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Highlights The attack on Saudi Arabian energy facilities brought oil price shocks back onto investors’ radar screens: Benchmark crude prices in Europe and the U.S. blasted higher following the September 14th attacks on Saudi oil installations. Although the initial price spike largely unwound, the incident demonstrated that oil infrastructure is vulnerable: Saudi officials say output will be restored sooner than markets initially feared, but oil production is now in play for bad actors. The probability of supply-driven price shocks has increased. How vulnerable is the U.S. economy to an oil price shock?: A whole heck of a lot less than it was at the time of the 1973-74 oil embargo. The U.S. is the world’s largest oil producer, and is on its way to becoming a net exporter. Higher oil prices now amount to much more than a tax on U.S. households and corporations. Feature On Saturday, September 14th, Saudi Arabia’s Abqaiq crude-oil processing facility and its Khurais oil field were struck by air attacks that caused multiple explosions. Yemeni forces claimed responsibility, in retaliation for Saudi Arabia’s involvement in its protracted civil war, though the Saudi and U.S. governments asserted that Iran was to blame. As our Commodity & Energy and Geopolitical Strategy colleagues have written, Iran’s involvement makes the situation more ticklish.1 It is unclear where escalating rounds of provocations between the U.S. and Iran might end up, but the geopolitical, energy and economic impacts could be quite serious. There are a lot of moving parts, and we will not rehash our colleagues’ analysis here. From the U.S. Investment Strategy perspective, the biggest takeaway is that Middle Eastern oil infrastructure is more vulnerable to malign state and non-state actors than markets previously realized. It is remarkable that the world’s single most important oil processing facility could be so easily and precisely targeted, though anyone who began flying after September 11th would likely be amazed to learn that passengers once boarded planes without anyone giving the contents of their baggage a second thought. Regardless of how quickly Abqaiq operations are fully restored, Middle East oil infrastructure has been exposed as a soft target. The net economic impact of higher oil prices is the sum total of a broad range of gross subsidiary impacts. The global oil market is therefore more vulnerable to shocks from unplanned supply outages than previously assumed, and should begin to price in a terrorism premium. Any given economy’s exposure to oil price shocks is a more important consideration than it was before the attack on Aramco operations. In this Special Report, we examine the U.S. economy’s susceptibility to an oil price shock. The good news is that we find the U.S. to be considerably less vulnerable to an oil price shock than it was at the time of the Arab oil embargo; the net “tax” from higher oil prices is a good bit lower than it was then, and it is no longer exclusively paid to foreign entities. Six Channels Of Economic Impact We count six primary channels through which oil prices impact the U.S. economy: consumption, capital expenditures, corporate profits, the trade balance, employment and financial conditions (Figure 1). Higher oil prices are unequivocally bad for consumption, because they reduce households’ discretionary income. They should be a net positive for capital expenditures, because oil exploration and production is a capital-intensive pursuit that would likely outweigh incremental cutbacks in investment by businesses in the rest of the economy. They directly increase input costs for the wide range of goods that incorporate petroleum, and the goods and services that use oil as fuel, though other businesses’ reduced profits will be offset somewhat by domestic oil producers’ increased profits. As long as the U.S. remains a net oil importer, they will act to widen the trade deficit; once it becomes a net exporter, possibly within the next few years, they will narrow it. Their net impact on employment and financial conditions is mixed. Figure 1Oil Prices And The Economy Consumption Consumption is the linchpin of the oil-shock/recession narrative, as typified by the 1973-74 oil embargo. During the October 1973 war between Israel and a coalition of Arab states, OPEC members angered by American support for Israel ceased exporting oil to the U.S. and sharply reduced production. Although the embargo lasted just six months, oil prices tripled. Inflation surged, consumer confidence suffered mightily amid ubiquitous images of gasoline lines, and a sharp recession and punishing equity bear market laid siege to the U.S. economy. Chart 1The '70s Oil Shocks ... The overthrow of Iran’s pro-western monarch in 1979 generated a second oil price shock (Chart 1). The U.S. soon entered the first phase of the Volcker double-dip recession, and the notion that oil price shocks cause recessions became entrenched in the introductory macroeconomics curriculum. Filling up the tank consumes a much smaller share of household budgets today than it did in the ‘70s, however, so household spending is nowhere near as vulnerable as it was then (Chart 2). Energy is no more expensive relative to the PCE basket than it was at the end of the ‘70s (Chart 3), allowing fuel efficiency gains to translate directly to increased discretionary income (Chart 4). The household savings rate is lower, as well (Chart 5), clearing the way for consumers to spend more of their discretionary income.2 Chart 2... Took A Big Bite Out Of Consumers' Wallets Chart 3Relative To Other Consumer Prices, Oil Costs What It Did After The Second Shock Chart 4New-Model Mileage Has Doubled Chart 5Consumers Are More Willing To Spend Than They Were In The '70s ... Bottom Line: Consumption will be undermined by higher oil prices, but not nearly to the degree it was in the 1970s, when fuel costs ate up a greater share of discretionary income. Corporate Profits Higher input costs stoked the wage-price cycle in the ‘70s, but low inflation expectations and supine unions have all but stamped out cost-push inflation pressures today. Chart 6... And Economic Output Is Far Less Dependent On Oil Higher oil prices’ negative impact on input costs is as clear-cut as their impact on consumption. Higher input costs helped trigger the ‘70s and ‘80s recessions, dragging down corporate profits and exacerbating cost-push inflation pressures as employees demanded higher wages to keep up with rising prices. That dynamic still applies, but its force is considerably attenuated, as tepid inflation expectations and the decline of unions’ collective bargaining power have all but wiped out cost-push inflation pressures. The continuing shift from manufacturing to services also limits the impact of higher input costs; the oil intensity of the U.S. economy is little more than a third of what it was at the time of the embargo (Chart 6). Growing energy self-sufficiency keeps some of the increased input costs from escaping the domestic economy. It is still valid to think of higher energy prices as a tax on businesses and consumers, but at least some of the tax revenue now accrues to U.S. parties. Shale drillers, pipeline companies, vendors and workers, and the states and localities where they reside, all share in the benefits. That limits the drag on domestic corporate profits, and the second-order drags on fixed investment, employment, consumption and creditworthiness. Capital Expenditures And The Other Channels Energy production’s increasing role within the U.S. economy came to the fore when crude prices collapsed from $107 to $26/barrel between June 2014 and February 2016. Per the ‘70s foreign-oil-dependency template, households would have gotten a huge discretionary income boost, while corporate margins would have surged. Employment and investment would likely have followed, and the consequent increase in consumption would have fed back into even more investment. Improved U.S. terms of trade would have improved living standards, and the trade balance would have narrowed. The U.S. economy no longer has a simple one-way relationship with oil price moves. Those happy growth outcomes did not materialize in the latest oil bust. Consumption growth was robust for the six quarters through 2Q16, but nonresidential fixed investment staggered across 2015 and into 2016 (Chart 7), failing to surpass its 4Q14 level (in real terms) for good until 3Q16. Swooning oil prices had no apparent effect on the trade deficit, which continued to grow at a steady pace (Chart 8). Chart 7Consumption Growth Surged During The Oil Bust, But Capex Growth Crashed Chart 8The Oil Bust Didn't Affect The Trade Deficit, ... Financial conditions tightened as high-yield credit spreads blew out, driven by bankruptcies and defaults in the oil patch (Chart 9, top panel). Oil patch capex evaporated as lenders and equity investors deserted the sector. That would happen in any oil bust, but it spread to the broader economy because shale plays had come to account for a close to a sixth of high-yield bond issuance (Chart 9, bottom panel). The net result was to reduce the supply of loanable funds for non-oil entities, while increasing their cost, bringing about a sharp tightening of financial conditions. Chart 9... But It Tightened Financial Conditions Employment suffered at the margin, as five years of steady oil and gas job gains from 2010-14 were wiped out in 2016 alone. Oil-related employment doesn’t account for a meaningful share of overall employment, but it has been a critical driver of new manufacturing employment since the crisis (Chart 10). The bottom line is that the economy’s failure to respond more positively to 2014-16’s long and steep oil price decline showed that it no longer has a one-way relationship with oil prices. Where sharply lower oil prices would previously have been an unmitigated boon for the economy, they now produce a range of offsetting effects. Chart 10Help Wanted In The Shale Patch Investment Implications Modeling the quantitative impact of a given rise in oil prices on any one factor is beyond the scope of this report, and there is no lack of published studies which have attempted to do so. Research recently cited by Dallas Fed President Kaplan suggests that a 10 percent increase in the real price of oil from a supply-driven oil price shock would lead to a roughly 10- to 30-basis-point decline in real GDP growth.3 In a general sense, we agree with both the direction and the magnitude of those studies’ conclusion. Higher oil prices would be a drag on the U.S. economy, but an increasingly modest one as domestic oil production rises and the country approaches true energy independence. Figure 1 shows that the modest negative net impact on the economy is the aggregation of several individual gross impacts, implying that the key investment takeaways are some layers below the broad macro level. When the arrows conflict within any of the individual channels in the figure, there may be an opportunity for investors to pair exposures. The need to protect vital oil infrastructure could bolster defense stocks, which have long been a favorite of our U.S. Equity Strategy and Geopolitical Strategy services. U.S. airlines, which (with one exception) scorn the idea of hedging their fuel costs, could be an attractive short/underweight candidate to pair with a defense overweight. From a macro perspective, the increased potential for oil price shocks enhances the appeal of TIPS relative to nominal Treasuries. As long as an oil supply shock would act as a headwind for U.S. growth, investors seeking to add some inflation protection to their portfolios should focus on shorter-maturity TIPS. A supply shock pushes inflation higher in the short term, but weighs on it in the long term, as investors revise their long-run inflation expectations lower upon factoring in its long-run growth-dampening effect.   Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com Footnotes 1 Please see the September 16, 2019 and September 19, 2019 Commodity & Energy Strategy and Geopolitical Strategy Special Reports, “Attacks On Critical Infrastructure In KSA Raise Questions About U.S. Response,” and “Policy Risk, Uncertainty Cloud Oil Price Forecast,” available at www.bcaresearch.com. 2 Disposable income is after-tax income. Discretionary income is what’s left of disposable income after the costs of necessities, like food, rent, clothing, gasoline and utilities, are backed out. 3 Kaplan, Robert S., “A Perspective on Oil,” June 19, 2018. Downloaded September 16, 2019 from https://www.dallasfed.org/-/media/Documents/news/speeches/kaplan/2018/rsk180619.pdf.

ハイライト 政治的不確実性の重しがあるにもかかわらず、英国経済は比較的堅調に推移している。 しかし、英国が実際にE.U.を離脱する以前から、ブレグジットは高まった不確実性、企業設備投資の深刻な弱さ、低迷する生産性を通じて英国経済に持続的な影響を残している。 その結果、トレンド成長が低下し、構造的に弱い為替レートと相対的に高い国内インフレを抱える経済となっている。 ブレグジットは10月31日を超えて先送りされるだろう。合意なき離脱（ノー・ディール）は、ボリス・ジョンソンの手を強化する早期選挙が起きない限り、過度に強調されたリスクである。それは起こりそうにない。 英ポンドと英国債（ギルト）に対する投資見通しは二極的である：「円滑な」ブレグジットはポンドにとって強気、ギルトにとって弱気であり、一方で合意なき離脱はポンドとギルト利回りの双方をさらに低下させるだろう。 特集 2016年に英国が欧州連合（E.U.）からの離脱を決めて以来、経済と金融資産の見通しは、離脱が秩序ある形で行われるか否かという二者択一の帰着に結びついている。これは甚大な不確実性の源であり、イングランド銀行（BoE）を中央銀行がこれまで直面した中で最も扱いにくい立場の一つに置いている。 今週のレポートでは、いくつかのハイレベルな疑問に答えようとする。まず、世界的な製造業の景気後退を考慮すると、英経済の減速は平凡なものだったのか。それとも、政治的不確実性の高まりを受けて不当に長引いているのか。後者であるなら、もし「合意なき離脱」が避けられた場合、反発の見込みはどうか。最後に、遅延した投資のためにすでに取り返しのつかないダメージが経済に生じており、E.U.との関係結果にかかわらず長期的な影響を残しているのか、である。 雇用ブーム 英国は現在、第二次世界大戦以来の最良の雇用回復を経験している。過去10年間で420万人の新規雇用が創出され、就業人口比率はほぼ50年ぶりの高水準に達している。注目すべきは、この回復は労働市場の状況が非常に堅調な米国の回復よりもさらに印象的に見える点だ。例えば米国の就業率は60.9％で、わずかに英国を下回るが、危機前のピークから依然としてほぼ4ポイント低い（チャート 1）。ユーロ圏と比べると、英国の労働市場のアウトパフォーマンスは非常に明白である。 この回復にもかかわらず、賃金の上昇はボーア戦争以来で最も鈍い。 雇用の質も優れており、フルタイム雇用の創出はパートタイムを上回り、女性の就業率も急増している。雇用の恩恵は地域や産業に広く行き渡っている。確かに製造業はやや変動が見られるが、イースト・ミッドランド地域を除き、失業率は英国全体で引き続き低下している（チャート 2）。 チャート 1 雇用ブーム 雇用ブーム 雇用ブーム チャート 2 回復は広範囲に及ぶ 回復は幅広く進んでいる 回復は幅広く進んでいる     この回復にもかかわらず、賃金の上昇はボーア戦争以来で最も鈍い。7月の演説で、イングランド銀行（BoE）のチーフエコノミスト、アンディ・ホールデンは、賃金の失われた10年が主要な英国地域全体にわたる均等な災害であったと正しく指摘した。1950年代から大不況（グレート・リセッション）までの間、英国の実質賃金は年率約2%で成長していた。グレート・リセッション以降、実質賃金は年率-0.4%で停滞している（チャート 3）。1 チャート 3 賃金は最近まで停滞 賃金は最近まで停滞していた 賃金は最近まで停滞していた これにはいくつかの理由がある。第一に、個人事業主、ゼロアワー契約、派遣労働の伸びが強いことだ。したがって、危機後の期間にフルタイムの割合は上昇しているものの、危機前の高水準には程遠いままである。これは労働市場の流動性を高め、事業遂行コストを下げている。個人事業主やゼロアワー契約労働者の報酬は正規雇用者よりも大幅に低い。明るい点は、この現象が英国特有ではなく、特に欧州で労働市場の硬直性が構造改革によって解きほぐされている中で世界的に起きていることである。 今後の鍵となる問いは、賃金の新たな上昇が持続するかどうかである。循環的な時間軸では、雇用の好調なトレンドが続くなら、英国はかなり強い賃金圧力を経験し始める可能性があると我々は考えている。これには四つの基本的な理由がある: 求人は求職者数を上回り続けている。指標によるが、求人は応募者より20%〜40%多い（チャート 4）。この行き詰まりは、（就業率が世俗的高水準にあるため）より高い就業率やより低い失業率で容易に解消されるものではない。 BoEは英国のNAIRUを4.4%と推定しており、現在の失業率は構造的水準を下回っている。企業調査は依然として、熟練労働の不足が企業が直面する主要な問題の一つであることを示唆している。 英国のフィリップス曲線はここ数年フラット化してきたが、最近賃金成長は上向きに転じ始めている。他国と同様に、英国のフィリップス曲線は折れ線状で、失業ギャップが縮小するにつれて賃金成長の凸性が増す。 職から職への移動率、いわゆるジョブ・トゥ・ジョブ・フローの循環速度が上昇している。これは歴史的に賃金成長にとってプラスである（チャート 5）。これは2012年以降加速している退職率（クイッツ率）にも反映されている。 チャート 4 賃金圧力は高まるはず 賃金上昇圧力は強まる見込みだ 賃金上昇圧力は強まる見込みだ チャート 5 英国の雇用循環速度は上昇 英国の雇用増加ペースが加速 英国の雇用増加ペースが加速 現時点では、タイトな労働市場から賃金上昇への伝達メカニズムは政治的不確実性によって阻害されており、これは長期的な雇用計画に短期的な影を落とし続けるだろう。例えば、英国が金融センターであるという議論にもかかわらず、銀行・保険業の雇用の減少は根強く続いている（チャート 6）。英国は特に外国為替市場で多くの金融業務を引き付け続けているが、ブレグジット国民投票が行われた2016年には取引量に明確な打撃があった（チャート 7）。一方で製造業は、景況感を再燃させて外国直接投資を呼び戻すまでに時間を要するだろう。 チャート 6 製造業と金融業の雇用における離脱 製造業および金融業の雇用における離職 製造業および金融業の雇用における離職 チャート 7 英国は重要な金融センターである 英国：循環的な減速か、それとも構造的な停滞か？ 英国：循環的な減速か、それとも構造的な停滞か？ とはいえ、英国経済は主としてサービスによって牽引されているため、賃金には依然として上方向の圧力がかかることになる。サービス部門の賃金成長は堅調であり、製造業の不況が深刻化して他の部門に波及しない限り、賃金の下への抵抗力は限られており、上向きの方が自然な道筋である。 結論：政治的不確実性の重しがあるにもかかわらず、英国経済は比較的堅調に推移している。 支出の好循環 英国の所得パイは拡大し得るが、自信の欠如が支出を抑制している。チャート 8は英消費者信頼感が米国およびユーロ圏のトレンドから負の乖離を示していることを示す。ブレグジット不確実性の雲が晴れれば、支出が再加速することを示唆するいくつかの相殺要因が働いている。 タイトな労働市場から賃金上昇への伝達メカニズムは政治的不確実性によって阻害されており、これは短期的な影を落とし続ける。 英国の小売売上の大きなドライバーは観光客の到着であり、安いポンドは引き続き来訪者の流入を呼び込む可能性が高い（チャート 9）。 チャート 8 回復にとって鍵となるのは信頼感##br##である いかなる回復においても、信頼が鍵となる いかなる回復においても、信頼が鍵となる チャート 9 安いポンドは外国人買い物客を促す##br##だろう 安いポンドは外国人の買い物を促す 安いポンドは外国人の買い物を促す 英国は多くの世界的な主要ブランドを擁しており、安い通貨から恩恵を受けるだろう。 家計のデレバレッジ（債務削減）プロセスはかなり進んでおり、借入や住宅ローン申請の回復は英住宅価格の下落を緩和している。これは英国の住宅ローン借入コストが利回りとともに急落している事実によって支えられている（チャート 10）。ただし、借入の増加は英国の家計債務対GDPが他の多くの先進経済より高いという事実によって相殺されるだろう。 チャート 10 低金利は住宅を支援するはず 低金利は住宅市場を後押しするはずだ 低金利は住宅市場を後押しするはずだ チャート 11 コストプッシュ型インフレ コスト・プッシュ・インフレーション コスト・プッシュ・インフレーション インフレ期待は通貨安の影響もあって急上昇している。注目すべきは、ポンドは購買力平価（PPP）ベースのファンダメンタルよりもはるかに大きく下落したことだ。これは輸入インフレを引き起こすだろう（チャート 11）。 結論: 英国経済にとって大きなリスクはスタグフレーションに陥ることだ。BoEの調査は、合意なき離脱の場合の生産に対する損失をGDPの約3%と見積もっているが、これは経済調整の大部分が為替レートを通じて発生する可能性があるため推定値である。合意なき離脱の経済的影響の推定レンジ（表 1）は、おそらく偶然ではないが、20世紀の英国の景気後退のレンジと類似している（チャート 12）。これによりBoEは特に不快な「待機観察」モードに置かれている。例えば、ハードな離脱がポンド下落とインフレ期待の上昇を引き起こした場合、BoEの金融政策委員会がインフレ目標を満たすために利下げを行うのかは明らかでない。 表 1 合意なき離脱の影響に関する幅広い推定##br## 英国：景気の循環的減速か、それとも構造的低迷か？ 英国：景気の循環的減速か、それとも構造的低迷か？ チャート 12 過去の英国の景気後退は合意なき影響の指針を提供する##br## 英国：循環的な減速か、それとも構造的な停滞か？ 英国：循環的な減速か、それとも構造的な停滞か？ ブレグジット不確実性は既に英国の成長に持続的なダメージを与えている 過去3年間にわたる英国経済成長の主な足かせは、企業信頼感の崩壊とそれに伴う設備投資の縮小であった（チャート 13）。 2016年のブレグジット投票以降、企業の設備投資は過去の類似の英国景気循環の時点に比べて実質的に弱くなっており、BoEによれば累積で26%に達する（チャート 14）。2019年に見られた軟化の一部は、世界経済の成長鈍化や米中貿易戦争に関連する不確実性にも起因するが、英国の資本支出は他の先進経済と比べてはるかに弱い（チャート 15）。 2016年のブレグジット投票以降、企業投資は過去の類似時点に比べて累積で26%弱い。 これは、ブレグジットの「不確実性」だけで英国経済に既に与えられた長期的なダメージを評価する際に重要なポイントである。このダメージを評価する最良の方法は設備投資の視点を通じてであり、その成長は生産性変化と潜在成長に強く相関している（チャート 16）。 チャート 13 悲観的な英国企業は投資を止めた 悲観的な英国企業は投資を停止した 悲観的な英国企業は投資を停止した チャート 14 歴史と比べた英国の設備投資の大幅なアンダーパフォーマンス ... 英国：景気循環的な減速か、それとも構造的な低迷か？ 英国：景気循環的な減速か、それとも構造的な低迷か？ チャート 15 ...および##br##世界の同業他社と比べて ...そして世界の同業他社と比較して ...そして世界の同業他社と比較して チャート 16 ブレグジット不確実性による英国経済への持続的打撃 ブレグジットの不確実性が英国経済に与える持続的な打撃 ブレグジットの不確実性が英国経済に与える持続的な打撃     先月BoEが公表した重要な研究論文（BoE金融政策委員会の現職メンバーであるベン・ブロードベントとシルヴァナ・テネイロ共著）は、ブレグジット不確実性、設備投資、英国の生産性の連関を論じている。2 著者らは、ブレグジット国民投票の結果の経済効果は、英国の貿易可能部門の生産性成長が持続的に低下すると予想されるという反応として分類できると結論づけた。その枠組みでは、「生産性の低下が予想される」という“ニュース”（すなわちブレグジット投票結果）が公表された後、次のような連鎖が発生することになる： チャート 17 資源のミスアロケーション 資源の誤配分 資源の誤配分 非貿易財の相対価格が貿易財に対して即時かつ恒久的に下落する、すなわち実質為替レートの低下。 相対価格が高いため資源が貿易財部門にシフトし、産出が増加し輸出が上昇する。 しかしブレグジット投票で予告されたように、貿易財部門の生産性成長が低下し、資源は生産性の高い非貿易財部門へ再びシフトする。 金融市場が英国の生産性が相対的に緩やかに推移すると織り込むため、英国の金利は世界に対して低下する。 企業の設備投資の成長は鈍化するが、全体の雇用成長は 耐性を保つ。 これはまさに2016年のブレグジット投票以降の英国経済の進展の仕方である： BoEのポンドの通商加重インデックスは名目および実質の両面で下落している。 英実質GDPに占める輸出比率は27%から30%に上昇し、実質GDPに占める投資比率は10%から9%に低下した（チャート 17、上段）。 非貿易であるサービスの年次雇用成長は2.1%から2018年末にゼロまで低下したが、その後回復し始めている。貿易財である製造業の雇用成長は、ブレグジット投票の1年以内に0.5%から2.7%へ増加したが、2018年には0%へ再び鈍化し、こちらも上昇し始めている（チャート 17、第3パネル）。 生産性成長は1.9%からゼロへ低下しており、低失業率の時期に安定した労働需要により賃金成長は加速している（チャート 17、下段）。 産業別に見ると、実現した生産性成長の最悪の伸びは金属製品や金融サービスのような貿易可能産業で発生しており、最高の生産性成長は専門サービスや小売のような非貿易産業で見られる（チャート 18）。3 チャート 18 業種別最新の英国生産性成長率 英国：循環的な減速か、それとも構造的な低迷か？ 英国：循環的な減速か、それとも構造的な低迷か？ 総括すると、BoEの研究論文の分析枠組みによれば、ブレグジット国民投票の結果は、ポンドの暴落によって示されたシグナルとして、英国資源の配分が生産性の高い非貿易産業から生産性の低い貿易産業へ誤って移転されることを本質的に生み出したと解釈できる。もしこれが正しければ、我々は次の現象も観察するはずである： チャート 19 ブレグジット不確実性のインフレ的結果 ブレグジットの不確実性によるインフレへの影響 ブレグジットの不確実性によるインフレへの影響 サービスや賃金のようなより国内志向の指標でのはるかに高いインフレ率。 賃金の加速と生産性の停滞のギャップの結果としての単位労働費用のより速い上昇。 構造的に高いインフレ期待。 他の先進国に比べて英国で低い実質金利。 為替レートの長期的な弱さ。 これらはすべて英国で現実化している（チャート 19）： サービスCPIのインフレ率は現在2.2%で、全体のCPIインフレの1.7%を上回っている。 単位労働費用の成長は、ブレグジット国民投票前のマイナスから、2016年末以降は2%〜3%の範囲に加速している。 実質10年ギルト利回り（10年のCPIスワップ率でデフレート）は現在-3.1%であり、これに対して米国の10年実質利回りは0%である。 通商加重の英ポンドはブレグジット国民投票後の安値近辺に留まっている。 ブレグジット不確実性が構造的により弱く、よりインフレ的な英国経済をもたらしたことは明らかであり、合意なき離脱が回避されたとしても迅速に逆転する結果ではない可能性がある。これはBoEの将来の金融政策決定とポンドおよび英ギルトへの投資見通しに重要な意味を持つ。 結論: 英国が実際にE.U.を離脱する前であっても、ブレグジットは高まった不確実性、企業設備投資支出の深刻な弱さ、そして低迷する生産性を通じて英国経済に持続的な痕跡を残している。結果として、トレンド成長が低く、構造的に弱い為替レートと相対的に高い国内インフレを抱える経済となっている。 政治的不確実性が支配的 チャート 20 国民は合意なき離脱に反対 英国：循環的な減速か、それとも構造的な低迷か？ 英国：循環的な減速か、それとも構造的な低迷か？ このレポートで扱ったような循環的・構造的な英国経済の状況を考慮しても、短期の見通しは依然としてブレグジットの結果に完全に依存している。 ブレグジットの現状は、議会停止に対する政府に対する最高裁の訴訟や、首相ボリス・ジョンソンが議会の命令に従って離脱期限の延長を求めることを拒否したことにより、かつてないほど不確実になっている。疑いの余地がないのは、議会が無秩序な合意なき離脱に反対しているという点だ。最良の世論調査は国民も合意なき離脱に反対していることを示している（チャート 20）。 議員たちは9月にボリス・ジョンソンの交渉戦略を明確に拒否した — 彼らは合意なき離脱を禁止し、早期総選挙の実施にも2回にわたり反対票を投じた（チャート 21）。ジョンソンは連立による議会の過半数を失い、それでも議会が再開するまでは新たな選挙に踏み切れず、動きが取れない状況に置かれている。 結果にかかわらず起こりそうなのは、財政支出の大幅な増加である、 英国は17世紀のスチュアート王朝ではない — 議会は憲法上の最高の政治機関であり、その決定は永続的に無視されたり従わなかったりすることはできない。議会が再開すれば、おそらく10月14日頃、離脱期限を延長する手立てを講じることが可能だ。E.U.は離脱を遅らせるか取りやめることが自らの利益になるため、延長を認める可能性が高い。結果として総選挙が行われるだろう。 チャート 21 ボリス・ジョンソンの交渉戦略は失敗した 英国：循環的な減速か、それとも構造的な停滞か？ 英国：循環的な減速か、それとも構造的な停滞か？ チャート 22 ハング・パーラメントが最もあり得る結果 ハング・パーラメントが最も可能性の高い結果だ ハング・パーラメントが最も可能性の高い結果だ 選挙の世論調査は保守党の躍進、自由民主党が労働党を上回る状況、そしてブレグジット党が優勢を保つことを示している（チャート 22）。これらの世論を議席に翻訳するのは簡単ではない。小選挙区制（先頭打者勝利方式）では、小規模政党がもっとも人気のある党から重要な票を奪うことで、2位や3位だった党が議席を取る可能性があるからだ。 重要なのは、ブレグジット党は単一課題政党であり、ジョンソンの下の保守党は現在同じ課題を独占しているということだ。この状況が続けば、自由民主党は労働党の票を分裂させる脅威を保守党の票を分裂させるブレグジット党より大きく与える可能性がある。その結果、保守党が過半数を獲得することは依然として可能性として残るが、325議席以上が必要であり、問題児議員の追放やスコットランドでのリーダーシップ喪失により議席は288に減少しているため、可能性は低い。ハング・パーラメントがよりあり得る結果である。 ハング・パーラメントは優柔不断と不確実性を長引かせるだろう — しかしまた合意なき離脱に対しては結束して反対する可能性も高い。野党連合政権であれば合意なき離脱を阻止するだろう。単一党の保守党過半数であっても必ずしも悲惨な結果ではない。なぜならそれはジョンソンのE.U.に対する交渉力を高め、E.U.が離脱協定を通すための譲歩をする可能性を高め、結果として合意に基づく秩序ある離脱をもたらす可能性があるからだ（具体的には、バックストップの北アイルランドに関する制限、あるいは同様のサンセット条項や離脱メカニズム）。そのような合意はジョンソンにとって利益が大きく、彼が政権に復帰した瞬間から不況を引き起こすことを避けたいだろう。これらの結果はいずれも、離脱合意か、あるいは議会が新たな国民投票を模索する新章へと向かうことを示唆している。 チャート 23 財政支出の増加を予想せよ 財政支出の増加が見込まれる 財政支出の増加が見込まれる 市場にとって最悪の結果は、アイルランド問題で合意できず離脱協定を通せない弱い保守党の連立過半数であり、これはテリーザ・メイ時代と同様に麻痺につながる可能性がある。その場合、首相はあらゆる手段で離脱を実行しようとするため、再び合意なき離脱が現実的なリスクとなる。我々は主観的に合意なき離脱のリスクを約30%と見積もっているが、これは9月に議会がその結果に対して強い反対多数を示したことにより現在は低下しており、変化をもたらすのは総選挙だけである。 ブレグジットの結末が分からないまま英国の将来の政治情勢を予測することは無益である。結果にかかわらず起こりそうなのは財政支出の大幅な増加であり、これはグレート・リセッション後の「緊縮財政」からの反転を意味する。この傾向は既にジョンソンが今秋の保守党党大会で寛大な社会支出パッケージを提示しようとしていることから明らかである — もしそれが新たな選挙で支持されれば、保守党の財政政策の転換を意味する（チャート 23）。 より多くの財政支出は、無秩序な離脱の悪影響に対抗するため、あるいはE.U.離脱が英国の問題の万能薬ではないことが明らかになった場合に中産階級を宥めるため、あるいは政権交代時に野党が掲げる議題を実行するために必要となるだろう。 合意なき離脱が発生した場合、英国は混乱した経済的余波に直面するだけでなく、北アイルランドへの悪影響やスコットランド独立運動の再燃の可能性により三王国間の憲法的争いが再燃するだろうし、スコットランド独立の動きも再び活発化する可能性がある。 結論: 英国は独裁国ではなく、首相は議会の意思に従うことを拒むことはできない。議会は合意なき離脱を遅延させることを明確に投票しており、今後もそうするだろう。無秩序な離脱は、最終的に選挙で保守党が政権に返り咲く可能性があるため依然リスクとして残る。しかしその場合、E.U.は議会が離脱法案を可決できるよう譲歩を提供する可能性が高い。合意なき離脱の確率は30%を超えない。構造的な結論としては、結果にかかわらず財政支出は増加するだろう。 投資に関する結論 1992年のポンド暴落をめぐるエピソードは今日にとって重要な教訓を含んでいる。4  重要なのは、ポンドの調整の多くは急速に起きたが、今日と異なる点は欧州為替相場メカニズム（ERM）からの離脱は予期せぬ出来事だったのに対し、ブレグジットは予見されていたことである。外国為替市場は非常に流動的であり、期待に素早く反応する。ピークから谷まで、ケーブルは既に約30%下落しており、下落の大部分は既に起きていることを示唆している。 チャート 24 ギルトに対するブレグジットの二極的帰結 ギルツにとってのブレグジットの二者択一的結果 ギルツにとってのブレグジットの二者択一的結果 英通貨は変動相場制であり、固定相場制の時期に比べて「隠れた罪」は少ない。それでもポンドの公正価値は構造的に弱まっている。我々のバイアスは、ハードなブレグジットであればポンドは容易に1.10〜1.15ゾーンまで下落し得るというものだ。この動きの一部はアンダーシュート（行き過ぎ）となるだろう。ソフトなブレグジット（または離脱が起きない場合）には、ポンドは実質実効為替レートの歴史的範囲の中点に収束し、15%〜20%高となるか、概ね1.50付近に落ち着くだろう。リスク・リワードの観点から見ると魅力的に映る。 英ギルトの利回りの方向性もブレグジットの帰結に依存しており、英OISカーブ（オーバーナイト・インデックス・スワップ）には政策金利の変化が織り込まれていない（チャート 24）。 「円滑な」ブレグジットはBoEが高まった英国のインフレ期待と戦うことに再び焦点を戻すことを可能にするだろう。それは将来のBoE利上げを市場が織り込むことで、ギルト利回りの上昇とイールドカーブのフラット化、そして長期のインフレ期待の低下をもたらす可能性が高い。ポンド上昇もインフレ期待を抑えるだろう。このシナリオではギルトや英国のインフレ連動債は良いパフォーマンスを示さないだろう。 一方、合意なき離脱は、企業と消費者の信頼感への打撃を相殺するためにBoEが利下げを行うことを促すだろう。これはポンド安にもかかわらずインフレ期待が高止まりするかさらに上昇する場合でも起こり得る。そうなればギルト利回りは低下し、ギルトカーブはスティープ化するだろう。この結果に備える最善のポジションは、ギルトのオーバーウェイトとインフレ連動債のロングである。 前述した財政緩和のシナリオもギルトカーブの形状に影響し、ギルトカーブはより大きな財政赤字と将来の高インフレを織り込むことでややベア寄りのスティープ化を示すだろう、他条件が同じならば。 Robert Robis, CFA チーフ・フィクスト・インカム・ストラテジスト rrobis@bcaresearch.com Chester Ntonifor, 外国為替ストラテジスト chestern@bcaresearch.com Matt Gertken, 地政学ストラテジスト mattg@bcaresearch.com Ray Park, CFA, リサーチ・アナリスト ray@bcaresearch.com 脚注 1 Andrew G Haldane, “Climbing the Jobs Ladder,” イングランド銀行（Bank of England）, 2019年7月23日 2 Bank of England External MPC Unit Discussion Paper No. 51, “The Brexit vote, productivity growth and macroeconomic adjustments in the United Kingdom”, 2019年8月 3 ロンドンが主要な世界的金融センターとしての役割を果たしているため、英国の金融サービス産業はその産出のかなりの割合が非英国ユーザー向けに「トレード」されるという点で「貿易可能」部門である。 4 Mathias Zurlinden, “The Vulnerability of Pegged Exchange Rates: The British Pound in the ERM,” Economic Research, Vol. 75, No. 5 (September/October 1993). トレード＆予測 予測サマリー コア・ポートフォリオ タクティカル・トレード リミット注文 クローズ済みトレード

Highlights The fundamental backdrop continues to be mixed, but last week’s key data releases were encouraging on balance: While the U.S. manufacturing ISM survey entered contraction territory, and European manufacturing PMIs remained moribund, the services surveys were quite strong, and services contribute much more to developed economies’ total output. The U.S. economy should be able to grow at trend for the next six to twelve months: Consumption is underpinned by a robust labor market, federal government spending will not flag ahead of the 2020 elections, and state and local revenues are well supported. Investment is unlikely to sabotage the other two pillars of the U.S. economy. The view that inflation is deader than New York Mayor de Blasio’s presidential ambitions is widespread and entrenched: Participating on a panel at an inflation-themed conference last week, we were struck by the conviction that inflation is going nowhere over the next few years. The risk-reward of taking the other side of that debate may be quite attractive. Feature Another week, another mixed set of data releases. Last Tuesday, the bears’ most cherished fantasies seemed to be within reach as the ISM Manufacturing Index slid below the boom-bust line in a print that fell well short of consensus expectations. The S&P 500, which had probed around August’s 2,945 resistance level in the final pre-Labor Day session, quickly shed more than a percentage point in response. The U.S. data confirmed the message from the previous day’s European manufacturing PMIs: global manufacturing remains in a deep funk, and a turnaround is not yet at hand. It’s hard to get a recession without tight monetary policy, and it’s hard to get a bear market without a recession, ... Wednesday’s European services PMI releases gave the bulls a lift. Though manufacturing activity truly stinks (Chart 1), it shows no signs of contaminating the services sector, which is still expanding at a solid clip (Chart 2). The U.S. ISM Non-Manufacturing Index surged in August, beating consensus expectations by the same two-point margin by which manufacturing fell short. U.S. equities were already trading higher on the back of an imminent resumption of U.S.-China negotiations when the series was released Thursday morning, and the combination helped the S&P 500 decisively break through the level that had held it in check for a month (Chart 3). Chart 1Global Manufacturing ##br##Is Ailing ... Chart 2... But The Service Sector Is Expected To Expand Chart 3Breakout Taking a step back from the consistently mixed data, recessions don’t occur when monetary conditions are easy. Equity bear markets rarely occur outside of recessions, so our default position is to remain at least equal weight equities in a balanced portfolio. We estimate that the equilibrium fed funds rate is somewhere in the neighborhood of 3 to 3.25%, so the monetary backdrop remains comfortably accommodative with fed funds at 2.25% and seemingly heading to 2% or lower in the coming months. Our estimate of equilibrium is no more than an estimate, however, so we are reprising our analysis of where consumption, investment and government spending are headed over the next six to twelve months. We remain constructive on the basis of that analysis. The GDP Equation GDP is the sum of consumption, investment, government spending and net exports. Rendered as an equation, GDP = C + I + G + (X-M). Net exports are not terribly meaningful for the comparatively closed U.S. economy, and we take a small fixed trade deficit as a given, so we reduce the equation to GDP = C + I + G. Ex-trade, consumption accounts for two-thirds of output, and fixed investment and government spending for one-sixth each. At four times each of the other components’ weight, consumption is the dominant driver of U.S. activity. Investment is considerably more variable, however, making it more likely to wipe out trend growth from the other drivers (Chart 4). As we showed the first time we performed the (C+I+G) analysis, investment would only have to fall to 0.83 standard deviations below its long-run mean to zero out 2% growth in consumption and government spending.1 Chart 4Investment Is The Wild Card In a normal distribution, events 0.83 or more standard deviations below the mean are expected to occur randomly about 20% of the time. It would take a -1.31-sigma consumption event (probability ≈ 10%) to zero out 2% growth in the rest of the economy. An expansion-killing decline in government spending would be a -1.86-sigma event (probability ≈ 3%). Investment is most likely to be the swing factor tilting the economy in the direction of a recession. Consumption Both retail sales and personal consumption expenditures have accelerated since early April (Chart 5). A robust labor market should continue to support consumption spending, as our payroll model projects a pickup in hiring (Chart 6, top panel), thanks to more ambitious NFIB hiring plans (Chart 6, second panel) and falling initial unemployment claims (Chart 6, bottom panel). Job openings are at their highest level in the 19-year history of the series, indicating that demand for new employees is high, and an elevated quits rate indicates that employers are paying up to poach workers from each other to satisfy that demand. We reiterate that more Americans will be working at the end of 2019 than at the end of 2018, and that all of them will be getting paid more, on average. A robust labor market will give household incomes a boost, and solid balance sheets will give them leave to spend it. Households don’t have to spend income gains, however. If they choose instead to save them, or divert them to paying down debt, consumption won’t get much of a near-term boost. The state of household balance sheets is also a driver of consumption’s direction, and they’ve improved at the margin since our last review. The savings rate moved sharply higher in the interim (Chart 7, top panel) and household debt as a share of GDP ticked lower (Chart 7, second panel), while the burden of servicing existing debt remains light (Chart 7, bottom panel). Chart 5Consumption Is Healthy Chart 6Hiring Is Poised To ##br##Tick Higher, ... Chart 7... And Households Are In A Position To Spend Bottom Line: Consumption remains well supported and will likely continue to be over a six- to twelve-month horizon. Investment Despite hopes that the reduction in corporate income tax rates and immediate expensing of qualified investments would promote capital expenditures, growth in nonresidential fixed investment has been uninspiring. Looking ahead, surveys of corporate investment intentions are decent coincident indicators of capex, and their monthly releases provide some leading insights into quarterly GDP investment. Capital spending plans in the NFIB small business survey have bounced since early April (Chart 8, top panel), but capex plans in the regional Fed surveys have weakened (Chart 8, bottom panel). Although both surveys have turned down, they remain at fairly elevated levels, suggesting that an investment plunge capable of negating trend growth in consumption and government spending is unlikely. Chart 8Neither Here Nor There Residential investment is less than a quarter of nonresidential investment and therefore typically only has a marginal impact on investment. It remains in a slump, with momentum in starts and permits sputtering (Chart 9, top panel); existing home sales running in place (Chart 9, middle panel); and inventories of homes for sale up since April, albeit still at low levels relative to history (Chart 9, bottom panel). Despite a sharp decline in mortgage rates since the end of last year, housing activity has failed to revive. Conversations with various market participants lead us to believe that zoning restrictions, sparse quantities of affordable land, difficulty in assembling construction crews, and a general idling of smaller developers in the wake of the crisis have all contributed to insufficient supplies of the entry-level and first-move-up homes for which there is ample demand. Chart 9Housing Is Weaker Than It Should Be, But It Doesn't Mean The Economy Is In Trouble Bottom Line: Neither nonresidential nor residential investment appears vulnerable enough to spark a decline in investment that could cause the economy to stall out. Government Spending All systems are go from a fiscal perspective. The federal spending taps will surely be open in a hotly contested presidential election year. State income and sales tax revenues have improved since our last review in April (Chart 10, top two panels), and should be well supported by a strong labor market. Solid home price appreciation will nudge the appraisals underpinning property taxes higher (Chart 10, third panel), supporting municipal tax receipts. Government spending will continue to hold up its end. Chart 10State And Local Revenues Will Hold Up Is Inflation Dead? Chart 11Another Upleg Is Coming We participated in a panel discussion last week at an inflation-linked products conference. The panel included Fed researchers and a veteran inflation-products trader turned investment manager. After a wide-ranging discussion that touched on U.S. economic prospects, the message from the yield curve, the impact of trade tensions and the continuing relevance of the Phillips Curve, each panelist was asked if inflation has already peaked for the cycle. The response was a resounding unanimous yes until we got our turn. The other panelists were not laypeople, traders, bottom-up analysts, or anyone else with only a passing interest in macroeconomics. They were experts, and we were struck by the conviction with which they dismissed the possibility that inflation could yet break out in the current cycle. Judging by the shrinking scale of the annual conference (this year’s edition was half the size of the previous two years’), the idea that inflation is dead for the foreseeable future has found a wide following. We do not think that inflation, and bond yields, will go anywhere in the immediate future, but it is far from assured that they will remain moribund for the rest of the expansion (Chart 11). Taking the other side looks attractive to us, given the preponderance of inflation-is-dead opinions. It is not terribly surprising that wide output gaps opened following an especially job-destructive downturn. With economic capacity considerably ahead of aggregate demand across the major economies, inflation had little chance of taking hold at an economy-wide level. The picture is changing, however, with the IMF estimating that the U.S. output gap closed in 2017 and in the advanced economies as a whole sometime last year (Chart 12). Goods inflation is primarily a global phenomenon, and with the IMF estimating that output gaps persist in Australia, Canada, Japan and the U.K., international slack can still mitigate domestic price pressures, though new tariff barriers would bind inflation more closely to domestic conditions. Services inflation, which is much more domestically driven, could begin to perk up now that unemployment is below NAIRU in the Eurozone as well as the U.S. (Chart 13). Finally, while central banks are hardly omnipotent, Milton Friedman’s always-and-everywhere admonition leaves little doubt that the monetary authorities can boost inflation expectations if they really want to. Chart 12Demand Has Caught Up To Capacity Chart 13Mind The Gap Investment Implications The investing backdrop is hardly ideal. Spreads are tight, stocks aren’t cheap, the two largest standalone economies are trying to inflect pain on each other, the U.K. can’t agree on how to get divorced from the EU, and the fate of the longest U.S. expansion on record is in doubt. The risks are well known, however, and save-haven assets have gotten pretty crowded. While the danger that shaky confidence could become self-fulfilling is real, our base case is that the expansion will trundle along, allowing stocks to rise as the worst-case scenarios fail to come to pass. It is at least possible that rumors of inflation’s demise have been greatly exaggerated. We continue to recommend that investors remain at least equal weight equities in balanced portfolios and at least equal weight spread product within bond allocations. We enthusiastically endorse our bond colleagues’ overweight TIPS recommendation. When nearly everyone agrees that a particular outcome cannot happen, it is often worth carving out some space in a portfolio in the event it actually does.   Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com   Footnotes 1 Please see Table 1 of the April 8, 2019 U.S. Investment Strategy Weekly Report, “If We Were Wrong,” available at usis.bcaresearch.com

特別レポート

Highlights It will be impossible for China to undertake even mild deleveraging and simultaneously accelerate household income growth. All deposits in the banking system have been created by banks “out of thin air” and have not been engendered by household savings. Contrary to widespread beliefs, mainland households are highly leveraged. Cyclically, high equity valuations, crowded investor positioning and the delayed cyclical recovery in the Chinese economy pose downside risks to consumer stocks. Structurally, real income growth per capita is contingent on productivity growth. The latter will slow in China but remain relatively elevated. Overall, investors should consider buying Chinese consumer plays on weakness. Feature Deliberations about China’s successful rebalancing often boils down to whether one believes that consumers will be able to offset the slowdown in investment and exports and keep overall real GDP growth close to current levels. The narrative typically presumes that Chinese households are not spending enough and can boost their spending counteracting the ongoing slowdowns in capital spending as well as in exports. This conjecture is fallible. Chart I-1The Myth Of Deficient Consumer Demand In China Consumer spending in China has in fact been booming over the past 20 years – it has been growing at a compounded annual growth rate (CAGR) of 10% in real terms since 1998 (Chart I-1, top panel). Hence, the imbalance in China has not been sluggish consumer spending. Rather, capital expenditure has been too strong for too long (Chart I-1, bottom panel). Healthy rebalancing entails a slowdown in investment spending – not an acceleration in household demand. Hence, the market relevant question is: Can the growth rate of household expenditure accelerate above 10% CAGR in real terms as capital spending and exports decelerate? Our hunch is that this is unlikely. As the authorities attempt to contain credit and investment excesses and trade war-induced relocation of manufacturers out of China gathers steam, the pertinent question is whether the slowdown in household expenditures in real terms will be mild (from the current 10% pace to 7.5-9% CAGR), medium (6-7.5%) or material (below 6%). In our opinion, the medium scenario has the highest odds of playing out. There are many positives about the vitality of Chinese consumers and we do not mean to downplay them. Nevertheless, many of these positives are well known, and the objective of our report is to reveal misconceptions about this segment.  Deleveraging And Consumers If and when deleveraging does transpire in China, the household income growth rate will decelerate, resulting in weaker spending growth. It will be impossible for the mainland economy to undertake even mild deleveraging and simultaneously accelerate household income growth. Chart I-2Capital Spending Is Much More Important Than Exports Our focus for this report is on a slowdown in credit and capital spending rather than exports. The basis is that the latter in general, and shipments to the U.S. in particular, have a much smaller impact than investment expenditures (Chart I-2). In turn, capital spending is mostly financed by credit. It is crucial to understand the significance of credit in driving national and household income growth in China since 2008. Currently, 2.5 yuan of new credit is needed to generate one yuan of GDP growth. This certifies that the mainland economy has become addicted to credit. As we have argued in depth in past reports, commercial banks do not intermediate savings into credit, but rather create new money/credit “out of thin air” when they lend to or buy securities from non-banks. This entails that output and income growth would have been much weaker had banks not provided credit equal to RMB 19 trillion over the past 12 months. For instance, a company affiliated with the provincial government has borrowed money from banks to build three bridges over the past 10 years, accumulating a lot of debt in the process. Ostensibly, operating these bridges does not generate enough cash flow to service its debt – a common occurrence in China. With the three bridges completed, the company would then apply for a new loan to build a fourth bridge. Should banks lend additional money to construct it? Notwithstanding this hypothetical company’s low creditworthiness, if banks provide additional financing, the credit bubble will become larger, and the issue of overcapacity will intensify. On the other hand, household income and spending growth will remain robust. If banks do not finance the construction of the fourth bridge, labor income growth in the province – employees of this company and its suppliers – will slump. Thus, if for whatever reason banks are unable or unwilling to extend as much in new credit as last year, output and income growth in this province will decelerate, all else equal. Given credit has been playing an enormous role in driving China’s economic growth over the past 10 years, it will be almost impossible to slow down credit without a downshift in household income growth. This example and analysis is not meant to suggest that bank credit origination is the sole growth driver in China. Theoretically, GDP can expand even with bank credit/money contracting. According to the quantity theory of money: Nominal GDP = Money Supply x Velocity of Money This means nominal GDP can grow even when the supply of money/credit is shrinking. For this to happen, the velocity of money should rise faster than the pace of decline in the supply of money/credit. From a practical perspective, this requires enterprises and consumers to increase the turnover (velocity) of their bank deposits and cash on hand (money supply). We have deliberated in past reports that the velocity of money and the savings rate are inversely related: A rising velocity of money entails a declining savings rate, and vice versa. Going back to our example of bridge construction, the relevant question is: Will companies and households in that province increase their spending (i.e., reduce their savings rate) if banks do not finance the construction of the fourth bridge? The realistic answer is not likely. If the fourth bridge does not receive financing, weaker income growth in that province – due to employment redundancies among construction companies and their suppliers – would lead to slower spending growth. Faced with slowing demand growth, other enterprises and households would likely turn cautious and increase their savings rates – i.e., reduce the velocity of money supply. In short, reduced credit origination will mostly likely generate slower household income growth and, consequently, spending. Chart I-3China: No Deleveraging So Far Broadly speaking, household income growth has not yet downshifted because deleveraging in China has not started. Chart I-3 illustrates that aggregate domestic credit – including public sector, enterprises and households – continues to grow above 10% and well above nominal GDP growth. In fact, credit growth has exceeded nominal GDP growth since 2008. This is local currency credit and does not include foreign currency debt, but the latter is small at 14.5% of GDP (or about US$ 2 trillion). To us, deleveraging implies credit growth that is no greater than nominal GDP growth – i.e., a flat or declining credit-to-GDP ratio for at least several years. If China is serious about deleveraging and curbing its money/credit bubble, the pace of credit expansion should decline to or below nominal GDP growth – which is presently 8%. If and when this occurs it will dampen household income and spending growth. Bottom Line: Chinese household income and spending will inevitably slow if money/credit growth slumps, given the Chinese economy’s excessive reliance on new credit origination over the past 10 years. Do Households Have A Savings Or Debt Glut? What about households’ enormous savings in China? Why wouldn’t households reduce their savings and boost spending? When referring to household savings, most allude to bank deposits. But in conventional economic theory – and according to the way household savings are statistically calculated at a national level – savings actually have no relation to bank deposits. Chart I-4No Empirical Evidence That Deposits = Savings Chart I-4 illustrates that in China, the annual change in household deposits is not equal to household savings (Chart I-4, top panel). Similarly, the annual rise in all deposits (based on central bank data) is vastly different from annual national savings (as defined by conventional macroeconomics and calculated by the National Bureau of Statistics) (Chart I-4, bottom panel). Bank deposits are a monetary concept that we will refer to as “money savings.” Deposits are created by banks “out of thin air,” as illustrated in our past reports.Meanwhile, the term “savings” in conventional macroeconomics denotes goods and services that are produced but not consumed, which is a real economic (not monetary) variable. Not surprisingly, there is no relationship between these “real savings” and “money savings,” as illustrated in Chart I-4. To illustrate that household “savings” (as defined by conventional macroeconomics) are not related to money supply/deposits, let us go back to the example of the company building bridges in China. When the company wire transfers a salary of RMB 1,000 to an employee, the amount of money supply in the banking system does not change. Suppose this employee decides to save 100% of her income this month. Will the supply of money increase or decrease? The answer is that it will not change: the deposit will remain at her bank account. Alternatively, if she decides to spend all RMB 1,000 (100% of her income), the supply of money also will not change – deposits will be transferred to other banks where her suppliers have their accounts.  If she cashes out her deposit and puts it under her mattress, the amount of bank deposits will decline, but cash in circulation will rise by the same amount. Provided money supply is equal to the sum of all bank deposits and cash in circulation, the amount of money supply will not change. The only way the supply of money will decline is if she pays down her loan to a bank. Conversely, the supply of money only rises when banks originate loans or buy assets from non-banks. In short, saving/not spending does not alter the amount of money supply. Rather, broad money supply is equal to the cumulative net money creation “out of thin air” primarily by commercial banks and less so by the central bank over the course of their history. This has nothing to do with household and national “savings.” The latter stand for goods and services produced but not consumed. We have discussed what “savings” mean in conventional economics in past reports. Chart I-5Chinese Households Are More Leveraged Than U.S. Ones Critically, Chinese households presently carry more debt as a share of their disposable income than American households (Chart I-5). This chart compares household debt to disposable income using official data from both China and the U.S. In the case of China, we add Peer-to-Peer (P2P) credit to consumer credit data published by the People’s Bank of China to calculate household debt. The argument by many commentators that consumers in China are not highly leveraged is grounded on the comparison of their debt to GDP. However, in all countries, household debt is assessed versus disposable income – not GDP. The income available to households to service their debt is their disposable income – not GDP. It is correct that Chinese households’ assets have surged in the past two decades as they have purchased significant amounts of real estate, and property prices have skyrocketed. A survey by China Economic Trend Institute holds that property accounts for 66% of household assets in China. To assess creditworthiness, investors should not rely on debtors’ asset values. If debtors are en masse forced to sell their assets to service debt, equity prices would tumble well beforehand. Rather, creditworthiness should be assessed based on recurring cash flow (income) available to debtors to service their debt. One should not be surprised as to why real estate prices are very high in China. Money and credit have been surging – have grown four-fold – over the past 10 years (Chart I-6) and are still expanding at close to a 10% pace. In particular, household debt is still growing at a whopping 15.5% annually (Chart I-7). If and as money/credit growth downshifts, property prices will deflate. Chart I-6Helicopter Money In China Chart I-7Household Credit Is Expanding Twice As Fast As Income Growth Importantly, housing affordability is low and households’ ability to service their mortgages is troubling. Chart I-8 exhibits the nationwide house price-to-income ratio for China and the U.S. In the Middle Kingdom, it is currently about 7.2, while in the U.S. the ratio has never been above 4. It only approached 4  at the peak of the housing bubble in 2006. Chart I-8House Prices Are Very Expensive In China   In turn, Table I-1 illustrates mortgage interest-only payments as a share of household disposable income. The national average is 25.5%. These are very high ratios, suggesting an average new home buyer will have to allocate about a quarter of her or his household income just to pay the interest on a mortgage. These averages do not divulge enormous variations among households. High-income and rich households probably do not have much debt, and debt sustainability is not an issue for them. This also implies that there are many low-income households for whom the interest payments on mortgages absorb more than 25% of their disposable income.  Bottom Line: All deposits in the banking system have been created by banks “out of thin air” and have not been engendered by household savings. Contrary to widespread beliefs, mainland households have a lot of debt, and the latter is still expanding faster than nominal disposable income growth (Chart I-7 above). Positives And The Cyclical Outlook This section lists some positives for household incomes and spending, while also highlighting inherent risks: In the long run, per-capita real income growth in any country is equal to productivity growth. Productivity in China is still booming, justifying high real income growth. The question is whether such buoyant productivity growth can be sustained at a high level to justify robust real-income per-capita growth. Typically, easy money breeds complacency, misallocation of capital and ultimately lower productivity growth. Can China sustain productivity growth of 6% to assure a similar growth rate in real income per capita if the nation continues to experience easy money and a misallocation of capital? Forecasting productivity is not easy; only time will tell. Chart I-9Nominal Household Income, Wages And Salaries Per capita aggregate income as well as both wages and salaries are still expanding briskly – by about 8.5% in nominal terms from a year ago (Chart I-9). This is a formidable growth rate and entails vigorous spending power. The cyclical and long-term concern is whether the current rate of income growth is sustainable. So far there has been few redundancies, despite the fact that corporate revenue and profits have slumped. There is anecdotal evidence that the authorities are actively discouraging dismissals among both state-owned and private enterprises. If layoffs are avoided in this cycle, it will imply that the full pain of the slowdown is absorbed by shareholders. As a result, wages and salaries will rise as a share of GDP, causing a profit margin squeeze for companies. Will private shareholders be willing to invest in the future? Over the past year,  authorities have targeted the stimulus at consumers by cutting personal income taxes. However, this has not boosted consumption: First, the individual taxpayers’ base was very small; only one quarter of total employment (or 16% of the population) was paying personal income taxes before the most recent cut. Second, personal income tax savings have amounted to less than 2% of disposable income.   Finally, the savings from tax cuts are unevenly distributed across households. High-income families will probably get higher tax savings than lower-income ones, whereas the propensity to spend is higher for the latter than the former. Household deposit expansion has accelerated at the expense of enterprises (Chart I-10). This confirms that companies have not slowed the payments to employees (wage bill). Consequently, households have firepower which can be unleashed at any time.  However, there are presently no signs of a growing appetite to spend. Quite the contrary, our proxy for household marginal propensity to spend is falling (Chart I-11). Chart I-10Households Are Hoarding Money, Not Spending Chart I-11Household Marginal Propensity To Spend Is Still Falling Non-discretionary consumer spending has remained very robust. In contrast, discretionary spending has been extremely weak and shows no signs of recovery (Chart I-12). Finally, the impulses of non-government credit, broad money and household credit are weak (Chart I-13). Without these improving substantially and households’ marginal propensity to spend rising, it is difficult to expect a meaningful recovery in consumption. Chart I-12Discretionary Spending Is Sluggish Chart I-13Credit/Money Impulses Are Much Weaker Than In Previous Stimulus Bottom Line: A cyclical recovery in consumer spending hinges on another round of major credit and fiscal stimulus as well as improvement in households’ willingness to spend. Structurally, real income growth is contingent on China’s ability to sustain high productivity growth. Investment Implications If and as capital spending and exports growth slow further, the pace of expansion in consumer expenditure will also moderate. In such a scenario, overall economic growth in China will inevitably downshift. Structurally, Chinese consumer spending will slow from the torrid pace of 10% CAGR of the past 10 years to around 6-7.5% CAGR in real terms. This is a formidable growth rate, and warrants a bullish stance on the consumer sector. We identified Chinese consumers as a major investment theme for the current decade in our 2010 report titled How To Play EM This Decade? 1 In that report, we recommended selling commodities and sectors exposed to Chinese construction and instead favoring consumer plays, especially in the health care and tech sectors. This structural theme has played out well and has further to go. Chinese household spending on health care, education and other high-value services will rise as income per capita expands, albeit at a slower rate than before. Chart I-14 demonstrates that Chinese imports of medical and pharmaceutical products are surging, even though overall imports are currently contracting. Domestically, profit margins are expanding within the medical and pharmaceuticals industries but stagnating for the overall industrial sector (Chart I-15). Chart I-14Surging Demand For Medical Products/Goods Chart I-15Continue Favoring Companies In Health Care/Medical Space All that said, a bullish growth story does not always translate into strong equity returns. Charts I-16A and I-16B reveal that share prices of Chinese investible consumer sub-sectors have had mixed performance. With the exception of Alibaba and Tencent, a few of consumer equity sub-sectors have generated strong equity returns. Chart I-16AChinese Consumer Stocks: Mixed Performance Chart I-16BChinese Consumer Stocks: Mixed Performance Such poor equity performance given strong headline consumption growth has often been due to bottom-up problems such as profit margins squeeze, overexpansion, over-indebtedness, equity dilution, quality of management and other issues. Apart from company specific risks, investors should also consider valuations. Buying good companies in great industries at very high equity multiples will probably produce meager returns. Table I-2 shows the trailing P/E ratio for various consumer sub-sectors. The majority of them trade at a trailing P/E ratio of above 20 and in some cases above 30. Besides, China’s consumer story has been well known for some time, and many portfolios are overweight China consumer plays. Consequently, investor positioning adds to near-term risks. Cyclically, high equity valuations, crowded investor positioning and the delayed cyclical recovery in the Chinese economy pose downside risks to consumer stocks as well. However, such a selloff will create conditions for selectively investing in reasonably valued high quality companies.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Lin Xiang, Research Analyst linx@bcaresearch.com   Footnotes 1      Please see Emerging Markets Strategy Special Report, “How To Play Emerging Market Growth In The Coming Decade”, dated June 10, 2010, available at ems.bcaresearch.com Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights Markets expressed disappointment over last week’s FOMC meeting, … : Equities sold off, Treasury yields slid, and the curve flattened. … but we didn’t think there was all that much to get excited about, … : Data dependence remains the Fed’s mantra, and it was never likely that the FOMC would signal that policy through September has been pre-programmed. … though the specter of escalating trade tensions was a bummer: We have followed our repeated exogenous-shock caveat with an acknowledgement of the gravity of trade barriers. Our geopolitical strategists don’t expect a resolution any time soon, though, and White House tweets are here to stay. Marginally easier monetary policy is not likely to have all that much of an effect on the economy: A reduction in the fed funds rate from 2.5% to 2% isn’t likely to turbo-charge housing or corporate investment, but we do expect that the major central banks’ easing bias will support risk assets. Feature The FOMC delivered the result we expected at the conclusion of its meeting last week: a 25-basis-point cut and a dovish adjustment to its balance sheet runoff plans. Markets acted as if they’d been blindsided. Apparently it really isn’t what you say, it’s how you say it. Or maybe, as our colleague Martin Barnes has long contended, press conferences and all the other assorted communications strategies do more harm than good. We have nearly reached the point of Fed fatigue ourselves, but there’s no ignoring the elephant in the room. The Fed is squarely in the center of every investor’s mind and may well remain there for the rest of what was shaping up as a slow-news month before the latest tariff move. American and Chinese negotiators have called it quits until September; lawmakers have left the building in London and Brussels; the ECB’s Governing Council will be idle until mid-September; and the winnowing of the Democratic field is so far off that even Bill de Blasio remains a presidential candidate. We devote this week’s report to an examination of increased accommodation’s implications for financial markets and the U.S. economy. What did the FOMC do on Wednesday? Chart 1An Adjustment, Not A New Direction The FOMC cut the fed funds rate by 25 basis points, to a range of 2-2.25%, and terminated its modest balance sheet reduction effort two months ahead of time. It studiously kept its options open with regard to future policy rate adjustments, with Chair Powell describing the cut as a “mid-cycle adjustment,” rather than a transition to full-on policy easing. The mid-cycle reference kiboshed hopes that the cut was meant to bring the curtain down on the tightening cycle that began at the end of 2015 (Chart 1). The hawkish surprise concerning the future direction of the fed funds rate overwhelmed the modestly dovish news that the Fed is immediately ending small-scale quantitative tightening. How did markets take the developments? Not so well, especially over the two hours of Wednesday afternoon trading following the decision. The S&P 500 sold off by close to 2% during the press conference, the dollar surged against the euro, and the yield curve flattened as long-dated Treasuries surged while the 2-year note sold off sharply. Equities recovered their losses in Thursday morning’s trading, though bonds and the dollar held much of their gains, before the latest salvo in the U.S.-China dispute sent investors in all markets scurrying for cover. Overall, financial markets were disappointed that they didn’t get a clearer signal that additional accommodation is on the way. Did markets overreact? In retrospect, it looks like they’d gotten their hopes up too high. The Fed wants to avoid surprises by keeping markets apprised of future developments, but it’s hard to envision it deliberately boxing itself in. It wants to preserve the flexibility to act as it sees fit, so data dependence remains the order of the day, just as it has for the last several years. We continue to take the Fed at its word that policy is not on a pre-set course. Markets seemed to be looking for a little more solicitousness from the Fed. Central bankers will presumably always attempt to guard their discretion, but the monetary policy path is far from clear, given elevated economic uncertainty. Between the stop-and-start trade hostilities with China and the Whack-a-Mole emergence of tariff threats against long-standing allies and trade partners, global manufacturing is reeling and corporate managers have every reason to hold back on capex. The differences of opinion within BCA reflect the lack of an obvious economic direction. Dissention within the Fed – Boston’s Rosengren and Kansas City’s George voted against last week’s cut, while Minneapolis’ Kashkari surely wanted it to be larger – shows that the way forward is not so clear-cut. So is it a good thing or a bad thing that the Fed cut rates? We view easier policy as a market positive over the one-year timeframe that drives most investors. There will come a point of diminishing returns, when risk assets no longer respond to incremental accommodation, but we don’t think we’re there yet. Equity multiples have room to expand before they become silly and the ECB is apparently preparing a new round of asset purchases. Given that it’s exhausted the supply of Eurozone sovereigns, it will have to proceed to evicting incumbent holders from their positions somewhat further out the risk curve, prodding them to venture out still further to redeploy the proceeds, putting downward pressure on spreads globally. How will a lower fed funds rate impact the economy? How much time do you have? The textbook answer is that a lower fed funds rate directly reduces the cost of financing big-ticket consumer purchases and corporate initiatives while indirectly nudging households and corporate managers to make them by boosting their confidence. Unconventional measures like asset purchases (QE) push investors further out the risk curve, lifting the prices of risky assets, lowering lending spreads and increasing asset holders’ wealth. They also promote a broader sense of well-being (the CNBC screen is framed in green, print headlines are cheerful, and jobs are increasingly easier to find), fueling confidence that helps reinforce the direct effects of easier policy. As Chair Powell put it in January, “Our policy works through changing financial conditions[,] … it’s … the essence of what we do.” The logic behind the textbook answer is undeniably sound, and it’s displayed in the simple six-channel model in Figure 1. People respond to incentives, and when the cost of consumption and investment falls, they are likely to save less and consume and invest more (Interest Rates/Substitution Effect). Increasing numbers of observers are becoming restless, however, as events on the ground don’t seem to jibe with the theory. Ten years of a negative real fed funds rate has failed to generate much oomph, and markets sputtered on cue once it tiptoed into positive territory (Chart 2), coinciding with the current global economic softness. Chart 2Real Rates Are Still Low Relative To History Martin Barnes, our resident grumpy economist, scoffs at how little extraordinary accommodation has been able to achieve. (Don’t get him started on the communication strategies.) Even after adjusting for how a half-century of Scotland and Montreal weather has colored his perspective, he has a point. “Do you really want to buy equities and riskier bonds in an economy that needs this much help just to grow at 2%?” he might ask. For the time being, yes, we still do. Although the channels promoting economic activity are not functioning as reliably as they have in the past, the channels boosting asset prices – Portfolio Balance, Confidence/Risk Taking, and Interest Rates/Substitution – are still A-Okay (Figure 1). The initial reaction to the FOMC meeting suggests that it will be very hard for the Fed to surprise dovishly in a relative sense, blocking the Currency channel for the time being. The Credit channel is still hindered by post-crisis regulations from Basel to Capitol Hill, at least in terms of the official banking system. Trade tensions have roiled net exports via retaliatory tariffs and suppressed global aggregate demand.1 Shouldn’t housing be at the forefront of any pickup in activity? Chart 3Lower Rates Haven't Helped Much Yet Housing is the classic proxy for tracing the effects of easier policy on the domestic economy, since nearly all of its end consumers finance their purchases, and its domestic concentration insulates it from trade effects. It has failed to respond much to the monetary policy shifts that have brought 30-year fixed mortgage rates down nearly 100 basis points year to date (Chart 3). Fed skeptics suggest that the muted response is evidence of the declining efficacy of easy policy, though we have been inclined to read the data as an indication that homebuilders aren’t building enough starter and move-up homes to bring homeownership within reach of first-time homebuyers and median-income households. Housing should exhibit a high sensitivity to changes in monetary policy, but an abundance of other debt burdens and a lack of affordable supply may be holding it back.   One should have expected that the housing pickup would be muted, and slower to take hold in this expansion, given the severity of the recession and its mortgage-lending roots. Adjusted for inflation, private residential investment, which has declined slightly for four straight quarters, is just over two-thirds of its 2005 peak (Chart 4, middle panel). In the past, residential investment has been more sensitive to the level of the fed funds rate than its direction. Since 1961, the Fed has hiked rates in as many quarters as it has cut them, and the difference in annualized growth has been relatively modest: 2.8% when the Fed has been cutting rates, and 1.6% when it’s been raising them. Chart 4Residential Investment Responds To The Monetary Policy Backdrop... Per our equilibrium fed funds rate framework, we deem monetary policy to be accommodative when the fed funds rate is below our estimate of equilibrium, and restrictive when the funds rate exceeds it (Chart 4, top panel). Despite the fact that the Fed has hiked as often as it has cut since 1961, we estimate that policy has been easy for two-thirds of the time, and the difference in residential investment growth in the two policy states has been dramatic: 6.8% when policy is easy and -6.6% when policy is tight (Chart 4, bottom panel). With the Fed keeping policy easy for longer, housing will have the wind at its back, though it isn’t much more than a breeze at the moment. The same goes for construction employment, which has grown more rapidly under accommodative monetary policy (2.1% versus 0.7% when policy is tight), but has merely treaded water over the last 11 years of easy policy (Chart 5). Chart 5... And So Does Construction Employment The bottom line is that the jury is still out on housing activity. Low mortgage rates will help renters buy homes (and fill them with furniture and appliances), and put more cash in the pockets of homeowners who refinance their existing loans, but the market remains soft. Though it can’t be captured by the aggregate data, it does seem possible that median-income households may be burdened by too much student loan, automobile and/or credit card debt to save the required down payment.2 Disparities between households may well be holding the economy back, but they have a silver lining if they encourage the Fed to pursue accommodative policies for longer than it otherwise would. Will rate cuts give the economy a tangible lift? We don’t know for sure, but no one else does, either. We are convinced that easier monetary conditions will help the economy at the margin. Ten years into the expansion, though, it is not clear if the economy has pent-up demand that easier conditions will help release. Externally, worsening trade tensions could exacerbate the global manufacturing slowdown, further squeezing global aggregate demand, and exporting recession pressures to the U.S. Our mandate is not to forecast the economy in itself, though. We and our clients are investors, not government officials or public-policy professors, and we focus on the economy only to the extent that it impacts financial markets. In the near term, incremental accommodation should boost risk asset prices, provided that trade tensions don’t ratchet up enough to undermine investor, consumer and business confidence. Animal spirits matter, and if they shift decisively from greed and toward fear, they can become a self-fulfilling prophecy that sweeps monetary policy efforts before them. Ex-a significantly negative exogenous event, we remain constructive on the U.S. economy, and continue to look for a global revival outside of the U.S. Investment Implications The incremental information received this week – an FOMC meeting that mostly went off as we expected, a modest escalation in U.S. pressure on China in line with our geopolitical strategists’ warnings that a final deal is not at hand, mixed global manufacturing PMIs, a surge in U.S. consumer confidence, a straight-down-the-middle employment situation report, and an upward inflection in S&P 500 earnings growth that has 2Q EPS now tracking to a 2.7% year-over-year gain – did not change our perspective. We see U.S. economic growth decelerating from its 2018 pace, but remaining above trend, and an absence of imbalances that would make the economy more vulnerable. We have made our peace with recurring flare-ups of hostilities between the U.S. and China, and trade tensions will only change our investment outlook if they worsen materially. The Fed is not magic, but it is doing the best it can to keep the expansion going for the purpose of spreading its gains as broadly as possible, and the easing bias among major central banks is gathering force. On balance, the new information received last week didn’t do anything to change our overall take. We remain constructive, and think investment portfolios should as well. We recognize that the climate is uncertain, and that we should accordingly dial back our conviction. Part of the reason the agency mortgage REITs appeal to us at this juncture is that they offer the opportunity to reduce equity beta and enhance a balanced portfolio’s capacity to absorb shocks. We watched the flattening in the yield curve with dismay, but we continue to expect that incremental monetary accommodation will promote a steeper curve. Easier monetary conditions promote growth, boosting the real component of interest rates, and can stoke inflation pressures when an economy is operating at or above capacity, as the U.S. has been for over a year. We remain vigilant, but our base-case constructive take is unchanged.   Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com Footnotes 1 As we were preparing to go to press on Thursday, the U.S. announced the imposition of new tariff levies on the subset of Chinese imports that hadn’t yet been subjected to tariffs. The move supported our geopolitical strategists’ view that the trade war is unlikely to be settled soon. 2 Andriotis, AnnaMaria; Brown, Ken; and Shifflett, Shane, “Families Go Deep in Debt to Stay in the Middle Class,” Wall Street Journal, August 1, 2019.

Chart Of The WeekEM Profits Contraction Today we are publishing a review of domestic demand conditions in each of the 22 emerging economies we cover. Domestic demand growth is either sluggish, decelerating or contracting in the overwhelming majority of countries. This is in addition to the export contraction currently taking place in many EMs. Consistently, EM overall EPS and small-cap EPS growth rates have fallen to zero in local currency terms (Chart Of The Week). In U.S. dollar terms, overall EM EPS are contracting. The recent dollar weakness versus EM currencies has allowed some EM central banks to cut rates. However, we expect the greenback to strengthen, as we elaborated in last week's report, and that will prevent central banks in high-yielding EMs from easing monetary policy further. Hence, a domestic demand revival in EM is not imminent. We reiterate our negative stance on EM currencies and risk assets. China: Consumer Is Mixed; Capex Is Weak Chart I-1 Chart I-2 India: Domestic Demand Is Decelerating Chart I-3 Chart I-4 Indonesia: Domestic Demand Is Very Weak Chart I-5 Chart I-6 Malaysia: Is The Downturn Late? Chart I-7 Chart I-8 Singapore: Domestic Demand Is Contracting Chart I-9 Chart I-10 Thailand: Stable Domestic Demand Growth Chart I-11 Chart I-12 Philippines: From Boom To Bust? Chart I-13 Chart I-14 Korea: Exports Recession Will Dampen Domestic Demand Chart I-15 Chart I-16 Taiwan: Moderate Domestic Demand Growth Chart I-17 Chart I-18 Vietnam: Robust Domestic Demand Chart I-19 Chart I-20 Brazil: The Economy Needs Stimulus Chart II-1 Chart II-2 Chart II-3 Chart II-4 Mexico: Heading Into A Mild Recession? Chart II-5 Chart II-6 Chile: Heading Into A Recession? Chart II-7 Chart II-8 Chart II-9 Argentina: As Bad As It Gets? Chart II-10 Chart II-11 Chart II-12 Chart II-13​​​​​​ Colombia: Entering Another Downtrend Chart II-14 Chart II-15 Chart II-16 Peru: External Sector Drives Credit Cycle Chart II-17 Chart II-18 South Africa: More Downside Ahead? Chart III-1 Chart III-3 Chart III-2   Turkey: As Bad As It Gets? Chart III-4 Chart III-5 Chart III-6 Chart III-7 Russia: Sluggish Economy Chart III-8 Chart III-9 Chart III-10 Central Europe: Strong Demand/Weak Manufacturing Chart III-11 Chart III-12   Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights U.S. consumption remains robust despite the recent intensification of global growth headwinds. The G-20 meeting will not result in an escalation nor a major resolution of Sino-U.S. tensions. Kicking the can down the road is the most likely outcome. China’s reflationary efforts will intensify, impacting global growth in the second half of 2019. Fearful of collapsing inflation expectations, global central banks are easing policy, which is supporting global liquidity conditions and growth prospects. Bond yields have upside, especially inflation expectations. Equities have some short-term downside, but the cyclical peak still lies ahead. The equity rally will leave stocks vulnerable to the inevitable pick-up in interest rates later this cycle. Gold stocks may provide an attractive hedge for now. A spike in oil prices creates a major risk to our view. Stay overweight oil plays. Feature Global growth has clearly deteriorated this year, and bond yields around the world have cratered. German yields have plunged below -0.3% and U.S. yields briefly dipped below 2%. Even if the S&P 500 remains near all-time highs, the performance of cyclical sectors relative to defensive ones is corroborating the message from the bond market. Bonds and stocks are therefore not as much in disagreement as appears at first glance. To devise an appropriate strategy, now more than ever investors must decide whether or not a recession is on the near-term horizon. Answering yes to this question means bond prices will continue to rise, the dollar will rally further, stocks will weaken, and defensive stocks will keep outperforming cyclical ones. Answering no, one should sell bonds, sell the dollar, buy stocks, and overweight cyclical sectors. The weak global backdrop can still capsize the domestic U.S. economy. We stand in the ‘no’ camp: We do not believe a recession is in the offing and, while the current growth slowdown has been painful, it is not the end of the business cycle. Logically, we are selling bonds, selling the dollar and maintaining a positive cyclical stance on stocks. We also expect international equities to outperform U.S. ones, and we are becoming particularly positive on gold stocks. Oil prices should also benefit from the upcoming improvement in global growth. Has The U.S. Economy Met Its Iceberg? Investors betting on a recession often point to the inversion of the 3-month/10-year yield curve and the performance of cyclical stocks. However, we must also remember Paul Samuelson’s famous quip that “markets have predicted nine of the five previous recessions.” In any case, these market moves tell us what we already know: growth has weakened. We must decide whether it will weaken further. A simple probit model based on the yield curve slope and the new orders component of the ISM Manufacturing Index shows that there is a 40% probability of recession over the next 12 months. We need to keep in mind that in 1966 and 1998, this model was flagging a similar message, yet no recession followed over the course of the next year (Chart I-1). This means we must go back and study the fundamentals of U.S. growth. Chart I-1The Risk Of A Recession Has Risen, But It Is Not A No Brainer Chart I-2Lower Rates Will Help Residential Investment On the purely domestic front, the U.S. economy is not showing major stresses. Last month, we argued that we are not seeing the key symptoms of tight monetary policy: Homebuilders remain confident, mortgage applications for purchases are near cyclical highs, homebuilder stocks have been outperforming the broad market for three quarters, and lumber prices are rebounding.1 Moreover, the previous fall in mortgage yields is already lifting existing home sales, and it is only a matter of time before residential investment follows (Chart I-2). Households remain in fine form. Real consumer spending is growing at a 2.8% pace, and despite rising economic uncertainty, the Atlanta Fed GDPNow model expects real household spending to expand at a 3.9% rate in the second quarter (Chart I-3). This is key, as consumers’ spending and investment patterns drive the larger trends in the economy.2 Chart I-3Consumers Are Spending Chart I-4The Labor Market Is Still Doing Fine... Going forward, we expect consumption to stay the course. Despite its latest dip, consumer confidence remains elevated, household debt levels have fallen from 134% of disposable income in 2007 to 99% today, and debt-servicing costs only represent 9.9% of after-tax income, a multi-generational low. In this context, stronger household income growth should support spending. The May payrolls report is likely to have been an anomaly. Layoffs are still minimal, initial jobless claims continue to flirt near 50-year lows, the Conference Board’s Leading Credit index shows no stress, and the employment components of both the manufacturing and non-manufacturing ISM are at elevated levels (Chart I-4). If these leading indicators of employment are correct, both the employment-to-population ratio for prime-age workers and salaries have upside (Chart I-5), especially as productivity growth is accelerating. Despite these positives, the weak global backdrop can still capsize the domestic U.S. economy, and force the ISM non-manufacturing PMI to converge toward the manufacturing index. If global growth worsens, the dollar will strengthen, quality spreads will widen and stocks will weaken, resulting in tighter financial conditions. Since economic and trade uncertainty is still high, further deterioration in external conditions will cause U.S. capex to collapse. Employment would follow, confidence suffer and consumption fall. Global growth still holds the key to the future. Following The Chinese Impulse As the world’s foremost trading nation, Chinese activity lies at the center of the global growth equation. The China-U.S. trade war remains at the forefront of investors’ minds. The meeting between U.S. President Donald Trump and Chinese President Xi Jinping over the next two days is important. It implies a thawing of Sino-U.S. trade negotiations. However, an overall truce is unlikely. An agreement to resume the talks is the most likely outcome. No additional tariffs will be levied on the remaining $300 billion of untaxed Chinese exports to the U.S., but the previous levies will not be meaningfully changed. Removing this $300 billion Damocles sword hanging over global growth is a positive at the margin. However, it also means that the can has been kicked down the road and that trade will remain a source of headline risk, at least until the end of the year. Chart I-6The Rubicon Has Been Crossed Trade uncertainty will nudge Chinese policymakers to ease policy further. In previous speeches, Premier Li Keqiang set the labor market as a line in the sand. If it were to deteriorate, the deleveraging campaign could be put on the backburner. Today, the employment component of the Chinese PMI is at its lowest level since the Great Financial Crisis (Chart I-6). This alone warrants more reflationary efforts by Beijing. Adding trade uncertainty to this mix guarantees additional credit and fiscal stimulus. More Chinese stimulus will be crucial for Chinese and global growth. Historically, it has taken approximatively nine months for previous credit and fiscal expansions to lift economic activity. We therefore expect that over the course of the summer, the imports component of the Chinese PMI should improve further, and the overall EM Manufacturing PMI should begin to rebound (Chart I-7, top and second panel). More generally, this summer should witness the bottom in global trade, as exemplified by Asian or European export growth (Chart I-7, third and fourth panel). The prospect for additional Chinese stimulus means that the associated pick-up in industrial activity should have longevity. Global central banks are running a brand new experiment. We are already seeing one traditional signpost that Chinese stimulus is having an impact on growth. Within the real estate investment component of GDP, equipment purchases are growing at a 30% annual rate, a development that normally precedes a rebound in manufacturing activity (Chart I-8, top panel). We are also keeping an eye out for the growth of M1 relative to M2. When Chinese M1 outperforms M2, it implies that demand deposits are growing faster than savings deposits. The inference is that the money injected in the economy is not being saved, but is ready to be deployed. Historically, a rebounding Chinese M1 to M2 ratio accompanies improvements in global trade, commodities prices, and industrial production (Chart I-8, bottom panel). Chart I-7The Turn In Chinese Credit Will Soon Be Felt Around The World Chart I-8China's Stimulus Is Beginning To Have An Impact   To be sure, China is not worry free. Auto sales are still soft, global semiconductor shipments remain weak, and capex has yet to turn the corner. But the turnaround in credit and in the key indicators listed above suggests the slowdown is long in the tooth. In the second half of 2019, China will begin to add to global growth once again. Advanced Economies’ Central Banks: A Brave New World Chart I-9The Inflation Expectations Panic While China is important, it is not the only game in town. Global central banks are running a brand new experiment. It seems they have stopped targeting realized inflation and are increasingly focused on inflation expectations. The collapse in inflation expectations is worrying central bankers (Chart I-9). Falling anticipated inflation can anchor actual inflation at lower levels than would have otherwise been the case. It also limits the downside to real rates when growth slows, and therefore, the capacity of monetary policy to support economic activity. Essentially, central banks fear that permanently depressed inflation expectations renders them impotent. The change in policy focus is evident for anyone to see. As recently as January 2019, 52% of global central banks were lifting interest rates. Now that inflation expectations are collapsing, other than the Norges Bank, none are doing so (Chart I-10). Instead, the opposite is happening and the RBA, RBNZ and RBI are cutting rates. Moreover, as investors are pricing in lower policy rates around the world, G-10 bond yields are collapsing, which is easing global liquidity conditions. Indeed, as Chart I-11 illustrates, when the share of economies with falling 2-year forward rates is as high as it is today, the BCA Global Leading Indicator rebounds three months later. Chart I-10Central Banks Are In Easing Mode, Everywhere The European Central Bank stands at the vanguard of this fight. As we argued two months ago, deflationary pressures in Europe are intact and are likely to be a problem for years to come.3 The ECB is aware of this headwind and knows it needs to act pre-emptively. Four months ago, it announced a new TLRTO-III package to provide plentiful funding for stressed banks in the European periphery. On June 6th, ECB President Mario Draghi unveiled very generous financing terms for the TLTRO-III. Last week, at the ECB’s Sintra conference in Portugal, ECB Vice President Luis de Guindos professed that the ECB could cut rates if inflation expectations weaken. The following day, Draghi himself strongly hinted at an upcoming rate cut in Europe and a potential resumption of the ECB QE program. These measures are starting to ease financial conditions where Europe needs it most: Italy. An important contributor to the contraction in the European credit impulse over the past 21 months was the rapid tightening in Italian financial conditions that followed the surge in BTP yields from May 2018. Now that the ECB is becoming increasingly dovish, Italian yields have fallen to 2.1%, and are finally below the neutral rate of interest for Europe. BTP yields are again at accommodative levels. Chart I-11This Much Of An Easing Bias Boosts Growth Prospects With financial conditions in Europe easing and exports set to pick up in response to Chinese growth, European loan demand should regain some vigor. Meanwhile, the TLTRO-III measures, which are easing bank funding costs, should boost banks’ willingness to lend. The European credit impulse is therefore set to move back into positive territory this fall. European growth will rebound, and contribute to improving global growth conditions. The Fed’s Patience Is Running Out The Federal Reserve did not cut interest rates last week, but its intentions to do so next month were clear. First, the language of the statement changed drastically. Gone is the Fed’s patience; instead, there is an urgency to “act as appropriate to sustain the expansion.” Second, the fed funds rate projections from the Summary of Economic Projections were meaningfully revised down. In March, 17 FOMC participants expected the Fed to stay on hold for the remainder of 2019, while six foresaw hikes. Today, eight expect a steady fed funds rate, but seven are calling for two rate cuts this year. Only one member is still penciling in a hike. Moreover, nine out of 17 participants anticipate that rates will be lower in 2020 than today (Chart I-12). The FOMC’s unwillingness to push back very dovish market expectations signals an imminent interest rate cut. Like other advanced economy central banks, the Fed’s sudden dovish turn is aimed at reviving moribund inflation expectations (Chart I-13). In order to do so, the Fed will have to keep real interest rates at low levels, at least relative to real GDP growth. Even if the real policy rate goes up, so long as it increases more slowly than GDP growth, it will signify that money supply is growing faster than money demand.4 TIPS yields are anticipating these dynamics and will likely remain soft relative to nominal interest rates. Chart I-13...As Inflation Expectations Plunge Since the Fed intends to conduct easy monetary policy until inflation expectations have normalized to the 2.3% to 2.5% zone, our liquidity gauges will become more supportive of economic activity and asset prices over the coming two to three quarters: Our BCA Monetary indicator has not only clearly hooked up, it is now above the zero line, in expansionary territory (see Section III, page 41). Excess money growth, defined as money-of-zero-maturity over loan growth, is once again accelerating. This cycle, global growth variables such as our Global Nowcast, BCA’s Global Leading Economic Indicator, or worldwide export prices have all reliably followed this variable (Chart I-14). After collapsing through 2018, our U.S. Financial Liquidity Index is rebounding sharply, and the imminent end of the Fed’s balance sheet runoff will only solidify this progress. This indicator gauges how cheap and plentiful high-powered money is for global markets. Its recovery suggests that commodities, globally-traded goods prices, and economic activity are all set to improve (Chart I-15). Chart I-14Excess Money Has Turned Up Chart I-15Improving Liquidity Conditions Argue That Nominal Growth Will Pick Up...   The dollar is losing momentum and should soon fall, which will reinforce the improvement in global liquidity conditions. A trough in our U.S. Financial Liquidity Index is often followed by a weakening dollar (Chart I-16). Moreover, the Greenback’s strength has been turbocharged by exceptional repatriations of funds by U.S. economic agents (Chart I-17). The end of the repatriation holiday along with a more dovish Fed and the completion of the balance sheet runoff will likely weigh on the dollar. Once the Greenback depreciates, the cost of borrowing for foreign issuers of dollar-denominated debt will decline, along with the cost of liquidity, especially if the massive U.S. repatriation flows are staunched. This will further support global growth conditions. Chart I-16...And That The Dollar Will Turn Down... Trade relations are unlikely to deteriorate further, China is likely to stimulate more aggressively; and easing central banks around the world, including the Fed, are responding to falling inflation expectations. This backdrop points to a rebound in global growth in the second half of the year. As a corollary, the deflationary patch currently engulfing the world should end soon after. As a result, this growing reflationary mindset should delay any recession until late 2021 if not 2022. However, as the business cycle extends further, greater inflationary pressures will build down the road and force the Fed to lift rates – even more than it would have done prior to this wave of easing. Chart I-17...Especially If Repatriation Flows Slow Investment Implications Bonds BCA’s U.S. Bond Strategy service relies on the Golden Rule of Treasury Investing. This simple rule states that when the Fed turns out to be more dovish than anticipated by interest rate markets 12 months prior, Treasurys outperform cash. If the Fed is more hawkish than was expected by market participants, Treasurys underperform (Chart I-18). Today, the Treasury market’s outperformance is already consistent with a Fed generating a very dovish surprise over the next 12 months. However, the interest rate market is already pricing in a 98% probability of two rates cuts this year, and the December 2020 fed funds rate futures imply a halving of the policy rate. The Fed is unlikely to clear these very tall dovish hurdles as global growth is set to rebound, the fed funds rate is not meaningfully above neutral and the household sector remains resilient. Chart I-18Treasurys Already Anticipate Large Dovish Surprises Reflecting elevated pessimism toward global growth, the performance of transport relative to utilities stocks is as oversold as it gets. The likely rebound in this ratio should push yields higher, especially as foreign private investors are already aggressively buying U.S. government securities (Chart I-19). As occurred in 1998, Treasury yields should rebound soon after the Fed begins cutting rates. Moreover, with all the major central banks focusing on keeping rates at accommodative levels, the selloff in bonds should be led by inflation breakevens, also as occurred in 1998 (Chart I-20), especially if the dollar weakens. Chart I-19Yields Will Follow Transportation Relative To Utilities Stocks Chart I-201998: Yields Rebounded As Soon As The Fed Began Cutting     Equities A global economic rebound should provide support for equities on a cyclical horizon. The tactical picture remains murky as the stock market may have become too optimistic that Osaka will deliver an all-encompassing deal. However, this short-term downside is likely to prove limited compared to the cyclical strength lying ahead. This is particularly true for global equities, where valuations are more attractive than in the U.S. Chart I-21Easier Liquidity Conditions Lead To Higher Stock Prices Even if the S&P 500 isn’t the prime beneficiary of the recovery in global growth, it should nonetheless generate positive absolute returns on a cyclical horizon. As Chart I-21 illustrates, a pickup in our U.S. Financial Liquidity Index often precedes a rally in U.S. stocks. Since the U.S. Financial Liquidity Index has done a superb job of forecasting the weakness in stocks over the past 18 months, it is likely to track the upcoming strength as well. A weaker dollar should provide an additional tailwind to boost profit growth, especially as U.S. productivity is accelerating. This view is problematic for long-term investors. The cheapness of stocks relative to bonds is the only reason why our long-term valuation index is not yet at nosebleed levels Chart I-22). If we are correct that the current global reflationary push will build greater inflationary pressures down the road and will ultimately result in even higher interest rates, this relative undervaluation of equities will vanish. The overall valuation index will then hit near-record highs, leaving the stock market vulnerable to a very sharp pullback. Long-term investors should use this rally to lighten their strategic exposure to stocks, especially when taking into account the risk that populism will force a retrenchment in corporate market power, an issue discussed in Section II. Gone is the Fed’s patience; instead, there is an urgency to “act as appropriate to sustain the expansion.” In this environment, gold stocks are particularly attractive. Central banks are targeting very accommodative policy settings, which will limit the upside for real rates. Moreover, generous liquidity conditions and a falling dollar should prove to be great friends to gold. These fundamentals are being amplified by a supportive technical backdrop, as gold prices have broken out and the gold A/D line keeps making new highs (Chart I-23). Chart I-22Beware What Will Happen To Valuations Once Rates Rise Again Chart I-23Strong Technical Backdrop For The Gold   Structural forces reinforce these positives for gold. EM reserve managers are increasingly diversifying into gold, fearful of growing geopolitical tensions with the U.S. (Chart I-24). Meanwhile, G-10 central banks are not selling the yellow metal anymore. This positive demand backdrop is materializing as global gold producers have been focused on returning cash to shareholders instead of pouring funds into capex. This lack of investment will weigh on output growth going forward. Chart I-24EM Central Banks Are Diversifying Into Gold This emphasis on returning cash to shareholders makes gold stocks particularly attractive. Gold producers are trading at a large discount to the market and to gold itself as investors remain concerned by the historical lack of management discipline. However, boosting dividends, curtailing debt levels and only focusing on the most productive projects ultimately creates value for shareholders. A wave of consolidation will only amplify these tailwinds. Our overall investment recommendation is to overweight stocks over bonds on a cyclical horizon while building an overweight position in gold equities. Our inclination to buy gold stocks transcends our long-term concerns for equities, as rising long-term inflation should favor gold as well. The Key Risk: Iran The biggest risk to our view remains the growing stress in the Middle East. BCA’s Geopolitical Strategy team assigns a less than 40% chance that tensions between the U.S. and Iran will deteriorate into a full-fledged military conflict. The U.S.’s reluctance to respond with force to recent Iranian provocations may even argue that this probability could be too high. Nonetheless, if a military conflict were to happen, it would involve a closing of the Strait of Hormuz, a bottleneck through which more than 20% of global oil production transits. In such a scenario, Brent prices could easily cross above US$150/bbl. Chart I-25Oil Inventories Are Set To Decline To mitigate this risk, we recommend overweighting oil plays in global portfolios. Not only would such an allocation benefit in the event of a blow-up in the Persian Gulf, oil is supported by positive supply/demand fundamentals and Brent should end the year $75/bbl. After five years of limited oil capex, Wood Mackenzie estimates that the supply of oil will be close to 5 million barrels per day smaller than would have otherwise been the case. Moreover, OPEC and Russia remain disciplined oil producers, which is limiting growth in crude output today. Meanwhile, in light of the global growth deceleration, demand for oil has proved surprisingly robust. Demand is likely to pick up further when global growth reaccelerates in the second half of the year. As a result, BCA’s Commodity and Energy Strategy currently expects additional inventory drawdowns that will only push oil prices higher in an environment of growing global reflation (Chart I-25). A falling dollar would accentuate these developments.   Mathieu Savary Vice President The Bank Credit Analyst June 27, 2019 Next Report: July 25, 2019   II. The Productivity Puzzle: Competition Is The Missing Ingredient Productivity growth is experiencing a cyclical rebound, but remains structurally weak. The end of the deepening of globalization, statistical hurdles, and the possibility that today’s technological advances may not be as revolutionary as past ones all hamper productivity. On the back of rising market power and concentration, companies are increasing markups instead of production. This is depressing productivity and lowering the neutral rate of interest. For now, investors can generate alpha by focusing on consolidating industries. Growing market power cannot last forever and will meet a political wall. Structurally, this will hurt asset prices.   “We don’t have a free market; don’t kid yourself. (…) Businesspeople are enemies of free markets, not friends (…) businesspeople are all in favor of freedom for everybody else (…) but when it comes to their own business, they want to go to Washington to protect their businesses.” Milton Friedman, January 1991. Despite the explosion of applications of growing computing power, U.S. productivity growth has been lacking this cycle. This incapacity to do more with less has weighed on trend growth and on the neutral rate of interest, and has been a powerful force behind the low level of yields at home and abroad. In this report, we look at the different factors and theories advanced to explain the structural decline in productivity. Among them, a steady increase in corporate market power not only goes a long way in explaining the lack of productivity in the U.S., but also the high level of profit margins along with the depressed level of investment and real neutral rates. A Simple Cyclical Explanation The decline in productivity growth is both a structural and cyclical story. Historically, productivity growth has followed economic activity. When demand is strong, businesses can generate more revenue and therefore produce more. The historical correlation between U.S. nonfarm business productivity and the ISM manufacturing index illustrates this relationship (Chart II-1). Chart II-1The Cyclical Behavior Of Productivity Chart II-2Deleveraging Hurts Productivity Since 2008, as households worked off their previous over-indebtedness, the U.S. private sector has experienced its longest deleveraging period since the Great Depression. This frugality has depressed demand and contributed to lower growth this cycle. Since productivity is measured as output generated by unit of input, weak demand growth has depressed productivity statistics. On this dimension, the brief deleveraging experience of the early 1990s is instructive: productivity picked up only after 1993, once the private sector began to accumulate debt faster than the pace of GDP growth (Chart II-2). The recent pick-up in productivity reflects these debt dynamics. Since 2009, the U.S. non-financial private sector has stopped deleveraging, removing one anchor on demand, allowing productivity to blossom. Moreover, the pick-up in capex from 2017 to present is also helping productivity by raising the capital-to-workers ratio. While this is a positive development for the U.S. economy, the decline in productivity nonetheless seems structural, as the five-year moving average of labor productivity growth remains near its early 1980s nadir (Chart II-3). Something else is at play. The Usual Suspects Three major forces are often used to explain why observed productivity growth is currently in decline: A slowdown in global trade penetration, the fact that statisticians do not have a good grasp on productivity growth in a service-based economy, and innovation that simply isn’t what it used to be. Slowdown In Global Trade Penetration Two hundred years ago, David Ricardo argued that due to competitive advantages, countries should always engage in trade to increase their economic welfare. This insight has laid the foundation of the argument that exchanges between nations maximizes the utilization of resources domestically and around the world. Rarely was this argument more relevant than over the past 40 years. On the heels of the supply-side revolution of the early 1980s and the fall of the Berlin Wall, globalization took off. The share of the world's population participating in the global capitalist system rose from 30% in 1985 to nearly 100% today. The collapse in new business formation in the U.S. is another fascinating development. Generating elevated productivity gains is simpler when a country’s capital stock is underdeveloped: each unit of investment grows the capital-to-labor ratio by a greater proportion. As a result, productivity – which reflects the capital-to-worker ratio – can grow quickly. As more poor countries have joined the global economy and benefitted from FDI and other capital inflows, their productivity has flourished. Consequently, even if productivity growth has been poor in advanced economies over the past 10 years, global productivity has remained high and has tracked the share of exports in global GDP (Chart II-4). Chart II-4The Apex Of Globalization Represented The Summit Of Global Productivity Growth This globalization tailwind to global productivity growth is dissipating. First, following an investment boom where poor decisions were made, EM productivity growth has been declining. Second, with nearly 100% of the world’s labor supply already participating in the global economy, it is increasingly difficult to expand the share of global trade in global GDP and increase the benefit of cross-border specialization. Finally, the popular backlash in advanced economies against globalization could force global trade into reverse. As economic nationalism takes hold, cross-border investments could decline, moving the world economy further away from an optimal allocation of capital. These forces may explain why global productivity peaked earlier this decade. Productivity Is Mismeasured Recently deceased luminary Martin Feldstein argued that the structural decline in productivity is an illusion. As the argument goes, productivity is not weak; it is only underestimated. This is pure market power, and it helps explain the gap between wages and productivity. A parallel with the introduction of electricity in the late 19th century often comes to mind. Back then, U.S. statistical agencies found it difficult to disentangle price changes from quantity changes in the quickly growing revenues of electrical utilities. As a result, the Bureau Of Labor Statistics overestimated price changes in the early 20th century, which depressed the estimated output growth of utilities by a similar factor. Since productivity is measured as output per unit of labor, this also understated actual productivity growth – not just for utilities but for the economy as a whole. Ultimately, overall productivity growth was revised upward. Chart II-5Plenty Of Room To Mismeasure Real Output Growth In today’s economy, this could be a larger problem, as 70% of output is generated in the service sector. Estimating productivity growth is much harder in the service sector than in the manufacturing sector, as there is no actual countable output to measure. Thus, distinguishing price increases from quantity or quality improvements is challenging. Adding to this difficulty, the service sector is one of the main beneficiaries of the increase in computational power currently disrupting industries around the world. The growing share of components of the consumer price index subject to hedonic adjustments highlight this challenge (Chart II-5). Estimating quality changes is hard and may bias the increase in prices in the economy. If prices are unreliably measured, so will output and productivity. Chart II-6A Multifaceted Decline In Productivity Pushing The Production Frontier Is Increasingly Hard Another school of thought simply accepts that productivity growth has declined in a structural fashion. It is far from clear that the current technological revolution is much more productivity-enhancing than the introduction of electricity 140 years ago, the development of the internal combustion engine in the late 19th century, the adoption of indoor plumbing, or the discovery of penicillin in 1928. It is easy to overestimate the economic impact of new technologies. At first, like their predecessors, the microprocessor and the internet created entirely new industries. But this is not the case anymore. For all its virtues, e-commerce is only a new method of selling goods and services. Cloud computing is mainly a way to outsource hardware spending. Social media’s main economic value has been to gather more information on consumers, allowing sellers to reach potential buyers in a more targeted way. Without creating entirely new industries, spending on new technologies often ends up cannibalizing spending on older technologies. For example, while Google captures 32.4% of global ad revenues, similar revenues for the print industry have fallen by 70% since their apex in 2000. If new technologies are not as accretive to production as the introduction of previous ones were, productivity growth remains constrained by the same old economic forces of capex, human capital growth and resource utilization. And as Chart II-6 shows, labor input, the utilization of capital and multifactor productivity have all weakened. Some key drivers help understand why productivity growth has downshifted structurally. Chart II-8Demographics Are Hurting Productivity Let’s look at human capital. It is much easier to grow human capital when very few people have a high-school diploma: just make a larger share of your population finish high school, or even better, complete a university degree. But once the share of university-educated citizens has risen, building human capital further becomes increasingly difficult. Chart II-7 illustrates this problem. Growth in educational achievement has been slowing since 1995 in both advanced and developing economies. This means that the growth of human capital is slowing. This is without even wading into whether or not the quality of education has remained constant. Human capital is also negatively impacted by demographic trends. Workers in their forties tend to be at the peak of their careers, with the highest accumulated job know-how. Problematically, these workers represent a shrinking share of the labor force, which is hurting productivity trends (Chart II-8). The capital stock too is experiencing its own headwinds. While Moore’s Law seems more or less intact, the decline in the cost of storing information is clearly decelerating (Chart II-9). Today, quality adjusted IT prices are contracting at a pace of 2.3% per annum, compared to annual declines of 14% at the turn of the millennium. Thus, even if nominal spending in IT investment had remained constant, real investment growth would have sharply decelerated (Chart II-10). But since nominal spending has decelerated greatly from its late 1990s pace, real investment in IT has fallen substantially. The growth of the capital stock is therefore lagging its previous pace, which is hurting productivity growth. Chart II-10The Impact Of Slowing IT Deflation Chart II-11A Dearth Of New Businesses   The collapse in new business formation in the U.S. is another fascinating development (Chart II-11). New businesses are a large source of productivity gains. Ultimately, 20% of productivity gains have come from small businesses becoming large ones. Think Apple in 1977 versus Apple today. A large decline in the pace of new business formation suggests that fewer seeds have been planted over the past 20 years to generate those enormous productivity explosions than was the case in the previous 50 years. The X Factor: Growing Market Concentration Chart II-12Wide Profit Margins: A Testament To The Weakness Of Labor The three aforementioned explanations for the decline in productivity are all appealing, but they generally leave investors looking for more. Why are companies investing less, especially when profit margins are near record highs? Why is inflation low? Why has the pace of new business formation collapsed? These are all somewhat paradoxical. This is where a growing body of works comes in. Our economy is moving away from the Adam Smith idea of perfect competition. Industry concentration has progressively risen, and few companies dominate their line of business and control both their selling prices and input costs. They behave as monopolies and monopsonies, all at once.1 This helps explain why selling prices have been able to rise relative to unit labor costs, raising margins in the process (Chart II-12). Let’s start by looking at the concept of market concentration. According to Grullon, Larkin and Michaely, sales of the median publicly traded firms, expressed in constant dollars, have nearly tripled since the mid-1990s, while real GDP has only increased 70% (Chart II-13).2 The escalation in market concentration is also vividly demonstrated in Chart II-14. The top panel shows that since 1997, most U.S. industries have experienced sharp increases in their Herfindahl-Hirshman Index (HHI),3 a measure of concentration. In fact, more than half of U.S. industries have experienced concentration increases of more than 40%, and as a corollary, more than 75% of industries have seen the number of firms decline by more than 40%. The last panel of the chart also highlights that this increase in concentration has been top-heavy, with a third of industries seeing the market share of their four biggest players rise by more than 40%. Rising market concentration is therefore a broad phenomenon – not one unique to the tech sector.     This rising market concentration has also happened on the employment front. In 1995, less than 24% of U.S. private sector employees worked for firms with 10,000 or more employees, versus nearly 28% today. This does not seem particularly dramatic. However, at the local level, the number of regions where employment is concentrated with one or two large employers has risen. Azar, Marinescu and Steinbaum developed Map II-1, which shows that 75% of non-metropolitan areas now have high or extreme levels of employment concentration.4 Chart II-15The Owners Of Capital Are Keeping The Proceeds Of The Meagre Productivity Gains This growing market power of companies on employment can have a large impact on wages. Chart II-15 shows that real wages have lagged productivity since the turn of the millennium. Meanwhile, Chart II-16 plots real wages on the y-axis versus the HHI of applications (top panel) and vacancies (bottom panel). This chart shows that for any given industry, if applicants in a geographical area do not have many options where to apply – i.e. a few dominant employers provide most of the jobs in the region – real wages lag the national average. The more concentrated vacancies as well as applications are with one employer, the greater the discount to national wages in that industry.5 This is pure market power, and it helps explain the gap between wages and productivity as well as the widening gap between metropolitan and non-metropolitan household incomes. Growing market power and concentration do not only compress labor costs, they also result in higher prices for consumers. This seems paradoxical in a world of low inflation. But inflation could have been even lower if market concentration had remained at pre-2000s levels. In 2009, Matthew Weinberg showed that over the previous 22 years, horizontal mergers within an industry resulted in higher prices.6 In a 2014 meta-study conducted by Weinberg along with Orley Ashenfelter and Daniel Hosken, the authors showed that across 49 studies ranging across 21 industries, 36 showed that horizontal mergers resulted in higher prices for consumers.7 While today’s technology may be enhancing the productive potential of our economies, this is not benefiting output and measured productivity. Instead, it is boosting profit margins. In a low-inflation environment, the only way for companies to garner pricing power is to decrease competition, and M&As are the quickest way to achieve this goal. After examining nearly 50 merger and antitrust studies spanning more than 3,000 merger cases, John Kwoka found that, following mergers that augmented an industry’s concentration, prices increased in 95% of cases, and on average by 4.5%.8 In no industry is this effect more vividly demonstrated than in the healthcare field, an industry that has undergone a massive wave of consolidation – from hospitals, to pharmacies to drug manufacturers. As Chart II-17 illustrates, between 1980 and 2016, healthcare costs have increased at a much faster pace in the U.S. than in the rest of the world. However, life expectancy increased much less than in other advanced economies. In this context of growing market concentration, it is easy to see why, as De Loecker and Eeckhout have argued, markups have been rising steadily since the 1980s (Chart II-18, top panel) and have tracked M&A activity (Chart II-18, bottom panel).9 In essence, mergers and acquisitions have been the main tool used by firms to increase their concentration. Another tool at their disposal has been the increase in patents. The top panel of Chart II-19 shows that the total number of patent applications in the U.S. has increased by 3.6-fold since the 1980s, but most interestingly, the share of patents coming from large, dominant players within each industry has risen by 10% over the same timeframe (Chart II-19, bottom panel). To use Warren Buffet’s terminology, M&A and patents have been how firms build large “moats” to limit competition and protect their businesses. Chart II-18Markups Rise Along With Growing M&A Activity Chart II-19How To Build A Moat?   Why is this rise in market concentration affecting productivity? First, from an empirical perspective, rising markups and concentration tend to lead to lower levels of capex. A recent IMF study shows that the more concentrated industries become, the higher the corporate savings rate goes (Chart II-20, top panel).10 These elevated savings reflect wider markups, but also firms with markups in the top decile of the distribution display significantly lower investment rates (Chart II-20, bottom panel). If more of the U.S. output is generated by larger, more concentrated firms, this leads to a lower pace of increase in the capital stock, which hurts productivity.   Second, downward pressure on real wages is also linked to a drag on productivity. Monopolies and oligopolies are not incentivized to maximize output. In fact, for any market, a monopoly should lead to lower production than perfect competition would. Diagram II-I from De Loecker and Eeckhout shows that moving from perfect competition to a monopoly results in a steeper labor demand curve as the monopolist produces less. As a result, real wages move downward and the labor participation force declines. Does this sound familiar? The rise of market power might mean that in some way Martin Feldstein was right about productivity being mismeasured – just not the way he anticipated. In a June 2017 Bank Credit Analyst Special Report, Peter Berezin showed that labor-saving technologies like AI and robotics, which are increasingly being deployed today, could lead to lower wages (Chart II-21).11 For a given level of technology in the economy, productivity is positively linked to real wages but inversely linked to markups – especially if the technology is of the labor-saving kind. So, if markups rise on the back of firms’ growing market power, the ensuing labor savings will not be used to increase actual input. Rather, corporate savings will rise. Thus, while today’s technology may be enhancing the productive potential of our economies, this is not benefiting output and measured productivity. Instead, it is boosting profit margins.12 Unsurprisingly, return on assets and market concentration are positively correlated (Chart II-22).     Finally, market power and concentration weighing on capex, wages and productivity are fully consistent with higher returns of cash to shareholders and lower interest rates. The higher profits and lower capex liberate cash flows available to be redistributed to shareholders. Moreover, lower capex also depresses demand for savings in the economy, while weak wages depress middle-class incomes, which hurts aggregate demand. Additionally, higher corporate savings increases the wealth of the richest households, who have a high marginal propensity to save. This results in higher savings for the economy. With a greater supply of savings and lower demand for those savings, the neutral rate of interest has been depressed. Investment Implications First, in an environment of low inflation, investors should continue to favor businesses that can generate higher markups via pricing power. Equity investors should therefore continue to prefer industries where horizontal mergers are still increasing market concentration. Second, so long as the status quo continues, wages will have a natural cap, and so will the neutral rate of interest. This does not mean that wage growth cannot increase further on a cyclical basis, but it means that wages are unlikely to blossom as they did in the late 1960s, even within a very tight labor market. Without too-severe an inflation push from wages, the business cycle could remain intact even longer, keeping a window open for risk assets to rise further on a cyclical basis. Third, long-term investors need to keep a keen eye on the political sphere. A much more laissez-faire approach to regulation, a push toward self-regulation, and a much laxer enforcement of antitrust laws and merger rules were behind the rise in market power and concentration.13 The particularly sharp ascent of populism in Anglo-Saxon economies, where market power increased by the greatest extent, is not surprising. So far, populists have not blamed the corporate sector, but if the recent antitrust noise toward the Silicon Valley behemoths is any indication, the clock is ticking. On a structural basis, this could be very negative for asset prices. An end to this rise in market power would force profit margins to mean-revert toward their long-term trend, which is 4.7 percentage-points below current levels. This will require discounting much lower cash flows in the future. Additionally, by raising wages and capex, more competition would increase aggregate demand and lift real interest rates. Higher wages and aggregate demand could also structurally lift inflation. Thus, not only will investors need to discount lower cash flows, they will have to do so at higher discount rates. As a result, this cycle will likely witness both a generational peak in equity valuations as well as structural lows in bond yields. As we mentioned, these changes are political in nature. We will look forward to studying the political angle of this thesis to get a better handle on when these turning points will likely emerge. Mathieu Savary Vice President The Bank Credit Analyst   III. Indicators And Reference Charts Over the past two weeks, the ECB has made a dovish pivot, President Trump announced he would meet President Xi, and the Fed telegraphed a rate cut for July. In response, the S&P 500 made marginal new highs before softening anew. This lack of continuation after such an incredible alignment of stars shows that the bulls lack conviction. These dynamics increase the probability that the market sells off after the G-20 meeting, as we saw last December following the supposed truce in Buenos Aires. The short-term outlook remains dangerous. Our Revealed Preference Indicator (RPI) confirms this intuition. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive readings from the policy and valuation measures. Conversely, if stong market momentum is not supported by valuation and policy, investors should lean against the market trend. Cheaper valuations, a pick-up in global growth or an actual policy easing is required before stocks can resume their ascent. The cyclical outlook is brighter than the tactical one. Our Willingness-to-Pay (WTP) indicator for the U.S. and Japan continues to improve. However, it remains flat in Europe. The WTP indicator tracks flows, and thus provides information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. In aggregate, the WTP currently suggests that investors are still inclined to add to their stock holdings. Hence, we expect global investors will continue to buy the dips. Our Monetary Indicator is moving deeper into stimulative territory, supporting our cyclically constructive equity view. The Fed and the ECB are set to cut rates while other global central banks have been opening the monetary spigots. This will support global monetary conditions. The BCA Composite Valuation Indicator, an amalgamation of 11 measures, is in overvalued territory, but it is not high enough to negate the positive message from our Monetary Indicator, especially as our Composite Technical Indicator remains above its 9-month moving average. These dynamics confirm that despite the near-term downside, equities have more cyclical upside. According to our model, 10-year Treasurys are now expensive. Moreover, our technical indicator is increasingly overbought while the CRB Raw Industrials is oversold, a combination that often heralds the end of bond rallies. Additionally, duration surveys show that investors have very elevated portfolio duration, and both the term premium and Fed expectations are very depressed. Considering this technical backdrop, BCA’s economic view implies minimal short-term downside for yields, but significant downside for Treasury prices over the upcoming year. On a PPP basis, the U.S. dollar remains very expensive. Additionally, after forming a negative divergence with prices, our Composite Technical Indicator is falling quickly. Being a momentum currency, the dollar could suffer significant downside if this indicator falls below zero. Monitor these developments closely. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation Chart III-6U.S. Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance   FIXED INCOME: Chart III-9U.S. Treasurys And Valuations Chart III-10Yield Curve Slopes Chart III-11Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets   CURRENCIES: Chart III-16U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning   ECONOMY: Chart III-28U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot Chart III-30U.S. Growth Outlook Chart III-31U.S. Cyclical Spending Chart III-32U.S. Labor Market Chart III-33U.S. Consumption Chart III-34U.S. Housing Chart III-35U.S. Debt And Deleveraging   Chart III-36U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China   Mathieu Savary Vice President The Bank Credit Analyst Footnotes 1       Please see The Bank Credit Analyst "June 2019," dated May 30, 2019, available at bca.bcaresearch.com 2       Please see Global Investment Strategy Special Report "Give Credit Where Credit Is Due," dated November 27, 2015, available at gis.bcaresearch.com 3       Please see The Bank Credit Analyst Special Report "Europe: Here I Am, Stuck In A Liquidity Trap," dated April 25, 2019, available at bca.bcaresearch.com 4       Money demand is mostly driven by the level of activity and wealth. If the price of money – interest rates – is growing more slowly than money demand, the most likely cause is that money supply is increasing faster than money demand and policy is accommodative. 5       A monopsony is a firm that controls the price of its input because it is the dominant, if not unique, buyer of said input. 6       G. Grullon, Y. Larkin and R. Michaely, “Are Us Industries Becoming More Concentrated?,” April 2017. 7       The Herfindahl-Hirschman Index (HHI) is calculated by taking the market share of each firm in the industry, squaring them, and summing the result. Consider a hypothetical industry with four total firm where firm1, firm2, firm3 and firm4 has 40%, 30%, 15% and 15% of market share, respectively. Then HHI is 402+302+152+152 = 2,950. 8       J. Azar, I. Marinescu, M. Steinbaum, “Labor Market Concentration,” December 2017. 9     J. Azar, I. Marinescu, M. Steinbaum, “Labor Market Concentration,” December 2017. 10     M. Weinberg, “The Price Effects Of Horizontal Mergers”, Journal of Competition Law & Economics, Volume 4, Issue 2, June 2008, Pages 433–447. 11     O. Ashenfelter, D. Hosken, M. Weinberg, "Did Robert Bork Understate the Competitive Impact of Mergers? Evidence from Consummated Mergers," Journal of Law and Economics, University of Chicago Press, vol. 57(S3), pages S67 - S100. 12    J. Kwoka, “Mergers, Merger Control, and Remedies: A Retrospective Analysis of U.S. Policy,” MIT Press, 2015. 13     J. De Loecker, J. Eeckhout, G. Unger, "The Rise Of Market Power And The Macroeconomic Implications," Mimeo 2018. 14     “Chapter 2: The Rise of Corporate Market Power and Its Macroeconomic Effects,” World Economic Outlook, April 2019. 15     Please see The Bank Credit Analyst Special Report "Is Slow Productivity Growth Good Or Bad For Bonds?"dated May 31, 2017, available at bca.bcaresearch.com. 16     Productivity can be written as: 17     J. Tepper, D. Hearn, “The Myth of Capitalism: Monopolies and the Death of Competition,” Wiley, November 2018. EQUITIES:FIXED INCOME:CURRENCIES:COMMODITIES:ECONOMY:

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

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

Highlights Treasury yields have tumbled despite a solid U.S. economy: The 10-year Treasury bond yielded just under 3% when we started beating the below-benchmark-duration drum last summer; now it’s hovering around 2.3%. The golden rule of bond investing argues against positioning for further declines, … : The returns to duration strategies hinge on the difference between actual and expected moves in the fed funds rate. With the money market looking for two cuts over the next twelve months, the fed funds rate is more likely to surprise to the upside than the downside. … but could a lack of borrowing keep yields low?: If debt-fueled spending has gone out of fashion in the U.S., global savings could overwhelm investment, and rates might have to fall further to bring them back into balance. Feature The ride has gotten bumpier as the trade tensions between the U.S. and China have heated up, but our recommendations have held up well since last summer. Equal-weighting equities, underweighting bonds and overweighting cash helped preserve capital during the fourth-quarter selloff, while our early and late January upgrades of equities (while downgrading cash) and spread product (while further downgrading Treasuries), respectively, have proven to be beneficial.1 On a total return basis, the S&P 500 is up over 12% since our upgrade, and the Barclays Bloomberg Corporate and High Yield Indexes have generated excess returns over Treasuries of around 175 and 75 basis points (“bps”), respectively, despite ceding much of their previous leads.2 Even the TIPS ETF (TIP) has held its own with the equivalent-duration nominal-Treasury ETF (IEF). The below-benchmark duration call has eroded some of the overall outperformance, however, and there has been some debate within BCA about whether or not we should change the view. We still do not believe the monetary policy outlook merits a duration-view change. We remain constructive on the outlook for global growth, despite the escalation in tensions between U.S. and Chinese trade negotiators, and therefore do not see a fundamental reason to expect lower real rates. The idea that soft credit growth could hold rates down is interesting, but one would have to believe the spendthrift U.S. leopard really has changed its spots to position a portfolio in line with it. Fed Policy Chart 1Caution: Falling Rate Expectations As of Thursday’s close, the money market was pricing in a 100% chance of a 25-bps rate cut by Thanksgiving, a 100% chance of a 50-bps rate cut by this time next year, and a 45% chance of a third cut by Thanksgiving 2020 (Chart 1, bottom panel). The FOMC has paused its rate-hiking campaign, to be sure, but the idea that it will soon embark on a rate-cutting campaign seems like a stretch. The minutes from the FOMC’s April 30th-May 1st meeting, released last week, painted a picture of a fundamentally solid economy. The balance between hawks and doves remained roughly equal, with “a few participants” calling for a coming need to firm policy, given the swiftness with which inflation pressures can build in a tight labor market, while “a few other participants” noted that the unemployment rate is not the be-all and end-all measure of resource utilization. From an investment strategy perspective, we think our U.S. Bond Strategy service’s golden rule provides the best insight. Below-benchmark-duration positioning will outperform if the Fed cuts less (or hikes more) over the next twelve months than markets expect; above-benchmark-duration will win if the Fed cuts more (or hikes less) than markets expect. Some strategists within BCA have raised the possibility that market expectations could force the Fed’s hand. The reason that the Fed is especially loath to disappoint markets in what might be called the forward-guidance era of central banking, but we think there’s an important distinction between taking care not to surprise markets and surrendering one’s free will to them, as parents of young children can attest. Bottom Line: We think the money markets are significantly overestimating the possibility that the Fed will soon cut the fed funds rate, increasing the potential returns from below-benchmark-duration positioning. The Rates Checklist Table 1Rates View Checklist We developed our rates checklist3 to provide a list of real-time measures that bear on our rates view. Of the eleven items on the list, only three have met our threshold for reassessing our bearish rates call at any point over the last eight months, so we have stayed the course (Table 1). The checked boxes indicate that the evidence has been moving against us, though we would argue that the stingy 10-year Treasury yield has gotten overly carried away with discounting that evidence (Chart 1, top panel).  Policy Perceptions The spread between our monetary policy expectations and the markets’ remains wide, so the prospective returns from our Fed call remain ample, and the first box remains unchecked. Thanks to last week’s two-day, 11-bps decline in the 10-year Treasury yield, we have again checked the inverted yield curve box, which first inverted for five days near the end of March, and has inverted for four days so far in May. Our empirical study of the inverted curve’s recession-signaling properties used month-end closes for the 10-year Treasury yield and the 3-month Treasury Bill rate, and found that an inverted curve had called the seven recessions that have occurred over the last 50 years with just one false positive (Chart 2). Now that the curve has inverted over a couple of daily stretches, clients have asked us just what constitutes bona fide inversion. Chart 2Accurate Yield Curve Signals Tend To Last Per the curve’s moves over the last 50 years, we would say inversion doesn’t issue an actionable signal until it persists for at least a few months (Table 2). 1998’s false alarm encompassed just seven days between late September and early October, and covered just one month end. The intuition behind the inverted yield curve’s predictive power is that the bond market sniffs out economic weakness before the Fed officially changes course. Recognizing that the Fed will have to begin cutting rates soon, bond investors buy longer-maturity instruments to reap the biggest rewards. Investors shouldn’t overreact to tentative inversions of the yield curve. Table 2Yield Curve Inversions We have argued that the next recession will not occur until the Fed has hiked the fed funds rate to a level above the equilibrium fed funds rate. Since we cannot observe the equilibrium rate in real time, we have looked to interest-rate-sensitive segments of the economy to gauge if higher rates are beginning to bite. Housing is on the front line of interest-rate sensitivity, and it remains quite affordable relative to history, suggesting that monetary policy has not yet become restrictive. Every time the inverted curve preceded a recession, the affordability index was below its long-run mean or rapidly making its way there (mid-1973); when the yield curve briefly inverted in September 1998, homes remained more affordable than average (Chart 3). Chart 3If Higher Rates Aren't Squeezing The Economy, The Yield Curve May Be Crying Wolf Inflation We concede that realized inflation measures (Chart 4), and inflation expectations as proxied by the difference in TIPS and nominal Treasury yields (Chart 5), have lost momentum since last summer. Washington’s unexpected grant of six-month waivers for importing Iranian oil caused crude prices to plunge, taking headline inflation measures and inflation expectations down with them (Chart 6). Given our Commodity And Energy Strategy team’s view that oil prices will extend their rebound across the rest of this year and into next, we expect that they will again move higher. Chart 4Consumer Price Indexes, ... chart 5... And Inflation Breakevens, ... Chart 6... Are Joined At The Hip With Oil Prices The Labor Market And Imbalances At Home And Abroad The labor market remains tight, so none of the labor market indicators argue for easier monetary policy and lower rates across the term structure. As far as the instability indicators go, there is as yet no sign of unsustainable activity in the economy’s key cyclical sectors. The Fed has stopped emphasizing the idea that financial sector imbalances alone might justify tighter policy, but anecdotal reports about lending standards suggest that potential vulnerabilities remain. There has not yet been an outbreak of major international distress that could deter the Fed from tightening policy, but worsening trade tensions and continued dollar strength would seem to make it slightly more likely. Bottom Line: We have checked a few boxes on our rates checklist, but the available evidence does not support adopting a more constructive view on rates. Hey, Big Spender The American consumer has long been a punching bag for Austrian School adherents and other moralists. As much as they scorn American households for living beyond their means, U.S. consumption has long played a symbiotic role in the global economy. As the engine powering the world’s largest economy, it makes an essential contribution to global aggregate demand, and provides an outlet for export powerhouses like China and Germany. An economy can only run a current account surplus provided that there are other economies running current account deficits capable of offsetting it. Measured inflation and inflation expectations were beginning to get some traction before oil collapsed upon the issuance of Iranian import waivers. In a recent blog post, former BCA Editor-in-Chief Francis Scotland posited that interest rates may not go anywhere as long as American households embrace their nascent post-crisis frugality. Using U.S. household demand as a proxy for global aggregate demand, Francis argues that if households don’t borrow and spend the way they did throughout the pre-crisis postwar era, global aggregate demand will suffer unless another profligate spender emerges to pick up the slack. Add China to the mix, and global savings could swamp global investment. Against that backdrop, savings and investment would only realign if rates fell. Newly frugal U.S. households may be helping to cap interest rates, but it’s too early to declare the end of the Debt Supercycle. Broadening the scope to include all public- and private-sector U.S. borrowing, the nominal 10-year Treasury yield has taken some cues from growth in aggregate borrowing (Chart 7). The relationship with real yields is not as strong (Chart 8), but if borrowing has some relationship to inflation, as under the guns-and-butter fiscal policy of the late sixties, nominal yields might well be a better measure. We can easily go along with the supply-and-demand intuition behind the observed relationship: when there’s stronger demand for credit, rates have to rise to entice savings and discourage investment to bring them back into balance, and vice versa. Chart 7Nominal Treasury Yields Have Been Tightly Linked With The Pace Of Loan Growth, ... Chart 8... And Real Yields Have Broadly Followed The Pattern As Well Government borrowing filled the void left by retrenching households and corporations in the immediate aftermath of the crisis. Household and corporate loan demand has been choppy since, however, and growth in aggregate borrowing has bumped around its mid-1950s lows throughout the expansion. We are not ready to declare that Americans have turned over a new, parsimonious leaf. The federal budget deficit soared following the passage of the stimulus package, and the CBO projects that it will continue to widen. Household debt growth is at its pre-crisis lows, but it has been accelerating ever since 2010 (Chart 9), and with debt service as a share of disposable income at its lowest level in at least 40 years, households have plenty of capacity to borrow. Chart 9Don't Count Consumers Out Just Yet Bottom Line: Interest rates have moved directionally with aggregate loan growth across the postwar era. Tepid loan demand growth may well keep a lid on rates, but we are not convinced that the Debt Supercycle has really breathed its last. Investment Implications Now that the 10-year Treasury yield has drifted back down to 2.3%, we believe the distribution of potential rate outcomes a year from now is skewed to the upside. We are thereby sticking with our recommendation that investors underweight Treasuries and maintain below-benchmark-duration positioning in all fixed-income portfolios. Even if there is not a clear catalyst on the immediate horizon for higher rates, we do not think that either the U.S. or the global economy is so fragile that investors should position for further rate declines. Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com Footnotes 1 Please see the January 7 and January 28, 2019 U.S. Investment Strategy Weekly Reports, “What Now?” and “Double Breaker,” available at usis.bcaresearch.com. 2 All return data calculated as of the Thursday, May 23rd close. 3 Please see the September 17, 2018 U.S. Investment Strategy Weekly Report, “What Would It Take To Change Our Bearish Rates View?” available at usis.bcaresearch.com.