Economy

Highlights The intense focus on the weakening of global oil demand expected in the wake of another coronavirus outbreak in China – dubbed 2019-nCoV – obscures likely supply-side responses by OPEC 2.0. The producer coalition likely will rebalance markets by extending production cuts from end-March to at least the end of June when it meets in Vienna March 5-6.  OPEC 2.0 producers will be exquisitely sensitive to Asian refiner demand. They will use it as a gauge for how severe 2019-nCoV’s impact will be on EM demand, and adjust production and exports accordingly. On the demand side, it is difficult to analogue the 2019-nCoV outbreak to the 2003 SARS outbreak, given all the conflicting fundamentals at play at that time.  Forward curves for the principal benchmark crude oils – Brent and WTI – remain backwardated, in spite of the 2019-nCoV-related sell-off. Longer-dated WTI (out to December 2023) traded below $50/bbl earlier in the week, roughly in line with shale-breakeven costs reported by the Dallas Fed earlier this month. This likely will continue to pressure capex in the US shales, keeping future supply growth constrained. Feature Forward curves for the principal benchmark crude oils – Brent and WTI – remain backwardated, in spite of the 2019-nCoV-related sell-off. Chart of the WeekChina's Oil Demand Drives Global Growth Oil markets are rightly focused on the demand implications of the 2019-nCoV outbreak in China.1 Since 2000, China has accounted for 42% of annual oil-demand growth worldwide (Chart of the Week). China is second only to the US in oil demand, accounting for 14% of total global demand of 100.7mm b/d at the end of 2019; its oil imports averaged more than 10mm b/d last year, and are expected to remain strong as it continues to build out its refining sector. Chart 2Asian Air Travel Hit Hard By SARS Historical analogues for 2019-nCoV are difficult. The immediate analogue is the SARS coronavirus outbreak identified in China in February 2003, which lasted six months and hit Asian air travel especially hard (Chart 2). During the height of the SARS outbreak in April 2003, air-travel passenger demand in Asia plunged 45%, according to the International Air Transport Association (IATA). This pushed jet fuel prices lower in Asia and in other key markets, along with distillate prices generally (Chart 3).2 Chart 3Fundamental Supply-Demand Balances Support Higher Crude Oil Prices China now is an extremely large share of global jet fuel consumption. Chart 4BCA Models, Base Metals Prices Suggest SARS Effect Was Short-Lived The industry now is more reliant on Chinese travelers. Since 2003, the number of annual air passengers has more than doubled, with China growing to become the world’s largest outbound travel market. In 2003, close to 7mm passengers from China traveled on international flights. By 2018, that number had grown close to 64mm people, according to China’s aviation authority.  As Chart 2 demonstrates, China now is an extremely large share of global jet fuel consumption. Still, oil is a global market – the avoidance of China during the SARS outbreak in 2003 would have impacted global air travel, and, as a result, global jet-fuel prices. Our proprietary EM commodity-demand models and the behavior of base metals prices, which were and remain heavily influenced by China’s economy, suggest China’s GDP growth slowed in 2003 (mainly 1H03) because of the SARS outbreak (Chart 4).  The LME’s base metals index fell 9% between February and July 2003, while copper prices fell 11%. By year-end, these markets had fully recovered. Oil-Supply Management Drives Price Evolution In the modern era of the oil market beginning roughly around 2000, there have been numerous demand shocks requiring a supply response from OPEC.  During the SARS outbreak in 2003, oil-market fundamentals at the time were complicated by the sudden loss of Venezuelan output in December 2002 to a general strike, which lasted three months and removed more than 2mm b/d from the market, and the US invasion of Iraq on March 2003. Both of these supply-side shocks hit markets just as demand was being hit by SARS. This makes it difficult to extract a pure price response on the demand side to the SARS episode. In the modern era of the oil market beginning roughly around 2000, there have been numerous demand shocks requiring a supply response from OPEC. These including the 9/11 terror attacks in the US in 2001; the SARS outbreak in late 2002-03; the Global Financial Crisis in 2007-08; and the euro debt crisis in 2011-12 (Chart 5).3 Chart 5Demand Shocks Abound In 21st Century Chart 6OPEC Lost Key Members' Output During SARS Outbreak   OPEC 2.0’s goal – similar to OPEC’s goal before it – is to avoid an unintended inventory accumulation. Importantly, these demand shocks were accompanied by supply shocks – Venezuela's general strike; the US invasion of Iraq continues to play havoc with global supply; the BP Macondo blowout in the Gulf of Mexico in 2010; the Arab Spring and the loss of Libyan output in 2011 – all of which complicated OPEC’s decision making (Chart 6). Much of OPEC’s adjustment then and now is made by the Kingdom of Saudi Arabia (KSA), which functions as the central bank of the global oil market increasing and decreasing production to balance markets (Chart 7). Chart 7KSA Primarily Balances Markets During Supply, Demand Shocks OPEC 2.0’s goal – similar to OPEC’s goal before it – is to avoid an unintended inventory accumulation, which would push prices lower and severely alter the forward curves for the principal crude oil pricing benchmarks, WTI and Brent (Chart 8). Chart 8OPEC 2.0’s Goal: Avoid Unintended Inventory Accumulation Navigating The 2019-nCoV Outbreak Oil prices – like all commodity prices – are a function of supply and demand, which clear the market instantaneously (here and now), and across time as buyers and sellers contract for forward delivery. The relentless focus on the demand-side consequences of the 2019-nCoV outbreak is not helpful in determining how oil prices will trade going forward. Oil prices – like all commodity prices – are a function of supply and demand, which clear the market instantaneously (here and now), and across time as buyers and sellers contract for forward delivery. The discussion above is meant to highlight this, by recalling OPEC’s production management during various demand shocks, not just the SARS outbreak in 2003. OPEC then, and OPEC 2.0 now, is not forced to produce oil and export regardless of the physical realities it confronts. It can adjust production and exports in response to direct demand indications from its refinery buyers and traders lifting its crude oil. Demand slowdowns, all else equal, typically will show up in falling crack-spread differentials between refined products and crude oil prices (Chart 9).4 Chart 9Crack Spreads Inform Crude Oil Production Decisions It still is too early to gauge the extent of the fall-off in demand arising from 2019-nCoV, but it will become apparent in cracks and in OPEC 2.0 producers’ responses to lower refiner demand. Falling crack spreads inform crude oil producers they need to throttle back on production – refiners are not able to profitably run all the crude being made available to them and crude and product are backing up in inventory.  It still is too early to gauge the extent of the fall-off in demand arising from 2019-nCoV, but it will become apparent in cracks and in OPEC 2.0 producers’ responses to lower refiner demand, which will determine how much production they need to cut in order to balance the market. This will be done against a backdrop of supply concerns that are not too dissimilar to those prevailing during the 2003 SARS crisis – e.g., instability in Iraq and Iran that could threaten production, and the loss of Venezuelan exports. Bottom Line: Markets still are in the process of assessing how damaging 2019-nCoV will be for industrial commodity demand – oil, bulks and base metals, in particular. As has been the case in all such demand shocks, OPEC’s supply response (and now OPEC 2.0’s) will determine how deeply and for how long prices are impacted.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com   Commodities Round-Up Energy: Overweight Brent prices fell 8% since last Monday amid the coronavirus outbreak in China. The number of confirmed cases is rapidly expanding, reaching more than 6,000 as of Wednesday which surpasses the trajectory of SARS in the first month of the outbreak in 2003. Nonetheless, the fatality rate remains below that of SARS, estimated at less than 3% vs. ~ 10% for SARS. Separately, the WCS discount to WTI averaged -$23/bbl this month. This is in line with our view that the discount would drop below -$20/bbl in 1Q20. This level is appropriate to incentivize additional rail transportation to the US. We expect the discount will remain close to current levels and for crude-by-rail volumes to pick up this year (Chart 10). Base Metals: Neutral Base metals have been severely impacted this week by the coronavirus outbreak – copper, aluminum, zinc, and lead are down 9%, 4%, 9%, and 5%. A prolonged slowdown in China’s economic activity – the driver of the global industrial activity recovery we expect – would plunge metals’ prices. China’s base metal consumption more than doubled since 2003. Thus, the potential impact of 2019-nCoV is much larger compared to SARS and market participants are pricing in the probability of damaging scenarios to global growth. This explains the pronounced decline in metals’ prices this year vs. 2003. Precious Metals: Neutral Gold was one of the few commodities in the green since last week. The yellow metal rose 1% since last Monday, supported by renewed safe-haven demand flows. Gold and the USD have been rising simultaneously amid the virus outbreak, which is typical of uncertain periods. The spectrum of possible outcomes is wide and negatively skewed. This warrants protection through safe-haven assets. We remain strategically long gold as a portfolio hedge. Our recommendation is up 28% since inception. Ags/Softs: Underweight Corn markets focused on USDA reports of rising exports, highlighted by the sale of 124,355 MT to Mexico. CBOT March corn futures were up 6% Tuesday, reversing earlier losses Monday. Beans remain under pressure, as traders await tangible evidence that China will go ahead with purchases announced in the so-called phase-one deal negotiated between the US and China (Chart 11).  Chart 10WCS Discount Under Pressure Chart 11Markets Waiting For China Demand   Footnotes 1     The US Centers for Disease Control and Prevention’s 2019-nCoV website highlights the marked differences between China’s response to the current coronavirus outbreak vs the 2003 SARS outbreak. One notable response by the Chinese government this time around – besides the rapid lockdown on travel – has been the alacrity with which officials posted the genome for the virus to a global research database, which allowed US researchers to quickly compare it to the strain they isolated. Separately, Reuters reported Australian researchers were able to grow the virus in a lab, which could accelerate development of a vaccine.  2     Distillates comprise the so-called middle of the refined barrel, and include jet fuel, diesel fuel and heating oil (also known as gasoil). These are primarily associated with industrial markets – mining and transportation, e.g. – and are key barometers of economic activity generally.  3     The "modern" era for oil began roughly in 2000, when oil prices became a random walk. WTI prices were mean-reverting from 1986 to roughly 2000, then became a random walk. Please see Helyette Geman, (2007), "Mean Reversion versus Random Walk in Oil and Natural Gas Prices," in Advances in Mathematical Finance, Birkhäuser, Boston; and Haidar, I. and C.R. Wolff, "Forecasting crude oil price (revisited)," The proceeding of the 30th USAEE Conference, Washington , D.C. USA. 9-12 October, 2011. 4     The “crack spread” is the USD/bbl difference between refined-product prices and crude-oil prices. It represents the gross margin of refiners.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q4 Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades

Bank Credit Analyst

Our top five geopolitical “Black Swans” are risks that the market is seriously underpricing. With the “phase one” trade deal signed, Chinese policy could become less accommodative, resulting in a negative economic surprise. The trade deal may fall victim to domestic politics, raising the risk of a US-China military skirmish. A Biden victory at the Democratic National Convention or a Democratic takeover of the White House could trigger social unrest and violence in the US. A pickup in the flow of migrants to Europe would fundamentally undermine political stability there. Russia’s weak economy will add fuel to domestic unrest, risking an escalation beyond the point of containment. Over the past four years, BCA’s Geopolitical Strategy service has started off each year with their top five geopolitical “Black Swans.” These are low-probability events whose market impact would be significant enough to matter for global investors. Unlike the great Byron Wien’s perennial list of market surprises, we do not assign these events a “better than 50% likelihood of happening.” We offer risks that the market is seriously underpricing by assigning them only single-digit probabilities when we think the reality is closer to 10%-15%, a level at which a risk premium ought to be assigned. Some of our risks below are so obscure that it is not clear how exactly to price them. We exclude issues that are fairly probable, such as flare-ups in Indo-Pakistani conflict. The two major risks of the year – discussed in our Geopolitical Strategy’s annual outlook – are that either US President Donald Trump or Chinese President Xi Jinping overreaches in a major way. But what would truly surprise the market would be a policy-induced relapse in Chinese growth or a direct military clash between the two great powers. That is how we begin. Other risks stem from domestic affairs in the US, Europe, and Russia. Black Swan 1: China’s Financial Crisis Begins Chart II-1A Crackdown On Financial Risk Could Cause China's Economy To Derail The risk of Xi Jinping’s concentration of power in his own person is that individuals can easily make mistakes, especially if unchecked by advisors or institutions. Lower officials will fear correcting or admonishing an all-powerful leader. Inconvenient information may not be relayed up the hierarchy. Such behavior was rampant in Chairman Mao Zedong’s time, leading to famine among other ills. Insofar as President Xi’s cult of personality successfully imitates Mao’s, it will be subject to similar errors. If President Xi overreaches and makes a policy mistake this year, it could occur in economic policy or other policies. We begin with economic policy, as we have charted the risks of Xi’s crackdown on the financial system since early 2017 (Chart II-1). This year is supposed to be the third and final year of Xi Jinping’s “three battles” against systemic risk, pollution, and poverty. The first battle actually focuses on financial risk, i.e. China’s money and credit bubble. The regime has compromised on this goal since mid-2018, allowing monetary easing to stabilize the economy amid the trade war. But with a “phase one” trade deal having been signed, there is an underrated risk that economic policy will return to its prior setting, i.e. become less accommodative (Chart II-2). When Xi launched the “deleveraging campaign” in 2017, we posited that the authorities would be willing to tolerate an annual GDP growth rate below 6%. This would not only cull excesses in the economy but also demonstrate that the administration means business when it says that China must prioritize quality rather than quantity of growth. While Chinese authorities are most likely targeting “around 6%” in 2020, it is entirely possible that the authorities will allow an undershoot in the 5.5%-5.9% range. They will argue that the GDP target for 2020 has already been met on a compound growth rate basis (Chart II-3), as astute clients have pointed out. They may see less need for stimulus than the market expects. Chart II-2Easing Of Trade Tensions May Re-Incentivize Tighter Policy Chart II-3Chinese Authorities Might Tolerate A Growth Undershoot In 2020   Similarly, while urban disposable income is ostensibly lagging its target of doubling 2010 levels by 2020, China’s 13th Five Year Plan, which concludes in 2020, conspicuously avoided treating urban and rural income targets separately. If the authorities focus only on general disposable income, then they are on track to meet their target (Chart II-4). This would reduce the impetus for greater economic support. The Xi administration may aim only for stability, not acceleration, in the economy. There are already tentative signs that Chinese authorities are “satisfied” with the amount of stimulus they have injected: some indicators of money and credit have already peaked (Chart II-5). The crackdown on shadow banking has eased, but informal lending is still contracting. The regime is still pushing reforms that shake up state-owned enterprises. Chart II-4Lower Impetus For Economic Support Due To Improvements In National Income? Chart II-5Has China's Stimulus Peaked?   An added headwind for the Chinese economy stems from the currency. The currency should track interest rate differentials. Beijing’s incremental monetary stimulus, in the form of cuts to bank reserve requirement ratios (RRRs), should also push the renminbi down over time (Chart II-6). However, an essential aspect of any trade deal with the Trump administration is the need to demonstrate that China is not competitively devaluing. Hence the CNY-USD could overshoot in the first half of the year. This is positive for global exports to China, but it tightens Chinese financial conditions at home. A stronger than otherwise justified renminbi would add to any negative economic surprises from less accommodative monetary and fiscal policy. Conventional wisdom says China will stimulate the economy ahead of two major political events: the centenary of the Communist Party in 2021 and the twentieth National Party Congress in 2022. The former is a highly symbolic anniversary, as Xi has reasserted the supremacy of the party in all things, while the latter is more significant for policy, as it is a leadership reshuffle that will usher in the sixth generation of China’s political elite. But conventional wisdom may be wrong – the Xi administration may aim only for stability, not acceleration, in the economy. It would make sense to save dry powder for the next US or global recession. The obvious implication is that China’s economic rebound may lose steam as early as H2 – but the black swan risk is that negative surprises could cause a vicious spiral inside of China. This is a country with massive financial and economic imbalances, a declining potential growth profile, and persistent political obstacles to growth both at home and abroad. Corporate defaults have spiked sharply. While the default rate is lower than elsewhere, the market may be sniffing out a bigger problem as it charges a much higher premium for onshore Chinese bonds (Chart II-7). Chart II-6CNY/USD Overshoot Would Tighten Chinese Financial Conditions Chart II-7Is China's Bond Market Sniffing Out A Problem?   Bottom Line: Our view is that China’s authorities will remain accommodative in 2020 in order to ensure that growth bottoms and the labor market continues to improve. But Beijing has compromised its domestic economic discipline since 2018 in order to fight trade war. The risk now, with a “phase one” deal in hand, is that Xi Jinping returns to his three-year battle plan and underestimates the downward pressures on the economy. The result would be a huge negative surprise for the Chinese and global economy in 2020. Black Swan 2: The US And China Go To War In 2013, we predicted that US-China conflict was “more likely than you think.” This was not just an argument for trade conflict or general enmity that raises the temperature in the Asia-Pacific region – we included military conflict. At the time, the notion that a Sino-American armed conflict was the world’s greatest geopolitical threat seemed ludicrous to many of our clients. We published this analysis in October of that year, months after the Islamic State “Soldier’s Harvest” offensive into Iraq. Trying to direct investors to the budding rivalry between American and Chinese naval forces in the South China Sea amidst the Islamic State hysteria was challenging, to say the least. Chart II-8Americans’ Attitudes Toward China Plunged… The suggestion that an accidental skirmish between the US and China could descend into a full-blown conflict involved a stretch of the imagination because China was not yet perceived by the American public as a major threat. In 2014, only 19%of the US public saw China as the “greatest threat to the US in the future.” This came between Russia, at 23%, and Iran, at 16%. Today, China and Russia share the top spot with 24%. Furthermore, the share of Americans with an unfavorable view of China has increased from 52% to 60% in the six intervening years (Chart II-8). The level of enmity expressed by the US public toward China is still lower than that toward the Soviet Union at the onset of the Cold War in the 1950s (Chart II-9). However, the trajectory of distrust is clearly mounting. We expect this trend to continue: anti-China sentiment is one of the few sources of bipartisan agreement remaining in Washington, DC (Chart II-10). Chinese sentiment toward the United States has also darkened dramatically. The geopolitical rivalry is deepening for structural reasons: as China advances in size and sophistication, it seeks to alter the regional status quo in its favor, while the US grows fearful and seeks to contain China. Chart II-9…But Not Yet To War-Inducing Levels Chart II-10Distrust Of China Is Bipartisan Chart II-11Newfound American Concern For China’s Repression One example of rising enmity is the US public’s newfound concern for China’s domestic policies and human rights, specifically Beijing’s treatment of its Uyghur minority in Xinjiang. A Google Trends analysis of the term “Uyghur” or “Uyghur camps” shows a dramatic rise in mentions since Q2 of 2018, around the same time the trade war ramped up in a major way (Chart II-11). While startling revelations of re-education camps in Xinjiang emerged in recent years, the reality is that Beijing has used heavy-handed tactics against both militant groups and the wider Uyghur minority since at least 2008 – and much earlier than that. As such, the surge of interest by the general American public and legislators – culminating in the Uyghur Human Rights Policy Act of 2019 – is a product of the renewed strategic tension between the two countries. The same can be said for Hong Kong: the US did not pass a Hong Kong Human Rights and Democracy Act in 2014, during the first round of mass protests, which prompted Beijing to take heavy-handed legal, legislative, and censorship actions. It passed the bill in 2019, after the climate in Washington had changed. Why does this matter for investors? There are two general risks that come with a greater public engagement in foreign policy. First, the “phase one” trade deal between China and the US could fall victim to domestic politics. This deal envisions a large step up in Sino-American economic cooperation. But if China is to import around $200 billion of additional US goods and services over the next two years – an almost inconceivable figure – the US and China will have to tamp down on public vitriol. This is notably the case if the Democratic Party takes over the White House, given its likely greater focus on liberal concerns such as human rights. And yet the latest bills became law under President Trump and a Republican Senate, and we fully expect a second Trump term to involve a re-escalation of trade tensions to ensure compliance with phase one and to try to gain greater structural concessions in phase two. Second, mounting nationalist sentiment will make it more difficult for US and Chinese policymakers to reduce tensions following a potential future military skirmish, accidental or otherwise. While our scenario of a military conflict in 2013 was cogent, the public backlash in the United States was probably manageable.1 Today we can no longer guarantee that this is the case. The “phase one” trade deal risks falling victim to domestic politics due to greater public engagement in foreign policy. China has greater control over the domestic narrative and public discourse, but the rise of the middle class and the government’s efforts to rebuild support for the single-party regime have combined to create an increase in nationalism. Thus it is also more difficult for Chinese policymakers to contain the popular backlash if conflict erupts. In short, the probability of a quick tamping down of public enmity is actively being reduced as American public vilification of China is closing the gap with China’s burgeoning nationalism at an alarming pace. Another of our black swan risks – Taiwan island – is inextricably bound up in this dangerous US-China dynamic. To be clear, Washington will tread carefully, as a conflict over Taiwan could become a major war. Nevertheless Taiwan’s election, as we expected, has injected new vitality into this already underrated geopolitical risk. It is not only that a high-turnout election (Chart II-12) gave President Tsai Ing-wen a greater mandate (Chart II-13), or that her Democratic Progressive Party retained its legislative majority (Chart II-14). It is not only that the trigger for this resounding victory was the revolt in Hong Kong and the Taiwanese people’s rejection of the “one country, two systems” formula for Taiwan. It is also that Tsai followed up with a repudiation of the mainland by declaring, “We don’t have a need to declare ourselves an independent state. We are an independent country already and we call ourselves the Republic of China, Taiwan.” Chart II-12Tsai Ing-Wen Enjoys A Greater Mandate On Higher Turnout… Chart II-13…Popular Support… Chart II-14…And A Legislative Majority This statement is not a minor rhetorical flourish but will be received as a major provocation in Beijing: the crystallization of a long-brewing clash between Beijing and Taipei. Additional punitive economic measures against Taiwan are now guaranteed. Saber-rattling could easily ignite in the coming year and beyond. Taiwan is the epicenter of the US-China strategic conflict. First, Beijing cannot compromise on its security or its political legitimacy and considers the “one China principle” to be inviolable. Second, the US maintains defense relations with Taiwan (and is in the process of delivering on a relatively large new package of arms). Third, the US’s true willingness to fight a war on Taiwan’s behalf is in doubt, which means that deterrence has eroded and there is greater room for miscalculation. Bottom Line: A US-China military skirmish has been our biggest black swan risk since we began writing the BCA Geopolitical Strategy. The difference between then and now, however, is that the American public is actually paying attention. Political ideology – the question of democracy and human rights – is clearly merging with trade, security, and other differences to provoke Americans of all stripes. This makes any skirmish more than just a temporary risk-off event, as it could lead to a string of incidents or even protracted military conflict. Black Swan 3: Social Unrest Erupts In America There are numerous lessons that one can learn from the ongoing unrest in Hong Kong, but perhaps the most cogent one is that Millennials and Generation Z are not as docile and feckless as their elders think. Images of university students and even teenagers throwing flying kicks and Molotov cocktails while clad in black body armor have shocked the world. Perhaps all those violent video games did have a lasting impact on the youth! What is surprising is that so few commentators have made the cognitive leap from the ultra-first world streets of Hong Kong to other developed economies. Perhaps what is clouding analysts’ minds is the idiosyncratic nature of the dispute in Hong Kong, the “one China” angle. However, Hong Kong youth are confronted with similar socio-economic challenges that their peers in other advanced economies face: overpriced real estate and a bifurcated service-sector labor market with few mid-tier jobs that pay a decent wage. There is a risk of rebellion from Trump’s most ardent supporters if he loses the White House. In the US, Millennials and Gen Z are also facing challenges unique to the US. First, their debt burden is much more toxic than that of the older cohorts, given that it is made up of student loans and credit card debt (Chart II-15). Second, they find themselves at odds – demographically and ideologically – with the older cohorts (Chart II-16). Chart II-15Younger American Cohorts Plagued By Toxic Debt Chart II-16Younger And Older Cohorts At Odds Demographically Chart II-17Massive Turnout To The 2016 Referendum On Trump The adage that the youth are apolitical and do not turn out to vote may have ended thanks to President Trump. The 2018 midterm election, which the Democratic Party successfully turned into a referendum on the president, saw the youth (18-29) turnout nearly double from 20% to 36% (the 30-44 year-old cohort also saw a jump in turnout from 35.6% to 48.8%). The election saw one of the highest turnouts in recent memory, with a 53.4% figure, just two points off the 2016 general election figure (Chart II-17). Despite the high turnout in 2018, the-most-definitely-not-Millennial Vice President Joe Biden continues to lead the Democratic Party in the polls. His probability of winning the nomination is not overwhelming, but it is the highest of any contender. In recent polls, Biden comes third place in Millennial/Gen-Z vote preferences (Chart II-18). Yet he is hardly out of contention, especially for the 30-44 year-old cohort. The view that “Uncle Joe” does not fit the Democratic Party zeitgeist has become so entrenched in the Democratic Party narrative that it became conventional wisdom last year, pulling oddsmakers and betting markets away from the clear frontrunner (Chart II-19). Chart II-18Biden Unpopular Among Young American Voters Chart II-19Bookies Pulled Down 'Uncle Joe’s' Odds, Capturing Democratic Party Zeitgeist     As such, a Biden victory at the Democratic National Convention in Milwaukee, Wisconsin on July 13-16 may come as an affront to the left-wing activists who will surely descend on the convention. This will particularly be the case if Biden wins despite the progressive candidates amassing a majority of overall delegates, which is possible judging by the combined progressive vote share in current polling (Chart II-20). He would arrive in Milwaukee without clearing the 1990 delegate count required to win on the first ballot. On the second ballot, his presidency would then receive a boost from “superdelegates” and those progressives who are unwilling to “rock the boat,” i.e. unify against an establishment candidate with the largest share of votes. This is also how Mayor Michael Bloomberg could pull off a surprise win. Chart II-20Progressives Come Closest To Victory Such a “brokered” – or contested – convention has not occurred since 1952. However, several Democratic Party conventions came close, including 1968, 1972, and 1984. The 1968 one in Chicago was notable for considerable violence and unrest. Even if the Milwaukee Democratic Party convention does not produce unrest, it could sow the seeds for unrest later in the year. First, a breakout Biden performance in the primaries is unlikely. As such, he will likely need to pledge a shift to the left at the convention, including by accepting a progressive vice-presidential candidate. Second, an actual progressive may win the primary. Chart II-21Zealots In Both Parties Perceive Each Other As A National Threat It is likely that either of the two options would be seen as an existential threat to many of Trump’s loyal supporters across the United States. President Trump’s rhetoric often paints the scenario of a Democratic takeover of the White House in apocalyptic terms. And data suggests that the zealots in both parties perceive each other as a “threat to the nation’s wellbeing” (Chart II-21). The American Civil War in the nineteenth century began with the election of a president. This is not just because Abraham Lincoln was a particularly reviled figure in the South, but because the states that ultimately formed the Confederacy saw in his election the demographic writing-on-the-wall. The election was an expression of a general will that, from that point onwards, was irreversible. Given demographic trends in the US today, it is possible that many would see in Trump’s loss a similar fait accompli. If one perceives progressive Democrats as an existential threat to the US constitution, rebellion is the obvious and rational response. Bottom Line: Year 2020 may be a particularly violent one for the US. First, left wing activists may be shocked and angered to learn that Joe Biden (or Bloomberg) is the nominee of the Democratic Party come July. With so much hype behind the progressive candidates throughout the campaign, Biden’s nomination could be seen as an affront to what was supposed to be “the big year” for left-wing candidates. Second, investors have to start thinking about what happens if Biden – or a progressive candidate – goes on to defeat President Trump in the general election. While liberal America took Trump’s election badly, it has demographics – and thus time – on its side. Trump’s most ardent supporters may conclude that his defeat means the end of America as they know it. Black Swan 4: Europe’s Migration Crisis Restarts It is a testament to Europe’s resilience that we do not have a Black Swan scenario based on an election or a political crisis set on the continent in 2020. Support for the common currency and the EU as a whole has rebounded to its highest since 2013. Even early elections in Germany and Italy are unlikely to produce geopolitical risk. The populists in the former are in no danger of outperforming whereas the populists in the latter barely deserve the designation. But what if one of the reasons for the surge in populism – unchecked illegal immigration – were to return in 2020? Chart II-22Decline In Illegal Immigration Dampened European Populism The data suggests that the risk of migrant flows has massively subsided. From its peak of over a million arrivals in 2015, the data shows that only 125,472 migrants crossed into Europe via land and sea routes in the Mediterranean last year (Chart II-22). Why? There are five reasons that we believe have checked the flow of migrants: Supply: The civil wars in Syria, Iraq, and Libya have largely subsided. Heterogenous regions, cities, and neighborhoods have been ethnically cleansed and internal boundaries have largely ossified. It is unlikely that any future conflict will produce massive outflows of refugees as the displacement has already taken place. These countries are now largely divided into armed, ethnically homogenous, camps. Enforcement: The EU has stepped up border enforcement since 2015, pouring resources into the land border with Turkey and naval patrols across the Mediterranean. Individual member states – particularly Italy and Hungary – have also stepped up border enforcement policy. While most EU member states have publicly chided both for “draconian” policies, there is no impetus to force Rome and Budapest to change policy. Libyan Imbroglio: Conflict in Libya has flared up in 2019 with military warlord Khalifa Haftar looking to wrest control from the UN-backed Government of National Accord led by Fayez al-Serraj. The Islamic State has regrouped in the country as well. Ironically, the conflict is helping stem the flow of migrants as African migrants from sub-Saharan countries dare not cross into Libya as they did in 2015 when there was a brief lull in fighting. Turkish benevolence: Ankara is quick to point out that it is the only thing standing between Europe and a massive deluge of migrants. Turkey is said to host somewhere between two and four million refugees from various conflicts in the Middle East. Fear of the crossing: If crossing the Mediterranean was easy, Europe would have experienced a massive influx of migrants throughout the twentieth century. Not only is it not easy, it is costly and quite deadly, with thousands lost each year. Furthermore, most migrants are not welcomed when they arrive to Europe, many are held in terrible conditions in holding camps in Italy and Greece. Over time, migrants who made it into Europe have reported these dangers and conditions, reducing the overall demand for illegal migration. We do not foresee these five factors changing, at least not all at once. However, there are several reasons to worry about the flow of migrants in 2020. US-Iran tensions have sparked outright military action, while unrest is flaring up across Iran’s sphere of influence. Going forward, Iran could destabilize Iraq or fuel Shia unrest against US-backed regimes. Second, Afghanistan has been the source of most migrants to Europe via sea and land Mediterranean routes – 19.2%. The conflict in the country continues and may flare up with President Trump’s decision to formally withdraw most US troops from the country in 2020. Third, a break in fighting in Libya may encourage sub-Saharan migrants to revisit routes to Europe. Migrants from Guinea, Cote d’Ivoire, and the Democratic Republic of Congo make up over 10% of migrants to Europe. Finally, Turkish relationship with the West could break up further in 2020, causing Ankara to ship migrants northward. We highly doubt that President Erdogan will risk such a break, given that 50% of Turkish exports go to Europe. A European embargo on Turkish exports – which would be a highly likely response to such an act – would crush the already decimated Turkish economy. Bottom Line: While we do not see a return to the 2015 level of migration in 2020, we flag this risk because it would fundamentally undermine political stability in Europe. Black Swan 5: Russia Faces A “Peasant Revolt” Our fifth and final black swan risk for the year stems from Russia. This risk may seem obvious, since the US election creates a dynamic that revives the inherent conflict in US-Russian relations. Russia could seek to accomplish foreign policy objectives – interfering in US elections, punishing regional adversaries. The Trump administration may be friendly toward Russia but Trump is unlikely to veto any sanctions passed by the House and Senate in an election year, should an occasion for new sanctions arise. Conversely Russia could anticipate greater US pressure if the Democrats win in November. Yet it is Russia’s domestic affairs that represent the real underrated risk. Putin’s fourth term as president has been characterized by increased focus on domestic political control and stability as opposed to foreign adventurism. The creation of a special National Guard in 2016, reporting directly to Putin and responsible for quelling domestic unrest, symbolizes the shift in focus. So too does Russia’s adherence to the OPEC 2.0 regime of production control to keep oil prices above their budget breakeven level. Meanwhile Putin’s courting of Europe for the Nordstream II pipeline, and his slight peacemaking efforts with Ukraine, has suggested a slightly more restrained international posture. Strategically it makes little sense for Russia to court negative attention at a time when the US and Europe are at odds over trade and the Middle East, the US is preoccupied with China and Iran, and Russia itself faces mounting domestic problems. The domestic problems are long in coming. The central bank has maintained a stringent monetary policy for the better part of the decade. Despite cutting interest rates recently, monetary and credit conditions are still tight, hurting domestic demand. Moscow has also imposed fiscal austerity, namely by cutting back on state pensions and hiking the value added tax. Real wage growth is weak (Chart II-23), retail sales are falling, and domestic demand looks to weaken further, as Andrija Vesic of BCA Emerging Markets Strategy observes in a recent Special Report. The effect of Russia’s policy austerity has been a drop in public approval of the administration (Chart II-24). Protests erupted in 2019 but were largely drowned out by the larger and more globally significant protests in Hong Kong. These were met by police suppression that has not removed their underlying cause. Putin’s first major decision of the new year was to reshuffle the government, entailing Prime Minister Dmitri Medvedev’s transfer to a new post and the appointment of a new cabinet. This move reveals the need to show some accountability to reduce popular pressure. While Moscow now has room to cut interest rates and ease fiscal policy, it is behind the curve and the weak economy will add fuel to domestic unrest. Chart II-23Sluggish Wage Growth Threatens Russian Stability Chart II-24Austerity Weighed On The Administration's Popularity In Russia   Meanwhile Putin’s efforts to alter the Russian constitution so he can stay in power beyond current term limits, effectively becoming emperor for life, like Xi Jinping, should not be dismissed merely because they are expected. They reflect a need to take advantage of Putin’s popular standing to consolidate domestic political power at a time when the ruling United Russia party and the federal government face discontent. They also ensure that strategic conflict with the United States will take on an ideological dimension. Russia's recent cabinet shakeup is positive from the point of view of economic reform. And the country's monetary and fiscal room provide a basis for remaining overweight equities within EM, as our Emerging Markets Strategy recommends. However, Russian equities have rallied hard and the political risk is understated. Chart II-25Russian Political Risk Is Unsustainably Low Bottom Line: It is never easy predicting Putin’s next international move. Our market-based indicators of Russian political risk have hit multi-year lows, but both the domestic and international context suggest that these lows will not be sustained (Chart II-25). A new bout of risk can emanate from Putin, or from changes in Washington, or from the Russian people themselves. What would take the world by surprise would be domestic unrest on a larger scale than Russia can easily suppress through the police force. Housekeeping We are closing our long European Union / short Chinese equities strategic trade with a 1.61% loss since inception on May 10, 2019. Dhaval Joshi of BCA’s European Investment Strategy downgraded the Eurostoxx 50 to underweight versus the S&P 500 and the Nikkei 225 this week. He makes the point that the Euro Area bond yield 6-month impulse hit 100 bps – a critical technical level – and will be a strong headwind to growth. We will look to reopen this trade at a later date when the euphoria over the “phase one” trade deal subsides, as we still favor European equities and DM bourses over EM. We will reinstitute our long Brent crude H2 2020 versus H2 2021 tactical position, which was stopped out on January 9, 2020. We remain bullish on oil fundamentals and expect Middle East instability to add a political risk premium. China's stimulus and the oil view also give reason for us to reinitiate our long Malaysian equities relative to EM as a tactical position. The Malaysian ringgit will benefit as oil prices move higher, helping Malaysian companies make payments on their large pile of dollar-denominated debt and improving household purchasing power. Higher oil prices also correlate with higher equity prices, while China's stimulus and the US trade ceasefire will push the US dollar lower and help trade revive in the region. Marko Papic Chief Strategist, Clocktower Group Matt Gertken Geopolitical Strategist Footnotes 1 Observe how little attention the public paid to US-China saber-rattling around China’s announcement of an Air Defense Identification Zone in the East China Sea that year.

Bank Credit Analyst

Highlights The liquidity-driven rally will soon be followed by an acceleration in global growth. The economic recovery will bump up expectations of long-term profit growth. The dollar has downside, but the euro will not benefit much. Overweight stocks relative to bonds and bet on traditional cyclical sectors and commodities. The potential for outperformance of value relative to growth favors European equities. The probability of a tech mania is escalating: how should investors factor an expanding bubble into their portfolios? Feature Chart I-1A Bull Market In Stocks And Volatility? Despite all odds, the nCoV-2019 outbreak is barely denting the S&P 500’s frenetic rally. Plentiful liquidity, thawing Sino-US trade relations and improving economic activity in Asia, all have created ideal conditions for risk assets to appreciate on a cyclical basis. Stocks may look increasingly expensive and are primed to correct, but the bubble will expand further. After lifting asset valuations, monetary policy easing will soon boost worldwide economic activity. Consequently, earnings in the US and Europe will improve. As long as central bankers remain unconcerned about inflation, investors will bid up stocks. Investors should remember we are in the final innings of a bull market. Stocks can deliver outsized returns during this period, but often at the cost of elevated volatility, and the options market is not pricing in this uncertainty (Chart I-1). Moreover, timing the ultimate end of the bubble is extremely difficult. Hence, we prefer to look for assets that can still benefit from easy monetary conditions and rebounding growth, but are not as expensive as equities. Industrial commodities fit that description, especially after their recent selloff. The dollar remains a crucial asset to gauge the path of least resistance for assets. If it refuses to swoon, then it will indicate that global growth is in a weaker state than we foresaw. The good news is that the broad trade-weighted dollar seems to have peaked. Accommodative Monetary Conditions Are Here To Stay Easy liquidity has been the lifeblood of the S&P 500’s rally. The surge in the index coincided with the lagged impact of the rise in our US Financial Liquidity Index (Chart I-2). Low rates have allowed stocks to climb higher, yet earnings expectations remain muted. For example, since November 26, 2018, the forward P/E ratio for the S&P 500 has increased from 15.2 to 18.7, while 10-year Treasury yields have collapsed from 3.1% to 1.6%. Meanwhile, expectations for long-term earnings annual growth extracted from equity multiples using a discounted cash flow model have dropped from 2.4% to 1.2%. Historically, easier monetary policy pushes asset prices higher before it lifts economic activity. Historically, easier monetary policy pushes asset prices higher before it lifts economic activity. Yet, stocks and risk assets normally continue to climb when the economy recovers. Even without any additional monetary easing, as long as policy remains accommodative, risk assets will generate positive returns. Expectations for stronger cash flow growth become the force driving asset prices higher. Policy will likely remain accommodative around the world. Within this framework, peak monetary easing is probably behind us, even though liquidity conditions remain extremely accommodative. Nominal interest rates remain very low, and real bond yields are still falling. Unlike in 2018 and 2019, dropping TIPs yields reflect rising inflation expectations (Chart I-3). Those factors together indicate that policy is reflationary, which is confirmed by the gold rally. Chart I-2A Liquidity Driven Rally Chart I-3Today, Lower TIPS Yields Are Reflationary   Chart I-4Economic Activity To Respond To Liquidity Based on the historical lags between monetary easing and manufacturing activity, the global industrial sector is set to mend (Chart I-4). Moreover, the liquidity-driven surge in stock prices, combined with low yields and compressed credit spreads, has eased financial conditions, which creates the catalyst for an industrial recovery. Where will the growth come from? First, worldwide inventory levels have collapsed after making negative contributions to growth since mid-2018 (Chart I-5). Thus, there is room for an inventory restocking. Secondly, auto sales in Europe and China have rebounded to 18.5% from -23% and to -0.1% from -16.4%, respectively. Thirdly, China’s credit and fiscal impulse has improved. The uptick in Chinese iron ore imports indicates that the pass-through from domestic reflation to global economic activity will materialize soon (Chart I-6). Finally, following the Phase One Sino-US trade deal, global business confidence is bottoming, as exemplified by Belgium’s business confidence, Switzerland KOF LEI, Korea's manufacturing business survey, or US CFO and CEO confidence measures. The increase in EM earnings revisions shows that US capex intentions should soon re-accelerate, which bodes well for investment both in the US and globally (Chart I-7). Chart I-5Room For Inventory Restocking Chart I-6China Points To Stronger Global Growth   Construction activity, a gauge of the monetary stance, is looking up across the advanced economies. In the US, housing starts – a leading indicator of domestic demand – have hit a 13-year high. A pullback in this volatile data series is likely, but it should be limited. Vacancies remain at a paltry 1.4%, household formation is solid and affordability is not demanding (Chart I-8). In Europe, construction activity has been relatively stable through the economic slowdown. Even in Canada and Australia, housing transactions have gathered steam quickly following declines in mortgage rates (Chart I-9). Chart I-7Capex Is Set To Recover Chart I-8US Housing Is Robust Chart I-9Even The Canadian And Australian Housing Markets Are Stabilizing Consumers will remain a source of strength for the global economy. The dichotomy between weak manufacturing PMIs and the stable service sector reflects a healthy consumer spending. December retail sales in Europe and the US corroborate this assessment. The stabilization in US business confidence suggests that household incomes are not in as much jeopardy as three months ago. As household net worth and credit growth improve further, a stable outlook for household income will underwrite greater gains in consumption. Policy will likely remain accommodative around the world. For the time being, US inflationary pressures are muted. The New York Fed’s Underlying Inflation Gauge has rolled over, hourly earnings growth has moved back below 3%, our pipeline inflation indicator derived from the ISM is weak, and core producer prices are flagging (Chart I-10). This trend is not US-specific. In the OECD, core consumer price inflation is set to decelerate due to the lagged impact of the manufacturing slowdown. Central banks are also constrained to remain dovish by their own rhetoric. The Fed's statement this week was a testament to this reality. Central banks are increasingly looking to set symmetrical inflation targets. After a decade of missing their targets, a symmetric target would imply keeping policy easier for longer, even if realized inflation moves back above 2%. A rebound in global growth and weak inflation should create a poisonous environment for the US dollar. Finally, fiscal policy will make a small positive contribution to growth in most major advanced economies in 2020, particularly in Germany and the UK (Table I-1). Chart I-10Limited Inflation Will Allow The Fed To Remain Easy Table I-1Modest Fiscal Easing In 2020   The Dollar And The Sino-US Phase One Deal At first glance, a rebound in global growth and weak inflation should create a poisonous environment for the US dollar (Chart I-11). As we have often argued, the dollar’s defining characteristic is its pronounced counter-cyclicality. Chart I-11A Painful Backdrop For The Greenback Deteriorating dollar fundamentals make this risk particularly relevant. US interest rates are well above those in the rest of the G10, but the gap in short rates has significantly narrowed. Historically, the direction of rates differentials and not their levels has determined the trend in the USD (Chart I-12). Moreover, real differentials at the long end of the curve support the notion that the maximum tailwinds for the dollar are behind us (Chart I-12, bottom panel). Furthermore, now that the US Treasury has replenished its accounts at the Federal Reserve, the Fed’s addition of excess reserves in the system will likely become increasingly negative for the dollar, especially against EM currencies. Likewise, relative money supply trends between the US, Europe, Japan and China already predict a decline in the dollar (Chart I-13). Chart I-12Interest Rate Differentials Do Not Favor The Dollar... Chart I-13...Neither Do Money Supply Trends   Chart I-14The Phase One Deal Is Ambitious The recent Sino-US trade agreement obscures what appears to be a straightforward picture. According to the Phase One deal signed mid-January, China will increase its US imports by $200 billion in the next two years vis-à-vis the high-water mark of $186 billion reached in 2017. This is an extremely ambitious goal (Chart I-14). Politically, it is positive that China has committed to buy manufactured goods and services in addition to commodities. However, the scale of the increase in imports of US manufactured goods is large, at $77 billion. China cannot fulfill this obligation if domestic growth merely stabilizes or picks up just a little, especially now that the domestic economy is in the midst of a spreading illness. It will have to substitute some of its European and Japanese imports with US goods. A consequence of this trade deal is that the euro’s gains will probably lag those recorded in normal business cycle upswings. Historically, European growth outperforms the US when China’s monetary conditions are easing and its marginal propensity to consume is rising (Chart I-15). However, given the potential for China to substitute European goods in favor of US ones, China’s economic reacceleration probably will not benefit Europe as much as it normally does. China may not ultimately follow through with as big of US purchases as it has promised, but it is likely, at least initially, to show good faith in the agreement. The euro’s gains will probably lag those recorded in normal business cycle upswings. While the trade agreement is a headwind for the euro, it is a positive for the Chinese yuan. The US output gap stands at 0.1% of potential GDP and the US labor market is near full employment. The US industrial sector does not possess the required spare capacity to fulfill additional Chinese demand. To equilibrate the market for US goods, prices will have to adjust to become more favorable for Chinese purchasers. The simplest mechanism to achieve this outcome is for the RMB to appreciate. Meanwhile, the euro is trading 16% below its equilibrium, which will allow European producers to fulfill US domestic demand. A widening US trade deficit with Europe would undo improvements in the trade balance with China. The probability that US equities correct further in the short-term is elevated. The implication for the dollar is that the broad trade-weighted USD will likely outperform the Dollar Index (DXY). The euro represents 18.9% of the broad trade-weighted dollar versus 57.6% of the DXY. Asian currencies, EM currencies at large, the AUD and the NZD, all should benefit from their close correlation with the RMB (Chart I-16). Chart I-15Europe Normally Wins When China Recovers Chart I-16EM, Asian, And Antipodean Exchange Rates Love A Strong RMB   Obviously, before the RMB and the assets linked to it can appreciate further, the panic surrounding the coronavirus will have to dissipate. However, the economic damage created by SARS was short lived. This respiratory syndrome resulted in a 2.4% contraction Hong-Kong’s GDP in the second quarter of 2003. The economy of Hong Kong recovered that loss quickly afterward. Investment Forecasts BCA continues to forecast upside in safe-haven yields. Global interest rates remain well below equilibrium and a global economic recovery bodes poorly for bond prices (Chart I-17). However, inflation expectations and not real yields will drive nominal yield changes. The dovish slant of global central banks and the growing likelihood that symmetric inflation targets will become the norm is creating long-term upside risks for inflation. Moreover, if symmetric inflation targets imply lower real short rates in the future, then they also imply lower real long rates today. Investors should begin switching their risk assets into industrial commodity plays, especially after their recent selloff. Easy monetary conditions, decreased real rates and an improvement in economic activity are also consistent with an outperformance of assets with higher yields. High-yield bonds, which offer attractive breakeven spreads, will benefit from this backdrop (Chart I-18). Furthermore, carry trades will likely continue to perform well. In addition to low interest rates across most of the G10, the low currency volatility caused by an extended period of easy policy will continue to encourage carry-seeking strategies. Chart I-17Bonds Are Still Expensive Chart I-18Where Is The Value In Credit?   An environment in which growth is accelerating and monetary policy is accommodative argues in favor of stocks. Our profit growth model for the S&P 500 has finally moved back into positive territory. As earnings improve, investors will likely re-rate depressed long-term growth expectations for cash flows (Chart I-19). The flip side is that equity risk premia are elevated, especially outside the US (Chart I-19). Hence, as long as accelerating growth (but not tighter policy) drives up yields, equities should withstand rising borrowing costs. The use of passive investing and the prevalence of “closet indexers” accentuates the risk that a tech mania could blossom. The 400 point surge in the S&P 500 since early October complicates the picture. The probability that US equities correct further in the short-term is elevated, based on their short-term momentum and sentiment measures, such as the put/call ratio (Chart I-20). Foreign equities will continue to correct along US ones, even if they are cheaper. Chart I-19Elevated Stock Multiples Reflect Low Yields, Not Growth Exuberance Chart I-20Tactical Risks For Stocks   Chart I-21Buy Commodities/Sell Stocks? The coronavirus panic seems to be the catalyst for such a correction. When a market is overextended, any shock can cause a pullback in prices. Moreover, as of writing, medical professionals still have to ascertain the virus’s severity and potential mutations. Therefore, risk assets must embed a significant risk premium for such uncertainty, even if ultimately the infection turns out to be mild. However, that risk premium will likely prove to be short lived. During the SARS crisis in 2003, stocks bottomed when the number of reported new cases peaked. The tech sector has plentiful downside if the correction gathers strength. As indicated in BCA’s US Equity Sector Strategy, Apple, Microsoft, Google, Amazon and Facebook account for 18% of the US market capitalization, which is the highest market concentration since the late 1990s tech bubble. Investors should begin switching their risk assets into industrial commodity plays, especially after their recent selloff. Commodity prices are trading at a large discount to US equities. Moreover, the momentum of natural resource prices relative to stocks has begun to form a positive divergence with the price ratio of these two assets (Chart I-21). Technical divergences such as the one visible in the ratio of commodities to equities are often positive signals. Low real rates, an ample liquidity backdrop, a global economic recovery, a weak broad trade-weighted dollar and a strong RMB, all benefit commodities over equities. Tech stocks underperform commodities when the dollar weakens and growth strengthens. Moreover, our positive stance on the RMB justifies stronger prices for copper, oil and EM equities (Chart I-22). Chart I-22The Winners From A CNY Rebound Our US Equity Strategy Service has also reiterated its preference for industrials and energy stocks, and it recently upgraded materials stocks to neutral.1 All three sectors trade at significant valuation discounts to the broad market and to tech stocks in particular. They are also oversold in relative terms. Finally, their operating metrics are improving, a trend which will be magnified if global growth re-accelerates. Do not make these bets aggressively. A weakening broad trade-weighted dollar would allow for a rotation into foreign equities and an outperformance of value relative to growth stocks. The share of US equities in the MSCI All-Country World Index is a direct function of the broad trade-weighted dollar (Chart I-23). Moreover, since 1971, the dollar and the relative performance of growth stocks versus value stocks have exhibited a positive correlation (Chart I-24). Thus, the dollar’s recent strength has been a key component behind the run enjoyed by tech stocks. Chart I-23Global Stocks Love A Soft Dollar Chart I-24Value Stocks Needs A Weaker Dollar To Outperform Growth Stocks Despite the risks to the euro discussed in the previous section, European equities could still outperform US equities. Such a move would be consistent with value stocks beating growth equities (Chart I-24, bottom panel). This correlation exists because the euro area has a combined 17.7% weighting to tech and healthcare stocks compared with a 37.1% allocation in US benchmarks. Moreover, a cheap euro should allow European industrials and materials to outperform their US counterparts. Finally, the recent uptick in the European credit impulse indicates that an acceleration in European profit growth is imminent, a view that is in line with our preference for European financials (Chart I-25).2 Chart I-25Euro Area Profits Should Improve Bottom Line: The current environment remains favorable for risk assets on a 12-month investment horizon. As such, we expect stocks and bond yields to continue to rise in 2020. Moreover, a pick-up in global growth, along with a fall in the broad trade-weighted dollar, should weigh on tech and growth stocks, and boost the attractiveness of commodity plays, industrial, energy and materials stocks, as well as European and EM equities. Forecast Meets Strategy Liquidity-driven rallies, such as the current one, can carry on regardless of the fundamentals. As Keynes noted 90 years ago: “Markets can remain irrational longer than you can stay solvent.” The gap between forecast and strategy can be great. The use of passive investing and the prevalence of “closet indexers” accentuates the risk that a tech mania could blossom. We assign a substantial 30% probability to the risk of another tech mania. Outflows from equity ETFs and mutual funds have been large. Investors will be tempted to move back into those vehicles if stocks continue to rally on the back of plentiful liquidity and improving global growth (Chart I-26). In the process, the new inflows will prop up the over-represented, over-valued, and over-extended tech behemoths. Chart I-26Depressed Equity Flows Should Pick Up The current tech bubble can easily run a lot further. Based on current valuations, the NASDAQ trades at a P/E ratio of 31 compared with 68 in March 2000 (Chart I-27). Moreover, momentum is becoming increasingly favorable for the NASDAQ and other high-flying tech stocks. The NASDAQ is outperforming high-dividend stocks and after a period of consolidation, its relative performance is breaking out. Momentum often performs very well in liquidity-driven rallies. Chart I-27Where Is The Bubble? Chart I-28Debt Loads Are Already High Everywhere A full-fledged tech mania would make our overweight equities / underweight bonds a profitable call, but it would invalidate our sector and regional recommendations. Moreover, with a few exceptions in China and Taiwan, the major tech bellwethers are listed in the US. A tech bubble would most likely push our bearish dollar stance to the offside. Bubbles are dangerous: participating on the upside is easy, but cashing out is not. Moreover, financial bubbles tend to exacerbate the economic pain that follows the bust. During manic phases, capital is poorly invested and the economy becomes geared to the sectors that benefit from the financial excesses. These assets lose their value when the bubble deflates. Moreover, bubbles often result in growing private-sector indebtedness. Writing off or paying back this debt saps the economy’s vitality. Making matters worse, today overall indebtedness is unprecedented and central banks have little room to reflate the global economy once the bubble bursts (Chart I-28). Finally, US/Iran tensions will create additional risk in the years ahead. Matt Gertken, BCA’s Geopolitical Strategist, warns that the ratcheting down of tensions following Iran’s retaliation to General Soleimani’s assassination is temporary.3 As a result, the oil market remains a source of left-handed tail-risk. Section II discusses other potential black swans lurking in the geopolitical sphere. We continue to recommend that investors overweight industrials and energy, upgrade materials to neutral, Europe to overweight, and curtail their USD exposure as long as US inflation remains well behaved and the US inflation breakeven rate stays below the 2.3% to 2.5% range. However, do not make these bets aggressively. Moreover, some downside protection is merited. Due to our very negative view on bonds, we prefer garnering these hedges via a 15% allocation to gold and the yen. The yen is especially attractive because it is one of the few cheap, safe-haven plays (Chart I-29). Chart I-29The Yen Offers Cheap Portfolio Protection Mathieu Savary Vice President The Bank Credit Analyst January 30, 2020 Next Report: February 27, 2020   II. Five Black Swans In 2020 Our top five geopolitical “Black Swans” are risks that the market is seriously underpricing. With the “phase one” trade deal signed, Chinese policy could become less accommodative, resulting in a negative economic surprise. The trade deal may fall victim to domestic politics, raising the risk of a US-China military skirmish. A Biden victory at the Democratic National Convention or a Democratic takeover of the White House could trigger social unrest and violence in the US. A pickup in the flow of migrants to Europe would fundamentally undermine political stability there. Russia’s weak economy will add fuel to domestic unrest, risking an escalation beyond the point of containment. Over the past four years, BCA’s Geopolitical Strategy service has started off each year with their top five geopolitical “Black Swans.” These are low-probability events whose market impact would be significant enough to matter for global investors. Unlike the great Byron Wien’s perennial list of market surprises, we do not assign these events a “better than 50% likelihood of happening.” We offer risks that the market is seriously underpricing by assigning them only single-digit probabilities when we think the reality is closer to 10%-15%, a level at which a risk premium ought to be assigned. Some of our risks below are so obscure that it is not clear how exactly to price them. We exclude issues that are fairly probable, such as flare-ups in Indo-Pakistani conflict. The two major risks of the year – discussed in our Geopolitical Strategy’s annual outlook – are that either US President Donald Trump or Chinese President Xi Jinping overreaches in a major way. But what would truly surprise the market would be a policy-induced relapse in Chinese growth or a direct military clash between the two great powers. That is how we begin. Other risks stem from domestic affairs in the US, Europe, and Russia. Black Swan 1: China’s Financial Crisis Begins Chart II-1A Crackdown On Financial Risk Could Cause China's Economy To Derail The risk of Xi Jinping’s concentration of power in his own person is that individuals can easily make mistakes, especially if unchecked by advisors or institutions. Lower officials will fear correcting or admonishing an all-powerful leader. Inconvenient information may not be relayed up the hierarchy. Such behavior was rampant in Chairman Mao Zedong’s time, leading to famine among other ills. Insofar as President Xi’s cult of personality successfully imitates Mao’s, it will be subject to similar errors. If President Xi overreaches and makes a policy mistake this year, it could occur in economic policy or other policies. We begin with economic policy, as we have charted the risks of Xi’s crackdown on the financial system since early 2017 (Chart II-1). This year is supposed to be the third and final year of Xi Jinping’s “three battles” against systemic risk, pollution, and poverty. The first battle actually focuses on financial risk, i.e. China’s money and credit bubble. The regime has compromised on this goal since mid-2018, allowing monetary easing to stabilize the economy amid the trade war. But with a “phase one” trade deal having been signed, there is an underrated risk that economic policy will return to its prior setting, i.e. become less accommodative (Chart II-2). When Xi launched the “deleveraging campaign” in 2017, we posited that the authorities would be willing to tolerate an annual GDP growth rate below 6%. This would not only cull excesses in the economy but also demonstrate that the administration means business when it says that China must prioritize quality rather than quantity of growth. While Chinese authorities are most likely targeting “around 6%” in 2020, it is entirely possible that the authorities will allow an undershoot in the 5.5%-5.9% range. They will argue that the GDP target for 2020 has already been met on a compound growth rate basis (Chart II-3), as astute clients have pointed out. They may see less need for stimulus than the market expects. Chart II-2Easing Of Trade Tensions May Re-Incentivize Tighter Policy Chart II-3Chinese Authorities Might Tolerate A Growth Undershoot In 2020   Similarly, while urban disposable income is ostensibly lagging its target of doubling 2010 levels by 2020, China’s 13th Five Year Plan, which concludes in 2020, conspicuously avoided treating urban and rural income targets separately. If the authorities focus only on general disposable income, then they are on track to meet their target (Chart II-4). This would reduce the impetus for greater economic support. The Xi administration may aim only for stability, not acceleration, in the economy. There are already tentative signs that Chinese authorities are “satisfied” with the amount of stimulus they have injected: some indicators of money and credit have already peaked (Chart II-5). The crackdown on shadow banking has eased, but informal lending is still contracting. The regime is still pushing reforms that shake up state-owned enterprises. Chart II-4Lower Impetus For Economic Support Due To Improvements In National Income? Chart II-5Has China's Stimulus Peaked?   An added headwind for the Chinese economy stems from the currency. The currency should track interest rate differentials. Beijing’s incremental monetary stimulus, in the form of cuts to bank reserve requirement ratios (RRRs), should also push the renminbi down over time (Chart II-6). However, an essential aspect of any trade deal with the Trump administration is the need to demonstrate that China is not competitively devaluing. Hence the CNY-USD could overshoot in the first half of the year. This is positive for global exports to China, but it tightens Chinese financial conditions at home. A stronger than otherwise justified renminbi would add to any negative economic surprises from less accommodative monetary and fiscal policy. Conventional wisdom says China will stimulate the economy ahead of two major political events: the centenary of the Communist Party in 2021 and the twentieth National Party Congress in 2022. The former is a highly symbolic anniversary, as Xi has reasserted the supremacy of the party in all things, while the latter is more significant for policy, as it is a leadership reshuffle that will usher in the sixth generation of China’s political elite. But conventional wisdom may be wrong – the Xi administration may aim only for stability, not acceleration, in the economy. It would make sense to save dry powder for the next US or global recession. The obvious implication is that China’s economic rebound may lose steam as early as H2 – but the black swan risk is that negative surprises could cause a vicious spiral inside of China. This is a country with massive financial and economic imbalances, a declining potential growth profile, and persistent political obstacles to growth both at home and abroad. Corporate defaults have spiked sharply. While the default rate is lower than elsewhere, the market may be sniffing out a bigger problem as it charges a much higher premium for onshore Chinese bonds (Chart II-7). Chart II-6CNY/USD Overshoot Would Tighten Chinese Financial Conditions Chart II-7Is China's Bond Market Sniffing Out A Problem?   Bottom Line: Our view is that China’s authorities will remain accommodative in 2020 in order to ensure that growth bottoms and the labor market continues to improve. But Beijing has compromised its domestic economic discipline since 2018 in order to fight trade war. The risk now, with a “phase one” deal in hand, is that Xi Jinping returns to his three-year battle plan and underestimates the downward pressures on the economy. The result would be a huge negative surprise for the Chinese and global economy in 2020. Black Swan 2: The US And China Go To War In 2013, we predicted that US-China conflict was “more likely than you think.” This was not just an argument for trade conflict or general enmity that raises the temperature in the Asia-Pacific region – we included military conflict. At the time, the notion that a Sino-American armed conflict was the world’s greatest geopolitical threat seemed ludicrous to many of our clients. We published this analysis in October of that year, months after the Islamic State “Soldier’s Harvest” offensive into Iraq. Trying to direct investors to the budding rivalry between American and Chinese naval forces in the South China Sea amidst the Islamic State hysteria was challenging, to say the least. Chart II-8Americans’ Attitudes Toward China Plunged… The suggestion that an accidental skirmish between the US and China could descend into a full-blown conflict involved a stretch of the imagination because China was not yet perceived by the American public as a major threat. In 2014, only 19%of the US public saw China as the “greatest threat to the US in the future.” This came between Russia, at 23%, and Iran, at 16%. Today, China and Russia share the top spot with 24%. Furthermore, the share of Americans with an unfavorable view of China has increased from 52% to 60% in the six intervening years (Chart II-8). The level of enmity expressed by the US public toward China is still lower than that toward the Soviet Union at the onset of the Cold War in the 1950s (Chart II-9). However, the trajectory of distrust is clearly mounting. We expect this trend to continue: anti-China sentiment is one of the few sources of bipartisan agreement remaining in Washington, DC (Chart II-10). Chinese sentiment toward the United States has also darkened dramatically. The geopolitical rivalry is deepening for structural reasons: as China advances in size and sophistication, it seeks to alter the regional status quo in its favor, while the US grows fearful and seeks to contain China. Chart II-9…But Not Yet To War-Inducing Levels Chart II-10Distrust Of China Is Bipartisan   Chart II-11Newfound American Concern For China’s Repression One example of rising enmity is the US public’s newfound concern for China’s domestic policies and human rights, specifically Beijing’s treatment of its Uyghur minority in Xinjiang. A Google Trends analysis of the term “Uyghur” or “Uyghur camps” shows a dramatic rise in mentions since Q2 of 2018, around the same time the trade war ramped up in a major way (Chart II-11). While startling revelations of re-education camps in Xinjiang emerged in recent years, the reality is that Beijing has used heavy-handed tactics against both militant groups and the wider Uyghur minority since at least 2008 – and much earlier than that. As such, the surge of interest by the general American public and legislators – culminating in the Uyghur Human Rights Policy Act of 2019 – is a product of the renewed strategic tension between the two countries. The same can be said for Hong Kong: the US did not pass a Hong Kong Human Rights and Democracy Act in 2014, during the first round of mass protests, which prompted Beijing to take heavy-handed legal, legislative, and censorship actions. It passed the bill in 2019, after the climate in Washington had changed. Why does this matter for investors? There are two general risks that come with a greater public engagement in foreign policy. First, the “phase one” trade deal between China and the US could fall victim to domestic politics. This deal envisions a large step up in Sino-American economic cooperation. But if China is to import around $200 billion of additional US goods and services over the next two years – an almost inconceivable figure – the US and China will have to tamp down on public vitriol. This is notably the case if the Democratic Party takes over the White House, given its likely greater focus on liberal concerns such as human rights. And yet the latest bills became law under President Trump and a Republican Senate, and we fully expect a second Trump term to involve a re-escalation of trade tensions to ensure compliance with phase one and to try to gain greater structural concessions in phase two. Second, mounting nationalist sentiment will make it more difficult for US and Chinese policymakers to reduce tensions following a potential future military skirmish, accidental or otherwise. While our scenario of a military conflict in 2013 was cogent, the public backlash in the United States was probably manageable.3 Today we can no longer guarantee that this is the case. The “phase one” trade deal risks falling victim to domestic politics due to greater public engagement in foreign policy. China has greater control over the domestic narrative and public discourse, but the rise of the middle class and the government’s efforts to rebuild support for the single-party regime have combined to create an increase in nationalism. Thus it is also more difficult for Chinese policymakers to contain the popular backlash if conflict erupts. In short, the probability of a quick tamping down of public enmity is actively being reduced as American public vilification of China is closing the gap with China’s burgeoning nationalism at an alarming pace. Another of our black swan risks – Taiwan island – is inextricably bound up in this dangerous US-China dynamic. To be clear, Washington will tread carefully, as a conflict over Taiwan could become a major war. Nevertheless Taiwan’s election, as we expected, has injected new vitality into this already underrated geopolitical risk. It is not only that a high-turnout election (Chart II-12) gave President Tsai Ing-wen a greater mandate (Chart II-13), or that her Democratic Progressive Party retained its legislative majority (Chart II-14). It is not only that the trigger for this resounding victory was the revolt in Hong Kong and the Taiwanese people’s rejection of the “one country, two systems” formula for Taiwan. It is also that Tsai followed up with a repudiation of the mainland by declaring, “We don’t have a need to declare ourselves an independent state. We are an independent country already and we call ourselves the Republic of China, Taiwan.” Chart II-12Tsai Ing-Wen Enjoys A Greater Mandate On Higher Turnout… Chart II-13…Popular Support… Chart II-14…And A Legislative Majority This statement is not a minor rhetorical flourish but will be received as a major provocation in Beijing: the crystallization of a long-brewing clash between Beijing and Taipei. Additional punitive economic measures against Taiwan are now guaranteed. Saber-rattling could easily ignite in the coming year and beyond. Taiwan is the epicenter of the US-China strategic conflict. First, Beijing cannot compromise on its security or its political legitimacy and considers the “one China principle” to be inviolable. Second, the US maintains defense relations with Taiwan (and is in the process of delivering on a relatively large new package of arms). Third, the US’s true willingness to fight a war on Taiwan’s behalf is in doubt, which means that deterrence has eroded and there is greater room for miscalculation. Bottom Line: A US-China military skirmish has been our biggest black swan risk since we began writing the BCA Geopolitical Strategy. The difference between then and now, however, is that the American public is actually paying attention. Political ideology – the question of democracy and human rights – is clearly merging with trade, security, and other differences to provoke Americans of all stripes. This makes any skirmish more than just a temporary risk-off event, as it could lead to a string of incidents or even protracted military conflict. Black Swan 3: Social Unrest Erupts In America There are numerous lessons that one can learn from the ongoing unrest in Hong Kong, but perhaps the most cogent one is that Millennials and Generation Z are not as docile and feckless as their elders think. Images of university students and even teenagers throwing flying kicks and Molotov cocktails while clad in black body armor have shocked the world. Perhaps all those violent video games did have a lasting impact on the youth! What is surprising is that so few commentators have made the cognitive leap from the ultra-first world streets of Hong Kong to other developed economies. Perhaps what is clouding analysts’ minds is the idiosyncratic nature of the dispute in Hong Kong, the “one China” angle. However, Hong Kong youth are confronted with similar socio-economic challenges that their peers in other advanced economies face: overpriced real estate and a bifurcated service-sector labor market with few mid-tier jobs that pay a decent wage. There is a risk of rebellion from Trump’s most ardent supporters if he loses the White House. In the US, Millennials and Gen Z are also facing challenges unique to the US. First, their debt burden is much more toxic than that of the older cohorts, given that it is made up of student loans and credit card debt (Chart II-15). Second, they find themselves at odds – demographically and ideologically – with the older cohorts (Chart II-16). Chart II-15Younger American Cohorts Plagued By Toxic Debt Chart II-16Younger And Older Cohorts At Odds Demographically   Chart II-17Massive Turnout To The 2016 Referendum On Trump The adage that the youth are apolitical and do not turn out to vote may have ended thanks to President Trump. The 2018 midterm election, which the Democratic Party successfully turned into a referendum on the president, saw the youth (18-29) turnout nearly double from 20% to 36% (the 30-44 year-old cohort also saw a jump in turnout from 35.6% to 48.8%). The election saw one of the highest turnouts in recent memory, with a 53.4% figure, just two points off the 2016 general election figure (Chart II-17). Despite the high turnout in 2018, the-most-definitely-not-Millennial Vice President Joe Biden continues to lead the Democratic Party in the polls. His probability of winning the nomination is not overwhelming, but it is the highest of any contender. In recent polls, Biden comes third place in Millennial/Gen-Z vote preferences (Chart II-18). Yet he is hardly out of contention, especially for the 30-44 year-old cohort. The view that “Uncle Joe” does not fit the Democratic Party zeitgeist has become so entrenched in the Democratic Party narrative that it became conventional wisdom last year, pulling oddsmakers and betting markets away from the clear frontrunner (Chart II-19). Chart II-18Biden Unpopular Among Young American Voters Chart II-19Bookies Pulled Down 'Uncle Joe’s' Odds, Capturing Democratic Party Zeitgeist     As such, a Biden victory at the Democratic National Convention in Milwaukee, Wisconsin on July 13-16 may come as an affront to the left-wing activists who will surely descend on the convention. This will particularly be the case if Biden wins despite the progressive candidates amassing a majority of overall delegates, which is possible judging by the combined progressive vote share in current polling (Chart II-20). He would arrive in Milwaukee without clearing the 1990 delegate count required to win on the first ballot. On the second ballot, his presidency would then receive a boost from “superdelegates” and those progressives who are unwilling to “rock the boat,” i.e. unify against an establishment candidate with the largest share of votes. This is also how Mayor Michael Bloomberg could pull off a surprise win. Chart II-20Progressives Come Closest To Victory Such a “brokered” – or contested – convention has not occurred since 1952. However, several Democratic Party conventions came close, including 1968, 1972, and 1984. The 1968 one in Chicago was notable for considerable violence and unrest. Even if the Milwaukee Democratic Party convention does not produce unrest, it could sow the seeds for unrest later in the year. First, a breakout Biden performance in the primaries is unlikely. As such, he will likely need to pledge a shift to the left at the convention, including by accepting a progressive vice-presidential candidate. Second, an actual progressive may win the primary. Chart II-21Zealots In Both Parties Perceive Each Other As A National Threat It is likely that either of the two options would be seen as an existential threat to many of Trump’s loyal supporters across the United States. President Trump’s rhetoric often paints the scenario of a Democratic takeover of the White House in apocalyptic terms. And data suggests that the zealots in both parties perceive each other as a “threat to the nation’s wellbeing” (Chart II-21). The American Civil War in the nineteenth century began with the election of a president. This is not just because Abraham Lincoln was a particularly reviled figure in the South, but because the states that ultimately formed the Confederacy saw in his election the demographic writing-on-the-wall. The election was an expression of a general will that, from that point onwards, was irreversible. Given demographic trends in the US today, it is possible that many would see in Trump’s loss a similar fait accompli. If one perceives progressive Democrats as an existential threat to the US constitution, rebellion is the obvious and rational response. Bottom Line: Year 2020 may be a particularly violent one for the US. First, left wing activists may be shocked and angered to learn that Joe Biden (or Bloomberg) is the nominee of the Democratic Party come July. With so much hype behind the progressive candidates throughout the campaign, Biden’s nomination could be seen as an affront to what was supposed to be “the big year” for left-wing candidates. Second, investors have to start thinking about what happens if Biden – or a progressive candidate – goes on to defeat President Trump in the general election. While liberal America took Trump’s election badly, it has demographics – and thus time – on its side. Trump’s most ardent supporters may conclude that his defeat means the end of America as they know it. Black Swan 4: Europe’s Migration Crisis Restarts It is a testament to Europe’s resilience that we do not have a Black Swan scenario based on an election or a political crisis set on the continent in 2020. Support for the common currency and the EU as a whole has rebounded to its highest since 2013. Even early elections in Germany and Italy are unlikely to produce geopolitical risk. The populists in the former are in no danger of outperforming whereas the populists in the latter barely deserve the designation. But what if one of the reasons for the surge in populism – unchecked illegal immigration – were to return in 2020? Chart II-22Decline In Illegal Immigration Dampened European Populism The data suggests that the risk of migrant flows has massively subsided. From its peak of over a million arrivals in 2015, the data shows that only 125,472 migrants crossed into Europe via land and sea routes in the Mediterranean last year (Chart II-22). Why? There are five reasons that we believe have checked the flow of migrants: Supply: The civil wars in Syria, Iraq, and Libya have largely subsided. Heterogenous regions, cities, and neighborhoods have been ethnically cleansed and internal boundaries have largely ossified. It is unlikely that any future conflict will produce massive outflows of refugees as the displacement has already taken place. These countries are now largely divided into armed, ethnically homogenous, camps. Enforcement: The EU has stepped up border enforcement since 2015, pouring resources into the land border with Turkey and naval patrols across the Mediterranean. Individual member states – particularly Italy and Hungary – have also stepped up border enforcement policy. While most EU member states have publicly chided both for “draconian” policies, there is no impetus to force Rome and Budapest to change policy. Libyan Imbroglio: Conflict in Libya has flared up in 2019 with military warlord Khalifa Haftar looking to wrest control from the UN-backed Government of National Accord led by Fayez al-Serraj. The Islamic State has regrouped in the country as well. Ironically, the conflict is helping stem the flow of migrants as African migrants from sub-Saharan countries dare not cross into Libya as they did in 2015 when there was a brief lull in fighting. Turkish benevolence: Ankara is quick to point out that it is the only thing standing between Europe and a massive deluge of migrants. Turkey is said to host somewhere between two and four million refugees from various conflicts in the Middle East. Fear of the crossing: If crossing the Mediterranean was easy, Europe would have experienced a massive influx of migrants throughout the twentieth century. Not only is it not easy, it is costly and quite deadly, with thousands lost each year. Furthermore, most migrants are not welcomed when they arrive to Europe, many are held in terrible conditions in holding camps in Italy and Greece. Over time, migrants who made it into Europe have reported these dangers and conditions, reducing the overall demand for illegal migration. We do not foresee these five factors changing, at least not all at once. However, there are several reasons to worry about the flow of migrants in 2020. US-Iran tensions have sparked outright military action, while unrest is flaring up across Iran’s sphere of influence. Going forward, Iran could destabilize Iraq or fuel Shia unrest against US-backed regimes. Second, Afghanistan has been the source of most migrants to Europe via sea and land Mediterranean routes – 19.2%. The conflict in the country continues and may flare up with President Trump’s decision to formally withdraw most US troops from the country in 2020. Third, a break in fighting in Libya may encourage sub-Saharan migrants to revisit routes to Europe. Migrants from Guinea, Cote d’Ivoire, and the Democratic Republic of Congo make up over 10% of migrants to Europe. Finally, Turkish relationship with the West could break up further in 2020, causing Ankara to ship migrants northward. We highly doubt that President Erdogan will risk such a break, given that 50% of Turkish exports go to Europe. A European embargo on Turkish exports – which would be a highly likely response to such an act – would crush the already decimated Turkish economy. Bottom Line: While we do not see a return to the 2015 level of migration in 2020, we flag this risk because it would fundamentally undermine political stability in Europe. Black Swan 5: Russia Faces A “Peasant Revolt” Our fifth and final black swan risk for the year stems from Russia. This risk may seem obvious, since the US election creates a dynamic that revives the inherent conflict in US-Russian relations. Russia could seek to accomplish foreign policy objectives – interfering in US elections, punishing regional adversaries. The Trump administration may be friendly toward Russia but Trump is unlikely to veto any sanctions passed by the House and Senate in an election year, should an occasion for new sanctions arise. Conversely Russia could anticipate greater US pressure if the Democrats win in November. Yet it is Russia’s domestic affairs that represent the real underrated risk. Putin’s fourth term as president has been characterized by increased focus on domestic political control and stability as opposed to foreign adventurism. The creation of a special National Guard in 2016, reporting directly to Putin and responsible for quelling domestic unrest, symbolizes the shift in focus. So too does Russia’s adherence to the OPEC 2.0 regime of production control to keep oil prices above their budget breakeven level. Meanwhile Putin’s courting of Europe for the Nordstream II pipeline, and his slight peacemaking efforts with Ukraine, has suggested a slightly more restrained international posture. Strategically it makes little sense for Russia to court negative attention at a time when the US and Europe are at odds over trade and the Middle East, the US is preoccupied with China and Iran, and Russia itself faces mounting domestic problems. The domestic problems are long in coming. The central bank has maintained a stringent monetary policy for the better part of the decade. Despite cutting interest rates recently, monetary and credit conditions are still tight, hurting domestic demand. Moscow has also imposed fiscal austerity, namely by cutting back on state pensions and hiking the value added tax. Real wage growth is weak (Chart II-23), retail sales are falling, and domestic demand looks to weaken further, as Andrija Vesic of BCA Emerging Markets Strategy observes in a recent Special Report. The effect of Russia’s policy austerity has been a drop in public approval of the administration (Chart II-24). Protests erupted in 2019 but were largely drowned out by the larger and more globally significant protests in Hong Kong. These were met by police suppression that has not removed their underlying cause. Putin’s first major decision of the new year was to reshuffle the government, entailing Prime Minister Dmitri Medvedev’s transfer to a new post and the appointment of a new cabinet. This move reveals the need to show some accountability to reduce popular pressure. While Moscow now has room to cut interest rates and ease fiscal policy, it is behind the curve and the weak economy will add fuel to domestic unrest. Chart II-23Sluggish Wage Growth Threatens Russian Stability Chart II-24Austerity Weighed On The Administration's Popularity In Russia   Meanwhile Putin’s efforts to alter the Russian constitution so he can stay in power beyond current term limits, effectively becoming emperor for life, like Xi Jinping, should not be dismissed merely because they are expected. They reflect a need to take advantage of Putin’s popular standing to consolidate domestic political power at a time when the ruling United Russia party and the federal government face discontent. They also ensure that strategic conflict with the United States will take on an ideological dimension. Russia's recent cabinet shakeup is positive from the point of view of economic reform. And the country's monetary and fiscal room provide a basis for remaining overweight equities within EM, as our Emerging Markets Strategy recommends. However, Russian equities have rallied hard and the political risk is understated. Chart II-25Russian Political Risk Is Unsustainably Low Bottom Line: It is never easy predicting Putin’s next international move. Our market-based indicators of Russian political risk have hit multi-year lows, but both the domestic and international context suggest that these lows will not be sustained (Chart II-25). A new bout of risk can emanate from Putin, or from changes in Washington, or from the Russian people themselves. What would take the world by surprise would be domestic unrest on a larger scale than Russia can easily suppress through the police force. Housekeeping We are closing our long European Union / short Chinese equities strategic trade with a 1.61% loss since inception on May 10, 2019. Dhaval Joshi of BCA’s European Investment Strategy downgraded the Eurostoxx 50 to underweight versus the S&P 500 and the Nikkei 225 this week. He makes the point that the Euro Area bond yield 6-month impulse hit 100 bps – a critical technical level – and will be a strong headwind to growth. We will look to reopen this trade at a later date when the euphoria over the “phase one” trade deal subsides, as we still favor European equities and DM bourses over EM. We will reinstitute our long Brent crude H2 2020 versus H2 2021 tactical position, which was stopped out on January 9, 2020. We remain bullish on oil fundamentals and expect Middle East instability to add a political risk premium. China's stimulus and the oil view also give reason for us to reinitiate our long Malaysian equities relative to EM as a tactical position. The Malaysian ringgit will benefit as oil prices move higher, helping Malaysian companies make payments on their large pile of dollar-denominated debt and improving household purchasing power. Higher oil prices also correlate with higher equity prices, while China's stimulus and the US trade ceasefire will push the US dollar lower and help trade revive in the region. Marko Papic Chief Strategist, Clocktower Group Matt Gertken Geopolitical Strategist   III. Indicators And Reference Charts The S&P 500 rally looks increasingly vulnerable from a tactical perspective. The US benchmark is overbought, and the percentage of NYSE stocks above their 30-week and 10-week moving averages is rolling over at elevated levels. Additionally, the number of NYSE new highs minus new lows has moved in a parabolic fashion and has hit levels that in previous years have warned of an imminent correction. The spread of nCoV-2019 is likely to be the catalyst to a pullback that could cause the S&P 500 to retest its October 2019 breakout. An improving outlook for global growth, limited inflationary pressures and global central banks who maintain an accommodative monetary stance bode well for stocks. Therefore, the anticipated equity correction will not morph into a bear market. For now, our Monetary Indicator remains at extremely elevated levels. Furthermore, our Composite Technical Indicator has strengthened. Additionally, our BCA Composite Valuation index suggests that stocks are expensive, but not so much as to cancel out the supportive monetary and technical backdrop. Finally, our Speculation Indicator is elevated, but is not so high as to warn of an imminent market top. This somewhat muted level of speculation is congruent with the expectation of low long-term growth rates for profits embedded in equity prices. In contrast to our Revealed Preference Indicator, our Willingness-to-Pay (WTP) is moving in accordance with our constructive cyclical stance for stocks. Indeed, the WTP for the US, Japan and Europe continues to improve. The WTP indicator tracks flows, and thus provides information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. This broad-based improvement therefore bodes well for equities. Meanwhile, net earnings revisions appear to be forming a trough. 10-year Treasury yields remain extremely expensive. Moreover, according to our Composite Technical Indicator, T-Note prices are losing momentum. The fear surrounding the spread of the new coronavirus has cause bonds to rally again, but this is likely to be the last hurrah for the Treasury markets before a major reversal takes hold. The rising risk premia linked to the coronavirus is also helping the dollar right now, but signs that global growth is bottoming, such as the stabilization in the global PMIs, the pick-up in the German ZEW and Belgium’s Business Confidence surveys, or the improvement in Asia’s export growth, point to a worsening outlook for the counter-cyclical US dollar. Moreover, the dollar trades at a large premium of 24.5% relative to its purchasing-power parity equilibrium. Additionally, the negative divergence between the dollar and our Composite Momentum Indicator suggests that the dollar is technically vulnerable. In fact, the very modest pick-up in the dollar in response to the severe fears created by the spreading illness in China argues that dollar buying might have become exhausted. Finally, commodity prices have corrected meaningfully in response to the stronger dollar and the growth fears created by the spread of the coronavirus. However, they have not pulled back below the levels where they traded when they broke out in late 2019. Moreover, the advance/decline line of the Continuous Commodity Index remains at an elevated level, indicating underlying strength in the commodity complex. Natural resources prices will likely become the key beneficiaries of both the eventual pullback in virus-related fears and the weaker dollar.   EQUITIES: Chart III-1US Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Chart III-5US Stock Market Valuation Chart III-6US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance   FIXED INCOME: Chart III-9US Treasurys And Valuations Chart III-10Yield Curve Slopes Chart III-11Selected US Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets   CURRENCIES: Chart III-16US Dollar And PPP Chart III-17US Dollar And Indicator Chart III-18US Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning   ECONOMY: Chart III-28US And Global Macro Backdrop Chart III-29US Macro Snapshot Chart III-30US Growth Outlook Chart III-31US Cyclical Spending Chart III-32US Labor Market Chart III-33US Consumption Chart III-34US Housing Chart III-35US Debt And Deleveraging   Chart III-36US Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China   Mathieu Savary Vice President The Bank Credit Analyst   Footnotes 1 Please see US Equity Strategy Weekly Report "Three EPS Scenarios," dated January 13, 2020, available at uses.bcaresearch.com; US Equity Strategy Insight Report "Bombed Out Energy," dated January 8, 2020, available at uses.bcaresearch.com; US Equity Strategy Special Report "Industrials: Start Your Engines," dated January 21, 2020, available at uses.bcaresearch.com 2  Please see The Bank Credit Analyst Monthly Report "January 2020," dated December 20, 2019 available at bca.bcaresearch.com; The Bank Credit Analyst Monthly Report "OUTLOOK 2020: Heading Into The End Game," dated November 22, 2019 available at bca.bcaresearch.com 3 Please see Geopolitical Strategy "A Reprieve Amid The Bull Market In Iran Tensions," dated January 8, 2020, available at gps.bcaresearch.com 4 Observe how little attention the public paid to US-China saber-rattling around China’s announcement of an Air Defense Identification Zone in the East China Sea that year.

An analysis on Hong Kong is available below. Highlights The correction in EM risk assets and currencies will be larger than during the SARS outbreak. A number of market indicators that are pertinent for EM assets are sending a disconcerting message. The trouble is that they have relapsed from already low levels. We are closing our long position in EM stocks to manage risk and continue recommending underweighting EM equities and credit versus their DM counterparts. Stay short EM currencies versus the US dollar. A new trade: Go short Hong Kong banks / long Taiwanese banks. Feature Chart I-1Global Equity Correction: SARS- And Coronavirus-Episodes It is tempting to compare the potential impact of the current coronavirus outbreak on the global economy and financial markets with that of SARS in the spring of 2003. The correction in global equities due to the SARS outbreak lasted only a couple of days during April 2003, and global share prices sold off by only 2.5% (Chart I-1). During that period, the EM equity index dropped by 4% and emerging Asian bourses by 8% in US dollar terms (Chart I-2). Presently, the drawdowns in global stocks and EM share prices have been 2.5% and 4%, respectively. Thus, the magnitude of the current correction is on a par with what occurred during the 2003 SARS outbreak (Charts I-1 and I-2). Further, in 2003, share prices bottomed when the number of registered new SARS infections – on a rolling fortnight basis – declined (Chart I-3). This was true both worldwide and in the case of Hong Kong. Chart I-2EM And Asian Stock Corrections: SARS- And Coronavirus-Episodes Chart I-3Number Of New Cases And Share Prices: Global And Hong Kong However, such simplistic comparisons between SARS in 2003 and the current coronavirus outbreak are uninformative. There are striking economic differences between these two episodes. The impact on both the Chinese and global economies will be larger today compared with the effects of SARS. This is true even if the spread of the coronavirus is contained soon and the number of infections and deaths peaks earlier and at much lower levels compared to the SARS outbreak. The rationale behind the meaningful impact on Chinese and global growth is two-fold: The safety measures undertaken by the Chinese authorities, including the extension of the Lunar New Year holiday period and imposition of limits on travel – are much greater than their response in 2003. These efforts might contain the spread of the virus and save human lives, but they will likely dampen economic activity in the near term. The importance of the Chinese economy in the world and hence its impact have grown immensely since early 2003. Overall, the current correction in EM risk assets and currencies will be larger than the one during the SARS outbreak. China’s Share Of The Global Economy: Today Versus 2003 Table I-1China’s Importance Now And In 2003 China’s economy is much more important to global aggregate demand and growth today than it was in 2003 (Table I-1). Specifically: China’s GDP at purchasing power parity accounts for 19.3% of world GDP compared to 8.3% in 2002 before the SARS outbreak occurred. In nominal US dollar terms, the mainland currently accounts for 17% of global GDP versus 4.3% in 2002. We use 2002 because the SARS outbreak occurred in early 2003, so China’s share of world GDP in 2002 is the more accurate measure of the country’s importance in early 2003. Chinese imports of goods and services make up 13.5% of global trade at present, significantly greater than their 4.5% share in 2002. The mainland’s share of consumption of various industrial metals has surged, from between 10-20% in 2002 to 50-60% presently (Table I-1). For copper, it has soared from 18% in 2002 to its current share of 53%. China’s iron ore imports have risen from 21% of the global total in 2002 to 64% presently. The nation’s oil consumption presently accounts for 13.5% compared with 6.6% in 2002. Total semiconductor sales in China currently constitute 34.6% of global semiconductor sales versus 5% in 2002. Personal computer sales in China make up 20% of worldwide sales compared with 2.4% in 2002. Mobile phones sales in China constituted 11% of worldwide sales in 2002. Today, smartphone sales account for 29% of global sales. Finally, in the past 12 months, passenger car sales in China were 21.5 million units, or 34.5% of the global total. In 2002, China’s share in global passenger auto demand was only 7.3%. Other relevant differences between China’s economy then and now include: Chart I-4China's Leverage In 2003 And Now First, leverage among companies and households was low in 2002 compared with the current debt bubble. Aggregate local currency indebtedness of companies, households and the various levels of government stood at 120% of GDP in 2002, compared with 260% currently (Chart I-4). Even a temporary reduction in cash flows of enterprises due to shutdowns and a plunge in demand will weigh on their ability to service debt. This could in turn temporarily curtail their appetite for new investments and hiring. Second, by 2003 China had just completed a major overhaul of its state-owned enterprises (SOEs) and banks. As a result, the nation was in the early stages of a structural economic boom driven by higher productivity growth. Presently, neither SOE reforms nor deleveraging are meaningfully advanced (Chart I-4, bottom panel). Consequently, China is still in a structural decline in terms of productivity growth. Third, China entered the World Trade Organization in late 2001, and by early 2003 it was enjoying an FDI inflow boom and was on the verge of rapidly increasing its market share in global trade (Chart I-5). Presently, both multinational and Chinese producers are moving their production and supply chains out of China in response to US trade protectionism. Chart I-5China's Global Export Market Share In 2003 And Now Finally, enterprises and organizations were not forced to shut down because of the SARS virus in the spring of 2003. Consequently, the hit to economic activity in the spring of 2003 was mild, as shown in Chart I-6A and I-6B. In contrast, the government today has extended the Chinese New Year holidays by a few days, and some companies will be operating on a part-time basis for a couple of weeks. It is impossible to forecast the evolution of the outbreak, but the odds are that a hit to economic activity in China due to the coronavirus outbreak is likely to be worse than during the SARS episode. Chart I-6AChina: Cyclical Variables During SARS Outbreak Chart I-6BChina: Cyclical Variables During SARS Outbreak On a positive note, the Chinese authorities will certainly augment their stimulus, especially fiscal spending, to counteract the negative impact of the shutdowns on the economy. However, it remains to be seen how long it will take for these stimulus efforts to filter through the economy and offset the drag from poor sentiment. Market Signals Are Disconcerting There are several financial market signals that are often important in terms of gauging primary trends in EM risk assets and currencies: Chart I-7Industrial Metal Prices Are Back To Their Cyclical Lows Base metal prices in general and copper prices in particular have relapsed to their cyclical lows (Chart I-7). In short, industrial metal prices are not confirming a durable recovery in global manufacturing and China/EM domestic demand. Industrial metal prices are leveraged to China’s growth as well as closely correlated with EM ex-China currencies (Chart I-8). This is a bearish signpost for EM exchange rates. Notably, Korea’s bond yields are drifting lower, casting doubt on the sustainability of the nation’s export growth (Chart I-9). The latter is a good barometer of global trade. EM assets are very sensitive to global trade and as such remain at risk. EM small-cap stocks have failed to enter a cyclical bull market, despite investor enthusiasm for EM financial markets following the US-China Phase One trade agreement. Their much-muted rebound is not confirming a broad-based recovery in EM/China growth and improvement in EM domestic fundamentals. Chart I-8EM Currencies: Rebound Has Faded Chart I-9Korean Bond Yields And Global Manufacturing Chart I-10EM Risks Are Tilted To The Downside Similarly, the rebound in our Risk-On/Safe-Haven currency ratio has faded and this indicator has rolled over (Chart I-10). It correlates well with EM share prices, and presently heralds further downside in the latter.  The disconcerting message from these market indicators is that they – unlike the S&P 500 - are not correcting from very overbought levels, but have relapsed and are gapping down from already low levels. Economic data from China and Asia in the coming months will be weak due to coronavirus-related disruptions. Therefore, investors cannot rely on economic data to gauge the direction of the business cycle, Instead, market signals and market-based indicators might become the predominant tools for gauging financial markets directions.     Investment Strategy Last week we recommended investors consider going long EM volatility. The levels of EM and DM currencies’ implied volatility were at all-time lows (Chart I-11). We are reiterating this recommendation. Notably, the previous historical lows in EM and DM currencies’ implied volatility occurred just before major bear markets in EM share prices (Chart I-11). Hence, the odds of a major drawdown in EM share prices are considerable. We gave the benefit of the doubt to the market action and went long EM stocks on December 19, 2019. Given the latest market action, indicators and uncertainty over the Chinese/Asian business cycle, we are closing the open position in EM equities. This trade has been flat since its initiation. The EM equity index in US dollar terms is hovering above major technical support lines (Chart I-12). If this level is decisively broken, the downside could be substantial. Alternatively, if EM share prices find support around these levels, it would signal a budding major bull market. We will monitor market action and indicators and adjust our strategy accordingly. Chart I-11A Record Low Vol = A Major Top In Risk Assets Chart I-12EM Stocks: Will Long-Term Technical Support Hold? Although we upgraded our view on the absolute performance of EM stocks in December, we have continued recommending underweighting EM versus DM. In recent weeks, we have been arguing that we will upgrade EM stocks and credit from underweight to overweight relative to their DM peers if EM share prices and currencies demonstrate resilience amid a correction in global risk assets. So far, they have not been resilient – EM equities have sold off more than their DM peers (Chart I-13) and the weakness in EM currencies has been broad-based. For now, investors should continue underweighting EM equities and credit versus their DM counterparts. The odds of a breakdown in EM currencies are rising. Investors should continue shorting a basket of EM currencies versus the US dollar. Our favored shorts are BRL, CLP, COP, IDR, MYR, PHP, KRW and ZAR. Finally, EM local currency bond yields as well as sovereign and corporate credit spreads are either at record lows or at extremely low levels (Chart I-14). EM sovereign credit spreads appear elevated because the index includes de-facto defaulted sovereigns like Argentina, Venezuela, and others. EM currency trends hold the key for these asset classes. If EM currencies break down, as we expect, EM domestic bond yields will rise, and sovereign and credit spreads will widen. Chart I-13EM Equities Versus DM: New Lows Ahead? Chart I-14Too Much Complacency In EM Local Bonds And Credit Markets     Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com           Hong Kong: Into Uncharted Waters The Hong Kong economy is in recession and its equity prices – stocks domiciled in Hong Kong and included in the MSCI Hong Kong equity index – have underperformed considerably. Is it time to turn positive on Hong Kong equities? We continue to recommend underweighting Hong Kong-domiciled stocks, because the heavyweight sectors – financials and property – remain at risk. The basis is that Hong Kong’s interest rates will likely creep higher as capital outflows persist. Higher borrowing costs will weigh on this highly leveraged economy. Capital Flows And Interest Rates The currency board system mandates the Hong Kong Monetary Authority (HKMA) to maintain a pegged exchange rate with the US dollar. With an open capital account and a fixed exchange rate, the HKMA has little control over interest rates. Chart II-1Banks Excess Reserves AT HKMA And Interest Rates Capital outflows exert depreciation pressure on the currency, forcing the monetary authorities to sell their foreign currency reserves to defend the exchange rate peg. This drains commercial banks’ excess reserves at the central bank, thereby tightening interbank liquidity and lifting interest rates (Chart II-1). In brief, interbank rates need to rise to inhibit capital flight. For now, we expect the heightened socio-political uncertainty in Hong Kong to linger. This will hurt economic growth, thereby depressing economic sentiment and return on capital. In turn, this will continue to spur capital outflows. The latter will exert upward pressure on interest rates. Overall, this could unleash a feedback loop of deteriorating growth conditions, capital outflows and higher interest rates. While it is doubtful that Hong Kong will experience a full-blown crisis, the most likely scenario is a slow leakage of capital out of the city and gradually rising interest rates. A mirror image of capital outflows from Hong Kong is foreign capital inflows in Singapore. In particular, foreigners’ Singapore dollar deposits rose by S$6.8 billion from May to November 2019, and foreign currency deposits in Singaporean banks increased by S$9 billion during the same period (Chart II-2). Chart II-2Non-Residents Deposits In Singapore Confirm Capital Flight Out Of HK Real Estate Blues Hong Kong’s property market is under stress from both falling income/cash flow and slowly rising interest rates. Odds are that various segments of the Hong Kong property market – especially the retail, commercial and high-end residential – have entered an extended downturn. The protests and the coronavirus outbreak have all but halted tourism, especially from the mainland. Mainland Chinese visitors accounted for 75% of total arrivals a year ago, and their spending accounted for over 10% of personal consumption expenditures in Hong Kong. Tourists from the mainland are not expected to return soon due to both Hong Kong’s protests and the travel limitations due to the coronavirus outbreak. Hong Kong’s domestic demand is also anemic, and will stay so given poor business sentiment and a weakening labor market. In a nutshell, the value of retail sales in November plunged by a record 23.6% from a year earlier (Chart II-3). Contracting consumption has resulted in sharply rising vacancies and pushed retail property rents and prices off the cliff for the first time since 2008 (Chart II-4). Retail sector rents and prices have on average deflated by 10% from last year. Consistently, high-street rents have also fallen by about 18% in 2019. In short, rising vacancy rates of retail properties herald further rent decline. Chart II-3HK: Retail Sales Have Collapsed Chart II-4HK Retail Properties: Vacancy, Rents And Prices Hong Kong’s office market is also at risk, with vacancy rates climbing (Chart II-5). Office property prices have dropped by 8%, and prime grade A property prices have plunged a whopping 20% from a year earlier (Chart II-5, bottom panel). Multinational companies and financial firms have been relocating to reduce their rental costs. In the third quarter of this year, office vacancies in the center of Hong Kong reached 7.4%, their highest in 14 years. With respect to Hong Kong‘s residential market, it is a mixed bag. On average, home prices have so far declined by only 3% from their peak in 2019. (Chart II-6, top panel). That said, luxury residential prices have already plunged by 27% from a year ago (Chart II-6, second panel).  The residential sector’s resilience in the middle- and low-ends can be explained by strong end-user demand and lack of speculative purchases over the past three years due to the government’s anti-speculative measures. For example, the number of residential transactions involving stamp duties – a proxy for foreign purchases – has fallen sharply since Q4 2016 due to tougher regulations. Chart II-5HK Offices: Vacancy, Rents And Prices Chart II-6HK Residential Vacancy, Rents And Prices Chart II-7HK: Retail Yields And Interest Rates Even only marginally higher interest rates will be sufficient to hurt real estate. Rental yields on all types of properties are very low and close to borrowing costs (Chart II-7). There is not much of a valuation buffer if borrowing costs rise or rents deflate. In a nutshell, the high-end property market as well as commercial real estate are vulnerable. Importantly, the Hong Kong authorities cannot use lower interest rates to help the economy, leaving fiscal policy as the sole tool. The government has accumulated enormous fiscal surpluses, and it will ramp up spending to stimulate the economy. The authorities have so far announced three tiny fiscal stimulus packages amounting to only 0.8% of GDP in aggregate. This is clearly insufficient to jump start the business cycle amid lingering headwinds. Nevertheless, government expenditures account for only 10% of GDP, and any reasonable jump in spending in the coming months will not be sufficient to preclude a downtrend in the broader economy. Banks Holds The Key Chart II-8HK-Domiciled Banks: Profit Outlook Is Downbeat Hong Kong-domiciled bank share prices are at risk from a deceleration in loan growth, rising non-performing loans (NPLs) and a drop in their net interest rate margins (Chart II-8). Banks’ domestic loans are concentrated in real estate: About 55% of domestic loans consist of lending to property developers and mortgages. Such a high concentration of real estate lending makes Hong Kong banks vulnerable to a property market correction. If banks begin tightening lending standards, the game will be over. At the moment, bankers might be relaxed as they are comparing the current episode with short-lived corrections in the property market and the economy in 2008, 2013 and 2015. However, odds are that this downturn will be more severe. As the economic stress heightens, banks might begin tightening lending standards. In such a case, property prices and construction activity will sink, feeding back into the economy. Notably, this process seems to have started, as evidenced by bank tightening of credit standards for small businesses (Chart II-9). Importantly, the debt service ratio for Hong Kong’s nonfinancial sectors is among the highest in the world (Chart II-10). Provided all outstanding mortgages are floating-rate, any rise in interest rates will increase borrowing costs. Coupled with shrinking nominal incomes, debtors – both households and companies – will struggle to service their debt. Chart II-9HK Banks Have Been Tightening Credit For Small Businesses Chart II-10HK Private Sector: Debt-Service Ratio Is the Highest Investment conclusions We continue to reiterate our underweight position in Hong Kong equities within emerging markets, global and Asian equity portfolios (Chart II-11). The Hong Kong currency peg will be maintained for now, even at the cost of rising interest rates and debt deflation in the real economy. We discussed the Hong Kong exchange rate outlook in a special report last June,  and the main points of that analysis remain valid. The HKMA has an enormous amount of foreign exchange reserves to defend the currency peg. However, the cost of defending the exchange rate will be higher interest rates. The latter will hurt Hong Kong’s highly leveraged economy in general and its property market in particular. As a bet on property market travails, we continue to recommend being short Hong Kong property stocks and long Singapore real estate equities (Chart II-12). The macro justification for this trade is the ability of Singapore to drop interest rates and tolerate currency depreciation, and Hong Kong’s inability to do so. Finally, as a new trade, we recommend shorting Hong Kong-domiciled banks relative to Taiwanese banks. As discussed, Hong Kong banks are exposed to rising borrowing costs, weakening real estate and rising NPLs. Chart II-11Continue Underweighting HK Stocks Chart II-12Stay Short HK Property / Long Singapore Property Stocks We chose Taiwanese banks because they are defensive in nature – i.e., they will likely be a low-beta play within the Asia equity universe.   Lin Xiang, CFA Research Analyst linx@bcaresearch.com   Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Informe especial

Highlights BCA’s “Golden Rule of Bond Investing” framework, which links developed economy government bond returns to central bank policy rate “surprises” versus market expectations, also works in China. The relationship between unexpected changes in China’s de facto short-term policy rate and government bond yields has been surprisingly strong over the past decade. Any additional easing by the PBoC this year is likely to be focused on reducing lending rates to the real economy, not interbank rates (which drive government bond yields). As such, yields at the short-end are likely to be flat until later this year at the earliest, whereas yields at the long-end are likely to move modestly higher, at most. The persistent historical gap between economic growth and bond yields in China makes it difficult to forecast the structural outlook for yields using conventional methods. To the extent that Chinese policymakers succeed at shifting the drivers of growth from investment to consumption, we believe that bond yields are more likely to structurally rise than fall. Over the coming 6-12 months, investors should underweight Chinese government bonds versus Chinese equities and onshore corporate bonds. Within a regional government bond portfolio, however, investors should overweight USD-hedged China versus US and developed markets ex-US, as well as in unhedged terms. Feature Last year’s inclusion of Chinese onshore government and policy bank bonds in the Bloomberg Barclays Global Aggregate Index was a significant milestone of China’s journey to internationalize its capital markets. Other bond benchmark providers have since followed suit, highlighting that the trend of increased passive exposure to Chinese assets is likely to continue. Over the past year, the bulk of the market discussion concerning the addition of China to the major bond indices has focused on estimating the size of potential capital inflows that could be triggered and the related impact on onshore bond yields. By contrast, comparatively little work has been done to analyze the core drivers of Chinese government bond yields, and how they compare to the factors that influence yields in the developed markets that dominate the bond indices. This Special Report attempts to fill a hole in the analysis of Chinese bonds. This Special Report attempts to fill that hole in the analysis of Chinese bonds. We look at the predictability of China’s government bond market through the lens of BCA’s “golden rule” framework, and find a surprisingly strong relationship between changes in China’s de facto short-term policy rate and government bond yields. We then present our cyclical (6-12 month) and secular outlooks for government yields given this relationship, and conclude by presenting four specific investment recommendations pertaining to China’s fixed-income market with two audiences in mind: mainland/onshore investors who are focused on returns in unhedged RMB terms, and global fixed-income investors who are primarily focused on hedged US-dollar regional bond exposure. The Golden Rule Of Bond Investing, With Chinese Characteristics In a July 2018 Special Report,1 BCA’s Chief US Bond Strategist, Ryan Swift, elegantly distilled the cyclical US government bond call into a simple question: During the next 12-months, will the Federal Reserve move interest rates by more or less than what is currently priced into the market? Chart 1The (US) Golden Rule Of Bond Investing In Practice Ryan argued that a predictive framework for US Treasury returns built around the answer to this question has historically worked so well that it should be referred to as the “Golden Rule of bond investing” (Chart 1). In a follow-up report, our Global Fixed Income Strategy service confirmed that the Golden Rule also largely works in non-US developed market economies, with the exception of Japan due to the absence of any meaningful fluctuation in policy rates over the past two decades.2 The Golden Rule provides a very strong framework to aid fixed-income investors with their cyclical (i.e. 6-12 month) asset allocation decisions, by quantitatively linking government bond returns relative to cash – in other words, the excess return earned by taking duration risk - to policy rate “surprises” compared to what is discounted in shorter-term money markets. The practical application is that a decision to allocate to longer-maturity government bonds is reduced to a bet on whether a central bank will adjust policy rates by more or less than the market expects. The first question we address in this report is to what degree does the Golden Rule apply in China (in yield space rather than in return space), along with an explanation of any differences that may exist. However, we must first note why the Golden Rule of bond investing works, particularly in the US. The first reason is that there is a strong relationship between the US 3-month T-bill rate and Treasury yields of all other maturities. Conceptually, all fixed income investors have a choice when buying US government bonds: they can purchase a 3-month Treasury bill and simply perpetually roll over the position as it matures, or they can purchase a Treasury bond of a longer maturity. This means that yields on longer maturity Treasury bonds simply reflect investor expectations for the average 3-month T-bill rate over the life of the bond, plus some positive risk premium to compensate for the inherent uncertainty of the path and tendency of short-term yields. This helps explain the close link between cyclical changes in 3-month T-bill rates and yields on longer maturity Treasurys. Chart 2In The US, The 3-Month T-Bill Rate Perfectly Tracks The Fed Funds Rate The second reason for the Golden Rule’s success is that there is a very tight relationship between the effective Fed funds rate and the 3-month T-bill rate. While it is the (higher) discount rate that is the theoretical no-arbitrage ceiling for the 3-month rate, in practice T-bill rates trade extremely close to the Fed funds rate (Chart 2). This means that Fed funds rate “surprises” (relative to traded market expectations) are akin to surprises in the 3-month rate, which in turn strongly influence the expected future path of short-term interest rates and thus yields on longer maturity Treasurys. In China, we noted in a February 2018 Special Report3 that the 7-day interbank repo rate is now the de jure short-term policy rate in China following the establishment of an interest rate corridor system in 2015. Chart 3 presents our first test of the Golden Rule in China (in yield space rather than in return space), by plotting the annual change in the level of Chinese government bond yields alongside the 7-day repo rate “surprise” over the past year from 2010 to the present. Here, we use the first principal component of zero coupon Chinese government bond yields to represent the average level of yields (rather than selecting a particular maturity), and we use the 12-month RMB swap rate (versus 7-day repo) to represent market expectations for the policy rate. The chart highlights that the fit is good, as measured by a 50% R-squared between the two series. However, deviations in the relationship do exist, with the most notable exception having occurred in 2017: Chinese government bond yields rose considerably more than what the annual surprise in the 7-day repo rate would have suggested. Chart 3In China, The Golden Rule Works Decently Well Using 7-Day Repo... Chart 4...And Extremely Well Using 3-Month SHIBOR Chart 4 helps resolve a good portion of the 2017 discrepancy, and clarifies the link between Chinese monetary policy and government bond yields. Chart 4 is similar to Chart 3, except that it replaces the 7-day repo rate surprise with that of 3-month SHIBOR (which trades very closely to the 3-month repo rate). The chart illustrates an even closer fit between the two series (with an R-squared close to 80%), and shows that the 3-month SHIBOR surprise does a meaningfully better job at explaining the 2017 rise in Chinese government bond yields. The Golden Rule of bond investing works surprisingly well in China. The fact that the annual surprise in 3-month SHIBOR has done a better job at predicting changes in bond yields over the past decade underscores that the 3-month repo rate is the de facto short-term policy rate in China, a point that we have made in several previous reports. We have noted that the spike in the 3-month/7-day repo rate spread that occurred in late-2016 and lasted until mid-2018 happened because of China’s crackdown on shadow banking activity. This crackdown caused a funding squeeze for China’s small & medium banks, which caused a material rise in lending rates and government bond yields. This episode highlights that future changes in the 3-month repo rate are likely to reflect both underlying changes in net liquidity provided to large commercial banks (measured by the 7-day repo rate), and any dislocations in the interbank market that have the potential to push up lending rates and government bond yields. Bottom Line: BCA’s “Golden Rule” framework, which links developed economy government bond returns to central bank policy rate “surprises” versus market expectations, works for China as well – using the correct measure of the PBOC policy rate. This provides a useful investment framework for Chinese government bonds, which are now significant part of major global bond market benchmarks. The Cyclical Outlook For Chinese Government Bond Yields Given the establishment of the relationship between Chinese short-term interbank rates and government bond yields detailed above, we are now able to more precisely discuss the likely cyclical trajectory of Chinese government bond yields as a function of Chinese monetary policy. Two opposing forces have the potential to affect China’s government bond market this year. The first, a stabilization and modest rebound in Chinese economic activity, may exert upward pressure on yields due to expectations of eventual policy tightening. The second, continued attempts by the PBoC to ease corporate lending rates, may exert downward pressure on yields as it will reflect not just easy but easier monetary conditions. Yields at the long-end are likely to move modestly higher this year, at most. For investors, the raises the obvious question of whether Chinese government bond yields are likely to move up, down, or trend sideways this year. In our view, yields at the short-end are likely to be flat until later this year at the earliest, whereas yields at the long-end are likely to move modestly higher, at most. Yields at the short-end of China’s government bond curve are likely to stay flat for most of this year. There are two reasons why yields at the short-end of China’s government bond curve are likely to stay flat for most of this year. The first is that the PBoC is generally a reactive central bank and has historically lagged a pickup in economic activity, as illustrated in Chart 5. The chart shows the historical path of 3-month SHIBOR in the year following a bottom in economic activity in 2009, 2012, and 2015, and makes it clear that there has been no precedent for a significant rise in interbank rates in the first nine months of an economic recovery. The 2012 episode did see a very sharp rise in 3-month SHIBOR once the PBoC shifted into tightening mode, but we doubt that this experience will be repeated again unless economic growth accelerates much more aggressively than we expect. The second reason why we expect yields at the short-end of the curve to remain muted this year is because any additional easing by the PBoC is likely to be focused on reducing corporate lending rates, not interbank rates. Chart 6 highlights that while there is a strong correlation between changes in Chinese government bond yields and average lending rates in the economy, the former leads the latter. In the past, this relationship has existed because changes in interbank rates have coincided with reductions in the now obsolete benchmark lending rate, with the former usually occurring earlier than the latter. But in a scenario where the PBoC reduces the loan prime rate (LPR) and keeps net banking sector liquidity roughly constant, the extremely tight relationship shown in Chart 4 suggests that short-term bond yields are unlikely to be affected by a reduction in lending rates. Any meaningful decline in short-term yields below short-term interbank rates would simply prompt banks to stop buying these bonds. Chart 5The PBoC Is Generally A Reactive Central Bank Chart 6Average Lending Rates Lag Short-Term Bond Yields Chart 7China's Yield Curve Is Generally Pro-Cyclical Additional easing by the PBoC does have the potential to impact the long-end of the government bond curve if investors view these actions as a sign that interbank rates will remain low for some time. This view is reinforced by the fact that China’s yield curve is not particularly flat, and thus has room to move lower. However, Chart 7 also shows that China’s yield curve, defined here as the second principal component of zero coupon Chinese government bond yields, is positively correlated with the relative performance of investable Chinese equities. This suggests that there is a procyclical element to the curve. We suspect that this procyclical element will dominate a potential decline in expectations for future short-term interest rates, but that yields at the long-end are likely to move modestly higher this year, at most. Bottom Line: Any additional easing by the PBoC this year is likely to be focused on reducing lending rates to the real economy, not interbank rates (which drive government bond yields). As such, yields at the short-end are likely to be flat until later this year at the earliest, whereas yields at the long-end are likely to move modestly higher, at most. The Secular Outlook For Chinese Government Bond Yields A common approach to forecasting the likely structural trend for nominal government bond yields is to estimate the trajectory of real long-term potential output growth and to add the monetary authority’s inflation target. This framework is based on the idea that interest rates are in equilibrium when the cost of borrowing is roughly equal to nominal income growth, a condition that results in no change in the burden to service existing debt. Chart 8China's Potential Growth Is Likely To Trend Lower... Based on this framework, we would expect Chinese government bond yields to trend down over time, or possibly flat if the PBoC were to tolerate higher inflation over the coming decade. Chart 8 illustrates the IMF’s forecast of falling real potential growth in China over the coming several years, which is consistent with a shift in the composition of growth from investment to consumption as well as China’s looming demographic crisis. But Chart 9highlights an obvious problem with applying this framework to forecast the secular trend in Chinese government bond yields: over the past decade, yields have persistently averaged below actual nominal GDP growth, both in China and in the developed world. In the latter case, it is an open question whether this will continue to be true in the future, but in China’s case it is clear that government bond yields have little connection (in magnitude) to the pace of GDP growth. This reflects the longstanding strategy of Chinese policymakers to promote investment via persistently low interest rates, as has occurred in other manufacturing and export-oriented Asian economies (Chart 10). Chart 9...But Bond Yields Are Well Below GDP Growth, Just Like In Developed Markets Chart 10In Industrial Asian Economies, Low Bond Yields Are A Policy Choice   The persistent historical gap between economic growth and bond yields in China makes it difficult to forecast the structural outlook for yields using conventional methods, and largely limits us to inference. To the extent that Chinese policymakers succeed at shifting the drivers of growth from investment to consumption, bond yields are more likely to rise than fall over time. This is because as long as interest rates remain well below the pace of income growth, the incentive to excessively borrow (and invest) is likely to persist. Chart 11China Needs Higher Interest Rates, But Only To A Point However, even in a scenario where Chinese government bond yields structurally trend higher, we expect the rise to be modest. Chart 11 highlights that China’s “private sector” debt service ratio is extremely elevated, underscoring that the country’s ability to tolerate significantly higher bond yields is not strong. In addition, since 2015, China’s debt service ratio has been mostly flat despite rising a rising debt-to-GDP ratio, which has been achieved through lower short-term interest rates. To the extent that policymakers fail to make meaningful progress in shifting China’s growth drivers away from investment over the coming few years, lower (potentially sharply lower) bond yields would appear to be all but inevitable to cope with what would become a permanently growing drag on economic activity from the servicing of debt. For now, we would characterize this scenario as a risk to our base case view, but it is a risk that we will be closely monitoring over the coming years. Bottom Line: The persistent gap between Chinese nominal GDP growth and government bond yields is likely contributing to the problem of excessive leveraging. To the extent that Chinese policymakers succeed at shifting the drivers of growth from investment to consumption, bond yields are more likely to structurally rise than fall. Investment Conclusions Our analysis above points to four recommendations for investors over the coming year: Overweight Chinese stocks versus Chinese government bonds in RMB and USD terms Overweight Chinese onshore corporate bonds versus duration-matched Chinese government bonds in RMB terms Overweight 7-10 year USD-hedged Chinese government bonds versus their US and developed market (DM) counterparts For offshore US dollar-based investors, long 7-10 year Chinese government bonds in unhedged terms Regarding the first two recommendations, our view that yields are likely to be flat at the short-end and modestly higher at the long-end suggests that investors can expect total returns on the order of 2-3% from Chinese government bonds this year. Barring a major and lasting economic slowdown from the 2019-nCoV outbreak, we expect Chinese domestic and investable equities to outperform government securities over the coming 6-12 months. Onshore corporate bonds have a similar outlook: onshore spreads are pricing in (massively) higher default losses than we believe is warranted, meaning that they will outperform duration-matched government equivalents without any changes in yield. Chart 12Within Global Fixed-Income, Hedged Chinese 10-Year Yields Are Relatively Attractive Chart 13Unhedged Yield Spreads Predict Hedged Relative Performance Versus The US For global fixed-income investors, Charts 12-14 present USD-hedged 10-year Chinese government yields versus the US and DM/DM ex-US, along with the historical relative return profile of USD-hedged Chinese bonds versus hedged and unhedged returns. In hedged space, Chinese 10-year government bond yields are modestly attractive: 2.2% versus 1.6% in the US and 1.8% in DM ex-US. China’s historically low yield beta to the overall level of global 10-year bond yields (Chart 15) suggests that Chinese yields should perform well in 2020 – a year where we expect global bond yields to drift higher as economic growth rebounds. Combined with relatively attractive valuation, this bodes well for the relative performance of Chinese debt versus DM equivalents. A low yield beta against a backdrop of drifting higher global yields implies that longer-maturity Chinese government bonds will outperform their DM equivalents. Chart 14Unhedged Yield Spreads Predict Hedged Relative Performance Versus DM Chart 15China's Yield Beta Has Been Rising, But Is Still Japan-Like   We would also recommend longer-maturity Chinese government bonds in unhedged terms versus a USD-hedged global government bond portfolio. Chart 16 highlights that the relative return of this trade is strongly (negatively) linked to USD-CNY, and we expect further (albeit more modest) gains in RMB over the cyclical horizon. Chart 16Modest Further RMB Upside Means Unhedged Chinese Bonds Will Outperform As a final point, investors should note that today’s report is part of a heightened focus on China’s fixed income market, in terms of both forecasting fixed income returns and analyzing the cyclical and structural implications of the increasing investability of China’s financial markets. More research on this topic is likely to come in 2020 and beyond: Stay Tuned!   Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com         Footnotes 1    Please see US Bond Strategy Special Report "The Golden Rule Of Bond Investing," dated July 24, 2018, available at usbs.bcaresearch.com 2   Please see Global Fixed Income Strategy Special Report "The Global Golden Rule Of Bond Investing," dated September 25, 2018, available at gfis.bcaresearch.com 3   Please see China Investment Strategy Special Report "Seven Questions About Chinese Monetary Policy," dated February 22, 2018, available at cis.bcaresearch.com

Informe especial

Dear clients, Please note that in next week’s China Macro And Market Review, we will include a section explaining our view on the coronavirus outbreak and its economic as well as financial market implications. We maintain our overweight stance on both Chinese investable and A-share equities, over a tactical (0-3 months) and cyclical (6-12 months) time horizon. Please stay tuned. Jing Sima, China Strategist   Highlights BCA’s “Golden Rule of Bond Investing” framework, which links developed economy government bond returns to central bank policy rate “surprises” versus market expectations, also works in China. The relationship between unexpected changes in China’s de facto short-term policy rate and government bond yields has been surprisingly strong over the past decade. Any additional easing by the PBoC this year is likely to be focused on reducing lending rates to the real economy, not interbank rates (which drive government bond yields). As such, yields at the short-end are likely to be flat until later this year at the earliest, whereas yields at the long-end are likely to move modestly higher, at most. The persistent historical gap between economic growth and bond yields in China makes it difficult to forecast the structural outlook for yields using conventional methods. To the extent that Chinese policymakers succeed at shifting the drivers of growth from investment to consumption, we believe that bond yields are more likely to structurally rise than fall. Over the coming 6-12 months, investors should underweight Chinese government bonds versus Chinese equities and onshore corporate bonds. Within a regional government bond portfolio, however, investors should overweight USD-hedged China versus US and developed markets ex-US, as well as in unhedged terms. Feature Last year’s inclusion of Chinese onshore government and policy bank bonds in the Bloomberg Barclays Global Aggregate Index was a significant milestone of China’s journey to internationalize its capital markets. Other bond benchmark providers have since followed suit, highlighting that the trend of increased passive exposure to Chinese assets is likely to continue. Over the past year, the bulk of the market discussion concerning the addition of China to the major bond indices has focused on estimating the size of potential capital inflows that could be triggered and the related impact on onshore bond yields. By contrast, comparatively little work has been done to analyze the core drivers of Chinese government bond yields, and how they compare to the factors that influence yields in the developed markets that dominate the bond indices. This Special Report attempts to fill a hole in the analysis of Chinese bonds. This Special Report attempts to fill that hole in the analysis of Chinese bonds. We look at the predictability of China’s government bond market through the lens of BCA’s “golden rule” framework, and find a surprisingly strong relationship between changes in China’s de facto short-term policy rate and government bond yields. We then present our cyclical (6-12 month) and secular outlooks for government yields given this relationship, and conclude by presenting four specific investment recommendations pertaining to China’s fixed-income market with two audiences in mind: mainland/onshore investors who are focused on returns in unhedged RMB terms, and global fixed-income investors who are primarily focused on hedged US-dollar regional bond exposure. The Golden Rule Of Bond Investing, With Chinese Characteristics In a July 2018 Special Report,1 BCA’s Chief US Bond Strategist, Ryan Swift, elegantly distilled the cyclical US government bond call into a simple question: During the next 12-months, will the Federal Reserve move interest rates by more or less than what is currently priced into the market? Chart 1The (US) Golden Rule Of Bond Investing In Practice Ryan argued that a predictive framework for US Treasury returns built around the answer to this question has historically worked so well that it should be referred to as the “Golden Rule of bond investing” (Chart 1). In a follow-up report, our Global Fixed Income Strategy service confirmed that the Golden Rule also largely works in non-US developed market economies, with the exception of Japan due to the absence of any meaningful fluctuation in policy rates over the past two decades.2 The Golden Rule provides a very strong framework to aid fixed-income investors with their cyclical (i.e. 6-12 month) asset allocation decisions, by quantitatively linking government bond returns relative to cash – in other words, the excess return earned by taking duration risk - to policy rate “surprises” compared to what is discounted in shorter-term money markets. The practical application is that a decision to allocate to longer-maturity government bonds is reduced to a bet on whether a central bank will adjust policy rates by more or less than the market expects. The first question we address in this report is to what degree does the Golden Rule apply in China (in yield space rather than in return space), along with an explanation of any differences that may exist. However, we must first note why the Golden Rule of bond investing works, particularly in the US. The first reason is that there is a strong relationship between the US 3-month T-bill rate and Treasury yields of all other maturities. Conceptually, all fixed income investors have a choice when buying US government bonds: they can purchase a 3-month Treasury bill and simply perpetually roll over the position as it matures, or they can purchase a Treasury bond of a longer maturity. This means that yields on longer maturity Treasury bonds simply reflect investor expectations for the average 3-month T-bill rate over the life of the bond, plus some positive risk premium to compensate for the inherent uncertainty of the path and tendency of short-term yields. This helps explain the close link between cyclical changes in 3-month T-bill rates and yields on longer maturity Treasurys. Chart 2In The US, The 3-Month T-Bill Rate Perfectly Tracks The Fed Funds Rate The second reason for the Golden Rule’s success is that there is a very tight relationship between the effective Fed funds rate and the 3-month T-bill rate. While it is the (higher) discount rate that is the theoretical no-arbitrage ceiling for the 3-month rate, in practice T-bill rates trade extremely close to the Fed funds rate (Chart 2). This means that Fed funds rate “surprises” (relative to traded market expectations) are akin to surprises in the 3-month rate, which in turn strongly influence the expected future path of short-term interest rates and thus yields on longer maturity Treasurys. In China, we noted in a February 2018 Special Report3 that the 7-day interbank repo rate is now the de jure short-term policy rate in China following the establishment of an interest rate corridor system in 2015. Chart 3 presents our first test of the Golden Rule in China (in yield space rather than in return space), by plotting the annual change in the level of Chinese government bond yields alongside the 7-day repo rate “surprise” over the past year from 2010 to the present. Here, we use the first principal component of zero coupon Chinese government bond yields to represent the average level of yields (rather than selecting a particular maturity), and we use the 12-month RMB swap rate (versus 7-day repo) to represent market expectations for the policy rate. The chart highlights that the fit is good, as measured by a 50% R-squared between the two series. However, deviations in the relationship do exist, with the most notable exception having occurred in 2017: Chinese government bond yields rose considerably more than what the annual surprise in the 7-day repo rate would have suggested. Chart 3In China, The Golden Rule Works Decently Well Using 7-Day Repo... Chart 4...And Extremely Well Using 3-Month SHIBOR Chart 4 helps resolve a good portion of the 2017 discrepancy, and clarifies the link between Chinese monetary policy and government bond yields. Chart 4 is similar to Chart 3, except that it replaces the 7-day repo rate surprise with that of 3-month SHIBOR (which trades very closely to the 3-month repo rate). The chart illustrates an even closer fit between the two series (with an R-squared close to 80%), and shows that the 3-month SHIBOR surprise does a meaningfully better job at explaining the 2017 rise in Chinese government bond yields. The Golden Rule of bond investing works surprisingly well in China. The fact that the annual surprise in 3-month SHIBOR has done a better job at predicting changes in bond yields over the past decade underscores that the 3-month repo rate is the de facto short-term policy rate in China, a point that we have made in several previous reports. We have noted that the spike in the 3-month/7-day repo rate spread that occurred in late-2016 and lasted until mid-2018 happened because of China’s crackdown on shadow banking activity. This crackdown caused a funding squeeze for China’s small & medium banks, which caused a material rise in lending rates and government bond yields. This episode highlights that future changes in the 3-month repo rate are likely to reflect both underlying changes in net liquidity provided to large commercial banks (measured by the 7-day repo rate), and any dislocations in the interbank market that have the potential to push up lending rates and government bond yields. Bottom Line: BCA’s “Golden Rule” framework, which links developed economy government bond returns to central bank policy rate “surprises” versus market expectations, works for China as well – using the correct measure of the PBOC policy rate. This provides a useful investment framework for Chinese government bonds, which are now significant part of major global bond market benchmarks. The Cyclical Outlook For Chinese Government Bond Yields Given the establishment of the relationship between Chinese short-term interbank rates and government bond yields detailed above, we are now able to more precisely discuss the likely cyclical trajectory of Chinese government bond yields as a function of Chinese monetary policy. Two opposing forces have the potential to affect China’s government bond market this year. The first, a stabilization and modest rebound in Chinese economic activity, may exert upward pressure on yields due to expectations of eventual policy tightening. The second, continued attempts by the PBoC to ease corporate lending rates, may exert downward pressure on yields as it will reflect not just easy but easier monetary conditions. Yields at the long-end are likely to move modestly higher this year, at most. For investors, the raises the obvious question of whether Chinese government bond yields are likely to move up, down, or trend sideways this year. In our view, yields at the short-end are likely to be flat until later this year at the earliest, whereas yields at the long-end are likely to move modestly higher, at most. Yields at the short-end of China’s government bond curve are likely to stay flat for most of this year. There are two reasons why yields at the short-end of China’s government bond curve are likely to stay flat for most of this year. The first is that the PBoC is generally a reactive central bank and has historically lagged a pickup in economic activity, as illustrated in Chart 5. The chart shows the historical path of 3-month SHIBOR in the year following a bottom in economic activity in 2009, 2012, and 2015, and makes it clear that there has been no precedent for a significant rise in interbank rates in the first nine months of an economic recovery. The 2012 episode did see a very sharp rise in 3-month SHIBOR once the PBoC shifted into tightening mode, but we doubt that this experience will be repeated again unless economic growth accelerates much more aggressively than we expect. The second reason why we expect yields at the short-end of the curve to remain muted this year is because any additional easing by the PBoC is likely to be focused on reducing corporate lending rates, not interbank rates. Chart 6 highlights that while there is a strong correlation between changes in Chinese government bond yields and average lending rates in the economy, the former leads the latter. In the past, this relationship has existed because changes in interbank rates have coincided with reductions in the now obsolete benchmark lending rate, with the former usually occurring earlier than the latter. But in a scenario where the PBoC reduces the loan prime rate (LPR) and keeps net banking sector liquidity roughly constant, the extremely tight relationship shown in Chart 4 suggests that short-term bond yields are unlikely to be affected by a reduction in lending rates. Any meaningful decline in short-term yields below short-term interbank rates would simply prompt banks to stop buying these bonds. Chart 5The PBoC Is Generally A Reactive Central Bank Chart 6Average Lending Rates Lag Short-Term Bond Yields Chart 7China's Yield Curve Is Generally Pro-Cyclical Additional easing by the PBoC does have the potential to impact the long-end of the government bond curve if investors view these actions as a sign that interbank rates will remain low for some time. This view is reinforced by the fact that China’s yield curve is not particularly flat, and thus has room to move lower. However, Chart 7 also shows that China’s yield curve, defined here as the second principal component of zero coupon Chinese government bond yields, is positively correlated with the relative performance of investable Chinese equities. This suggests that there is a procyclical element to the curve. We suspect that this procyclical element will dominate a potential decline in expectations for future short-term interest rates, but that yields at the long-end are likely to move modestly higher this year, at most. Bottom Line: Any additional easing by the PBoC this year is likely to be focused on reducing lending rates to the real economy, not interbank rates (which drive government bond yields). As such, yields at the short-end are likely to be flat until later this year at the earliest, whereas yields at the long-end are likely to move modestly higher, at most. The Secular Outlook For Chinese Government Bond Yields A common approach to forecasting the likely structural trend for nominal government bond yields is to estimate the trajectory of real long-term potential output growth and to add the monetary authority’s inflation target. This framework is based on the idea that interest rates are in equilibrium when the cost of borrowing is roughly equal to nominal income growth, a condition that results in no change in the burden to service existing debt. Chart 8China's Potential Growth Is Likely To Trend Lower... Based on this framework, we would expect Chinese government bond yields to trend down over time, or possibly flat if the PBoC were to tolerate higher inflation over the coming decade. Chart 8 illustrates the IMF’s forecast of falling real potential growth in China over the coming several years, which is consistent with a shift in the composition of growth from investment to consumption as well as China’s looming demographic crisis. But Chart 9highlights an obvious problem with applying this framework to forecast the secular trend in Chinese government bond yields: over the past decade, yields have persistently averaged below actual nominal GDP growth, both in China and in the developed world. In the latter case, it is an open question whether this will continue to be true in the future, but in China’s case it is clear that government bond yields have little connection (in magnitude) to the pace of GDP growth. This reflects the longstanding strategy of Chinese policymakers to promote investment via persistently low interest rates, as has occurred in other manufacturing and export-oriented Asian economies (Chart 10). Chart 9...But Bond Yields Are Well Below GDP Growth, Just Like In Developed Markets Chart 10In Industrial Asian Economies, Low Bond Yields Are A Policy Choice   The persistent historical gap between economic growth and bond yields in China makes it difficult to forecast the structural outlook for yields using conventional methods, and largely limits us to inference. To the extent that Chinese policymakers succeed at shifting the drivers of growth from investment to consumption, bond yields are more likely to rise than fall over time. This is because as long as interest rates remain well below the pace of income growth, the incentive to excessively borrow (and invest) is likely to persist. Chart 11China Needs Higher Interest Rates, But Only To A Point However, even in a scenario where Chinese government bond yields structurally trend higher, we expect the rise to be modest. Chart 11 highlights that China’s “private sector” debt service ratio is extremely elevated, underscoring that the country’s ability to tolerate significantly higher bond yields is not strong. In addition, since 2015, China’s debt service ratio has been mostly flat despite rising a rising debt-to-GDP ratio, which has been achieved through lower short-term interest rates. To the extent that policymakers fail to make meaningful progress in shifting China’s growth drivers away from investment over the coming few years, lower (potentially sharply lower) bond yields would appear to be all but inevitable to cope with what would become a permanently growing drag on economic activity from the servicing of debt. For now, we would characterize this scenario as a risk to our base case view, but it is a risk that we will be closely monitoring over the coming years. Bottom Line: The persistent gap between Chinese nominal GDP growth and government bond yields is likely contributing to the problem of excessive leveraging. To the extent that Chinese policymakers succeed at shifting the drivers of growth from investment to consumption, bond yields are more likely to structurally rise than fall. Investment Conclusions Our analysis above points to four recommendations for investors over the coming year: Overweight Chinese stocks versus Chinese government bonds in RMB and USD terms Overweight Chinese onshore corporate bonds versus duration-matched Chinese government bonds in RMB terms Overweight 7-10 year USD-hedged Chinese government bonds versus their US and developed market (DM) counterparts For offshore US dollar-based investors, long 7-10 year Chinese government bonds in unhedged terms Regarding the first two recommendations, our view that yields are likely to be flat at the short-end and modestly higher at the long-end suggests that investors can expect total returns on the order of 2-3% from Chinese government bonds this year. Barring a major and lasting economic slowdown from the 2019-nCoV outbreak, we expect Chinese domestic and investable equities to outperform government securities over the coming 6-12 months. Onshore corporate bonds have a similar outlook: onshore spreads are pricing in (massively) higher default losses than we believe is warranted, meaning that they will outperform duration-matched government equivalents without any changes in yield. Chart 12Within Global Fixed-Income, Hedged Chinese 10-Year Yields Are Relatively Attractive Chart 13Unhedged Yield Spreads Predict Hedged Relative Performance Versus The US For global fixed-income investors, Charts 12-14 present USD-hedged 10-year Chinese government yields versus the US and DM/DM ex-US, along with the historical relative return profile of USD-hedged Chinese bonds versus hedged and unhedged returns. In hedged space, Chinese 10-year government bond yields are modestly attractive: 2.2% versus 1.6% in the US and 1.8% in DM ex-US. China’s historically low yield beta to the overall level of global 10-year bond yields (Chart 15) suggests that Chinese yields should perform well in 2020 – a year where we expect global bond yields to drift higher as economic growth rebounds. Combined with relatively attractive valuation, this bodes well for the relative performance of Chinese debt versus DM equivalents. A low yield beta against a backdrop of drifting higher global yields implies that longer-maturity Chinese government bonds will outperform their DM equivalents. Chart 14Unhedged Yield Spreads Predict Hedged Relative Performance Versus DM Chart 15China's Yield Beta Has Been Rising, But Is Still Japan-Like   We would also recommend longer-maturity Chinese government bonds in unhedged terms versus a USD-hedged global government bond portfolio. Chart 16 highlights that the relative return of this trade is strongly (negatively) linked to USD-CNY, and we expect further (albeit more modest) gains in RMB over the cyclical horizon. Chart 16Modest Further RMB Upside Means Unhedged Chinese Bonds Will Outperform As a final point, investors should note that today’s report is part of a heightened focus on China’s fixed income market, in terms of both forecasting fixed income returns and analyzing the cyclical and structural implications of the increasing investability of China’s financial markets. More research on this topic is likely to come in 2020 and beyond: Stay Tuned!   Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com         Footnotes 1    Please see US Bond Strategy Special Report "The Golden Rule Of Bond Investing," dated July 24, 2018, available at usbs.bcaresearch.com 2   Please see Global Fixed Income Strategy Special Report "The Global Golden Rule Of Bond Investing," dated September 25, 2018, available at gfis.bcaresearch.com 3   Please see China Investment Strategy Special Report "Seven Questions About Chinese Monetary Policy," dated February 22, 2018, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations