Inflation/Deflation

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Highlights Mega-theme 1: A hypersensitivity to higher interest rates. Overweight equities versus bonds until 10-year bond yields rise 75 bps. At which point, switch into bonds. Mega-theme 2: Europe conquers its disintegration forces. Overweight European currencies, and underweight core European bonds within a fixed income portfolio. Mega-theme 3: Non-China exposed investments outperform structurally. Overweight non-China plays, underweight materials and resources, and underweight commodity currencies. Mega-theme 4: The rise of blockchain and alternative energy. Overweight alternative energy, underweight oil and gas, and underweight financials. Feature Feature ChartUnderweight Materials And Resources In The 2020s “Study the past if you would divine the future” – Confucius To paraphrase Confucius, we must study the mega-themes of the 2010s if we are to identify the mega-themes of the 2020s. From an economic, financial, and political perspective, the mega-themes of the past decade were: ‘universal QE’; Europe’s threatened disintegration; China becoming the world’s ‘stimulator of last resort’; and the decentralization of information, which threatened the established hierarchies in politics and society. These mega-themes of the 2010s point the way to four mega-themes for the 2020s: A hypersensitivity to higher interest rates. Europe conquers its disintegration forces. Non-China exposed investments outperform structurally. The rise of blockchain and alternative energy. Mega-Theme 1: A Hypersensitivity To Higher Interest Rates The 2010s was the decade of ‘universal QE’. One after another, the world’s major central banks bought trillions of dollars of government bonds (Chart I-2). Yet for all its apparent mystique, QE is nothing more than a signalling mechanism – signalling that central banks intend to keep policy interest rates depressed for a long time. Thereby, QE depresses long-term bond yields – which themselves are nothing more than the expected path of policy interest rates. Chart I-2The 2010s Was The Decade Of 'Universal QE' Something else happens. Close to the lower bound of interest rates, bonds become riskier investments. As holders of Swiss bonds discovered in 2019, low-yielding bonds become a ‘lose-lose’ proposition: prices can no longer rise much, but they can fall a lot. The upshot is that all long-duration assets become risky, and the much higher return required on formerly riskier assets – such as equities – collapses to the feeble return offered on equally-risky bonds. 'Universal QE' has boosted the valuation of all risky assets. Ten years ago, when the global 10-year bond yielded 3.5 percent, equities offered a prospective 10-year return of 9 percent (per annum). Today, when the bond is yielding around 1.5 percent, equities are offering a paltry 3 percent (Chart I-3 and Chart I-4). Meaning that while the present value of the 10-year bond is up around 20 percent, the present value of equities has surged by 60 percent.1 Chart I-3Equities Are Offering A Paltry 3 Percent Return Chart I-4The Return Offered By Equities Has Collapsed To The Feeble Return Offered By Bonds This exponential dynamic has applied to all risky assets in the 2010s. Most notably, real estate prices have sky-rocketed: Shenzhen 325 percent; Beijing 285 percent; Berlin 125 percent; Bangkok 120 percent; San Francisco 90 percent; Los Angeles 85 percent; Sydney 75 percent; and so on. From 2010 to 2020, the value of global real estate surged from an estimated $160 trillion to $300 trillion.2 The market value of equities also doubled from $35 trillion to $70 trillion.3 But global GDP grew by less than a third from $66 trillion to $85 trillion.3 The upshot is that in 2010 the value of real estate plus equities stood at 2.9 times GDP, whereas in 2020 it stands at 4.5 times GDP. Now add in the aforementioned exponentiality of risk-asset valuations at low bond yields. In 2010, a 1 percent rise in yields required a 10 percent decline in present values, whereas in 2020 it might require a 30 percent decline. In 2010, this meant a decline equivalent to 29 percent of global GDP, but in 2020 it means a decline equivalent to a staggering 135 percent of global GDP.4 So mega-theme 1 for the early 2020s is that any monetary policy tightening – in response to, say, wage inflation fears – will unleash a massive deflationary impulse into the economy from falling stock and real estate prices. This deflationary sledgehammer will annihilate the inflationary peanut, and almost certainly trigger the next major recession. But the good news is that it is unlikely to be a 2020 story, as all the major central banks are in ‘wait-and-see’ mode. Structural recommendation: Overweight equities versus bonds until 10-year bond yields rise 75 bps. At which point, switch into bonds. Mega-Theme 2: Europe Conquers Its Disintegration Forces In sub-atomic physics, a nucleus disintegrates when the electrostatic forces pulling it apart becomes stronger than the nuclear forces holding it together. Using the nucleus as a metaphor for Europe, two of the forces pulling it apart have weakened, while one of the forces holding it together has strengthened. We now know that Europe’s biggest rebel – the UK – is leaving the European Union in 2020. In the sub-atomic metaphor, the UK has become a free radical which will try and attach itself to the largest attractive body it can find. But in losing its most wayward member the European nucleus has, by definition, become more cohesive. A second destructive force has been the economic divergences between the ‘core’ and ‘periphery’ European member states. But over the past decade, these divergences have narrowed substantially. Relative to Germany, unit labour costs have declined by 25 percent in Spain, and 15 percent in Italy. More convergence is needed, but the economic forces pulling the European nucleus apart are much weaker in 2020 than they were in 2010 (Chart I-5). Chart I-5The Economic Divergence Between Europe's Core And Periphery Has Narrowed Meanwhile, a force holding the European nucleus together has strengthened. In 2010, the Target2 banking imbalance stood at €0.3 trillion; in 2020, it stands close to €1.5 trillion. In simple terms, this means Germany’s exposure to ‘Italian euro’ assets has surged via the ECB’s massive purchases of Italian BTPs. At the same time, Italian investors have parked their cash in German banks, meaning they are owed ‘German euros’ (Chart I-6). Chart I-6Europe’s Target2 Banking Imbalance Stands Close To €1.5 Trillion With such a massive Target2 imbalance, the biggest casualty of the euro’s disintegration would be Germany, whose 2008 recession would look like a stroll in the park. Giving Germany a huge incentive to become more conciliatory to its partners, for example on the use of fiscal stimulus. The best way to play mega-theme 2 is through the currency and bond markets. European equity markets are plays on their dominant sectors, and as we are about to see, many of the sectors over-weighted in Europe face structural headwinds. Structural recommendation: Overweight European currencies, and underweight core European bonds within a fixed income portfolio. Mega-Theme 3: Non-China Exposed Investments Outperform Structurally The 2010s was the decade when China became the global ‘stimulator of last resort’. Prior to the 2010s, the credit impulse in China was inconsequential compared to the credit impulses in the US and Europe. But in the 2010s the tables turned. The credit impulses in the US and Europe became inconsequential, as the amplitude of China’s waves of stimulus swamped all others (Chart I-7). Chart I-7In The 2010s, China Became The Global 'Stimulator Of Last Resort' China became the global stimulator of last resort because in 2010 its indebtedness was significantly less than in other major economies. But today, China’s indebtedness has overtaken the others, and is levelling off at a point that has proved to be a reliable upper bound (Chart I-8). Chart I-8China's Indebtedness Is Reaching Its Upper Bound An upper bound to indebtedness exists because further debt creates mal-investments whose returns are lower than the cost of the debt. And as indebtedness approaches the upper bound, each wave of stimulus loses potency compared to the preceding wave. For example, in 2011 China’s nominal GDP growth accelerated to 20 percent, but in 2017 it accelerated to 10 percent. In the financial markets, China’s waves of stimulus enabled short bursts of countertrend outperformance within the structural bear market in materials and resources – sectors which feature large in European markets. However, as Chinese stimulus loses its potency in the 2020, the structural bear markets in China-exposed investments will re-establish (Chart I-1). Structural recommendation: Overweight non-China plays, underweight materials and resources, and underweight commodity currencies. Mega Theme 4: The Rise Of Blockchain And Alternative Energy Historian Niall Ferguson describes history as a perpetual oscillation between periods dominated by centralized hierarchies and periods dominated by decentralized networks. And quite often, he says, the switch is enabled by a revolutionary new technology. For example, the advent of the printing press in the mid-15th century catalysed the Protestant Reformation and turbocharged the Renaissance by unleashing a decentralization of knowledge, information, and news. Sound familiar? In the early-21st century the internet has similarly decentralized the production and consumption of knowledge, information, and news. And the new networked age has threatened the established hierarchies in politics and society, fuelled populism, and disrupted many sectors in the economy. Yet Ferguson points out that it is futile (as well as Luddite) to resist such shifts from hierarchical structures towards decentralized networks. In the 2020s the decentralization baton will pass from the internet to the blockchain. Just as the internet decentralizes information, the blockchain decentralizes intermediation and trust functions. Hence, the blockchain will be maximally disruptive to any economic sector whose raison d’être is intermediation and trust – most notably finance and law. The blockchain will be maximally disruptive to any economic sector whose raison d’être is intermediation and trust – most notably finance and law.  By the end of the decade, you will no longer need a bank to intermediate your excess savings to a borrower. And you will no longer need a lawyer to oversee a change of ownership. The blockchain will do these for you just as securely and much more cost effectively. One consequence is that the nature of the world’s energy requirements will change. The blockchain is very energy intensive, but unlike the internal combustion engine, the energy does not have to be portable. Hence, there will be a structural shift towards energy in the form of ‘moving electrons’ and away from energy in the form of the ‘chemical bonds’ in fossil fuels. This will be a boon for the alternative energy sector at the expense of oil and gas (Chart I-9). Chart I-9Underweight Oil And Gas In The 2020s We will cover this mega-theme in more detail in a Special Report next year. Structural recommendation: Overweight alternative energy, underweight oil and gas, underweight financials. And with that, it’s time to sign off for this year and for this decade. I do hope that you have found the past decade’s reports insightful, sometimes provocative, but always enjoyable. We promise to continue in the same vein in the 2020s. It just remains for me and the team to wish you a happy new year and a happy new decade! Fractal Trading System* The Conservatives won a surprise landslide victory in the UK election last week, but fractal structures suggest that some of the market euphoria is now overdone. Specifically, the 30 percent rally in UK homebuilders through the last 65 days is vulnerable to a short-term countertrend move. Accordingly, this week’s recommended trade is short UK homebuilders / long UK oil and gas. Set the profit target at 9 percent with a symmetrical stop-loss. Chart I-10UK: Homebuilders Vs. Oil and Gas In other trades, short MSCI AC World versus the global 10-year bond was closed at its 2.5 percent stop-loss, leaving three trades in comfortable profit, one neutral, and one in loss. When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated   December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 In simple terms, if the 10-year yield declines by 2 percent, a 2 percent a year lower return for 10 years requires the present value to rise by 2 percent times 10, which equals 20 percent. In the case of equities, the equivalent calculation is 6 percent times 10, which equals 60 percent. 2 Source: Savills 3 Source: Thomson Reuters 4 2.9 times 10 percent equals 29 percent, 4.5 times 30 percent equals 135 percent. Fractal Trading System   Cyclical Recommendations Structural Recommendations Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity

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This is the final report of the year from BCA’s Global Fixed Income and US Bond Strategies. Our regular publication schedule will resume on January 7, 2020. We wish you a happy, healthy and prosperous new year.   Highlights Interest Rate Policy: The Fed’s next interest rate move will be a hike, but it probably won’t occur until 2021. It will not occur until either long-maturity TIPS breakeven inflation rates reach our target band of 2.3%-2.5% or financial asset valuations reach extreme levels. We provide several indicators to monitor to assess the timing of the next Fed hike. Balance Sheet Policy: The era of balance sheet shrinkage is over. The Fed will continue to grow its balance sheet in 2020, and will also tweak regulations to make banks more indifferent between holding Treasury securities and reserves. Strategic Review: The exact form of any new policy strategy is uncertain, but we expect the Fed to make an announcement in mid-2020 that makes it clear that it will explicitly target above-2% inflation for some unspecified period of time in order to re-anchor inflation expectations and make up for past inflation misses. Feature Last week, both our Global Fixed Income Strategy and US Bond Strategy services published their key fixed income views for 2020.1  Those reports presented investment ideas that we think will be profitable next year, but only discussed Fed policy to the extent that it informs those views. This Special Report delves into exactly what we expect to see from the US Federal Reserve in 2020. Specifically, we consider what the Fed will do with its interest rate and balance sheet policies in 2020, and also what might result from the Fed’s ongoing strategic review. Interest Rate Policy The final FOMC meeting of 2019 took place last week, and we learned that the Fed’s reaction function underwent a significant dovish shift between the September and December meetings. Currently, only 4 FOMC participants expect to lift rates in 2020 while the remaining 13 expect the funds rate to stay in its present range between 1.5% and 1.75% (Chart 1). Back in September, 9 participants thought the fed funds rate would be above 1.75% by the end of 2020. Chart 1Fed Will Stay On Hold In 2020, Market Still Priced For Cuts The yield curve is still discounting a slight decline in the funds rate next year, and the Fed will of course deliver more rate cuts if economic growth deteriorates. However, given our positive global growth outlook for 2020, we think rate cuts are unlikely.2 Rather, we expect a flat fed funds rate next year followed by rate hikes in 2021. The Fed’s reaction function underwent a significant dovish shift between the September and December meetings.  If our economic view pans out, then getting a sense of what will be required for the Fed to lift rates is the most pressing monetary policy issue. On that front, we continue to believe that inflation expectations and financial conditions are the two most important factors to monitor.3  Recent remarks from Fed officials have only strengthened our conviction in that view. Inflation Expectations & The Fed’s Phillips Curve Model Last week, when Chair Powell was asked what it will take to lift rates again, he said that he wants to see “a significant move up in inflation that’s also persistent”. This scripted response reveals a lot about the Fed’s reaction function in 2020, and about the importance of inflation expectations. To see why, let’s consider the Expectations-Augmented Phillips Curve, the typical model that the Fed uses to assess trends in inflation. An example of this sort of model, taken from a 2015 Janet Yellen speech, is presented in Box 1.4 Box 1The Fed's Inflation Model According to the Fed’s model, core inflation is determined by: (i) inflation expectations, (ii) resource utilization and (iii) relative import prices. But inflation expectations are especially important because they determine inflation’s long-run trend. As explained by former Chair Yellen: Chart 2The Importance Of Inflation Expectations … economic slack, changes in imported goods prices, and idiosyncratic shocks all cause core inflation to deviate from its longer-term trend that is ultimately determined by long-run inflation expectations. This is what Chair Powell means when he says he wants to see a “persistent” move up in inflation. He wants to make sure that inflation expectations return to levels that are consistent with the Fed’s target in order to re-anchor inflation’s long-run trend. The widespread consensus that the “Phillips Curve is flat” makes inflation expectations even more important in the minds of Fed policymakers. When people say that the “Phillips Curve is flat”, they mean that there is very little relationship between resource utilization and inflation. In other words, the coefficient b4 in Box 1 is very small. Logically, if the relationship between resource utilization and inflation is weak, then expectations become an even more important driver of core inflation. As Fed Vice Chair Richard Clarida recently said:5 A flatter Phillips Curve makes it all the more important that inflation expectations remain anchored at levels consistent with our 2 percent inflation objective. Simply put, the Fed needs to see a re-anchoring of inflation expectations before it lifts rates. Our sense is that this will be achieved when both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates reach a range between 2.3% and 2.5%. We are not yet close to those levels. The 10-year and 5-year/5-year forward TIPS breakeven rates currently sit at 1.71% and 1.79%, respectively (Chart 2). Meanwhile, household survey measures from the University of Michigan and the New York Fed also show very low inflation expectations (Chart 2, bottom 2 panels). With all this in mind, the big question for monetary policy is how long will it take for inflation expectations to rise back to “well anchored” levels? Will it occur next year, or not until 2021? How Long Until Inflation (And Inflation Expectations) Return To Target? Chart 3High Inflation No Longer A Worry We have long held the view that inflation expectations adapt only slowly to changes in the actual inflation data.6 In other words, inflation expectations are low today because actual inflation has been consistently below the Fed’s target for much of the past decade. This makes it very difficult for people to believe that inflation will be high in the future. In fact, when asked what CPI inflation is likely to average over the next 10 years, most forecasters think it will be in a range between 2% and 2.5%, consistent with the Fed’s target.7 This is similar to what forecasters thought in 2004 when TIPS breakeven rates were well-anchored within our target band (Chart 3). The main difference between 2004 and today is that in 2004 a sizeable minority thought inflation might average above 2.5% over the next 10 years. Now, almost nobody expects a significant overshoot of the Fed’s inflation target, and a sizeable minority think inflation will undershoot. The lesson we take from these survey responses is that in order for TIPS breakeven inflation rates to reach our 2.3%-2.5% target, more people need to expect a significant overshoot of the Fed’s 2% inflation target. This will only happen if actual inflation rises to the Fed’s target, or above, and stays there for a significant period of time. Long enough to bring the fear of high inflation back to the forefront of investors’ minds. To further quantify this notion, our Adaptive Expectations Model of the 10-year TIPS breakeven inflation rate pegs current fair value for the 10-year breakeven at 1.94% (Chart 4). The model’s fair value is primarily determined by the 10-year rate of change in core CPI, meaning that a prolonged period of year-over-year core inflation near (or above) the Fed’s target will be required before our model’s fair value pushes above 2.3%. So how long will it take before core inflation is sustainably running at, or above, the Fed’s target? While we expect core inflation to continue along its slow upward trend. It probably won’t be high enough to push long-maturity TIPS breakevens into our target range until 2021, or late-2020 at the earliest. Chart 4Adaptive Expectations Model Chart 5Trimmed Means Are Rising... At present, core PCE inflation is running at a year-over-year rate of 1.59%, considerably below the Fed’s 2% target. One point in favor of rising core inflation is that trimmed mean price measures are accelerating more quickly than core measures (Chart 5). This will tend to drag core inflation higher over time. However, there is still a long way to go before core inflation reaches the Fed’s target and many leading inflation indicators have moderated this year (Chart 6):   Chart 6...But Many Headwinds Remain Unit labor cost growth rebounded in the past few quarters, but has yet to break out of its post-crisis range (Chart 6, top panel). The New York Fed’s Underlying Inflation Gauge rolled over sharply in 2019 (Chart 6, panel 2). NFIB surveys of planned and reported price increases have also turned down (Chart 6, bottom 2 panels). Considering the main components of core inflation, we find that the strong month-over-month core inflation prints of June, July and August were driven mostly by accelerating goods prices (Chart 7). Goods inflation has reversed course since then, and should continue to be a drag on core inflation going forward. This is because core goods inflation follows import price inflation with a long lag, and some import price deflation is already baked in (Chart 8). Chart 7CPI Components Chart 8Expect Some Import Price Deflation On the flipside, we have also seen core services inflation (excluding shelter and medical care) inflect higher during the past six months (Chart 7, panel 4). Continued strength in this component is essential if overall core inflation is going to move up. Shelter is the largest component of core inflation and we expect it to trend sideways as we head into 2020. The rental vacancy rate has flattened off at a low level, and the Apartment Market Tightness Index is just barely in net tightening territory (Chart 9). Neither indicator is sending a strong signal in either direction. Chart 9Shelter Inflation Trending Sideways All in all, we see core inflation and TIPS breakeven rates moving slowly higher in 2020. But it will take some time before inflation is strong enough to push long-maturity breakeven rates into our target range of 2.3%-2.5%. Given the importance placed on re-anchoring inflation expectations, the Fed won’t hike rates again until our TIPS breakeven target is met. We don’t expect this to occur until 2021, or late-2020 at the earliest. The Financial Conditions Wildcard Chart 10The Importance Of Financial Conditions We mentioned above that the Fed’s interest rate policy will be determined by two factors: inflation expectations and financial conditions. In a perfect world, financial market valuations will stay at reasonable levels and inflation expectations will determine the timing of the next Fed rate hike. However, we must also consider what is likely to happen if it takes a very long time for inflation expectations to reach our target. The longer it takes, the longer that monetary conditions will be accommodative, and any extended period of easy money could lead to an asset bubble. Eventually, if valuations look bubbly enough, there may be a case for the Fed to sacrifice a bit on its inflation target and attempt to deflate a potentially de-stabilizing bubble in financial markets. This is not just a hypothetical situation. As Governor Lael Brainard remarked last December:8 The last several times resource utilization approached levels similar to today, signs of overheating showed up in financial-sector imbalances rather than in accelerating inflation. With greater focus on financial stability than in the past, it is conceivable that we could eventually see Fed tightening to head off an asset bubble. But we are not close to such bubbly conditions yet (Chart 10). The Financial Conditions component of our Fed Monitor is close to neutral, and while corporate bond spreads are tighter than average, they are well above the lows seen in the mid-2000s. Meanwhile, the S&P 500’s forward multiple is not yet back to its early-2018 level, let alone the highs of the late 1990s (Chart 10, bottom panel). Bottom Line: The Fed’s next interest rate move will be a hike, but it probably won’t occur until 2021. It will not occur until either long-maturity TIPS breakeven inflation rates reach our target band of 2.3%-2.5% or financial asset valuations reach extreme levels. Balance Sheet Policy 2019 was a tumultuous year for the Fed’s balance sheet policy. At the start of the year, the Fed was continuing the process of balance sheet shrinkage that started in October 2017. The goal was never to return the Fed’s balance sheet to its pre-crisis size. Policymakers had already decided that they would shift permanently to a floor system of monetary policy implementation. A floor system is one where the central bank supplies more reserves to the banking system than are demanded, pushing interest rates down toward a floor that is set by the Fed. In this case, the floor is the Fed’s overnight reverse repo facility (ON RRP). Using this facility, the Fed agrees to borrow any excess cash at the ON RRP rate in return for a security from the Fed’s balance sheet as collateral. To implement this policy correctly, the Fed’s balance sheet must remain large so that bank reserves are plentiful. The Fed thought that it was supplying more reserves than the banking system demanded, but banks found themselves hoarding liquidity for a few days in September. Everything was going smoothly until September when this strategy hit a snag. The Fed thought that it was supplying more reserves than the banking system demanded, but banks found themselves hoarding liquidity for a few days in September. The result was that the fed funds rate shot higher, and actually printed outside the Fed’s target band for one day (Chart 11).9 Chart 11The Fed Briefly Lost Control Of Rates In September Clearly, the Fed had actually not been supplying the banking system with more reserves than it wanted, otherwise overnight liquidity would have remained plentiful throughout September. Even more vexing is that surveys of primary dealers and market participants all showed that reserve supply was comfortably above demand (Chart 12), even though this turned out not to be the case. Chart 12The Fed Was Blindsided Though there are many questions that still need to be answered, the Fed quickly took action and intervened in the repo market to increase the daily reserve supply. It also re-started T-bill purchases at a rate of $60 billion per month, ending the period of balance sheet shrinkage. Then just last week, the Fed announced a program of term repo agreements that will increase overnight liquidity heading into the volatile year-end period. After all that, the Fed’s balance sheet is once again growing as we head into 2020. But there is much uncertainty about how the balance sheet will evolve during the next 12 months.  A Two-Pronged Strategy In 2020 the Fed will attack its balance sheet problems on two fronts. 1) Increase Reserve Supply First, it will purchase T-bills in order to increase the supply of reserves. Chart 13 shows how the Fed’s securities holdings and bank reserves will evolve in the first half of 2020, assuming that the Fed buys $60 billion of T-bills per month. We also assume that maturing MBS roll over into Treasury securities and that currency in circulation grows at a rate of 5% per year. Table 1 gives a breakdown of what the Fed’s balance sheet looks like today and what it will look like at the end of June, according to our assumptions. Chart 13The Fed's Balance Sheet Over Time But increasing the reserve supply will be a bit more difficult than that. For one thing, Table 1 shows that the Treasury Department’s General Account at the Fed is expected to grow by another $106 billion. All else equal, this will drain $106 billion of reserve supply. The Treasury depleted its cash holdings down to $130 billion in August, as it took extraordinary measures to stay under the debt ceiling. But now that the debt ceiling has been suspended until July 2021, the Treasury has been re-building its cash stores, targeting a level of $410 billion. Table 1Fed’s Balance Sheet: Projections Second, Table 1 assumes that Fed repos stay flat at $213 billion. But if the Fed decides to extricate itself from the repo market in the first half of 2020 then, all else equal, reserve supply will shrink by $213 billion. So far the Fed has provided very little guidance about its future presence in the repo market, but we expect it to err on the side of caution. That is, the Fed will not completely unwind its repo operations until it is confident that reserve supply is comfortably above demand. What we can say for certain is that the Fed will try to increase the reserve supply in early-2020. Then, at some point during the year, it will decide that the reserve supply is high enough and it will shift to purchasing only enough securities to keep pace with growth in non-reserve liabilities, holding reserve supply flat. It is unknown when that shift will occur, but whenever it does, the Fed’s balance sheet will still be growing, just more slowly. We can say decisively that the era of balance sheet shrinkage is over. At some point in 2020 the Fed will probably also introduce a standing repo facility. This will act as the mirror image of the current ON RRP, providing a ceiling on interest rates. The facility will promise to supply overnight cash at a stated rate in return for Treasury collateral. If reserve supply is sufficiently high, then the standing repo facility is irrelevant. It would merely be a safety measure in case of periods like last September when reserve demand spiked. 2) Decrease Reserve Demand Other than increasing reserve supply, the Fed will also take steps in 2020 to reduce the amount of reserves demanded by the banking sector. It will do this by tweaking some banking regulations that possibly encouraged banks to hoard reserves in September. The Liquidity Coverage Ratio is the regulation that requires banks to hold enough high-quality liquid assets (HQLA) to cover 30 days of cash outflows in a stressed scenario. Bank reserves and Treasury securities both count as HQLAs, as do other fixed income securities with a haircut. In theory, the Liquidity Coverage Ratio shouldn’t prevent banks from swapping reserves for Treasuries in the repo market. But banks also undergo frequent internal stress testing, in preparation for the Fed’s periodic stress tests, and those internal tests may place a premium on reserves over Treasuries. It is very likely that, in 2020, the Fed will take steps to make banks increasingly indifferent between holding reserves and Treasury securities. This should reduce overall reserve demand and make cash more freely available in the overnight repo market. Investment Implications With all that said, we place very little importance on the Fed’s balance sheet policy in terms of what it means for asset returns. Our longstanding view is that asset purchases were only an effective policy tool because they reinforced the Fed’s forward guidance about changes in the funds rate. In fact, any perceived correlation between changes in the size of the Fed’s balance sheet and financial asset prices is only because balance sheet policy was moving in the same direction as interest rate policy. That is, during the past few years, periods of Fed asset purchases have always coincided with easier interest rate policy and periods of balance sheet shrinkage have always coincided with tighter interest rate policy. It is the interest rate policy that determines movements in asset prices, not the balance sheet. Finally, in 2019, we witnessed a period when balance sheet policy diverged from interest rate policy and we were able to test our thesis. Between December 2018 and July 2019, the Fed was shrinking its balance sheet but also easing its forward rate guidance and preparing for rate cuts. Outstanding bank reserves fell by $124 billion, but the expected 12-month change in the fed funds rate fell from +11 bps to -88 bps. It is very likely that, in 2020, the Fed will take steps to make banks increasingly indifferent between holding reserves and Treasury securities. What happened during this period? Bond yields declined and the dollar depreciated (Chart 14). Meanwhile, risk asset prices shot higher (Chart 15). In other words, markets behaved as you would expect if the Fed were easing policy, clearly taking their cues from interest rate policy not the balance sheet. Chart 14Rates Policy Trumps Balance Sheet Part I Chart 15Rates Policy Trumps Balance Sheet Part II Bottom Line: The era of balance sheet shrinkage is over. The Fed will continue to grow its balance sheet in 2020, and will also tweak regulations to make banks more indifferent between holding Treasury securities and reserves. But more importantly, the Fed’s balance sheet policy is now completely de-linked from its interest rate policy. That being the case, investors should largely ignore trends in the Fed’s balance sheet and focus on interest rate policy as the main driver of asset returns. The Fed’s Strategic Review The Fed is currently undertaking a strategic review of its monetary policy strategy, tools and communications practices. Chair Powell has said that he expects the review to be completed by the middle of 2020, and it is likely that some important changes will be announced. According to the Fed, the review is taking place because “the US economy appears to have changed in ways that matter for the conduct of monetary policy.” Specifically, the Fed believes that the neutral fed funds rate – the rate consistent with stable inflation – is structurally lower. The Fed is concerned that this increases the risk of the fed funds rate being pinned at its effective lower bound (ELB), making it more difficult to consistently hit its inflation target. The review is about considering different strategies and tools that the Fed could use to more consistently hit its 2% inflation target in the future, but the 2% target itself is not up for discussion. The Fed has already decided that 2% inflation is most consistent with its price stability mandate. Policy Strategy Chart 16A Big Miss One thing that’s clear is that most Fed participants agree that some changes to policy strategy are necessary. There is widespread concern about the fact that the Fed has not hit its inflation target during the past decade. The Fed officially adopted a 2% target for PCE inflation in January 2012, but inflation has not come close to those levels since. Headline and core PCE have increased at average annual rates of only 1.3% and 1.6%, respectively, since 2012 (Chart 16). At the July and September FOMC meetings, the Fed discussed several different strategies that could make it easier to hit its inflation target. Most of the proposals fall into the category of “makeup strategies”, strategies where the Fed tries to make up for a period of below-2% inflation by targeting above-2% inflation for a stretch of time. In theory, most Fed members agree that such strategies make sense. From the September FOMC minutes:10 Because of the downside risk to inflation and employment associated with the ELB, most participants were open to the possibility that the dual-mandate objectives of maximum employment and stable prices could be best served by strategies that deliver inflation rates that over time are, on average, equal to the Committee’s longer-run objective of 2 percent. Promoting such outcomes may require aiming for inflation somewhat above 2 percent when the policy rate was away from the ELB, recognizing that inflation would tend to be lower than 2 percent when the policy rate was constrained by the ELB. The main problem with these sorts of makeup strategies is what Fed Governor Lael Brainard calls the time-inconsistency problem.11 For example, if inflation has been running well below – or above – target for a sustained period, when the time arrives to maintain inflation commensurately above – or below – 2 percent for the same amount of time, economic conditions will typically be inconsistent with implementing the promised action. In other words, when it comes time to deliver on its past promises, the Fed may not want to. But if it fails to deliver, it makes any future promises less impactful. Governor Brainard thinks that this problem can be mitigated by adopting a more flexible approach. That is, rather than following a strict rule that says that the Fed must aim for average inflation of 2 percent over a specific timeframe, it could simply opportunistically change its target inflation range based on the circumstances. She gives the following example: For instance, following five years when the public has observed inflation outcomes in the range of 1-1/2 to 2 percent, to avoid a decline in expectations, the Committee would target inflation outcomes in a range of, say, 2 to 2-1/2 percent for the subsequent five years to achieve inflation outcomes of 2 percent on average overall. We think it is very likely that something similar to Brainard’s plan will be announced when the review is completed in 2020. There is widespread consensus that the Fed should temporarily target an overshoot of its 2 percent inflation target to ensure that inflation expectations stay anchored near target levels. Opportunistically shifting the inflation target to 2%-2.5% on a temporary basis seems like the easiest way to communicate that goal. ELB Tools In addition to potential changes to policy strategy, the Fed has also been talking about potential policy tools that could be deployed the next time that interest rates reach the ELB. Policymakers took up this question in detail at the October FOMC meeting and generally agreed that the combination of forward guidance and asset purchases had been effective at delivering policy accommodation at the lower bound. Now that the committee is comfortable with these tools, we would expect them to be deployed very quickly the next time that the fed funds rate reaches zero. In all likelihood, if the funds rate reaches zero again, the Fed will quickly announce a round of asset purchases and pledge to keep rates on hold until some economic outcome – likely related to inflation – is met. The Fed also discussed the possibility of cutting rates into negative territory, but there is very little appetite for negative rates policy in the US. From the October FOMC minutes:12 All participants judged that negative interest rates currently did not appear to be an attractive monetary policy tool in the United States. Participants commented that there was limited scope to bring the policy rate into negative territory, that the evidence on the beneficial effects of negative interest rates abroad was mixed, and that it was unclear what effects negative rates might have on the willingness of financial intermediaries to lend and on the spending plans of households and businesses. If, during the next ELB phase, the combination of forward rate guidance and asset purchases does not appear to be working quickly enough, we think it’s most likely that the Fed will follow the Bank of Japan and simply extend these policies further out the yield curve. For example, the Fed would set a cap on some intermediate-maturity Treasury yield (say the 2-year yield), and pledge to buy as many securities as necessary to keep the yield below that cap. This potential tool was discussed at the October FOMC meeting, and it received a more favorable response than the negative rates policy. Results Of The Strategic Review The exact form of any new policy strategy is uncertain, but we expect the Fed to make an announcement in mid-2020 that makes it clear that it will explicitly target above-2% inflation for some unspecified period of time in order to re-anchor inflation expectations and make up for past inflation misses. This will make it even more important to use inflation expectations as our guide for detecting shifts in Fed policy, rather than the actual inflation data. In many ways, the Fed’s reaction function has already moved toward targeting expectations. The results of the 2020 strategic review will make that even more explicit. There is less urgency to announce any potential new tools for conducting policy at the ELB, and we do not expect much in that regard. Other than some ideas for further study.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see Global Fixed Income Strategy Special Report, “2020 Key Views: Delay Of Reckoning”, dated December 10, 2019, available at gfis.bcaresearch.com and US Bond Strategy Special Report, “2020 Key Views: US Fixed Income”, dated December 10, 2019, available at usbs.bcaresearch.com 2 For details on BCA’s economic outlook for 2020 please see The Bank Credit Analyst, “Outlook 2020: Heading Into The End Game”, dated November 22, 2019, available at bca.bcaresearch.com 3 Please see US Bond Strategy Weekly Report, “The New Battleground For Monetary Policy”, dated March 26, 2019, available at usbs.bcaresearch.com 4  https://www.federalreserve.gov/newsevents/speech/yellen20150924a.htm 5  https://www.federalreserve.gov/newsevents/speech/clarida20190926a.htm 6 Please see US Bond Strategy Weekly Report, “Adaptive Expectations In The TIPS Market”, dated November 20, 2018, available at usbs.bcaresearch.com 7 CPI inflation runs about 0.4%-0.5% above PCE inflation, so the Fed’s 2% PCE target translates to a 2.4%-2.5% target for CPI. 8  https://www.federalreserve.gov/newsevents/speech/brainard20181207a.htm 9 This September episode is discussed in detail in the US Bond Strategy Weekly Report, “What’s Up In US Money Markets?”, dated September 24, 2019, available at usbs.bcaresearch.com 10 https://www.federalreserve.gov/monetarypolicy/fomcminutes20190918.htm 11 https://www.federalreserve.gov/newsevents/speech/brainard20191126a.htm 12 https://www.federalreserve.gov/monetarypolicy/files/fomcminutes20191030.pdf

Highlights An analysis on Thailand is available below. In all scenarios of global market performance, EM will underperform DM in the first half of 2020. Absolute return investors should be mindful of downside risks in EM financial markets. The principal drivers for EM corporate profits are domestic demand in both China and EM ex-China. US and European demand are not particularly relevant. We do not expect a recovery in domestic demand in China and the rest of EM in the early months of 2020. EM corporate profit growth is unlikely to turn positive in H1 2020. Volatility Is A Coiled Spring Chart I-1EM Stocks And Profits: An Unsustainable Divergence EM share prices and currencies have been range-bound in 2019, despite the strong rally in DM share prices. On one hand, growing hopes of a US-China trade deal, global monetary easing and expectations of a global growth recovery have put a floor under EM (Chart I-1, top panel). On the other hand, a lack of actual growth recovery in EM/China, a deepening contraction in EM corporate profits and lingering structural malaises in many EM economies have capped upside potential (Chart I-1, bottom panel). Consistent with this sideways market action, implied volatility measures for EM equities and currencies have dropped to record lows (Chart I-2, top and middle panels). Similarly, implied volatility measures for commodities currencies – which tend to be strongly correlated with EM risk assets – have plummeted close to their historic lows (Chart I-2, bottom panel). Remarkably, DM currency markets’ implied volatility has also collapsed to the all-time lows recorded in 2007 and 2014 (Chart I-3, top panel). Chart I-2EM Vol Is A Coiled Spring Chart I-3DM Currency Vol Is At Record Low   Nevertheless, past performance does not guarantee future performance. The fact that global financial market volatility has been very low over the past 12 months does not imply that it will remain subdued going forward. On the contrary, when DM currency volatility was this low in 2007 and 2014, it was followed by a bear market in EM risk assets (Chart I-3, bottom panel). Both EM and DM market volatility resemble a coiled spring. As such, it is quite likely these coiled springs will snap sometime in the first half of 2020. If this is indeed the case, it will be accompanied by a selloff in EM risk assets. We devote this report to discussing the reasons why such dynamics are likely to play out. An urge on the part of investors to deploy capital in EM has supported EM financial markets despite shrinking corporate profits. Hence, investment portfolios should be positioned for a resurgence in financial market volatility in general and currency volatility in particular in H1 2020. As we argued in our November 14 report, the US dollar is still enjoying tailwinds, especially versus EM and commodities currencies. All in all, asset allocators should continue to underweight EM stocks, credit markets and currencies relative to their DM counterparts. In all scenarios of global market performance, EM will underperform DM in the first half of 2020. Absolute return investors should be mindful of downside risks in EM financial markets. As always, the list of our recommended country allocations across EM equities, currencies, credit markets and domestic bonds is presented in the tables at the end of our report – please refer to pages 18-19. An Urge To Deploy Capital Amid Poor EM Fundamentals Investors’ unrelenting urge to deploy capital in EM financial markets put a floor under EM equities and currencies in 2019. Yet poor fundamentals have prevented EM equities and currencies from rallying. Such a battle between two opposing forces has produced a stalemate in EM financial markets. The same is true for commodities and many global market segments sensitive to global growth. Chart I-4Global Industrials: A Rally Without Profit Amelioration This stalemate is unlikely to last forever. Next year will likely be a year of either an EM breakout or breakdown. EM corporate earnings hold the key, and China’s domestic demand is of paramount importance to the EM profit cycle. We discuss our outlook for both the China and EM business cycles below. Following are the reasons why we believe market expectations of a rebound in global growth are too optimistic, and that EM risk assets are at risk: First, there is a widening gap between share prices and corporate profits. Not only are EM per-share earnings shrinking at a double-digit rate, as shown in Chart I-1 on page 1, but also EM EPS net revisions have not yet turned positive. This widening gap between share prices and net EPS revisions is also striking for global industrials (Chart I-4). If corporate profits stage an imminent recovery, stocks will continue to advance. Alternatively, investor expectations will not be met, and a selloff will ensue. As the top panel of Chart I-5 illustrates, the annual growth rate of EM EPS will at best begin bottoming – from double-digit contraction territory – only in the second quarter of 2020. Odds are that investor patience might run out before that occurs and EM markets will sell off in such a scenario. Second, improvement in US and European growth is not in and of itself a sufficient reason to be positive on EM/China growth. In fact, neither US nor euro area consumer spending have been weak (Chart I-5, middle and bottom panels). Yet, EM growth and corporate profits have plunged. Hence, EM growth is by and large not contingent on consumer spending in the US and Europe. As we have repeatedly argued, EM profit growth and risk assets are driven by China/EM domestic demand, rather than by US or European growth cycles. Third, EM financial markets are not cheap. Our composite valuation indicators based on 20% trimmed-mean and equal-weighted multiples indicate that stocks are trading close to their fair value (Chart I-6). These indicators are composed based on the trailing and forward P/E ratios, price-cash earnings, price-to-book value and price-to-dividend ratios for 50 EM equity subsectors. Chart I-5EM Profits Are Driven By China Not US Or Europe Chart I-6EM Equities Are Fairly Valued   When valuations are neutral, stock prices can rise or drop depending on the outlook for corporate profits. Provided we believe EM corporate profits will continue to contract for now, risks to share prices are skewed to the downside. Finally, several markets are still conveying a cautious message regarding EM assets. Specifically: There are cracks forming in EM credit markets. EM sovereign credit spreads are widening. Remarkably, emerging Asian high-yield corporate bond yields – shown inverted in Chart I-7 – are beginning to rise. Rising borrowing costs for high-yield borrowers in emerging Asia have historically heralded lower share prices in the region (Chart I-7). Chains often break in their weak links. Similarly, selloffs commence in the weakest segments and then spread from there. Hence, the budding weakness in emerging Asian junk corporate bonds and EM sovereign credit could be signals of a forthcoming selloff in EM/China plays. Remarkably, emerging Asian and Chinese small-cap stocks have failed to stage a rally in the past three months – despite global risk appetite having been strong (Chart I-8). This also signifies the lack of a meaningful recovery in emerging Asia in general and China in particular. Chart I-7A Canary In A Coal Mine? Chart I-8No Rally In Chinese And Emerging Asian Small Caps Chart I-9Semiconductor Prices Are Still Subdued Last but not least, cyclical currencies and commodities markets are not signaling a global business cycle recovery. Neither industrial metals nor oil prices have been able to rally meaningfully. EM currencies have also failed to appreciate versus the dollar. In addition, semiconductor prices – both DRAM and NAND – remain weak (Chart I-9). Bottom Line: An urge on the part of investors to deploy capital in EM has supported EM financial markets despite a poor growth background, in general, and shrinking corporate profits, in particular. China: Structural Malaises To Delay A Cyclical Recovery Recent macro data, particularly PMIs, have once again raised hopes of a business cycle recovery in China. While it is reasonable to infer that the industrial cycle in China has recently stabilized, sequential improvements will be hard to achieve in the coming months for the following reasons: The credit and fiscal spending impulse has historically led the manufacturing cycle in China on average by about nine months. However, this time gap has varied – from three months in the first quarter of 2009 to about 20 months in 2017 (Chart I-10). Chart I-10China Credit/Fiscal Impulse And Business Cycle: Varying Time Lags There are several reasons why the time lag could be longer than nine months in the current cycle: (1) The US-China confrontation is dampening sentiment among both enterprises and households in China. Marginal propensity to spend among households and enterprises is low and has not improved (Chart I-11). A Phase One deal is unlikely to reverse this. The fact remains that the US and China have failed to reach an even small and limited accord in the past year of negotiations. With this in mind, even if there is a Phase One deal, businesses both in China and around the world are unlikely to alter their investment plans substantially. (2) Regulatory pressures on banks and on the shadow banking sector to deleverage remain acute. Although the People’s Bank of China has reduced interest rates and is providing ample liquidity, the regulatory tightening measures from 2016-2018 have not been reversed. Consistently, commercial banks’ assets and broad bank credit growth are rolling over anew (Chart I-12). Chart I-11China: Lack Of Appetite To Spend For Enterprises And Households Chart I-12Banking System Is Now More Restrained Compared With Previous Stimulus Episodes   (3) There has been no stimulus targeting the real estate market. Without a recovery in the property market – both strong price appreciation and construction activity – it will be difficult to achieve a business cycle recovery. The basis is that real estate – not exports to the US – has been the key pillar driving China’s growth over the past 10 years. Even if there is a Phase One deal, businesses both in China and around the world are unlikely to alter their investment plans substantially. In the onshore bond market, government bond yields do not confirm the sustainability of the improvement in the national manufacturing PMI (Chart I-13). China’s local currency government bond yields have generally been a good coincident indicator for the industrial cycle, and they are not flashing green. Chart I-13Chinese Local Bond Yields Doubt The Sustainability Of A Stronger PMI November Asian and Chinese trade data have been somewhat mixed. Korea’s total exports and exports to China still show double-digit contraction (Chart I-14, top panel). Similarly, Japanese foreign machine tool orders – both total and from China – remain in deep contraction (Chart I-14, middle panel). In contrast, Taiwanese exports to China and to the world ex-China have improved (Chart I-14, bottom panel). The recuperation in Taiwanese exports to China could be attributed to stockpiling of semiconductors by mainland companies. Odds are that China has decided to stockpile semiconductors from Taiwan, given the lingering uncertainty over the China-US relationship, especially regarding China’s access to semiconductors. Real estate – not exports to the US – has been the key pillar driving China’s growth over the past 10 years. Infrastructure spending remains lackluster, despite a surge in special bond issuance by local governments over the past 12 months (Chart I-15, top panel). Chart I-14Asian Trade Was Still Very Weak In November Chart I-15China: Domestic Demand Is Lackluster   Chart I-16EM Ex-China: No Recovery In Domestic Demand The reason is that special bond issuance accounts for a small share of infrastructure investment. Bank loans, corporate bond issuance by LFGVs and land sales are still the main source of funding for capital expenditures on infrastructure. Finally, on the consumer side, auto sales are contracting for a second straight year, while smartphone sales are flat-to-down for a third year in a row (Chart I-16, middle and bottom panels). EM Ex-China: Mind The Deflationary Forces In EM ex-China, Korea and Taiwan, not only are their exports weak, but their domestic demand trajectory is also downbeat (Chart I-16). Despite rate cuts by EM central banks, their interest rates remain elevated in real terms (adjusted for inflation). The basis is that inflation has dropped as much as policy rate cuts. In fact, in many economies, inflation is flirting with all-time lows (Chart I-17). Furthermore, lending rates by banks have not been adjusted sufficiently low in line with the declines in policy rates. Consequently, local borrowing costs in EM remain elevated. Not surprisingly, broad money growth is close to a record low (Chart I-18). Chart I-17EM Ex-China: Inflation Is At A Record Low Chart I-18EM Ex-China: More Aggressive Monetary Easing Is Necessary   Table I-1EM Corporate Profits Across Sectors Without recognizing non-performing loans and recapitalizing banks, a sustainable credit cycle - and hence domestic demand recovery - is implausible in many EM countries. This will impede the corporate profit recovery, especially for banks that account for 28% of MSCI EM corporate profits (Table I-1). As we argued in our November 14 report, such deflationary tendencies in many EM economies warrant a weaker currency. Bottom Line: The principal drivers for EM corporate profits are domestic demand in China and EM ex-China, rather than the ones in the US or Europe. We do not expect a recovery in domestic demand in both China and the rest of EM in the early months of 2020. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Thailand: Bet On More Monetary Easing Chart II-1Thailand Is Flirting With Deflation Deflationary pressures are mounting in Thailand. This will lead the central bank to cut interest rates much further. We therefore recommend to continue overweighting Thai domestic bonds within an EM local bond portfolio, currency unhedged.  Thailand’s economy is flirting with deflation and needs lower interest rates, a cheaper currency and a fiscal boost: Core inflation has fallen to a mere 0.5%. Likewise, headline inflation has plunged to 0.2%, which is far below the central bank’s lower-bound target of 1% (Chart II-1). Further, nominal GDP growth has dropped below the prime lending rate (Chart II-2). Adjusted for core inflation, real lending rates are too high for the economy to handle. If lending rates are not brought down, credit demand will decline further and non-performing loans will mushroom (Chart II-3). Chart II-2Thailand: Nominal GDP Growth Is Below Prime Lending Rate Chart II-3Thailand: Decelerating Domestic Credit   High borrowing costs are especially detrimental for the non-financial private sector – households in particular. Consumer debt currently stands at 125% of disposable income. The central bank is set to deliver more rate cuts and will probably begin intervening in the foreign exchange market to weaken the baht. Thailand’s economic growth has decelerated and more downside is likely. Business sentiment is deteriorating, companies’ book orders are falling and manufacturing production is contracting (Chart II-4, top panel). Overall, corporate earnings are shrinking 8% from a year ago in local currency terms (Chart II-4, bottom panel). Declining corporate profitability is beginning to hurt capex and employment. In turn, slower employment and wage growth have hit consumer confidence. Private consumption volume has decelerated decisively (Chart II-5, top panel) and passenger vehicle sales are falling (Chart II-5, bottom panel). Chart II-4Thailand: Business Sentiment Is Falling Chart II-5Thailand: Consumer Spending Has Been Hit Chart II-6Thailand's Real Estate Market Is Weak The real estate market is also slowing down. Chart II-6 shows various types of residential property prices. Specifically, house price appreciation has either decelerated or turned into deflation. Accordingly, construction activity has been weak. Overall, the Thai economy needs significant monetary and fiscal easing. Yet the 2020 fiscal budget entails only a 6% increase in expenditures in nominal terms, which is insufficient to halt the economy’s downtrend momentum. With the budget already set, aggressive monetary easing - in the form of generous rate cuts and foreign exchange interventions to induce some currency depreciation – is the only tool available to the authorities at the moment. Bottom Line: The Thai economy is facing strong deflationary forces and requires lower interest rates and a cheaper currency. The central bank is set to deliver more rate cuts and will probably begin intervening in the foreign exchange market to weaken the baht. Investment Recommendations Local interest rates will drop further and the Bank of Thailand (BoT) will keep cutting interest rates next year in the face of mounting deflationary trends in the economy. For dedicated EM fixed-income portfolios, we recommend keeping overweight positions in Thai local currency bonds and sovereign credit within their respective EM portfolios. While the Thai baht could depreciate because of monetary easing, the currency will still perform better than many other EM currencies. Thailand carries a very robust current account surplus of 6% of GDP. This will provide a cushion for the baht. Furthermore, foreign ownership of local currency bonds is low at 18%. This limits potential foreign outflows from local bonds in case the currency depreciates. In addition, Thailand’s foreign debt obligations - which are calculated as the sum of short-term claims, interest payments and amortization over the next 12 months - are small, accounting for 14% of exports. This limits hedging needs by Thai debtors with foreign currency liabilities and, hence, the currency’s potential downside. We recommend EM equity investors to keep an overweight position in Thai equities. First, Thai bourse is defensive in nature – with utilities, consumer staples and healthcare accounting for 27% of the MSCI Thailand market cap – and will begin outperforming as EM share prices come under renewed stress (Chart II-7, top panel). Second, net EPS revision in Thailand vs. EM has plummeted to a 16-year low (Chart II-7, bottom panel). This entails that a lot of bad news has already been priced in relative terms. Finally, narrow money (M1) growth seems to be bottoming. This is occurring because the central bank has begun accumulating foreign exchange reserves. While it might take some time before monetary easing leads to an economic recovery, Thai share prices will benefit from it early on (Chart II-8). Chart II-7Thailand vs. EM: Relative Stock Prices And Earnings Revisions Chart II-8Thailand: Narrow Money And Share Prices   Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com   Footnotes     Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights Structurally overweight US T-bonds versus core European bonds. Our preferred expression is long T-bonds versus Swiss bonds. US yields can fall a lot more than European yields, and European yields can rise a lot more than US yields. Structurally underweight the overvalued dollar versus undervalued European currencies. Our preferred expression is long SEK/USD. Structurally underweight price-sensitive European export sectors. Undervalued European currencies cannot fall much further, and those European exporters that depend on price competitiveness will struggle to outperform. But structurally overweight soft luxuries. Despite President Trump’s threat to tariff French products, soft luxuries retain very strong pricing power and sustainable long term demand growth from rising female labour participation rates globally. Fractal trade: The 65-day fractal structure of global equities suggests that they are vulnerable to a near-term countertrend move. Feature Chart of the WeekLike-For-Like, Structural Inflation Is Lower In the US Than In Europe A seemingly trivial disagreement between Europeans and Americans on how to measure inflation turns out to be the culprit for three major distortions in the world right now: Deeply divergent monetary policies across the developed economies. Huge valuation anomalies in the foreign exchange markets. President Trump’s threat of a trade war to counter the huge trade surpluses that Europe and China are running against the US. The inflation measurement disagreement wouldn’t really matter if inflation were running in the mid-single digits. But when inflation is near zero, the seemingly trivial difference in inflation measurement methodologies has ended up generating massive distortions. European And American Inflation Are Not The Same European inflation excludes the maintenance and upkeep costs associated with owning your home, whereas US inflation includes these costs at a hefty 25 percent weighting, making owner occupied housing by far the largest single item in the US inflation basket. By omitting the largest item in the US inflation basket, European inflation is subtly yet crucially different to American inflation. The European statisticians argue that unlike all the other items in the inflation basket, there is no independent market price for the ongoing cost of home ownership, and therefore this cost should be excluded. The American statisticians argue that the ongoing cost of home ownership is the single largest expense for most people and, as such, it should be ‘imputed’ from a concept known as ‘owner equivalent rent’ – essentially, asking homeowners how much it would cost to rent their own home. Different definitions of inflation will trigger very different policy responses from central banks. Both the European and American approaches have their merits and drawbacks, and it is not our intention to endorse one approach over the other. Our intention is simply to point out that the two approaches can give very different results for inflation – and therefore trigger very different policy responses from inflation-targeting central banks, with their consequent economic and political repercussions. If Americans used the European definition of inflation, then headline inflation in the US today would be running at the same sub-par rate as in the euro area, 1 percent, and well below the Fed’s 2 percent target (Chart I-2 and Chart I-3). More important, the five year annualised rate of inflation – let’s call it US structural inflation – would have been stuck below 1 percent since 2016 (Chart I-1 and Chart I-4). Under these circumstances, it would have been impossible for the Fed to hike the funds rate eight times, as it did through 2017-18. Chart I-2Like-For-Like, Headline Inflation Is Identical In The US And The Euro Area... Chart I-3...And Core Inflation Is ##br##Very Similar   Chart I-4Using The European Definition Of Inflation, The Fed Couldn't Have Hiked Rates Instead, what if Europeans used the American definition of inflation? European inflation does not include owner equivalent rent, but it does include housing rent for those that do rent their homes. In the US, these two items tend to move in lockstep (Chart I-5). If we assume the same for Europe, we can deduce that a US type weighting for owner equivalent rent would have boosted the headline inflation rate in the euro area by 0.3-0.4 percent through 2014-16, and by a possible 0.5 percent in Sweden through 2013-15 (Chart I-6 and Chart I-7). Under these circumstances, it would have been very difficult for the ECB and Riksbank to take and maintain policy rates deeply in negative territory, as they did through 2015-19. Chart I-5Owner Equivalent Rent Tracks ##br##Housing Rent Chart I-6Using The American Definition Of inflation, Euro Area Inflation Would Have Been Higher... Chart I-7...And Swedish Inflation Would Have Been Much Higher The Different Definitions Of Inflation Have Created Dangerous Distortions If Europeans and Americans were using the same definition of inflation then, one way or the other, their monetary policies would not be as deeply divergent as they are now. One important implication is that European currencies would not be as undervalued as they are now. If Europeans and Americans were using the same definition of inflation then their monetary policies would not be as deeply divergent as they are now.  Based on the ECB’s own analysis, the euro area is over-competitive versus its top 19 trading partners – meaning the euro is undervalued – by at least 10 percent. Moreover, the ECB admits that this sizable undervaluation only appeared after the ECB and Fed started taking their monetary policies in opposite directions in 2015 (Chart I-8). Chart I-8The Euro Is Undervalued By More Than 10 Percent Put the other way, the dollar would not be as overvalued as it is now. In turn, the stronger dollar has created its own dangerous spill-overs. As we explained last week in The Hidden Sales Recession Of 2015… And Why It Matters Now, the surging dollar in 2015 could not have come at a worse time for China. Given that the Chinese economy was already slowing sharply, and the yuan was pegged to the dollar, the resulting loss of Chinese competitiveness just exacerbated the slump. Forcing China to loosen the dollar peg in August 2015. All of which brings us neatly to the hot topic of 2019, and likely 2020 too – President Trump’s threat of a trade war to counter the huge trade imbalances that Europe and China are running against the US. As it happens, President Trump has a good point. Trade wars almost always stem from trade imbalances; and trade imbalances almost always stem from exchange rate manipulations or, at least, exchange rate distortions that advantage one economy to the detriment of another. The euro's undervaluation only happened after monetary policies diverged in 2015. Most of the euro area’s €150 billion trade surplus with the US appeared after 2015, so it cannot be a structural issue. In fact, the evolution of the trade imbalance has tracked relative monetary policy between the Fed and ECB almost tick for tick (Chart I-9), via the exchange rate channel and the over-competitiveness of the euro which the ECB fully admits. Chart I-9Excessively Divergent Monetary Policies Caused The Euro Area's Huge Trade Surplus With The US Of course, neither the ECB nor the Fed are deliberately targeting trade or the exchange rate; they are targeting inflation. But to repeat, they are targeting different definitions of inflation. Crucially, with a backdrop of near zero inflation, small definitional differences in inflation can generate huge economic and financial distortions, with dangerous political consequences. The Compelling Structural Opportunities The definitional difference between European and American inflation explain many of the economic and financial distortions we are witnessing now, as well as the dangerous political consequences. The main counterargument is that the inflation definitions are what they are; neither the ECB nor the Fed are likely to change them anytime soon. Nevertheless, there are compelling structural opportunities. Since 2015, American inflation has outperformed European inflation for one reason and one reason only: owner equivalent rents have surged by almost 20 percent relative to other prices (Chart I-10 and Chart I-11). The historic evidence suggests that such a pace of outperformance is unsustainable structurally and, absent this tailwind, US and European headline inflation rates have to converge, one way or the other. Chart I-10An Unsustainable Surge In US Owner Equivalent Rent... Chart I-11...Has Lifted US Headline ##br##Inflation In this inevitable convergence, the asymmetric starting point of bond yields favours a long US T-bonds, short core European bonds structural position. Because, if the inflation convergence is downwards, T-bond yields will fall much further than European yields; whereas if the inflation convergence is upwards, European yields will likely rise more than T-bond yields. Our preferred structural expression is: long US T-bonds, short Swiss bonds. For currencies it is the opposite message. The overvalued dollar is likely to underperform, at least versus other developed market currencies. Given that Swedish inflation has been the most understated by the exclusion of owner equivalent rents, combined with the Riksbank’s intention to exit negative interest rate policy imminently, our preferred structural expression is: long SEK/USD. American inflation has outperformed European inflation for one reason and one reason only: owner equivalent rents have surged by almost 20 percent relative to other prices. Lastly, European export growth – even in Germany – has been heavily reliant on a cheapening euro (Chart I-12). Undervalued European currencies cannot fall much further, and those European exporters that depend on price competitiveness will struggle to outperform. Even those multinationals that sell their products in dollars will lose out in the accounting translation back into a strengthening domestic currency. Hence, structurally underweight price-sensitive European export sectors. Chart I-12Without A Weaker Euro, Most European Exporters Will Struggle To Outperform The one exception to this is the soft luxuries sector. Despite President Trump’s threat to tariff French products, soft luxuries retain very strong pricing power and sustainable long term demand growth from rising female labour participation rates globally. Stay structurally overweight soft luxuries. Fractal Trading System* The 65-day fractal structure of global equities suggests that they are vulnerable to a near-term countertrend move. Accordingly, this week’s recommended trade is to short the MSCI All Country World versus the global 10-year bond (simple average of US, euro area, and China), setting a profit target and symmetrical stop-loss at 2.5 percent. In other trades, long NZD/JPY and long SEK/JPY both achieved their profit targets of 3 percent and 1.5 percent respectively. Against this, long Poland versus World reached its 4 percent stop-loss. The rolling 1-year win ratio now stands at 65 percent. Chart I-13MSCI All-Country World Vs. Global 10-Year Bond When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated  December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System   Cyclical Recommendations Structural Recommendations Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations    

Highlights China’s PMIs continue to flash a positive signal, but the hard data trend remains negative. There has been a notable improvement in China’s cyclical sectors (versus defensives) over the past month, but broad equity market performance has been flat-to-down. China’s lackluster equity index performance in the face of rising PMIs suggests that investors can afford to wait for an improvement in the hard economic data before tactically upgrading to overweight. Cyclically, we continue to recommend an overweight stance towards both the investable and A-share markets versus the global benchmark, favoring the former over the latter. Feature Tables 1 and 2 on pages 2 and 3 highlight key developments in China’s economy and its financial markets over the past month. On the growth front, China’s November PMIs were clearly positive, and the rise in the official manufacturing PMI above the 50 mark is notable. However, the odds continue to favor a bottoming in the economy in Q1 rather than Q4, in large part because China’s “hard” economic data has continued to deteriorate during the time that the Caixin PMI has been signaling an expansion in manufacturing activity. In this vein, China’s November update for producer prices and total imports have high potential to be market-moving, and should be closely monitored. Table 1China Macro Data Summary Table 2China Financial Market Performance Summary Within financial markets, China’s cyclical sectors have outperformed defensives, which is consistent with the positive message from China’s PMIs. But China’s broad equity markets have been flat-to-down versus the global index over the past month, suggesting that investors can afford to wait for confirmation of a hard data improvement before upgrading their tactical stance to overweight (from neutral). Cyclically, we continue to recommend an overweight stance towards both the investable and A-share markets, but favor the former over the latter in a trade truce scenario. In reference to Tables 1 and 2, we provide below several detailed observations concerning developments in China’s macro and financial market data: Both measures of the Li Keqiang index (LKI) that we track indicated no obvious improvement in Chinese economy activity in October. The BCA China Activity indicator, a broader coincident measure of China’s economy, also moved sideways in October and (for now) remains in a downtrend. Thus, based on the “hard data”, Chinese economic activity has not yet bottomed. Chart 1A Moderate Strength Economic Recovery Will Begin In Q1 The components of our LKI leading indicator continue to tell a story of easy monetary conditions and sluggish money & credit growth (Chart 1). The indicator itself remains in an uptrend, but it is a shallow one that does not match the intensity of previous credit cycles. While the uptrend in the indicator suggests that China’s economy will soon bottom, the shallow pace suggests that the coming rebound in growth will be less forceful than during previous economic recoveries. The uptrend in headline CPI is a notable macro development, with prices having risen 3.8% year-over-year in Oct (the fastest pace in almost eight years). This rise has been driven almost entirely by a surge in pork prices, which have risen over 60% relative to last year (panel 1 of Chart 2). While some investors have questioned whether the rise in headline inflation will cause the PBoC to tighten its stance at the margin, we argued with high conviction in our November 20 Weekly Report that this will not occur.1 Panel 2 of Chart 2 shows that periods of easy monetary policy line up strongly with periods of deflating producer prices, arguing that the PBoC will see through transient shocks to headline inflation. China’s October housing market data highlighted three points: housing sales are modestly improving, the pace of housing construction has again deviated from the trend in sales, and housing price appreciation is slowing in Tier 2 and Tier 3 markets. For now, we are inclined to discount the surge in floor space started, given previous divergences that proved to be unsustainable. The bigger question is whether investors should be concerned about slowing housing prices. Chart 3 shows that floor space sold and property prices have been negatively correlated over the past three years, in contrast to a previously positive relationship. Deteriorating affordability and tight housing regulations have contributed to this shift in correlation, which helps explain why the PBoC’s Pledged Supplementary Lending (PSL) program has been so closely related to housing sales over the past few years. While the growth in PSL injections is becoming less negative, it has not risen to the point that it would be associated with a strong trend in sales. As such, we continue to see poor affordability as a threat to further housing price appreciation, absent stronger funding assistance. Poor affordability will continue to be a headwind for China’s housing market. Chart 2The PBoC Will See Through Transient Shocks To Headline Inflation Chart 3Poor Affordability Will Continue To Weigh On Housing Demand Chart 4Investors Need To See Concrete Signs Of A Hard Data Improvement China’s November PMIs were quite positive, which legitimately increases the odds that China’s economy is beginning the process of recovery. However, we see two reasons to believe that the odds continue to favor a bottoming in the economy in Q1 rather than Q4. First, while they improved in November, several important elements of the official PMI remain in contractionary territory, particularly the new export orders subcomponent. Second, while the Caixin PMI has now been above the 50 mark for 4 consecutive months, China’s hard data has continued to deteriorate since the summer (Chart 4). Given the historical volatility of the Caixin PMI, we advise investors to wait for concrete signs of a hard data improvement before firmly concluding that China’s economy is recovering. Over the last month, China’s investable stock market has rallied roughly 1% in absolute terms, while domestic stocks have fallen about 3%. In relative terms, A-shares underperformed the global benchmark, while the investable market moved sideways. In our view, the underperformance of China’s domestic market reflects increased sensitivity to monetary conditions and credit growth compared with the investable market,2 and a weaker credit impulse in October appears to have been the catalyst for A-share underperformance. Over the cyclical horizon, earnings will improve in both the onshore and offshore markets in response to a modest improvement in economic activity, suggesting that an overweight stance is justified for both markets. But we think the investable market has more upside potential in a trade truce scenario. The outperformance of cyclical versus defensive sectors is sending a positive signal, but investors can afford to wait for better economic data before tactically upgrading. Chart 5A Positive Sign From Cyclicals Versus Defensives Within China’s investable stock market, it is quite notable that cyclicals have outperformed defensives over the past month on an equally-weighted basis (Chart 5). Interestingly, key defensive sectors such as investable health care and utilities have sold off significantly, and equally-weighted cyclicals have also outperformed defensives in the domestic market. The outperformance of cyclicals and underperformance of defensives is consistent with the positive message from China’s PMIs, but the fact that this improvement is occurring against the backdrop of flat-to-down relative performance for China’s equity market suggests that investors can afford to wait for confirmation of a hard data improvement before upgrading their tactical stance to overweight. In this vein, China’s November update for producer prices and total imports have high potential to be market-moving, and should be closely monitored. China’s government bond yields fell slightly in November, potentially reflecting expectations of further modest easing. Our view that monetary policy will likely remain easy over the coming year even in a modest recovery scenario suggests that Chinese interbank rates and government bond yields are likely to range-trade over the coming 6-12 months. We expect onshore corporate bonds to continue to outperform duration-matched government bonds in 2020. Chinese onshore corporate bond spreads eased modestly over the past month. Despite continued concerns about onshore corporate defaults, the yield advantage offered by onshore corporate bonds have helped the asset class generate a 5.4% year-to-date return in local currency terms. Barring a substantial intensification of the pace of defaults, we expect onshore corporate bonds to continue to outperform duration-matched government bonds in 2020. The RMB has moved sideways versus the US dollar over the last month. USD-CNY had fallen below 7 in October following the announcement of the intention to sign a “phase one” trade deal, but the move ultimately proved temporary given the deferral of an agreement. We would expect the RMB to appreciate following a deal of any kind (a truce or something more), and it is also likely to be supported next year by improving economic activity. Still, it would not be in the PBoC’s best interests to let the RMB appreciate too rapidly, because an appreciating Chinese currency would act as a deflationary force on China’s export and manufacturing sectors. As such, we expect a modest downtrend in USD-CNY over the coming year.   Qingyun Xu, CFA Senior Analyst qingyunx@bcaresearch.com Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1    Please see China Investment Strategy Weekly Report "Questions From The Road: Timing The Turn," dated November 20, 2019, available at cis.bcaresearch.com 2   Please see China Investment Strategy Special Report "A Guide To Chinese Investable Equity Sector Performance," dated November 27, 2019, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

特別レポート

Highlights Economy & Inflation: The macro backdrop in Japan remains bond friendly for JGBs; growth momentum is only starting to bottom out, but will lag the recovery heralded by improving global leading economic indicators, while inflation remains closer to 0% than the BoJ's 2% target. BoJ Options: The BoJ has limited policy choices available to provide more stimulus, with negative policy rates crushing Japanese bank profitability and the central bank already owning massive amounts of JGBs and ETFs. 2020 Japan Bond Strategy: Dedicated bond investors should overweight Japan in global government bond portfolios over the next year, as a complement to an overall below-benchmark duration exposure. Expect some mild yield curve steepening pressure if the BoJ attempts to use its limited remaining policy tools, like targeting shorter maturities for its asset purchases, to try and alleviate the pressure on banks from negative rates and a flat yield curve. Feature Chart 1The Role Of Japan In Global Bond Investing Is Complex In a year where the majority of global bond markets have delivered stellar returns, Japanese fixed income performance has predictably languished in 2019 compared to the other developed economies. Despite a cyclically weak economy with very low inflation, Japanese government bond (JGB) yields have been locked in narrow ranges at or below 0% throughout the year. Monetary policy is a big reason for that, as the Bank of Japan (BoJ) has run of out of fresh stimulus options to try and push JGB yields even lower. In this Special Report, we make the case for owning JGBs as a low-beta, defensive asset in global fixed income portfolios over the next 6-12 months – a period when improving growth is expected to exert upward pressure on global bond yields, but where JGB yields are expected to remain anchored with Japan likely to lag the global upturn (Chart 1). The Japanese Growth & Inflation Backdrop Is No Threat To JGBs Japan’s economy has suffered alongside the global industrial downturn in 2019, with the Japanese manufacturing PMI struggling below 50 for seven consecutive months. Both business investment and exports have been contracting, in response to the slump in global and trade and increase in uncertainty related to the US-China tariff war. The underlying trend in consumer spending – the largest component of Japan’s economy – is more difficult to interpret, however, because of the volatility surrounding the October hike in the consumption tax. On October 1st, Japanese Prime Minister Abe’s government finally passed its long-desired hike in the consumption tax rate from 8% to 10%, in a bid to begin chipping away at Japan’s massive fiscal debt burden. The timing of the move, which had been twice delayed previously, appears ill-advised given the overall weakness in the economy. That can be seen in the response of consumer demand to the tax increase. Japanese consumers, quite rationally, front-loaded purchases in September in advance of the tax hike, but that surge was followed by a collapse in nominal retail sales in October of -14% on a month-over-month basis (Chart 2). This was much larger than the decreases seen after the previous consumption tax increases in 1997 and 2014. This may seem surprising given that the Japanese unemployment rate is a stunningly low 2.4%, suggesting a tight labor market that should be boosting wage growth and consumer confidence. Quite the opposite is happening, however, as consumer confidence is depressed and wage growth is contracting in real terms (bottom panel). Even more unusual is that real disposable income growth for Japanese households is now up to 5% (year-over-year), after stagnating for much of the previous decade. The acceleration is due to more people, especially women and senior citizens, having joined the labor force and found work – on a “per worker” basis, income growth is much less impressive and is more in line with stagnant wage growth. Therefore, unless there is clear acceleration of wages, a sustainable improvement in aggregate consumption is not expected. In the absence of an unlikely consumer boom, a pickup in global trade and manufacturing activity is a necessary requirement to stabilize the Japanese economy where the manufacturing sector is relatively larger than that of other major developed countries (20% of GDP).1 On that front, the news is getting better with the recent improvement seen in the global manufacturing PMI, global ZEW and our own global leading economic indicator (LEI). Looking at the overall conditions in Japan's manufacturing sector, however, there are still mixed signals indicating that a true bottom has been reached (Chart 3): Chart 2Challenging Times For Japanese Consumers Chart 3A Trough In Japanese Manufacturing the Markit manufacturing PMI did rise modestly in November, but remains at only 48.9 (top panel); the most recent Tankan survey from the BoJ showed that both large and small firms in the manufacturing sector expect business conditions to worsen (second panel); real capital spending growth did perk up in the third quarter in the GDP accounts, but additional gains are unlikely given the still moderate reading on manufacturing business confidence (third panel); machine tool orders continue to contract on a year-over-year basis, although the growth in domestic orders may be stabilizing; foreign orders remain depressed due to weakening Chinese demand for automotive and electronic equipment (bottom panel). Chart 4Japan"s Non-Manufacturing Sector Is Struggling Turning to the services sector, which accounts for around 80% of the Japanese economy, the data also show only moderate growth. This is mainly because demand for services is less influenced by global economic conditions, and more related to the tight labor market and rising household income growth. Even given that better fundamental backdrop, however, it is still not clear that services can drive growth in the Japanese economy in 2020 (Chart 4): Chart 5Past The Worst For Japanese Exports while the Tankan survey of large non-manufacturing firms has stayed at the same high level seen since 2014, the data for smaller firms has weakened steadily throughout 2019; the Markit services PMI index has remain solidly above the 50 boom/bust line all year long, yet overall sales for non-manufacturers contracted by -3.1% on a year-over-year basis in the third quarter of the year according to Japan’s Ministry of Finance. One potential ray of hope for Japanese growth comes from exports. While growth in total nominal exports is still contracting by –9.2% on a year-over-year basis, the recent pickup in our global LEI is heralding a potential bottoming in export momentum (Chart 5). In particular, the emerging market sub-component of our global LEI is signaling a potentially sharp pickup in demand for Japanese exports to Asia (middle panel). A similar optimistic message is given regarding Chinese demand, based on the modest improvement in the OECD China LEI (bottom panel). Yet these developments are still in the early stages and could be derailed by a breakdown of the US-China trade negotiations (not the base case scenario of BCA’s geopolitical strategists). Summing it all up, the Japanese economy remains in a fragile state after absorbing multiple blows from trade uncertainty, contracting global manufacturing activity and, more recently, an ill-timed hike in the consumption tax. While some data is showing signs of bottoming, the momentum is unlikely to be strong enough in 2020 to generate much upward pressure on Japanese bond yields. Japanese Inflation Remains A No-Show Japan remains the poster child for the global low inflation backdrop of the post-crisis decade. Even an economy with an unemployment rate near record lows can still not generate inflation sustainably above 0%. Headline CPI inflation is now at only 0.2%, while and core CPI inflation is slightly higher at 0.7% (Chart 6). The former is being dragged down by the lagged impact of lower oil prices and the stubbornly firm Japanese yen. More worrisome, however, is that services CPI inflation dipped slightly below 0% in November (middle panel), in line with the contraction seen in the domestic corporate goods prices and import prices indices (bottom panel). Chart 6Inflation Remains WELL Below The BoJ"s Target Chart 7Not A Consistent Story From Japanese Inflation Expectations Market-based inflation expectations, measured using either CPI swap rates or breakevens from inflation-linked bonds, are also hovering close to 0% (Chart 7). In a bit of a surprise, survey-based measures of inflation expectations produced by the BoJ are closer to the 2-3% range, even though realized inflation only reached that range once, on an annual calendar year basis, since 1991 – in 2014, unsurprisingly another year with a consumption tax increase. The market-based inflation indicators are more important for bond investors, however. It will take a sustained increase in realized inflation before the JGB market begins to worry about inflation again. Perhaps that can begin to happen in 2020 if Japanese and global growth improves, coming alongside some yen weakness. More likely, next year will be another year of mushy inflation readings from Japan as the economy tries to emerge from the slowdown seen in 2019 and the unnecessary tightening of fiscal policy coming from the consumption tax hike (which is likely to cause a temporary, but not sustained, blip in realized inflation rates in 2020). Bottom Line: The macro backdrop in Japan remains bond friendly for JGBs; growth momentum is only starting to bottom out, but will lag the recovery heralded by improving global leading economic indicators, while inflation remains closer to 0% than the BoJ's 2% target. There’s Not Much New The BoJ Can Do The BoJ remains in a bind with regards to future monetary policy decisions. Inflation remains far below its target, while the economy is struggling to generate above-potential growth. Yet unemployment remains exceptionally low and, by the BoJ’s own estimates, Japan’s economy is operating with no spare capacity (i.e. the output gap is a positive number). For a traditional central bank that believes in the tradeoff between spare capacity/unemployment and inflation, like the BoJ, the data is sending a very confusing message about the next policy move. Can A Weaker Yen Solve Japan’s Low Inflation Problem? Chart 8The Balance Of Payments Remains Yen-Supportive The BoJ’s job in setting the right policy to get Japanese inflation higher would be made a lot easier if the yen were not so stubbornly firm. On a trade-weighted basis, the yen is 10.1% above the low seen in 2018 and 22.9% above the 2015 low (Chart 8). This has happened despite the disappointing performance of the Japanese economy and the negative interest rates that have typically made the yen a good funding currency for global carry trades. While there has been likely been some safe-haven demand for the yen given the global growth uncertainties and sharp decline in non-Japanese bond yields in 2019, the root cause for the yen strength is more fundamental. Our colleagues at BCA Research Foreign Exchange Strategy published a Special Report last week, reviewing the balance of payments of the major global currencies.2 Going through the components for Japan, the current account balance remains firmly positive at 3.4% of GDP, despite the fact that the trade balance is now negative. The main reason for that is the steady 4% of GDP in the investment income balance – an inevitable result given Japan’s massive net foreign asset position. On the capital account side, there has been a steady increase in net foreign direct investment (FDI) outflows over the past several years, as more Japanese companies have moved productive capacity offshore (and fewer foreign companies invest in Japan). In addition, portfolio outflows have been gaining momentum with Japanese investors ramping up their purchases of foreign long term assets. Add it all up and Japan's basic balance (the current account plus net FDI) is now negative for the first time since 2015 (bottom panel). Thus, Japan’s balance of payments may now finally be in a position to generate some yen weakness that can help boost domestic inflation – if some of the uncertainties over global growth and the US-China trade negotiations begin to dissipate, as we expect in 2020. So what can the BoJ do? The BoJ has maintained a negative policy interest rate for 45 months since cutting rates below zero in February 2016. Yet according to our BoJ Monitor, there is still a need for additional monetary policy easing to combat weak growth and inflation (Chart 9). Chart 9The BoJ"s Policy Options Are Limited Interest rate markets do not expect the BoJ to do much with short-term interest rates in 2020, with only -5bps of cuts discounted in the Japanese overnight index swap (OIS) curve. BoJ officials have not outright dismissed the possibility that another rate cut could happen, but policymakers have learned that negative rates are lethal for the profits of the banking system. That can be seen in Japan, where bank profits have contracted -19.4% over the past year as negative borrowing rates have become more deeply entrenched. Other parts of the Japanese financial system, like insurance companies and pension funds that need income to meet payouts and liabilities, also suffer from negative interest rates on domestic fixed income assets. Therefore, the BoJ cutting policy rates deeper into negative territory is a very unlikely outcome, even if the economy and inflation continue to struggle, as the risks to the financial system would be worsened. So what else can the BoJ do to provide further monetary stimulus, if necessary? The choices are limited. The BoJ could alter its forward guidance to signal to the market that rates will remain low for a very long time, but that would have a limited effect with rate levels already so low. The central bank could also ramp up its pace of asset purchases, but that will also prove difficult as it owns nearly 50% of outstanding JGBS and nearly 80% of outstanding ETFs. Buying more assets would likely not generate any easier financial conditions, and would simply further disrupt the liquidity of Japan’s financial markets. A March 2019 academic study found that the impact on Nikkei 225 stock returns from the BoJ ETF buying has grown smaller over time despite the increased purchase amounts.3 Chart 10More Room For The BoJ To Buy Shorter Maturity Bonds The BoJ could lower its “Yield Curve Control” target yield for 10-year JGBs to below 0%, but that would also prove difficult as the BoJ already owns a whopping 75% of all outstanding 10-year JGBs (Chart 10) – a figure that would likely need to increase if global bond yields continue to drift higher in 2020, as we expect, forcing the BoJ to buy more 10-year JGBs to ensure that yields do not rise. A unique option might be for the BoJ to purchase foreign bonds. This would potentially help further weaken the yen, which would help increase exports and inflation. Although given the current global backdrop of populism and trade protectionism, a policy specifically designed to weaken the yen would likely not be greeted warmly by other countries. In our view, there is only one plausible option that the BoJ could consider to ease policy further in 2020 to fight low inflation – choosing a different maturity point for its Yield Curve Target. For example, instead of targeting a 10-year JGB near 0%, the BoJ could target a 5-year JGB near 0%. The BoJ owns a lower share of outstanding bonds in that part of the curve (around 45%, by our calculations). The net result could be a steeper JGB curve, which could help ease the drag on profits of the Japanese banks from negative longer-term yields and a flat curve (Chart 11). One thing is for certain: none of the conditions that we have long believed would be necessary before the BoJ would consider abandoning its yield curve target and letting yields rise – a USD/JPY exchange rate between 115 and 120; core CPI inflation and nominal wage inflation both above 1.5%; and clear signs of JGB overvaluation - are currently in place (Chart 12). The BoJ has to continue to stay accommodative, even if other central banks turn less dovish as global growth improves in 2020. Chart 11Shifting BoJ Purchases Could Generate A Steeper JGB Curve Chart 12These Must ALL Happen Before The BoJ Lifts Its JGB Yield Target   Bottom Line: The BoJ has limited policy choices available to provide more stimulus, with negative policy rates crushing Japanese bank profitability and the central bank already owning massive amounts of JGBs and ETFs. Overweight Low-Beta JGBs In Global Bond Portfolios In 2020 Chart 13Overweight Low-Beta JGBs In 2020 As we have discussed in previous reports, yield betas of developed market sovereign bonds to changes in the “global” bond yield are a good tool to use when considering fixed income country allocation decisions when yields are rising everywhere.4 We are currently recommending overweight allocations to government bonds in countries with more dovish central banks and/or where yields are low in relative terms – namely, Germany, Japan and Australia. Not by coincidence, those are also countries whose government bonds have the lowest yield betas among the major developed economies. The rolling 52-week yield betas for JGB yields to the “global” yield (defined as the yield-to-maturity of the Bloomberg Barclays Global Treasury index) is shown in Chart 13. We show the betas for different maturity “buckets” across the yield curve, and we also present the same betas for US Treasuries and German government bonds for comparison. The betas for JGBs are consistent but positive across the entire yield curve, around 0.5 or less. German yields have a similar beta at shorter maturities but a beta close to 1.0 at the longer-end of the curve. US Treasuries, to no surprise, are the highest beta market, with yield betas of 1.5 or more across the entire yield curve. The positive low beta for JGBs means that Japanese bond yields will still move in the same direction as global yields, but with far less volatility. Thus, during the period when global government bonds are rallying, low-beta markets like Japan underperform versus global benchmarks. That has been the story in 2019, when much of the world needed to ease monetary policy but Japan was already at very accommodative policy settings. When global yields are rising, however, lower beta markets should see smaller yield increases and better relative performance. That will be the story for JGBs in 2020, given the strong likelihood that Japan will lag the global economic rebound that we expect next year and the BoJ will be forced to, once again, be the most dovish central bank among the major economies. Bottom Line: Dedicated bond investors should overweight Japan in global government bond portfolios over the next year, as a complement to an overall below-benchmark duration exposure. Expect some mild yield curve steepening pressure if the BoJ attempts to use its limited remaining policy tools, like targeting shorter maturities for its asset purchases, to try and alleviate the pressure on banks from negative rates and a flat yield curve.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Ray Park, CFA Research Analyst ray@bcaresearch.com Footnotes 1 Based on the value added from manufacturing as % of GDP. Other countries, by comparison: China: 29%; Germany: 21%; World: 16%; US: 11%. Source: United Nations and World Bank. 2 Please see BCA Research Foreign Exchange Strategy Special Report, “Updating Our Balance Of Payments Monitor” dated November 29, 2019, available at fes.bcaresearch.com. 3 Kimie Harada and Tatsuyoshi Okimoto, "The BOJ’s ETF Purchases and Its Effects on Nikkei 225 Stocks", RIETI Discussion Paper Series 19-E-014, March 2019. 4 Please see BCA Research Global Fixed Income Strategy Weekly Report, " Cracks Are Forming In The Bond-Bullish Narrative", dated October 23, 2019, available at gfis.bcaresearch.com.

Feature Recommended Allocation In late November, BCA Research published its 2020 Outlook titled Heading Into The End Game, an annual discussion between BCA’s managing editors and the firm’s longstanding clients Mr. and Ms X.1 We recommend GAA clients read that document for a full analysis of the macro and investment environment we expect in 2020. In this Monthly Portfolio Outlook, we focus on portfolio construction: how we would recommend positioning a global multi-asset portfolio for the 12-month investment horizon in light of that analysis. First, a brief summary of the BCA macro outlook. We believe the global manufacturing cycle is starting to bottom out, partly because of its usual periodicity of 18 months from peak to trough, and also because of easier financial conditions, and some moderate fiscal and credit stimulus from China (Chart 1).  Central banks will remain dovish next year despite accelerating growth. The Fed, in particular, worries that inflation expectations have become unanchored (Chart 2) and, moreover, will be reluctant to raise rates ahead of the US presidential election. This environment implies a moderate rise in long-term interest rates, with the US 10-year Treasury yield rising to 2.2-2.5%. Chart 1Reasons To Expect A Rebound Chart 2Unanchored Inflation Expectations Worry The Fed For an asset allocator, this combination of an improving manufacturing cycle and easy monetary policy looks like a very positive environment for risk assets (Chart 3). We, therefore, remain overweight equities and underweight fixed income. We have discussed over the past few months the timing to turn more risk-on and pro-cyclical in our recommendations.2 Since we are increasingly confident about the probability of the manufacturing cycle turning up, this is the time to make that change. Consequently, the shifts we are recommending in our global portfolio, shown in the Recommended Allocation table and discussed in detail below, add to its beta (Chart 4).   Chart 3A Positive Environment For Risk Assets Chart 4Raising The Beta Of Our Portfolio Chart 5Some Signs Of Risk-On Still Missing Nonetheless, we still have some concerns. China’s stimulus (particularly credit growth) remains half-hearted compared to previous cyclical rebounds in 2012 and 2016. We expect a “phase one” ceasefire in the trade war. But even that is not certain, and it would not anyway solve the long-term structural disputes. To turn fully risk-on, we would want to see signs of a clear rebound in commodity prices and a depreciation of the US dollar, which have not yet happened (Chart 5). The 2020 Outlook proposed some milestones to monitor whether our scenario is playing out and whether we should turn more or less risk-on. We summarize these milestones in Table 1. Given these uncertainties, to hedge our pro-cyclical positioning we continue to recommend an overweight in cash, and we are instituting an overweight position in gold. Table 1Milestones For 2020 Chart 6Recessions Are Caused By Inflation Or Debt How will this cycle end? All recessions in modern history have been caused either by a sharp rise in inflation, or by a debt-fueled asset bubble (Chart 6). The Fed will likely fall behind the curve at some point as, after further tightening in the labor market, inflation starts to pick up. How the Fed reacts to that will determine what triggers the recession. If – as is most likely – it lets inflation run, that could blow up an asset bubble (and it was the bursting of such bubbles which caused the 2000 and 2007 recessions); if it decides to tighten monetary policy to kill inflation, the recession would look more like those of the 1970s and 1980s. But it is hard to see either happening over the next 12-18 months. Equities: As part of our shift to a more pro-risk, pro-cyclical stance, we are cutting US equities to underweight, and raising the euro zone to overweight, and Emerging Markets and the UK to neutral. US equities have outperformed fairly consistently since the Global Financial Crisis (Chart 7) – except during the two periods of accelerating global growth, in 2012-13 (when Europe did better) and 2016-17 (when EM particularly outperformed). The US today is expensive, particularly in terms of price/sales, which looks more expensive than the P/E ratio because the profit margin is at a record high level (Chart 8). The upside for US stocks in 2020 is likely to be limited. In 2019 so far, US equities have risen by 29% despite earnings growth close to zero. Multiples expanded because the Fed turned dovish, but investors should not assume further multiple expansion in 2020. Our rough model for US EPS growth points to around 8% next year (sales in line with nominal GDP growth of 4%, margins expanding by a couple of points, plus 2% in share buybacks). Add a dividend yield of 2%, and US stocks might give a total return of 10% or so. Chart 7US Doesn't Always Outperform Chart 8US Equities Are Expensive To play the cyclical rebound, we prefer euro zone stocks over those in EM or Japan. Euro zone stocks have a higher weighting in sectors we like such as Financials and Industrials (Table 2). European banks, in particular, look attractively valued (Chart 9) and offer a dividend yield of 6%, something investors should find appealing in this low-yield world. EM is more closely linked to China and commodities prices, which are not yet sending strong positive signals. We worry about the excess of debt in EM (Chart 10), which remains a structural headwind: the IMF and World Bank put total external EM debt at $6.8 trillion (Chart 11). Table 2Equity Sector Composition Chart 9Euro Zone Banks Are Especially Cheap Chart 10EM Debt Remains A Headwind Japan is another likely beneficiary of a cyclical recovery. But, before we turn positive, we want to see (1) signs of a stabilization of consumption after the recent tax rise (retail sales fell by 7% year-on-year in October), and (2) clarification of a worrying new investment law (which will require any investor which intends to “influence management” to get prior government approval before buying as little as a 1% stake in many sectors). For an asset allocator this combination of an improving manufacturing cycle and easy monetary policy looks very positive for risk assets. We raise the UK to neutral. The market has been a serial underperformer over the past few years, but this has been due to the weak pound and derating, rather than poor earnings growth (Chart 12). It now looks very cheap and, with the risk of a no-deal Brexit off the table, sterling should rebound further. The UK is notably overweight the sectors we like (Table 2). However, political risk makes us limit our recommendation to neutral. Although the Conservatives look likely to win a majority in this month’s general election, which will allow them to push through the negotiated Brexit deal, subsequent arguments over the future trade relationship with the EU will be divisive. Chart 116.8 Trillion In EM External Debt Chart 12The UK Has Been Derated Since 2016   Fixed Income: We remain underweight government bonds. Stronger economic growth is likely to push up long-term rates (Chart 13). Nonetheless, the rise in yields should be limited. The Fed looks to be on hold for the next 12 months, but the futures market is not far away from that view: it has priced in only a 60% probability of one rate cut over that time. The gap between market expectations and what the Fed actually does is what our bond strategists call the “golden rule of bond investing”. US inflation is also likely to soften over the next few months due to the lagged effect of this year’s weaker growth and appreciating dollar. We do not expect the 10-year US Treasury to rise above 2.5% – the current FOMC estimate of the long-run equilibrium level of short-term rates (Chart 14). Chart 13Growth Will Push Up Rates...   Chart 14...But Only As Far As 2.5%   Within the fixed-income universe, we remain positive on corporate credit. But US investment-grade bond spreads are no longer attractive and so we downgrade them to neutral (Chart 15). Investors looking for high-quality bond exposure should prefer Agency MBS, which trade on an attractive spread relative to Aa- and A-rated corporate bonds. European IG should do better since spreads are not so close to historical lows, risk-free rates should rise less than in the US, and because the ECB is increasing its purchases of corporate bonds. Chart 15US IG Spreads Are Close To Historical Lows Chart 16US Caa Bonds Have Some Catching Up To Do We continue to like high-yield bonds, both in the US and Europe. But we would suggest moving down the credit curve and increasing the weight in Caa-rated bonds. These have underperformed this year (Chart 16), mainly because of technical factors such as their overweight in the energy sector and relatively smaller decline in duration.3 With a stronger economy and rising oil prices, they should catch up to their higher-rated HY peers in 2020. To play the cyclical rebound, we prefer euro zone stocks over those in EM or Japan. Currencies: Since the US dollar is a counter-cyclical currency (Chart 17), we would expect it to weaken against more cyclical currencies such as the euro, and commodity currencies such as the Australian dollar and Canadian dollar. But it should appreciate relative to the yen and Swiss franc, which are the most defensive major currencies. We expect EM currencies to continue to depreciate. Most emerging markets are experiencing disinflation (Chart 18), which will push central banks to cut rates and inject liquidity into the banking system. This will tend to weaken their currencies. Overall, we are neutral on the US dollar. Chart 17The Dollar Is A Counter-Cyclical Currency Chart 18Disinflation Will Push EM Currencies Down Further     Commodities: Industrials metals prices are closely linked to Chinese stimulus (Chart 19). A moderate recovery in Chinese growth should be a positive, and so we raise our recommendation to neutral. But with question-marks still lingering over the strength of the rebound in the Chinese economy, we would not be more positive than that. Oil prices should see moderate upside over the next 12 months, with supply tight and demand growth recovering in line with the global economy. Our energy strategists forecast Brent crude to average $67 a barrel in 2020 (compared to a little over $60 today). Chart 19Metals Prices Depend On China Chart 20Gold: Short-Term Negatives, But Remains A Good Hedge   Gold looks a little overbought in the short term, and less monetary stimulus and a rise in rates next year would be negative factors (Chart 20). Nonetheless, we see it as a good hedge against our positive economic view going awry, and against geopolitical risks. If central banks do decide to let economies run hot next year and ignore rising inflation, gold could do particularly well. We, therefore, raise our recommendation to overweight on a 12-month horizon.     Garry Evans, Senior Vice President Chief Global Asset Allocation Strategist garry@bcaresearch.com Footnotes 1    Please see "Outlook 2020," dated November 22 2019, available at bcaresearch.com 2   Please see, for example, last month’s GAA Monthly Portfolio Update, “Looking For The Turning-Point,” dated November 1, 2019, available at gaa.bcaresearch.com 3   For a more detailed explanation, please see US Bond Strategy Weekly Report, “Caa-Rated Bonds: Warning Signs Or Buying Opportunity,” dated 26 November 2019, available at usbs.bcaresearch.com GAA Asset Allocation

Highlights Investors should remain overweight global stocks relative to bonds over the next 12 months and begin shifting equity exposure towards non-US markets. Bond yields will rise next year as global growth picks up, while the dollar will sell off. The extent to which bond yields increase over the long term depends on whether inflation eventually stages a comeback. Today’s high debt levels could turn out to be deflationary if they curtail spending by overstretched households, firms, and governments. However, high debt levels could also prompt central banks to engineer higher inflation in order to reduce the real burden of debt obligations. Which of these two effects will win out depends on whether central banks are able to gain traction over the economy. This ultimately boils down to whether the neutral rate of interest is positive or negative in nominal terms. While there is little that policymakers can do to alter certain drivers of the neutral rate such as the trend rate of economic growth, they do have control over other drivers such as the stance of fiscal policy. Ironically, a structural shift towards easier fiscal policy could lead to a decline in government debt-to-GDP ratios if higher inflation, together with central bankers' reluctance to raise nominal rates, pushes real rates down far enough. This suggests that the endgame for today’s high debt levels is likely to be overheated economies and rising inflation.   Stay Bullish On Stocks But Shift Towards Non-US Equities We returned to a cyclically bullish stance on global equities following the stock market selloff late last year, having temporarily moved to the sidelines in June 2018. We have remained overweight global equities throughout 2019. Two weeks ago, we increased our pro-cyclical bias by upgrading non-US stocks within our recommended equity allocation at the expense of their US peers. Our decision to upgrade non-US equities stems from the conviction that global growth has turned the corner. Manufacturing has been at the heart of the global slowdown. As we have often pointed out, manufacturing cycles tend to last about three years – 18 months of weaker growth followed by 18 months of stronger growth (Chart 1). The current slowdown began in the first half of 2018, and right on cue, the recent data has begun to improve. The global manufacturing PMI has moved off its lows, with significant gains seen in the new orders-to-inventories component. Global growth expectations in the ZEW survey have rebounded. US durable goods orders surprised on the upside in October. The regional Fed manufacturing surveys have also brightened, suggesting upside for the ISM next week (Chart 2). Chart 1A Fairly Regular Three-Year Manufacturing Cycle Chart 2Some Manufacturing Green Shoots     Unlike in 2016, China has not allowed a major reacceleration in credit growth this year. Instead, fiscal policy has been loosened significantly. The official general government deficit has increased from around 3% of GDP in mid-2018 to 6.5% of GDP at present. The augmented budget deficit – which includes spending through local government financing vehicles and other off-balance sheet expenditures – is on track to reach nearly 13% of GDP in 2019. This is a bigger deficit than during the depths of the Great Recession (Chart 3). As a result of all this fiscal easing, the combined Chinese credit/fiscal impulse has continued to move up. It leads global growth by about nine months (Chart 4). Chart 3China Has Been Stimulating, Fiscally Chart 4Chinese Stimulus Should Boost Global Growth The dollar tends to weaken when global growth strengthens (Chart 5). The combination of stronger global growth and a softer dollar will disproportionately benefit cyclical equity sectors. Financials will also gain thanks to steeper yield curves (Chart 6). The sector weights of non-US stock markets tend to be more tilted towards deep cyclicals and financials. As a consequence, non-US stocks typically outperform when global growth picks up (Chart 7). Chart 5The Dollar Is A Countercyclical Currency Chart 6Steeper Yield Curves Will Benefit Financials In addition, valuations favor stocks outside the US. Non-US equities currently trade at 13.8-times forward earnings, compared to 18.1-times for the US. The valuation gap is even greater if one looks at price-to-book, price-to-sales, and other measures (Chart 8). Chart 7Non-US Equities Usually Outperform When Global Growth Improves Chart 8US Stocks Are Relatively More Expensive Trade War Remains A Key Risk The US-China trade war remains a key risk to our bullish equity view. President Trump continues to send conflicting signals about the status of the talks. He complained last week that Beijing is not “stepping up” in finalizing a phase 1 agreement, adding that China wants a deal “much more than I do.” This Wednesday he struck a more optimistic tone, saying that negotiators were in the “final throes” of deal. However, he made this statement on the same day that he decided to sign the Hong Kong Human Rights and Democracy Act into law, a decision that was bound to antagonize China. According to our BCA geopolitical team, Trump had little choice but to sign the bill. The Senate approved it unanimously, while the House voted for it 417-1. Failure to sign it would have resulted in an embarrassing veto by the Senate. The key point is that the new law does not force Trump to take any immediate actions against China. This suggests that the trade talks will continue. In fact, from China's point of view, Congress’ desire to pass a Hong Kong bill may provide a timely reminder that getting a deal done with Trump now may be preferable to waiting until after the election and potentially facing someone like Elizabeth Warren who is likely to make human rights a key element of any deal to roll back tariffs. Waiting For Inflation If global growth accelerates next year, history suggests that bond yields will rise (Chart 9). Looking further out, the extent to which bond yields will continue to increase depends on whether inflation ultimately stages a comeback. Right now, most of our forward-looking inflationary indicators remain well contained (Chart 10). However, this could change if falling unemployment eventually triggers a price-wage spiral. Chart 9Stronger Economic Growth Will Put Upward Pressure On Government Bond Yields Chart 10An Inflation Breakout Is Not Imminent     Many investors are skeptical that such a price-wage spiral could ever emerge. They argue that automation, globalization, weak trade unions, and demographic changes make an inflationary outburst rather implausible. We have addressed these arguments in the past1 and will not delve into them in this report. Instead, we will focus on one argument that also gets a fair bit of attention, which is that high debt levels will prove to be deflationary. Are High Debt Levels Inflationary Or Deflationary? Total debt levels in developed economies are no lower today than they were during the Great Recession. While private debt has fallen, public debt has risen by roughly the same magnitude, leaving the overall debt-to-GDP ratio unchanged (Chart 11). Meanwhile, debt levels in emerging markets have risen substantially. A common rebuttal to any suggestion that inflation might rise over the medium-to-longer term is that high debt levels around the world will cause households, firms, and governments to pare back spending. While this may be true, it could also be argued that high debt levels could prompt central banks to engineer higher inflation in order to reduce the real burden of debt obligations. So which effect will win out? Given the choice, it is likely that most policymakers would opt for higher inflation. This is partly because high unemployment and fiscal austerity are politically toxic. It is also because falling prices make it very difficult to reduce real debt burdens. The experience of the Great Depression bears this out: Private debt declined by 25% in absolute terms between 1929 and 1933. However, due to the collapse in nominal GDP, the ratio of debt-to-GDP actually increased more in the first half of the 1930s than during the Roaring Twenties (Chart 12). Chart 11Global Debt Levels Remain High Chart 12The Experience Of The Great Depression Shows Deleveraging Is Impossible Without Growth   Means, Motive And Opportunity Chart 13A Kinked Relationship: It Takes Time For Inflation To Break Out There is a big difference between wanting to engineer higher inflation and being able to do so. The distinction between success and failure ultimately boils down to a seemingly technical question: Is the neutral rate of interest – the interest rate consistent with full employment and stable inflation – positive or negative in nominal terms? When the neutral rate is above zero, central banks can gain traction over the economy. Even if the neutral rate is only slightly positive, a zero rate would be enough to keep monetary policy in expansionary territory. When monetary policy is accommodative, the unemployment rate will tend to drop. Eventually the “kink” in the Phillips curve will be reached, resulting in higher inflation (Chart 13). In contrast, when the neutral rate is firmly below zero, monetary policy loses traction over the economy. Since there is a limit to how deeply negative policy rates can go before people decide to hold cash, the central bank could find itself out of ammunition. This could set off a vicious circle where high unemployment causes inflation to drift lower, leading to an increase in real rates. Rising real rates will then further curb spending, causing inflation to fall even more. Drivers Of The Neutral Rate Two of the more important determinants of the neutral rate of interest are the growth rate of the economy and the national savings rate. If either the savings rate rises or economic growth slows, the stock of fixed capital will tend to pile up in relation to GDP, leading to a higher capital-to-output ratio.2 As Chart 14 shows, this has already happened in Europe and Japan. An increase in the capital-to-GDP ratio will drag down the rate of return on capital. A lower interest rate will be necessary to ensure that the capital stock is fully utilized. Chart 14Capital Stock-To-Output Ratios Have Risen Realistically, there is not much that policymakers can do to raise trend GDP growth. While looser immigration policy would allow for a faster expansion of labor force growth, this is politically contentious. Increasing productivity growth is also easier said than done. Fiscal Policy And The Neutral Rate In contrast, policymakers already have a ready-made mechanism for lowering the savings rate: fiscal policy. The fiscal balance is a component of national savings. If the government runs a larger budget deficit in order to finance tax cuts or higher transfer payments to households, national savings will decline and aggregate demand will rise. Is the endgame for today’s high debt levels deflation or inflation? The answer is inflation. Since one can think of the neutral rate as the interest rate that brings aggregate demand in line with the economy’s supply-side potential, anything that raises demand will also lift the neutral rate. Once the neutral rate has risen above the zero bound, monetary policy will gain traction again. This implies that central banks should never run out of ammunition in countries whose governments can issue debt in their own currencies. While higher inflation stemming from fiscal stimulus will erode the real value of private sector debt obligations, won’t the impact on total debt be offset by the increase in public debt? Not necessarily. True, larger budget deficits will raise the stock of government debt. However, nominal GDP will also rise on account of higher inflation. Standard debt sustainability equations state that the government debt-to-GDP ratio could actually fall if higher inflation pushes real policy rates down far enough. As discussed in Box 1, such an outcome is quite likely when inflation accelerates in response to an overheated economy, but the central bank nevertheless refrains from raising nominal rates. The Final Verdict We are finally ready to answer the question posed in the title of this report: Is the endgame for today’s high debt levels deflation or inflation? The answer is inflation. People with a 30-year fixed rate mortgage will always favor inflation over deflation. And there are more voters who owe mortgage debt than own mortgage debt. Chart 15Germany's Competitive Advantage Over The Rest Of The Euro Area Is Deteriorating Politics is moving in a more populist direction. Whether it is left-wing populism of the Elizabeth Warren/Jeremy Corbyn variety or right-wing populism of the Donald Trump/Matteo Salvini variety, the result is usually bigger budget deficits and higher inflation. Even in those countries where populism has been slow to take hold, there may be pragmatic reasons for loosening fiscal policy. For example, Germany’s trade surplus with the rest of the euro area has fallen in half since 2007, largely because German unit labor costs have increased more than elsewhere (Chart 15). As Germany loses its ability to ship excess production to the rest of the world, it may end up having to rely more on easier fiscal policy to bolster demand. Of course, the path to higher inflation is paved with interest rates that stay lower for much longer than the economy needs to reach full employment. This means we are entering a period where first the US economy, and then many other economies, will start to overheat, and yet central banks will still refrain from tightening monetary policy until inflation rises well above their comfort zones. Such an environment will be positive for stocks for as long as it lasts, even if it eventually produces a mighty hangover.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com   Box 1 When Does A Large Budget Deficit Lead To A Lower Government Debt-to-GDP Ratio?   Footnotes 1    Please see Global Investment Strategy Special Report, “1970s-Style Inflation: Could It Happen Again? (Part 2),” dated August 24, 2018. 2   This point can be seen through the lens of the widely used Solow growth model. In steady state, the desired level of investment in the model is given by the formula: I=(a/r)(n+g+d)Y where a denotes the output elasticity of capital, r is the real rate of interest, n is labor force growth, g is productivity growth, d is the depreciation rate, and Y is GDP. Savings is assumed to be a constant fraction of income, S=sY. Equating savings with investment yields: r=(a/s)(n+g+d). A decrease in the growth rate of the economy (n+g) shifts the investment schedule downward, leading to a lower equilibrium rate of interest. This initially makes investing in fixed capital more attractive than buying bonds. Over time, however, the marginal return on capital will fall as the capital stock expands in relation to GDP.    Strategy & Market Trends MacroQuant Model And Current Subjective Scores Strategic Recommendations Closed Trades

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Highlights Building on a previous special report focused on the investable market, in this report we construct and present models designed to predict the odds of Chinese domestic equity sector outperformance. BCA Research's China Investment Strategy service will aim to use our newly developed sector outperformance probability models to better understand the drivers of performance at any given moment, and to make more active equity sector recommendations in the future. Episodes of domestic equity sector outperformance over the past decade appear to be more idiosyncratic (or sector specific) than has been the case for the investable market, suggesting that periods of “abnormal” relative sector performance may occur more frequently than in the investable universe. Among the predictors included in our model, our Li Keqiang leading indicator (based on monetary conditions, money, and credit growth) has been the most important. Our base case view argues in favor of domestic cyclicals over defensives over the coming year, but recent sector performance suggests that domestic consumer discretionary and tech should be favored within a cyclical equity portfolio over energy, materials, and industrials barring a surge in oil prices or a capitulation by Chinese policymakers in favor of “flood irrigation-style” stimulus. Over the long-term, we argue that investors have a good reason to favor domestic defensives over cyclicals until the latter demonstrates meaningfully better earnings performance. Feature We examined China’s investable equity sector performance in detail in our October 30 Special Report,1 with a particular emphasis on understanding the specific macroeconomic or equity market factors that have historically predicted relative sector performance. In today’s report, we extend our approach to China’s A-share market. Our research focused on constructing and presenting models that quantify a checklist-based approach to determining the odds of equity sector performance. The aim is to use these models to better understand the drivers of performance at any given moment, and to make more active equity sector recommendations in the future. These recommendations will not mechanically follow the models; rather, we plan to use them as a stand in for what typically would be expected given the macro and financial market environment, and as a basis to investigate “abnormal” relative performance. We find that episodes of domestic equity sector outperformance over the past decade appear to be more idiosyncratic (or sector specific) that has been the case for the investable market, suggesting that periods of “abnormal” relative sector performance may occur more frequently than in the investable universe. Among the macroeconomic and equity market factors that we found to be important predictors, our Li Keqiang leading indicator was the most significant. This confirms that China’s domestic market is more sensitive to monetary conditions, money, and credit growth than its investable peer. We also note the sharp difference in the relative performance of cyclicals versus defensives in the domestic market compared with the investable market, and what this means for investors over the coming 6-12 months. Finally, we argue that investors should maintain a structural bias towards defensive stocks in the domestic market until cyclicals demonstrate meaningfully better earnings performance, and point to an existing position in our trade book for investors interested in strategically allocating to the A-share market. Detailing Our Approach In our effort to better understand historical periods of domestic sector performance, we have chosen to model the probability of outperformance of each level 1 GICS sector (plus banks) based on a set of macro and equity market variables. Specifically, we use an analytical tool called a logistic regression, which forecasts the probability of a discrete event rather than forecasting the value of a dependent variable. We utilized this approach when building our earnings recession model for China (first presented in our January 16 Special Report).2 The “events” that we modeled are historical periods of individual Chinese investable sector outperformance from 2010 to 2018, relative to the MSCI China index (the “broad market”). We find that episodes of domestic equity sector outperformance over the past decade appear to be more idiosyncratic (or sector specific) than has been the case for the investable market. Chart I-1A and Chart I-1B illustrate these periods with shading in each panel. We then attempt to explain these episodes of outperformance with the following macro predictors: Chart I-1AThis Report Builds Models ##br##Aimed At... Chart I-1B...Predicting The Shaded Regions Of These Charts Periods of accelerating economic activity, represented by our BCA's China Activity Index Periods of rising leading indicators of economic activity, represented by our BCA Li Keqiang (LKI) Leading Indicator Episodes of tight monetary policy, defined as periods where China’s 3-month interbank repo rate is rising Periods of accelerating inflation, measured both by headline and core inflation We also include several equity market variables: uptrends in relative sector earnings, periods of rising broad market stock prices, uptrends in broad market earnings, and episodes of extreme technical conditions and relative over/undervaluation for the sector in question. In the case of energy stocks, we also include oil prices as a predictor. Chart I-2A and Chart I-2B illustrate these periods as well as the macro & market variables that we have included as predictors. Chart I-2AWe Use These Macroeconomic And Equity Market Factors... Chart I-2B...To Predict Periods Of Equity Sector Outperformance Our approach also accounts for the existence of any leading or lagging relationships between the macro and market variables we have used as predictors and sector relative performance. In most cases the predictors lead relative sector performance, but in some cases it is the opposite. In the case of the latter, we have limited the lead of any variable in our models to three months in order to reduce the need to forecast. Finally, our approach also limits the extent to which we consider a leading relationship between our predictors and relative sector performance, in order to avoid picking up overlapping economic cycles. This issue, and the evidence supporting the existence of a 3½-year credit cycle in China, is detailed in Box I-1 of our October 30 Special Report (please see footnote 1). Key Drivers Of Sector Performance: Domestic Versus Investable Pages 11-22 present the results of each sector’s outperformance probability model, along with a list of factors that were found to be useful predictors and a summary of the results. The importance of the factors included in the models is shown in each of the tables at the top right of pages 11-22 by a score of 1-3 stars, (loosely representing key levels of statistical significance) as well as each factor’s optimal lead or lag. A minus sign shows that the predictor leads sector relative performance, whereas a plus sign shows that it lags. Following a review of our domestic equity sector outperformance models, differences in the results from those presented in our previous report can be organized into three distinct elements: 1) the breadth of macro & equity market factors in predicting sector performance, 2) the relative importance of our LKI leading indicator, and 3) the difference between domestic/investable cyclical versus defensive performance. The Breath Of Predictive Factors Chart I-3In The Domestic Market, The Breadth Of Predictive Factors Is Narrower Compared with the models for investible sector performance that we detailed in our previous report, our work modeling domestic equity sector performance highlights that the breadth of predictive factors is narrower, particularly among cyclical sectors (Chart I-3). Our model for domestic materials (shown on page 12) is one exception to this rule, but we found that our models for energy, industrial, and consumer discretionary relative performance were all focused on fewer predictors than is the case for the investable market. In addition, our domestic utilities model has considerably worse predictive power than our model for investable utilities. The case of industrials is particularly notable: our model for investable industrials highlighted the importance of tight monetary policy, rising core inflation, rising broad market stock prices & earnings, and overbought and oversold technical conditions in explaining past periods of industrial sector outperformance. By contrast, our domestic industrials model is quite simple: the sector has been more likely to outperform, with a lag, when our BCA China Activity Index and LKI leading indicator have been rising, and underperform following periods of extreme overvaluation. One of the core conclusions of our previous report was that investors should view the relative performance of investable industrials versus consumer staples as a reflationary barometer, given the strong sensitivity of both sectors to tight monetary policy. We explained this sensitivity by pointing to the substantial difference in corporate health between the two sectors: industrial firms are heavily debt-laden and thus experience deteriorating operating performance and an environment of rising interest rates. In comparison, food and beverage firms appear to have the strongest balance sheets among the sub-sectors that we have examined, suggesting that they would benefit less from easier monetary conditions than firms in other industries. Our leading indicator for Chinese economic activity has been considerably more important in predicting domestic equity sector outperformance than in the investable market. However, these dynamics appear to be completely absent in influencing performance in China’s domestic equity market. Not only has domestic industrial sector relative performance not been negatively linked to periods of tight monetary policy, but our model for consumer staples (shown on page 15) highlights that periods of staples performance have been driven by two simple factors: the relative trend in staples EPS  (positive sign), and the trend in broad market EPS (negative sign). The Relative Importance Of Monetary Conditions, Money, And Credit Growth Chart I-4 summarizes the significance of the factors in predicting sector performance in general, by summing up each predictor’s number of stars across all of the models. The chart shows that our LKI leading indicator is the most important signal of sector performance that emerged from our analysis, followed by rising core inflation, rising broad market stock prices, rising economic activity, and oversold technical conditions. The ranking of results shown in Chart I-4 is fairly similar to those that we listed for the investable market, with two exceptions. First, for the domestic market, periods of tight monetary policy were considerably less important than in the investable market as an important predictor of relative sector performance. Instead, our LKI leading indicator was by far the most important predictor, which underscores a point that we have made in previous reports: domestic stocks appear to be much more sensitive to the trend in monetary conditions, money, and credit growth than for the investable market. This increased sensitivity has helped explain the difference in performance this year between the investable and domestic market, underscoring that the former has more catch-up potential than the latter in a trade truce scenario. Chart I-4Monetary Conditions, Money, & Credit Growth Drive A-Share Performance Second, in the investable market, episodes of significant overvaluation had essentially no power to predict future episodes of equity market underperformance. But this factor was an important or very important contributor to our domestic industrials, health care, and tech models. This finding is consistent with our May 23 Special Report, which noted that value stocks have outperformed in China’s domestic equity market over the past five years and underperformed in the investable market (Chart I-5). Chart I-5Value Has Been A More Successful ##br##Factor In The Domestic Market   Major Differences In The Performance Of Cyclicals Versus Defensives The results of our models for domestic equity sector performance did not change the cyclical & defensive labels that we applied in our previous report. The signs of the predictors shown in the tables on pages 11-22 clearly highlight that the domestic energy, materials, industrials consumer discretionary, and information technology sectors are cyclical sectors, and that consumer staples, health care, financials, telecom services, utilities, and real estate are defensive. What is striking, however, is that there is a major difference in the relative performance of equally-weighted domestic cyclicals versus defensives compared with what has occurred in the investable market over the past decade. Chart I-6A and Chart I-6B illustrate the different relative performance trends, along with their corresponding trends in relative P/E and relative EPS. Whereas the relative performance of investable cyclicals versus defensives has had somewhat of a stable mean over the past decade, domestic cyclicals have badly underperformed since early-2011. The charts also make it clear that this underperformance has been driven by a downtrend in relative EPS, not due to trend differences in relative valuation. Chart I-6ACyclicals/Defensives Somewhat Mean-Reverting In The Investable Market... Chart I-6B...But Not So In The Domestic##br## Market Digging further, it appears that this discrepancy can be largely explained by the significant difference in performance between investable and domestic tech over the past decade (Chart I-7). Whereas the former has outperformed the overall investable index by roughly 4-5 times since 2010, the relative performance of the latter has only very modestly risen. In effect, Charts I-6 and I-7 highlight that Chinese cyclical sectors have been structurally impaired over the past decade and have only been “saved” in the investable market by massive outsized outperformance of the tech sector. The fact that investable tech sector performance itself has been largely driven by 2 extremely successful firms underscores how narrowly based the investible cyclical versus defensives performance trend has been. Chart I-7A Huge Gap In Tech Explains Domestic Cyclical Underperformance Investment Conclusions There are three conclusions that investors can draw from our analysis. First, our research shows that episodes of domestic equity sector outperformance over the past decade appear to be more idiosyncratic (or sector specific) that has been the case for the investable market. This does not mean that domestic sector performance is not significantly impacted by macro and top down equity market factors, but it suggests that periods of “abnormal” relative sector performance may occur more frequently than in the investable universe. As such, investors should be prepared to include episode-specific investigation of abnormal performance as a regular part of their domestic equity sector allocation decisions. Investors should favor domestic cyclicals over the coming year, with exposure focused on consumer discretionary and tech. Second, the fact that our LKI leading indicator is in an uptrend suggests that investors should favor domestic cyclicals over defensives over the coming year, with a caveat. We have noted in several previous reports that our indicator is in a shallow uptrend, and the slower pace of money and credit growth than during previous economic upswings suggests that the bar may be higher for some cyclical sectors to outperform. We would advise investors to watch closely over the coming 3-6 months for signs of a technical breakout in all cyclical sectors. But sector performance in Q1 of this year, when the overall A-share market rose sharply versus global stocks, suggests that domestic consumer discretionary and tech should be favored within a cyclical equity portfolio over energy, materials, and industrials barring a surge in oil prices or a capitulation by Chinese policymakers in favor of “flood irrigation-style” stimulus (Chart I-8). Within resources, we prefer the investable energy sector to its domestic peer, due to a sizeable valuation advantage. Chart I-8Favor Select Domestic Cyclical Sectors Over The Coming Year As a third and final point, abstracting from our bullish outlook for select cyclical sectors over the coming year, Charts 6 and 7 clearly argue for investors to maintain a structural bias towards defensive stocks in the domestic market until cyclicals demonstrate meaningfully better earnings performance. In the May 23 Special Report that we referred to above, we noted that an A-share portfolio formed of industry groups with above-median return on equity and below-median ex-post beta has significantly outperformed over the past decade. Table I-1 presents the current industry group weights of this portfolio, and shows that overweight exposure is concentrated in the health care, consumer staples, and real estate sectors (all of which are defensive), and a heavy underweight towards industrials. Table I-1Current High ROE / Low Beta Factor Industry Group Portfolio Weights* For clients who are interested in strategically allocating to the A-share market, we maintain a long position in this portfolio relative to the MSCI China A Onshore index in our trade book, and plan to continue to update the performance of the trade on a weekly basis. Energy Chart II-1 Table II-1 Similar to the investable energy sector, periods of domestic energy sector outperformance are strongly positively related to rising oil prices and rising headline inflation in China. We noted in our previous report that this is a behavioral relationship, rather than a fundamental one. Domestic energy stocks are negatively associated with rising broad market stock prices, unlike their investable peers. This largely reflects the fact that the relative performance of domestic energy stocks has been in a structural downtrend over the past decade. From 2010 to mid-2016, this decline was caused by a persistent underperformance in earnings. Since mid-2016, domestic energy sector EPS have been rising in relative terms, meaning that more recent underperformance has been due to multiple contractions. While not as relatively cheap as their investable peers, domestic energy stocks are heavily discounted versus the broad domestic market based on both the price/earnings ratio and the dividend yield. Consequently, it is possible that domestic energy stocks may at some point begin to outperform in a rising broad equity market environment. For now, our model argues for an underweight stance towards domestic energy due to the lack of a clear uptrend in oil prices. As a pure value play, investable energy stocks maintain a dividend yield of nearly 6.5%, and are thus more attractive than their domestic peers. Materials Chart II-2 Table II-2 Our model for the domestic materials highlights that the sector’s performance has been related to strengthening economic activity and strongly related to a rising Li Keqiang leading indicator. Among the equity market variables that we tested, materials outperformance has been positively associated with rising relative EPS, rising broad market EPS, and prior oversold technical conditions. Similarly, the investable materials sector, these results show that domestic materials are a strong play on accelerating Chinese economic activity. The factors included in our domestic materials sector model are similar to those included in our investable material, except that relative material earnings have also been a significant predictor of sector relative performance. In addition, the macro & equity market predictors included in our domestic materials model have done a better job of leading material sector performance. The odds of domestic materials outperformance rose twice above the 50% mark this year according to our model, without any corresponding improvement in relative stock prices. The spikes in the model occurred largely because domestic materials became significantly oversold; technical conditions for the sector have only twice been weaker over the past decade. This underscores that investors should be watching domestic materials closely in Q1 of next year for signs of a relative rebound. Industrials Chart II-3 Table II-3 The results of our model for domestic industrial sector outperformance are interesting, as they imply that the drivers of performance are different between the domestic and investable markets. In the investable index, we found that industrials were heavily sensitive to monetary policy, rising core inflation, relative sector earnings, and periods of rising broad market stock prices. Our domestic model is considerably simpler: industrials outperform, with a lag, when our activity index and Li Keqiang leading indicator are rising. Periods of strong overvaluation have also been significant in predicting future episodes of domestic industrial sector underperformance. It is not clear to us why the drivers of relative performance for domestic industrials have been different than in the investable equity index, But the good news is that the relative simplicity of the model makes the investment decision making process for domestic industrials considerably easier. Today, domestic industrials are significantly undervalued, and our Li Keqiang leading indicator is in a shallow uptrend. This suggests that domestic industrials are likely to begin outperforming at some point in early-2020 following a bottoming in Chinese economic activity, unless policymakers are quick to tighten once activity begins to improve (which would be contrary to our expectations). Consumer Discretionary Chart II-4 Table II-4 Our domestic consumer discretionary model highlights that the sector’s relative performance is positively associated with a rising Li Keqiang leading indicator, rising core inflation, and rising broad market stock prices. Similar to its investable peers, domestic consumer discretionary stocks are cyclical, and positive relationship with core inflation may reflect improved pricing power for the sector. Unlike investable consumer discretionary, the domestic consumer discretionary has not been meaningfully impacted by the December 2018 changes to the global industry classification standard. Hence, our model does not exclude the internet & direct marketing retail sector as we did in our previous report on investable sectors. For now, our model suggests that the domestic consumer discretionary sector is likely to continue to underperform, given decelerating core inflation and the lack of a clear uptrend in the broad domestic equity index. However, as a cyclical sector, we will be watching closely for an upside breakout in domestic consumer discretionary performance in the first quarter as a signal to increase exposure to the sector. Consumer Staples Chart II-5 Table II-5 Our domestic consumer staples model is significantly different than that shown in our previous report for investable staples. This reflects sizeable differences in investable/domestic staples relative performance over the past decade, particularly from mid-2015 to late-2017 (where domestic staples outperformed significantly and investable staples languished). Of the two predictors found to be significant in explaining historical periods of domestic staples performance, a negative relationship with the trend in broad market EPS has been the most important. This underscores that staples are defensive sector. The trend in staples relative earnings has closely followed in importance, showing that the tremendous outperformance in domestic consumer staples over the past several years has, at least in part, been driven by fundamentals. Still, domestic consumer staples are currently priced at 34x earnings per share, compared with 15x for the overall domestic market. While our model currently argues for continued staples outperformance, the risk of a valuation mean reversion next year, against the backdrop of an improving economy, is above average. Over the coming 6-12 months, investors should be closely monitoring domestic staples for signs of waning earnings momentum and/or a major technical breakdown as potential signals to reduce domestic staples exposure. Health Care Chart II-6 Table II-6 Over the past decade, periods of domestic health care outperformance have been negatively associated with rising economic activity, rising core inflation, and rising broad market stock prices. Oversold technical conditions and periods of overvaluation have also helped predict future episodes of health care relative performance. These factors clearly point to the defensive nature of domestic health care, similar to health care stocks in the investable index. However, one clear difference between investable and domestic health care is that the former appears to have leading properties and the latter does not. We noted in our previous report that periods of investable health care underperformance appeared to lead, on average, our BCA Activity Index, periods of rising core inflation, and uptrends in the broad investable index. By contrast, domestic health care lags the Activity Index and core inflation by just over a year, and also lags the trend in broad market EPS. Our model points to further health care outperformance, but we would expect domestic health care stocks to underperform at some point next year following an improvement in economic activity and a resumed uptrend in broad domestic EPS. Financials Chart II-7 Table II-7 Our outperformance probability model for domestic financials highlights that the sector is countercyclical: periods of outperformance have been negatively related to our LKI leading indicator, rising core inflation, and rising broad market stock prices. Similar to the case of the investable index and unlike the case globally, financials are clearly defensive. Investable financials have exhibited atypical performance this year according to the model presented in our previous report. By contrast, domestic financials have performed in line with what our model has suggested: our LKI leading indicator is in a shallow uptrend, and the relative performance of domestic financials has trended flat-to-down since late-2018. Barring a major shift by the PBoC towards a hawkish stance in the coming year (which we do not expect), our base case view for the Chinese economy implies that domestic financials are likely to continue to underperform. Banks Chart II-8 Table II-8 Our model for domestic banks is similar to that of financials, with some important differences. In addition to being sensitive to our LKI leading indicator, domestic bank performance is negatively related to our Activity Index. Oversold technical conditions have also been quite important in predicting future episodes of domestic bank outperformance. The model is currently forecasting domestic bank underperformance, although it was late in predicting the selloff in bank stocks that began late last year. Similar to the case for domestic financials, our baseline view for the Chinese economy implies that domestic bank are likely to continue to underperform over the coming year. Information Technology Chart II-9 Table II-9 Our model for the domestic technology sector is different than that of investable tech, which reflects the vast difference in performance between the two sectors. While the relative performance of domestic tech has trended sideways over the past decade, investable tech stock prices have risen fourfold relative to the broad investable index. This difference is largely accounted for by the absence of the BAT stocks (Baidu, Alibaba, Tencent) from the domestic market. Similar to investable tech, domestic technology stocks are negatively related to tight monetary policy, and positively linked with a pro-cyclical economic variable (a rising LKI leading indicator). However, strangely, domestic tech has been strongly and negatively related to rising headline inflation, a finding with no clear fundamental basis. The model has been less successful in predicting domestic tech performance over the past year than in the past, which appears to be linked to the inclusion of headline inflation in the model. Rising headline inflation has been clearly associated with three major episodes of domestic tech underperformance since 2010, but over the past year domestic tech has outperformed as headline inflation accelerated. For now we would advise investors to focus on the other factors in the model: the lack of overvaluation, and our view that policy will remain easy on a measured basis, supports an overweight stance towards domestic tech over the coming year. Telecom Services Chart II-10 Table II-10 Our domestic telecom services relative performance model highlights that the sector is defensive like its investable peer, but the factors driving performance are somewhat different. The only similarity between the two models is that periods of outperformance are negatively related to rising broad market stocks prices for both investable and domestic telecom services, with domestic telecom stocks responding with a lag. Among the macro factors included in the model, periods of domestic telecom services outperformance are negatively and coincidently related to our LKI leading indicator, and positively related to tight monetary policy (with a slight lead). Oversold technical conditions have also proven to help predict future episodes of outperformance. The model failed to predict a brief period of outperformance in mid-2018, but has generally accurately predicted underperformance of domestic telecom stocks since early-2017. Barring a collapse in the US/China trade talks or considerably weaker near-term economic conditions than we expect, domestic telecom services will likely continue to underperform until the specter of tighter monetary policy emerges. This is unlikely to occur until the middle of 2020, at the earliest. Utilities Chart II-11 Table II-11 Overall, our domestic utilities model has considerably worse predictive power than our model for investable utilities. The model shows that the performance of domestic utilities is negatively related to rising core inflation (with a lag) and rising broad market EPS, but these relationships are not particularly strong. We noted in our June 19 Special Report that domestic utilities ranked highly on the impact that relative EPS had on predicting relative stock prices , yet relative sector earnings did not register as a significant predictor in our model. This apparent discrepancy is resolved by differences in the time horizon between these two approaches. The analysis that we presented in our June 19 Special Report examined the relationship between earnings and stock prices over the entire sample period (2011-2018), meaning that it examined the predictive power of earnings over the long-term. The models built in this report have focused strongly on explaining periods of outperformance over a 6-12 month time horizon, there have been enough deviations in the trend between the relative performance of utilities and relative utilities earnings that the relationship between the two was not sufficiently strong to show up in the model. In other words, the long-term link between utilities relative earnings and stock prices is strong, but the short-term link is fairly weak. Real Estate Chart II-12 Table II-12 Similar to investable real estate, our model shows that domestic real estate is a counter-cyclical sector in that it is negatively related to periods of rising economic activity, a rising LKI leading indicator, tight monetary policy, and rising core inflation. Overbought technical conditions have also aided in predicting future episodes of domestic real estate underperformance. Our model for domestic real estate stocks has performed quite well on average, but its predictive success since late-2017 has been mixed. This period of atypical underperformance has coincided with a considerably weaker rebound in residential floor space sold than has occurred in previous recoveries in the real estate market. This suggests that domestic real estate stocks are more susceptible to trends in housing sales than their investable peers (which appear to be mostly sensitive to rising house prices). We noted in our November 6 Weekly Report that floor space sold is picking up , but it still remains weak when compared with history. This, in combination with our view that the Chinese economy will improve over the coming year, suggests that investors should avoid domestic real estate exposure relative to the overall domestic equity market. Footnotes 1  Please see China Investment Strategy Special Report "A Guide To Chinese Investable Equity Sector Performance," dated October 30, 2019, available at cis.bcaresearch.com 2  Please see China Investment Strategy "Six Questions About Chinese Stocks," dated January 16, 2019, available at cis.bcaresearch.com 3  Please see China Investment Strategy Special Report "Chinese Equity Sector Earnings: Predictability, Cyclicality, And Relevance," dated June 19, 2019, available at cis.bcaresearch.com 4  Please see China Investment Strategy Weekly Report "China Macro And Market Review," dated November 6, 2019, available at uses.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations