Global

Special Report

Highlights Actively managed U.S. equity mutual funds have been hemorrhaging assets under management (AUM), with the lost AUM flowing directly to ETFs and index mutual funds. Chatter about the adverse consequences of too much passive investing is intensifying, and BCA clients are increasingly asking if a bubble is inflating in passive investing or ETFs more generally. We view passive investing as the surest cure for passive investing and do not worry that index tracking is undermining price discovery or distorting equity markets. Temporary distortions are manna from heaven for professional investors and we would like to have more of them. Active mutual fund management may not be all it’s cracked up to be, in any event. The Active Share metric, which measures the portion of a portfolio that differs from its benchmark, has been in steady decline for the last 30 years, indicating that active management practices have undergone a sea change. We have faith in ETFs’ underlying architecture and continue to recommend investing in them. They are an efficient, inexpensive and liquid way to gain market exposure and investors need not worry about getting stuck when the music stops. Feature Dear Client, The market impact of passive investing continues to be a hot topic among investors, sell-side researchers and the financial media. To contribute our view to the discussion, we are sending you a lightly edited update of a review of passive investing’s implications first published under our Global ETF Strategy banner in September 2017. We met with clients in China last week, and will be taking some time off this week, so we will not be publishing on April 29th. We will resume publication on Monday, May 6th. Best regards, Doug Peta   Over the last few years, we have received a thin but steady stream of questions from clients asking about a potential ETF bubble. We note that ETFs do not exhibit any of the characteristics delineated by economic historian Charles Kindleberger in Manias, Panics and Crashes. There is a difference between the increasingly widespread adoption of a useful innovation and a febrile spell of mass exuberance or suspension of disbelief. We have duly expressed the view in one-on-one communications with clients that ETFs shouldn’t inspire any particular worry. The related chatter about a passive investment bubble only seems to intensify, however, and we focus on it in this Special Report. We ultimately fail to see the justification for the most extreme warnings about the dangers of passive investing. Perhaps the emergence and bursting of two bubbles in rapid succession has sparked a mini-bubble in searching for bubbles among academics, investors and reporters. We do not think that the popularity of ETFs is distorting pricing mechanisms, though we would welcome a good distortion to break up the logjam of full-but-not-extreme valuations that portend tepid intermediate- and long-term balanced portfolio returns. The Active Management Exodus The causes and consequences may be a matter of debate, but the facts are clear: actively managed U.S. equity mutual funds have been losing ground to index mutual funds for two-and-a-half decades (Chart 1). Before ETFs began to boom ahead of the crisis, active equity mutual funds still managed to attract annual net inflows despite their share losses, but they have now suffered net outflows in every one of the last 12 years. Index ETF and index mutual fund inflows have amounted to nearly 90% of the active mutual funds’ outflows, with index ETFs drawing more than twice the AUM as their mutual fund counterparts (Chart 2). Chart 2Mirror Image Given the near symmetry of active mutual fund outflows and index fund inflows, it appears that an extended active-to-passive migration is well under way. The move is rational, and has helped investors at the expense of asset managers, as index funds cost considerably less than actively managed funds. (In 2017, the asset-weighted average expense ratio for actively managed and index equity mutual funds was 0.78% and 0.09%, respectively.) If mutual fund managers tend to be wealthier than their clients, the fee savings give the economy a modest boost by shifting wealth to households with a higher marginal propensity to consume. The Spoilsport Chorus What’s not to like about lower fees for the same, or better, returns?1 Plenty, as it turns out. The myriad objections to passive investing’s increasing sway boil down to three major arguments: passive investing undermines price discovery; passive investing undermines capital allocation; and passive investing is potentially anti-competitive. Price insensitivity carries the seeds of its own demise. An index-tracking investor is a price-insensitive investor, and a surfeit of passive investment could undermine equity markets’ price-discovery function. Index-trackers are free riders, living off of the active investors whose trading decisions set prices. Just as a parasite cannot live without a host, naive passive investors need price-setters to keep them safe. The passive investing naysayers’ heads are filled with images of lemmings rushing over the edge of a cliff after active investors are routed, but we are not so sure. It’s important to remember that the price an investor pays for a security2 is the major determinant of his/her long-run return, and a price-insensitive investor is all but certain to underperform a price-aware investor over time, perhaps by a material margin. Thus the cure for passive investment is passive investment; the fewer active investors participating in the markets, the greater the prospective returns accruing to active investment. Greater prospective returns will draw an increasing proportion of assets until active management is no longer likely to outperform. Then the pendulum will swing back to index investing – lather, rinse, repeat – but skilled security analysts will have a field day while their talents are underappreciated. Passive investing’s impact on markets’ capital allocation function is indirect at best. Only primary market transactions channel capital to, or from, ideas and enterprises. Secondary market transactions merely involve exchanges of capital between incumbents and new owners, and index tracking is a secondary-market function. The sell-siders that found passive investing wanting in comparison with central planning would seem to have been trying too hard to be provocative.3 The late John Bogle may have been a bit of a scold, but we’d take him over Karl Marx any day. The notion that high concentrations of ownership among passive holders could be anti-competitive strikes us as especially strained. An article published in The Atlantic a year and a half ago bore the provocative headline, “Are Index Funds Evil?” and sub-header, “A growing chorus of experts argue that they’re strangling the economy – and must be stopped.4” The article highlighted a working paper from a team of newly-minted PhDs that argued that high common ownership in the airline industry has been associated with decreased route competition and increased fares. If the same entities hold significant stakes in all of the companies in a particular industry, those entities may have an incentive to collude to restrain competition within the industry and thereby increase the size of the pie for the industry as a whole. This may be so at the airline-industry level, but as passive owners of the entire market, Vanguard, BlackRock and State Street own considerable stakes in every other industry as well, so increasing the profitability of a single portfolio segment at the expense of other portfolio segments would seem to be self-defeating, not to mention personally risky, given stiff antitrust penalties. What Makes A Bubble? Bubbles differ in their specifics, but they share several common empirical characteristics. Kindleberger homes in on the easy availability of credit and its role in enabling the euphoria that fuels temporarily self-reinforcing, albeit ultimately unsustainable, price gains. The gains generated by the headlong pursuit of short-term capital gains are the key to keeping the bubble going, but the upward price movement is halted in its tracks when credit availability slows, and prices plunge like Wile E. Coyote once it’s cut off. Neither ingredient has been a part of the ETF boom. Index ETFs are the opposite of a get-rich-quick scheme; they’re what investors buy when they decide to stop chasing after buried treasure. The easy and inexpensive availability of credit has surely contributed to elevated equity multiples (Chart 3) and narrow bond spreads (Chart 4). The instruments ETFs hold are somewhat pricey and will be vulnerable when the next recession comes, but they are not discounting euphoric expectations that cannot realistically be met. ETF sponsors do not rely on debt; launching an ETF is such a capital-light process that the field is full to bursting with several funds that amount to unfinished experiments. Without the burden of servicing debt, sponsors are free to throw their ideas up against a wall and see what sticks. Chart 3Equity Multiples Are Elevated... Chart 4... And Spreads Are Tight ETFs are not being bought on margin in any significant degree; they are not the apple of frenzied gain-chasers’ eyes. Aside from leveraged ETFs that provide a designated multiple of daily returns, pooled investment vehicles that amalgamate the performance of several securities are the antithesis of an ideal speculative instrument. Index ETFs allow an investor to obtain benchmark returns at low cost and with a minimum of fuss, and are a sane alternative to speculation. As Benjamin Graham put it, the dumb money ceases to be dumb when it acknowledges its limitations, and index investing is an explicit acknowledgement of one’s limitations. ETF Flows Are Not Coming Out Of Thin Air To the notion that “so much money is flowing into ETFs that it’s distorting prices across the board,” we say not necessarily. If the money to buy ETFs were materializing out of thin air (as it is in Tokyo and Zurich thanks to the efforts of the BoJ and the SNB), one could argue that ETF inflows are inflating multiples and narrowing spreads. But the money to purchase U.S.-listed ETFs comes almost entirely from sales of actively managed mutual funds. ETF purchases are a reallocation of existing investment capital, not new marginal investment with the potential to move markets. Just How Active Are The “Active” Outflows? Chart 5Indexing Hasn't Hijacked Equity Correlations On the subject of changes at the margin, if the capital to purchase index ETFs comes from mutual funds that are active in name only, they simply shift cash from one passive pocket to another, and don’t amount to any change at all. The professor-investors who created the Active Share metric to measure how much a portfolio deviates from its benchmark5 describe a mutual fund industry that has steadily migrated away from stock picking. By their reckoning, the share of mutual fund assets managed by closet indexers rose from 1% in 1980 to nearly 33% in 2009.6 Using the Active Share calculator at https://activeshare.info/, we find that one-third of AUM in actively-managed U.S. equity mutual funds with AUM of at least $1 billion are held by closet-indexing mutual funds (funds with Active Share of 60% or less). Our large-fund sample suggests that two-thirds of active fund AUM is truly active. The loss of even that amount of actively managed assets does not appear to have been enough to hijack internal market dynamics. If everyone became an index tracker, and all trades were trades of the entire market, correlations at the stock and sector level would go to 1. Despite ETFs’ growing muscle, and their capture of share from stock-picking funds, correlations have not consistently risen over the 2015-17 period that has witnessed a stampede from active to indexed equity funds (Chart 5). Investment Implications We do not believe that the steadily expanding investment in passive vehicles poses a threat to markets or investors. Passive vehicles offer investors the most cost-effective way to obtain market exposure and the actively managed funds they’re exchanging for index trackers have become increasingly less active as benchmark indexes have become more prominent. If the passive trend continues, and a rising share of capital is invested without regard for distinctions between companies, the ex-ante returns to active strategies will increase and investors will return to them in droves. In the meantime, if passive investing’s share reaches the tipping point, wherever it may be, fundamentally-focused investors will feast on excess returns. Active investors will clean up if passive investing ever crosses the tipping point. We do not worry that passive investing will weigh on the economy by hindering the efficient allocation of capital to the ideas with the most merit. Index tracking is confined to the secondary markets and will not consign the U.S. economy to a Soviet fate. We view the suggestion that index tracking may lead to collusion among operating companies as unfounded conjecture. Investors need not worry that ETFs are in a bubble, or that investing in passive strategies will be a drag on economic output.   Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com   Footnotes 1 In a typical year, a majority of mutual funds underperform their benchmarks. 2 Price is defined as starting real yield for bonds, and cyclically-adjusted P/E for equities. 3 “The Silent Road to Serfdom: Why Passive Investing Is Worse Than Marxism,” August 23, 2016, Sanford C. Bernstein & Co., LLC. 4    Partnoy, Frank, “Are Index Funds Evil?” The Atlantic, September 2017. 5 Cremers, K.J. Martijn and Petajisto, Antti. “How Active Is Your Fund Manager? A New Measure That Predicts Performance,” Review of Financial Studies, September 2009. 6 Petajisto, Antti. “Active Share and Mutual Fund Performance,” Financial Analysts Journal, July/August 2013.

Highlights Solid credit growth numbers from China last week suggest an emerging window for pro-cylical currency trades. However, since 2009, these currency pairs have tended to work in real time rather than with a lag. Continued muted currency action over the next few weeks will be cause for concern. Our favorite currency pairs to play U.S. dollar downside for now are the SEK, NOK and GBP. With the Aussie dollar close to the epicenter of Chinese stimulus, data down under is increasingly stabilizing. Place a limit buy on AUD/USD at 0.70. Improving global growth will eventually put downward pressure on the broad trade-weighted U.S. dollar. Meanwhile, the risk-reward profile for safe-haven currencies has been greatly augmented in this low-volatility environment. Rising net short positioning on the yen and swiss franc is making them attractive from a contrarian standpoint. Feature The unambiguous message from incoming data is that we are entering a reflationary window. Our report last week highlighted the fact that the Chinese economy is in a bottoming process.1 Since then, data out of China has come out much stronger than expected. Export growth in March surged from -21% to 14%, new yuan-denominated loans came in at 1.7 trillion RMB versus 886 billion RMB the previous month, and industrial production in March grew at 8.5% on an annual basis – the strongest print since July 2014. Retail sales were also stronger and house prices are re-inflating, suggesting construction activity will pick up steam. Historically, March data is a cleaner print compared to prior months since it evades nuances from the Chinese lunar new year. As such, these numbers are consistent with a re-acceleration in domestic demand in the Chinese economy in the coming months. As we embrace confirmation that the Chinese economy has bottomed, it will be important to monitor if this cycle plays out like those in the past. Since 2009, the evolution of the Chinese credit cycle has been an important driver of pro-cyclical currency trades. However, in recent years there appears to have been diminishing returns to these trades. Continued lack of more pronounced strength in the Australian, New Zealand, and Canadian dollar exchange rates in light of solid hard data out of China will be genuine reason for concern. Our general assessment is that while the credit impulse in China has clearly bottomed, the magnitude of the rise is unlikely to be what we saw in 2015-2016. Given this backdrop, not all pro-cyclical currency pairs are going to benefit equally. We are long the SEK, NOK, and GBP and recommend adding AUD to the list of pro-cyclical favorites. Paradoxically, the risk-reward profile for safe-haven currencies has also been greatly augmented in this low-volatility environment, but it is still too early to begin putting on currency hedges. Pro-Cyclical Trades Need Broad Dollar Weakness Chart I-1 highlights the fact that pro-cyclical currencies have had diverging performances over the evolution of the business cycle since 2009. The aftermath of the global financial crisis was most bullish for commodity currencies, with the AUD, CAD, NOK, and NZD rising around 20%-30% versus the U.S. dollar. The DXY index was roughly flat during this period, but the broad trade-weighted dollar did weaken. The biggest driver back then was rising commodity prices, driven by Chinese demand and a revaluation of these currency pairs from deeply oversold levels. The weakest currencies were the euro and yen. Chart I-2New Lows In Currency Volatility The second phase of the business cycle upswing occurred from July 2012 to February 2014, using the global Purchasing Managers’ Index from J.P. Morgan. During this phase, the best-performing currency pairs were the euro and swiss franc, and the worst was the Japanese yen. Commodity currencies fared poorly back then. The driver then was monetary policy, with European Central Bank Governor Mario Draghi’s “whatever it takes” put and the launch of “Abenomics.” Notably, the 4% weakness in the DXY did not help pro-cyclical currencies much, given commodity prices had peaked. From February 2016 to December 2017, the upswing was driven again by Chinese stimulus. Commodity prices rallied and the dollar did weaken significantly, which helped pro-cyclical currencies. However, the returns were modest compared to 2009-2010 episode. The yen was flat during the period. Finally, NOK, SEK and NZD have been winners throughout all three business cycle upswings. This time around, more evidence will need to emerge that the broad trade-weighted U.S. dollar has peaked for pro-cyclical currencies to outperform. For now, the calm in developed currency markets seems very eerie, given the flow of incoming economic data. We have highlighted in recent bulletins that most currency pairs have been narrowly trading towards the apex of very tight wedge formations, which has severely dampened volatility (Chart I-2). In the post-Bretton Woods world, it has been very rare for periods of extended currency stability to persist. We eventually expect the U.S. dollar to weaken, but we will need to closely monitor the forces that have so far been keeping a bid under it.  Liquidity, Global Growth And The Dollar Most measures of relative trends still favor the dollar. The April Markit manufacturing PMI releases this week showed that while both Japan and the euro area remain in contraction territory, the U.S. reading of 52.4 puts it solidly above the rest of the world. It is true that the momentum of this leadership has been rolling over recently, but historically such growth divergences between the U.S. and the rest of the world have generated anywhere from 10%-15% rallies in the greenback over a period of six months (Chart I-3). So far, the DXY dollar index is up 1% for the year. Repatriation flows have had a non-neglible influence on the broad trade-weighted dollar. Meanwhile, even though the Federal Reserve has paused hiking interest rates, relative policy trends still favor the greenback. The interest rate gap between the U.S. and the rest of the world pins the broad trade-weighted dollar index at 128, or 7% above current levels (Chart I-4). And even today, unless the Fed moves toward outright rate cuts, the dovish shift by other central banks around the world remains an immediate tailwind for the U.S. dollar. It will be important for yield curves to steepen globally as confirmation that other central banks are getting ahead of the curve, which should be a headwind for the dollar. Chart I-3U.S. Growth Leadership ##br##Is Rolling Over Chart I-4Interest Rate Differentials Still Favor The Dollar Internationally, dollar liquidity will need to increase significantly for the greenback to meaningfully weaken. The Fed’s tapering of asset purchases has been a net drain on dollar liquidity, despite a widening U.S. current account deficit. This is expected to end by September, but has already triggered a severe contraction in the U.S. monetary base. Our preferred measure of international liquidity is foreign central bank reserves deposited at the Fed, and this is still contracting at its worst pace in over 40 years (Chart I-5). At a minimum, an end to the balance sheet runoff will steer growth in the U.S. monetary base from deeply negative to zero. A rising external profit environment will be needed for an increase in foreign central bank reserves. Finally, data from the U.S. Treasury International Capital (TIC) system show that on a rolling 12-month basis, the U.S. continues to repatriate back a net of about $400 billion in assets, or close to 2% of GDP. Repatriation flows have had a non-neglible influence on the broad trade-weighted dollar (Chart I-6). Unless these flows roll over and begin to weaken, it will make it very difficult for the greenback to depreciate. Chart I-5International Dollar Liquidity Remains Tight Chart I-6Repatriation Flows Still Favor The Dollar Chart I-7Watch The Gold-To-Bond Ratio The bottom line is that pro-cyclical currencies will need broad dollar weakness to outperform. Our favorite indicator for gauging ultimate downside in the dollar is the gold-to-bond ratio (Chart I-7). Any sign that the balance of forces are moving away from the U.S. dollar will favor a breakout in the gold-to-bond ratio. For now, our favorite currency pairs to play U.S. dollar downside are the SEK, NOK, and GBP. What About Safe Havens? During bull markets, countries that have negative interest rates are subject to powerful outflows from carry trades. The impact of these outflows are difficult to measure, but it is fair to assume that periods of low hedging costs (which tend to correspond to periods of lower volatility) can be powerful catalysts. As markets get volatile and these trades get unwound, unhedged trades become victim to short-covering flows. With many yield curves around the world flattening, the danger is that the frequency of this short-covering implicitly rises, since long bond returns are falling short of spot rates. One winner as volatility starts to rise is the yen (Chart I-8). Investors should consider initiating small short USD/JPY and USD/CHF positions in the coming weeks as a portfolio hedge. Back in late 2016, global growth was soft, the yen was very cheap and everyone was short the currency on the back of a dovish shift by the Bank of Japan. Having recently introduced yield curve control (YCC), the market was grappling with the dovish implications for the currency, arguably the most significant change in monetary policy by any central bank at the time in several years. Given that backdrop, the yen strengthened by circa 10% from December 2016 to mid-2017, even as equity markets remained resilient. When the equity market drawdown finally arrived in early 2018, it carried the final legs of the yen rally. Dollar weakness was a significant reason for yen strength given global growth was accelerating, a negative for the counter-cyclical dollar. But with a net international investment position of almost 60% of GDP, and yearly income receipts of almost 4% of GDP, any volatility in markets could lead to powerful repatriation flows back to Japan. Chart I-9The Consumption Tax Hike Will Hurt Japanese Growth We expect the BoJ to remain on hold at next week’s policy meeting, but the incentive for the central bank to act preemptively this time around is getting stronger. The starting point is that the consumption tax hike, scheduled for October this year, will be disastrous for the economy. Since the late 1990s, every time the consumption tax has been hiked, the economy has slumped by an average of over 1.3% in subsequent quarters. For an economy with a potential growth rate of just 0.5-1%, this is a highly unpalatable outcome (Chart I-9). More importantly, similar to past episodes, the consumption tax is being hiked at a time when the economy is slowing. This week’s data show that exports continued to contract for the month of March. Machine tool orders, a good proxy for Japanese machinery sales, are still falling by almost 30% year-on-year. The Japanese PMI remains below the 50 boom/bust line, even though it has ticked marginally higher in April. Both household and business confidence are falling. The Economy Watcher’s Survey is currently at 44.8, well below the 50 boom/bust line and the lowest reading since 2016. In its April regional outlook, the BoJ downgraded most of the prefectures in Japan, with only Hokkaido receiving an upgrade in the aftermath of the earthquake. As domestic deflationary pressures intensify, this should nudge the BoJ towards more stimulus. This also raises the probability that the government defers the consumption tax hike. However, the yen could benefit from any short-covering rallies in the interim. We expect the BoJ to remain on hold at next week’s policy meeting, but the incentive for the central bank to act preemptively this time around is getting stronger. Bottom Line: The risk-reward profile for safe-haven currencies has been greatly augmented in this low-volatility environment. The rise in net short positioning on the yen and Swiss franc is becoming attractive from a contrarian standpoint. Investors should consider initiating short USD/JPY and short USD/CHF positions in the coming weeks as a hedge. Place A Limit-Buy On AUD/USD At 0.70 Data out of Australia are showing tentative signs of a bottom. This week’s important jobs report showed that the economy added 25,700 jobs, more than double the consensus forecast. Importantly, this was driven by full-time jobs, with a net gain of 48,300. And despite the participation rate ticking higher, unemployment stayed near a six-year low at 5%. Admittedly, the most recent Reserve Bank of Australia minutes showed there was discussion about rate cuts, but this could change if the economy begins to benefit from an acceleration in Chinese growth. Outright short AUD bets are at risk from either upside surprises in global growth or simply the forces of mean reversion. For more than two decades, the Australian dollar has tended to be mostly driven by external conditions, especially the commodity cycle. But for the first time in several years, domestic factors have joined in to exert powerful downward pressure on the currency. The Australian Prudential Regulation Authority (APRA) succeeded in its mission to deflate the overvalued housing market, and with house prices deflating by over 5% year-on-year, Australia may already be far along its adjustment path, especially vis-à-vis its antipodean counterpart (Chart I-10). In terms of currency performance, a lot of the bad news already appears priced in to the Australian dollar, which is down 12% from its 2018 peak and 35% from its 2011 peak. This suggests outright short AUD bets are at risk from either upside surprises in global growth or simply the forces of mean reversion (Chart I-11). We are already long the Aussie dollar versus the kiwi and suggest placing a limit-buy on AUD/USD at 0.7. Chart I-10The Aussie Housing Market Has Already Adjusted Chart I-11Chinese Growth Will Benefit The Aussie Dollar Chart I-12LNG Exports Will Benefit The Aussie Dollar Finally, the AUD/USD cross will benefit from rising terms-of-trade. Iron ore prices are already surging, reflecting supply-related issues but also rising demand in China. Meanwhile, Beijing’s clear environmental push has lifted the share of liquefied natural gas in Australia’s export mix (Chart I-12). Given that eliminating pollution is a strategic goal in China, this will be a multi-year tailwind. As the market becomes more liberalized and long-term contracts are revised to reflect higher spot prices, the Aussie dollar will get a boost.   Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Weekly Report, titled “Reading The Tea Leaves From China,” dated April 12, 2019, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. suggest a slower pace of growth: The preliminary U. of Mich. consumer sentiment index fell to 96.9 in April. The NY empire state manufacturing index surprised to the upside, coming in at 10.1 in April. Industrial production contracted by 0.1% month-on-month in March. Trade balance came in at a lower-than-expected deficit of $49.4B in February. Retail sales increased by 1.6% month-on-month in March. Preliminary April Markit composite PMI fell to 52.8; manufacturing component and services component fell to 52.4 and 52.9, respectively. DXY index edged up by 0.35% this week. The Fed’s Beige Book was released on Wednesday, summarizing that economic activity expanded at a slight-to-moderate pace in March and early April, with some states showing more signs of relative strength. The Book suggests that going forward, a similarly muted pace of growth should be anticipated for the coming months. Report Links: Not Out Of The Woods Yet - April 5, 2019 Tug OF War, With Gold As Umpire - March 29, 2019 Into A Transition Phase - March 8, 2019 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area remain soft: Industrial production came in at -0.3% year-on-year in February, outperforming expectations. April ZEW economic sentiment index improved to 4.5 in euro area. The German ZEW current conditions component fell to 5.5, while sentiment improved to 3.1 nonetheless. The current account balance fell to €26.8B, while trade balance increased to €19.5B in February. March headline inflation and core inflation were unchanged at 1.4% and 0.8% year-on-year, respectively. The euro area April composite PMI fell to 51.3; the services component fell to 52.5; the manufacturing component increased to 47.5. German composite PMI increased to 52.1; manufacturing and services components increased to 44.5 and 55.6, respectively. French composite PMI increased to 50; manufacturing component fell to 49.6; services component increased to 50.5. EUR/USD fell by 0.34% this week. As the Chinese economy bottoms, this should benefit European exports and the euro. Report Links: Reading The Tea Leaves From China - April 12, 2019 Into A Transition Phase - March 8, 2019 A Contrarian Bet On The Euro - March 1, 2019 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been neutral: The adjusted trade balance decreased, coming in at a ¥177.8 billion deficit in March. Exports contracted by 2.4% year-on-year, while imports grew by 1.1% year-on-year. Industrial production fell by 1.1% year-on-year in February. The preliminary Nikkei manufacturing PMI improved to 49.5 in April. USD/JPY has been trading flat this week. During the most recent IMF meeting, global finance chiefs have warned that global growth uncertainties remain at a high level. With currency volatility at record lows, any flight to safety could support safe-haven currencies like the yen. Report Links: Tug OF War, With Gold As Umpire - March 29, 2019 A Trader’s Guide To The Yen - March 15, 2019 Balance Of Payments Across The G10 - February 15, 2019 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. have been mostly positive: Rightmove house price index slightly improved to -0.1% year-on-year in April.  On the labor market front, 179K jobs were created in February; ILO unemployment rate was unchanged at 3.9%; average weekly earnings came in line at 3.5% year-on-year.  On the inflation front, headline inflation and core inflation were unchanged at 1.9% and 1.8% year-on-year, respectively, underperforming expectations. Retail sales came in at 6.7% year-on-year in March, surprising to the upside. GBP/USD fell by 0.5% this week. With Brexit being kicked down the road, the volatility of sterling has dropped, and attention is moving towards U.K. fundamentals. Economic surprises in the U.K. relative to both the U.S. and euro area are soaring. This will put a bid under sterling. Report Links: Not Out Of The Woods Yet - April 5, 2019 A Trader’s Guide To The Yen - March 15, 2019 Balance Of Payments Across The G10 - February 15, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 The labor market in Australia remains robust: Westpac leading index increased by 0.19% month-on-month in March. 25.7K jobs were created in total in March, with 48.3K new full-time jobs and a loss of 22.6K part-time jobs. The participation rate increased to 65.7% in March, slightly higher than expected which nudged the unemployment rate to 5%, in line with expectations. AUD/USD appreciated by 0.7% this week, now approaching 0.72. The RBA published its meeting minutes on Tuesday. The minutes stated that the Australian dollar is still near its recent lower end. However, the strength in commodity prices and improving trade terms are supporting the currency. Report Links: Not Out Of The Woods Yet - April 5, 2019 Into A Transition Phase - March 8, 2019 Balance Of Payments Across The G10 - February 15, 2019 New Zealand Dollar Chart II-11NZD Technicals 1   Chart II-12NZD Technicals 2   Recent data in New Zealand are slowing: Q1 inflation fell to 1.5% year-on-year, underperforming expectations. NZD/USD fell by 0.8% this week. The relative underperformance of New Zealand growth could further weaken the Kiwi on a cyclical basis. Our long AUD/NZD position is now 1.6% in the money. Report Links: Not Out Of The Woods Yet - April 5, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been mostly positive: The Teranet/National Bank HPI fell to 1.5% year-on-year in March. Existing home sales in March grew by 0.9% month-on-month, higher than the previous reading of -9.1% while still lower than the expected 2%. Trade balance came in at a smaller deficit of 2.9 billion CAD. Headline inflation and core inflation climbed to 1.9% and 1.6% year-on-year respectively. The ADP number of new jobs created fell to 13.2K in March. Retail sales increased by 0.8% month-on-month in February, outperforming expectations. USD/CAD fell by 0.3% this week. The spring 2019 BoC Business Outlook Survey was released on Monday. It’s worth mentioning that the Business Outlook Survey Indicator fell from a strongly positive level in the winter survey to slightly negative, implying the softening in recent business sentiment. Report Links: A Shifting Landscape For Petrocurrencies - March 22, 2019 Into A Transition Phase - March 8, 2019 Balance Of Payments Across The G10 - February 15, 2019 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland have been positive: Producer and import prices came in at -0.2% year-on-year in March, higher than the previous reading of -0.7%. Trade balance increased to a surplus of 3.2 billion CHF in March. Exports increased to 21 billion CHF, and imports increased to 17.9 billion CHF. Swiss watch exports increased by 4.4% year-on-year in March. USD/CHF rose by 1% this week. The global growth stabilization and improving sentiment in the euro area are offsetting the attractiveness of the safe-haven franc. We are long EUR/CHF for a 1% profit. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Waiting For A Real Deal - December 7, 2018 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 There is little data from Norway this week: Trade balance in March fell to 13.9 billion NOK. USD/NOK fell after the spike overnight, returning flat this week. The Norwegian krone is still trading at around one sigma band below its fair value, while the economic activity is improving with rising oil prices. Our long NOK/SEK position is now at a 3.6% profit. Report Links: A Shifting Landscape For Petrocurrencies - March 22, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been negative: The unemployment rate increased to 6.7% in March. USD/SEK appreciated by 0.2% this week. Like the Norwegian krone, the Swedish krona is undervalued, trading at a large discount to its fair value. We remain overweight the SEK, which will benefit from a bottoming in global growth. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Global Liquidity Trends Support The Dollar, But... - January 25, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Chinese credit origination surpassed expectations in March. Credit growth is now clearly trending higher, and the latest data suggest that economic activity is rebounding. This bodes well for global growth. The conventional wisdom is that China’s releveraging efforts represent “short-term gain for long-term pain.” We disagree. For the most part, Chinese releveraging is inevitable, desirable, and sustainable. Credit growth is inevitable because rising debt is necessary for transforming the country’s copious savings into fixed-asset investment. It is desirable for ensuring that GDP growth stays close to trend. It is broadly sustainable because the interest rate at which the government and much of the private sector are able to borrow is well below the economy’s growth rate. In fact, under a plausible set of assumptions, faster credit growth in China could lead to a lower debt-to-GDP ratio. Stronger global growth later this year should weaken the U.S. dollar. We are closing our long DXY trade for a carry-adjusted gain of 16.4% and exiting our long USD/CNY trade for a loss of 3.1%. We are also taking profits on our short AUD/CAD, short EUR/CAD, and short EUR/RUB trades of 1.6%, 3.9%, and 8.6%, respectively, and initiating two new currency trades: short USD/RUB and long EUR/JPY. The combination of a weaker dollar and faster Chinese growth should benefit EM and European stocks. Gold hit our limit buy order of $1275/ounce and we are now long the yellow metal. Feature A Blockbuster Month For Chinese Credit Growth After turning cautious for about six months, we moved back to being bullish on global equities in late December. We also sold our put on the EEM ETF on January 3rd for a gain of 104% in anticipation of a wave of Chinese credit stimulus. Credit growth blew past expectations in January, but surprised on the downside in February. This made the March release particularly important. In the end, the March data did not disappoint those who were hoping for a solid reading. New CNY loans rose by RMB 1690 billion, above Bloomberg consensus estimates of RMB 1250 billion. Our adjusted aggregate financing measure, which excludes a number of items such as equity financing but includes local government bond issuance, rose by 12.3% year-over-year, up from 11.6% in February (Chart 1). China’s credit impulse leads the import component of its manufacturing PMI (Chart 2). The credit impulse bottomed in November 2018, which should feed into higher imports over the coming months. This week’s release of better-than-expected data on industrial production, retail sales, and housing activity all suggest that the rebound in Chinese growth is already afoot. Chart 1Chinese Credit Growth Is Rebounding... Chart 2...Which Should Bode Well For Global Exports To China   Short-Term Gain For Long-Term Pain? At times like these, the bears are always ready with their standby argument: Sure, China may be stimulating, but all that credit growth will just make the debt bubble even bigger. Once the bubble bursts, there will be hell to pay. Long-term investors should steer clear of any growth-sensitive assets. It is a seductive argument. But it is wrong. Chinese releveraging is: 1) inevitable; 2) desirable; and 3) sustainable. The fundamental macroeconomic problem that China faces is that it consumes too little of what it produces. 1. Chinese Debt Growth Is Inevitable The fundamental macroeconomic problem that China faces is that it consumes too little of what it produces. The result is a national savings rate of 45%, by far the highest of any major economy (Chart 3). Chart 3China Still Saving A Lot Chart 4From Exporting Savings To Investing Domestically And Building Up Debt   There was a time when China was able to export a large part of its excess production. Its current account surplus reached nearly 10% of GDP in 2007. As its economy has grown in relation to the rest of the world, running massive trade surpluses has become more difficult. This is especially true today, when the country is being targeted by the Trump administration and much of the international community for alleged unfair trade practices. As China’s ability to churn out large current account surpluses declined, the government moved to Plan B: propping up growth by recycling the country’s copious savings into fixed-asset investment. This process saw households park their savings in banks and other financial institutions which, in turn, lent the money out to companies and local governments in order to finance various investment projects. Not surprisingly, debt levels exploded higher (Chart 4). As China’s population ages and more workers leave the labor force, savings will decline. However, this is likely to be a slow process. In the meantime, further debt growth is inevitable. 2. Chinese Debt Growth Is Desirable In an ideal world, Chinese households would consume more of their incomes, leaving only enough savings to finance high-quality private and public investment projects. That is not the world we are living in. In a far-from-ideal world, we need to think about second-best solutions. Yes, a sizable share of Chinese investment spending goes towards projects of dubious value. Yet, the same could have been said about Japan’s fabled “bridges to nowhere.” One may regard the construction of a seldom-used bridge as a misallocation of capital. But what is the counterfactual? If the bridge had not been built, would the workers have found productive work? If not, then there also would have been a misallocation of capital – human capital – which is arguably a much more serious problem. In any case, keep in mind that the rate of return on private investment depends on the state of the economy. If an economy is suffering from chronic lack of demand, only the most worthwhile projects will be undertaken. As the economic outlook improves, the set of viable projects will expand. It is only when all excess private-sector savings have been depleted, and interest rates are rising, that public spending starts to crowd out private investment. 3. Chinese Debt Growth Is Sustainable Even if one accepts the proposition that China needs continued debt growth to maintain full employment, is it still possible that all this additional debt will push the economy into a full-blown debt crisis? Most self-professed “serious-minded” observers would say yes. But then again, many of these same observers were predicting that Japan was heading for a debt crisis when government debt reached 100% of GDP in the late 1990s. Today, Japan’s government debt-to-GDP ratio stands at about 240% of GDP, and yet interest rates remain at rock-bottom levels. China will avoid a debt crisis for the same reason Japan has been able to avoid one. Much of China’s debt stock is composed of state-owned enterprise, local government, and other forms of quasi-public sector debt. Credit policy in China is often indistinguishable from fiscal policy. Given the abundant supply of savings in the economy, most of this debt can be internally financed at fairly low interest rates. The standard equation for government debt dynamics says that the change in the debt-to-GDP ratio, D/Y, can be expressed as:1 G - T is the primary budget deficit, r  is the borrowing rate, and g is the growth rate of the economy (it is irrelevant whether r and g are defined in nominal or real terms, as long as they are both expressed the same way). China will avoid a debt crisis for the same reason Japan has been able to avoid one. The Chinese 10-year government bond yield is currently four percentage points below projected GDP growth over the next decade, which is one of the biggest gaps among the major economies (Chart 5). Arithmetically, this means that China can have as large a primary fiscal deficit as it wants. As long as r remains below g, the debt-to-GDP ratio will converge to a stable level. Chart 6 shows this point analytically. In fact, it is possible that a permanently larger budget deficit could lead to a decline in the equilibrium debt-to-GDP ratio. How could that be? The answer is revealed by the equation above. If the debt-to-GDP ratio is fairly high to begin with and an increase in the primary budget deficit leads to higher inflation (and hence, lower real rates and/or faster nominal GDP growth), this could more than fully counteract the increase in the deficit. Chart 7Stronger Growth Coincided With Accelerating Inflation And Lower Real Rates This is not just a theoretical curiosity. Historically, Chinese inflation has risen while real rates have fallen whenever GDP growth has accelerated (Chart 7). Given China’s high debt levels, even a modest amount of additional inflation could put significant downward pressure on the debt-to-GDP ratio.2  Of course, all this is predicated on the assumption that faster credit growth will not cause interest rates to rise above the growth rate of the economy. For the portion of China’s debt stock that is either directly or indirectly backstopped by the central government, this seems like a safe assumption. After all, if credit/fiscal stimulus is simply being undertaken in response to inadequate demand, there is no need for policymakers to hike rates. Things get trickier when we look at private debt. In the past, the government has encouraged state-owned banks to roll over souring loans for fear that a wave of defaults would undermine the economy and endanger social stability. More recently, however, policymakers have been backing away from this strategy due to the well-founded view that it encourages moral hazard. Faster growth in China in the second half of this year will lift Chinese imports. This will be welcome news for the rest of the world. We expect the authorities to continue taking steps to instill market discipline by allowing failing firms to, well, fail. Realistically, however, the transition to a full market-based economy will take quite a bit of time. In the interim, the government will keep cutting taxes and increasing on-budget spending in order to ensure that any decline in employment among failing firms is offset by employment growth elsewhere. In such an environment, neither a debt crisis nor a deep economic slowdown appear likely. Investment Conclusions Faster growth in China in the second half of this year will lift Chinese imports. This will be welcome news for the rest of the world. Chart 9Germany Welcomes The Upturn In Chinese Credit Growth While the U.S. will benefit from a revival in Chinese growth, Europe will gain even more (Chart 8). Germany, in particular, should see a pronounced acceleration in growth. China’s credit impulse leads Chinese automobile spending which, in turn, reliably leads euro area automobile exports, as well as overall exports (Chart 9). The recent rebound in the expectations component of the German ZEW index, as well as in the manufacturing output component of the April flash PMI, suggests that green shoots are starting to sprout (Chart 10). Italy should also benefit from the steep drop in bond yields since last October (Chart 11). Italian industrial production strongly surprised to the upside in February, suggesting that the euro area’s third biggest economy may have finally turned the corner. Chart 10Tentative Green Shoots Out Of Germany Chart 11Italy: The Drop In Bond Yields Should Boost The EconomyThe ECB will not hike rates this year even if growth shifts into higher gear, but the market will probably price in a bit more monetary tightening in 2020 and 2021. This should help lift the euro. We recommend that investors position themselves for this by going long EUR/JPY. Relatedly, we are closing our short EUR/CAD trade for a gain of 3.9%.   The U.S. dollar tends to be a countercyclical currency, meaning that it moves in the opposite direction of the global business cycle (Chart 12). This countercyclicality stems from the fact that the U.S. is more geared towards services than manufacturing compared with most other economies (Chart 13). As such, when global growth accelerates, capital tends to flow from the U.S. to the rest of the world, translating into more demand for foreign currency and less demand for dollars. Chart 12The Dollar Is A Countercyclical Currency Chart 13The U.S. Is A Low-Beta Play On Global Growth A “patient” Fed and the prospect of stronger global growth in the second half of this year are bearish for the dollar. As such, we are closing our long DXY trade for a carry-adjusted gain of 16.4% and exiting our long USD/CNY trade for a loss of 3.1%. We are also closing our short AUD/CAD trade for a gain of 1.6%. Faster Chinese growth will boost metal prices, which is bullish for the Aussie dollar. Lastly, we are switching our short EUR/RUB trade (which is currently up 8.6%) into a short USD/RUB trade. A weaker greenback and stronger global growth will be manna from heaven for international stocks, especially when priced in U.S. dollars. Investors should prepare to move European and EM equities to overweight within a global equity portfolio during the coming weeks. A “patient” Fed and the prospect of stronger global growth in the second half of this year are bearish for the dollar. We are less keen on upgrading Japanese equities. While Japanese exporters will benefit from stronger Chinese growth, the domestic economy will be weighed down by the upcoming hike in the sales tax, which is slated to take place in October. Moreover, the yen is likely to experience headwinds as global bond yields rise in relation to JGB yields. Investors contemplating buying Japanese stocks should hedge any currency risk. Finally, the price of gold fell to $1275/ounce earlier this week, triggering our buy order. With the Fed on pause, the U.S. economy starting to overheat, and the dollar likely to trend lower, bullion could shine over the coming months.   Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Footnotes 1      Please see Global Investment Strategy Weekly Report, “Is There Really Too Much Government Debt In The World?” dated February 22, 2019, for a fuller discussion of this debt sustainability equation. Strategy & Market Trends MacroQuant Model And Current Subjective Scores Tactical Trades Strategic Recommendations Closed Trades

Special Report

Dear Client, This Special Report is the full transcript and slides of a keynote presentation I recently gave to the Sovereign Investor Institute in London titled: 'The Biggest Risks To The Global Economy Are…' The short presentation pulls together several concepts and observations which identify the ‘weak links’ in the global economy. Therefore, the presentation should serve as a useful summary of the global economy’s current vulnerabilities. The report then explains how each of the risks translates into a European investment context. I hope you find it insightful. Best regards, Dhaval Joshi, Chief European Investment Strategist Feature Full Transcript And Slides Good morning Thank you for inviting me to give today’s keynote presentation under the title: ‘The Biggest Risks To The Global Economy Are…’ (Slide 1). I will not discuss all the risks out there, but the four risks that I will present are the ones that I think are the most significant. And the biggest of these four risks I will leave to the end. So let’s begin. Risk 1 is China’s Credit Cycle (Slide 2). You can see this very clearly in this slide (Slide 3) which shows the short-term accelerations and decelerations in credit within the world’s three largest economies – Europe, the United States, and China. In essence, it is showing how much new credit was created in the last six months compared with the preceding six months. Was it more credit creation or was it less, and how much more or less? Everything is in dollars to allow a fair comparison. Now look at the red line. The red line is China. Just ten years ago, China’s credit cycle was irrelevant. It simply didn’t matter. But after the GFC, China’s short-term credit expansions and contractions suddenly became as large as those in Europe and the U.S. More recently, China’s cycle is dwarfing the others, so now it is the European and the U.S. credit cycles that are irrelevant! This means that whenever China’s short-term credit cycle turns down, as it did in late 2015, early 2017, and 2018, the global economy feels a chill. The point is that this short-term cycle is a near-perfect oscillator. Down-oscillations will occur every eighteen months or so, and any of them has the potential to turn nasty. Though we are currently in an up-oscillation, the next down-oscillation is due later this year. And I predict that it will pose a big risk to the global economy. Risk 2 is Trade Imbalances (Slide 4). This slide (Slide 5) has a mischievous title ‘Where President Trump Is Right About Europe’. The red line shows where the president is absolutely right: Europe is running a massive – a record-high – trade surplus with the United States. It is an undeniable fact. But the president is wrong about the underlying cause. The underlying cause is not unfair trade practices or tariffs, the underlying cause is the other line, the blue line, which shows the divergent monetary policies of the ECB and the Fed. The trade imbalance and monetary policy divergence are moving together tick for tick, and the transmission mechanism is of course the exchange rate. The divergent monetary policies have depressed the euro, and a depressed euro obviously makes German cars cheaper for American consumers. That is the reason that the president is seeing so many BMWs driving down Fifth Avenue! My point is that these record-high imbalances are being used to justify economic nationalism – retaliatory tariffs, restricted trade, and potentially all-out trade wars. Alternatively, this chart suggests that the imbalances would correct with large-scale movements of exchange rates. But to me, either of these options poses a big risk to the global economy. Risk 3 Is Technological Disruption (Slide 6). To understand why, I want to introduce you to a concept known as Moravec’s Paradox (Slide 7). A professor of robotics, Hans Moravec, noticed something odd. He realized that things that we find very hard are actually very easy for AI. Things like complex mathematics, speaking multiple languages, or advance pattern recognition. Typically, as few people have these skills, they are well-paid skills. Whereas things that we find very easy are incredibly difficult for AI. Things like human movement and recognizing, and responding to, emotional signals. Typically, as everybody has these skills, they are low-paid skills.  Moravec’s Paradox means that the current wave of technological progress is much more disruptive than previous waves. The steam engine destroyed low-paid jobs, forcing workers up the income ladder. But the current wave of technology, led by AI, is destroying well-paid jobs forcing workers down the income ladder. You can see it in the data. While job creation in most major economies is on the face of it very strong, just look at what type of jobs are being created (Slide 8). Food delivery, bar work, care work and social work. Now you’ll agree that this is not highly paid work with career prospects!  In essence, the current wave of technology is revealing a huge misallocation of capital. You might have invested huge amounts of time and money in say, becoming a linguist. Only to find that AI can translate languages much better than you – and your employment opportunities are limited to lower-income work. Well that misallocation of capital is very disruptive.  In my opinion, it’s one of the main reasons why even though economies are growing and unemployment is very low, people don’t feel good. Making them susceptible to simplistic fixes such as ‘take back control’ and economic nationalism. My point is that the current wave of AI-led job disruption has much further to run, and the populist backlash will remain a big risk to the global economy. But now I want to turn to what I believe is the biggest risk of all. Risk 4 Is Higher Bond Yields (Slide 9). Most people believe that economic downturns cause financial market downturns. But the truth is the complete opposite: the causality almost always runs the other way! In the vast majority of cases, it is financial market imbalances and mispricing that cause economic downturns and crises. Take the last three economic downturns – in 2001, in 2008 and in 2011. They all had their roots in financial mispricing – the dot com bubble, the U.S. mortgage market, and euro area sovereign debt. Likewise for the Great Depression in the 30s, Japan’s recession in the early 90s. I could go on. You get the point… What is the financial vulnerability today that could cause an economic downturn? (Slide 10) The answer is that the very rich valuation of equities and other risk-assets is highly sensitive to bond yields. Which means that substantially higher bond yields pose a very big risk to the global economy. You see, at very low bond yields, the bond price can no longer go up much but it can go down massively (Slide 11). The latest advances in financial theory now conclusively show that this unattractive ‘negative’ asymmetry is what defines ‘risk’ for investors. The crucial point is that at low bond yields, bonds become as risky, or more risky, than equities (Slide 12). And this necessarily means that equities no longer need to deliver a superior return, a risk-premium, over the low bond yield (Slide 13). As bond yields decline this means equity valuations get an exponential boost because both components of the equity’s required return – the risk-free component and the risk-premium component – are collapsing simultaneously (Slide 14). But if bond yields rise substantially, the process would go into vicious reverse and equity valuations would fall off a cliff. Other risk-assets too, and bear in mind that if we include real estate – as we should – global risk-assets are worth $400 trillion, five times the size of the global economy!   Our research shows that the point of vulnerability is if the global 10-year bond yield approaches 2 percent, which is about 50 basis points above where it stands right now. And that, to me, is by far the biggest risk to the global economy. So to summarise, the biggest risks to the global economy are: China’s credit cycle; trade imbalances and technological disruption and their associated populist backlash; and the biggest risk is higher bond yields (Slide 15). In the near future I think alarm bells should start to ring if China’s credit cycle has tipped into a down-oscillation and/or the global 10-year bond yield is 50 bps higher. Don’t worry, the alarm bells are not ringing right now but they might be later this year. Finally, given the title you gave me, this presentation has necessarily focussed on the key risks. But I don’t want you to get too negative. I also have another presentation called ‘The Biggest Positives For The Global Economy Are…’ And for balance, I hope you invite me to present that next time! Thank you. How Do The Risks Translate Into A European Investment Context? Risk 1: China’s Credit Cycle, is highly relevant to European investors, for two reasons. First, the European economy is very open, meaning that exports make a substantial contribution to GDP growth. This is especially true in Europe’s engine economy, Germany, but it is also important for other major economies like Sweden. And it is evidenced in large trade surpluses as, for example, illustrated in Slide 5. Therefore, whenever China’s credit cycle enters a down-oscillation, as it did last year, Germany cannot escape the nasty chill coming through its all-important net export channel. Second, the European equity market is over-exposed to global growth sensitive sectors and companies – specifically, Industrials, Materials, and Financials. These sectors tend to have a very high operational gearing to global growth. Meaning that a small change in global growth has a disproportionate effect on these companies’ profits and share price performance. The upshot is that in a credit cycle up-oscillation, Europe’s global-growth sensitive stock markets and sectors benefit from a sharp burst of outperformance. The opposite applies in a credit cycle down-oscillation. It follows that if China’s credit cycle is due to tip into a down-oscillation later this year, it would be time to close our successful relative overweighting to European equities and to the global growth sensitive cyclical sectors. Risk 2: Trade Imbalances, is also highly relevant to European investors, for the obvious reason that European economies – especially Germany – are running huge trade surpluses. This puts these economies squarely in the cross-hairs of a retaliatory salvo involving tariffs, trade barriers, or worse, an all-out trade war. Clearly, Europe’s ‘exporting champions’ are the most vulnerable to this risk. The issue is important for the exchange rate too. We showed conclusively that Europe’s trade imbalance is the consequence of the depressed euro. It follows that another way to correct this imbalance is via a stronger euro. In this sense, the fundamentals imply euro upside from here. Risk 3: Technological Disruption, manifests through disruption in the jobs market, the lack of feel good, and the ensuing backlash leading to populism and nationalism. This is particularly relevant to Europe because its collection of nations, each with its own political processes, provides more scope for a political tail-event. A lull in the major political-event cycle is a good thing for Europe. In this regard, the upcoming EU parliamentary elections is not a big risk given the EU parliament’s inability, by itself, to drive policy. The risk increases approaching a meaningful political event, and this includes the date of Brexit. Therefore, this risk is likely to rise somewhat towards the end of the year. Risk 4: Higher Bond Yields, is clearly very relevant to Europe because many of the core euro area bond yields are at their lower bound. This means that the negative asymmetry of returns has its maximum impact on, for example, German bunds. It follows that German bunds are a sell in the near-term. Nevertheless, the upside to yields is ultimately limited given the aforementioned vulnerability of risk-asset valuations to higher bond yields. Therefore, the better long-term strategy is to short German bunds relative to U.S. T-bonds. Finally, a 50 basis points rise in 10-year yields from current levels would be a trigger to flip to underweight European equities.  Fractal Trading System* Crude oil is at a technical reversal level. The best way to play this is on a hedged basis versus metals: short WTI, long LMEX. Set the profit target at 5 percent with a symmetrical stop-loss. In other trades, we are pleased to report long AUD/CNY achieved its profit target at which it was closed. This leaves five open positions. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com Dhaval Joshi, Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading Model Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart I-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields   Interest Rate Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations   Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Highlights Q1/2019 Performance Breakdown: Our recommended model bond portfolio underperformed the custom benchmark index by -17bps in the first quarter of the year. Winners & Losers: The underperformance came from the government side of the portfolio (-40bps), where our below-benchmark duration stance was mainly implemented through underweight positions in long-ends of government bond yield curves. On the other side was a solid outperformance from spread product allocations (+23bps) after our tactical upgrade to global corporates in January. Scenario Analysis For The Next Six Months: An improving global growth backdrop, and benign monetary policy backdrop, should help generate an outperformance of the model bond portfolio – mostly through credit, but also through moderate bear-steepening of government bond yield curves. Feature For fixed income markets, the start of 2019 has been categorized by three main trends: falling bond yields, narrowing credit spreads, and slower global growth. Central bankers have been forced to shift to a much more dovish stance on monetary policy, in response to heightened uncertainties over the global economy, helping trigger rallies in both government bonds and credit. In this report, we review the performance of the BCA Global Fixed Income Strategy (GFIS) model bond portfolio during the surprisingly eventful first quarter of 2019. We also present our updated scenario analysis, and total return projections, for the portfolio over the next six months. As a reminder to existing readers (and to new clients), the model portfolio is a part of our service that complements the usual macro analysis of global fixed income markets. The portfolio is how we communicate our opinion on the relative attractiveness between government bond and spread product sectors. This is done by applying actual percentage weightings to each of our recommendations within a fully invested hypothetical bond portfolio. Q1/2019 Model Portfolio Performance Breakdown: Overweight Credit Pays Off, Below-Benchmark Duration Does Not Chart of the WeekDuration Losses Offset Credit Gains In Q1/2019 Table 1GFIS Model Bond Portfolio Q1/2019 Overall Return Attribution   The total return for the GFIS model portfolio (hedged into U.S. dollars) in the first quarter was 3.1%, underperforming the custom benchmark index by -17bps (Chart of the Week).1 The bulk of the underperformance came from the government bond side of the portfolio (-40bps) - a function of both our below-benchmark duration tilt and underweight stance on sovereign bonds (Table 1). Of course, the flipside of that government bond underweight is a spread product overweight. The tactical upgrade to global corporate debt (favoring the U.S.) that we introduced back on January 15 helped boost the credit piece of the model bond portfolio, which outperformed the custom benchmark by +23bps. The tactical upgrade to global corporate debt (favoring the U.S.) that we introduced back on January 15 helped boost the credit piece of the model bond portfolio, which outperformed the custom benchmark by +23bps. The bar charts showing the total and relative returns for each individual government bond market and spread product sector are presented in Charts 2 and 3. The main individual sectors of the portfolio that drove the excess returns were the following: Biggest outperformers Overweight U.S. investment grade industrials (+11bps) Overweight U.S. high-yield Ba-rated (+10bps) Overweight U.S. high-yield B-rated (+8bps) Overweight U.S. investment grade financials (+5bps) Overweight Japanese government bonds with maturity of 7-10 years (+4bps) Biggest underperformers Underweight Japanese government bonds with maturity beyond 10+ years (-17bps) Underweight U.S. government bonds with maturity beyond 10+ years (-12bps) Underweight France government bonds with maturity beyond 10+ years (-8bps) Underweight Emerging Markets U.S. dollar denominated corporates (-7bps) Underweight U.S. government bonds with maturity of 7-10 years (-4bps) Chart 4 presents the ranked benchmark index returns of the individual countries and spread product sectors in the GFIS model bond portfolio for Q1/2019. The returns are hedged into U.S. dollars (we do not take active currency risk in this portfolio) and are adjusted to reflect duration differences between each country/sector and the overall custom benchmark index for the model portfolio. We have also color-coded the bars in each chart to reflect our recommended investment stance for each market during Q1/2019 (red for underweight, blue for overweight, gray for neutral). It was a great quarter for global fixed income, as all countries and spread products generated positive total returns. Generally, our allocations did reasonably well. There were more blue bars than red bars on the left side of Chart 4 (i.e. more overweights than underweights where returns were higher), and vice versa on the right side (more underweights than overweights where returns were lower). Some of the hit to performance from below-benchmark duration is already starting to be recouped in the first weeks of Q2 as markets become more comfortable with early signs of improving global growth. The negative overall Q1/2019 result is obviously not satisfactory, but we are still pleased with the positive returns generated from the spread product side after we did our January upgrade. More importantly, some of the hit to performance from below-benchmark duration is already starting to be recouped in the first weeks of Q2 as markets become more comfortable with early signs of improving global growth, pushing bond yields higher. Bottom Line: Our recommended model bond portfolio underperformed the custom benchmark index in the first quarter of the year. The underperformance came from the government side of the portfolio, where our below-benchmark duration stance was mainly implemented through underweight positions on the long-ends of government bond yield curves. On the other side was a solid outperformance from spread product allocations after our tactical upgrade to global corporates in January. Future Drivers Of Portfolio Returns Chart 6Overall Portfolio Duration: Below-Benchmark Looking ahead, the performance of the model bond portfolio will benefit from two main factors: our below-benchmark duration bias and our overweight stance on global corporate debt (favoring the U.S.) versus government bonds. In terms of the specific high-level weightings in the model portfolio, we are maintaining our tactical overweight tilt, equal to seven percentage points, on spread product versus government debt (Chart 5). This reflects a more constructive view on global growth, which appears to be bottoming out after the sharp slowdown seen in 2018, to the benefit of corporate bond performance. That faster growth backdrop will also benefit our below-benchmark duration stance through a rebound in government bond yields. This should happen only slowly, however, as global central bankers are likely to keep their newly-dovish policy bias in place for some time until there are more decisive signs of accelerating growth AND inflation. We are maintaining our significant below-benchmark duration tilt (one year short of the custom benchmark), but we recognize that the underperformance from duration seen in Q1 will only be clawed back slowly over the next 3-6 months (Chart 6). As for country allocation, we continue to favor regions where tighter monetary policy is least likely (overweight Japan, the U.K., and Australia, neutral core Europe and Canada). We are staying underweight the U.S., however, as the market’s expectations for the Fed is too dovish, with -25bps of rate cuts now discounted over the next twelve months. We expect to make some changes to those country allocations over the next few months, however - most notably a potential downgrade in core Europe, and upgrade in Peripheral Europe, if the euro area stabilizes on the back of firmer global growth. We expect to make some changes to those country allocations over the next few months, however - most notably a potential downgrade in core Europe, and upgrade in Peripheral Europe, if the euro area stabilizes on the back of firmer global growth. The overall yield from the model bond portfolio is modestly above that of the benchmark (+7bps). That is admittedly a fairly small amount of positive carry (Chart 7) given the overweight credit position. It is a consequence of our below-benchmark duration stance, which is focused on underweights in longer, higher-yielding ends of government bond yield curves (i.e. we have a bear-steepening bias in the U.S., core Europe and even the very long-end in Japan). Chart 7Portfolio Yield: Small Positive Carry Chart 8Portfolio Risk Budget Usage: Cautious   Even though we have decent-sized overall tilts on global duration and spread product allocation, our estimated tracking error (excess volatility of the portfolio versus its benchmark) remains low (Chart 8). This is a function of some of the offsetting country and sector tilts within the overall allocations (i.e. more Japan than Germany, more Spain than Italy, more U.S. corporates than EM corporates). We remain comfortable maintaining a tracking error target range of between 40-60bps, well below our self-imposed 100bps ceiling, as our internal weightings are helping keep overall portfolio volatility at a modest level. Scenario Analysis & Return Forecasts In April 2018, we introduced a framework for estimating total returns for all government bond markets and spread product sectors, based on common risk factors.2 For credit, returns are estimated as a function of changes in the U.S. dollar, the Fed funds rate, oil prices and market volatility as proxied by the VIX index (Table 2A). For government bonds, non-U.S. yield changes are estimated using historical betas to changes in U.S. Treasury yields (Table 2B). This framework allows us to conduct scenario analysis of projected returns for each asset class in the model bond portfolio by making assumptions on those individual risk factors. In Tables 3A & 3B, we present our three main scenarios for the next six months, defined by changes in the risk factors, and the expected performance of the model bond portfolio in each case. The scenarios, described below, are all driven by what we continue to believe will be the most important driver of market returns in 2019 – the path of U.S. monetary policy. Our Base Case: the Fed stays on hold, the U.S. dollar remains flat, oil prices rise by +10%, the VIX index hovers around 15, and there is a mild bear-steepening of the U.S. Treasury curve. This is the case of a pickup in U.S. and global growth that is strong enough to support higher commodity prices, but not intense enough to rapidly boost U.S. core inflation, allowing the Fed to keep rates unchanged. A Very Hawkish Fed: the Fed does a surprise +25bps rate hike in June or September, the U.S. dollar rises by +3%, oil prices increase +10%, the VIX index climbs to 25 and there is a sharp bear-flattening of the U.S. Treasury curve. This would occur if the U.S. economy reaccelerates alongside improved global growth, U.S. core inflation and inflation expectations move higher, and market volatility increases from a surprisingly hawkish Fed. A Very Dovish Fed: the Fed cuts the funds rate by -25bps, the U.S. dollar falls by -3%, oil prices decline -15%, the VIX index increases to 35 and there is a sharp bull steepening of the U.S. Treasury curve. This is a scenario where U.S./global growth momentum fades once again, leaving the Fed little choice but to ease monetary policy as market volatility surges alongside elevated recession risks. The scenario inputs for the four main risk factors (the fed funds rate, the price of oil, the U.S. dollar and the VIX index) are all unchanged from our late portfolio review in early January (Chart 9). The U.S. Treasury yield changes, however, are more moderate than what we used three months ago (Chart 10). That reflects the Fed’s dovish turn since then, which limits the upside for yields from multiple Fed hikes in 2019. Chart 9Risk Factors Assumptions For The Scenario Analysis Chart 10U.S. Treasury Yield Assumptions For The Scenario Analysis     The model bond portfolio is expected to outperform the custom benchmark index by +43bps in our Base Case scenario. This comes from the relative outperformance of credit versus government bonds in an environment of slowly rising bond yields (below-benchmark duration), and tighter credit spreads (overweighting U.S. corporates). In the Very Hawkish Fed scenario, our model portfolio is projected to outperform the benchmark by +29bps. This comes mostly from below-benchmark duration, with more muted credit performance as spreads widen and volatility increases due to the unexpected Fed rate hike. In the Very Dovish Fed scenario, the model bond portfolio is expected to lag the benchmark by -49bps. Performance would get hit from both credit and duration, as government bond yields fall and credit spreads widen sharply against a backdrop of even slower global growth. The overall expected excess return of our model bond portfolio over the benchmark is positive, given that the scenario analysis produces positive excess returns in the Base Case and Very Hawkish Fed scenarios. While we do not place probabilities on our scenarios in this analysis, if we did, the Very Dovish Fed scenario would be far less likely than the Very Hawkish Fed scenario (by definition, the Base Case is our most likely outcome). Global growth is much more likely to rebound than decelerate further over the rest of 2019. Thus, the overall expected excess return of our model bond portfolio over the benchmark is positive, given that the scenario analysis produces positive excess returns in the Base Case and Very Hawkish Fed scenarios. Bottom Line: An improving global growth backdrop, and benign monetary policy backdrop, should help generate an outperformance of the model bond portfolio – mostly through credit, but also through moderate bear-steepening of government bond yield curves.   Robert Robis, CFA, Chief Fixed Income Strategist rrobis@bcaresearch.com   Ray Park, CFA, Research Analyst ray@bcaresearch.com   Footnotes 1 The GFIS model bond portfolio custom benchmark index is the Bloomberg Barclays Global Aggregate Index, but with allocations to global high-yield corporate debt replacing very high quality spread product (i.e. AA-rated). We believe this to be more indicative of the typical internal benchmark used by global multi-sector fixed income managers. 2 Please see BCA Global Fixed Income Strategy Weekly Report, “GFIS Model Bond Portfolio Q1/2018 Performance Review: A Rough Start”, dated April 10th 2018, available at gfis.bcareseach.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Special Report

Highlights Portfolio rebalancing is the process of realigning portfolio weights back to their strategic allocations. Frequent rebalancing is essentially a counter-cyclical, or value, strategy. In effect, investors buy low and sell high. Infrequent rebalancing is a momentum-factor investing strategy. Maximizing risk-adjusted return is the reason investors should rebalance, not maximizing return per se. We find that calendar, deviation, or a combination of both methods of rebalancing, can all improve risk-adjusted return compared to a non-rebalanced portfolio. Feature What Do We Mean By Rebalancing? The first step of portfolio construction is strategic asset allocation. Simply put, it is determining a set of asset weights that best suits the investor’s return target, risk appetite, capabilities, and other considerations. Once a portfolio is constructed, divergent returns among asset classes cause the weights of the portfolio to shift. Portfolio rebalancing is therefore, the process of realigning portfolio weights back to their strategic allocations. Chart 1Rebalancing Can Imply Style Rebalancing is a means of reducing portfolio risk rather than increasing returns, and is necessary to maintain the desired risk exposure over time. Frequent rebalancing can be viewed as value investing: a style in which investors “buy low and sell high” (Chart 1). Given the mean-reverting nature of asset performance, buying the undervalued asset and selling the overvalued should imply that future returns would be higher than past returns. Through this process, investors are hoping to obtain a “rebalancing premium”. It is crucial to recognize that rebalancing works best at inflection points. Hence, that premium is gained when the rebalancing frequency is similar to the frequency of the mean-reversion feature of assets. Rebalancing also allows a portfolio to be consistent with the investor’s risk appetite in order to avoid a particular asset class dominating. However, this is easier said than done. An investor’s intuition usually acts in the opposite direction, pushing him or her to follow momentum rather than cut back the weight of a “winning” asset. The question that this Special Report aims to answer is not whether investors should rebalance or not, but rather what kind of rebalancing they should do. We discuss three different conventional rebalancing methods that investors can use, illustrating the risk-return characteristics of a simple two-asset-class (60% equity/40% bonds) portfolio since 1973. In doing so, we rebalance the portfolio back to its 60/40 strategic weights. Rebalancing is a means of reducing portfolio risk rather than increasing returns, and is necessary to maintain the desired risk exposure over time. It is important to note that rebalancing is no free lunch. Costs vary depending on the method used. Costs include trading and transaction costs, operational costs (trade lags, labor, and time to monitor the portfolio), and tax costs (capital gains on appreciated assets). In this paper, we do not consider the operational and tax costs (as they differ from investor to investor). Rather, we examine portfolio returns given: (1) zero trading costs, and (2) a variable cost of 10 bps dependent on trade size. Additionally, frequent rebalancing can introduce “negative convexity”, a return profile in which large divergences in asset performance exceed the rebalancing premiums investors obtain.1 Throughout our explanations, we show two tables for each method: Table A illustrates the returns given zero costs, while Table B illustrates the returns given the variable costs. It is key to note however that there is no one-size-fits-all rebalancing method. The important thing to realize is that rebalancing, done correctly, must find an optimal balance between cost minimization and managing portfolio risk. As a benchmark, we examine how an unbalanced portfolio, which we will refer to as a “drift portfolio”, comprised of 60% equities and 40% bonds in 1973, would have evolved over the past 46 years. Given that equities outperform bonds over the long run due to their riskier nature, the drift portfolio ends with an 86% allocation to equities, and a maximum allocation of 87% over the period (Chart 2). Chart 3Broken Equity/Bond Correlation   Before describing how each methodology performed, we need to highlight a key point in understanding the results that follow: the equity/bond correlation underwent a step-change around 1998. Between 1975 and 1998, the correlation between equities and bonds averaged about 0.4. However, declining inflation expectations led to a reversal of this relationship. Since 1998, the equity/bond correlation averaged -0.3 (Chart 3, top panel). It is key to note however that there is no one-size-fits-all rebalancing method. The important thing to realize is that rebalancing, done correctly, must find an optimal balance between cost minimization and managing portfolio risk. How does this affect the results? A positive correlation between equities and bonds means that asset-class returns moved together, reducing the advantages of rebalancing. Therefore, between the start of our sample period, 1973, and 1998, rebalanced portfolios only slightly outperformed a non-rebalanced portfolio. It is crucial to recognize that rebalancing portfolios should continue to be most advantageous during times when asset returns exhibit negative correlation. Portfolio Rebalancing can take place in different ways2 (Table 1). Table 1Conventional Methods Of Rebalancing Rebalancing Methodologies Time-Only Rebalancing The most common rebalancing methodology used by investors is on a simple calendar basis. A survey conducted by the Financial Planning Association showed that 48%, 36%, and 14% of financial planners rebalance quarterly, annually, and monthly respectively; 1% of respondents said they rebalanced based on a client’s request.3 This form of rebalancing involves bringing the asset-class weights back to the agreed-upon benchmark at the end of a specified period. Periods can range from daily (which is rare) to multiple years. Several academic papers and practitioners call for investors to rebalance at least annually. For the purpose of this report, we look at monthly, quarterly, semi-annual, annual, and bi-annual rebalancing.4 Rebalancing not only increases return at the margin, but also reduces portfolio risk and hence improves risk-adjusted returns. The risk-adjusted return increases as the rebalancing frequency decreases. Bi-annual rebalancing had a risk-adjusted return of 1.016 versus 0.895 for a non-rebalanced portfolio and 0.985 for a monthly-rebalanced portfolio over our entire sample period (Tables 2A and 2B). All calendar-rebalancing dates outperformed a non-rebalanced portfolio on a risk-adjusted basis due to lower volatility. The same results persist even when costs are factored in. Rebalancing too frequently not only increased costs, but also limited upside potential. That is noticeable from the number of rebalancing events for a monthly-rebalanced portfolio versus an annually or a bi-annually rebalanced portfolio. Unsurprisingly, we found that all rebalanced portfolios on average underperformed the drift portfolio during equity bull markets, and outperformed in the period leading up to recessions and equity corrections (Chart 4). Given that stocks peak on average six to 12 months before a recession, the higher weighting in bonds at the start of a correction explains the outperformance of a frequently rebalanced portfolio versus a drift portfolio during recessions and equity market corrections. To put this into context, the drift portfolio’s equity weight at the time of the S&P 500’s peak in the dot-com bubble was 84%, versus an average of 61% across the rebalanced portfolios. Similarly, at the peak before the latest market selloff starting on October 3, 2018, the drift portfolio had an 87% equity allocation versus a 61% average allocation for the frequently rebalanced portfolios. Chart 5 shows that rebalancing reduces downside risk relative to a drift portfolio during downturns and recessions. Chart 4Calendar Rebalancing: Relative Performance Chart 5Calendar Rebalancing: Lower Drawdown Threshold-Only Rebalancing Threshold rebalancing allows asset-class weights to be readjusted back to their target weights once they deviate away by a certain percentage. This can be set in terms of either a percentage-point or a percent deviation. Given that, in this paper, we illustrate our findings using just a two-asset class portfolio with relatively large weights in each asset, percentage-point deviations are more appropriate. However, percent deviations should be used when a certain asset class has only a small weight within a portfolio, for example, a 20% deviation away from the 5% target weight of an asset class. A key benefit of threshold-only rebalancing over calendar rebalancing in a multi-asset portfolio is lower transaction costs. Unlike calendar-only rebalancing where all asset classes are brought back to target weights, only the assets that have moved away from benchmark by the set deviation have to be bought and sold. For example, in a five-asset class portfolio, it could be the case that only the best and worst performers have hit their thresholds and have to be adjusted, whereas the other asset classes do not. Tables 3A and 3B show the risk-return characteristics of rebalanced portfolios based on 1, 5, 10, and 20 percentage-point deviations. Similarly to calendar rebalancing, the wider the threshold, the better the risk-adjusted return. The rebalanced portfolio with a 20-percentage point threshold outperforms all other deviations on both a return and risk-adjusted basis. All rebalanced portfolios led to better risk-adjusted returns than the drift portfolio, even after costs are factored in. Also similar to calendar rebalancing, threshold deviation rebalancing also outperforms during recessions and market corrections (Charts 6 & 7). Chart 6Threshold Rebalancing: Relative Performance Chart 7Threshold Rebalancing: Lower Drawdown The table also illustrates that picking the right threshold is crucial. A threshold set too wide will miss all turning-points and hence turn into a drift portfolio. Whereas, thresholds set too narrow will produce only a small improvement in return at the expense of more rebalancing events, and therefore higher costs. Time-And-Threshold Rebalancing A time-and-threshold rebalancing combines the merits of both strategies. The portfolio is rebalanced only when an asset class has deviated from its target allocation by a set threshold on the date of rebalancing. Assuming, for example, monthly rebalancing with a 10% deviation, a portfolio would be rebalanced on the next monthly date only if it had deviated by more than 10 percentage points. Otherwise, the portfolio would not be rebalanced. This implies that two decisions have to be made: a threshold band and a rebalancing frequency. We present the results of this method in a slightly different way. In this case, we show each metric (annualized return (Tables 4A & 5A), annualized volatility (Tables 4B & 5B) and risk-adjusted return (Tables 4C & 5C)) separately under assumptions of both zero costs and variable costs.   The highest risk-adjusted return of 1.023 was achieved with quarterly rebalancing and a 20 percentage point deviation. This resulted in only three rebalancing events throughout the 46-year period. However, this was not as good as simply relying on a 20 percentage point threshold deviation. Investors wanting to keep a tighter control over their portfolio could use a tighter band with a more frequent rebalancing. As noted earlier, rebalancing is a way to maximize risk-adjusted return rather than maximize return. To simply maximize return, annual rebalancing with a 10-percentage point threshold, which had an annualized return of 9.80%, would be the best combination. However, that came at the expense of high volatility and a higher average equity allocation. Having fewer rebalancing events does not necessarily mean lower costs. In fact, we noted that the fewer the rebalancing events, the higher the annualized cost per trade5 (Tables 6 and 7). Given that our variable cost was dependent on trade size, a rebalancing method that relied on wider bands would incur higher costs per trade relative to narrower bands. Table 6Time-And-Threshold Rebalancing: Rebalancing Events Table 7Time-And-Threshold Rebalancing: Cost Per Trade (Bps) Beyond The Conventional Methods New rebalancing strategies have evolved that rely on different metrics. These include timing rebalancing events using tracking error or risk deviation, absolute momentum, or analyzing the stage of the economic cycle. A recent paper published by Northern Trust discussed the merits of risk-based tracking-error rebalancing as a superior method to traditional strategies. The paper concluded that risk-based tracking had outperformed most other rebalancing strategies while requiring fewer rebalancing events. Within the core strategies mentioned, several adjustments could be made to obtain better results from rebalancing events. Some argue that rebalancing back to a tolerance band, rather than to the precise allocation target, could improve risk-adjusted returns. That band is usually set at half of the deviation threshold band, but can vary at the investor’s discretion. Given costs that vary based on trade size, it might be cheaper for an investor to use tolerance bands. However, relying on such a method can easily rack up costs if the investor is going against momentum prior to its end, since relying on tolerance bands would require more frequent rebalancing. Bottom Line Rebalancing is a means of maximizing risk-adjusted return, rather than increasing absolute return. Rebalancing is no free lunch. Investors must take various associated costs into account before considering how and when to rebalance. The added benefit of rebalancing might seem small in annualized returns. However, on average, rebalancing led to an annualized decrease in volatility in excess of 1% over the 46-year period. It might be best for investors to use a time-and-threshold rebalancing to find a balance between cost minimization and maximizing risk-adjusted returns. Amr Hanafy, Research Associate amrh@bcaresearch.com   1 Nick Granger, Douglas Greenig, Campbell Harvey, Sandy Rattray, David Zou, "The Unexpected Costs of Rebalancing And How To Address Them," AHL Partners LLP, July 2014. 2 Colleen Janconetti, Francis Kinniry Jr., Yan Zilbering, "Best Practices For Portfolio Rebalancing," Vanguard, July 2010. 3 Financial Planning Association, Longboard, and Journal Of Financial Planning, “2017 Trends In Investing,” www.onefpa.org. 4 We assumed that monthly rebalancing occurs on the first trading day of every month, quarterly rebalancing occurs on the first trading day of January, April, July, afn_4nd October, semiannual rebalancing on the first trading day of January and July, and annual rebalancing on the first trading day of the year. 5 Calculated as the difference in annualized return between 10 bps cost assumptions and 0 cost assumption multiplied by the number of years within the sample period divided by the number of trades.  

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

Special Report

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