Asia

Highlights We expect tensions from the Sino-US trade war to marginally ease in 2020, in the run-up to the US presidential election. The “Phase One” trade deal will likely be signed with a good possibility of some tariff rollbacks. Chinese policymakers will roll out more stimulus to secure an economic recovery in 2020, and external demand will improve. But we expect growth in both the domestic economy and exports to only modestly accelerate. During the next 6 to 12 months, investors should remain bullish on both Chinese A shares and investable stocks, while keeping in mind that relative outperformance, particularly for A-shares, could be frontloaded in the first half of the year. Despite sharply rising amount of defaults, Chinese onshore bonds are priced at a much higher premium than warranted by their default risk. We continue to favor Chinese onshore corporate bonds in both absolute terms and in relative to duration-matched government bonds. Feature BCA Research recently published its special year end Outlook report for 2020, which described the macro themes that are likely to drive global financial markets over the coming year. In this week’s China Investment Strategy report we elaborate on the Outlook, by reviewing our four key themes for China in the year ahead. Key Theme #1: Tension From The Trade War With The US Will Ease In 2020 Despite the harsh rhetoric and threats of retaliation from both the US and China, we expect that the real risks to the global economy from the Sino-US trade war will decline in 2020. In trade negotiations next year, both President Trump and President Xi will need to adjust to their respective constraints. Both President Trump and President Xi will need to adjust to their respective constraints next year. Trump must sustain a strong domestic economy to increase his re-election odds. He will cater to the US economy and financial markets, by trying to de-escalate trade tensions and keeping negotiations going with China. This means he is likely to hold off on tariffs on China, and quite possibly even agree to roll back tariffs to August 2019 or April 2019 levels (Chart 1). Chart 1Some Tariff Rollback Is Possible Some Tariff Rollback Is Possible Some Tariff Rollback Is Possible President Xi also faces economic constraints as the Chinese economy is on an unsure footing.  The buildup in leverage in the non-financial sector over the past decade has prevented Chinese policymakers from aggressively stimulating the economy by relying on the old debt-oriented policies. Chinese policymakers are concerned about employment stability.1 The private sector, which accounts for 80% of all job creation in China, has been disproportionally hit by the trade war and tariffs compared to the more domestically oriented state-owned enterprises. These economic constraints suggest that it is in China’s best interest to avoid any further friction with the US. Therefore, the “Phase One” trade deal will likely be signed, with a good possibility of some tariff rollbacks. Trade talks will continue in the run-up to the US presidential election, and any escalation will probably occur in non-trade, non-tariff areas. This means that policy uncertainty surrounding the Sino-US trade war will decline in 2020. Bottom Line: We expect tensions from the Sino-US trade war to marginally ease in 2020. However, the risk to this base case view is high and geopolitical uncertainty remains elevated, as suggested by our Geopolitical Strategy team.2 Trade war tensions could re-emerge, which potentially could end the global business cycle and equity bull market. Key Theme #2: Stimulus Versus Shock: Approaching An Inflection Point We presented some simple “arithmetic” in May showing that in order for investors to be bullish on Chinese stocks, the impact of China’s reflationary efforts needed to more than offset the negative shock to the economy from tariffs.3 In other words, a bullish Chinese equity scenario required Stimulus – Shock > 0. In terms of China’s real economy, 2019 essentially panned out to be a Stimulus – Shock =0 scenario, with a “half strength” reflationary response (measured by its credit impulse) barely offsetting the trade shock to the economy (Chart 2). So far on an aggregate level, the shock from tariffs on China’s economy has had a limited direct impact.  This is because exports to the US account for only 3.6% of China’s aggregate economy, whereas domestic capex accounts for more than 40% (Chart 3). Our calculation suggests a 10% annualized decline in export growth to the US would shave off 0.4 percentage points from China’s nominal GDP growth. Chart 2This Year, Measured Stimulus Has Just Offset Shocks To The Economy This Year, Measured Stimulus Has Just Offset Shocks To The Economy This Year, Measured Stimulus Has Just Offset Shocks To The Economy Chart 3Domestic Demand Much More Important Than Exports To The US Domestic Demand Much More Important Than Exports To The US Domestic Demand Much More Important Than Exports To The US Additionally, evidence suggests that a large portion of China’s exports to the US has been rerouted through peripheral countries, such as Taiwan and Vietnam (Chart 4). This fact explains why China’s exports have been in-line with the trend of global trade this year (Chart 5). Chart 4Chinese Exports Finding Alternative Routes To The US... Chinese Exports Finding Alternative Routes To The US... Chinese Exports Finding Alternative Routes To The US... Chart 5...And Total Exports Have Been Holding Up ...And Total Exports Have Been Holding Up ...And Total Exports Have Been Holding Up Chart 6China's Economic Slowdown Predates The Trade War China's Economic Slowdown Predates The Trade War China's Economic Slowdown Predates The Trade War It is important for investors to remember that China’s current economic slowdown predates the trade war and is due to its domestic financial deleveraging campaign that began in early 2017. The trade war exacerbated an existing downward trend in the economy, but was not the cause of it (Chart 6).  In 2020, while we expect a ceasefire in the trade war and a potential rollback of tariffs would ease the shock to China’s economy, we also believe that more pro-growth policy support is underway.4 From an investment perspective, this means both China’s economic conditions and corporate earnings will improve, supporting a bullish cyclical outlook for China-related assets. Still, several reasons point to the overall scale of stimulus being less than that of 2015-16, and the upside to China’s export growth will likely be limited given elevated geopolitical uncertainties. Therefore, it is unrealistic to expect a material acceleration in Chinese economic growth in 2020: China is still falling short of its target to double urban income by 2020. Chart 7A 6% Growth Next Year May Just Make The Cut A 6% Growth Next Year May Just Make The Cut A 6% Growth Next Year May Just Make The Cut Next year will mark the final year for Chinese policymakers to accomplish the goal of “Doubling GDP by 2020”. Without the recent upward revision to the level of its 2018 nominal GDP by 2.1%, China's economy would have to expand by at least 6.1% in 2020 to achieve the goal. The upward revision allows a lower economic growth rate in 2020 to reach the goal (Chart 7). China is still falling short of its target to double urban income by 2020 (Chart 8). While keeping economic growth and employment stable remains a top priority, the recent slight improvement in employment should provide some relief to Chinese policymakers (Chart 9). Chart 8China Is Falling Short Of Urban Income Target... China Is Falling Short Of Urban Income Target... China Is Falling Short Of Urban Income Target... Chart 9...But There Is Some Relief In The Labor Market ...But There Is Some Relief In The Labor Market ...But There Is Some Relief In The Labor Market     Monetary policy will remain accommodative, with room for further cuts to interest rates and the reserve requirement ratio (RRR). Nonetheless, we think Chinese policymakers will only allow monetary policy to loosen incrementally and modestly, while keeping a lid on corporate leverage. According to a recent article published by Yi Gang, the governor of China’s central bank, the PBoC will be keen to avoid another boom-bust cycle.5  Fiscal stimulus will continue to take the center stage in supporting growth in 2020, as noted in our November 20th China Investment Strategy Weekly.6  We expect that the National People’s Congress in March 2020 will approve higher quotas on issuing local government bonds, and loosened capital requirements will likely further boost local governments’ infrastructure project funding and expenditures. Transportation and urban development infrastructure projects will likely to continue receiving the most policy support in 2020. Other areas such as environmental protection, education, and social security will continue to be the Chinese government’s focus. These areas are unlikely to translate into immediate economic growth, but will improve China’s long-term economic and social structures. In contrast, compared to the 2015-2016 cycle, housing construction will receive less fiscal support (Chart 10). Overall, we expect the Chinese government to set next year’s real GDP growth target between 5.5 - 6.0%, a half of a percentage point lower than the growth target for 2019. Despite slower real output growth, nominal GDP and economic conditions will bottom in the first quarter of 2020, subsequently pushing up core inflation and reversing an ongoing deflation in the industrial sector (Chart 11). Chart 10Transportation And Urban Development Projects Are Again In Favor 2020 Key Views: Four Themes For China In The Coming Year 2020 Key Views: Four Themes For China In The Coming Year Chart 11Nominal Output Will Tick Up Soon Nominal Output Will Tick Up Soon Nominal Output Will Tick Up Soon   Bottom Line: Chinese policymakers will roll out more stimulus to secure an economic recovery in 2020, and external demand will improve. But we expect growth in both the economy and export to only modestly accelerate. Key Theme #3: Improved Earnings Outlook Supports A Cyclically Bullish View On Chinese Stocks A combination of further policy support, improved earnings and decreased trade tensions should provide tailwinds to Chinese stocks in 2020. Chinese stocks will outperform the global benchmark over a cyclical time horizon (6- to 12-months), for the following reasons:   Valuations are depressed relative to global averages: the forward P/E ratios of both China’s onshore A-shares and offshore investable stocks are well below the global benchmark (Chart 12).  While the forward P/E ratio of the A-share index is hovering around 12 times, the investable market has particularly suffered a setback from uncertainties surrounding the trade war. Even taking into account that structural weakness in the Chinese corporate earnings growth justifies for a lower multiple than the global average, both Chinese onshore and offshore stocks are offering even deeper discounts than their peaks in 2018, compared to global benchmarks. Chart 12Valuations Of Chinese Stocks Are Depressed Valuations Of Chinese Stocks Are Depressed Valuations Of Chinese Stocks Are Depressed Chart 13Chinese Corporate Earnings Closely Track Economic Conditions Chinese Corporate Earnings Closely Track Economic Conditions Chinese Corporate Earnings Closely Track Economic Conditions Both the economy and earnings growth will improve: We expect the Chinese economy to bottom in the first quarter of 2020. Given the close correlation between the coincident economic activity and earnings cycle, we expect earnings to also improve in 2020 (Chart 13).  Improved corporate earnings next year will be the catalyst for the currently cheap multiples in Chinese stocks to re-rate, and re-approach their early 2018 high. Our Earnings Recession Probability Model shows that the probability of an upcoming earnings recession has dropped to 35% from its peak of 85% in early 2019 (Chart 14).  Additionally, Chart 15 highlights that the 12-month forward EPS momentum has turned modestly positive. Chart 14Probability Of An Upcoming Earnings Recession Has Significantly Dropped Probability Of An Upcoming Earnings Recession Has Significantly Dropped Probability Of An Upcoming Earnings Recession Has Significantly Dropped Chart 1512-Month Forward EPS Momentum Has Turned Modestly Positive 12-Month Forward EPS Momentum Has Turned Modestly Positive 12-Month Forward EPS Momentum Has Turned Modestly Positive There are, however, a few caveats to our bullish cyclical view on Chinese stocks. First, while it is not our base case view, geopolitical risks, particularly the Sino-US trade war, could end the global business cycle and equity bull market in 2020. Within the context of falling global stocks, we think Chinese domestic A shares would passively outperform global benchmarks, as A shares are mostly driven by China’s domestic credit and economic growth, and are less sensitive to trade frictions. But investable stocks would clearly underperform in this scenario. The odds are decent that all of the outperformance of Chinese stocks in 2020 will be frontloaded in the first half of the year. Secondly, the odds are decent that all of the outperformance of Chinese stocks in 2020 will be frontloaded in the first half of the year. We expect credit growth, infrastructure spending and the economy to improve in the first quarter. If the “Phase One” trade deal is also signed during that period, onshore A shares and investable stocks will significantly outperform their global counterparts in the first and possibly the early part of the second quarter. However, in the second half of next year, if the Chinese economy stabilizes but stimulus does not ramp up further, then the upside potential in both bourses may be capped as investors will question whether Chinese stocks will continue to gain ground in relative terms. We will closely monitor Chinese credit growth and trade negotiations throughout 2020 to determine if there is more eventual upside potential to economic growth, and thus Chinese earnings prospects, than we currently believe.  While we recommend a cyclically bullish stance towards Chinese stocks for next year, our tactical (i.e. 0-3 month) stance remains neutral. We expect to align our tactical and cyclical stances soon, and are awaiting confirmation of a hard data improvement alongside a breakout of key technical conditions to do so.7 Bottom Line: During the next 6 to 12 months, investors should remain bullish on both Chinese A shares and investable stocks within a global equity portfolio. However, investors should also keep in mind that the relative outperformance, particularly for the A-share market, could be frontloaded in the first half of 2020. Key Theme #4: We Continue To Favor Chinese Onshore Bonds, Despite Default Concerns  Chart 16Global Investors Are Piling Into The Chinese Bond Market Global Investors Are Piling Into The Chinese Bond Market Global Investors Are Piling Into The Chinese Bond Market Despite sharply rising defaults, Chinese onshore bonds are still priced at a much higher premium than warranted by their default risk. This view is increasingly shared by global investors, as evident in the capital flows into China’s onshore bond market (Chart 16). While the total amount of bond defaults in the first eleven months of 2019 was an astonishing 120.4 billion yuan, they account for only half percent of China’s total onshore bonds issued.  A 0.5 percent default rate is in line with global ex-US, and 160 bps below the default rate in the US (Chart 17). Yet, Chinese corporate bond spreads are about 150-175 bps higher than their US counterparts, an overpriced risk premium in our view (Chart 18). Recently, despite mounting defaults, China’s corporate bond spreads have continued to narrow. This suggests that investors do not expect the record-high level of defaults in the past two years to damage China’s corporate sector in the near future. Moreover, China’s monetary policy remains ultra-loose, liquidity conditions have been largely stable, RMB devaluation and capital outflows have both been under control, and the Chinese economy is expected to bottom in the next quarter. Chart 17Chinese Default Rate Well Below Global Average Chinese Default Rate Well Below Global Average Chinese Default Rate Well Below Global Average Chart 18The Risk Premium Assigned To Chinese Corporate Bonds Seems Overdone The Risk Premium Assigned To Chinese Corporate Bonds Seems Overdone The Risk Premium Assigned To Chinese Corporate Bonds Seems Overdone Bottom Line: We continue to favor Chinese onshore corporate bonds in both absolute terms, and in relative to duration-matched government bonds.   Jing Sima China Strategist jings@bcaresearch.com     Footnotes 1    “China to take multi-pronged measures to keep employment stable,” State Council Executive Meeting, December 4, 2019. 2   Please see Geopolitical Strategy Special Report "2020 Key Views: The Anarchic Society," dated December 6, 2019, available at gps.bcaresearch.com 3   Please see China Investment Strategy Weekly Report "Simple Arithmetic," dated May 15, 2019, available at cis.bcaresearch.com. 4, 6, 7   Please see China Investment Strategy Weekly Report "Questions From The Road: Timing The Turn," dated November 20, 2019, available at cis.bcaresearch.com. 5   https://www.chainnews.com/articles/745634370915.htm Cyclical Investment Stance Equity Sector Recommendations

Highlights The Fed is the usual culprit for killing business cycles — but the Fed is on hold. This makes geopolitics the likeliest candidate to kill the cycle. The key geopolitical risks are US political turmoil, China’s economic policy, and the US-Iran confrontation. Nevertheless, policymakers are adjusting to the threat of recession, which points to a continuation of this long-in-the-tooth expansion. The US-China talks will be driven by Trump’s need for an economic boost ahead of the US election. If the economy or Trump’s approval rating fails anyway, then all bets are off. Go long gold as a strategic hedge. Feature Great power struggle, or “multipolarity,” continues to be our mega-theme in 2020. The world does not operate like a normal society, with a single government that possesses a monopoly on the use of force and ensures stability. Nations are individualistic, armed, and dangerous, creating what scholar Hedley Bull once called “The Anarchical Society.” This is not pure chaos, but rather a community of nations that lacks a clear and undisputed leader. Hence, quarrels break out often. Updating our geopolitical power index shows that the rise of China remains the most disruptive trend in global politics (Chart 1). The gap between the US and China has closed until recently, with China’s downshift in growth rates, but American fear is just being awakened (Chart 2). Given that Beijing threatens the US’s military and technological dominance over the long run, Washington will continue to develop a containment policy. Chart 1China's Geopolitical Rise Is Disruptive 2020 Key Views: The Anarchic Society 2020 Key Views: The Anarchic Society Chart 2China-US Power Gap Is Narrowing 2020 Key Views: The Anarchic Society 2020 Key Views: The Anarchic Society China is too big to quarantine, especially for a relatively unpopular first-term American president who eschews international coalition-building. The European Union’s decline in relative power is more marked than that of the United States, but China does not pose as much of a security threat to Europe. This trend exacerbates the already serious divergence in the trans-Atlantic alliance – which will worsen if Trump wins on November 3, 2020. Hence, globalization faces persistent challenges, as indicated by the falling import share of global output (Chart 3). This multi-decade process has peaked, creating a headwind for trade-exposed firms over the long run. What about the next 12 months? Will geopolitics kill the bull market? Not necessarily. Just as central bankers have cut interest rates to guard against deflationary risks (Chart 4), so the key governments are adjusting policies to avoid recessionary risks, especially with the memory of 2008 still fresh. Simply put: The Fed is on pause, Trump wants to be reelected, and China cannot afford a hard landing. Chart 3Globalization Faces Challenges 2020 Key Views: The Anarchic Society 2020 Key Views: The Anarchic Society Chart 4Policymakers Are Reacting To Deflationary Risks 2020 Key Views: The Anarchic Society 2020 Key Views: The Anarchic Society Clearly the risks to this view are elevated. The chief ones: (1) President Trump becomes a lame duck, cannot run on an economic platform, and thus makes a desperate attempt to win as a “war president” (2) Xi Jinping overestimates his advantage, in domestic or foreign policy, and makes a policy mistake (3) the US-Iran conflict spirals out of control due to Iran’s economic vulnerability. Other risks, such as Brexit, pale by comparison. Fear And Loathing On The Campaign Trail It is too soon to declare that Trump’s presidency is finished. On the contrary he is slightly favored to win reelection: • The Senate is unlikely to remove him from office. Republican support for the president is well above average despite evidence that Trump tried to get Ukrainian officials to investigate his political rival (Chart 5). The implication is that a year from now Democrats will have suffered a policy failure while Trump will have been cleared of charges. Chart 5Trump Still Popular Among Republicans 2020 Key Views: The Anarchic Society 2020 Key Views: The Anarchic Society • The odds of recession in the coming year are low. The US voter is buffered by rising real incomes and wages and high net wealth (Chart 6). To unseat a sitting president requires a recessionary backdrop that fundamentally discredits him and his party – not just slowing growth. Chart 6Pocketbook Voter Theory To The Test 2020 Key Views: The Anarchic Society 2020 Key Views: The Anarchic Society • Trump’s low approval rating does not prohibit him from reelection. While historically low, it is also historically stable. Our quantitative election model – which predicts Trump will win the Electoral College with 279 votes by clinging onto Pennsylvania – shows that Trump’s victory margin would increase if we looked not at the average level of his approval but at its change, momentum, or low range (i.e. stability). Table 1 shows the results of all four variations of his approval rating, with ascending chances of winning key swing states. Table 1All Measures Of Trump’s Approval Rating Get Him 270 Electoral College Votes 2020 Key Views: The Anarchic Society 2020 Key Views: The Anarchic Society Trump’s odds of winning will affect the US equity market throughout the year. As long as he remains competitive, i.e. neither scandal nor the economy cause his approval rating to break down, he will have reason to temper his policies to cater to US financial markets. Foreign and trade policies are Trump’s only ways to improve the economy and voter support. Trump’s only remaining way to boost the economy and improve voter support lies in foreign policy and trade policy. Specifically, he will stop increasing tariffs on China – and maybe even roll back tariffs to August 2019 or even April 2019 levels (Chart 7) – at least as long as the manufacturing recession persists. Chart 7Some Tariff Rollback Is Possible 2020 Key Views: The Anarchic Society 2020 Key Views: The Anarchic Society China is unlikely to implement painful structural changes when Trump could be gone in 12 months’ time. Strategic tensions outside of trade will undermine any ceasefire. Hence economic policy uncertainty will remain elevated even though it will drop off from recent peaks. Assuming the electoral constraint prevents Trump from levying sweeping tariffs on China or Europe, he will be limited to other foreign and trade policies to try to boost his approval rating or fire up his base: • We expect a third summit with Kim Jong Un of North Korea. Trump is rumored to be considering some troop reduction in exchange for progress on denuclearization (neither of which would be irreversible). • Otherwise Trump could turn to saber-rattling, since Pyongyang is threatening to resume long-range tests and the economic consequences of another round of “fire and fury” would be limited. • Trump could also rattle the saber against Iran, Venezuela, or other rogue states. If Trump becomes uncompetitive in the election, then the market will sell off. The market will have to price not only policy discontinuity (e.g. higher taxes), but also the chance of a progressive-populist taking the White House. Moreover, if a Democrat is able to unseat an incumbent president, the Democrats will take the Senate as well. Trump is a known unknown; this scenario would be an unknown unknown. The Democratic Party’s primary election will consume the first half of the year. It culminates in the Democratic National Convention, strategically chosen to take place in Milwaukee, Wisconsin on July 13-16. Wisconsin is one of three critical swing states. Will former Vice President Joe Biden win the nomination? A high conviction is not warranted. Biden is clearly the frontrunner, but we think a progressive can pull it off. A simulation of the Democratic Convention “pledged delegates,” based on November polling in the first four primary elections, shows Biden far short of a majority (Chart 8). He needs to outperform his polls, but this will be difficult given that he is well-known, has not performed well in debates, and will have Mayors Pete Buttigieg and Michael Bloomberg nipping at his heels in the Midwest and Northeast, respectively. Chart 8Do Not Discount A Progressive Win 2020 Key Views: The Anarchic Society 2020 Key Views: The Anarchic Society Over time, candidates will drop out, so it is more informative to look at the “centrist” candidates as a whole compared to the “progressives.” Here the early primary polling suggests that the progressives will come closest to victory (Chart 9). Chart 9Progressives Come Closest To Victory 2020 Key Views: The Anarchic Society 2020 Key Views: The Anarchic Society The trend within the party is to move to the left. Senators Elizabeth Warren and Bernie Sanders are tied as voters’ second choice – even Buttigieg supporters are split between Biden and Warren (Chart 10). What is unknown is whether Warren (or Sanders) can consolidate the progressive vote faster than Biden (or Buttigieg) consolidates the centrist vote. Chart 10If Biden Falters, Progressives Are Next In Line 2020 Key Views: The Anarchic Society 2020 Key Views: The Anarchic Society Chart 11Structural Imbalances Give Rise To Populism 2020 Key Views: The Anarchic Society 2020 Key Views: The Anarchic Society Trends pointing toward a progressive victory may not at first trouble the market, but any signs that a progressive is pulling ahead decisively will force investors to sharply upgrade the probability that he or she will win the White House. This will cause equity volatility, which could become self-reinforcing. A progressive nominee would force investors to recognize that populism and political risk are here to stay – which is our expectation given that they are motivated by polarization, inequality, and other structural imbalances in the United States (Chart 11). Left-wing or progressive populism is far more negative for corporate earnings than Trump’s right-wing or “pluto-populism.” Sanders or Warren present the worst case for investors because they favor trade protectionism in addition to higher taxes and minimum wages. Most presidents achieve their chief legislative priority in their first term and there is no reason to assume a progressive presidency would be any different. The implication is higher corporate taxes as well as individual taxes to pay for a sweeping expansion of the social safety net – positive for the economy perhaps but negative for corporate earnings. Chart 12A Progressive Win Threatens Key Sectors 2020 Key Views: The Anarchic Society 2020 Key Views: The Anarchic Society An extensive re-regulation of the US economy would occur regardless, since it falls under executive authority. It would affect the key equity sectors in the US bourse, technology and health (Chart 12), as well as energy and financials. The choice of a centrist Democrat like Biden (or Buttigieg) would be the least negative outcome for US equities of all the Democrats. The market would probably cheer a Trump versus Biden matchup for this reason. Biden favors higher taxes and regulation but is an establishment politician and known quantity. However, even Biden will be pulled to the left by the current within his party once in office; and Buttigieg will govern to the left of Biden. Trump’s reelection would spur a relief rally in US equities, but it would be short-lived. He would solidify low taxes and deregulation and would have a real chance of passing an infrastructure package. But he would also curtail labor force growth with his border wall and double down on trade protectionism – likely against Europe as well as China this time. His unpredictable and aggressive tendencies would be turbo-charged by a new popular mandate. We expect to cut back on risk exposure upon Trump’s reelection, assuming the bull market has survived to return him to office. A Democratic victory would mark another reversal in US policy orientation. Given our view that the White House call is also the Senate call, this would be the third time since 2008 that the country has witnessed a total reversal. Domestic American political risk will not end with the election: a legitimacy crisis could follow a narrow election, and institutional erosion continues regardless. It is too soon to call peak polarization, as the election will result in either a left-wing government bent on redistributing wealth or a right-wing Trump administration that exacerbates inequality. A centrist "return to normalcy" is possible with a Biden or Buttigieg victory. This reinforces our constructive cyclical view. Bottom Line: The chief risk from US politics in 2020 is Trump becoming a lame duck and resorting to belligerent foreign policy to try to win back voters through a rally around the flag. The chief risk of the Democratic nomination, and the general election, is a left-wing populist winning the White House. Any Democratic victory would likely bring the Senate, removing a key constraint. Over time the median voter is moving to the left. The Man Who Changed China Chart 13Xi Is Purging Misallocated Capital 2020 Key Views: The Anarchic Society 2020 Key Views: The Anarchic Society Xi Jinping undoubtedly represents a “new era” in China – a reassertion of Communist Party rule. The party faced a crisis of legitimacy amid the Great Recession and Arab Spring and was determined to regain political, economic, and social control. Xi had previously been anointed but was all too happy to take on the role of neo-Maoist strongman. Yet Xi’s playbook is close to that of President Jiang Zemin’s: centralize the party, repress dissent, modernize the military, restructure banks and the economy, upgrade the country’s science and technology, and expand China’s global influence. The difference is that while Jiang rode the high tide of globalization, Xi is riding the receding tide. Jiang culled two-thirds of the country’s state-owned enterprises, laying off over 40 million people, confident that a surge of new growth would ensue. Xi is also cracking down – allowing bankruptcies to purge misallocated capital (Chart 13) – but with a large debt load and shrinking labor force, he needs the state sector to put a floor under growth rates. The takeaway is that Xi will act pragmatically to boost growth when China’s stability is threatened, as he did in 2015-16. The trade war has already forced him to backtrack on the 2017-18 deleveraging campaign and stimulate the economy. The combined fiscal and credit impulse amounts to 6.6% of GDP from trough to now, and it hasn’t peaked. The implication is that Chinese growth – and global growth – will pick up from here (Chart 14). Chinese authorities are still trying to contain the growth in leverage, which has kept this year’s stimulus in check. But the chief banking regulator has also stated that as long as the macro-leverage ratio is not growing faster than 10%, this goal is met (Chart 15). Chart 14Chinese Growth Will Pick Up 2020 Key Views: The Anarchic Society 2020 Key Views: The Anarchic Society Chart 15China Says Leverage Already Contained 2020 Key Views: The Anarchic Society 2020 Key Views: The Anarchic Society The economy has not yet durably bottomed, so the state will continue adding support. The coming year is the third and final year of the “Three Battles” – against poverty, pollution, and systemic risk – as well as the final year of the thirteenth five-year plan. Beijing is falling short on its targets for real urban per capita income (Chart 16) and poverty elimination (Chart 17). A last-minute rush to meet these targets is likely and will require more fiscal stimulus. Chart 16Beijing Falls Short Of Urban Income Target... 2020 Key Views: The Anarchic Society 2020 Key Views: The Anarchic Society Chart 17...And Poverty Target 2020 Key Views: The Anarchic Society 2020 Key Views: The Anarchic Society This is not an argument for a blowout credit splurge. China is saving dry powder for a further escalation in the US containment strategy and a worse economic downturn. Do not expect a blowout Chinese credit splurge. The core constraint on policy is unemployment. Stimulus efforts have created a bottom in the employment component of the manufacturing PMI as well as a notable uptick in the demand for urban labor (Chart 18). To withdraw stimulus now – or tighten policy – would be to trigger a relapse in an economy that is ultimately at risk of a debt-deflation trap. Chart 18Chinese Stimulus Shows Up In Employment 2020 Key Views: The Anarchic Society 2020 Key Views: The Anarchic Society Chart 19A Banking Crisis Is A Risk To The Chinese Economy 2020 Key Views: The Anarchic Society 2020 Key Views: The Anarchic Society Tougher controls on credit and shadow banking have seen an uptick in corporate defaults and bank failures. With the government deliberately imposing pain on bloated sectors of the economy, financial turmoil could spread. Newspaper mentions of defaults, layoffs, and bankruptcies have only slightly subsided since stimulus efforts began (Chart 19). If bank failures spiral out of control, the economy will tank. The state will have to fight fires. Tariffs have accelerated the trend of firms relocating out of China, which began because of rising wages and a darkening business environment (Chart 20). A questionable trade ceasefire will not reverse the process as American and Asian companies are seeking a lasting solution, which requires them to set up shop elsewhere. China will want to mitigate the process, first by stabilizing domestic growth, and second by accepting Trump’s tactical trade retreat. Xi is also trying to avoid diplomatic isolation by courting trade partners other than the US, since the ceasefire is unreliable and the US containment strategy is presumed to continue. This involves outreach to the rest of Asia, Russia, and Europe, and even to distrustful neighbors like Japan and India. Europe is the swing player. China’s Asian neighbors, and Australia and New Zealand, have reason to fear Beijing’s growing clout and seek the US’s security umbrella. Russia and China are informal allies. But the European public is not interested in the new cold war – China does not threaten Europe from next door, like Russia does, and the Trump administration is threatening Europe with both trade war and Middle Eastern instability. European leaders are happy to take the market share that the US is leaving, as is clear from direct investment (Chart 21). Only a concentrated US diplomatic effort can address this divergence, which is not forthcoming in 2020. Chart 20Firms Are Relocating Out Of China 2020 Key Views: The Anarchic Society 2020 Key Views: The Anarchic Society Chart 21Europe Exploits US-China Rift 2020 Key Views: The Anarchic Society 2020 Key Views: The Anarchic Society A new Democratic administration, or a change in Trump strategy in the second term, could eventually produce a multilateral western coalition demanding that China open up and liberalize parts of its economy. But Europe will need to be convinced of the underlying reality that China is doubling down on the state-led industrial policies that provoked the Americans to begin with. Beijing is after economic self-sufficiency, indigenous innovation, and leadership in high-tech production and new frontiers. Its official research and development budget is not its only means for achieving this end (Chart 22) – it also has state-backed acquisitions and cyber campaigns. Germany and Europe have begun scrutinizing Chinese investment, separately from the United States. Chart 22Beijing Is After Economic Self-Sufficiency 2020 Key Views: The Anarchic Society 2020 Key Views: The Anarchic Society The danger to China – and the world – is that Xi Jinping might overplay his hand. He could overtighten money, credit, or property regulations and spoil the economy when global growth is vulnerable. His anti-corruption campaign is a telling reminder of his heavy hand in domestic affairs (Chart 23). Chart 23Xi Jinping Risks Overplaying His Hand 2020 Key Views: The Anarchic Society 2020 Key Views: The Anarchic Society Chart 24China Needs To Calm Things Down 2020 Key Views: The Anarchic Society 2020 Key Views: The Anarchic Society He could also suppress protesters in Hong Kong and rattle sabers over Taiwan or the South China Sea in a way that undermines the trade ceasefire. Or he could fail to bring the North Koreans to heel. These strategic tensions are significant only insofar as they undermine the trade ceasefire or provoke US-China saber-rattling. Failing to act as an honest broker in the Iran crisis would also irk Europeans and give them an excuse to side with the US. Bottom Line: China will continue modestly stimulating the economy next year to achieve a durable stabilization in growth. The risk of debt-deflation and rising unemployment ultimately necessitates this policy. Beijing can accept Trump’s tariff rollback for the sake of stability – China’s policy uncertainty relative to the rest of the world is off the charts and Beijing has an interest in calming things down (Chart 24). Yet Beijing will double down on indigenous innovation, while courting the rest of the world so as to preempt criticism and isolate the Americans. The risk is that Xi proves too heavy-handed when it comes to domestic leverage, the tech grab, strategic disputes, or trade talks with Washington. The Strait Of Hormuz Risk Chart 25US-Iran Conflict Still Unresolved 2020 Key Views: The Anarchic Society 2020 Key Views: The Anarchic Society In a special report earlier this year entitled “The Polybius Solution” we argued that while the US-China conflict is the major long-term geopolitical conflict, the US-Iran showdown could supersede it in the short term. This remains a risk for 2020, as the Trump administration’s confrontation with Iran is fundamentally unresolved (Chart 25). The Trump administration is still enforcing “maximum pressure” sanctions, which have reduced Iranian oil exports from 1.8 million barrels per day at their recent peak to 100,000 barrels per day in November (Chart 26). These are crippling sanctions that have sent Iran’s economy reeling. Chart 26Iran Remains Under 2020 Key Views: The Anarchic Society 2020 Key Views: The Anarchic Society Iran’s Supreme Leader Ayatollah Ali Khamenei has ruled out negotiations with Trump. They would be unpopular at home without a major reversal on sanctions from Trump (Chart 27). Chart 27Major US Reversal Prerequisite For Iran Talks 2020 Key Views: The Anarchic Society 2020 Key Views: The Anarchic Society Trump presumably aims to avoid an oil shock ahead of the election. The US and its allies have visibly shied away from conflict in the wake of Iran’s provocations, including the spectacular attack on eastern Saudi Arabia that knocked 5.7 million barrels of oil per day offline in September. However, this does not mean the odds of war are zero. The Americans or the Iranians could miscalculate. Both sides might think they can improve their standing at home by flexing their muscles abroad. Iran is a rational actor and would not normally court American airstrikes or antagonize a potentially lame duck president. Yet it is under extreme pressure due to the sanctions. It faces significant unrest both at home and in its sphere of influence (Iraq and Lebanon). Opinion polls show that the public primarily blames the government for the collapsing economy, and yet that American sanctions are siphoning off some of this anger (Chart 28). This could tempt the leaders to continue staging provocations in the Strait of Hormuz or elsewhere in the region. Chart 28Iranians Blame Tehran, Tehran Blames America 2020 Key Views: The Anarchic Society 2020 Key Views: The Anarchic Society Hardline military leaders and politicians currently receive the most favor in polling, while the reformist President Rouhani – undercut by the American withdrawal from the 2015 deal – is among the least popular (Chart 29). The Majlis (parliament) elections in February will likely reverse the reformist turn in Iranian politics that began in 2012. The regime stalwarts are gearing up for the supreme leader’s succession in the coming years. While a Democratic White House could restore the 2015 deal, that ship may have sailed. Chart 29Rouhani And Reformists In Trouble 2020 Key Views: The Anarchic Society 2020 Key Views: The Anarchic Society A historic oil supply disruption is a fatter tail risk than investors realize. Chart 30The Iranians May Take Excessive Risk 2020 Key Views: The Anarchic Society 2020 Key Views: The Anarchic Society Trump, under impeachment, could seek to distract the public. This was Bill Clinton’s tactic with Operations Infinite Reach, Desert Fox, and Allied Force in 1998-99. These operations were minor and not comparable to a conflict with Iran. However, Trump may be emboldened. On paper the US strategic petroleum reserve (along with OPEC and other petroleum reserves) could cover most major oil shock scenarios. According to Hugo Bélanger, Senior Analyst at BCA Research Commodity & Energy Strategy, a supply outage the size of the Abqaiq attack in September would have to persist for four months to cause enough price pressure to harm the US economy and decrease Trump’s chances of winning reelection. The simulations in Chart 30 overstate the gasoline price impact by assuming that global oil reserves remain untapped. Thus while the Iranians may take excessive risks, the Trump administration may not refrain this time from airstrikes. Bottom Line: While the Middle East is always full of risks to oil supply, Iran’s vulnerability and Trump’s status at home make the situation unusually precarious. A historic oil supply disruption is a fatter tail risk than investors realize. Europe Is A Price Taker, Not A Price Maker Just as the US and China have a shared incentive to avoid tariff-induced recession, so the UK and EU have a shared incentive to prevent a shock reversion to basic WTO tariffs. The December 31, 2020 deadline for the UK-EU trade deal, like the various deadlines for Brexit itself, can be delayed. Even Prime Minister Boris Johnson has proved unwilling to exit without a deal and even a hung parliament has proved capable of preventing him from doing so. The negotiation of a trade deal – which is never easy and always drags on – will be a lower-order risk in the wake of the past two years’ Brexit-induced volatility. Johnson will not be held hostage by hardline Brexiters given that Brexit itself will be complete. If our view on Chinese growth is correct, then Europe’s economy can recover and European political risk will be a “red herring” in 2020, as it was in 2019. Instead the EU presents an opportunity. Chart 31Euro Area Breakup Risk Has Subsided 2020 Key Views: The Anarchic Society 2020 Key Views: The Anarchic Society Euro Area break-up risk has subsided after a series of challenges in the wake of the sovereign debt crisis (Chart 31). There is not a basis for a reversal of this trend, at least not until a full-blown recession afflicts the continent. The rise in anti-establishment parties coincided with a one-off surge in migration that is finished – and successful populists from Greece to Italy have moderated on euro membership once in power. Germany is entering a profound transition driven by de-globalization and tensions with the United States. It is more likely to have an early election than the consensus holds. But it is fundamentally stable and supportive of European integration. In fact the great debate about fiscal policy poses an upside risk over the long run both for European equities and the European project. We remain optimistic on French structural reforms even though President Emmanuel Macron must overcome significant public opposition. An eerie quiet hangs over Russia, making it one of our “Black Swan” risks for 2020. Oil prices are not very high, which discourages foreign adventures, and President Vladimir Putin has spent his fourth term trying to consolidate international gains and improve domestic stability. But approval of the government is weak, the job market is deteriorating, and social unrest is cropping up. There is plenty of room to ease monetary and fiscal policy, but a sharp downturn could provide the basis for an aggressive foreign policy action to shore up regime support. The US election also presents the risk of renewed US-Russian tensions, whether over election interference or a Democratic victory. Investment Conclusions Geopolitics is the likeliest candidate to derail the global bull market in 2020. Nevertheless, policymakers are adjusting to their constraints. Trump and Xi are negotiating a ceasefire and a disorderly Brexit is off the table. Even Trump’s impeachment shows that the US system of checks and balances remains intact. After all, there is nothing to prevent removal from office if Trump further antagonizes public opinion and the Republican Senate. This means that policy uncertainty will decline on the margin in 2020, even as it remains elevated due to the danger of the underlying events. The nature of US economic imbalances suggests that the policy discontinuity of a Democratic victory on November 3, 2020 would be better for the economy (via household consumption) than it would be for corporate earnings. Policy continuity with the Trump administration suggests the opposite. On a sectoral basis we recommend going long US energy large cap stocks and short info-tech and communications. Energy has limited downside even if a progressive wins whereas tech has limited upside even if Trump wins. The BCA Research House View expects the US dollar to weaken as global growth rebounds, stocks to outperform bonds and cash, and developed market equities to outperform those of the United States. But a Republican victory in November would push against these trends as it is more bullish for the greenback and for US equities relative to global. As a play on the global growth rebound we expect, we recommend going long industrial metals. Like our colleagues at BCA Research Commodity & Energy Strategy, we are initiating this as a tactical trade but it may become strategic. We are reinitiating a tactical long Korea / short Taiwan equity trade. Taiwanese political risk is understated ahead of January’s election and the island is the epicenter of the US-China cold war. We are restoring our long gold trade as a strategic hedge. Populism and de-globalization are potentially inflationary, but they are also linked with great power competition which will increase the frequency of geopolitical crises. In either case, gold is the right safe haven to own.   Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com

Highlights We are upgrading Pakistani equities to overweight within an EM equity portfolio. Fixed-income investors should consider purchasing 5-year local currency government bonds. The balance-of-payments adjustment is probably over. Hence, the currency will be stable, allowing inflation and interest rates to drop. Feature The country’s macro dynamics have shown signs of stabilization. This has begun benefiting share prices in both absolute terms and relative to the EM equity benchmark. Chart I-1Pakistani Stocks: The Worst Is Over Pakistani Stocks: The Worst Is Over Pakistani Stocks: The Worst Is Over We downgraded Pakistani equities in March 2017  and put this bourse on our upgrade watch list this past May (Chart I-1). In the past two years, the country has been going through a severe balance-of-payments crisis and a correspondingly painful adjustment. In recent months, the country’s macro dynamics have shown signs of stabilization. This has begun benefiting share prices in both absolute terms and relative to the EM equity benchmark. Today we are upgrading Pakistani stocks to overweight within an EM equity portfolio and recommend buying 5-year local currency government bonds. The worst is over for the economy and its financial markets for the following reasons. First, the country’s balance-of-payments position will improve. In real effective exchange rate (REER) terms, the Pakistani rupee has depreciated 15% over the past two years (Chart I-2). This will boost exports and cap imports, narrowing both trade and current account deficits further (Chart I-3).   Chart I-2Considerable Depreciation In Pakistani Rupee… Considerable Depreciation In Pakistani Rupee... Considerable Depreciation In Pakistani Rupee... Chart I-3…Will Boost Exports And Cap Imports ...Will Boost Exports And Cap Imports ...Will Boost Exports And Cap Imports We expect exports to grow 5-10% next year. The country’s competitiveness has improved considerably, with its top commodities exports all having shown impressive growth in volume terms, despite weakening global growth (Chart I-4). Besides, in order to boost exports, the government has reduced the cost of raw materials and semi-finished products used in exportable products by exempting them from all customs duties in fiscal 2020 (July 2019 – June 2020). The government has also promised to provide sales tax refunds to the export sector. Chart I-4Increasing Competitiveness In Pakistan Exports Increasing Competitiveness In Pakistan Exports Increasing Competitiveness In Pakistan Exports In addition, falling oil prices will help reduce the country’s import bill. Remittance inflows – currently equaling 9% of GDP – have become an extremely important source of financing for Pakistan’s trade deficit. In the past 12 months, remittances sent from overseas have risen to US$22 billion, and have covered most of the US$28 billion trade deficit.   Financial inflows are also likely to increase in 2020 and will be sufficient to finance the current account deficit. The IMF will disburse roughly US$2 billion to Pakistan. Other multilateral/bilateral lending/grants and planned issuance of Sukuk or Euro bonds will provide the government with much-needed foreign funding.  As the economy recovers, net foreign direct inflows are also likely to increase. Net foreign direct investment received by Pakistan has grown 24% year-on-year in the past six months, with 56% of the increase coming from China. Overall, the improvement in Pakistan’s balance-of-payments position will continue, resulting in a refill of the country’s foreign currency reserves. Odds are that the central bank will purchase foreign currency from the government as the latter gets foreign funding. This will provide the government with local currency to spend. At the same time, the central bank’s purchases of these foreign exchange inflows will boost the local currency money supply – a positive development for the economy and stock market. Chart I-5 shows that the Pakistani stock market closely correlates with swings in the nation’s narrow money growth. The Pakistani central bank will soon start a rate-cutting cycle as the exchange rate stabilizes. This is a typical recovery process following a balance-of-payments crisis and substantial currency devaluation. Chart I-5Pakistan: Ameliorating Balance-Of-Payments Position Will Benefit Stock Prices Pakistan: Ameliorating Balance-Of-Payments Position Will Benefit Stock Prices Pakistan: Ameliorating Balance-Of-Payments Position Will Benefit Stock Prices Chart I-6Pakistan: Improving Fiscal Balance Pakistan: Improving Fiscal Balance Pakistan: Improving Fiscal Balance Second, Pakistan’s fiscal balance also shows signs of improvement. Pakistan and the IMF have agreed to set the target for the overall budget and primary deficits at 7.2% of GDP and 0.6% of GDP, respectively, for the current fiscal year (Chart I-6). This will be a considerable improvement from the 8.9% of GDP and 3.3% of GDP, respectively, last fiscal year. In early November, the IMF praised Pakistan for having successfully managed to post a primary budget surplus of 0.9% of GDP during the first quarter (July 1, 2019 – September 30, 2019) of its current fiscal year. The authorities are determined to maintain strict fiscal discipline. The country’s tax-to-GDP ratio is at about 12%, one of the lowest in the world, so there is room to expand the tax base. Third, the Pakistani central bank will soon start a rate-cutting cycle as the exchange rate stabilizes. This is a typical recovery process following a balance-of-payments crisis and substantial currency devaluation. Both headline and core inflation seem to have peaked (Chart I-7). Headline inflation fell to 11% in October, which already lies within the central bank’s target range of 11-12% for the current fiscal year. The policy rate is currently 225 basis points higher than headline inflation. As inflation drops and the currency finds support, interest rates will be reduced to facilitate the economic recovery. In addition, there has been much less public debt monetization by the central bank. After borrowing Rs3.16 trillion from the central bank in the previous fiscal year, the federal government has curtailed such borrowing to only Rs122 billion in the first three months of this fiscal year. Diminishing debt monetization will also help ease domestic inflation. Chart I-7Inflation Has Peaked Inflation Has Peaked Inflation Has Peaked Chart I-8Manufacturing Activity Is Likely To Recover Soon Manufacturing Activity Is Likely To Recover Soon Manufacturing Activity Is Likely To Recover Soon Fourth, manufacturing activity in Pakistan has plunged to extremely low levels, comparable to the 2008 Great Recession (Chart I-8). With a more stabilized local currency, easing domestic inflation and interest rate reductions, Pakistan’s economic activity is set to recover soon from a very low base.  Finally, Phase II of the China-Pakistan Economic Corridor (CPEC) is set to begin this month. Under Phase II of the CPEC, five special economic zones will be established with Chinese industrial relocation. Phase II will also bring forward dividends from Phase I projects. The nation’s infrastructure facilities built by China over the past several years have enhanced the productive capacity of the Pakistani economy. The significant increase in electricity supply and improved railway/highway transportation will promote higher productivity/efficiency gains. Bottom Line: We are upgrading Pakistani equities to overweight within the emerging markets space. Both absolute and relative valuations of Pakistani stocks appear attractive (Charts I-9 and I-10). Chart I-9Pakistani Stocks: Valuations Are Attractive In Absolute Terms... Pakistani Stocks: Valuations Are Attractive In Absolute Terms... Pakistani Stocks: Valuations Are Attractive In Absolute Terms... Chart I-10…And Relative To EM Equities ...And Relative To EM Equities ...And Relative To EM Equities Meanwhile, we recommend going long Pakistani 5-year local currency government bonds currently yielding 11.5%, as we expect interest rates to drop quite a bit (Chart I-11).  Chart I-11Go Long Pakistani 5-Year Local Currency Government Bonds Go Long Pakistani 5-Year Local Currency Government Bonds Go Long Pakistani 5-Year Local Currency Government Bonds   Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

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 China Macro And Market Review China Macro And Market Review Table 2China Financial Market Performance Summary China Macro And Market Review China Macro And Market Review 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 A Moderate Strength Economic Recovery Will Begin In Q1 A 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 The PBoC Will See Through Transient Shocks To Headline Inflation The PBoC Will See Through Transient Shocks To Headline Inflation Chart 3Poor Affordability Will Continue To Weigh On Housing Demand Poor Affordability Will Continue To Weigh On Housing Demand Poor Affordability Will Continue To Weigh On Housing Demand Chart 4Investors Need To See Concrete Signs Of A Hard Data Improvement Investors Need To See Concrete Signs Of A Hard Data Improvement Investors 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 A Positive Sign From Cyclicals Versus Defensives A 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

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 A Fairly Regular Three-Year Manufacturing Cycle A Fairly Regular Three-Year Manufacturing Cycle Chart 2Some Manufacturing Green Shoots Some Manufacturing Green Shoots Some 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 China Has Been Stimulating, Fiscally China Has Been Stimulating, Fiscally Chart 4Chinese Stimulus Should Boost Global Growth Chinese Stimulus Should Boost Global Growth Chinese 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 The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency Chart 6Steeper Yield Curves Will Benefit Financials Steeper Yield Curves Will Benefit Financials Steeper 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 Non-US Equities Usually Outperform When Global Growth Improves Non-US Equities Usually Outperform When Global Growth Improves Chart 8US Stocks Are Relatively More Expensive US Stocks Are Relatively More Expensive US 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 Stronger Economic Growth Will Put Upward Pressure On Government Bond Yields Stronger Economic Growth Will Put Upward Pressure On Government Bond Yields Chart 10An Inflation Breakout Is Not Imminent An Inflation Breakout Is Not Imminent An 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 Global Debt Levels Remain High Global Debt Levels Remain High Chart 12The Experience Of The Great Depression Shows Deleveraging Is Impossible Without Growth The Debt Supercycle Endgame: Deflation Or Inflation? The Debt Supercycle Endgame: Deflation Or Inflation?   Means, Motive And Opportunity Chart 13A Kinked Relationship: It Takes Time For Inflation To Break Out The Debt Supercycle Endgame: Deflation Or Inflation? The Debt Supercycle Endgame: Deflation Or Inflation? 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 The Debt Supercycle Endgame: Deflation Or Inflation? The Debt Supercycle Endgame: Deflation Or Inflation? 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 Germany's Competitive Advantage Over The Rest Of The Euro Area Is Deteriorating Germany'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?   The Debt Supercycle Endgame: Deflation Or Inflation? The Debt Supercycle Endgame: Deflation Or Inflation? 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 The Debt Supercycle Endgame: Deflation Or Inflation? The Debt Supercycle Endgame: Deflation Or Inflation? Strategic Recommendations Closed Trades