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Highlights A resurfacing of trade tensions could weigh on risk sentiment in the near term. A somewhat less dovish tone from the FOMC this month could further rattle risk assets. While we would not exclude the possibility of an “insurance cut,” the Fed is probably uncomfortable with the amount of easing that markets now expect. That being said, a trade truce is still more likely than not, and while the Fed will resist cutting rates this year, it will not raise them either. The neutral rate of interest in the U.S. is higher than widely believed, which means that monetary policy will remain accommodative. That’s good news for global equities. Investors should maintain a somewhat cautious stance over the next month or so. However, they should overweight stocks, while underweighting bonds, over a 12-month horizon. The equity bull market will only end when U.S. inflation rises to a level that forces the Fed to pick up the pace of rate hikes. That is unlikely to occur until late-2020 at the earliest. Feature Stocks Bounce Back We turned positive on global equities in late December after a six-month period on the sidelines. While we have remained structurally bullish over the course of this year, we initiated a tactical hedge to short the S&P 500 on May 10th following what we regarded as an overly complacent reaction by investors to President Trump’s decision to increase tariffs on Chinese imports. Our reasoning at the time was that a period of market pressure would likely be necessary to forge an agreement between the two sides. Our thesis was looking prescient for a while. However, the rebound in stocks since last week has brought the S&P 500 close to the level where we initiated the trade. Is it time to drop the hedge? Not yet. First, market internals do not inspire much confidence. Even though the S&P 500 is just below its year-to-date (and all-time) high, the Russell 2000 is 5.1% below its May highs, and 11.8% below where it was last August (Chart 1). The S&P mid cap and small cap indexes are 6.8% and 16.2%, respectively, below their highs reached last August. Such weak breadth is disconcerting. Chart 1U.S. Stocks: Not As Strong As They Appear Second, President Trump’s decision to suspend raising the tariffs on Mexican imports may have had less to do with his desire to seek a more conciliatory tone, and more to do with pressure from Congressional Republicans. Various news reports suggested that Mitch McConnell and other Republican leaders opposed the action, and threatened to revoke the President’s authority to unilaterally impose tariffs.1 In the end, the deal with Mexico contained many of the same measures that the Mexicans had already agreed to implement months earlier. Our geopolitical team remains skeptical of a grand bargain in trade talks with China.2 In the United States, protectionist sentiment is politically more popular towards China than it is towards other countries (Chart 2). A breakthrough is still probable, but again, it may take a stock market selloff to produce a trade truce.   Third, we have become increasingly concerned that the market has gotten ahead of itself in pricing in Fed easing. While we would not rule out the possibility that the Fed takes out an “insurance cut” to guard against downside risks to the economy, the 80 basis points of easing that the market has priced in over the next 12 months seems excessive to us. Chart 3Financial Conditions Have Not Tightened Much Unlike late last year, U.S. financial conditions have tightened only modestly over the past nine weeks (Chart 3). The economy is also performing reasonably well. According to the Atlanta Fed GDPNow model, real final sales to domestic purchasers3 are set to grow by 2.5% in the second quarter, up from 1.5% in Q1 (Chart 4). Real personal consumption expenditures are on track to rise by 3.2%. Gasoline futures have tumbled, which will support discretionary spending over the next few quarters (Chart 5).   Chart 5Lower Gasoline Prices Should Bode Well For Discretionary Spending Granted, the labor market has cooled down. Payrolls increased by only 75K in May. However, the Council of Economic Advisers estimated that flooding in the Midwest shaved 40K from payrolls. And even with this adverse impact, the three-month average for payroll growth still stands at 151K, well above the 90K-to-100K or so that is needed to keep up with labor force growth. Meanwhile, initial unemployment claims remain muted and the employment component of the nonmanufacturing ISM hit a seven-month high in May. Chart 6Trimmed Mean PCE Inflation Back To 2% Inflation expectations are on the low side, but actual inflation is proving to be reasonably sturdy. The core PCE index rose by 0.25% month-over-month in April. Trimmed mean PCE inflation increased above 2% on a year-over-year basis for the first time in seven years (Chart 6). According to a recent Fed study, the trimmed mean calculation is superior to the core PCE index as a summary measure of underlying inflationary trends.4 Ultimately, the fact that the U.S. economy is holding up well is a positive sign for equity returns over the next 12 months. In the short term, however, it does create the risk that the Fed will sound less dovish than investors are anticipating, leading to a temporary selloff in stocks. Hence our view: near-term cautious, longer-term bullish. Who Determines Interest Rates? Central banks decide where rates will go in the short run, but it is the economy that determines where interest rates will go in the long run. The neutral rate of interest is the rate that corresponds to full employment and stable inflation. One can also think of it as the rate that aligns the level of aggregate demand with the maximum potential output the economy is capable of achieving without overheating. Both the Fed dots and the widely-used Laubach Williams model suggest that rates are close to neutral. But are they really? If a central bank keeps rates below their neutral level for too long, inflation will eventually break out, forcing the central bank to raise rates. Conversely, if a central bank raises rates above their neutral level, growth will slow, inflation will decline, and the central bank will be forced to cut rates. The problem is that changes in monetary policy typically affect the economy with a lag of 12-to-18 months. Inflation is also a highly lagging indicator. It usually peaks well after a recession has begun and troughs long after the recovery is under way (Chart 7). Thus, central banks have to make an educated guess as to where the neutral rate lies and try to steer the economy towards that rate in a way that achieves a soft landing. Needless to say, this is easier said than done. Today, both the Fed dots and the widely-used Laubach Williams model suggest that rates are close to neutral (Chart 8). Chart 8The Fed Thinks Rates Are Close To Neutral But are they really? That’s the million dollar question. Not only will the answer determine the medium-term path of interest rates, it will also determine how long the current U.S. economic expansion will last. Recessions rarely occur when monetary policy is accommodative, and equity bear markets almost never happen outside of recessionary periods (Chart 9). Thus, if rates are currently well below neutral, investors should maintain a bullish equity tilt. Chart 9Recessions And Bear Markets Usually Overlap Chart 10U.S.: Federal Fiscal Policy Has Been Expansionary Where Is Neutral? The neutral rate of interest is a function of many variables, most of which are not in the Laubach Williams model. Let us consider a few: Fiscal Policy A larger budget deficit boosts aggregate demand, while higher interest rates lower demand. Thus, once an economy has achieved full employment, an easing of fiscal policy must be counterbalanced by an increase in interest rates, which is another way of saying that looser fiscal policy raises the neutral rate of interest. The U.S. cyclically-adjusted budget deficit has risen by about 3% of GDP since 2015. Both tax cuts and increased federal discretionary spending have contributed to the deterioration in the fiscal balance (Chart 10). Standard “Taylor Rule” equations suggest that a 1% of GDP increase in aggregate demand will raise the appropriate level of the fed funds rate by 0.5-to-1 percentage points.5 This implies that easier fiscal policy has lifted the neutral rate of interest by 1.5-to-3 percentage points over the past five years. Labor Market Developments A tight labor market tends to increase the share of national income accruing to workers (Chart 11). Workers generally spend more of every dollar of income than businesses. Thus, a shift of income from businesses to workers raises the neutral rate of interest. The fact that a tight labor market usually generates the biggest gains for workers at the bottom of the income distribution – who have the highest marginal propensity to spend – further amplifies the positive effect on aggregate spending. Chart 11Workers Garner A Larger Piece Of The Income Pie When The Labor Market Is Tight The labor share of income has rebounded since reaching a record low in 2014. The lowest-paid workers have also seen the largest wage increases during the past 12 months (Chart 12). Neither of these nascent developments have come close to unwinding the beating that labor has suffered in relation to capital over the past four decades, but if the unemployment rate keeps falling, workers are going to start gaining the upper hand. Thus, one would expect the neutral rate of interest to rise further as the labor market continues to tighten. Credit Growth The Great Recession ushered in a painful deleveraging cycle. Household debt fell from 86% of GDP in 2009 to 70% of GDP in 2012. The household debt-to-GDP ratio has edged slightly lower since then due to continued declines in mortgage debt and home equity lines of credit. A return to the rapid pace of credit growth seen before the financial crisis is unlikely. Nevertheless, a modest releveraging of household balance sheets would not be surprising. Some categories such as student and auto loans have seen fairly robust debt growth (Chart 13). Housing-related debt could also stage a modest comeback due to rising home prices and buoyant consumer confidence. Conceptually, the rate of credit growth determines the level of aggregate demand.6 Thus, if household credit growth picks up at the margin, this would push up the neutral rate of interest. Corporate debt levels also have scope to rise further. Net corporate debt is only modestly higher than it was in the late 1980s, a period when the fed funds rate averaged nearly 10% (Chart 14). Chart 13U.S. Housing Deleveraging Has Slowed Chart 14U.S. Corporate Debt (I): No Cause For Alarm   Thanks to low interest rates and rapid asset accumulation, the economy-wide interest coverage ratio is above, while the ratio of debt-to-assets is below, their respective long-term averages (Chart 15). The corporate sector financial balance – the difference between what businesses earn and spend – is still in surplus. Almost every recession in the post-war era has begun when the corporate sector financial balance was in deficit (Chart 16). Chart 15U.S. Corporate Debt (II): No Cause For Alarm Chart 16U.S. Corporate Debt (III): No Cause For Alarm     The Value Of The U.S. Dollar A stronger dollar reduces net exports. This drains demand from the economy, which lowers the neutral rate of interest. The real broad trade-weighted dollar index has risen 10% since 2014. According to the New York Fed’s econometric model, this would be expected to reduce the level of real GDP by 0.5% in the first year and by a further 0.2% in the second year, for a cumulative decline of 0.7%, equivalent to a decrease in the neutral rate of 0.35%-to-0.7%. The New York Fed model assumes an “all things equal” environment. All things have not been quite equal, however. The U.S. has benefited from a modest improvement in its terms of trade7 over the past five years (Chart 17). The shale boom has also significantly cut into oil imports. As a result, the trade deficit has fallen from 5.9% of GDP in 2005 to 2.9% of GDP at present. Chart 17The Dollar Has Appreciated Since 2014 Chart 18The Savings Rate Has (A Lot Of) Room To Drop, Judging From The Historical Relationship With Wealth Asset Prices An increase in asset values – whether they be equities, bonds, or homes – makes people and businesses feel wealthier, which leads to more consumption and investment spending. As such, higher asset prices raise the neutral rate of interest. Today, U.S. household net worth stands near a record high as a percent of disposable income (Chart 18). The personal savings rate, in contrast, still stands at an elevated 6.4%. If the savings rate falls over the coming months, this would further boost aggregate demand. Demographics Slower labor force growth has led to a decline in trend GDP growth in the U.S. and most other economies. Slower economic growth tends to reduce the neutral rate of interest. The Bureau of Labor Statistics expects labor force growth to be broadly stable over the next 5-to-10 years, with immigration compensating for the withdrawal of baby boomers from employment (Chart 19). Chart 20Savings Over The Life Cycle In the current political climate, there is quite a bit of uncertainty over how many immigrants will settle in the United States. On the one hand, less immigration would reduce labor force growth, thus lowering the neutral rate. On the other hand, a decline in immigration would lead to an even tighter labor market, thus potentially raising the neutral rate. An additional question is how population aging, which will continue even if immigration remains elevated, will affect the neutral rate. Older people work less, but consume more than younger people, once health care spending is accounted for (Chart 20). If overall national output falls in relation to consumption, national savings will go down. This will raise the neutral rate of interest. The Shift To A Capital-Lite Economy Firms increasingly need less physical capital to carry out their activities. Larry Summers has labeled this the “demassification” of the economy. Lower investment spending would translate into a lower neutral rate. While plausible, it is not clear how important this phenomenon is. Companies may need less physical capital, but they need more human capital. Instead of more lending to businesses to finance purchases of machinery, we get additional lending to students. If our thesis that the neutral rate of interest is higher than widely believed turns out to be correct, this means that the Fed will eventually need to start hiking rates again. The question is when. The share of R&D and other intangibles in business investment has risen from around 14% in the 1960s to 33% today (Chart 21). Importantly, the depreciation rate for intangible investment is much higher than for other forms of capital spending. As intangible investment has increased, the overall depreciation rate for the economy has risen (Chart 22). Conceptually, an increase in the depreciation rate should lead to a higher neutral rate of interest.8 Chart 21A Larger Share Of Business Investment Is Intangible... Chart 22...And That Puts Upward Pressure On The Depreciation Rate   Watch Housing And Business Capex The discussion above suggests that the neutral rate of interest is probably higher than widely believed. That said, there is significant uncertainty around any estimate of the neutral rate. As such, we recommend that investors track the more interest-rate sensitive sectors of the economy to gauge whether monetary policy is becoming restrictive. Housing, and to a lesser extent, business capital expenditures are the key indicators to watch. As a long-lived asset, housing is very sensitive to mortgage rates. Chart 23 shows that changes in mortgage rates tend to lead residential investment and home sales by about six months. Chart 23Housing Is Interest-Rate Sensitive If the decline in mortgage rates since last fall fails to spur housing, this would support the claim that monetary policy turned restrictive last year. Fortunately, the jump in homebuilder confidence, the outperformance of homebuilder stocks, and the surge in mortgage applications for purchases all suggest that the housing sector remains on firm ground (Chart 24). Despite the broad-based weakness in the global manufacturing sector, U.S. capex intentions remain reasonably buoyant (Chart 25). This week’s release of the May NFIB small business survey, which showed that the share of firms citing “now is a good time to expand” jumped five points to a seven-month high, provides further evidence in support of this view. Chart 24Some Positives For U.S. Housing Chart 25U.S. Capex Intentions Remain Solid   A Two-Stage Fed Cycle Chart 26Inflation Expectations Are Not Where The Fed Wants Them To Be If our thesis that the neutral rate of interest is higher than widely believed turns out to be correct, this means that the Fed will eventually need to start hiking rates again. The question is when. Right now, the Fed has the luxury of time on its side. Even though some measures of core inflation such as the trimmed mean calculation discussed above have reached the Fed’s 2% target, this follows a prolonged period of below-target inflation. A few years of above-trend inflation would hardly be the worst thing in the world. The Fed’s failure to reach its inflation target has pushed long-term inflation expectations below the central bank’s comfort zone (Chart 26). Given the asymmetric risks created by the zero lower bound on interest rates - if inflation rises too fast, the Fed can always hike rates; but if inflation falls too much, it may be impossible to ease monetary policy by enough to avert a recession - the Fed can afford to remain patient. Thus, while the Fed is unlikely to cut rates as much as investors currently expect, it is also unlikely to raise them this year. Thanks to a cyclical revival in productivity growth, unit labor cost inflation has actually declined over the past 12 months (Chart 27). However, as we get into late next year and 2021, circumstances may change. If an increasingly tight jobs market continues to push up wage growth, unit labor costs will start to reaccelerate. Cost-push inflation will kick in. At that point, the Fed may have no choice but to pick up the pace of monetary tightening. All this suggests that Fed policy will evolve in two stages: an initial stage lasting for the next 12-to-18 months where the Fed is doing little-to-no tightening (and could even cut rates if the trade war heats up), followed by a second stage where the central bank is scrambling to raise rates to cool an overheated economy. U.S. Treasury yields are likely to rise modestly during the first stage in response to stronger-than-expected economic growth. We see the 10-year yield clawing its way back to the high-2% range by early next year. Yields could rise more precipitously, to around 4%, in the second stage once inflation begins to move decisively higher. The dollar is unlikely to strengthen during the first stage. Indeed, our baseline forecast calls for a period of modest dollar weakness stretching into late next year driven by a reacceleration in European and Chinese/EM growth. The sharp rebound in Chinese real estate equipment purchases from -18% on a six-month basis late last year to +30% in April suggests that the government’s stimulus efforts are working (Chart 28). Chart 27No Imminent Threat Of A Wage-Price Inflationary Spiral Chart 28China: A Sign That Stimulus Is Finding Its Way Into The Economy   The greenback will likely appreciate, perhaps significantly so, once the Fed picks up the pace of rate hikes in late 2020. The accompanying tightening in global financial conditions is likely to sow the seeds for a worldwide downturn in 2021. The combination of faster global growth and a weaker dollar will support global equities over the next 12 months. European and EM bourses will benefit the most. Investors should begin derisking in the second half of next year. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com   Footnotes 1      Patricia Zengerle, “U.S. Lawmakers Seek To Block Trump On Tariffs,” Reuters, June 5, 2019. 2      Please see Geopolitical Strategy Weekly Report, “Is Trump Ready For The New Long March?” dated May 24, 2019. 3      Final sales to domestic purchasers is equal to gross domestic product (GDP) excluding net exports of goods and services, less the change in private inventories. 4      Jim Dolmas and Evan F. Koenig, “Two Measures Of Core Inflation: A Comparison,” Federal Reserve Bank Of Dallas, Working Paper 1903, February 25, 2019. 5      Depending on which specification of the Taylor Rule one uses, a one percent of GDP increase in aggregate demand will increase the neutral rate of interest by half a point (John Taylor’s original specification) or by a full point (Janet Yellen’s preferred specification). John B. Taylor's 1993 specification is based on the following equation: rt = 2 + pt + 0.5(pt - 2) + 0.5yt. Janet Yellen's preferred specification is based on the following equation: rt = 2 + pt+ 0.5(pt - 2) + 1.0yt. Please note: For both specifications above, rt is the federal funds rate; pt is core PCE expressed as a year-over-year percent change; and yt is the output gap (as approximated using the unemployment gap and Okun's law). For further discussion, please see Janet L. Yellen, "The Economic Outlook And Monetary Policy," April 11, 2012. 6      Recall that GDP is a flow variable (how much production takes place every period), whereas credit is a stock variable (how much debt there is outstanding). By definition, a flow is a change in a stock. Thus, credit growth affects GDP and the change in credit growth affects GDP growth. 7      Ratio (multiplied by 100) of the price index for exports of goods and services to the price index for imports of goods and services. 8      The higher the depreciation rate, the more investment is necessary to maintain the existing capital stock. More investment demand for any given level of savings implies a higher interest rate. One can see this in the Solow growth model, which posits that the neutral rate of interest (r*) should be equal to: Where a is the output elasticity of capital, s is the savings rate, n is labor force growth, g is the growth in total factor productivity, and d is the depreciation rate. The equation implies that the neutral rate of interest will increase if capital intensity increases, the savings rate declines, the rate of labor force growth picks up, technological progress accelerates, or the depreciation rate increases.     Strategy & Market Trends MacroQuant Model And Current Subjective Scores Tactical Trades Strategic Recommendations Closed Trades

Dear Client, Tomorrow we will publish a debate piece on China shedding more light on the ongoing discussions at BCA on this topic. This report will articulate the conceptual and analytical differences between my colleague, Peter Berezin, and I relating to our respective outlooks on China’s credit cycle. Peter believes that the credit boom in China is a natural outcome of a high household “savings” rate. I maintain that household “savings” have no bearing on credit growth, debt or bank deposit levels. Rather, China’s credit and money excesses are pernicious and will precipitate negative macro outcomes. I hope you will find this report valuable and interesting. Today we are publishing analysis and market strategy updates on Russia and Chile. Best regards, Arthur Budaghyan Chief Emerging Markets Strategist   Russia: A Fiscal And Monetary Fortress Underpins A Low-Beta Status Russian financial markets and the ruble have entered a low-beta paradigm. A combination of ultra-conservative fiscal and monetary policies over the past four years will help Russian equities, local bonds as well as sovereign and corporate credit to continue outperforming their respective EM benchmarks.   First, both the overall and primary fiscal surpluses now stand at over 3% of GDP (Chart I-1). The authorities have sufficient fiscal leeway to undertake substantial fiscal easing. They have announced a major fiscal spending program, which is planned to be in the order of $390 billion or 25% of GDP, over the next six years. Chart I-1Fiscal Balance Is In Large Surplus Importantly, government non-interest expenditures have dropped to 15.5% of GDP from 18% in 2016. Therefore, it makes perfect sense to ease fiscal policy materially to counteract the impact of lower commodities prices on the economy. What’s more, gross public debt is at 13% of GDP – out of which the foreign component is only 4% of GDP – and remains the lowest in the EM space. A fiscal fortress, as well as the potential for significant fiscal stimulus amid the current EM selloff, will help the Russian currency, local bonds and sovereign and corporate credit markets behave as a lower beta play within the EM universe. Second, there is scope for the Central Bank of Russia (CBR) to cut interest rates. Both nominal and real interest rates have remained high, particularly lending rates (Chart I-2). Furthermore, growth has been mediocre and inflation is likely to fall again (Chart I-3). Chart I-2Russian Real Interest Rates Are High Chart I-3Russia: Growth Has Been Weakening Prior To Oil Price Decline   Although overwhelming evidence warrants lower interest rates in Russia, it is not clear if the ultra-conservative Central Bank Governor Elvira Nabiullina will resort to rate reductions as oil prices and EM assets continue selling off – as we expect. Even if Governor Elvira Nabiullina delivers rate cuts, they will be delayed and small. Hence, real rates will remain high, helping the ruble outperform other EM currencies. Provided the central bank remains behind the curve, odds are that the yield curve will probably invert as long-term bond yields drop below the policy rate (Chart I-4). In short, a conservative central bank will provide a friendly environment for fixed-income and currency investors. Third, the Russian ruble will depreciate only modestly despite the ongoing carnage in oil prices due to high foreign exchange reserves and a positive balance of payments. The current account surplus stands at 7.5% of GDP, or $115 billion. Both the central bank and the Ministry of Finance (MoF) have been buying foreign currency. In particular, based on the fiscal rule, the MoF buys U.S. dollars when oil prices are above $40/barrel and sells U.S. dollars when the oil price is below that level. As such, policymakers have created a counter-cyclical ballast to counteract any negative shocks. A fiscal fortress, as well as the potential for significant fiscal stimulus amid the current EM selloff, will help the Russian currency, local bonds and sovereign and corporate credit markets behave as a lower beta play within the EM universe. Remarkably, the monetary authorities have siphoned out the additional liquidity that has been injected as part of their foreign currency purchases. In fact, the CRB’s net liquidity injections have been negative. This is in contrast to what has been happening in many other EMs. These prudent macro policies will limit the downside in the ruble versus the dollar and the euro. Chart I-4Russia: Yield Curve Will Probably Invert Chart I-5Cash Flow From Operations: Russia Versus EM Finally, rising profits in the non-financial corporate sector and balance sheet improvements justify Russian equity outperformance relative to EM. Specifically, Russian firms’ cash flows from operation have been diverging from EM, suggesting the former is in better financial health than its EM counterparts (Chart I-5). Bottom Line: Even though we expect oil prices to drop further,1 investors should continue to overweight Russian equities, sovereign and corporate credit and local currency bonds relative to their respective EM benchmarks (Chart I-6). Chart I-6Continue Overweighting Russian Stocks And Bonds To express our positive view on the ruble, we have been recommending a long RUB / short COP trade since May 31, 2018. This position has generated a 10.8% gain, and remains intact. Andrija Vesic, Research Analyst andrijav@bcaresearch.com   Chile: Heading Into A Recession? Our recommended strategy2 for Chile has been to (1) receive three-year swap rates, (2) favor local bonds versus stocks for domestic investors, (3) short the peso versus the U.S. dollar, and (4) overweight Chilean equities within an EM equity portfolio. Chart II-1Chile's Central Bank Is Behind The Curve The first three strategies have played out nicely as the economy has slowed, rate expectations have dropped and the peso has plunged (Chart II-1). Yet the Chilean bourse has recently substantially underperformed the EM benchmark, challenging our overweight equity stance. At the moment, we recommend staying with these recommendations, as the growth slowdown in Chile has much further to run and the central bank will cut rates substantially: Our proxy for marginal propensity to spend among both households and companies – which leads the business cycle by six months – has been falling (Chart II-2). The outcome is that growth conditions will worsen, and a recession is probable. There are already segments of the economy – retail sales volumes, car sales, non-mining exports and mining output, to name a few – that are contracting (Chart II-3). Chart II-2More Growth Retrenchment In The Next 6 Months Chart II-3Chilean Economy: Certain Segments Are Contracting   Shockwaves from the global slump in general and China’s slowdown in particular are taking a toll on this open economy. Copper prices are breaking down, and Chile’s industrial pulp and paper prices are falling in dollar terms (Chart II-4). Bank loan growth as well as employment growth have not yet decelerated. The latter are typically lagging indicators in Chile. Therefore, as weakening growth erodes business and consumer confidence, credit growth as well as hiring and wages will retrench. Finally, both core consumer prices and service inflation rates are at the lower end of the central bank’s inflation target band. It is a matter of time before the growth deterioration leads to even lower inflation. We argued in our last analysis on Chile3 that large net immigration has boosted labor supply and is hence disinflationary. This, along with forthcoming hiring cutbacks, will depress wages and lead to lower inflation. Overall, Chile’s central bank is well behind the curve. A major rate reduction cycle is in the cards, as both growth and inflation will undershoot the Chilean central bank’s targets. Chart II-4Chile: Industrial Paper And Pulp Prices Are Deflating Chart II-5The Chilean Peso Is Not Cheap Lower interest rates, shrinking exports and a large current account deficit will weigh on the exchange rate. In addition, Chilean companies have large amounts of foreign currency debt ($75 billion or 26% of GDP), and peso depreciation is forcing them to hedge their foreign currency liabilities. This will heighten selling pressure on the peso. Notably, the currency is not yet cheap and bear markets usually do not end until valuations become cheap (Chart II-5). That said, the main reasons to continue overweighting Chilean equities within an EM universe are potential monetary and fiscal easing in Chile that many other EM are not in a position to do amid their own ongoing currency depreciation. Besides, this bourse’s relative equity performance versus the EM benchmark is already very oversold and is likely to rebound as the EM stock index drops more than Chilean share prices. The main reasons to continue overweighting Chilean equities within an EM universe are potential monetary and fiscal easing in Chile that many other EM are not in a position to do. Our recommended strategy remains intact: Fixed-income investors should continue receiving three-year swap rates; Local investors should overweight domestic bonds versus stocks; Currency traders should maintain the short CLP / long U.S. dollar trade; Dedicated EM equity portfolio managers should maintain an overweight in this bourse versus the EM benchmark. One trade we are closing is our short copper / long CLP, which has returned a 1.6% gain since its initiation on September 6, 2017. The original motive for this trade was to express our negative view on copper. While we believe copper prices have more downside, the peso could undershoot, which tips the balances in favor of closing this trade. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Juan Egaña, Research Associate juane@bcaresearch.com Footnotes 1      The Emerging Markets Strategy team’s negative view on oil prices is different from the BCA house view which is bullish on oil. 2      Please see "Chile: Stay Overweight Equities, Receive Rates," dated May 31, 2018 and "Chile: Favor Bonds Over Stocks," dated February 7, 2019. 3      Please see "Chile: Favor Bonds Over Stocks," dated February 7, 2019. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Feature Markets have turned jittery in the past month. Global growth data have deteriorated further (Chart 1), with Korean exports, the German manufacturing PMI, and even U.S. industrial production weak. Moreover, trade negotiations between the U.S. and China appear to have broken down, with China threatening to retaliate against U.S. sanctions on Huawei by blocking sales of rare earths, and refusing to negotiate further unless the U.S. eases tariffs. BCA’s Geopolitical Strategists now give only a 40% probability of a trade deal by the time of the G20 summit at the end of June (Table 1). As a result, BCA alerted clients on 10 May to the risk of a further short-term 5% correction in global equities.1 Recommended Allocation Chart 1Worrying Signs? Table 1Chances Of A Trade Deal Fading Fast What is essentially behind the global slowdown, especially outside the U.S., is that both China and the U.S. last year were tightening monetary policy – China by slowing credit growth, the U.S. via Fed hikes. The U.S. economy was robust enough to withstand this, but economies in Europe, Asia, and Emerging Markets were not (Chart 2). The question now is whether the Chinese authorities and the Fed will come to the rescue and add stimulus that will cause a recovery in global growth. China has already triggered a rebound in credit growth since January (Chart 3). Chart 2U.S. Holding Up Better Than Elsewhere Chart 3China Stimulus Has Only Just Begun This has not come through clearly in Chinese – and other countries’ – activity data yet, partly because there is usually a lag of 3-12 months before this happens, and partly because Chinese authorities seemingly eased back somewhat on the gas pedal in April given rising expectations of a trade deal. But, judging by previous episodes such as 2009 and 2016, the Chinese will stimulate now based on the worst-case scenario. The risk is more that they overdo the stimulus than that they fail to do enough. Yes, China is worried about its excess debt situation. But this year they will prioritize growth – not least because of some sensitive anniversaries in the months ahead (for example, the 70th anniversary of the People’s Republic on October 1), and because the government is falling behind on its promise to double per capita real income between 2010 and 2020 (Chart 4). Chart 4Chinese Communist Party Needs To Prioritize Growth Chart 5U.S. Consumers Look In Fine State     In the U.S., consumption is likely to continue to buoy the economy. Wages are growing 3.2% a year and set to accelerate further, and consumer confidence is close to a 50-year high (Chart 5). It is easy to exaggerate the impact of even an all-out trade war. For China, exports to the U.S. are only 3.4% of GDP. A hit to this could easily be offset by stimulus leading to greater capital expenditure. For the U.S, most academic studies show that the impact of tariffs will largely be passed on to the consumer via higher prices.2 But even if the U.S. imposes 25% tariffs on all Chinese exports and all is passed on to the consumer with no substitutions for goods from other countries the impact, about $130 billion, would represent only 1% of total U.S. consumption. The question now is whether the Chinese authorities and the Fed will come to the rescue and add stimulus that will cause a recovery in global growth. But if China will bail out the global economy, we are not so convinced that the Fed will cut rates any time soon. The market has priced in two Fed rate cuts over the next 12 months (Chart 6). But we agree with comments from Fed officials that recent softness in inflation is transitory. For example, financial services inflation (mostly comprising financial advisor fees, linked to assets under management, and therefore very sensitive to the stock market) alone has deducted 0.4 percentage points from core PCE inflation over the past six months (Chart 7). The trimmed mean PCE (which cuts out other volatile items besides energy and food, which are excluded from the commonly used core PCE measure) is close to 2% and continues to drift up. Chart 6Will The Fed Really Cut Twice In 12 Months? Chart 7Soft Inflation Probably Is Transitory     Fed policy remains mildly accommodative: the current Fed Funds Rate is still two hikes below the neutral rate, as defined by the median terminal-rate dot in the FOMC’s Summary of Economic Projections (Chart 8). The market may be trying to push the Fed into cutting rates and could be disappointed if it does not. For now, we tend to agree with the Fed’s view that policy is about correct (Chart 9) but, if global growth does recover before the end of the year, one hike would be justified in early 2020 – before the upcoming Presidential election in November 2020 makes it less comfortable for the Fed to move. Chart 8Fed Policy Is Still Accommodative Chart 9Fed Doesn't Need To Move For Now     In this macro environment, we see global bond yields bottoming not far below their current (very depressed) levels, and equities eking out reasonable gains over the next 12 months. The risk of a global recession over the next year or so is not high, in our opinion. We, therefore, continue to recommend an overweight on global equities and underweight on bonds over the cyclical horizon.  We see global bond yields bottoming not far below their current (very depressed) levels, and equities eking out reasonable gains over the next 12 months. Fixed Income: Government bond yields have fallen sharply over the past eight months (by 110 basis points for the U.S. 10-year, for example) because of 1) falling inflation expectations, caused mostly by a weak oil price, 2) expectations of Fed rate cuts, 3) especially weak growth in Europe, which pulled German yields down to -20 basis points in May, and 4) global risk aversion which pushed asset allocators into government bonds, and lowered the term premium to near record low levels (Chart 10). If Brent crude rises to $80 a barrel this year as we forecast, the Fed does not cut rates, and European growth rebounds because of Chinese stimulus, we find it highly improbable that yields will fall much further. Ultimately, the global risk-free rate is driven by global growth (Chart 11). Investors are already positioned very aggressively for a further fall in yields (Chart 12). We would expect the U.S. 10-year yield to move back towards 3% over the next 12 months. We remain moderately positive on credit, which should also benefit from a growth rebound: U.S. high-yield spreads are still around 70 basis points for Ba-rated bonds, and 110 basis points for B-rated ones, above the levels at which they typically bottom in expansions; investment-grade bonds, though, have less room for spread contraction (Chart 13). Chart 10Term Premium Near Record Low Chart 11Global Rebound Would Push Up Yields   Chart 12Investors Very Long Duration Chart 13Credit Spreads Can Tighten Further     Equities:  We remain overweight U.S. equities, partly as a hedge against our overweight on the equity asset class, since the U.S. remains a relatively low beta market. Our call for the second half will be 1) when will Chinese stimulus start to boost growth disproportionately for commodity and capital-goods exporters, and 2) does that justify a shift out of the U.S. (which may be somewhat hurt short term by the Trade War) and into euro zone and Emerging Markets equities. Given the structural headwinds in both (the chronically weak banking system and political issues in Europe; high debt and lack of structural reforms in EM), we want clear evidence that the Chinese stimulus is working before making this call. We are likely to remain more cautious on Japan, even though it is a clear beneficiary of Chinese growth, because of the risk presented by the rise in the consumption tax in October: after previous such hikes, consumption not only slumped immediately afterwards but remained depressed (Chart 14). Chart 14Japan's Sales Tax Hike Is A Worry Chart 15Dollar Is A Counter-Cyclical Currency   Currencies:  Again, China is the key. The dollar is a counter-cyclical currency, and a pickup in global growth would weaken it (Chart 15). Any further easing by the ECB – for example, significantly easier terms on the next Targeted Longer-Term Refinancing Operations (TLTRO) – might actually be positive for the euro since it would augur stronger growth in the euro area. Moreover, long dollar is a clear consensus view, with very skewed market positioning (Chart 16). Also, on a fundamental basis, compared to Purchasing Power Parity, the dollar is around 15% overvalued versus the euro and 11% versus the yen. Chart 17Industrial Metals Driven By China Too Commodities: Industrial metals prices have generally been weak in recent months with copper, for example, falling by 10% since mid-April. It will require a sustained rebound in Chinese infrastructure spending to push prices back up (Chart 17). Oil continues to be driven by supply-side factors, not demand. With OPEC discipline holding, Iran sanctions about to be reimposed, political turmoil in Libya and Venezuela, BCA’s energy strategists continue to see inventories drawing down this year, and therefore forecast Brent crude to reach $80 during 2019 (Chart 18). Chart 18Oil Supply Remains Tight Garry Evans Chief Global Asset Allocation Strategist garry@bcaresearch.com Footnotes 1       Please see Global Investment Strategy, Special Report, “Stay Cyclically Overweight Global Equities, But Hedge Near-Term Downside Risks From An Escalation Of A Trade War,” dated May 10, 2019, available at gis.bcaresearch.com 2      Please see, for example, Mary Amiti, Sebastian Heise, and Noah Kwicklis, “The Impact of Import Tariffs on U.S. Domestic Prices,” Federal Reserve Bank of New York Liberty Street Economics, dated 4 January 2019. Recommended Asset Allocation  

Highlights Monetary policy remains accommodative in Japan, but will tighten on a relative basis if the Bank Of Japan (BoJ) stands pat. The BoJ’s margin of error is non-trivial, since a small external shock could well tip the economy back into deflation. Historically, the BoJ has needed an external shock to act, suggesting the path towards additional stimulus could be lined with a stronger yen. Our bias is that USD/JPY could weaken to 104 in the next three to six months, especially if market volatility spikes further. We are carefully monitoring any shift in the yen’s behavior, in particular its role as a counter-cyclical currency. If global growth eventually picks up, the yen will surely weaken on its crosses, but could still strengthen versus the dollar. Feature The powerful bounce in global markets since the December lows is sitting at a critical juncture. With the S&P 500 at its 200-day moving average, crude oil and Treasury yields plunging and the dollar taking a bid, it may only require a small shift in market prices to change sentiment sharply. The yen has strengthened in sympathy with these moves, but the balance of evidence suggests the possibility of a much bigger adjustment. Should the selloff in global risk assets persist, the yen will strengthen further. On the other hand, if global growth does eventually pick up, the yen could weaken on its crosses but strengthen vis-à-vis the dollar. This places short USD/JPY bets in an enviable “heads I win, tails I do not lose too much” position. BoJ: Out Of Policy Bullets For most of the 1990s, Japan was in a deflationary bust. In hindsight, the reason was simple: The structural growth rate of the economy was well below interest rates, which meant paying down debt was preferable to investing. Tight money also led to a structurally strong currency, reinforcing the negative feedback loop (Chart I-1). Chart I-1The Story Of Japan In One Chart Much farther down the road, the three arrows of ‘Abenomics’ arrived, ushering in a paradigm shift. Since 2012, Japan has enjoyed one of its longest economic expansions in recent history, having fine-tuned monetary policy each time private sector GDP growth has fallen close to interest rates. The result has been remarkable. The unemployment rate is close to a 26-year low, and the Nikkei index has tripled. But if the economy once again flirts with deflation, additional monetary policy options may be hard to come by, since there have been diminishing economic returns to additional stimulus. Chart I-2Stealth Tapering By ##br##The BoJ Chart I-32 Percent Inflation Equal Mission Impossible? The end of the Heisei era1 has brought forward the urgency of the above quandary. At its latest monetary policy meeting, the BoJ strengthened forward guidance, expanded collateral requirements for the provision of credit, and stated that it will continue to “conduct purchases of JGBs in a flexible manner so that their amount outstanding will increase at an annual pace of about 80 trillion yen.”2 But with the BoJ owning 46% of outstanding JGBs, about 75% of ETFs, and almost 5% of JREITs, this will be a tall order. The supply side obviously puts a serious limitation on how much more stimulus the central bank can provide. In recent years, the yen has become extremely sensitive to shifts in the relative balance sheets of the Federal Reserve and the BoJ. Total annual asset purchases by the BoJ are currently running at about ¥27 trillion, while JGBs purchases are running at ¥20 trillion. This is a far cry from the central bank’s soft target of ¥80 trillion, and is unlikely to change anytime soon. In recent years, the yen has become extremely sensitive to shifts in the relative balance sheets of the Federal Reserve and the BoJ. If the BoJ continues to purchase securities at its current pace, then the rate of expansion in its balance sheet will severely slow, and could trigger a knee-jerk rally in the yen (Chart I-2). The BoJ targets an inflation rate of 2%, but it is an open question as to whether it can actually achieve this. It pays attention to three main variables when looking at inflation: Core CPI, the GDP deflator, and the output gap. All indicators are pointing in the right direction, but the recent slowdown in the global economy could reverse this trend. It is always important to remember that the overarching theme for prices in Japan is a falling (and aging) population leading to deficient demand (Chart I-3). More importantly, almost 40% of the Japanese consumption basket is in tradeable goods, meaning domestic inflation is as much driven by the influence of the BoJ as it is by globalization. Even for prices within the BoJ’s control, an aging demographic that has a strong preference for falling prices is a powerful conflicting force. For example, over the years the government has been a thorn in the side of telecom companies, pushing them to keep cutting prices, given domestic pressures from its voting base. Transportation and telecommunications make up 17% of the core consumption basket in Japan, a non-negligible weight. This is and will remain a powerful drag on CPI (Chart I-4), making it difficult for the BoJ to re-anchor inflation expectations upward. On the other side of the coin, the importance of financial stability to the credit intermediation process has been a recurring theme among Japanese policymakers, with the health of the banking sector an important pillar. YCC and negative interest rates have been anathemas for Japanese net interest margins and share prices (Chart I-5). This, together with QE, has pushed banks to search for yield down the credit spectrum. Any policy shift that is increasingly negative for banks could easily tip them over. Chart I-4The Japanese Prefer Falling Prices Chart I-5Negative Rates Are Anathema To Banks Bottom Line: Inflation expectations are falling to rock-bottom levels in Japan, at a time when the BoJ may be running out of policy bullets. Meanwhile, the margin of error for the BoJ is non-trivial, since a small external shock could tip the economy back into deflation. The BoJ will eventually act, but it might first require a riot point. Go short USD/JPY. High Hurdle For Delaying Consumption Tax Since the late 1990s, every time Japan’s consumption tax has been hiked, the economy has slumped by an average of over 1.3% in subsequent quarters. For an economy with a potential growth rate of just 0.5-1%, this is a disastrous outcome. More importantly, similar to past episodes, the consumption tax is being hiked at a time when the economy is at the precipice of a major slowdown. Foreign and domestic machinery orders are slowing, employment growth has halved from 2% to 1%, and wages are inflecting lower (Chart I-6). This is especially worrisome since the labor market has been the poster child of the Japanese recovery.3 The consumption tax is being hiked at a time when the economy is at the precipice of a major slowdown. Why go ahead with the consumption tax then? The answer lies in the concept of Ricardian equivalence.4 Despite relatively robust economic conditions since the Fukushima disaster, Japanese consumption has remained tepid. By the same token, the savings ratio for workers has surged (Chart I-7). If consumers are caught in a Ricardian equivalence negative feedback loop, exiting deflation becomes a pipe dream. Chart I-6A Bad Omen Increased social security spending: This will be particularly geared towards child education. For example, preschool and tertiary education will be made free of charge. Promoting cashless transactions: Transactions made via cashless payments (for example, via mobile pay) will not be subject to the 2% tax increase for nine months. Cashless payments in Japan account for less than 25% of overall transactions – among the lowest of developed economies. This incentive should help lift the velocity of money. Chart I-7Strong Labor Market, Weak Consumption Construction spending: This will offset the natural disasters that afflicted Japan last year. Construction orders in Japan accelerated at a 66% pace in March. The Abe government’s strategy has so far been to offset the consumption tax hike with increased domestic spending. The thinking is that once in a liquidity trap, the fiscal multiplier tends to be much larger. Some of these outlays include: Chart I-8Japan Needs More Fiscal Stimulus The new immigration law will also help. Foreign workers were responsible for 30% of all new jobs filled in Japan in 2017. Assuming public aversion towards immigration remains benign, as is the case now (these are mostly lower-paying jobs in sectors with severe labor shortages), the government’s target to attract 350,000+ new workers by 2025 will be beneficial for consumption. To be sure, this may not be enough. The IMF still projects the fiscal drag in Japan to be 0.1% of GDP in 2019 and 0.6% in 2020 (Chart I-8). This puts the onus back on the BoJ to ease financial conditions. A combination of easier fiscal and monetary policy will be a headwind for the yen. This could happen if the U.S./China trade war escalates, and twists the arm of the finance ministry. But the hurdle is high for the government to roll back the consumption tax, given significant spending offsets. The Yen As A Safe Haven Correlations do shift from time to time, but one longstanding rule of thumb still holds for yen investors: Buy the currency on any market turbulence (Chart I-9). This is because with a net international investment position of almost 60% of GDP and net income receipts of almost 4% of GDP, volatility in markets tend to lead to powerful repatriation flows back to Japan. Real interest rates also tend to be higher in Japan in recessions as already-low inflation expectations fall further. Correlations do shift from time to time, but one longstanding rule of thumb still holds for yen investors: Buy the currency on any market turbulence. Some have suggested that the BoJ’s asset purchases are pushing investors out of Japan and weakening the safe-haven status of the yen. While plausible, our view is that other factors have been at play. First, tax changes led to repatriation of capital back to the U.S. in 2018. This unduly pressured foreign direct investment in Japan as well as other safe-haven countries like Switzerland. Second, Japan, by virtue of its current account surplus, runs a capital account deficit. This means that portfolio outflows are the norm. This is how it has managed to build the biggest net international investment position in the world. Only in times of severe flight to safety are those investments liquidated and brought home. More importantly, the time may now be very ripe for yen long positions, given rising suspicion towards the currency as a haven. To see why, one only has to return to late 2016. Back then, global growth was soft, the yen was very cheap and everyone was short the currency on the back of a dovish shift by the BoJ. Despite that backdrop, the yen strengthened by almost 10% from December 2016 to mid-2017, even as equity markets remained resilient. When the equity market drawdown finally arrived in early 2018, it carried the final legs of the yen rally. With U.S. interest rates having risen significantly versus almost all G10 countries in recent years, including Japan’s, the dollar has become a carry currency. It will be difficult for the dollar to act as both a safe-haven and carry currency, because the forces that drive both move in opposite directions. As markets become volatile and these trades get unwound, this will be a powerful undercurrent for the yen (Chart I-10). Chart I-9The Yen Remains A Safe Haven Chart I-10The Yen Has Financed Carry Trades Bottom Line: Every diversified currency portfolio should hold the yen as insurance against rising market volatility. What If Global Growth Picks Up? The eventual bottom in global growth is a key risk to our scenario. However, inflows into Japan could accelerate, given cheap equity valuations and improved corporate governance that has been raising the relative return on capital (Chart I-11). The propensity of investors to hedge these purchases will dictate the yen’s path. The traditional negative relationship between the yen and the Nikkei still holds, but it will be important to monitor if this correlation shifts during the next equity market rally. Over the past few years, an offshoring of industrial production has been marginally eroding the benefit of a weak yen/strong Nikkei. If a company’s labor costs are no longer incurred in yen, then the translation effect for profits is reduced on currency weakness. USD/JPY and the DXY tend to have a positive correlation because the dollar drives the yen most of the time. Our contention is that the yen will surely weaken at the crosses, but could strengthen versus the dollar. USD/JPY and the DXY tend to have a positive correlation because the dollar drives the yen most of the time. Meanwhile, large net short positioning in the yen versus the dollar makes it attractive from a contrarian standpoint (Chart I-12). Chart I-11Japan: Better Governance, Higher ROIC Chart I-12Short USD/JPY: A Contrarian Bet Bottom Line: Short USD/JPY trades have entered into an envious “heads I win, tails I do not lose too much” position. Should the selloff in global risk assets persist, the yen will strengthen further. On the other hand, if global growth does eventually pick up later this year, the yen could weaken on its crosses but may actually strengthen versus the dollar. Housekeeping We are closing our short EUR/CZK position with a 4.7% profit. Interest rate differentials between the Czech Republic and the euro area have widened significantly, at a time when growth and labor market tightness could be fraying at the edges. Meanwhile, possible weakness in the dollar will be a risk to this position.   Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 The Heisei era refers to the period corresponding to the reign of Japanese Emperor Akihito from 1989 until 2019. 2 Please see “Minutes of the Monetary Policy Meeting,” Bank of Japan, dated May 8, 2019, p.27. 3 Sample changes last year make it more difficult to have an apples-to-apples comparison for wages. 4 Ricardian equivalence suggests in simple terms that public sector dissaving will encourage private sector savings. Currencies U.S. Dollar USD Technicals 1 USD Technicals 2 Recent data in the U.S. have been negative: Total durable goods orders decreased by 2.1% in April. On the housing front, FHFA house price growth fell to 0.1% month-on-month in March. MBA Mortgage applications fell by 3.3% in May. Conference Board consumer confidence index improved to 134.1 in May. Dallas Fed Manufacturing activity index fell to -5.3 in May. Annualized GDP came in at 3.1% quarter-on-quarter in Q1, revised from the previous 3.2% but higher than the consensus of 3%. Q1 headline and core PCE both fell to 0.4% and 1% quarter-on-quarter respectively. DXY index increased by 0.6% this week. In the long-term, we maintain a pro-cyclical stance, and continue to believe that the path of least resistance for the dollar in down. In the short-term however, there is more room for the trade-weighted dollar to rise before eventually reversing, amid global data weakness and political uncertainties. Report Links: President Trump And The Dollar - May 9, 2019 Take Out Some Insurance - May 3, 2019 Currency Complacency Amid A Global Dovish Shift - April 26, 2019 The Euro EUR Technicals 1 EUR Technicals 2 Recent data in the euro area have shown improvement: Private loans increased by 3.4% year-on-year in April. Money supply (M3) increased by 4.7% year-on-year in April. Business climate indicator fell to 0.3 in May. Despite the weak business climate indicator, soft data in the euro area have generally improved in May: economic confidence rose to 104; industrial confidence increased to -2.9; services confidence climbed to 12.2. Lastly, the consumer confidence increased to -6.5. EUR/USD fell by 0.7% this week. During this weekend’s European Parliament election, the European People’s Party (EPP) won with 24% of the seats. However, 43 seats were lost compared with their last election result. The S&D party also lost 34 seats, together ending the 40-year majority of the center-right and center-left coalitions. Report Links: Take Out Some Insurance - May 3, 2019 Reading The Tea Leaves From China - April 12, 2019 Into A Transition Phase - March 8, 2019 The Yen JPY Technicals 1 JPY Technicals 2 Recent data in Japan have been negative: All industry activity index fell by 0.4% month-on-month in March. The leading index and coincident index both fell to 95.9 and 99.4 respectively in March. PPI services fell to 0.9% year-on-year in April, below the expected 1.1%. Labor market  and CPI data will be released after we go to press today. USD/JPY rose by 0.3% this week. BoJ Governor Haruhiko Kuroda has given two speeches this week, warning about the high degree of uncertainty, and potential downside risks worldwide. On the positive side, Kuroda thinks that EM capital outflows are less at risk than during recent financial crises, given a better framework for risk management. In the meantime, uncertainties remain regarding the U.S.-Japan trade disputes, especially vis-à-vis Japanese auto exports. Report Links: Beware Of Diminishing Marginal Returns - April 19, 2019 Tug OF War, With Gold As Umpire - March 29, 2019 A Trader’s Guide To The Yen - March 15, 2019 British Pound GBP Technicals 1 GBP Technicals 2 Recent data in the U.K. continue to outperform: Total retail sales increased by 5.2% year-on-year in April, surprising to the upside. BBA mortgage a pprovals increased to 43 thousand in April. GBP/USD fell by 0.8% this week. The uncertainties of Brexit increased with the resignation of Prime Minister Theresa May last Friday. With a Brexit decision not due until October 31, 2019, the U.K. has participated in the recent EU election. The newly formed Brexit Party led by Nigel Farage, won with more than 31% of the votes. This reflects a growing dissatisfaction with traditional parties within U.K. Report Links: A Contrarian View On The Australian Dollar - May 24, 2019 Take Out Some Insurance - May 3, 2019 Not Out Of The Woods Yet - April 5, 2019 Australian Dollar AUD Technicals 1 AUD Technicals 2 Recent data in Australia have been mostly negative: ANZ Roy Morgan weekly consumer confidence index increased to 118.6 this week. HIA new home sales fell by 11.8% month-on-month in April. Moreover, building permits decreased by 24.2% year-on-year. Private capital expenditure in Q1 fell by 1.7% quarter-on-quarter. Building approvals fell by 4.7% month-on-month in April. AUD/USD fell by 0.2% this week. As we argued in last week’s report, we favor the Aussie dollar from a contrarian point of view. Despite the negative data points on the surface, the recent election result and dovish shift by RBA all support the Australian economy in the long-term. Moreover, the robust job market, rising terms of trade, and Chinese stimulus will likely put a floor under AUD/USD. Report Links: A Contrarian View On The Australian Dollar - May 24, 2019 Beware Of Diminishing Marginal Returns- April 19, 2019 Not Out Of The Woods Yet - April 5, 2019 New Zealand Dollar NZD Technicals 1 NZD Technicals 2 Recent data in New Zealand have been mixed: ANZ activity outlook increased by 8.5% in May, well above consensus. Building permits fell by 7.9% month-on-month in April. ANZ business confidence remained low at -32 in May. NZD/USD fell by 0.6% this week. The Financial Stability Report, released by RBNZ this week, highlighted the worrisome debt levels, particularly in the household and dairy sectors. Ongoing efforts are necessary to bolster system soundness and efficiency, according to RBNZ governor Adrian Orr. Report Links: Not Out Of The Woods Yet - April 5, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Canadian Dollar CAD Technicals 1 CAD Technicals 2 Recent data in Canada have been positive: Bloomberg Nanos confidence index improved to 55.7, from the previous 55.1. Current account deficit increased to C$17.35 billion from C$16.62 billion, but it is lower than the expected C$ 18 billion. USD/CAD increased by 0.4% this week. On Wednesday, the Bank of Canada (BoC) held interest rates steady at 1.75%, as widely expected. Despite the recent trade uncertainties, the BoC views the slowdown in late 2018 and early 2019 as temporary, and expects growth to pick up again in the second quarter this year, supported by recovering oil prices, stabilizing housing sector, robust job market and easy financial conditions. Report Links: Currency Complacency Amid A Global Dovish Shift - April 26, 2019 A Shifting Landscape For Petrocurrencies - March 22, 2019 Into A Transition Phase - March 8, 2019 Swiss Franc CHF Technicals 1 CHF Technicals 2 Recent data in Switzerland have been mixed: Q1 GDP came in higher-than-expected at 1.7% year-on-year, from the previous reading of 1.5%. Trade surplus reduced to 2.3 million CHF in April, mostly due to the decrease in exports. KOF leading indicator fell to 94.4 in May. ZEW expectations fell in May to -14.3. USD/CHF appreciated by 0.7% this week. We favor the Swiss franc as a safe haven when market volatility rises. In the longer term, the high domestic savings rate, rising productivity, and current account surplus should all underpin the franc. Report Links: What To Do About The Swiss Franc? - May 17, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Balance Of Payments Across The G10 - February 15, 2019 Norwegian Krone NOK Technicals 1 NOK Technicals 2 There is little data from Norway this week: Retail sales increased by 1.6% year-on-year in April. Credit expanded by 5.7% year-on-year in April USD/NOK increased by 0.9% this week. Our Commodity & Energy Strategy team believe that the energy market is underpricing the U.S. - Iran war risk, and overestimating the short-term effects of the trade war. In the long run, the Chinese stimulus, dollar weakness, and supply uncertainties should lift oil prices, which will support the Norwegian krone. Report Links: Currency Complacency Amid A Global Dovish Shift - April 26, 2019 A Shifting Landscape For Petrocurrencies - March 22, 2019 Balance Of Payments Across The G10 - February 15, 2019 Swedish Krona SEK Technicals 1 SEK Technicals 2 Recent data in Sweden have been mostly negative: Producer price inflation fell to 4.9% year-on-year in April from 6.3% in March. Consumer confidence fell to 91 in May. Moreover, manufacturing confidence fell to 103.7 in May. Trade surplus fell from 6.4 billion to 1.4 billion SEK in April. Q1 GDP came in at 2.1% year-on-year, outperforming expectations but lower than the previous 2.4%. USD/SEK has been flat this week. Swedish exports, a reliable barometer for global business confidence, fell from 133.4 billion SEK to 128 billion SEK in April, which is a total decrease of 5.4 billion SEK in exports, implying that the global growth remains in a volatile bottoming process. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Global Liquidity Trends Support The Dollar, But... - January 25, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Global equities face near-term downside risks from the trade war, but should be higher in 12 months’ time. Its claims to novelty notwithstanding, Modern Monetary Theory is basically indistinguishable from standard Keynesian economics except that MMT assumes that changes in interest rates have no discernible effect on aggregate demand. This straightforward but unrealistic assumption allows MMT’s proponents to argue that the neutral rate of interest does not exist, that crowding out is impossible, and that while fiscal deficits do matter (because too much government spending can stoke inflation), debt levels do not. Despite its many shortcomings, MMT’s focus on financial balances and the role of sovereign-issued money is laudable. A better understanding of these concepts would have made investors a lot of money during the past decade. Today, most economies are still running large private-sector financial surpluses. This surplus of desired savings relative to investment has kept interest rates low, which have allowed governments to finance their budgets at favorable terms. As these surpluses decline, inflation will rise. Feature Greetings From Down Under I have been meeting clients in Australia and New Zealand this week. The mood has been generally negative on the outlook for both the domestic and global economies. As one might imagine, the brewing China-U.S. trade war has been a hot topic of discussion. We went tactically short the S&P 500 on May 10th, a move that for the time being effectively neutralizes our structurally overweight stance on global equities. As we indicated when we initiated the hedge, we will take profits on the position if the S&P 500 drops below 2711. Despite the darkening clouds hanging over the trade war, we still expect a detente to be reached that prevents a further escalation of the conflict. Both sides would suffer from an extended trade war. For China, it is no longer just about losing access to the vast U.S. market. It is also about losing access to vital technology. The blacklisting of Huawei deprives China of critical components needed to realize its dream of becoming a world leader in AI and robotics. The trade war will not harm the U.S. as much as it will China, but it has still raised prices for American consumers, while lowering the prices of key agricultural exports such as soybeans. It has also hurt the stock market, which Trump seems to view as a barometer for his own success as president. If a trade detente is eventually reached, market attention will shift back to the outlook for global growth. We expect the combination of aggressive Chinese fiscal/credit stimulus and the palliative effects of falling global bond yields over the past seven months to lift growth in the back half of the year. As a countercyclical currency, the U.S. dollar is likely to weaken when global growth starts to strengthen. This will provide an opportune time to go overweight EM and European equities as well as the more cyclical sectors of the stock market. Are You Now Or Have You Ever Been A Member Of The MMT Movement? Last week’s report1 argued that a global deflationary ice age is unlikely to transpire because politicians will pursue large-scale fiscal stimulus to preclude this outcome. We noted that many countries are easing fiscal policy at the margin, partly in response to populist pressures. Even in Japan, the likelihood that the government will raise the sales tax this year has diminished, while structural forces will continue to drain savings for years to come. This will set the stage for higher inflation in Japan, something the market is not at all anticipating. Somewhat controversially, we contended that larger budget deficits are unlikely to imperil debt sustainability, at least for countries that are able to issue debt in their own currencies. This implies that any government with its own printing press should simply ease fiscal policy until long-term inflation expectations reach their target level. MMT can best be thought of as a special case of Keynesian economic theory where monetary policy is not just relegated to the back burner, but banished from the kitchen altogether. A number of readers pointed out that our analysis sounded suspiciously supportive of Modern Monetary Theory (MMT). Are we really closet MMT devotees? No, we are not. Our approach shares some commonalities with MMT (so if you want to call me a “MMT sympathizer,” go ahead). However, it also differs from MMT in a number of important respects. As we discuss below, these differences have significant implications for market outcomes, particularly one’s views about the long-term direction of government bond yields. MMT: A “Special Case” Of Keynesian Economics Modern Monetary Theory is not nearly as novel as its backers claim. In fact, MMT can best be thought of as a special case of Keynesian economic theory where monetary policy is not just relegated to the back burner, but banished from the kitchen altogether. Outside of liquidity trap conditions, most economists believe that monetary policy is an effective aggregate demand management tool. MMT’s supporters reject this. In their view, changes in interest rates have no impact on spending. In the technical parlance of economics, MMT is basically the Hicksian IS/LM model but with a vertical IS curve and an LM curve that intersects the IS curve at an interest rate of zero (Chart 1). This seemingly small variation on the traditional Keynesian framework has far-reaching consequences. For one thing, it renders meaningless the entire concept of the neutral rate of interest. If changes in interest rates have no effect on aggregate demand, then one cannot identify an equilibrium level of interest rates that is consistent with full employment and stable inflation. Given their leftist roots, it is not surprising that most MMTers favor keeping rates low, preferably near zero. Higher rates shift income from borrowers to lenders. The latter tend to be richer than the former. Why reward fat cats when you don’t have to? Low rates also allow the government to spend more without putting the debt-to-GDP ratio on an unsustainable trajectory. If the interest rate at which the government borrows stays below the growth rate of the economy, the government can run a stable Ponzi scheme, perpetually issuing new debt to pay the interest on existing debt (Chart 2). In such a world, budget deficits only matter to the extent that too much fiscal stimulus can stoke inflation. The level of debt, in contrast, never matters. Interest Rates Do Affect Aggregate Demand Chart 3Mortgage Rate Swings Matter For The Housing Market Despite MMT’s efforts to deny any role for monetary policy in stabilizing the economy, the empirical evidence clearly shows that changes in interest rates do affect consumption and investment decisions. Housing activity, in particular, is very sensitive to movements in mortgage rates. The recent drop in mortgage rates bodes well for U.S. housing activity during the remainder of the year (Chart 3). The dollar, like most currencies, is also influenced by shifts in interest rate differentials (Chart 4). Changes in the dollar affect net exports, and hence overall employment. Once we acknowledge that interest rates affect aggregate demand, we are back in a world of trade-offs between monetary and fiscal policy. One can have easy monetary policy and tight fiscal policy, or tight monetary policy and easy fiscal policy. But outside of liquidity trap conditions, one cannot have both easy monetary and fiscal policies for a prolonged period of time without tolerating higher and rising inflation.   Chart 4Historically, The Dollar Has Moved In Line With Interest Rate Differentials The Perils Of Accounting Identities MMT proponents love accounting identities. They are particularly fond of saying that government deficits endow the private sector with additional wealth in the form of government bonds or cash. Unfortunately, the penchant to “argue by accounting identity” is almost always a recipe for disaster since such arguments usually fail to identify the causal forces by which one thing affects the other. For example, no competent economist would deny that an increase in the fiscal deficit must tautologically imply an increase in the private sector’s financial balance (the difference between the private sector’s income and spending). What MMT adherents fail to appreciate is that private-sector savings can increase either if incomes rise or spending falls. Ironically, what often gets overlooked is that the predictions made by standard Keynesian economic theory over the past decade have proven to be broadly accurate. When an economy is depressed, fiscal stimulus is likely to increase employment. In such a setting, rising payrolls will boost incomes, leading to a larger private-sector surplus. In contrast, when the economy is operating at full employment, any increase in the private-sector surplus must come about through a decline in private-sector spending. That is to say, if the government consumes more of the economy’s output, the private sector has to consume less.  There is a huge difference between the two cases. MMTers tend to gloss over this distinction because they do not really have a theory for why the private-sector financial balance moves around in the first place. To them, private-sector spending is completely exogenous. It is determined by such things as animal spirits that the government has no control over. The government’s only job is to adjust the fiscal balance to ensure that it is the mirror image of the private-sector’s balance. Budget deficits cannot crowd out private-sector spending in this context because the government plays no role in determining how much the private sector wishes to spend. Investment Conclusions Economics gets a bad rap these days. Although most people would not go as far as Nassim Taleb who once mused about running over economists in his Lexus, it is fair to say that there is a lot of disillusionment towards the economics profession. Ostensibly heterodox theories like MMT help fill an intellectual void for those hoping to rewrite the economics textbooks for the 21st century. Ironically, what often gets overlooked is that the predictions made by standard Keynesian economic theory over the past decade have proven to be broadly accurate. Shortly after the financial crisis, when the world was still mired in a deep slump, Keynesian economics predicted that large budget deficits would not push up interest rates and that QE would not lead to runaway inflation. In contrast, Taleb said in early February 2010, when the 10-year Treasury yield was trading at around 3.6%, that Ben Bernanke was “immoral” and that “Every single human being should short Treasury bonds. It’s a no-brainer.” The study of financial balances is not unique to MMT, nor is MMT’s approach to thinking about financial balances the best one. Even so, a basic understanding of the concept would have prevented Taleb and countless others from making the mistakes they did. The fact that MMT has brought the discussion of financial balances, along with related concepts such as the role of sovereign-issued money in an economy, back into the spotlight is its greatest virtue. Today, most economies are still running large private-sector financial surpluses (Chart 5). Given that interest rates are so low, it is difficult to argue that budget deficits are crowding out private spending. This may change over time, however. Falling unemployment is boosting consumer confidence, which will bolster spending. U.S. wage growth has already accelerated sharply among workers at the bottom end of the income distribution (Chart 6). These are the workers with the highest marginal propensity to consume. Chart 5AMost Major Countries Run Private-Sector Surpluses (I) Chart 5BMost Major Countries Run Private-Sector Surpluses (II) Meanwhile, baby boomers are leaving the labor force. More retirees means less production, but not necessarily less consumption. Once health care spending is added to the tally, consumption actually increases in old age (Chart 7). If production falls in relation to consumption, excess savings will decline and the neutral rate of interest will rise. Chart 7Savings Over The Life Cycle When this happens, will governments tighten fiscal policy, as the MMT prescription requires? In a world where entitlement programs are politically sacrosanct, that seems unlikely. The end result is that economies will overheat and inflation will rise. Will central banks tighten monetary policy in response to higher inflation? That depends on what one means by tighten. Central banks will undoubtedly raise rates, but in a world of high debt levels, they will be loath to push interest rates above the growth rate of the economy. Interest rates will rise in nominal terms, but probably very little or not at all in real terms. In such an environment, investors should maintain below-benchmark duration exposure in their fixed-income portfolios, while favouring inflation-linked bonds over nominal bonds. Owning traditional inflation hedges such as gold would also make sense.    Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Footnotes 1          Please see Global Investment Strategy Weekly Report, “Ice Age Cometh?” dated May 24, 2019.   Strategy & Market Trends MacroQuant Model And Current Subjective Scores Tactical Trades Strategic Recommendations Closed Trades