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Highlights A sooner-than-anticipated end to the Federal Reserve’s balance-sheet runoff should give a welcome boost to international liquidity conditions. Moreover, reflationary efforts in China, cautious global central banks, and easing global financial conditions all point to a rebound in economic surprises. This will support pro-cyclical versus defensive currencies and argues against a strong USD. At this point, it is too early to tell how long a pro-cyclical FX stance will be warranted. Sell NZD/CAD. Feature Since the turn of the year, this publication has argued that a correction in the dollar was increasingly likely, and that the main beneficiaries of this move should be the more pro-cyclical currencies. Because U.S. domestic fundamentals remain much stronger than the rest of the G10’s, our preference has been to favor commodity currencies versus the yen instead of playing dollar weakness outright. This theme remains in place for now. However, we are increasingly concerned about the dollar and think the outperformance of commodity currencies could last longer than originally expected. Essentially, an end to the Federal Reserve’s balance-sheet runoff, more cautious central banks, and easier global financial conditions could set the stage for a significant rebound in commodity currencies. U.S. Excess Reserves Vs. Commodity Currencies Whether it is from Governor Lael Brainard, Cleveland Fed President Loretta Mester, or the FOMC minutes, the message is clear: The days of the Fed’s balance sheet runoff are numbered. Ryan Swift, BCA’s Chief U.S. Bond Strategist, has written at length that the Fed’s balance sheet attrition has had a limited direct impact on U.S. growth. However, Ryan and the FOMC members both agree that a smaller balance sheet impacts the ability of the Fed to control the level of the fed funds rate.1 With less excess reserves in the banking system, the New York Fed has to intervene more often to keep the policy rate below its ceiling. This might seem like a very technical point, but it is an important one for many FX markets. Prior to the financial crisis, expanding excess reserves on U.S. commercial banks would coincide with improving dollar-based liquidity. Moreover, since 2011, reserves even lead our financial liquidity index (Chart I-1). Since there is 14 trillion of USD-denominated foreign-currency debt around the world, these fluctuations in U.S. excess reserves, and thus global liquidity, can have an impact on the price of assets most levered to global growth conditions. Chart I-1U.S. Excess Reserves Contribute To The Global Liquidity Backdrop Chart I-2 illustrates that commodity currencies are indeed very responsive to changes in U.S. excess reserves, particularly when these pro-cyclical currencies are compared to counter-cyclical ones like the JPY. Meanwhile, the trade-weighted dollar tends to move in the opposite direction of excess reserves, reflecting the dollar’s countercyclical nature (Chart I-3). This relationship, however, is not as tight as the one between commodity currencies and the reserves. Chart I-2Improving Growth In Excess Reserves Leads To Stronger Commodity Currencies... Chart I-3...And To A Weaker Greenback A corollary to the growing consensus within the FOMC to end the balance-sheet runoff sooner than later is that the contraction in excess reserves will end. A bottoming in the rate of change of the reserves is consistent with a rebound in commodity currencies, especially against the yen, and with a correction in the dollar. Gold prices are very sensitive to global liquidity conditions. Today, not only is the yellow metal moving closer to the US$1350-US$1370 zone that marked its previous highs in 2016, 2017, and 2018, but also, the gold rally is broadening, as exemplified by the advance / decline line of gold prices versus nine currencies, which is making new highs (Chart I-4, top panel). This indicates that the precious metal could punch above this resistance level. Gold is probably sniffing out an improvement in global liquidity conditions. Since rising gold prices tend to lead EM high-yield bond prices higher (Chart I-4, bottom panel), investors need to monitor this move closely. Chart I-4A Broadening Gold Rally Is Consistent With Easing Liquidity Conditions Bottom Line: The growing chorus among FOMC members singing the praises of the end of the Fed’s balance-sheet runoff points toward a significant slowdown in U.S. excess reserves attrition. While this may not be a significant development for U.S. domestic economic variables, it should help liquidity conditions outside the U.S. While this could weigh on the greenback, the probability is higher that it will help commodity currencies in the short run, especially against the yen. Global Policy And Commodity Currencies In China, new total social financing hit CNY 4.6 trillion in January, well above the normal seasonal strength. Accordingly, the Chinese fiscal and credit impulse is starting to improve (Chart I-5). While this rebound is currently embryonic, our Geopolitical Strategy team has argued that a massive increase in Chinese credit this January would indicate a change in Beijing’s economic priorities.2 The Chinese government may be trying to limit the downside to growth, and reflation may expand. This would result in a further pick-up in the credit impulse. Chart I-5The Chinese Credit Impulse May Be Bottoming Easing EM financial conditions – courtesy of rebounding EM high-yield bond prices – and rising Chinese credit flows should ultimately lead to improving growth conditions across EM. As a result, our diffusion index of EM economic activity – which tallies improvements across 23 EM economic variables – should bounce from currently very depressed levels. Such a recovery is normally associated with a weaker trade-weighted dollar, a stronger euro, rising commodity prices and rising commodity currencies – both against the USD and the JPY (Chart I-6). Chart I-6IF EM Growth Conditions Improve, This Will Have A Profound Impact On the FX Market We can expand this line of thinking to the global economy. Our Leading Economic Indicator Diffusion Index, which compares the number of countries with a rising LEI versus those with a falling LEI, already rebounded five months ago. Historically, this signals an upcoming rebound in the BCA global LEI. Additionally, other major central banks are also sounding an increasingly cautious tone. This should accentuate the easing in global financial conditions that began in late December, creating another support for global growth. However, global investors remain very pessimistic on global growth, as exemplified by this week’s very poor global growth expectations computed from the German ZEW survey (Chart I-7). This dichotomy between depressed growth expectations and burgeoning green shoots suggests that risk asset prices have room to rally further in the coming quarter or two. Chart I-7Investors Remain Pessimistic About Growth, Yet Green Shoots Are Popping Up These dynamics are positive for commodity currencies and negative for the dollar. This cycle, the pattern has been for the trade-weighted dollar to correct and hypersensitive pro-cyclical currencies like the AUD and the NZD to perk up only after our Global LEI diffusion index has trough, and around the same time as risk asset prices rebound (Chart I-8). Chart I-8Thinking About Growth, Asset Prices, The Dollar, And Commodity Currencies Treasury yields will most likely also be forced higher by improving risk asset prices and economic activity, especially as bond market flows suggest T-notes currently are a coiled spring. The U.S. Treasury International Capital System data released at the end of last week was very revealing. The press emphasized the large-scale selling of Treasurys from the Cayman Islands – interpreted as selling by hedge funds. Missing from the picture was the enormous buying from these same players over the past 12 months, which corresponded with falling yields and a rallying trade-weighted dollar (Chart I-9). It was a sign of growing fear that pushed up the price of bonds. Chart I-9Hedge Funds Have Room To Liquidate Their Treasury Holdings If, as we expect, global growth beats dismal expectations and risk assets rebound further, the countercyclical dollar should correct. This will further ease global financial conditions and justifying even more a wholesale liquidation of stale bond holdings by hedge funds and further pushing the Fed toward resuming its hiking campaign faster than the market is currently anticipating. This combination is highly bond bearish. Unsurprisingly, this means that the yen, which normally trades closely in line with U.S. Treasury yields, is likely to weaken. Hence, USD/JPY and EUR/JPY could experience significant upside over the coming months (Chart I-10). Chart I-10A Bond Bearish Backdrop Is Also Bad For The Yen Bottom Line: Global growth conditions are evolving away from a dollar-bullish, commodity currency-bearish backdrop. Not only is the dollar-based liquidity set to improve, but China is also releasing the proverbial brake. Additionally, a generally more cautious tone among global central banks will contribute to easing global financial conditions. These developments are likely to result in a period of positive global economic surprises – and an environment where the greenback weakens and where pro-cyclical currencies outperform. But For How Long? It remains a question mark as to how long this pro-growth cycle will last. Parts of the dynamics described above are very self-defeating. If global growth conditions and asset prices rebound strongly, the Fed will be in a better position to increase rates once again. This could quickly curtail the improvement in global financial conditions and favor a strong dollar. Additionally, it is not clear how far Beijing will go in terms of pushing reflation through the Chinese economy. Chinese policymakers are worried about too-pronounced a slowdown but are equally worried about too much debt in their economy, and do not want to repeat the debt binge witnessed in 2010 and 2016. Therefore, they may be much quicker to lift their foot off the gas pedal. This conflicting attitude is best illustrated by recent opposing remarks made by Chinese policymakers. On the one hand, Premier Li-Keqiang expressed concerns regarding the January credit surge, suggesting that some Chinese policymakers are already trying to dampen expectations that stimulus will be substantial. On the other hand, the PBoC sounded utterly unconcerned.  Moreover, as our Emerging Markets Strategy service highlights, EM earnings are likely to continue to suffer from the lagged effect of China’s previous tightening. This creates the risk that even if global growth rebounds, EM stock prices, EM FX and all related plays do not follow. This would maintain the dollar-bullish environment and hurt pro-cyclical commodity currencies while supporting the yen. Despite these risks, it is nonetheless too early to tell how short-lived this period of dollar softness and commodity currency strength will be.  After all, the dollar is a momentum currency. If the dollar weakness gathers steam, a virtuous cycle could emerge: improving global growth begets a weaker dollar, a weaker dollar begets easier global financial conditions, easier global financial conditions beget stronger growth, and so on.          Gold prices may hold the key to cut this Gordian knot. If gold cannot maintain its recent gains, then the pro-cyclical positioning will not be valid for more than three months. However, if gold prices can remain at elevated levels or even rally further, then this pro-cyclical positioning will stay appropriate for at least six to nine months. What is clear is that for now, buying risk in the FX space makes sense. Bottom Line: At this point, too many crosscurrents are at play to evaluate confidently the length of any rally in pro-cyclical currencies relative to defensive ones. Since easier financial conditions ultimately force the Fed to resume hiking and since it is far from clear how committed to reflation Chinese policymakers are, our base case remains that this move will last a quarter or so. However, the fact that a falling dollar further eases global financial conditions, fomenting greater global growth in the process, suggests that a virtuous circle that create additional dollar downside can also emerge. Gold may provide early signals as to when investors should once again adopt a defensive posture. Sell NZD/CAD Something exceptional happened three months ago. For the second time in 25 years, Canadian policy rates fell in line with New Zealand’s. As Chart I-11 shows, this last happened from 1998 to 1999, when NZD/CAD subsequently depreciated 26%. However, today Canada’s and New Zealand’s current accounts are roughly in line while back then New Zealand had a substantially larger deficit, such a decline is unlikely to repeat itself. Nonetheless, we posit that NZD/CAD possesses ample downside. Chart I-11Bad News For NZD/CAD First, like in 1998-‘99, the real trade-weighted NZD exhibits a larger premium to its fair value than the real trade-weighted CAD (Chart I-12). In fact, the relative premium of the NZD to the CAD is roughly comparable as it was back then. Moreover, our Intermediate-Term Timing Model for NZD/CAD reinforces this message as it suggests that short-term valuations are also stretched (Chart I-13). Chart I-12NZD/CAD Is Pricey... Chart I-13...And Our Short-Term Valuation Metric Agrees Second, the New Zealand economy is currently weaker than that of Canada. Relative consumer confidence and business confidence have been in a downward trend for three years. Historically, while NZD/CAD can deviate from such dynamics, ultimately this cross tends to revert toward relative growth trends. The recent collapse in New Zealand’s economic surprises relative to Canada’s suggests that the timing for such a reversion is increasingly ripe, as there is currently scope for investors to discount a more hawkish Bank of Canada than Reserve Bank of New Zealand. Indeed, 1-year/1-year forward yields in Canada have fallen much more relative to the BoC overnight rate than similar forwards have fallen relative to the RBNZ policy rate. Third, New Zealand real bond yields have collapsed relative to Canada’s. As Chart I-14 illustrates, NZD/CAD tends to follow real yield differentials. So far, NZD/CAD has been less-weak than the real-yield gap would imply, but from late 2003 to early 2005 this cross also managed to defy gravity for an extended time, only to ultimately succumb to the inevitable. Chart I-14Falling Real Yield Spreads Will Weigh On NZD/CAD Fourth, as the top panel of Chart I-15 illustrates, the performance of kiwi stocks relative to Canadian equities tend to lead NZD/CAD, especially at tops. While tentative, the ratio of New Zealand to Canadian stocks seems to have peaked in early 2016. Supporting this judgment, kiwi profits have fallen relative to their Canadian counterparts and relative net earnings revisions are following a similar path – a move normally associated with a weaker NZD/CAD (Chart I-15, bottom panel). Chart I-15Relative Stock Market Dynamics Look Poor Fifth, terms of trades are becoming a growing headwind for NZD/CAD (Chart I-16). The price of agricultural commodities relative to energy products drives this pair, reflecting the comparative advantages of the two countries. BCA’s Commodity & Energy service is currently much more positive on the outlook for the energy complex than the agricultural complex. NZD/CAD is a perfect instrument to implement this view, especially now that the NZD suffers from a very rare negative carry against the CAD. Chart I-16A Negative Tems-Of-Trade Shock For NZD/CAD Bottom Line: NZD/CAD is set to experience an important fall. The NZD currently suffers from a very rare negative carry against the CAD. The last time this happened, a large depreciation ensued. Moreover, valuations and economic trends argue in favor of shorting this pair. Finally, relative bond yields, equity dynamics and term-of-trade outlooks also point to a lower NZD/CAD. Sell at 0.900, with a stop at 0.927 for a target of 0.800.     Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy Weekly Report, titled “Caught Offside”, dated February 12, 2019, and the U.S. Bond Strategy Weekly Report, titled “The Great Unwind”, dated September 19, 2017, available at usbs.bcaresearch.com 2 Please see Geopolitical Strategy Special Report titled “China: Stimulating Amid The Trade Talks,” dated February 20, 2019 available at gps.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. has been mixed: Capacity Utilization underperformed expectations, coming in at 78.2%. However, Michigan Consumer Sentiment outperformed expectations, coming in at 95.5. Finally, the NAHB Housing Market Index also surprised to the upside, coming in at 62. The DXY has fallen by 0.2% this week. We remain bullish on the U.S. dollar on a cyclical basis, given that the Fed will end up hiking rates more than expected. However, the current easing of monetary conditions by Chinese authorities should tactically hurt the dollar and help commodity currencies. Moreover, the fact that the Fed announced that it might bring about an end to the balance sheet runoff sooner than expected will further help global liquidity conditions. The real question now is how long the coming dollar correction will last? Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Global Liquidity Trends Support The Dollar, But... - January 25, 2019 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area has been mixed: The annual growth in construction output underperformed expectations, coming in at 0.7%. The current account balance also surprised to the downside, coming in at 33 billion euros. However, the Zew Survey – Economic sentiment, though negative, surprised to the upside, coming in at -16.6. EUR/USD has risen by 0.4% this week. We remain bearish on EUR/USD on a cyclical basis; given that, we expect real rates to rise much faster in the U.S. than in the euro area. This is because we think that the U.S. economy  will remain stronger than Europe’s, a consequence of the fact that the former has experienced a significant private sector deleveraging since 2008 while the latter has not. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 2019 Key Views: The Xs And The Currency Market - December 7, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: Machinery orders yearly growth outperformed to the upside, coming in at 0.9%. Hurt by a very sharp contraction in shipments to China, the yearly growth of Japanese exports also surprised to the downside, coming in at -8.4%. However, imports yearly growth outperformed to the upside, coming in at -0.6%. USD/JPY has risen by 0.2% this week. We are bearish towards the yen on a tactical basis as the current upturn in liquidity conditions should hurt safe haven currencies. Moreover, reflationary efforts by Chinese Authorities should provide a boon to risk assets and make low yield currencies like the yen even less attractive. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Yen Fireworks - January 4, 2019 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been strong: Retail sales and retail sales ex-fuel yearly growth both outperformed expectations, coming in at 4.2% and 4.1%. Moreover, the yearly growth of average hourly earnings excluding bonus also surprised positively, coming in at 3.4%. GBP/USD has risen by 0.9% this week. We expect that a soft Brexit deal remains the most probable outcome out of Westminster. Thus, this factor, along with how cheap the pound is, make us bullish on the pound on a long-term basis. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Deadlock In Westminster - January 18, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia has been mixed: The wage price index yearly growth underperformed expectations, coming in at 0.5%. However, the employment change surprised to the upside, coming in at 39.1 thousand in January. The participation rate also surprised positively, coming in at 65.7%. AUD/USD has fallen 0.7% this week. We are positive on the AUD on a tactical basis. Global monetary conditions have eased thanks to the rising Chinese credit and more cautious global central banks. Moreover, the announcement that the Fed is looking to halt its balance sheet reduction sooner than expected has provided further relief. However, the fundamentals of Australia remain poor, and thus long-term investors should continue to avoid this currency, Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 CAD And AUD: Jumping Higher To Plunge Deeper - February 1, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 The recent data in New Zealand has been mixed: The business PMI in January fell to 53.1. However, the input of the producer price index on a quarter-over-quarter basis surprised to the upside, coming in at 1.6%. NZD/USD depreciated by 0.7% this week. While NZD/USD might have some upside in the short term, we remain bearish on the NZD/USD on a cyclical basis. Both the short-term and long-term interest rates in New Zealand are lower than in the U.S., while the real trade-weighted NZD is trading at 7% premium to its fair value. Thus, the kiwi is relatively overvalued which means that any tactical upside of NZD won’t have legs.  Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Updating Our Intermediate Timing Models - November 2, 2018 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 The recent data in Canada has been neutral: The December new housing price index stays unchanged at 0%, on both month-over-month and year-over-year basis. The CAD has risen by 0.2% against USD this week. As BCA anticipates oil prices to strengthen more, we also expect the CAD to outperform the AUD and the NZD over the next few months. However, we remain bearish on CAD/USD on a structural basis. The unhealthy housing market in Canada could be a potential risk to the Canadian financial industry and the economy as a whole. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 CAD And AUD: Jumping Higher To Plunge Deeper - February 1, 2019 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 The recent data in Switzerland has been positive: The December exports increased to 19,682 million, while the imports increased to 16,639 million. The trade balance in December thus increased to 3,043 million, surprised to the upside. EUR/CHF has been flat this week. We are bullish on EUR/CHF on a cyclical basis. Easy global financial conditions should hurt safe haven currencies like the franc. Moreover, we believe that the SNB will continue to play a heavily dovish bias in order to counteract the fall in inflation caused by the surge in the franc last year. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Waiting For A Real Deal - December 7, 2018 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway has been positive: January trade balance increased to 28.8 million, from previous 25 billion. USD/NOK was flat this week. In general, we are overweight the krone, since we believe the pickup in oil prices will help the Norwegian economy, ultimately boosting the performance of NOK against the EUR,  the SEK, the AUD and the NZD. Moreover, the NOK is undervalued and currently trading at a large discount to its fair value, which could further lift the performance of the NOK on a cyclical basis. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Global Liquidity Trends Support The Dollar, But... - January 25, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden has been negative: January unemployment rate has increased to 6.5%. Moreover, the monthly inflation rate comes in at -1%, surprising to the downside. USD/SEK rallied by more than 1% this week. We remain bearish on EUR/SEK since the SEK is currently trading at a discount to its long-term fair value. Moreover, there are many signs pointing to a Swedish economy rebound. The negative rate in the country and easy financial conditions could stimulate the domestic demand and if global growth perks up, the weak inflation readings will prove transitory. The Riksbank has already abandoned it pledge to suppress the krona and it will move this year to lift rates again. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Global Liquidity Trends Support The Dollar, But... - January 25, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

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Highlights So What? China’s January credit data suggest that stimulus is here. Why? January credit growth was a blowout number. Trade uncertainty is likely to be prolonged with an extension of talks. Equity bourses in South Korea and Russia are the most likely to benefit from Chinese stimulus. Industrial metals such as copper will also benefit – with a delay. Feature New credit data for China in January improves the chances that Beijing’s stimulus measures will overshoot this year, causing China’s economy to bottom in 2019 and jumpstart global growth. In our annual outlook for this year we argued that while China was stimulating the economy, the magnitude of stimulus would be the decisive factor for the global macro environment in 2019. We argued that the type of stimulus would remain primarily fiscal – tax cuts for households and small and medium-sized enterprises – and hence that it would be modest as fiscal easing would merely offset relatively weak credit growth. This view stemmed from our assessment of the Xi Jinping administration, highlighted in April 2017, as an “elitist” (not populist) administration. Its policy priorities are to discipline the Chinese economy, and in particular to contain systemic financial risk, which President Xi has cited as a national security threat. This view is not wrong, but the latest data clearly show that Xi has decided to pause these painful efforts at limiting leverage and rebalancing China’s economy. Witness January’s decisive uptick in both total social financing (total private credit) and local government bond issuance (Chart 1). Chart 1Higher Risk Of An Overshoot A massive spike in new credit is the single most important criterion in our “Checklist For A Stimulus Overshoot.” Thus, from a policy perspective, we are now at higher risk of an overshoot (Table 1). Not only credit as a whole but also informal lending saw a surge in January, implying that the government is relenting in its crackdown on the shadow banks. The approval of local government bond issuance for early in the year – and the People’s Bank of China’s announcement of a “Central Bank Bills Swap” program – reinforce this policy shift.1 Table 1Checklist For A Chinese Stimulus Overshoot In 2019   A stimulus overshoot is positive for Chinese demand in the short run but negative for potential GDP in the long run. A “traditional” credit surge of this nature cannot be surgically targeted at SMEs or households. It will go to state-owned enterprises, privileged corporations, property developers, and the like, which have always had the advantage in China’s financial system. SOEs have taken a much larger share of new loans than private companies in recent years,2 and the only silver lining of this trend was the possibility that tighter credit controls would discipline the SOEs. That silver lining is now fading, barring some new and surprising development on the reform front. China needs to create 26 trillion renminbi in new credit over the course of the year to avoid a corporate earnings contraction. These January numbers put China on track to do just that (Chart 2), assuming that President Xi and U.S. President Donald Trump agree to a short-term, framework trade deal this year. Chart 2On Track To Avoid An Earnings Contraction Of course, a few caveats are in order. First, January’s credit number is only one data point and credit growth is always abnormally strong in the first month of the year. Early in the year, banks seek to expand their assets rapidly in a bid to get as much market share as possible before administrative credit quotas kick in. Because of Chinese New Year, it is best to combine January and February data to get a sense of the rate of credit expansion in the first part of the year. To do that, investors will have to wait for mid-March when the February data is out. This year’s January numbers are very strong relative to previous Januaries (Chart 3) and the context is more accommodative than the 2017 January credit surge, when authorities were beginning to tighten rather than ease macroprudential policy. Still a rapid rate of credit expansion will have to be sustained in the coming months in order to meet the 26 trillion RMB requirement highlighted above. Second, there is some risk that China’s households and private businesses will not respond as positively today as in the past. The intensification of Communist Party control over the society and economy, President Xi’s cancellation of term limits, and the strategic confrontation with the United States have created a bearish sentiment in the private sector. Our Emerging Markets Strategy would point out that if the propensity to consume, and money velocity,3 do not accelerate, then a surge in new credit may fail to ignite a reacceleration in China (Chart 4). Chart 4Chinese Are Holding On To Their Money Still, what we now know is that Xi Jinping and his top economic adviser, Vice Premier Liu He, are not initiating the “assault phase of reform” that their predecessors initiated in the late 1990s in order to cleanse China’s economy of bad loans and zombie companies. Instead, they are likely reestablishing the “Socialist Put” in order to reverse the current deceleration, demonstrate China’s continued economic might and face down the United States’ threat of tariffs. Bottom Line: China’s stimulus measures are increasingly likely to overshoot, with positive implications for both Chinese and global growth. China is still facing a corporate earnings recession, but the odds of averting it are increasing.    Trade Deadline More Likely To Be Extended What of the trade war? First, we would warn clients that China’s annual credit origination is a much bigger factor for the global economy than China’s exports to the United States (Chart 5). The trade war can escalate from here and yet, if China’s stimulus works as it has in the past, the results will be manageable for China’s economy save for Chinese companies expressly exposed to the U.S. economy through exports. In reality, both the U.S. and China are now effectively stimulating their economies and in this sense global trade as a whole will benefit regardless of bilateral tariffs. Chart 5Watch China Credit, Not So Much The Trade War But it is possible that just as global equity markets ignored China’s economic slowdown and only sold off when the tariffs were levied (Chart 6), they may not continue to rally much on China’s credit data. Given the already considerable rally in global risk assets since October, markets may not be satisfied merely with one or two months of solid credit data out of China without a clear resolution to the trade conflict. After all, if a collapse in U.S.-China trade talks portends a new Cold War, then institutional investors may be justified in taking a wait-and-see approach despite China’s credit cycle upswing. Chart 6Will Equities Ignore China Data (Again)? In the past, we have highlighted that the U.S. and China are not economically prohibited from engaging in a trade war – the export exposure is too small – and China’s new stimulus reinforces this point. However, President Trump is concerned about causing a sell-off in the tech sector and hence the broad equity market which could translate into a bear market and raise the probability of a recession occurring prior to November 2020. Meanwhile, in China, given Beijing’s reported trade concessions, there is apparently a desire to pacify the relationship and discourage U.S. unilateral tariffs and sanctions that could become seriously destabilizing for the Chinese economy and society. The need to have a happy 2021 centenary celebration for the Communist Party may factor into policymakers’ thinking. The latest news flow is mildly positive for the odds of getting a framework deal sometime this year. President Trump visited the Chinese negotiators in Washington, D.C. while President Xi reciprocated with the American negotiators in Beijing. Trump has signaled that an extension of the March 1 deadline is possible, and a two-month extension is being bandied about in the press. China’s National People’s Congress is likely to pass a new Foreign Investment Law that ostensibly guarantees many of the American demands on forced tech transfer, intellectual property theft, and discriminatory treatment of U.S. companies (Table 2). Even the second Trump summit with Kim Jong Un, this time in Vietnam, should be seen as a mild positive for U.S.-China negotiations. Table 2New Foreign Investment Law Would Be A Positive For U.S.-China Negotiations However, Presidents Trump and Xi have yet to schedule a new summit, which is probably necessary for a final deal. And there are murmurs from the press suggesting that China’s new law and other concessions are not going to satisfy the U.S. negotiators on the critical point of “structural changes” and a verification process. This leaves us inclined to change our trade war probabilities to increase the odds of an extension (Table 3). The improvement in U.S. financial conditions and China’s stimulus, if anything, make it more likely that negotiations will be extended, as both sides feel their economic and financial constraints less acutely. Table 3Updated Trade War Probabilities Bottom Line: Global and Chinese risk assets should rally on China’s credit uptick, but the lack of resolution of the trade war could continue to inhibit animal spirits – and the odds of a March 1 resolution are declining. Who Are The Equity Winners Of China’s Stimulus? China’s strong January credit number is supportive of global equity markets. That much is obvious. But which equity markets will benefit the most? In what follows we examine the relationship between Chinese credit and MSCI equity returns of various countries. We find that Malaysian, Australian, South Korean, and Indonesian equities are the most highly correlated with Chinese credit growth and are thus most likely to benefit from the recent upturn (Chart 7). On the other hand, France and Italy stand out as countries whose bourses are more insulated. Out of the markets that are positively correlated, South Korea and Russia stand out as relatively cheap (Chart 8). Thus we expect these equities to do especially well. By contrast, while Indonesia and the Philippines are highly leveraged to China, these markets are currently relatively expensive. BCA’s Emerging Markets Strategy is currently overweight Korean and Russian equities within the EM space, neutral Turkey (although recently upgraded from underweight), and underweight Indonesia and the Philippines. In addition to credit stimulus, we expect Chinese household consumption to also gain support going forward. This will likely be driven by policy stimulus targeting the consumer specifically and is best exemplified by the recently announced tax cuts (Chart 9), which we expect to trickle down to greater consumer demand and growth in retail sales. Our base case calls for 8%-10% growth in household consumption over the coming 12 months, up from the current 3.5%. However, consumer sentiment in China is weak. BCA’s Emerging Markets Strategy’s proxy for household marginal propensity to spend ticked up recently, after falling since early last year (see Chart 4 above). A resumption in the decline would highlight that households are increasingly unwilling to spend, which would translate into weaker retail sales despite policy efforts to boost consumption. Such a scenario – in which credit growth accelerates without a substantial uptick in consumer spending – is plausible, given that it occurred between mid-2015 and mid-2016 (Chart 10). In any case, whether Chinese stimulus comes in the form of the traditional credit channel, or instead in the form of fiscal stimulus to household consumption, the same equity markets will generally benefit the most (Chart 11). Chart 10...But Flattish Retail Sales Are Also A Possibility Indeed, global equity markets react the same way regardless of the type of stimulus implemented. For instance, MSCI returns for the Philippines, Sweden, Malaysia, Indonesia, and Turkey are more closely correlated to both Chinese credit growth and retail sales growth compared to Italy, Japan, and France.  The same conclusion is reached when we look at the correlations between Chinese credit growth or consumption growth and individual MSCI sectors such as industrials and consumer discretionary (Chart 12). The relatively stronger correlation between Chinese credit growth and equity returns – as opposed to Chinese retail sales and equity returns – can be put down to the nature of Chinese imports. While industrial goods account for the bulk of China’s purchases of foreign goods, consumer goods excluding autos make up only 15% of China’s imports (Table 4). However, as Chart 12 illustrates, the relationship between China’s retail sales growth and global equities is much tighter in the case of the consumer discretionary sector, whether the latter is compared to global industrials sectors or the overall MSCI index. Table 4Import Composition Of Chinese Imports Equity market exposure to China is not always in line with the extent of each country’s trade exposure to China (Chart 13). There are some clear exceptions – most notably Mexico, which has the highest correlation coefficient with Chinese credit and consumption variables since 2010. However, this is likely due to idiosyncratic factors.4 Correlation does not imply causation, and we cannot conclude with certainty that Mexican equities will outperform amid China’s new round of stimulus. Nevertheless, given that Mexico is a very deeply liquid market that benefits amid EM bull markets, this may not be entirely coincidental. The correlations between global equity markets and Chinese credit peak two months after the stimulus measures are first implemented (Chart 14). This is more or less in line with adjusted total social financing’s correlation versus industrial metals. However BCA’s Commodity & Energy Strategy has shown that copper’s correlations versus other measures of Chinese money and credit peak after roughly three quarters (Chart 15).5 This is evident in both the 2012 and 2015-16 stimulus episodes in which the bottom in copper prices lagged the bottom in China’s credit growth. Thus we may witness a rebound in equity markets on the back of China’s credit splurge before we see an improvement in annual returns on copper prices.  Chart 15Copper Rallies Lag China Credit Stimulus Bottom Line: South Korean and Russian equities are best positioned to benefit from the positive surprise in China’s credit data. France and Italy are the worst positioned. Copper prices will rebound with a delay.  Investment Implications BCA’s Geopolitical Strategy recommends that investors stay long Chinese equities ex-tech relative to the emerging market benchmark. This is a tactical call initiated in August 2018 that is now becoming a cyclical call on the basis of the credit upswing. We also remain long the “China Play Index,” a basket of China-sensitive assets, and long China’s “Big Five” banks relative to other banks. A rebound in China’s credit data and stronger global growth will support copper demand. Prices are still 15% below the mid-2018 peak and are poised to benefit in this environment, especially given that global inventories are already falling. BCA’s Geopolitical Strategy recommends that investors go long copper. Meanwhile, BCA’s China Investment Strategy recommends (for now) staying only tactically overweight Chinese equities relative to the global benchmark, pending higher conviction that the pace of credit growth will be strong enough to overwhelm the negative ramifications of a continued deceleration in actual activity over the coming few months on sentiment and 12-month forward earnings expectations. Over the long run, Geopolitical Strategy would look to underweight Chinese equities, as we are not optimistic about China’s productivity and potential GDP. This is because of the negative structural consequences of continuing the Socialist Put (i.e., bad loans, zombie companies, trade protectionism).  We would expect CNY/USD to remain relatively buoyant in the context of both trade negotiations with the U.S. and fiscal-and-credit stimulus. The trade talks can hardly succeed if CNY/USD is falling. Depending on whether and how soon China’s stimulus results in a durable economic bottom, global growth could stabilize and the USD could see a substantial countertrend selloff.   Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Roukaya Ibrahim, Editor/Strategist roukayai@bcaresearch.com   Footnotes 1          Please see Emerging Markets Strategy Special Report titled “China: Prepping A Bazooka?” dated February 14, 2019 available at ems.bcaresearch.com 2      Please see Nicholas Lardy, “The State Strikes Back: The End Of Economic Reform In China?” Peterson Institute For International Economics, January 29, 2019, available at piie.com. 3          Please see Emerging Markets Strategy Weekly Report titled “Dissecting China’s Stimulus,” dated January 17, 2019 available at ems.bcaresearch.com 4       The 2012 election of President Enrique Peña Nieto caused Mexican equities to outperform their EM counterparts. Similarly in 2015-16, U.S. outperformance relative to EM also supported Mexico relative to EM because Mexico’s economy is highly leveraged to its northern neighbor. In both periods Mexico’s outperformance was not caused by – but instead coincided with – Chinese credit stimulus. These idiosyncratic events biased the correlation between Mexico’s equity markets and Chinese credit growth to the upside. 5      Please see Commodity & Energy Strategy Weekly Report titled “Trade Wars, China Credit Policy Will Roil Global Copper Markets,” dated June 21, 2018, available at ces.bcaresearch.com.                  

Highlights Investors like to hear non-consensus views, … : Part of our role is to help clients think about all of the potential outcomes, including ones that may not be as improbable as commonly believed. … but it seems that our Fed/rates call is starting to strike them as a little too non-consensus: Clients are having a hard time seeing the potential for inflation after ten years of errant predictions that it’s just around the corner. From our perspective, the probability of higher-rate outcomes is considerably higher than the probability of lower-rate outcomes, … : An investor with a low-duration bias has a whole lot more ways to win than an investor with a high-duration bias. … so we’re staying the course: We continue to recommend underweighting Treasuries and maintaining below-benchmark duration exposure, which aligns with our constructive take on markets and the economy. It’s too early to get defensive if a recession is at least a year away. Feature BCA clients like to hear contrarian calls, and there is little that’s more deflating from a strategist’s perspective than to be told in a meeting that his/her views are the same as everyone else’s. Except for the handful of strategists who make their living from provocative views that have almost no chance of coming to fruition, however, the calls have to be plausible. For many investors, our inflation concerns seem to be straining the bounds of plausibility. Even if BCA has only lately begun to beat the inflation drums, investors have had enough of warnings about inflation and interest-rate spikes that have repeatedly failed to come to pass. Regular readers are familiar with our contention that the sizable injection of fiscal stimulus into an economy already operating at capacity is a sure-fire recipe for inflation. They are also familiar with our view that an extremely tight labor market will necessarily give rise to robust wage gains. We have repeatedly argued that the Fed will respond to the combination of inflation pressures by hiking the fed funds rate above its equilibrium level, bringing the curtain down on the expansion and the equity bull market. With a Special Report examining the links between wage gains, consumer price inflation, and the Fed’s reaction function on the way, we’re instead devoting this week’s report to several other reasons why an investor would want to maintain below-benchmark duration in a fixed-income portfolio. Oil Prices Will Rise There is a good reason for devising core price indexes that smooth out the volatility inherent in food and energy prices. Core indexes provide a better read on the underlying inflation trend, and are a better predictor of moves in headline inflation than the headline indexes themselves. Inflation-linked Treasuries (TIPS) are tied to headline CPI, however, leaving the long-run inflation break-evens at the mercy of swings in oil prices (Chart 1). As we have previously written, our commodity strategists view the October-November swoon as a one-off event disconnected from market fundamentals that will quickly be unwound1 (Chart 2). Chart 1As Oil Goes, So Go Inflation Expectations, ... Chart 2... And Oil Prices Are Poised To Rise One need not fear that a rise in oil prices, while giving a fillip to headline inflation, would slow the economy and thereby offset inflation’s upward pressure on rates. Now that the U.S. is the world’s largest oil producer, its economy and financial markets are no longer negatively correlated with oil prices (Chart 3). It is still true that falling oil prices amount to a tax cut for American businesses and households, but they now also amount to fewer high-paying jobs in the oil patch, reduced earnings in an important domestic industry, and tighter monetary conditions as fracking bond spreads widen. Chart 3No Longer A Contrary Indicator Bottom Line: Higher oil prices will push headline inflation and inflation expectations higher, while also boosting the economy at the margin. The combination promotes higher bond yields, all else equal. The Economy’s Improved. Yields Haven’t Budged. Though we attributed the bulk of the fourth-quarter selloff to misplaced fears that the Fed was pulling the rug out from under the expansion, the economy was finding it harder and harder to produce positive surprises. By late January, however, the expectations bar had been reset low enough that new releases began surpassing it, day in and day out (until the end of last week). So far, though, the 10-year Treasury yield has stubbornly failed to reflect the improvement (Chart 4). Chart 4Surprises Turned Around, But Yields Didn't Financial conditions tightened sharply upon the sudden widening in corporate bond spreads and the sudden drop in equity prices. We viewed the seize-up as equivalent to at least a quarter-point increase in the fed funds rate and thereby found pausing to be a perfectly logical course of action for the Fed. The swiftness of the subsequent bounce in risk assets – the S&P 500 has retraced more than two-thirds of its losses and high-yield bonds have retraced close to 60% of their spread widening – has gone a long way toward undoing last quarter’s tightening. With the recovery in financial conditions, all three components of our Fed monitor now point to a need for tighter monetary conditions (Chart 5). Chart 5The Fed Can Pause, But It Can't Stop Adaptive Expectations’ Sluggish Response Investors’ inflation outlooks adhere closely to an adaptive expectations framework in which future predictions are largely a function of inflation’s recent path (Chart 6). This is not unreasonable; one could do a lot worse than pick the Patriots to reach the Super Bowl or only South American and European (ex-England) teams to win the World Cup. Adaptive expectations can fall prey to the recency bias, however, in which individuals overemphasize the most recent data points to the exclusion of older, potentially more representative data when forming their future views. From a recency-bias perspective, adaptive expectations can trap investors like the mythical frog contentedly lingering in a pot of water that’s only slowly brought to a boil. Chart 6Inflation Forecasts Take Their Cue From The Past ... We are skeptical of the notion that there will be no more inflation because there’s been no inflation since the crisis. The trend may be your friend, but not once the output gap has closed and the unemployment gap is persistently negative. Using the 10-year CPI forecast from the Philly Fed’s Survey of Professional Forecasters as an inflation-expectations proxy, one could argue that the lion’s share of the outsized gains in the pre-crisis phase of the bond bull market resulted from excessively generous inflation compensation (Chart 7, bottom panel). Chart 7... Which Is Great For Investors When Inflation Trends Lower The excessive compensation was a by-product of adaptive expectations. After the experience of the mid-seventies and early eighties (Chart 8), investors and issuers both assumed inflation would be higher than it turned out to be. Today’s bond-market participants, conditioned by ten years of soggy post-crisis readings, could well assume that inflation will be lower than it ultimately turns out to be. That may leave long-maturity bondholders with insufficient compensation, just like their early-fifties forebears. Chart 8Long Stretches Of Low Inflation May Be Bad For Future Treasury Returns Reversal Of Globalization The apex of globalization has been a key theme of our Geopolitical Strategy service since its launch. We cannot go as far as they sometimes do, arguing that globalization did more to bring inflation to heel than Paul Volcker, but it surely has been an important factor in limiting wage gains for low- and semi-skilled workers (Chart 9), and has helped to stymie retail price increases. The imposition of new tariffs have exacerbated globalization’s reversal, but it had already begun before the 2016 presidential election. The Reagan-Thatcher-Koizumi policies that were ascendant after the fall of the Berlin Wall, boosting global growth while tamping down inflation, have been in retreat in the developed world ever since the crisis. Chart 9China Syndrome Decomposing Core CPI When assessing inflation’s future direction, our U.S. Bond Strategy colleagues decompose the core CPI series into its primary components: Shelter (42% of the index); Goods (25%); Services, excluding shelter and medical care (25%); and Medical Care (8%). They then look at the drivers for each of the largest three components for an advance read on their future direction. Home price appreciation and the rental vacancy rate power their shelter costs model. With home price appreciation decelerating but still positive, and the rental vacancy rate hovering around its all-time lows, the model projects that shelter costs will remain well above 3% (Chart 10, top panel). Chart 10Core Inflation Isn't About To Melt Core goods inflation lags non-oil import prices by about a year and a half. The path of import prices suggests that core goods inflation will have a tailwind for much of the rest of the year before facing a headwind next year that will push it back to its current levels (Chart 10, second panel). Wage growth is the best predictor of core services inflation, ex-shelter and medical care (Chart 10, third panel). We expect continued upward pressure on services inflation, as labor-market slack continues to be absorbed, keeping wage growth accelerating. The Golden Rule Of Bond Investing Simplicity is a virtue in investment recommendations, models, and rationales, and our U.S. Bond Strategy colleagues’ golden rule of bond investing is elegantly simple.2 If Fed rate hikes exceed market expectations over a given time horizon, overweight duration positions will underperform over that horizon, and if Fed hikes fail to meet market expectations, overweight duration positions will outperform. Now that the money market has entirely priced out any rate-hike prospects over the next two years (Chart 11), overweight duration positions face a challenging backdrop. How will the fed funds rate surprise to the downside from here? Chart 11The Money Market Is Calling For A Rate Cut It can’t unless the Fed carries out more than one 25-basis-point cut in the next year or so. Given the underlying strength of the economy, gathering inflation pressures, and the swift unwinding of much of the tightening in financial conditions, rate cuts are a stretch. Against the current backdrop, the golden rule is a stern warning away from the longer-maturity reaches of the Treasury curve. Investment Implications We continue to stay the course with our fixed-income recommendations. If the Fed’s pause will extend the expansion for a few more months, it will extend the shelf life of our underweight Treasuries and overweight spread product recommendations, as well. As outlined above, we see many more potential catalysts for higher interest rates than we do for lower rates. We reiterate our recommendation that investors maintain below-benchmark duration across fixed-income segments. The expansion, and the bull markets in risk assets, will eventually end, but it’s too soon to position portfolios for it.   Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com   Footnotes 1 Please see the U.S. Investment Strategy Weekly Report, “What Does Oil’s Slide Mean?,” published November 26, 2018. Available at usis.bcaresearch.com. 2 Please see the U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing,” published July 24, 2018. Available at usbs.bcaresearch.com.

Highlights We would fade fears of an “earnings recession.” EPS growth should increase during the remainder of this year. While high debt burdens around the world may exacerbate deflationary pressures by restraining spending, they may also motivate policymakers to raise inflation in order to reduce the real value of outstanding debt. Ultimately, whether high debt levels turn out to be deflationary or inflationary depends on the extent to which policymakers have both an incentive and the means to increase inflation. The spread of political populism has made governments more inclined to boost nominal incomes by allowing economies to overheat. Central bankers have also become increasingly convinced that they should wait to see “the whites of inflation’s eyes” before tightening monetary policy any further. With inflation expectations still well anchored, it may take at least another 18 months for inflation in the U.S. to break out, and longer still elsewhere. Stay bullish on global stocks for now. However, be prepared to dial back equity exposure late next year, while shifting bond duration to a maximum underweight. Feature Fade Fears Of An “Earnings Recession” We upgraded global stocks in December following the post-FOMC meeting selloff. Our recommendation to go long the MSCI All-Country World Index has gained 9.0% since we initiated it. Although our enthusiasm for stocks has waned somewhat given the recent run-up, we continue to see upside for global bourses over the next 12-to-18 months. Admittedly, earnings growth has come down sharply from a year ago. To some extent, this reflects base effects (U.S. EPS rose by 23% in Q1 of 2018, thanks in part to the tax cuts). However, slower global growth and higher tariffs have also taken their toll. The good news is that the trade war is likely to stay on hiatus over the coming months. We also expect nominal GDP growth in the U.S. and the rest of the world to pick up by the middle of this year. Chart 1 shows that earnings growth tends to move in lock-step with nominal GDP growth. Chart 1Earnings And Nominal GDP Growth Move In Lock-Step Equity prices usually bottom when earnings growth bottoms (Chart 2). Analyst estimates based on IBES data foresee EPS growth troughing in Q1 and then accelerating modestly over the remainder of the year. If this happens, global equities will move higher over the coming months. What’s The Bigger Risk? Deflation Or Inflation? Last week, we argued that the next global economic downturn would probably be sparked by a surge in inflation which forces central banks to raise interest rates more aggressively than they would like.1 Given the absence of inflationary pressures today, and the still-ample spare capacity that exists in many economies, we noted that such an outcome is far from imminent. This implies that the global expansion still has plenty of room to run, thus justifying an overweight stance towards risk assets. One common objection to this thesis posits that deflation, rather than inflation, is the main risk to the global economy. And unlike its inflationary cousin, the next deflationary shock could be lurking just around the corner. Italy serves as a good example of the dangers of high debt levels. While many things can contribute to deflationary pressures, elevated debt levels are often cited as being the most important. An excessive debt burden can lead to a prolonged period of deleveraging. Since borrowers typically spend a larger share of their cash flows than lenders, overall spending could decline, leading to lower prices and wages. High debt levels can also make an economy vulnerable to interest-rate shocks. This is particularly the case when a country is reliant on external debt or issues debt in a currency it does not control. The Italian Lesson Italy serves as a good example of the dangers of high debt levels. Italy entered the euro area with one of the highest public debt ratios in the world. Private debt also soared in anticipation of euro membership as well as during the period leading up to the Global Financial Crisis, almost doubling as a share of GDP between 1998 and 2008 (Chart 3). Chart 3Italy's Debt Inferno Worries about high indebtedness, poor growth prospects, and contagion from Greece sent the 10-year Italian bond yield to nearly 7.5% on November 9, 2011. Yields tumbled after Mario Draghi pledged to do “whatever it takes” to preserve the common currency, but rose again last April after Italians brought an anti-austerity populist government into power. Today, the Italian government finds itself in the unenviable position of having to devote 3.4% of GDP to interest payments, more than double the euro area average (Chart 4). Domestic investors own less than half of Italian government debt, so most of those interest payments do little to stimulate domestic spending. Chart 4The Italian Government's Interest Payments Are Higher Than Elsewhere In The Euro Area The Inflation Solution When debt reaches elevated levels, faster nominal growth via higher inflation becomes an increasingly appealing solution for reducing debt ratios. A one percentage-point increase in nominal GDP will cut debt-to-GDP by half a percentage point when it stands at 50%, but by three full percentage points when it stands at 300%. Given the attractiveness of inflating away debt burdens, why don’t more governments pursue this strategy? Part of the answer is politics. The long history of hyperinflation in Europe and many other economies has cast a long shadow over how central banks operate. Unanticipated inflation also redistributes wealth from creditors to debtors. While the latter usually outnumber the former, the former typically have more political sway. Means And Opportunities Political will is a necessary condition for generating inflation, but it is not a sufficient one. Policymakers also need to possess the ability to accomplish their goal. What determines whether they will succeed? The answer, to a large extent, is the level of the neutral rate of interest. The neutral rate of interest is the long-term interest rate that is appropriate for the economy. When interest rates are above the neutral rate, growth will tend to fall below trend, while inflation will decline. Conversely, when rates are below their neutral level, the economy will grow at an above-trend pace and inflation will accelerate. Many things can influence the neutral rate of interest. These include: Trend GDP growth: Faster growth will incentivize firms to expand capacity in anticipation of rising demand. This will push up the neutral rate of interest. National savings: Lower taxes and increased government spending will drain national savings, while stimulating aggregate demand. This will push up the neutral rate of interest. Likewise, a decrease in private-sector savings — whether it be the result of easier access to credit or greater optimism about future income growth — will raise the neutral rate. The capital intensity of the economy: Economies that require a lot of physical capital will tend to have a higher neutral rate of interest. By the same token, economies where the capital stock needs to be replenished quickly in order to offset depreciation will have a higher neutral rate of interest.  The exchange rate: A weaker exchange rate will boost net exports. This resulting increase in aggregate demand will translate into a higher neutral rate of interest. With the exception of the currency effect, all of the factors listed above are captured by the canonical Solow growth model which undergraduate economics students usually encounter in their studies (See Appendix 1 for a derivation of the neutral rate of interest in this model). Inflation And The Neutral Rate Economists tend to define the neutral rate in real terms. However, when thinking about inflation, it is useful to consider the neutral rate’s nominal counterpart. Conceptually, the nominal neutral rate of interest can be either negative or positive. When the nominal neutral rate is negative, even a policy rate of zero will be insufficient to allow the economy to overheat. One might call this outcome the “strong form” version of the secular stagnation thesis. In contrast, when the neutral rate is low, but still positive, an interest rate of close to zero will be low enough to allow the economy to overheat, which will eventually generate inflation. One may refer to this as the “weak form” version of the secular stagnation thesis. Political will is a necessary condition for generating inflation, but it is not a sufficient one. The Danger Of Strong-Form Secular Stagnation In situations where the strong form version of secular stagnation prevails, deflationary pressures will feed on themselves. If an economy suffers from a chronic shortfall of aggregate demand, inflation is liable to drift lower. A lower inflation rate will push down the nominal interest rate that is consistent with any given real rate. For example, if the economy requires a real rate of -1% in order to grow at trend and inflation is 2%, a 1% nominal rate will suffice. But if inflation is 0%, then the policy rate would need to be -1%, which may be difficult to achieve. Japan serves as a case study for how this vicious circle can unfold. Following the simultaneous bursting of the property and stock market bubbles in the early 1990s, the Japanese private sector entered a prolonged deleveraging cycle. Inflation drifted steadily lower, ultimately falling into negative territory during the 1997-98 Asian Crisis (Chart 5). High debt levels in Japan were deflationary because the nominal neutral rate of interest was negative. Even if the Bank of Japan wanted to, it was greatly constrained in its ability to raise inflation. Chart 5Japan: A Case Study In Strong-Form Secular Stagnation Europe Is Not Japan… Yet Next to Japan, the euro area comes the closest to meeting the criteria for strong form secular stagnation. The euro area has low trend growth, owing to its slow population growth rate, as well as a banking system that is still focused on deleveraging. There is a silver lining, however: Despite the many woes the euro area has experienced, long-term inflation expectations are still over 100 basis points higher than in Japan (Chart 6). Fiscal policy is also turning somewhat more accommodative. Our base case is that the ECB will be slow to unwind its balance sheet and will only raise rates if the economy is showing more verve. This should be enough to move inflation towards target over the next two years. Chart 6Long-Term Inflation Expectations In The Euro Area Are Still Well Above Japanese Levels Inflation In The U.S. When inflation does break out early next decade, it will probably happen first in the United States. A large structural budget deficit and the revival of credit growth to the household sector following an intense period of deleveraging have boosted the neutral rate of interest. An overheated labor market is driving up real wages, which will lead to more consumer spending. December’s weaker-than-expected retail sales report will prove to be a fluke. Not only was it influenced by the sharp drop in the stock market and worries about a pending government shutdown (both of which have reversed), but the report itself was probably compromised by delays in the collection of data, which may have pushed some responses into January (historically, the weakest month for retail sales). This interpretation is consistent with strong holiday sales reported by online retailers and solid growth in the Johnson Redbook index of same-store sales. The latter captures over 80% of the sales surveyed by the Department of Commerce in its retail sales report, and featured a 9.3% year-over-year increase in sales in the final week of December, the fastest since the start of this series in 1997 (Chart 7). Chart 7The December Retail Sales Report Was Probably A Fluke Yes, corporate debt in the U.S. is high, but it is not particularly elevated relative to most other countries (Chart 8). Despite the collapse in equity prices and the spike in credit spreads late last year, U.S. corporations are still eager to expand capacity (Chart 9). This is not an economy teetering on the brink of recession. Chart 8U.S. Corporate Debt Is Not Extreme By Global Standards Chart 9U.S. Capex Plans Have Come Off Their Highs, But Remain Solid Policymakers in the U.S., and in much of the world, have grown more comfortable in letting economies overheat. Whether it be Trump’s unfunded tax cuts or the “Green New Deal” championed by the more liberal members of the Democratic Party, fiscal stimulus is in, austerity is out. Policymakers in the U.S., and in much of the world, have grown more comfortable in letting economies overheat. Even mainstream voices have given their nod of approval. Just this week, former IMF Chief Economist Olivier Blanchard argued that the U.S. could safely increase public debt without endangering economic stability.2 Meanwhile, central banks have increasingly bought into the mantra, famously espoused by Larry Summers, that they should wait to see the “the whites of inflation’s eyes” before tightening monetary policy.3 What this mantra overlooks is that inflation is a highly lagging indicator. By the time you see the whites of a tiger’s eyes, you are already destined to be its dinner. Investment Conclusions The spread of populist economic policies offers a one-two punch to inflation. Not only are populist prescriptions apt to stimulate demand, but that stimulus will raise the neutral rate of interest, thereby giving central banks greater traction to further boost spending by keeping rates below their neutral level. For investors, this implies a dichotomy between the medium-term and longer-term asset market outlook. Easy money policies are a boon to risk assets when they are first introduced, as they typically combine low interest rates with fast nominal GDP growth. But the path to higher rates is lined with lower rates, meaning that the longer central banks keep rates below their neutral level, the more economies will overheat, and the larger the eventual inflation overshoot will be. As growth outside the U.S. begins to accelerate in the second half of 2019, the dollar will come under downward pressure. As such, investors should overweight global equities and high-yield credit for the next 12 months. However, be prepared to dial back equity exposure late next year, while shifting bond duration to a maximum underweight. In terms of regional equity allocation, we continue to see global growth bottoming by the middle of this year. As growth outside the U.S. begins to accelerate in the second half of 2019, the dollar will come under downward pressure. The resulting reflationary impulse will be manna from heaven for the more cyclically-sensitive sectors of the stock market, as well as Europe and EM. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com   Laura Gu Research Associate Footnotes 1      Please see Global Investment Strategy Weekly Report, “Minsky’s Corollary,” dated February 8, 2019. 2       Olivier Blanchard, “Public Debt and Low Interest Rates,” Peterson Institute for International Economics and MIT American Economic Association (AEA) Presidential Address, (January 2019); Noah Smith, “The U.S. Can Take on a Lot More Debt Within Limits,” Bloomberg Opinion, (February 2019). 3      Lawrence Summers, “Only raise US rates when whites of inflation’s eyes are visible,” Financial Times, (February 2015). Strategy & Market Trends MacroQuant Model And Current Subjective Scores Tactical Trades Strategic Recommendations Closed Trades

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Highlights In their current form and size, perpetual bonds issuance and the central bank bills swap program are unlikely game-changers for the banking system in China. However, this mechanism constitutes monetization of banks’ capital and bad assets, i.e., recapitalization of banks, by the PBoC via quantitative easing. Hence, this scheme can be presently viewed as a bazooka that has not yet been loaded by the government. If the authorities pursue this program on a large scale without forcing banks to acknowledge and write off bad assets, banks would regain power to expand their balance sheets, fostering a cyclical economic recovery. Nevertheless, the growth model based on continuous “out of thin air” money and credit expansion inevitably leads to falling productivity growth and rising inflation. Therefore, the economic outcome over the course of several years would be stagflation, which is profoundly bearish for the currency. Feature The Chinese authorities recently launched a Central Bank Bills Swap (CBS) program to boost liquidity and facilitate issuance of commercial banks’ perpetual bonds. Box I-1 on pages 12-13 elaborates on the scheme and provides more detail about the program. Under the CBS program, Chinese banks can buy each other’s perpetual bonds, then exchange these bonds for central bank bills and pledge those bills at the People Bank of China (PBoC) to receive funding. Insurance companies are also allowed to purchase perpetual bonds, but they cannot pledge them with the central bank for funding. What are the macro implications of this program? Can the government use this scheme to recapitalize the banking system? Does the CBS program amount to quantitative easing? Will it be sufficient to boost credit growth in China in 2019? We have conditional answers to these questions – i.e., they all depend on the extent to which the scheme is actually utilized by the authorities. On the one hand, the CBS program could potentially become a proverbial bazooka used by the government to recapitalize the banking system via the PBoC monetizing banks’ bad assets. By doing so, the PBoC would be expanding its balance sheet by injecting excess reserves into the banking system – i.e., quantitative easing. Consequently, it could help banks accelerate credit and money growth, in turn helping the economy. The long-run collateral damage in this scenario, however, would be an RMB depreciation. On the other hand, the authorities could limit the usage of the scheme via various regulatory approvals and norms. In such a case, the impact of the program on money/credit growth and the real economy as well as on the exchange rate would be limited. In other words, it might end up being no more than a tool to help the four large banks meet BIS's TLAC requirements. At the moment, there is not enough information to determine whether the program will be a game changer for the banking system in China, leading to a surge in credit and broader economic recovery. Both total assets and broad credit growth among banks remain very weak for now (Chart I-1). In other words, it is a bazooka that has not been loaded, and may never be loaded because of the potential for seriously negative ramifications over the long term. Chart I-1Chinese Banks: Total Assets And Broad Credit Growth Consequently, we maintain our view that China’s growth will continue to disappoint in the first half of 2019, and that China-related plays, including many emerging markets (EM), remain at risk of a renewed selloff. Bank Recapitalization? In theory, the issuance of perpetual bonds along with the CBS program can be used to recapitalize the banking system. Each bank can buy perpetual bonds issued by other banks up to 10% of their core Tier-1 capital. These banks can get cheap financing from the PBoC by swapping these perpetual bonds with central bank bills, and then pledging those bills at the central bank to get funding. Hence, under this scheme, the PBoC will be financing purchases of perpetual bonds, which means the monetary authorities will indirectly be funding banks’ recapitalization. It is an “open secret” that Chinese banks would be considerably undercapitalized if they were forced to recognize non-performing assets. The non-performing loan (NPL) ratio currently stands at 1.9%, and the special-mention loans ratio is at 3.2%; and the sum of both is at 5.1% of total loans (Chart I-2, top panel). NPL provisions presently amount to 3.4% of total loans. Chart I-2Chinese Banks Are Massively Under-Provisioned When expressed as a share of total risk-weighted assets, the aggregate NPLs and special-mention loans are equal to 4.2% (Chart I-2, bottom panel). At 2.8% of risk-weighted assets, NPL provisions are extremely inadequate. Assuming non-performing assets turn out to be 10% of total risk-weighted assets, some 40% of banks' capital would be wiped out, according to our simulation presented in Table I-1. This is after accounting for existing provisions and assuming a 20% recovery rate of non-performing assets. Provided that risk-weighting assigns a zero weight to banks’ claims on the government, a 50% risk weight to claims on households and a 100% weight to claims on companies, the assumption of 10% of non-performing assets in total risk-weighted assets is reasonable. This is especially the case when the enormous credit boom of the past 10 years is taken into consideration. As a result, in this scenario the capital adequacy ratio (CAR) will drop from its current level of 13.8% to 9.4%. This will bring the CAR below the regulatory minimum of 11%. To raise the CAR to the regulatory minimum of 11%, the banking system would require RMB 2 trillion of capital. This is greater than the maximum potential demand for perpetual bonds that we estimate to be up to RMB 1.4 trillion. To estimate this number, we assumed all banks purchase perpetual bonds in amounts equal to 5% of their core Tier-1 capital and all insurance companies buy perpetual bonds in an amount equal to 5% of assets. This is not an underestimation of potential demand for perpetual bonds since there are currently limitations on banks’ ability to issue and purchase these bonds as elaborated in Box I-1 on pages 12-13. In short, it is not clear if perpetual bond issuance and the CBS will be sufficient to undertake full recapitalization of the banking system and allow banks to accelerate their balance sheet expansion to finance an economic recovery. Bottom Line: In their current form and shape, perpetual bonds and the CBS program are unlikely to be a game-changer for the banking system in China. However, if the authorities eliminate limitations and change regulatory norms, the scheme could potentially be used to recapitalize China’s banking system. This is why this scheme can presently be viewed as a bazooka that has not yet been loaded by the government. Does CBS Represent QE? Its Impact On Liquidity And Money Supply The CBS program is a form of quantitative easing (QE). It will expand the PBoC’s balance sheet and banking system liquidity (excess reserves at the central bank), as elaborated in Box I-1 and Diagram I-1 on pages 12-14. If pursued on a large scale, this scheme would constitute monetization of banks’ capital and their bad assets by the central bank. The mechanism is already in place, but the extent to which authorities will use it to recapitalize banks remains unclear. Even though the CBS program will expand banking system liquidity – i.e., excess reserves at the central bank – it will not – however - affect broad money supply. The basis is simple: Banks’ excess reserves at the central bank are not part of the broad money supply in any country. Banks use excess reserves to settle payments between one another and with the central bank. Banks do not lend out excess reserves. Further, only a central bank can create excess reserves, and it does so “out of thin air.” In brief, excess reserves rather than corporate and individual deposits constitute genuine banking system liquidity. Barring lending to or buying assets from non-banks – which does not typically occur outside of QE programs – central banks do not create broad money or deposits.1 Money/deposits, the ultimate purchasing power for economic agents, is created by commercial banks “out of thin air,” as we have discussed and illustrated in our series of reports on money, credit and savings.2 Having adequate capital and liquidity as well as positive risk appetite, banks can expand their balance sheets, i.e., originate loans and buy various securities. When banks make loans or purchase assets from non-banks, they simultaneously create deposits and new purchasing power. Chart I-3 demonstrates that in recent years, excess reserves in China’s banking system have been flat, yet banks’ assets and the supply of money has expanded tremendously. The opposite can also occur: Banks’ excess reserves can mushroom, but banks may actually be reluctant to grow their balance sheets. This was the case after the Lehman crisis with U.S. banks and in the wake of the European debt crisis with euro area banks. Chart I-3China: Excess Reserves And Broad Money Finally, we have elaborated at great length in our past reports that China’s money and credit excesses do not stem from its high household savings rate. Rather, like any credit bubble in any country, China’s leverage is due to the creation of credit/money “out of thin air.”2 Bottom Line: Perpetual bond issuance and the CBS program will expand the banking system’s excess reserves, but not broad money supply. Besides, it is not certain that excess reserves will accelerate loan growth. Credit origination by banks depends on many other factors such as banks’ willingness to expand their risk assets, loan demand and the regulatory regime and norms. Deleveraging Has Not Yet Started One cannot discuss the potential for a monetary bazooka in China without an update on the status of deleveraging. The fact is that deleveraging in China has not even begun: Credit is still expanding faster than nominal GDP growth. The most common way to measure leverage/debt is to compare it with the cash flow that is used to service debt. Nominal GDP is a measure of cash flow in an economy from a macro perspective. The debt-to-asset ratio is a poor measure of leverage because asset valuations are often subjective: Assets are valued by debtors themselves. Besides, apart from distressed credit investors, one does not want to be a creditor to a country or company that has to sell assets to service its debt. Stock and bond prices of debtor countries or companies tailspin when the latter have to sell assets to service debt. The top panel of Chart I-4 illustrates that China’s enterprise and household domestic credit/debt is still expanding at an annual rate of close to 10% at a time when nominal GDP growth has slowed to 8%. Chart I-4China: Deleveraging Has Not Even Begun Consistently, the debt to GDP ratio has not declined at all (Chart I-4, bottom panel). In this context, a rhetorical question is in order: Should China ramp up money/credit growth and monetize banks’ NPLs, given that deleveraging has yet to take place? Economic Ramifications Of Deploying The Bazooka What would be the economic ramifications if the Chinese authorities once again promote and allow unrelenting money/credit expansion “out of thin air” to bail out zombie banks and companies? Cyclically: If the authorities compel banks to acknowledge NPLs and write them off as and when the PBoC finances their recapitalization, banks may not be in a position to accelerate loan growth. This scenario entails that credit growth and hence cyclical sectors in China would remain weak for a while. In contrast, if the authorities pursue recapitalization of banks without forcing them to acknowledge and write off bad assets, banks would regain their power to expand their balance sheets, fostering a cyclical economic recovery. Structurally (in the long term): The growth model based on continuous “out of thin air” money and credit expansion inevitably breeds economic inefficiencies, falling productivity growth and rising inflation. In short, the economic outcome over the course of several years would be stagflation. Chart I-5 illustrates that China’s ICOR (incremental capital-to-output ratio) is rising, or inversely that the output-to-capital ratio is falling. This entails worsening economic efficiency and slowing productivity growth. Chart I-5Symptoms Of Rising Inefficiencies Chart I-6 shows a potential stylized roadmap for the Chinese economy in the years ahead if the credit and money bubbles are inflated further without corporate restructuring, bankruptcies, the imposition of hard budget constraints and meaningfully improved capital/credit allocation. The red line represents potential GDP growth, and the dotted red line is our projection. In any economy, the potential growth rate is equal to the sum of growth rates of the labor force and productivity. China’s labor force is no longer expanding and will begin shrinking in the coming years (Chart I-7). Hence, going forward, the sole source of potential GDP growth in China will be productivity growth. Productivity growth has been slowing and will continue to do so if structural market-oriented reforms are not implemented (Chart I-8, top panel). Besides, the industrialization ratio has already risen a lot (Chart I-8, bottom panel). Chart I-7China: No Tailwind From Labor Force Chart I-8China: Productivity Is Slowing With the potential GDP growth rate in China declining, future fiscal and credit stimulus may lead to higher nominal – but not real – growth. The latter will be constrained by a slowing rate of potential real GDP growth. Higher nominal but weaker potential (real) growth entails rising inflation. The combination of higher inflation along with the need to maintain very low nominal interest rates to assist debtors is bearish for the currency. In such a scenario, there will be intensifying depreciation pressure on the yuan from the tremendous overhang of RMBs in the banking system (Chart I-9). The PBoC’s foreign exchange reserves of $3 trillion will not be sufficient to backstop the enormous amount of RMB (money) supply of RMB 210 trillion – which is equivalent to US$30 trillion (Chart I-10). Chart I-9Helicopter Money In China Chart I-10PBoC FX Reserves Are Equal To 10% Of Broad Money Supply If broad money supply continues to expand at an annual rate of close to 9-10% or above, downward pressure on the yuan will escalate immensely, and the Chinese authorities will have no choice but to close the capital account completely and also heavily regulate current account transactions. Bottom Line: If the authorities do not restrain the PBoC’s financing of perpetual bond issuance via the CBS and in the interim do not force banks to write off bad assets, the upshot will be the monetization of banks’ bad assets by the PBoC. This will constitute the ultimate socialist put for banks and zombie debtors, as well as for the entire economy. Business cycle swings, bankruptcies and deflation are inherent features of a market-driven/capitalist economy. A socialist put via promoting unlimited money and credit creation entails long-term stagflation – lower productivity growth and rising inflation. This is very bearish for the currency. Investment Conclusions To be sure, the above analysis suggests that the bazooka has not been loaded and the Chinese economy is not about to stage an imminent recovery. BCA’s Emerging Markets Strategy team maintains its bearish stance on China-related plays worldwide. We are closely monitoring China’s money and credit aggregates as well as indicators from the real economy to gauge when China’s business cycle will revive. So far, these indicators continue to point south. EM risk assets and currencies have recently been boosted by the Federal Reserve’s dovish turn. But as we argued in last week’s report, this will prove short-lived. Global trade, China’s growth and commodities prices are the key drivers of EM financial markets, not the Fed. Provided our negative outlook for these three factors due to the ongoing slowdown in China, we continue to recommend a negative stance on EM in absolute terms, and underweighting EM stocks and credit versus their U.S. peers. The dollar’s weakness stemming from the downshift in U.S. interest rate expectations is running out of steam. Chart I-11 shows that the broad trade-weighted dollar is trying to find support at its 200-day moving average. Conversely, the EM stocks index and copper prices are struggling to break above their 200-day moving averages (Chart I-11, middle and bottom panels). Chart I-11Dollar And EM / Commodities: Mirror Images We believe the dollar is poised for a breakout, and EM and copper are due for a breakdown. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Lin Xiang, Research Analyst linx@bcaresearch.com   Box 1 Issuance Of Perpetual Bonds And CBS Program The authorities are promoting the issuance of perpetual bonds and the CBS program as a scheme for the country’s big-four banks to raise capital to meet BIS ’s Total Loss-absorbing Capacity (TLAC) requirements for globally systemically important banks. Limitations and other details on the perpetual bonds issuance and CBS program: 24 out of 30 banks listed on the A-share market are presently qualified to issue perpetual bonds as their assets exceed RMB 200 billion, a threshold established by the PBoC. Perpetual bonds will boost the Tier-1 capital of issuing banks. Banks are allowed to purchase perpetual bonds issued by other banks in amounts up to 10% of their core Tier-1 capital. Only primary dealers (46 banks and 2 brokers) can exchange qualified perpetual bonds they hold for PBoC bills, with a maximum exchange period of three years. The incentive for banks to purchase perpetual bonds will for now be low because these bonds consume large amounts of capital. The risk weights for these perpetual bonds ranges between 150-250%. How Does It Work? As Diagram I-1 on page 14 illustrates, when Bank B purchases perpetual bonds from Bank A, the former transfers excess reserves to the latter. The amount of outstanding deposits, i.e., money supply, is not affected at all. Hence, there is no direct impact on the broad money supply. Banks do not require deposits to make loans and buy securities. Banks need excess reserves at the central bank to pay for or settle payments with other banks. When Bank B transfers excess reserves to Bank A, the aggregate amount of excess reserves in the banking system does not change. Bank B can swap these perpetual bonds with central bank bills, and then pledge these bills at the PBoC to get excess reserves. As it does so, Bank B will replenish its excess reserves. Consequently, the amount of excess reserves in the banking system will expand, as will the PBoC’s balance sheet. Overall, the issuance of perpetual bonds and CBS swaps lead to both bank recapitalization and banking system liquidity (excess reserves) expansion. Why has the PBoC decided to fund the issuance of perpetual bonds? Without PBoC funding, demand for perpetual bonds might be very low, and yields on them could spike. Higher yields could lure away capital from other corporate bonds, producing higher borrowing costs in credit markets. On the positive side, the monetary authorities will not only recapitalize a number of large banks but will also do so by capping borrowing costs in the credit markets and injecting more liquidity into the banking system. On the negative side, yields of these perpetual bonds will not be determined by the market. Rather they will be artificially suppressed by potential open-ended PBoC funding. This will preserve China’s inefficient credit allocation system and misallocation of capital in general. In a market economy, the authorities will typically force banks to raise capital in securities markets or privately. More issuance, especially when it comes from many banks simultaneously, typically pushes down the prices of bank stocks and bonds. The basis is securities issuance often dilutes existing shareholders and is also negative for bondholders. This threat of dilution and losing money incentivizes existing shareholders and bondholders of a bank to impose discipline on the bank’s management. Consequently, banks would be better run and capital allocation would be more efficient than it would otherwise be in a system where such oversight and incentives are absent. In brief, the market mechanism deters banks from risky and speculative behavior and contributes to the long-term health of the banking system, as well as the efficiency of capital allocation in the real economy. By allowing banks to purchase each other’s bonds, and with the PBoC financing it, China is not imposing the much-needed market discipline on bank shareholders, bondholders and by extension, bank management. This does not promote efficient capital allocation and higher productivity growth in the long run. Footnotes 1      Money supply is the sum of all deposits in the banking system. Hence, we use terms money and deposits interchangeably. 2      Please see the Emerging Markets Strategy Special Report “Misconceptions About China's Credit Excesses”, dated October 26, 2016, Special Report “China's Money Creation Redux And The RMB?”, dated November 23, 2016, Special Report “Do Credit Bubbles Originate From HIgh National Savings?”, dated January 18, 2017, Special Report “The True Meaning Of China's Great 'Savings Wall'”, dated December 20, 2017 Special Report “Is Investment Constrained By Savings? Tales Of China and Brazil”, dated March 22, 2018, available at www.bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

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Highlights So What? India is overcoming the economic constraints to its strategic rise.  Why? India faces rising political risk once again as public opinion puts Modi’s tenure in power at risk. However, India will continue to improve its economy, as outside pressures will force it to act coherently as a nation. Stay on the sidelines for now but remain constructive over the long run. Feature “An enemy of my enemy is my friend.” This is to paraphrase Kautilya, a philosopher of the Mauryan Empire, circa 200 BC. Kautilya was the Indian Machiavelli and wrote the Arthashastra to give hard-nosed political advice to rulers who wanted to know how kingdoms and states really behave rather than how they ought to behave.1   The quotation is no less true today than it was in ancient times. It explains why risks are rising to our view that Prime Minister Narendra Modi will remain in power after the election in April or May. This reinforces our underweight position on Indian risk assets over a 12-month time horizon. The quotation also explains why China’s growing influence in South Asia will drive India to continue reforming its economy and befriend the United States, thus supporting an optimistic view of India’s economic and investment potential in the long run (Chart 1). What Is India’s Grand Strategy? India’s geopolitical predicament stems from the fact that it is a relatively rational geographic unit, but one whose political unity is extremely difficult to maintain. Almost every side of the subcontinent is demarcated by forbidding geology: the Himalayas, the Bay of Bengal, the Arabian Sea, the thick jungles of Burma. Even the northwest, the traditional route of invaders, hosts vast obstacles like the Hindu Kush and Thar Desert. Any kingdom that takes shape can soon dream of expanding its borders to a natural stopping place (Map 1). Yet formidable obstacles stand between the cradles of Indian civilization – the Indus and Ganges Rivers – and the river ways and coastal outlets of the south. The Vindhya-Satpura mountains, the Deccan plateau, and the eastern and western Ghats make it extremely difficult for a northern power to govern the various cultures of the southern cone.  This geography ensures that empires are always trying and failing to unify the subcontinent into a coherent whole. As a result, India rarely projects power beyond it. When it does, the projection is short-lived.2    Historically India has seen the rise of five major empires that dominated the subcontinent: the Mauryans, the Guptas, the Mughals, the British, and the modern Republic of India (Chart 2). The Mughals and many other invaders periodically streamed in from the northwest – most often from modern-day Afghanistan and northern Pakistan, but also from Iran and southern Pakistan. Meanwhile several European empires invaded from the sea and established coastal settlements. The British East India Company settled in Bengal and then drove west and south, cutting off the French who had settled on the southeastern shores.   The modern Republic of India, founded in 1947 after Mahatma Gandhi and his followers harassed the British into leaving, feared that the United States would follow in Britain’s footsteps, being the world’s preeminent naval power. The Indians also distrusted the U.S.’s constructive relations with China and Pakistan that aimed to “contain” the Soviet Union. The Soviets, by contrast, could apply great pressure on Pakistan’s flank in Afghanistan and thus proved useful to India. They could also sell India weapons and capital goods as founding Prime Minister Jawaharlal Nehru pursued a socialist path of economic development.  The collapse of the Soviet Union coincided with a balance-of-payments crisis in India in 1991 that resulted in the abandonment of the old command-style economy and the adoption of modern capitalism under the reforms of Narasimha Rao. India also supported the U.S.’s intervention in the region after September 11, 2001 as a way of maintaining pressure on Pakistan’s back door. From this brief history we can glean a few solid points about India’s grand strategy: An Indian empire must establish control along the Indus or Ganges rivers, or both; An Indian empire must assimilate or drive out foreign rulers and unify the north and south; An Indian empire must strive to become the kingmaker across the subcontinent, through influence if not conquest; An Indian empire must fend off an invasion from the sea. The result of Rao’s reforms, India’s achievement of nuclear status in 1998, and nearly three decades of economic growth have been an India that is clearly an emerging “great power.” According to our Geopolitical Power Index, India is today on the cusp of supplanting Russia as the world’s third most powerful state (Chart 3). It surpassed the U.K., its former colonial master, in 1993. Chart 3India On Cusp Of Overtaking Russia In Comprehensive National Power Like China in East Asia, India is modernizing its vast army, developing a blue-water navy, and carving out a sphere of influence in South Asia (Chart 4). Also like China, India’s ambitions of regional hegemony are frustrated by its neighbors. India’s rivalry with Pakistan is foundational and existential – it is as if China faced Taiwan with nuclear weapons. Chart 4India's Military Clout Quietly Rising Today the fragile world order that prevailed in the wake of the Cold War is under severe strain. China’s grand regional ambitions are provoking a harsh reaction from the United States, which is setting up a new “containment policy” to limit China’s technological advance. The U.S. is withdrawing military forces from the Middle East and South Asia as it becomes energy self-sufficient and looking to counter-balance China with its free hand. Meanwhile China’s influence on the subcontinent is growing – already it is a rival to India as a trade partner for India’s South Asian neighbors (Chart 5). The Sino-Indian rivalry has often been overstated – the Himalayas are more than a hindrance. But China’s Belt and Road Initiative (BRI) means that this logic is increasingly out of date. Historically, India faced overland invasions from the northwest and maritime invasions from the northeast. The Belt and Road – of which Pakistan is probably the most comprehensive beneficiary – potentially threatens India from both directions sometime in the future. Chart 5China Encroaching In India's Sphere Of Influence Of course the U.S. and India still face tensions between each other – foremost being the impending withdrawal from Afghanistan and the U.S. “maximum pressure” policy towards Iran (Chart 6). There are also trade tensions with the Trump administration and a broader problem of inconsistent U.S. outreach to India. Nevertheless the logic of “the enemy of my enemy is my friend” suggests that over the long run the U.S. will grow warmer with India as a regional counterweight to China, while India will wish to become less isolationist and cultivate its relationship with the U.S. as a counter both to Pakistan and China. Simply put, China is making historic advances into India’s neighborhood in South Asia and the Indian Ocean basin. Chart 6A Good Sign For U.S.-India Ties: Cooperation On Iran This logic also suggests that India will be driven to continue reforming its economic structure so as to preserve internal unity and South Asian influence. If its economy languishes, it will lose preponderance within its neighborhood and become vulnerable to foreign aggression. Bottom Line: India and the U.S. are likely to see an ever-strengthening strategic partnership. They will overcome hurdles to the relationship because of their mutual need to counter China’s regional ascendancy. India’s Economic Hang-Up India has been ineffective in establishing an international presence because it has only reluctantly and haltingly reformed its economy. Today India’s middle class – measured by the share of adults with total wealth from  $10,000 to $100,000 – is less than 10%, comparable to the Philippines and Thailand. China’s is now above 50%, according to Credit Suisse’s Global Wealth Report (Chart 7).    This weakness stems in great part from policy decisions, namely the dogged pursuit of socialism through the latter stages of the Cold War. The same ruling ideology that prized independence also prized self-sufficiency, doubling down on import-substitution and thus missing the chance to industrialize with the export-oriented Asian Tigers in the 1970s or China in the 1980s. The result of insufficient measures to limit the state, curtail monopolies, contain inflation, and promote trade and private enterprise has been a chronic shortfall of national savings (Chart 8), which are needed to invest in capital projects and boost productivity (Chart 9).3   Chart 8India Lacks National Savings Chart 9India's Lagging Productivity Many of these historic hang-ups have begun to change, however, first under the reforms of the 1990s-2000s and more recently under the government of Prime Minister Narendra Modi since 2014. As a result, there are a number of “truisms” about India’s economy that are no longer true. For instance, while India’s government is said to be small and weak due to its federal structure – which empowers the states – the truth is that its government is not notably smaller than that of other comparable emerging markets (Chart 10). There is no doubt that it is harder for India’s leaders to drive their agenda than it is for Russia’s and China’s leaders, but this is due to the type of government rather than the size. India inherited liberal democracy and rule of law from the British and its own revolutionary leaders built on this foundation, providing relative stability despite its patchwork of languages, ethnicities, and castes. Democratic checks and balances have led to better governance. Chart 10India's Government Neither Small Nor Weak The contrast has had clear effects on demography. India has a strong demographic foundation and hence a large internal market and robust labor force growth. China, by contrast, is suffering from the distortive effects of the “One Child Policy” on its working age population. As a result India’s population will increasingly provide the global labor force as China’s workers become scarcer and rise in cost (Chart 11) and as trade conflicts between China and the West drive investors to relocate supply chains. This is also a risk to India, of course, if job creation lags. But that is where other economic improvements come in. Cumulatively, Modi’s policies have improved the trajectory of a capital formation relative to consumption, which will increase productivity, potential growth, and job creation (Chart 12). Chart 12Modi Corrected India's Investment Trajectory On openness to trade, India has largely closed the gap with China and other comparable EMs like Indonesia (Chart 13). And while India has long been highly restrictive toward foreign investment, it is much less so than China (Chart 14), and a slew of policies to ease restrictions has resulted in a surge in foreign direct investment that only recently came off the boil (Chart 15). Chart 13India Not So Closed To Trade Anymore Chart 15Modi Opened India To Foreign Investment Further, while India remains broadly under-invested and has not managed to rebalance its overall economy toward manufacturing, it has created some bright spots within the manufacturing sector, such as autos (Chart 16).4 Modi’s government has significantly improved other conditions that will encourage private investment: the ease of doing business, global competitiveness, infrastructure effectiveness, and human capital (Chart 17). Chart 16Cars A Bright Spot In Indian Manufacturing Bottom Line: India’s grand strategy has historically suffered because internal unity and regional influence could not be achieved with a floundering economy. Over recent decades, however, India’s reforms have accumulated into substantial improvements – and the Modi administration has made some key improvements. But Will Modi Survive? Our baseline case for the general election due in April or May is that Modi and his ruling Bharatiya Janata Party (BJP), along with their allies in the National Democratic Alliance (NDA), will remain in power, if narrowly. However, in recent weeks the public opinion polling has taken a turn for the worse for Modi (Chart 18), raising the odds of a hung parliament or opposition victory. Modi still remains well ahead of Rahul Gandhi, the dynastic leader of the opposition Indian National Congress and its United Progressive Alliance (UPA), in terms of popularity (Chart 19). But in some polling he is barely holding onto a double-digit lead. Meanwhile Gandhi’s sudden viability as a candidate is a significant change from only a year ago. Nevertheless the range of seat projections for the lower house of parliament, the Lok Sabha, is very wide and suggests that Modi’s coalition could still win a majority, as long as the opposition’s current rally breaks (Chart 20).   A critical election dynamic points back to Kautilya’s ancient advice. Recently, two major parties in Uttar Pradesh – the key bellwether state – have joined forces to avoid stealing each other’s votes and thus help the opposition take seats. If this scheme works, then the NDA could be outmatched at the polls.5 For investors, however, the key takeaway is that Modi’s reform agenda is past its peak and policy uncertainty can only rise from here: Modi’s seats will certainly shrink from the landslide of 2014 – the BJP is likely to lose its single-party majority, weakening Modi and his party members on their reform agenda. The support of their NDA allies will have to be bought with favorable policy tradeoffs (Chart 21); The high tide of Modi’s movement has already come and gone in the state governments, where the BJP recently lost Madhya Pradesh, Rajasthan, and Chhattisgarh, among others (Map 2). It is possible to lose these states and still win the general election, as largely occurred in 2004 and 2009, but state governments are a decisive factor in implementing federal policies and Modi’s influence is now clearly on the wane; Estimates of the NDA’s future gains in the Rajya Sabha, the upper house, suggest that even if Modi stays in power, he will never obtain a majority there (Diagram 1) – meaning that lower house bills other than supply bills will be subject to a veto; Diagram 1Modi Unlikely To Gain Majority In Upper House … Ever Modi is unlikely to have enough seats in the two houses to have the option of driving key legislation through a joint session of parliament. This is a rare occurrence but it would be a valuable ace up the sleeve. Modi’s reform movement has already seen high tide. He will struggle to institute reforms if he is weakened in parliament and the states. This is even truer if a hung parliament occurs, or if the UPA ekes out a slim majority. In essence, the next Indian government will likely be hobbled if Modi’s polling and performance do not recover from here – and even then he will not reclaim the political capital of his first term in office. It would be a mistake, however, to believe that reforms cannot get done without Modi. Prime Minister Rao came from the Congress Party, after all. Moreover, it is possible for India to undertake major reforms with a weak coalition or minority government. This was the backdrop of the critical pro-market reforms of the 1990s. But this implies that there would need to be a market riot to induce additional reform momentum, as was the case at that time, and India is not at a comparable crisis point today.  Bottom Line: Modi’s reform momentum is over. The next government will be weaker and less able to drive major pro-productivity reforms. But eventually reform momentum will recover, driven by the geopolitical forces outlined above. Does Modi Matter? What is the basis for Modi’s loss of momentum? The gist of the problem is that Modi’s reforms were structural and therefore entailed substantial economic and social costs. As a result, Modi has lost support. The good news is that Modi’s achievements thus far will continue to yield benefits for India. To highlight a few: The creation of a single market by means of the Goods and Services Tax (GST) is a significant reform that will ensure a strong legacy for Modi in the long run. However, the new tax obviously does not get voters enthused. The new Bankruptcy Law has helped to cleanse economic inefficiencies. But it has resulted in layoffs and financial deleveraging, weighing on credit growth and the broader economy. Demonetization, the sudden replacement of key denominations of money in circulation, has helped to formalize gray and black parts of the economy. But it was executed in a hugely disruptive manner and various scandals have arisen in the wake of it, hurting the ruling party. Controlling the fiscal deficit has been a federal government objective that has had some success. However, Modi and the state governments are more recently boosting spending ahead of the election to avoid what otherwise would be a negative fiscal thrust this year. This is a factor that should play to Modi’s advantage, although it has not so far. It also highlights the difficulty of fiscal consolidation over the long run (Chart 22). Chart 22Election Cycle Fiscal Easing Is The Norm More concerning, both for Modi and for India, is the unemployment rate. Even the official unemployment rate is rising despite the fast clip of economic growth and the pro-growth reforms (Chart 23). A leaked government statistical report suggests that unemployment has indeed gone up and labor participation has fallen more than the government is willing to admit. Chart 23Even Official Unemployment Is Rising The jury is still out on the extent of the current growth slowdown. Some estimates suggest that the output gap is closed, others say slightly negative. While there has been a soft patch in wage growth – particularly among the important 40% of the population that still works on the farm (Chart 24) – the latest data show improvement. Unit labor costs are ebullient and suggest that employee compensation is rising (Chart 25). The reality could make all the difference for Modi’s coalition at the ballot box. Chart 24Rural Wages Improving... But Is It Enough? Chart 25Will Workers Reward Modi? More importantly, if India cannot keep unemployment down amidst significant labor force growth, then Modi will only become the near-term casualty of a more profound problematic trend. Another long-term concern is Modi’s political pressure on the Reserve Bank of India. This has resulted in the replacement of two orthodox and credible central bankers under Modi’s watch. The result is a noticeably dovish policy shift, as confirmed by the cut of the repo rate to 6.25% (from 6.5%) on February 7. This cut and later cuts may be supported by global growth fears but will raise suspicions of political influence. Any damage to the central bank’s credibility will have lasting negative effects since the election result cannot reverse it (at least not fully). It will feed inflation expectations marginally and insofar as it does it will worsen the conditions for sustainable private sector capital investment. However, inflation is currently low and other reforms – such as the RBI’s adoption of inflation-targeting and ample domestic grain production – will help to offset any new monetary policy risk. Bottom Line: Modi’s reform legacy is mostly positive for India structurally, although the erosion of central bank independence is a critical exception. Investment Implications In the short run, cooperation among Modi’s political opponents poses a risk of removing him from power and short-circuiting his reform agenda. In the long run, cooperation between China and India’s South Asian neighbors poses a risk of undermining India’s grand strategy, driving it into the arms of the United States. In both cases Kautilya’s ancient wisdom is on display.   In the first case, a Modi defeat would be negative for India’s policy continuity, currency, and risk assets. The upside to our baseline view of a Modi victory is not high, however, unless Modi and the BJP surprise to the upside and win a substantial majority. This is unlikely unless the polling changes. In the second case, the geopolitical environment will pressure India to continue reforming and improving its economy so as to maintain internal stability, influence its neighbors, and ward off unwanted foreign influence. With China’s Belt and Road putting pressure on India’s strategic interests, leaders in New Delhi will have a continual motivation to focus on improving the economy as well as seeking alliances. This is the only way to ensure India retains its influence within its neighborhood.  For now, investors should steer clear of the Indian currency and risk assets in absolute terms because Modi’s reforms are priced in; election cycle dynamics are undermining monetary and fiscal policy; and the risk of sharp policy discontinuity is rising. On a relative basis, India may also underperform EM in the short term while oil prices rise: oil prices and India’s equity performance relative to EM are negatively correlated.6 Beyond that, however, India is a structural opportunity. Capital investment in China, which has powered much of the structural bull market in commodities and EM assets over the past two decades, is declining, while India’s is improving (Chart 26). Capex is the key to improving India’s productivity and keeping inflation in check even as the demographic dividend pushes up growth rates. Although many EM economies will suffer from a slowdown in Chinese capex, India is not overly exposed to China or global trade, and it is further along than other EMs in its process of bank deleveraging, which opens the prospect of a new credit cycle that will improve its investment outlook (Chart 27).    Chart 26China Capex Down, India Capex Up Chart 27Deleveraging Enables A New Credit Cycle   Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1      Kajari Kamal, “Kautilya’s Arthashastra: Indian Strategic Culture and Grand Strategic Preferences,” Journal of Defence Studies 12:3 (2018), pp. 27-54, available at idsa.in 2      The medieval Chola Kingdom sailed across the Bay of Bengal and as far as Malacca in 1025. Please see  Manjeet Singh Pardesi, “Deducing India’s Grand Strategy of Regional Hegemony from Historical and Conceptual Perspectives,” Institute of Defense and Strategic Studies, Working Paper 76 (April 2005), available at www.rsis.edu. For an in-depth study of India’s strategic history, see Graham P. Chapman, The Geopolitics of South Asia: From Early Empires to the Nuclear Age (Burlington, VT: Ashgate, 2009). 3      Please see BCA Emerging Market Strategy Special Report, “Capital Rationing Is Deterring Growth,” February 28, 2012, and “India’s Inflation: How Serious Is The Problem?” January 26, 2010, available at www.bcaresearch.com. 4      Please see BCA Commodity and Energy Strategy Weekly Report, “India’s Commodity Demand, With Or Without Modi,” February 7, 2019, available at ces.bcaresearch.com. 5      Please see Milan Vaishnav and Jamie Hintson, “As Uttar Pradesh Goes, So Goes India,” Carnegie Endowment for International Peace, February 5, 2019, available at carnegieendowment.org. 6      Please see BCA Emerging Markets Strategy Weekly Report, “EM: Sustained Decoupling, Or Domino Effect?”June 14, 2018, available at ems.bcaresearch.com.