Emerging Markets

Highlights BCA’s “Golden Rule of Bond Investing” framework, which links developed economy government bond returns to central bank policy rate “surprises” versus market expectations, also works in China. The relationship between unexpected changes in China’s de facto short-term policy rate and government bond yields has been surprisingly strong over the past decade. Any additional easing by the PBoC this year is likely to be focused on reducing lending rates to the real economy, not interbank rates (which drive government bond yields). As such, yields at the short-end are likely to be flat until later this year at the earliest, whereas yields at the long-end are likely to move modestly higher, at most. The persistent historical gap between economic growth and bond yields in China makes it difficult to forecast the structural outlook for yields using conventional methods. To the extent that Chinese policymakers succeed at shifting the drivers of growth from investment to consumption, we believe that bond yields are more likely to structurally rise than fall. Over the coming 6-12 months, investors should underweight Chinese government bonds versus Chinese equities and onshore corporate bonds. Within a regional government bond portfolio, however, investors should overweight USD-hedged China versus US and developed markets ex-US, as well as in unhedged terms. Feature Last year’s inclusion of Chinese onshore government and policy bank bonds in the Bloomberg Barclays Global Aggregate Index was a significant milestone of China’s journey to internationalize its capital markets. Other bond benchmark providers have since followed suit, highlighting that the trend of increased passive exposure to Chinese assets is likely to continue. Over the past year, the bulk of the market discussion concerning the addition of China to the major bond indices has focused on estimating the size of potential capital inflows that could be triggered and the related impact on onshore bond yields. By contrast, comparatively little work has been done to analyze the core drivers of Chinese government bond yields, and how they compare to the factors that influence yields in the developed markets that dominate the bond indices. This Special Report attempts to fill a hole in the analysis of Chinese bonds. This Special Report attempts to fill that hole in the analysis of Chinese bonds. We look at the predictability of China’s government bond market through the lens of BCA’s “golden rule” framework, and find a surprisingly strong relationship between changes in China’s de facto short-term policy rate and government bond yields. We then present our cyclical (6-12 month) and secular outlooks for government yields given this relationship, and conclude by presenting four specific investment recommendations pertaining to China’s fixed-income market with two audiences in mind: mainland/onshore investors who are focused on returns in unhedged RMB terms, and global fixed-income investors who are primarily focused on hedged US-dollar regional bond exposure. The Golden Rule Of Bond Investing, With Chinese Characteristics In a July 2018 Special Report,1 BCA’s Chief US Bond Strategist, Ryan Swift, elegantly distilled the cyclical US government bond call into a simple question: During the next 12-months, will the Federal Reserve move interest rates by more or less than what is currently priced into the market? Chart 1The (US) Golden Rule Of Bond Investing In Practice The (US) Golden Rule Of Bond Investing In Practice The (US) Golden Rule Of Bond Investing In Practice Ryan argued that a predictive framework for US Treasury returns built around the answer to this question has historically worked so well that it should be referred to as the “Golden Rule of bond investing” (Chart 1). In a follow-up report, our Global Fixed Income Strategy service confirmed that the Golden Rule also largely works in non-US developed market economies, with the exception of Japan due to the absence of any meaningful fluctuation in policy rates over the past two decades.2 The Golden Rule provides a very strong framework to aid fixed-income investors with their cyclical (i.e. 6-12 month) asset allocation decisions, by quantitatively linking government bond returns relative to cash – in other words, the excess return earned by taking duration risk - to policy rate “surprises” compared to what is discounted in shorter-term money markets. The practical application is that a decision to allocate to longer-maturity government bonds is reduced to a bet on whether a central bank will adjust policy rates by more or less than the market expects. The first question we address in this report is to what degree does the Golden Rule apply in China (in yield space rather than in return space), along with an explanation of any differences that may exist. However, we must first note why the Golden Rule of bond investing works, particularly in the US. The first reason is that there is a strong relationship between the US 3-month T-bill rate and Treasury yields of all other maturities. Conceptually, all fixed income investors have a choice when buying US government bonds: they can purchase a 3-month Treasury bill and simply perpetually roll over the position as it matures, or they can purchase a Treasury bond of a longer maturity. This means that yields on longer maturity Treasury bonds simply reflect investor expectations for the average 3-month T-bill rate over the life of the bond, plus some positive risk premium to compensate for the inherent uncertainty of the path and tendency of short-term yields. This helps explain the close link between cyclical changes in 3-month T-bill rates and yields on longer maturity Treasurys. Chart 2In The US, The 3-Month T-Bill Rate Perfectly Tracks The Fed Funds Rate In The US, The 3-Month T-Bill Rate Perfectly Tracks The Fed Funds Rate In The US, The 3-Month T-Bill Rate Perfectly Tracks The Fed Funds Rate The second reason for the Golden Rule’s success is that there is a very tight relationship between the effective Fed funds rate and the 3-month T-bill rate. While it is the (higher) discount rate that is the theoretical no-arbitrage ceiling for the 3-month rate, in practice T-bill rates trade extremely close to the Fed funds rate (Chart 2). This means that Fed funds rate “surprises” (relative to traded market expectations) are akin to surprises in the 3-month rate, which in turn strongly influence the expected future path of short-term interest rates and thus yields on longer maturity Treasurys. In China, we noted in a February 2018 Special Report3 that the 7-day interbank repo rate is now the de jure short-term policy rate in China following the establishment of an interest rate corridor system in 2015. Chart 3 presents our first test of the Golden Rule in China (in yield space rather than in return space), by plotting the annual change in the level of Chinese government bond yields alongside the 7-day repo rate “surprise” over the past year from 2010 to the present. Here, we use the first principal component of zero coupon Chinese government bond yields to represent the average level of yields (rather than selecting a particular maturity), and we use the 12-month RMB swap rate (versus 7-day repo) to represent market expectations for the policy rate. The chart highlights that the fit is good, as measured by a 50% R-squared between the two series. However, deviations in the relationship do exist, with the most notable exception having occurred in 2017: Chinese government bond yields rose considerably more than what the annual surprise in the 7-day repo rate would have suggested. Chart 3In China, The Golden Rule Works Decently Well Using 7-Day Repo... In China, The Golden Rule Works Decently Well Using 7-Day Repo... In China, The Golden Rule Works Decently Well Using 7-Day Repo... Chart 4...And Extremely Well Using 3-Month SHIBOR ...And Extremely Well Using 3-Month SHIBOR ...And Extremely Well Using 3-Month SHIBOR Chart 4 helps resolve a good portion of the 2017 discrepancy, and clarifies the link between Chinese monetary policy and government bond yields. Chart 4 is similar to Chart 3, except that it replaces the 7-day repo rate surprise with that of 3-month SHIBOR (which trades very closely to the 3-month repo rate). The chart illustrates an even closer fit between the two series (with an R-squared close to 80%), and shows that the 3-month SHIBOR surprise does a meaningfully better job at explaining the 2017 rise in Chinese government bond yields. The Golden Rule of bond investing works surprisingly well in China. The fact that the annual surprise in 3-month SHIBOR has done a better job at predicting changes in bond yields over the past decade underscores that the 3-month repo rate is the de facto short-term policy rate in China, a point that we have made in several previous reports. We have noted that the spike in the 3-month/7-day repo rate spread that occurred in late-2016 and lasted until mid-2018 happened because of China’s crackdown on shadow banking activity. This crackdown caused a funding squeeze for China’s small & medium banks, which caused a material rise in lending rates and government bond yields. This episode highlights that future changes in the 3-month repo rate are likely to reflect both underlying changes in net liquidity provided to large commercial banks (measured by the 7-day repo rate), and any dislocations in the interbank market that have the potential to push up lending rates and government bond yields. Bottom Line: BCA’s “Golden Rule” framework, which links developed economy government bond returns to central bank policy rate “surprises” versus market expectations, works for China as well – using the correct measure of the PBOC policy rate. This provides a useful investment framework for Chinese government bonds, which are now significant part of major global bond market benchmarks. The Cyclical Outlook For Chinese Government Bond Yields Given the establishment of the relationship between Chinese short-term interbank rates and government bond yields detailed above, we are now able to more precisely discuss the likely cyclical trajectory of Chinese government bond yields as a function of Chinese monetary policy. Two opposing forces have the potential to affect China’s government bond market this year. The first, a stabilization and modest rebound in Chinese economic activity, may exert upward pressure on yields due to expectations of eventual policy tightening. The second, continued attempts by the PBoC to ease corporate lending rates, may exert downward pressure on yields as it will reflect not just easy but easier monetary conditions. Yields at the long-end are likely to move modestly higher this year, at most. For investors, the raises the obvious question of whether Chinese government bond yields are likely to move up, down, or trend sideways this year. In our view, yields at the short-end are likely to be flat until later this year at the earliest, whereas yields at the long-end are likely to move modestly higher, at most. Yields at the short-end of China’s government bond curve are likely to stay flat for most of this year. There are two reasons why yields at the short-end of China’s government bond curve are likely to stay flat for most of this year. The first is that the PBoC is generally a reactive central bank and has historically lagged a pickup in economic activity, as illustrated in Chart 5. The chart shows the historical path of 3-month SHIBOR in the year following a bottom in economic activity in 2009, 2012, and 2015, and makes it clear that there has been no precedent for a significant rise in interbank rates in the first nine months of an economic recovery. The 2012 episode did see a very sharp rise in 3-month SHIBOR once the PBoC shifted into tightening mode, but we doubt that this experience will be repeated again unless economic growth accelerates much more aggressively than we expect. The second reason why we expect yields at the short-end of the curve to remain muted this year is because any additional easing by the PBoC is likely to be focused on reducing corporate lending rates, not interbank rates. Chart 6 highlights that while there is a strong correlation between changes in Chinese government bond yields and average lending rates in the economy, the former leads the latter. In the past, this relationship has existed because changes in interbank rates have coincided with reductions in the now obsolete benchmark lending rate, with the former usually occurring earlier than the latter. But in a scenario where the PBoC reduces the loan prime rate (LPR) and keeps net banking sector liquidity roughly constant, the extremely tight relationship shown in Chart 4 suggests that short-term bond yields are unlikely to be affected by a reduction in lending rates. Any meaningful decline in short-term yields below short-term interbank rates would simply prompt banks to stop buying these bonds. Chart 5The PBoC Is Generally A Reactive Central Bank The PBoC Is Generally A Reactive Central Bank The PBoC Is Generally A Reactive Central Bank Chart 6Average Lending Rates Lag Short-Term Bond Yields Average Lending Rates Lag Short-Term Bond Yields Average Lending Rates Lag Short-Term Bond Yields Chart 7China's Yield Curve Is Generally Pro-Cyclical China's Yield Curve Is Generally Pro-Cyclical China's Yield Curve Is Generally Pro-Cyclical Additional easing by the PBoC does have the potential to impact the long-end of the government bond curve if investors view these actions as a sign that interbank rates will remain low for some time. This view is reinforced by the fact that China’s yield curve is not particularly flat, and thus has room to move lower. However, Chart 7 also shows that China’s yield curve, defined here as the second principal component of zero coupon Chinese government bond yields, is positively correlated with the relative performance of investable Chinese equities. This suggests that there is a procyclical element to the curve. We suspect that this procyclical element will dominate a potential decline in expectations for future short-term interest rates, but that yields at the long-end are likely to move modestly higher this year, at most. Bottom Line: Any additional easing by the PBoC this year is likely to be focused on reducing lending rates to the real economy, not interbank rates (which drive government bond yields). As such, yields at the short-end are likely to be flat until later this year at the earliest, whereas yields at the long-end are likely to move modestly higher, at most. The Secular Outlook For Chinese Government Bond Yields A common approach to forecasting the likely structural trend for nominal government bond yields is to estimate the trajectory of real long-term potential output growth and to add the monetary authority’s inflation target. This framework is based on the idea that interest rates are in equilibrium when the cost of borrowing is roughly equal to nominal income growth, a condition that results in no change in the burden to service existing debt. Chart 8China's Potential Growth Is Likely To Trend Lower... China's Potential Growth Is Likely To Trend Lower... China's Potential Growth Is Likely To Trend Lower... Based on this framework, we would expect Chinese government bond yields to trend down over time, or possibly flat if the PBoC were to tolerate higher inflation over the coming decade. Chart 8 illustrates the IMF’s forecast of falling real potential growth in China over the coming several years, which is consistent with a shift in the composition of growth from investment to consumption as well as China’s looming demographic crisis. But Chart 9highlights an obvious problem with applying this framework to forecast the secular trend in Chinese government bond yields: over the past decade, yields have persistently averaged below actual nominal GDP growth, both in China and in the developed world. In the latter case, it is an open question whether this will continue to be true in the future, but in China’s case it is clear that government bond yields have little connection (in magnitude) to the pace of GDP growth. This reflects the longstanding strategy of Chinese policymakers to promote investment via persistently low interest rates, as has occurred in other manufacturing and export-oriented Asian economies (Chart 10). Chart 9...But Bond Yields Are Well Below GDP Growth, Just Like In Developed Markets ...But Bond Yields Are Well Below GDP Growth, Just Like In Developed Markets ...But Bond Yields Are Well Below GDP Growth, Just Like In Developed Markets Chart 10In Industrial Asian Economies, Low Bond Yields Are A Policy Choice In Industrial Asian Economies, Low Bond Yields Are A Policy Choice In Industrial Asian Economies, Low Bond Yields Are A Policy Choice   The persistent historical gap between economic growth and bond yields in China makes it difficult to forecast the structural outlook for yields using conventional methods, and largely limits us to inference. To the extent that Chinese policymakers succeed at shifting the drivers of growth from investment to consumption, bond yields are more likely to rise than fall over time. This is because as long as interest rates remain well below the pace of income growth, the incentive to excessively borrow (and invest) is likely to persist. Chart 11China Needs Higher Interest Rates, But Only To A Point China Needs Higher Interest Rates, But Only To A Point China Needs Higher Interest Rates, But Only To A Point However, even in a scenario where Chinese government bond yields structurally trend higher, we expect the rise to be modest. Chart 11 highlights that China’s “private sector” debt service ratio is extremely elevated, underscoring that the country’s ability to tolerate significantly higher bond yields is not strong. In addition, since 2015, China’s debt service ratio has been mostly flat despite rising a rising debt-to-GDP ratio, which has been achieved through lower short-term interest rates. To the extent that policymakers fail to make meaningful progress in shifting China’s growth drivers away from investment over the coming few years, lower (potentially sharply lower) bond yields would appear to be all but inevitable to cope with what would become a permanently growing drag on economic activity from the servicing of debt. For now, we would characterize this scenario as a risk to our base case view, but it is a risk that we will be closely monitoring over the coming years. Bottom Line: The persistent gap between Chinese nominal GDP growth and government bond yields is likely contributing to the problem of excessive leveraging. To the extent that Chinese policymakers succeed at shifting the drivers of growth from investment to consumption, bond yields are more likely to structurally rise than fall. Investment Conclusions Our analysis above points to four recommendations for investors over the coming year: Overweight Chinese stocks versus Chinese government bonds in RMB and USD terms Overweight Chinese onshore corporate bonds versus duration-matched Chinese government bonds in RMB terms Overweight 7-10 year USD-hedged Chinese government bonds versus their US and developed market (DM) counterparts For offshore US dollar-based investors, long 7-10 year Chinese government bonds in unhedged terms Regarding the first two recommendations, our view that yields are likely to be flat at the short-end and modestly higher at the long-end suggests that investors can expect total returns on the order of 2-3% from Chinese government bonds this year. Barring a major and lasting economic slowdown from the 2019-nCoV outbreak, we expect Chinese domestic and investable equities to outperform government securities over the coming 6-12 months. Onshore corporate bonds have a similar outlook: onshore spreads are pricing in (massively) higher default losses than we believe is warranted, meaning that they will outperform duration-matched government equivalents without any changes in yield. Chart 12Within Global Fixed-Income, Hedged Chinese 10-Year Yields Are Relatively Attractive Within Global Fixed-Income, Hedged Chinese 10-Year Yields Are Relatively Attractive Within Global Fixed-Income, Hedged Chinese 10-Year Yields Are Relatively Attractive Chart 13Unhedged Yield Spreads Predict Hedged Relative Performance Versus The US Unhedged Yield Spreads Predict Hedged Relative Performance Versus The US Unhedged Yield Spreads Predict Hedged Relative Performance Versus The US For global fixed-income investors, Charts 12-14 present USD-hedged 10-year Chinese government yields versus the US and DM/DM ex-US, along with the historical relative return profile of USD-hedged Chinese bonds versus hedged and unhedged returns. In hedged space, Chinese 10-year government bond yields are modestly attractive: 2.2% versus 1.6% in the US and 1.8% in DM ex-US. China’s historically low yield beta to the overall level of global 10-year bond yields (Chart 15) suggests that Chinese yields should perform well in 2020 – a year where we expect global bond yields to drift higher as economic growth rebounds. Combined with relatively attractive valuation, this bodes well for the relative performance of Chinese debt versus DM equivalents. A low yield beta against a backdrop of drifting higher global yields implies that longer-maturity Chinese government bonds will outperform their DM equivalents. Chart 14Unhedged Yield Spreads Predict Hedged Relative Performance Versus DM Unhedged Yield Spreads Predict Hedged Relative Performance Versus DM Unhedged Yield Spreads Predict Hedged Relative Performance Versus DM Chart 15China's Yield Beta Has Been Rising, But Is Still Japan-Like China's Yield Beta Has Been Rising, But Is Still Japan-Like China's Yield Beta Has Been Rising, But Is Still Japan-Like   We would also recommend longer-maturity Chinese government bonds in unhedged terms versus a USD-hedged global government bond portfolio. Chart 16 highlights that the relative return of this trade is strongly (negatively) linked to USD-CNY, and we expect further (albeit more modest) gains in RMB over the cyclical horizon. Chart 16Modest Further RMB Upside Means Unhedged Chinese Bonds Will Outperform Modest Further RMB Upside Means Unhedged Chinese Bonds Will Outperform Modest Further RMB Upside Means Unhedged Chinese Bonds Will Outperform As a final point, investors should note that today’s report is part of a heightened focus on China’s fixed income market, in terms of both forecasting fixed income returns and analyzing the cyclical and structural implications of the increasing investability of China’s financial markets. More research on this topic is likely to come in 2020 and beyond: Stay Tuned!   Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com         Footnotes 1    Please see US Bond Strategy Special Report "The Golden Rule Of Bond Investing," dated July 24, 2018, available at usbs.bcaresearch.com 2   Please see Global Fixed Income Strategy Special Report "The Global Golden Rule Of Bond Investing," dated September 25, 2018, available at gfis.bcaresearch.com 3   Please see China Investment Strategy Special Report "Seven Questions About Chinese Monetary Policy," dated February 22, 2018, available at cis.bcaresearch.com

Dear clients, Please note that in next week’s China Macro And Market Review, we will include a section explaining our view on the coronavirus outbreak and its economic as well as financial market implications. We maintain our overweight stance on both Chinese investable and A-share equities, over a tactical (0-3 months) and cyclical (6-12 months) time horizon. Please stay tuned. Jing Sima, China Strategist   Highlights BCA’s “Golden Rule of Bond Investing” framework, which links developed economy government bond returns to central bank policy rate “surprises” versus market expectations, also works in China. The relationship between unexpected changes in China’s de facto short-term policy rate and government bond yields has been surprisingly strong over the past decade. Any additional easing by the PBoC this year is likely to be focused on reducing lending rates to the real economy, not interbank rates (which drive government bond yields). As such, yields at the short-end are likely to be flat until later this year at the earliest, whereas yields at the long-end are likely to move modestly higher, at most. The persistent historical gap between economic growth and bond yields in China makes it difficult to forecast the structural outlook for yields using conventional methods. To the extent that Chinese policymakers succeed at shifting the drivers of growth from investment to consumption, we believe that bond yields are more likely to structurally rise than fall. Over the coming 6-12 months, investors should underweight Chinese government bonds versus Chinese equities and onshore corporate bonds. Within a regional government bond portfolio, however, investors should overweight USD-hedged China versus US and developed markets ex-US, as well as in unhedged terms. Feature Last year’s inclusion of Chinese onshore government and policy bank bonds in the Bloomberg Barclays Global Aggregate Index was a significant milestone of China’s journey to internationalize its capital markets. Other bond benchmark providers have since followed suit, highlighting that the trend of increased passive exposure to Chinese assets is likely to continue. Over the past year, the bulk of the market discussion concerning the addition of China to the major bond indices has focused on estimating the size of potential capital inflows that could be triggered and the related impact on onshore bond yields. By contrast, comparatively little work has been done to analyze the core drivers of Chinese government bond yields, and how they compare to the factors that influence yields in the developed markets that dominate the bond indices. This Special Report attempts to fill a hole in the analysis of Chinese bonds. This Special Report attempts to fill that hole in the analysis of Chinese bonds. We look at the predictability of China’s government bond market through the lens of BCA’s “golden rule” framework, and find a surprisingly strong relationship between changes in China’s de facto short-term policy rate and government bond yields. We then present our cyclical (6-12 month) and secular outlooks for government yields given this relationship, and conclude by presenting four specific investment recommendations pertaining to China’s fixed-income market with two audiences in mind: mainland/onshore investors who are focused on returns in unhedged RMB terms, and global fixed-income investors who are primarily focused on hedged US-dollar regional bond exposure. The Golden Rule Of Bond Investing, With Chinese Characteristics In a July 2018 Special Report,1 BCA’s Chief US Bond Strategist, Ryan Swift, elegantly distilled the cyclical US government bond call into a simple question: During the next 12-months, will the Federal Reserve move interest rates by more or less than what is currently priced into the market? Chart 1The (US) Golden Rule Of Bond Investing In Practice The (US) Golden Rule Of Bond Investing In Practice The (US) Golden Rule Of Bond Investing In Practice Ryan argued that a predictive framework for US Treasury returns built around the answer to this question has historically worked so well that it should be referred to as the “Golden Rule of bond investing” (Chart 1). In a follow-up report, our Global Fixed Income Strategy service confirmed that the Golden Rule also largely works in non-US developed market economies, with the exception of Japan due to the absence of any meaningful fluctuation in policy rates over the past two decades.2 The Golden Rule provides a very strong framework to aid fixed-income investors with their cyclical (i.e. 6-12 month) asset allocation decisions, by quantitatively linking government bond returns relative to cash – in other words, the excess return earned by taking duration risk - to policy rate “surprises” compared to what is discounted in shorter-term money markets. The practical application is that a decision to allocate to longer-maturity government bonds is reduced to a bet on whether a central bank will adjust policy rates by more or less than the market expects. The first question we address in this report is to what degree does the Golden Rule apply in China (in yield space rather than in return space), along with an explanation of any differences that may exist. However, we must first note why the Golden Rule of bond investing works, particularly in the US. The first reason is that there is a strong relationship between the US 3-month T-bill rate and Treasury yields of all other maturities. Conceptually, all fixed income investors have a choice when buying US government bonds: they can purchase a 3-month Treasury bill and simply perpetually roll over the position as it matures, or they can purchase a Treasury bond of a longer maturity. This means that yields on longer maturity Treasury bonds simply reflect investor expectations for the average 3-month T-bill rate over the life of the bond, plus some positive risk premium to compensate for the inherent uncertainty of the path and tendency of short-term yields. This helps explain the close link between cyclical changes in 3-month T-bill rates and yields on longer maturity Treasurys. Chart 2In The US, The 3-Month T-Bill Rate Perfectly Tracks The Fed Funds Rate In The US, The 3-Month T-Bill Rate Perfectly Tracks The Fed Funds Rate In The US, The 3-Month T-Bill Rate Perfectly Tracks The Fed Funds Rate The second reason for the Golden Rule’s success is that there is a very tight relationship between the effective Fed funds rate and the 3-month T-bill rate. While it is the (higher) discount rate that is the theoretical no-arbitrage ceiling for the 3-month rate, in practice T-bill rates trade extremely close to the Fed funds rate (Chart 2). This means that Fed funds rate “surprises” (relative to traded market expectations) are akin to surprises in the 3-month rate, which in turn strongly influence the expected future path of short-term interest rates and thus yields on longer maturity Treasurys. In China, we noted in a February 2018 Special Report3 that the 7-day interbank repo rate is now the de jure short-term policy rate in China following the establishment of an interest rate corridor system in 2015. Chart 3 presents our first test of the Golden Rule in China (in yield space rather than in return space), by plotting the annual change in the level of Chinese government bond yields alongside the 7-day repo rate “surprise” over the past year from 2010 to the present. Here, we use the first principal component of zero coupon Chinese government bond yields to represent the average level of yields (rather than selecting a particular maturity), and we use the 12-month RMB swap rate (versus 7-day repo) to represent market expectations for the policy rate. The chart highlights that the fit is good, as measured by a 50% R-squared between the two series. However, deviations in the relationship do exist, with the most notable exception having occurred in 2017: Chinese government bond yields rose considerably more than what the annual surprise in the 7-day repo rate would have suggested. Chart 3In China, The Golden Rule Works Decently Well Using 7-Day Repo... In China, The Golden Rule Works Decently Well Using 7-Day Repo... In China, The Golden Rule Works Decently Well Using 7-Day Repo... Chart 4...And Extremely Well Using 3-Month SHIBOR ...And Extremely Well Using 3-Month SHIBOR ...And Extremely Well Using 3-Month SHIBOR Chart 4 helps resolve a good portion of the 2017 discrepancy, and clarifies the link between Chinese monetary policy and government bond yields. Chart 4 is similar to Chart 3, except that it replaces the 7-day repo rate surprise with that of 3-month SHIBOR (which trades very closely to the 3-month repo rate). The chart illustrates an even closer fit between the two series (with an R-squared close to 80%), and shows that the 3-month SHIBOR surprise does a meaningfully better job at explaining the 2017 rise in Chinese government bond yields. The Golden Rule of bond investing works surprisingly well in China. The fact that the annual surprise in 3-month SHIBOR has done a better job at predicting changes in bond yields over the past decade underscores that the 3-month repo rate is the de facto short-term policy rate in China, a point that we have made in several previous reports. We have noted that the spike in the 3-month/7-day repo rate spread that occurred in late-2016 and lasted until mid-2018 happened because of China’s crackdown on shadow banking activity. This crackdown caused a funding squeeze for China’s small & medium banks, which caused a material rise in lending rates and government bond yields. This episode highlights that future changes in the 3-month repo rate are likely to reflect both underlying changes in net liquidity provided to large commercial banks (measured by the 7-day repo rate), and any dislocations in the interbank market that have the potential to push up lending rates and government bond yields. Bottom Line: BCA’s “Golden Rule” framework, which links developed economy government bond returns to central bank policy rate “surprises” versus market expectations, works for China as well – using the correct measure of the PBOC policy rate. This provides a useful investment framework for Chinese government bonds, which are now significant part of major global bond market benchmarks. The Cyclical Outlook For Chinese Government Bond Yields Given the establishment of the relationship between Chinese short-term interbank rates and government bond yields detailed above, we are now able to more precisely discuss the likely cyclical trajectory of Chinese government bond yields as a function of Chinese monetary policy. Two opposing forces have the potential to affect China’s government bond market this year. The first, a stabilization and modest rebound in Chinese economic activity, may exert upward pressure on yields due to expectations of eventual policy tightening. The second, continued attempts by the PBoC to ease corporate lending rates, may exert downward pressure on yields as it will reflect not just easy but easier monetary conditions. Yields at the long-end are likely to move modestly higher this year, at most. For investors, the raises the obvious question of whether Chinese government bond yields are likely to move up, down, or trend sideways this year. In our view, yields at the short-end are likely to be flat until later this year at the earliest, whereas yields at the long-end are likely to move modestly higher, at most. Yields at the short-end of China’s government bond curve are likely to stay flat for most of this year. There are two reasons why yields at the short-end of China’s government bond curve are likely to stay flat for most of this year. The first is that the PBoC is generally a reactive central bank and has historically lagged a pickup in economic activity, as illustrated in Chart 5. The chart shows the historical path of 3-month SHIBOR in the year following a bottom in economic activity in 2009, 2012, and 2015, and makes it clear that there has been no precedent for a significant rise in interbank rates in the first nine months of an economic recovery. The 2012 episode did see a very sharp rise in 3-month SHIBOR once the PBoC shifted into tightening mode, but we doubt that this experience will be repeated again unless economic growth accelerates much more aggressively than we expect. The second reason why we expect yields at the short-end of the curve to remain muted this year is because any additional easing by the PBoC is likely to be focused on reducing corporate lending rates, not interbank rates. Chart 6 highlights that while there is a strong correlation between changes in Chinese government bond yields and average lending rates in the economy, the former leads the latter. In the past, this relationship has existed because changes in interbank rates have coincided with reductions in the now obsolete benchmark lending rate, with the former usually occurring earlier than the latter. But in a scenario where the PBoC reduces the loan prime rate (LPR) and keeps net banking sector liquidity roughly constant, the extremely tight relationship shown in Chart 4 suggests that short-term bond yields are unlikely to be affected by a reduction in lending rates. Any meaningful decline in short-term yields below short-term interbank rates would simply prompt banks to stop buying these bonds. Chart 5The PBoC Is Generally A Reactive Central Bank The PBoC Is Generally A Reactive Central Bank The PBoC Is Generally A Reactive Central Bank Chart 6Average Lending Rates Lag Short-Term Bond Yields Average Lending Rates Lag Short-Term Bond Yields Average Lending Rates Lag Short-Term Bond Yields Chart 7China's Yield Curve Is Generally Pro-Cyclical China's Yield Curve Is Generally Pro-Cyclical China's Yield Curve Is Generally Pro-Cyclical Additional easing by the PBoC does have the potential to impact the long-end of the government bond curve if investors view these actions as a sign that interbank rates will remain low for some time. This view is reinforced by the fact that China’s yield curve is not particularly flat, and thus has room to move lower. However, Chart 7 also shows that China’s yield curve, defined here as the second principal component of zero coupon Chinese government bond yields, is positively correlated with the relative performance of investable Chinese equities. This suggests that there is a procyclical element to the curve. We suspect that this procyclical element will dominate a potential decline in expectations for future short-term interest rates, but that yields at the long-end are likely to move modestly higher this year, at most. Bottom Line: Any additional easing by the PBoC this year is likely to be focused on reducing lending rates to the real economy, not interbank rates (which drive government bond yields). As such, yields at the short-end are likely to be flat until later this year at the earliest, whereas yields at the long-end are likely to move modestly higher, at most. The Secular Outlook For Chinese Government Bond Yields A common approach to forecasting the likely structural trend for nominal government bond yields is to estimate the trajectory of real long-term potential output growth and to add the monetary authority’s inflation target. This framework is based on the idea that interest rates are in equilibrium when the cost of borrowing is roughly equal to nominal income growth, a condition that results in no change in the burden to service existing debt. Chart 8China's Potential Growth Is Likely To Trend Lower... China's Potential Growth Is Likely To Trend Lower... China's Potential Growth Is Likely To Trend Lower... Based on this framework, we would expect Chinese government bond yields to trend down over time, or possibly flat if the PBoC were to tolerate higher inflation over the coming decade. Chart 8 illustrates the IMF’s forecast of falling real potential growth in China over the coming several years, which is consistent with a shift in the composition of growth from investment to consumption as well as China’s looming demographic crisis. But Chart 9highlights an obvious problem with applying this framework to forecast the secular trend in Chinese government bond yields: over the past decade, yields have persistently averaged below actual nominal GDP growth, both in China and in the developed world. In the latter case, it is an open question whether this will continue to be true in the future, but in China’s case it is clear that government bond yields have little connection (in magnitude) to the pace of GDP growth. This reflects the longstanding strategy of Chinese policymakers to promote investment via persistently low interest rates, as has occurred in other manufacturing and export-oriented Asian economies (Chart 10). Chart 9...But Bond Yields Are Well Below GDP Growth, Just Like In Developed Markets ...But Bond Yields Are Well Below GDP Growth, Just Like In Developed Markets ...But Bond Yields Are Well Below GDP Growth, Just Like In Developed Markets Chart 10In Industrial Asian Economies, Low Bond Yields Are A Policy Choice In Industrial Asian Economies, Low Bond Yields Are A Policy Choice In Industrial Asian Economies, Low Bond Yields Are A Policy Choice   The persistent historical gap between economic growth and bond yields in China makes it difficult to forecast the structural outlook for yields using conventional methods, and largely limits us to inference. To the extent that Chinese policymakers succeed at shifting the drivers of growth from investment to consumption, bond yields are more likely to rise than fall over time. This is because as long as interest rates remain well below the pace of income growth, the incentive to excessively borrow (and invest) is likely to persist. Chart 11China Needs Higher Interest Rates, But Only To A Point China Needs Higher Interest Rates, But Only To A Point China Needs Higher Interest Rates, But Only To A Point However, even in a scenario where Chinese government bond yields structurally trend higher, we expect the rise to be modest. Chart 11 highlights that China’s “private sector” debt service ratio is extremely elevated, underscoring that the country’s ability to tolerate significantly higher bond yields is not strong. In addition, since 2015, China’s debt service ratio has been mostly flat despite rising a rising debt-to-GDP ratio, which has been achieved through lower short-term interest rates. To the extent that policymakers fail to make meaningful progress in shifting China’s growth drivers away from investment over the coming few years, lower (potentially sharply lower) bond yields would appear to be all but inevitable to cope with what would become a permanently growing drag on economic activity from the servicing of debt. For now, we would characterize this scenario as a risk to our base case view, but it is a risk that we will be closely monitoring over the coming years. Bottom Line: The persistent gap between Chinese nominal GDP growth and government bond yields is likely contributing to the problem of excessive leveraging. To the extent that Chinese policymakers succeed at shifting the drivers of growth from investment to consumption, bond yields are more likely to structurally rise than fall. Investment Conclusions Our analysis above points to four recommendations for investors over the coming year: Overweight Chinese stocks versus Chinese government bonds in RMB and USD terms Overweight Chinese onshore corporate bonds versus duration-matched Chinese government bonds in RMB terms Overweight 7-10 year USD-hedged Chinese government bonds versus their US and developed market (DM) counterparts For offshore US dollar-based investors, long 7-10 year Chinese government bonds in unhedged terms Regarding the first two recommendations, our view that yields are likely to be flat at the short-end and modestly higher at the long-end suggests that investors can expect total returns on the order of 2-3% from Chinese government bonds this year. Barring a major and lasting economic slowdown from the 2019-nCoV outbreak, we expect Chinese domestic and investable equities to outperform government securities over the coming 6-12 months. Onshore corporate bonds have a similar outlook: onshore spreads are pricing in (massively) higher default losses than we believe is warranted, meaning that they will outperform duration-matched government equivalents without any changes in yield. Chart 12Within Global Fixed-Income, Hedged Chinese 10-Year Yields Are Relatively Attractive Within Global Fixed-Income, Hedged Chinese 10-Year Yields Are Relatively Attractive Within Global Fixed-Income, Hedged Chinese 10-Year Yields Are Relatively Attractive Chart 13Unhedged Yield Spreads Predict Hedged Relative Performance Versus The US Unhedged Yield Spreads Predict Hedged Relative Performance Versus The US Unhedged Yield Spreads Predict Hedged Relative Performance Versus The US For global fixed-income investors, Charts 12-14 present USD-hedged 10-year Chinese government yields versus the US and DM/DM ex-US, along with the historical relative return profile of USD-hedged Chinese bonds versus hedged and unhedged returns. In hedged space, Chinese 10-year government bond yields are modestly attractive: 2.2% versus 1.6% in the US and 1.8% in DM ex-US. China’s historically low yield beta to the overall level of global 10-year bond yields (Chart 15) suggests that Chinese yields should perform well in 2020 – a year where we expect global bond yields to drift higher as economic growth rebounds. Combined with relatively attractive valuation, this bodes well for the relative performance of Chinese debt versus DM equivalents. A low yield beta against a backdrop of drifting higher global yields implies that longer-maturity Chinese government bonds will outperform their DM equivalents. Chart 14Unhedged Yield Spreads Predict Hedged Relative Performance Versus DM Unhedged Yield Spreads Predict Hedged Relative Performance Versus DM Unhedged Yield Spreads Predict Hedged Relative Performance Versus DM Chart 15China's Yield Beta Has Been Rising, But Is Still Japan-Like China's Yield Beta Has Been Rising, But Is Still Japan-Like China's Yield Beta Has Been Rising, But Is Still Japan-Like   We would also recommend longer-maturity Chinese government bonds in unhedged terms versus a USD-hedged global government bond portfolio. Chart 16 highlights that the relative return of this trade is strongly (negatively) linked to USD-CNY, and we expect further (albeit more modest) gains in RMB over the cyclical horizon. Chart 16Modest Further RMB Upside Means Unhedged Chinese Bonds Will Outperform Modest Further RMB Upside Means Unhedged Chinese Bonds Will Outperform Modest Further RMB Upside Means Unhedged Chinese Bonds Will Outperform As a final point, investors should note that today’s report is part of a heightened focus on China’s fixed income market, in terms of both forecasting fixed income returns and analyzing the cyclical and structural implications of the increasing investability of China’s financial markets. More research on this topic is likely to come in 2020 and beyond: Stay Tuned!   Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com         Footnotes 1    Please see US Bond Strategy Special Report "The Golden Rule Of Bond Investing," dated July 24, 2018, available at usbs.bcaresearch.com 2   Please see Global Fixed Income Strategy Special Report "The Global Golden Rule Of Bond Investing," dated September 25, 2018, available at gfis.bcaresearch.com 3   Please see China Investment Strategy Special Report "Seven Questions About Chinese Monetary Policy," dated February 22, 2018, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Highlights Portfolio Strategy There are high odds that China’s real GDP deceleration will continue for the next decade, casting a shadow over the profit prospects of the S&P 1500 metals & mining index. A structural below benchmark allocation is warranted. Rising total mutual fund assets under management, improved trading revenue prospects, rising investor confidence along with a revival in IPO and M&A activity, all signal that it still pays to be overweight the S&P capital markets index. Recent Changes There are no changes in our portfolio this week. Table 1 When The Music Stops... When The Music Stops... Feature “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” - Charles Owen "Chuck" Prince III (ex-CEO of Citigroup) The SPX remains near all time highs and the invincible tech sector continues to lead the pack. Two weeks ago we showed that the market capitalization concentration of the top five stocks in the S&P 500 surpassed the late-1990s parallel (Chart 1), and Table 2 shows that late in the cycle a handful of stocks explain a sizable part of the broad market’s return.1 However, in terms of valuation overshoot the current forward P/E of these top five stocks is roughly half the late-1990s parabolic episode (Chart 2). Chart 1Vertigo Warning Vertigo Warning Vertigo Warning Chart 2Unlike The Late-1990s Unlike The Late-1990s Unlike The Late-1990s While the overall market does not fully resemble the excesses of the dot.com bubble era, at least not yet, there are elements that are eerily reminiscent of the late-1990s. Table 2Contribution To Late Cycle Rallies In The SPX When The Music Stops... When The Music Stops... Chart 3Correlation Breakdown Correlation Breakdown Correlation Breakdown Contrary to popular belief, during manias historical correlations break down and the forward multiple becomes positively correlated with the discount rate. So in the late 1990s, the fed funds rate and the 10-year yield jumped 200bps in a short time span and the SPX forward P/E soared 40% from roughly 18x to 25x (Chart 3) before collapsing to 14x soon thereafter. Simultaneously, the US dollar was roaring as real interest rates were 4%, but the NASDAQ 100 outperformed the emerging markets, another break in historical correlations. As Chuck Prince mused in 2007, there is a narrative in the equity market today that, “as long as the music is playing, you’ve got to get up and dance”. While the overall market does not fully resemble the excesses of the dot.com bubble era, at least not yet, there are elements that are eerily reminiscent of the late-1990s. We filtered for large cap stocks that are at all-time highs and have increased in value at a minimum 10x since 2010. Among the stocks that met these criteria, five really stand out, Apple, Tesla, Lam Research, Amd & Salesforce, and comprise our “ATLAS” index; the mania in these stocks will likely end in tears (Chart 4). Even their forward P/E ratio has gone exponential, hitting a 60 handle last year similar to top five SPX stocks in the late-1990s. Chart 4ATLAS: Holding The World On His Shoulders ATLAS: Holding The World On His Shoulders ATLAS: Holding The World On His Shoulders Currently, SPX profits are barely growing and the sole reason equities are higher is the massive injection of liquidity via the drubbing in interest rates and the restart of QE. From peak-to-trough the 10-year yield fell 175bps in nine months, and the Fed commenced expanding its balance sheet by $60bn/month since last September; yet profits have barely budged. Ultimately, profits have to show up and the news on this front remains grim. The current non-inflationary trend-growth backdrop is a “goldilocks” scenario especially for tech stocks that thrive during disinflationary periods. While stocks can go higher defying weak EPS fundamentals as they have yet to reach a fully euphoric state according to our Complacency-Anxiety Indicator (Chart 5), a sell-off in the bond market will likely cause some consternation in equities in general and tech stocks in particular similar to early- and late-2018. Chart 5Not Max Complacent Yet Not Max Complacent Yet Not Max Complacent Yet Other catalysts that can suddenly cause “the music to stop” are either the recent coronavirus becoming an epidemic or a geopolitical event that would result in a risk off backdrop. Ultimately, profits have to show up and the news on this front remains grim. Our mid-January “Three EPS Scenarios” analysis still suggests that the SPX is 9% overvalued.2 This week we are updating our capital markets view and adding a sixth long-term theme and a related investment implication to our mid-December 2019, Special Report titled, “Top US Sector Investment Ideas For The Next Decade”.3 Sixth Big Theme For The Decade And Investment Implications China’s ascendancy on the world scene was a mega driver of equity markets in the 2000s following its inclusion in the WTO. The commodity super-cycle captured investors’ imaginations and China’s insatiable appetite for commodities caused a massive bubble in the commodity complex in general and commodity-related equities in particular. Nevertheless, the Great Recession posed a severe threat to China and the authorities injected an extraordinary amount of stimulus into the economy (15% of GDP over two years). This succeeded in doubling real GDP growth, but only temporarily. The unintended consequence was an enormous debt binge fueled by cheap money. Moreover, this debt burden along with falling labor force growth and productivity forced the government to re-think its policies as they caused a steady down drift in real output growth. The sixth big theme for the 2020s is a sustained deceleration of Chinese real GDP growth to a range of 4% to 2% (Chart 6). Not only is the debt overhang weighing on real output growth, but Chinese leaders are adamant about transitioning the economy to developed market status, which is synonymous with higher consumption expenditures at the expense of gross fixed capital formation. Chart 6From Boom… From Boom… From Boom… Chart 7…To Bust …To Bust …To Bust In other words, China remains committed to weaning its economy off of investment and reconfiguring it toward consumption (Chart 7). This is a strategic plan but it is possible that the Chinese economy can achieve this transition in due time. While this will not happen overnight, the implication is steadily lower real GDP growth as is common among large, mature, developed market economies. China will remain one of the top commodity consumers in the world, as urbanization is ongoing, but the intensity of commodity consumption will continue to decelerate (Chart 8). At the margin, this change in consumption behavior will have knock on effects on the broad basic resources sector in general and the S&P 1500 metals & mining index in particular. Were this Chinese backdrop to pan out in the coming decade as we expect, it would sustain the relative underperformance of metals & mining equities as Chart 6 & 7 depict. Chart 8Commodity Consumption Deceleration Will… Commodity Consumption Deceleration Will… Commodity Consumption Deceleration Will… Chart 9…Continue To Weigh On Metals & Mining Profits …Continue To Weigh On Metals & Mining Profits …Continue To Weigh On Metals & Mining Profits Importantly, these commodity producers will have to adjust their still bloated cost structures to lower run rates which is de facto negative both for relative sales and profit growth (Chart 9). Tack on the large negative footprint mining extraction has on the environment, and if ESG investing (our fifth big theme for the decade4) also takes off, investors should avoid the S&P 1500 metals & mining index on a secular basis. Bottom Line: There are high odds that China’s real GDP deceleration will continue for the next decade, casting a shadow over the profit prospects of the S&P 1500 metals & mining index. A structural below benchmark allocation is warranted. The ticker symbols for the stocks in this index are: BLBG S15METL – NEM, FCX, NUE, RS, RGLD, STLD, CMC, ATI, CRS, CLF, CMP, X, KALU, WOR, MTRN, HCC, AKS, SXC, HAYN, CENX, TMST, ZEUS. Capital Markets Update Capital markets stocks have come out of hibernation recently and are on the cusp of breaking out – in a bullish fashion – of their 18-month trading range. A number of the indicators we track signal that an earnings-led outperformance period is in the cards for this financials sub-group and we reiterate our overweight stance. Sloshing liquidity has pushed investors out the risk spectrum and high yield bond option adjusted spreads are flirting with multi-year lows. Such a tame junk bond market backdrop coupled with easy financial conditions are conducive to rising M&A activity (Chart 10). Importantly, the Fed’s Senior Loan Officer Survey paints an improving profit backdrop for investment banks. Not only are bankers willing extenders of credit, but demand for credit for the majority of loan categories that the Fed tracks is squarely in positive territory (top panel, Chart 11). Chart 10Subsiding Risks Are A Boon To Capital Markets Subsiding Risks Are A Boon To Capital Markets Subsiding Risks Are A Boon To Capital Markets Chart 11Positive Profit Catalysts Positive Profit Catalysts Positive Profit Catalysts This is likely a consequence of last year’s drubbing in the price of credit. M&A activity usually goes hand in hand with loan growth, underscoring that business combinations are on track to accelerate (third panel, Chart 10). This will revive a lucrative business line for capital markets firms. Total mutual fund assets are expanding at a brisk rate and hitting fresh all-time highs, signaling an uptick in risk appetite (third panel, Chart 11). Rising investor confidence will facilitate both new and secondary share issuance, an important source of fee generation for capital markets firms. Moreover, equity trading volumes have sprang back to life in recent weeks underscoring that the recent impressive Q4 earnings results will likely continue into Q1/2020 (bottom panel, Chart 10). Meanwhile, the three Fed rate cuts last year should work through the economy and at least stem further losses in the ISM manufacturing survey. The US/China trade détente will also lead to a stabilization in global growth. In fact, the V-shaped recovery in the global ZEW survey suggests that capital markets profits will likely outpace the broad market this year (second & bottom panels, Chart 11). Finally, the recent surge in the stock-to-bond ratio reflects a massive psychological shift, from last year’s recessionary fears to growing investor confidence that tail risks are abating (Chart 12). Still depressed valuations neither reflect the firming capital markets profit outlook nor the rising industry ROE (bottom panel, Chart 12). Adding it all up, accelerating total mutual fund assets under management, improved trading revenue prospects, rising investor confidence and a revival in IPO and M&A activity, all signal that it still pays to be overweight the S&P capital markets index.  Bottom Line: Stay overweight the S&P capital markets index. The ticker symbols for the stocks in this index are: BLBG S5CAPM – GS, CME, SPGI, MS, BLK, SCHW, ICE, MCO, BK, TROW, STT, MSCI, NTRS, AMP, MKTX, CBOE, NDAQ, RJF, ETFC, BEN, IVZ. Chart 12Valuation Re-Rating Looms Valuation Re-Rating Looms Valuation Re-Rating Looms     Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com     1     Please see BCA US Equity Strategy Weekly Report, “Three EPS Scenarios” dated January 13, 2020, available at uses.bcaresearch.com. 2     Ibid. 3     Please see BCA US Equity Strategy Special Report, “Top US Sector Investment Ideas For the Next Decade” dated December 16, 2019, available at uses.bcaresearch.com. 4     Ibid.   Current Recommendations Current Trades Size And Style Views Stay neutral cyclicals over defensives (downgrade alert) Favor value over growth Favor large over small caps (Stop 10%)

Highlights The US election cycle is an understated risk to US equities – and the risk of a left-wing populist outperforming in the Democratic primary election is frontloaded in February. The US-Iran conflict is unresolved and remains market-relevant. Iraq is at the center of the conflict and oil supply disruption there or elsewhere in the region is a substantial risk. Even if war does not erupt, Iran has the potential to give President Trump’s foreign policy a black eye and thus could marginally impact the election dynamic. Feature Stocks have rallied mightily since our August report on Trump’s “tactical trade retreat,” but new headwinds face the market. In this report we call attention to four hurdles arising from US election uncertainty. Then we focus on the status of Iran and Iraq in the wake of this month’s hostilities, which brought the US and Iran to the brink of outright war. We maintain that the Iran risk is unresolved and will remain market-relevant in advance of the US election. Primarily due to the US Democratic primary election, we urge caution on US equities in the near term, along with our Global Investment Strategy, despite our cyclically bullish House View. Four Hurdles In The US Election Cycle The US election cycle is the chief political risk to the bull market this year – and geopolitical risks largely radiate from it. There are four immediate hurdles that financial markets are underestimating: Risks to Trump's re-election: Global investors have come around to our view since 2018 that Trump is slightly favored to win re-election (Chart 1). Bets on the related question of which party will hold the White House have flipped from Democratic to Republican (Chart 2). Everyone now recognizes that Trump will not be removed from office through impeachment. Chart 1Trump Re-election Odds Add To Risk-On Trump Re-election Odds Add To Risk-On Trump Re-election Odds Add To Risk-On Chart 2Republicans Now Favored For White House Market Hurdles: From Sanders To Iran Market Hurdles: From Sanders To Iran Yet, anecdotally, investors may be becoming complacent about Trump’s chances. He is not a shoo-in. Subjectively we have argued that his odds of victory are 55%. Our quantitative election model shows that Wisconsin has shifted to the Republican camp since November, but it places the odds of winning that state (and Pennsylvania) at less than 52% (Chart 3). This gives Trump 289 electoral votes, only 19 more than necessary. If both of these states tipped in the opposite direction then investors would be facing a major policy reversal in the United States. Chart 3Our US 2020 Election Model Shows Trump Win With 289 Electoral College Votes Market Hurdles: From Sanders To Iran Market Hurdles: From Sanders To Iran Chart 4The US Economy Is Still A Risk To Trump The US Economy Is Still A Risk To Trump The US Economy Is Still A Risk To Trump Trump’s low approval rating remains a liability – and in this sense impeachment is still relevant, in that it can either help or hurt his approval, or prompt him to seek distractions abroad that could deliver negative surprises. Moreover the US manufacturing sector and labor market are not out of the woods yet (Chart 4). In short, the election is still ten months away and a lot can happen between now and then. We see Trump as only slightly favored. Moreover other hurdles are more immediate than the benefits of policy continuity upon a Trump win. 2. Risks to Biden's nomination: Throughout last year we maintained that former Vice President Joe Biden was the frontrunner for the Democratic nomination, albeit with very low conviction. In particular, after Vermont Senator Bernie Sanders’s poor showing in the third debate and subsequent heart attack, we expected Massachusetts Senator Elizabeth Warren to consolidate the progressive vote and trigger a policy-induced selloff in US equities. This never occurred because Biden held firm, Sanders recovered, and Warren fell. The risk to equities from a left-wing populist Democratic nominee is frontloaded in February and March. Now, however, the risk to equities is back. The Democratic Party faces a last-ditch effort from its left or “progressive” wing and anti-establishment voters to oppose Biden. With the primary election now upon us – the Iowa Caucus is February 3 – national opinion polls show that Sanders is pushing up against Biden (Chart 5). It is less clear if Sanders is breaking through in the primary polling state-by-state, where multiple candidates remain competitive (Chart 6). But online gamblers are reasserting Biden over Sanders at just the moment when progressives are set to launch their biggest push (Chart 7). Meanwhile New York Mayor Michael Bloomberg is finally gaining some traction – and he eats away at Biden’s support from centrist voters. Everything is in flux, which warrants caution. Chart 5Biden Is The Frontrunner, But Sanders Is Challenger Market Hurdles: From Sanders To Iran Market Hurdles: From Sanders To Iran Chart 6Biden Not A Shoo-In For Early Democratic Primary States Market Hurdles: From Sanders To Iran Market Hurdles: From Sanders To Iran Biden is still favored to win the nomination, but he has not clinched it. The market faces volatility during the period when Democrats get “cold feet” about nominating another establishment candidate. Moreover the fundamental knock against Sanders – that he is not as “electable” as Biden – is debatable, judging by head-to-head polls against Trump (Chart 8). This means that a shift in momentum – for instance, if Biden lurches from disappointments in early states to underperformance in his bulwark of South Carolina – would have legs. Ultimately a “contested convention” is not impossible. This would be a negative surprise to market participants currently assuming that the world faces the relatively benign choice of two known quantities: an establishment Democrat or a continuation of Trump policies. Chart 7Betting Markets Overlooking Party 'Cold Feet' Over Biden Betting Markets Overlooking Party 'Cold Feet' Over Biden Betting Markets Overlooking Party 'Cold Feet' Over Biden Chart 8Electability Fears May Not Stop Sanders Rally Market Hurdles: From Sanders To Iran Market Hurdles: From Sanders To Iran Risks to the Republican Senate: Assuming Biden clinches the nomination, he has a 45% chance of winning the election – and in that case, his chance of bringing the Senate over to the Democrats is higher than investors realize. This is another risk that the market will awaken to later this year. Chart 9Democrats Underestimated In Senate Market Hurdles: From Sanders To Iran Market Hurdles: From Sanders To Iran The consensus holds that Republicans will hold the Senate, particularly with Republican senators in Maine and Iowa leading their Democratic challengers in polling. The problem is that for Democrats to unseat an incumbent president they will necessarily have generated strong turnout from key demographic groups: young people, suburbanites, women, and minorities. If that is the case, then the election will not be as tight as expected and Republicans will be less likely to hold the Senate. This would require rising unemployment or some other blow that fundamentally damages the Trump administration’s popular support in key swing states. At least until it becomes clear that the manufacturing sector is out of the woods, the Democrats should be seen as far more likely to take the Senate than the Republicans are to retake the House of Representatives – yet this goes against the consensus (Chart 9). Rising odds of a Senate victory would mean that even a “centrist” Democrat like Biden would have fewer political constraints in office – he would pose a greater threat of increasing taxes, minimum wages, and passing legislative regulation than the market currently expects. In short, Biden would be pulled to the left of the political spectrum by his party and expectations of an establishment Democrat posing a minimal threat to corporate profits would be greatly disappointed. Risks of Trump's second term: Finally, assuming the manufacturing sector rebounds and that Trump’s odds of re-election rise above 55%, market complacency becomes an even bigger concern for a long-term investor. For in his second term Trump would become virtually unshackled with regard to economic and financial constraints, since he cannot run for office again. He would still face the senate, the Supreme Court, and other constraints, but these would certainly not preclude a doubling down on trade war (or confrontations with nuclear-aspirants like Iran or North Korea). We have argued that Trump will not instigate a trade war with Europe, at least until the economy has clearly rebounded, and most likely not until his second term. But we fully expect chapter two of the trade war to begin in 2021 – and this could mean China, Europe, or even a two-front war. Re-election could go to Trump’s head and prompt him to overreach on the global stage. Hence we expect the relief rally on Trump’s re-election to be short-lived and would be looking to sell the news. But the S&P 500 faces more immediate hurdles anyway, and that is why we urge caution in the very near term. Iran is still a major geopolitical risk this year. Bottom Line: None of these hurdles are insurmountable, but the US election cycle is now an understated risk to the equity bull market. We agree with our Global Investment Strategy that it is prudent to shift to a neutral position tactically on US equities, especially for the February and March period when uncertainty rises over the Democratic Party primary. This does not change our view that the underlying global economy is improving, largely on China’s rebound, and that the cyclical outlook is positive. Don’t Bet On Regime Collapse In Iran (Yet) The January 8 Iranian attack on US bases in Iraq was intended to serve as a breather for Iranian leaders. It was meant to put on pause the rapid escalation in US-Iran tensions – allowing Iranian leaders to recover from the assassination of top military commander Qassem Suleimani – all the while appeasing the public through a public show of revenge. As fate would have it, however, the Iranian regime was granted no such respite. Days later, domestic unrest descended on the Islamic Republic as protesters returned to the streets across the country, criticizing the regime’s downing of a civilian airliner and re-stating their long-running complaints against the regime. Civil strife is not uncommon in Iran (Table 1). Economic inefficiencies, corruption, and discriminatory policies which serve to reward regime loyalists while suppressing the private sector are only some of the grievances faced by Iranians.1 Table 1Civil Strife Ongoing Problem In Iran Market Hurdles: From Sanders To Iran Market Hurdles: From Sanders To Iran Today’s strife is relevant, however, because it is fueled by US-imposed “maximum pressure” sanctions that have created an even bleaker economic reality. Iranian exports were down 37% in 2019 following an 18% decline the previous year. Oil exports fell to 129 thousand barrels per day in December 2019, down from an average 2.1 million barrels per day in 2017 (Chart 10). Households are facing the brunt, experiencing a 17% unemployment rate and a whopping 36% inflation rate (Chart 11). Chart 10US 'Maximum Pressure' Sanctions On Iranian Oil Exports US 'Maximum Pressure' Sanctions On Iranian Oil Exports US 'Maximum Pressure' Sanctions On Iranian Oil Exports Chart 11Iranian Households Bear Brunt Of Economic Shock Iranian Households Bear Brunt Of Economic Shock Iranian Households Bear Brunt Of Economic Shock The 2020-21 budget, released in December and described as a weapon of “resistance against US sanctions,” intends to plug the deficit using state bonds and state property sales (Chart 12). However Iran’s fiscal condition is shaky. The International Monetary Fund estimates a fiscal breakeven oil price of $194.6 per barrel for Iran, more than 3 times higher than current oil prices. Chart 12Iran’s Fiscal Condition Is Shaky Market Hurdles: From Sanders To Iran Market Hurdles: From Sanders To Iran Chart 13Iran Avoiding Devaluation Under Trump Iran Avoiding Devaluation Under Trump Iran Avoiding Devaluation Under Trump Chart 14Iranians Also Blame Their Government For Malaise Market Hurdles: From Sanders To Iran Market Hurdles: From Sanders To Iran The solution of former President Mahmoud Ahmadinejad, the populist hawk who led the government during the US’s previous round of sanctions, was to devalue the official exchange rate. The weaker rial raised local currency revenues for each barrel of exported oil and encouraged import substitution in other industries. However devaluation came at a steep political cost and sparked riots and protests. So far President Hassan Rouhani has eschewed this strategy, instead maintaining a stable official exchange rate, used as the reference for subsidized basic goods and medicine (Chart 13). Nevertheless, the unofficial market rate has weakened 68% since the beginning of 2018. It is no surprise then that Iranians all over the country are taking to the streets. The latest bout of unrest is significant in size, geographic reach, and in that protesters are calling on Grand Ayatollah Ali Khamenei to step down as supreme leader. Despite US sanctions, Iranian protesters are partially blaming Khamenei and the government for the country’s malaise (Chart 14). Even prior to the US withdrawal from the 2015 nuclear deal, Joint Comprehensive Plan of Action (JCPA), Iranians were angry about economic mismanagement. Nevertheless, according to our checklist for an Iranian revolution, the regime is not yet at risk of collapse (Table 2). Although the street movement is picking up pace, it is not organized or unified. There is no alternative being offered against the all-powerful supreme leader, and the political elite are mostly united in preserving the current system. Table 2Iran Regime Stability Checklist Market Hurdles: From Sanders To Iran Market Hurdles: From Sanders To Iran The regime has two main options going forward: seek immediate economic relief through negotiations with the United States, or hunker down and wait to see whether President Trump is reelected and able to sustain his campaign of maximum pressure, and go from there. We fully expect the latter. Domestic dissent can still be suppressed for the time being. The parliamentary – or Majlis – elections scheduled for February 21 could in theory offer Iranians an opportunity to voice their discontent through the ballot box. However this democratic exercise conceals the known political reality that the supreme leader holds supreme authority, even in the selection of parliament or the president (Diagram 1). Thus the election result will not drive major policy change. Diagram 1Supreme Leader Controls Iran Market Hurdles: From Sanders To Iran Market Hurdles: From Sanders To Iran A case in point was the regime’s 2016 strategy in the parliamentary election. At that time, the conservative-dominated Guardian Council, responsible for screening potential candidates, rejected well-known reformist applicants (Chart 15). As a result, the reformists who were able to win seats were either lesser-known figures or unaligned with liberals in the reformist movement. Thus while the reformist presence in parliament nominally surged, these lawmakers were ineffective, reneging on campaign promises or collaborating with the conservative faction. The 2016 election serves as a blueprint for what to expect in the upcoming elections in February. The Guardian Council ruled that out of around 15,000 candidates, only 60 (relatively unknown) reformist candidates were qualified to run for the election.2 The elections will not change anything, but this means the grievances of the population will fester in the coming years, especially if the US does not change policies. This is where the medium-term risk to regime stability – namely through elite divisions – becomes apparent. The impending leadership succession is a major source of uncertainty. Supreme Leader Khamenei is the main barrier to political change. At 80 years old and reportedly suffering from poor health, a change in leadership is imminent. However, no one has been officially endorsed as his successor. This is an immense source of uncertainty in the coming years. There are several possibilities for the succession.3 A successor is appointed by the Assembly of Experts. Because we exclude Rouhani as a candidate for supreme leader, the potential candidates for Iran’s top position listed below ascribe to Khamanei’s hardline ideology: Hojjat ol-Eslam Ebrahim Raisi, head of judiciary and of the Imam Reza shrine since March 2019. Raisi is reportedly Khamenei’s favorite for succession. He is a hardliner who lost the May 2017 presidential election to Rouhani.4 Ayatollah Sadeq Larijani, the conservative former head of the judiciary and current chairman of the Expediency Discernment Council, which is responsible for resolving disputes among government branches. Larijani is also a member of the Guardian Council.5 Ayatollah Ahmad Khatemi, hardline Tehran Friday prayer leader and senior member of the Assembly of Experts. The Iranian Revolutionary Guard Corps (IRGC) – a military force with immense influence in the regime – may choose to rule itself. We assign a low likelihood of this occurring. The IRGC is more likely to ensure that Khamenei’s successor is someone who supports its hardline ideology and vision for Iran. Some moderate clerics are advocating a change in structure, whereby the position of supreme leader is abolished. This school of thought argues that political leaders should be selected based on popular election rather than appointment.6 We do not assign high odds to this scenario. Until the Assembly of Experts selects the successor, a three-member council made up of the Iranian president, the head of judiciary, and a theologian of the Guardian Council, will assume the functions of supreme leader. Such a “triumvirate” could last longer than expected, or could even be formally decided as an alternative to a new supreme leader. In the context of such extreme uncertainty for the regime’s leadership in the coming decade, it is highly unlikely that the current political leaders will engage in negotiations with President Trump until they are sure of his staying power (Chart 16). First, the Iranians will continue to refuse talks prior to the US election. They will seek to undermine the Trump administration, yet without crossing red lines on the nuclear program (one year till nuclear breakout) or militant activities (killing American citizens). Chart 15Iran’s Guardians Vet Election Candidates Market Hurdles: From Sanders To Iran Market Hurdles: From Sanders To Iran Second, if Trump wins, then the shift to negotiations may or may not come, but the subsequent diplomatic process will be prolonged. Trump will have to gain the full cooperation of Europe, Russia, and China – and any new US-Iran deal is an open question and will involve tensions flaring up more than once. Chart 16Iranians Opposed To Talks With Trump Market Hurdles: From Sanders To Iran Market Hurdles: From Sanders To Iran Third, even if the Democrats win, the regime will play “hard to get” and will not immediately return to status quo ante Trump, although eventually there could be a restoration of the 2015 Joint Comprehensive Plan of Action or something like it. This process could also involve saber-rattling despite the Democrats’ more dovish disposition toward Iran. Bottom Line: The US maximum pressure campaign is not aimed at regime change in Iran, but if it brings any political change it will be a shift in a more hawkish direction as the regime faces immense internal and external pressures and an uncertain succession in the coming years. Iran’s leaders will continue to suppress unrest and can probably succeed in the near term. The confrontation with the US discredits any political actors who advocate negotiations. The path toward reform and improved relations with the West is closed until after the US election at minimum. Since Iran will seek to undermine both President Trump and the US presence in the Middle East in the meantime, US-Iran tensions remain a market-relevant source of risk in 2020. Iraq Still Poses An Oil Supply Risk Chart 17Iraqis Suffering From Poor Governance Market Hurdles: From Sanders To Iran Market Hurdles: From Sanders To Iran Iraq is ground zero for the US-Iran showdown, since the two powers have eschewed direct military confrontation. Iraqis have also been suffering the consequences of an ill-functioning political system (Chart 17). Corruption has prevented the trickle down of oil revenues, resulting in endemic poverty and inequality (Chart 18). Yet unlike its neighbor, Iraq is not ruled by a supreme leader who controls a powerful armed forces to which anger can be directed. Instead, protesters have been blaming the deep seated influence of the Iranian regime, which often results in what Iraqis’ argue to be a prioritization of foreign – i.e. Iranian – objectives over national ones. The demonstrations were successful in forcing the resignation of Prime Minister Adel Abdul Mahdi and the passing of a new electoral law. However Iraq remains in a state of chaos as Iraqis have vowed to remain on the street until all their conditions are met, including the appointment of an acceptable prime minister and early elections. Chart 18Poverty, Inequality, Corruption Plague Iraq Poverty, Inequality, Corruption Plague Iraq Poverty, Inequality, Corruption Plague Iraq This batch of reforms has been challenging for politicians to execute. For one, there is a lack of clarity as to which political group holds the majority of seats in Iraq’s Council of Representatives. Both the Iran-backed al-Binaa bloc as well as the al-Islah coalition led by Muqtada al-Sadr claim this position (Chart 19). A list of candidates for the temporary position of prime minister until early elections are held, proposed by Binaa in December, was rejected by President Barham Salih on grounds that it did not include anyone who would possess the support of the demonstrators. Chart 19Iraqi Parliamentary Control Up For Grabs Market Hurdles: From Sanders To Iran Market Hurdles: From Sanders To Iran Iraqi protesters have consistently reiterated their desire for a sovereign state, free from both American and Iranian interference. However, this nationalistic call has been disrupted and overshadowed by the US-Iran conflict. Importantly, the protest movement has now lost its most influential backer within the Iraqi political system: Sadr of the Islah bloc. This year’s Iran tensions and the parliamentary resolution to eject US troops from Iraq have unified the warring Shia political blocs. Sadr has called on the Mahdi army – a notoriously anti-American force also known as the Peace Brigades – to re-assemble. On January 13, in what can only be interpreted as a rapprochement among the main Shia political factions, Sadr met with paramilitary leaders making up the Popular Mobilization Forces in the Iranian city of Qom. They discussed the creation of a “united resistance” and the need jointly to expel foreign troops. Sadr also called for a “million-man march” against US troops in Iraq.7 Sadr’s pivot to Iran has not gone down well in Iraq’s streets, where protesters are accusing him of putting aside national goals for his own personal aspirations. While the protest movement will keep going, it is now largely headless and competing with the unified priorities of the Shia parties. This state of affairs weakens the odds of a sovereign Iraq that curbs Iranian regional influence. The political class is more likely to turn a blind eye to the repression of protesters, which is likely to increase as the system notches up its crackdown on dissent. A return to the status quo ante in Iraq is also now more likely. A new government may be elected. It may include more technocratic politicians in a nod to the protestors, but the pro-Iranian faction has fortified its position as kingmaker. Meanwhile, Sadr has decided that reform should be postponed for a later day. Iraqis who have been camping out on the streets for nearly four months, risking their lives, are unlikely to be easily put down. Instead their frustrations will manifest in more aggressive forms, such as through violence and the sabotage of infrastructure. Saudi Arabia may or may not seek to interfere in Iraq to maintain the pressure on Iranian interests. If it does so, it risks escalating the situation and provoking retaliation from Iran. Iraqi efforts to force a US troop withdrawal will clash with US interests. President Trump wants to reduce commitments but does not want to risk anything remotely resembling a Saigon-style evacuation during an election year. As such, some form of sanctions against Iraq is possible. The US administration may pass up imposing sanctions on oil sales and instead target USD flows to Iraq’s central bank. Blocking or reducing access to Iraqi accounts at the Federal Reserve Bank in New York – to which all revenues from Iraqi oil sales are directed – would debilitate the economy and amplify the risk to stability and hence oil flows. Washington’s decision whether to renew waivers allowing Iraq to import Iranian gas – set to expire mid-February – will signal whether the events earlier this year changed the US’s calculus. Iraq is extremely dependent on Iranian gas to generate power. A decision not to extend the waivers would cause greater friction between the Iraqi street and the ruling elite.8 Bottom Line: Baghdad is getting dragged deeper into chaos. Alignment with Iran, and delays in government formation and economic reform, will aggravate tensions between the street and the political class. Dissent may take on more violent forms going forward. Middle Eastern oil supply will remain vulnerable to instability and sabotage in Iraq and the broader Persian Gulf. Investment Conclusions In the very near term we expect US equities to encounter headwinds due to the over extension of the rally and immediate risks from the US election cycle. We also see global risk appetite suffering due to US uncertainty, as well as to fears about the new coronavirus. These may reach a crescendo in the wake of Chinese New Year travel season. However, China’s stimulative policy trajectory will ultimately be reinforced due to the economic threat from the outbreak. And China’s economy is showing signs of rebounding. This reinforces our constructive view on the global business cycle overall, on commodities, and on select emerging markets that produce oil or are undertaking structural reforms. The US-Iran conflict is ongoing and we expect it to continue injecting a risk premium into oil markets. The two sides are effectively playing Russian roulette.   Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com   Roukaya Ibrahim Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com Footnotes 1 The IRGC and bonyads – para-governmental organizations that provide funding for groups supporting the Islamic Republic – have access to subsidies, favorable contracts, and cheap loans. Together they run a considerable part of the economy. 2 Questions Loom In Iran As Reformist Factions Lose Hope In Elections," dated January 23, 2020, available at en.radiofarda.com. 3 In an interview with Fars news agency in June 2019, Ayatollah Mohsen Araki, a prominent member of the Assembly of Experts, mentioned that a committee of three members from the Assembly of Experts were working on a list of prospective supreme leaders, which they will present to the full AE when necessary. Please see "Is Iran’s Next Supreme Leader Already Chosen?," dated June 18, 2019, available at en.radiofarda.com. 4 Please see "Ebrahim Raisi: The Cleric Who Could End Iranian Hopes For Change," dated January 5, 2019, available at aljazeera.com. 5 Please see “A Right-Wing Loyalist, Sadeq Larijani, Gains More Power in Iran,” dated January 8, 2019, available at atlanticcouncil.org. 6 Mohsen Kadivar, an unorthodox cleric who was forced to flee Iran due to his political views, and is now an instructor at Duke University is a critic of the system of Velayet-e Faqih, or clerical rule. He claims that since the death of Khomeini, a majority of Iran’s religious scholars hold a “secretive belief” that supreme clerical rule should be abolished as it only leads to despotism. 7 In response to Sadr’s call for a “million man march”, Ayatollah al-Sistani repeated his warning against “those who seek to exploit the protests that call for reforms to achieve certain goals that will hurt the primary interests of the Iraqi people and are not in line with their true values.” 8 The last time Iran reduced electricity exports to Iraq resulted in mass protests in Iraq in July 2018. Thus if the sanction waivers are not renewed the cutoff of gas risks a greater clash between the Iraqi street and government, especially during the hot summer months.

Highlights Global growth is poised to accelerate this year, although the spread of the coronavirus could dampen spending in the very short term. History suggests that the likelihood of a recession rises when unemployment falls to very low levels. Three channels have been proposed to explain why that is: 1) Low unemployment can prompt households and businesses to overextend themselves, making the economy more fragile; 2) Faster wage growth stemming from a tight labor market can compress profit margins, leading to less capital spending and hiring; 3) Shrinking spare capacity can fuel inflation, forcing central banks to raise rates. The first channel is highly relevant for some smaller, developed economies where housing bubbles have formed and household debt has reached very high levels. However, it is not an immediate concern in the US, Japan, and most of the euro area. We would downplay the importance of the second channel, as faster wage growth is also likely to raise aggregate demand and incentivize firms to increase capital spending on labor-saving technologies. The third channel poses the greatest long-term risk, but is unlikely to be market-relevant this year. Investors should remain bullish on global equities over the next 12-to-18 months. A more prudent stance will be warranted starting in the second half of 2021. Global Equities: Sticking With Bullish Global equities are vulnerable to a short-term correction after having gained 16% since their August lows. Nevertheless, we continue to maintain a positive outlook on stocks for the next 12 months due to our expectation that global growth will gather steam over the course of the year. The latest data on global manufacturing activity has generally been supportive of our constructive thesis. The New York Fed Manufacturing PMI beat expectations, while the Philly Fed PMI jumped nearly 15 points to the highest level in eight months. The business outlook (six months ahead) component of the Philly Fed index rose to its best level since May 2018. European manufacturing should also improve this year. Growth expectations for Germany in the ZEW index surged in January, rising to the highest level since July 2015 (Chart 1). The Sentix and IFO indices have also moved higher. Encouragingly, euro area car registrations rose by 22% year-over-year in December. In the UK, business confidence in the CBI survey of manufacturers surged from -44 in Q3 of 2019 to +23 in Q4, the largest increase in the 62-year history of the survey. Fiscal stimulus and diminished risk of a disorderly Brexit should also bolster growth this year. Chart 1Some Green Shoots Emerging In The Euro Area Some Green Shoots Emerging In The Euro Area Some Green Shoots Emerging In The Euro Area Chart 2EM Asia Is Rebounding EM Asia Is Rebounding EM Asia Is Rebounding The manufacturing and trade data in Asia have been improving. Following last week’s better Chinese trade data, Korean exports recovered on a rate-of-change basis for a fourth month in a row. Japanese exports to China increased for the first time since last February. In Taiwan, industrial production increased by more than expected in December, as did export orders. Our EM Asia Economic Diffusion Index has risen to the highest level since October 2018 (Chart 2). Coronavirus: Nothing To Sneeze At? The outbreak of the coronavirus represents a potential short-term threat to the budding global economic recovery. Conceptually, outbreaks can affect the economy in two ways. One, they can reduce demand by curtailing spending on travel, entertainment, restaurants, or anything that requires close proximity to others. Two, they can reduce supply by causing people to avoid going to work. In practice, the first effect usually dominates the second. As a result, such outbreaks tend to have a deflationary impact. The Brookings Institution estimates that the 2003 SARS epidemic shaved about one percentage point from Chinese growth that year.1 The fact that this outbreak is happening during the Chinese New Year celebrations, when over 400 million people will be on the move, has the potential to exacerbate the transmission of the virus, and in the process, amplify the economic damage. That said, while it is from the same class of zoonotic viruses, early indications suggest that this particular strain is less lethal than SARS. In addition, the Chinese authorities have moved faster to address the risks than they did during the SARS outbreak. The government has effectively quarantined Wuhan, a city of 11 million people, where the virus appears to have originated. They have also sequenced the virus and shared the information with the global medical community. This has allowed the US Centers for Disease Control (CDC) to develop a test for the virus, which is likely to become available over the coming weeks. The Dark Side Of Low Unemployment Provided the coronavirus outbreak is contained, stronger global growth should continue to soak up lingering labor market slack. This raises the question of whether, at some point, declining unemployment could become counterproductive. The outbreak of the coronavirus represents a potential short-term threat to the budding global economic recovery. The unemployment rate in the OECD currently stands at 5.1%, below the low of 5.5% set in 2007 (Chart 3). In the US, the unemployment rate has dropped to a 50-year low. Chart 3Unemployment Rates Are Below Their Pre-Crisis Lows In Most Economies Who’s Afraid Of Low Unemployment? Who’s Afraid Of Low Unemployment? No one would deny that the decline in unemployment since the financial crisis has been a welcome development. However, it does carry one major risk: Historically, the likelihood of a recession has risen when unemployment has fallen to very low levels (Chart 4). Chart 4Recessions Become More Likely When The Labor Market Begins To Overheat Who’s Afraid Of Low Unemployment? Who’s Afraid Of Low Unemployment? Three channels have been proposed to explain this positive correlation: 1) Low unemployment can prompt households and businesses to overextend themselves, making the economy more fragile; 2) Faster wage growth stemming from a tight labor market can compress profit margins, leading to less capital spending and hiring; 3) Shrinking spare capacity can fuel inflation.  This can force central banks to raise rates, choking off growth. Let’s examine each in turn. Unemployment And Irrational Exuberance Chart 5Growing Housing Imbalances In Some Economies Growing Housing Imbalances In Some Economies Growing Housing Imbalances In Some Economies A strong economy promotes risk-taking. While some risk-taking is essential for capitalism, an excessive amount can lead to the buildup of imbalances, thereby setting the stage for an eventual downturn. In Australia, New Zealand, Canada, and the Scandinavian economies, the combination of low interest rates and strong economic growth has stoked debt-fueled housing bubbles (Chart 5, panel 3). As we discussed last week, higher interest rates in those economies could sow the seeds for economic distress.2 In most other countries, financial imbalances are not severe enough to trigger recessions. Chart 6 shows that the private-sector financial balance – the difference between what the private sector earns and spends – still stands at a healthy surplus of 3.4% of GDP in advanced economies. In 2007, the private-sector financial balance fell to 0.4% in advanced economies, reaching a deficit of 2% in the US. The private-sector balance also deteriorated sharply in the lead-up to the 2001 recession (Chart 7). Chart 6The Private Sector Spends Less Than It Earns In Most Economies Who’s Afraid Of Low Unemployment? Who’s Afraid Of Low Unemployment? Chart 7The Private-Sector Surplus Is Larger Than It Was Before The End Of Previous Expansions The Private-Sector Surplus Is Larger Than It Was Before The End Of Previous Expansions The Private-Sector Surplus Is Larger Than It Was Before The End Of Previous Expansions   In the US, the personal savings rate has risen to nearly 8%, much higher than one would expect based on the level of household net worth (Chart 8). Despite growing at around 2.5% in 2018/19, real personal consumption has increased at a slower pace than predicted by the level of consumer confidence. This suggests that households have maintained a fairly prudent disposition. Consistent with this, the ratio of household debt-to-disposable income has declined by 32 percentage points since 2008. Chart 8Households Are Saving More Than One Would Expect Households Are Saving More Than One Would Expect Households Are Saving More Than One Would Expect Granted, some credit categories have seen large increases (Chart 9). Student debt has risen to 9% of disposable income. Auto loans have moved back to their pre-recession highs. We would not worry too much about the former, as the vast majority of student debt is guaranteed by the government. Auto loans are more of a concern. However, it is important to keep in mind that the auto loan market is less than one-sixth as large as the mortgage market. Moreover, after loosening lending standards for vehicle loans between 2011 and 2016, banks have since tightened them. This adjustment appears to be largely complete. Lending standards did not tighten any further in the latest Senior Loan Officer Survey, while demand for auto loans rose at the fastest pace in two years. The share of auto loans falling into delinquency has been trending lower, which suggests that delinquency rates are peaking (Chart 10). Chart 9US Household Debt Levels Have Fallen, Despite Increases in Student And Auto Loans US Household Debt Levels Have Fallen, Despite Increases in Student And Auto Loans US Household Debt Levels Have Fallen, Despite Increases in Student And Auto Loans Chart 10Auto Loans: Monitoring Trends In Credit Standards And Delinquency Rates Auto Loans: Monitoring Trends In Credit Standards And Delinquency Rates Auto Loans: Monitoring Trends In Credit Standards And Delinquency Rates Lastly, we would point out that despite all the hoopla over the state of the auto market, auto loan asset-backed securities have performed well (Chart 11). While default rates have risen, lenders have generally set interest rates high enough to absorb incoming losses. Chart 11Securitized Auto Loans Have Performed Well Securitized Auto Loans Have Performed Well Securitized Auto Loans Have Performed Well Will Falling Profit Margins Derail The Expansion? Profit margins usually peak a few years before the onset of a recessions (Chart 12, top panel). This has led some to speculate that falling margins could usher in a recession by curbing companies’ willingness to hire workers and invest in new capacity. Chart 12A Peak In Profit Margins: An Ominous Sign? A Peak In Profit Margins: An Ominous Sign? A Peak In Profit Margins: An Ominous Sign? While it is an interesting theory, it does not stand up to closer scrutiny. Surveys of business sentiment clearly show that capital spending intentions are positively correlated with plans to raise wages (Chart 13, left panel). Far from cutting capital expenditures in response to rising wages, firms are more likely to boost capex if they are also planning to increase labor compensation.  Chart 13AFaster Wage Growth, Increased Hiring, And More Capex Go Hand In Hand (I) Faster Wage Growth, Increased Hiring, And More Capex Go Hand In Hand (I) Faster Wage Growth, Increased Hiring, And More Capex Go Hand In Hand (I) Chart 13BFaster Wage Growth, Increased Hiring, And More Capex Go Hand In Hand (II) Faster Wage Growth, Increased Hiring, And More Capex Go Hand In Hand (II) Faster Wage Growth, Increased Hiring, And More Capex Go Hand In Hand (II) One reason for this is that rising wages make automation more attractive. By definition, automation requires more capital spending. However, that is not the entire story because firms also tend to hire more workers during periods when wage growth is rising (Chart 13, right panel). This implies that a third factor – strong economic growth – is responsible for both accelerating wages and rising hiring intentions. The fact that real business sales are strongly correlated with both employment growth and nonresidential investment is evidence for this claim (Chart 12, bottom panel). Falling Margins: A Symptom Of A Problem The discussion above suggests that faster wage growth is unlikely to dissuade firms from either hiring more workers or boosting capital spending. Indeed, the opposite is probably true: Since workers normally spend more of every dollar of income than firms do, an increase in the share of national income flowing to workers will lift aggregate demand. So why do profit margins usually peak before recessions? The answer is that declining labor market slack tends to push up unit labor costs, forcing central banks to hike interest rates in an effort to stave off rising inflation. Thus, falling margins are just a symptom of an underlying problem: economic overheating. Don’t blame lower margins for recessions. Blame central banks. Inflation Is Not A Threat... Yet For now, unit labor cost inflation remains reasonably well contained in the major economies (Chart 14). However, there is little evidence to suggest that the historic relationship between labor market slack and wage growth has broken down (Chart 15). Barring a major surge in productivity growth, inflation is likely to accelerate eventually as companies try to pass on higher labor costs to their customers. Chart 14AUnit Labor Costs Are Well Behaved For Now (I) Unit Labor Costs Are Well Behaved For Now (I) Unit Labor Costs Are Well Behaved For Now (I) Chart 14BUnit Labor Costs Are Well Behaved For Now (II) Unit Labor Costs Are Well Behaved For Now (II) Unit Labor Costs Are Well Behaved For Now (II)       Chart 15Correlation Between Labor Market Slack And Wage Growth Remains Intact Correlation Between Labor Market Slack And Wage Growth Remains Intact Correlation Between Labor Market Slack And Wage Growth Remains Intact We do not know exactly when such a price-wage spiral will emerge. Inflation is a notoriously lagging indicator (Chart 16). Our best guess is that inflation could become a serious risk for investors in late 2021 or 2022. Thus, investors should remain overweight global equities for the next 12-to-18 months, but be prepared to turn more cautious in the second half of 2021.  Chart 16Inflation Is A Lagging Indicator Who’s Afraid Of Low Unemployment? Who’s Afraid Of Low Unemployment?   Peter Berezin Chief Global Strategist peterb@bcaresearch.com   Footnotes 1   Jong-Wha Lee and Warwick J. McKibbin, “Globalization and Disease: The Case of SARS,” Brookings Institution, dated February 2004. 2  Please see Global Investment Strategy Weekly Report, “Bond Yields: How High Is Too High?” dated January 17, 2020.   Global Investment Strategy View Matrix Who’s Afraid Of Low Unemployment? Who’s Afraid Of Low Unemployment? MacroQuant Model And Current Subjective Scores Who’s Afraid Of Low Unemployment? Who’s Afraid Of Low Unemployment? Strategic Recommendations Closed Trades