Developed Countries

Highlights So What? The odds of the Democrats taking the Senate have fallen. Meanwhile China's policy easing will benefit China itself, or consumer goods exporters, more so than other EMs. Why? China is the fulcrum of global macro at the moment - only a sharp spike in credit growth will signal a total capitulation by President Xi Jinping. We are lowering the odds of a Democratic takeover of the House from 70% to 65%, while in the Senate the odds fall from 50% to 40%. Generational warfare is one of our new long-run investment themes - it will help define the 2020 election. Feature Amidst the market correction last week, it was easy for investors to take their eyes off the ball: Chinese policy. Chart 1U.S. Is In Rude Health... The ongoing macro environment is one of policy divergence, with the U.S. economy in "rude health," (Chart 1) - to quote BCA's Chief U.S. Strategist Doug Peta - while Chinese growth disappointed under the pressure of macroprudential structural reforms (Chart 2). The dueling policies have converged to produce epic tailwinds for the U.S. dollar (Chart 3) and correspondingly headwinds for global risk assets. Chart 2...But China Still Struggling Chart 3Epic Tailwinds For The Dollar Amidst this backdrop, investors have finally come to terms with the first portion of our thesis: the Fed will respond to robust U.S. growth. Merely weeks ago, markets doubted that the Fed had the temerity to raise interest rates beyond a single hike in 2019. Today, despite President Trump's rhetoric, there is no doubt which way the Fed will guide interest rates next year (Chart 4). Chart 4The Fed Will Keep Hiking A surge in expectations for hawkish Fed policy beyond 2018 should be detrimental for global risk assets. A determined Fed, racing to meet the rising U.S. neutral rate, may tighten global monetary policy too much given that the global neutral rate is likely lower. That view would support remaining overweight U.S. assets and underweight EM well into 2019. Chart 5Signs That China Is Stimulating China is the fulcrum upon which this view will balance. Beijing continues to signal policy easing. BCA Foreign Exchange Strategy's "China Play Index" has perked up, suggesting that global assets are sniffing out the bottoming of restrictive policy (Chart 5). Our own checklist, which would falsify our thesis that Chinese policymakers will avoid a stimulus "overshoot," is starting to see some movement (Table 1). Table 1Will China's Policy Easing Produce A Stimulus Overshoot? If China ramps up stimulus to keep pace with U.S. growth - itself a product of pro-cyclical fiscal stimulus - global risk assets may rally significantly. Our recommendation that investors buy the China Play Index as a portfolio hedge to our bearish view of global risk assets has only returned 0.7% since August 8. China: Credit Data Holds The Key Is it time to ditch the safety of U.S. stocks and embrace ROW? Chart 6What Will September Credit Data Bring? No, at least not yet. It is true that China is clearly shifting towards stimulus. As we go to press, the credit data for September has not yet appeared, but a sharp reversal in credit growth will be necessary to convince global markets that Xi Jinping has fully abandoned his efforts to impose more discipline on China's banks, shadow banks, local governments, and local government financing vehicles (Chart 6). It will be crucial to watch for a reversal in non-bank credit growth, which would suggest that Xi is capitulating on shadow banking, which would then imply a larger reflationary push overall (Chart 7). Chart 7Shadow Bank Crackdown To Lighten Up? The monetary policy setting is currently as easy as in 2016, although there has been no substantive change since July and People's Bank of China chief Yi Gang has signaled that while more can be done, his policy remains "prudent and neutral" (Chart 8). So far this year there have been four cuts to banks' required reserve ratios - it will take additional cuts to signify policy easing beyond expectations as of July (Chart 9). Easier monetary policy implies additional currency depreciation, which could have a reflationary effect. Chart 8Lending Rates Will Decline Substantially If Repo Rates Don't Rise Chart 9RRR Cuts Can Continue Local government brand new bond issuance is catching up to the previous two years', despite a late start. We expect this indicator to be abnormally strong in the closing months of the year, making for an overall increase year-on-year (Chart 10). Local governments are responding to the central government's encouragement to borrow and spend more. Chart 10Local Governments Borrowing More Further, global trade war concerns may abate in the coming months. There is still no guarantee that U.S. President Donald Trump will meet his Chinese counterpart Xi Jinping at the G20 leaders' summit in Argentina at the end of November. Both sides are expected to bring negotiating teams to this meeting if it goes forward. While no formal talks have taken place since August 23, Treasury Secretary Steven Mnuchin did meet with China's central bank Governor Yi Gang on the sidelines of the World Bank Annual Meeting in Bali, Indonesia. They discussed China's foreign exchange policy and the potential meeting between Trump and Xi. Our structural view is that the Sino-American tensions are hurtling towards a modern version of a Cold War. However, that structural view can have cyclical deviations. A pause in U.S.-China acrimony - though not a reversion to status quo ante - could manifest by the end of the year. Chart 11U.S. Is Winning The Trade War... Trade policy uncertainty has greatly favored U.S. assets relative to global, both in terms of equities (Chart 11) and the U.S. dollar (Chart 12). Even a temporary truce, if combined with further Chinese stimulus, could reverse the trend. Chart 12...And So Is The U.S. Dollar As such, we can see a temporary pullback in our central thesis of policy divergence, one that benefits global risk assets in the immediate term. However, we caution investors from believing that a structural shift is in place that favors EM and high-beta assets. Put simply, we doubt that China will stimulate as aggressively as it did in 2016, 2012, or 2009 (Chart 13). There is just too much political capital already sunk into macroprudential reforms. Beijing policymakers are therefore sending mixed signals, both looking to stabilize growth rates and contain leverage. Chart 13Expect A Weaker Jolt This Time Several clients have pointed out that the pace and intensity of stimulus is not important. Even a modest turn in Chinese policy will be a strong catalyst for global risk assets at the moment given that the context of 2018-2019 is much more favorable than 2015-2016. In other words, the world is not facing a global manufacturing recession precipitated by a historic decline in commodity prices as it was in 2015. Today, the world needs a lot less from China to spark a cyclical recovery. We are not so sure. First, the big difference between 2015-2016 and today is not the health of the global economy but the health of the U.S. economy and the fact that the Fed is much further along in its tightening cycle. In 2016, the Fed took a 12-month vacation after hiking rates in December 2015, as the amount of slack in the U.S. economy was much larger (Chart 14). Today, the market has begun to price in expectations of further rate hikes in 2019. Chart 14Output Gap Is Closed Second, China's foreign exchange policy could still prove globally deflationary. China faces an exogenous risk today - the trade war - that it did not face in 2015-16. At that time the currency fell amidst financial turmoil, capital outflows, and policy devaluation. But it bottomed in late 2016 after the PBoC defended it robustly, the government imposed strict capital controls, and stimulus stabilized growth. Today the CNY has come under downward pressure again from slower growth, easing monetary policy, and manipulation to retaliate against U.S. tariffs. Despite capital controls, the one year swap-rate differential between China and the U.S. appears to be leading CNY/USD further downward (Chart 15). Given that China's current policy easing is heavily reliant on monetary easing, CNY/USD has more downside. Chart 15Interest Rate Differentials And CNY-USD: A Tight Link Chinese currency trajectory is therefore an important gauge for global investors. Downside beyond the psychological barrier of 6.9-7.0 CNY/USD will at some point have a deflationary rather than reflationary global impact. The PBoC may hold the line and prevent further depreciation, in which case any additional stimulus measures will reinforce this line. But if China adopts more aggressive fiscal and credit stimulus and yet the currency still depreciates due to the U.S. conflict, then China's import demand will not rise by as much as the stimulus would imply. Domestic sentiment will worsen, causing capital outflow pressure to rise, and EM currencies and global growth expectations will suffer. As such, we prefer to play Chinese stimulus through exposure to Chinese equities (ex-tech) relative to other EM equities. Chinese stimulus, we argue, will stay in China, rather than rescue global risk assets. Within EM ex-China, we generally prefer equity indices that are exposed to the Chinese consumer over those exposed to resource-oriented "old China." A key point about China's current policy easing is the use of tax cuts more so than credit-fueled infrastructure construction: the goal of the reform agenda is to boost the consumption share of the economy. As such, we have been recommending that clients overweight South Korea and Malaysia relative to EM benchmarks. Bottom Line: Chinese policy is the fulcrum upon which global policy divergence will turn. If Chinese stimulus overshoots, investors should expand beyond the safety of U.S. assets and spring for global risk assets. At the moment, our view is that Chinese stimulus will not cause global economies to re-converge. Instead, it will benefit Chinese equities relative to other EM plays, and EM markets that export consumer goods to China. Overall, however, we remain cautious on global risk assets. Midterm Update: Did Trump Declare A Generational War? Chart 16GOP Improves In Key Senate Races The Democratic Party's midterm election strategy of opposing Supreme Court Justice Brett Kavanaugh's nomination has failed to work in key Senate races, where President Trump has rallied his base in reaction to the contentious nomination hearings. Polls now indicate that several Republican Senate candidates are in the lead, including the three that we are watching most closely: Tennessee, Arizona, and Nevada (Chart 16). Our own Senate model, which has been generous to Democrats, now sees Arizona, Tennessee, and Missouri as likely going to the Republican Party (Chart 17). Nevada is still projected to flip to the Democratic Party, but the GOP retains the current 51-49 Senate makeup. Chart 17Our Model Suggests Senate Race Will Be A Wash Political betting markets have sniffed out the shift in Senate polls, with the probability of the GOP maintaining control of the Senate now soaring to above 80%. However, the odds of retaining the House have actually reversed after initial gains in October (Chart 18). Why? Chart 18Republican Odds Surge For Senate First, because President Trump remains unpopular despite the surge of support for GOP Senate candidates in some states (Chart 19). Second, the generic ballot continues to give Democrats a robust lead of 7.3% (Chart 20). The lead has narrowed from a high of 9.5% in early September, but does not suggest that Republicans will benefit in the House as much as in the Senate. Chart 19Trump Still Has Popularity Deficit Chart 20Democrats' Robust Lead In Generic Polls Third, Justice Kavanaugh is now sitting on the Supreme Court! Had his nomination been stalled or outright rejected, the anger of the GOP base would have been more sustainable and broad-based going into the voting booth. The paradox for President Trump is that by winning the Supreme Court battle, the shot of adrenaline to the GOP base has been expended. Nonetheless, the fight itself shows yet again that anger works as an election strategy. After all, as counterintuitive as it may seem, there is no evidence that economic performance helps win midterm elections. Our research actually suggests that there is a mildly negative correlation between economic performance and congressional election performance (Chart 21). Voters only vote with their stomachs when they are hungry. Chart 21Strong Economy Won't Save The GOP In The House Of Representatives Midterm voters tend to be motivated by non-economic issues. With the Supreme Court settled in favor of the GOP base, the question arises: Is Trump out of ways to motivate his base with anger? Maybe not (there is still a Wall to be built!), but it may be too late to rally the GOP base sufficiently by November 6. The House appears to be lost, especially if GOP polling momentum stalls at its current level. However, the two parties have given us a glimpse into their strategies for 2020 - outrage versus outrage. President Trump, in an op-ed for USA Today, blasted the Democratic Party as a party of "open border socialism" that seeks to "model America's economy after Venezuela."1 Specifically, he cited plans by the Democratic Party to reform healthcare in such a way as to transfer the benefits that seniors currently enjoy under Medicare to the rest of the population, ending Medicare benefits in the process. The veracity of President Trump's claims is beyond the scope of this report - and has been covered extensively by the media. What is important is that President Trump may have revealed his strategy for 2020: Generational Warfare. Chart 22Here Comes Generational Warfare Investors caught glimpses of this strategy in 2016, when Vermont Senator Bernie Sanders appealed directly to Millennial voters in his surprisingly robust battle against Secretary Hillary Clinton. For Democrats, appealing to Millennials is a no brainer. First, they are the largest voting bloc in the country (Chart 22). Their numbers relative to Baby Boomers will necessarily grow. Chart 23Beware The Crisis Of Expectations Second, the share of 30-year-olds earning more than their parents at a similar age has fallen by nearly half (Chart 23). Despite the poor economic situation of today's youth, government spending continues to accrue mainly to the elderly (Chart 24). Chart 24Get Grandma! The problem for Democrats is that the more they appeal to the youth, the more likely that President Trump's charges of socialism will ring true. After all, the 18-29 age cohort has more favorable views of socialism than capitalism (Chart 25). Yes, even in America! Chart 25Uh-Oh... Where does this leave investors? First, American politics is no longer merely ideologically polarized. In 2020, we expect generational polarization to emerge as a major theme. Second, the kind of Generational Warfare practised by President Trump leaves no room for cuts to public services. Trump is not opposing Democratic "open border socialism" with traditional, centrist, Republican calls for entitlement reform. Instead, he is casting himself as a champion and defender of Baby Boomer entitlements, which, as Chart 24 clearly illustrates, leave spending on the youth in the dust. The point is that President Trump is not preaching fiscal conservativism. There is no room for entitlement reform in the new GOP. Generational Warfare will simply seek to prevent Democrats from shifting more benefits to the non-Baby Boomer share of the population by preserving the already unsustainable Baby Boomer entitlements. BCA Research's House View sees 2020 as the likeliest date for the next U.S. recession. At the end of 2020, The Congressional Budget Office projects that the U.S. budget deficit will be around 5% (Chart 26). Given that the last four recessions raised the U.S. budget deficit by an average of 5% of GDP, it is safe to say that the U.S. budget deficit may rise to 2010 levels after the next downturn. Chart 26U.S. Deficits Will Be Extremely Large For A Non-Recessionary Period Given President Trump's and the Democratic Party's focus on Generational Warfare, it is unlikely that entitlement reform will occur proactively either before or after the next recession. This suggests that bond yields could rise significantly after the next downturn. Bottom Line: Our baseline odds for the midterm recession are due for an adjustment. We are lowering the odds of a Democratic House takeover to 65% (from 70%) and of a Senate takeover to 40% (from 50%). President Trump's USA Today op-ed signals a turn towards Generational Warfare. Neither the GOP nor the Democratic Party are interested in entitlement reform. The former, under Trump, seeks to preserve the already unsustainable Baby Boomer benefits, while the latter seeks to expand them to the rest of the population. The 2020 election may be fought along the lines of who is more profligate toward their base. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see "Donald Trump: Democrats Medicare for All plan will demolish promises to seniors," published by USA Today, dated October 12, 2018.