Bubbles/Crises/Manias

Highlights The sharp rally in Chinese developer stocks this year reflects a combination of the unwinding of "doomsday" bets and notable improvement in fundamentals rather than a bubble formation. The positive re-rating has further to run. Tighter policy imposed by local governments will probably keep developers in dormancy, but a major downturn is highly unlikely simply because there is not much excess to begin with. Urbanization still provides a powerful tailwind for residential construction from a long-term perspective. Chinese housing market will continue to experience cyclical swings, but the powerful structural tailwind will make the cyclical downturn shallow and fleeting. Feature Chart 1A Sharp Re-Rating Of Developer Stocks A Sharp Re-Rating Of Developer Stocks A Sharp Re-Rating Of Developer Stocks Chinese real estate developer stocks have more than doubled so far this year, making them the best performing sector in the investable universe - easily outpacing even the world-beating Chinese technology sector (Chart 1). The recent moves in developer stock prices have become parabolic, which combined with recent measures by some major cities to further tighten housing transactions raises the odds of profit-taking and a technical correction in the near term. However, the sharp rally since the beginning of the year has largely been a mean-reverting positive re-rating process rather than an overshoot. Moreover, the latest housing tightening measures are unlikely to have a long-lasting impact on housing demand. Therefore developer stocks should continue to advance after a period of consolidation. Beyond the cyclical horizon, residential development will remain a long-term growth driver for Chinese business activity. Positive Re-Rating Has Further To Run Chart 2Improvement In Developers' Fundamentals Improvement In Developers' Fundamentals Improvement In Developers' Fundamentals It is tempting to dismiss this year's sharp rally in developer stocks as a speculative frenzy, as the dramatic boom in stock price has been accompanied by cooling property sales and moderating home prices amid regulatory tightening in various cities. In our view, the sharp rally in property stocks has been a powerful positive re-rating in multiples after being deeply depressed for several consecutive years. The bottom panel of Chart 1 shows strong multiples expansion of developer stocks since the beginning of 2017. The message here is that China's cyclical improvement in the past two years has led to an aggressive repricing of Chinese equities, particularly in some of the hardest hit sectors. Investors' overwhelming bearishness towards China's macro situation in previous years took a heavy toll on Chinese investable stocks. The market had essentially priced in a chaotic hard-landing scenario, which is now being reversed due to growth improvement. In recent years we have consistently argued that the risk premium embedded in Chinese equities was exceptionally high and ultimately unsustainable, and one of our major investment themes has been a "positive re-rating in Chinese equities" - a view that has been quickly validated. Moreover, developers' stock prices have also reflected some notable improvements in earnings and balance sheet fundamentals, which can also be observed among their domestically listed peers (Chart 2): Deleveraging: The median liabilities-to-assets ratio of developers has dropped notably from the peak of 2015. Destocking: Developers have been focusing on selling inventories, and have been cautious on new projects. The median inventory-to-assets ratio has dropped from a peak of 63% in late 2015 to below 50% currently. Stronger cash positions: Aggressive de-stocking and conservative expansion have also significantly improved developers' cash flows. Cash position as a share of total assets has improved significantly, returning to the all-time highs reached in 2010. Total profits have also recovered strongly with strengthening margins.1 In short, the rally in developer stocks reflects a combination of the unwinding of "doomsday" bets and notable improvement in fundamentals rather than a bubble formation. There is little froth in the marketplace just yet. In fact, property stocks still remain quite cheap based on some conventional valuation indicators - even after this year's sharp rally. Property stocks are trading at 13 times trailing earnings and nine times forward earnings, and are still trading at hefty discounts to bottom-up net-asset-value (NAV) estimates. This means the bull market should have more legs in the coming months. Will Policy Constraints Lead To Another Major Downturn? Recent policy tightening on the residential market clearly creates some headwinds for the sector, and policy risk has been a key factor driving developer stock prices in previous tightening cycles. Historically, the government's tightening campaigns have typically restricted land supplies and bank credit to developers, and have been combined with tighter lending standards and higher interest rates for mortgage borrowers - and even outright bans on household investment demand for residential properties in major cities. In the current tightening cycle that began early last year, regulations on developers have remained largely unchanged, while the rein on households has been much tighter. Mortgage interest rates have also begun to inch higher (Chart 3). In the latest round of tightening measures announced late last week, eight major cities tightened controls on home sales, with a ban on reselling of homes within two to five years of purchase. The government's tightening measures have already led to a moderation in both home sales and prices, as shown in Chart 3, and the impact needs to be closely monitored. For now, our view is that policy constraints will not lead to major negative surprises both for developer stock prices and overall construction activity. On the demand side, household residential demand has been exceptionally strong of late. The central bank's most recent survey showed that a record high percentage of households intend to buy a home in the near future, a dramatic turnaround since the beginning of 2016 (Chart 4). The reason for the surge in home-buying intentions is not clear - we suspect it is the combination of pent-up demand accumulated in previous years and the herd-following mentality that typically follows a period of rapid increase in home prices. On the supply side, developers' inventory de-stocking and stronger cash positions have improved their ability to deal with sales slowdowns. In fact, home sales have significantly outpaced housing completions since 2015, leading to a sharp decline in inventories. Even including floor space under construction, the sellable inventories-to-sales ratio has dropped to its lowest level since 2010 (Chart 5). In our view, the sharp decline in inventories has been a key reason for the rampant increase in home prices since early last year. Chart 3Housing Market Has Been Moderating Housing Market Has Been Moderating Housing Market Has Been Moderating Chart 4Booming Demand For Home Purchases Booming Demand For Home Purchases Booming Demand For Home Purchases Taken together, with no inventory overhang and strong demand, we expect the impact of the current episode of housing tightening to be limited. In fact, real estate investment has been pretty subdued in recent years, despite surging home sales and improvement in business confidence among developers (Chart 6). Previous housing tightening measures were often implemented after a prolonged period of construction boom, leading to a sudden halt in investment and construction activity. This time around, tighter policy will probably keep developers in dormancy, but a major downturn is highly unlikely simply because there is not much excess to begin with. Chart 5Housing Destocking Becomes Advanced Housing Destocking Becomes Advanced Housing Destocking Becomes Advanced Chart 6Real Estate Investment Will Unlikely Slump Anew Real Estate Investment Will Unlikely Slump Anew Real Estate Investment Will Unlikely Slump Anew It's The Supply Side, Stupid! It appears that Chinese policymakers as well as global investors have perpetual fears of a "housing bubble" in China. The authorities are deeply worried about potential housing excesses and the negative impact on macro stability. Investors share similar concerns, and chronically worry about the global repercussions of a Chinese housing bust. Some have taken aggressive bets against Chinese developers and other asset classes that are leveraged on Chinese construction activity. While there are some idiosyncrasies in the motives of every tightening cycle in recent years, there is one common theme: the authorities' repeated attempts to cool off the housing sector are deeply rooted in the belief that both residential supplies and home prices were excessive, and therefore tighter controls on both supply and demand were warranted. Remarkably, concerns about housing excesses began to emerge almost immediately after the residential sector was privatized and a housing "market" began to develop in the early 2000s. In a special report dated April 29th 2004 titled, "What Housing Bubble?",2 I disputed for the first time the then-prevailing view on Chinese housing excesses. Fast forwarded 13 years and China's urban landscape has changed profoundly - yet the arguments for a "housing bubble" have remained essentially unchanged: speculative demand, excess supply, parabolic price increases and extreme unaffordability. To some China watchers, the housing sector's remarkable resilience despite repeated policy attacks from the early 2000s was simply an accumulation of a bigger accident waiting to eventually happen. In our analysis in recent years, we have repeatedly emphasized that the supply side shortages have been a key reason for the massive increase in Chinese home prices. While the government's various tightening measures to restrict speculators and cool off demand are well warranted, harsh supply side restrictions during various tightening campaigns have proven counterproductive, as they have amplified supply shortages, creating even more upward pressure on prices. Indeed, the supply-side restrictions are fairly easy to observe. China's leadership is fundamentally concerned about self-sufficiency of agricultural products, and therefore is reluctant to sacrifice farmland for urban development. Moreover, land supplies zoned for residential construction have accounted for an increasingly smaller share of total land supply, due to competition from infrastructure, industrial and commercial projects (Chart 7). Similarly, land purchased by developers plateaued in the early 2000s, and has dropped substantially in recent years. As a highly levered business by nature, developers have also been constantly challenged by limited access to bank loans due to regulatory restrictions. Loans to developers account for about 7% of banks' total loan book, largely unchanged in the past decade despite the massive construction boom. Tight credit controls have forced developers to other "shadow" financing options, which are both costlier and less reliable than formal bank loans, further limiting their ability to bring new housing projects to market. The prevailing heightened concerns on residential excesses and tougher regulations have pushed real estate companies to increasingly shift to commercial and industrial property development. Residential accounted for almost 80% of total real estate development in the early 2000s; the share has dropped to below 70% in recent years (Chart 8). Finally, the government's ill-informed judgement on the degree of excessive supply and speculative demand in the residential sector also prevented them from formulating a multi-tier residential market. Rental residential properties owned by professional institutional investors are rare, and "renters" often suffer discrimination for some public services, making homeownership essentially the only way for new families to establish themselves in urban areas. Chart 7Residential Land Supply Has Been Shrinking Residential Land Supply Has Been Shrinking Residential Land Supply Has Been Shrinking Chart 8Residential Construction's Dwindling Importance Residential Construction's Dwindling Importance Residential Construction's Dwindling Importance From a big-picture point of view, China is still in the midst of a spectacular urbanization process. Residential development is not only part of the growth process, but also an essential component to accommodating the massive increase in the urban population. Mainstream media often hype about "ghost towns" but ignore the fact that millions of young migrant workers still reside in dorm rooms provided by employers in sub-standard living conditions. Adjusting for the increase in the urban population, China's new residential construction in recent years has been a lot smaller than in other countries such as Japan and Korea at the prime stage of their respective urbanization process, according to our calculations (Chart 9) - likely the critical reason why Chinese home prices have remained stubbornly high, despite numerous rounds of government crackdowns. Chart 9China's Construction Boom In Perspective Chinese Real Estate: Which Way Will The Wind Blow? Chinese Real Estate: Which Way Will The Wind Blow? Since last year it appears the Chinese authorities have been paying more attention to increasing residential housing supply by providing more funding for social housing projects and shanty town reconstruction, as well as increasing land supply for residential projects. Meanwhile, there are recent proposals to develop rental markets in some major cities, allowing developers to build solely for rental, rather than for sales. In our view, policies boosting residential supplies will be a lot more effective in improving housing affordability for urban citizens. All in all, after the massive boom in recent years, home prices in certain major cities certainly feel a lot more "bubbly" than any time before, and it is easy to make a bearish structural case, as many have been doing over the past decade. However, urbanization still provides a powerful tailwind for residential construction from a long-term perspective. The Chinese housing market will continue to experience cyclical swings, but powerful structural tailwinds will make the cyclical downturn shallow and fleeting, as repeatedly demonstrated in previous policy tightening cycles. Looking forward, construction will remain an important growth driver for China for decades to come. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "China: Earnings Scorecard And Market Tea Leaves", dated September 7, 2017, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Special Report, "What Housing Bubble?" dated April 29, 2004, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights Hong Kong property prices are frothy and will continue to face headwinds. Real estate currently offers a poor risk-return trade off from an investment perspective, and will likely lag other asset classes in the medium to long run. A replay of another spectacular housing bust is highly unlikely. Several critical differences between the current environment and that of 1997 prevent a meltdown. Favor Hong Kong property developers over property owners strategically. Aim to upgrade the property sector on further decline in prices. Feature Chart 1Hong Kong Property Prices Remain Red Hot Hong Kong Property Prices Remain Red Hot Hong Kong Property Prices Remain Red Hot This coming weekend marks the 20th anniversary of Hong Kong's handover from Great Britain to the People's Republic of China - as well as the onset of the spectacular bust of a massive housing bubble that saw home prices collapsing by 70%. Fast forward 20 years and Hong Kong home prices are once again standing at bubbly highs, with growing consensus that the market is on the verge of another major crash. Some analysts are predicting a 50% decline in the coming years, and officials are also issuing stern warnings. Financial Secretary Paul Chan Mo-po has cautioned that "the risk in the property market is very high." Norman Chan Tak-lam, chief executive of the Hong Kong Monetary Authority (HKMA) has also noted that market conditions today are reminiscent of those in 1997, and has warned there are risks that the property bubble might burst again. We have been equally concerned about Hong Kong housing for a while,1 and have been surprised by its remarkable resilience (Chart 1). After a temporary dip between mid-2015 and early 2016, Hong Kong home prices bounced right back and have been touching records again, even though the authorities have significantly tightened regulations to cool off demand. Stamp duties for home sales have been raised to 15% for local households, except for first-time homebuyers, or as high as 30% for foreign buyers - both of which are draconian measures that immediately squeezed out speculative buyers. The fact that Hong Kong home prices have been able to withstand the aggressive policy crackdown suggests that fundamentals are probably stronger than commonly perceived. We maintain the view that the Hong Kong real estate market will likely continue to face downward pressure, but prevailing concerns in the marketplace appear overdone. The surprise could be that any decline in home prices will likely be smaller than many anticipate. The Anatomy Of Two Property Bubbles Chart 2Monetary Conditions Set The Broad Trend##br## In Property Prices Monetary Conditions Set The Broad Trend In Property Prices Monetary Conditions Set The Broad Trend In Property Prices At the onset, current housing market conditions in Hong Kong share some disturbing similarities with the real estate bubble 20 years ago. From a macro perspective, our fundamental concern is the tightening in monetary conditions, which have historically always boded poorly for Hong Kong asset prices in general and real estate prices in particular (Chart 2). Hong Kong's currency board system copies U.S. monetary policy in totality, and the Federal Reserve's current tightening cycle has led to a notable tightening in Hong Kong monetary conditions, especially through exchange rate appreciation. Moreover, tightening in monetary conditions often leads peaks in asset prices by a long interval. In the 1997 episode, monetary conditions began to tighten in 1993, four years ahead of the ultimate housing bubble peak. This time around, our monetary conditions index for Hong Kong has rolled over since 2012, casting a shadow on home prices from a macro standpoint. Specific to the housing market, there are also plenty of warning signs that home prices are unsustainable at current levels. Home prices have quadrupled in the past 15 years, outpacing nominal GDP as well as household income by a wide margin. In fact, the gap between home prices and household income levels has become much wider than in 1997 (Chart 3). On the surface, housing affordability does not appear as dire as during the peak of the previous bubble. A closer look, however, reveals it is almost entirely due to increasing maturities of mortgage loans over the past two decades (Chart 4). Indeed, the average contractual life of new mortgages has increased from 200 months in the early 2000s to about 320 months currently, leading to a smaller monthly payment for mortgage borrowers but an additional 10 years to pay back all the debt. If mortgage terms were held constant, our calculation shows that housing affordability would be as bad as during the 1997 bubble peak, even considering today's exceedingly low interest rates (bottom panel, Chart 4). Rental yields of Hong Kong residential properties are standing at close to record lows, only marginally higher than government bond yields. In comparison, rental yields dropped below the risk-free rate in the 1990s, but were still much higher even at the peak of the housing bubble than today's level (Chart 5). It is true that interest rates may be structurally lower than in the past, but the Hong Kong housing market is priced for "perfection," leaving no room for negative interest rate surprises. Chart 3Home Prices Massively Outpaced Income Home Prices Massively Outpaced Income Home Prices Massively Outpaced Income Chart 4Housing Affordability: Worse Than Appears Housing Affordability: Worse Than Appears Housing Affordability: Worse Than Appears Chart 5Hong Kong Property Yields: Priced For Perfection Hong Kong Property Yields: Priced For Perfection Hong Kong Property Yields: Priced For Perfection Taken together, investors should remain cautious on the Hong Kong housing sector. It offers a poor risk-return trade off from an investment perspective, and will likely lag other asset classes in the medium to long run. However, there are also some critical differences between the current environment and that of 1997 that make a replay of another spectacular housing bust highly unlikely. Five Key Differences First, there is currently much less speculative activity in the Hong Kong housing market than two decades ago, thanks to regulators' punitive measures against non-first time homebuyers and home "flippers." Overall housing transactions currently are a fraction of the overheated levels in the early 1990s. So-called "confirmor transactions," deals in which properties are re-sold before the original transaction is completed, were as high as 10% of total sales in the run-up to the 1997 housing bubble peak, while today they are practically non-existent (Chart 6). This has made home prices much less vulnerable to a self-feeding downward spiral, when speculators rush to exit when market conditions shift. Second, banks' lending practices, especially for new mortgages, are significantly tighter now than it was in the 1990s. Prior to the 1997 bust, commercial lenders were required to maintain a loan-to-value (LTV) ratio for mortgage loans at a minimum of 70%. The LTV ratio was only cut to 60% in January 1997 when home prices were already excessively high, which in hindsight may well have sown the seeds for the market collapse. This time around, the HKMA has been tightening mortgage and lending standards going as far back as 2009, and the macro-prudential supervision on housing related activity has continued to increase in recent years. Overall, banks' mortgage LTV ratio is currently hovering at 50%, underscoring a massive buffer between banks' asset quality and home prices (Chart 7). Anecdotally, some developers have been offering mortgage loans with higher LTVs for newly built projects. However, new projects account for less than a quarter of total housing transactions, and therefore such practices, even if they were widespread, would not change the situation in a meaningful way. Overall, mortgage lending in Hong Kong is fairly conservative and closely monitored by regulators. In fact, even in the previous dramatic housing downturn, Hong Kong banks' mortgage delinquency ratio peaked out at 1.5%, an extremely low number by any standard. Tightened lending regulations have made the banking sector even less vulnerable to home price declines than 20 years ago. Chart 6Much Less Speculative Housing Demand ##br##Than 20 Years Ago Much Less Speculative Housing Demand Than 20 Years Ago Much Less Speculative Housing Demand Than 20 Years Ago Chart 7Banks Have Significantly Tightened##br## Mortgage Lending Standards Banks Have Significantly Tightened Mortgage Lending Standards Banks Have Significantly Tightened Mortgage Lending Standards Third, it is important to note that another critical reason for the housing crash home prices after 1997 was a dramatic increase in new housing supply. To ease the housing shortage and rampant upward pressure on prices, then-Chief Executive Tung Chee-hwa came to office in 1997 with a promise to build 85,000 units annually for the next 10 years - 35,000 by private developers and 50,000 by the public sector. Mr. Tung was not able to reach these targets, and the housing plan was quickly suspended as home prices collapsed, but his policy still led to a sharp increase in land supply and housing starts, which in turn led to rising housing completions in the following years at a time when demand had vanished - compounding downward pressure on prices (Chart 8). In recent years, even though the Hong Kong government has acknowledged the acute housing shortage, there has been no ambitious plan to increase housing supply. The government expects a total of 96,000 new housing units in the coming three to four years, barely higher than current levels and less than a third of the early 2000s. Without oversupply, any downside in home prices will prove self-limiting. Chart 8Housing Supply: This Time Is Different Housing Supply: This Time Is Different Housing Supply: This Time Is Different Chart 9No Longer Hong Konger's Hong Kong No Longer Hong Konger's Hong Kong No Longer Hong Konger's Hong Kong Fourth, a major difference between now and 20 years ago is the dramatic wealth creation among mainland households, which will offer critical support for the Hong Kong housing market if prices drop precipitously. Chart 9 shows total value of Hong Kong residential properties as a share of local GDP has already surpassed that during the 1997 housing bubble peak, according to our estimate, but as a share of Chinese GDP it is currently standing at a record low. The point is that Hong Kong property has become a store of wealth for rich mainland investors and households. The Hong Kong authorities have been working hard to squeeze out mainland demand for local properties with punitively high taxes - homes purchased by non-Hong Kong permanent residents, mostly mainland Chinese, currently account for less than 1% of total home sales, compared with about 6% in 2012 (Chart 10). These discriminative taxes against mainland buyers can be reversed, should Hong Kong home price drop beyond the Hong Kong authorities' comfort zone. We doubt the Hong Kong government would allow home prices to drop by more than 30% from current levels. Finally, currently Hong Kong property developers' stock prices have priced in a sharp decline in home prices, while the market in general is a lot more complacent than in the previous episode. A simple regression between Hong Kong developers' stocks and property prices suggests that developers' stock prices are about 30% below some intrinsic "fair value" - roughly in line with the developers' current price-to-book ratio (Chart 11, top panel). In 1997, Hong Kong developers' PB ratio was 1.7, roughly comparable to their global peers, despite the obvious froth in underlying property prices (Chart 11, middle and bottom panel). This time around, developers' PB ratio is currently 0.7, on par with the 2003 levels, when home prices had already crashed by 70%. Hong Kong property stocks are trading at over 50% discount to their DM and EM counterparts, based on PB ratios. Chart 10Mainland Chinese Buyers ##br## Have Been Pushed Out Hong Kong Housing Bubble: A Replay Of 1997? Hong Kong Housing Bubble: A Replay Of 1997? Chart 11Hong Kong Property Stocks: ##br##Priced In A Sharp Housing Downturn Hong Kong Property Stocks: Priced In A Sharp Housing Downturn Hong Kong Property Stocks: Priced In A Sharp Housing Downturn Looking forward, our base-case scenario is that Hong Kong developers' stocks will likely remain under downward pressure along with softening home prices. Stock markets are an emotional discounting mechanism, and the Hong Kong bourse has been notoriously volatile. Therefore, periods of undershoots cannot be ruled out. However, it is noteworthy that developers' stock prices may have priced in at least a 30% decline in home prices. Strategically, we still prefer property developers over property owners and aim to upgrade the property sector on further decline in prices. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "The Fed "Lift Off", Hong Kong And The RMB," dated August 12, 2015, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights Through the 18 years of the euro, growth in 'core' Germany and France and 'periphery' Spain has equalled that in the U.S., U.K. and Canada. But Italy has severely underperformed since 2008. Italy's economic underperformance is due to the uncured malaise in its banks. Fixing Italian banks will fix Italy and reduce euro breakup risk. Euro area equities and periphery bonds do offer long-term relative value on the premise that euro breakup risk does ultimately fade. But for those who can time their entry, await the outcome of the Italian election. Feature The euro recently had its 18th birthday.1 Through the formative, testing and often tempestuous first 18 years of its life, how have the euro area's main economies performed - and how do these performances compare with the developed world's other major economies? The answers might come as a surprise (Chart of the Week). Chart of the WeekItaly Has Severely Underperformed Since 2008. Why? Italy Has Severely Underperformed Since 2008. Why? Italy Has Severely Underperformed Since 2008. Why? To allow for the different demographics, we must look at growth in real GDP per head.2 On this metric, the gold medal goes to Japan, with 34% growth. During the euro's lifetime, Japan's real GDP has grown by 18%, but its working age population has shrunk by 12%, resulting in the developed world's best real growth per head.3 The silver medal winner is probably not surprising: Germany, with 28% growth. But the bronze medal winner might surprise you. It is a euro 'periphery' country: Spain, with 26% growth - a medal shared with the U.K. Then come Canada, 24%; the U.S., 22%; and France, 19%. So through the 18 years of the euro, Germany, France and Spain have performed more or less in line with the U.S., U.K. and Canada. Making it very difficult to argue that being in the single currency has penalized the growth of either 'core' Germany and France or 'periphery' Spain. Italy Isn't Partying... But Don't Blame The Euro Unfortunately, there's a problem - Italy. Through the 18 years of the euro, Italy's real GDP per head has grown by just 5%, substantially below any other G10 or G20 economy. If the euro is to blame for the significant underperformance of its third largest economy with 60 million people, then the single currency's long-term viability has to be in serious doubt. However, two pieces of evidence suggest that the euro per se is not to blame for Italy's painful underperformance. First, observe that through 1999-2007, Italian real GDP per head kept up with many of its G10 peers. Even without a substantial tailwind from a credit-fuelled housing boom - which other economies had - Italian real growth per head performed in line with France, the U.S. and Canada (Chart I-2). Chart I-2Through 1999-2007, Italy Grew In Line With France, The U.S. And Canada Through 1999-2007, Italy Grew In Line With France, The U.S. And Canada Through 1999-2007, Italy Grew In Line With France, The U.S. And Canada Second, in the post-crisis years, there was little to distinguish the economic performance of Italy from Spain until 2013 (Chart I-3). Only after 2013 has a huge gap opened up. While Italy has struggled to grow, Spain has taken off, expanding by more than 12%. This recent strong recovery in Spain makes it hard to attribute Italy's underperformance to membership of the single currency (per se). Chart I-3Post-Crisis, There Was Little To Distinguish Italy and Spain Until 2013 Post-Crisis, There Was Little To Distinguish Italy and Spain Until 2013 Post-Crisis, There Was Little To Distinguish Italy and Spain Until 2013 Fix Italian Banks To Fix Italy We believe that Italy's economic underperformance is down to the as yet uncured malaise in its banks. Italy's banking malaise has built up stealthily, generating frequent financial tremors but without an outright crisis. In contrast, the housing-related credit booms in the U.S., U.K., Spain and Ireland did eventually cause housing busts and full-blown financial crises - requiring urgent government-led and central bank-led bailouts. Crucially, the acute financial crises in the U.S., U.K., Spain and Ireland forced their policymakers to recapitalize the banks, and thereby allowed the bank credit flow channel to function again. For example, Spain's turning point came in 2013, when bank equity capital as a multiple of non-performing loans (NPLs) started to recover (Chart I-4), allowing Spanish banks to operate more normally. Chart I-4Spanish Banks' Solvency Recovered In 2013 Spanish Banks' Solvency Recovered In 2013 Spanish Banks' Solvency Recovered In 2013 But Spanish banks' health did not recover because NPLs declined; indeed, if anything, NPLs continued to increase (Chart I-5). Spanish banks' health improved because of a large injection of bailout equity capital (Chart I-6). By contrast, Italian banks have not yet received the injection of equity capital that is desperately needed to fix Italy's bank credit flow channel. Chart I-5NPLs Continued To Rise Everywhere NPLs Continued To Rise Everywhere NPLs Continued To Rise Everywhere Chart I-6French And Spanish Banks Have Raised Equity. Italian Banks Have Not. French And Spanish Banks Have Raised Equity. Italian Banks Have Not. French And Spanish Banks Have Raised Equity. Italian Banks Have Not. To lift Italian banks' equity capital to NPL multiple to the lowest level that Spanish banks reached before recovery would require €80-100 billion of fresh bank equity capital. Which equates to 5-6% of Italian GDP. The good news is that this is an affordable price if it kick starts long-term growth. The bad news is that Italy's avoidance of outright financial crisis (thus far) has now tied its hands. The EU Bank Recovery and Resolution Directive (BRRD), which came into full force on January 1 2016, has blocked the state bailout escape route that Spain and Ireland used. Granted, in a crisis, the BRRD would allow Italian government state intervention to aid a troubled bank. But the overarching aim would be to protect banks' critical functions and stakeholders, specifically: payment systems, taxpayers and depositors. "Other parts may be allowed to fail in the normal way... after shares in full... then evenly on holders of subordinated bonds and then evenly on senior bondholders." Without a crisis, the process to recapitalise Italian banks and expunge NPLs would be largely up to the private sector and markets. But a long chain of events from the repossession of assets under bankruptcy law, to valuation, to full divestment from the banks' balance sheets could take years. Our concern is that such a protracted nursing to health will keep Italy's bank credit channel dysfunctional, thereby leaving economic growth in a 60 million people economy sub-par for an extended period. Only when the Italian banks are adequately recapitalized, will the danger of a financial or political tail-event - and a euro breakup - be fully exorcised. Unfortunately, the danger may first have to rise before policymakers allow the necessary action. But ultimately they will. Some Investment Thoughts If euro breakup risk does ultimately fade, then euro area equities will receive a tailwind relative to other markets. This is because relative to these other markets, euro area equity prices are discounted to generate a 1.5% excess annual return through the next 10 years - as a risk premium for euro breakup.4 So if this risk premium suddenly and fully vanished, relative prices would have to rise by 15%. Likewise, euro area periphery bond yields can compress further - as the yield premium effectively equals the perceived annual probability of euro breakup multiplied by the expected currency redenomination loss after the breakup. So euro area equities and periphery bonds do offer long-term relative value on the premise that the policy steps needed to boost Italian growth are affordable and relatively minor - and that euro breakup risk does ultimately fade. However, for those who can time their entry, await the outcome of the Italian election due to take place within the next year. Breakup risk may flare up again before it does ultimately fade. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 The euro was born on January 1st 1999. 2 Zeal GDP divided by working age (15-64) population 3 1.18/(1-0.12)=1.34 4 Please see the European Investment Strategy Weekly Report "Markets Suspended In Disbelief" published on April 13 2007 and available at eis.bcaresearch.com Fractal Trading Model* There are no new trades this week. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-7 Short CAC40 / Long EUROSTOXX600 Short CAC40 / Long EUROSTOXX600 * 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 The post-June 9, 2016 fractal trading model rules are: 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. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch ##br##- Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

The secular bond bull market is over. Safety is in a bubble. The shift from monetary to fiscal easing is the most likely candidate to prick the bubble in safety.
In this piece we revise our yield portfolio to increase its resilience to interest rate shocks.

Cuba will become a notable frontier market now that the Communist regime has no foreign geopolitical partner to prop it up. A poor demographic profile does not prevent the country from capitalizing on American tourism. It also stands to benefit from access to U.S. consumers and rising Chinese consumerism.

The complete annihilation of all human life represents the mother of all tail risks. We estimate that there is a 50% chance that doomsday will occur by 2290, and a 95% chance that it will occur by 2710. If the risk of doomsday is elevated, what is an investor to do?

The complete annihilation of all human life represents the mother of all tail risks. We estimate that there is a 50% chance that doomsday will occur by 2290, and a 95% chance that it will occur by 2710. If the risk of doomsday is elevated, what is an investor to do?

Investors are being forced into riskier asset classes by the TINA effect, but the gaping macro disequilibria makes it difficult for investors to see how we move back to equilibrium in a benign way. Monetary policy on its own is limited in its ability to soften the adjustment, but the good news is that the political pendulum is swinging toward fiscal stimulus.

The exponential rise in banks' non-standard credit assets has occurred in spite of the government's efforts to contain and regulate it. The government does not have full control over shadow banking and non-large banks. These have become a large part of the credit system. Hence, the assumption that the central government in Beijing can sustain any rate of credit growth it desires is overly simplistic. Short small bank stocks in China.