Economy

Highlights Central bankers appear to be in a rush to boost inflation expectations before the next economic downturn. This in practice should be stimulative for the global economy. Historically, currencies of small, open economies are typically the first to benefit from rebounding global growth. Ditto for those whose output gaps have fully closed. However, there appears to be a shift in the behavior of certain currency pairs in the current cycle. For example, the U.S. dollar has tended to perform better in a low-volatility environment in recent years, a shift from the past. Correspondingly, its safe-haven status may have been marginally eroded. The U.S. decision not to extend waivers on Iranian oil exports beyond the May 2 deadline is bullish for petrocurrencies such as the RUB and NOK. The Bank of Canada kept rates on hold but will be hard pressed to meet its inflation mandate before the next downturn. This suggests standing aside on USD/CAD. Rising net short positioning on the yen and Swiss franc is making them attractive from a contrarian standpoint. Place a limit-buy on CHF/NZD at 1.45. Feature Chart I-1Volatility Is Due For A Bounce The four most important financial variables that could give a near-complete snapshot of the world economy at any point in time are probably the level of the S&P 500, the U.S. 10-year Treasury yield, the trade-weighted dollar and a commodity bellwether, say, crude oil prices. Any permutation of these variables can identify what quadrant the world economy is operating in, with the two most important states being either boom or bust. Taking three of those variables today – the S&P 500 breaking to all-time highs, crude oil prices up 40% from their lows and U.S. 10-year Treasury yields off by almost 100 basis points from their October highs – it is hard to justify why the dollar has hardly budged, this week’s rally aside. Obviously, this is a very simplified view of an intricately complex world economy. But it highlights a point we have been making in recent bulletins: that extended periods of low currency volatility have been very unusual in the post-Bretton Woods world (Chart I-1). The typical narrative has been that as we enter a reflationary window, pro-cyclical currencies should outperform. The reason is simple enough: These economies are export-oriented and tied to the global cycle. So, a rising current account surplus as demand for their goods and services picks up provides underlying support for the currency. Should there be little slack in their domestic economies, this also raises the probability that the central bank tightens monetary policy to fend off future inflationary pressures. It does not hurt if these countries are also commodity producers, since rising terms of trade also provides an additional exchange-rate boost. The reality is that the world is not static, and some of these dynamics have been shifting. The evidence is in the counterfactual: At current levels, China’s credit injection should have lit a fire under pro-cyclical trades because they tend to work in real-time rather than with a lag. The foreign exchange market is one of the deepest and most liquid where new information tends to get digested and discounted instantaneously. As such, the lack of more pronounced strength in pro-cyclical currencies like the Australian, New Zealand and Canadian dollar exchange rates is genuine reason for concern and worth investigation. Why Is The Dollar Breaking Higher? Our Special Report1 on March 29th highlighted the fact that the dollar should be 5-10% higher simply based on measures of relative trends, and recent data corroborate this view. The growth differential between the U.S. and the rest of the world remains wide. Meanwhile, exports and industrial production from Southeast Asia continue to decelerate. Interbank rates in China are spiking higher, suggesting most of the monetary stimulus may have already been frontloaded. And on the earnings front, U.S. profit leadership also continues. It is unclear which of these catalysts was the actual trigger for dollar strength, since these have been in place for a while now, but confirmation from any and all of them was sufficient to reinvigorate the dollar bulls. That said, it is important to pay heed to shifting market forces, but it will be imprudent to change investment strategy on this week’s moves alone. Given these moves, a few observations are in order: Almost all currencies are already falling versus the U.S. dollar – a trend that has been in place for several months now (Chart I-2). This means most of the factors putting upward pressure on the dollar are well understood by the market. For example, global growth has been slowing for well over a year, based on the global PMI. Putting on fresh U.S. long positions is at risk of a washout from stale investors, just as it was back in 2015, a year after growth had peaked. Dollar technicals are also very unfavorable (Chart I-3). Speculators are holding near-record long positions, sentiment is stretched and our intermediate-term indicator is also flagging yellow. Over the past five years, confirmation from all three indicators has been followed by some period of U.S. dollar indigestion. This time should be no different. Chart I-2Is It Time To Initiate Fresh Dollar Longs? Chart I-3Dollar Technicals Are Unfavourable A breakout in the dollar along with rising equity markets suggests that the correlation is once again shifting. The dollar has tended to trade as a counter-cyclical currency for most of the time, with a negative correlation even to global equities (Chart I-4). Importantly, given current low levels of volatility and elevated equity market valuations, the dollar would have been a great insurance policy for any stock market correction. But with U.S. interest rates having risen significantly versus almost all G10 countries in recent years, the dollar has itself become the object of carry trades. This has also come with a good number of unhedged trades, as the rising exchange rate has lifted hedging costs (Table I-1). Chart I-4The Dollar Remains A 'Risk-Off' Currency It will be difficult for the dollar to act as both a safe-haven and carry currency, because the forces that drive both move in opposite directions. For one, safe-haven assets tend to be lower-yielding but also during episodes of capital flight, investors choose to repatriate capital to pay down debt, with creditor nations having the upper hand. And given U.S. investors have already been repatriating close to $400 billion in assets over the past 12 months, it is unlikely this pace persists (Chart I-5). The bottom line is that investors who believe that the U.S. dollar has become a high-beta currency should be prepared to stampede out the door on any rise in volatility. Our bias remains that the U.S. dollar will ultimately weaken, given that the forces driving it higher are mostly behind us. Meanwhile, currencies such as the Japanese yen or even Swiss franc that have been used to fund carry trades are very ripe for short-covering flows. Putting everything together suggests at minimum building portfolio hedges. It will be difficult for the dollar to act as both a safe-haven and carry currency. One such hedge is going long CHF/NZD. This trade has a high negative carry, so we do not intend to hold it for longer than three months. But speculative positioning and relative economic trends also support this cross for the time being (Chart I-6). We are placing a limit-buy at 1.45. Chart I-5How Much More Will Repatriation Flows Help? Chart I-6CHF/NZD Is An Attractive ##br##Hedge A Shifting Landscape If the dollar eventually weakens, let’s consider the premise that the most export-dependent economies should benefit more from a rebound in global growth, and by extension, their currencies should appreciate the most. Within the G10 universe, this will be notably the European currencies led by the Swiss franc, the Swedish Krona, the euro and the pound (Chart I-7). However, from the trough in the global Purchasing Managers’ Index (PMI) in December 2008 until the peak in April 2010, it was the commodity currencies that outperformed. During that time frame, the Swiss franc actually fell. It is well known that Switzerland’s persistent trade surplus over the decades has been a key factor behind structural appreciation in the currency. However, at any point in time, other nuances such as whether the rebound is China or commodities driven, the starting point for valuations or even interest rate differentials take center stage in explaining currency moves. The lesson is that investors have to become nimble with currency investment strategy. The lesson is that investors have to become nimble with currency investment strategy. For pro-cyclical currencies, there have been dramatic shifts in the export share of GDP for various countries, according to World Bank data. Most euro area countries have massively expanded their export share of GDP as they have gained ground in value-added products and services. Meanwhile, the export share in Australian GDP has been stuck at 20% for many years, while that in Norway, New Zealand and Canada has seen a huge drop, even since 2009 (Chart I-8). At first blush, this suggests diminishing marginal returns to their currencies from global growth. Chart I-8A Shifting Export ##br##Landscape Take the example of New Zealand, where commodities are over 75% of exports. Since the 2000s, the government has been actively trying to redistribute growth from net exports to domestic demand. This has been mainly via the skilled workers program. The result has been a collapse in the export share of GDP from 36% to about 26%. This means that the New Zealand dollar, which has typically been a higher-beta play on global growth, is giving way to other currencies such as the euro and the Swedish krone (Chart I-4). In addition to this, while global growth might eventually recover, part of the widespread deterioration since the global financial crisis may be structural. If the overarching theme over slowing global trade is a global economy that is trying to lift its precautionary savings and spend less, then the world may not see the high rates of trade growth registered in the 1990s anytime soon. This is because at a lower rate of potential GDP growth, trade elasticities also tend to fall.2 There are many reasons for this, including less willingness among creditor nations to finance current account deficits, the paradox of thrift or just outright saturation in the turnover of trade. All of this dampens marginal returns toward all pro-cyclical currency trades. Chart I-9Trade Volatility Has Fallen The bottom line is that the overall magnitude and volatility of trade relative to GDP has fallen, at least until the recent China – U.S. trade spat (Chart I-9). This has had the effect of dampening the volatility of the corresponding mediums of trade exchanges. Part of this is clearly cyclical, but a part may be structural as well. If we embrace confirmation that the Chinese economy has bottomed, it will be important to monitor if this cycle plays out like those in the past. Notes On Petrocurrencies, And The BoC The U.S. has decided not to extend waivers on Iranian oil exports beyond the May 2 deadline. Supposedly, a coalition with both Saudi Arabia and the United Arab Emirates would ensure that oil markets remain adequately supplied, though Saudi Arabia has since signaled they are in no rush to raise production. Overall, this increases the bullish narrative for oil. First, the Iranian response to a shutoff in their exports could be unpredictable. The U.S. threat of driving Iranian oil exports to zero increases the geopolitical risk premium in prices, as full implementation pushes Iran to a wall, raising the odds of retaliation. Chart I-10Iran Is A Meaningful Oil Supplier Second, oil production is being curtailed at a time when Venezuelan output is rapidly falling, conflict in Libya is reviving and OPEC spare capacity remains tight. This could nudge the oil market dangerously close to a negative supply shock (Chart I-10). Meanwhile, there is the non-negligible risk of unplanned outages which have been rising in 2019, which is another source of risk for oil supply Oil futures have responded positively to the news, with both Brent and WTI making fresh 2019 highs. However, while initially reacting favorably, petrocurrencies such as the Canadian dollar, Russian ruble and Norwegian krone are selling off amid dollar strength. We think Brent will continue to trade at a premium to WCS crude. This bodes well for currencies tied to North Sea production. Hold short CAD/NOK and long NOK/SEK positions, despite the selloff this week. As for Canada, we are neutral on the loonie both short and medium term. The dovish shift by the BoC and looser fiscal policy are likely to be growth tailwinds. So is the rise in oil prices. However, there appears to be a genuine slowdown in the Canadian economy that is not yet fully reflected in economic forecasts.  The key drivers for the CAD/USD exchange rate are interest rate differentials with the U.S. (which we think will compress further) and energy prices (which we think Canada benefits less from due to the discount Canadian oil sells for, and persistent infrastructure problems). As such, we think domestic conditions will continue to knock down whatever benefit comes from rising oil prices (Chart I-11). Chart I-11CAD/USD Will Benefit From##br## Rising Terms Of Trade Chart I-12Can The BoC Hike Given ##br##This Backdrop? (1) On the consumer side, real retail sales are deflating at the worst pace since the financial crisis, and demand for housing loans is falling off (Chart I-12). This is unlikely to improve if house prices continue to roll over (Chart I-13). A study by the Reserve Bank of New Zealand shows that on average, the elasticity of consumption growth to house price changes is asymmetric with negative housing shocks, hurting consumption by more than the boost received from positive shocks. This asymmetry may be due to the fact that at very elevated debt levels, leveraged gains are used to pay down debt aggressively, whereas leveraged losses hit bottom lines directly. There appears to be a genuine slowdown in the Canadian economy that is not yet fully reflected in economic forecasts. On the corporate side of the equation, the latest Canadian Business Outlook Survey is very telling. Firms’ expectations for sales have softened significantly, as businesses in several sectors are less optimistic about demand. This is driven by uncertainty in the oil patch, weak housing and weak external conditions. This in turn, has led to a steep drop in plans to increase capex (Chart I-14). For external investors, the large stock of debt in the Canadian private sector and overvaluation in the housing market are likely to continue leading to equity outflows on a rate-of-change basis. Chart I-13Can The BoC Hike Given This Backdrop? (2) Chart I-14Can The BoC Hike Given This Backdrop? (3) Technically, USD/CAD failed to break below the upward sloping trendline drawn from its 2017 lows. The next resistance zone is the 1.36-1.38 level. Our bias is that this zone will prove to be formidable resistance. We continue to recommend investors short the CAD, mainly via the euro. Housekeeping Our limit-buy on AUD/USD was triggered at 0.70. Place tight stops at 0.68 until further evidence that global growth has bottomed. Our short USD/SEK position garnered losses this week. The RiksBank’s dovish shift surprised the market, and triggered panic selling as important technical levels were broken. With a manufacturing PMI at 52.8, inflation at 1.8% and wages growing near 3%, this is not exactly the symptoms of an economy that needs more stimulus. We recommend holding onto positions, but will respect our stop loss a few hundred pips away. Finally, the dovish shift by the Bank of Japan does not change our thinking on the yen. The resilience in the currency might indicate the pool of yen bears has been exhausted.   Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Special Report, titled “Tug Of War With Gold As Umpire,” dated March 29, 2019, available at fes.bcaresearch.com. 2 Cristina Constantinescu, Aaditya Mattoo, and Michele Ruta, “The Global Trade Slowdown: Cyclical Or Structural?” IMF working paper (2015). Currencies U.S. Dollar Chart II-1 Chart II-2​​​​​ Recent data in the U.S. suggest a weaker housing market: In March, building permits contracted by 1.7% month-on-month, falling to 1.27 million; housing starts decreased by 0.3% month-on-month, coming in at 1.14 million. March new home sales grew by 4.5% month-on-month, coming in at 0.69 million. However, existing home sales contracted by 4.9% month-on-month, falling to 5.21 million. The house price index grew by 0.3% month-on-month in February, in line with expectations. MBA mortgage applications decreased by 7.3% in April. The Chicago Fed National Activity index fell to -0.15 in March, underperforming expectations. Durable goods orders increased by 2.7% in March, surprising to the upside. DXY index appreciated by 1% this week, hitting the highest level since June 2017. While a more accommodative monetary policy stance has been taken in China, global growth momentum remains weak, which is a cause for concern. Report Links: Beware Of Diminishing Marginal Returns - April 19, 2019 Not Out Of The Woods Yet - April 5, 2019 Tug OF War, With Gold As Umpire - March 29, 2019 The Euro Chart II-3 Chart II-4 Recent data in the euro area continue to soften: Italian business confidence and consumer confidence in March fell to 100.6 and 110.5, respectively. April preliminary consumer confidence in the euro area fell to -7.9, below expectations. German IFO business climate fell to 99.2 in April; expectations and current assessment fell to 95.2 and 103.3, respectively. French business confidence improved to 105, while business climate decreased to 101 in April. Italian trade balance came in at a larger surplus of 3.42 billion euro in April. EUR/USD depreciated by 1% this week. The incoming data from the euro area and globally have been weaker than expected. The recent ECB Economic Bulletin remains positive for the growth outlook going forward, stating that “the supportive financing conditions, favorable labor market dynamics and rising wage growth should continue to underpin the euro area expansion.” Report Links: Reading The Tea Leaves From China - April 12, 2019 Into A Transition Phase - March 8, 2019 A Contrarian Bet On The Euro - March 1, 2019 The Yen Chart II-5 Chart II-6 Recent data in Japan have been negative: Headline inflation and core inflation were unchanged at 0.5% and 0.4% year-on-year in March, respectively. Machine tool orders in March contracted by -28.5% year-on-year. All industry activity index fell by 0.2% month-on-month in February, in line with expectations. USD/JPY surged initially by 0.4% ahead of BoJ’s rate decision, then fell sharply, returning flat this week. The BoJ has decided to keep the interest rate on hold at -0.1%. The shift to a calendar-based form of forward guidance is unlikely to be a game-changer on its own. Moreover, the BoJ expects the Japanese economy to pick up through 2021 supported by highly accommodative financial conditions and government spending, despite the weakness of global growth and scheduled consumption tax hike. Report Links: Beware Of Diminishing Marginal Returns - April 19, 2019 Tug OF War, With Gold As Umpire - March 29, 2019 A Trader’s Guide To The Yen - March 15, 2019 British Pound Chart II-7 Chart II-8 Recent data in the U.K. have been positive: Public sector net borrowing increased to 0.84 billion pounds in March. In April, the CBI retailing reported sales increased to 13. The CBI business optimism came in at -16 in April, an improvement compared to the last reading of -23. GBP/USD fell by 1% this week, mostly affected by the U.S. dollar’s broad strength. The pound is likely to rebound once we see more signs confirming the strength in global growth, given Brexit has been kicked down the road. Report Links: Not Out Of The Woods Yet - April 5, 2019 A Trader’s Guide To The Yen - March 15, 2019 Balance Of Payments Across The G10 - February 15, 2019 Australian Dollar Chart II-9 Chart II-10 Recent data in Australia have been negative: Headline inflation fell to 1.3% year-on-year in Q1, missing expectations. Trimmed mean inflation in Q1 fell to 1.6% year-on-year. AUD/USD fell by 2.3% this week, which triggered our limit buy order at 0.7 on Wednesday. Inflation is a lagging indicator. While the Q1 inflation number missed expectations, the Australian dollar is likely to bottom as Chinese stimulus plays out and global growth starts to pick up. Report Links: Beware Of Diminishing Marginal Returns - April 19, 2019 Not Out Of The Woods Yet - April 5, 2019 Into A Transition Phase - March 8, 2019 New Zealand Dollar Chart II-11 Chart II-12 Recent data in New Zealand has been negative: Credit card spending contracted by 5.1% year-on-year in March, underperforming expectations. NZD/USD fell by 1.36% this week. We remain bearish on the New Zealand dollar due to the Achilles’ heel of an overvalued housing market. Moreover, the Kiwi is still expensive compared to its fair value. Report Links: Not Out Of The Woods Yet - April 5, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Canadian Dollar Chart II-13 Chart II-14 Recent data in Canada have been positive: Wholesale sales grew by 0.3% month-in-month in February, surprising to the upside. CFIB business barometer increased to 56.7 in April. USD/CAD surged by 0.95% this week. The Canadian dollar seems to be less responsive to the energy prices this week due to lots of concerns regarding the pipeline issue in Alberta. The Bank of Canada maintained its overnight interest rate target at 1.75% on Wednesday. In the April Monetary Policy Report, the BoC projects real GDP growth of 1.2% in 2019, and around 2% in 2020 and 2021. Given the current developments in household spending, energy investment, and trade conditions, a dovish stance by BoC is warranted. Report Links: A Shifting Landscape For Petrocurrencies - March 22, 2019 Into A Transition Phase - March 8, 2019 Balance Of Payments Across The G10 - February 15, 2019 Swiss Franc Chart II-15 Chart II-16 Recent data in Switzerland have been mostly positive: Money supply M3 grew by 3.5% year-on-year in March, same as last month. ZEW survey expectations increased to -7.7 from the previous reading of -26.9. USD/CHF increased by 0.66% this week. While global growth is set to rebound, the uncertainties regarding geopolitical risks, trade conditions, and oil prices will weigh on the growth pace. We remain neutral on the Swiss franc against U.S. dollar, but acknowledge that the large short positioning is attractive from a contrarian standpoint. Report Links: Beware Of Diminishing Marginal Returns - April 19, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Norwegian Krone Chart II-17 Chart II-18 There is no significant data from Norway this week. USD/NOK appreciated by 2.2% this week. We remain overweight the NOK based on our bullish outlook for oil. The Trump administration said they would not renew the waivers for Iranian oil exports, a move that roiled the energy market. The spike in oil prices will eventually benefit the Norwegian krone once global growth stabilizes. Report Links: A Shifting Landscape For Petrocurrencies - March 22, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Swedish Krona Chart II-19 Chart II-20 Recent data in Sweden suggest a more positive sentiment: Consumer confidence increased to 95.8 in April, surprising to the upside. Economic tendency survey increased to 102.7 in April. Moreover, the manufacturing confidence also improved to 108.4 in April. USD/SEK appreciated by 2.64% this week. The Riksbank has kept its interest rate unchanged at -0.25% this week, as widely expected. The dovish shift of central banks worldwide is likely to help the global economy, which will benefit the Swedish krona. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Global Liquidity Trends Support The Dollar, But... - January 25, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights The U.S. dollar will ultimately reach fresh cycle highs, but not before going through a weak phase starting this summer that could last 12 months. We closed our long DXY trade for a carry-adjusted return of 16.4% last week. We will go tactically short the index if it breaches 101 (about 3% above current levels). As a countercyclical currency, the dollar is likely to stumble in the second half of this year as global growth accelerates. Positioning and sentiment are currently very dollar bullish, which is likely to exacerbate any sell-off in the greenback. The dollar should begin to rally again late next year, as global growth decelerates while the Fed is forced to turn more hawkish in the face of rising inflation. Go long European banks as a tactical trade. Feature Moving To The Sidelines On The Dollar We closed our long DXY trade recommendation for a carry-adjusted gain of 16.4% at last Thursday’s close – too early it turns out, as the DXY has gained another 0.7% since then. The dollar is a high-momentum currency (Chart 1). The trend is the dollar’s friend at the moment, which makes betting against the greenback risky. Nevertheless, we would not chase the dollar higher at these levels. Long dollar positioning is highly stretched and sentiment is overly bullish (Chart 2). This makes a price reversal increasingly probable. Perhaps more importantly, the macro fundamentals, which have worked in favor of the dollar since early 2018, will likely start working against it as the summer months approach. Chart 2There Are A Lot Of Dollar Bulls Out There   Stronger Global Growth Will Hurt The Greenback The dollar is a countercyclical currency, meaning that it tends to move in the opposite direction of global growth (Chart 3). Global growth has been decelerating since early 2018, and that has helped boost the dollar’s value. The dollar is a countercyclical currency, meaning that it tends to move in the opposite direction of global growth. Chart 3The Dollar Is A Countercyclical Currency If anything, the growth divergence between the U.S. and the rest of the developed world has increased over the past few months. Goldman’s Current Activity Indicator (CAI) for the U.S. has been rising since January, while the European and Japanese CAIs have continued to fall (Chart 4). Looking out, the rest of the world is likely to catch up to the United States. The Chinese CAI has already moved sharply higher thanks in part to an acceleration in Chinese credit growth. Chart 4Growth Is Recovering In The U.S. And China Chart 5China: Credit Is Growing At A Moderately Faster Pace Than GDP We would downplay recent market speculation that the Chinese authorities are preparing to restart their deleveraging campaign. Credit growth is now running only modestly above nominal GDP growth (Chart 5). With the ratio of debt-to-GDP broadly stable, there is no need to further clamp down on credit formation. The Chinese government also wants to keep the economy buoyant in order to gain negotiating leverage in trade talks with the Trump administration.   Better Chinese Data Will Benefit The Rest Of The World Fluctuations in Chinese growth usually affect Europe with a lag of around six months (Chart 6). This suggests that European exports should strengthen starting this summer. Meanwhile, European domestic demand should benefit from an easing of fiscal policy of around 0.5% of GDP. Chart 6Europe Will Benefit From Improving Chinese Growth Chart 7Swings In Interest Rate Differentials Explain Some Currency Moves   Faster growth in the U.S. in relation to the euro area has caused the spread in expected interest rates to widen between the two regions. The spread in one-month, five-year forward OIS rates now stands at 202 bps, similar to the highs seen in late-2016 (Chart 7). If euro area growth recovers this summer, the market will price in a bit of tightening from the ECB starting late next year. This will cause the spread to narrow, leading to a stronger euro. A revival in Chinese growth should also help EM and commodity currencies. The market is currently pricing in 44 basis points of rate cuts in Australia, 33 bps of cuts in New Zealand, and 21 bps of cuts in Canada over the next 12 months. While domestic concerns around high household debt levels and overvalued real estate markets will keep central banks on guard in all three economies, a more robust global growth backdrop should allow some of the expected easing to be priced out. Japan remains a bit of a wildcard due to the government’s stated intention to raise the sales tax this October. We see little justification for increasing the sales tax given that inflation expectations are still nowhere close to the BOJ’s target. Japan needs easier, not tighter, fiscal policy. There is still an outside chance that the tax hike will be postponed, but even if it is, rising bond yields in the rest of the world will still hurt the yen. The BOJ has no intention of abandoning its yield curve targeting system anytime soon. In fact, it introduced new forward guidance at this week’s monetary policy meeting promising not to raise rates at least until the spring of 2020. Investors looking to trade the yen should consider going long EUR/JPY or AUD/JPY. We recommend going long European banks outright for a tactical trade. Bottom Line: If global growth accelerates later this year, the dollar will probably weaken. Accordingly, investors should use this week’s rally in the dollar to scale back exposure to the currency. We are also putting in a limit order to go short the DXY index if it reaches 101 (about 3% above its current level). Looking Further Out… Chart 8Low Odds Of An Imminent Major Inflationary Upswing In The U.S. Mini-cycles within the broader global business cycle tend to last around 12-to-18 months. If this pattern continues to hold, global growth will probably falter again in the second half of next year. At that point, the dollar is likely to strengthen again. By how much can the dollar rise? That depends on what the Fed does. A stronger dollar would entail a tightening in financial conditions. Normally that would cause the Fed to turn more dovish, limiting the upside for the greenback. The risk is that rising inflation prevents the Fed from turning more accommodative. Inflation is not much of a concern now. Leading indicators of inflation such as core intermediate goods prices and the prices paid component of the ISM remain well contained (Chart 8). Wage growth has picked up, but productivity growth has risen even more. As a result, unit labor costs, which tend to lead core inflation, have been decelerating since the middle of last year. If the U.S. economy continues to grow above trend, however, inflation could begin to break out late next year. That would force the Fed to start raising rates more aggressively than it would like, even in the face of slower growth. Such a stagflationary outcome will be awful for equities and other risk assets. As U.S. financial conditions tighten, global growth will slow, giving the dollar a further boost. The upshot is that the dollar could see a meaningful rally starting late next year. Stay Bullish On Stocks For Now… Until that fateful day arrives, we are inclined to maintain our bullish equity bias. We upgraded global stocks to overweight in December after having moved to the sidelines in June. Despite the run-up in stock prices, the forward P/E ratio on the MSCI All-Country World Index is still 7% below where it was at the start of 2018 and 3% below its long-term (30-year) average (Chart 9). Earnings estimates are also finally starting to increase (Chart 10). Accelerating global economic growth will ensure that profits continue to rise into year-end. Chart 9Global Stocks Are Not That Expensive Chart 10Earnings Estimates Have Turned The Corner     … And Buy Some European Banks For A Tactical Trade European banks are trading at distressed valuations (Chart 11). One can debate the long-term prospects for the European banking sector, but in the near term, one thing is clear: If European growth begins to surprise on the upside, bond yields in core European markets will rise, which should help European bank stock prices (Chart 12). Stronger economic growth will also translate into more credit demand and lower non-performing loans. This will boost bank earnings (Chart 13). With all this in mind, we recommend going long European banks outright for a tactical trade. Chart 11European Banks: A Good Value Play Chart 12Euro Area: Higher Bond Yields Bode Well For Bank Stocks Chart 13More Credit, Fatter Bank Earnings   Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com   Strategy & Market Trends MacroQuant Model And Current Subjective Scores Tactical Trades Strategic Recommendations Closed Trades

Analysis on the Philippines and Argentina are below. Highlights Analysis on the Philippines starts on page 9 and Argentina on page 12. Relative return on capital for non-financial corporations points to continuous EM equity underperformance versus the U.S. and probably versus other DMs as well. Taking into consideration the poor corporate profitability, EM equity valuations are not attractive in absolute or relative terms. The rationale for continuous U.S. dollar appreciation is a superior return on capital in the U.S. relative to the rest of the world. Short the Korean won and the Philippines peso versus the U.S. dollar. Feature In general, the most important drivers of relative equity performance between emerging and developed markets are corporate profitability and exchange rates. The outlook for corporate earnings and profitability at the current juncture is poor for EM in both absolute terms and versus the U.S. Further, the U.S. dollar is in the process of breaking out. As this breakout transpires, EM equities will continue to underperform their U.S. and probably DM counterparts. The most important drivers of relative equity performance between emerging and developed markets are corporate profitability and exchange rates. Corporate Profitability Chart I-1Relative Corporate Profitability And Share Prices: EM Versus U.S. Chart I-1 shows relative share prices in common currency terms along with the average of relative return on equity (RoE) and return on assets (RoA) for non-financial companies in EM and the U.S. This chart portends that in the medium- and long term, relative RoE and RoA explain relative equity prices in common currency terms reasonably well. Importantly, both RoE and RoA are ratios and are therefore not impacted by exchange rates. Consequently, it is reasonable to use RoE and RoA to gauge both share prices and exchange rates. Critically, relative RoE and RoA are not impacted by currency movements either. Further, we use EBITDA to calculate these profitability ratios for both EM and the U.S. As a result, they are not influenced by last year’s U.S. tax cuts as well as by corporate depreciation and one-off adjustments (Chart I-2). What’s more, we use data for non-financial companies because profitability measures for financial companies, especially banks, are contingent on their recognition of bad loans and provisioning. If banks lend a lot but do not provision, their profitability becomes unjustifiably inflated. Chart I-2Non-Financials Corporate Profitability: EM And U.S. Going forward, the outlook for EM versus DM share price performance largely hinges on currency market dynamics. If the dollar experiences a broad-based upsurge, which appears to be emerging, EM will likely underperform not only the U.S., but DM ex-U.S. as well. The rationale is that currency depreciation will be more positive for equity markets in Europe, Japan, Canada and Australia than for EM bourses. The former group does not have U.S. dollar debt, while currency weakness will boost the profits of their non-financial companies. Meanwhile, many EM companies are sitting on U.S. dollar debt, and as such currency depreciation is toxic for them. Bottom Line: Relative RoE and RoA for non-financials point to continuous EM underperformance versus the U.S. Profitability And Equity Valuations Is it possible that EM corporate profitability is currently improving, and valuations are already discounting a lot of the negatives? Shouldn’t relative corporate profitability be compared with relative equity valuations between EM and the U.S.? For now, there are no signs that EM corporate profitability is improving. On the contrary, our best indicator for EM EPS in dollar terms points to continuous profit contraction until the end of this year (Chart I-3). As EM EPS shrinks, RoE and RoA will also decline. Stabilization and potential improvement in China’s growth could benefit EM corporate revenues and profits toward year-end. However, to date, China’s imports from EM and the rest of the world continue to contract. China’s credit and fiscal spending impulse leads its manufacturing PMI's import sub-component by nine months and predicts a bottoming around August (Chart I-4). Chart I-3EM EPS Is ##br##Contracting Chart I-4Chinese Imports Will Stabilize Around August Notably, the continued deterioration in EM top and bottom lines implies that EM ex-financials’ RoE and RoA will roll over at their 2008 lows -- reached at the nadir of the global recession (Chart I-5). Investors should elect the multiples they want to pay for companies that cannot deliver RoE and RoA above their 2008 lows. Chart I-5EM Corporate Profitability And Multiples Taking into consideration such historically low RoE and RoA, EM equity valuations do not appear cheap. The bottom panel of Chart I-5 illustrates that, stripping out the 10% of sub-sectors with the highest and lowest multiples, EM equity multiples are at their historical mean. As to U.S. corporate profits, the key risks are a strong dollar and a potential profit margin squeeze. Nevertheless, a rising dollar is an even bigger risk to EM equities than it is to U.S. equity prices. U.S. share prices always outperform EM equities in common currency terms when the greenback is appreciating. Bottom Line: After adjusting for corporate profitability, EM equity valuations are not attractive in absolute or relative terms. Return On Capital Drives Exchange Rates The U.S. dollar is attempting to break out, and odds are that it will succeed. This will again challenge EM risk assets, as the latter typically perform poorly when the greenback appreciates. The rationale for continuous U.S. dollar appreciation is the superior return on capital in the U.S. relative to the rest of the world. Currency markets are often driven by relative return on capital.1 Chart I-6 shows the average of U.S. non-financials’ RoE and RoA relative to the same measure for DM ex-U.S. Broadly, the long-term trends in the narrow trade-weighted dollar have tracked the relative corporate profitability ratios between non-financial companies in the U.S. and other DMs. Relative return on capital at the moment suggests an upleg in the greenback. Chart I-6Relative Return On Capital And U.S. Dollar The thesis that exchange rate gyrations are steered by the relative trajectory of return on capital is especially true in EM. As exhibited in Chart I-7, relative RoE and RoA between EM- and U.S.-listed non-financial companies foreshadows EM exchange rate movements reasonably well, and points to further EM currency depreciation. Chart I-7Relative Return On Capital And EM Currencies While interest rate differentials also correlate with exchange rates in DM, the former often reflect a relative return-on-capital differential. For example, when an economy performs well amid rising interest rates, it implies that its potential growth and potential return on capital are sufficiently high. Typically, the currency of that country will tend to appreciate. By contrast, when an economy struggles amid rising interest rates, it is a sign that its potential growth and potential return on capital are poor, and that the current level of interest rates is unsustainably high. In this scenario, the exchange rate will most likely depreciate despite rising interest rates. In a nutshell, return on capital is an important driver of exchange rates. Chart I-8Interest Rates Do Not Drive EM Currencies In developing countries, the interest rate differential with the U.S. cannot be used to forecast exchange rates. As can be seen from Chart I-8, high-yielding currencies such as the ZAR and BRL have often been negatively correlated with their respective interest rate spread over U.S. rates. Crucially, in the case of high-yielding EM currencies, exchange rate swings often steer interest rates. When these currencies depreciate, both their interest rates and their spread over U.S. rates rise. In contrast, appreciation of high-yielding EM currencies prompt interest rates in their respective economies to drop, and their spread with U.S. rates to narrow. Bottom Line: U.S. relative return on capital is ascending versus both EM and other DM, heralding further dollar appreciation. Investment Observations And Conclusions The snapshot of the above analysis is that the relative return on capital explains both relative share price performance and exchange rates. Chart I-9 demonstrates that EM relative equity performance tracks the trajectory of EM relative EPS versus the U.S. in both common and local currency terms. Chart I-9EM Versus U.S.: EPS And Stock Prices It is tempting to bet on a mean reversal in EM relative equity performance against the U.S. However, our indicators do not point to such a reversal in EM underperformance for now. In short, we continue to recommend underweighting EM stocks versus DM in general and versus the U.S. in particular. Finally, the U.S. dollar is poised to stage a meaningful rally. Last week, we showed that currency volatility has dropped to historic lows. Typically, this occurs before a major market move (Chart I-10). Our view has been one of dollar appreciation, and recent market actions vindicate this stance. In our Special Report on Korea published on February 28, we flagged a tapering wedge pattern in the KRW/USD exchange rate and recommended going long the KRW on a breakout, or short on a breakdown. The won seems to have broken down, so we now recommend shorting the KRW versus the U.S. dollar (Chart I-11). In the meantime, we are taking profits on our short KRW/long equal-weighted basket of the U.S. dollar and JPY trade. This trade has generated a 3.9% gain since its initiation on February 14, 2018. Chart I-10The Dollar Is On Verge Of Major Move Chart I-11The Korean Won Is Breaking Down ​​​​​​To play EM exchange rate depreciation, we continue to recommend shorting the following basket of EM currencies against the U.S. dollar: ZAR, CLP, IDR, MYR, PHP and KRW. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   The Philippines: Dovish Central Bank Amid Rising Inflation = Currency Plunge Philippine stocks have outperformed the EM benchmark lately and have risen in absolute terms due to the sharp drop in U.S. rates (Chart II-1). Chart II-1Philippine Stocks Relative Performance Yet, investors have been ignoring the buildup in genuine inflationary pressures in the economy. Consequently, the latter will carry negative repercussions for Philippine financial markets. In particular, unit labor costs are on the cusp of rising precariously. For instance, the minimum wage in Metro Manila increased by 5% in 2019 – the highest largest hike in six years. Meanwhile, President Rodrigo Duterte issued an executive order raising salaries for government workers and military personnel. Worryingly, President Duterte is also attempting to pass a bill to abolish contractual labor. The latter is a very favorable form of hiring for employers. President Duterte made the successful passing of this bill a top priority and has been urging Congress to fast-track it. In the meantime, President Dueterte issued an executive order banning companies from hiring certain types of contract-based employment. This policy is already starting to take a toll on companies. For instance, Murata Manufacturing, a Japanese electronics parts maker, saw its labor costs surge by 20% in the Philippines as it was ordered to convert 400 of its contract employees to full-time workers. Higher labor costs will push up inflation and/or squeeze companies’ profit margins. Investors have been ignoring the buildup in genuine inflationary pressures in the economy. In the meantime, the Philippines’ fiscal policy remains extremely stimulative. Government expenditures are currently growing at an 18% rate annually. This is despite the fact that the fiscal deficit is widening sharply (Chart II-2, top panel). Chart II-2The Philippines: A Large Twin Deficit Consequently, higher wages and fiscal spending will keep domestic demand robust, worsening the Philippines’ current account deficit (Chart II-2, bottom panel). The latter is a form of hidden inflation as it gauges the level of excess demand relative to the productive capacity of the economy. Crucially, given president Duterte’s reluctance to cut government spending, it will be up to monetary policy to solely contain inflation. Yet the independence of Philippine’s central bank – Bangko Sentral ng Pilipinas or BSP – is questionable: In March, president Duterete appointed his former budget secretary Benjamin Diokno as the new governor of the central bank. Therefore, the BSP will continue to err on the side of easy monetary policy and will further fall behind the curve. In particular, the BSP might justify staying on hold by the fact that headline and core inflation are now falling. However, that might prove to be a temporary development. Muted headline and core consumer inflation mainly reflect the crash in oil prices late last year. In particular, core inflation dipped because prices of items sensitive to oil prices – such as transportation costs and electricity – fell. The recent spike in oil prices will push inflation higher in the coming months. Crucially, the Philippines inflation problem is genuine in nature because it emanates from higher wages, rising unit labor costs and credit and fiscal stimulus-driven demand excesses. Genuine inflation coupled with a central bank that is behind the curve is a disastrous recipe for the currency. We recommend shorting the peso versus the U.S. dollar. A plunging Philippine peso will cause local bond yields to rise, hurting the stock market. While the central bank could choose to defend the currency by selling foreign exchange reserves, such policy will shrink the banking system liquidity – excess reserves at the BSP – which will result in higher interbank rates. On the whole, the BSP is facing the Impossible Trinity dilemma: given the nation has an open capital account, it cannot control both interest rates and the exchange rate simultaneously. Commercial banks and property stocks – which make up 15% and 29% of the Philippines MSCI market cap – will sell off hard as the currency depreciates and interest rates come under upward pressure. We continue to recommend shorting property stocks. The previous rise in interest rates is already hurting interest-rate sensitive sectors in the Philippines as credit growth is slowing sharply – albeit from a high level (Chart II-3). Commercial banks will in turn face rising NPLs and will be forced to raise provisions markedly. Both NPLs and provisions are currently too low in light of the relentless credit boom of the past several years. Finally, commercial banks have been lowering their provisions to boost their profits (Chart II-4, top panel). This means provisions will have to rise aggressively and bank earnings will contract severely. This will come on top of low net interest income margins (Chart II-4, bottom panel). Chart II-3Philippine Real Estate Stocks Are Ignoring Slowing Credit Growth Chart II-4Weak Profitability Ahead For Commercial Banks Bottom Line: We are initiating a new trade: short the PHP against the U.S. dollar. Equity investors should continue underweighting Philippine stocks relative to the EM benchmark, and within this bourse short property stocks. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com   Argentina: A Point Of No Return? The Argentine peso remains vulnerable due to deficient external funding and public debt sustainability concerns. A lack of external funding and a depreciating peso are causing rising inflation and interest rates. The latter are spurring a downfall in the economy diminishing incumbent President Mauricio Macri’s re-election chances. Chart III-1A Point Of No Return? Importantly, a depreciating peso, as well as high and rising external and domestic borrowing costs are making public debt unsustainable. All of these dynamics are feeding into plunging investor confidence creating a powerful negative feedback loop. Argentina may have reached a point of no return (Chart III-1). The odds that the authorities can stabilize financial markets are rapidly diminishing. Foreign currency-denominated public debt currently stands at $250 billion, and the country’s foreign debt service obligations for 2019 alone are $40 billion. We estimate the country will require an additional $10 billion of external funding this year (Table III-1). Given worsening investor sentiment, both the public and private sectors will not be able to raise external funding. As icing on the proverbial cake, potential U.S. dollar appreciation and portfolio outflows out of EM will reinforce the turmoil in Argentine markets. Argentina may have reached a point of no return. The odds that the authorities can stabilize financial markets are rapidly diminishing. Hence, without the IMF’s authorization for the central bank to use a large share of its foreign currency reserves to defend the exchange rate, the peso will continue to fall. How much more downside could there be in Argentina’s financial markets and economy? When compared with the major financial crises, bank share prices could drop much more. For example, Argentine banks stocks plunged by 95% in U.S. dollar terms during the nation’s 2001-2002 crisis (Chart III-2, top panel). During the 1997-1998 Asian financial crisis, bank equities in Korea and Thailand on average dropped by 95% in dollar terms (Chart III-2, bottom panel). Chart III-2History Suggests More Downside In Argentine Equities By comparison, since their peak in January 2018, Argentine banks are down 66% in dollar terms. Hence, more downside should not come as a surprise. As to currency depreciation, the peso’s real effective exchange rate has so far depreciated by 36% and remains undervalued by one standard deviation (Chart III-3). This compares with median and mean of 52% devaluations during previous crises in Argentina (Table III-2). Thus, more downside is likely in the currency in both real and nominal terms. The contraction in economic activity in this recession has so far been 6.5% (Table III-2). This is on par with median and mean contractions of 7% during previous crises but economic activity can undershoot this time. Chart III-3The Currency Can Get Cheaper Bottom Line: Investors should continue to avoid Argentine financial markets, as the downside could still be substantial. Do not catch a falling knife.   Andrija Vesic, Research Analyst AndrijaV@bcaresearch.com Footnotes 1 We herein use the term return on capital in a broader sense. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Bank Credit Analyst

Highlights An aging population, a banking sector in poor health, and a private sector focused on building up savings are the key factors undermining euro area growth on a structural basis. A large manufacturing sector makes the euro area vulnerable to EM competition. Unlike the U.S., the region’s tech sector is held back by regulatory burdens, taxes and heavy dependence on bank funding. The euro area growth faces decades of low growth and inflation. Euro area rates will stay depressed, but paradoxically, the euro can still experience structural appreciation. Euro area equities are cheap for a good reason, and banks will continue to weigh on performance. Feature Over the past 10 years, the euro area has gone through a sovereign debt crisis, a double-dip recession, persistent below-target inflation, and most recently, yet another major growth slowdown. Moreover, this economic malaise materialized despite highly stimulative monetary policy, including negative interest rates. The ongoing economic weakness has raised the specter that the euro area is the new Japan. Nearly three decades after the bursting of the Nikkei bubble, the Land of the Rising Sun remains mired in low growth and mild but persistent deflation. Consequently, charts showing that European policy rates or bond yields are tracking Japanese developments with a 17-year lag (Chart II-1) have not only become commonplace, they elicit fears that European growth, interest rates and asset valuations will lag the rest of the world for decades to come. Chart II-1Europe Is Following The Japanese Example In this piece, we discuss the various forces that explain why the euro area economy has been so weak this decade, and why such low interest rates have had so little impact on growth. We also study what sets the U.S. and euro area apart, and whether or not Europe will follow the trail blazed by Japan nearly 30 years ago. The Three Headwinds Three ills have kept European growth particularly depressed this cycle and are likely to remain significant headwinds into the foreseeable future: demographics, the banking sector’s poor health, and nonfinancial private sector balance sheet cleansing. 1)   Demographics This is the most well understood and acknowledged problem impacting Europe today. Since 2008, the European population has grown by 2%, or only 0.2% a year, with the working age population having peaked around that year. Going forward, the picture will only deteriorate: The UN expects Europe’s population to contract by 12% over the next 27 years, and the working age population to fall by 15%. This also means that the dependency ratio – the number of individuals aged less than 15 and above 65 per 100 working-age people – will approximately double over the coming 40 years. This is a clear parallel with Japan. As Chart II-2 illustrates, Europe’s population, the number of working-age individuals and the dependency ratio are all tracking Japan with a 17-year lag. Like Japan, Europe’s trend growth will thus only deteriorate further. Not only will Europe not be able to add as many workers as the U.S. to its total, but it will need to build even fewer schools, malls, office buildings or units of housing. Consequently, both the supply and demand sides of the economy will lag due to this factor alone. 2)   Banking Sector Health The poor health of the euro area banking sector is well known. BCA’s Global Asset Allocation service published an in-depth analysis of the European banking sector last December.4 The piece demonstrated that European banks have been much slower to recognize non-performing loans, curtail credit and rebuild capital than their U.S. counterparts. U.S. bank loans to the private sector fell by 13% in the two years during the crisis, while in Europe, these same loans have only fallen by 2% since 2008. Euro area banks generally remain burdened with significant non-performing loans as a percentage of regulatory capital. Moreover, net interest margins are also dismal, implying that the income cushion against bad loans is thin. Consequently, outside of France, Finland and Germany, European banks have either not grown their loan books to the private sector or, as is the case with Spain, Portugal, and Ireland, these books are continuously shrinking (Chart II-3). Chart II-2Same Demography In Europe Now Than In Japan Then Chart II-3Peripheral Banks Continue To Curtail Credit   The poor health of the European banking system is now constraining the supply of new credit to the rest of the economy. This is a much bigger problem than is the case in the U.S. given that in Europe, 72% of corporate funding comes from the banking system while 88% of household liabilities are also funded this way. In the U.S., the share of bank funding for these sectors is 32% and 29%, respectively (Chart II-4). A weak euro area banking system prevents the nonfinancial private sector from growing as robustly as it could. 3)   Nonfinancial Private Sector Balance Sheet Cleanse Another major drag on European growth has been the continued efforts of the European private sector to rebuild its balance sheet. To use the terminology developed by our upcoming conference speaker Richard Koo, the euro area has been in the thralls of a powerful balance sheet recession. Households in the euro area, Japan and the U.S. are all accumulating more financial assets than liabilities. However, only in the U.S. is the nonfinancial corporate sector building more liabilities than it is accumulating assets (Chart II-5). In Japan and Europe, the nonfinancial corporate sector is also a source of savings for the economy. Moreover, in Europe, the government runs a much smaller financial deficit. The current account balance tells this story vividly. A country’s current account is equal to the private sector’s savings minus investment and minus government deficits. As Italy, Spain, and other peripheral economies increased their aggregate savings after 2008, their large current account deficits vanished. Meanwhile, the governments of countries like Germany or the Netherlands, which sported healthy public finances, did not increase their spending in a commensurate way. This adjustment transformed an overall euro area current account deficit of 1.5% in 2008 into a surplus of 3.0% of GDP today, sending some of Europe’s excess savings abroad. This mimics the post-1990 Japanese experience. In the U.S., where the private sector savings did not rise as durably as in Europe, the current account stopped improving meaningfully in 2010 (Chart II-6). Chart II-5European Businesses Are Savers, Like In Japan Chart II-6The Current Account Dynamics Epitomise The Savings Dynamics   A private sector squarely focused on rebuilding its balance sheet liquidity can lead to a liquidity trap. In this state, monetary policy can become ineffective as spending does not respond to lower interest rates. This is where Europe is currently stuck, explaining why the European Central Bank is finding that inflation and growth are not experiencing much lift, despite seemingly incredibly accommodative monetary conditions. Why Such An Urge To Save? The fact that the household sector is a net saver is not surprising, as this is a normal state of affairs across most economies. But why is the European nonfinancial corporate sector still trying to improve its balance sheet liquidity by accumulating more assets than liabilities? Like Japanese businesses 30 years ago, European firms have large debt loads. Another problem is the lack of capex opportunities in Europe. Why do we make this assertion? The return on assets in Europe has been at rock-bottom levels ever since the introduction of the euro (Chart II-7). In the decade from 1998 to 2008, this was a non-issue. Strong global growth flattered European sales, and easy access to credit meant that via rising leverage euro area-listed nonfinancial corporations were able to generate returns on equity comparable to U.S. firms (Chart II-8, top panel). Once European banks got cold feet and European nonfinancial businesses began focusing on deleveraging, the low level of return on assets became more apparent. Part of the problem is that European profit margins are much closer to Japanese than U.S. levels (Chart II-8, middle panel). Even more damning, asset turnover – how much sales are generated by a unit of assets – has been structurally lower in Europe than in both Japan and the U.S. for multiple decades (Chart II-8, bottom panel). Chart II-7Europe Suffers From A Lower RoA Chart II-8DuPont's Decomposition Shows Why The Euro Area RoA Is Poor   The first factor weighing on the level of asset utilization and returns in Europe is the elevated level of capital stock. As Chart II-9 illustrates, the capital stock as a share of output in Italy, Spain and France dwarfs that of Japan, China or the U.S. Even Germany’s capital stock, which stands well below that of other large euro area economies, is nearly 100 percentage points of GDP larger than the U.S’s. Europe has too large a pool of assets to make any additional investments profitable, especially in light of its poor demographic profile. The second factor weighing on European asset utilization and returns is the poorer level of labor productivity. From the 1950s to the early 1980s, European GDP per worker rose relative to the U.S., albeit peaking at 92% of the levels across the Atlantic. Due to falling working hours in Europe relative to the U.S. since the 1980s, relative output per hour continued to rise until the mid-1990s, peaking at 105% of the U.S. level. However, since their respective zeniths, both relative productivity measures have collapsed (Chart II-10, top panel). Chart II-10Another Symptom Of Europe's Misallocation Of Capital In The 2000s These collapses are in fact worse than Japan’s performance since its lost decades began. As the second panel of the chart shows, since the early 1990s, Japan’s relative output per hour and per worker have flattened – not declined – at around 65% and 72%, respectively, of U.S. levels. Instead, relative European productivity levels are currently converging toward Japanese levels (Chart II-10, third and fourth panels). The particularly poor level of European asset utilization and productivity principally reflects the duality between the peripheral as well as French economies on one side, and Germany as well as the Netherlands on the other side. The exceptionally large capital stock outside of Germany is a legacy of the years directly after the euro’s introduction. Back then, the ECB kept rates low to help Germany, the then-sick man of Europe. These rates were too low for the rest of Europe, encouraging large capital stock build-ups. Moreover, this capital was misallocated, as demonstrated by the tepid growth of output per hour and output per capita in Europe post 2000. Since funds were poorly allocated, the output-to-capital ratio in the periphery collapsed. In other words, the peripheral capital-stock-to-GDP ratios continued rising because the denominator, GDP, lagged. An additional problem for Europe’s asset utilization has been its large manufacturing sector. Even after declining, 20% of Europe’s GDP still comes from the secondary sector versus less than 12% in the U.S. (Chart II-11). This has two consequences for Europe’s asset utilization relative to the U.S. First, a large manufacturing sector requires a much larger asset base than a large service or tech sector. Second, the manufacturing sector is more exposed to competition from emerging markets than the tech sector, or than the domestically-focused service sector. Chart II-11Europe Is Left Exposed To EM Competition In other words, not only has the U.S. experienced less capital misallocation than a large swath of the European economy, it has also re-aligned its economy to make it more robust in the face of competition from emerging economies, while Europe mostly has not. Consequently, hurt by foreign competition and unable or unwilling to re-invent itself, Europe has been left with dwindling relative productivity levels and poor degrees of asset utilization and returns. Why Did The U.S. Economy Transition Better than Europe To A Globalized World? There are many reasons why the U.S. has maintained higher RoAs and has been more successful at transitioning away from a manufacturing-led economy than the euro area. First, the level of product and service market regulation in Europe is highly punitive. As Chart II-12 illustrates, like Japan, most euro area countries fare poorly in the World Bank’s Ease of Doing Business survey. In fact, Italy scores even lower than China! Meanwhile, the U.S. ranks near the top, not far from Singapore. This means that starting new businesses, competing, and so on is easier in the U.S. than in Europe, helping foster a greater level of entrepreneurialism. Consequently, established businesses have been able to maintain the status quo longer in Europe than in the U.S., preventing creative destruction from purging the system of bad assets. Second, most large euro area economies are burdened by heavy taxes. As Chart II-13 shows, while the U.S. public sector extracts taxes equal to 27.1% of GDP, German, Italian and French taxes equal 37.5%, 42.4% and 46.2% of GDP, respectively, well above the OECD average of 34.2%. Such high levels of taxation disincentivize risk-taking. Lower levels of risk taking by individuals further prevented the degree of creative destruction necessary for Europe to better use its capital stock. Third, and linked to the previous point, government spending equals 34.9% of GDP in the U.S., compared to 48.2% and 56.0% in Italy or France, respectively. A large government has historically stifled innovation and favored the status quo. By no means does this implies that the U.S. system is free of imbalances, but it highlights that compared to two of the three largest European economies, the U.S. public sector has had a less deleterious impact on growth conditions and entrepreneurialism. Moreover, Italy and France have been in deep need of structural reforms that have been lacking. On this front, while the outlook is improving in France under Macron’s presidency, Italy remains mired in immobilism. Europe has too large a pool of assets to make any additional investments profitable, especially in light of its poor demographic profile. Fourth, the financing structure in the U.S. favors investing in new businesses and industries, especially when compared to the euro area. Equities represent 78% of the capital structure of nonfinancial corporations in the U.S. while they represent only 61% in the euro area. Moreover, within debt-financing, capital markets account for 68% of sourced funds in the U.S. compared to 28% in the euro area. In fact, junk bond market capitalization only accounts for 2.2% of GDP in Europe compared to 6.0% in the U.S. This suggests that financing risky ventures – and entrepreneurialism is inherently risky – is tougher in Europe than in the U.S. In fact, as a share of GDP, the European venture capital business is less than a sixth the size of the U.S.’s (Chart II-14), a gap that has existed for more than 30 years. Chart II-14U.S. Financing Allows For Greater Risk Taking With all these hurdles, it is unsurprising that Europe has taken more time to make its economy more dynamic in the globalized economy of the 21st century. It also explains why Europe might be suffering more from EM competition than the U.S. Interestingly, this last point may be changing as U.S. voters seem to want to move back toward a larger manufacturing sector. This transition is unlikely to happen without more protectionism. This is a topic for another report. Is Europe Doomed To Japanification… Or Worse? It is easy to see why Europe cannot hope to grow as fast as the U.S., and therefore why the ECB will not be able to lift rates as high as the Fed and why bund yields are likely to lag Treasurys for years to come. Europe has a much more dire demographic profile than the U.S. It needs to purge its capital stock and invigorate its economy through reforms, a smaller public sector, and more diversified financing channels. But can the euro area fare better than Japan has over the past 30 years? On three fronts, the euro area looks better than Japan. First, as Chart II-15 shows, the overall European nonfinancial private sector entered its crisis in 2008 with lower leverage than Japan’s in the early 1990s. Additionally, European stocks were much cheaper in 2007 than the Nikkei was in 1989 (Chart II-16, top panel). Even Spanish real estate was more reasonably valued in 2007 than Japanese real estate in the early 1990s (Chart II-16, bottom panel). This combination means that now that the acute part of the crisis is over, the hole in the European private sector’s balance sheet is much smaller than the one Japan needed to plug 30 years ago. Thus, from a balance-sheet perspective, the need to rebuild savings is lower in Europe than Japan, and we could expect the current period of elevated savings to be shorter in the euro area than it has been in Japan. Chart II-16...And European Assets Were Not As Expensive As Japanese Ones At The Onset Of The Crisis   Second, despite former ECB President Jean-Claude Trichet’s policy mistake of raising interest rates in 2011, the ECB was much quicker to implement extreme easing policy measures than the Bank of Japan was in its day. It took 10 years for the BoJ to cut rates to zero after the Nikkei peaked in December 1989. It took one year for the ECB to do so after stock prices peaked in 2007. It took nine years for the BoJ to expand its balance sheet aggressively, but it took less than two years for the ECB to do so. One of the key benefits of this greater European proactivity has been to keep European inflation expectations much higher than in Japan, curtailing real interest rates in the process. Third, Europe purged economic excesses much more quickly than Japan. The Japanese unemployment rate increased from 2% to 6% between 1990 and 2010. In peripheral Europe, where the worst pre-crisis excesses existed, unemployment rose from 7.5% in 2008 to 18% in 2013 (Chart II-17, top panel). Meanwhile, real wages never adjusted in Japan, but fell 27.0% at their worst in Spain and 32.5% in Greece (Chart II-17, bottom panel). Moreover, the Rajoy reforms in Spain and the Macron reforms in France show that outside of Italy, European governments have been reforming their economies faster than Japan did after the bubble burst in 1990. Chart II-17Bigger Labor Market Purge In Europe Than Japan However, on three fronts Europe is faring worse than Japan. First, up until the last 10 years, Japan benefited from a robust global economy where trade grew strongly. Europe is entering its second decade of low growth in an environment where global economic activity is much weaker, as potential U.S. GDP growth has slowed and China is not growing at a double-digit pace anymore. Moreover, budding protectionism in the U.S. is creating another hurdle for European economic output. Second, the excess capital stock in the European periphery is in fact greater than was the case in Japan in 1990. This suggests that the periphery needs to curtail investments by a greater margin than Japan did. Consequently, peripheral growth will continue to exert downward pressure on aggregate European activity for an extended period. Third, the European fiscal response will not match Japan’s. Investors often decry Japan’s large government debt of 238.2% of GDP as a sign of profligacy. It is not. It is mainly a mirror image of the private sector’s savings surplus. The Japanese government’s ability to run large deficits has prevented a larger fall in output – one that would have equaled the annual savings of the private sector. Without the government’s dissaving, the Japanese private sector would have found its debt load even more onerous to service, and the need to curtail spending would have been even greater as economy-wide cash flows would have been even smaller. Europe does not have a unified fiscal authority that can run such large-scale deficits. Instead, each nation’s government has a limited capacity to accumulate debt as investors worry that overly-indebted governments may very well redenominate what they have borrowed in much weaker currencies than the euro. This risk is made even greater by the fact that there is no euro-area wide deposit insurance scheme. Since Italian and Spanish banks hold large amounts of BTPs and Bonos, respectively, a so-called doom-loop exists that links the health of banks in those countries to the health of their governments, further limiting the public sector’s ability to act as a spender of last resort. This makes the efforts of the private sector in Italy, France, and Spain to increase its savings and bring down its excess capital stock more difficult, and thus, likely to last longer. Even if 10 years after the crisis first emerged, Europe has done more to purge its economy from its pre-crisis excesses than Japan had after its first lost decade, a lack of unified fiscal lever in Europe nullifies this positive. Thus, so long as the European integration efforts remain on the backburner, euro area growth, inflation, and interest rates will continue to look more like Japan’s have over the past 30 years than the U.S. This is likely to cause a big problem once the next recession emerges. Europe will enter that slowdown without any ammunition to reflate growth. Therefore, the next recession is likely to prove very deflationary and test the recent improvement in support for the euro seen across all euro area nations (Chart II-18). If the euro area survives this crisis, and we suspect it will, the probability of a fiscal union will only grow.2 After all, it has been through various crises that Europe has moved closer together, and the rise of a multipolar geopolitical environment dominated by large countries makes this imperative ever more vital. Chart II-18Support For The Euro Is Resilient Bottom Line: We expect European growth and inflation to continue to lag well behind the U.S. for years to come if not a full decade. Ultimately, bringing down the expensive capital stock in the European periphery will be a slow process, especially if governments remain tight fisted. Investment Implications First, core euro area interest rates are likely to remain well below U.S. levels. As long as the European private sector pares back investments in order to normalize its capital stock-to-GDP ratio - a phenomenon that will be most pronounced in the periphery and France - European growth and inflation will lag behind the U.S. This also means that as long as European governments remain shy spenders and do not compensate for the lack of spending from the private sector, in the euro area periphery, European banks will suffer from depressed net interest margins and be structural underperformers. Second, the euro is likely to experience a structural upward drift. The euro is trading at a 10.5% discount to its purchasing power parity. Moreover, high private sector savings not only weigh on inflation, they will also push Europe’s net international investment position higher via an accumulated current account surplus. Both these factors are long-term bullish for the euro. Moreover, the fact that the euro area will soon become a net creditor nation, along with a lack of room to stimulate growth via monetary easing in times of recessions, means that the euro could increasingly become a counter-cyclical currency like the yen. So long as the European integration efforts remain on the backburner, euro area growth, inflation, and interest rates will continue to look more like Japan’s have over the past 30 years than the U.S. Third, European equities are trading at a discount to U.S. equities, but we do not think this guarantees long-term outperformance. European equities are cheap because European growth prospects are poor. If Japan is any guide, European stocks may be set to continue underperforming. This is especially true as financials are over-represented in European equity benchmarks, and banks stand at the epicenter of the European economic malaise. Fourth, European stocks will remain slaves to the global business cycle. Since the crisis, European growth has become hypersensitive to global growth, making European equities very responsive to the global business cycle. The same phenomenon happened in post-1990 Japan. In other words, the beta of European stocks is likely to continue to rise. This phenomenon could be exacerbated if the euro indeed does become a counter-cyclical currency, in which case the euro and European equities would become negatively correlated, like the yen and the Nikkei. Finally, the period from 1999 to 2005 showed how ECB policy targeted at supporting Germany resulted in imbalances that boosted real estate and equity returns in the periphery – in Spain and Ireland in particular. Today, the periphery is the worst offender when it comes to poor bank health and private sector balance sheet rebuilding. This means that the ECB is likely to keep monetary conditions too accommodative for Germany, where balance sheets are more robust and where the capital stock is not as excessive. As a result, financial market plays linked to German real estate are likely to continue outperforming other European domestic plays. They therefore warrant an overweight within European portfolios. Mathieu Savary Vice President The Bank Credit Analyst   Footnotes 1 Please see Global Asset Allocation Special Report "Euro Area Banks: Value Play Or Value Trap?" dated December 14, 2018, available at gaa.bcaresearch.com 2 The European Commission Eurobarometer Surveys show that Europeans overwhelmingly see Europe as a peace project and as a way to maintain a voice in a world dominated by huge players like the U.S., China, or Russia, a world where France, Germany, or Italy individually are marginal players. In 2016, the U.K. population did not share this opinion. Moreover, even after what amounts to a depression, the support for the euro continues to rise in Greece, showing the growing commitment of Europeans to the euro, and the resilience of this commitment to economic shocks.

Bank Credit Analyst

Highlights The recent dovish shift in tone from central banks around the world is here to stay this year, providing support for global growth. As a result, stock prices will benefit from a combination of easy policy and rebounding activity, while safe-haven yields will grind higher. The recent deterioration in profit margins is not due to rising costs but reflects weaknesses in pricing power. Pricing power is pro-cyclical: If global growth improves and the dollar weakens, margins should recover. Overweight financials and energy. We are upgrading European equities to neutral, and placing them on a further upgrade watch. Feature Easy Does It The global monetary environment has eased over the past four months. Some major central banks like the Federal Reserve and the Bank of Canada have backed away from tightening. Others, like the Bank of Japan, the Reserve Bank of Australia, the Reserve Bank of New Zealand and the Swedish Riksbank have provided very dovish forward guidance. And one major policy setting institution – the European Central Bank – has even eased policy outright by announcing a large-scale injection of liquidity in the banking sector through its TLTRO-III operation that will begin in September. This phenomenon is not limited to advanced economies. Important EM central banks are also targeting easier liquidity conditions. The Reserve Bank of India has cut interest rates by 50 basis points; the Monetary Authority of Singapore is now targeting a flat exchange rate; and the Bank of Korea has issued a somewhat dovish forward guidance. Most importantly, Chinese policymakers are once again forcing debt through the system, with total social financing flows amounting to RMB 2.9 trillion last quarter, more than the RMB 2.4 trillion pumped through the economy in the first quarter of 2016. These reflationary efforts will bear fruit. Policy easing, especially when it relies as largely on forward guidance as the current wave does, should result in lower forward interest rates. And as Chart I-1 illustrates, when a large proportion of global forward rates are falling, a rebound in global economic activity typically follows. This time will not be different. Chart I-1Monetary Guardians Are Coming To The Rescue The S&P 500 and global equities have already rebounded by 18.9% and 17.2%, respectively since late December. Have markets already fully discounted the growth improvement that lies ahead, leaving them vulnerable to disappointments? Or do global stocks have more upside? While a rest may prove necessary, BCA anticipates that global equity prices have more upside over the coming 12 months. Are Central Banks About To Abandon Their Newfound Dovish Bias? We sincerely doubt it. Reversing the recent tone change soon would only hurt the battered credibility that central banks are fighting so hard to maintain. In the case of the U.S., the most recent FOMC minutes were clear: The Fed does not intend to tighten policy soon, even if growth remains decent. The minutes confirmed the idea we espoused last month, that FOMC members are focused on avoiding a Japan-like outcome for the U.S. where low expected inflation begets low realized inflation. Such an outcome would greatly increase the probability that an entrenched deflationary mindset develops in the U.S. in the next recession. As a result, we anticipate that the Fed will refrain from tightening policy until inflation expectations move back up toward their historical range (Chart I-2). Further justifying the Fed’s new stance, a small rebound in productivity is keeping unit labor costs at bay, despite a pick-up in wages. This is likely to put a lid on core inflation for now (Chart I-3). Chart I-2Inflation Expectations: Too Low For The FOMC's Comfort Chart I-3A Whiff Of Disinflation There is little reason for the ECB to adopt a more hawkish stance either. The euro area PMIs have stabilized but are still flirting with the boom/bust line. Realized core inflation is a paltry 0.8% and the ECB’s own forecast is inconsistent with its definition of price stability, which dictates that the inflation rate should be “below but close to 2% over the medium term.” Our ECB Monitor captures these dynamics, remaining in the neutral zone (Chart I-4).   In China, the case for quickly removing credit accommodation is weak. Property developer stocks have rebounded 41% from their October lows, but sales of residential floor space remain soft, keeping real estate speculation in check. Meanwhile, our proxy for the marginal propensity to consume of Chinese households – based on the ratio of demand deposits to time deposits – continues to deteriorate (Chart I-5). The recent pick up in credit growth should put a floor under those trends, but it will take some time before these variables overheat enough to call for policy tightening. Chart I-4Our ECB Monitor Supports An ECB Standing Still Chart I-5Key Domestic Variables Argue Against Tightening Policy In China   Bottom Line: The three most important policymakers in the world are not set to suddenly slam on the brake pedal. As a result, the global policy backdrop will remain accommodative for at least two to three quarters. The few economic green shoots observed around the world should therefore blossom into a full-fledge global growth pick-up. From Green Shoots To Green Gardens If central banks adopt an easier bias but global growth is slowing sharply without any end in sight, stock prices are unlikely to find a floor. After all, stock prices represent the discounted value of future cash flows. If those cash flows are expected to decline at a faster pace than the risk-free rate, then stock prices can fall – even if policy is becoming more accommodative. However, if economic activity is stabilizing, easier policy should generate substantial equity gains. Stimulative financial conditions will result in an improvement in global activity indicators, including emerging economies (Chart I-6, top panel). This is very important as emerging markets were at the epicenter of the slowdown in global trade, and because they historically lead global industrial activity (Chart I-6, bottom panel). The few economic green shoots observed around the world should therefore blossom into a full-fledge global growth pick-up. Policy easing in China is of particular significance. Our Chinese activity indicator is still slowing, but BCA’s Li-Keqiang Leading Indicator, which mostly tracks developments in the credit sector, has stabilized (Chart I-7, top panel). The rebound in the credit impulse also points to an acceleration in Chinese nominal manufacturing output (Chart I-7, bottom panel). This should lift Chinese imports, resulting in a positive growth impulse for the rest of the world. Chart I-6The Dance Of FCI And Activity Chart I-7Chinese Industrial Activity Will Rebound Soon   At the moment, the euro area remains weak, but it will become a key beneficiary of improving growth. As the top panel of Chart I-8 illustrates, the Eurozone’s exports to China tend to follow the trend in the Chinese Adjusted Total Social Financing impulse. Moreover, European exports to the rest of the world are set to enjoy a recovery, as highlighted by the upturn in the diffusion index of our Global Leading Economic Indicator (Chart I-8, bottom panel). This external-sector improvement is happening as the euro area domestic credit impulse is rebounding, and as the region’s fiscal thrust increases from roughly zero to 0.4% of GDP. In the U.S., it is unlikely that 2019 growth will top that of 2018, but activity should nonetheless rebound from a lukewarm first quarter. Importantly, the fed funds rate is holding below its equilibrium (Chart I-9). Additionally, household fundamentals remain solid. A tight labor market means that wages have upside and household debt levels and debt servicing costs are all well behaved relative to disposable income (Chart I-10). Moreover, housing dynamics are generally stronger than reported by the press, as mortgage applications for purchases are making cyclical highs and the NAHB Homebuilder confidence index is rebounding (Chart I-11). Offsetting some of these positives, capex intentions – a robust forecaster of actual corporate investments – have rolled over from their heady mid-2018 levels. Even so, they remain consistent with positive capex growth. Also, U.S. fiscal policy is becoming increasingly less growth-friendly starting in mid-2019. Netting it all out, U.S. growth should remain above-trend, at about 2.5%. Chart I-8Europe Will Benefit From Stabilizing Growth Elsewhere Chart I-9U.S. Policy Remains Accommodative   Chart I-10U.S. Households Are Doing Alright Chart I-11Forward-Looking Housing Indicators Point To A Pick-Up Bottom Line: While U.S. growth may be weaker than in 2018, it should not fall below trend. Meanwhile, Chinese credit trends suggest that growth there should clearly pick up in the coming months, which should also lead to stronger activity in Europe. In other words, exactly as central banks have removed policy constraints, global growth is set to re-accelerate. This is a positive backdrop for risk assets over the coming 12 months.   What Does It Mean For Asset Prices? Simply put, a dovish shift in policy along with a tentative stabilization in growth should result in both higher stock prices and rising safe-haven bond yields. First, a rebound in global economic activity means that depressed profit growth expectations could easily be bested (Chart I-12, top panel). Bottom-up estimates point to EPS growth of 3.4% in the U.S. and 5.3% in the rest of the world in 2019, using MSCI data. However, profits are extremely pro-cyclical, and a combination of easy financial conditions and improving growth conditions in the second half of the year should result in better-than-expected earnings. Chart I-12Profit Expectations Are Low Second, the Fed is extending its pause, as other global central banks are also adopting more accommodative policies. This implies that global real interest rates, both at the short- and long-end of the curve, will remain below equilibrium for longer than would have been the case if policy had remained on its previous path. Consequently, not only do lower real rates decrease the discount factor for stocks, they also imply a longer business cycle expansion. This should result in narrower risk premia for stocks and higher multiples. Since they offer cheaper valuations than those in the U.S., international equities may stand to benefit more from policy-led multiple expansion (Chart I-12, bottom panel). Third, the global duration indicator developed by BCA’s Global Fixed Income Strategy service is forming a bottom.1 This gauge – levered to global growth variables like the Global ZEW growth expectations survey, our Global Leading Economic Indicator and the Global LEI’s diffusion index – has perked up in response to green shoots around the globe. An upturn in global safe-haven yields is imminent (Chart I-13). Additionally, the global Policy Uncertainty Index is currently recording very high readings, congruent with depressed yields (Chart I-14). A benign resolution to the Sino-U.S. trade tensions along with the low likelihood of the implementation of a No-Deal Brexit should push this indicator down, lifting yields in the process. Chart I-13Global Dynamics Argue For Fading The Bond Rally Chart I-14Policy Uncertanity Is At An Apex: Look The Other Way   Fourth, while we expect the Fed to stay on pause for the remainder of 2019 and probably through the lion’s share of 2020 as well, this is a more hawkish forecast than what the market is currently pricing in (Chart I-15). As we argued last month, a fed funds rate that turns out to be higher over the next year than what is currently discounted often results in the underperformance of Treasurys relative to cash. Finally, a rebound in global growth, even if the Fed proves more hawkish than the market anticipates, generally pushes the dollar lower (Chart I-16). Since speculators currently hold large net short bets on the euro, the AUD, the CAD, and so on, the probability is high that this historical pattern will assert itself. The recent period of dollar strength is unlikely to last more than a couple of weeks. A weak dollar, easy policy and rebounding growth should boost commodity prices, especially metals and oil. The latter should benefit most from this set up as the end of the waivers of U.S. sanctions on Iran will constrain the availability of crude in international markets. Chart I-16The Dollar Last Hurrah Will End Very Soon   Rebounding global growth should also allow equity prices to be resilient in the face of rising bond yields, up to a point. When yields and inflation expectations are low, multiples and equity prices tend to move in tandem. This is because in an environment where central banks are frightened by deflationary risks, monetary authorities do not lift rates as quickly as nominal activity would warrant. Thus, improving nominal growth lifts the growth component of equity multiples more than it raises yields. In other words, we expect yields and stocks to rise together because low but rising inflation expectations, but not surging real rates, will drive the upside in bond yields. Obviously, this cannot last forever. Once the Fed starts suggesting that rates will rise again, and the entire yield curve moves closer to neutral, higher yields will curtail equity advances. This is a constructive cyclical setup; but the tactical environment is murkier. The problem is that equity prices have already moved up significantly over the past four months. With volatility across asset classes having once again plunged toward historical lows, risk assets display a high degree of vulnerability to disappointing economic data. This means that unless growth rebounds strongly and quickly, stocks could experience a short-term correction in the coming months. While staying overweight equities, it is nonetheless prudent to buy some protection. Investors should also wait on the sidelines to deploy any excess cash. Rebounding global growth should also allow equity prices to be resilient in the face of rising bond yields, up to a point. Bottom Line: The current environment is favorable for risk assets on a cyclical basis. Low real rates will not only continue to nurture the nascent improvement in the global economy. They also imply lower discount rates. Meanwhile, improving economic activity and a decline in policy uncertainty will push safe-haven yields higher. Consequently, it remains sensible to be long stocks and underweight bonds for the remainder of the year, even if the risk of a short-term stock correction has risen. Within fixed-income portfolios, a below-benchmark duration makes sense, especially as oil prices are rising, Sino-U.S. trade negotiations should end in a benign outcome, and a No-Deal Brexit remains unlikely. Margins Are The Greatest Risk At the current juncture, the biggest risk for stocks is that profits fall short of depressed analysts’ estimates for 2019 – not because revenue growth disappoints, but because profit margins contract. Our U.S. Equity Sector Strategy service has recently highlighted that the S&P 500 operating earnings margin stands at 10.1% after having peaked at 12% in Q3 2018 (Chart I-17).2 Despite this decline, margins remain both elevated by historical standards and above their long-term upward-sloping trend. As Chart I-18 illustrates, the decline in margins is not an S&P 500-only phenomenon: It is an economy wide one as well, as the pattern is repeated using national accounts data. Chart I-17Will This Margin Deterioration Continue? Chart I-18Margins: All About Labor Costs Versus Selling Prices   At first glance, the Fed’s current pause may undermine profit margins. As Chart I-19 shows, when the unemployment rate stands below NAIRU, on average, wages grow faster than when the labor market is not at full employment. Since the unemployment gap stands as -0.8% today, we are likely to see continued wage pressures in the U.S. economy. Chart I-19Wages Have Upside The problem with this story is that productivity has been accelerating – from a -0.3% annual rate in the second quarter of 2016 to 1.8% in the fourth quarter of 2018. Because wage inflation did not experience as large a change, unit labor cost inflation is still growing at 1% annually, as they did in Q2 2016. In fact, real unit labor costs are currently contracting at a 0.4% pace. The pick-up in capex over the past three years suggests that productivity can continue to improve over the coming quarters. Consequently, as has been the case over the past two years, rising wages will only have a limited negative impact on margins. The key source of variance in profit margins has been, and will likely remain over the next year or so, corporate pricing power, which today stands at its lowest level since the deflationary episode of 2015-2016 (Chart I-20). As was the case back then, the slowdown in global growth has played a role, since it has resulted in falling global export prices. Not only do they affect foreign revenues for U.S. businesses, they also impact the price of goods sold at home, and thus have a broad impact on aggregate pricing power. Chart I-20Pricing Power Follows The Global Business Cycle Last year’s dollar strength amplified those headwinds. A strengthening dollar affects profitability through four channels. First, it negatively impacts global growth by tightening financial conditions for foreign borrowers who fund themselves in USD. They are thus more financially constrained when the dollar appreciates. Second, a strong dollar hurts commodity prices and industrial goods prices. Third, a strong dollar negatively impacts the competitiveness of U.S. firms, forcing them to cut their prices to stay competitive. Finally, a strong dollar hurts the translation of overseas earnings back into USDs. As a result, a strong dollar weighs on earnings estimates (Chart I-21).   Chart I-21The Dollar Amplified Margins Problems Since we anticipate global growth to improve and the greenback to buckle, the current pricing power problem faced by corporate America should fade and profit margins should rebound in the second half of 2019. This suggests that for now, declining profit margins remain a risk that needs to be monitored – not a base case to embrace. Our U.S. Equity Sector Strategy service has highlighted that the tech sector has the poorest earnings outlook within the S&P 500. An economic upswing could counteract some of the recent declines in tech margins, but the much more pronounced rise in labor costs in Silicon Valley than in other sectors suggests that tech profits could lag behind other heavyweights like financials and energy. Consequently, BCA recommends a neutral allocation to tech stocks. We instead recommend overweighting financials and the energy sector. Financials will benefit from an easy monetary policy setting that should help credit growth. Moreover, net interest margins are at cycle highs of 3.5%, as banks have prevented interest costs on deposits from rising in line with short rates. Finally, buybacks by financial services firms are rising and will likely battle the tech sector’s buybacks for the pole position this year (Chart I-22).3 Chart I-22Why Are We Neutral On Tech? Our positive stance on energy stems from undue pessimism surrounding the sector. Bottom-up analysts currently pencil in such a large contraction in earnings for this group that, according to their forecasts, energy will curtail 2019 S&P 500 earnings by 18%. With WTI prices back above $65/bbl, rising per-well productivity and easing financing costs, the hurdle to beat is already low. Moreover, the end of U.S. waivers on Iranian sanctions further supports oil prices. In this context, if global growth rebounds and the dollar depreciates, energy stocks could catch fire. Bottom Line: The biggest risk to our positive stance on equities is that earnings are dragged down by declining margins. While the recent softness in margins is concerning, it does not reflect an increase in labor costs. Instead, it is a consequence of eroding pricing power. Falling pricing power is itself a symptom of the slowdown in global growth and a stronger dollar. As both these ills pass, margins should recover in the second half of 2019. Within equities, we prefer financials and energy, as their earnings prospects outshine tech stocks. Upgrading European Equities To Neutral, And Looking For More For equity investors competing against a global benchmark, there is a simple way to express the view that global growth will rebound, safe-haven yields have upside, the dollar will weaken, and that profit margins are a risk to monitor. It is to abandon underweight allocations to European equities and overweight positions to U.S. stocks. This month, we are upgrading European equities to neutral and downgrading U.S. stocks to neutral. Even after this upgrade, we are putting European equities on a further upgrade watch. First, the euro area is much more sensitive than the U.S. to Chinese growth. This also has implication for equities. As Chart I-23 shows, when the ratio of M1 to M2 money supply in China perks up, as it is currently doing, European stocks end up outperforming their U.S. counterparts. This is because the M1-to-M2 ratio ultimately reflects the growth of demand deposits relative to savings deposits in the Chinese banking sector. It therefore informs how spending is likely to evolve. Currently, China’s reflationary efforts point toward a pickup in spending that should lift European exports, and European profits as well. Chart I-23Monetary Dynamics In China Favor Fading Euro Area Bearishness Second, European exports have upside, and unsurprisingly, the bottoming in the BCA Boom/Bust indicator – which captures global growth dynamics beyond just China – is also flagging the end of European equity underperformance (Chart I-24, top panel). Moreover, if the global reflationary period is sustained, the decline in forward interest rates will reverse. This too is consistent with a period of outperformance for European equities (Chart I-24, bottom panel). Third, our overweight stance on financials relative to tech equates to European equities beating their U.S. counterparts. This simply reflects the fact that financials constitute 17.9% of the MSCI euro area index, while tech stocks account for 9.2%. The same sectors represent 12.9% and 26.8% of the U.S. market, respectively. Not only are European banks trading at 0.6-times book value compared to 1.2-times for U.S. lenders, but European banks stand to benefit more than U.S. banks from rising bond yields as they garner a larger share of their income from lending activity. Fourth, European profit margins are toward the bottom third of their distribution relative to U.S. profit margins. As Chart I-25 shows, European profit margins tend to rise when euro area unit labor costs lag U.S. ones. Since the euro area output gap is not as positive as that of the U.S., it is unlikely that European wages will outpace U.S. wages this year. Also, since European stocks are more heavily weighted toward industrials, materials and energy, the sectors that suffered the greatest loss of pricing power during the global economic slowdown, pricing power in Europe could rebound more strongly than in the U.S. This too should flatter European profit margins relative to the U.S. Chart I-24European Equities To Benefit From Rebounding Global Growth Chart I-25European Profit Margins Can Experience A Further Cyclical Lift   Finally, even after adjusting for sectoral composition, European equities trade at a discount to U.S. stocks. On an equal-sector basis, the 12-month forward P/E ratio is 14.2, and the price-to-book ratio is 2.0. For the U.S., the same multiples stand at 20.7 and 4.0, respectively. This means that European stocks are not yet pricing in an improving outlook. Be warned: The positive outlook for European equities relative to the U.S. is a cyclical story. As Section II of this report argues, poor demographics and an excessively large capital stock suggest that European rates of return will continue to lag the U.S. As a result, the return from investing in European stocks is unlikely to beat that of the U.S. beyond 12 to 18 months. Bottom Line: Within a global equity portfolio, we are upgrading the euro area from underweight to neutral at the expense of the U.S., which moves to neutral. We are also putting European equities on a further upgrade watch. Mathieu Savary Vice President The Bank Credit Analyst April 25, 2019 Next Report: May 30, 2019 II. Europe: Here I Am, Stuck In A Liquidity Trap An aging population, a banking sector in poor health, and a private sector focused on building up savings are the key factors undermining euro area growth on a structural basis. A large manufacturing sector makes the euro area vulnerable to EM competition. Unlike the U.S., the region’s tech sector is held back by regulatory burdens, taxes and heavy dependence on bank funding. The euro area growth faces decades of low growth and inflation. Euro area rates will stay depressed, but paradoxically, the euro can still experience structural appreciation. Euro area equities are cheap for a good reason, and banks will continue to weigh on performance. Over the past 10 years, the euro area has gone through a sovereign debt crisis, a double-dip recession, persistent below-target inflation, and most recently, yet another major growth slowdown. Moreover, this economic malaise materialized despite highly stimulative monetary policy, including negative interest rates. The ongoing economic weakness has raised the specter that the euro area is the new Japan. Nearly three decades after the bursting of the Nikkei bubble, the Land of the Rising Sun remains mired in low growth and mild but persistent deflation. Consequently, charts showing that European policy rates or bond yields are tracking Japanese developments with a 17-year lag (Chart II-1) have not only become commonplace, they elicit fears that European growth, interest rates and asset valuations will lag the rest of the world for decades to come. Chart II-1Europe Is Following The Japanese Example In this piece, we discuss the various forces that explain why the euro area economy has been so weak this decade, and why such low interest rates have had so little impact on growth. We also study what sets the U.S. and euro area apart, and whether or not Europe will follow the trail blazed by Japan nearly 30 years ago. The Three Headwinds Three ills have kept European growth particularly depressed this cycle and are likely to remain significant headwinds into the foreseeable future: demographics, the banking sector’s poor health, and nonfinancial private sector balance sheet cleansing. 1)   Demographics This is the most well understood and acknowledged problem impacting Europe today. Since 2008, the European population has grown by 2%, or only 0.2% a year, with the working age population having peaked around that year. Going forward, the picture will only deteriorate: The UN expects Europe’s population to contract by 12% over the next 27 years, and the working age population to fall by 15%. This also means that the dependency ratio – the number of individuals aged less than 15 and above 65 per 100 working-age people – will approximately double over the coming 40 years. This is a clear parallel with Japan. As Chart II-2 illustrates, Europe’s population, the number of working-age individuals and the dependency ratio are all tracking Japan with a 17-year lag. Like Japan, Europe’s trend growth will thus only deteriorate further. Not only will Europe not be able to add as many workers as the U.S. to its total, but it will need to build even fewer schools, malls, office buildings or units of housing. Consequently, both the supply and demand sides of the economy will lag due to this factor alone. 2)   Banking Sector Health The poor health of the euro area banking sector is well known. BCA’s Global Asset Allocation service published an in-depth analysis of the European banking sector last December.4 The piece demonstrated that European banks have been much slower to recognize non-performing loans, curtail credit and rebuild capital than their U.S. counterparts. U.S. bank loans to the private sector fell by 13% in the two years during the crisis, while in Europe, these same loans have only fallen by 2% since 2008. Euro area banks generally remain burdened with significant non-performing loans as a percentage of regulatory capital. Moreover, net interest margins are also dismal, implying that the income cushion against bad loans is thin. Consequently, outside of France, Finland and Germany, European banks have either not grown their loan books to the private sector or, as is the case with Spain, Portugal, and Ireland, these books are continuously shrinking (Chart II-3). Chart II-2Same Demography In Europe Now Than In Japan Then Chart II-3Peripheral Banks Continue To Curtail Credit   The poor health of the European banking system is now constraining the supply of new credit to the rest of the economy. This is a much bigger problem than is the case in the U.S. given that in Europe, 72% of corporate funding comes from the banking system while 88% of household liabilities are also funded this way. In the U.S., the share of bank funding for these sectors is 32% and 29%, respectively (Chart II-4). A weak euro area banking system prevents the nonfinancial private sector from growing as robustly as it could. 3)   Nonfinancial Private Sector Balance Sheet Cleanse Another major drag on European growth has been the continued efforts of the European private sector to rebuild its balance sheet. To use the terminology developed by our upcoming conference speaker Richard Koo, the euro area has been in the thralls of a powerful balance sheet recession. Households in the euro area, Japan and the U.S. are all accumulating more financial assets than liabilities. However, only in the U.S. is the nonfinancial corporate sector building more liabilities than it is accumulating assets (Chart II-5). In Japan and Europe, the nonfinancial corporate sector is also a source of savings for the economy. Moreover, in Europe, the government runs a much smaller financial deficit. The current account balance tells this story vividly. A country’s current account is equal to the private sector’s savings minus investment and minus government deficits. As Italy, Spain, and other peripheral economies increased their aggregate savings after 2008, their large current account deficits vanished. Meanwhile, the governments of countries like Germany or the Netherlands, which sported healthy public finances, did not increase their spending in a commensurate way. This adjustment transformed an overall euro area current account deficit of 1.5% in 2008 into a surplus of 3.0% of GDP today, sending some of Europe’s excess savings abroad. This mimics the post-1990 Japanese experience. In the U.S., where the private sector savings did not rise as durably as in Europe, the current account stopped improving meaningfully in 2010 (Chart II-6). Chart II-5European Businesses Are Savers, Like In Japan Chart II-6The Current Account Dynamics Epitomise The Savings Dynamics   A private sector squarely focused on rebuilding its balance sheet liquidity can lead to a liquidity trap. In this state, monetary policy can become ineffective as spending does not respond to lower interest rates. This is where Europe is currently stuck, explaining why the European Central Bank is finding that inflation and growth are not experiencing much lift, despite seemingly incredibly accommodative monetary conditions. Why Such An Urge To Save? The fact that the household sector is a net saver is not surprising, as this is a normal state of affairs across most economies. But why is the European nonfinancial corporate sector still trying to improve its balance sheet liquidity by accumulating more assets than liabilities? Like Japanese businesses 30 years ago, European firms have large debt loads. Another problem is the lack of capex opportunities in Europe. Why do we make this assertion? The return on assets in Europe has been at rock-bottom levels ever since the introduction of the euro (Chart II-7). In the decade from 1998 to 2008, this was a non-issue. Strong global growth flattered European sales, and easy access to credit meant that via rising leverage euro area-listed nonfinancial corporations were able to generate returns on equity comparable to U.S. firms (Chart II-8, top panel). Once European banks got cold feet and European nonfinancial businesses began focusing on deleveraging, the low level of return on assets became more apparent. Part of the problem is that European profit margins are much closer to Japanese than U.S. levels (Chart II-8, middle panel). Even more damning, asset turnover – how much sales are generated by a unit of assets – has been structurally lower in Europe than in both Japan and the U.S. for multiple decades (Chart II-8, bottom panel). Chart II-7Europe Suffers From A Lower RoA Chart II-8DuPont's Decomposition Shows Why The Euro Area RoA Is Poor   The first factor weighing on the level of asset utilization and returns in Europe is the elevated level of capital stock. As Chart II-9 illustrates, the capital stock as a share of output in Italy, Spain and France dwarfs that of Japan, China or the U.S. Even Germany’s capital stock, which stands well below that of other large euro area economies, is nearly 100 percentage points of GDP larger than the U.S’s. Europe has too large a pool of assets to make any additional investments profitable, especially in light of its poor demographic profile. The second factor weighing on European asset utilization and returns is the poorer level of labor productivity. From the 1950s to the early 1980s, European GDP per worker rose relative to the U.S., albeit peaking at 92% of the levels across the Atlantic. Due to falling working hours in Europe relative to the U.S. since the 1980s, relative output per hour continued to rise until the mid-1990s, peaking at 105% of the U.S. level. However, since their respective zeniths, both relative productivity measures have collapsed (Chart II-10, top panel). Chart II-10Another Symptom Of Europe's Misallocation Of Capital In The 2000s These collapses are in fact worse than Japan’s performance since its lost decades began. As the second panel of the chart shows, since the early 1990s, Japan’s relative output per hour and per worker have flattened – not declined – at around 65% and 72%, respectively, of U.S. levels. Instead, relative European productivity levels are currently converging toward Japanese levels (Chart II-10, third and fourth panels). The particularly poor level of European asset utilization and productivity principally reflects the duality between the peripheral as well as French economies on one side, and Germany as well as the Netherlands on the other side. The exceptionally large capital stock outside of Germany is a legacy of the years directly after the euro’s introduction. Back then, the ECB kept rates low to help Germany, the then-sick man of Europe. These rates were too low for the rest of Europe, encouraging large capital stock build-ups. Moreover, this capital was misallocated, as demonstrated by the tepid growth of output per hour and output per capita in Europe post 2000. Since funds were poorly allocated, the output-to-capital ratio in the periphery collapsed. In other words, the peripheral capital-stock-to-GDP ratios continued rising because the denominator, GDP, lagged. An additional problem for Europe’s asset utilization has been its large manufacturing sector. Even after declining, 20% of Europe’s GDP still comes from the secondary sector versus less than 12% in the U.S. (Chart II-11). This has two consequences for Europe’s asset utilization relative to the U.S. First, a large manufacturing sector requires a much larger asset base than a large service or tech sector. Second, the manufacturing sector is more exposed to competition from emerging markets than the tech sector, or than the domestically-focused service sector. Chart II-11Europe Is Left Exposed To EM Competition In other words, not only has the U.S. experienced less capital misallocation than a large swath of the European economy, it has also re-aligned its economy to make it more robust in the face of competition from emerging economies, while Europe mostly has not. Consequently, hurt by foreign competition and unable or unwilling to re-invent itself, Europe has been left with dwindling relative productivity levels and poor degrees of asset utilization and returns. Why Did The U.S. Economy Transition Better than Europe To A Globalized World? There are many reasons why the U.S. has maintained higher RoAs and has been more successful at transitioning away from a manufacturing-led economy than the euro area. Europe has too large a pool of assets to make any additional investments profitable, especially in light of its poor demographic profile. First, the level of product and service market regulation in Europe is highly punitive. As Chart II-12 illustrates, like Japan, most euro area countries fare poorly in the World Bank’s Ease of Doing Business survey. In fact, Italy scores even lower than China! Meanwhile, the U.S. ranks near the top, not far from Singapore. This means that starting new businesses, competing, and so on is easier in the U.S. than in Europe, helping foster a greater level of entrepreneurialism. Consequently, established businesses have been able to maintain the status quo longer in Europe than in the U.S., preventing creative destruction from purging the system of bad assets. Second, most large euro area economies are burdened by heavy taxes. As Chart II-13 shows, while the U.S. public sector extracts taxes equal to 27.1% of GDP, German, Italian and French taxes equal 37.5%, 42.4% and 46.2% of GDP, respectively, well above the OECD average of 34.2%. Such high levels of taxation disincentivize risk-taking. Lower levels of risk taking by individuals further prevented the degree of creative destruction necessary for Europe to better use its capital stock. Third, and linked to the previous point, government spending equals 34.9% of GDP in the U.S., compared to 48.2% and 56.0% in Italy or France, respectively. A large government has historically stifled innovation and favored the status quo. By no means does this implies that the U.S. system is free of imbalances, but it highlights that compared to two of the three largest European economies, the U.S. public sector has had a less deleterious impact on growth conditions and entrepreneurialism. Moreover, Italy and France have been in deep need of structural reforms that have been lacking. On this front, while the outlook is improving in France under Macron’s presidency, Italy remains mired in immobilism. Fourth, the financing structure in the U.S. favors investing in new businesses and industries, especially when compared to the euro area. Equities represent 78% of the capital structure of nonfinancial corporations in the U.S. while they represent only 61% in the euro area. Moreover, within debt-financing, capital markets account for 68% of sourced funds in the U.S. compared to 28% in the euro area. In fact, junk bond market capitalization only accounts for 2.2% of GDP in Europe compared to 6.0% in the U.S. This suggests that financing risky ventures – and entrepreneurialism is inherently risky – is tougher in Europe than in the U.S. In fact, as a share of GDP, the European venture capital business is less than a sixth the size of the U.S.’s (Chart II-14), a gap that has existed for more than 30 years. Chart II-14U.S. Financing Allows For Greater Risk Taking With all these hurdles, it is unsurprising that Europe has taken more time to make its economy more dynamic in the globalized economy of the 21st century. It also explains why Europe might be suffering more from EM competition than the U.S. Interestingly, this last point may be changing as U.S. voters seem to want to move back toward a larger manufacturing sector. This transition is unlikely to happen without more protectionism. This is a topic for another report. Is Europe Doomed To Japanification… Or Worse? It is easy to see why Europe cannot hope to grow as fast as the U.S., and therefore why the ECB will not be able to lift rates as high as the Fed and why bund yields are likely to lag Treasurys for years to come. Europe has a much more dire demographic profile than the U.S. It needs to purge its capital stock and invigorate its economy through reforms, a smaller public sector, and more diversified financing channels. But can the euro area fare better than Japan has over the past 30 years? On three fronts, the euro area looks better than Japan. First, as Chart II-15 shows, the overall European nonfinancial private sector entered its crisis in 2008 with lower leverage than Japan’s in the early 1990s. Additionally, European stocks were much cheaper in 2007 than the Nikkei was in 1989 (Chart II-16, top panel). Even Spanish real estate was more reasonably valued in 2007 than Japanese real estate in the early 1990s (Chart II-16, bottom panel). This combination means that now that the acute part of the crisis is over, the hole in the European private sector’s balance sheet is much smaller than the one Japan needed to plug 30 years ago. Thus, from a balance-sheet perspective, the need to rebuild savings is lower in Europe than Japan, and we could expect the current period of elevated savings to be shorter in the euro area than it has been in Japan. Chart II-16...And European Assets Were Not As Expensive As Japanese Ones At The Onset Of The Crisis   Second, despite former ECB President Jean-Claude Trichet’s policy mistake of raising interest rates in 2011, the ECB was much quicker to implement extreme easing policy measures than the Bank of Japan was in its day. It took 10 years for the BoJ to cut rates to zero after the Nikkei peaked in December 1989. It took one year for the ECB to do so after stock prices peaked in 2007. It took nine years for the BoJ to expand its balance sheet aggressively, but it took less than two years for the ECB to do so. One of the key benefits of this greater European proactivity has been to keep European inflation expectations much higher than in Japan, curtailing real interest rates in the process. Third, Europe purged economic excesses much more quickly than Japan. The Japanese unemployment rate increased from 2% to 6% between 1990 and 2010. In peripheral Europe, where the worst pre-crisis excesses existed, unemployment rose from 7.5% in 2008 to 18% in 2013 (Chart II-17, top panel). Meanwhile, real wages never adjusted in Japan, but fell 27.0% at their worst in Spain and 32.5% in Greece (Chart II-17, bottom panel). Moreover, the Rajoy reforms in Spain and the Macron reforms in France show that outside of Italy, European governments have been reforming their economies faster than Japan did after the bubble burst in 1990. Chart II-17Bigger Labor Market Purge In Europe Than Japan However, on three fronts Europe is faring worse than Japan. First, up until the last 10 years, Japan benefited from a robust global economy where trade grew strongly. Europe is entering its second decade of low growth in an environment where global economic activity is much weaker, as potential U.S. GDP growth has slowed and China is not growing at a double-digit pace anymore. Moreover, budding protectionism in the U.S. is creating another hurdle for European economic output. Second, the excess capital stock in the European periphery is in fact greater than was the case in Japan in 1990. This suggests that the periphery needs to curtail investments by a greater margin than Japan did. Consequently, peripheral growth will continue to exert downward pressure on aggregate European activity for an extended period. Third, the European fiscal response will not match Japan’s. Investors often decry Japan’s large government debt of 238.2% of GDP as a sign of profligacy. It is not. It is mainly a mirror image of the private sector’s savings surplus. The Japanese government’s ability to run large deficits has prevented a larger fall in output – one that would have equaled the annual savings of the private sector. Without the government’s dissaving, the Japanese private sector would have found its debt load even more onerous to service, and the need to curtail spending would have been even greater as economy-wide cash flows would have been even smaller. Europe does not have a unified fiscal authority that can run such large-scale deficits. Instead, each nation’s government has a limited capacity to accumulate debt as investors worry that overly-indebted governments may very well redenominate what they have borrowed in much weaker currencies than the euro. This risk is made even greater by the fact that there is no euro-area wide deposit insurance scheme. Since Italian and Spanish banks hold large amounts of BTPs and Bonos, respectively, a so-called doom-loop exists that links the health of banks in those countries to the health of their governments, further limiting the public sector’s ability to act as a spender of last resort. This makes the efforts of the private sector in Italy, France, and Spain to increase its savings and bring down its excess capital stock more difficult, and thus, likely to last longer. Even if 10 years after the crisis first emerged, Europe has done more to purge its economy from its pre-crisis excesses than Japan had after its first lost decade, a lack of unified fiscal lever in Europe nullifies this positive. Thus, so long as the European integration efforts remain on the backburner, euro area growth, inflation, and interest rates will continue to look more like Japan’s have over the past 30 years than the U.S. This is likely to cause a big problem once the next recession emerges. Europe will enter that slowdown without any ammunition to reflate growth. Therefore, the next recession is likely to prove very deflationary and test the recent improvement in support for the euro seen across all euro area nations (Chart II-18). If the euro area survives this crisis, and we suspect it will, the probability of a fiscal union will only grow.2 After all, it has been through various crises that Europe has moved closer together, and the rise of a multipolar geopolitical environment dominated by large countries makes this imperative ever more vital. Chart II-18Support For The Euro Is Resilient Bottom Line: We expect European growth and inflation to continue to lag well behind the U.S. for years to come if not a full decade. Ultimately, bringing down the expensive capital stock in the European periphery will be a slow process, especially if governments remain tight fisted. Investment Implications First, core euro area interest rates are likely to remain well below U.S. levels. As long as the European private sector pares back investments in order to normalize its capital stock-to-GDP ratio - a phenomenon that will be most pronounced in the periphery and France - European growth and inflation will lag behind the U.S. This also means that as long as European governments remain shy spenders and do not compensate for the lack of spending from the private sector, in the euro area periphery, European banks will suffer from depressed net interest margins and be structural underperformers. Second, the euro is likely to experience a structural upward drift. The euro is trading at a 10.5% discount to its purchasing power parity. Moreover, high private sector savings not only weigh on inflation, they will also push Europe’s net international investment position higher via an accumulated current account surplus. Both these factors are long-term bullish for the euro. Moreover, the fact that the euro area will soon become a net creditor nation, along with a lack of room to stimulate growth via monetary easing in times of recessions, means that the euro could increasingly become a counter-cyclical currency like the yen. So long as the European integration efforts remain on the backburner, euro area growth, inflation, and interest rates will continue to look more like Japan’s have over the past 30 years than the U.S. Third, European equities are trading at a discount to U.S. equities, but we do not think this guarantees long-term outperformance. European equities are cheap because European growth prospects are poor. If Japan is any guide, European stocks may be set to continue underperforming. This is especially true as financials are over-represented in European equity benchmarks, and banks stand at the epicenter of the European economic malaise. Fourth, European stocks will remain slaves to the global business cycle. Since the crisis, European growth has become hypersensitive to global growth, making European equities very responsive to the global business cycle. The same phenomenon happened in post-1990 Japan. In other words, the beta of European stocks is likely to continue to rise. This phenomenon could be exacerbated if the euro indeed does become a counter-cyclical currency, in which case the euro and European equities would become negatively correlated, like the yen and the Nikkei. Finally, the period from 1999 to 2005 showed how ECB policy targeted at supporting Germany resulted in imbalances that boosted real estate and equity returns in the periphery – in Spain and Ireland in particular. Today, the periphery is the worst offender when it comes to poor bank health and private sector balance sheet rebuilding. This means that the ECB is likely to keep monetary conditions too accommodative for Germany, where balance sheets are more robust and where the capital stock is not as excessive. As a result, financial market plays linked to German real estate are likely to continue outperforming other European domestic plays. They therefore warrant an overweight within European portfolios. Mathieu Savary Vice President The Bank Credit Analyst III. Indicators And Reference Charts The S&P 500 is retesting its all-time high made last fall. While our indicators suggest that U.S. equity have additional upside, the violence of the rally since December argues that a period of digestion may first be needed. Our Willingness-to-Pay (WTP) indicator for the U.S. and Japan continues to improve, while for the euro area, it is flat-lining after a tentative rebound. The WTP indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. The current readings in major advanced economies thus suggest that investors are still inclined to add to their stock holdings. Our Revealed Preference Indicator (RPI) is not echoing this message. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. The pick-up in global growth remains too feeble for the RPI to validate the advance in stocks. This is why we worry that a correction is likely until economic activity around the globe confirms the rally in stocks. According to BCA’s composite valuation indicator, an amalgamation of 11 measures, the U.S. stock market remains slightly overvalued from a long-term perspective. Nonetheless, the S&P 500 is not at nosebleed valuation levels anymore. Hence, we are betting that once global growth picks up, stocks will be able to move even higher and any correction will prove temporary. Moreover, our Monetary Indicator remains into stimulative territory. The Fed has reiterated its dovish message and global central banks have all engaged in dovish talks, thus monetary conditions should stay supportive. As a result, our speculation indicator has also now fully moved out of the “speculative activity” zone. Our Composite Technical indicator for stocks had broken down in December, but it has now moved back above its 9-month moving average. This positive cyclical signal reinforces our confidence that any correction in stocks should prove tactical in nature, and that on a nine- to twelve-month basis equities have upside. According to our model, 10-year Treasurys are slightly expensive. However, we should not read too much into this. Essentially, yields are currently within their neutral range. Moreover, our technical indicator flags a similar picture. That being said, since BCA expects that over the next 24 months, the Fed will lift rates more than the OIS curve anticipates, and since the term premium is incredibly low, once green shoots for global growth fully bloom, bonds could suffer a violent selloff. Since our duration indicator has begun to deteriorate, it is probably a good time to begin moving out of safe-haven bonds. On a PPP basis, the U.S. dollar has only gotten more expensive. Additionally, our Composite Technical Indicator is becoming increasingly overbought. This combination suggests that the greenback could experience further downside this year. However, this downside will only materialize once global growth shows greater signs of strength. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation Chart III-6U.S. Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance   FIXED INCOME: Chart III-9U.S. Treasurys And Valuations Chart III-10Yield Curve Slopes Chart III-11Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets   CURRENCIES: Chart III-16U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning   ECONOMY: Chart III-28U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot Chart III-30U.S. Growth Outlook Chart III-31U.S. Cyclical Spending Chart III-32U.S. Labor Market Chart III-33U.S. Consumption Chart III-34U.S. Housing Chart III-35U.S. Debt And Deleveraging   Chart III-36U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China   Mathieu Savary Vice President The Bank Credit Analyst Footnotes 1       Please see Global Fixed Income Strategy Weekly Report, “A Sustainable Bottom In Global Bond Yields,” dated April 9, 2019, available at gfis.bcaresearch.com 2       Please see U.S. Equity Strategy Weekly Report, “Have SPX Margins Peaked?” dated March 25, 2019, available at uses.bcaresearch.com 3       Please see U.S. Equity Strategy Weekly Report, “Mixed Signals,” dated April 22, 2019, available at uses.bcaresearch.com 4       Please see Global Asset Allocation Special Report "Euro Area Banks: Value Play Or Value Trap?" dated December 14, 2018, available at gaa.bcaresearch.com 5       The European Commission Eurobarometer Surveys show that Europeans overwhelmingly see Europe as a peace project and as a way to maintain a voice in a world dominated by huge players like the U.S., China, or Russia, a world where France, Germany, or Italy individually are marginal players. In 2016, the U.K. population did not share this opinion. Moreover, even after what amounts to a depression, the support for the euro continues to rise in Greece, showing the growing commitment of Europeans to the euro, and the resilience of this commitment to economic shocks. EQUITIES:FIXED INCOME:CURRENCIES:COMMODITIES:ECONOMY:

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