is on the way. Did markets overreact? In retrospect, it looks like they’d gotten their hopes up too high. The Fed wants to avoid surprises by keeping markets apprised of future developments, but it’s hard to envision it deliberately boxing itself in. It wants to preserve the flexibility to act as it sees fit, so data dependence remains the order of the day, just as it has for the last several years. We continue to take the Fed at its word that policy is not on a pre-set course. Markets seemed to be looking for a little more solicitousness from the Fed. Central bankers will presumably always attempt to guard their discretion, but the monetary policy path is far from clear, given elevated economic uncertainty. Between the stop-and-start trade hostilities with China and the Whack-a-Mole emergence of tariff threats against long-standing allies and trade partners, global manufacturing is reeling and corporate managers have every reason to hold back on capex. The differences of opinion within BCA reflect the lack of an obvious economic direction. Dissention within the Fed – Boston’s Rosengren and Kansas City’s George voted against last week’s cut, while Minneapolis’ Kashkari surely wanted it to be larger – shows that the way forward is not so clear-cut. So is it a good thing or a bad thing that the Fed cut rates? We view easier policy as a market positive over the one-year timeframe that drives most investors. There will come a point of diminishing returns, when risk assets no longer respond to incremental accommodation, but we don’t think we’re there yet. Equity multiples have room to expand before they become silly and the ECB is apparently preparing a new round of asset purchases. Given that it’s exhausted the supply of Eurozone sovereigns, it will have to proceed to evicting incumbent holders from their positions somewhat further out the risk curve, prodding them to venture out still further to redeploy the proceeds, putting downward pressure on spreads globally. How will a lower fed funds rate impact the economy? How much time do you have? The textbook answer is that a lower fed funds rate directly reduces the cost of financing big-ticket consumer purchases and corporate initiatives while indirectly nudging households and corporate managers to make them by boosting their confidence. Unconventional measures like asset purchases (QE) push investors further out the risk curve, lifting the prices of risky assets, lowering lending spreads and increasing asset holders’ wealth. They also promote a broader sense of well-being (the CNBC screen is framed in green, print headlines are cheerful, and jobs are increasingly easier to find), fueling confidence that helps reinforce the direct effects of easier policy. As Chair Powell put it in January, “Our policy works through changing financial conditions[,] … it’s … the essence of what we do.” The logic behind the textbook answer is undeniably sound, and it’s displayed in the simple six-channel model in Figure 1. People respond to incentives, and when the cost of consumption and investment falls, they are likely to save less and consume and invest more (Interest Rates/Substitution Effect). Increasing numbers of observers are becoming restless, however, as events on the ground don’t seem to jibe with the theory. Ten years of a negative real fed funds rate has failed to generate much oomph, and markets sputtered on cue once it tiptoed into positive territory (Chart 2), coinciding with the current global economic softness. Chart 2Real Rates Are Still Low Relative To History Martin Barnes, our resident grumpy economist, scoffs at how little extraordinary accommodation has been able to achieve. (Don’t get him started on the communication strategies.) Even after adjusting for how a half-century of Scotland and Montreal weather has colored his perspective, he has a point. “Do you really want to buy equities and riskier bonds in an economy that needs this much help just to grow at 2%?” he might ask. For the time being, yes, we still do. Although the channels promoting economic activity are not functioning as reliably as they have in the past, the channels boosting asset prices – Portfolio Balance, Confidence/Risk Taking, and Interest Rates/Substitution – are still A-Okay (Figure 1). The initial reaction to the FOMC meeting suggests that it will be very hard for the Fed to surprise dovishly in a relative sense, blocking the Currency channel for the time being. The Credit channel is still hindered by post-crisis regulations from Basel to Capitol Hill, at least in terms of the official banking system. Trade tensions have roiled net exports via retaliatory tariffs and suppressed global aggregate demand.1 Shouldn’t housing be at the forefront of any pickup in activity? Chart 3Lower Rates Haven't Helped Much Yet Housing is the classic proxy for tracing the effects of easier policy on the domestic economy, since nearly all of its end consumers finance their purchases, and its domestic concentration insulates it from trade effects. It has failed to respond much to the monetary policy shifts that have brought 30-year fixed mortgage rates down nearly 100 basis points year to date (Chart 3). Fed skeptics suggest that the muted response is evidence of the declining efficacy of easy policy, though we have been inclined to read the data as an indication that homebuilders aren’t building enough starter and move-up homes to bring homeownership within reach of first-time homebuyers and median-income households. Housing should exhibit a high sensitivity to changes in monetary policy, but an abundance of other debt burdens and a lack of affordable supply may be holding it back.   One should have expected that the housing pickup would be muted, and slower to take hold in this expansion, given the severity of the recession and its mortgage-lending roots. Adjusted for inflation, private residential investment, which has declined slightly for four straight quarters, is just over two-thirds of its 2005 peak (Chart 4, middle panel). In the past, residential investment has been more sensitive to the level of the fed funds rate than its direction. Since 1961, the Fed has hiked rates in as many quarters as it has cut them, and the difference in annualized growth has been relatively modest: 2.8% when the Fed has been cutting rates, and 1.6% when it’s been raising them. Chart 4Residential Investment Responds To The Monetary Policy Backdrop... Per our equilibrium fed funds rate framework, we deem monetary policy to be accommodative when the fed funds rate is below our estimate of equilibrium, and restrictive when the funds rate exceeds it (Chart 4, top panel). Despite the fact that the Fed has hiked as often as it has cut since 1961, we estimate that policy has been easy for two-thirds of the time, and the difference in residential investment growth in the two policy states has been dramatic: 6.8% when policy is easy and -6.6% when policy is tight (Chart 4, bottom panel). With the Fed keeping policy easy for longer, housing will have the wind at its back, though it isn’t much more than a breeze at the moment. The same goes for construction employment, which has grown more rapidly under accommodative monetary policy (2.1% versus 0.7% when policy is tight), but has merely treaded water over the last 11 years of easy policy (Chart 5). Chart 5... And So Does Construction Employment The bottom line is that the jury is still out on housing activity. Low mortgage rates will help renters buy homes (and fill them with furniture and appliances), and put more cash in the pockets of homeowners who refinance their existing loans, but the market remains soft. Though it can’t be captured by the aggregate data, it does seem possible that median-income households may be burdened by too much student loan, automobile and/or credit card debt to save the required down payment.2 Disparities between households may well be holding the economy back, but they have a silver lining if they encourage the Fed to pursue accommodative policies for longer than it otherwise would. Will rate cuts give the economy a tangible lift? We don’t know for sure, but no one else does, either. We are convinced that easier monetary conditions will help the economy at the margin. Ten years into the expansion, though, it is not clear if the economy has pent-up demand that easier conditions will help release. Externally, worsening trade tensions could exacerbate the global manufacturing slowdown, further squeezing global aggregate demand, and exporting recession pressures to the U.S. Our mandate is not to forecast the economy in itself, though. We and our clients are investors, not government officials or public-policy professors, and we focus on the economy only to the extent that it impacts financial markets. In the near term, incremental accommodation should boost risk asset prices, provided that trade tensions don’t ratchet up enough to undermine investor, consumer and business confidence. Animal spirits matter, and if they shift decisively from greed and toward fear, they can become a self-fulfilling prophecy that sweeps monetary policy efforts before them. Ex-a significantly negative exogenous event, we remain constructive on the U.S. economy, and continue to look for a global revival outside of the U.S. Investment Implications The incremental information received this week – an FOMC meeting that mostly went off as we expected, a modest escalation in U.S. pressure on China in line with our geopolitical strategists’ warnings that a final deal is not at hand, mixed global manufacturing PMIs, a surge in U.S. consumer confidence, a straight-down-the-middle employment situation report, and an upward inflection in S&P 500 earnings growth that has 2Q EPS now tracking to a 2.7% year-over-year gain – did not change our perspective. We see U.S. economic growth decelerating from its 2018 pace, but remaining above trend, and an absence of imbalances that would make the economy more vulnerable. We have made our peace with recurring flare-ups of hostilities between the U.S. and China, and trade tensions will only change our investment outlook if they worsen materially. The Fed is not magic, but it is doing the best it can to keep the expansion going for the purpose of spreading its gains as broadly as possible, and the easing bias among major central banks is gathering force. On balance, the new information received last week didn’t do anything to change our overall take. We remain constructive, and think investment portfolios should as well. We recognize that the climate is uncertain, and that we should accordingly dial back our conviction. Part of the reason the agency mortgage REITs appeal to us at this juncture is that they offer the opportunity to reduce equity beta and enhance a balanced portfolio’s capacity to absorb shocks. We watched the flattening in the yield curve with dismay, but we continue to expect that incremental monetary accommodation will promote a steeper curve. Easier monetary conditions promote growth, boosting the real component of interest rates, and can stoke inflation pressures when an economy is operating at or above capacity, as the U.S. has been for over a year. We remain vigilant, but our base-case constructive take is unchanged.   Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com Footnotes 1 As we were preparing to go to press on Thursday, the U.S. announced the imposition of new tariff levies on the subset of Chinese imports that hadn’t yet been subjected to tariffs. The move supported our geopolitical strategists’ view that the trade war is unlikely to be settled soon. 2 Andriotis, AnnaMaria; Brown, Ken; and Shifflett, Shane, “Families Go Deep in Debt to Stay in the Middle Class,” Wall Street Journal, August 1, 2019.

Chart Of The WeekEM Profits Contraction Today we are publishing a review of domestic demand conditions in each of the 22 emerging economies we cover. Domestic demand growth is either sluggish, decelerating or contracting in the overwhelming majority of countries. This is in addition to the export contraction currently taking place in many EMs. Consistently, EM overall EPS and small-cap EPS growth rates have fallen to zero in local currency terms (Chart Of The Week). In U.S. dollar terms, overall EM EPS are contracting. The recent dollar weakness versus EM currencies has allowed some EM central banks to cut rates. However, we expect the greenback to strengthen, as we elaborated in last week's report, and that will prevent central banks in high-yielding EMs from easing monetary policy further. Hence, a domestic demand revival in EM is not imminent. We reiterate our negative stance on EM currencies and risk assets. China: Consumer Is Mixed; Capex Is Weak Chart I-1 Chart I-2 India: Domestic Demand Is Decelerating Chart I-3 Chart I-4 Indonesia: Domestic Demand Is Very Weak Chart I-5 Chart I-6 Malaysia: Is The Downturn Late? Chart I-7 Chart I-8 Singapore: Domestic Demand Is Contracting Chart I-9 Chart I-10 Thailand: Stable Domestic Demand Growth Chart I-11 Chart I-12 Philippines: From Boom To Bust? Chart I-13 Chart I-14 Korea: Exports Recession Will Dampen Domestic Demand Chart I-15 Chart I-16 Taiwan: Moderate Domestic Demand Growth Chart I-17 Chart I-18 Vietnam: Robust Domestic Demand Chart I-19 Chart I-20 Brazil: The Economy Needs Stimulus Chart II-1 Chart II-2 Chart II-3 Chart II-4 Mexico: Heading Into A Mild Recession? Chart II-5 Chart II-6 Chile: Heading Into A Recession? Chart II-7 Chart II-8 Chart II-9 Argentina: As Bad As It Gets? Chart II-10 Chart II-11 Chart II-12 Chart II-13​​​​​​ Colombia: Entering Another Downtrend Chart II-14 Chart II-15 Chart II-16 Peru: External Sector Drives Credit Cycle Chart II-17 Chart II-18 South Africa: More Downside Ahead? Chart III-1 Chart III-3 Chart III-2   Turkey: As Bad As It Gets? Chart III-4 Chart III-5 Chart III-6 Chart III-7 Russia: Sluggish Economy Chart III-8 Chart III-9 Chart III-10 Central Europe: Strong Demand/Weak Manufacturing Chart III-11 Chart III-12   Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights U.S. consumption remains robust despite the recent intensification of global growth headwinds. The G-20 meeting will not result in an escalation nor a major resolution of Sino-U.S. tensions. Kicking the can down the road is the most likely outcome. China’s reflationary efforts will intensify, impacting global growth in the second half of 2019. Fearful of collapsing inflation expectations, global central banks are easing policy, which is supporting global liquidity conditions and growth prospects. Bond yields have upside, especially inflation expectations. Equities have some short-term downside, but the cyclical peak still lies ahead. The equity rally will leave stocks vulnerable to the inevitable pick-up in interest rates later this cycle. Gold stocks may provide an attractive hedge for now. A spike in oil prices creates a major risk to our view. Stay overweight oil plays. Feature Global growth has clearly deteriorated this year, and bond yields around the world have cratered. German yields have plunged below -0.3% and U.S. yields briefly dipped below 2%. Even if the S&P 500 remains near all-time highs, the performance of cyclical sectors relative to defensive ones is corroborating the message from the bond market. Bonds and stocks are therefore not as much in disagreement as appears at first glance. To devise an appropriate strategy, now more than ever investors must decide whether or not a recession is on the near-term horizon. Answering yes to this question means bond prices will continue to rise, the dollar will rally further, stocks will weaken, and defensive stocks will keep outperforming cyclical ones. Answering no, one should sell bonds, sell the dollar, buy stocks, and overweight cyclical sectors. The weak global backdrop can still capsize the domestic U.S. economy. We stand in the ‘no’ camp: We do not believe a recession is in the offing and, while the current growth slowdown has been painful, it is not the end of the business cycle. Logically, we are selling bonds, selling the dollar and maintaining a positive cyclical stance on stocks. We also expect international equities to outperform U.S. ones, and we are becoming particularly positive on gold stocks. Oil prices should also benefit from the upcoming improvement in global growth. Has The U.S. Economy Met Its Iceberg? Investors betting on a recession often point to the inversion of the 3-month/10-year yield curve and the performance of cyclical stocks. However, we must also remember Paul Samuelson’s famous quip that “markets have predicted nine of the five previous recessions.” In any case, these market moves tell us what we already know: growth has weakened. We must decide whether it will weaken further. A simple probit model based on the yield curve slope and the new orders component of the ISM Manufacturing Index shows that there is a 40% probability of recession over the next 12 months. We need to keep in mind that in 1966 and 1998, this model was flagging a similar message, yet no recession followed over the course of the next year (Chart I-1). This means we must go back and study the fundamentals of U.S. growth. Chart I-1The Risk Of A Recession Has Risen, But It Is Not A No Brainer Chart I-2Lower Rates Will Help Residential Investment On the purely domestic front, the U.S. economy is not showing major stresses. Last month, we argued that we are not seeing the key symptoms of tight monetary policy: Homebuilders remain confident, mortgage applications for purchases are near cyclical highs, homebuilder stocks have been outperforming the broad market for three quarters, and lumber prices are rebounding.1 Moreover, the previous fall in mortgage yields is already lifting existing home sales, and it is only a matter of time before residential investment follows (Chart I-2). Households remain in fine form. Real consumer spending is growing at a 2.8% pace, and despite rising economic uncertainty, the Atlanta Fed GDPNow model expects real household spending to expand at a 3.9% rate in the second quarter (Chart I-3). This is key, as consumers’ spending and investment patterns drive the larger trends in the economy.2 Chart I-3Consumers Are Spending Chart I-4The Labor Market Is Still Doing Fine... Going forward, we expect consumption to stay the course. Despite its latest dip, consumer confidence remains elevated, household debt levels have fallen from 134% of disposable income in 2007 to 99% today, and debt-servicing costs only represent 9.9% of after-tax income, a multi-generational low. In this context, stronger household income growth should support spending. The May payrolls report is likely to have been an anomaly. Layoffs are still minimal, initial jobless claims continue to flirt near 50-year lows, the Conference Board’s Leading Credit index shows no stress, and the employment components of both the manufacturing and non-manufacturing ISM are at elevated levels (Chart I-4). If these leading indicators of employment are correct, both the employment-to-population ratio for prime-age workers and salaries have upside (Chart I-5), especially as productivity growth is accelerating. Despite these positives, the weak global backdrop can still capsize the domestic U.S. economy, and force the ISM non-manufacturing PMI to converge toward the manufacturing index. If global growth worsens, the dollar will strengthen, quality spreads will widen and stocks will weaken, resulting in tighter financial conditions. Since economic and trade uncertainty is still high, further deterioration in external conditions will cause U.S. capex to collapse. Employment would follow, confidence suffer and consumption fall. Global growth still holds the key to the future. Following The Chinese Impulse As the world’s foremost trading nation, Chinese activity lies at the center of the global growth equation. The China-U.S. trade war remains at the forefront of investors’ minds. The meeting between U.S. President Donald Trump and Chinese President Xi Jinping over the next two days is important. It implies a thawing of Sino-U.S. trade negotiations. However, an overall truce is unlikely. An agreement to resume the talks is the most likely outcome. No additional tariffs will be levied on the remaining $300 billion of untaxed Chinese exports to the U.S., but the previous levies will not be meaningfully changed. Removing this $300 billion Damocles sword hanging over global growth is a positive at the margin. However, it also means that the can has been kicked down the road and that trade will remain a source of headline risk, at least until the end of the year. Chart I-6The Rubicon Has Been Crossed Trade uncertainty will nudge Chinese policymakers to ease policy further. In previous speeches, Premier Li Keqiang set the labor market as a line in the sand. If it were to deteriorate, the deleveraging campaign could be put on the backburner. Today, the employment component of the Chinese PMI is at its lowest level since the Great Financial Crisis (Chart I-6). This alone warrants more reflationary efforts by Beijing. Adding trade uncertainty to this mix guarantees additional credit and fiscal stimulus. More Chinese stimulus will be crucial for Chinese and global growth. Historically, it has taken approximatively nine months for previous credit and fiscal expansions to lift economic activity. We therefore expect that over the course of the summer, the imports component of the Chinese PMI should improve further, and the overall EM Manufacturing PMI should begin to rebound (Chart I-7, top and second panel). More generally, this summer should witness the bottom in global trade, as exemplified by Asian or European export growth (Chart I-7, third and fourth panel). The prospect for additional Chinese stimulus means that the associated pick-up in industrial activity should have longevity. Global central banks are running a brand new experiment. We are already seeing one traditional signpost that Chinese stimulus is having an impact on growth. Within the real estate investment component of GDP, equipment purchases are growing at a 30% annual rate, a development that normally precedes a rebound in manufacturing activity (Chart I-8, top panel). We are also keeping an eye out for the growth of M1 relative to M2. When Chinese M1 outperforms M2, it implies that demand deposits are growing faster than savings deposits. The inference is that the money injected in the economy is not being saved, but is ready to be deployed. Historically, a rebounding Chinese M1 to M2 ratio accompanies improvements in global trade, commodities prices, and industrial production (Chart I-8, bottom panel). Chart I-7The Turn In Chinese Credit Will Soon Be Felt Around The World Chart I-8China's Stimulus Is Beginning To Have An Impact   To be sure, China is not worry free. Auto sales are still soft, global semiconductor shipments remain weak, and capex has yet to turn the corner. But the turnaround in credit and in the key indicators listed above suggests the slowdown is long in the tooth. In the second half of 2019, China will begin to add to global growth once again. Advanced Economies’ Central Banks: A Brave New World Chart I-9The Inflation Expectations Panic While China is important, it is not the only game in town. Global central banks are running a brand new experiment. It seems they have stopped targeting realized inflation and are increasingly focused on inflation expectations. The collapse in inflation expectations is worrying central bankers (Chart I-9). Falling anticipated inflation can anchor actual inflation at lower levels than would have otherwise been the case. It also limits the downside to real rates when growth slows, and therefore, the capacity of monetary policy to support economic activity. Essentially, central banks fear that permanently depressed inflation expectations renders them impotent. The change in policy focus is evident for anyone to see. As recently as January 2019, 52% of global central banks were lifting interest rates. Now that inflation expectations are collapsing, other than the Norges Bank, none are doing so (Chart I-10). Instead, the opposite is happening and the RBA, RBNZ and RBI are cutting rates. Moreover, as investors are pricing in lower policy rates around the world, G-10 bond yields are collapsing, which is easing global liquidity conditions. Indeed, as Chart I-11 illustrates, when the share of economies with falling 2-year forward rates is as high as it is today, the BCA Global Leading Indicator rebounds three months later. Chart I-10Central Banks Are In Easing Mode, Everywhere The European Central Bank stands at the vanguard of this fight. As we argued two months ago, deflationary pressures in Europe are intact and are likely to be a problem for years to come.3 The ECB is aware of this headwind and knows it needs to act pre-emptively. Four months ago, it announced a new TLRTO-III package to provide plentiful funding for stressed banks in the European periphery. On June 6th, ECB President Mario Draghi unveiled very generous financing terms for the TLTRO-III. Last week, at the ECB’s Sintra conference in Portugal, ECB Vice President Luis de Guindos professed that the ECB could cut rates if inflation expectations weaken. The following day, Draghi himself strongly hinted at an upcoming rate cut in Europe and a potential resumption of the ECB QE program. These measures are starting to ease financial conditions where Europe needs it most: Italy. An important contributor to the contraction in the European credit impulse over the past 21 months was the rapid tightening in Italian financial conditions that followed the surge in BTP yields from May 2018. Now that the ECB is becoming increasingly dovish, Italian yields have fallen to 2.1%, and are finally below the neutral rate of interest for Europe. BTP yields are again at accommodative levels. Chart I-11This Much Of An Easing Bias Boosts Growth Prospects With financial conditions in Europe easing and exports set to pick up in response to Chinese growth, European loan demand should regain some vigor. Meanwhile, the TLTRO-III measures, which are easing bank funding costs, should boost banks’ willingness to lend. The European credit impulse is therefore set to move back into positive territory this fall. European growth will rebound, and contribute to improving global growth conditions. The Fed’s Patience Is Running Out The Federal Reserve did not cut interest rates last week, but its intentions to do so next month were clear. First, the language of the statement changed drastically. Gone is the Fed’s patience; instead, there is an urgency to “act as appropriate to sustain the expansion.” Second, the fed funds rate projections from the Summary of Economic Projections were meaningfully revised down. In March, 17 FOMC participants expected the Fed to stay on hold for the remainder of 2019, while six foresaw hikes. Today, eight expect a steady fed funds rate, but seven are calling for two rate cuts this year. Only one member is still penciling in a hike. Moreover, nine out of 17 participants anticipate that rates will be lower in 2020 than today (Chart I-12). The FOMC’s unwillingness to push back very dovish market expectations signals an imminent interest rate cut. Like other advanced economy central banks, the Fed’s sudden dovish turn is aimed at reviving moribund inflation expectations (Chart I-13). In order to do so, the Fed will have to keep real interest rates at low levels, at least relative to real GDP growth. Even if the real policy rate goes up, so long as it increases more slowly than GDP growth, it will signify that money supply is growing faster than money demand.4 TIPS yields are anticipating these dynamics and will likely remain soft relative to nominal interest rates. Chart I-13...As Inflation Expectations Plunge Since the Fed intends to conduct easy monetary policy until inflation expectations have normalized to the 2.3% to 2.5% zone, our liquidity gauges will become more supportive of economic activity and asset prices over the coming two to three quarters: Our BCA Monetary indicator has not only clearly hooked up, it is now above the zero line, in expansionary territory (see Section III, page 41). Excess money growth, defined as money-of-zero-maturity over loan growth, is once again accelerating. This cycle, global growth variables such as our Global Nowcast, BCA’s Global Leading Economic Indicator, or worldwide export prices have all reliably followed this variable (Chart I-14). After collapsing through 2018, our U.S. Financial Liquidity Index is rebounding sharply, and the imminent end of the Fed’s balance sheet runoff will only solidify this progress. This indicator gauges how cheap and plentiful high-powered money is for global markets. Its recovery suggests that commodities, globally-traded goods prices, and economic activity are all set to improve (Chart I-15). Chart I-14Excess Money Has Turned Up Chart I-15Improving Liquidity Conditions Argue That Nominal Growth Will Pick Up...   The dollar is losing momentum and should soon fall, which will reinforce the improvement in global liquidity conditions. A trough in our U.S. Financial Liquidity Index is often followed by a weakening dollar (Chart I-16). Moreover, the Greenback’s strength has been turbocharged by exceptional repatriations of funds by U.S. economic agents (Chart I-17). The end of the repatriation holiday along with a more dovish Fed and the completion of the balance sheet runoff will likely weigh on the dollar. Once the Greenback depreciates, the cost of borrowing for foreign issuers of dollar-denominated debt will decline, along with the cost of liquidity, especially if the massive U.S. repatriation flows are staunched. This will further support global growth conditions. Chart I-16...And That The Dollar Will Turn Down... Trade relations are unlikely to deteriorate further, China is likely to stimulate more aggressively; and easing central banks around the world, including the Fed, are responding to falling inflation expectations. This backdrop points to a rebound in global growth in the second half of the year. As a corollary, the deflationary patch currently engulfing the world should end soon after. As a result, this growing reflationary mindset should delay any recession until late 2021 if not 2022. However, as the business cycle extends further, greater inflationary pressures will build down the road and force the Fed to lift rates – even more than it would have done prior to this wave of easing. Chart I-17...Especially If Repatriation Flows Slow Investment Implications Bonds BCA’s U.S. Bond Strategy service relies on the Golden Rule of Treasury Investing. This simple rule states that when the Fed turns out to be more dovish than anticipated by interest rate markets 12 months prior, Treasurys outperform cash. If the Fed is more hawkish than was expected by market participants, Treasurys underperform (Chart I-18). Today, the Treasury market’s outperformance is already consistent with a Fed generating a very dovish surprise over the next 12 months. However, the interest rate market is already pricing in a 98% probability of two rates cuts this year, and the December 2020 fed funds rate futures imply a halving of the policy rate. The Fed is unlikely to clear these very tall dovish hurdles as global growth is set to rebound, the fed funds rate is not meaningfully above neutral and the household sector remains resilient. Chart I-18Treasurys Already Anticipate Large Dovish Surprises Reflecting elevated pessimism toward global growth, the performance of transport relative to utilities stocks is as oversold as it gets. The likely rebound in this ratio should push yields higher, especially as foreign private investors are already aggressively buying U.S. government securities (Chart I-19). As occurred in 1998, Treasury yields should rebound soon after the Fed begins cutting rates. Moreover, with all the major central banks focusing on keeping rates at accommodative levels, the selloff in bonds should be led by inflation breakevens, also as occurred in 1998 (Chart I-20), especially if the dollar weakens. Chart I-19Yields Will Follow Transportation Relative To Utilities Stocks Chart I-201998: Yields Rebounded As Soon As The Fed Began Cutting     Equities A global economic rebound should provide support for equities on a cyclical horizon. The tactical picture remains murky as the stock market may have become too optimistic that Osaka will deliver an all-encompassing deal. However, this short-term downside is likely to prove limited compared to the cyclical strength lying ahead. This is particularly true for global equities, where valuations are more attractive than in the U.S. Chart I-21Easier Liquidity Conditions Lead To Higher Stock Prices Even if the S&P 500 isn’t the prime beneficiary of the recovery in global growth, it should nonetheless generate positive absolute returns on a cyclical horizon. As Chart I-21 illustrates, a pickup in our U.S. Financial Liquidity Index often precedes a rally in U.S. stocks. Since the U.S. Financial Liquidity Index has done a superb job of forecasting the weakness in stocks over the past 18 months, it is likely to track the upcoming strength as well. A weaker dollar should provide an additional tailwind to boost profit growth, especially as U.S. productivity is accelerating. This view is problematic for long-term investors. The cheapness of stocks relative to bonds is the only reason why our long-term valuation index is not yet at nosebleed levels Chart I-22). If we are correct that the current global reflationary push will build greater inflationary pressures down the road and will ultimately result in even higher interest rates, this relative undervaluation of equities will vanish. The overall valuation index will then hit near-record highs, leaving the stock market vulnerable to a very sharp pullback. Long-term investors should use this rally to lighten their strategic exposure to stocks, especially when taking into account the risk that populism will force a retrenchment in corporate market power, an issue discussed in Section II. Gone is the Fed’s patience; instead, there is an urgency to “act as appropriate to sustain the expansion.” In this environment, gold stocks are particularly attractive. Central banks are targeting very accommodative policy settings, which will limit the upside for real rates. Moreover, generous liquidity conditions and a falling dollar should prove to be great friends to gold. These fundamentals are being amplified by a supportive technical backdrop, as gold prices have broken out and the gold A/D line keeps making new highs (Chart I-23). Chart I-22Beware What Will Happen To Valuations Once Rates Rise Again Chart I-23Strong Technical Backdrop For The Gold   Structural forces reinforce these positives for gold. EM reserve managers are increasingly diversifying into gold, fearful of growing geopolitical tensions with the U.S. (Chart I-24). Meanwhile, G-10 central banks are not selling the yellow metal anymore. This positive demand backdrop is materializing as global gold producers have been focused on returning cash to shareholders instead of pouring funds into capex. This lack of investment will weigh on output growth going forward. Chart I-24EM Central Banks Are Diversifying Into Gold This emphasis on returning cash to shareholders makes gold stocks particularly attractive. Gold producers are trading at a large discount to the market and to gold itself as investors remain concerned by the historical lack of management discipline. However, boosting dividends, curtailing debt levels and only focusing on the most productive projects ultimately creates value for shareholders. A wave of consolidation will only amplify these tailwinds. Our overall investment recommendation is to overweight stocks over bonds on a cyclical horizon while building an overweight position in gold equities. Our inclination to buy gold stocks transcends our long-term concerns for equities, as rising long-term inflation should favor gold as well. The Key Risk: Iran The biggest risk to our view remains the growing stress in the Middle East. BCA’s Geopolitical Strategy team assigns a less than 40% chance that tensions between the U.S. and Iran will deteriorate into a full-fledged military conflict. The U.S.’s reluctance to respond with force to recent Iranian provocations may even argue that this probability could be too high. Nonetheless, if a military conflict were to happen, it would involve a closing of the Strait of Hormuz, a bottleneck through which more than 20% of global oil production transits. In such a scenario, Brent prices could easily cross above US$150/bbl. Chart I-25Oil Inventories Are Set To Decline To mitigate this risk, we recommend overweighting oil plays in global portfolios. Not only would such an allocation benefit in the event of a blow-up in the Persian Gulf, oil is supported by positive supply/demand fundamentals and Brent should end the year $75/bbl. After five years of limited oil capex, Wood Mackenzie estimates that the supply of oil will be close to 5 million barrels per day smaller than would have otherwise been the case. Moreover, OPEC and Russia remain disciplined oil producers, which is limiting growth in crude output today. Meanwhile, in light of the global growth deceleration, demand for oil has proved surprisingly robust. Demand is likely to pick up further when global growth reaccelerates in the second half of the year. As a result, BCA’s Commodity and Energy Strategy currently expects additional inventory drawdowns that will only push oil prices higher in an environment of growing global reflation (Chart I-25). A falling dollar would accentuate these developments.   Mathieu Savary Vice President The Bank Credit Analyst June 27, 2019 Next Report: July 25, 2019   II. The Productivity Puzzle: Competition Is The Missing Ingredient Productivity growth is experiencing a cyclical rebound, but remains structurally weak. The end of the deepening of globalization, statistical hurdles, and the possibility that today’s technological advances may not be as revolutionary as past ones all hamper productivity. On the back of rising market power and concentration, companies are increasing markups instead of production. This is depressing productivity and lowering the neutral rate of interest. For now, investors can generate alpha by focusing on consolidating industries. Growing market power cannot last forever and will meet a political wall. Structurally, this will hurt asset prices.   “We don’t have a free market; don’t kid yourself. (…) Businesspeople are enemies of free markets, not friends (…) businesspeople are all in favor of freedom for everybody else (…) but when it comes to their own business, they want to go to Washington to protect their businesses.” Milton Friedman, January 1991. Despite the explosion of applications of growing computing power, U.S. productivity growth has been lacking this cycle. This incapacity to do more with less has weighed on trend growth and on the neutral rate of interest, and has been a powerful force behind the low level of yields at home and abroad. In this report, we look at the different factors and theories advanced to explain the structural decline in productivity. Among them, a steady increase in corporate market power not only goes a long way in explaining the lack of productivity in the U.S., but also the high level of profit margins along with the depressed level of investment and real neutral rates. A Simple Cyclical Explanation The decline in productivity growth is both a structural and cyclical story. Historically, productivity growth has followed economic activity. When demand is strong, businesses can generate more revenue and therefore produce more. The historical correlation between U.S. nonfarm business productivity and the ISM manufacturing index illustrates this relationship (Chart II-1). Chart II-1The Cyclical Behavior Of Productivity Chart II-2Deleveraging Hurts Productivity Since 2008, as households worked off their previous over-indebtedness, the U.S. private sector has experienced its longest deleveraging period since the Great Depression. This frugality has depressed demand and contributed to lower growth this cycle. Since productivity is measured as output generated by unit of input, weak demand growth has depressed productivity statistics. On this dimension, the brief deleveraging experience of the early 1990s is instructive: productivity picked up only after 1993, once the private sector began to accumulate debt faster than the pace of GDP growth (Chart II-2). The recent pick-up in productivity reflects these debt dynamics. Since 2009, the U.S. non-financial private sector has stopped deleveraging, removing one anchor on demand, allowing productivity to blossom. Moreover, the pick-up in capex from 2017 to present is also helping productivity by raising the capital-to-workers ratio. While this is a positive development for the U.S. economy, the decline in productivity nonetheless seems structural, as the five-year moving average of labor productivity growth remains near its early 1980s nadir (Chart II-3). Something else is at play. The Usual Suspects Three major forces are often used to explain why observed productivity growth is currently in decline: A slowdown in global trade penetration, the fact that statisticians do not have a good grasp on productivity growth in a service-based economy, and innovation that simply isn’t what it used to be. Slowdown In Global Trade Penetration Two hundred years ago, David Ricardo argued that due to competitive advantages, countries should always engage in trade to increase their economic welfare. This insight has laid the foundation of the argument that exchanges between nations maximizes the utilization of resources domestically and around the world. Rarely was this argument more relevant than over the past 40 years. On the heels of the supply-side revolution of the early 1980s and the fall of the Berlin Wall, globalization took off. The share of the world's population participating in the global capitalist system rose from 30% in 1985 to nearly 100% today. The collapse in new business formation in the U.S. is another fascinating development. Generating elevated productivity gains is simpler when a country’s capital stock is underdeveloped: each unit of investment grows the capital-to-labor ratio by a greater proportion. As a result, productivity – which reflects the capital-to-worker ratio – can grow quickly. As more poor countries have joined the global economy and benefitted from FDI and other capital inflows, their productivity has flourished. Consequently, even if productivity growth has been poor in advanced economies over the past 10 years, global productivity has remained high and has tracked the share of exports in global GDP (Chart II-4). Chart II-4The Apex Of Globalization Represented The Summit Of Global Productivity Growth This globalization tailwind to global productivity growth is dissipating. First, following an investment boom where poor decisions were made, EM productivity growth has been declining. Second, with nearly 100% of the world’s labor supply already participating in the global economy, it is increasingly difficult to expand the share of global trade in global GDP and increase the benefit of cross-border specialization. Finally, the popular backlash in advanced economies against globalization could force global trade into reverse. As economic nationalism takes hold, cross-border investments could decline, moving the world economy further away from an optimal allocation of capital. These forces may explain why global productivity peaked earlier this decade. Productivity Is Mismeasured Recently deceased luminary Martin Feldstein argued that the structural decline in productivity is an illusion. As the argument goes, productivity is not weak; it is only underestimated. This is pure market power, and it helps explain the gap between wages and productivity. A parallel with the introduction of electricity in the late 19th century often comes to mind. Back then, U.S. statistical agencies found it difficult to disentangle price changes from quantity changes in the quickly growing revenues of electrical utilities. As a result, the Bureau Of Labor Statistics overestimated price changes in the early 20th century, which depressed the estimated output growth of utilities by a similar factor. Since productivity is measured as output per unit of labor, this also understated actual productivity growth – not just for utilities but for the economy as a whole. Ultimately, overall productivity growth was revised upward. Chart II-5Plenty Of Room To Mismeasure Real Output Growth In today’s economy, this could be a larger problem, as 70% of output is generated in the service sector. Estimating productivity growth is much harder in the service sector than in the manufacturing sector, as there is no actual countable output to measure. Thus, distinguishing price increases from quantity or quality improvements is challenging. Adding to this difficulty, the service sector is one of the main beneficiaries of the increase in computational power currently disrupting industries around the world. The growing share of components of the consumer price index subject to hedonic adjustments highlight this challenge (Chart II-5). Estimating quality changes is hard and may bias the increase in prices in the economy. If prices are unreliably measured, so will output and productivity. Chart II-6A Multifaceted Decline In Productivity Pushing The Production Frontier Is Increasingly Hard Another school of thought simply accepts that productivity growth has declined in a structural fashion. It is far from clear that the current technological revolution is much more productivity-enhancing than the introduction of electricity 140 years ago, the development of the internal combustion engine in the late 19th century, the adoption of indoor plumbing, or the discovery of penicillin in 1928. It is easy to overestimate the economic impact of new technologies. At first, like their predecessors, the microprocessor and the internet created entirely new industries. But this is not the case anymore. For all its virtues, e-commerce is only a new method of selling goods and services. Cloud computing is mainly a way to outsource hardware spending. Social media’s main economic value has been to gather more information on consumers, allowing sellers to reach potential buyers in a more targeted way. Without creating entirely new industries, spending on new technologies often ends up cannibalizing spending on older technologies. For example, while Google captures 32.4% of global ad revenues, similar revenues for the print industry have fallen by 70% since their apex in 2000. If new technologies are not as accretive to production as the introduction of previous ones were, productivity growth remains constrained by the same old economic forces of capex, human capital growth and resource utilization. And as Chart II-6 shows, labor input, the utilization of capital and multifactor productivity have all weakened. Some key drivers help understand why productivity growth has downshifted structurally. Chart II-8Demographics Are Hurting Productivity Let’s look at human capital. It is much easier to grow human capital when very few people have a high-school diploma: just make a larger share of your population finish high school, or even better, complete a university degree. But once the share of university-educated citizens has risen, building human capital further becomes increasingly difficult. Chart II-7 illustrates this problem. Growth in educational achievement has been slowing since 1995 in both advanced and developing economies. This means that the growth of human capital is slowing. This is without even wading into whether or not the quality of education has remained constant. Human capital is also negatively impacted by demographic trends. Workers in their forties tend to be at the peak of their careers, with the highest accumulated job know-how. Problematically, these workers represent a shrinking share of the labor force, which is hurting productivity trends (Chart II-8). The capital stock too is experiencing its own headwinds. While Moore’s Law seems more or less intact, the decline in the cost of storing information is clearly decelerating (Chart II-9). Today, quality adjusted IT prices are contracting at a pace of 2.3% per annum, compared to annual declines of 14% at the turn of the millennium. Thus, even if nominal spending in IT investment had remained constant, real investment growth would have sharply decelerated (Chart II-10). But since nominal spending has decelerated greatly from its late 1990s pace, real investment in IT has fallen substantially. The growth of the capital stock is therefore lagging its previous pace, which is hurting productivity growth. Chart II-10The Impact Of Slowing IT Deflation Chart II-11A Dearth Of New Businesses   The collapse in new business formation in the U.S. is another fascinating development (Chart II-11). New businesses are a large source of productivity gains. Ultimately, 20% of productivity gains have come from small businesses becoming large ones. Think Apple in 1977 versus Apple today. A large decline in the pace of new business formation suggests that fewer seeds have been planted over the past 20 years to generate those enormous productivity explosions than was the case in the previous 50 years. The X Factor: Growing Market Concentration Chart II-12Wide Profit Margins: A Testament To The Weakness Of Labor The three aforementioned explanations for the decline in productivity are all appealing, but they generally leave investors looking for more. Why are companies investing less, especially when profit margins are near record highs? Why is inflation low? Why has the pace of new business formation collapsed? These are all somewhat paradoxical. This is where a growing body of works comes in. Our economy is moving away from the Adam Smith idea of perfect competition. Industry concentration has progressively risen, and few companies dominate their line of business and control both their selling prices and input costs. They behave as monopolies and monopsonies, all at once.1 This helps explain why selling prices have been able to rise relative to unit labor costs, raising margins in the process (Chart II-12). Let’s start by looking at the concept of market concentration. According to Grullon, Larkin and Michaely, sales of the median publicly traded firms, expressed in constant dollars, have nearly tripled since the mid-1990s, while real GDP has only increased 70% (Chart II-13).2 The escalation in market concentration is also vividly demonstrated in Chart II-14. The top panel shows that since 1997, most U.S. industries have experienced sharp increases in their Herfindahl-Hirshman Index (HHI),3 a measure of concentration. In fact, more than half of U.S. industries have experienced concentration increases of more than 40%, and as a corollary, more than 75% of industries have seen the number of firms decline by more than 40%. The last panel of the chart also highlights that this increase in concentration has been top-heavy, with a third of industries seeing the market share of their four biggest players rise by more than 40%. Rising market concentration is therefore a broad phenomenon – not one unique to the tech sector.     This rising market concentration has also happened on the employment front. In 1995, less than 24% of U.S. private sector employees worked for firms with 10,000 or more employees, versus nearly 28% today. This does not seem particularly dramatic. However, at the local level, the number of regions where employment is concentrated with one or two large employers has risen. Azar, Marinescu and Steinbaum developed Map II-1, which shows that 75% of non-metropolitan areas now have high or extreme levels of employment concentration.4 Chart II-15The Owners Of Capital Are Keeping The Proceeds Of The Meagre Productivity Gains This growing market power of companies on employment can have a large impact on wages. Chart II-15 shows that real wages have lagged productivity since the turn of the millennium. Meanwhile, Chart II-16 plots real wages on the y-axis versus the HHI of applications (top panel) and vacancies (bottom panel). This chart shows that for any given industry, if applicants in a geographical area do not have many options where to apply – i.e. a few dominant employers provide most of the jobs in the region – real wages lag the national average. The more concentrated vacancies as well as applications are with one employer, the greater the discount to national wages in that industry.5 This is pure market power, and it helps explain the gap between wages and productivity as well as the widening gap between metropolitan and non-metropolitan household incomes. Growing market power and concentration do not only compress labor costs, they also result in higher prices for consumers. This seems paradoxical in a world of low inflation. But inflation could have been even lower if market concentration had remained at pre-2000s levels. In 2009, Matthew Weinberg showed that over the previous 22 years, horizontal mergers within an industry resulted in higher prices.6 In a 2014 meta-study conducted by Weinberg along with Orley Ashenfelter and Daniel Hosken, the authors showed that across 49 studies ranging across 21 industries, 36 showed that horizontal mergers resulted in higher prices for consumers.7 While today’s technology may be enhancing the productive potential of our economies, this is not benefiting output and measured productivity. Instead, it is boosting profit margins. In a low-inflation environment, the only way for companies to garner pricing power is to decrease competition, and M&As are the quickest way to achieve this goal. After examining nearly 50 merger and antitrust studies spanning more than 3,000 merger cases, John Kwoka found that, following mergers that augmented an industry’s concentration, prices increased in 95% of cases, and on average by 4.5%.8 In no industry is this effect more vividly demonstrated than in the healthcare field, an industry that has undergone a massive wave of consolidation – from hospitals, to pharmacies to drug manufacturers. As Chart II-17 illustrates, between 1980 and 2016, healthcare costs have increased at a much faster pace in the U.S. than in the rest of the world. However, life expectancy increased much less than in other advanced economies. In this context of growing market concentration, it is easy to see why, as De Loecker and Eeckhout have argued, markups have been rising steadily since the 1980s (Chart II-18, top panel) and have tracked M&A activity (Chart II-18, bottom panel).9 In essence, mergers and acquisitions have been the main tool used by firms to increase their concentration. Another tool at their disposal has been the increase in patents. The top panel of Chart II-19 shows that the total number of patent applications in the U.S. has increased by 3.6-fold since the 1980s, but most interestingly, the share of patents coming from large, dominant players within each industry has risen by 10% over the same timeframe (Chart II-19, bottom panel). To use Warren Buffet’s terminology, M&A and patents have been how firms build large “moats” to limit competition and protect their businesses. Chart II-18Markups Rise Along With Growing M&A Activity Chart II-19How To Build A Moat?   Why is this rise in market concentration affecting productivity? First, from an empirical perspective, rising markups and concentration tend to lead to lower levels of capex. A recent IMF study shows that the more concentrated industries become, the higher the corporate savings rate goes (Chart II-20, top panel).10 These elevated savings reflect wider markups, but also firms with markups in the top decile of the distribution display significantly lower investment rates (Chart II-20, bottom panel). If more of the U.S. output is generated by larger, more concentrated firms, this leads to a lower pace of increase in the capital stock, which hurts productivity.   Second, downward pressure on real wages is also linked to a drag on productivity. Monopolies and oligopolies are not incentivized to maximize output. In fact, for any market, a monopoly should lead to lower production than perfect competition would. Diagram II-I from De Loecker and Eeckhout shows that moving from perfect competition to a monopoly results in a steeper labor demand curve as the monopolist produces less. As a result, real wages move downward and the labor participation force declines. Does this sound familiar? The rise of market power might mean that in some way Martin Feldstein was right about productivity being mismeasured – just not the way he anticipated. In a June 2017 Bank Credit Analyst Special Report, Peter Berezin showed that labor-saving technologies like AI and robotics, which are increasingly being deployed today, could lead to lower wages (Chart II-21).11 For a given level of technology in the economy, productivity is positively linked to real wages but inversely linked to markups – especially if the technology is of the labor-saving kind. So, if markups rise on the back of firms’ growing market power, the ensuing labor savings will not be used to increase actual input. Rather, corporate savings will rise. Thus, while today’s technology may be enhancing the productive potential of our economies, this is not benefiting output and measured productivity. Instead, it is boosting profit margins.12 Unsurprisingly, return on assets and market concentration are positively correlated (Chart II-22).     Finally, market power and concentration weighing on capex, wages and productivity are fully consistent with higher returns of cash to shareholders and lower interest rates. The higher profits and lower capex liberate cash flows available to be redistributed to shareholders. Moreover, lower capex also depresses demand for savings in the economy, while weak wages depress middle-class incomes, which hurts aggregate demand. Additionally, higher corporate savings increases the wealth of the richest households, who have a high marginal propensity to save. This results in higher savings for the economy. With a greater supply of savings and lower demand for those savings, the neutral rate of interest has been depressed. Investment Implications First, in an environment of low inflation, investors should continue to favor businesses that can generate higher markups via pricing power. Equity investors should therefore continue to prefer industries where horizontal mergers are still increasing market concentration. Second, so long as the status quo continues, wages will have a natural cap, and so will the neutral rate of interest. This does not mean that wage growth cannot increase further on a cyclical basis, but it means that wages are unlikely to blossom as they did in the late 1960s, even within a very tight labor market. Without too-severe an inflation push from wages, the business cycle could remain intact even longer, keeping a window open for risk assets to rise further on a cyclical basis. Third, long-term investors need to keep a keen eye on the political sphere. A much more laissez-faire approach to regulation, a push toward self-regulation, and a much laxer enforcement of antitrust laws and merger rules were behind the rise in market power and concentration.13 The particularly sharp ascent of populism in Anglo-Saxon economies, where market power increased by the greatest extent, is not surprising. So far, populists have not blamed the corporate sector, but if the recent antitrust noise toward the Silicon Valley behemoths is any indication, the clock is ticking. On a structural basis, this could be very negative for asset prices. An end to this rise in market power would force profit margins to mean-revert toward their long-term trend, which is 4.7 percentage-points below current levels. This will require discounting much lower cash flows in the future. Additionally, by raising wages and capex, more competition would increase aggregate demand and lift real interest rates. Higher wages and aggregate demand could also structurally lift inflation. Thus, not only will investors need to discount lower cash flows, they will have to do so at higher discount rates. As a result, this cycle will likely witness both a generational peak in equity valuations as well as structural lows in bond yields. As we mentioned, these changes are political in nature. We will look forward to studying the political angle of this thesis to get a better handle on when these turning points will likely emerge. Mathieu Savary Vice President The Bank Credit Analyst   III. Indicators And Reference Charts Over the past two weeks, the ECB has made a dovish pivot, President Trump announced he would meet President Xi, and the Fed telegraphed a rate cut for July. In response, the S&P 500 made marginal new highs before softening anew. This lack of continuation after such an incredible alignment of stars shows that the bulls lack conviction. These dynamics increase the probability that the market sells off after the G-20 meeting, as we saw last December following the supposed truce in Buenos Aires. The short-term outlook remains dangerous. Our Revealed Preference Indicator (RPI) confirms this intuition. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive readings from the policy and valuation measures. Conversely, if stong market momentum is not supported by valuation and policy, investors should lean against the market trend. Cheaper valuations, a pick-up in global growth or an actual policy easing is required before stocks can resume their ascent. The cyclical outlook is brighter than the tactical one. Our Willingness-to-Pay (WTP) indicator for the U.S. and Japan continues to improve. However, it remains flat in Europe. The WTP indicator tracks flows, and thus provides information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. In aggregate, the WTP currently suggests that investors are still inclined to add to their stock holdings. Hence, we expect global investors will continue to buy the dips. Our Monetary Indicator is moving deeper into stimulative territory, supporting our cyclically constructive equity view. The Fed and the ECB are set to cut rates while other global central banks have been opening the monetary spigots. This will support global monetary conditions. The BCA Composite Valuation Indicator, an amalgamation of 11 measures, is in overvalued territory, but it is not high enough to negate the positive message from our Monetary Indicator, especially as our Composite Technical Indicator remains above its 9-month moving average. These dynamics confirm that despite the near-term downside, equities have more cyclical upside. According to our model, 10-year Treasurys are now expensive. Moreover, our technical indicator is increasingly overbought while the CRB Raw Industrials is oversold, a combination that often heralds the end of bond rallies. Additionally, duration surveys show that investors have very elevated portfolio duration, and both the term premium and Fed expectations are very depressed. Considering this technical backdrop, BCA’s economic view implies minimal short-term downside for yields, but significant downside for Treasury prices over the upcoming year. On a PPP basis, the U.S. dollar remains very expensive. Additionally, after forming a negative divergence with prices, our Composite Technical Indicator is falling quickly. Being a momentum currency, the dollar could suffer significant downside if this indicator falls below zero. Monitor these developments closely. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation Chart III-6U.S. Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance   FIXED INCOME: Chart III-9U.S. Treasurys And Valuations Chart III-10Yield Curve Slopes Chart III-11Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets   CURRENCIES: Chart III-16U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning   ECONOMY: Chart III-28U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot Chart III-30U.S. Growth Outlook Chart III-31U.S. Cyclical Spending Chart III-32U.S. Labor Market Chart III-33U.S. Consumption Chart III-34U.S. Housing Chart III-35U.S. Debt And Deleveraging   Chart III-36U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China   Mathieu Savary Vice President The Bank Credit Analyst Footnotes 1       Please see The Bank Credit Analyst "June 2019," dated May 30, 2019, available at bca.bcaresearch.com 2       Please see Global Investment Strategy Special Report "Give Credit Where Credit Is Due," dated November 27, 2015, available at gis.bcaresearch.com 3       Please see The Bank Credit Analyst Special Report "Europe: Here I Am, Stuck In A Liquidity Trap," dated April 25, 2019, available at bca.bcaresearch.com 4       Money demand is mostly driven by the level of activity and wealth. If the price of money – interest rates – is growing more slowly than money demand, the most likely cause is that money supply is increasing faster than money demand and policy is accommodative. 5       A monopsony is a firm that controls the price of its input because it is the dominant, if not unique, buyer of said input. 6       G. Grullon, Y. Larkin and R. Michaely, “Are Us Industries Becoming More Concentrated?,” April 2017. 7       The Herfindahl-Hirschman Index (HHI) is calculated by taking the market share of each firm in the industry, squaring them, and summing the result. Consider a hypothetical industry with four total firm where firm1, firm2, firm3 and firm4 has 40%, 30%, 15% and 15% of market share, respectively. Then HHI is 402+302+152+152 = 2,950. 8       J. Azar, I. Marinescu, M. Steinbaum, “Labor Market Concentration,” December 2017. 9     J. Azar, I. Marinescu, M. Steinbaum, “Labor Market Concentration,” December 2017. 10     M. Weinberg, “The Price Effects Of Horizontal Mergers”, Journal of Competition Law & Economics, Volume 4, Issue 2, June 2008, Pages 433–447. 11     O. Ashenfelter, D. Hosken, M. Weinberg, "Did Robert Bork Understate the Competitive Impact of Mergers? Evidence from Consummated Mergers," Journal of Law and Economics, University of Chicago Press, vol. 57(S3), pages S67 - S100. 12    J. Kwoka, “Mergers, Merger Control, and Remedies: A Retrospective Analysis of U.S. Policy,” MIT Press, 2015. 13     J. De Loecker, J. Eeckhout, G. Unger, "The Rise Of Market Power And The Macroeconomic Implications," Mimeo 2018. 14     “Chapter 2: The Rise of Corporate Market Power and Its Macroeconomic Effects,” World Economic Outlook, April 2019. 15     Please see The Bank Credit Analyst Special Report "Is Slow Productivity Growth Good Or Bad For Bonds?"dated May 31, 2017, available at bca.bcaresearch.com. 16     Productivity can be written as: 17     J. Tepper, D. Hearn, “The Myth of Capitalism: Monopolies and the Death of Competition,” Wiley, November 2018. EQUITIES:FIXED INCOME:CURRENCIES:COMMODITIES:ECONOMY: