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Dear Client, I am travelling this week so this report is a joint effort juxtaposing two contrasting observations about France. The ‘opulence’ part highlights France as the world’s dominant producer of luxury goods, and makes the case that some of the French luxury goods companies should form a core part of a long-term investment portfolio. The ‘rebellion’ part borrows from a recent Special Report on French politics penned by my colleague Jeremie Peloso. It analyses the recent yellow vest protests in France, and assesses whether they are a cause for concern. Best regards, Dhaval Joshi, Chief European Investment Strategist Feature Opulence Made In France Global luxury goods sales amount to a quarter of a trillion dollars, and Europe dominates in the production of these luxury goods. Measured by the number of companies, the leading luxury goods country is Italy. But on the more important metric of share of total global sales, the undisputed world leader is France. In fact, just four French companies produce a quarter of the world’s luxury goods sales. The four are: LVMH, Kering, L’Oreal, and Hermes1 (Chart of the Week, Chart I-2, and Table I-1). France’s luxury goods sector is an excellent diversifier for investors. This is because, compared to other goods and services, luxuries follow very different laws of economics: The demand for luxuries has a positive elasticity to price. Put more simply, the desirability of a luxury increases as its price goes up. This is opposite to the demand for non-luxuries which has a negative elasticity to price: for non-luxury items, the demand declines as the price goes up. By definition, you cannot compete with a luxury item by undercutting its price. Given that a luxury implies fine-craftsmanship rather than mass production, the sector is highly resilient to the existential threats confronting other European industries that emanate from out-sourcing to lower cost economies and from automation. Luxury demand is also relatively insensitive to exchange rate movements. The barrier to entry into the luxuries sector is extremely high. It takes years, or even decades, for a luxury item to acquire its premium status based on consistent high quality in materials and craftsmanship. This high barrier to entry makes it much harder for other economies to challenge the European and French dominance in providing these luxury products. Despite these attractive characteristics the sector does still require a source of structural demand. Our premise, expounded in our Special Report “Buying European Clothes: An Investment Megatrend”, is that the feminisation of consumer spending, particularly in Europe, is providing a strong structural tailwind to the demand for ‘soft’ luxury goods. A recent industry study by Deloitte corroborates this thesis, pointing out that the strongest growth in the luxury sector is to be found in cosmetics, fragrances, bags and accessories. On this premise, the four leading French companies are big beneficiaries.2,3   Are market valuations already aware of, and fully discounting, the thesis of feminisation of consumer spending? We think not, as most investors are surprised by the thesis and unaware of the on-going dynamics behind it. On this basis, three of the four French luxury companies, trading on forward PE multiples in the 20s or below, still appear reasonably valued for their growth prospects (Table I-2). The exception is Hermes which, on a multiple of 40, does seem richly priced. The bottom line is that the three other leading French luxury goods companies – LVMH, Kering, and L’Oreal – do deserve to be a core part of a long-term investment portfolio. Rebellion Made In France The yellow vest protest movement is not a coherent force led by a clear leadership. What started on the social media as a protest against the fuel tax in rural areas has evolved into a movement against President Macron. This transition occurred in part because a large segment of the population believes that Macron’s reforms have mainly benefited the wealthy. 77 percent of respondents in a recent poll view him as the “president of the rich.” The modification of the ‘wealth tax’ – which mostly shifts the focus toward real estate assets instead of financial assets – was highly criticized for favouring the wealthiest households. It resonated strongly with the perception that past governments helped the wealthiest households to accumulate more wealth on the back of the middle class. But it is not clear how intense or durable this popular sentiment will be, given that this type of inequality is not extreme in France and has not been rising (Chart I-3). Chart I-3What Income Inequality? Public support for the protests has hovered consistently around 70 percent since they started in November 2018 (Chart I-4). However, there are now more respondents who think that the protests should stop as that they should continue (Chart I-5). As a sign of things to come, a demonstration against the yellow vests and in support of Macron and his government – held by the “red scarves” – managed to gather more people on the streets of Paris than the regionally based yellow vests have done in the capital city.4 Who are the yellow vests? They are mostly rural, mostly hold a high school degree (or less), and overwhelmingly support anti-establishment political leaders Marine Le Pen (right-wing leader of the National Rally) or Jean-Luc Mélenchon (left-wing leader of La France Insoumise). This suggests that the movement has failed to cross the ideological aisle and win converts from the centre (Diagram I-1). How many French people are actually protesting? Although there was a slight pickup in protests at the beginning of January, the numbers countrywide are not high. In fact, they are far from what they were back in November and therefore would have to get much larger for markets to become concerned anew (Chart I-6). If we are to compare these protests to those in 1995 or 2010, the numbers pale in comparison (Table I-3). For instance, the protest of December 1995 brought a million people onto the streets while the demonstrations against the Woerth pension reform in 2010 lasted for seven months and gathered close to nine million protesters across eight different events (Chart I-7). We would compare the yellow vest protests to the 15-month long Spanish Indignados in 2011, which gathered between six and eight million protesters overall, and the U.S. Occupy Wall Street protests that same year. The two movements were similarly disorganized and combined disparate and often contradictory demands. In both cases, the governments largely ignored the protesters. Thus the yellow vests should not have a major impact on Macron’s reform agenda. As expected, Macron has not mentioned changing course on his most business-friendly reforms, which we see as a signal to investors that, despite the recent chaos, the plan remains the same. There is no strategic reason why Macron would reverse course. His popularity is already in the doldrums. His only chance at another term is to plough ahead and campaign in 2022 on his accomplishments. Nevertheless, to ensure that he does not plough into a rock, Macron will adjust course to calm the protesters. For example, the recent increase in the minimum wage that the government announced in response to the demonstrations was not supposed to be implemented until later in the presidential term. In a similar vein, pension reforms will likely be postponed given the ongoing protests. Macron hoped to introduce a universal, unified pension system by the middle of 2019 to replace an overly complex and fragmented system in which 42 different types of pension coexist, each one having its own rules of calculation. Though protests (both yellow vest and otherwise) have been unimpressive by historical standards, it might be too risky for the government to push the pension reform so close to these events. Such adjustments to the reform agenda should help reduce the protest movement’s fervour or otherwise its support. The bottom line is that the yellow vest protests were to be expected – they are the natural consequence of Emmanuel Macron’s push to reform the French economy and state. However, when compared to previous efforts to derail government reforms, the numbers simply do not stack up. Their disunited and broad objectives are likely to limit the effectiveness of the movement going forward.5   Dhaval Joshi,  Chief European Investment Strategist dhaval@bcaresearch.com Jeremie Peloso, Research Analyst jeremiep@bcaresearch.com Footnotes 1 In the case of L’Oreal this refers to the L’Oreal Luxe division. 2  Please see the European Investment Strategy “Buying European Clothes: An Investment Megatrend”, dated December 6, 2018 available at eis.bcaresearch.com. 3 Deloitte: Global Powers of Luxury Goods 2018, Shaping the future of the luxury industry 4 According to the government, 10,500 “red scarves” marched in Paris on January 27, 2018. 5 For the full report, please see the Geopolitical Strategy Special Report “France: La March A Suivre?”, dated February 27, 2019, available at gps.bcaresearch.com.  

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Highlights European Growth: Europe’s economy is slowing, while core inflation remains subdued. The ECB must now contemplate the need for a monetary policy ease so soon after ending its bond buying program. Likely ECB Options: The ECB will likely have no choice but to initiate a new round of LTROs – likely to be announced in either April or May – to prevent an unwanted tightening of credit conditions at a time of slowing economic growth. Fixed Income Implications: Stay below-benchmark on euro area duration, with inflation expectations likely to rebound alongside a more dovish ECB and rising global oil prices. Stay underweight Italian government bonds and neutral overall euro area corporate credit exposure, however, until there are more decisive signs that growth is stabilizing. Feature Back in December, the European Central Bank (ECB) - confident that the euro zone economy was healthy enough to allow the slow process of policy normalization to begin - ended its Asset Purchase Program and signaled that rate hikes could commence as soon as late 2019. Just two months later, the central bank is faced with an unexpectedly persistent and broad-based growth slump. Markets now expect no change in short-term interest rates until well into 2020. By most conventional measures, the ECB is running a very accommodative monetary stance, with a €4.7 trillion balance sheet and negative interest rates (both in nominal and inflation-adjusted terms). On a rate-of-change basis, however, policy has become incrementally less stimulative, with the balance sheet no longer expanding and real interest rates unchanged from levels of a year ago (Chart 1). An additional potential tightening of liquidity conditions is on the horizon with the ECB’s long-term funding operations for euro zone banks (LTROs and TLTROs) set to begin rolling off next year. Chart 1The ECB Needs To Ease Policy Somehow Our ECB Monitor indicates that fresh monetary easing will soon be required if the current downtrend in growth persists. Given the persistent fragilities within the European banking system, not only in Italy but increasingly in core countries like Germany, a combination of slowing economic momentum and tightening monetary liquidity is a potentially toxic brew. Weaker growth raises the specter of a rise in non-performing loans held by banks that also have significant sovereign debt exposures (the so-called “Doom Loop”). In this Special Report, we consider the policy options that the ECB could realistically deliver in the coming months - given the state of the economy, inflation and banking system – with the associated investment implications for European fixed income markets. Our conclusion: the ECB will be forced to take a dovish turn as an insurance policy against tighter credit conditions and weak growth. Eurozone Economy: Broad-Based Mediocrity The ECB has categorized the current downturn, which has pushed real GDP growth in the Eurozone to a below-trend pace of 1.7% and triggered a technical recession in Italy, as simply the product of a bunch of idiosyncratic country-specific shocks (a cut in Germany auto production due to changing emissions standards, Italy-EU fiscal policy debates that raised the cost of capital in Italy, and political unrest in France damaging consumer spending). The biggest shock, however, has been exogenous. Trade policy uncertainty and a weakening Chinese economy have both been a major drag on growth for euro zone countries that rely heavily on exports, in general, and Chinese import demand, in particular. The “one-off shocks” narrative is incorrect because the slowdown has been broad-based. The majority of countries within the euro zone are suffering slowing GDP growth, falling leading economic indicators and decelerating headline inflation, according to our diffusion indices for each (Chart 2). The previous three times such a synchronized slowdown unfolded (2001, 2009 and 2012), the ECB responded with a full-blown rate cutting cycle. Inflation trends today, however, make it a bit more difficult for the ECB to consider any such possible shift in a more dovish direction. Chart 2ECB Typically Eases After A Broad-Based Economic Downturn The overall unemployment rate for the region is 7.8%, well below the OECD’s estimate of the full employment NAIRU1 rate. In contrast to our diffusion indicators for the economy, the majority of euro area countries (83%) have unemployment rates lower than NAIRU (Chart 3). The previous two times labor markets were so tight in the euro area, wage inflation reached 4%, core inflation climbed beyond 2.5% and the ECB pushed policy interest rates to between 4-5%. Today, a large majority of countries are witnessing faster wage growth and core inflation, but the overall level of both is still relatively low (2.5% and 1%, respectively). Chart 3ECB Policy Is Already Very Easy So from the point of view of the state of overall growth and inflation, the ECB is in a difficult position. Euro area growth has slowed, but not by enough to ease the nascent inflation pressures in labor markets. The story gets more complex when looking at growth and inflation at the individual country level. For the four largest economies in the region – Germany, France, Italy and Spain – the latter two remain a source of concern. Unemployment in both Spain and Italy remains in double-digits, with headline and core inflation rates at 1% or lower (Chart 4). Italy’s manufacturing PMI is now at 47.6 and Spain’s is now at 49.9, both below the 50 level indicating an expanding economy. Chart 4Italy & Spain Are Becoming An Issue (Again) Credit growth exhibits a similar pattern. Total bank lending is contracting on a year-over-year basis in Italy (-4.3%) and Spain (-2.1%), while still growing at a positive, albeit decelerating, rate in Germany (+1.5%) and France (+5.3%). The most recent ECB Bank Lending Survey for the fourth quarter of 2018 showed that lending standards were becoming more stringent in Italy and Spain than in Germany or France (Chart 5). In Italy, where the growth downturn has been deeper and borrowing costs have gone up due to the Italian populist government’s repudiation of EU deficit limits, banks are actually tightening lending standards. Chart 5Credit Conditions Tightening At The Margin The last thing the ECB wants to see now is a sustained credit contraction in the large economies where growth and banking systems are the most fragile – most notably, Italy. Bottom Line: Europe’s economy is slowing, while core inflation remains subdued. Weakness is more pronounced in the Peripheral countries compared to the Core, especially Italy. The ECB must now contemplate the need for a monetary policy ease so soon after ending its bond buying program. Italy’s Banks Are Still A Huge Headache For The ECB European banks have struggled to generate acceptable profits in recent years against a backdrop of sluggish economic growth, negative interest rates and increased regulatory capital requirements. Bank equity values remain near post-2008 crisis lows, with Italian bank stocks severely underperforming their competitors within the euro zone (Chart 6). Credit spreads for Italian banks are also far more elevated than those of their euro area peers, a reflection of the higher yields and wider spreads on Italian government bonds (which, given Italy’s BBB sovereign credit rating, means that the floor on Italian yields and credit spreads is higher than those of other euro zone countries with better credit ratings). Chart 6Italy's Fiscal Problems Impacting The Banks Even given the economic fragility in Italy, Italian banks remain reasonably well-capitalized. According to the data from the European Banking Authority (EBA), Italian banks have a Common Equity Tier 1 (CET1) capital ratio of 13.8%, well above the minimum levels required by Basel III bank regulations and close to the overall euro area CET1 ratio of 14.7% (Chart 7). The problem for Italian banks, however, remains the high level of non-performing loans (NPLs). EBA data shows that Italian banks have an NPL ratio of 9.4%, nearly three times the total euro area NPL ratio of 3.4%. While this is a substantial improvement from the near-20% NPL ratio seen after the 2011 European debt crisis, the absolute level of NPLs remains high. The other major risk for Italian banks is their large holdings of Italian sovereign bonds, which raises the risk of mark-to-market losses hitting the banks’ capital position as government bond yields rise (i.e. the “Doom Loop”). The ECB’s bond purchases have helped to reduce the share of Italian sovereign debt held by Italy’s banks from 25% to around 19% over the past five years (Chart 8). Yet with Italy’s sovereign credit rating now BBB – on the cusp of junk – Italian bank balance sheets remain heavily exposed to sovereign debt risk. The ECB has tried to mitigate the impact of its extraordinary monetary stimulus on the profitability of Europe’s banks by offering longer-term loans (against acceptable collateral) at low interest rates. These programs, known as Long-Term Refinancing Operations (LTROs), have mostly been used by banks in Italy and Spain, which have taken up a combined 56% of all outstanding LTROs (Chart 9). Chart 956% Of ECB LTROs Have Gone To Italy & Spain The most recent LTRO operation launched in 2016 was a Targeted LTRO (TLTRO) that tied the extension of ECB funding directly to the amount of new loans made by any bank that received the funding. Those TLTROs were offered at the ECB’s Marginal Deposit Rate of -0.4%, effectively providing a 40bps subsidy for new bank lending. The impact on loan growth from the TLTROs was far greater in Italy and Spain, where the share of total bank lending funded by LTROs in each country is now 10% compared to 4% for all euro area bank loans (Chart 10). Chart 10LTROs Funding 10% Of Bank Lending In Italy & Spain The TLTROs extended in 2016 had a maturity of four years, which means that the loans will begin to mature next year.2 If the ECB lets these operations expire without any offering of a new program, then banks that have used that cheap liquidity will be faced with one of two choices: replace that funding with bank debt at much higher market interest rates, or reduce the size of their loan books (i.e. delever their balance sheets). For Italy’s banks, replacing all of that cheap TLTRO funding with expensive bank debt is highly unlikely. According to the Bank of Italy’s latest Financial Stability Report, bank debt represents as large a share of overall Italy bank funding as the TLTROs (around 10%), but the growth rate of that debt has been contracting at a -15% to -20% rate over the past couple of years (Table 1).3 This is how rising Italian sovereign bond yields translate into higher bank debt yields and market funding costs, restricting lending activity. Table 1Italian Banks Have Slashed Expensive Debt Market Funding Already, Italian banks have been cutting back on lending to the most risky borrowers, according to Bank of Italy data (Chart 11). The growth rates of loans deemed “risky” and “vulnerable” contracted at a faster pace in 2018 than during 2015-17, while loans extended to “solvent” and “safe” borrowers grew more quickly in 2018 than the prior three years. These trends are likely to continue with credit standards now being tightened by Italian banks according to the ECB Bank Lending Survey. An additional factor for the banks to consider is the upcoming implementation of the Basel III regulatory requirement that banks must maintain a minimum amount of funding with a maturity greater than one year (the Net Stable Funding Ratio, or NSFR). Even though the current round of TLTROs do not begin to expire until June 2020, they will turn into “short-term” funding as of June of this year when it comes to banks calculating their NSFR. That ratio is not yet binding, but banks will likely seek to plan ahead for their long-term funding and will seek guidance from the ECB. So the ECB is now faced with the prospect of letting the TLTROs begin to expire next year, placing 4% of total euro area bank lending and 10% of Italian and Spanish bank lending at risk. Given the current fragile state of growth in the euro area, especially in Italy, the central bank would be taking a huge gamble by risking an even deeper downturn through banks shrinking their loan books. The easiest way to prevent that outcome – more LTROs. Bottom Line: The ECB will likely have no choice but to initiate a new round of LTROs – likely to be announced in April or May - to prevent an unwanted tightening of credit conditions amid slowing economic growth. The ECB’s Likely Next Move? New LTROs With More Dovish Forward Guidance The ECB Governing Council meets this week. There will be a new set of economic projections prepared for this meeting, and the ECB has typically chosen to make changes to its monetary policies alongside shifts in its economic forecasts. ECB President Mario Draghi has already noted that the growth risks in the euro zone are now tilted to the downside. Even noted monetary hawks like German Bundesbank President Jans Weidmann and Dutch Central Bank President Klaas Knot – both candidates to replace Draghi when his term expires in October – have toned down their calls for monetary tightening given the weak growth in their own economies. We expect the ECB to follow a dovish script at the March ECB meeting, along these lines: Downgrade the ECB’s growth forecasts Delay the date when inflation is projected to return back to 2% target Extend forward guidance on the first rate hike out to “mid-2020 or later” (which only validates current market pricing) A pessimistic assessment of the outlook for bank lending based on elevated bank funding costs impairing the transmission of ECB’s “highly accommodative” monetary policy A discussion about the need for a new LTRO program to replace the ones that start expiring in 2020 Step 4 in that script could be delayed until the April or May ECB meetings, to allow for more time to see how the economic data unfolds. Almost all of the current downturn in real GDP growth can be attributed to the plunge in net exports – the contribution to growth from domestic demand has been stable over the past year (Chart 12). Thus, the ECB will likely want to see if the current indications of a U.S.-China trade deal, combined with more stimulus from China’s policymakers, puts a floor under the downturn in euro area trade activity. Chart 12ECB Growth Forecasts Require A Rebound In Exports Step 5 in our March ECB meeting script can also be delayed to April or May, but the ECB is not likely to wait longer than that and run the risk of letting the current slowing of euro area credit growth turn into a full-blown contraction due to the end of cheap funding (Chart 13). Chart 13Tightening Lending Standards: Trigger For A New LTRO? There has also been some speculation that the ECB could satisfy both the hawks and doves on the Governing Council by announcing a hike in the ECB Overnight Deposit rate at the same time as a new LTRO program. The Overnight Deposit rate represents the floor of the ECB’s policy interest rate corridor, with the Marginal Lending rate representing the ceiling and the Main Refinancing rate acting as the midpoint of the corridor. Yet with the ECB maintaining such a large balance sheet, with €1.2 trillion in excess reserves, the effective short-term interest rate (1-week EONIA) has traded near the Overnight Deposit Rate floor. Thus, lifting only the Overnight Deposit Rate, which is -0.4% and has been blamed for damaging the earnings of euro area banks, would effectively be the same as a traditional hike in the ECB’s main interest rate tool, the Main Refinancing Rate (Chart 14). Chart 14The ECB Cannot Bottom Line: Offering a new LTRO, but perhaps for only a shorter time period than the expiring TLTROs (i.e. two years instead of four), seems to be the best solution for the ECB. This will prevent a potential liquidity-driven bank credit crunch in the most vulnerable parts of the European economy – Italy and Spain. Fixed Income Investment Implications Of Our ECB View 1. Duration: the benchmark 10-year German Bund yield had fallen as low as 0.09% in the most recent global bond rally, largely driven by a collapse in inflation expectations. The ECB’s likely dovish guidance on rate hikes will prevent any meaningful rise in real Bund yields. Inflation expectations, however, do have a lot more upside if BCA’s bullish oil forecast is realized – especially so if the ECB also takes a more dovish turn (Chart 15). Stay below-benchmark on euro zone duration, and stay long inflation-linked instruments like CPI swaps. Chart 15Stay Below-Benchmark On European Duration Exposure 2. Italian Sovereign Debt: A new LTRO program, combined with more dovish forward guidance, should help prevent the current Italian growth downturn from intensifying. However, a weak economy will sustain pressure on Italian sovereign spreads. Stay underweight for now, but look to upgrade when growth stabilizes (Chart 16). Chart 16Stay Cautious On Euro Area Spread Product Until Growth Bottoms 3. Euro Area Corporates: A more dovish ECB will help stabilize corporate credit spreads in the euro area, but like Italian sovereign debt, signs of more stable growth are required before spreads can meaningfully compress. Stay neutral for now.   Robert Robis, CFA, Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Non-accelerating inflation rate of unemployment. 2 The loans were offered in four allotments in June 2016, September 2016, December 2016 and March 2017. Hence, the loans will mature in June 2020, September 2020, December 2020 and March 2021. 3 The November 2018 Bank of Italy Financial Stability Report can be found here: https://www.bancaditalia.it/pubblicazioni/rapporto-stabilita/2018-2/index.html Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns