Economy

Highlights The recent dovish shift in tone from central banks around the world is here to stay this year, providing support for global growth. As a result, stock prices will benefit from a combination of easy policy and rebounding activity, while safe-haven yields will grind higher. The recent deterioration in profit margins is not due to rising costs but reflects weaknesses in pricing power. Pricing power is pro-cyclical: If global growth improves and the dollar weakens, margins should recover. Overweight financials and energy. We are upgrading European equities to neutral, and placing them on a further upgrade watch. Feature Easy Does It The global monetary environment has eased over the past four months. Some major central banks like the Federal Reserve and the Bank of Canada have backed away from tightening. Others, like the Bank of Japan, the Reserve Bank of Australia, the Reserve Bank of New Zealand and the Swedish Riksbank have provided very dovish forward guidance. And one major policy setting institution – the European Central Bank – has even eased policy outright by announcing a large-scale injection of liquidity in the banking sector through its TLTRO-III operation that will begin in September. This phenomenon is not limited to advanced economies. Important EM central banks are also targeting easier liquidity conditions. The Reserve Bank of India has cut interest rates by 50 basis points; the Monetary Authority of Singapore is now targeting a flat exchange rate; and the Bank of Korea has issued a somewhat dovish forward guidance. Most importantly, Chinese policymakers are once again forcing debt through the system, with total social financing flows amounting to RMB 2.9 trillion last quarter, more than the RMB 2.4 trillion pumped through the economy in the first quarter of 2016. These reflationary efforts will bear fruit. Policy easing, especially when it relies as largely on forward guidance as the current wave does, should result in lower forward interest rates. And as Chart I-1 illustrates, when a large proportion of global forward rates are falling, a rebound in global economic activity typically follows. This time will not be different. Chart I-1Monetary Guardians Are Coming To The Rescue The S&P 500 and global equities have already rebounded by 18.9% and 17.2%, respectively since late December. Have markets already fully discounted the growth improvement that lies ahead, leaving them vulnerable to disappointments? Or do global stocks have more upside? While a rest may prove necessary, BCA anticipates that global equity prices have more upside over the coming 12 months. Are Central Banks About To Abandon Their Newfound Dovish Bias? We sincerely doubt it. Reversing the recent tone change soon would only hurt the battered credibility that central banks are fighting so hard to maintain. In the case of the U.S., the most recent FOMC minutes were clear: The Fed does not intend to tighten policy soon, even if growth remains decent. The minutes confirmed the idea we espoused last month, that FOMC members are focused on avoiding a Japan-like outcome for the U.S. where low expected inflation begets low realized inflation. Such an outcome would greatly increase the probability that an entrenched deflationary mindset develops in the U.S. in the next recession. As a result, we anticipate that the Fed will refrain from tightening policy until inflation expectations move back up toward their historical range (Chart I-2). Further justifying the Fed’s new stance, a small rebound in productivity is keeping unit labor costs at bay, despite a pick-up in wages. This is likely to put a lid on core inflation for now (Chart I-3). Chart I-2Inflation Expectations: Too Low For The FOMC's Comfort Chart I-3A Whiff Of Disinflation There is little reason for the ECB to adopt a more hawkish stance either. The euro area PMIs have stabilized but are still flirting with the boom/bust line. Realized core inflation is a paltry 0.8% and the ECB’s own forecast is inconsistent with its definition of price stability, which dictates that the inflation rate should be “below but close to 2% over the medium term.” Our ECB Monitor captures these dynamics, remaining in the neutral zone (Chart I-4).   In China, the case for quickly removing credit accommodation is weak. Property developer stocks have rebounded 41% from their October lows, but sales of residential floor space remain soft, keeping real estate speculation in check. Meanwhile, our proxy for the marginal propensity to consume of Chinese households – based on the ratio of demand deposits to time deposits – continues to deteriorate (Chart I-5). The recent pick up in credit growth should put a floor under those trends, but it will take some time before these variables overheat enough to call for policy tightening. Chart I-4Our ECB Monitor Supports An ECB Standing Still Chart I-5Key Domestic Variables Argue Against Tightening Policy In China   Bottom Line: The three most important policymakers in the world are not set to suddenly slam on the brake pedal. As a result, the global policy backdrop will remain accommodative for at least two to three quarters. The few economic green shoots observed around the world should therefore blossom into a full-fledge global growth pick-up. From Green Shoots To Green Gardens If central banks adopt an easier bias but global growth is slowing sharply without any end in sight, stock prices are unlikely to find a floor. After all, stock prices represent the discounted value of future cash flows. If those cash flows are expected to decline at a faster pace than the risk-free rate, then stock prices can fall – even if policy is becoming more accommodative. However, if economic activity is stabilizing, easier policy should generate substantial equity gains. Stimulative financial conditions will result in an improvement in global activity indicators, including emerging economies (Chart I-6, top panel). This is very important as emerging markets were at the epicenter of the slowdown in global trade, and because they historically lead global industrial activity (Chart I-6, bottom panel). The few economic green shoots observed around the world should therefore blossom into a full-fledge global growth pick-up. Policy easing in China is of particular significance. Our Chinese activity indicator is still slowing, but BCA’s Li-Keqiang Leading Indicator, which mostly tracks developments in the credit sector, has stabilized (Chart I-7, top panel). The rebound in the credit impulse also points to an acceleration in Chinese nominal manufacturing output (Chart I-7, bottom panel). This should lift Chinese imports, resulting in a positive growth impulse for the rest of the world. Chart I-6The Dance Of FCI And Activity Chart I-7Chinese Industrial Activity Will Rebound Soon   At the moment, the euro area remains weak, but it will become a key beneficiary of improving growth. As the top panel of Chart I-8 illustrates, the Eurozone’s exports to China tend to follow the trend in the Chinese Adjusted Total Social Financing impulse. Moreover, European exports to the rest of the world are set to enjoy a recovery, as highlighted by the upturn in the diffusion index of our Global Leading Economic Indicator (Chart I-8, bottom panel). This external-sector improvement is happening as the euro area domestic credit impulse is rebounding, and as the region’s fiscal thrust increases from roughly zero to 0.4% of GDP. In the U.S., it is unlikely that 2019 growth will top that of 2018, but activity should nonetheless rebound from a lukewarm first quarter. Importantly, the fed funds rate is holding below its equilibrium (Chart I-9). Additionally, household fundamentals remain solid. A tight labor market means that wages have upside and household debt levels and debt servicing costs are all well behaved relative to disposable income (Chart I-10). Moreover, housing dynamics are generally stronger than reported by the press, as mortgage applications for purchases are making cyclical highs and the NAHB Homebuilder confidence index is rebounding (Chart I-11). Offsetting some of these positives, capex intentions – a robust forecaster of actual corporate investments – have rolled over from their heady mid-2018 levels. Even so, they remain consistent with positive capex growth. Also, U.S. fiscal policy is becoming increasingly less growth-friendly starting in mid-2019. Netting it all out, U.S. growth should remain above-trend, at about 2.5%. Chart I-8Europe Will Benefit From Stabilizing Growth Elsewhere Chart I-9U.S. Policy Remains Accommodative   Chart I-10U.S. Households Are Doing Alright Chart I-11Forward-Looking Housing Indicators Point To A Pick-Up Bottom Line: While U.S. growth may be weaker than in 2018, it should not fall below trend. Meanwhile, Chinese credit trends suggest that growth there should clearly pick up in the coming months, which should also lead to stronger activity in Europe. In other words, exactly as central banks have removed policy constraints, global growth is set to re-accelerate. This is a positive backdrop for risk assets over the coming 12 months.   What Does It Mean For Asset Prices? Simply put, a dovish shift in policy along with a tentative stabilization in growth should result in both higher stock prices and rising safe-haven bond yields. First, a rebound in global economic activity means that depressed profit growth expectations could easily be bested (Chart I-12, top panel). Bottom-up estimates point to EPS growth of 3.4% in the U.S. and 5.3% in the rest of the world in 2019, using MSCI data. However, profits are extremely pro-cyclical, and a combination of easy financial conditions and improving growth conditions in the second half of the year should result in better-than-expected earnings. Chart I-12Profit Expectations Are Low Second, the Fed is extending its pause, as other global central banks are also adopting more accommodative policies. This implies that global real interest rates, both at the short- and long-end of the curve, will remain below equilibrium for longer than would have been the case if policy had remained on its previous path. Consequently, not only do lower real rates decrease the discount factor for stocks, they also imply a longer business cycle expansion. This should result in narrower risk premia for stocks and higher multiples. Since they offer cheaper valuations than those in the U.S., international equities may stand to benefit more from policy-led multiple expansion (Chart I-12, bottom panel). Third, the global duration indicator developed by BCA’s Global Fixed Income Strategy service is forming a bottom.1 This gauge – levered to global growth variables like the Global ZEW growth expectations survey, our Global Leading Economic Indicator and the Global LEI’s diffusion index – has perked up in response to green shoots around the globe. An upturn in global safe-haven yields is imminent (Chart I-13). Additionally, the global Policy Uncertainty Index is currently recording very high readings, congruent with depressed yields (Chart I-14). A benign resolution to the Sino-U.S. trade tensions along with the low likelihood of the implementation of a No-Deal Brexit should push this indicator down, lifting yields in the process. Chart I-13Global Dynamics Argue For Fading The Bond Rally Chart I-14Policy Uncertanity Is At An Apex: Look The Other Way   Fourth, while we expect the Fed to stay on pause for the remainder of 2019 and probably through the lion’s share of 2020 as well, this is a more hawkish forecast than what the market is currently pricing in (Chart I-15). As we argued last month, a fed funds rate that turns out to be higher over the next year than what is currently discounted often results in the underperformance of Treasurys relative to cash. Finally, a rebound in global growth, even if the Fed proves more hawkish than the market anticipates, generally pushes the dollar lower (Chart I-16). Since speculators currently hold large net short bets on the euro, the AUD, the CAD, and so on, the probability is high that this historical pattern will assert itself. The recent period of dollar strength is unlikely to last more than a couple of weeks. A weak dollar, easy policy and rebounding growth should boost commodity prices, especially metals and oil. The latter should benefit most from this set up as the end of the waivers of U.S. sanctions on Iran will constrain the availability of crude in international markets. Chart I-16The Dollar Last Hurrah Will End Very Soon   Rebounding global growth should also allow equity prices to be resilient in the face of rising bond yields, up to a point. When yields and inflation expectations are low, multiples and equity prices tend to move in tandem. This is because in an environment where central banks are frightened by deflationary risks, monetary authorities do not lift rates as quickly as nominal activity would warrant. Thus, improving nominal growth lifts the growth component of equity multiples more than it raises yields. In other words, we expect yields and stocks to rise together because low but rising inflation expectations, but not surging real rates, will drive the upside in bond yields. Obviously, this cannot last forever. Once the Fed starts suggesting that rates will rise again, and the entire yield curve moves closer to neutral, higher yields will curtail equity advances. This is a constructive cyclical setup; but the tactical environment is murkier. The problem is that equity prices have already moved up significantly over the past four months. With volatility across asset classes having once again plunged toward historical lows, risk assets display a high degree of vulnerability to disappointing economic data. This means that unless growth rebounds strongly and quickly, stocks could experience a short-term correction in the coming months. While staying overweight equities, it is nonetheless prudent to buy some protection. Investors should also wait on the sidelines to deploy any excess cash. Rebounding global growth should also allow equity prices to be resilient in the face of rising bond yields, up to a point. Bottom Line: The current environment is favorable for risk assets on a cyclical basis. Low real rates will not only continue to nurture the nascent improvement in the global economy. They also imply lower discount rates. Meanwhile, improving economic activity and a decline in policy uncertainty will push safe-haven yields higher. Consequently, it remains sensible to be long stocks and underweight bonds for the remainder of the year, even if the risk of a short-term stock correction has risen. Within fixed-income portfolios, a below-benchmark duration makes sense, especially as oil prices are rising, Sino-U.S. trade negotiations should end in a benign outcome, and a No-Deal Brexit remains unlikely. Margins Are The Greatest Risk At the current juncture, the biggest risk for stocks is that profits fall short of depressed analysts’ estimates for 2019 – not because revenue growth disappoints, but because profit margins contract. Our U.S. Equity Sector Strategy service has recently highlighted that the S&P 500 operating earnings margin stands at 10.1% after having peaked at 12% in Q3 2018 (Chart I-17).2 Despite this decline, margins remain both elevated by historical standards and above their long-term upward-sloping trend. As Chart I-18 illustrates, the decline in margins is not an S&P 500-only phenomenon: It is an economy wide one as well, as the pattern is repeated using national accounts data. Chart I-17Will This Margin Deterioration Continue? Chart I-18Margins: All About Labor Costs Versus Selling Prices   At first glance, the Fed’s current pause may undermine profit margins. As Chart I-19 shows, when the unemployment rate stands below NAIRU, on average, wages grow faster than when the labor market is not at full employment. Since the unemployment gap stands as -0.8% today, we are likely to see continued wage pressures in the U.S. economy. Chart I-19Wages Have Upside The problem with this story is that productivity has been accelerating – from a -0.3% annual rate in the second quarter of 2016 to 1.8% in the fourth quarter of 2018. Because wage inflation did not experience as large a change, unit labor cost inflation is still growing at 1% annually, as they did in Q2 2016. In fact, real unit labor costs are currently contracting at a 0.4% pace. The pick-up in capex over the past three years suggests that productivity can continue to improve over the coming quarters. Consequently, as has been the case over the past two years, rising wages will only have a limited negative impact on margins. The key source of variance in profit margins has been, and will likely remain over the next year or so, corporate pricing power, which today stands at its lowest level since the deflationary episode of 2015-2016 (Chart I-20). As was the case back then, the slowdown in global growth has played a role, since it has resulted in falling global export prices. Not only do they affect foreign revenues for U.S. businesses, they also impact the price of goods sold at home, and thus have a broad impact on aggregate pricing power. Chart I-20Pricing Power Follows The Global Business Cycle Last year’s dollar strength amplified those headwinds. A strengthening dollar affects profitability through four channels. First, it negatively impacts global growth by tightening financial conditions for foreign borrowers who fund themselves in USD. They are thus more financially constrained when the dollar appreciates. Second, a strong dollar hurts commodity prices and industrial goods prices. Third, a strong dollar negatively impacts the competitiveness of U.S. firms, forcing them to cut their prices to stay competitive. Finally, a strong dollar hurts the translation of overseas earnings back into USDs. As a result, a strong dollar weighs on earnings estimates (Chart I-21).   Chart I-21The Dollar Amplified Margins Problems Since we anticipate global growth to improve and the greenback to buckle, the current pricing power problem faced by corporate America should fade and profit margins should rebound in the second half of 2019. This suggests that for now, declining profit margins remain a risk that needs to be monitored – not a base case to embrace. Our U.S. Equity Sector Strategy service has highlighted that the tech sector has the poorest earnings outlook within the S&P 500. An economic upswing could counteract some of the recent declines in tech margins, but the much more pronounced rise in labor costs in Silicon Valley than in other sectors suggests that tech profits could lag behind other heavyweights like financials and energy. Consequently, BCA recommends a neutral allocation to tech stocks. We instead recommend overweighting financials and the energy sector. Financials will benefit from an easy monetary policy setting that should help credit growth. Moreover, net interest margins are at cycle highs of 3.5%, as banks have prevented interest costs on deposits from rising in line with short rates. Finally, buybacks by financial services firms are rising and will likely battle the tech sector’s buybacks for the pole position this year (Chart I-22).3 Chart I-22Why Are We Neutral On Tech? Our positive stance on energy stems from undue pessimism surrounding the sector. Bottom-up analysts currently pencil in such a large contraction in earnings for this group that, according to their forecasts, energy will curtail 2019 S&P 500 earnings by 18%. With WTI prices back above $65/bbl, rising per-well productivity and easing financing costs, the hurdle to beat is already low. Moreover, the end of U.S. waivers on Iranian sanctions further supports oil prices. In this context, if global growth rebounds and the dollar depreciates, energy stocks could catch fire. Bottom Line: The biggest risk to our positive stance on equities is that earnings are dragged down by declining margins. While the recent softness in margins is concerning, it does not reflect an increase in labor costs. Instead, it is a consequence of eroding pricing power. Falling pricing power is itself a symptom of the slowdown in global growth and a stronger dollar. As both these ills pass, margins should recover in the second half of 2019. Within equities, we prefer financials and energy, as their earnings prospects outshine tech stocks. Upgrading European Equities To Neutral, And Looking For More For equity investors competing against a global benchmark, there is a simple way to express the view that global growth will rebound, safe-haven yields have upside, the dollar will weaken, and that profit margins are a risk to monitor. It is to abandon underweight allocations to European equities and overweight positions to U.S. stocks. This month, we are upgrading European equities to neutral and downgrading U.S. stocks to neutral. Even after this upgrade, we are putting European equities on a further upgrade watch. First, the euro area is much more sensitive than the U.S. to Chinese growth. This also has implication for equities. As Chart I-23 shows, when the ratio of M1 to M2 money supply in China perks up, as it is currently doing, European stocks end up outperforming their U.S. counterparts. This is because the M1-to-M2 ratio ultimately reflects the growth of demand deposits relative to savings deposits in the Chinese banking sector. It therefore informs how spending is likely to evolve. Currently, China’s reflationary efforts point toward a pickup in spending that should lift European exports, and European profits as well. Chart I-23Monetary Dynamics In China Favor Fading Euro Area Bearishness Second, European exports have upside, and unsurprisingly, the bottoming in the BCA Boom/Bust indicator – which captures global growth dynamics beyond just China – is also flagging the end of European equity underperformance (Chart I-24, top panel). Moreover, if the global reflationary period is sustained, the decline in forward interest rates will reverse. This too is consistent with a period of outperformance for European equities (Chart I-24, bottom panel). Third, our overweight stance on financials relative to tech equates to European equities beating their U.S. counterparts. This simply reflects the fact that financials constitute 17.9% of the MSCI euro area index, while tech stocks account for 9.2%. The same sectors represent 12.9% and 26.8% of the U.S. market, respectively. Not only are European banks trading at 0.6-times book value compared to 1.2-times for U.S. lenders, but European banks stand to benefit more than U.S. banks from rising bond yields as they garner a larger share of their income from lending activity. Fourth, European profit margins are toward the bottom third of their distribution relative to U.S. profit margins. As Chart I-25 shows, European profit margins tend to rise when euro area unit labor costs lag U.S. ones. Since the euro area output gap is not as positive as that of the U.S., it is unlikely that European wages will outpace U.S. wages this year. Also, since European stocks are more heavily weighted toward industrials, materials and energy, the sectors that suffered the greatest loss of pricing power during the global economic slowdown, pricing power in Europe could rebound more strongly than in the U.S. This too should flatter European profit margins relative to the U.S. Chart I-24European Equities To Benefit From Rebounding Global Growth Chart I-25European Profit Margins Can Experience A Further Cyclical Lift   Finally, even after adjusting for sectoral composition, European equities trade at a discount to U.S. stocks. On an equal-sector basis, the 12-month forward P/E ratio is 14.2, and the price-to-book ratio is 2.0. For the U.S., the same multiples stand at 20.7 and 4.0, respectively. This means that European stocks are not yet pricing in an improving outlook. Be warned: The positive outlook for European equities relative to the U.S. is a cyclical story. As Section II of this report argues, poor demographics and an excessively large capital stock suggest that European rates of return will continue to lag the U.S. As a result, the return from investing in European stocks is unlikely to beat that of the U.S. beyond 12 to 18 months. Bottom Line: Within a global equity portfolio, we are upgrading the euro area from underweight to neutral at the expense of the U.S., which moves to neutral. We are also putting European equities on a further upgrade watch. Mathieu Savary Vice President The Bank Credit Analyst April 25, 2019 Next Report: May 30, 2019 II. Europe: Here I Am, Stuck In A Liquidity Trap An aging population, a banking sector in poor health, and a private sector focused on building up savings are the key factors undermining euro area growth on a structural basis. A large manufacturing sector makes the euro area vulnerable to EM competition. Unlike the U.S., the region’s tech sector is held back by regulatory burdens, taxes and heavy dependence on bank funding. The euro area growth faces decades of low growth and inflation. Euro area rates will stay depressed, but paradoxically, the euro can still experience structural appreciation. Euro area equities are cheap for a good reason, and banks will continue to weigh on performance. Over the past 10 years, the euro area has gone through a sovereign debt crisis, a double-dip recession, persistent below-target inflation, and most recently, yet another major growth slowdown. Moreover, this economic malaise materialized despite highly stimulative monetary policy, including negative interest rates. The ongoing economic weakness has raised the specter that the euro area is the new Japan. Nearly three decades after the bursting of the Nikkei bubble, the Land of the Rising Sun remains mired in low growth and mild but persistent deflation. Consequently, charts showing that European policy rates or bond yields are tracking Japanese developments with a 17-year lag (Chart II-1) have not only become commonplace, they elicit fears that European growth, interest rates and asset valuations will lag the rest of the world for decades to come. Chart II-1Europe Is Following The Japanese Example In this piece, we discuss the various forces that explain why the euro area economy has been so weak this decade, and why such low interest rates have had so little impact on growth. We also study what sets the U.S. and euro area apart, and whether or not Europe will follow the trail blazed by Japan nearly 30 years ago. The Three Headwinds Three ills have kept European growth particularly depressed this cycle and are likely to remain significant headwinds into the foreseeable future: demographics, the banking sector’s poor health, and nonfinancial private sector balance sheet cleansing. 1)   Demographics This is the most well understood and acknowledged problem impacting Europe today. Since 2008, the European population has grown by 2%, or only 0.2% a year, with the working age population having peaked around that year. Going forward, the picture will only deteriorate: The UN expects Europe’s population to contract by 12% over the next 27 years, and the working age population to fall by 15%. This also means that the dependency ratio – the number of individuals aged less than 15 and above 65 per 100 working-age people – will approximately double over the coming 40 years. This is a clear parallel with Japan. As Chart II-2 illustrates, Europe’s population, the number of working-age individuals and the dependency ratio are all tracking Japan with a 17-year lag. Like Japan, Europe’s trend growth will thus only deteriorate further. Not only will Europe not be able to add as many workers as the U.S. to its total, but it will need to build even fewer schools, malls, office buildings or units of housing. Consequently, both the supply and demand sides of the economy will lag due to this factor alone. 2)   Banking Sector Health The poor health of the euro area banking sector is well known. BCA’s Global Asset Allocation service published an in-depth analysis of the European banking sector last December.4 The piece demonstrated that European banks have been much slower to recognize non-performing loans, curtail credit and rebuild capital than their U.S. counterparts. U.S. bank loans to the private sector fell by 13% in the two years during the crisis, while in Europe, these same loans have only fallen by 2% since 2008. Euro area banks generally remain burdened with significant non-performing loans as a percentage of regulatory capital. Moreover, net interest margins are also dismal, implying that the income cushion against bad loans is thin. Consequently, outside of France, Finland and Germany, European banks have either not grown their loan books to the private sector or, as is the case with Spain, Portugal, and Ireland, these books are continuously shrinking (Chart II-3). Chart II-2Same Demography In Europe Now Than In Japan Then Chart II-3Peripheral Banks Continue To Curtail Credit   The poor health of the European banking system is now constraining the supply of new credit to the rest of the economy. This is a much bigger problem than is the case in the U.S. given that in Europe, 72% of corporate funding comes from the banking system while 88% of household liabilities are also funded this way. In the U.S., the share of bank funding for these sectors is 32% and 29%, respectively (Chart II-4). A weak euro area banking system prevents the nonfinancial private sector from growing as robustly as it could. 3)   Nonfinancial Private Sector Balance Sheet Cleanse Another major drag on European growth has been the continued efforts of the European private sector to rebuild its balance sheet. To use the terminology developed by our upcoming conference speaker Richard Koo, the euro area has been in the thralls of a powerful balance sheet recession. Households in the euro area, Japan and the U.S. are all accumulating more financial assets than liabilities. However, only in the U.S. is the nonfinancial corporate sector building more liabilities than it is accumulating assets (Chart II-5). In Japan and Europe, the nonfinancial corporate sector is also a source of savings for the economy. Moreover, in Europe, the government runs a much smaller financial deficit. The current account balance tells this story vividly. A country’s current account is equal to the private sector’s savings minus investment and minus government deficits. As Italy, Spain, and other peripheral economies increased their aggregate savings after 2008, their large current account deficits vanished. Meanwhile, the governments of countries like Germany or the Netherlands, which sported healthy public finances, did not increase their spending in a commensurate way. This adjustment transformed an overall euro area current account deficit of 1.5% in 2008 into a surplus of 3.0% of GDP today, sending some of Europe’s excess savings abroad. This mimics the post-1990 Japanese experience. In the U.S., where the private sector savings did not rise as durably as in Europe, the current account stopped improving meaningfully in 2010 (Chart II-6). Chart II-5European Businesses Are Savers, Like In Japan Chart II-6The Current Account Dynamics Epitomise The Savings Dynamics   A private sector squarely focused on rebuilding its balance sheet liquidity can lead to a liquidity trap. In this state, monetary policy can become ineffective as spending does not respond to lower interest rates. This is where Europe is currently stuck, explaining why the European Central Bank is finding that inflation and growth are not experiencing much lift, despite seemingly incredibly accommodative monetary conditions. Why Such An Urge To Save? The fact that the household sector is a net saver is not surprising, as this is a normal state of affairs across most economies. But why is the European nonfinancial corporate sector still trying to improve its balance sheet liquidity by accumulating more assets than liabilities? Like Japanese businesses 30 years ago, European firms have large debt loads. Another problem is the lack of capex opportunities in Europe. Why do we make this assertion? The return on assets in Europe has been at rock-bottom levels ever since the introduction of the euro (Chart II-7). In the decade from 1998 to 2008, this was a non-issue. Strong global growth flattered European sales, and easy access to credit meant that via rising leverage euro area-listed nonfinancial corporations were able to generate returns on equity comparable to U.S. firms (Chart II-8, top panel). Once European banks got cold feet and European nonfinancial businesses began focusing on deleveraging, the low level of return on assets became more apparent. Part of the problem is that European profit margins are much closer to Japanese than U.S. levels (Chart II-8, middle panel). Even more damning, asset turnover – how much sales are generated by a unit of assets – has been structurally lower in Europe than in both Japan and the U.S. for multiple decades (Chart II-8, bottom panel). Chart II-7Europe Suffers From A Lower RoA Chart II-8DuPont's Decomposition Shows Why The Euro Area RoA Is Poor   The first factor weighing on the level of asset utilization and returns in Europe is the elevated level of capital stock. As Chart II-9 illustrates, the capital stock as a share of output in Italy, Spain and France dwarfs that of Japan, China or the U.S. Even Germany’s capital stock, which stands well below that of other large euro area economies, is nearly 100 percentage points of GDP larger than the U.S’s. Europe has too large a pool of assets to make any additional investments profitable, especially in light of its poor demographic profile. The second factor weighing on European asset utilization and returns is the poorer level of labor productivity. From the 1950s to the early 1980s, European GDP per worker rose relative to the U.S., albeit peaking at 92% of the levels across the Atlantic. Due to falling working hours in Europe relative to the U.S. since the 1980s, relative output per hour continued to rise until the mid-1990s, peaking at 105% of the U.S. level. However, since their respective zeniths, both relative productivity measures have collapsed (Chart II-10, top panel). Chart II-10Another Symptom Of Europe's Misallocation Of Capital In The 2000s These collapses are in fact worse than Japan’s performance since its lost decades began. As the second panel of the chart shows, since the early 1990s, Japan’s relative output per hour and per worker have flattened – not declined – at around 65% and 72%, respectively, of U.S. levels. Instead, relative European productivity levels are currently converging toward Japanese levels (Chart II-10, third and fourth panels). The particularly poor level of European asset utilization and productivity principally reflects the duality between the peripheral as well as French economies on one side, and Germany as well as the Netherlands on the other side. The exceptionally large capital stock outside of Germany is a legacy of the years directly after the euro’s introduction. Back then, the ECB kept rates low to help Germany, the then-sick man of Europe. These rates were too low for the rest of Europe, encouraging large capital stock build-ups. Moreover, this capital was misallocated, as demonstrated by the tepid growth of output per hour and output per capita in Europe post 2000. Since funds were poorly allocated, the output-to-capital ratio in the periphery collapsed. In other words, the peripheral capital-stock-to-GDP ratios continued rising because the denominator, GDP, lagged. An additional problem for Europe’s asset utilization has been its large manufacturing sector. Even after declining, 20% of Europe’s GDP still comes from the secondary sector versus less than 12% in the U.S. (Chart II-11). This has two consequences for Europe’s asset utilization relative to the U.S. First, a large manufacturing sector requires a much larger asset base than a large service or tech sector. Second, the manufacturing sector is more exposed to competition from emerging markets than the tech sector, or than the domestically-focused service sector. Chart II-11Europe Is Left Exposed To EM Competition In other words, not only has the U.S. experienced less capital misallocation than a large swath of the European economy, it has also re-aligned its economy to make it more robust in the face of competition from emerging economies, while Europe mostly has not. Consequently, hurt by foreign competition and unable or unwilling to re-invent itself, Europe has been left with dwindling relative productivity levels and poor degrees of asset utilization and returns. Why Did The U.S. Economy Transition Better than Europe To A Globalized World? There are many reasons why the U.S. has maintained higher RoAs and has been more successful at transitioning away from a manufacturing-led economy than the euro area. Europe has too large a pool of assets to make any additional investments profitable, especially in light of its poor demographic profile. First, the level of product and service market regulation in Europe is highly punitive. As Chart II-12 illustrates, like Japan, most euro area countries fare poorly in the World Bank’s Ease of Doing Business survey. In fact, Italy scores even lower than China! Meanwhile, the U.S. ranks near the top, not far from Singapore. This means that starting new businesses, competing, and so on is easier in the U.S. than in Europe, helping foster a greater level of entrepreneurialism. Consequently, established businesses have been able to maintain the status quo longer in Europe than in the U.S., preventing creative destruction from purging the system of bad assets. Second, most large euro area economies are burdened by heavy taxes. As Chart II-13 shows, while the U.S. public sector extracts taxes equal to 27.1% of GDP, German, Italian and French taxes equal 37.5%, 42.4% and 46.2% of GDP, respectively, well above the OECD average of 34.2%. Such high levels of taxation disincentivize risk-taking. Lower levels of risk taking by individuals further prevented the degree of creative destruction necessary for Europe to better use its capital stock. Third, and linked to the previous point, government spending equals 34.9% of GDP in the U.S., compared to 48.2% and 56.0% in Italy or France, respectively. A large government has historically stifled innovation and favored the status quo. By no means does this implies that the U.S. system is free of imbalances, but it highlights that compared to two of the three largest European economies, the U.S. public sector has had a less deleterious impact on growth conditions and entrepreneurialism. Moreover, Italy and France have been in deep need of structural reforms that have been lacking. On this front, while the outlook is improving in France under Macron’s presidency, Italy remains mired in immobilism. Fourth, the financing structure in the U.S. favors investing in new businesses and industries, especially when compared to the euro area. Equities represent 78% of the capital structure of nonfinancial corporations in the U.S. while they represent only 61% in the euro area. Moreover, within debt-financing, capital markets account for 68% of sourced funds in the U.S. compared to 28% in the euro area. In fact, junk bond market capitalization only accounts for 2.2% of GDP in Europe compared to 6.0% in the U.S. This suggests that financing risky ventures – and entrepreneurialism is inherently risky – is tougher in Europe than in the U.S. In fact, as a share of GDP, the European venture capital business is less than a sixth the size of the U.S.’s (Chart II-14), a gap that has existed for more than 30 years. Chart II-14U.S. Financing Allows For Greater Risk Taking With all these hurdles, it is unsurprising that Europe has taken more time to make its economy more dynamic in the globalized economy of the 21st century. It also explains why Europe might be suffering more from EM competition than the U.S. Interestingly, this last point may be changing as U.S. voters seem to want to move back toward a larger manufacturing sector. This transition is unlikely to happen without more protectionism. This is a topic for another report. Is Europe Doomed To Japanification… Or Worse? It is easy to see why Europe cannot hope to grow as fast as the U.S., and therefore why the ECB will not be able to lift rates as high as the Fed and why bund yields are likely to lag Treasurys for years to come. Europe has a much more dire demographic profile than the U.S. It needs to purge its capital stock and invigorate its economy through reforms, a smaller public sector, and more diversified financing channels. But can the euro area fare better than Japan has over the past 30 years? On three fronts, the euro area looks better than Japan. First, as Chart II-15 shows, the overall European nonfinancial private sector entered its crisis in 2008 with lower leverage than Japan’s in the early 1990s. Additionally, European stocks were much cheaper in 2007 than the Nikkei was in 1989 (Chart II-16, top panel). Even Spanish real estate was more reasonably valued in 2007 than Japanese real estate in the early 1990s (Chart II-16, bottom panel). This combination means that now that the acute part of the crisis is over, the hole in the European private sector’s balance sheet is much smaller than the one Japan needed to plug 30 years ago. Thus, from a balance-sheet perspective, the need to rebuild savings is lower in Europe than Japan, and we could expect the current period of elevated savings to be shorter in the euro area than it has been in Japan. Chart II-16...And European Assets Were Not As Expensive As Japanese Ones At The Onset Of The Crisis   Second, despite former ECB President Jean-Claude Trichet’s policy mistake of raising interest rates in 2011, the ECB was much quicker to implement extreme easing policy measures than the Bank of Japan was in its day. It took 10 years for the BoJ to cut rates to zero after the Nikkei peaked in December 1989. It took one year for the ECB to do so after stock prices peaked in 2007. It took nine years for the BoJ to expand its balance sheet aggressively, but it took less than two years for the ECB to do so. One of the key benefits of this greater European proactivity has been to keep European inflation expectations much higher than in Japan, curtailing real interest rates in the process. Third, Europe purged economic excesses much more quickly than Japan. The Japanese unemployment rate increased from 2% to 6% between 1990 and 2010. In peripheral Europe, where the worst pre-crisis excesses existed, unemployment rose from 7.5% in 2008 to 18% in 2013 (Chart II-17, top panel). Meanwhile, real wages never adjusted in Japan, but fell 27.0% at their worst in Spain and 32.5% in Greece (Chart II-17, bottom panel). Moreover, the Rajoy reforms in Spain and the Macron reforms in France show that outside of Italy, European governments have been reforming their economies faster than Japan did after the bubble burst in 1990. Chart II-17Bigger Labor Market Purge In Europe Than Japan However, on three fronts Europe is faring worse than Japan. First, up until the last 10 years, Japan benefited from a robust global economy where trade grew strongly. Europe is entering its second decade of low growth in an environment where global economic activity is much weaker, as potential U.S. GDP growth has slowed and China is not growing at a double-digit pace anymore. Moreover, budding protectionism in the U.S. is creating another hurdle for European economic output. Second, the excess capital stock in the European periphery is in fact greater than was the case in Japan in 1990. This suggests that the periphery needs to curtail investments by a greater margin than Japan did. Consequently, peripheral growth will continue to exert downward pressure on aggregate European activity for an extended period. Third, the European fiscal response will not match Japan’s. Investors often decry Japan’s large government debt of 238.2% of GDP as a sign of profligacy. It is not. It is mainly a mirror image of the private sector’s savings surplus. The Japanese government’s ability to run large deficits has prevented a larger fall in output – one that would have equaled the annual savings of the private sector. Without the government’s dissaving, the Japanese private sector would have found its debt load even more onerous to service, and the need to curtail spending would have been even greater as economy-wide cash flows would have been even smaller. Europe does not have a unified fiscal authority that can run such large-scale deficits. Instead, each nation’s government has a limited capacity to accumulate debt as investors worry that overly-indebted governments may very well redenominate what they have borrowed in much weaker currencies than the euro. This risk is made even greater by the fact that there is no euro-area wide deposit insurance scheme. Since Italian and Spanish banks hold large amounts of BTPs and Bonos, respectively, a so-called doom-loop exists that links the health of banks in those countries to the health of their governments, further limiting the public sector’s ability to act as a spender of last resort. This makes the efforts of the private sector in Italy, France, and Spain to increase its savings and bring down its excess capital stock more difficult, and thus, likely to last longer. Even if 10 years after the crisis first emerged, Europe has done more to purge its economy from its pre-crisis excesses than Japan had after its first lost decade, a lack of unified fiscal lever in Europe nullifies this positive. Thus, so long as the European integration efforts remain on the backburner, euro area growth, inflation, and interest rates will continue to look more like Japan’s have over the past 30 years than the U.S. This is likely to cause a big problem once the next recession emerges. Europe will enter that slowdown without any ammunition to reflate growth. Therefore, the next recession is likely to prove very deflationary and test the recent improvement in support for the euro seen across all euro area nations (Chart II-18). If the euro area survives this crisis, and we suspect it will, the probability of a fiscal union will only grow.2 After all, it has been through various crises that Europe has moved closer together, and the rise of a multipolar geopolitical environment dominated by large countries makes this imperative ever more vital. Chart II-18Support For The Euro Is Resilient Bottom Line: We expect European growth and inflation to continue to lag well behind the U.S. for years to come if not a full decade. Ultimately, bringing down the expensive capital stock in the European periphery will be a slow process, especially if governments remain tight fisted. Investment Implications First, core euro area interest rates are likely to remain well below U.S. levels. As long as the European private sector pares back investments in order to normalize its capital stock-to-GDP ratio - a phenomenon that will be most pronounced in the periphery and France - European growth and inflation will lag behind the U.S. This also means that as long as European governments remain shy spenders and do not compensate for the lack of spending from the private sector, in the euro area periphery, European banks will suffer from depressed net interest margins and be structural underperformers. Second, the euro is likely to experience a structural upward drift. The euro is trading at a 10.5% discount to its purchasing power parity. Moreover, high private sector savings not only weigh on inflation, they will also push Europe’s net international investment position higher via an accumulated current account surplus. Both these factors are long-term bullish for the euro. Moreover, the fact that the euro area will soon become a net creditor nation, along with a lack of room to stimulate growth via monetary easing in times of recessions, means that the euro could increasingly become a counter-cyclical currency like the yen. So long as the European integration efforts remain on the backburner, euro area growth, inflation, and interest rates will continue to look more like Japan’s have over the past 30 years than the U.S. Third, European equities are trading at a discount to U.S. equities, but we do not think this guarantees long-term outperformance. European equities are cheap because European growth prospects are poor. If Japan is any guide, European stocks may be set to continue underperforming. This is especially true as financials are over-represented in European equity benchmarks, and banks stand at the epicenter of the European economic malaise. Fourth, European stocks will remain slaves to the global business cycle. Since the crisis, European growth has become hypersensitive to global growth, making European equities very responsive to the global business cycle. The same phenomenon happened in post-1990 Japan. In other words, the beta of European stocks is likely to continue to rise. This phenomenon could be exacerbated if the euro indeed does become a counter-cyclical currency, in which case the euro and European equities would become negatively correlated, like the yen and the Nikkei. Finally, the period from 1999 to 2005 showed how ECB policy targeted at supporting Germany resulted in imbalances that boosted real estate and equity returns in the periphery – in Spain and Ireland in particular. Today, the periphery is the worst offender when it comes to poor bank health and private sector balance sheet rebuilding. This means that the ECB is likely to keep monetary conditions too accommodative for Germany, where balance sheets are more robust and where the capital stock is not as excessive. As a result, financial market plays linked to German real estate are likely to continue outperforming other European domestic plays. They therefore warrant an overweight within European portfolios. Mathieu Savary Vice President The Bank Credit Analyst III. Indicators And Reference Charts The S&P 500 is retesting its all-time high made last fall. While our indicators suggest that U.S. equity have additional upside, the violence of the rally since December argues that a period of digestion may first be needed. Our Willingness-to-Pay (WTP) indicator for the U.S. and Japan continues to improve, while for the euro area, it is flat-lining after a tentative rebound. The WTP indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. The current readings in major advanced economies thus suggest that investors are still inclined to add to their stock holdings. Our Revealed Preference Indicator (RPI) is not echoing this message. 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 signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. The pick-up in global growth remains too feeble for the RPI to validate the advance in stocks. This is why we worry that a correction is likely until economic activity around the globe confirms the rally in stocks. According to BCA’s composite valuation indicator, an amalgamation of 11 measures, the U.S. stock market remains slightly overvalued from a long-term perspective. Nonetheless, the S&P 500 is not at nosebleed valuation levels anymore. Hence, we are betting that once global growth picks up, stocks will be able to move even higher and any correction will prove temporary. Moreover, our Monetary Indicator remains into stimulative territory. The Fed has reiterated its dovish message and global central banks have all engaged in dovish talks, thus monetary conditions should stay supportive. As a result, our speculation indicator has also now fully moved out of the “speculative activity” zone. Our Composite Technical indicator for stocks had broken down in December, but it has now moved back above its 9-month moving average. This positive cyclical signal reinforces our confidence that any correction in stocks should prove tactical in nature, and that on a nine- to twelve-month basis equities have upside. According to our model, 10-year Treasurys are slightly expensive. However, we should not read too much into this. Essentially, yields are currently within their neutral range. Moreover, our technical indicator flags a similar picture. That being said, since BCA expects that over the next 24 months, the Fed will lift rates more than the OIS curve anticipates, and since the term premium is incredibly low, once green shoots for global growth fully bloom, bonds could suffer a violent selloff. Since our duration indicator has begun to deteriorate, it is probably a good time to begin moving out of safe-haven bonds. On a PPP basis, the U.S. dollar has only gotten more expensive. Additionally, our Composite Technical Indicator is becoming increasingly overbought. This combination suggests that the greenback could experience further downside this year. However, this downside will only materialize once global growth shows greater signs of strength. 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 Global Fixed Income Strategy Weekly Report, “A Sustainable Bottom In Global Bond Yields,” dated April 9, 2019, available at gfis.bcaresearch.com 2       Please see U.S. Equity Strategy Weekly Report, “Have SPX Margins Peaked?” dated March 25, 2019, available at uses.bcaresearch.com 3       Please see U.S. Equity Strategy Weekly Report, “Mixed Signals,” dated April 22, 2019, available at uses.bcaresearch.com 4       Please see Global Asset Allocation Special Report "Euro Area Banks: Value Play Or Value Trap?" dated December 14, 2018, available at gaa.bcaresearch.com 5       The European Commission Eurobarometer Surveys show that Europeans overwhelmingly see Europe as a peace project and as a way to maintain a voice in a world dominated by huge players like the U.S., China, or Russia, a world where France, Germany, or Italy individually are marginal players. In 2016, the U.K. population did not share this opinion. Moreover, even after what amounts to a depression, the support for the euro continues to rise in Greece, showing the growing commitment of Europeans to the euro, and the resilience of this commitment to economic shocks. EQUITIES:FIXED INCOME:CURRENCIES:COMMODITIES:ECONOMY:

Highlights The short-term trade is to overweight the DAX or Euro Stoxx 50… …versus German bunds or the S&P 500. These trades have outperformed since late last year and can continue to do so for a while longer. But moving into the second half of the year, it will be time to take profits in these growth-sensitive trades. The long-term position is to own German real estate equities. The hedged position is long German real estate equities, short Swedish real estate equities. Feature Let’s begin with a trivia question. What do Germany, Finland, and Ireland have in common, that the other EU28 countries do not have? Chart of the WeekEuro Stoxx 50 Vs. S&P500 And EM Vs. DM Have Followed Near Carbon Copy Profiles The answer: Germany, Finland, and Ireland are the only three European countries that have a trade surplus with China.1 Germany Catches A Cold When China Sneezes… Chart 2Slowdown In Germany And Finland, No Slowdown In France And Spain Germany and Finland are the European economies most exposed to China, with 17 percent and 14 percent respectively of their extra-EU28 exports heading to the dominant emerging economy (for Ireland it is only 7 percent). This equates to almost 3 percent of GDP for Germany and around 1.5 percent for Finland. Hence, when China sneezes – as it did last year – Germany and Finland are the European economies most likely to catch a cold. It is not a coincidence that Germany and Finland suffered near identical short-term slowdowns in 2018 with the pain focussed in the third quarter. By contrast, the European economies with much less exposure to China – say, France and Spain – suffered no discernible slowdown (Chart I-2). In fact, Spain seemed completely unaffected, growing at a steady and robust 2 percent clip throughout 2018! The corollary is that when China rebounds – as it has recently – Germany and Finland are the European countries most likely to benefit. Since early January, Germany’s DAX has outperformed the 10-year German bund by 15 percent. For the past three months, the DAX has also outperformed the S&P 500, albeit modestly. The trends can continue for a while, but be warned: these short-term cyclical moves are likely to reverse later in the year, perhaps viciously. More about this later. …But Germany’s Structural Growth Model Has Changed Germany’s gross exports of €1.6 trillion equate to almost half of its €3.4 trillion economy. Inevitably, this makes the German economy highly vulnerable to down-oscillations in global growth as, for example, when China sneezes. But here’s the paradox: while the level of German exports is very high, it has been flat-lining at this elevated level since 2012 (Chart I-3). Hence, Germany is no longer deriving any structural growth from its export sector. All of Germany’s post-2012 structural growth has come from domestic demand. Germany’s structural growth model has changed. Through 1999-2007, Germany’s net export contribution accounted for the vast majority of its structural growth; and in 2008, net exports accounted for two-thirds of Germany’s severe economic contraction. But remarkably, since 2012, net exports have made no contribution to Germany’s structural growth (Chart I-4). Meaning that all of Germany’s post-2012 structural growth has come from domestic demand. Chart 3The Level Of German Exports Is High But Flat-Lining Chart 4Since 2012, Net Exports Have Made No Contribution To Germany's Structural Growth One manifestation of this is the post-2012 recovery in Germany’s real estate market. When Germany was deriving most of its growth from external demand, the domestic real estate market withered. In recent years, when growth has come from domestic demand, Germany’s real estate market has started to flourish (Chart I-5). Chart 5German Real Estate Prices Still Need To Catch Up Chart 6German Real Estate Book Values Have Trebled With Germany’s average house price, in real terms, at the same level as it was in 1995, there is still considerable upside outside the major cities such as Berlin, Frankfurt, and Munich. Especially so, because one of the main enemies of the real estate market – substantially higher bond yields – will be absent for some time.2 The strong performance of German real estate equities – a near trebling since 2012 – is just tracking the strong performance of their book values (Chart I-6), which itself is a leveraged function of real estate prices. On the basis that the real estate sector is benefiting from a structural tailwind, the sector is a long-term hold, but for those who want to hedge their exposure, the recommendation is: long German real estate equities, short Swedish real estate equities. What Is Driving Euro Stoxx Outperformance? In response to this week’s title question, some people will ask: has Euro Stoxx 50 outperformance even started? The answer is a clear yes. Relative to both global equities and the S&P 500, the Euro Stoxx 50 has been in a well-established – though modest – uptrend since last September. Interestingly, emerging markets (EM) versus developed markets (DM) has followed a near carbon copy profile, albeit the outperformance was front-end loaded (Chart of the Week and Chart I-7). Euro Stoxx 50 has been gently outperforming. Can this continue? Recent history is not very encouraging. Since the Global Financial Crisis, no bout of Euro Stoxx 50 outperformance has lasted more than a year (Chart I-8). If this pattern continues to hold, it implies that the current bout of Euro Stoxx 50 outperformance will be exhausted within another four months. Chart 7Euro Stoxx 50 Has Been Gently Outperforming Chart 8Euro Stoxx 50 Vs. S&P500 ##br##Follows…   Chart 9…Euro Area Banks Vs. U.S. Tech Could it be different this time? We think not. Euro Stoxx 50 performance relative to the S&P 500 lines up almost perfectly with the relative performance of euro area banks versus U.S. tech (Chart I-9). Given that this defines the sector skew ‘fingerprint’ of the relative position, this defining relationship is fundamental. Meaning that for the Euro Stoxx 50 to outperform the S&P 500 on a sustained basis, euro area banks have to outperform U.S. tech. Likewise, EM versus DM lines up almost perfectly with the relative performance of global resources versus global healthcare (Chart I-10 and Chart I-11). Again, this is not surprising as this just defines the sector skew fingerprint of EM versus DM. Admittedly, in this case the causality could sometimes run from the EM economy to the sector performance – given China’s role in driving resource demand – rather than from sector relative performance to EM versus DM. Nevertheless, for EM to outperform DM, resources have to outperform healthcare. EM versus DM lines up almost perfectly with the relative performance of global resources versus global healthcare. Since last autumn, Euro Stoxx 50 versus S&P 500 and EM versus DM have followed near carbon copy profiles because growth-sensitive financials and resources have outperformed less growth-sensitive technology and healthcare. Chart 10EM Vs. DM Follows… Chart 11…Basic Resources Vs. Healthcare From Sweet Spot To Weak Spot Nevertheless, there is a puzzle: why have growth-sensitive sectors, the DAX, Euro Stoxx 50, and EM outperformed since late last year when the high-profile hard economic data – such as GDP growth and CPI inflation – have been unambiguously weak? High-profile hard data are a record of what happened in the past. The simple answer is that these high-profile hard data are a record of what happened in the past, sometimes the distant past. Yet they matter because central banks’ increasingly ‘data dependent’ reaction functions have become slaves to this backward-looking data. Here’s the paradox: the ‘sweet spot’ for growth-sensitive sectors and markets is when the high-profile backward-looking data – GDP and inflation – are actually weak, while real-time measures of growth – such as short-term credit impulses – are strengthening. This creates a win-win for markets because the dovish pivot by data-dependent central banks lifts asset valuations and the acceleration in real-time growth lifts profit expectations. Sound familiar? It describes the situation since last autumn, and explains why the DAX, Euro Stoxx 50, and EM have outperformed. Now comes the unfortunate corollary: the ‘weak spot’ for growth-sensitive sectors and markets is when the high-profile backward-looking data are strong, while real-time measures of growth – such as short-term credit impulses – are weakening. This is a lose-lose for markets because the hawkish pivot by central banks weighs on asset valuations and the deceleration in real-time growth depresses profit expectations. Almost certainly, this will be the situation later in the year as the high-profile hard data starts to perk up – removing some of the central bank support for valuations – just as short-term credit impulses inevitably roll over – weighing on profit growth expectations. To sum up, growth-sensitive sectors, the DAX, and Euro Stoxx 50 have outperformed since late last year, especially versus bonds and cash – in line with our house view. These trends can continue for a while longer. But moving into the second half of the year, these growth-sensitive positions will transition from sweet spot to weak spot, and it will be time to take profits. As ever, we will tell you when. Stay tuned.   Dhaval Joshi, Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System* This week, we note that that the 65-day fractal dimension for technology versus healthcare is at an all-time low – implying that the recent strong outperformance is highly vulnerable to a technical reversal. Accordingly, this week’s recommended trade is short technology versus healthcare with a profit target of 6.5 percent and a symmetrical stop-loss. In other trades, we are pleased to report that long aluminium versus tin achieved its 6.5 percent profit target at which it was closed. This leaves five open positions. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com. Footnotes 1 Based on the EU28 net exports of goods to China in 2018 by Member State. 2 Please see the European Investment Strategy Weekly Report ‘Monetarists, Keynesians, And Modern Monetary Theory’ April 11 2019 available at eis.bcaresearch.com. Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Highlights We continue to recommend overweighting Mexican local fixed-income markets, the peso and sovereign credit relative to their respective EM benchmarks. A new trade: Sell Mexican CDS / buy Brazilian and South African CDS. Continue holding the long MXN / short ZAR position. We have a lower conviction view that Mexican equities will outperform the EM benchmark. Feature Since the election of Andrés Manuel López Obrador – or AMLO, as he is commonly known – as President, investors have been worrying about Mexico’s fiscal policy and public debt sustainability. Specifically, investors have expressed concern over the debt dynamics of state-owned petroleum company Pemex and its impact on the country’s public debt. While these concerns are not groundless, on balance we find the risk-reward profile of Mexico’s sovereign credit and local currency bonds superior relative to their respective EM peers. Fiscal Sustainability: A Comparative Analysis We discussed debt sustainability in Brazil and South Africa in two of our recent reports, and concluded that their public debt dynamics are unsustainable without drastic fiscal reforms. However, a closer look at debt sustainability in Mexico reveals a different picture. Chart 1Public Debt Burden Including SOE Debt Mexico’s public debt level including the debt of state-owned enterprises is lower than those in Brazil and South Africa (Chart 1). Notably, Mexico’s public debt-to-GDP ratio has been flat over the past three years. Importantly, as detailed below, the two primary conditions for public debt sustainability – the level of government borrowing costs and the primary fiscal balance - are far superior in Mexico relative to Brazil and South Africa. Government borrowing costs in local currency terms are only slightly above nominal GDP in Mexico. Brazil and South Africa score much worse on this measure (Chart 2). The primary fiscal balance in Mexico is much better than in Brazil and South Africa (Chart 3). In fact, Mexico is targeting a primary surplus of 1% for 2019. Chart 2Local Borrowing Costs Versus Nominal GDP Chart 3Primary Fiscal Balances Even with potential pension reforms, Brazil will continue to run primary deficits for the next few years. As we discussed in our recent report on Brazil, the government’s submitted draft on social security reforms will save only BRL190 billion over the next four years, or 0.7% of GDP per year. The current primary deficit is 1.5% of GDP. Unless nominal GDP growth and government revenue growth shoot up, the primary deficit will not be eliminated in the next four years. Unlike Brazil and South Africa, the growth of public sector debt in Mexico is not outpacing nominal GDP growth (Chart 4). Critically, the latter point is also true in Mexico if one includes state-owned enterprises’ debt. Brazil and South Africa sovereign spreads are currently only 40 and 85 basis points above those in Mexico, respectively. The spread will widen further in favor of Mexico, given the latter’s superior fundamentals (Chart 5). In terms of local currency bonds, real yields in Mexico are also on par with Brazil but are well above those in South Africa (Chart 6). Hence, Mexican local bonds offer relative value versus many of their EM peers. Chart 4Public Debt and GDP Growth Chart 5Sell Mexican CDS / Long South African and Brazilian CDS             Nominal local currency bond yields in Mexico are about 200 basis points above the EM GBI benchmark domestic bond yield index (Chart 7). This is great value. Clearly, Mexico’s fiscal worries are overblown relative to those in Brazil and South Africa. Besides, relative valuations of sovereign credit and local bonds adjusted for relative fundamentals warrant outperformance in Mexico versus the other two markets as well as against the respective EM benchmarks in the months ahead. Chart 6Real Bond Yields: Decent Value In Mexico Chart 7Nominal Bond Yields: Great Value In Mexico In addition, AMLO’s administration has proven to be committed to fiscal austerity. Last month, the Ministry of Finance reinforced this notion by announcing a reduction in public spending on social programs in order to balance the loss of fiscal revenue from decreasing oil revenues and lower GDP estimates. Mexico’s fiscal worries are overblown relative to those in Brazil and South Africa. Besides, relative valuations of sovereign credit and local bonds adjusted for relative fundamentals warrant outperformance in Mexico versus the other two markets as well as against the respective EM benchmarks in the months ahead. We view the primary fiscal target of 1% for 2019 as aggressive and potentially unattainable due to a shortfall in revenues. However, these actions prove that AMLO’s administration is not intending to run a large fiscal deficit to finance populist spending programs, as investors had feared. Adding Pemex To Public Finances Pemex’s financial position and the government budget’s reliance on oil revenues are an Achilles’ heel for Mexico’s public finances. Therefore, we have incorporated Pemex into the budget. The resulting fiscal deterioration is not calamitous. Specifically, international credit agencies estimate that Pemex needs an additional $13 billion to $20 billion in capital expenditures per year in order to maintain current operations and replenish reserves. This is in addition to its debt service obligations in the coming years, as shown in Table 1. Table 1Pemex Debt Servicing We have the following considerations on this issue: First, this year the government announced $5.7 billion of financing for Pemex in the form of direct investment, tax breaks, deductions for drilling and exploration costs and revenue recovered from oil theft. In addition, the government will also do a one-time transfer of $6.8 billion from its $15.4 billion budget stabilization fund in order to finance Pemex’s debt payments due by the end of this year. While Congress must first approve the use of these funds, odds are that the bill will pass as AMLO’s party holds a majority. That would bring total capital injection into Pemex to $12.5 billion for the year, almost enough to finance the company’s capital spending this year. Second, in order to revive operations at Pemex in the medium to long term, the government must maintain this level of investment on an annual basis. Essentially, AMLO’s administration will inevitably have to sacrifice part of the $29 billion in net oil transfers it receives every year to finance the oil company and prevent further downgrades to its credit rating. How large is this required Pemex financing as a share of the public budget? We performed a simulation including into the public budget all of Pemex’s payments and all its receipts from the government. While the overall fiscal position deteriorates, it is not unsustainable. The primary and overall deficits would widen to 1.9% and 4.4% of GDP, respectively, if the government eliminates all transfers to Pemex and if the company stops all payments to the government budget, including direct transfers and indirect oil taxes1 (Table 2, Scenario 1). Table 2Mexico: Pemex And Government Budget In such a scenario, Pemex would gain $ 29 billion each year to invest in exploration and production. Pemex is the largest fiscal challenge for Mexico. Yet, even including Pemex debt and required financing, the nation’s fiscal accounts are not worrisome. Chart 8Mexico's Budget Balance Adjusted For Financing To Pemex Third, provided Pemex’s capital spending needs could be met by half of this $29 billion, the government could provide the company just half of this amount (Table 2, Scenario 3). In this scenario, the oil company will have sufficient funds to invest. Meanwhile, the government’s primary and overall fiscal deficit will deteriorate only moderately to 0.7% and 3.2% of GDP, respectively (Chart 8 and Table 2). Finally, the importance of oil revenues – both directly from Pemex and via indirect taxation on the oil industry – have already declined as a share of total fiscal revenues – from 40% in 2012 to 18.3% currently (Chart 9). In short, Mexico’s budget is less reliant on oil revenues. If economic growth picks up, non-oil revenues will improve. Consequently, the government’s fiscal position will improve, giving it more maneuvering room to deal with Pemex. Bottom Line: Pemex is the largest fiscal challenge for Mexico. Yet, even including Pemex debt and required financing, the nation’s fiscal accounts are not worrisome. Cyclical Economic Conditions The Mexican economy is slowing and inflationary pressures are subsiding. Narrow money (M1) and retail sales growth are decelerating (Chart 10, top panel) Capital spending is contracting and non-oil exports will be in a soft spot over the next six months, according the U.S. manufacturing ISM new orders-to-inventory ratio (Chart 10, bottom panel). Core inflation is at 3.55% and is heading south. Chart 9Dependence On Oil Revenues Has Declined A Lot Chart 10Mexico: Cyclical Conditions   Barring major turmoil in EM currency markets that weighs on the peso, weakening growth and disinflation will lead the domestic fixed-income market to discount rate cuts. Mexico’s central bank is very hawkish and will be slow to ease policy. Yet, such a policy stance warrants a bullish view on domestic bonds. The basis is that the longer they delay rate cuts, the more they will need to cut in the future. Investment Strategy We have been recommending an overweight position in Mexico in EM local currency and sovereign credit portfolios, and are reiterating these strategies. Relative value investors should consider this trade: Sell Mexico CDS / buy Brazilian and South African CDS. The Mexican sovereign credit market has made a major bottom versus the EM benchmark and the path of least resistance is now up (Chart 11). EM local currency bond portfolios should continue overweighting Mexico while underweighting Brazil and South Africa (Chart 12). Chart 11Sovereign Excess Returns: A Relative Bull Market In Mexico Chart 12Total Return on Local Currency Bonds in Dollar Terms Similarly, among EM currencies, we favor the Mexican peso because it is cheap (Chart 13). Specifically, we continue to hold the long MXN / short ZAR position; investors who are not yet in this trade should consider entering it now. Chart 13The Mexican Peso Is Cheap Finally, in the EM equity universe, we are overweight Mexican stocks, but our conviction level is lower than in the case of fixed-income markets. The basis is that AMLO’s policies intend to weaken oligopolies and monopolies and undermine their pricing power. These policies are very positive for fixed-income markets and the exchange rate in the long run, as they entail lower inflation resulting from a more competitive environment. Yet, they could hurt profits of incumbent monopolies and oligopolies. This is why we recommend equity investors focus on Mexican small-caps. That said, from a macro perspective, resulting disinflation and lower local rates are also positive for equity multiples. Hence, the Mexican stock market will also likely outperform the EM benchmark in common currency terms.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Juan Egaña, Research Associate juane@bcaresearch.com     Footnotes 1 Indirect oil taxation includes different taxes for the oil fund for stabilization and development, such as rights on drilling and exploration, import and export duties on oil and gas and financing for oil and gas research.

Special Report

Highlights We continue to recommend overweighting Mexican local fixed-income markets, the peso and sovereign credit relative to their respective EM benchmarks. A new trade: Sell Mexican CDS / buy Brazilian and South African CDS. Continue holding the long MXN / short ZAR position. We have a lower conviction view that Mexican equities will outperform the EM benchmark. Feature Since the election of Andrés Manuel López Obrador – or AMLO, as he is commonly known – as President, investors have been worrying about Mexico’s fiscal policy and public debt sustainability. Specifically, investors have expressed concern over the debt dynamics of state-owned petroleum company Pemex and its impact on the country’s public debt. While these concerns are not groundless, on balance we find the risk-reward profile of Mexico’s sovereign credit and local currency bonds superior relative to their respective EM peers. Fiscal Sustainability: A Comparative Analysis We discussed debt sustainability in Brazil and South Africa in two of our recent reports, and concluded that their public debt dynamics are unsustainable without drastic fiscal reforms. However, a closer look at debt sustainability in Mexico reveals a different picture. Chart 1Public Debt Burden Including SOE Debt Mexico’s public debt level including the debt of state-owned enterprises is lower than those in Brazil and South Africa (Chart 1). Notably, Mexico’s public debt-to-GDP ratio has been flat over the past three years. Importantly, as detailed below, the two primary conditions for public debt sustainability – the level of government borrowing costs and the primary fiscal balance - are far superior in Mexico relative to Brazil and South Africa.   Government borrowing costs in local currency terms are only slightly above nominal GDP in Mexico. Brazil and South Africa score much worse on this measure (Chart 2). The primary fiscal balance in Mexico is much better than in Brazil and South Africa (Chart 3). In fact, Mexico is targeting a primary surplus of 1% for 2019. Chart 2Local Borrowing Costs Versus Nominal GDP Chart 3Primary Fiscal Balances Even with potential pension reforms, Brazil will continue to run primary deficits for the next few years. As we discussed in our recent report on Brazil, the government’s submitted draft on social security reforms will save only BRL190 billion over the next four years, or 0.7% of GDP per year. The current primary deficit is 1.5% of GDP. Unless nominal GDP growth and government revenue growth shoot up, the primary deficit will not be eliminated in the next four years. Unlike Brazil and South Africa, the growth of public sector debt in Mexico is not outpacing nominal GDP growth (Chart 4). Critically, the latter point is also true in Mexico if one includes state-owned enterprises’ debt. Brazil and South Africa sovereign spreads are currently only 40 and 85 basis points above those in Mexico, respectively. The spread will widen further in favor of Mexico, given the latter’s superior fundamentals (Chart 5). In terms of local currency bonds, real yields in Mexico are also on par with Brazil but are well above those in South Africa (Chart 6). Hence, Mexican local bonds offer relative value versus many of their EM peers. Chart 4Public Debt and GDP Growth Chart 5Sell Mexican CDS / Long South African and Brazilian CDS             Nominal local currency bond yields in Mexico are about 200 basis points above the EM GBI benchmark domestic bond yield index (Chart 7). This is great value. Clearly, Mexico’s fiscal worries are overblown relative to those in Brazil and South Africa. Besides, relative valuations of sovereign credit and local bonds adjusted for relative fundamentals warrant outperformance in Mexico versus the other two markets as well as against the respective EM benchmarks in the months ahead. Chart 6Real Bond Yields: Decent Value In Mexico Chart 7Nominal Bond Yields: Great Value In Mexico In addition, AMLO’s administration has proven to be committed to fiscal austerity. Last month, the Ministry of Finance reinforced this notion by announcing a reduction in public spending on social programs in order to balance the loss of fiscal revenue from decreasing oil revenues and lower GDP estimates. Mexico’s fiscal worries are overblown relative to those in Brazil and South Africa. Besides, relative valuations of sovereign credit and local bonds adjusted for relative fundamentals warrant outperformance in Mexico versus the other two markets as well as against the respective EM benchmarks in the months ahead. We view the primary fiscal target of 1% for 2019 as aggressive and potentially unattainable due to a shortfall in revenues. However, these actions prove that AMLO’s administration is not intending to run a large fiscal deficit to finance populist spending programs, as investors had feared. Adding Pemex To Public Finances Pemex’s financial position and the government budget’s reliance on oil revenues are an Achilles’ heel for Mexico’s public finances. Therefore, we have incorporated Pemex into the budget. The resulting fiscal deterioration is not calamitous. Specifically, international credit agencies estimate that Pemex needs an additional $13 billion to $20 billion in capital expenditures per year in order to maintain current operations and replenish reserves. This is in addition to its debt service obligations in the coming years, as shown in Table 1. Table 1Pemex Debt Servicing We have the following considerations on this issue: First, this year the government announced $5.7 billion of financing for Pemex in the form of direct investment, tax breaks, deductions for drilling and exploration costs and revenue recovered from oil theft. In addition, the government will also do a one-time transfer of $6.8 billion from its $15.4 billion budget stabilization fund in order to finance Pemex’s debt payments due by the end of this year. While Congress must first approve the use of these funds, odds are that the bill will pass as AMLO’s party holds a majority. That would bring total capital injection into Pemex to $12.5 billion for the year, almost enough to finance the company’s capital spending this year. Second, in order to revive operations at Pemex in the medium to long term, the government must maintain this level of investment on an annual basis. Essentially, AMLO’s administration will inevitably have to sacrifice part of the $29 billion in net oil transfers it receives every year to finance the oil company and prevent further downgrades to its credit rating. How large is this required Pemex financing as a share of the public budget? We performed a simulation including into the public budget all of Pemex’s payments and all its receipts from the government. While the overall fiscal position deteriorates, it is not unsustainable. The primary and overall deficits would widen to 1.9% and 4.4% of GDP, respectively, if the government eliminates all transfers to Pemex and if the company stops all payments to the government budget, including direct transfers and indirect oil taxes1 (Table 2, Scenario 1). Table 2Mexico: Pemex And Government Budget In such a scenario, Pemex would gain $ 29 billion each year to invest in exploration and production. Pemex is the largest fiscal challenge for Mexico. Yet, even including Pemex debt and required financing, the nation’s fiscal accounts are not worrisome. Chart 8Mexico's Budget Balance Adjusted For Financing To Pemex Third, provided Pemex’s capital spending needs could be met by half of this $29 billion, the government could provide the company just half of this amount (Table 2, Scenario 3). In this scenario, the oil company will have sufficient funds to invest. Meanwhile, the government’s primary and overall fiscal deficit will deteriorate only moderately to 0.7% and 3.2% of GDP, respectively (Chart 8 and Table 2). Finally, the importance of oil revenues – both directly from Pemex and via indirect taxation on the oil industry – have already declined as a share of total fiscal revenues – from 40% in 2012 to 18.3% currently (Chart 9). In short, Mexico’s budget is less reliant on oil revenues. If economic growth picks up, non-oil revenues will improve. Consequently, the government’s fiscal position will improve, giving it more maneuvering room to deal with Pemex. Bottom Line: Pemex is the largest fiscal challenge for Mexico. Yet, even including Pemex debt and required financing, the nation’s fiscal accounts are not worrisome. Cyclical Economic Conditions The Mexican economy is slowing and inflationary pressures are subsiding. Narrow money (M1) and retail sales growth are decelerating (Chart 10, top panel) Capital spending is contracting and non-oil exports will be in a soft spot over the next six months, according the U.S. manufacturing ISM new orders-to-inventory ratio (Chart 10, bottom panel). Core inflation is at 3.55% and is heading south. Chart 9Dependence On Oil Revenues Has Declined A Lot Chart 10Mexico: Cyclical Conditions   Barring major turmoil in EM currency markets that weighs on the peso, weakening growth and disinflation will lead the domestic fixed-income market to discount rate cuts. Mexico’s central bank is very hawkish and will be slow to ease policy. Yet, such a policy stance warrants a bullish view on domestic bonds. The basis is that the longer they delay rate cuts, the more they will need to cut in the future. Investment Strategy We have been recommending an overweight position in Mexico in EM local currency and sovereign credit portfolios, and are reiterating these strategies. Relative value investors should consider this trade: Sell Mexico CDS / buy Brazilian and South African CDS. The Mexican sovereign credit market has made a major bottom versus the EM benchmark and the path of least resistance is now up (Chart 11). EM local currency bond portfolios should continue overweighting Mexico while underweighting Brazil and South Africa (Chart 12). Chart 11Sovereign Excess Returns: A Relative Bull Market In Mexico Chart 12Total Return on Local Currency Bonds in Dollar Terms Similarly, among EM currencies, we favor the Mexican peso because it is cheap (Chart 13). Specifically, we continue to hold the long MXN / short ZAR position; investors who are not yet in this trade should consider entering it now. Chart 13The Mexican Peso Is Cheap Finally, in the EM equity universe, we are overweight Mexican stocks, but our conviction level is lower than in the case of fixed-income markets. The basis is that AMLO’s policies intend to weaken oligopolies and monopolies and undermine their pricing power. These policies are very positive for fixed-income markets and the exchange rate in the long run, as they entail lower inflation resulting from a more competitive environment. Yet, they could hurt profits of incumbent monopolies and oligopolies. This is why we recommend equity investors focus on Mexican small-caps. That said, from a macro perspective, resulting disinflation and lower local rates are also positive for equity multiples. Hence, the Mexican stock market will also likely outperform the EM benchmark in common currency terms.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Juan Egaña, Research Associate juane@bcaresearch.com     Footnotes 1 Indirect oil taxation includes different taxes for the oil fund for stabilization and development, such as rights on drilling and exploration, import and export duties on oil and gas and financing for oil and gas research.

Special Report

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