Economy

Highlights Low Bond Volatility: Weakening non-U.S. growth and a more dovish Fed have crushed global government bond volatility, especially in Europe and Japan where yields are struggling to stay above 0%. Treasury-Bund and Treasury-JGB spreads, which now largely reflect long-run real growth differentials between the U.S and Europe/Japan, are likely to stay range bound. USTs vs Bunds/JGBs: Stay overweight Bunds & JGBs versus Treasuries, on a hedged basis in U.S. dollars, given the boost to returns from hedging into higher-yielding dollars. Feature Bond Yields Are In Winter Hibernation Developed market (DM) government bonds, never the most exciting of asset classes to begin with, have become boring of late. While benchmark 10-year yields since the end of January have moved in line with our recommended country allocations - lower in Germany (-7bps), Japan (-3bps), the U.K. (-5bps) and Australia (-11bps) where we are overweight, higher in the U.S. (+5bps), Canada (+2bps) and Italy (+19bps) where we are underweight – government bonds have settled into trading ranges and lack direction. The proximate trigger for the muted yield volatility was the Federal Reserve shifting to a neutral stance on U.S. monetary policy in January. Investors have priced out any possibility of a Fed rate hike over the next year, and now even discount a modest rate cut, according to the U.S. Overnight Index Swap (OIS) curve. Yet while most of the attention for bond investors have been focused on the U.S., there are developments in other major economies that are also depressing yields – namely, weakening economic momentum and sluggish inflation. In particular, the downturn has shown no signs of stabilizing in the eurozone and Japan, with the latest readings on manufacturing PMIs now below the 50 line, signaling a contraction (Chart of the Week). The latest data in both regions still shows that core inflation is nowhere near the inflation targets of the European Central Bank (ECB) and Bank of Japan (BoJ). The story is much different in the U.S, with the manufacturing PMI still well above 50 and core inflation hovering close to the Fed’s 2% inflation target. Yet Treasury yield volatility has collapsed, with the MOVE index of Treasury options prices now back to the lows of this cycle. Chart Of The WeekAre Treasuries Leading Or Following? For the time being, non-U.S. factors are driving the direction of global bond yields. We think that will change later this year, as steady U.S. growth and surprisingly firm U.S. inflation readings will prompt the Fed to begin hiking rates again. Yet until there are signs that non-U.S. growth is stabilizing, the low yields in Europe and Japan will act as an anchor on U.S. Treasury yields, particularly given how wide U.S./non-U.S. yield differentials already reflect faster growth and inflation in the U.S. Decomposing Treasury-Bund & Treasury-JGB Spreads When looking at the pricing of the “Big 3” DM government bond markets – the U.S., Germany and Japan – there are some major differences but also some similarities as well. Even with the benchmark 10-year U.S. Treasury sitting at 2.68% compared to a mere 0.11% and -0.03% on the 10-year German Bund and 10-year Japanese government bond (JGB), respectively. Simply looking at the breakdown of those nominal 10-year yields into the real and inflation expectations components, there is not much of a comparison (Chart 2). The real 10-year Treasury yield is in positive territory at 0.6%, compared to -1.4% and +0.2% for JGBs and German bunds, respectively. Inflation expectations, measured by 10-year CPI swap rates, are 2.1% in the U.S., 1.5% in Germany and 0.2% in Japan. Thus, the current wide 10-year Treasury-Bund spread (just under +260ps) can be broken down into a real yield spread of +200bps and an inflation expectations gap of +60bps. In the case of the 10-year Treasury-JGB spread (just under +270bps), that breaks down into a real yield differential of +80bps and an inflation gap of +190bps. Chart 2Big Differentials Here... So while the Treasury-Bund and Treasury-JGB spreads are of similar magnitude, the valuation components driving the spread are much different. The former is more of a real yield gap, while the latter is more of an inflation expectations gap. That is no surprise given the BoJ’s Yield Curve Control policy that maintains a ceiling on the 10-year JGB yield of between 0.1% and 0.2%, limiting how much real yields can move (there are no BoJ restrictions on the level of CPI swap rates). Yet the U.S.-Japan inflation expectations gap is not too far off the spread between realized headline and core inflation measures in both countries - both are 1.4 percentage points higher in the U.S. as of January. Looking at other valuation metrics, the cross-county differentials are less pronounced (Chart 3). Chart 3...But Less So For Other Yield Measures Yield curves are quite flat, with the 2-year/10-year slope a mere +16bps in the U.S., +14bps in Japan and only +66bps in Germany. Our estimates of the term premia on 10-year government debt are negative for all three markets, most notably in the countries that have seen quantitative easing in recent years (-10bps in the U.S., -90bps in Germany and -60bps in Japan). Perhaps most importantly, our preferred measure of the market pricing of the real terminal policy rate – the 5-year OIS rate, 5-years forward minus the 5-year CPI swap rate, 5-years forward – is +0.2% in the U.S., -0.5% in Germany and 0.0% in Japan. That means the market is pricing in only a +70bp differential, in real terms, between the neutral policy rates of the Fed and ECB. That gap is only +20bps between market pricing of the neutral real rates for the Fed and BoJ. That narrower gap between the market-implied pricing of the real neutral rate is consistent with the theoretical macroeconomic drivers of real rate differentials, like growth rates of potential GDP and labor productivity. According to OECD estimates, potential GDP growth is 1.8% in the U.S., 1.5% in the overall euro area and 1.2% in Japan (Chart 4). This implies a long-run real yield gap between the U.S. and Germany of +60bps and the U.S. and Japan of +30bps – very close to the market pricing for the real terminal rate differentials.1 When looking at the 5-year annualized growth rates of labor productivity data from the OECD, there is no difference between the three regions with all growing at a mere 0.5% (suggesting that either a faster growth rate of the labor input, or greater productivity of capital, accounts for the higher potential growth rate in the U.S.). Chart 4No Major Differences In Long-Run Real Growth With the cross-country yield spreads now effectively priced for the long-run real growth differentials between the U.S. and Europe/Japan, this will limit the ability for nominal Treasury-Bund and Treasury-JGB spreads to widen much further. Right now, U.S. inflation expectations are rising faster than those of Europe and Japan, in response to the Fed’s more dovish stance. Yet if those expectations continue to rise, likely in the context of stickier realized U.S. inflation alongside solid U.S. growth, then the Fed will return to a hawkish bias. That ultimately means higher U.S. real yields and, most likely, some pullback in U.S. inflation expectations since the markets would begin to price in the implications of the Fed moving to a restrictive policy stance (including a stronger U.S. dollar that will help dampen U.S. inflation, at the margin). So that means inflation differentials between the U.S. and Germany/Japan can move wider now but will narrow later; and vice versa for real yield differentials (narrower now and wider later). The main investment implication: nominal UST-Bund and UST-JGB spreads are unlikely to move much wider, likely for the remainder of this business cycle/Fed tightening cycle. The main takeaway is that bond yields in core Europe and Japan are effectively anchoring global yields, in general, and U.S. yields, in particular. Treasury yields will not be able to break out of the current narrow trading ranges until there are signs that growth has stabilized in Europe and Japan. Reduced global trade tensions and faster Chinese growth (and import demand) are necessary conditions to reflate the export-heavy economies of Europe and Japan. Yet even if that scenario does unfold in the months ahead (which is BCA’s base case scenario), there is still a case to prefer Bunds and JGBs over U.S. Treasuries on a currency-hedged basis in U.S. dollars. Given the wide short-term interest rate differentials between the U.S. and Europe/Japan, those near-zero 10-year Bund and JGB yields, after hedging into U.S. dollars, are actually higher than 10-year Treasury yields, which benefits the relative hedged performance of the low-yielders versus the U.S. (Chart 5) Chart 5Stay Overweight Bunds & JGBs Vs. USTs (Hedged Into USD) Thus, we continue to recommend an overweight stance on core Europe and Japan, versus an underweight tilt on the U.S., in global U.S. dollar-hedged government bond portfolios. Bottom Line: Weakening non-U.S. growth and a more dovish Fed have crushed global government bond volatility, especially in Europe and Japan where yields are struggling to stay above 0%. Treasury-Bund and Treasury-JGB spreads, which now largely reflect long-run real growth differentials between the U.S and Europe/Japan are likely to stay range bound. Stay overweight Bunds & JGBs versus Treasuries, on a hedged basis in U.S. dollars, given the boost to returns from hedging into higher-yielding dollars.   Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com    Footnotes 1      We are using the full euro area data for these economic comparisons, even though we are discussing U.S.-German yield differentials in this report. We think this is reasonable given the status of German government bonds as the benchmark for the euro area, and with the ECB setting its monetary policy for the overall euro area. The differences between the data for Germany and the overall euro area are modest, with German potential GDP and 5-year productivity growth both only 0.3 percentage points higher. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Special Report

Highlights The Phillips curve, which encouraged economic policymakers of the sixties and early seventies to believe in a mechanical tradeoff between inflation and unemployment, fell into disrepute once stagflation strangled the U.S. economy. We do not view the idea that there is an inverse relationship between the unemployment rate and wage gains as controversial. This weak form of the Phillips curve simply formalizes the interplay between supply and demand in the labor market. We have found, however, that any reference to the Phillips curve has the potential to provoke strong reactions from investors. The criticism that the link between compensation gains and consumer prices is questionable has merit. Over the last 30 years, changes in compensation have exhibited a sporadic correlation with changes in consumer prices. Even if the empirical evidence between labor market tightness and inflation is somewhat wobbly, the Fed remains squarely in the Phillips curve camp, and its take on the relationship is the only one that matters for monetary policy. The investment implication is that labor market strength will prove self-limiting. An unemployment rate bound for 3.5% or lower will pull the Fed back off the sidelines, ultimately bringing down the curtain on the expansion and the equity bull market. Feature The stagflation of the seventies was a near-death experience for the Phillips curve and its proposition that unemployment and inflation are inversely related. As both Milton Friedman and Edmund Phelps had predicted, the trade-off could not survive beyond the short term because workers would adjust their expectations as they caught on to the pattern, demanding wages that kept pace with inflation even when unemployment was high. Duly modified, the Phillips curve’s appeal was rekindled, and the Phelps-Phillips expectations-augmented version has gone mostly unchallenged within the economics profession ever since. The Fed and other policymakers may have given up on the notion that they could manage their economies via a mechanical tradeoff between inflation and unemployment, but the inverse relationship remains a pillar of their macroeconomic models. We don’t find the idea that the unemployment rate and wage inflation are inversely related the least bit controversial, as it fully accords with the laws of supply and demand. Unemployment’s link to consumer price inflation is uncertain, however, and even the narrow unemployment/wages form of the Phillips curve relationship we favor often invites controversy. Discussing upward wage pressures within the context of consumer price inflation and the Fed’s reaction function can elicit spirited resistance. As one client put it in a January meeting, “it is unbecoming for BCA to subscribe to these sorts of cost-plus notions of inflation.” This Special Report examines the record in an effort to determine the influence the Phillips curve thesis will have on policy and markets going forward. It asks the following questions along the way: What is the Phillips curve? Where does inflation come from? Is there a relationship between wage inflation and price inflation? Where does the Fed stand? What impact will a falling unemployment rate have on the economy and financial markets? A Brief History Of The Phillips Curve The Phillips curve arose from a study of the unemployment rate and wages in the U.K. from the mid-nineteenth to the mid-twentieth centuries. William Phillips discovered a consistent inverse relationship between the unemployment rate and changes in wages: high unemployment was associated with muted wage gains, and low unemployment was associated with robust wage gains. He posited that the unemployment rate revealed the level of tightness in the labor market, and the extent to which employers had to compete to attract workers. Other researchers extended the relationship from wage inflation to price-level inflation and suggested that policy makers could use the tradeoff between unemployment and inflation to fine-tune the course of the economy. The stagflation of the seventies blew up the notion of a mechanical tradeoff, but a modified form of the inverse relationship between unemployment and wage gains resides at the heart of mainstream macroeconomic forecasting models. Those models have become more sophisticated, and now include the concept of a natural rate of unemployment, but the inverse relationship between unemployment and inflation remains at their core. Investor skepticism aside, the Phillips curve is deeply embedded in orthodox economic narratives relating inflation and unemployment. As New York Fed President Williams put it last Friday in the first line of a speech discussing the issues raised in a new Phillips curve paper, “The Phillips curve is the connective tissue between the Federal Reserve’s dual mandate goals of maximum employment and price stability.1” Where Does Inflation Come From? Thousands of dissertations have grappled with this subject without providing a definitive solution, but there are two broad explanations we find most compelling. The first is that inflation responds to the level of slack in the economy. That’s to say that inflation is a by-product of the relative balance between aggregate supply and aggregate demand. When the output gap is wide (demand falls well short of the economy’s capacity), inflation is unlikely to find a footing. When the output gap is closed (demand and capacity are in balance) or negative (demand exceeds capacity), inflation will gain traction unless imported capacity bridges the gap. For the second, we combine the idea that inflation expectations play a central role with Milton Friedman’s always-and-everywhere admonition. The stable inflation of the last couple of decades has coincided with stable inflation expectations. The causation mostly appears to run from (trailing) inflation to expectations (Chart 1), but expectations surely influence economic actors’ price negotiations and open the door to a monetary influence. Inflation expectations are likely to be well anchored under a central bank that convinces households and businesses of its commitment to price stability. When the monetary authority lacks inflation credibility, inflation expectations may become unmoored and impel economic actors to insist upon higher wages and selling prices to keep pace with a rising price level. Chart 1Seeing The Future In The Recent Past The expectations-augmented Phillips curve makes it clear that inflation is a function of inflation expectations just as surely as it is a function of the unemployment rate. The more firmly expectations are anchored, the more unemployment has to drift from its natural rate (NAIRU, or u-star (u*)) to move the inflation needle. In other words, when expectations are as well-anchored as they have been since the crisis, wages will be so unresponsive to changes in the unemployment rate that the Phillips curve will appear to be broken. Believing that inflation will permanently remain at 2% or lower, workers feel no urgency to press for larger wage/salary increases. The Empirical Record – Unemployment And Wages The seventies played havoc with the Phillips curve, but over the last twenty-five years, the inverse relationship between changes in the unemployment rate and wage gains has held up very well once the unemployment rate has reached threshold levels at or near u-star. When there is ample slack in the labor market, wages are nearly insensitive to changes in the unemployment rate. When the unemployment rate moves from 10% to 9%, 9% to 8%, or 8% to 7%, there are multiple qualified candidates for every job opening and employers have no reason to bid wages higher (Chart 2, top panel). Below 5%, roughly around u*, employers have to compete for workers and wage gains are very sensitive to moves in the unemployment rate (Chart 2, bottom panel). Chart 3 illustrates the threshold concept, segmenting the last 30 years of observations by their relationship to the unemployment gap. Observations for which the unemployment gap is greater than or equal to 2% are shown in gray; their best-fit line with wage gains is nearly flat. Positive, but small, unemployment-gap observations are shown in orange; their best-fit line is steeper and indicates a more robust correlation with moves in wages. Negative unemployment-gap observations are colored blue; they have the steepest best-fit line and exhibit the tightest correlation with changes in wages. A skeptic might seek more convincing evidence, but period-to-period noise in the data limits the amount of variation in wages explained by the unemployment rate (just under 40% over the last 30 years). Noting that the unemployment gap tends to persist in negative and positive territory for extended periods, we measured the annualized rate of wage gains for negative-gap and positive-gap phases. The results were robust, with wage gains in negative-gap phases consistently topping gains in positive-gap phases (Chart 4). Both groups exhibited remarkably consistent growth rates – the three complete negative-gap phases featured wage gains of 3.8%, 3.8% and 3.9%, while the three positive-gap phases had wage growth of 2.7%, 2.5% and 2.4%. At 3%, the current negative-gap phase has already separated itself from the last three decades’ positive-gap phases, though the 3.8% level is still a ways away. Chart 4Mind The Gap The Empirical Record – Wage Inflation And Price Inflation If businesses were omniscient, omnipotent and able to adjust selling prices in real time – something like Amazon, in another words – they might seek to preserve their profit margins by instantaneously raising prices to offset wage gains. Wage inflation and price inflation would then move together in lockstep without any lags. Businesses do not have unlimited power or unlimited knowledge, however, and neither do workers. There are information and expectation lags, and price-making/price-taking status is fluid. The empirical record over the 50-plus years covered by the average hourly earnings series shows that the wage-price relationship is constantly shifting. Under a cost-push inflation framework, tightness in the labor market shows up in consumer prices after employees negotiate raises, and employers subsequently raise prices to recoup lost profits. In a demand-pull model, businesses perceiving signs of excess demand take the opportunity to raise prices, spurring employees to demand raises to preserve their purchasing power. There is room for both models, as BCA’s analysis of wage/price dynamics over the years has shown that leadership between prices and wages regularly shifts. For the purposes of this report, it is sufficient to note that the wage/price skeptics have a point. A decade-by-decade review of year-on-year gains in average hourly earnings (“AHE”) and core CPI shows that correlations between AHE and consumer prices regularly make big swings. The ‘60s, ‘80s and ‘00s were pretty good to Phillips curve adherents (Chart 5), but the ‘70s, ‘90s and the current decade mocked them, featuring repeated instances of outright decoupling (Chart 6). The bottom line is that the direction of causation between wages and consumer price inflation, as well as the sensitivity of the relationship, is fluid. The empirical record does not support the idea that wage inflation translates to overall inflation in a consistent and timely fashion. Chart 5Moving In Lockstep One Decade... Chart 6... Decoupling The Next The Fed’s Reaction Function Wage gains exhibit little sensitivity to changes in the unemployment rate when there is a lot of slack in the labor market. Even at lower levels of unemployment, inflation expectations can temper wages’ sensitivity to the unemployment rate. There is assuredly an inverse relationship between wages and unemployment, nonetheless, and wage gains are especially sensitive when the unemployment gap is negative. The jury is out on the relationship between unemployment and inflation, however. The direction of causation is not constant and the response lags between the series can be quite long. Inflation expectations play a sizable role, and are capable of smothering wage gains in times of low unemployment if they’re well-anchored, or goosing them even in times of high unemployment if they’re spiraling upward. Believing in the Phillips curve relationship requires a lot of assumptions, and if the theory were brand-new today, it might have a hard time surviving peer review. Markets don’t take their cues from peer-reviewed journals, however. When it comes to interest rates and the entire gamut of financial assets impacted by monetary policy, the Fed has the last word. What it believes about the Phillips curve is much more important than whether or not its conclusions have iron-clad empirical support. It has long been BCA’s view, informed by our contacts within the Fed, the former central bankers who sat on our Research Advisory Board, the Bank of Canada veterans who have worked at BCA, and careful observation of the Fed’s own comments and research, that the Fed maintains a Phillips curve view of the world. The Fed has plenty of company in this regard. Nearly all central banks are Phillips curve believers; in the absence of a mainstream alternative model of inflation, they all have to fall back on the expectations-augmented hypothesis. Investors and economics enthusiasts can rail against the Phillips curve’s empirical shortcomings, and posit that globalization, robotics/AI, Amazon and the gig economy have rendered it null and void. Those theories have not been confirmed by the data,2 however, and until the profession unites behind an alternative narrative, the Phillips curve will continue to heavily influence monetary policy. New York Fed President Williams clearly subscribes to the tell-‘em-what-you’re-gonna-tell-‘em/tell-‘em/tell-‘em-what-you-just-told-‘em method of constructing speeches. One need look no further than his remarks last Friday, when discussing a paper co-authored by former Fed governor Frederic Mishkin, for his view. “[T]he Phillips curve is very much alive in very tight labor markets,” he said near the beginning of his remarks. “[T]he Phillips curve is alive and kicking,” he said more than halfway through. “In summary, the Phillips curve is alive and well,” he said in conclusion, in case anyone in the audience had been napping. The bottom line for an investor today is that the Fed’s reaction function ensures that labor market strength will ultimately prove to be self-limiting. Assuming that Baby Boomer retirements will stifle further gains in the labor force participation rate, the unemployment rate is likely to ratchet lower across 2019.3 As it dips further and further below NAIRU, the Fed can be counted upon to remove accommodation, ultimately triggering a recession (Chart 7). Chart 7Expansions End When Unemployment Rises Investment Implications As the Fed’s pause allows the economy to regather momentum, hiring and wage growth should be well supported. The accompanying decline in the unemployment rate will drive the Fed to revive its tightening campaign. The irony is the longer the Fed grants the economy, and investors, a respite by holding its fire, the more accommodation it will have to remove to stamp out inflation pressures. It will take until 2020 for the Fed to complete its tightening campaign, but we expect the terminal fed funds rate in this cycle will be at least 3.25 to 3.5%, far above the OIS curves’ projection that fed funds will end 2020 at 2.25%. Such a wide disparity between our expectations and market expectations leaves considerable room for the Treasury curve to shift out along all maturities. We expect the curve will ultimately invert, but the process will follow a bear-flattening course, and long maturities will suffer the worst capital losses. We therefore advocate underweighting Treasuries in all fixed-income portfolios, while maintaining below-benchmark duration in all bond sleeves. We expect that Fed tightening will bring the curtain down on the equity bull market before the recession officially begins (Chart 8). Until it does, however, we expect the Fed’s forbearance to help the economy generate evident momentum, pushing risk-asset values higher. We continue to recommend that investors overweight equities and spread product for now, but the clock is ticking. Watch the unemployment gap for the cue to position portfolios more defensively. Chart 8Inducing A Recession Is Tantamount To Inducing A Bear Market Doug Peta, CFA, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com     Footnotes 1      Williams, John C., “Discussion of ‘Prospects for Inflation in a High Pressure Economy: Is the Phillips Curve Dead or Is It Just Hibernating?’” Remarks at the U.S. Monetary Policy Forum, New York City, February 22, 2019. https://www.newyorkfed.org/newsevents/speeches/2019/wil190222 2      Please see the September 2017 Bank Credit Analyst Special Report, “Did Amazon Kill the Phillips Curve?” available at bcaresearch.com. 3      Holding the participation rate constant, the U.S. economy has to create 110,000 jobs a month to keep the unemployment rate at a steady state. Please see the Atlanta Fed’s online jobs calculator at https://www.frbatlanta.org/chcs/calculator.aspx.

Highlights Portfolio Strategy The ongoing capex upcycle, resurgent credit growth, easy Chinese policy trifecta, upbeat signals from high frequency financial market data and depressed technicals, all suggest that a re-rating phase looms in the S&P industrials sector. Leading indicators of chip end-demand are flashing green, at a time when the chip liquidation phase is clearing excess supplies. It no longer pays to be bearish the S&P semiconductors index.             Recent Changes Lift the S&P semiconductors index to neutral today; it is now also on upgrade alert. Table 1 Feature The SPX continued to grind higher last week, and is now within reach of the key 2,800 level. We expect stiff resistance to persist at that mark; 2,800 has served as a barrier on several occasions last year as we highlighted in recent research (please refer to Chart 1 from the January 28 Weekly Report).1  Year-to-date, we have identified three pillars that would propel the market higher – a more dovish Fed alongside a softer U.S. dollar, a year-over-year increase in SPX EPS for calendar 2019 and a positive resolution to the U.S./China trade spat. As the S&P 500 has come full circle and returned to the early December level, this slingshot recovery suggests that there is positive progress on all three pillars. However, our sense is that the bond market now has to remain tamed in order to cement these equity market gains and vault to fresh all-time highs, likely in the back half of the year. Chart 1 highlights this goldilocks macro backdrop. Chart 1Staying Divorced For A While In other words, as U.S. GDP downshifts from last year’s fiscal easing-induced sugar-high back down to trend growth and most importantly avoids recession, equities should excel. Why? Not only will this entice the Fed to stand pat for longer, but the 10-year Treasury yield will also remain on a lower trajectory than previously anticipated. Crudely put, a neither too-hot nor too-cold economic backdrop will allow equities to reflate away. As such, there are high odds that stocks stay divorced from bond yields for a while longer, and we interpret this bond market backdrop as reflationary rather than recessionary. Meanwhile on the Chinese front, following news of the PBoC’s quasi QE that we highlighted in early February as a positive SPX and cyclicals over defensives catalyst,2 it appears that Chinese authorities could not stomach a below 50 print in the Chinese manufacturing PMI for long and are aggressively opening the fiscal taps anew (Chart 2). Chart 2Chinese reflation... This enormous lending/fiscal stimulus complements ongoing monetary easing and the recent PBoC’s quasi QE, and should ensure that the Chinese economy at least steadies. The upshot is that global growth should also stabilize and put an end to its yearlong deceleration (Chart 3).        Chart 3... Should Aid Global Growth In addition, as U.S. and Chinese negotiation teams race to the finish line in order to get some sort of a deal done before the March 1st deadline, it is clear that a positive outcome is already discounted by the stock market as the SPX enjoys one of the best starts to the year in recent memory. Once this trade policy uncertainty permanently dies down, then last year’s worst performing sectors that were hit hard by the trade dispute will turn into this year’s stock market champions (Chart 4). Chart 4Trade War Hit Deep Cyclicals The Most In that light, we reiterate our cyclical over defensive portfolio bent and this week we highlight that a deep cyclical sector stands to benefit greatly from China’s reflation and the apparent resolution of the U.S./China trade spat; another tech subsector weighed down by the trade tussle is also going to enjoy a reversal of fortune and it no longer pays to be bearish. Don’t Write Off Mighty Industrials Year-to-date, industrials stocks are the best performing GICS1 sector, outperforming the SPX by a massive 650bps (Chart 5). While such a breakneck pace is unsustainable and a short term breather is likely, from a cyclical perspective more gains are in store in this still underowned sector. In this report we highlight the top five reasons it still pays to be overweight this deep cyclical sector. Capex upcycle. The capex upcycle theme remains intact and while there has been some softness recently in the national accounts reported investment outlays, it is highly unlikely that spending plans will grind to a halt similar to the late-2015/early-2016 episode (third panel, Chart 6). Capital goods producers have since replenished their cash coffers and remain committed to develop their capital expenditure projects. Importantly, leading indicators of capex corroborate this backdrop; regional Fed surveys suggest that capital outlays will remain firm for the rest of the year (second panel, Chart 6). Chart 6Capex Upcycle Supports Industrials Resurgent credit growth. Loan growth is on fire in the U.S. and commercial and industrial loan growth is leading the pack, galloping higher and breaching the 10%/annum mark. Bankers are providing the needed fuel to bring to fruition industrials capex plans and, given that historically loan growth and relative profit growth have been positively correlated, the current message is upbeat (Chart 7). Chart 7Loan Growth Fueling The Fire Chinese easy policy trifecta: credit, fiscal & monetary. Beyond the positive resolution in the U.S./China trade dispute, China has opened up its central bank liquidity tap to complement ongoing easy monetary policy. Tack on the recent monster loan origination and reaccelerating infrastructure spending and factors are falling into place for a pick up in end demand, which is a boon for U.S. capitals goods producers (Chart 8). Chart 8Heed The Chinese Reflation Message... Upbeat signal from high frequency EM related financial market data. Emerging market stocks have been outperforming the MSCI ACW Index since early-October and even in absolute terms have troughed in late-October. The ultimate leading EM indicator, EM FX, put in a bottom in early September, sniffing out some sort of reflationary impulse. Meanwhile, momentum in the CRB raw industrials commodity index has also troughed, confirming the high-frequency EM data points. As a reminder, industrials stocks and the global commodity complex move in lockstep, and we heed the positive message all these financial market indicators are emitting (Chart 9). Chart 9...EM Financial Variables Concur Downtrodden sector sentiment and compelling valuations. Despite this year’s rebound in industrial equities, sour investor sentiment appears deeply ingrained. Relative EPS breadth and oversold technical conditions are contrarily positive. Relative valuations are also beaten down and still offer a compelling entry point (Chart 10). Even on a forward P/E basis industrials are trading at a 4% discount to the broad market and below the historical average. Finally, industrials profit and revenue expectations for the coming 12-months are forecast to trail the broad market according to the sell-side community. Were our thesis to pan out, these would represent low hurdles for capital goods producers to surpass. Chart 10Underowned And Unloved Nevertheless, there is a key macro variable, the U.S. dollar, that is a risk to our sanguine S&P industrials sector view. Chart 11 shows that the greenback and industrials sector fortunes are tightly inversely correlated. Not only is an appreciating U.S. dollar deflationary for global commodities that are priced in the reserve currency, but it also weighs on industrials P&Ls via negative translation effects. As a reminder, roughly 40% of industrials sales are international. Chart 11Rising Greenback Is A Risk Netting it all out, the ongoing capex upcycle, resurgent credit growth, easy Chinese policy trifecta, upbeat signals from high frequency EM related financial markets and depressed technicals, all suggest that a re-rating phase looms in the S&P industrials sector.         Bottom Line: Stay overweight the S&P industrials sector. The Chip Cycle Is Turning It no longer pays to be bearish chip stocks; lift the S&P semiconductors index to neutral from underweight today. There are high odds that the chip cycle will soon take a turn for the better. Global chip sales have been decelerating for 17 months and are now on the cusp of contraction (Chart 12). Over the past two decades, steep contractions have been associated with recession. Given that BCA’s view does not call for recession this year, it is highly unlikely for global semi sales to suffer a major setback. While we do not rule out a brief and shallow dip below zero similar to the 2011/12 and 2015/16 parallels, leading indicators of global semi sales suggest that a trough is near. Chart 12Global Semi Cycle... Namely, BCA’s Global Leading Economic Indicator (GLEI) diffusion index is in a V-shaped recovery signaling that global growth is close to a nadir (middle panel, Chart 12). Similarly the U.S. dollar is decelerating which is a boon to global growth and conducive to higher global chip sales (trade-weighted U.S. dollar shown inverted, bottom panel, Chart 12). With regard to U.S. domiciled semi producers, a depreciating currency provides tremendous leverage to profits as foreign sourced revenues are roughly 80% of the total or twice as high compared with the SPX. Table 2, shows the one year trailing internationally- and China-derived revenues of the ten largest firms in the S&P semiconductors index, representing over 95% of the index. On a weighted basis, 80% of sales are sourced from overseas, including 36% of total sales coming from China. Clearly, global growth in general and Chinese growth in particular are key drivers of semi top line growth. Thus, any positive U.S./China trade dispute resolution would provide more relief for the S&P semi index. Table 2Semi Sales Geographical Exposure Moreover, electronics activity is an excellent gauge for semi end-demand. The all-important Chinese electronics imports have ticked up recently. In the U.S., consumer outlays on electronics are firing on all cylinders. Taken together, there is tentative evidence that global semi demand will soon bottom (Chart 13). Chart 13...Is Turning Importantly, the global semi inventory liquidation is ongoing and this supply backdrop should help balance the market. Already Asian DRAM prices, our pricing power gauge for the semi industry, are contracting, underscoring that the semi market is clearing (second & third panels, Chart 14). Importantly, global semi billings that tend to lead global semi sales by a few months have also ticked higher of late (top panel, Chart 14). Chart 14Improving Supply/Demand Dynamics Unfortunately, none of these positive catalysts are picked up by sell-side analysts. In fact, despite the recent rebound in relative share prices, 12-month forward EPS and revenue expectations remain in free fall. Net EPS revisions are as bad as they get, and have sunk near previous troughs that have coincided with durable relative share price rallies (second panel, Chart 15). Chart 15Analysts Have Thrown In The Towel On the relative technical and valuation fronts, pessimism reigns supreme. Our Technical Indicator hovers near one standard deviation below the historical mean and our Valuation Indicator is probing all-time lows. Interestingly, the S&P semi index sports a higher dividend yield than the SPX currently, underscoring that semi stocks are cheap (Chart 16). Chart 16Compelling Valuations And Technicals Our Chip Stock Timing Model (CSTM) does an excellent job in capturing all these moving parts and is currently sending a bullish signal (Chart 17). We heed the signal from our CSTM and are compelled to lift exposure to neutral. Chart 17Prepare To Deploy Capital Bottom Line: Lift the S&P semiconductors index to neutral and it is now also on our upgrade watch list; we are looking for an opportunity to boost to overweight on a pullback, stay tuned. Finally, from a risk management perspective we are enticed to increase our trailing stop to 15% in our tactical overweight in the S&P semi equipment index, in order to protect gains. The ticker symbols for the stocks in the S&P semiconductors index are: BLBG: S5SECO – INTC, AVGO, TXN, NVDA, QCOM, MU, ADI, XLNX, AMD, MCHP, MXIM, SWKS, QRVO.   Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com   Footnotes 1      Please see BCA U.S. Equity Strategy Weekly Report, “Trader’s Paradise” dated January 28, 2019, available at uses.bcaresearch.com. 2      Please see BCA U.S. Equity Strategy Weekly Report, “Don’t Fight The PBoC” dated February 4, 2019, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Highlights It may seem self-evident that most governments are overly indebted, but both theory and evidence suggest otherwise. Higher debt today does not require higher taxes tomorrow if the growth rate of the economy exceeds the interest rate on government bonds. Not only is that currently the case, but it has been the norm for most of history. Unlike private firms or households, governments can choose the interest rate at which they borrow, provided that they issue debt in their own currencies. Ultimately, inflation is the only constraint to how large fiscal deficits can get. Today, most governments would welcome higher inflation. There are increasing signs China is abandoning its deleveraging campaign. Fiscal policy will remain highly accommodative in the U.S. and will turn somewhat more stimulative in Europe. Remain overweight global equities/underweight bonds. We do not have a strong regional equity preference at the moment, but expect to turn more bullish on EM versus DM by the middle of this year. Feature A Fiscal Non-Problem? Debt levels in advanced economies are higher today than they were on the eve of the Global Financial Crisis. Rising private debt accounts for some of this increase, but the lion’s share has occurred in government debt (Chart 1). Chart 1Global Debt Levels Have Risen, Especially In The Public Sector Not surprisingly, rising public debt levels have elicited plenty of consternation. While there has been a lively debate about how fast governments should tighten their belts, few have disputed the seemingly self-evident opinion that some degree of “fiscal consolidation” is warranted. Given this consensus view, one would think that the economic case for public debt levels being too high is airtight. It’s not. Far from it. Debt Sustainability, Quantified Start with the classic condition for debt sustainability, which specifies the primary fiscal balance (i.e., the overall balance excluding interest payments) necessary to maintain a constant debt-to-GDP ratio (See Box 1 for a derivation of this equation).   An increase in the economy’s growth rate (g), or a decrease in real interest rates (r), would allow the government to loosen the primary fiscal balance without causing the debt-to-GDP ratio to increase (Chart 2).1 If the government were to ease fiscal policy beyond that point, debt would rise in relation to GDP. But by how much? It is tempting to assume that the debt-to-GDP ratio would then begin to increase exponentially. However, that is only true if the interest rate is higher than the growth rate of the economy. If the opposite were true, the debt-to-GDP ratio would rise initially but then flatten out at a higher level.2 A Fiscal Free Lunch The last point is worth emphasizing. As long as the interest rate is below the economic growth rate, then any primary fiscal balance – even a permanent deficit of 20%, or even 30% of GDP – would be consistent with a stable long-term debt-to-GDP ratio. In such a setting, the government could just indefinitely rollover the existing stock of debt, while issuing enough new debt to cover interest payments. No additional taxes would be necessary. In fact, stabilizing the debt-to-GDP ratio becomes easier the higher it rises. Chart 3 shows this point analytically.    Ah, one might say: If the government issues a lot of debt, then interest rates would rise, and before we know it, we are back in a world where the borrowing rate is above the economy’s growth rate, at which point the debt dynamics go haywire. Now, that sounds like a sensible statement, but it is actually quite misleading. As long as a government is able to issue its own currency, it can always create money to pay for whatever it purchases. If people want to turn around and use that money to buy bonds, they are welcome to do so, but the government is under no obligation to pay them the interest rate that they want. If they do not wish to hold cash, they can always use the cash to buy goods and services or exchange it for foreign currency. As long as a government is able to issue its own currency, it can always create money to pay for whatever it purchases. Wouldn’t that cause inflation and currency devaluation? Yes, it might, and that’s the real constraint: What limits the ability of governments with printing presses to run large deficits is not the inability to finance them. Rather, it is the risk that their citizens will treat their currencies as hot potatoes, rushing to exchange them for goods and services out of fear that rising prices will erode the purchasing power of their cash holdings. When Is Saving Desirable? The reason governments pay interest on bonds is because they want people to save more. However, more savings is not necessarily a good thing. This is obviously the case when an economy is depressed, but it may even be true when an economy is at full employment. Just like someone can work so much that they have no time left over for leisure, or buy a house so big that they spend all their time maintaining it, it is possible for an economy to save too much, leading to an excess of capital accumulation. Under such circumstances, steady-state consumption will be permanently depressed because so much of the economy’s resources are going towards replenishing the depreciation of the economy’s capital stock.  Economists have a name for this condition: “dynamic inefficiency.” What determines whether an economy is dynamically inefficient? As it turns out, the answer is the same as the one that determines whether debt ratios are on an explosive path or not: The difference between the interest rate and the economy’s growth rate. Economies where interest rates are below the growth rate will tend to suffer from excess savings. In that case, government deficits, to the extent that they soak up national savings, may increase national welfare.   r < g Has Been The Norm Today, the U.S. 10-year Treasury yield stands at 2.69%, compared to the OECD’s projection of nominal GDP growth of 3.8% over the next decade. The gap between projected growth and bond yields is even greater in other major economies (Chart 4). Granted, equilibrium real rates are likely to rise over the next few years as spare capacity is absorbed. Structural factors might also push up real rates over time. Most notably, the retirement of baby boomers could significantly curb income growth, leading to a decline in national savings. Chart 5 shows that the ratio of workers-to-consumers globally is in the process of peaking after a three-decade long ascent. Economic growth could also fall if cognitive abilities continue to deteriorate, a worrying trend we discussed in a recent Special Report.3 Chart 5The Global Worker-To-Consumer Ratio Has Peaked It may take a while before real rates rise above GDP growth. Still, it may take a while before real rates rise above GDP growth. As Olivier Blanchard, the former chief economist at the IMF, noted in his Presidential Address to the American Economics Association earlier this year, periods in U.S. history where GDP growth exceeds interest rates have been the rule rather than the exception (Chart 6).4 The same has been true for most other economies.5 Chart 6GDP Growth Above Interest Rates: Historically, The Rule, Not The Exception What’s Next For Fiscal Policy? Austerity fatigue has set in. In the U.S., fiscally conservative Republicans, if they ever really existed, are a dying breed. Trump’s big budget deficits and his “I love debt” mantra are the waves of the future. For their part, the Democrats are shifting to the left, with the “Green New Deal” proposal being the latest manifestation. The case for fiscal stimulus is stronger in the euro area than for the United States. The European Commission expects the euro area to see a positive fiscal thrust of 0.40% of GDP this year, up from a thrust of 0.05% of GDP last year (Chart 7). This should help support growth. Chart 7The Euro Area Will Benefit From A Modest Amount Of Fiscal Easing This Year Additional fiscal easing would be feasible. This is clearly true in Germany, but even in Italy, the cyclically-adjusted government primary surplus is larger than what is necessary to stabilize the debt ratio.6 Unfortunately, the situation in southern Europe is greatly complicated by the ECB’s inability to act as an unconditional lender of last resort to individual sovereign borrowers. When a government cannot print its own currency, its debt markets can be subject to multiple equilibria. Under such circumstances, a vicious spiral can develop where rising bond yields lead investors to assign a higher default risk, thus leading to even higher yields (Chart 8).   Mario Draghi’s now-famous “whatever it takes” pledge has gone a long way towards reassuring bond investors. Nevertheless, given the political constraints the ECB faces, it is doubtful that Italy or other indebted economies in the euro area will be able to pursue large-scale stimulus. Instead, the ECB will keep interest rates at exceptionally low levels. A new round of TLTROs is also looking increasingly likely, which should protect against a rise in bank funding costs and a potential credit crunch. Our European team believes that a TLTRO extension would be particularly helpful to Italian banks.  Even in Italy, the cyclically-adjusted government primary surplus is larger than what is necessary to stabilize the debt ratio. Despite having one of the highest sovereign debt ratios in the world, Japan faces no pressing need to tighten fiscal policy. Instead of raising the sales tax this October, the government should be cutting it. A loosening of fiscal policy would actually improve debt sustainability if, as is likely, a larger budget deficit leads to somewhat higher inflation (and thus, lower real borrowing rates) and, at least temporarily, faster GDP growth. We expect the Abe government to counteract at least part of the sales tax increase with new fiscal measures, and ultimately to abandon plans for further fiscal tightening over the next few years. In the EM space, Brazil, Turkey, and South Africa are among a handful of economies with vulnerable fiscal positions. They all have borrowing rates that exceed the growth rate of the economy, cyclically-adjusted primary budget deficits, and above-average levels of sovereign debt (Chart 9).   In contrast, China stands out as having the biggest positive gap between projected GDP growth and sovereign borrowing rates of any major economy. The problem is that the main borrowers have been state-owned companies and local governments, neither of which are backstopped by the state. Not officially, anyway. Unofficially, the government has been extremely reluctant to allow large-scale defaults anywhere in the economy. Despite all the rhetoric about market-based reforms, they are unlikely to start now. Historically, the Chinese government has allowed credit growth to reaccelerate whenever it has fallen towards nominal GDP growth. As we recently argued in a report entitled “China’s Savings Problem,” China needs more debt to sustain aggregate demand.7 Historically, the government has allowed credit growth to reaccelerate whenever it has fallen towards nominal GDP growth (Chart 10). The stronger-than-expected jump in credit origination in January suggests that we are approaching such an inflection point. Chart 10Historically, China Has Scaled Back On Deleveraging When Credit Growth Has Fallen Close To Nominal GDP Growth Investment Conclusions The consensus economic view is that deflation is a much harder problem to overcome than inflation. When dealing with inflation, all you have to do is raise interest rates and eventually the economy will cool down. With deflation, however, a central bank could very quickly find itself up against the zero lower bound constraint on interest rates, unable to ease policy any further via conventional means. While this standard argument is correct, it takes a very monetary policy-centric view of macroeconomic policy. When interest rates are low, fiscal policy becomes very potent. Indeed, the whole notion that deflation is a bigger problem than inflation is rather peculiar. Just as it is easier to consume resources than to produce them, it should be easier to get people to spend than to save. People like to spend. And even if they didn’t, governments could go out and buy goods and services directly. Looking out, our bet is that policymakers will increasingly lean towards the ever-more fiscal stimulus. If structural trends end up causing the so-called neutral rate of interest to rise – the rate of interest that is necessary to avoid overheating – policymakers will have no choice but to eventually raise rates and tighten fiscal policy (Box 2). However, they will only do so begrudgingly. The result, at least temporarily, will be higher inflation. Fixed-income investors should maintain below benchmark duration exposure over both a cyclical and structural horizon. Reflationary policies that increase nominal GDP growth will help support equities, at least over the next 12 months. Chart 11 shows that corporate earnings tend to accelerate whenever nominal GDP growth rises. We upgraded global equities to overweight following the December FOMC meeting selloff. While our enthusiasm for stocks has waned with the year-to-date rally, we are sticking with our bullish bias. Chart 11Earnings And Nominal GDP Growth Tend To Move In Lock-Step A reacceleration in Chinese credit growth will put a bottom under both Chinese and global growth by the middle of this year. As a countercyclical currency, the dollar will likely come under pressure in the second half of this year. Until then, we expect the greenback to be flat-to-modestly stronger. The combination of faster global growth and a weaker dollar later this year will be manna from heaven for emerging markets. We closed our put on the EEM ETF for a gain of 104% on Jan 3rd, and are now outright long EM equities. I do not have a strong view on the relative performance of EM versus DM at the moment, but expect to shift EM equities to overweight by this summer.8 Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com   Box 1 The Arithmetic Of Debt Sustainability   Box 2 Debt Sustainability And Full Employment: The Role Of Fiscal And Monetary Policy Policymakers should strive to stabilize the ratio of debt-to-GDP over the long haul, while also ensuring that the economy stays near full employment. The accompanying chart shows the tradeoffs involved. The DD schedule depicts the combination of the primary fiscal balance and the gap between the borrowing rate and GDP growth (r minus g) that is consistent with a stable debt-to-GDP ratio. In line with the debt sustainability equation derived in Box 1, the slope of the DD schedule is simply equal to the debt/GDP ratio. Any point below the DD schedule is one where the debt-to-GDP ratio is rising, while any point above is one where the ratio is falling. The EE schedule depicts the combination of the primary fiscal balance and r - g that keeps the economy at full employment. The schedule is downward-sloping because an increase in the primary fiscal balance implies a tightening of fiscal policy, and hence requires an offsetting decline in interest rates. Any point above the EE schedule is one where the economy is operating at less than full employment. Any point below the EE schedule is one where the economy is operating beyond full employment and hence overheating. Suppose there is a structural shift in the economy that causes the neutral rate of interest – the rate of interest consistent with full employment and stable inflation – to increase. In that case, the EE schedule would shift to the right: For any level of the fiscal primary balance, the economy would need a higher interest rate to avoid overheating. The arrows show three possible “transition paths” to a new equilibrium. Scenario #1 is one where policymakers raise rates quickly but are slow to tighten fiscal policy. This results in a higher debt-to-GDP ratio. Scenario #2 is one where policymakers tighten fiscal policy quickly but are slow to raise rates. This results in a lower debt-to-GDP ratio. Scenario #3 is one where the government drags its feet in both raising rates and tightening fiscal policy. As the economy overheats, real rates actually decline, sending the arrow initially to the left. This effectively allows policymakers to inflate away the debt, leading to a lower debt-to-GDP ratio. Note: In Scenario #2, and especially in Scenario #3, the DD line will become flatter (not shown on the chart to avoid clutter). Consequently, the final equilibrium will be one where real rates are somewhat higher, but the primary fiscal balance is somewhat lower, than in Scenario #1.   Footnotes 1          One can equally define the interest rate and GDP growth rate in nominal terms (see Box 1 for details).  2       Japan is a good example of this point. The primary budget deficit averaged 5% of GDP between 1993 and 2010, a period when government net debt rose from 20% of GDP to 142% of GDP. Since then, Japan’s primary deficit has averaged 5.1% of GDP, but net debt has risen to only 156% of GDP (and has been largely stable for the past two years). 3      Please see Global Investment Strategy Special Report, “The Most Important Trend In The World Has Reversed And Nobody Knows Why,” dated February 1, 2019. 4      Olivier Blanchard, “Public Debt And Low Interest Rates,” Peterson Institute for International Economics and MIT American Economic Association (AEA) Presidential Address, (January 2019). 5      Paolo Mauro, Rafael Romeu, Ariel Binder, and Asad Zaman, “A Modern History Of Fiscal Prudence And Profligacy,” IMF Working Paper, (January 2013). 6      The Italian 10-year bond yield is 2.83% while nominal GDP growth is 2.64%. Multiplying the difference by net debt of 118% of GDP results in a required primary surplus of .22% of GDP that is necessary to stabilize the debt-to-GDP ratio. This is lower than the IMF’s 2018 estimate of cyclically-adjusted government primary surplus of 2.14%. 7      Please see Global Investment Strategy Weekly Report, “China’s Savings Problem,” dated January 25, 2019. 8      Please note that my colleague, Arthur Budaghyan, BCA’s Chief EM strategist, remains bearish on both EM and DM equities and expects EM to underperform DM over the coming months. Strategy & Market Trends MacroQuant Model And Current Subjective Scores Tactical Trades Strategic Recommendations Closed Trades        

Highlights Please note that analysis on India is published below. Even if the recent upturn in the Chinese credit impulse is sustained, there will likely still be a six- to nine-month lag between the impulse’s trough and the bottom in the mainland’s business cycle. EM corporate earnings cycles typically lag Chinese stimulus efforts by about nine months. Therefore, EM profits will be contracting in the first three quarters of 2019. This will short-circuit the current rebound in EM share prices. EM equity valuations are not cheap enough to shield stocks from profit contraction. Feature China’s credit growth was very strong in January. We contend that even if the upturn in the credit impulse proves to be persistent, there will likely be a six- to nine-month lag between its low point and the bottom in the mainland’s business cycle. Chart I-1 demonstrates that the credit impulse leads both nominal manufacturing output growth and the manufacturing PMI’s import subcomponent by roughly nine months. Chinese imports are the most pertinent variable to gauge China’s economic impact on the rest of the world. Chart I-1China: Credit Impulse Leads Business Cycle By Nine Months In the meantime, will financial markets exposed to Chinese growth look through the valley of the ongoing growth deceleration and continue to rally? Or will they experience a major relapse in the coming months? In our opinion, corporate profits will be the key to broader financial market performance. So long as corporate profits do not shrink, investors will likely look beyond weak macro data, and any weakness in stocks will be minor. However, if corporate profits contract in the next nine months, then share prices will plummet anew. EM Profits Are Heading Into Contraction Chart I-2 illustrates that China’s credit impulse leads both EM and Chinese corporate earnings per share (EPS) by at least nine months and that it currently foreshadows EPS contraction in the first three quarters of 2019. Even if the recent upturn in the credit impulse is sustained, EM and Chinese EPS growth will likely bottom only in August – while they are in negative territory. Chart I-2EM EPS Is Beginning To Contract EM corporate earnings growth has already dropped to zero and will turn negative in 2019. Chart I-3A reveals that EPS in U.S. dollar terms are already contracting in six out of 10 sectors – industrials, consumer staples, consumer discretionary, telecom, utilities and health care. Chart I-3AEM EPS By Sector Chart I-3BEM EPS By Sector EPS growth has not yet turned negative for financials, technology, energy and materials (Chart I-3B). Notably, corporate earnings within these four sectors collectively account for 70% of EM total corporate earnings, as shown in Table I-1. Over the course of 2019, these sectors’ EPS are also set to shrink: Technology (accounts for 20% of MSCI EM corporate earnings): NAND semiconductor prices have been plunging for some time, and DRAM prices are also beginning to drop (Chart I-4). This reflects broad-based weakness in global trade – global auto sales are shrinking for the first time since the 2008 global financial crisis, global semiconductor sales are relapsing and global mobile phones shipments are falling (Chart I-5). Chart I-4Semiconductor Prices Are Falling Chart I-5Broad-Based Weakness In Global Trade Semiconductors accounted for 77% of Samsung’s operating profits in the first three quarters of 2018, suggesting the potential drop in DRAM prices will be devastating for its profits. Next week we will publish a Special Report on Korea and discuss the outlook for both semiconductors and Korean profits in more detail. In addition, the ongoing contraction in Taiwanese exports of electronics parts confirms downside risks to EM tech earnings (please refer to top panel of Chart I-3B). In brief, the ongoing decline in semiconductor prices will bring about EPS contraction in the EM technology sector. Financials/Banks (financials make up 31% of EM corporate earnings): Banks’ profits often correlate with fluctuations in economic activity, because the latter drive non-performing loan (NPL) cycles (Chart I-6). NPL cycles outside Brazil, Russia and India – where the banking systems have already gone through substantial NPL recognition and provisioning – will deteriorate, and push banks to increase their provisions. The latter will be a major drag on EM banks’ profits. Chart I-6EM Banks EPS And Economic Activity Regarding Chinese banks in particular, if the credit revival in January is sustained, it would strongly suggest that the government is resorting to its old, credit-driven growth playbook. Following 10 years of an enormous credit frenzy and a 20-year capital spending boom, it is currently difficult to find many financially viable projects. Hence, a renewed credit binge will once again be associated with further capital misallocation and more NPLs. Many of these projects will fail to generate sufficient cash flow to service debt. NPLs will thus rise considerably and the need to raise capital will dilute the banks’ existing shareholders. Of course, this will happen with a time lag. Chart I-7 shows that the gap between Chinese banks’ EPS and non-diluted profits has once again widened, and that EPS are beginning to contract. Chart I-7Chinese Banks: Earnings Dilution Chinese banks could issue perpetual bonds – discussed in great detail in last week’s report – to recapitalize themselves. Nevertheless, this will be negative for existing shareholders. In a nutshell, despite low multiples, share prices of Chinese banks will drop because more credit expansion amid the lingering credit bubble is negative for existing shareholders. The basis is that it will ultimately lead to their dilution. Chinese banks make up 4.5% of the MSCI’s EM equity market cap and 10% of aggregate EM profits. Hence, their EPS contraction will have a non-trivial impact on overall EM EPS. Resource sectors (energy and materials together make 20% of EM corporate earnings): The ongoing slowdown in China will exert renewed selling pressure in commodities markets. As shown in Chart I-9 on page 8, base metals prices lag the turning points in the Chinese credit impulse by several months and are still at risk of renewed price decline. Hence, profits of firms in the materials sector are at risk. Energy companies’ trailing EPS growth is still positive because the late-2018 carnage in oil prices has not yet filtered through to corporate earnings announcements (Chart I-3B on page 3). More importantly, the recent oil price rebound can be attributed to both Saudi Arabia’s output cuts as well as stronger demand – in the form of a surge in Chinese imports of oil and petroleum products. Chart I-8 illustrates that growth rates of China’s intake of oil and related products approached zero when crude prices were rising but has dramatically accelerated following their plunge. This is consistent with China’s pattern of buying commodities on dips. The point is that the upside in oil prices will be capped by China, which will likely moderate its oil purchases going forward, as crude prices have recently rallied. Chart I-8China And Oil Bottom Line: EM profit cycles lag Chinese’s stimulus by about nine months. EM profits will be contracting in the first three quarters of 2019. This will short-circuit the current rebound in EM share prices. China’s Credit Cycles And Financial Markets What has been the relationship between China’s credit cycle and related financial markets over the past 10 years? The time lag between turning points in China’s credit impulse and relevant financial markets can be anywhere from zero to 18 months. Chart I-9 illustrates historical time lags between the Chinese credit impulse on the one hand and EM share prices, base metals prices and the global manufacturing PMI on the other. The time lag has not been consistent over time. Chart I-9Chinese Credit Impulse And Financial Markets: Understanding Time Lags In late 2015-early 2016, the rebound in China’s credit impulse led financial markets by six months. At the recent market peak in January 2018, the credit impulse led financial markets and the global manufacturing PMI by about 18 months. In the meantime, in the 2012-13 mini cycle, EM share prices and commodities markets did not rally much, despite the meaningful upturn in China’s credit impulse. Finally, at the 2010-2011 peak, the credit impulse led EM stocks and base metals prices by 12 months. In short, the credit impulse led those financial markets by a few months to as much as a year and a half. Further, not only do time lags to the stimulus vary, but the impact on both economic activity and financial markets varies as well. This is because both economic activity and financial markets are driven by human psychology and behavior; iterations in stimulus, economic activity and financial markets are chaotic and complex in nature and do not follow well-defined patterns. Given the poor state of sentiment among Chinese consumers, business managers and entrepreneurs, more stimulus and more time may be required to turn the mainland’s business cycle this time around. Besides, unlike in previous episodes, there has not been any stimulus for the property market and no tax reductions on auto sales. Finally, although China and the U.S. may strike a deal on trade, it is unlikely to be a comprehensive agreement that is sustainable in the long run. This would be consistent with our Geopolitical Strategy team’s view that China and the U.S. are in a long-term and broad geopolitical confrontation – not a trade war. The trade war and tariffs are just one dimension of this. Hence, Chinese consumers and businesses, as well as the global business community may well look through this potential deal and not significantly alter their cautious behavior, at least for some time. In other words, the genie of geopolitical confrontation is out of the bottle, and the presidents of the U.S. and China are unlikely to succeed in putting it back. Bottom Line: Turning points in China’s credit impulse generally lead financial markets exposed to Chinese growth by several months. Given that the improvement in the credit impulse is both very recent and modest, odds are that China-related plays including EM risk assets will go through a major selloff before putting in a durable bottom.1 EM Equity Valuations In terms of the ability of EM stocks to withstand profit contraction, would cheap valuations not shield share prices from a considerable drop? We do not think EM equities are cheap; their valuations are neutral. Hence, there is no real valuation cushion in EM stocks to help them endure a period of negative EPS growth. We have written frequently about valuations and will touch on the topic only briefly here. Market cap-based multiples indeed appear very low. However, some segments of the EM universe such as Chinese banks and state-owned companies in Russia, Brazil, China and India have had low multiples for years. In other words, they are a value trap and their multiples are low for a reason. We elaborated above why Chinese banks are chronically “cheap”. For many other companies, low multiples are due to structural issues such as the lack of focus on profitability and shareholder value, or the high cyclicality of profits. Many of these stocks have large market caps, which pull down the EM index’s aggregate multiple. To remove market-cap bias, we have calculated 20% trimmed-mean multiples by ranking 50 MSCI EM industry groups (sub-sectors) and cutting off the top and bottom 10%. Then, we calculate the equal-weighted average of the remaining 80% of the sub-sectors. We did this calculation for the following five ratios: trailing P/E, forward P/E, price-to-cash earnings, price-to-book value and price-to-dividend. Then, we combined them into a composite valuation indicator (Chart I-10, top panel). This indicator shows that EM equity valuations are neutral. Chart I-10EM Equity Valuations In Absolute Terms In addition, we calculated the median and equal-weighted composite valuation indicators (Chart I-10, middle and bottom panels). They also remove market cap bias and tell the same message: EM stocks are trading close to their fair value. EM equities are also close to their historical average relative to developed markets (DM). Chart I-11 illustrates relative EM versus DM valuation indicators based on 20%-trimmed mean, median and equal-weighted metrics. Chart I-11EM Equity Valuations Versus DM In sum, EM valuations are not cheap neither in absolute terms, nor relative to DM. According to both measures, valuations are neutral. Hence, valuations will not prevent share prices from falling as profits begin to contract. This is why we continue to recommend a defensive strategy for absolute-return investors, and we continue to underweight EM versus DM within a global equity portfolio. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com India: Beware Of Rural Growth Lapse Indian share prices are weak and are underperforming the emerging markets benchmark in U.S. dollar terms (Chart II-1, top panel). Small cap stocks are in a full-fledged bear market (Chart II-1, bottom panel). Chart II-1Indian Stocks Are Weak The latest earnings season turned out to be disappointing. Many companies missed their earnings estimates. Chart II-2 shows that net profit margins of listed non-financial companies have turned down and overall EPS growth is weakening. Chart II-2Indian Corporate Profits Are Sluggish Disappointing corporate earnings are confirmed by macro data as well. Chart II-3A shows that manufacturing production is decelerating and intermediate goods production is contracting. Further, sales of two-wheelers, three-wheelers, passenger and commercial vehicles, as well as tractors, are either slowing or contracting (Chart II-3B). Chart II-3ACyclical Spending Is Decelerating Chart II-3BCyclical Spending Is Decelerating This weakness emanates from rural areas. The basis is that food prices have been falling since the summer of 2018 – and are deflating for the first time since the early 2000s. This is hurting rural incomes. Several indicators confirm considerable weakness in rural income growth and the latter’s underperformance versus urban income and spending: The top panel of Chart II-4 illustrates that our proxy for spending in rural areas relative to urban areas has deteriorated massively along with the decline in Indian food prices. Chart II-4Rural Spending Is Weaker Than Urban One This measure is calculated as revenue growth of four rural-exposed listed companies minus the revenue growth of four urban-exposed listed companies. In both cases, the companies largely operate in the consumer goods space. Credit growth in rural areas has lagged that of urban areas, explaining the underperformance of rural spending (Chart II-4, bottom panel). Corroborating this, stock prices of these urban-exposed companies have outperformed their rural peers substantially (Chart II-5). Chart II-5Urban-Exposed Stocks Have Outperformed Rural Ones Such a slump in rural income is posing a challenge to Modi’s re-election in May. His government – which lost three key state elections in late 2018 – is aware of these ominous trends and is acting boldly to revive income growth in rural areas. The government announced an expansionary budget that appeases rural voters. In particular, the budget aims to strengthen farmers’ support schemes, cut taxes for low- and middle-income earners and introduce a pension scheme for social security coverage of unorganized labor. However, there is a significant risk that the authorities’ fiscal and monetary stimulus are too late to lift growth before May’s elections. According to the past relationship between fiscal spending and India’s business cycle, higher government expenditure growth will only begin to have an effect on the economy in the second half of this year – i.e. after the elections are held (Chart II-6). Hence, the BJP could lose its majority, meaning it would either rule in a minority government or be forced to turn over power to the Congress Party and its allies. Chart II-6Government Expenditures To Lift Growth In H2 2019 Beyond the elections, food prices might be approaching their lows. Well-below average rain will likely result in weak agricultural production and, hence, higher food prices in the second half of 2019 (Chart II-7). Chart II-7Below Trend Monsoon = Food Prices Will Likely Rise Therefore, in the second half of 2019, both fiscal easing and higher food prices will revive rural incomes and spending. In the meantime, monetary easing and credit growth acceleration will support demand in urban areas. Overall, Indian financial markets will likely remain in a risk zone until the elections as economic growth and corporate profits will continue to disappoint. If the opposition Congress Party’s alliance wins the election, Indian stocks and the currency will initially sell off. After this point, Indian assets could offer a buying opportunity because growth will likely revive in the second half of 2019. Bottom Line: For now, we continue to recommend an underweight position in Indian equities relative to the EM equity benchmark. Weakening growth, the very low interest rate differential versus U.S. rates and political uncertainty ahead of the general elections, pose risks of renewed rupee depreciation. A weaker rupee will continue to benefit India’s export-oriented software companies. Therefore, we also reiterate our long Indian software / short EM stocks recommendation. Finally, fixed-income investors should stay with the yield curve steepening trade. The central bank could further cut rates in the near term. However, long-term bond yields will not fall substantially and will likely start drifting higher sooner than later. The widening fiscal deficit, expectations of growth revival in the second half of 2019, and eventually higher food prices and inflation expectations, will all lead to a continuous steepening in the local yield curve. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com Footnotes 1      This is the view of BCA’s Emerging Markets Strategy team and it is different from BCA’s house view on China-related assets and the global business cycle. The primary source of the difference is the outlook for China’s growth.   Equity Recommendations Fixed-Income, Credit And Currency Recommendations