Developed Countries

Highlights The first quarter is in the books, … : Risk may have been out in the fourth quarter, but it is squarely back in fashion so far this year, with equities and high yield posting gaudy first-quarter returns. … and events have compelled us to modify our high-conviction Fed call, … : There may yet be another four or more rate hikes, but they’re not going to occur this year. … but we’re still confident in our asset-allocation recommendations, … : The Fed may no longer be a menacing presence, but that doesn’t mean Treasuries and longer-maturity bonds are going to have it easy from here. … which should benefit from a more accommodative monetary policy outlook: Conditions remain favorable for equities and spread product, and unfavorable for Treasuries, even if the underlying drivers have shifted. Feature Table 1Whipsaw Newton’s Third Law holds that for every action there is an equal and opposite reaction. Markets have been busy supporting the theorem, as the fourth quarter’s sharp selloff has been nearly erased by the potent first-quarter rally (Table 1). Risk assets have been on a rollercoaster ride, though our economic outlook has been more or less unchanged. We chalked up the fourth quarter’s selloff to fears that the Fed was threatening the expansion. Conversely, the first quarter’s snapback likely owed quite a bit to the Fed’s pivot. By shifting its emphasis from trying to prevent inflation from getting away on the upside to trying to keep inflation expectations from falling too far, the Fed has gone from removing the punch bowl to promising to keep it full. In financial markets, risk assets should be the biggest relative beneficiaries. The Fed’s turn thwarted our more-hikes-than-expected call, at least in the near term. That surprise has been compounded by the administration’s seeming intent to pack the board of governors with nominees chosen solely on the basis of their uber-dovishness, and has inspired us to reflect on our calls. We like to share our reflections, as well as the internal BCA discussions and the client questions that shed light on our views. This week’s report examines some of the most important issues on our minds, and the minds of our colleagues and clients. Q: What does the Fed do from here? The quarterly summary of economic projections compiles FOMC meeting participants’ expectations for the likely path of key economic indicators (real GDP growth, unemployment and inflation) and monetary policy. The latest release revealed that Fed governors and regional presidents sharply dialed back their rate hike expectations between the December meeting and the March meeting (Chart 1). The median participant lopped 50 basis points (“bps”) off of his/her year-end 2019 and terminal fed funds rate projections, calling for no hikes in 2019 and just one more for the current cycle, in 2020. The rationale is a bit of a mystery, as the median participant’s estimates of GDP and inflation only came down modestly, and his/her unemployment rate estimates only rose modestly. It made sense for the Fed to turn away from the gradual pace of hikes it pursued in 2017 and 2018 in response to the sharp tightening in financial conditions brought on by the fourth-quarter selloff. The ensuing rallies in equities and high-yield bonds have undone much of that tightening, however. From a data perspective, it seems the Fed is mostly holding off to see how the outlook for the rest of the world evolves. The minutes of the March meeting, released last week, suggested that there may be more nuance to the Fed’s embrace of patience than markets initially perceived. The money markets had been calling for a 25-bps cut in the fed funds rate, to 2.25%, by the end of 2020; following the March meeting, they swiftly moved to price in a high likelihood of a second cut, to 2% (Chart 2). That outlook does not exactly accord with the committee’s more measured take: “Several participants observed that the [‘patient’] characterization … would need to be reviewed regularly[.] … A couple of participants noted that the ‘patient’ characterization should not be seen as limiting the Committee’s options[.] … Several participants noted that their views of the appropriate target range for the federal funds rate could shift in either direction[.] … Some participants indicated that if the economy evolved as they currently expected, … they would likely judge it appropriate to raise the target range … modestly later this year[.]” Chart 2... To Keeping It Full We continue to believe that the Phillips Curve is alive and well inside the Fed’s policy framework. The inverse relationship between inflation and unemployment is embedded in its macroeconomic models, and will compel the Fed to tighten policy in response to an unemployment rate that is nosing around 50-year lows (Chart 3). With the committee seemingly willing to let inflation get a bit of a head start before it tightens policy, it may well have to hike faster, and establish a higher terminal rate, than it otherwise would have if it had continued to follow a steady course. We believe the tightening cycle has been postponed rather than truncated, contrary to the money market’s view. Chart 3Sixties Flashback Bottom Line: The Fed is not going to take the fed funds rate to 3.25 - 3.5% by year end, as we expected late last year. We still believe the terminal rate is in that neighborhood, however, and the longer the Fed cools its heels, the greater the potential that it could exceed our estimate. Q: What is the outlook for the rest of the world? The March minutes revealed that conditions in the rest of the world continue to influence the Fed’s policy decisions. The slowdown in China, the uncertain outcomes of ongoing trade talks and Britain’s separation from the EU shadow the outlook in emerging economies and the major non-U.S. developed economies. The outlook for China, other emerging markets, and Europe have been a spirited subject of discussion within BCA. With a majority of the managing editors perceiving the signs of some green shoots, we upgraded Chinese equities to overweight from equal weight, and European and EM equities to equal weight from underweight, at our monthly View Meeting last week. An end to China’s deleveraging campaign may be all the rest of the world needs to show a little more life. Chart 4As China Goes China is a critical influence on our global view. We expect that policymakers have already begun de-emphasizing their deleveraging campaign, as suggested by March’s credit data, released Friday, and will encourage lenders to lend. No one at BCA expects a stimulus campaign on the order of the massive 2008 and 2016 efforts, but the general view is that policymakers can take steps to end the deceleration in China’s growth, since it was rooted in their deleveraging drive. The deceleration weighed on trade and manufacturing activity around the world (Chart 4), and may have been the catalyst for the global mini-slowdown. The rest of the world should benefit from the easing in financial conditions driven by the global equity rally. The decline in bond yields has also helped ease financial conditions, and the nearly unanimous dovishness of major-economy central banks may provide investors and consumers with additional comfort. The key issue for the U.S. economy, and U.S.-oriented investors, is whether or not the other major economies will slow enough to cool off the U.S. at a time when its fiscal impulse is slowing. We have a sense that China and Europe are beginning to turn, and we do not expect spillovers to drag on U.S. growth, but continued rallies in U.S. risk assets probably require some sort of revival beyond its shores. Q: How do corporate profits look? Is the consensus overly optimistic? The corporate profit outlook is getting less ambitious by the day. Over the last three months, consensus expectations for first quarter S&P 500 share-weighted earnings have fallen by 6.5%, as analysts downwardly revised their year-over-year growth projections from +3.5% to -2.2%. Management teams seek to under-promise and over-deliver, and do their best to guide analyst expectations to a level their companies can exceed. Since 1994, according to Thomson Reuters, about two-thirds of companies have reported earnings that beat estimates. On average over that stretch, companies have beaten estimates by a margin of 3.2%. We are therefore inclined to take the projected earnings contraction with a grain of salt. Corporations seem to have lowered the bar to a level they should be able to clear without too much trouble. Chart 5Wages Aren't Yet Pressuring Margins ... We are further inclined to question the projected 2.2% contraction in earnings, given that revenues are projected to grow by 5% in the quarter. The disparity implies margin contraction of close to 7%. Compensation is the largest component of corporate expenses, with the remainder roughly split between interest expense and other input costs. The other meaningful input is the dollar, which should most often exhibit an inverse relationship with margins. Real unit labor costs is the compensation series that most directly impacts profit margins, and it has been contracting on a year-over-year basis, augmenting margins (Chart 5). It will continue to do so as long as nominal wage growth lags inflation and productivity gains. BBB-rated corporate yields were materially higher in the first quarter than they were a year ago, and may have taken a modest bite out of margins, but they’re now back to where they were then and cannot explain the projected 7-ppt margin haircut by themselves (Chart 6). Producer prices grew just 2.2% on a year-over-year basis, slightly ahead of consumer prices (Chart 7), suggesting that margins only slightly narrowed from the disparity between input costs and selling costs. Chart 6... And Interest Rates Aren't Anymore Chart 7Input Costs Are Manageable The broad trade-weighted dollar gained 6% from 1Q18 to 1Q19. Assuming corporations lower prices to defend market share against foreign competitors, profit margins should fall when the dollar rises. Dollar appreciation likely exerted some incremental pressure on margins, but the internal model we’ve previously referenced pegs the EPS impact of a 10% rise in the dollar at 2.5%, far too small for a 6% rise in the dollar to drive a 7-ppt fall in margins. If the revenue estimates are accurate, it seems to us that management must be sandbagging its earnings guidance to some degree. The 10-year Treasury yield will have a harder time falling further now that the Fed is already awfully dovish. Q: Are you having any second thoughts about your duration recommendation? Our below-benchmark duration call was largely founded on our expectation that the Fed was going to surprise complacent markets by hiking more than they expected. It instead surprised dovishly, and the OIS curve responded by pricing in an additional rate cut by the end of next year. The 10-year Treasury yield melted, in accordance with our U.S. Bond Strategy service’s golden rule1 (Chart 8). Chart 8The Golden Rule The surest way to mess up a Fed call is to allow what one thinks the Fed should do to intrude on one’s assessment of what the Fed will do. We did not fall into that trap: our view that the Phillips Curve exerts considerable influence over the Fed and other central banks is founded in the observation that virtually every mainstream macroeconomic model incorporates an inverse relationship between inflation and unemployment. As noted above, we see the Fed’s hiking campaign as extended rather than ended. We believe pausing the hiking campaign will extend the expansion and allow the economy to build up more momentum. More momentum would merit higher real rates, and we also expect it would promote inflation pressures given that the output gap is already closed. We were admittedly on the wrong side as the 10-year Treasury yield fell from 3.25% to 2.4%, but still lower yields would be incompatible with our constructive view of the U.S. economy. With much of the drag on Treasury yields seeming to have come from overseas, it’s also important to note that lower major-economy yields would be incompatible with our house view that the global economy is on the cusp of rebounding (Chart 9). Chart 9Yields Rise When Green Shoots Appear Bottom Line: We missed the slide in the 10-year Treasury yield because we failed to foresee the Fed’s pivot, and because we may have focused too much on U.S., rather than global, conditions. We do not see yields falling much further, however, now that the Fed’s capacity for dovish surprises is spent, and green shoots are starting to appear in China and Europe. Q: How was the Final Four? Fantastic, and we recommend gathering some old college friends and making the trip to cheer on your alma mater should it qualify. Bring your kids if they’re old enough. If your school wins it all, you’ll share lifelong memories of the sort the Virginia alumni who attended the games will cherish. We’ll always have Minneapolis. Go ‘Hoos!   Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com     Footnotes 1      Treasuries beat cash when the Fed hikes less than the money market expects, and lag cash when it hikes more than expected. Please see the U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing,” published July 24, 2018. Available at usbs.bcaresearch.com.

Special Report

Dear Client, I hosted a Webcast on Thursday, April 4th, during which I discussed the major investment themes and views I see playing out for the rest of the year and beyond. A replay can be accessed from this link. Best regards, Peter Berezin, Chief Global Strategist Highlights The exodus of baby boomers from the labor market is likely to lower income growth, which will reduce sales growth among publicly-listed companies over the coming years. After-tax profit margins may also come under pressure, while both the risk-free interest rate and the equity risk premium could rise. While it is difficult to estimate the magnitude of these effects, our best guess is that aging will have a moderately negative, though far from catastrophic, effect on equity prices. Even if the headwinds to equities from population aging turn out to be minimal, long-term investors are still likely to earn subpar returns given that valuations are fairly stretched today. In such an environment, a nimble investment approach, which focuses on the state of the business cycle among other things, will be necessary for generating alpha. Investors should maintain a cyclically bullish stance towards global equities for the time being, but begin paring back exposure late next year in advance of a recession in 2021. Feature Will Grandpa Sink The Stock Market? About 55% of U.S. stock market wealth is held by the baby boom generation – those born between 1946 and 1964 (Chart 1). As baby boomers increasingly exit the labor force and draw down their accumulated savings, there is a growing concern that equity prices will come under pressure.  Financial pundit Robert Kiyosaki published a book more than a decade ago arguing, in his usual hyperbolic style, that retiring boomers would trigger “the biggest stock market crash in history.”1 Conveniently, he even gave a date for the crash: 2016, the year when the first baby boomers would celebrate their 70th birthdays. Kiyosaki’s prophesized crash never happened. But does he still have a point? Will aging populations torpedo stocks? A Framework For Thinking About The Value Of The Stock Market Conceptually, the value of the stock market should equal the present value of the cash flows which shareholders can expect to receive. As Appendix 1 explains, this means that today’s dividend yield should equal the difference between the rate that investors use to discount those cash flows and the expected growth rate of cash flows. The discount rate is the sum of the risk-free rate and an equity risk premium. Cash flow growth tends to track earnings growth. The latter can be broken down into sales growth and margin growth. Thus, one can express the dividend yield ( D/P )  as the sum of four variables: The formula shows that an increase in either sales growth or profit margins will reduce the dividend yield (thus implying an increase in equity prices), while an increase in either the risk-free rate (rf) or the equity risk premium (rp) will raise the dividend yield. As we discuss below, demographic trends are likely to shift all four variables in the direction of lower equity prices. As baby boomers increasingly exit the labor force and draw down their accumulated savings, there is a growing concern that equity prices will come under pressure. 1. Aging And Sales Growth At the economy-wide level, business sales closely track GDP growth (Chart 2). GDP growth, in turn, is simply the sum of employment growth and productivity growth. Chart 2Business Sales Closely Track GDP Growth As baby boomers continue to age, more and more of them will leave the labor force. This will result in slower labor force growth. While this development will weigh on GDP growth, it is important to recognize that most of the decline in labor force growth in developed economies has already occurred (Chart 3). Chart 3ADM Labor Force Growth: Most Of The Decline Has Already Taken Place (I) Chart 3BDM Labor Force Growth: Most Of The Decline Has Already Taken Place (II) The annual growth rate of the labor force in the G7 peaked at 1.7% in 1980, but has averaged only 0.3% over the past decade. The UN estimates that the number of people in G7 economies between the ages of 15 and 64 – a crude proxy for the potential size of the labor force – will contract by 0.1% per year over the next twenty years, a modest step down from positive growth of 0.1% over the past decade. Productivity growth has been quite weak in developed economies since the mid-2000s (Chart 4). Whether this trend persists remains to be seen. On the positive side, robotics, AI, and genetic engineering could all boost productivity growth. On the negative side, cognitive test scores in developed economies have peaked and are now trending lower. Consistent with this observation, Heckman and LaFontaine have shown that properly measured, the U.S. high school graduation rate has been falling since the early 1970s.2 This makes baby boomers arguably the best educated generation in history. An open question concerns the extent to which slower economy-wide GDP growth filters down to sales growth among listed companies. While it is highly likely that S&P 500 sales growth will decline in an environment of weaker growth, the impact of falling GDP growth on sales may be blunted by at least three factors. First, developed economy firms will still be able to benefit from rising sales to emerging markets, even if they are suffering from sluggish sales growth at home. Second, domestic consumption will decelerate more slowly than income growth as older workers deplete their savings. Third, lower productivity growth will coincide with less “creative destruction,” which will benefit incumbent firms. In fact, this is already happening. Chart 5 shows that net firm formation has fallen dramatically since the 1970s. Chart 4In Developed Markets, Productivity Growth Has Been Falling For Over A Decade Chart 5A Sharp Drop In New Firm Formation   2. Aging And Profit Margins Population aging can affect profit margins in two ways: First, it can shift spending across sectors. For example, if age-related spending migrates from sectors with high margins to those with low margins, aggregate profit margins will decline. Second, aging can affect margins within sectors. Looking across sectors, health care spending is likely to rise in response to population aging. According to the Congressional Budget Office, health care expenditures are set to increase from 5.2% of GDP to 9.2% of GDP by 2048 (Chart 6). There once was a time when health care margins were double the S&P 500 average (Chart 7). During the past two decades, however, health care margins have fallen, and are now slightly below the S&P average. Chart 7AS&P 500 Margins By Sector (I) Chart 7BS&P 500 Margins By Sector (II) Looking out, it is likely that health care margins will continue to contract, as cash-strapped governments look for ways to cut health care costs. Presidential hopefuls Bernie Sanders, Elizabeth Warren, and Kamala Harris have all championed “Medicare for all.” If implemented, such a policy prescription would decimate health care sector profits by reducing demand for private insurance while giving the federal government more bargaining power to negotiate lower drug prices. Most of the decline in labor force growth in developed economies has already occurred. The only silver lining, pardon the pun, for margins is that older people tend to display greater brand loyalty (Chart 8). Whether this is because of experience, habit, or nostalgia is not clear, but older consumers switch products less often, preferring to stick with “what they know.”3 Perhaps reflecting a general tendency for self-reported happiness to increase in old age, elderly consumers also tend to express greater satisfaction with their purchases. Nevertheless, on balance, we expect aging to make a slightly negative contribution to profit margins. 3. Aging And The Risk-Free Rate Proponents of the secular stagnation thesis posit that demographic trends have led to a decline in the neutral rate of interest. As Chart 9 shows, aging could depress the neutral rate if an older population causes the aggregate investment schedule to shift inwards or the aggregate savings schedule to shift outwards. Chart 9Two Ways For Real Rates To Fall According to the standard “accelerator” model, the optimal level of investment spending is determined by the growth rate of aggregate demand.4 To the extent that slower population growth discourages firms from expanding capacity, this will lead to a lower neutral rate of interest. That said, as noted above, most of the decline in labor force growth in developed economies has already occurred. This implies that investment spending may not fall much further from current levels. What about savings? At the outset, aging will increase savings as more people move into their prime saving years (ages 30-to-50). Declining fertility rates will also tend to reduce spending on children, while allowing more women to join the labor force. Aging could morph from a force that has dragged down the neutral rate of interest to one that will start slowly pushing it back up. Over time, however, aging is likely to reduce the savings rate, as more workers retire, leaving fewer workers in the labor force. Once health care spending is included, consumption actually increases in old age, especially in the last few years of life (Chart 10). Globally, the ratio of workers-to-consumers increased from the early 1970s to the middle of this decade, but has now begun to decline (Chart 11). This suggests that aging could morph from a force that has dragged down the neutral rate of interest to one that will start slowly pushing it back up. Chart 10Savings Over The Life Cycle Chart 11The Worker-To-Consumer Ratio Has Peaked Globally   Instead of running larger deficits to finance pension and health care spending, governments could raise taxes. This would reduce private consumption, thus generating additional savings for the economy. While such a step could prevent the risk-free interest rate from rising, some of the tax burden would likely end up falling on the owners of capital in the form of higher taxes on dividends, capital gains, and business profits. This would lead to lower after-tax profit margins and slower sales growth. The end result would still be the same: weaker equity prices. 4. Aging And The Equity Risk Premium When people discuss the impact that aging baby boomers will have on the stock market, they are usually – whether they realize it or not – talking about the equity risk premium. By definition, for every seller of stock there must be a buyer of stock. If baby boomers start selling shares to finance their retirement spending, someone will need to buy their shares, provided the price is low enough. The question is by how much do share prices need to fall to clear the market? In theory, households should accumulate assets over their working years and then deplete their savings in retirement. In practice, uncertainty about the timing of death, the desire to pass on wealth to future generations, and the need to maintain enough assets to finance unforeseen health care expenses all tend to induce households to run down wealth at only a modest pace during retirement. A study by John Ameriks and Stephen Zeldes using a random sample of 16,000 accounts from a major retirement fund found no evidence that households gradually decrease equity allocations as they age.5 Looking out, it is possible that baby boomers will run down their equity holdings more quickly than prior generations. For instance, the decline in family size over the past fifty years and evolving societal norms may end up causing boomers to bequeath smaller estates than in the past. The increasing popularity of annuities may also reduce the likelihood of unintended bequests. In addition, the proliferation of target-date funds may produce a more rapid shift out of equities than would occur if investors had to consciously decide to reduce exposure to the stock market. Nevertheless, we suspect that any additional selling by baby boomers will only put modest downward pressure on equity prices. This is because the wealthiest 10% of U.S. households hold 84% of all stock market wealth, while the bottom 50% hold less than 1% (Chart 12). Households in the top one percent of the wealth distribution hold close to half of all stocks. These ultra-wealthy households tend to consume a fairly small share of their assets during retirement. As a result, most of their assets end up being bequeathed to family members and/or charities when they pass away. Chart 12The Wealthiest 10% In The U.S. Own The Bulk Of Equities Chart 13Foreign Ownership Of U.S. Stocks Has Grown Foreign purchases of U.S. stocks should also blunt the impact of any selling by retiring baby boomers. Foreigners now hold 27% of U.S. stock market wealth, up from 5% in the mid-1970s (Chart 13). If foreign demand for U.S. equities increases in line with global ex-U.S. real GDP, this will add about $250 billion in demand for U.S. stocks (in constant dollars) over the next twenty years. This is five times greater than the roughly $50 billion in annual net selling that would occur if all investors followed the popular rule of thumb which instructs them to take their age and subtract it from 100 in order to determine how much of their financial wealth to allocate to equities. Investment Implications The discussion above suggests that aging is likely to have a moderately negative, though far from catastrophic, effect on equity prices by: 1) reducing sales growth among listed companies; 2) putting downward pressure on after-tax profit margins; 3) increasing the risk-free rate of interest; and 4) raising the equity risk premium. It is difficult to be precise about how large these effects will turn out to be. Three factors cloud any potential calculation. First, as the equation presented at the outset of this report illustrates, small shifts in any one variable can lead to big changes in the fair value of the stock market. To see this point, let us take the current S&P 500 dividend yield of 2.0% and add 1.5% to account for net share buybacks (gross buybacks less share issuance). This gives a “cash flow to shareholders” yield of 3.5%. Now consider a one percentage-point increase in the equity risk premium. An increase in the equity risk premium of this magnitude would require the cash flow yield to rise to 4.5%. This, in turn, would necessitate that equity prices fall by 22%. That’s a lot. The second factor that makes it difficult to be precise about the extent to which demographic changes will affect stock prices is that there are likely to be interaction effects among the variables in the equation above. For instance, rising labor shortages stemming from the withdrawal of baby boomers from the labor market could put downward pressure on profit margins. The resulting increase in labor’s share of income would likely boost aggregate demand, thereby contributing to a higher neutral rate of interest. Chart 14Japan’s Population Bust Was Largely Foreseen At this point, one of two things could happen. On the one hand, if central banks failed to raise rates, this would cause the economy to overheat, leading to higher inflation. Higher inflation could push up the equity risk premium, as was the case in the 1970s. On the other hand, if central banks did raise interest rates, this could cause debt burdens to become unsustainable. That could also push up the equity risk premium. The third factor that makes it challenging to estimate the impact of demographics on stocks is that it is difficult to know the proper baseline for computing the effects of aging on stock market valuations. To the extent that the variables in the equation are all forward-looking, they should incorporate the market’s views on how the retirement of baby boomers will affect the relevant drivers of equity returns. This implies that shifts in equity valuations must stem from forecast revisions rather than from anticipated trends. Thus, as an example, any change to the “sales growth” term should be properly viewed as expressing not how future sales growth will differ from past sales growth, but by how much future sales growth will differ from what investors are currently projecting. It is tempting to assume that the market has already priced in the impact of population aging.  After all, the fact that baby boomers are exiting the labor force is not exactly breaking news. Yet, in the past, markets have proven to be surprisingly oblivious to easy-to-predict demographic developments. For example, Japanese investors were keen to buy stocks and real estate in the late 1980s, despite the fact that published projections at the time showed that the country’s working-age population would decline at an accelerating pace over the subsequent decade (Chart 14). Academic work supports the view that investors tend to understate the importance of demographic forces. Stefano Della Vigna and Joshua Pollet have shown that a trading strategy that exploits predictable age-related changes in spending on such items as toys, bicycles, beer, and life insurance would have earned an annualized risk-adjusted return of approximately six percent.6 Chart 15Poor Long-Term Returns In Store For U.S. Stocks The fact that equity valuations today are stretched in the U.S., and no better than middling in the rest of the world, should add to investor concerns. Chart 15 shows that the ratio of household equity holdings-to-total financial assets has been an extremely reliable predictor of 10-year equity returns in the post-war era. Today, this indicator is pointing to low single-digit returns for U.S. stocks over the next decade. This suggests that even if the headwinds to equities from population aging turn out to be minimal, long-term investors will still earn subpar returns from stocks relative to recent history. In such an environment, a nimble investment approach, which focuses on the state of the business cycle among other things, will be necessary for generating alpha. As discussed in our recently published Strategy Outlook, investors should maintain a cyclically bullish stance towards stocks for the time being, but begin paring back exposure late next year in advance of a recession in 2021.7   Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com   Footnotes 1      Robert T. Kiyosaki, and Sharon L. Lechter, “Rich Dad's Prophecy: Why the Biggest Stock Market Crash in History Is Still Coming...And How You Can Prepare Yourself and Profit from It!” Time Warner, 2003. 2      James Heckman and Paul LaFontaine, "The American High School Graduation Rate: Trends and Levels," The Review of Economics and Statistics 92:2, (May 2010): 244–262. 3      Please see Rajesh Iyer, Timothy H. Reisenwitz, and Jacqueline K. Eastman, “The Impact Of Cognitive Age On Seniors’ Lifestyles,” Marketing Management Journal, 18:2, (Fall 2008); and Komal Gyani Karani, and Katherine A. Fraccastoro, “Resistance To Brand Switching: The Elderly Consumer,“ Journal of Business & Economics Research, 8:12, (December 2010). 4      In most economic models, the capital-to-output ratio is assumed to converge towards a stable level over time. By definition, the capital stock in Year t is determined by the capital stock in Year t-1 plus whatever net investment (gross investment minus depreciation) takes place in Year t. In general, the optimal net investment-to-GDP ratio will equal the product of the capital-to-output ratio and the growth rate of GDP. For example, suppose that the capital-to-output ratio is three (meaning that the capital stock is three times as large as GDP). If output does not change from one year to the next, no additional net investment would be necessary to maintain a stable capital-to-output ratio. However, if output is growing at 2%, net investment of 3X2%=6% of GDP would be required. 5      John Ameriks and Stephen P. Zeldes, “How Do Household Portfolio Shares Vary with Age?” Working Paper, 2004. 6      Stefano Della Vigna, and Joshua M. Pollet, “Demographics and Industry Returns,” American Economic Review, 97:5 (2007). 7      Please see Global Investment Strategy, “Second Quarter 2019 Strategy Outlook: From Dead Zone To End Zone,” dated March 29, 2019.   Strategy & Market Trends MacroQuant Model And Current Subjective Scores Tactical Trades Strategic Recommendations Closed Trades

Highlights Evidence continues to mount that the Chinese economy is in a bottoming process. This suggests the path of least resistance for the RMB is up. Meanwhile, as the U.S. and China move closer to a trade deal, any geopolitical risk premium in the RMB will slowly erode. The ultimate catalyst for CNY longs will be depreciation in the U.S. dollar, which we believe is slowly underway. The ECB is turning more dovish at a time when euro area growth is hitting a nadir. This will be bullish for the euro beyond the near term. Our limit buy on the pound was triggered at 1.30. Target 1.45 with stops at 1.25. With the Aussie dollar close to the epicenter of Chinese stimulus, data down under is increasingly stabilizing. We are closing our short AUD/NOK position for a small profit. Feature Chart I-1The Chinese Yuan Is Pro-cyclical In addition to the dovish shift by global central banks, most investors are rightly fixated on China at this juncture in the economic cycle.  For one, it has been mostly responsible for the mini cycles in the global economy since 2014. And with improvements in both Chinese credit and manufacturing data in recent months, the consensus is drawing closer to the fact that we may be entering a reflationary window. Looking at risk assets, MSCI China is up 25% from its lows, while the S&P 500 is up 20%. Commodity prices are also rising, with crude oil hitting a new calendar-year high this week. The corollary is that if the improvement in Chinese data proves sustainable, it will propel these asset markets to fresh highs. The evolution of the cycle has important implications for the yuan exchange rate, because the RMB has been trading like a pro-cyclical currency in recent years. The USD/CNY has been moving tick for tick with emerging market equities, Asian currencies, and even some commodity prices (Chart I-1). Ever since its liberalization over a decade ago, the RMB may finally be behaving like a free-floating exchange rate. Therefore, a simple evaluation of how relative prices between China and the rest of the world evolve will be valuable input for the fair value of the RMB exchange rate. Reading the tea leaves from Chinese credit data can be daunting, but we agree with the assessment of our China Investment Strategy team that while the credit impulse has clearly bottomed,1 the magnitude of the rise is unlikely to be what we saw in 2015-2016. That said, a higher credit-to-GDP ratio also requires a smaller increase in credit growth to have an outsized effect on GDP. As such, monitoring what is happening with hard data in the economy concurrently – in particular, green shoots – could add valuable evidence to the reflation theme. A Repeat Of 2016? Cycle bottoms can be protracted and volatile, but also V-shaped. So it is useful when economic data is at a nadir to pay attention to any green shoots emerging, because by the time the last piece of pertinent economic data has turned around, it may well be too late to call the cycle. Admittedly, most measures of Chinese (and global) growth remain weak. But there have been notable improvements in recent months that suggest economic velocity may be picking up: Production of electricity and steel, all inputs into the overall manufacturing value chain, are inflecting higher. Intuitively, these tend to lead overall industrial production. Overall industrial production remains weak, but the production of electricity and steel, all inputs into the overall manufacturing value chain, are inflecting higher. Intuitively, these tend to lead overall industrial production (Chart I-2). Electricity production for the month of February grew 5% after grinding to a halt in 2015-2016. Production of steel also rose by 7%. If these advance any further, they will begin to exceed Q4 GDP growth, indicating a renewed mini-cycle. Chart I-2A Revival In Industrial Activity Chart I-3Metal Prices Are Sniffing A Rebound   In recent weeks, both steel and iron ore prices have been soaring. Many commentators have attributed these increases to supply bottlenecks and/or seasonal demand. However, it is evident from both the manufacturing data and the trend in prices that demand is also playing a role (Chart I-3). Overall residential property sales remain soft, but evidence from tier-1 and even tier-2 cities is signalling that this may be behind us, given robust sales. Over the longer term, the ebb and flow of property sales has tended to be in sync across city tiers. A revival in the property market will support construction activity and investment. House prices have been rising to the tune of 10% year-on-year, and real estate stocks in China may be sniffing an eventual pick-up in property volumes (Chart I-4). Over the last 20 years or so, Chinese credit growth has been a reliable indicator for car sales with a lead of about six months. Government expenditures were already inflecting higher ahead of last month’s China National People’s Congress (NPC). Again, this suggests stimulus this time around may be more fiscal than monetary (Chart I-5). In addition to the recent VAT cut for manufacturing firms from 16% to 13%, a string of policy easing measures will begin to accrue, including a cut to social security contributions effective May 1st, and perhaps a pickup in infrastructure spending. Already, real estate infrastructure spending growth is perking up, with that in the mining sector soaring to multi-year highs. Chart I-4Real Estate Volumes Could Pick Up Chart I-5The Fiscal Spigots Are Opening Finally, Chinese retail sales including those of durable goods remain very weak. Car sales are deflating at the fastest pace in over two decades. But the latest VAT cut by the government is being passed through to consumers, with an increasing number of car manufactures cutting retail prices. Chart I-6Car Sales Typically Have V-Shaped Recoveries   Over the last 20 years or so, Chinese credit growth has been a reliable indicator for car sales with a lead of about six months (Chart I-6). The indicator right now suggests we could witness a coiled-spring rebound in Chinese car sales over the next few months. Bottom Line: Both Chinese stocks and commodity prices have been suggesting a bottoming process in the domestic economy for a while now. Incoming data is beginning to corroborate this view. This has important implications for both the Chinese yuan and other global assets. Capital Flows Improving domestic and external conditions will likely offset any renewed pressure on the Chinese yuan from capital outflows. Our China Investment Strategy team reckons that even after adjusting for cross-border RMB settlements and illicit capital outflows, there is less evidence of capital flight today than there was in 2015-2016.2  Chart I-7Offshore Markets Don't See RMB Weakness Typically, offshore markets have had a good track record of anticipating depreciation in the yuan. Back in 2014, offshore markets started pricing in a rising USD/CNY rate, and maintained that view all the way through to 2018, when the yuan eventually bottomed. Right now, no such depreciation is being priced in (Chart I-7). The reason offshore markets in Hong Kong and elsewhere can be prescient is because more often than not, they are the destination for illicit flows out of China. For example, one of the often-rumored ways Chinese money has left the country is through junkets, key operators in Macau casinos.3 These junkets bankroll their Chinese clients in Macau while collecting any debts in China allowing for illicit capital outflows. This was particularly rampant ahead of the Chinese 2015-2016 corruption clampdown, when Macau casino equities were surging while equity prices in China remained subdued. Historically, both equity markets tend to move together, since over 70% of visitors to Macau come from China (Chart I-8). Right now, both the Chinese MSCI index and Macau casino stocks are rising in tandem, suggesting gains are more related to fundamentals than hot money outflows. Chart I-8Macau Casinos: A Good Proxy For Chinese Spending A surge in illicit capital outflows could also be part of the reason for an explosion in sight deposits in Hong Kong ahead of the 2015-2016 clampdown (Chart I-9). Admittedly, most of these deposits were and still are due to cross-border RMB settlements, but it is also possible that part of these constituted hot money outflows. With these sight deposits rising at a more reasonable pace, it suggests little evidence of capital flight. Chart I-9The Chinese Government Has Clamped Down On Illicit Flows Trade Truce A trade truce between the U.S. and China will be the final catalyst for a stronger yuan. The news flow so far has been positive, with both U.S. President Donald Trump and Chinese President Xi Jinping publicly acknowledging they are closer to a deal. Even well-known China hawk Peter Navarro, head of the U.S. National Trade Council, has admitted that the two sides are in the final stages of talks. But with a still-ballooning U.S. trade deficit with China, Trump will want to take home a win (Chart I-10). Chart I-10Trump Needs To Take A Win Back To America Concessions on the Chinese side so far seem reasonable, allowing us to speculate that there is a rising probability of a deal. They have agreed to increase agriculture and energy imports from the U.S. by about $1 trillion over the next six years, announced a cut on import tariffs, revised their Patent Law to improve protection of intellectual property, and provided a clear timeline for when foreign caps will be removed in sectors such as autos and financial services. These seem like very reasonable concessions that will allow Trump to go home and declare victory. Trade wars are usually synonymous with recessions. As such, there are acute political constraints inching both sides towards an agreement. For President Trump, a deteriorating U.S. manufacturing sector in the midwestern battleground states is a thorn in his side. For President Xi, rising unemployment is a key constraint. On the currency front, the details of any agreement are still unknown, but should Chinese economic fundamentals start to genuinely improve, it will put upward pressure under rates – and ergo the yuan (Chart I-11). A gradually rising yuan exchange rate will further assuage any doubts or concerns that Trump may have. Bottom Line: Our fundamental models show the yuan as undervalued by about 3%. This means China could allow its currency to gradually appreciate towards fair value, with little impact on the domestic economy or even exports. Given some green shoots in incoming economic data, little risk of capital flight, and the rising likelihood of a trade deal between the U.S. and China, our bias is that the path of least resistance for the Chinese RMB is up (Chart I-12). Chart I-11Rising Chinese Rates Will Favor The Yuan Chart I-12The RMB Is Not Expensive     Another Dovish Shift By The ECB In another dovish twist, the European Central Bank kept monetary policy unchanged following this week’s meeting, while highlighting that it might be on hold for longer. Unsurprisingly, incoming data has been weak of late, which the ECB (like other central banks) blamed on the external environment. It did fall short of speculation that it will introduce a tiered system for its marginal deposit facility, which would have alleviated some cash flow pressures for euro area banks. Our bias is for the new Targeted Long Term Refinancing Operation (TLTRO III – in other words, cheap loans), to remain a better policy tool than a tiered central bank deposit system. In the case of a TLTRO, the ECB can effortlessly decentralize monetary policy, since liquidity gravitates towards the countries that need it the most. While a tiered system can allow a bank to offer higher rates and attract deposits, there is no guarantee that these deposits will find their way into new loans. It is also likely to benefit countries with the most excess liquidity. In the case of a TLTRO, the ECB can effortlessly decentralize monetary policy. Beyond any short-term volatility in the euro, we think the ECB’s dovish shift could be paradoxically bullish. If a central bank eases financing conditions at a time when growth is hitting a nadir, it is tough to argue that it is bearish for the currency. Meanwhile, fiscal policy is also set to be loosened. Swedish new orders-to-inventories lead euro area growth by about five months, and the recent bounce could be a harbinger of positive euro area data surprises ahead (Chart I-13). Chart I-13Euro Area Growth Will Recover Bottom Line: European rates are further below equilibrium compared to the U.S., and the ECB’s dovish shift will help lift the euro area’s growth potential. Meanwhile, investors are currently too pessimistic on euro area growth prospects. Our bias is that the euro is close to a floor. House Keeping Our buy-stop on the British pound was triggered at 1.30. We recommend placing stops at 1.25, with an initial target of 1.45. As we argued last week,4 the odds of a hard Brexit continue to fall, with U.K. Prime Minister Theresa May explicitly saying this week that the path for the U.K. going forward is either a deal with the EU or with no Brexit at all. As we go to press, EU leaders have granted the U.K. an extension until the end of October, with a review in June. Chart I-14What Next For The Pound? Back when the referendum was held in June 2016, even the pro-Brexit Tories, a minority in the party, promised continued access to the Common Market. Fast forward to today and there are simply not enough committed Brexiters in Westminster to deliver a hard exit. Given that the can has been kicked down the road, markets are likely to turn their focus on incoming economic data. On that front, economic surprises in the U.K. relative to both the U.S. and euro area are soaring (Chart I-14). Elsewhere, we are also taking profits on our short AUD/NOK position. Since 2015, the market has been significantly dovish on Australia, in part due to a more accelerated downturn in house prices and a marked slowdown in China. The reality is that the downturn in Australia has allowed some cleansing of sorts and has brought it far along the adjustment path relative to its potential. Any potential growth pickup in China will light a fire under the Aussie dollar, which is a risk to this position. Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see China Investment Strategy Special Report, titled “China: Stimulating Amid The Trade Talks,” dated February 20, 2019, available at fes.bcaresearch.com 2 Please see China Investment Strategy Special Report, titled “Monitoring Chinese Capital Outflows,” dated March 20, 2019, available at fes.bcaresearch.com 3 Farah Master, “Factbox: How Macau's casino junket system works,” Reuters, October 21, 2011. 4 Please see Foreign Exchange Strategy Weekly Report, titled “Not Out Of The Woods Yet,” dated April 5, 2019, available at bca.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. have been mostly positive: In March, 196K nonfarm jobs were created, surprising to the upside; unemployment rate stayed low at 3.8%, though average hourly earnings growth fell to 3.2% year-on-year. The factory orders in February contracted by 0.5% month-on-month. More importantly, headline consumer price inflation in March rose to 1.9% year-on-year, however this was mostly lifted by rising energy prices. Core inflation excluding food and energy dropped by 10 basis points to 2%. JOLTs job openings unexpectedly fell to 7.1 million in February, from 7.6 million. However, initial jobless claims fell to 196K. After a 3-month lull, producer prices are inflecting higher at a pace of 2.2% year-on-year for the month of March. DXY index fell by 0.44% this week. Global risk assets are on the rise this week. Meanwhile, the Fed minutes highlighted that members are in no rush to raise rates. Stalling interest rate differentials will be a headwind for the dollar.  Report Links: Not Out Of The Woods Yet - April 5, 2019 Tug OF War, With Gold As Umpire - March 29, 2019 Into A Transition Phase - March 8, 2019 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have been positive: The Sentix Investor Confidence index continues to inflect higher, coming in at -0.3 from -2.2.  German industrial production grew by 0.7% month-on-month in February. Trade balances improved across the euro area. In France, the trade deficit fell to €-4.0B in February. In Germany, the trade surplus increased to €18.7B. Italian retail sales increased by 0.9% year-on-year in February. On the inflation front, consumer price inflation in Germany and France both stayed at 1.3% year-on-year in March. EUR/USD rose by 0.57% this week. On Wednesday, the ECB has decided to leave policy unchanged as expected. Mario Draghi also highlighted more uncertainties and downside risks to the euro area amid the ongoing trade disputes. While the global trade war might add volatility to the pro-cyclical euro, easier financial conditions should eventually backstop growth. Report Links: Into A Transition Phase - March 8, 2019 A Contrarian Bet On The Euro - March 1, 2019 Balance Of Payments Across The G10 - February 15, 2019 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been negative: Preliminary cash earnings fell by 0.8% year-on-year in February, the only decline since mid-2017. Household confidence continues to tick lower, coming in at 40.5 in March. The trade balance in February came in at a surplus of ¥489.2B. Capex is rolling over. Machinery orders fell by 5.5% year-on-year in February. Machine tool orders remain extremely weak, at -28.5% year-on-year for the month of March. Lastly, the foreign investment in Japanese stocks increased to ¥1,463.7B. USD/JPY fell by 0.46% this week. In its April regional outlook, the BoJ downgraded most of the prefectures in Japan, with only Hokkaido that had an upgrade in the aftermath of the earthquake. As domestic deflationary pressures intensify, this will favor the yen.  This also raises the probability the government defers the consumption tax hike. Report Links: Tug OF War, With Gold As Umpire - March 29, 2019 A Trader’s Guide To The Yen - March 15, 2019 Balance Of Payments Across The G10 - February 15, 2019 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. have been strong: In February, manufacturing production increased by 0.6% year-on-year; industrial production also increased by 0.1% year-on-year, both surprising to the upside. Both were deflating in January. The goods trade balance in February fell to £-14.1B, however the total trade balance came in at a smaller deficit of £4.86B. Monthly GDP also came in higher at 2% year-on-year in February. House prices gains have pared the increase of previous years, but the Halifax house price index still increased by 2.6% year-on-year for the month of March.  GBP/USD rose by 0.41% this week. Theresa May got an extension for Brexit to October 31. Meanwhile, U.K. data have been stronger than consensus recently. We are long GBP/USD from 1.30, with a 0.6% profit. Report Links: Not Out Of The Woods Yet - April 5, 2019 A Trader’s Guide To The Yen - March 15, 2019 Balance Of Payments Across The G10 - February 15, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have continued to improve: Investment lending for homes in February grew by 2.6%. Home loans in February increased by 2% month-on-month, surprising to the upside. Westpac consumer confidence came in at 100.7 in April, increasing by 1.9%.  AUD/USD surged by 0.64% this week. The RBA Deputy Governor Guy Debelle hinted that a wait-and-see approach for interest rates seemed like the appropriate path, signaling that policy will continue to be accommodative. Meanwhile, the Australian dollar is probably anticipating better upcoming data from China, as it is Australia’s largest trading partner. If the world’s second largest economy can turn around, the Aussie dollar is likely to grind higher. Report Links: Not Out Of The Woods Yet - April 5, 2019 Into A Transition Phase - March 8, 2019 Balance Of Payments Across The G10 - February 15, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 There was little data out of New Zealand this week: The food price index came in at 0.5% month-on-month in March, shy of the estimate of 1.3%. NZD/USD plunged after rising by 0.5% initially this week, returning flat. Incoming data in New Zealand is likely to lag its commodity currency counterparts pushing the kiwi relatively lower. Our long AUD/NZD position is now 0.7% in the money since entry last Friday. Report Links: Not Out Of The Woods Yet - April 5, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been negative: On the labor market front, the participation rate in March fell slightly to 65.7%; 7,200 jobs were lost, underperforming the estimated creation of 1,000 jobs; unemployment rate was unchanged at 5.8%. On the housing market front, starts in March increased by 192.5K year-on-year, underperforming the expected 196.5K; building permits dropped by 5.7% month-on-month in February. USD/CAD rebounded quickly after falling by 0.7% earlier this week, offsetting the loss. While the dovish shift by the BoC and looser fiscal policy, together with rising oil prices are likely to be growth tailwinds, the data disappointment coming from the housing market and overall economy limit upside in the CAD. Report Links: A Shifting Landscape For Petrocurrencies - March 22, 2019 Into A Transition Phase - March 8, 2019 Balance Of Payments Across The G10 - February 15, 2019 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 There was scant data in Switzerland this week: The foreign currency reserves came in at 756B CHF in March. Unemployment rate in March was unchanged at 2.4%, in line with expectations. USD/CHF appreciated by 0.44% this week. With the euro area economy slowly recovering, the franc is likely to underperform as risk appetite rises. We are long EUR/CHF for a 0.1% profit. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Waiting For A Real Deal - December 7, 2018 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway have been strong, with inflation grinding higher: Headline consumer price inflation increased to 2.9% year-on-year in March; core inflation also rose to 2.7% year-on-year, both surprising to the upside. Producer price index grew by 5.2% year-on-year in March, outperforming expectations. USD/NOK depreciated by 1.16% this week. The improving domestic economy, rising oil prices, and the tick up in inflation are all the reasons why we favor the Norwegian krone. We are playing the NOK via a few pairs, notably long NOK/SEK and short AUD/NOK, which are currently 3.11% and 0.75% in the money, respectively. Report Links: A Shifting Landscape For Petrocurrencies - March 22, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been mixed: Industrial production fell to 0.7% year-on-year in February, lower than the previous reading of 3%. New manufacturing orders contracted by 2.8% year-on-year in February. However, the leading manufacturing new orders to inventory ratio is rising suggesting we might be near a bottom. Consumer price inflation came in higher at 1.9% year-on-year in March. USD/SEK fell by 0.21% this week. We remain bullish on the Swedish krona due to its cheap valuation and the imminent pickup in the euro area economy. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Global Liquidity Trends Support The Dollar, But... - January 25, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

  Underweight The relative resilience of consumer discretionary stocks has been puzzling over the past two years. Typically, rising interest rates prelude a period of underperformance in these highly rate sensitive stocks (fed funds rate shown inverted, bottom panel) but the divergence has grown exceptionally wide. Regardless, we believe our negative thesis is sound. Consumer confidence is near record highs (though it has started to decline), which appears to be driving the relative share price gains but consumer credit has not followed suit (second panel), implying consumers are not backing up their positivity with their wallets. The sell-side too appears to discount soaring consumer confidence as earnings estimates have not kept pace with share prices, driving sector valuations to a 25% premium to the broad market and well above sustainable average levels (third panel). However, this is partially explained by Amazon, which carries roughly 30% weight in the S&P consumer discretionary index but only 12.5% of operating profit, and its exceptional outperformance since the beginning of 2018. Nonetheless, we expect retail sales to follow the opposite path of interest rates, as it always has in past cycles, and a derating to occur. Bottom Line: We reiterate our below-benchmark allocation rating on the S&P consumer discretionary index as valuations have grown excessive and BCA’s view remains that interest rates are near their trough.