Developed Countries
Highlights A progressing Sino-U.S. trade truce, rallying commodities and EM FX as well as improving Swedish economic activity point to a respite in the global growth slowdown. This should support commodity currencies and cause a correction in the dollar – moves we would fade. Ultimately, tightening U.S. policy and a rising Chinese marginal propensity to save point to both slower growth and a stronger dollar over the coming six to nine months. The European Central Bank is extremely data dependent, and in our view, our outlook on global growth will compromise the ECB’s ability to lift rates in September 2019. A tactical trade: Sell EUR/GBP. Feature Glimmers of hope are emerging for dollar bears and EM bulls. The Sino-U.S. trade truce seems to be progressing: Meng Wanzhou, the CFO of Huawei, was released on bail this week, and U.S. President Donald Trump suggested he would lean in her favor; China dropped its tariffs on U.S. auto imports to 15%; and the communication channels between China and the U.S. are clearly open. Green shoots for global growth have also emerged, with commodity prices staging a bit of a rebound, and data in some small, open economies very levered to global growth showing improvement. These developments can easily help risk assets temporarily rebound, lifting EM currencies and G-10 commodity currencies in the process while hurting the greenback for a month or two. However, we remain doubtful that these glimmers of hope for global growth will morph into a sustained rebound in global industrial activity. Consequently, we are inclined to use any weakness in the greenback to buy the dollar, and any rebound in EM and commodity currencies to sell them in anticipation of deeper lows. A Set Up For Some Dollar Weakness… The continued warming up in Sino-U.S. relations is encouraging, but as we argued last week, a more important consideration is whether global growth is finding a floor.1 In recent weeks, a few market signals have offered some hope. The growth-sensitive CRB Raw Industrials index has been firming, and the Baltic Dry index has recouped 40% of its loss from August to November (Chart I-1). Chart I-1Green Shoots In The Commodity Space... EM FX has also staged a bit of a rebound, led by the Turkish lira. The most positive development on this front has been the recent gains in the yuan. Its rebound keeps at bay a large deflationary shock for the global economy, and the stability in EM FX means that EM financial conditions are not deteriorating further (Chart I-2). Chart I-2...Green Shoots In EM FX... In our view, the greatest source of optimism comes from the Swedish economy. Sweden is a small, open economy where industrial and intermediate goods account for 25% of exports, or 11% of GDP. Its manufacturing PMI have been rebounding – a phenomenon repeated across multiple data sets. In fact, our diffusion index of 15 Swedish economic variables has been recovering. Based on history, the current recovery in the Swedish economic advance/decline line points to an upcoming rebound in EM exports growth, and to a temporary stabilization in the Global Leading Economic Indicator (Chart I-3). Chart I-3...And Green Shoots In Sweden As Well! Any sign of stabilization in global economic activity will generate a period of weakness in the dollar, a traditionally countercyclical currency, which has now been made more vulnerable to good global growth by extended long speculative positioning. However, before bailing on the greenback, we need to see if this period of respite for the world will prove durable. Bottom Line: Indications that the Sino-U.S. trade truce has staying power for now, coupled with signs from both financial market prices and from Sweden – one of the G-10’s most growth sensitive economies – are likely to prompt a dollar correction over the next month or two. Short-term traders are likely to be able to take advantage of this move. ...But Not For A Cyclical Top… Even the most ferocious dollar bull markets can be punctuated by periods of weakness. This was the case throughout the first half of the 1980s and the second half of the 1990s. There is no reason why this rally will prove different. Thus, a period of stabilization in global growth prompting a dollar correction should not come as a surprise. However, at this juncture, the global policy set up still favors remaining long the dollar and using any correction to build up bigger long-dollar bets. Today, our BCA central bank monitor continues to point to the need of tightening U.S. monetary policy. However, the same cannot be said about the rest of the G-10 in aggregate. We estimated the performance of G-10 currency pairs versus the dollar when, like today, the BCA central bank monitors showed a greater need for policy tightening in the U.S. than in the rest of the world. What we found was during the past 26 years, this kind of environment is associated with depreciations versus the U.S. dollar in the euro, the yen, the Australian dollar, the Canadian dollar, the Swiss franc and the Scandinavian currencies (Chart I-4). Interestingly, the GBP and the NZD seem to buck this trend. Chart I-4The Current Currency Setup Is Dollar Bullish The EUR/USD pair is of particular interest, as it accounts for 58% of the DXY dollar index and is often the preferred vehicle for investors to bet on the dollar’s trend. Right now, in sharp contrast with the U.S., the euro area central bank monitor points to a need for easing policy in Europe (Chart I-5). Chart I-5Economic Conditions Warrant More Hikes In The U.S., But Not In Europe... We expect our monitors to continue to point toward the need for tighter U.S. than European monetary policy. Today, European growth has decelerated, and the slowdown in euro area M1 money supply indicates that continental growth will slow further before finding a bottom (Chart I-6, top panel). The European Central Bank is not immune to growth risks. Chart I-6...And This Is Not About To Change Meanwhile, the Federal Reserve is fixated on inflationary developments, especially those emanating from the labor market. While U.S. core PCE has disappointed, U.S. wages, as measured by average hourly earnings and the Atlanta Fed Wage Tracker, are all trending higher (Chart I-6, middle panel). Moreover, while there has been a concerning slowdown in the U.S. housing sector, mortgage applications are beginning to regain some vigor (Chart I-6, bottom panel). The Fed may thus pause in March, but we do not think it is done hiking for the remainder of 2019, as markets currently expect. As a result, we anticipate one-year-ahead policy differentials between the U.S. and the DXY-weighted G-10 central banks to widen, lifting the dollar in the process (Chart I-7). Therefore, any dollar correction should be short-lived. Investors with longer investment horizons than three months should ride the volatility and remain long the dollar. Chart I-7More Dollar Upside Bottom Line: BCA’s Fed monitor is pointing to the need for further U.S. rate hikes. Meanwhile, outside the U.S., G-10 policy should remain easy. Historically, this set-up is associated with dollar strength. The dichotomy between slowing European growth and growing U.S. wages suggests expected policy differentials will remain negative for EUR/USD. Stay long the dollar. ...Especially As China Remains Challenged China is now such an important diver of the global industrial cycle that it could nullify any of the conclusions noted above. However, at this point, Chinese economic dynamics seem to reinforce the dollar-bullish outcome, not weaken it. Chinese policy rates have collapsed, and the People’s Bank of China has cut the Reserve Requirement Ratio to 14.5%, injecting RMB 750 billion into the interbank market. This apparent easing in policy lifted hopes that we would see a significant rebound in the credit number in November. However, as Chart I-8 illustrates, total social financing excluding equity issuance has not picked up and continues to crawl along at a 16-year low. Moreover, the shadow-banking sector remains weak. Chart I-8Despite Stimulus, Chinese Credit Is Still Slowing Why is the Chinese economy not responding to what seems like an easing in liquidity conditions? First, it is far from clear that Beijing has abandoned its desire to limit the growth of indebtedness in China. As a result, bankers remain reluctant to open the lending taps aggressively. Second, Chinese borrowers themselves have curtailed their appetite for credit. After binging on easy credit, state-owned enterprises have misallocated vast amounts of capital and are now unable to generate sufficient returns on assets to cover their costs of borrowing (Chart I-9). Meanwhile, the private sector is also reluctant to borrow aggressively amid uncertainty regarding the Chinese growth outlook. Chart I-9Too Much Debt Leads To Misallocated Capital The result is a sharp rise in the Chinese marginal propensity to save (MPS). We can approximate China’s MPS by looking at the growth of M2 money supply relative to M1. The difference between the two monetary aggregates are savings deposits. If M2 grows faster than M1, Chinese economic agents are parking their funds in savings deposits faster than they are adding to their checking accounts, despite low interest rates. This suggests a greater desire to save. This means it will take much more stimulus than what has so far been injected into the Chinese economy to put a floor under growth. Indeed, this proxy for China’s MPS has historically been a reliable leading indicator of Chinese economic activity, announcing turning points in the Li Keqiang index (Chart I-10, top panel). The rising MPS is currently signaling a further deceleration in Chinese import volumes growth (Chart I-10, second panel), which is reflected in a call for greater downside to global export growth (Chart I-10, third panel). Finally, China’s MPS also forewarns that global industrial activity, as measured by our nowcast, will slow more (Chart I-10, bottom panel). In aggregate, China’s rising marginal propensity to save clearly points toward further global growth weakness. Chart I-10China's Rising Marginal Propensity To Save Hurts Global Growth As we have shown many times, slowing global growth is good for the dollar, as it has a more negative impact on economic activity outside the U.S. than inside.2 Additionally, when global growth decelerates in response to slowing Chinese economic activity, Chinese interest rates also normally fall relative to U.S. ones, as China is forced to ease policy vis-a-vis the U.S. This interest rate differential has already narrowed considerably. If the correlation of the past 12 years is any guide, this means the recent rebound in the CNY is to be faded, and that USD/CNY has significant upside in the upcoming six to nine months (Chart I-11). This is deflationary for the global economy. Chart I-11Chinese Rates Will Further Lag U.S. Ones, The Yuan Will Follow The impact of falling Chinese interest rates relative to the U.S. is not limited to the USD/CNY. As Chart I-12 shows, when U.S. one-year rates rise relative to China, the DXY also strengthens. This is again because U.S. rates overtake Chinese rates in an environment where global growth is slowing. Today, U.S. 12-month rates are higher than Chinese rates, and the differential will widen as Chinese policymakers are forced to continue stimulating. Hence, any correction in the USD should prove transitory. Chart I-12When U.S. Rates Rise Relative To China, The DXY Appreciates The impact of these dynamics is most evident in the currencies of the economies most exposed to the Chinese business cycle. As Chart I-13 shows, when Chinese 12-month interest rates fall relative to U.S. 12-month rates, EM FX and G-10 commodity currencies depreciate significantly. A further drop in the Sino-U.S. spread, a consequence of a high and rising MPS hurting Chinese growth, will lead to further weakness in EM FX, the AUD, the NZD, the CAD, and the NOK against the dollar. Thus, it seems any respite these currencies may currently enjoy will prove temporary. Chart I-13Falling Sino-U.S. Spreads Will Hurt EM FX And Commodity Currencies Bottom Line: Despite injections of stimulus, China’s credit growth is not rising because the Chinese marginal propensity to save has risen significantly. It will take much more stimulus before credit growth rises anew. Thus, Chinese and global growth will not find a durable bottom for at least two more quarters. This implies that rate differentials between China and the U.S. will fall further, and hence USD/CNY and the DXY have more upside on a six- to nine-month basis, even if they weaken in the coming weeks. Meanwhile, EM FX and commodity currencies have a lot more downside in their future. ECB: The End Of An Era Yesterday, the ECB announced the well-anticipated end of its asset purchase program, but couched its discussion in rather hedged terms. The ECB focused on the importance of forward guidance and is open to adding to the TLTRO program if need be. The first rate hike being through the summer of 2019 is clearly conditional on economic circumstances. In this regard, the ECB downgraded its growth forecast for 2018 and 2019 to 1.9% from 2% and to 1.7% from 1.8%, respectively. The inflation forecast was revised up to 1.8% from 1.7% in 2018 and was revised down to 1.6% from 1.7% in 2019. Additionally, ECB President Mario Draghi highlighted that risks to the forecasts are balanced, but downside risk is growing. Not only do we agree that downside risk is growing, we also agree on the source of this risk: foreign growth and global protectionism. However, on this front, we are more pessimist than the ECB as we expect a greater deterioration in EM conditions and global trade. As a result, we think that risks are very significant that the ECB will find it difficult to implement a first rate hike in September 2019, yet markets are currently pricing in a 10 basis-point move that month. Hence, we expect that if our view on global growth is correct, the ECB will guide markets to price in the first hike later than September 2019, a process that will weigh on the euro, especially as investors already take a dim view on the capacity of the Fed to lift rates next year. Bottom Line: The ECB is ending its asset purchase program, but it remains committed to supporting growth in the euro area. The ECB is now heavily leaning on forward guidance, and any policy tightening is conditional on economic circumstances. BCA’s view on global growth suggests that it will be hard for the ECB to lift rates in September 2019. Short-Term Trade: Sell EUR/GBP This week’s political survival of Prime Minister Theresa May means that for another year, the hard Brexiters cannot challenge her for leadership of the Conservative Party. While it does not mean that the Brexit saga is over, it does mean that the probability of a Hard, No-Deal Brexit has fallen even further. As such, this implies that the politically driven rally in EUR/GBP since mid November is likely to reverse (Chart I-14). Chart I-14Tactical Trade: Sell EUR/GBP Additionally, the outperformance of British wages relative to the euro area should also support the pound in the short term (Chart I-15). A lower risk of a crash Brexit together with an ECB displaying a somewhat dovish side should cause an upgrade by investors in the expected path of monetary policy in the U.K. relative to the euro area. Moreover, while the euro area current account surplus has rolled over, the U.K.’s is steadily improving, making the pound progressively less dependent on international flows. Chart I-15Relative Wages Favor BoE Hikes Versus ECB Hikes As such, we are opening a tactical trade: selling EUR/GBP with a tight stop at 0.9100 and a target at 0.8700. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Weekly Report, titled “Waiting For A Real Deal”, dated December 7, 2018, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report, titled “Appetite For Destruction? FX Investing For Slowing Global Growth And Inflation”, dated November 23, 2018, as well as the Foreign Exchange Strategy Weekly Report, titled “The Dollar And Risk Assets Are Beholden To China’s Stimulus”, dated August 3, 2018. Both are available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. has been mixed: Core inflation came in line with expectations at 2.2%. This measure also increased from last month’s reading. Meanwhile, the JOLTS job openings outperformed expectations, coming in at 7.079 million However, while nonfarm payrolls underperformed expectations, coming in at 155 thousand, U.S. average hourly earnings remains solid DXY has risen by 0.5% this past week. We continue to be bullish on the U.S. dollar. The current environment of falling global growth and inflation has historically been very positive for this currency. Moreover, the market has already priced out any Fed hikes beyond December. This means that the risk for U.S. rates vis-à-vis the rest of the world remains to the upside. Report Links: Waiting For A Real Deal - December 7, 2018 2019 Key Views: The Xs And The Currency Market - December 7, 2018 Six Questions From The Road - November 16, 2018 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area has been mixed: Industrial production yearly growth surprised to the upside, coming in at 1.2%. However, the Sentix Investor Confidence index surprised negatively, coming in at -0.3. Finally, Gross domestic product yearly growth underperformed expectations coming in at 1.6%. EUR/USD has been flat this week. Yesterday, the ECB downgraded its 2018 and 2019 growth forecasts. Moreover ECB president Mario Draghi hinted at increasing caution, as he remarked that downside risks where growing. We believe that EUR/USD has further downside, towards the 1.08-1.05 range, as the ECB will be unable to tighten monetary policy in the current environment of slowing global growth. Report Links: 2019 Key Views: The Xs And The Currency Market - December 7, 2018 Six Questions From The Road - November 16, 2018 Evaluating The ECB’s Options In December - November 6, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been negative: Machinery orders yearly growth underperformed expectations, coming in at 4.5%. Moreover, the final revisions to GDP annualized growth also surprised downside, coming in at -2.5%. Finally, the leading economic index also surprised negatively, coming in at 100.5. USD/JPY has risen by 0.8% this week. We are positive on the yen for the first quarter of 2019, especially on its crosses. The current risk off environment should be positive for safe havens like the yen. We are particularly negative on EUR/JPY, as this cross is very well correlated with bond yields, which have possess short-term downside. Report Links: 2019 Key Views: The Xs And The Currency Market - December 7, 2018 Updating Our Intermediate Timing Models - November 2, 2018 Will Rising Wages Cause An Imminent Change In Policy Direction In Europe And Japan? - October 5, 2018 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been mixed: Industrial production yearly growth underperformed expectations, coming in at -0.8%. Moreover, the claimant count change also surprised negatively, coming in at 21.9 thousand. However, average hourly earnings excluding and including bonus both outperformed expectations, coming in at 3.3%. GBP/USD has fallen by 1.2% this week on political risks. However, on Wednesday PM Theresa May survived a vote of no confidence that would have removed her from the leadership of the tory party. With this win, Prime Minister May is now protected from intra-party challenges for at least a year, strengthening her ability to fend-off demands by hard-brexiters. This event has created a tactical opportunity to sell EUR/GBP. Report Links: Six Questions From The Road - November 16, 2018 Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia has been positive: The house price index yearly growth came in line with expectations, declining by -1.5%. Moreover, home loans growth outperformed expectations, coming in at 2.2%. AUD/USD has been flat this week. We believe that the AUD is the currency with the most potential downside in the G10. After all, Australia is the G-10 economy most leveraged to the Chinese industrial cycle, due to Australia’s high reliance on industrial metal and coal exports. This means that the continued tightening by Chinese authorities should be most toxic for this currency. Report Links: Waiting For A Real Deal - December 7, 2018 Updating Our Intermediate Timing Models - November 2, 2018 Policy Divergences Are Still The Name Of The Game - August 14, 2018 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 NZD/USD has fallen by 0.5% this week. After being bullish in the NZD for a couple of months, we have recently turned bearish, as this currency is very likely to suffer in the current environment of declining inflation and global growth. said that being said, we remain bullish on the NZD relative to the AUD, given that the kiwi economy is less exposed to the Chinese industrial cycle than Australia’s. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 In Fall, Leaves Turn Red, The Dollar Turns Green - October 12, 2018 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada has been positive: Net change in employment surprised positively, coming in at 94.1 thousand. Moreover, the unemployment rate also surprised positively, coming in at 5.6%. Finally, housing starts growth also surprised to the upside, coming in at 216 thousand. After falling by nearly 1%, USD/CAD finished the week flat. While we are bearish on the Canadian dollar relative to the U.S. dollar, we are more positive on the CAD against the AUD. Renewed tightening in oil supply should serve as a support for global oil producers. Meanwhile, Chinese deleveraging will continue, hurting base metals in the process. This will cause oil to outperform base metals, which means that the CAD should have upside against currencies like the AUD. Finally, domestic economic conditions favor BoC hikes versus RBA hike, even after the recent pause flagged by the BoC. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 EUR/CHF has been flat this week. Our bullish view on EUR/CHF is a high conviction view for the first part of 2019. This is because the recent strength in the franc is choking out any inflationary pressures in the Swiss economy. Thus, we are reaching the threshold at which the SNB is very likely to intervene in the currency market to prevent the franc’s strength from derailing the path toward the inflation target. In fact, the SNB even acknowledged this reality this week by downgrading its inflation outlook. Report Links: Waiting For A Real Deal - December 7, 2018 Updating Our Intermediate Timing Models - November 2, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 USD/NOK has risen by 0.7% this week. While we maintain a bearish stance toward the krone versus the U.S. dollar, we are short AUD/NOK, as a way to take advantage of stabilizing oil prices and a continued growth slowdown in China. Moreover, AUD/NOK is expensive in PPP terms, and is technically overbought. Finally, this currency is one of the most mean-reverting within the G10, which means that the recent surge in this cross is likely to reverse. Report Links: Waiting For A Real Deal - December 7, 2018 Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 USD/SEK has risen by 0.9% this week. On a short-term basis, we are negative on the krona, given that this currency is very sensitive to global growth dynamics, which means that the continued tightening by both Chinese authorities and the Fed will create a headwind for any SEK rally. That being said, on a longer-term basis we are more positive on the krona, as the Riksbank has a lot of room to lift rates as the Swedish economy is increasingly displaying large internal imbalances that need to be addressed. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Highlights So What? Global divergence will persist beyond the near term. Why? China’s stimulus will be disappointing unless things get much worse. U.S.-China trade war will reignite and strategic tensions will continue. European risks are limited short-term, but will surge without reform. U.S. assets will outperform; oil and the yen will rise; the pound is a long-term play; EM pain will continue. Feature The year 2019 will be one of considerable geopolitical uncertainty. Three issues dominate our Outlook, with low-conviction views on all three questions: Question 1: How much will China stimulate? Question 2: Will the trade war abate? Question 3: Is Europe a Black Swan or a Red Herring? The main story in 2018 was policy divergence. American policymakers ramped up stimulus – both through the profligate tax cuts and fiscal spending – at the same time that Chinese policymakers stuck to their guns on de-levering the economy. The consequence of this policy mix was that the synchronized global recovery of late 2016 and 2017 evolved into a massive outperformance by the U.S. economy (Chart 1). The Fed responded to the bullish domestic conditions with little regard for the global economy, causing the DXY to rally from a 2018 low of 88.59 in February to 97.04 today. While the policy divergence narrative appears to be macroeconomic in nature, it is purely political. There is nothing cyclical about the ‘U.S.’ economic outperformance in 2018. President Donald Trump campaigned on an economic populist agenda and then proceeded to deliver on it throughout 2017 and 2018. He faced little opposition from fiscal conservatives, mainly because fiscal conservativism melts away from the public discourse when budget deficits are low (Chart 2) and when the president is a Republican (Chart 3). Meanwhile, Chinese policymakers have decided to tolerate greater economic pain in an effort to escape the Middle Income Trap (Chart 4). They believe this trap will envelop them if they cannot grow the economy without expanding the already-massive build-up of leverage (Chart 5). Geopolitics is not just about “things blowing up somewhere in the desert.” In today’s world, emblematized by paradigm shifts, politicians are more than ever in the driver’s seat. While technocrats respond to macroeconomic factors, politicians respond to political and geopolitical constraints. Few investment narratives last much longer than a year and policy divergence is coming to a close. Will the Fed pause given the turn in global growth? Will China respond with effective stimulus in 2019? If the answer to both questions is yes, global risk assets could light up in the next quarter and potentially beyond. Already EM has outperformed DM assets for a month and some canaries in the coal mine for global growth – like the performance of Swedish economic indicators – signal that the outperformance is real. We are skeptical that the move is sustainable beyond a quarter or two (Chart 6). As our colleague Peter Berezin has highlighted, the market is pricing less than one hike in 2019 (Chart 7). Regardless, the impact on the U.S. dollar, remains muted, with the DXY at 97.04. This suggests that the backing off that the Fed may or may not have already done is still not enough from the perspective of weakening global growth (Chart 8). Global risk assets need more from the Fed than what the market is already pricing. And with U.S. inflationary pressures building (Chart 9), the BCA House View expects to see multiple Fed hikes in 2019, disappointing investors bullish on EM and global risk assets. With our Fed view set by the House View, we therefore turn to where we can add value. To this end, the most important question of 2018 largely remains the same in 2019: How much will China stimulate? Question 1: How Much Will China Stimulate In 2019? China is undoubtedly already stimulating, with a surge in local government bond issuance earlier this year and a bottoming in the broad money impulse (Chart 10). M2 is in positive territory. However, the effort can best be characterized as tepid, with a late-year collapse in bond issuance (Chart 11) and a still-negative total social financing (TSF) impulse (Chart 12). TSF is the broadest measure of private credit in China’s economy. We expect a surge in TSF in Q1, but this is a normal seasonal effect. A typical Q1 credit surge will not be enough to set global risk assets alight for very long, particularly if the market has already priced in as much of a “pause” from the Fed as we are going to get. Investors should specifically focus on new local government bond issuance and whether the “shadow financing” component of TSF gets a bid, since the primary reason for the weakness in TSF over the past year is the government’s crackdown on shadow lending. As Chart 13A & B shows, it was new local government bonds that led the way for stimulus efforts in 2015, followed by a surge in both bank lending and shadow lending in 2016. We would also expect further monetary policy easing, with extra RRR cuts or even a benchmark policy rate cut. However, monetary policy has been easy all year and yet the impact on credit growth has remained muted. This begs two important questions: Is the credit channel impaired? A slew of macroprudential reforms – which we have dubbed China’s “Preemptive Dodd-Frank” – may have impaired the flow of credit in the system. The official policy of “opening the front door, closing the back door” has seen bank loans pick up modestly but shadow lending has been curtailed (Chart 14A & B). This way of controlling the rise of leverage has its costs. For private enterprises – with poor access to the official banking sector – the shadow financial system was an important source of funding over the past several years. Is policy pushing on a string? An even more dire scenario would be if China’s credit channel is not technically, but rather psychologically, impaired. Multiple reasons may be to blame: a negative net return on the assets of state-owned enterprises (Chart 15); widespread trade war worries; mixed signals from policymakers; or a general lack of confidence in the political direction of the country. The rising M2/M1 ratio suggests that the overall economy’s “propensity to save” is rising (Chart 16). Why would Chinese policymakers keep their cool despite a slow pickup in credit growth? Are they not concerned about unemployment, social unrest, and instability? Of course, they are. But Chinese policymakers are not myopic. They also want to improve potential GDP over the long run. Table 1China: The Trend In Domestic Demand, And The Outlook For Trade, Is Negative So far, the economy has weathered the storm relatively well. First, eight out of ten of our China Investment Strategy’s housing price indicators (Table 1) are flat-to-up – although it is true that the October deterioration in floor space started and especially floor space sold (Chart 17) is cause for concern. If and when the housing market weakens further, stimulus will be used to offset it, despite the fact that the government is attempting to prevent a sharp increase in prices at the same time. With so much of China’s middle-class savings invested in the housing market, the key pillar of socio-economic stability is therefore real estate. Second, credit has fueled China’s “old economy,” but policymakers want to buoy “new China” (Chart 18). This means that measures to boost consumption and the service sector economy will be emphasized in new rounds of stimulus, as has occurred thus far (tax cuts, tariff cuts, deregulation, etc). This kind of stimulus is not great news for global risk assets leveraged to “old China,” such as EM and industrial metals. Third, policymakers are not exclusively focused on day-to-day stability but are also focused on the decades-long perseverance of China’s political model. And that means moving away from leverage and credit as the sole fuel for the economy. This is not just about the Middle Income Trap, it is also about national security and ultimately sovereignty. Relying on corporate re-levering for stimulus simply doubles-down on the current economic model, which is still export-oriented given that most investment is geared toward the export sector. But this also means that China will be held hostage to foreign demand and thus geopolitical pressures, a fact that has been revealed this year through the protectionism of the White House. As such, moving away from the investment-led growth model and towards a more endogenous, consumer-led model is not just good macro policy, it makes sense geopolitically as well. Will the trade war – or the current period of trade truce – change Chinese policymakers’ decision-making? We do not see why it would. First, if the trade truce evolves into a trade deal, the expected export shock will not happen (Chart 19) and thus major stimulative measures would be less necessary. Second, if we understand correctly why policymakers have cited leverage as an “ill” in the first place, then we would assume that they would use the trade war as an excuse for the pain that they themselves have instigated. In other words, the trade war with the U.S. gives President Xi Jinping the perfect excuse for the slowdown, one that draws attention from the real culprit: domestic rebalancing. Bottom Line: Since mid-2018, we have been asking clients to focus on our “Stimulus Overshoot” checklist (Table 2). We give the first item – “broad money and/or total credit growth spike” – a premier spot on the list. If a surge in total credit occurs, we will know that policymakers are throwing in the towel and stimulating in a major way. It will be time to turn super-positive on global risk assets, beyond a mere tactical trade, as a cyclical view at that point. Note that if one had gone long EM in early February 2016, when January data revealed a truly epic TSF splurge, one would not have been late to the rally. Table 2Will China’s Stimulus Overshoot In 2019? Our low-conviction view, at the moment, is that the increase in credit growth that we will see in Q1 will be seasonal – the usual frontloading of lending at the beginning of the year – rather than an extraordinary surge that would signal a policy change. A modest increase in credit growth will not be enough to spark a sustainable – year-long – rally in global risk assets. The Fed has already backed off as far as the market is concerned. As such, a pickup in Chinese credit could temporarily excite investors. But global stabilization may only embolden the Fed to refocus on tightening after a Q1 pause. Question 2: Will The Trade War Abate? The first question for investors when it comes to the trade war is “Why should we care?” Sure, trade policy uncertainty appears to have correlated with the underperformance of global equity indices relative to the U.S. (Chart 20). However, such market action was as much caused by our policy divergence story – being as it is deeply negative for EM assets – as by a trade war whose impact on the real economy has not yet been felt. Nonetheless, we do believe that getting the trade war “right” is a big call for 2019. First, while the impact of the U.S.-China trade war has been minimal thus far, it is only because China front-loaded its exports ahead of the expected tariffs, cut interbank rates and RRRs, accelerated local government spending, and allowed CNY/USD to depreciate by 10%. A restart of trade tensions that leads to further tariffs will make frontloading untenable over time, whereas further currency depreciation would be severely debilitating for EMs. We doubt the sustainability of the trade truce for three reasons: U.S. domestic politics: The just-concluded midterm election saw no opposition to President Trump on trade. The Democratic Party candidates campaigned against the president on a range of issues, but not on his aggressive China policy. Polling from the summer also shows that a majority of American voters consider trade with China unfair (Chart 21). In addition, President Trump will walk into the 2020 election with a wider trade deficit, due to his own stimulative economic policy (Chart 22). He will need to explain why he is “losing” on the one measure of national power that he campaigned on in 2016. Structural trade tensions: Ahead of the G20 truce, the U.S. Trade Representative Robert Lighthizer issued a hawkish report that concluded that China has not substantively changed any of the trade practices that initiated U.S. tariffs. Lighthizer has been put in charge of the current trade negotiations, which is a step-up in intensity from Treasury Secretary Steven Mnuchin, who was in charge of the failed May 2018 round. Geopolitical tensions: The G20 truce did not contain any substantive resolution to the ongoing strategic tensions between the U.S. and China, such as in the South China Sea. Beyond traditional geopolitics, tensions are increasingly involving high-tech trade and investment between the two countries and American allegations of cyber theft and spying by China. The recent arrest of Huawei’s CFO in Canada, on an American warrant, will likely deepen this high-tech conflict in the short term. Since the G20 truce with Xi, President Trump has seen no significant pickup in approval ratings (Chart 23). Given that the median American voter has embraced protectionism – against China at least – we would not expect any. Meanwhile, U.S. equities have sold off, contrary to what President Trump, or his pro-trade advisors, likely expected in making the G20 decision to delay tariffs. At some point, President Trump will realize that he risks considerable political capital on a trade deal with China that very few voters actually want or that the U.S. intelligence and defense community supports. Democrats did not oppose his aggressive China policy in the midterm election because they know that the median voter does not want it. As such, it is guaranteed that Trump’s 2020 Democratic Party opponent will accuse him of “surrender,” or at least “weakness.” If, over the next quarter, the economic and market returns on his gambit are paltry, we would expect President Trump to end the truce. Furthermore, we believe that a substantive, and long-lasting, trade deal is unlikely given the mounting tensions between China and the U.S. These tensions are not a product of President Trump, but are rather a long-run, structural feature of the twenty-first century that we have been tracking since 2012.1 Tensions are likely to rise in parallel to the trade talks on the technology front. We expect 2019 to be the year when investors price in what we have called Bifurcated Capitalism: the segmentation of capital, labor, and trade flows into geopolitically adversarial – and yet capitalist in nature – economic blocs. Entire countries and sectors may become off-limits to Western investors and vice-versa for their Chinese counterparts. Countries will fall into either the Tencent and Huawei bloc or the Apple and Ericsson bloc. This development is different from the Cold War. Note our emphasis on capitalism in the term Bifurcated Capitalism. The Soviet Union was obviously not capitalist, and clients of BCA did not have interests in its assets in the 1970s and 1980s. Trade between Cold War economic blocs was also limited, particularly outside of commodities. The closest comparison to the world we now inhabit is that of the nineteenth century. Almost all global powers were quite capitalist at the time, but they engaged in imperialism in order to expand their economic spheres of influence and thus economies of scale. In the twenty-first century, Africa and Asia – the targets of nineteenth century imperialism – may be replaced with market share wars in novel technologies and the Internet. This will put a ceiling on how much expansion tech and telecommunication companies can expect in the competing parts of Bifurcated Capitalism. The investment consequences of this concept are still unclear. But what is clear is that American policymakers are already planning for some version of the world we are describing. The orchestrated effort by the U.S. intelligence community to encourage its geopolitical allies to ban the use of Huawei equipment in their 5G mobile networks suggests that there are limits to the current truce ever becoming a sustainable deal. So does the repeated use of economic sanctions originally designed for Iran and Russia against Chinese companies. President Trump sets short- and medium-term policies given that he is the president. However, the intelligence and defense communities have “pivoted to Asia” gradually since 2012. This shift has occurred because the U.S. increasingly sees China as a peer competitor, for the time being confined in East Asia but with intentions of projecting power globally. To what extent could President Trump produce a trade deal with Xi that also encompasses a change in the U.S. perception of China as an adversary? We assign a low probability to it. As such, President Xi has little reason to give in to U.S. pressure on trade, as he knows that the geopolitical and technology pressure will continue. In fact, President Xi may have all the reason to double-down on his transformative reforms, which would mean more pain for high-beta global plays. Bottom Line: What may have appeared as merely a trade conflict has evolved into a broad geopolitical confrontation. President Trump has little reason to conclude a deal with China by March. Domestic political pressures are not pushing in the direction of the deal, while America’s “Deep State” is eager for a confrontation with China. Furthermore, with President Trump “blinking” on Iranian sanctions, his administration has implicitly acknowledged the constraints discouraging a deeper involvement in the Middle East. This puts the geopolitical focus squarely on China. Question 3: Is Europe a Black Swan or a Red Herring? The last two years have been a dud in Europe. Since the Brexit referendum in mid-2016, European politics have not been a catalyst for global markets, save for an Italy-induced sell-off or two. This could substantively change in 2019. And, as with the first two questions, the results could be binary. On one hand, there is the positive scenario where the stalled and scaled-back reforms on the banking union and Euro Area budget get a shot in the arm in the middle of the year. On the other hand, the negative scenario would see European-wide reforms stall, leaving the continent particularly vulnerable as the next global recession inevitably nears. At the heart of the binary distribution is the broader question of whether populism in Europe is trending higher. Most commentators and our clients would say yes, especially after the protests and rioting in Paris over the course of November. But the answer is more complicated than that. While populists have found considerable success in the ballot box (Chart 24), they have not managed to turn sentiment in Europe against the currency union (Chart 25). Even in Italy, which has a populist coalition government in power, the support for currency union is at 61%, the highest since 2012. This number has apparently risen since populists took over. What explains this divergence? Effectively, Europe’s establishment parties are being blamed for a lot of alleged ills, liberal immigration policy first amongst them. However, European integration remains favored across the ideological spectrum. Few parties that solely focus on Euroskepticism have any chance of winning power, something that both Lega and Five Star Movement found out in Italy. Italy’s Deputy Prime Minister Matteo Salvini confirmed his conversion away from Euroskepticism by stating that he wants to “reform the EU from the inside” and that it was time to give the “Rome-Berlin axis” another go.2 Salvini is making a bet – correct in our view – that by moderating Lega’s populism on Europe, he can capture the center ground and win the majority in the next Italian election, which could happen as soon as 2019. As such, we don’t think that the “rise of populism” in Europe is either dramatic or market-relevant. In fact, mainstream parties are quickly adopting parts of the anti-establishment agenda, particularly on immigration, in a bid to recoup lost voters. A much bigger risk for Europe than populism is stagnation on the reform front, a perpetual Eurosclerosis that leaves the bloc vulnerable in the next recession. What Europe needs is the completion of a backstop to prevent contagion. Such a backstop necessitates greatly enhancing the just-passed banking union reforms. The watered-down reforms did not include a common backstop to the EU’s single resolution fund nor a deposit union. A working group will report on both by June 2019, with a potential legislative act set for some time in 2024. What could be a sign that the EU is close to a grand package of reforms in 2019? We see three main avenues. First, a political shift in Germany. Investors almost had one, with conservative Friedrich Merz coming close to defeating Merkel’s hand-picked successor Annegret Kramp-Karrenbauer (also known as AKK) for the leadership of the ruling Christian Democratic Union (CDU). Merz combined a right-leaning anti-immigrant stance with staunch pro-European integration outlook. It is unclear whether AKK will be willing to make the same type of “grand bargain” with the more conservative factions of the CDU electorate. However, AKK may not have a choice, with both Alternative for Germany (AfD) and the Green Party nibbling at the heels of the right-of-center CDU and left-of-center Social-Democratic Party (SPD) (Chart 26). The rise of the Green party is particularly extraordinary, suggesting that a larger portion of the German electorate is radically Europhile rather than Euroskeptic. AKK may have to adopt Merz’s platform and then push for EU reforms. Second, French President Emmanuel Macron may have to look abroad for relevance. With his reform agenda stalled and political capital drained, it would make sense for Macron to spend 2019 and beyond on European reforms. Third, a resolution of the Brexit debacle. The longer the saga with the U.K. drags on, the less focus there will be in Europe on integration of the Euro Area. If the U.K. decides to extend the current negotiating period, it may even have to hold elections for the European Parliament. As such, we are not focusing on the budget crisis in Italy – our view that Rome is “bluffing” is coming to fruition –or a potential early election in Spain. And we are definitely not focusing on the EU Parliamentary election in May. These will largely be red herrings. The real question is whether European policymakers will finally have a window of opportunity for strategic reforms. And that will require Merkel, AKK, and Macron to expend whatever little political capital they have left and invest it in restructuring European institutions. Finally, a word on Europe’s role in the global trade war. While Europe is a natural ally for the U.S. against China – given its institutional connections, existing alliance, and trade surplus with the latter and deficit with the former (Chart 27) – we believe that the odds are rising of a unilateral tariff action by the U.S. on car imports. This is because the just-concluded NAFTA deal likely raised the cost of vehicle production in the trade bloc, necessitating import tariffs in order for the deal to make sense from President Trump’s set of political priorities. The Trump administration may not have the stomach for a long-term trade war with Europe, but it can shake up the markets with actions in that direction. Bottom Line: In the near term, there are no existential political risks in Europe in 2019. As such, investors who are bullish on European assets should not let geopolitics stand in the way of executing on their sentiment. We remain cautious for macroeconomic reasons, namely that Europe is a high-beta DM play that needs global growth to outperform in order to catch a bid. However, 2019 is a make-or-break year on key structural reforms in Europe. Without more work on the banking union – and without greater burden sharing, broadly defined – the Euro Area will remain woefully unprepared for the next global recession. Question 4: Will Brexit Happen? Given the volume of market-relevant geopolitical issues, we have decided to pose (and attempt to answer) five additional questions for 2019. We start with Brexit. Prime Minister Theresa May has asked for a delay to the vote in the House of Commons on the Withdrawal Treaty, which she would have inevitably lost. The defeat of the subsequent leadership challenge is not confidence-inspiring as the vote was close and a third of Tory MPs voted against her. May likely has until sometime in January to pass the EU Withdrawal Agreement setting out the terms of Brexit, given that all other EU member states have to get it through their parliaments before the Brexit date on March 29. The real question is whether any deal can get through Westminster. The numbers are there for the softest of soft Brexits, the so-called Norway+ option where the U.K. effectively gets the same deal as Norway, if May convinces the Labour Party to break ranks. Such a deal would entail Common Market access, but at the cost of having to pay essentially for full EU membership with no ability to influence the regulatory policies that London would have to abide by. The alternative is to call for a new election – which may usher the even less pro-Brexit Labour Party into power – or to delay Brexit for a more substantive period of time, or simply to buckle under the pressure and call for a second referendum. We disagree that the delay signals that the “no deal Brexit,” or the “Brexit cliff,” is nigh. Such an outcome is in nobody’s interest and both May and the EU can offer delays to ensure that it does not happen. Whatever happens, one thing is clear: the median voter is turning forcefully towards Bremain (Chart 28). It will soon become untenable to delay the second referendum. And even if the House of Commons passes the softest of Soft Brexit deals, we expect that the Norway+ option will prove to be unacceptable when Westminster has to vote on it again in two or three year’s time. Is it time to buy the pound, particularly cable, which is cheap on a long-term basis (Chart 29)? It is a tough call. On one hand, our confidence that the U.K. ultimately has to remain in the EU is rising. However, to get there, the U.K. may need one last major dose of volatility, either in the form of a slow-burn crisis caused by Tory indecision or in the form of a far-left Labour government that tries its own hand at Brexit while pursuing a 1970s style left-wing economic agenda. Can any investor withstand this kind of volatility in the short and potentially long-ish term? Only the longest of the long-term investors can. Question 5: Will Oil Prices Rally Substantively In 2019? Several risks to oil supply remain for 2019. First, there is little basis for stabilization in Venezuelan oil production, and further deterioration is likely (Chart 30). Second, sectarian tensions in Iraq remain unresolved. Third, supply risks in other geopolitical hot spots – like Nigeria and Libya – could surprise in 2019. The most pressing geopolitical issue, however, is a decision on the Iranian sanction waivers. President Trump induced considerable market-volatility in 2019 by signaling that he would use “maximum pressure” against Iran. As a result, the risk premium contribution to the oil price – illustrated in Chart 31 by the red bar – rose throughout 2018, only to collapse as the White House offered six-month sanction waivers. Not only did the risk premium dissipate, but Saudi Arabia then scrambled to reverse the production surge it had instituted to offset the Iran sanctions. We agree with BCA’s Commodity & Energy Strategy that oil market fundamentals are tight and numerous supply risks loom. We also struggle to see why President Trump will seek to pick a fight with Iran in the summer of 2019. Our suspicion is that if President Trump was afraid of a gasoline-price spike right after the midterm election, why would he not “blink” at the end of the spring? Not only will the U.S. summer driving season be in full swing – a time of peak U.S. gasoline demand – but the 2020 election primaries will only be six months away. Furthermore, it is highly unlikely that OPEC and Russia will do the U.S. president’s bidding by turning on the taps to offset any unforeseen supply losses in 2019. They did not do so even when President Trump asked, very nicely, ahead of the just-concluded Vienna meeting. Once Trump prioritized domestic politics over Saudi geopolitical interests – by backing away from his maximum pressure tactic against Iran – he illustrated to Riyadh that his administration is about as reliable of an ally as the Obama White House. Meanwhile, his ardent defense of Riyadh in the Khashoggi affair, at a cost of domestic political capital, means that he lost the very leverage that he could have used to pressure Saudi Arabia. We therefore remain cautiously bullish on oil prices in 2019, but with the caveat that a big-bang surge in prices due to a U.S.-Iran confrontation – our main risk for 2019 just a few months ago – is now less likely. Question 6: Will Impeachment Become A Risk In 2019? While we have no way to forecast the Mueller investigation, it is undoubtedly clear that risks are rising on the U.S. domestic front. President Trump’s popularity among GOP voters is elevated and far from levels needed to convince enough senators to remove him from power (Chart 32). However, a substantive finding by Mueller may leave the moderate Democrats in the House with no choice but to pursue impeachment. This may rattle the market for both headline and fundamental reasons. The headline reasons are obvious. The fundamental reasons have to do with the looming stimulus cliff in 2020. A pitched battle between the House Democrats and the White House would make cooperation on another substantive stimulus effort less likely and thus a recession in 2020 more likely. The market may start pricing in such an outcome at some point in 2019. Furthermore, sentiment could be significantly impacted by a protracted domestic battle that impairs Trump’s domestic agenda. President Bill Clinton sought relevance abroad amidst his impeachment proceedings by initiating an air war against Yugoslavia. President Trump may do something similar. There is also an unclear relationship between domestic tensions and trade war. On one hand, President Trump may want a clear win and so hasten a deal. On the other hand, he may want to extend the trade war to encourage citizens to “rally around the flag” and show his geopolitical mettle amidst a distracting “witch hunt.” While we have faded these domestic risks in 2017 and 2018, we think that it may be difficult to do so in 2019. We stick by our view that previous impeachment bouts in the U.S. have had a temporary effect on the markets. But if market sentiment is already weakened by global growth and end of cycle concerns, a political crisis may become a bearish catalyst. Question 7: What About Japan? Japan faces higher policy uncertainty in 2019, after a period of calm following the 2015-16 global turmoil. We expect to see “peak Shinzo Abe” – in the sense that after this year, his political capital will be spent and all that will remain will be for him to preside over the 2020 Tokyo Olympics. The primary challenge for Abe is getting his proposed constitutional revisions passed despite economic headwinds. Assuming he goes forward, he must get a two-thirds vote in both houses of parliament plus a majority vote in a popular referendum. The referendum is unscheduled but could coincide with the July upper house elections. This will be a knife’s edge vote according to polling. If he holds the referendum and it passes, he will have achieved the historic goal of making Japan a more “normal” country, i.e. capable of revising its own constitution and maintaining armed forces. He will never outdo this. If he fails, he will become a lame duck – if he does not retire immediately like David Cameron or Matteo Renzi. And if he delays the revisions, he could miss his window of opportunity. This uncertain domestic political context will combine with China/EM and trade issues that entail significant risks for Japan and upward pressure on the yen. Hence government policy will resume its decidedly reflationary tilt in 2019. It makes little sense for Abe, looking to his legacy, to abandon his constitutional dream while agreeing to raise the consumption tax from 8% to 10% as expected in October. We would take the opposite side of the bet: he is more likely to delay the tax hike than he is to abandon constitutional revision. If Abe becomes a lame duck, whether through a failed referendum, a disappointing election, or a consumption tax hike amid a slowdown, it is important for investors to remember that “Abenomics” will smell just as sweet by any other name. Japan experienced a paradigm shift after a series of “earthquakes” from 2008-12. No leader is likely to raise taxes or cut spending aggressively, and monetary policy will remain ultra-easy for quite some time. The global backdrop is negative for Japan but its policy framework will act as a salve. Question 8: Are There Any Winners In EM? We think that EM and global risk assets could have a window of outperformance in early 2019. However, given the persistence of the policy divergence narrative, it will be difficult to see EM substantively outperforming DM over the course of 2019. Mexico Over Brazil That said, we do like a few EM plays in 2019. In particular, we believe that investors are overly bullish on Brazil and overly bearish on Mexico. In both countries, we think that voters turned to anti-establishment candidates due to concerns over violence and corruption. However, Brazilian President-elect Jair Bolsonaro has a high hurdle to clear. He must convince a traditionally fractured Congress to pass a complex and painful pension reform. In other words, Bolsonaro must show that he can do something in order to justify a rally that has already happened in Brazilian assets. In Mexico, on the other hand, Mexican President Andrés Manuel López Obrador (AMLO) remains constrained by the constitution (which he will be unable to change), the National Supreme Court of Justice, and political convention that Mexico is right-of-center on economic policy (an outwardly left-wing president has not won an election since 1924). In other words, AMLO has to show that he can get out of his constraints in order to justify a selloff that has already happened. To be clear, we are not saying that AMLO is a positive, in the absolute, for Mexico. The decision to scrap the Mexico City airport plans, to sideline the finance ministry from key economic decisions, and to threaten a return to an old-school PRI-era statism is deeply concerning. At the same time, we are not of the view that Bolsonaro is, in the absolute, a negative for Brazil. Rather, we are pointing out that the relative investor sentiment is overly bullish Bolsonaro versus AMLO. Especially given that both presidents remain constrained by domestic political intricacies and largely campaigned on the same set of issues that have little to do with their perceived economic preferences. They also face respective median voters that are diametrically opposed to their economic agendas – Bolsonaro, we think, is facing a left-leaning median voter, whereas the Mexican median voter is center-right. The macroeconomic perspective also supports our relative call. If our view on China and the Fed is correct, high-beta plays like Brazil will suffer, while an economy that is tied-to-the-hip of the U.S., like Mexico, ought to outperform EM peers. As such, we are putting a long MXN/BRL trade on, to capture this sentiment gap between the two EM markets. Investors will be receiving positive carry on Mexico relative to Brazil for the first time in a long time (Chart 33). The relative change in the current account balance also favors Mexico (Chart 34). Finally, the technicals of the trade look good as well (Chart 35). South Korea Over Taiwan Diplomacy remains on track on the Korean peninsula, despite U.S.-China tensions in other areas. Ultimately China believes that peace on the peninsula will remove the raison d’être of American troops stationed there. Moreover, Beijing has witnessed the U.S.’s resolve in deterring North Korean nuclear and missile tests and belligerent rhetoric. It will want to trade North Korean cooperation for a trade truce. By contrast, if Trump’s signature foreign policy effort fails, he may well lash out. We view deeply discounted South Korean equities as a long-term buy relative to other EMs. Taiwan, by contrast, is a similar EM economy but faces even greater short-term risks than South Korea. In the next 13-month period, the Tsai Ing-wen administration, along with the Trump administration, could try to seize a rare chance to upgrade diplomatic and military relations. This could heighten cross-strait tensions and lead to a geopolitical incident or crisis. More broadly, U.S.-China trade and tech tensions create a negative investment outlook for Taiwan. Thailand Over India Five state elections this fall have turned out very badly for Prime Minister Narendra Modi and his National Democratic Alliance (NDA). These local elections have a negative impact, albeit a limited one, on Modi’s and the NDA’s reelection chances in the federal election due in April (or May). Nevertheless, it is entirely possible to lose Chhattisgarh, Madhya Pradesh, and Rajasthan while still winning a majority in the Lok Sabha – this is what happened to the Indian National Congress in 2004 and 2009. So far federal election opinion polling suggests anything from a hung parliament to a smaller, but still substantial, BJP majority. Modi was never likely to maintain control of 20 out of 29 states for very long, nor to repeat his party’s sweeping 2014 victory. He was also never likely to continue his reform push uninhibited in the lead up to the general election. Nevertheless, the resignation of Reserve Bank of India Governor Urjit Patel on December 10 is a very worrisome sign. Given that Indian stocks are richly valued, and that we expect oil prices to drift upwards, we remain negative on India until the opportunity emerges to upgrade in accordance with our long-term bullish outlook. By contrast, we see the return to civilian rule in Thailand as a market-positive event in the context of favorable macro fundamentals. Thai elections always favor the rural populist “red” movement of the Shinawatra family, but presumably the military junta would not hold elections if it thought it had not sufficiently adjusted the electoral system in favor of itself and its political proxies. Either way, the cycle of polarization and social unrest will only reemerge gradually, so next year Thailand will largely maintain policy continuity and its risk assets will hold up better than most other EMs. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Roukaya Ibrahim, Editor Strategist roukayai@bcaresearch.com Ekaterina Shtrevensky, Research Analyst ekaterinas@bcaresearch.com Footnotes 1 Please see Geopolitical Strategy Special Report, “Power And Politics In East Asia: Cold War 2.0?” dated September 25, 2012, Global Investment Strategy Special Report, “Searing Sun: Japan-China Conflict Heating Up,” dated January 25, 2013, “Sino-American Conflict: More Likely Than You Think, Part II,” dated November 6, 2015, and “The South China Sea: Smooth Sailing?” dated March 28, 2017, available at gps.bcaresearch.com. 2 Yes. He literally said that. Geopolitical Calendar
Underweight The S&P utilities index has been on a roll recently as this fixed income proxy has reacted to the recent fall in Treasury yields (change in yields shown inverted, top panel) and jump in natural gas prices. Further, utilities are typically seen as a domestic defensive play and the recent trade troubles and stock market carnage have made utilities soar in a flight to safety. We think the tailwinds lifting utilities are transitory and likely to shift to headwinds. First, one of our key themes for the year ahead is rising interest rates; a move higher in yields will have a predictably negative impact on these high-dividend paying equities. Second, a flight to safety looks fleeting; the ISM manufacturing new orders index usually moves inversely in lock step with utilities and the most recent message is negative for the S&P utilities index (ISM manufacturing new orders index shown inverted, second panel). Meanwhile, S&P utilities earnings estimates have continued to trail the broad market, having taken a significant step down this year (third panel). As a result, sector valuations have spiked (bottom panel), leaving the S&P utilities index prone to a shock. Net, we reiterate our underweight recommendation.
… quick’s the word and sharp’s the action. Jack Aubrey1 Idiosyncratic supply-demand adjustments – some induced by head-spinning reversals of policy (e.g., the U.S. about-face on Iran oil export sanctions) – and uncertainty regarding monetary policy and trade will keep volatility in oil, metals and grains elevated in 2019. We remain overweight energy – particularly oil – expecting OPEC 2.0 to maintain production discipline, and for demand to remain resilient.2 We remain neutral base metals and precious metals, seeing the former relatively balanced, and the latter somewhat buoyant, even as the Fed continues its rates-normalization policy. We remain underweight ags, although weather-induced supply stress has reduced the global inventories some. While we continue to favor being long the energy-heavy S&P GSCI on a strategic basis, tactical positioning will continue to dominate commodity investing in 2019. Highlights Energy: Overweight. OPEC 2.0’s 1.2mm b/d of production cuts goes into effect in January vs. October levels, and should allow inventories to resume drawing. Base Metals: Neutral. Fundamentally, base metals are largely balanced, which is keeping us neutral going into 2019. Precious Metals: Neutral. Gold prices will remain sensitive to Fed policy and policy expectations. Palladium prices have soared as a growing physical deficit noted earlier widens.3 If China cuts sales taxes on autos again, demand could soar. Ags/Softs: Underweight. A strong USD will weigh on ag markets, particularly grains, next year. An agreement on contentious Sino – U.S. trade issues could re-open Chinese markets to U.S. exports. However, the arrest of the CFO of China’s Huawei Technologies in Canada for possible extradition to the U.S. complicates negotiations. Feature Going into 2019, commodity markets once again are sending conflicting signals. While we continue to favor exposure to commodities as an asset class by being long the energy-heavy S&P GSCI index, which fell 6% this year on the back of the collapse in crude oil prices and flattening of the forward curves in Brent and WTI. Nonetheless, we believe investors will continue to be rewarded by taking tactical exposure on an opportunistic basis. Volatility remains the watchword, particularly in 1H19, for the primary industrial commodities – oil and base metals. While idiosyncratic supply-demand adjustments will drive prices in each market, Fed policy also will contribute to volatility, as the U.S. central bank likely remains the only systemically important monetary authority following through on rates-normalization. In line with our House view, we expect the Fed to deliver its fourth rate hike of 2018 at its December meeting next week, and four additional hikes next year. On the back of Fed policy, we expect the broad trade-weighted USD to rise another 3-5% in 2019, following a 6% increase in 2018 (Chart of the Week). This will supress demand ex-U.S. for commodities priced in USD, by raising the USD cost of these commodities. Chart of the WeekStronger USD Pressures Commodity Demand Below, we highlight the key themes we believe will dominate commodities in 2019. Oil Markets Still Re-Calibrating Fundamentals We continue to expect global oil demand to remain strong next year, despite the slight downgrading of global GDP growth earlier this year by the IMF. We expect EM import volumes – one of the key variables we track to proxy EM income levels – to hold up in 1H19, which supports our assessment commodity demand will grow, albeit at a slower rate than this year (Chart 2).4 Chart 2Slowing Trade Volumes Might Pre-sage Softer Commodity Demand In 2H19, we see the volume of EM imports dipping y/y from higher levels, then recovering toward year-end. This indicates the all-important level of EM income – hence commodity demand – will remain resilient, but the rate of growth in incomes will slow. This is confirmed by the behavior of the Global Leading Economic Indicators we use to cross check our EM income expectation via import volumes (Chart 3). Chart 3Global Leading Economic Indicators Lead EM Import Volume Changes There is a chance Sino – U.S. trade relations will thaw, which would remove a large uncertainty over the evolution of demand next year. This would be supportive for EM trade volumes generally, particularly imports. However, this is not a given, and we are not assuming any pick-up in demand in anticipation of such a development. We need to see concrete actions, followed by tangible trade improvement first. On the supply side, oil markets still are in the process of re-adjusting to an extraordinary policy reversal by the Trump administration on its Iranian oil-export sanctions last month – i.e., the last-minute granting of waivers to Iran’s largest oil importers. However, following OPEC 2.0’s decision last week to cut 1.2mm b/d of production to re-balance markets in 1H19, we continue to expect prices to recover. Indeed, going into the OPEC 2.0 meeting last week, we had already lowered our December 2018 production estimates for OPEC 2.0, and also reduced 2019 output estimates by ~ 1mm b/d, so the producer coalition’s action did not come as a surprise (Chart 4).5 Chart 4BCA's Global Oil Balances Anticipated OPEC 2.0 Cuts In addition to the cuts by OPEC 2.0, the Alberta, Canada, government mandated production cuts, which will become effective January 1, 2019, to clear a persistent supply overhang that was decimating producers’ revenues in the province. We estimate there is ~ 200k b/d of trapped Alberta supply – i.e., excess production over takeaway capacity (pipeline and rail) – along with ~ 35mm bbls of accumulated excess production in storage the government intends to draw over the course of 2019 at a rate of ~ 96k b/d. This will lower overall OECD inventories, even if the Canadian barrels are transferred south. Net, in addition to the 1.2mm b/d of cuts from OPEC 2.0, the ~ 300k b/d coming from Canada next year will mean close to 1.5 mm b/d of production, or ~1.4mm b/d of actual supply when accounting for the inventory release, is being cut or curtailed from these two sources. We cannot, at this point, forecast over-compliance with the OPEC 2.0 accord, which was one of the signal features of the deal in 2017 and 1H18. The Trump administration’s waivers for Iran’s eight largest oil importers expire May 2019. We view it as highly unlikely the Trump administration will re-impose export sanctions in full on Iranian exports following the expiration of waivers, and fully expect they will be extended at least for 90 days. This is because oil fundamentals will remain tight next year, despite the massive de-bottlenecking of the Permian Basin in West Texas. While an additional 2mm b/d of new takeaway capacity will be added to the region, it will not be fully operational until 4Q19. We have ~ 300k b/d of additional supply coming out of the Permian after the pipeline expansions are done in 2H19. Even as pipeline capacity is filled, the U.S. still needs to significantly increase its deep-water oil-export capacity to get this crude to market.6 Bottom Line: We expect the oil market to re-balance in 1H19, as production falls by ~ 1.4mm b/d – the combination of OPEC 2.0 and Canadian production cuts – and consumption grows by a similar amount. The USD will continue to appreciate next year, which, at the margin, will temper demand growth and prices. Gold: Remaining Long Equity And Inflation Risks Trump Higher Rates in 2019 As the U.S. economic cycle matures and advances into its final innings, we continue to recommend holding gold in a diversified portfolio. U.S. inflationary pressure will surprise to the upside in 2019, per our House view, which will offset the effects of somewhat less accommodative U.S. monetary policy in the U.S. The October equity correction is a reminder that, when rising UST yields drag stocks down in late-cycle markets, gold works as an effective hedge against equity risks, and can outperform bonds. In fact, both of the corrections we saw in 2018 likely were caused by a sharp increase in bond yields. This convexity on the upside and downside is what makes gold our preferred portfolio hedge. Easy Monetary Policy + Rising Rate = Bullish Gold Prices Despite being negatively correlated with interest rates, gold tends to perform well when the fed funds rate is below r-star – known as the “natural rate of interest” – and is rising (Chart 5, panel 1).7 When this happens, policy rates are below the so-called natural interest rate consistent with a fully employed economy, which, all else equal, is inflationary. In these late-cycle environments, gold’s ability to hedge against inflation and equity risks dominate its price formation, while its correlation with U.S. real rates diminishes. Chart 5Gold Will Stay in Trading Range In our view, gold will remain in an upward trading range until rates become restrictive enough to depress the inflation outlook (Chart 5, panel 2). Our U.S. strategists estimate the equilibrium fed funds rate is at ~ 3%, and project it will rise to ~ 3⅜% by end-2019. Therefore, despite our House view of four rate hikes next year, we expect the U.S. economy to remain in a below-r-star-and-rising phase for most of the year. Consistent with our House view, we believe U.S. inflation is likely to surprise to the upside next year, which will push gold prices higher (Chart 6, panel 1). The U.S. economy remains strong, particularly on the employment front. This means wage growth will work its way through inflation rates. Chart 6U.S. Inflation Likely to Surprise Admittedly, this is not the consensus view. Investors are not worried about significantly higher inflation (Chart 6, panel 2). However, our Bond strategists argue that long-maturity TIPS breakeven inflation is stuck below historical levels because of this abnormally low fear of elevated inflation (i.e. > 2.5%). Once inflation starts drifting higher, there will be an upward shift in investors’ inflation expectations. Any short-term dip in inflation on the back of lower oil prices will be transitory, given our view that oil prices will recover next year. If such a transitory dip, or concerns about a global growth slowdown spilling back into the U.S. causes the Fed to pause, we would add to our precious metal view position, given our assessment that this would raise the probability of an inflation overshoot. Lastly, gold prices recently have been depressed by an abnormally high correlation with the U.S. dollar (Table 1). We put this down to speculative positioning: Net speculative positions are stretched for both the U.S. dollar and gold, Table 1Gold Vs. USD Correlations Running Higher Than Normal therefore, any change in expectations likely will be amplified by a reversal in positioning (Chart 7). In the medium-term, we expect the gold-dollar correlation to converge back to its average, which would mute the dollar’s impact on gold. This would, all else equal, raise inflation and equity risks factors. Chart 7Spec Positioning Stretched Bottom Line: We continue to recommend gold as a portfolio hedge for investors, given its convexity – it outperforms during equity downturns, and participates on the upside (albeit not as much). Given our out-of-consensus House view for inflation, we believe gold also will provide a hedge against this risk. Palladium: China Tax Policy Could Lift Price Palladium soared to dizzying heights this year, on the back of an expanding physical deficit (Chart 8). Were it not for the loss of an automobile-tax break in China, which reduced the rate of growth in sales there to unchanged y/y, this deficit likely would have been considerably wider, inventories would have drawn even harder, and palladium prices would have been higher (Chart 9). Chart 8Palladium's Physical Deficit Expanding Chart 9Palladium Inventories Collapse Palladium’s demand is mainly driven by its use in catalytic converters for gasoline-powered cars, which dominate sales in the U.S. and China, the world’s two largest car markets (Chart 10). U.S. sales growth has leveled off this year (Chart 11), as has China’s. However, the China Automobile Dealers Association (CADA) is pressing policymakers to reduce the 10% auto sales tax by half, which could keep palladium demand elevated relative to supply, should it happen.8 Chart 10Auto Catalyst Demand Dominates PalladiumChart 11China Car Sales Could Revive With Tax Cut Russian producers, led by Norilsk Nickel, supply ~ 40% of the world’s palladium. Markets have been fearful U.S. sanctions could be imposed on Norilsk and other Russian producers throughout the year by the U.S., most recently in re Russia’s seizure of Ukrainian naval vessels in international waters, and over Russia’s response to the threatened withdraw from the Intermediate-Range Nuclear Forces (INF) Treaty by the U.S., which could be keeping a risk premium firmly embedded in palladium prices.9 With platinum trading below $800/oz, or ~ 65% of palladium’s value, autocatalyst makers could begin to switch out their catalysts (Chart 12). Chart 12Platinum Could Fill Palladium Supply Gap Base Metals: Trade Tensions, USD Cloud Outlook Base metals remain inextricably bound up with EM income growth. When EM incomes are growing, commodity demand – particularly for base metals – is growing, and vice versa. This typically shows up in EM GDP and import volume levels, which we use as explanatory variables in our base-metals price modeling (Chart 13). Chart 13Base Metals Demand Tied To EM Income, Trade Volumes There are, in our view, two significant risks to EM income growth over the short and medium terms: Sino – U.S. trade disputes, which erupted earlier this year. They carry the risk of spreading globally and unwinding supply chains that have taken decades to develop between DM and EM economies;10 Fed monetary policy, which is immediately reflected in USD levels. A strong dollar raises the local-currency costs of commodities for consumers ex-U.S., and debt-servicing costs in EM economies. In addition, it lowers the local-currency costs of producing commodities ex-U.S., which incentivizes producers to raise production to capture this arbitrage, since they are paid in USD. The trade-war risk remains, despite the agreement between presidents Trump and Xi at the G20 in Buenos Aires to work on a trade deal. Even so, the actual level of tariffs imposed by both sides is trivial relative to the level of global trade, which is in excess of $20 trillion p.a. – ~$17 trillion for goods, $5 trillion for services, according to the WTO (Chart 14). Chart 14Sino – U.S. Tariffs Remain Trivial Relative to Overall Global Trade Fed policy, on the other hand, is a threat of far greater moment to EM income growth, and, through this, import volumes, which we use to proxy that growth. The LMEX index, a gauge of base-metals prices traded on the LME, is extremely sensitive to changes in EM import volumes. This is not unexpected, given the income elasticity of trade for EM economies is greater than 1.0. Our modeling finds a 1% increase in EM import volumes translates to a 1.3% increase in the LMEX, which is consistent with the World Bank’s estimate of EM income elasticity of trade.11 Per our House view, we believe markets are too sanguine regarding the possibility of a Sino – U.S. trade deal. Such an event, should it occur, would immediately affect base metals markets, as China accounts for roughly half of base metals demand globally(Chart 15). Market participants’ default setting appears to be the U.S. and China will resolve their trade differences in short order – i.e., by the March 1, 2019, deadline agreed at the G20 meeting – resulting in a win-win for both countries and the world. We are hopeful this view is correct, but we would not take any positions in base metals in expectation of such an outcome. Instead, we think the substantive technological and strategic differences between the two countries, and underlying distrust, will result in a renewed escalation of tensions. Chart 15China Demand Remains Pivotal Base Metals Demand Could Wobble Bottom Line: We remain neutral base metals going into 2019. Fundamentally, most of the metals in the LME index are in balance, or can get there in short order. The Fed’s rates-normalization policy continues to represent a larger short-term risk to EM income growth than Sino – U.S. trade tensions, but, longer term, we continue to expect tension between the world’s dominant economies to escalate. Ags: Trade Tensions, USD Cloud Outlook That’s not a typo in the sub-head above; ags – particularly soybeans – are dealing with the same headwinds bedeviling base metals. The agreement to work on a trade agreement reached at the G20 summit between the U.S. and China lifted grain markets, and supported the upward trend in grain and bean prices. All the same, Sino – U.S. trade relations are prone to go off the rails at any time. The Buenos Aries understanding, after all, only holds for 90 days. In addition to the hoped-for agreement to resolve trade-war issues, grain prices received support from the signing of the United States-Mexico-Canada Agreement (USMCA). This helped align supply-demand fundamentals globally with prices. Focusing too much on China can obscure the fact that the USMCA, which replaces the North American Free Trade Agreement (NAFTA), eliminated major uncertainties over the fate of U.S. grain exports to Mexico, the second-largest destination for U.S grains, beans and cotton. In fact, Mexico accounts for 13% of all U.S. ag exports (Chart 16).12 Chart 16Trade Negotiations Hit American Farmers Hard All the same, the Sino – U.S. trade war is hitting U.S. ags hard, particularly soybeans. The 25% tariff on China’s imports of U.S. grains created two parallel agriculture markets. In one market, China is scrambling to secure supplies, creating a deficit. In the other, U.S. farmers are struggling to market their produce overseas, suffering from storage shortages and in some cases left with no option but to leave their crops to rot. Close to 60% of U.S. bean exports historically went to China. The U.S. – China trade war caused a soybean shortage in Brazil, as demand from China for its crops soared, while a record 11% of American beans are projected to be left over after accounting for exports and domestic consumption (Chart 17). Chart 17Bean Shortage in Brazil, Supply Glut in the U.S. A successful resolution to the U.S. – China trade tensions is unlikely to reverse the over-supply of beans globally (Chart 18). In fact, we expect beans stocks-to-use (STU) ratios to build next year, unlike global corn and wheat stocks (Chart 19). This will set a record for the soybean STU ratios, pushing them above 30%. Chart 18Expect Another Bean Surplus Chart 19Bean STU Ratios Will Grow As is the case for metals, the USD will weigh on ag markets, which will make U.S. exports more expensive than their foreign competition (Chart 20). As is the case for all of the commodities we cover, a strong dollar will weigh on prices at the margin. Chart 20A Strong USD Will Make U.S. Exports Expensive Bottom Line: A thaw in the Sino – U.S. trade war should realign global grain markets, but will not keep soybeans from setting new global inventory records. A strong USD will be a headwind for ag markets, as it is for other commodity markets we cover. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com Footnotes 1 This is a fictional character in the movie Master and Commander, based on the novels of Patrick O’Brian. 2 OPEC 2.0 is the name we coined for the OPEC/non-OPEC coalition led by the Kingdom of Saudi Arabia (KSA) and Russia. It was formed in November 2016 to manage oil production. 3 Please see “Silver, Platinum At Risk As Fed Tightens; Palladium Less So,” published by BCA Research’s Commodity & Energy Strategy February 15, 2018. It is available at ces.bcaresearch.com. 4 Please see “The Role of Major Emerging Markets in Global Commodity Demand,” published as a Special Focus in the IMF’s Global Economic Prospects in June 2018 for a discussion of income elasticities for oil, base metals and other commodities in large EM economies. 5 In our current forecast for 2019, we expect Brent to average $82/bbl next year, and for WTI to trade $6/bbl below that. Please see “All Fall Down: Vertigo In the Oil Market … Lowering 2019 Brent Forecast to $82/bbl,” published by BCA Research’s Commodity & Energy Strategy November 15, 2018. We will be updating our supply-demand balances and price forecast next week. 6 At 11.7mm b/d and growing, the U.S. is the largest crude oil producer in the world, having recently eclipsed Russia’s total crude and liquids production of 11.4mm b/d, and the U.S. EIA’s projected 2019 output of 11.6mm b/d. U.S. crude oil exports hit 3.2mm b/d for the week ended November 30, 2018, an all-time high, according to EIA data. It is worthwhile recalling crude oil exports were illegal until December 2015. U.S. product exports totalled 5.8mm b/d for the week ended November 30, and 6.3mm b/d the week before that. Total U.S. crude and product exports are running ~ 9mm b/d at present, which placed them just above total imports of crude and products – i.e., the U.S. became a net exporter of crude and products at the end of November. 7 The San Francisco Fed defines r-star as the inflation-adjusted “natural” rate of interest consistent with a fully employed economy, with inflation close to the Fed’s target. r-star is used to guide interest-rate policy consistent with long-term macro goals set by the Fed. Please see “R-star, Uncertainty, and Monetary Policy,” by Kevin J. Lansing, published in the FRBSF Economic Letter May 30, 2017. 8 Please see “Exclusive: Reverse gear - China car dealers push for tax cut as auto growth stalls,” published by reuters.com October 11, 2018. 9 Please see “Is Norilsk Nickel too big to sanction?” published by ft.com on April 19, 2018, and “U.S. to Tell Russia It Is Leaving Landmark I.N.F. Treaty,” published by nytimes.com October 19, 2018. 10 We discuss this in “Escalating Trade Disputes Pressuring Base Metals,” published July 12, 2018, in BCA Research’s Commodity & Energy Strategy. It is available at ces.bcaresearch.com. 11 For a discussion of the World Bank’s trade elasticities, please see “Trade Wars, China Credit Policy Will Roil Global Copper Markets” published by BCA Research’s Commodity & Energy Strategy June 21, 2018. It is available at ces.bcaresearch.com. 12 Canada makes up a smaller share of U.S. exports, at ~ 2%. Investment Views and Themes Recommendations Strategic Recommendations Commodity Prices and Plays Reference Table Trade Recommendation Performance In 3Q18 Trades Closed in 2018 Summary of Trades Closed in 2017
The most recent National Federation of Independent Business (NFIB) small-business optimism index marked a notable shift in small business sentiment, coming in at its lowest level in seven months. Considering its correlation with the relative performance of small cap equities, it is no wonder the latter have been falling recently. Two drivers underlie the weak survey: first, far fewer respondents expect the economy to improve (a net 11% fewer month-over-month) and second, planned labor compensation increases have continued to push new highs (second panel). It is the latter of these that causes us the most concern, particularly considering the divergence from the national trend. Historically, small and large caps have shared similar levels of profitability but that relationship has steeply diverged over the last three years (bottom panel). We expect small caps will struggle harder to fill vacancies (currently the biggest challenge facing small business owners, according to the NFIB survey) relative to large caps, implying ongoing margin challenges from relatively higher compensation cost growth. In an era where small cap leverage ratios are skyrocketing relative to large caps,1 margin compression is especially worrying and the resulting higher equity risk premium should continue to drag small caps down. We reiterate our high-conviction underweight recommendation on small caps relative to large caps. 1 Please see BCA U.S. Equity Strategy Insight Report, “ The Days In The Sun Are Over For Small Caps,” dated December 7, 2018, available at uses.bcaresearch.com.
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