Economy

Highlights Looking past the day-to-day noise of trade-related announcements, we view the underlying odds of an actual trade agreement this year to have fallen below 50%. For the purposes of investment strategy, China-exposed investors should now simply assume that the U.S. proceeds with 25% tariffs on all imports from China. Given this, investors should stop focusing strictly on the odds of trade war, and should instead start focusing on the likely net impact of the tariff shock and China’s inevitable policy response. Simulated and empirical estimates of the impact of a 25% increase in tariffs affecting all U.S.-China trade suggest that economic conditions in China are likely to deteriorate to 2015/2016-like levels. This implies that a 2015/2016-style policy response will again be required in order for policymakers to be confident that the shock will be overcome. The preference of policymakers is to prevent another significant episode of releveraging, but the constraints facing policymakers suggest that one is unlikely to be avoided. We see a meaningful chance that this tension will be resolved by a classic market “riot” over the coming 3 months as financial markets force reluctant policymakers to capitulate. We would not recommend a long position in Chinese stocks, either in absolute terms or relative to the global benchmark, for investors with a time horizon of less than 3 months. However, over a strictly cyclical (i.e. 6-12 month) time horizon, we would recommend staying long/overweight on the basis that policymakers will ultimately respond as needed. We recommend investors hedge the inherent RMB exposure from a long US$ cyclical position in Chinese stocks by opening a long USD-CNH trade. Feature U.S. and Chinese negotiators failed last week to secure an agreement deferring the threatened increase in the second round tariff rate.1 The tariffs increased on Thursday at midnight for goods not already in transit to the U.S. (effectively doubling the existing tariffs), which was followed by the inevitable retaliation by China on Monday (scheduled to take effect on June 1). The retaliation, coupled with President Trump’s earlier warning that China should not do so, was taken by investors as a sign that 25% tariffs on all goods imported from China will soon be in place. As we go to press, the S&P 500, Hang Seng China Enterprises Index, and the CSI 300 are down 3.5%, 7%, and 6.9%, respectively, since President Trump’s May 5 tweet (Chart 1). Chart 1Investors Are Starting To Price In 25% Tariffs Affecting All U.S.-China Trade Stimulus Minus Shock Holding all else equal, the events of the past two weeks are strictly negative for Chinese economic growth and would thus justify a decisively bearish outlook for Chinese stock prices after the rally that has taken place over the past six months. However, all is not equal, because a substantial deterioration in the export outlook will invariably cause a response from Chinese policymakers. Over the coming few weeks, global investors are likely to remain highly focused on developments and announcements related to the trade conflict. But at this point, our geopolitical team believes that the conclusion of an actual trade agreement this year is now only a 40% probability. This underscores that China-exposed investors should, for the purposes of investment strategy, simply assume that the U.S. proceeds with 25% tariffs on all imports from China, and should broaden their focus to the outcome of a simple formula that describes the potential net outcome of this event. Two simple scenarios concerning this formula are outlined below: Scenario 1 (Bullish): Stimulus – Shock > 0 Scenario 2 (Bearish): Stimulus – Shock ≤ 0 In scenario 1, the impact of China’s reflationary efforts more than offsets the negative shock to aggregate demand from the sharp decline in exports to the U.S. In this scenario, investors should actually have a bullish cyclical outlook for China-related assets, even if the near-term outlook is deeply negative. Scenario 2 denotes a bearish outcome where China’s reflationary response is not larger than the magnitude of the shock, which includes a circumstance where the impacts are exactly offsetting (because of the higher uncertainty, and thus risk premium, that this would entail). “Solving” The Formula In order to “solve” this formula, investors need answers to the following three questions: What is the size and disposition of the likely shock to China’s economy in a full-tariff scenario? What kind of reflationary response is required in order to offset this shock? What are the odds that policymakers will deliver the required response? Simulated and empirical estimates of a 25% increase in tariffs affecting all U.S.-China trade suggest a sizeable economic impact. Charts 2 & 3 provide the IMF’s perspective on the first question. The charts show the simulated impact of a 25% increase in tariffs affecting all U.S.-China trade, and they estimate the near-term impact for China to be -1.25% for real GDP (-0.5% over the long-run) and -3.5% for real exports (-4.5% to -5.5% over the long run).   A recent IMF working paper came up with a more benign estimate of the first year impact, but a sizeable second year impact and a similar estimate of the long-term ramifications of tariff increases.2 Using a dataset with wide time and country coverage, the aggregate results of the study imply that Chinese output is only likely to fall about 0.2% in the year following the tariff increase. However, the cumulative shock to output increased sharply to roughly 1.6% in the second year of the tariff increase, with a negative yearly impact to output persisting for 5 years (with an average annual impact of -0.6% over the whole period, somewhat higher than the estimates shown in Charts 2 & 3). At the 90% confidence interval, the author’s estimates show that a tariff increase of this magnitude would imply a -1.7% average impact on output per year in the first two years following the increase. Chart 4The IMF's Shock Estimates Suggest A Serious Hit To China's Economy In order to answer the second question, investors need to have some sense of the relative magnitude of the estimates noted above. Chart 4 provides some perspective and highlights that the estimates above, were they to materialize, would do two things: Taking Chinese real GDP data at face value, it would cause the largest deceleration in China’s real GDP growth rate since 2012, when the economy slowed significantly and authorities responded forcefully. Based on the most recent data for Chinese real export growth, a 3.5% deceleration in export volume would push its growth rate to its lowest level since the global financial crisis. In practice, we doubt that China’s reported real GDP growth rate accurately reflects what occurred in 2015, and it is very possible that a similar deceleration happened in that year. However, economic similarity to the 2015/2016 episode implies that a similar policy response may also be required, a proposition that is supported by our MSCI China Index earnings recession model. Table 1 shows a set of earnings recession probabilities, based on a model that we presented in two recent reports.3 The scenarios express the odds as a function of new credit to GDP and our calculation of China’s export weighted exchange rate, and assume a substantial decline in the new export orders component of the official manufacturing PMI, and flat momentum in forward earnings. Table 1Our Earnings Recession Model Suggests That A 2015/2016 Style Response Is Needed To Counter This Shock The table clearly highlights that a significant further acceleration in new credit to GDP, coupled with a meaningful decline in the exchange rate, is needed in order to stabilize the earnings outlook. We have previously related stability in the outlook for earnings to stability in the economy itself, given the close correlation between Chinese investment-relevant economic activity and the earnings cycle (Chart 5). Given that new credit to GDP peaked at 31.5% during the 2015/2016 episode, it seems reasonable to conclude that a 2015/2016-style policy response will again be required in order for policymakers to be confident that the shock will be overcome. Policymaker Preferences Vs. Constraints This brings us to our third question: What are the odds that policymakers will deliver the stimulus required to confidently overcome the upcoming shock? It seems reasonable to conclude that a 2015/2016-style policy response will again be required in order for policymakers to be confident that the shock will be overcome. If the answer was only dependent on the preferences of policymakers, the odds would be low. China has relied heavily on credit to stimulate its economy over the past decade, and Chart 6 highlights that this has come at a high cost. The BIS’ estimate of the debt service ratio of China’s private non-financial sector is already extraordinarily high relative to other countries, and another round of meaningful re-leveraging will just make this problem even worse. Chart 5Earnings Stability = Economic ##br##Stability Chart 6Further Leveraging Will Undoubtedly Make A Big Problem Even Worse   We documented in detail how this has created the risk of a debt trap for China’s state-owned enterprises in an August Special Report,4 and have presented evidence arguing that China’s policymakers appear to have good economic reasons to try and shift China’s economy away from extremely high rates of investment towards more consumption.5 This implies that restraining credit growth to avoid further leveraging has been a reasonable policy objective during periods of relative economic stability. However, policy decisions cannot be made in a vacuum, and this is true even in the case of China. As such, instead of preferences, investors should be focused on policymaker constraints in judging likely policy actions. Given the potential for second round effects, Chinese policymakers need to calibrate their policy response to ensure a positive net impact of the stimulus minus the shock. In our view, three factors point to the conclusion that Chinese policymakers face serious economic constraints in setting their policy response: Charts 2-4 highlighted that 25% tariffs on all U.S.-China trade would constitute a meaningful shock, but it is also the case that this shock would be coming at a time when Chinese economic momentum is already relatively weak. This suggests that policymakers will have to act quickly and decisively to put a floor under economic activity. Charts 7 & 8 suggest that there are meaningful second round effects on Chinese domestic investment from external sector shocks, which raises the possibility that the impact on Chinese economic activity may be larger than Charts 2-4 suggest. Chart 7 shows that while the contribution to official real GDP growth from net exports is small, Chart 8 shows that past changes in net export contribution are reasonably correlated with subsequent changes in the contribution to growth from gross capital formation. While it is possible that this relationship is not actually causal, taking it at face value implies that the IMF’s estimate of the impact on output could be exceeded if the contribution to growth from net exports declines by 0.4% or more (holding the contribution to growth from final consumption expenditure constant). Since 2018’s change in net export contribution declined by three times this amount (1.2%), the downside risks to domestic investment from effectively quadrupling U.S. import tariffs are clear. China does not have a flexible labor market, and its political system is highly sensitive to significant job losses. Chart 9 shows that the employment situation has already seriously deteriorated in lockstep with actual economic activity, further underscoring the need for policymakers to act urgently. Chart 9The Employment Situation Is Already Deteriorating, And Will Do So Further We are open to the idea that policymakers may be able to devise a stimulative response of similar reflationary magnitude to the 2015/2016 episode without resorting to a major credit overshoot, but we are currently unable to articulate what it might be. This is an area of ongoing research for BCA’s China Investment Strategy service, but for now we assume that a credit overshoot remains the ultimate line of defense for China’s policymakers that will be deployed if the pursuit of alternative strategies fail to quickly stabilize economic activity. Investment Strategy Conclusions In our view, focusing on policymaker constraints rather than their preferences is much more likely to guide investors towards the right strategy conclusions over a 6-12 month time horizon. However, in the near-term, policy mistakes can occur, and are much more likely to occur if policymakers react to the imposition of constraints rather than anticipate their arrival. Over the coming three months, we see meaningful odds that Chinese policymakers remain reluctant to allow another episode of significant releveraging in the economy. If we are correct in our assessment of the damage that the tariff shock is likely to cause, this would set up a classic market “riot”, where policymakers are forced by financial markets to capitulate and respond forcefully to the seriousness of the economic situation. Further RMB weakness is likely. Investors should hedge their exposure and go long USD-CNH. Chart 10Investors Have A Green Light To Bet On A Lower RMB Given this, we would not recommend a long position in Chinese stocks, either in absolute terms or relative to the global benchmark, for investors with a time horizon of less than 3 months. However, over a cyclical (i.e. 6-12 month) time horizon, we would recommend staying long/overweight on the basis that policymakers will ultimately deliver the stimulus required to more than offset the upcoming shock to external demand. This means that our long MSCI China Index, MSCI China A onshore index, and MSCI China Growth index trades relative to the global benchmark are explicitly cyclical in orientation, and may suffer meaningful further losses over the coming few months before ultimately recovering. As a final point, Table 1 highlighted that a meaningful decline in the exchange rate is likely required in order to stabilize the earnings outlook. Chart 10 shows that currency weakness persisted well past the trough in relative Chinese investable equity performance during the 2015/2016 episode, and we would expect a similar result in the current environment given the nature of the shock. As such, we recommend investors hedge the inherent RMB exposure from a long US$ cyclical position in Chinese stocks by opening a long USD-CNH trade today, with high odds of a break above 7 in the coming weeks. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com Footnotes 1 The first, second, third “round” of tariffs reference the $50/$200/$300 billion tranches of imported goods subject to U.S. tariff announcements since last summer. 2 IMF Working Paper WP/19/9, “Macroeconomic Consequences of Tariffs”, by Davide Furceri, Swarnali A. Hannan, Jonathan D. Ostry, and Andrew K. Rose. 3 Please see China Investment Strategy Special Report “Six Questions About Chinese Stocks,” dated January 16, 2019, and Weekly Report “A Gap In The Bridge,” dated January 30, 2019 available at cis.bcaresearch.com. 3 Please see China Investment Strategy Special Report “Chinese Policymakers: Facing A Trade-Off Between Growth And Leveraging,” dated August 29, 2018, available at cis.bcaresearch.com. 4  Please see China Investment Strategy Weekly Report “Is China Making A Policy Mistake?,” dated October 31, 2018, available at cis.bcaresearch.com.   Cyclical Investment Stance Equity Sector Recommendations

Highlights We were on the road last week, discussing our economic and market outlooks: We met with a range of Midwestern clients who focus primarily on the U.S. A majority of our meetings were with fixed-income teams. The Fed will ultimately decide the fate of the expansion, … : Nearly everyone wanted to get a read on how much longer the expansion will last. We offered the view that the Fed will induce the next recession, provided that an exogenous event doesn’t beat it to the punch. … and inflation will be the catalyst that prompts the Fed to act: Inflation was typically far from investors’ minds, and several of our meetings centered on what will drive it, and where and when we expect it will show up. Feature We traveled throughout the Midwest last week, discussing our outlook for financial markets and the economy with a range of investors. We got the sense that our clients are constructive about the economy and are generally open to tilting portfolios in a risk-friendly direction, albeit somewhat grudgingly. They recognized the challenge that worsening U.S.-China trade relations would pose to a constructive call, but were content to wait for more information before adjusting their views or their portfolios. Our views continue to follow the outline we’ve laid out in our written reports. In the absence of economic or financial market excesses, or an exogenous shock that induces a material slowdown, we expect the expansion to roll on until the Fed begins to fear that it’s gone too far and imposes restrictive monetary policy settings to rein it in. Until it does, we expect that the equity bull market will continue and spread product will deliver positive excess returns over Treasuries. The investment strategy takeaway is that it is too early to de-risk portfolios. De-risking will become the order of the day once the Fed resumes tightening monetary conditions via rate hikes. There is currently no sign that the Fed is contemplating a meaningfully hawkish shift, but we expect that inflation pressures will eventually force its hand. Ten years of subdued inflation have made a mockery of recurring post-crisis inflation warnings, and clients have developed a robust immunity to them. What, they wanted to know, has changed enough to resuscitate inflation? Steroid-Fueled Demand Aggregate demand crashed during the crisis and was far short of the economy’s capacity when it bottomed in mid-2009. In economics lingo, that meant that the U.S. economy faced a sizable negative output gap when it embarked on the recovery/expansion. Although the economy grew at a tepid 2% rate over the ensuing decade, capacity grew even more slowly, held back by consistently weak capital expenditures, and the output gap finally closed around the beginning of 2018 (Chart 1), removing a stout inflation-absorbing buffer. Chart 1The Excess Capacity Cushion Is Gone The United States then poured fuel on the fire by injecting a significant quantity of stimulus into an economy that was already operating at capacity. Corporations and other businesses that viewed the pickup in aggregate demand as a one-off event refrained from expanding capacity to meet that demand, as it appeared as if it would be a poor use of capital. Imported goods from economies that still have excess capacity can relieve some of the pressure of inadequate domestic supply, but they’re unlikely to absorb all of the pressure from excess demand, even in the absence of new tariff barriers. The aggregate 2018-19 stimulus shapes up as a catalyst for higher prices. Capacity vastly exceeded demand when the economy began to turn around ten years ago, but the stimulus package has made it look a little thin. The trouble is that no one can pinpoint exactly when upward price pressures will reveal themselves. Inflation is the mother of all lagging indicators, peaking and bottoming well after business cycle transitions suggest it should (Chart 2). All we can say is that the steroid injection from the stimulus planted the seeds of inflation. Just when they’ll begin to sprout is uncertain, but we believe the Fed’s pause will give them a chance to take root. Wage Inflation The labor market is so tight that it squeaks. The unemployment rate has fallen to a 49-year low; baby boomer retirements will cap the labor force participation rate around its current level (Chart 3, top panel); and discouraged workers (Chart 3, middle panel) and involuntary part-time workers are few and far between (Chart 3, bottom panel). Now that it has been absorbed, the glut of idled workers will no longer serve as a buffer neutralizing upward wage pressures. The labor market is tight as a drum. The pool of discouraged workers and involuntary part-timers is smaller than it was at the last two cyclical peaks, while employer demand is more robust. Employees are starting to gain bargaining power. The Job Openings and Labor Turnover Survey (JOLTS) indicates that demand for new workers is intense. As a share of total filled positions, job openings are at an all-time high in the 18-year history of the series (Chart 4, middle panel). No one quits a job unless s/he has another one lined up, and it almost always requires higher pay to induce an employee to jump from Employer A to Employer B. The elevated quit rate thus reveals that employers are poaching workers from each other to meet that demand (Chart 4, bottom panel). After Employer B lures an employee away from Employer A, Employer A hires a worker from Employer C or Employer D, which now has an opening it needs to fill. The employment merry-go-round creates a self-reinforcing cycle pushing wages higher and endowing employees with newfound bargaining power. Chart 3With Fewer Workers On The Sidelines … Chart 4… Employers Have Turned To Poaching Self-sustaining wage gains could produce price-level increases via a demand-pull or a cost-push mechanism. In a demand-pull framework, businesses observing steady payroll expansions and increased household income may well attempt to push through selling price increases. Under cost-push, corporations raise prices in an attempt to offset increased labor costs. Then again, the pass-through from wage inflation to price inflation might not occur at all, as the dynamics of inflation are not fully understood. What The Fed Believes Investors may be frustrated by the lack of a clear connection between wages and prices, but they should not be put off by a little ambiguity – there would be no alpha without uncertainty. An absence of realized inflation does not eliminate the prospect of rate hikes. Our Inflation → Rate Hikes → Restrictive Monetary Policy → Recession → Bear Market roadmap may still come to pass. The first step in the chain would simply have to be perceived inflation as opposed to realized inflation, and it’s the Fed’s perception that drives monetary policy, not the public’s. As we stressed in our Special Report on the Phillips curve,1 there is no alternative explanation in mainstream economics connecting the dots between the elements of the Fed’s dual mandate. Every mainstream economic model posits an inverse relationship between inflation and the unemployment rate. Every economist learned about the expectations-augmented Phillips curve multiple times in the course of his or her undergraduate and graduate studies. Until the profession settles on an alternative narrative, the Fed and other major central banks will be beholden to the Phillips curve. The connection between wages and prices is a mystery, but the Phillips curve’s place in mainstream economics remains secure. It’s easy to talk of patience when inflation has been hibernating for ten years, even with the unemployment rate at 49-year lows, but once wage gains begin to exceed 3.5% and 4%, we expect the Fed will change its tune. Wages do not respond to changes in the unemployment rate when there’s ample slack in the labor market, but they do once it becomes difficult to find employees. The varying sensitivity of changes in wages at different levels of unemployment explains the kink in the Phillips curve, but we found the NAIRU-based unemployment gap2 to be a reliable proxy for identifying the point at which the labor market meaningfully tightens (Chart 5). Chart 5NAIRU, … The natural rate of unemployment is only a concept, however, and the CBO series we use to calculate the unemployment gap is subject to retroactive adjustments intended to better match the CBO’s estimates with real-world observations. We therefore incorporated two alternative measures of labor market slack to test the robustness of the unemployment-gap framework. The first is the Jobs Plentiful/Jobs Hard To Get responses from the Conference Board’s consumer confidence survey. The top panel of Chart 6 calculates the difference between Jobs Hard To Get and Jobs Plentiful; when it’s positive (negative), survey respondents are indicating that the labor market is soft (tight). The disparity in wage growth between the soft and the tight states, as estimated by the hoi polloi, is a little larger than under the CBO’s revised NAIRU estimates, suggesting Main Street may be better positioned to evaluate labor-market dynamics than D Street (the CBO’s address). Chart 6… The Consumer Confidence Survey, … To get away from the arbitrariness of the unemployment rate and the uncertainty of NAIRU estimates, we considered the employment gap from the perspective of the prime-age (non-)employment-to-population ratio (Chart 7). It also supports the conclusion that wage gains are a function of the degree of labor market slack, but the outlier results from the crisis render the mean non-employment ratio since 1985 a less-than-perfect boundary between tightness and slack. The prime-age (non-)employment-to-population ratio better fits the standard Phillips curve framework, producing a solidly linear relationship (Chart 8). It points to further wage gains as prime-age employment increases. Chart 7… And Prime-Age (Non-)Employment All Point To Faster Wage Gains If productivity continues to grow by leaps and bounds – the fourth-quarter gain was impressive, the first-quarter’s was eye-popping – the Fed won’t feel much pressure to hike rates. Productivity is a function of capital expenditures; workers are able to increase output when they’re provided with more and better tools. Capex has been extremely weak ever since the crisis in the U.S. and the rest of the world, however, and we do not think that investors should count on productivity remaining much above its low 1%-plus trend level of the last several years. Investment Implications The ultimate effect of the Fed’s pause will be to extend the duration of the expansion, assuming that an exogenous shock does not pull the plug on it. Extending the expansion will have the effect of extending the equity bull market, and the period in which spread product generates positive excess returns over Treasuries. There is no free lunch, and dovishness now will be offset by hawkishness later. Larger bull-market gains will ultimately be countered by larger bear-market losses. That is a concern for another day, however, and we continue to recommend that investors remain at least equal weight equities and spread product in balanced portfolios. We do not see a recession until the second half of 2020 at the earliest. Our best guess is that it will begin around the middle of 2021, so it is too early to de-risk portfolios or shift to a more defensive asset allocation profile.   Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com   Footnotes 1 Please see the U.S. Investment Strategy Special Report,  “The Phillips Curve: Science Or Superstition?”, published February 26, 2019. Available at usis.bcaresearch.com. 2 The unemployment gap in the top panel of Chart 5 is calculated by subtracting the Congressional Budget Office’s estimate of NAIRU from the official unemployment rate. NAIRU, or the natural rate of unemployment (u*), is the minimum unemployment rate that would exist even in a full-employment economy. It results from structural factors like skill and geographic mismatches. The CBO currently estimates that NAIRU is 4.7%; the Fed’s dots suggest that it estimates u* is around 4.6%.  

Special Report

We are strongly committed to our 2 percent inflation objective and to achieving it on a sustained and symmetric basis. – Jerome Powell, May 1, 2019 St Louis Fed President James Bullard, a voting member of the central bank’s policy committee, said he “certainly would be open to a cut” should inflation continue to fall short of expectations after the summer. – Financial Times, May 3, 2019 The Federal Reserve’s preferred measure of prices (the core personal consumption deflator) rose by 1.6% in the year to March, a shortfall from the 2% inflation target. Moreover, the 10-year-moving average of core inflation has remained persistently below the 2% level over the past 17 years (Chart 1). Recent comments from some policymakers and market analysts highlight growing concerns about this shortfall. Personally, I see little to worry about. Chart 1Core Inflation: Not Quite At 2% For investors, high and rising inflation is a terrible thing, as is its even more evil twin, a high and accelerating pace of deflation. The Holy Grail for investors and policymakers alike is for actual inflation and inflation expectations to remain both low and stable. It seems to me that this has been achieved, with resulting huge benefits to the economy and financial markets. It matters little that inflation has fallen slightly short of the arbitrary 2% target. If inflation was problematically low, what might we expect to see? Importantly, companies would be complaining about a tough pricing environment and pressure on profits. Yet, S&P 500 profit margins are close to an all-time high (Chart 2). And that is providing powerful support to the stock market, with the S&P 500 also close to its highs. If there were building deflationary pressures in the economy, then it also would be reasonable to expect spreading signs of economic distress. While not every indicator is flashing green, the overall economy is doing just fine. Healthy employment growth, rising real wages and strong profits are more consistent with a nascent inflation problem than with deflation. According to the National Federation of Independent Business survey, small companies’ main problem is the quality of labor, not concerns about demand. Excessively low inflation is a problem for debtors, but loan delinquency rates – albeit a lagging indicator – are well contained. The Fed makes a big deal about the importance of keeping inflation expectations anchored – i.e. stable at a low level. There does not appear to be any major problem on this front. For example, the New York Fed’s survey of consumers shows median expected inflation of 2.9% in three years’ time (Chart 3). The University of Michigan Survey of Consumers shows expected inflation of 2.3% over the next 5-10 years. The gap between nominal and real 10-year Treasury yields – a proxy for financial market inflation expectations – is lower (currently 1.88%), but that measure moves around a lot and is highly correlated with oil prices. No measures of expected inflation are in free-fall or dangerously low. Chart 2No Signs Of Pricing Distress Chart 3Inflation Expectations Are Contained   What If? Suppose that the Fed had been prescient enough to realize 10 years ago that, despite its best efforts, core inflation would average only 1.6% rather than the desired 2% over the coming decade. Presumably, the Fed would have taken even more extreme actions than actually occurred, implying a bigger expansion of its balance sheet. It is unclear whether it would have been any more successful in pushing up actual inflation. But we can be sure that it would have further inflated asset prices and encouraged even more leverage in the corporate sector. Increased financial imbalances in the economy – asset price overshoots and greater leverage – would not have been an attractive trade-off to pushing up inflation by an average 40 basis points. The core problem is that monetary policy is ill-equipped to deal with the forces that have held back economic growth. A combination of demographics, high debt and slower productivity growth have limited the U.S. economy’s potential. Thus, I have a lot of sympathy for Larry Summer’s secular stagnation thesis. Yes, that implies that the real equilibrium interest rate is very low and, therefore, that monetary policy needs to be accommodative. But it also implies that force-feeding the system with easy money is more likely to lead to asset bubbles and financial distortions than to increased consumer price inflation. What About Policy Ammo For The Next Downturn? One of the main arguments for getting inflation up is to give the Fed more scope to ease policy in the next recession. In the past, the Fed has cut the funds rate by an average of around 500 basis points during recessions. Going into the next downturn with inflation and thus interest rates close to current levels means it would not take long for the funds rate reach the constraints of the zero bound. However, this also would be the case if core inflation was at or modestly above the 2% target. That is why some commentators (e.g. Olivier Blanchard and Larry Summers) have argued for an inflation target of 4% during good times in order to allow for a large fall in interest rates when times turn bad. As long as inflation is in moderate single digits, its stability probably is more important than its level. In other words, if inflation was at 4% and was expected by all economic and financial agents to remain at that level for the foreseeable future, then the economy should not perform any worse than if inflation had stabilized at 2% - and it might even perform better. However, central banks have long had the view that the higher the inflation rate, the less stable it would be. And the same logic would apply to the downside if there was deflation. For example, once inflation rises from 2% to 4%, then it could easily move from 4% to 6% etc. Given the challenges of fine-tuning monetary policy, that view has merit. Raising the inflation target is all very well, but if central banks are having trouble getting the rate to 2%, how on earth would they get it to 4%. And the same point applies if the Fed were to shift from targeting the inflation rate to targeting the level of prices or of nominal GDP. If boosting the Fed’s balance sheet from less than $1 trillion to $4.5 trillion did not get inflation to 2%, what would it take to get inflation to 4%? It is always possible to increase inflation. For example, the government could give all households a check for $10,000 that had to be spent on domestically-produced goods and services. Furthermore, assume the checks were valid only for one year and the fiscal costs were directly financed by the Fed. This would undoubtedly unleash a powerful consumer boom and a spike in inflation. And the government could keep repeating the exercise until a sustained inflation upturn took hold. But that is an unrealistic scenario except in the event of an Armageddon economic situation. And it hardly would fit in with keeping inflation stable at a modestly higher pace. A recession is very likely within the next couple of years and monetary policy will indeed face major constraints on its actions. We undoubtedly would see renewed quantitative easing on a heroic scale with an expanded range of assets purchased by the central bank. And advocates of Modern Monetary Theory may well have their wishes granted with direct monetary financing of fiscal deficits. But, as already noted, policymakers would face these policy challenges regardless of whether inflation was modestly below or above the 2% target. Be Careful What You Wish For The Fed spent three decades squeezing inflation out of the system. In the 1970s and 1980s, high inflation expectations were deeply embedded in the behavior of consumers, companies and investors. It was a long and at times painful process to change that psychology. With inflation expectations now in the range of 2% to 3%, the Fed can claim success. Why would they want to risk undoing that achievement? Letting the economy run hot to try and offset sub-2% inflation with a period of above-2% inflation would be a dangerous strategy. History shows us that central banks have both limited understanding of the inflation process and limited control over the economy. If policymakers were successful in raising inflation, they run the risk that expectations would no longer be anchored. Moreover, the Fed would have a massive problem in communicating the logic of a pro-inflation strategy. Having spent so long in selling the message that low and stable inflation is the best way to maximize long-run economic growth, it likely would create considerable confusion to then say that a period of higher inflation was acceptable. Investors and businesses would face huge uncertainty about the magnitude and duration of an inflation overshoot and about whether the Fed could even control the process. The Fed’s credibility undoubtedly would suffer. It is true that policymakers know how to bring inflation back under control – they simply have to tighten policy. But that introduces increased instability into the economy and financial markets. Rather than be obsessed about hitting the 2% target, policymakers should be happy that they have met the requirements of the Federal Reserve Act: “to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” The Policy Outlook And Market Implications The Fed was right to stop raising interest rates. The economy does not appear to be on the verge of overheating and there are enough risks to the outlook to warrant a cautious wait-and-see approach to policy. Yet, I am somewhat troubled by the dovish tone of some Fed officials. Thank goodness President Trump’s recent choices for Fed Board positions are now out of the picture. If I am worried now, I can only imagine how much worse I would have felt with Stephen Moore and Herman Cain on the Board. With no recession on the horizon and the labor markets extremely tight, I fully expect to see inflation gather steam later this year. But I suspect that the Fed will be slow to react. And then the timing of the 2020 elections will become a factor. The FOMC is not particularly sensitive to political considerations, but this is no ordinary President. The Fed would have to be very sure of itself before it started raising rates again in the midst of the election cycle. The bottom line is that we are setting up for a monetary policy error with the Fed falling behind the inflation curve later this year or in early 2020. This will be positive for risk assets in the short run, but poses a big threat down the road. Notwithstanding our concerns about the near-term market impact of current U.S.-China trade tensions, our strategy is thus to remain overweight equities and corporate credit until we see signs that financial conditions are about to significantly tighten.   Martin H. Barnes, Senior Vice President Economic Advisor mbarnes@bcaresearch.com

Special Report

Highlights So What? Investors should look to European assets for considerable upside. Why? In the Euro Area, investors have constantly overestimated the angst of the median voter towards the currency union. The European Parliament has few real powers, so a fractured European Parliament does not really matter. Europe’s high-beta economy should benefit from a Chinese and global rebound. Stronger European growth will translate into more credit demand and lower non-performing loans, which will boost bank earnings. Go long European banks as a tactical trade, and long European equities versus Chinese equities as a strategic play. We will also consider going long EUR/USD as a strategic play once we get clarity on potential tariffs. Feature Europe’s economy and asset markets continue to underperform in 2019 despite a global policy pivot away from tightening monetary policy and a solid quarter of Chinese credit growth. Investors are broadly unattracted to continental Europe, regularly voicing fears that it is beset by a combination of hazards: from a no-deal Brexit to the ballooning Target 2 imbalances. According to the latest Bank of America Merrill Lynch survey of fund managers, the most crowded trade remains “short European equities” (Chart 1). The doom and gloom are intriguing considering that China is stimulating its economy and will continue to do so as long as trade tensions are elevated. “Higher beta” equities, including Europe and EM, should benefit from this stimulus (Chart 2). Exports, a key growth engine for the currency union, are closely linked to Chinese credit growth (Chart 3). Chart 2Chinese Stimulus Good For "High Beta" Economies Chart 3Europe Will Benefit From Improving Chinese Growth And yet Europe remains unloved. Given that most client questions focus on the political situation – and that many ask about the upcoming May 23 European Parliament (EP) elections – we focus on both in this analysis. First, we review the latest survey data on the collective sentiment towards Europe and integration. Second, we give our insights regarding the upcoming EP elections. Our broad conclusion is simple. If our house view that global growth is about to bottom is correct, and barring a collapse in U.S.-China trade talks, European assets – primarily equities and the euro – should be the top performers this year.   What Does The European Median Voter Want? The Median Voter Theory is a critical concept for investors. At BCA Research Geopolitical Strategy, we believe that the median voter – not the policymaker – is the price maker in the political market place. Politicians, especially in democracies, are price takers. They are bound by constraints, of which the preferences of the median voter are the most concrete impediments to action. This concept is simple to understand, but difficult to implement. It is far easier to get lost in rumor intelligence-driven analysis of political consultants and journalists who pass on the cocktail party chatter insights gathered through speaking with policymakers. These insights focus on the preferences of the people in power. But their preferences are secondary to those of the median voter. Trust in the EU remains below 50%, but this is in line with or better than the usual trust most governments achieve. Chart 4Support For The Euro Has Been Trending Upwards In the Euro Area, investors have constantly overestimated the angst of the median voter towards the currency union. This has led many investors to keep their money off the table, or take active short positions, even when it was prudent to remain invested. The prime example is the sentiment towards the common currency itself. Support for the euro hit a low in 2013 but has shot up since then across the continent (Chart 4). Even in Italy, the support for the euro is now at an eight-year high. Many investors have remained blind to this empirical fact. Not only has the support for the currency rebounded, but it has done so by converting doubters. Chart 5 shows that the increased support for the common currency – particularly in Spain, Germany, the Netherlands, and Italy – has occurred at the same time as the opposition has fallen. In other words, it is not the “undecideds” that are switching into supporters of the euro, rather it is the opponents who are relenting. Chart 5ASupport For The Common Currency Rising... Chart 5B...As Doubters Convert Chart 6Support For The EU Also On The Rise What of the support for the EU broadly defined? Latest Pew Research polling also shows a strong rebound in support among the public in the largest member states (Chart 6). The last time we published the data – in the summer of 2016 following Brexit – the figures were much lower. Given that for many Europeans the EU is merely another layer of bureaucracy and government, the support level is impressive when put in the international context. Chart 7 shows that the trust in the EU, compared to the trust Europeans have in their own governments, falls somewhere squarely in the middle. When compared to non-European countries, Europeans have considerably more trust in the EU than Americans have in their own government and in line with the sentiment of Japanese towards their own government. In other words, the trust in the EU remains below 50%, but this is in line with or better than the usual trust most governments achieve.   Why has the median voter remained supportive of European institutions despite mixed economic performance? For one, investors – particularly outside continental Europe – continue to overstate how much emphasis Europeans put on “economic prosperity” as a key goal of the integrationist process. Sure, everyone wants a humming economy, but Chart 8 shows that for most large European economies, “peace” and a “stronger say in the world” are more cogent explanations for the EU’s raison d’être than economic performance. Now, a skeptic might argue that this is because the EU has failed to deliver on the promise of prosperity. Nonetheless, the data suggest that Europeans today no longer expect European institutions to focus primarily on economic matters. Geopolitics, particularly security and foreign policy, are not just concerns of the shadowy elites and bureaucrats in Brussels. The median voter is concerned with these matters as well. The one worrying aspect of Chart 8 is that voters in Italy and Spain don’t think the EU means much to them at all. That level of nihilism might be compatible with continued European integration today. However, it also means that both countries, particularly Italy, remain a risk whenever a recession hits. The second reason for the improvement in median voter support of European institutions is that the migration crisis of 2015 – which peaked in October 2015, merely eight months ahead of the fateful referendum in the U.K. – is done and gone (Chart 9). Illegal immigration is an issue of concern, but it has been for over half a century. In fact, every decade has seen a turn against immigration, usually following a recession. It is a recurring problem that will remain a major policy issue for the rest of the century. The path from a “policy problem” to “the end of European integration” is neither direct nor immediate. Third, terrorism has abated as an existential threat to Europe. Chart 10 shows that we have seen the end of the “bull market in terror” in Europe. Unfortunately, the data for that chart only goes to 2017, otherwise it would show an even more jarring collapse in both attacks and casualties. Chart 9The Migration Crisis Is No Longer A Crisis Chart 10The "Bull Market In Terror" Is Over   The chart is also useful in putting the latest bout of terrorism – mainly of the radical Islamic variety – in its proper historical context. Europe has been riven with far left and nationalist terror (often both) since the late 1960s. The number of casualties per year in the 1970s was nearly two times greater than the peak of the recent bout of radical Islamic terror. This is largely the case even excluding the Troubles in Ireland and Northern Ireland. There is simply no evidence that the European median voter is moving towards Euroskepticism. Although it is difficult to make the connection, we would go on to posit that the abating of the migration crisis and bull market in radical Islamic terror has allowed the median voter in Europe to assess whether breaking apart the EU would truly resolve these crises. Elements of European integration, particularly the common labor market and Schengen Agreement – which is part and parcel of the integrationist evolution – definitely make it easier for migrants and terrorists to cross borders. However, the geopolitical forces that breed both are at least partly, if not completely, non-European in origin. As such, it is not clear how individual European countries that lack any hard power would deal with these events on their own. Thus European integration is not a policy born of strength but of weakness. Chart 11 illustrates this concept empirically. It shows the percent of respondents who think their country could better face the future outside the EU. The dotted line represents the pessimistic view. An astounding 87% of Dutch responders, for example, are pessimistic about the country’s future outside the EU. We pick on the Dutch because they have tended to vote for Euroskeptic parties. Similarly, a very high number of Germans, Finns, Swedes, French, and Spaniards are lacking confidence in “national sovereignty.” Only the Italians are flirting with “going it alone,” although even in their case the momentum for sovereignty appears to have stalled, as it has in traditionally Euroskeptic Austria. Chart 11AEuropeans Lack Confidence In National Sovereignty... Chart 11B...And Believe They Are Better Off Sticking Together Many investors approach European integration with an ideological slant. But charts don’t lie. Since we founded BCA Research Geopolitical Strategy, we have used Euro Area perseverance as the premier example of how an empirically-driven approach to political analysis can generate alpha. There is simply no evidence that the European median voter is moving towards Euroskepticism. A broad trend has existed since 2013 of rising support for the common currency, the euro. And a mini up-cycle in support for broader European institutions appears to be present since 2016, probably due to the combination of Brexit, an abating migration crisis, and the end of the bull market in terror. Bottom Line: The median voter supports both the euro and broad European integration. This is an empirical fact. But … Euroskeptics Are Winning Seats! Chart 12Anti-Establishment Parties Are Gaining Seats Despite the comfort of our empirical data, the reality is that anti-establishment parties continue to increase their share of parliamentary seats across the continent (Chart 12). In the recent Spanish election, for example, the populist Vox managed to win 10.3% of the vote. Headlines immediately picked up on the extraordinary performance, noting that Euroskeptics have finally established a foothold in Spain. Spanish Prime Minister Pedro Sánchez, the leader of the victorious Socialist Party, has welcomed the characterization as a foil to his program, promising to build a pro-European bloc with other left-leaning parties. Sánchez is playing politics. He understands how broadly European integration is supported in Spain and is trying to paint his opponents – who disagree with him on many issues, but not on Spain’s membership in the EU and EMU – as being on the other side of the median voter’s preferences. In reality, Vox is not a hard Euroskeptic party. It is right wing on immigration, multiculturalism, and the centralization of the Spanish state, but on Europe Vox merely wants less integration from the current, already highly integrated level. Anti-establishment parties are realizing that the median voter does not want to abandon European integration. As such, the right-leaning anti-establishment parties are focusing on anti-immigrant and anti-multicultural policies, while the left-leaning are focusing on anti-austerity politics. But there appears to be an emerging truce on integration. We forecast this transition in our 2016 report titled “After Brexit, N-Exit?” We posited that anti-establishment parties would increasingly focus on anti-immigration policies, while reducing the emphasis on Euroskepticism, in order to remain competitive. We now have a number of examples of this process, from Italy’s Lega to Finland’s the Finns Party. Which brings us to the election at hand: the EP election on May 23. Ironically, the EP election gives Euroskeptics the best chance at winning seats. First, the turnout has been falling for decades (Chart 13) given the dubious relevance of the legislative body (more on that below). Second, Euroskeptic voters tend to be highly motivated during EP elections as they get to vote “against Europe.” Third, ironically, EP elections allow Euroskeptics to build pan-European coalitions with their fellow skeptics. Despite the hype, the latest seat projections give Euroskeptics merely 26% of the seat total in the body, or just under 200 seats in the 750-seat body (Diagram 1). Chart 14 shows that the support for Euroskeptics has actually taken a serious dip following the Brexit referendum, with the overall continent-wide support remaining around 20%. This is broadly the same level at which the support was five years ago, giving Euroskeptic parties no gain in half a decade. Diagram 1Euroskeptics Expected To Hold Only A Quarter Of The Seats All that said, if a fifth of Europe’s electorate is voting for anti-integrationist parties in the midst of the most important European-wide election, that must be a bad sign for Europe. Right? Wrong. The media rarely unpacks the Euroskeptics beyond citing their overall support figures. However, we have gone beyond merely citing the three leading Euroskeptic blocs. Instead, we have separated the individual Members of European Parliament (MEPs) from across the three Euroskeptic blocs into four camps: Eastern European Camp – These are MEPs from EU member states that are former members of the Warsaw Pact or former Republics of the Soviet Union. Hardcore Camp – These are committed Euroskeptics who genuinely want their countries to leave European institutions. The Dutch Party for Freedom wants to see the Netherlands leave both the EU and the EMU. However, parties such as the Swedish Democrats and the Finns Party are more nuanced. Nonetheless, we erred on the side of apocalypse and added them all to the hardcore camp. Classical Camp – These are MEPs who would have fit the Euroskeptic definition back in the 1990s. They generally do not have a problem with the EU, but tend to be skeptical of the EMU and definitely do not want to see any further integration (although some would welcome integration on the military front). Italy’s Lega belongs to this camp, at least since the 2017 election, given the reorientation of the party’s policy away from criticizing the EMU and toward anti-immigrant policies.  On The Way Out Camp – The U.K. MEPs will eventually be forced to exit the EP given the eventual departure of the U.K. from the EU. In this camp, we have thrown all the U.K. MEPs who sit in Euroskeptic groupings, which includes both UKIP MEPs and Conservative Party members – even those who are not actually anti-EU. Diagram 2Almost Three Quarters Of Euroskeptic MEPs Are Bluffing Diagram 2 shows the distribution of the currently 311 Euroskeptic MEPs. The largest portion, by far, are Eastern European MEPs. The second-largest portion are MEPs from the U.K., who are either on their way out or about to become the “lamest ducks” in the history of any legislature. What does this mean? First, that almost three quarters of the Euroskeptic MEPs are essentially bluffing. Eastern European Euroskepticism is a geopolitical oxymoron. Investors should ignore any Euroskeptic rhetoric from Eastern Europe for two reasons. First, many Eastern European economies remain highly dependent on the EU for structural funding (Chart 15). But even that crude measure does not illustrate the benefit of EU membership. If Eastern and Central European countries were to leave the EU, they would lose access to the common market, a huge economic cost given their close integration with the German manufacturing supply chain. Second, and perhaps more importantly, the EU is a critical geopolitical anchor for the former Warsaw Pact member states. As much as the Polish and Hungarian Euroskeptic MEPs like to speak of the “tyranny of Brussels,” they all remember all too clearly the actual tyranny of Moscow. As such, Eastern Europe’s Euroskepticism is a bluff, a rhetorical political tool to blame the ills of poor governance on Brussels for the sake of domestic political gains. It holds no actual threat to European integration or its institutions given that the alternative to Brussels is… Moscow. This is why the three Euroskeptic blocs will find it difficult to cooperate in the future. The Eastern European-heavy European Conservatives and Reformists (ECR) are highly skeptical of Russia, as the largest party in the bloc is the Polish Law and Justice (PiS) Party. The PiS is highly critical of Moscow’s foreign policy and is the ruling party of Poland. Its rhetoric is on occasion illiberal and anti-EU, but it has also changed domestic policy when pressured by Brussels. The ECR is expected to be the smallest Euroskeptic party, with 55 MEPs. The genuinely hard-core Euroskeptic bloc is the Europe of Nations and Freedom (ENF). It is expected to win 58 MEPs and is dominated by genuine, long-time, anti-EU parties such as Marine Le Pen’s National Rally of France (formerly the National Front) and the Dutch Party for Freedom. However, its latest iteration is likely to be dominated by Matteo Salvini’s Lega, which is Italy’s ruling party and has taken a decided turn towards soft Euroskepticism. Finally, the moderately Euroskeptic Europe of Freedom and Direct Democracy (EFDD) is expected to win 57 seats. However, its largest bloc are the ruling Italian Five Star Movement (M5S) and an assortment of Euroskeptic British MEPs, including Niger Farage. Italy’s M5S has already toned down its Euroskeptic rhetoric given that it now sits in Rome and runs the EMU’s third-largest economy. Meanwhile, U.K. MEPs will be largely irrelevant, raising the question of whether EFDD should even be classified as Euroskeptic in the next EP. Bottom Line: When all is said and done, the European Parliament election is a much-hyped non-event. By our count, only about 60 out of approximately 190 Euroskeptic MEPs will be actual hard-core Euroskeptics (or, just 8% of the entire EP). The rest are either reformed centrists – the two major Italian parties, Lega and M5S – on their way out – U.K. Euroskeptics – or are just bluffing – all Eastern European MEPs. That said, the EP seat distribution will reflect the polarization and fracturing observed in most national parliaments across of Europe. It is likely that neither the center-left nor the center-right will have enough seats to select the European Commission President. Does Any Of This Even Matter? Does the EP election even matter? To answer this question, we first have to assess whether the European Parliament itself matters. Both the proponents and opponents of the EU overstate the bloc’s supranational institutions: the EP and the Commission. A fractured European Parliament does not really matter ... In fact, the European Parliament has few real powers. The true power in the EU is vested in the European Council. The European Council could be conceived of as an upper chamber of a combined EU legislature, the Senate to the European Parliament’s House of Representatives (to put into U.S. context). It is comprised of the heads of government of EU member states and is therefore elected on the national, not supranational, level. It is, by far, where most power resides in the EU. The Commission, on the other hand, is the EU’s technocratic executive. Its members are not democratically elected, but are chosen by the European Council and approved by both the Council and the EP.1  The EU Commission President is elected according to the Spitzenkandidat system. The party grouping that secures a majority governing coalition in the EP gets to name their leader as the candidate for the European Commission President. This system is not enshrined in EU law, it is merely a convention. In fact, it was designed to try to boost the voting turnout for the EP elections. The idea being that Europe’s voters would turn out to vote if it meant that their votes would ultimately determine who gets to head the European Commission. At the end of the day, the European Council has to approve the Spitzenkandidat. And, according to the letter of the law, the European Council can ultimately even ignore the Spitzenkandidat suggestions of the European Parliament and propose their own head of the European Commission. As such, the fact that Diagram 1 suggests a fractured European Parliament does not really matter. The European Council could, in the end, simply find a consensus candidate and have national governments instruct their MEPs to vote for that candidate in the EP. In fact, the European Parliament has few real powers. It is one of the only legislatures in the world with no actual legislative initiative (i.e., it cannot produce laws!). It gets to hold a ceremonial vote on new EU treaties – the treaties that act as a constitution of the bloc – but cannot veto them. On most important matters – including the EU budget – the Parliament cannot overrule the European Council (the heads of national governments), which means that it cannot subvert the sovereignty of the EU member states. In the political construct that is the EU, it is the upper-chamber that holds all the power (if we are to extend the analogy of the European Council as the “Senate”). Another important thing to remember is that MEPs are rarely unaffiliated. The vast majority are members of national parties on the national level. Few, if any, are actual supranational agents. In fact, most MEPs fall into two categories. They are either young up-and-comers being groomed for a successful career on the national level – the level that actually matters – or they are past-their-expiration-date elders looking for a cushy retirement posting that includes frequent, taxpayer-funded, trips between Brussels and Strasbourg.  Bottom Line: The importance of the EP is vastly overstated by both Europhiles and Euroskeptics. Its role within the EU legislative process has been increasing through treaty evolution and convention. However, the true power in the EU still rests with the national governments and the EP can be sidelined if the European capitals so desire. Furthermore, while the EP is a supranational body with supranational powers, its soul is very much national. This is because most of its MEPs either have an eye on returning to domestic politics or are emeriti of domestic politics looking for one last bout of relevance. Investment Implications Given our sanguine view of European politics, and the BCA House View that global growth should bottom (Chart 16), investors should look to European assets for considerable upside. This is particularly the case if the U.S. and China overcome their cold feet and conclude a trade deal. Our colleague Peter Berezin, BCA’s Chief Investment Strategist, has proposed that investors go long European banks as a tactical trade. Peter has pointed out that banks are now trading at distressed valuations (Chart 17).2  Given a Chinese and global rebound, and barring a total relapse into trade war, Europe’s high-beta economy should benefit, leading to higher bond yields in core European markets.This has tended to help European bank stocks in the past (Chart 18). Stronger economic growth will also translate into more credit demand and lower non-performing loans. This will boost bank earnings (Chart 19). Chart 16Growth Is Recovering In The U.S. And China Chart 17European Banks: A Good Value Play Chart 18Euro Area: Higher Bond Yields Bode Well For Bank Stocks Chart 19More Credit, Fatter Bank Earnings In addition, U.S. dollar outperformance is long-in-the-tooth. If global growth is truly bottoming, and assuming a trade deal is done,  then the policy divergence that has favored the greenback should be over (Chart 20). As such, we will consider going long EUR/USD as a strategic play once we get clarity on China tariffs and potential tariffs on U.S. auto imports (the latter risk is rising from 35% to 50% given Trump’s willingness to take risks this year). Chart 20If Trade War Subsides, Dollar May Fall Chart 21A Reversal In Tech Outperformance Supports Long Europe/China Finally, Dhaval Joshi, BCA’s Chief European Strategist, believes that Europe is a clear tactical overweight to China.3 Part of the reason is that the two markets are mirror opposites of each other in terms of sector skews. China is overweight technology and underweight healthcare, while Europe is overweight healthcare and underweight technology. The year-to-date outperformance by global technology stocks relative to healthcare is long in the tooth and ripe for a correction (Chart 21). Given our positive structural assessment of European political risk, we recommend going long European equities and short China as a strategic play.   Marko Papic Consulting Editor marko@bcaresearch.com Footnotes 1      For the American context, the Commission would be what the various U.S. Departments would look like if they were serving at the pleasure of the U.S. Senate. While the analogy is not perfect, it does capture the fact that the EU’s executive is controlled by the European Council. 2      Please see BCA Global Investment Strategy Weekly Report, “King Dollar Is Due For A Breather,” dated April 26, 2019, available at gis.bcaresearch.com. 3      Please see BCA Research European Investment Strategy Weekly Report, “Suffering Market Vertigo,” dated May 2, 2019, available at eis.bcaresearch.com.  

Highlights The clear and present deterioration in Sino-U.S. trade negotiations suggests the dollar will remain bid in the near term. While the probability of a trade deal has fallen, the situation remains highly fluid, and the odds could shift either way rather dramatically. Ultimately, it is beneficial for both parties to come to an agreement. We highlighted last week that in an environment where volatility was low and falling, it paid to have insurance in place. The yen and Swiss franc remain attractive from this standpoint. Our thesis remains that the path of least resistance for the dollar is down, but gauging how high the dollar can catapult before ultimately reversing course is paramount for strategy. Our estimation is that the trade-weighted dollar could rise 2-3% before ultimately cresting. Expect more pronounced USD moves vis-à-vis growth-sensitive currencies. We were stopped out of our short USD/SEK position with a 1.9% loss. If global growth rebounds, this will be a high-conviction trade, but we are standing aside for risk-management purposes. Feature Markets received a dose of volatility this week. First, evidence has emerged that China is retracting on previous commitments toward a Sino-U.S. trade deal. A systematic volte face to core pledges such as legally addressing the theft of U.S. intellectual property and trade secrets, fair competition policy, and removing foreign caps on financial services, aggravated the Trump administration and prompted a new round of tariffs. As we go to press, the final details have not been revealed, but the proposal is to raise tariffs on $200 billion worth of Chinese goods from 10% to 25%, while slapping an additional 25% tariff on the remaining $325 billion of Chinese goods “shortly” after (Chart I-1). Almost simultaneously, tensions between the U.S. and Iran are flaring up following President Trump’s decision not to extend sanction waivers to Iranian oil exports beyond May. The Iranian response has been to threaten to claw back some of the commitments it made in the landmark 2015 nuclear deal, mainly a halt to its uranium enrichment program. The risk of miscalculation and escalation is high. With an aircraft carrier strike group departing from U.S. shores, Tehran could be forced into a corner and begin striking key pipelines in the Iraqi region of Basra, which is home to significant oil traffic. Meanwhile, investor exuberance towards green shoots in the global economy continues to be watered down with incoming data. Chinese export data has weakened anew, both in April and on a rolling three-month basis, following weak PMI numbers last week. Money and credit numbers were soft. Swedish manufacturing data, a strong proxy for global growth, continue to disappoint, with industrial new orders contracting by 8.1% in March – the worst pace since November 2016. And after a brisk rise since the start of the year, many China plays including commodity prices, the yuan, emerging market stocks and even A-shares are rolling over (Chart I-2). Chart I-1Back To The Firing Lines Chart 1-2Reflation Indicators Are Topping Out These developments have unsurprisingly put a bid under the dollar against pro-cyclical currencies. However, the euro is up versus the dollar this week, while the DXY marginally down. The lack of more pronounced volatility in currency markets despite a ramp-up in trade-war rhetoric is eery. Our thesis remains that the path of least resistance for the dollar is down, but gauging how high the dollar can catapult before ultimately reversing course is paramount for strategy. Tariffs And Exchange Rates Standard theory suggests that exchange rates should move to equalize prices across any two countries. This is simply because if prices rise significantly higher in country B versus Country A, it pays to buy the goods from A and resell them to B for a profit, assuming other costs are minimal. Country A’s currency rises following increased demand, while that of Country B falls, until the price differential is arbitraged away. This very simple concept originated from the School Of Salamanca in 16th century Spain, and still applies to this day in the form of Purchasing Power Parity (PPP). The question that naturally follows is by how much should the currency increase? The answer is that the exchange rate will move by exactly the same percentage point as the price increase, everything else equal. If both countries produce homogeneous goods, then it is easy to see why, since there is perfect substitution. But assuming they produce heterogeneous goods, then the loss of purchasing power in Country A will lead to less demand for Country B’s goods. This means Country B’s currency will have to adjust downwards for the markets to clear. The decrease has to match the magnitude of the price increase, since there are no other outlets to liquidate Country A’s goods. If, say, Country A moves to hike prices as well, then both currencies remain at par. This is obviously a very simplified version of the real world economy, but it highlights an important point that is central to the discussion: The currency move necessary to realign competitiveness will always be equal to, or less, in percentage point terms to the price increase. In the case where the entire production base is tradeable, it will be the former. But with a rise in the number of trading partners, a more complex export basket, import substitution, shipping costs and many other factors that influence tradeable prices, the currency adjustment should be a fraction of the price increase. Since the onset of 2018, the U.S. has slapped various tariffs on China, the most important of which was 10% on $200 billion worth of Chinese goods. Assume for the sake of argument that only China and the U.S. were trading partners. The U.S. currently imports $522 billion worth of goods from China, about 17% of its total imports. However, as a percentage of overall U.S. demand, this only represents 2.5% (Chart I-3). This suggests that at best, a 25% increase on all Chinese imports will only lift import prices by 4.3% and consumer prices by much less. On the Chinese side of the equation, exports to the U.S. account for 20% of total exports, so a tariff of 25% should only lift export prices by 5%. The conclusion is that the yuan and dollar only need to adjust by 4-5% to negate the impact of a 25% tariff. Chart 1-3Sino-U.S. Trade Is Small Relative To Domestic Demand Chart 1-4No Disorderly Rise In ##br##The Dollar   The DXY index is up 10% since the 2018 trough (Chart I-4), and the dollar was up an average of 74 basis points versus the Chinese Yuan from the day major tariffs were announced until the peak in trade-war rhetoric (Table I-1). This would be in line with economic theory. But there is a caveat: With no corresponding export subsidy for U.S. goods, the rise in the dollar makes exporters worse off. And with over 40% of S&P 500 sales coming from outside the U.S., this would have a meaningful dent on corporate profits. A paper by the Peterson Institute for International Economics showed that imposing a border adjustment tax caused the real effective exchange rate (REER) of the country to rise, hurting competitiveness.1  In quantity terms, the IMF estimated that a 20% import tariff from East Asia would lift the U.S. dollar’s REER by 5% over five years, while dropping output by 0.6% over the same timeframe.2  With the dollar not currently overvalued on a REER basis, this does not bode well for future competitiveness (Chart I-5). Finally, trade wars are usually synonymous with recessions. As such, there are acute political constraints inching both sides toward an agreement. For President Trump, a deteriorating U.S. manufacturing sector in the Midwestern battleground states is a thorn in his side. The U.S. agricultural sector has continued to bleed from falling grain prices (Chart I-6). For President Xi, rising unemployment is a key constraint. April manufacturing and credit numbers out of China show that the economy is relapsing anew. So, either China compromises and inches towards a trade deal or launches another round of stimulus. Chart I-5The Dollar Is Not Undervalued On A REER Basis Chart I-6A Drought In Cash Flows For ##br##U.S. Farmers   Bottom Line: Standard theory suggests the dollar’s bid should be capped at 2-3% on the imposition of new tariffs. Getting the global growth picture right will be more important in dictating the dollar’s trend. Of course, a full-blown trade war puts the entire thesis in jeopardy. Questions From The Road We were on the road this week, talking to clients and teaching the BCA Academy. Most clients agreed that the dollar is in a transition phase, given the presence of emerging green shoots in the global economy (Chart I-7). However, most were also concerned to what degree this view could be offside. The concerns centered around the fact that the growth differential between the U.S. and the rest of the world remains wide, yield differentials still favor the U.S., profit leadership also continues to favor the U.S. and it is unclear to what degree the world is short of U.S. dollars. U.S. profit leadership in the world continues, but one prescient indicator for the dollar is whether banks are easing lending standards for large firms relative to smaller ones.  We continue to lean towards the narrative that most of the factors driving the dollar higher are behind us. U.S. growth tends to be low-beta relative to the world, so a rebound in the global economy will be negative for the dollar. An end to the Federal Reserve’s balance sheet runoff will steer growth in the U.S. monetary base from deeply negative to zero. Meanwhile, a rising external profit environment will lead to an increase in foreign central bank reserves. The yield differential between the U.S. and the rest of the world remains wide, but this has a natural limit since global bond yields tend to converge towards each other over time. Chart I-7Global Growth Should##br## Rebound Chart I-8Positive Earnings Revisions Bodes Well For Growth   U.S. profit leadership in the world continues (Chart I-8), but one prescient indicator for the dollar is whether banks are easing lending standards for large firms relative to smaller ones. A better external environment will suggest banks will allow credit to flow to larger firms relative to smaller ones, since the latter tend to be more domestic. This is also an environment where global equities tend to outperform. The latest Fed Senior Official Loan survey showed that on the margin, lending standards are easing for large relative to small firms. This may suggest that return on capital is starting to improve outside the U.S., which will be a headwind for the dollar (Chart I-9). Chart I-9S&P 500 Foreign Earnings Need A Weak Dollar From a technical standpoint, almost all currencies are already falling versus the U.S. dollar – a trend that has been in place for several months now. This means most of the factors putting upward pressure on the dollar are well understood by the market. For example, global growth has been slowing for well over a year, based on the global PMI. Putting on fresh U.S. dollar long positions is at risk of a washout from stale investors, just as it was back in 2015, a year after growth had peaked (Chart I-10). It will be difficult for the dollar to act as both a safe-haven and carry currency, because the forces that drive both move in opposite directions.  Dollar technicals are also very unfavorable. Speculators are holding near-record long positions, sentiment is stretched, and our intermediate-term indicator is also flagging yellow. Over the past five years, confirmation from all three indicators has been followed by some period of U.S. dollar indigestion (Chart I-11). This may help explain relative stability in the broad trade-weighted dollar, despite a flare up in global risk aversion. Chart I-10Dollar Bull Case Is Well Known Chart I-11Dollar Technicals Are Unfavorable   Finally, with U.S. interest rates having risen significantly versus almost all G10 countries in recent years, the dollar has itself become the object of carry trades. This has also come with a good number of unhedged trades, as the rising exchange rate has lifted hedging costs. It will be difficult for the dollar to act as both a safe-haven and carry currency, because the forces that drive both move in opposite directions. The strength in EUR/USD this week despite the rise in global risk aversion is testament to this thesis. Bottom Line: Aside from the renewed specter of a trade war, most of the factors driving the dollar higher are behind us. House Keeping Chart I-12Buy Some Insurance Rising market volatility suggests some trades could be at risk from being stopped out. First, our long AUD/USD sits right at the epicenter of any growth slowdown in China. Maintain stops of 68 cents. Second, in an environment where volatility is low and falling, it pays to have insurance in place. We continue to favour CHF/NZD (Chart I-12). Third, we were stopped out of our short USD/SEK position for a 1.9% loss. If global growth rebounds, this will be a high-conviction trade. However, we are standing aside for risk-management purposes. Finally, the Reserve Bank Of Australia kept rates on hold this week, while the Reserve Bank Of New Zealand cut rates. This bodes well for our strategic AUD/NZD position.     Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Caroline Freund and Joseph E. Gagnon, “Effects of Consumption Taxes on Real Exchange Rates and Trade Balances,” Peterson Institute for International Economics, April 2017. 2 Maurice Obstfeld, “Tariffs Do More Harm Than Good At Home,” IMFBlog, September 8, 2016. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. have been mostly positive: To begin with the labor market, the unemployment rate fell to a 50-year low of 3.6% in April, despite a slight fall in the participation rate to 62.8%. Change in nonfarm payrolls came in above expectations at 263K in April, while average hourly earnings was unchanged at 3.2%. Moreover, JOLTS job openings came in at 7.5 million, above expectations. On the PMI front, the Markit composite PMI fell to 53 in April. ISM non-manufacturing PMI fell below expectations to 55.5. On the housing market front, mortgage applications increased by 2.7%, an improvement from the last reading of -4.3%. This nudged the MBA Purchase Index from 259.4 to 270.2. DXY index fell by 0.2% this week. On Sunday, Trump tweeted that tariffs on $200 billion worth of Chinese imports will increase from 10% to 25%, which again toppled the market. The ongoing trade disputes increase uncertainty in the global growth outlook. Report Links: Take Out Some Insurance - May 3, 2019 Currency Complacency Amid A Global Dovish Shift - April 26, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area are improving: Headline and core inflation in the euro area rose to 1.7% and 1.2% year-on-year, respectively in April. Markit composite and services PMI came in at 51.5 and 52.8, respectively, both surprising to the upside. The French composite and services PMI increased to 50.1 and 50.5. The German composite and services PMI increased to 52.2 and 55.7. Sentix investor confidence rose to 5.3 in May, well above consensus. Retail sales increased by 1.9% year-on-year in March. EUR/USD appreciated by 0.3% this week. The European Commission (EU) released the spring 2019 Economic Growth Forecasts this week, citing that “growth continues at a more moderate pace.” While the global growth slowdown and trade policy uncertainties could weigh on the European economy, domestic dynamics are set to support the economy. According to the forecast, growth will continue to pick up in all EU member states next year. Report Links: Take Out Some Insurance - May 3, 2019 Reading The Tea Leaves From China - April 12, 2019 Into A Transition Phase - March 8, 2019 The Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been neutral: Nikkei composite PMI increased to 50.8 in April. The manufacturing PMI increased to 50.2, while the services PMI fell slightly to 51.8. Vehicle sales increased by 2.5% year-on-year in April. Consumer confidence index fell to 40.4 in April. USD/JPY fell by 0.9% this week. Volatility caused by the ongoing trade disputes has reduced risk appetite, enhancing the outperformance of the safe-haven yen. According to the BoJ minutes released this Wednesday, Japanese financial conditions remain highly accommodative, and the domestic demand is likely to bounce, despite the drag from external growth. Report Links: Beware Of Diminishing Marginal Returns - April 19, 2019 Tug OF War, With Gold As Umpire - March 29, 2019 A Trader’s Guide To The Yen - March 15, 2019 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. have been solid: Markit composite PMI increased to 50.9 in April. Services PMI also came in above expectations at 50.4 in April, an improvement from the last reading of 48.9. The British Retail Consortium (BRC) like-for-like retail sales increased by 3.7% year-on-year in April, outperforming expectations. Halifax house prices increased by 1.1% month-on-month in April and 5% year-on-year. GBP/USD fell by 0.9% this week, erasing the gains from last Friday after positive PMI data. We continue to favor the pound given its cheap valuation and healthy domestic fundamentals. However, the window for pound upside will rapidly close as we approach Brexit 2.0. Report Links: Take Out Some Insurance - May 3, 2019 Not Out Of The Woods Yet - April 5, 2019 A Trader’s Guide To The Yen - March 15, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been mostly positive: CBA Australia composite and services PMI both outperformed, increasing to 50 and 50.1, respectively. Building permits contracted by 27.3% year-on-year in March. However, this looks like a volatile bottoming process on a chart. Retail sales increased by 0.3% month-on-month in March. The trade balance came in at a surplus of A$4.95 million in March. AUD/USD has been flat this week. The Reserve Bank of Australia kept interest rate on hold at 1.5% this week, which disappointed the bears. Moreover, in the monetary policy statement, the RBA estimates the economy will grow around 2.75% in 2019 and 2020, supported by increased investment and a pickup in the resources sector. Report Links: Beware Of Diminishing Marginal Returns- April 19, 2019 Not Out Of The Woods Yet - April 5, 2019 Into A Transition Phase - March 8, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been mixed: ANZ commodity prices increased by 2.5% in April, higher than expected. 2-year inflation expectations remain at 2%. Dairy price index increased by 0.4% in April, above the estimated -1.1%. NZD/USD fell by 0.5% this week. On Tuesday, the RBNZ lowered its interest rate by 25 bps to 1.5%. Our long AUD/NZD position, which is currently 0.8% in the money, is likely to profit from the widened interest rate differential. In the monetary policy statement, the RBNZ stated that a lower rate is mostly consistent with the current employment and inflation outlook in New Zealand. Moreover, global uncertainties, coupled with domestic housing market softness and reduced immigration remain a headwind to the economy. Report Links: Not Out Of The Woods Yet - April 5, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been positive: Ivey Purchasing Managers’ Index increased to 55.9 in April, well above estimates. Housing starts increased by 236K year-on-year in April. Imports and exports increased to C$52 billion and C$49 billion respectively in March, resulting in a small deficit of C$3 billion. New housing price index increased by 0.1% year-on-year in March. USD/CAD has been flat this week. On Monday, Governor Poloz gave a speech focusing on the Canadian housing sector. He aims to provide more flexible mortgage choices for Canadian consumers, which could help the housing market to stabilize. The possible measures include diversifying mortgage terms, developing an MBS market, and encouraging different mortgage designs. Report Links: Currency Complacency Amid A Global Dovish Shift - April 26, 2019 A Shifting Landscape For Petrocurrencies - March 22, 2019 Into A Transition Phase - March 8, 2019 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland have been neutral: Headline inflation fell to 0.2% in April on a month-on-month basis, while unchanged at 0.7% on a year-on-year basis. Core inflation was unchanged at 0.5% year-on-year. Foreign currency reserves increased to 772 billion CHF in April. Unemployment rate was unchanged at 2.4% month-on-month in April. The SECO consumer climate fell to -6 in Q2. USD/CHF fell by 0.2% this week. While the trade disputes and increased global growth uncertainties could support the Swiss franc in the near term, we continue to favor the euro over the franc on a cyclical basis. Report Links: Beware Of Diminishing Marginal Returns - April 19, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway have been mixed: Registered unemployment fell to 2.3% in April. Manufacturing output contracted by 0.8% in March. House prices rose by 2.2% year-on-year in April, below March’s 3.2% annual growth. USD/NOK increased by 0.2% this week. On Thursday, the Norges Bank kept interest rates on hold at 1%, in line with expectations. The monetary policy continues to be accommodative, which is a tailwind for the Norwegian economy. Report Links: Currency Complacency Amid A Global Dovish Shift - April 26, 2019 A Shifting Landscape For Petrocurrencies - March 22, 2019 Balance Of Payments Across The G10 - February 15, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been negative: Industrial production contracted by 1.3% year-on-year in March. Manufacturing new orders decreased by 8.1% year-on-year in March, the worst since November 2016. USD/SEK increased by 0.8% this week. Our short USD/SEK position was stopped out at 9.6, due to the weaker-than- expected Swedish data and unexpected U.S. dollar resilience. We will look to put the trade back on when we see more clear signs of a global growth bottom. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Global Liquidity Trends Support The Dollar, But... - January 25, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades