Financials

Highlights Portfolio Strategy Melting inflation expectations, widening relative indebtedness, expensive adjusted relative valuations, high odds of a further drop in relative profit margins and the high-octane small cap status all signal that large caps continue to have the upper hand versus small caps. Modest deterioration in credit quality, weakening prospects for loan growth and falling inflation expectations, compel us to put the S&P bank index on downgrade alert. Recent Changes We got stopped out on the long S&P managed health care/short S&P semis trade on June 10 for a gain of 10% since inception. We got stopped out on the long S&P homebuilders/short S&P home improvement retailers trade on June 14 for a gain of 10% since inception. Table 1 Feature Equities surged to all-time highs last week, as investors cheered the Fed’s dovish stance and increasing likelihood of a late-July interest rate cut. The addiction to low interest rates and global dependence on QE are evident and simultaneously very worrisome signs. We are nervous that the U.S. economy is in a soft-patch, thus vulnerable to a shock (maybe sustained trade hawkishness is the negative catalyst) that can tilt the economy in recession. The risk/reward tradeoff on the overall equity market remains to the downside on a cyclical (3-12 month) time horizon as we first posited two weeks ago (this is U.S. Equity Strategy’s view and is going against BCA’s cyclically constructive equity market House View). In fact, using the NY Fed’s probability of a recession in the coming 12 months data series signals that there’s ample downside for stocks from current levels (recession probability shown inverted, Chart 1).1 We heed this message and reiterate our cautious equity market stance. Chart 1Watch Out Down Below Importantly, drilling deeper with regard to the excesses we are witnessing this cycle, Chart 2 is instructive and an unintended consequence of QE and zero interest rate policy. In previous research we highlighted the cumulative equity buybacks corporations have completed this cycle near the $5tn mark. Chart 2Financial Engineering What is worrying is that this “accomplishment” has come about at a great cost: a massive change in the capital structure of the firm. In other words, all of the buybacks are reflected in debt origination from the non-financial business sector (using the Fed’s flow of funds data), confirming our claim that the excesses this cycle are not in the financial or household sectors, but rather in the non-financial business sector (please refer to Chart 4A from the June 10 Weekly Report). One likely trigger of a jumpstart to a default cycle, other than a U.S./China trade dispute re-escalation, is dwindling demand. On that front, we are bemused on how much weight market participants place on the Fed’s shoulders bailing out the economy and the stock market. Chart 3 is a vivid reminder of this narrative. On the one side of the seesaw is the mighty Fed with its forecast interest rate cuts and on the other a slew of slipping indicators. Our sense is that these eighteen indicators will more than offset the Fed’s about-to-commence easing cycle and eventually tilt the U.S. economy in recession, especially if the Sino-American trade talks falter. S&P 500 quarterly earnings are contracting on a year-over-year basis and the semi down-cycle points to additional profit pain for the rest of the year (top panel, Chart 4). On the trade front, exports are below the zero line and imports are flirting with the boom/bust line (second panel, Chart 4). Overall rail freight, including intermodal (retail segment) freight is plunging and so is the CASS freight shipments index at a time when the broad commodity complex is also deflating (third & bottom panels, Chart 4). The latest Q2 update of CEO confidence was disconcerting, weighing on the broad equity market’s prospects (top panel, Chart 5). Non-residential capital outlays have petered out and private construction is sinking like a stone. In fact, the latter have never contracted at such a steep rate during expansions over the past five decades (second panel, Chart 5). Real residential investment has clocked its fifth consecutive quarter of negative growth during an expansion, for the first time since the mid-1950s. Single family housing starts and permits are contracting (third panel, Chart 5). Chart 4Cracks… Chart 5…Are… Light vehicle sales are ailing (bottom panel, Chart 5) and the latest senior loan officer survey continued to show that there is feeble demand for credit across nearly all the categories the Fed tracks (bottom panel, Chart 6). Non-farm payrolls fell to 75K on a month-over-month basis last month and layoff announcements are gaining steam signaling that the labor market, a notoriously lagging indicator, is also showing some signs of strain (layoffs shown inverted, third panel, Chart 6). The latest update of the U.S. Equity Strategy’s corporate pricing power gauge is contracting (please look forward to reading a more in-depth analysis on our quarterly update on July 2) following down the path of the market’s dwindling inflation expectations. Finally, the yield curve remains inverted (top and second panels, Chart 6). Chart 6…Forming Chart 7The “Hope" RallyAdding it all up, we deem that the equity market remains divorced from the economic reality and too much faith is placed on the Fed’s shoulders to save the day. Thus, we refrain from positioning the portfolio on “three hopes”: first that the Fed will engineer a soft landing, second that the U.S./China trade tussle will get resolved swiftly, and finally that the Chinese authorities will inject massive amounts of liquidity and reflate their economy (Chart 7). This week we are putting a key financials sub-sector on downgrade alert and update our view on the size bias. Large Cap Refuge While small caps shielded investors from the U.S./China trade dispute that heated up in 2018 (owing to their domestic focus), this year small caps have failed to live up to their trade war-proof expectations and have lagged their large cap brethren by the widest of margins. In fact, the relative share price ratio sits at multi-year lows giving back all the gains since the Trump election, and then some (Chart 8). Chart 8Stick With A Large Cap Bias As a reminder, our large cap preference has netted our portfolio 14% gains since the May 10 2018 cyclical inception and this size bias is also up 9% since our high-conviction call inclusion in early December 2018. Five key reasons underpin our large/mega cap preference in the size bias. Bearishness toward small vs. large caps has been pervasive raising the question: does it still pay to prefer large caps to small caps? The short answer is yes. Five key reasons underpin our large/mega cap preference in the size bias. First, melting inflation expectations have been positively correlated with the relative share price ratio, and the current message is to expect more downside (Chart 8). While the SPX has a higher energy weight than the S&P 600, financials and industrials dominate small cap indexes and likely explain the tight positive correlation with inflation expectations (Table 2). Table 2S&P 600/S&P 500 Sector Comparison Table Second, relative indebtedness has been widening. Debt saddled small caps have been issuing debt at an accelerating pace at a time when cash flow growth has not been forthcoming. Small cap net debt-to-EBITDA is now almost three times as high as large cap net debt-to-EBITDA. Investors have finally realized that rising indebtedness is worrisome, especially at the late stages of the business cycle, and that is why small caps have failed to insulate investors from the re-escalating trade dispute (top & middle panels, Chart 9). Third, a large number of small cap companies (100 in the S&P 600 and 600 in the Russell 2000) have no forward EPS. Very few S&P 500 companies have negative projected profits. Thus, while, relative valuations have been receding, the relative forward P/E trading at par is masking the relative value proposition of the indexes. Were the S&P or Russell to adjust for this, small caps would trade at a significant forward P/E premium to large caps (bottom panel, Chart 9). Chart 9Mind The Debt Gap Fourth, a small cap margin squeeze has been underway since the 2012 cyclical peak and the relative margin outlook is even grimmer. Simply put, small business labor costs are rising at a faster clip than overall wage inflation, warning that small cap profit margins have further to fall compared with large caps margins (Chart 10). Finally, small cap stocks are higher beta stocks and typically rise when volatility gets suppressed. As such, they also tend to outperform large caps when emerging markets outperform the SPX and vice versa. Tack on the recent yield curve inversion, and the odds are high that the size bias has entered a prolonged period of sustained small cap underperformance. Netting it all out, melting inflation expectations, widening relative indebtedness, expensive adjusted relative valuations, high odds of a further drop in relative profit margins and the high-octane small cap status all signal that large caps continue to have the upper hand versus small caps (Chart 11). Chart 10Relative Margin Trouble Chart 11Shay Away From Small Caps Bottom Line: Small cap underperformance has staying power. Continue to prefer large/mega caps to their small cap brethren. Put Banks On Downgrade Alert In the context of de-risking our portfolio we are taking the step and adding the S&P banks index on our downgrade watch list. The Fed’s signal of a cut in the upcoming July meeting steepened the yield curve last week. While the yield curve has put in higher lows in the past eight months, relative bank performance has been facing stiff resistance and has failed to follow the yield curve’s lead (Chart 12). One of the reasons for the Fed’s dovishness is melting inflation expectations. The latter are joined at the hip with relative bank performance and signal that downside risks are rising especially if the Fed fails to arrest the lower anchoring of inflation expectations (Chart 13). Chart 12Banks Are Not Participating Chart 13Melting Inflation Expectations Are Anchoring Banks With regard to credit demand, the latest Fed Senior Loan Officer survey remained subdued confirming the anemic reading from our Economic Impulse Indicator (a second derivative gauge of six parts of the U.S. economy, bottom panel, Chart 14). Lack of credit demand translates into lack of credit growth, despite the fact that bankers are, for the most part, willing extenders of credit. U.S. Equity Strategy’s overall loans & leases growth model has crested (second panel, Chart 15). Chart 14Anemic Loan Demand… Chart 15…Will Weigh On Loan Origination Similarly, the recent softness in a number of manufacturing surveys signal that C&I loan growth in particular – the largest credit category in bank loan books – is at risk of flirting with the contraction zone (third panel, Chart 15). Worrisomely, not only is the overall U.S. credit impulse contracting, but also U.S. Equity Strategy’s bank credit diffusion index is collapsing (second panel, Chart 16). Such broad breadth of loan growth deterioration warns that loan growth and thus bank earnings are at risk of underwhelming still optimistic sell-side analysts’ expectations (not shown). On the credit quality front there are now two loan categories that are starting to show some modest signs of stress. Credit card net chargeoffs and non-current loans are spiking and now C&I delinquent loans have ticked up for the first time since the manufacturing recession (third & bottom panel, Chart 16). Our bank EPS growth model does an excellent job in capturing all these forces and signals that bank EPS euphoria is misplaced (bottom panel, Chart 15). Nevertheless, despite these softening bank sector drivers there are four significant offsets. First the drubbing in the 10-year yield has been reflected nearly one-to-one on the 30-year fixed mortgage rate and the recent surge in mortgage applications signals that residential real estate loans (second largest bank loan category) may reaccelerate in the back half of the year (top panel, Chart 17). Chart 16Deteriorating Credit Quality Chart 17Some Significant… Second, while there have been credit card and C&I loan credit quality issues, as a percentage of total loans they just ticked higher and remain near cyclical lows, at a time when banks have been putting more money aside to cover for these potential loan losses (bottom panel, Chart 17). Third, bank source of funding remains very cheap as depositors have not been enjoying higher short term interest rates, at least not at the big money center banks. In other words, banks have not been passing higher interest rates to depositors sustaining relatively high NIMs (not shown). Finally, banks are one of the few sectors with pent up equity buyback demand. The upcoming release of the Fed’s stress test will likely continue to allow banks to pursue shareholder friendly activities, that they have been deprived from for so long, and raise dividend payments and increase share buybacks (Chart 18). Chart 18…Offsets In sum, melting inflation expectations, modest deterioration in credit quality, and weakening prospects for loan growth compel us to put the S&P bank index on downgrade alert. Bottom Line: We remain overweight the S&P banks index, but have put it on downgrade alert and are looking for an opportunity to downgrade to neutral. The ticker symbols for the stocks in this index are: BLBG: S5BANKX – WFC, JPM, BaAC, C, USB, PNC, BBT, STI, MTB, FITB, CFG, RF, KEY, HBAN, CMA, ZION, PBCT, SIVB, FRC.   Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com Footnotes 1      https://www.newyorkfed.org/research/capital_markets/ycfaq.html Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Special Report

Highlights The report reviews our framework for predicting broad market earnings in China based on the experience of the past decade, and documents the relationship between sector earnings and broad market earnings for both the investable and domestic market. We also review the cyclicality of earnings in each sector, and highlight the sectors where relative earnings have been successful at predicting relative performance. Energy and consumer discretionary in both markets, along with real estate and financials in the domestic market, have historically been the best candidates for a classic top-down fundamental “sector rotation” strategy. Compared with these sectors, investable telecom stocks have exhibited a weaker link between sector and index earnings, but this has occurred because of relatively steady, low volatility earnings growth. As such, telecom stocks are reliably defensive, but only in the investable market. We conclude by noting the extreme nature of long-term de/re-rating trends that have occurred for several of China’s equity sectors, and argue that the strength of the relationship between earnings and stock prices for these sectors is set to rise over a secular time horizon. Over the coming few years, investors should focus nearly exclusively on the earnings outlook for high flying and beaten down sectors, as further multiple expansion/contraction is unlikely to drive future returns (without an earnings catalyst). Feature Last week’s joint report with our Geopolitical Strategy service provided investors with an update on the trade war in the lead up to the G20 meeting in Osaka.1 While a new tariff ceasefire may emerge from the meeting, the report underscored why the odds are skewed against a positive outcome over the coming 18 months. Our bet is that investors are unlikely to assume that a deal will occur merely in response to a new timetable for talks, implying that any near-term boost to stock prices will be minimal until negotiators provide market participants with evidence (rather than hope) that a deal is achievable. This means that a financial market riot point remains likely over the coming few months, and that a cyclically bullish stance towards Chinese stocks rests on the likelihood of a major policy response in China to counter the likely shock to its export sector. During times of high policy uncertainty, we often take the opportunity to review and update our framework for key asset drivers. In today’s report we review our framework for predicting broad market earnings in China based on the experience of the past decade, and then document the relationship between sector earnings and broad market earnings for both the investable and domestic market. We review the cyclicality of earnings in each sector, and highlight the sectors where relative earnings have been successful at predicting relative performance. We conclude with a summary of what our results would imply over the tactical and cyclical investment horizons given our view of China’s likely growth trajectory, and highlight why several sectors may see a stronger relationship between their earnings and stock prices over the secular horizon. The report illustrates our key conclusions in the body of the text, but reference charts for each sector/industry group in both the investable and domestic market are provided as a convenience on pages 12 - 23. Predicting Chinese Equity Index Earnings Our framework for predicting index EPS is straightforward but reliable. Chart 1Stronger Economic Activity = Stronger Investable Earnings Chart 1 presents the first element of our framework for predicting Chinese investable earnings per share (EPS) growth. The chart illustrates the strong leading relationship between our BCA China Activity Indicator and the year-over-year growth rate of investable EPS, which underscores that the fundamental performance of Chinese equities is still predominantly driven by China’s “old economy”. The leading nature of our activity index partly reflects the fact that earnings per share are measured on a trailing basis; the key point for investors is that indicators such as our Activity Index have been more successful at capturing the coincident trend in China’s economy than, for example, real GDP growth has over the past several years. Chart 2illustrates that the earnings cycle for the investable and domestic equity markets is the same, with the magnitude of a given cycle accounting for the difference between the two markets. This means that investors exposed to the Chinese equity market should be focused heavily on predicting the coincident trend in the economy, as doing so will lead investors to the same conclusion about the trend in H- and A-share EPS growth. Chart 2Same Earnings Cycle In The Investable And Domestic Markets Chart 3Our Leading Indicator Reliably Predicts Economic Activity In turn, Chart 3 presents our framework for predicting Chinese economic activity, which we originally laid out in our November 30, 2017 Special Report.2 The chart shows that our leading activity indicator has reliably predicted inflection points in actual activity over the past several years, including the slowdown of the past two years (the leading indicator peaked in Q1 2017). As detailed in the report, our indicator is based on monetary conditions and money & credit growth. Panel 2 of Chart 3 shows that monetary conditions are very easy and credit growth is picking up, though it needs to continue to improve alongside a forceful pickup in money growth in order for the economy to strengthen. The key takeaway for investors is that the overall earnings cycle in China is strongly linked to “old economy” economic activity, which in turn appears to reliably predicted by our indicator. This provides us with a stable platform from which we can examine (and ultimately predict) equity sector EPS. Sector Earnings: Predictability And Cyclicality Given the strong link between Chinese economic activity and equity market EPS that we noted above, the question for equity-oriented investors is then to identify the relationship between sector and overall index EPS. In other words, to what degree are sector EPS in China linked to the overall earnings trend (versus being driven by idiosyncratic factors), and is this relationship pro- or counter-cyclical in nature? Charts 4 and 5 present the answers to these questions, based on the 2011 – 2018 period.3 The charts present the highest R-squared value resulting from a regression of detrended sector EPS versus broad market EPS for both the investable and domestic markets, after accounting for any leading/lagging relationships. The color/shading of each bar denotes whether the beta of the relationship for each sector or industry group is above or below 1. The charts present a mix of surprising and unsurprising results. Among the latter in the investable market, the cyclicality of typically high-beta sectors such as energy, materials, industrials, consumer discretionary, and technology would be readily accepted by most investors, as would the defensive characteristics of financials, telecom services, health care, utilities, and consumer staples. Investable consumer staples, health care, and utilities EPS are driven by either bottom-up/industry-specific factors or macro factors that are not fully captured by the trend in China’s business cycle. However, there were several less-intuitive results that emerged from our analysis, related to both the investable and domestic markets: Within the investable market, the low predictability of health care, utilities, and consumer staples EPS is somewhat difficult to explain. A weak relationship would easily be explained if EPS growth for these sectors were somewhat constant in the face of fluctuations in overall index EPS, but Chart 6 shows that the volatility in EPS growth for these sectors are not bottom-ranked (see also pages 16, 17 and 22). In fact, utilities EPS growth vol has been relatively high, and it is higher for health care and consumer staples than it is for financials and banks, whose EPS growth are highly linked to the overall earnings cycle. This result suggests that the determinants of earnings for these sectors are driven by either bottom-up/industry-specific factors or macro factors that are not fully captured by the trend in China’s business cycle. The low predictability of consumer staples and utilities EPS observed in the investable market is also evident in the domestic market, suggesting that this finding is not the result of quirky data. We noted earlier that overall index earnings are highly correlated with our BCA China Activity Index, and we have noted in past reports that China’s business cycle continues to be subject to its “old” growth model centered on investment and exports rather than the services and consumer sectors.4 This may explain the relatively idiosyncratic EPS profile for consumer staples, although it still fails to explain the low predictability and relatively high volatility of utilities earnings. Telecom services and technology earnings also have a very low correlation with overall earnings in the domestic market, which is similar to the investable market but more extreme. On the tech front, this is explained by the fact that Alibaba and Tencent, China’s tech giants, are not listed in the domestic market, underscoring that investable tech and domestic tech should be considered by investors to be distinctly separate sectors. In the investable market the low predictability and defensive characteristic of telecom services EPS can be explained by stable, low-volatility growth, but this is not true in the domestic market. In fact, over the past several years the volatility of domestic telecom EPS growth has been among the highest of any of China’s domestic equity sectors, and it has been cyclical rather than defensive in nature. These findings are difficult to explain from a top-down perspective. Finally, while Charts 4 and 5 show a difference in the cyclicality of real estate earnings between the investable and domestic markets, the difference is not substantial: the beta of the former is 1.03 versus 0.94 for the latter. The truly surprising result from real estate stocks is that their EPS growth is not considerably high-beta, given the boom & bust nature of Chinese property prices and the enormous amount of activity that has occurred in Chinese real estate over the past decade. Given that beta is determined relative to the overall index, this is emblematic (and an important reminder) of the underlying cyclicality of China’s economy and its financial markets relative to its global counterparts. Sector Earnings: Relevance For Stock Prices Following our review of the predictability and cyclicality of Chinese sector EPS, Charts 7 and 8 illustrate the relationship between relative EPS and relative stock price performance for these sectors. The charts highlight several notable points: In both the investable and domestic markets, the relative performance of energy and consumer discretionary stocks have been highly explained by the trend in relative EPS. Both of these sectors have also shown reasonably high EPS predictability (based on overall index EPS), suggesting that these two sectors have historically been the best candidates for a classic top-down fundamental “sector rotation” strategy. The relative re-rating of consumer staples and de-rating of banks reflects the existence of a long consumer economy / short industrial economy trade. Chart 9Multiples Have Been More Important In Driving The Returns Of These Sectors Within the investable market, relative EPS has not been successful at predicting relative stock price performance for financials/banks, health care, consumer staples, and industrials. This means that multiple expansion/contraction has been a relatively more important factor in driving returns, which can clearly be seen in Chart 9. The chart shows that investable banks, health care, and industrials have been meaningfully de-rated over the past several years, whereas the relative P/E ratio for consumer staples stocks has risen (albeit in a choppy fashion). Domestic consumer staples have also benefited from re-rating, although it has occurred entirely within the past three years and has merely made up for the substantial de-rating that took place in 2012 (Chart 9, panel 2). Taken together, the relative re-rating of consumer staples and de-rating of banks and industrials reflects, at least in part, the existence of a long consumer economy / short industrial economy trade. The relative EPS trend of utilities in both markets and that of telecom services stocks in the investable market have done a decent-to-good job of predicting relative stock price performance. We noted earlier that investable telecom services earnings appear to have a weak relationship with overall index earnings because of their low variability, meaning that they have also been a good top-down rotation candidate on the defensive side of the spectrum. The high responsiveness of the relative equity performance of Chinese utilities to relative EPS raises the importance of predicting the latter, which is likely to be a topic of future reports for BCA’s China Investment Strategy service. Finally, Chart 7 shows that the most important sector trend in the investable market over the past several years, the outperformance of information technology, has been strongly explained by the trend in relative EPS. This is good news for investors, as it suggests that relative tech returns can be reasonably predicted by accurate earnings analysis. From a top-down perspective, we noted earlier that the relationship between tech and overall index EPS has not been extremely high, which raises the bar for investors to understand the idiosyncratic drivers of earnings for the BAT (Baidu, Alibaba, and Tencent) stocks. Chinese consumer spending remains the most important macro factor for these stocks, but our understanding of this relationship is not complete and is an area of ongoing research at BCA. Investment Conclusions Chart 10 summarizes the results of Charts 4-5 and 7-8, by grouping investable and domestic equity sectors into four quadrants based on top-down EPS predictability (x-axis) and the impact of the trend in relative EPS on relative stock price performance (y-axis): Over a multi-year time horizon, the relationship between relative earnings and relative stock prices is likely to rise for several sectors. As we noted above, energy and consumer discretionary in both markets along with real estate and financials in the domestic market have had the strongest relationship across both dimensions (top-right quadrant). The EPS relationship is cyclical in both markets in the case of energy and consumer discretionary, whereas it is modestly cyclical for domestic real estate and defensive for domestic financials. Sectors in the top-left quadrant have shown a strong link between earnings and stock price performance, but a weaker link between sector and index earnings. This is the case for telecom services because of relatively steady, low volatility earnings growth, meaning that telecom stocks are reliably defensive. Fluctuations in the growth of index EPS do not explain the majority of changes in investable tech EPS, but it is an important driver in a cyclical relationship. Sectors in the bottom-right quadrant have a predominantly strong and defensive relationship with index earnings growth (with the exception of domestic industrials), but have experienced significant changes in multiples over the past several years that have materially impacted their relative stock price performance. We showed in Chart 9 that banks have been meaningfully de-rated over the past several years; this process appears to have halted at the end of 2017, suggesting that the relationship between relative earnings and relative stock prices may be stronger going forward. Chart 11Investable Real Estate And Materials Stocks Trade At A Huge Discount Finally, sectors in the bottom left quadrant have had relatively idiosyncratic earnings trends, and relative EPS have not explained a majority of the trend in relative performance. We would draw a distinction between investable industrials, real estate, and materials and the rest of the sectors shown, as they are on the cusp of being in the top-right or bottom-right quadrants, and all three appear to have suffered from meaningful de-rating. Investable real estate and materials now trade at over a 40% discount to the overall index (Chart 11), raising a serious question as to whether relative P/Es can continue to compress and explain the majority of relative equity performance. However, investable consumer staples and health care, along with domestic technology and telecom services stocks, do appear to be legitimately idiosyncratic, suggesting that an equity beta approach (regressing sector returns against index returns) is the best top-down method available to investors when allocating to these sectors. For investable staples and health care their equity return betas are clearly defensive, whereas domestic tech and telecom services stocks are market neutral. What does this all mean for investors? Our findings above lead us to some specific conclusions over the tactical (0-3 months), cyclical (6-12 months), and secular (multi-year) horizons: Over the cyclical horizon, we expect Chinese co-incident economic activity to pick up and for overall index EPS to improve, suggesting that global investors have a fundamental basis to be overweight investable energy, consumer discretionary, materials, media & entertainment (within the new communication services sector) and industrial stocks, at the expense of telecom services and financials.5 Investable health care, consumer staples, and utilities stocks are also likely to underperform, although this view is based on a statistical/empirical relationship rather than a fundamental one. In the domestic market, our findings support substituting real estate for technology in comparison to the investable sectors we listed above, but we are concerned that policymakers may crack down more heavily on the property sector if they allow overall credit growth to rise meaningfully as part of a stimulative response. For now, we would not recommend aggressive bets in favor of the domestic real estate sector. Chart 12Flagging Earnings Growth Heightens Tactical Risks To Chinese Stocks Over the tactical horizon, however, we would advise either the opposite stance, or a benchmark sector allocation. In addition to our view that a financial market riot point remains likely over the coming few months to force policymakers to address the economic weakness that an escalated tariff scenario would entail, broad-market Chinese EPS growth continues to decelerate (Chart 12). We see this continued slowdown as a lagged response to past economic weakness, which we expect will be reversed over the coming year due to stronger money & credit growth. However, sectors with pro-cyclical earnings growth may fare poorly in the near term until investors gain confidence that the (inevitable) policy response will stabilize the earnings outlook. Over the secular horizon, the most important conclusion is that there have been several long-term sectoral de/re-rating trends within China’s equity market. In the investable market, health care, consumer staples, and consumer discretionary (of which Alibaba is heavily represented) trade at 100-200% of a premium relative to the broad equity market on a trailing earnings basis, whereas financials, materials, and real estate stocks trade at a 40-60% discount. These divergences also exist in the domestic market, although the range is somewhat less extreme. A simple contrarian instinct might be to strategically overweight/underweight expensive/cheap sectors, but to us the simpler conclusion is that the extreme nature of these trends means that the strength of the relationship between EPS and stock prices for these sectors is set to rise. Over the coming few years, investors should focus nearly exclusively on the earnings outlook for high flying and beaten down sectors, a question that is very likely to be the topic of additional China Investment Strategy reports this year. Stay tuned!   Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com     Reference Charts Energy Chart 13 Chart 14 Materials Chart 15 Chart 16   Industrials Chart 17 Chart 18   Consumer Discretionary Chart 19 Chart 20   Consumer Staples Chart 21 Chart 22   Health Care Chart 23 Chart 24   Financials Chart 25 Chart 26   Banking Chart 27 Chart 28   Information Technology Chart 29 Chart 30   Telecom Services Chart 31 Chart 32   Utilities Chart 33 Chart 34   Real Estate Chart 35 Chart 36   Footnotes 1      Please see Geopolitical Strategy and China Investment Strategy Special Report, “Another Phony G20? And A Word On Hong Kong”, dated June 14, 2019, available at cis.bcaresearch.com. 2      Please see China Investment Strategy Special Report, “The Data Lab: Testing The Predictability Of China’s Business Cycle”, dated November 30, 2017, available at cis.bcaresearch.com. 3      S&P Dow Jones and MSCI Inc. implemented major structural changes to the Global Industry Classification Standard (GICS) in Q4 2018 that substantially altered the sector composition of the MSCI China Investable index. The weight of the information technology sector in the investable index dropped dramatically after the GICS changes occurred. Investors should note that we used Q3 2018 as the end date of our analysis in order to remove any impact from the GICS sector change; the reference charts shown on pages 12 – 23 provide all data since 2011. 4     Please see China Investment Strategy Weekly Report, “The Three Pillars Of China’s Economy”, dated May 16, 2018, available at cis.bcaresearch.com. 5      Due to the changes to the GICS classification structure noted in footnote 3, the tech sector relationships that we highlighted above now apply to the consumer discretionary sector (level 1) and media & entertainment industry-group (level 2, within the new level 1 communication services sector. Cyclical Investment Stance Equity Sector Recommendations

Special Report

Dear Client, Credit in China has expanded at an exponential pace, with the country’s debt-to-GDP ratio climbing from 143% to more than 250% over the last decade. The speed and scale of China’s debt surge dwarfs Japan and the U.S.’ respective credit binges in the 1980’s and 2000’s, each of which ultimately led to financial market meltdowns. Why should China’s experience be any different? Given that China has pursued a different economic model whereby the banking sector is largely state-sponsored and the currency is tightly managed by the central bank, the answer to this pressing question for global markets is the subject of spirited debate at BCA and within the investment community at large. Clients are already aware that my colleagues, Peter Berezin and Arthur Budaghyan, disagree on the macro and market ramifications of China’s decade-long credit boom. The aim of this report is to provide visibility on the root sources of the view divergence, not to reconcile the gaps. We hope these insights will help shape your own conviction about this important topic. Caroline Miller Global Strategy Feature   Caroline: Arthur, your cautious outlook towards emerging markets in general and China’s prospects in particular stems from your belief that China’s economy is dangerously addicted to credit as a growth driver. Please explain why you dismiss the more sanguine view that China’s elevated debt burden is a function of an equally unusually high household savings rate. Arthur: It is simple: When people use the word “savings,” they typically and intuitively refer to bank deposits or securities investments; but this is incorrect. Chart 1 (Arthur)No Empirical Evidence That Deposits = 'Savings' Money supply/deposits in the banking system have no relationship with the savings rate of a nation in general or households in particular (Chart 1). When households save, they do not change the amount of money supply and deposits. Hence, households’ decision to save neither alters liquidity in the banking system nor helps banks to originate loans. In fact, banks do not intermediate deposits into loans or savings into credit.1 The terms “savings” in economics does not denote an increase in the stock of money and deposits. The term “savings” in economics means the amount of goods and services produced but not consumed. When an economy produces a steel bar, it is registered as national “savings.” We cannot consume (say, eat or expense) a steel bar. Therefore, once a steel bar or any equipment is produced, economic statistics will count it as “savings.” Besides, the sole utilization of a steel bar is in capital goods and construction, and hence, it cannot be consumed. Once a steel bar is produced, both national savings and investment will rise. That is how the “savings” = “investment” identity is derived. Chart 2 (Arthur)Chinese Households Are More Leveraged Than U.S. Ones It would avoid confusion and help everyone if economists were to call it “excess production” not “excess savings.” Banks do not need “excess production” – i.e., national “savings” – to create loans. Critically, the enormous amount of bank deposits in China is not due to household “savings” but is originated by banks “out of thin air.” In fact, Chinese households are now more leveraged than U.S. ones (Chart 2). The surge of credit and money supply in China during the past 10 years has been due to animal spirits running wild among lenders and borrowers on the mainland, not its households’ “savings.” In short, the root of China’s credit bubble is not any different from Japan’s (in the 1980s), or the U.S.’ (in the 2000s) and so on. Peter: Yes, banks can create deposits “out of thin air,” as Arthur says. However, people must be willing to hold those deposits. The amount of deposits that households and businesses wish to hold reflects many things, including the interest rate paid on deposits and the overall wealth of the society. The interest rate is a function of savings. The more people save, the lower interest rates will be. And the lower interest rates are, the more demand for credit there will be (Chart 3). It’s like asking what determines how many apples are consumed. Is it how many apple trees farmers want to plant or how many apples people want to eat? The answer is both. Prices adjust so that supply equals demand. How about national wealth? To a large extent, wealth represents the accumulation of tangible capital – factories, plant and machinery, homes and office buildings: the sort of stuff that banks can use as collateral for lending. And what determines how much tangible capital a country possesses? The answer is past savings, of the exact sort Arthur is referring to: the excess of production over consumption. So this form of “economic” savings also plays an important indirect role in determining the level of bank deposits. Chart 4 (Peter)China: From Exporting Savings To Investing Domestically And Building Up Debt I think the main problem with Arthur’s argument is that he is observing an accounting identity, which is that total bank assets (mostly loans) must equal liabilities (mostly deposits and capital) in equilibrium, without fully appreciating the economic forces – savings being one of them – that produce this equilibrium. In any case, the whole question of whether deposits create savings or savings create deposits misses the point. China’s fundamental problem is that it does not consume enough of what it produces. In the days when China had a massive current account surplus, it could export its excess savings abroad (Chart 4). It can’t do that anymore, so the government has consciously chosen to spur investment spending in order to prop up employment. Since a lot of investment spending is financed through credit, debt levels have risen. It really is just that simple.   Arthur: First, neither the stock nor the flow of credit and deposits has any relevance to (1) the economic term “savings;” (2) a country’s capital stock; or (3) national wealth, contrary to what Peter claims. China’s broad money supply (M2) now stands at 190 trillion yuan, equivalent to US$28 trillion (Chart 5, top panel). It is equal to the size of broad money supply in the U.S. and the euro area combined (US$14 trillion each). Yet, China’s nominal GDP is only two-thirds the size of the U.S. Does the level of China’s wealth and capital stock justify it having broad money supply (US$28 trillion) equivalent to the U.S. and the euro area combined? Chart 5 (Arthur)“Helicopter” Money In China Second, are Chinese households and companies willing to hold all RMB deposits that banks have created “out of thin air”? The answer: not really. Without capital controls, a notable portion of these deposits would have rushed into the foreign exchange markets and caused currency depreciation. Another sign of growing reluctance to hold the yuan is that households have been swapping their RMB deposits for real assets (property) at astronomical valuations. There is a bubble in China but people are looking for reasons to justify why it is different this time. Caroline: OK, let’s get away from the term “savings,” and agree that China continues to generate a chronic surplus of production of goods and services relative to consumption, and that how China chooses to intermediate that surplus is the most market-relevant issue. Arthur, you have used the terms “money bubble” and “helicopter money” in relation to China. This implies that banks are unconstrained in their ability to make loans. Just because savings don’t equal deposits, and banks can create deposits when they make loans doesn’t mean there is no relationship between the flow of credit and the stock of deposits. Arthur: Money supply and deposits expand only when banks originate a loan or buy an asset from a non-bank. In short, both credit and money/deposits are created by commercial banks “out of thin air.” This is true for any country.2 Consider a loan transaction by a German commercial bank. When it grants a €100 loan to a borrower, two accounting entries occur on its balance sheet. On the assets side, the amount of loans, and therefore total assets, increases by €100. Simultaneously, on the liabilities side, this accounting entry creates €100 of new deposits “out of thin air” (Figure 1). Hence, new purchasing power of €100 has been created via a simple accounting entry, which otherwise would not exist. Critically, no one needed to save for this loan and money to be originated. The bank does not transfer someone else’s deposits to the borrower; it creates a new deposit when it lends. Banks also create deposits/money “out of thin air” when they buy securities from non-banks. In China, fiscal stimulus is largely financed by commercial banks – banks purchase more than 80% of government-issued bonds. This also leads to money creation. In short, when banks originate too much credit – as they have in China – they generate a money bubble. The money bubble is the mirror image of a credit bubble. Chinese banks have created 141 trillion yuan (US$21 trillion) of new money since 2009, compared with $8.25 trillion created in the U.S., euro area, and Japan combined over the same period (Chart 5, bottom panel). This is why I refer to it as “helicopter” money. Caroline: If banks need capital and liquidity to make loans, and deposits are one potential source of funds, don't these capital and liquidity constraints drive banks’ willingness and ability to lend, creating a link between the two variables? Arthur: Let me explain how mainland banks were able to circumvent those regulatory lending constraints. In 2009, they expanded their credit assets by about 30%. Even though a non-trivial portion of those loans were not paid back, banks did not recognize NPLs and instead booked large profits. By retaining a portion of those earnings, they boosted their equity, say, by 20%. As a result, the next year they were able to expand their credit assets by another 20% and so on. If banks lend and do not recognize bad loans, they can increase their equity and continue lending. With respect to liquidity, deposits are not liquidity for banks; excess reserves at the central bank are true liquidity for them. The reason why banks need to attract deposits is not to appropriate the deposits themselves, but to gain access to the excess reserves that come with them. When a person shifts her deposit from Bank A to Bank B, the former transfers a similar amount of excess reserves (liquidity) to the latter. When expanding their credit assets aggressively, banks can: (1) create more loans per one unit of excess reserves/liquidity, i.e., expand the money multiplier; and (2) borrow excess reserves/liquidity from the central bank or other banks. Chinese banks have used both channels to expand their balance sheets over the past 10 years (Chart 6). Chart 6 (Arthur)Broad Money Can Expand Without Growing Banks' Excess Reserves At The Central Bank Crucially, commercial banks create deposits, but they cannot create excess reserves (liquidity).3 The latter are issued only by central banks “out of thin air.” So, neither deposits nor excess reserves have any relevance to household or national “savings.” Caroline: Peter, Arthur argues that Chinese credit policy has been unconstrained by the traditional metrics of capital adequacy that prevail in capitalist, free-market economies. In other words, there is no connection between the availability of funds to lend via deposits in the banking system, and the pace of credit creation. Rather, the central bank has controlled the terms and volume of lending via regulation and fiat reserve provisioning. You’ve argued that credit creation has served the greater good of propping up employment via investment spending. Moreover, you posit that countries with a surplus of production over consumption will invariably experience high levels of credit creation. Our colleague, Martin Barnes, has analyzed national savings rates (as a proxy for over-production) relative to debt-GDP ratios in other countries. The relationship doesn’t look that strong elsewhere (Chart 7). Please elaborate on why you see credit growth as an inevitable policy response to the dearth of aggregate demand we observe in China? Peter: I would not say that countries with a surplus of production over consumption will invariably experience high levels of credit creation. For example, if most business investment is financed through retained earnings, you can have a lot of investment with little new debt. Debt can also result from activities not directly linked to the intermediation of savings. For instance, if you take out a mortgage to buy some land, your consumption and savings need not change, even though debt will be created. I think Arthur and I agree on this point. Thus, I am not saying that debt is always and everywhere the result of savings. I am simply pushing back against Arthur’s extremist position that debt never has anything to do with savings. Caroline: So what determines the level of debt in an economy in your view, Peter? Peter: In general, debt levels will rise if there are large imbalances between income and spending within society and/or if there are significant differences in the mix of assets people wish to hold. Think about the U.S. in the pre-financial crisis period. First, there was a surge in income inequality beginning in the early 1980s. For all intents and purposes, rich households with excess savings ended up lending their surplus income to poor households struggling to pay their bills. Overall savings did not rise, but debt levels still increased. That’s one reason why Martin’s chart doesn’t show a strong correlation between the aggregate savings rate and debt-to-GDP. Sometimes you need to look beneath the aggregate numbers to see the savings intermediation taking place. Unlike in the U.S., even poor Chinese households are net savers (Chart 8). Thus, the aggregate savings rate in China is very high4 (Chart 9). Much of these savings are funnelled to finance investment in the corporate and public sectors. This fuels debt growth. Chart 9 (Peter)Chinese Households Have More Savings Than The U.S., Europe And Japan Combined The second thing that happened in the U.S. starting in 2000 was a massive housing boom. If you bought a second home with credit, you ended up with one more asset (the house) but one more liability (the mortgage). The person who sold you the home ended up losing one asset (the house) but gaining another asset (a bigger bank deposit). The net result was both higher debt and higher bank deposits. Lending to finance asset purchases has also been a big source of debt growth in China, as it was in the U.S. before the crisis. The U.S. mortgage boom ended in tears, and so the question that we should be asking is whether the Chinese debt boom will end the same way. Arthur: We agreed not to use the term “savings,” yet Peter again refers to “savings” being funnelled into credit. As I explained above, banks do not funnel “savings” (i.e., “excess production”) into credit. China, Japan, and Germany have high “savings” rates because they produce a lot of steel, chemicals, autos, and machinery that literally cannot be consumed and, thus, are recorded as “savings.” The U.S. produces too many services that are consumed/expensed and, hence, not recorded as “savings.” That is why the U.S. has a lower “savings” rate. Chart 10 (Arthur)The Myth Of Deficient Demand In China Economic textbook discussions on “savings” and “investment” are relevant for a barter economy where banks do not exist. When this framework is applied to modern economies with banks, it generates a lot of confusion.5 Caroline: OK, so Peter argues that an imbalance between spending and income CAN be a marker for high debt levels. Arthur, please explain why you see no relationship between China’s chronic shortfall in demand and authorities’ explicit decision to support growth via credit creation. Arthur: First, China does not have deficient demand – consumer spending and capital expenditures have been growing at 10% and 9.4%, respectively, in real terms annually compounded for the past 10 years (Chart 10). The mainland economy has been suffering from excess production, not a lack of demand. China has invested a lot (Chart 11) and ended up with too much capacity to produce steel, cement, chemicals and other materials as well as machinery and industrial goods. So, China has an excess production of goods relative to firms’ and households’ underlying demand. In a market economy, these producers would become non-profitable, halt their investments, and shut down some capacity. Chart 11 (Arthur)China Has Been Over-Investing On An Unprecedented Scale In China, to keep the producers of these unwanted goods operating, the government has allowed and encouraged banks to originate loans creating new purchasing power literally “out of thin air” to purchase these goods. This has created a credit/money bubble. In a socialist system, banks do not ask debtors to repay loans and government officials are heavily involved in resource and capital allocation. China’s credit system and a growing chunk of its economy have been operating like a typical socialist system. Socialism leads to lower productivity growth for well-known reasons. With labor force growth set to turn negative, productivity is going to be the sole source of China’s potential growth rate. If the nation continues expanding this money/credit bubble to prop up zombie enterprises, its potential growth rate will fall considerably. As the potential growth rate drops, recurring stimulus will create nominal but not real growth. In short, the outcome will be stagflation. Caroline: The theoretical macro frameworks that you have both outlined make for interesting thought experiments, and spirited intellectual debate. However, investors are most concerned about the sustainability of China’s explosive credit growth, implications for the country’s growth rate, and the return on invested capital. Arthur, given your perspective on how Chinese credit policy has been designed and implemented, please outline the contours of how and when you see the music stopping, and the debt mountain crumbling. Arthur: Not every credit bubble will burst like the U.S. one did in 2008. For example, in the case of the Japanese credit bubble, there was no acute crisis. The bubble deflated gradually for about 20 years. In the cases of the U.S. (2008), Japan (1990), the euro area (2008-2014), Spain (2008-2014) and every other credit bubble, a common adjustment was a contraction in bank loans in nominal terms (Chart 12). Chart 12 (Arthur)All Credit Booms Have Been Followed By Contracting Bank Loans (I) Chart 12 (Arthur)All Credit Booms Have Been Followed By Contracting Bank Loans (II) Why do banks stop lending? The reason is that banks’ shareholders absorb the largest losses from credit booms. Given that banks are levered at least 20-to-1 at the peak of a typical credit boom, every $1 of non-performing loans leads to a $20 drop in their equity value. Bank shareholders halt the flow of credit to protect their wealth. Chart 13 (Arthur)China: Deleveraging Has Not Yet Begun In fact, credit in China is still growing at a double-digit rate, above nominal GDP growth (Chart 13). Hence, aggregate deleveraging in China has not yet begun. If banks do not curtail credit origination, the music will not stop. However, uninterrupted credit growth happens only in a socialist system where banks subsidize the economy at the expense of their shareholders. But even then, there is no free lunch. Credit origination by banks also expands the money supply as discussed above. An expanding money bubble will heighten devaluation pressure on the yuan in the long run. The enormous amount of money supply/deposits – the money bubble – in China is like “the sword of Damocles” hanging over the nation’s currency. Chinese households and businesses are becoming reluctant to hold this ballooning supply of local currency. Continuous “helicopter” money will only increase their desire to diversify their RMB deposits into foreign currencies and assets. Yet, there is an insufficient supply of foreign currency to accommodate this conversion. The nation’s current account surplus has almost vanished while the central bank carries US$3 trillion in foreign exchange reserve representing only 11% of the yuan deposits and cash in circulation (Chart 14). It is inconceivable that China can open its capital account in the foreseeable future. “Helicopter” money also discourages innovation and breeds capital misallocation, which reduces productivity growth. A combination of slowing productivity growth, and thus potential GDP, and strong money growth ultimately lead to stagflation – the dynamics endemic to socialist systems. Peter: Arthur’s answer implicitly assumes that private investment would increase if the government removed credit/fiscal stimulus. But where is the evidence for that? We had just established that the Chinese economy suffers from a lack of aggregate demand. Public-sector spending, to the extent that it increases employment and incomes, crowds in private-sector investment rather than crowding it out. Ask yourself what would have happened if China didn’t build that “bridge to nowhere.” Would those displaced construction workers have found more productive work elsewhere or would they have remained idle? The answer is almost certainly the latter. After all, the reason the Chinese government built the bridge in the first place was to increase employment in an economy that habitually struggles to consume enough of what is produces. Arthur talks about the “misallocation” of resources. But doesn’t an unemployed worker also represent a misallocation of resources? In my view, it certainly does – and one that is much more threatening to social stability than an underutilized bridge or road. If you understand the point above, you will also understand why Arthur’s comparison between Chinese banks and say, U.S. banks is misplaced. The Chinese government is the main shareholder in Chinese banks. The government cares more about social stability than anything else. There is no way it would let credit growth plunge. Moreover, as the main shareholder, the government has a strong incentive to raise the share price of Chinese banks. After all, it is difficult to have a reserve currency that rivals the U.S. dollar, as China aspires to have, if your largest banks trade like penny stocks. My guess is that the Chinese government will shut down a few small banks to “show” that it is concerned about moral hazard, but then turn around and allow the larger banks to sell their troubled loans to state-owned asset management companies on very favourable terms (similar to what happened in the early 2000s). Once investors get wind that this is about to happen, Chinese bank shares will rally like crazy. Caroline: Isn’t shuffling debt from one sector of the economy to another akin to a shell game? Wouldn’t rampant debt growth eventually cause investors to lose confidence in the currency? Peter: China has a problem with the composition of its debt, not with its total value. Debt is a problem when the borrower can’t or won’t repay the loan. Chart 15 (Peter)China Is On Course To Lose More Than 400 Million Workers I completely agree that there is too much shadow bank lending in China. There is also too much borrowing by state-owned enterprises. Ideally, the Chinese government would move all this quasi-public spending onto its own balance sheet. It would significantly raise social spending to discourage precautionary household savings. It would also adopt generous pro-natal policies — free childcare, education, government paid parental leave, and the like. The fact that the Chinese working-age population is set to shrink by 400 million by the end of the century is a huge problem (Chart 15). If the central government borrowed and spent more, state-owned companies and local governments would not have to borrow or spend as much. Banks could then increase their holding of high-quality central government bonds. Debt sustainability is only a problem if the interest rate the government faces exceeds the growth rate of the economy.6 That is manifestly not the case in China (Chart 16). And why are interest rates so low in relation to growth? Because Chinese households save so much! We simply can’t ignore the role of savings in the discussion. Chart 16 (Peter)China: High Levels Of Household Savings Have Kept Interest Rates Below The Growth Rate Of The Economy As far as the currency is concerned, if debt growth rose so much that the economy overheated and inflation soared, then yes, the yuan would plunge. But that’s not what we are talking about here. We are talking about bringing debt growth to a level that generates just enough demand to achieve something resembling full employment. No one is calling for raising debt growth beyond that point. Curbing debt growth in a demand-deficient economy, as Arthur seems to be recommending, would cause unemployment to rise. Investors would then bet that the Chinese government would try to boost net exports by engineering a currency devaluation. Capital outflows would intensify. Far from creating the conditions for a weaker yuan, fiscal/credit stimulus obviates the need for a currency depreciation. Caroline: Peter, even if we accept your argument that the counterfactual of curbing credit growth in a demand-deficient economy would be a more deflationary outcome than sustaining the government-sponsored credit growth engine, how is building bridges to nowhere a positive sum for investors? Even if this strategy maintains social stability in the interests of the CCP’s regime preservation, won’t investors eventually recoil at the retreat to socialism that Arthur outlines, reducing the appeal of holding the yuan, even if, as you both seem to agree, no apocalyptic debt crisis is at hand? In other words, isn’t two times nothing still nothing? Peter: First of all, many of these infrastructure projects may turn out to be quite useful down the road, pardon the pun. Per capita vehicle ownership in China is only one one-fifth of what it is in the United States, and one-fourth of what it is in Japan (Chart 17). A sparsely used expressway today may be a clogged one tomorrow. Chart 17 (Peter)The Automobile Ownership Rate Is Still Quite Low In China Would China really be better off if it had fewer infrastructure projects and more big screen TVs? An economy where people are always buying stuff they don’t need, with money they don’t have, to impress people they don’t like, is hardly a recipe for success. I am not sure what these references to socialism are supposed to accomplish. You want to see a real retreat to socialism? Try creating millions of unemployed workers with no jobs and no hope. All sorts of pundits decried Franklin Roosevelt’s New Deal as creeping socialism. The truth is that the New Deal took the wind out of the sails of the fledgling U.S. communist movement at the time. Arthur: I believe that Peter is confusing the structural and cyclical needs for stimulus. When an economy is in a recession – banks are shrinking their balance sheets and property prices are deflating – the authorities must undertake fiscal and credit stimulus. Chart 18 (Arthur)What Will Productivity Growth Look Like If Public Officials Allocate 55%-60% Of GDP? Credit and fiscal stimulus made sense in China in early 2009 when growth plunged. However, over the past 10 years, we have witnessed credit and property market booms of gigantic proportions. Does this economy warrant continuous stimulus? What will productivity growth look like if government bureaucrats continuously allocate 55-60% of GDP each year (Chart 18)? Caroline: Arthur and Peter, you can both argue with one another about the semantic economic definition of the term ‘savings’, the implications of chronic excess production (relative to consumption), and the root drivers of credit growth in China long past the expiry of every BCA client’s investment horizon. Clients benefit from understanding your distinct perspectives only to the extent that they inform your outlook for markets. Will each of you now please outline how you see high levels of credit in China’s economy impacting the following over a cyclical (6-12 month) and structural (3-5 year) horizon: Global growth Commodity prices China-geared financial assets Peter: Regardless of what one thinks about the root causes of China’s high debt levels, it seems certain to me that the Chinese are going to pick up the pace of credit/fiscal stimulus over the next six months in response to slowing growth and trade war uncertainties. If anything, the incentive to open the credit spigots this time around is greater than in the past because the Chinese government wants to have a fast-growing economy to gain leverage over trade negotiations with the U.S. Chart 19 (Peter)Stronger Chinese Credit Growth Bodes Well For Commodity Prices Chart 20 (Peter)The Dollar Is A Countercyclical Currency Stronger Chinese growth will boost growth in the rest of the world. Commodity prices will rise (Chart 19). As a counter-cyclical currency, the U.S. dollar will likely peak over the next month or so and then weaken in the back half of 2019 and into 2020 (Chart 20). The combination of stronger Chinese growth, higher commodity prices, and a weaker dollar will be manna from heaven for emerging markets. If a trade truce between China and the U.S. is reached, investors should move quickly to overweight EM equities. European stocks should also benefit. Looking further out, China’s economy will slow in absolute terms. In relative terms, however, Chinese growth will remain near the top of the global rankings. China has one of the most educated workforces in the world (Chart 21). Assuming that output-per-hour reaches South Korean levels by the middle of the century, Chinese real GDP would need to expand by about 6% per year over the next decade (Chart 22). That’s a lot of growth – growth that will eventually help China outgrow its debt burden. Chart 22 (Peter)China Has More Catching Up To Do Keep in mind that credit growth of 1% when the debt-to-GDP ratio is 300% yields 3% of GDP in credit stimulus, compared with only 1% of stimulus when the debt-to-GDP ratio is 100%. That does not mean that more debt is intrinsically a good thing, but it does mean that China will eventually be able to slow debt growth even if excess savings remains a problem. Structurally, Chinese and EM equities will likely outperform their developed market peers over a 3-to-5 year horizon. The P/E ratio for EM stocks is currently 4.7 percentage points below that of developed markets, which is below its long-term average (Chart 23). While EM EPS growth has lagged DM earnings growth over the past eight years, the long-term trend still favors EM (Chart 24). EM currencies will appreciate over this period, with the RMB leading the way. Chart 23 (Peter)EM Stocks: Valuations Are Attractive Chart 24 (Peter)Earnings Growth In EM Has Outpaced That Of DM Over The Long Haul Arthur: China is facing a historic choice between two scenarios. Medium- and long-term macro outcomes will impact markets differently in each case. Table 1 shows my cyclical and structural investment recommendations for each scenario. Table 1 (Arthur)Arthur’s Recommended Investment Strategy For China-Geared Financial Assets Allowing Markets to Play A Bigger Role = Lower credit growth (deleveraging), corporate restructuring, and weaker growth (Chart 25). This is bearish for growth and financial markets in the medium term but it will make Chinese stocks and the currency structural (long-term) buys. Credit/Money Boom Persists (Socialist Put) = Secular Stagnation, Inflation and Currency Depreciation: The structural outlook is downbeat but there are mini-cycles that investors could play (Chart 26). Cyclically, China-geared financial assets still remain at risk. However, lower asset prices and more stimulus in China could put a floor under asset prices later this year. Timing these mini-cycles is critical. A buy-and-hold strategy for Chinese assets will not be appropriate in this scenario. In short, capitalism is bad but socialism is worse. I hope China will pursue the first path. Caroline: Thank you both for clarifying your perspectives. Over a multi-year horizon, markets will render the ultimate judgement on whether China’s credit boom has represented a reckless misallocation of capital, or a rational policy response to an imbalance between domestic spending and income. In the meantime, we will monitor the complexion of Chinese stimulus and evidence of its global growth multiplier effect over the coming weeks and months. These will be the key variables to watch as we determine when and at what level to upgrade BCA’s cyclical outlook for China-geared assets. Can’t wait for that debate. Footnotes 1 For a detailed discussion of these issues, please see Emerging Markets Strategy Special Reports, “Misconceptions About China's Credit Excesses,” dated October 26, 2016 and “The True Meaning Of China's Great 'Savings' Wall,” dated December 20, 2017. 2 For a detailed discussion of these issues, please see Emerging Markets Strategy Special Reports, “Misconceptions About China's Credit Excesses,” dated October 26, 2016 and “The True Meaning Of China's Great 'Savings' Wall,” dated December 20, 2017. 3 For a detailed discussion of these issues, please see Emerging Markets Strategy Special Report, “China's Money Creation Redux And The RMB,” dated November 23, 2016. 4 For a discussion on the reasons behind China’s high savings rate, please see Global Investment Strategy Weekly Report, “China’s Savings Problem,” dated January 25, 2019. 5 For a detailed discussion of these issues, please see Emerging Markets Strategy Special Report, “Is Investment Constrained By Savings? Tales Of China And Brazil,” dated March 22, 2018. 6 For a detailed discussion of these issues, please see Global Investment Strategy Weekly Report, “Is There Really Too Much Government Debt In The World?” dated February 22, 2019 and “Chinese Debt: A Contrarian View,” dated April 19, 2019.

Special Report

Dear Client, Credit in China has expanded at an exponential pace, with the country’s debt-to-GDP ratio climbing from 143% to more than 250% over the last decade. The speed and scale of China’s debt surge dwarfs Japan and the U.S.’ respective credit binges in the 1980’s and 2000’s, each of which ultimately led to financial market meltdowns. Why should China’s experience be any different? Given that China has pursued a different economic model whereby the banking sector is largely state-sponsored and the currency is tightly managed by the central bank, the answer to this pressing question for global markets is the subject of spirited debate at BCA and within the investment community at large. Clients are already aware that my colleagues, Peter Berezin and Arthur Budaghyan, disagree on the macro and market ramifications of China’s decade-long credit boom. The aim of this report is to provide visibility on the root sources of the view divergence, not to reconcile the gaps. We hope these insights will help shape your own conviction about this important topic. Caroline Miller Global Strategy Feature   Caroline: Arthur, your cautious outlook towards emerging markets in general and China’s prospects in particular stems from your belief that China’s economy is dangerously addicted to credit as a growth driver. Please explain why you dismiss the more sanguine view that China’s elevated debt burden is a function of an equally unusually high household savings rate. Arthur: It is simple: When people use the word “savings,” they typically and intuitively refer to bank deposits or securities investments; but this is incorrect. Chart 1 (Arthur)No Empirical Evidence That Deposits = 'Savings' Money supply/deposits in the banking system have no relationship with the savings rate of a nation in general or households in particular (Chart 1). When households save, they do not change the amount of money supply and deposits. Hence, households’ decision to save neither alters liquidity in the banking system nor helps banks to originate loans. In fact, banks do not intermediate deposits into loans or savings into credit.1 The terms “savings” in economics does not denote an increase in the stock of money and deposits. The term “savings” in economics means the amount of goods and services produced but not consumed. When an economy produces a steel bar, it is registered as national “savings.” We cannot consume (say, eat or expense) a steel bar. Therefore, once a steel bar or any equipment is produced, economic statistics will count it as “savings.” Besides, the sole utilization of a steel bar is in capital goods and construction, and hence, it cannot be consumed. Once a steel bar is produced, both national savings and investment will rise. That is how the “savings” = “investment” identity is derived. Chart 2 (Arthur)Chinese Households Are More Leveraged Than U.S. Ones It would avoid confusion and help everyone if economists were to call it “excess production” not “excess savings.” Banks do not need “excess production” – i.e., national “savings” – to create loans. Critically, the enormous amount of bank deposits in China is not due to household “savings” but is originated by banks “out of thin air.” In fact, Chinese households are now more leveraged than U.S. ones (Chart 2). The surge of credit and money supply in China during the past 10 years has been due to animal spirits running wild among lenders and borrowers on the mainland, not its households’ “savings.” In short, the root of China’s credit bubble is not any different from Japan’s (in the 1980s), or the U.S.’ (in the 2000s) and so on. Peter: Yes, banks can create deposits “out of thin air,” as Arthur says. However, people must be willing to hold those deposits. The amount of deposits that households and businesses wish to hold reflects many things, including the interest rate paid on deposits and the overall wealth of the society. The interest rate is a function of savings. The more people save, the lower interest rates will be. And the lower interest rates are, the more demand for credit there will be (Chart 3). It’s like asking what determines how many apples are consumed. Is it how many apple trees farmers want to plant or how many apples people want to eat? The answer is both. Prices adjust so that supply equals demand. How about national wealth? To a large extent, wealth represents the accumulation of tangible capital – factories, plant and machinery, homes and office buildings: the sort of stuff that banks can use as collateral for lending. And what determines how much tangible capital a country possesses? The answer is past savings, of the exact sort Arthur is referring to: the excess of production over consumption. So this form of “economic” savings also plays an important indirect role in determining the level of bank deposits. Chart 4 (Peter)China: From Exporting Savings To Investing Domestically And Building Up Debt I think the main problem with Arthur’s argument is that he is observing an accounting identity, which is that total bank assets (mostly loans) must equal liabilities (mostly deposits and capital) in equilibrium, without fully appreciating the economic forces – savings being one of them – that produce this equilibrium. In any case, the whole question of whether deposits create savings or savings create deposits misses the point. China’s fundamental problem is that it does not consume enough of what it produces. In the days when China had a massive current account surplus, it could export its excess savings abroad (Chart 4). It can’t do that anymore, so the government has consciously chosen to spur investment spending in order to prop up employment. Since a lot of investment spending is financed through credit, debt levels have risen. It really is just that simple.   Arthur: First, neither the stock nor the flow of credit and deposits has any relevance to (1) the economic term “savings;” (2) a country’s capital stock; or (3) national wealth, contrary to what Peter claims. China’s broad money supply (M2) now stands at 190 trillion yuan, equivalent to US$28 trillion (Chart 5, top panel). It is equal to the size of broad money supply in the U.S. and the euro area combined (US$14 trillion each). Yet, China’s nominal GDP is only two-thirds the size of the U.S. Does the level of China’s wealth and capital stock justify it having broad money supply (US$28 trillion) equivalent to the U.S. and the euro area combined? Chart 5 (Arthur)“Helicopter” Money In China Second, are Chinese households and companies willing to hold all RMB deposits that banks have created “out of thin air”? The answer: not really. Without capital controls, a notable portion of these deposits would have rushed into the foreign exchange markets and caused currency depreciation. Another sign of growing reluctance to hold the yuan is that households have been swapping their RMB deposits for real assets (property) at astronomical valuations. There is a bubble in China but people are looking for reasons to justify why it is different this time. Caroline: OK, let’s get away from the term “savings,” and agree that China continues to generate a chronic surplus of production of goods and services relative to consumption, and that how China chooses to intermediate that surplus is the most market-relevant issue. Arthur, you have used the terms “money bubble” and “helicopter money” in relation to China. This implies that banks are unconstrained in their ability to make loans. Just because savings don’t equal deposits, and banks can create deposits when they make loans doesn’t mean there is no relationship between the flow of credit and the stock of deposits. Arthur: Money supply and deposits expand only when banks originate a loan or buy an asset from a non-bank. In short, both credit and money/deposits are created by commercial banks “out of thin air.” This is true for any country.2 Consider a loan transaction by a German commercial bank. When it grants a €100 loan to a borrower, two accounting entries occur on its balance sheet. On the assets side, the amount of loans, and therefore total assets, increases by €100. Simultaneously, on the liabilities side, this accounting entry creates €100 of new deposits “out of thin air” (Figure 1). Hence, new purchasing power of €100 has been created via a simple accounting entry, which otherwise would not exist. Critically, no one needed to save for this loan and money to be originated. The bank does not transfer someone else’s deposits to the borrower; it creates a new deposit when it lends. Banks also create deposits/money “out of thin air” when they buy securities from non-banks. In China, fiscal stimulus is largely financed by commercial banks – banks purchase more than 80% of government-issued bonds. This also leads to money creation. In short, when banks originate too much credit – as they have in China – they generate a money bubble. The money bubble is the mirror image of a credit bubble. Chinese banks have created 141 trillion yuan (US$21 trillion) of new money since 2009, compared with $8.25 trillion created in the U.S., euro area, and Japan combined over the same period (Chart 5, bottom panel). This is why I refer to it as “helicopter” money. Caroline: If banks need capital and liquidity to make loans, and deposits are one potential source of funds, don't these capital and liquidity constraints drive banks’ willingness and ability to lend, creating a link between the two variables? Arthur: Let me explain how mainland banks were able to circumvent those regulatory lending constraints. In 2009, they expanded their credit assets by about 30%. Even though a non-trivial portion of those loans were not paid back, banks did not recognize NPLs and instead booked large profits. By retaining a portion of those earnings, they boosted their equity, say, by 20%. As a result, the next year they were able to expand their credit assets by another 20% and so on. If banks lend and do not recognize bad loans, they can increase their equity and continue lending. With respect to liquidity, deposits are not liquidity for banks; excess reserves at the central bank are true liquidity for them. The reason why banks need to attract deposits is not to appropriate the deposits themselves, but to gain access to the excess reserves that come with them. When a person shifts her deposit from Bank A to Bank B, the former transfers a similar amount of excess reserves (liquidity) to the latter. When expanding their credit assets aggressively, banks can: (1) create more loans per one unit of excess reserves/liquidity, i.e., expand the money multiplier; and (2) borrow excess reserves/liquidity from the central bank or other banks. Chinese banks have used both channels to expand their balance sheets over the past 10 years (Chart 6). Chart 6 (Arthur)Broad Money Can Expand Without Growing Banks' Excess Reserves At The Central Bank Crucially, commercial banks create deposits, but they cannot create excess reserves (liquidity).3 The latter are issued only by central banks “out of thin air.” So, neither deposits nor excess reserves have any relevance to household or national “savings.” Caroline: Peter, Arthur argues that Chinese credit policy has been unconstrained by the traditional metrics of capital adequacy that prevail in capitalist, free-market economies. In other words, there is no connection between the availability of funds to lend via deposits in the banking system, and the pace of credit creation. Rather, the central bank has controlled the terms and volume of lending via regulation and fiat reserve provisioning. You’ve argued that credit creation has served the greater good of propping up employment via investment spending. Moreover, you posit that countries with a surplus of production over consumption will invariably experience high levels of credit creation. Our colleague, Martin Barnes, has analyzed national savings rates (as a proxy for over-production) relative to debt-GDP ratios in other countries. The relationship doesn’t look that strong elsewhere (Chart 7). Please elaborate on why you see credit growth as an inevitable policy response to the dearth of aggregate demand we observe in China? Peter: I would not say that countries with a surplus of production over consumption will invariably experience high levels of credit creation. For example, if most business investment is financed through retained earnings, you can have a lot of investment with little new debt. Debt can also result from activities not directly linked to the intermediation of savings. For instance, if you take out a mortgage to buy some land, your consumption and savings need not change, even though debt will be created. I think Arthur and I agree on this point. Thus, I am not saying that debt is always and everywhere the result of savings. I am simply pushing back against Arthur’s extremist position that debt never has anything to do with savings. Caroline: So what determines the level of debt in an economy in your view, Peter? Peter: In general, debt levels will rise if there are large imbalances between income and spending within society and/or if there are significant differences in the mix of assets people wish to hold. Think about the U.S. in the pre-financial crisis period. First, there was a surge in income inequality beginning in the early 1980s. For all intents and purposes, rich households with excess savings ended up lending their surplus income to poor households struggling to pay their bills. Overall savings did not rise, but debt levels still increased. That’s one reason why Martin’s chart doesn’t show a strong correlation between the aggregate savings rate and debt-to-GDP. Sometimes you need to look beneath the aggregate numbers to see the savings intermediation taking place. Unlike in the U.S., even poor Chinese households are net savers (Chart 8). Thus, the aggregate savings rate in China is very high4 (Chart 9). Much of these savings are funnelled to finance investment in the corporate and public sectors. This fuels debt growth. Chart 9 (Peter)Chinese Households Have More Savings Than The U.S., Europe And Japan Combined The second thing that happened in the U.S. starting in 2000 was a massive housing boom. If you bought a second home with credit, you ended up with one more asset (the house) but one more liability (the mortgage). The person who sold you the home ended up losing one asset (the house) but gaining another asset (a bigger bank deposit). The net result was both higher debt and higher bank deposits. Lending to finance asset purchases has also been a big source of debt growth in China, as it was in the U.S. before the crisis. The U.S. mortgage boom ended in tears, and so the question that we should be asking is whether the Chinese debt boom will end the same way. Arthur: We agreed not to use the term “savings,” yet Peter again refers to “savings” being funnelled into credit. As I explained above, banks do not funnel “savings” (i.e., “excess production”) into credit. China, Japan, and Germany have high “savings” rates because they produce a lot of steel, chemicals, autos, and machinery that literally cannot be consumed and, thus, are recorded as “savings.” The U.S. produces too many services that are consumed/expensed and, hence, not recorded as “savings.” That is why the U.S. has a lower “savings” rate. Chart 10 (Arthur)The Myth Of Deficient Demand In China Economic textbook discussions on “savings” and “investment” are relevant for a barter economy where banks do not exist. When this framework is applied to modern economies with banks, it generates a lot of confusion.5 Caroline: OK, so Peter argues that an imbalance between spending and income CAN be a marker for high debt levels. Arthur, please explain why you see no relationship between China’s chronic shortfall in demand and authorities’ explicit decision to support growth via credit creation. Arthur: First, China does not have deficient demand – consumer spending and capital expenditures have been growing at 10% and 9.4%, respectively, in real terms annually compounded for the past 10 years (Chart 10). The mainland economy has been suffering from excess production, not a lack of demand. China has invested a lot (Chart 11) and ended up with too much capacity to produce steel, cement, chemicals and other materials as well as machinery and industrial goods. So, China has an excess production of goods relative to firms’ and households’ underlying demand. In a market economy, these producers would become non-profitable, halt their investments, and shut down some capacity. Chart 11 (Arthur)China Has Been Over-Investing On An Unprecedented Scale In China, to keep the producers of these unwanted goods operating, the government has allowed and encouraged banks to originate loans creating new purchasing power literally “out of thin air” to purchase these goods. This has created a credit/money bubble. In a socialist system, banks do not ask debtors to repay loans and government officials are heavily involved in resource and capital allocation. China’s credit system and a growing chunk of its economy have been operating like a typical socialist system. Socialism leads to lower productivity growth for well-known reasons. With labor force growth set to turn negative, productivity is going to be the sole source of China’s potential growth rate. If the nation continues expanding this money/credit bubble to prop up zombie enterprises, its potential growth rate will fall considerably. As the potential growth rate drops, recurring stimulus will create nominal but not real growth. In short, the outcome will be stagflation. Caroline: The theoretical macro frameworks that you have both outlined make for interesting thought experiments, and spirited intellectual debate. However, investors are most concerned about the sustainability of China’s explosive credit growth, implications for the country’s growth rate, and the return on invested capital. Arthur, given your perspective on how Chinese credit policy has been designed and implemented, please outline the contours of how and when you see the music stopping, and the debt mountain crumbling. Arthur: Not every credit bubble will burst like the U.S. one did in 2008. For example, in the case of the Japanese credit bubble, there was no acute crisis. The bubble deflated gradually for about 20 years. In the cases of the U.S. (2008), Japan (1990), the euro area (2008-2014), Spain (2008-2014) and every other credit bubble, a common adjustment was a contraction in bank loans in nominal terms (Chart 12). Chart 12 (Arthur)All Credit Booms Have Been Followed By Contracting Bank Loans (I) Chart 12 (Arthur)All Credit Booms Have Been Followed By Contracting Bank Loans (II) Why do banks stop lending? The reason is that banks’ shareholders absorb the largest losses from credit booms. Given that banks are levered at least 20-to-1 at the peak of a typical credit boom, every $1 of non-performing loans leads to a $20 drop in their equity value. Bank shareholders halt the flow of credit to protect their wealth. Chart 13 (Arthur)China: Deleveraging Has Not Yet Begun In fact, credit in China is still growing at a double-digit rate, above nominal GDP growth (Chart 13). Hence, aggregate deleveraging in China has not yet begun. If banks do not curtail credit origination, the music will not stop. However, uninterrupted credit growth happens only in a socialist system where banks subsidize the economy at the expense of their shareholders. But even then, there is no free lunch. Credit origination by banks also expands the money supply as discussed above. An expanding money bubble will heighten devaluation pressure on the yuan in the long run. The enormous amount of money supply/deposits – the money bubble – in China is like “the sword of Damocles” hanging over the nation’s currency. Chinese households and businesses are becoming reluctant to hold this ballooning supply of local currency. Continuous “helicopter” money will only increase their desire to diversify their RMB deposits into foreign currencies and assets. Yet, there is an insufficient supply of foreign currency to accommodate this conversion. The nation’s current account surplus has almost vanished while the central bank carries US$3 trillion in foreign exchange reserve representing only 11% of the yuan deposits and cash in circulation (Chart 14). It is inconceivable that China can open its capital account in the foreseeable future. “Helicopter” money also discourages innovation and breeds capital misallocation, which reduces productivity growth. A combination of slowing productivity growth, and thus potential GDP, and strong money growth ultimately lead to stagflation – the dynamics endemic to socialist systems. Peter: Arthur’s answer implicitly assumes that private investment would increase if the government removed credit/fiscal stimulus. But where is the evidence for that? We had just established that the Chinese economy suffers from a lack of aggregate demand. Public-sector spending, to the extent that it increases employment and incomes, crowds in private-sector investment rather than crowding it out. Ask yourself what would have happened if China didn’t build that “bridge to nowhere.” Would those displaced construction workers have found more productive work elsewhere or would they have remained idle? The answer is almost certainly the latter. After all, the reason the Chinese government built the bridge in the first place was to increase employment in an economy that habitually struggles to consume enough of what is produces. Arthur talks about the “misallocation” of resources. But doesn’t an unemployed worker also represent a misallocation of resources? In my view, it certainly does – and one that is much more threatening to social stability than an underutilized bridge or road. If you understand the point above, you will also understand why Arthur’s comparison between Chinese banks and say, U.S. banks is misplaced. The Chinese government is the main shareholder in Chinese banks. The government cares more about social stability than anything else. There is no way it would let credit growth plunge. Moreover, as the main shareholder, the government has a strong incentive to raise the share price of Chinese banks. After all, it is difficult to have a reserve currency that rivals the U.S. dollar, as China aspires to have, if your largest banks trade like penny stocks. My guess is that the Chinese government will shut down a few small banks to “show” that it is concerned about moral hazard, but then turn around and allow the larger banks to sell their troubled loans to state-owned asset management companies on very favourable terms (similar to what happened in the early 2000s). Once investors get wind that this is about to happen, Chinese bank shares will rally like crazy. Caroline: Isn’t shuffling debt from one sector of the economy to another akin to a shell game? Wouldn’t rampant debt growth eventually cause investors to lose confidence in the currency? Peter: China has a problem with the composition of its debt, not with its total value. Debt is a problem when the borrower can’t or won’t repay the loan. Chart 15 (Peter)China Is On Course To Lose More Than 400 Million Workers I completely agree that there is too much shadow bank lending in China. There is also too much borrowing by state-owned enterprises. Ideally, the Chinese government would move all this quasi-public spending onto its own balance sheet. It would significantly raise social spending to discourage precautionary household savings. It would also adopt generous pro-natal policies — free childcare, education, government paid parental leave, and the like. The fact that the Chinese working-age population is set to shrink by 400 million by the end of the century is a huge problem (Chart 15). If the central government borrowed and spent more, state-owned companies and local governments would not have to borrow or spend as much. Banks could then increase their holding of high-quality central government bonds. Debt sustainability is only a problem if the interest rate the government faces exceeds the growth rate of the economy.6 That is manifestly not the case in China (Chart 16). And why are interest rates so low in relation to growth? Because Chinese households save so much! We simply can’t ignore the role of savings in the discussion. Chart 16 (Peter)China: High Levels Of Household Savings Have Kept Interest Rates Below The Growth Rate Of The Economy As far as the currency is concerned, if debt growth rose so much that the economy overheated and inflation soared, then yes, the yuan would plunge. But that’s not what we are talking about here. We are talking about bringing debt growth to a level that generates just enough demand to achieve something resembling full employment. No one is calling for raising debt growth beyond that point. Curbing debt growth in a demand-deficient economy, as Arthur seems to be recommending, would cause unemployment to rise. Investors would then bet that the Chinese government would try to boost net exports by engineering a currency devaluation. Capital outflows would intensify. Far from creating the conditions for a weaker yuan, fiscal/credit stimulus obviates the need for a currency depreciation. Caroline: Peter, even if we accept your argument that the counterfactual of curbing credit growth in a demand-deficient economy would be a more deflationary outcome than sustaining the government-sponsored credit growth engine, how is building bridges to nowhere a positive sum for investors? Even if this strategy maintains social stability in the interests of the CCP’s regime preservation, won’t investors eventually recoil at the retreat to socialism that Arthur outlines, reducing the appeal of holding the yuan, even if, as you both seem to agree, no apocalyptic debt crisis is at hand? In other words, isn’t two times nothing still nothing? Peter: First of all, many of these infrastructure projects may turn out to be quite useful down the road, pardon the pun. Per capita vehicle ownership in China is only one one-fifth of what it is in the United States, and one-fourth of what it is in Japan (Chart 17). A sparsely used expressway today may be a clogged one tomorrow. Chart 17 (Peter)The Automobile Ownership Rate Is Still Quite Low In China Would China really be better off if it had fewer infrastructure projects and more big screen TVs? An economy where people are always buying stuff they don’t need, with money they don’t have, to impress people they don’t like, is hardly a recipe for success. I am not sure what these references to socialism are supposed to accomplish. You want to see a real retreat to socialism? Try creating millions of unemployed workers with no jobs and no hope. All sorts of pundits decried Franklin Roosevelt’s New Deal as creeping socialism. The truth is that the New Deal took the wind out of the sails of the fledgling U.S. communist movement at the time. Arthur: I believe that Peter is confusing the structural and cyclical needs for stimulus. When an economy is in a recession – banks are shrinking their balance sheets and property prices are deflating – the authorities must undertake fiscal and credit stimulus. Chart 18 (Arthur)What Will Productivity Growth Look Like If Public Officials Allocate 55%-60% Of GDP? Credit and fiscal stimulus made sense in China in early 2009 when growth plunged. However, over the past 10 years, we have witnessed credit and property market booms of gigantic proportions. Does this economy warrant continuous stimulus? What will productivity growth look like if government bureaucrats continuously allocate 55-60% of GDP each year (Chart 18)? Caroline: Arthur and Peter, you can both argue with one another about the semantic economic definition of the term ‘savings’, the implications of chronic excess production (relative to consumption), and the root drivers of credit growth in China long past the expiry of every BCA client’s investment horizon. Clients benefit from understanding your distinct perspectives only to the extent that they inform your outlook for markets. Will each of you now please outline how you see high levels of credit in China’s economy impacting the following over a cyclical (6-12 month) and structural (3-5 year) horizon: Global growth Commodity prices China-geared financial assets Peter: Regardless of what one thinks about the root causes of China’s high debt levels, it seems certain to me that the Chinese are going to pick up the pace of credit/fiscal stimulus over the next six months in response to slowing growth and trade war uncertainties. If anything, the incentive to open the credit spigots this time around is greater than in the past because the Chinese government wants to have a fast-growing economy to gain leverage over trade negotiations with the U.S. Chart 19 (Peter)Stronger Chinese Credit Growth Bodes Well For Commodity Prices Chart 20 (Peter)The Dollar Is A Countercyclical Currency Stronger Chinese growth will boost growth in the rest of the world. Commodity prices will rise (Chart 19). As a counter-cyclical currency, the U.S. dollar will likely peak over the next month or so and then weaken in the back half of 2019 and into 2020 (Chart 20). The combination of stronger Chinese growth, higher commodity prices, and a weaker dollar will be manna from heaven for emerging markets. If a trade truce between China and the U.S. is reached, investors should move quickly to overweight EM equities. European stocks should also benefit. Looking further out, China’s economy will slow in absolute terms. In relative terms, however, Chinese growth will remain near the top of the global rankings. China has one of the most educated workforces in the world (Chart 21). Assuming that output-per-hour reaches South Korean levels by the middle of the century, Chinese real GDP would need to expand by about 6% per year over the next decade (Chart 22). That’s a lot of growth – growth that will eventually help China outgrow its debt burden. Chart 22 (Peter)China Has More Catching Up To Do Keep in mind that credit growth of 1% when the debt-to-GDP ratio is 300% yields 3% of GDP in credit stimulus, compared with only 1% of stimulus when the debt-to-GDP ratio is 100%. That does not mean that more debt is intrinsically a good thing, but it does mean that China will eventually be able to slow debt growth even if excess savings remains a problem. Structurally, Chinese and EM equities will likely outperform their developed market peers over a 3-to-5 year horizon. The P/E ratio for EM stocks is currently 4.7 percentage points below that of developed markets, which is below its long-term average (Chart 23). While EM EPS growth has lagged DM earnings growth over the past eight years, the long-term trend still favors EM (Chart 24). EM currencies will appreciate over this period, with the RMB leading the way. Chart 23 (Peter)EM Stocks: Valuations Are Attractive Chart 24 (Peter)Earnings Growth In EM Has Outpaced That Of DM Over The Long Haul Arthur: China is facing a historic choice between two scenarios. Medium- and long-term macro outcomes will impact markets differently in each case. Table 1 shows my cyclical and structural investment recommendations for each scenario. Table 1 (Arthur)Arthur’s Recommended Investment Strategy For China-Geared Financial Assets Allowing Markets to Play A Bigger Role = Lower credit growth (deleveraging), corporate restructuring, and weaker growth (Chart 25). This is bearish for growth and financial markets in the medium term but it will make Chinese stocks and the currency structural (long-term) buys. Credit/Money Boom Persists (Socialist Put) = Secular Stagnation, Inflation and Currency Depreciation: The structural outlook is downbeat but there are mini-cycles that investors could play (Chart 26). Cyclically, China-geared financial assets still remain at risk. However, lower asset prices and more stimulus in China could put a floor under asset prices later this year. Timing these mini-cycles is critical. A buy-and-hold strategy for Chinese assets will not be appropriate in this scenario. In short, capitalism is bad but socialism is worse. I hope China will pursue the first path. Caroline: Thank you both for clarifying your perspectives. Over a multi-year horizon, markets will render the ultimate judgement on whether China’s credit boom has represented a reckless misallocation of capital, or a rational policy response to an imbalance between domestic spending and income. In the meantime, we will monitor the complexion of Chinese stimulus and evidence of its global growth multiplier effect over the coming weeks and months. These will be the key variables to watch as we determine when and at what level to upgrade BCA’s cyclical outlook for China-geared assets. Can’t wait for that debate. Footnotes 1 For a detailed discussion of these issues, please see Emerging Markets Strategy Special Reports, “Misconceptions About China's Credit Excesses,” dated October 26, 2016 and “The True Meaning Of China's Great 'Savings' Wall,” dated December 20, 2017. 2 For a detailed discussion of these issues, please see Emerging Markets Strategy Special Reports, “Misconceptions About China's Credit Excesses,” dated October 26, 2016 and “The True Meaning Of China's Great 'Savings' Wall,” dated December 20, 2017. 3 For a detailed discussion of these issues, please see Emerging Markets Strategy Special Report, “China's Money Creation Redux And The RMB,” dated November 23, 2016. 4 For a discussion on the reasons behind China’s high savings rate, please see Global Investment Strategy Weekly Report, “China’s Savings Problem,” dated January 25, 2019. 5 For a detailed discussion of these issues, please see Emerging Markets Strategy Special Report, “Is Investment Constrained By Savings? Tales Of China And Brazil,” dated March 22, 2018. 6 For a detailed discussion of these issues, please see Global Investment Strategy Weekly Report, “Is There Really Too Much Government Debt In The World?” dated February 22, 2019 and “Chinese Debt: A Contrarian View,” dated April 19, 2019.   Strategy & Market Trends MacroQuant Model And Current Subjective Scores   Tactical Trades Strategic Recommendations Closed Trades

Underweight Stocks in the S&P insurance index have been mostly treading water since their collapse at the beginning of 2018, a result of reasonably solid premium growth and low catastrophe losses offsetting slowing growth in house & auto sales, the fundamental driver of insurers’ top line performance. However, we think another step down in relative performance is in the offing. House & auto sales have been in contraction for much of the past six months, which bodes ill for insurance profits that have already been struggling to keep pace with the broad market (second panel). This is largely reflected in the momentum of insurance pricing power, which has fallen into outright deflation for the first time since the post-GFC recovery (third panel). While insurers have seen a modest valuation contraction (bottom panel), the very slight discount does not offset the significant headwinds to future earnings. Bottom Line: Decelerating house & auto sales have caused insurers’ pricing power to fall off a cliff while valuations have proven, at least temporarily, more resilient; stay underweight the S&P insurance index. The ticker symbols for the stocks in this index are: BLBG: S5INSU – CB, MMC, MET, PGR, AON, PRU, AIG, AFL, TRV, ALL, WLTW, HIG, AJG, PFG, CINF, L, LNC, RE, TMK, UNM.      

Highlights In Indonesia, investors are ignoring the weakness in global growth, which is an important driver of the country’s financial markets. The Indonesian currency, equities and local currency bonds all remain vulnerable. We continue to recommend underweighting Indonesian assets for now. In Turkey, additional adjustments in the exchange rate and interest rates are unavoidable. Stay put/underweight Turkish financial markets. In the UAE, the economy is set to improve marginally this year. We recommend overweighting UAE equities and corporate spreads within their respective EM portfolios. Feature Indonesia: The Currency And Bank Stocks Are At Risk  Indonesian financial assets have benefited from the Federal Reserve’s dovish turn and corresponding fall in U.S. bond yields (Chart I-1, top panel). Moreover, the market is cheering President Joko Widodo’s lead in the presidential vote tally. Yet investors are ignoring the budding weakness in industrial metals prices, which has historically been an important driver of Indonesia’s exchange rate (Chart I-1, middle panel). Going forward, the Indonesian currency, equities and local currency bonds all remain vulnerable: Falling global growth in general and Chinese imports in particular will intensify Indonesia’s exports contraction and worsen the country’s already wide current account deficit. In turn, the latter will induce currency depreciation, which will then lead to higher interbank rates (Chart I-2). Chart I-1Global Growth Matters For Indonesian Markets Chart I-2Falling Current Account Deficit = Higher Local Rates Upward pressure on local interbank rates will cause a slowdown in domestic private loan growth.   The Indonesian central bank – Bank Indonesia (BI) – has been attempting to lower interbank rates, which have been hovering above the central bank's policy rate (Chart I-3). To achieve this, the central bank has substantially increased excess reserves in the banking system (Chart I-4). It has done so by purchasing central bank certificates from commercial banks, conducting foreign exchange swaps and providing repo lending. Chart I-3A Sign Of Liquidity Strains Chart I-4Bank Indonesia Is Injecting Liquidity   Yet by expanding banking system liquidity so aggressively, BI risks renewed currency depreciation. Like any central bank in a country with an open capital account, BI cannot expect to have full control over the exchange rate while simultaneously targeting local interest rates. The Impossibly Trinity dilemma dictates that a central bank needs to choose between controlling the two. Yet investors are ignoring the budding weakness in industrial metals prices, which has historically been an important driver of Indonesia’s exchange rate. Therefore, if BI continues to inject local currency liquidity to cap or bring down interest rates (interbank rates), the resulting excess liquidity could encourage and facilitate speculation against the rupiah. Scratching below the surface, the recent strong outperformance of Indonesian equities has been entirely due to the surge in the country’s bank share prices (Chart I-5, top panel). Remarkably, the performance of Indonesian non-financial as well as small-cap stocks has been especially dismal (Chart I-5, middle and bottom panels). This is an upshot of poor profitability among Indonesia’s non-financial listed companies (Chart I-6). Chart I-5Indonesian Bank Stocks Are The Only Outperformers Chart I-6Falling Non-Financial Corporate Profitability Furthermore, deteriorating financial health of non-financial corporates, especially small companies, will lead to higher NPLs on banks’ books. Notably, Indonesian banks are more heavily exposed to businesses than to households. As NPLs rise anew, Indonesian commercial banks will need to lift their bad-loan provisioning levels, generating a major profit relapse (Chart I-7). Importantly, Indonesian commercial banks have been boosting their profits by reducing NPL provisions since early 2018. Reversing this will materially affect their earnings. Chart I-7Indonesian Bank Share Prices Are Vulnerable Additionally, bank stocks are vulnerable due to falling net interest income margins. Moreover, their share prices are overbought and not cheap. To be clear, we are not negative on Indonesia’s structural outlook. The above-mentioned alarms are more near-to-medium terms issues. Still, foreign ownership of local currency bonds and stocks – at 38% each – are high, and could be a major source of potential outflows if the rupiah depreciates. This would cause Indonesian stocks and local currency bonds to sell off severely. Bottom Line: The global growth slowdown/commodities downturn and the U.S. dollar upturn are not yet over. Consequently, foreign flows into EM will diminish, which will be particularly negative for Indonesian financial markets. We recommend investors continue underweighting Indonesian equities and avoid Indonesian local currency bonds for now. We continue to recommend a short position in the IDR versus USD. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com Turkey’s Foreign Debt Bubble: The Worst Is Not Yet Behind Us Turkish financial assets, and the currency especially, will remain under selling pressure in the coming months. Additional adjustments in the exchange rate and interest rates - as well as in the real economy and current account balance - appear unavoidable. The key imbalance remains the gap between foreign debt obligations (FDOs) and the availability of foreign currency to meet these debt obligations. Turkey’s FDOs in 2019 are equivalent to $180 billion (Chart II-1). FDOs measure the sum of short-term claims, interest payments and amortization over the next 12 months. This consists of $15 billion in interest payments, $65 billion in debt amortization and $100 billion in maturing short-term (under one year) claims. In theory, these debt obligations can either be rolled over, or the nation should generate current account and capital account surpluses and use these surpluses to pay down FDOs. Even though the current account deficit is shrinking, it is still in a deficit of $18 billion. Net FDI inflows remain weak at US$10 billion. Hence, it appears that Turkey’s only options are either to roll over maturing foreign currency debt or to lure foreign investors into local currency assets and use the surplus in net portfolio inflows to meet these FDOs. The central bank’s foreign currency reserves excluding both commercial banks’ deposits at the Central Bank of Turkey and FX swaps now stand at $13 billion. However, due to a lack of credibility in the Turkish government’s macro policies - in addition to the ongoing deep economic recession and heightened financial market volatility - external creditors will be unwilling to roll over the debt. In fact, net portfolio flows into government debt and equities have tumbled for the same reason. Typically, when foreign funding dries up temporarily, a country can use its foreign exchange reserves to meet its FDOs. However, Turkey’s foreign exchange reserves have already plummeted to extremely low levels (Chart II-2). The central bank’s foreign currency reserves excluding both commercial banks’ deposits at the Central Bank of Turkey and FX swaps now stand at $13 billion. This is negligible compared with the $180 billion FDO figure due in 2019. Chart II-1Turkey: A Large Foreign Debt Servicing Burden Chart II-2Foreign Exchange Reserves Are Too Small   The recent plunge in the central bank’s net foreign exchange reserves excluding swaps (i.e. net international reserves) has put many pertinent metrics at record lows. In particular, net international reserves are at a precarious level relative to both total imports and external debt (Chart II-3). Finally, the net international reserves-to-broad money supply ratio has fallen to 7% (from 15% in 2014) despite the fact that the massive lira depreciation reduced the U.S. dollar measure of broad money supply (Chart II-4). Chart II-3FX Reserves Do Not Cover Imports Or External Debt Chart II-4Low Coverage Of Broad Money By International Reserves The currency will have to depreciate further and interest rates will have to move higher to shrink domestic demand/imports more. This is needed to generate a current account surplus that could be used to service FDOs, or that otherwise entices foreign creditors to be willing to roll over foreign debt or invest in Turkey. Finally, while the adjustment in the real economy is advanced, it is unlikely to be over, due to the large foreign debt bubble. Importantly, with large foreign and local currency debt obligations coming due for both companies and households - in addition to the deterioration in economic activity and higher interest rates - NPLs are bound to rise (Chart II-5). This is especially likely to occur because a lot of borrowing has been used in the property market both for construction and purchases. Notably, real estate volumes are shrinking, and prices are deflating in real terms (Chart II-6). Chart II-5NPLs Will Rise A Lot Chart II-6Turkey: Real Estate Is In Free Fall     Bottom Line: The macro adjustment in Turkey is not yet complete. The country still lacks foreign currency supply to service its enormous 2019 FDOs. Further currency depreciation and higher interest rates are required to depress domestic demand/imports and push the current account into surplus. Stay put / underweight Turkish financial markets. The authorities are becoming desperate, and the odds of capital control enforcement are not negligible. While such an outcome is not possible to forecast with any certainty or time frame, investors should consider this very real risk. Andrija Vesic, Research Analyst andrijav@bcaresearch.com Overweight UAE Equities And Corporate Bonds Over the next six to nine months, we believe both UAE equities and corporate spreads will outperform their respective emerging market (EM) benchmarks. The UAE economy is set to improve marginally this year (Chart III-1). It will benefit from expansionary fiscal policy, rising oil output, a buoyant tourism sector, a resilient banking sector and less of a drag from the real estate sector. First, sizable fiscal spending will lead to rising non-oil economic growth. The UAE’s federal budget spending for 2019 will increase by 17.3% from a year ago, much higher than the 5.5% year-on-year growth in 2018. Second, UAE oil output could increase by 15% later this year from current levels (Chart III-2). The U.S. announced on April 22 that all Iran sanction waivers will not be extended beyond the early-May expiration date. The U.S. administration also stated that it has secured pledges from Saudi Arabia and the UAE to increase their oil production in order to offset disrupted supply from Iran. Rising oil output will mitigate the negative impact of potentially lower oil prices on the UAE’s economy. Chart III-1Improving UAE Economy Chart III-2Rising Oil Output   Third, the outlook for the tourism sector is also positive. The number of tourists is set to rise as Expo 2020 approaches. The government is targeting 20 million visitors in 2020, 26% higher than last year’s levels. The UAE is building theme parks, museums, hotels and infrastructure to attract more tourists. The UAE economy is set to improve marginally this year. Fourth, the UAE’s banking sector will enjoy rising credit growth, robust profitability and improved asset quality this year. The banking system has been in consolidation mode since January 2016, with a 15% reduction in branches and a 14% drop in the number of employees. This has improved the banking sector’s profitability by cutting operating costs and increasing efficiency. The improving growth outlook will lift credit growth. The central bank’s most recent Credit Sentiment Survey suggests banks’ lending standards for both business and personal loans are loosening (Chart III-3). In addition, UAE banks enjoy large capital buffers. Despite rising non-performing loans (Chart III-4), UAE banks still reported a Tier-1 capital adequacy ratio of 17% as of December 2018. Chart III-3Credit Growth Is Likely To Increase Chart III-4Rising NPLs, But Still Large Capital Buffers   Lastly, the real estate markets in both Dubai and Abu Dhabi have suffered from oversupply (from both mushrooming supply and weaker demand) over the past several years. Property prices have already fallen over 20% in both Dubai and Abu Dhabi from their 2014 peaks (Chart III-5). Odds are high that the most dangerous phase of the property market downturn is behind us. Chart III-5Real Estate Adjustment Is Advanced In addition, the government’s efforts to attract people to stay in the country longer will somewhat offset the ongoing exodus of expatriates. Last May, the UAE introduced a new visa system that will allow investors, innovators and talented specialists in the medical, scientific, research and technical fields to stay in the country for up to 10 years. Overall, a potential bottom in property demand and restrained supply will likely make the real estate sector less of a drag on this bourse this year. Finally, the authorities are also more open to increasing the foreign ownership cap in the banking sector, albeit not up to 100%. For example, in early April, the largest UAE lender – First Abu Dhabi Bank – obtained regulatory approval to increase its foreign ownership limit to 40% from 25%. This has boosted foreign equity purchases and has supported the equity index. Bottom Line: We recommend an overweight position in UAE equities within an EM portfolio this year (Chart III-6). For fixed income investors, we recommend overweighting UAE corporate credit in an EM corporate credit portfolio. UAE corporate credit is a lower beta market and will outperform as EM corporate spreads widen (Chart III-7). Most UAE-dollar corporate bonds have been issued by banks. Banks in the UAE do not suffer from structural overhangs, and the cyclical downturn in the property market is well advanced. This is why they have been, and will remain, a lower beta sector within an EM corporate credit portfolio. Chart III-6Overweight UAE Equities Within An EM Portfolio Chart III-7UAE Corporate Credit Will Likely Outperform EM Benchmark   Ellen JingYuan He, Associate Vice President ellenj@bcaresearch.com Footnotes Equity Recommendations Fixed-Income, Credit And Currency Recommendations

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

Special Report

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.