Emerging Markets

Special Report

Highlights Pension reform in Brazil is pushing through. The upcoming 12-18 months offer a window of opportunity, most notably on the privatization and tax reform front. Ongoing efforts should sustain an improvement in “animal spirits” in the short term and create some potential for structural improvements over the long term. Nevertheless, Brazil’s slow grinding economic recovery remains vulnerable to a negative external or domestic shock that could cause it to “stall speed”. If structural reforms or the business cycle hit stall speed, financial markets will sell off. Weighing the pros and cons, we are upgrading Brazil from underweight to neutral. Feature Pension Reform Will (Eventually) Pass, But What Next? Recent progress on Brazil’s economic reform agenda is market-positive but is clearly at risk of “stall speed”1 if reform momentum is not sustained after the likely passage of social security cuts. Having cleared the Chamber of Deputies, the pension reform bill is now likely to pass the senate. The first round of voting is expected any day now and the government’s senate leader, Fernando Bezerra, expects the bill to pass the second round by mid-October (Diagram I-1). Diagram I-1Brazil: Pension Reform Timeline Chart I-1Pension Bill Will See The Light Of Day The reform is all but certain to be approved by congress, granting the Bolsonaro administration its first major legislative victory. Lower house deputies voted largely in line with party alliances – if this continues in the senate, the bill should rack up the support of at least 56 of the 81 senators – surpassing the 49 votes needed for passage (Chart I-1). We would not be surprised if the bill faced sudden hang-ups in the senate, such as delays or dilutions. The House bill was introduced in February and after some delay passed in August. Rodrigo Maia, President of the Chamber of Deputies, was instrumental in ensuring the bill’s smooth passage. While Senate President Davi Alcolumbre has a similar interest in ensuring its passage, there is no guarantee that it will be smooth. Fragmentation in the senate, for example, is at the highest level ever, unlike the lower house. The bill requires two rounds of voting. Bezerra’s expectation of voting on September 24 and October 15 is already a delay from the initial projection of September 18 and October 2. Bottom Line: Pension reform is highly likely to pass, if not as rapidly as its promoters say, and the Brazilian congress will soon need to turn to the next major item on the economic reform agenda. Tracking Bolsonaro’s Political Capital For The Post-Pension Reform Agenda Does Bolsonaro have enough political capital to pass other structural reforms? Or will he fall victim to stall speed as his policy focus shifts to less market-friendly areas, his relationship with the legislature breaks down, and his popular support continues to slide? With macroeconomic headwinds and a fragile governing coalition, the answer is a qualified yes that Bolsonaro has sufficient political capital to spend on additional reforms. But since it is impossible to know precisely what will occur after the pension reform goes through, we highlight the key signposts that we will use to monitor Bolsonaro’s progress. A fundamental premise is that neither Bolsonaro nor his party are instinctively or ideologically pro-market. He won the 2018 election due to a specific set of circumstances and popular policies. These form the four pillars of his political support: The Collapse Of The Left: The 2016 and 2018 elections wiped out the Worker’s Party, which had ruled Brazil since 2003, and swept Bolsonaro to power on a wave of deep disillusionment. The success of Bolsonaro’s right-wing Social Liberal Party (PSL), a decidedly minor party, over Fernando Haddad’s left-wing PT, one of the country’s biggest parties, highlighted Brazilians’ disenchantment after the worst recession in a century and a sprawling corruption scandal that implicated most of the political elite. Chart I-2The Left Is Still Wounded While Bolsonaro’s “honeymoon period” after election has ended, the PT has not recovered from its loss of legitimacy over the past decade. A poll conducted in late August reveals that if the 2022 election were held today, Bolsonaro would secure a sizable lead not only over the PT but also over the combined opposition (Chart I-2). Pension Reform: All of Brazil’s political elites recognize that the bloated pension system must be cut back to improve the country’s fiscal profile and debt sustainability. After the previous government failed to do so, this became a central Bolsonaro campaign promise. Consensus on pension reform has enabled him to form a majority coalition; it is among the most popular items on the government’s agenda not because people love having their pensions cut but because of the widespread perception that it is necessary and will improve Brazil’s overall economic circumstances (Chart I-3). Chart I-3Brazilians See The Value In Pension Reform Ironically, however, passing this reform will also remove this pillar of the administration’s political capital. Bolsonaro will be left with less political capital to spend on other reforms and he will face less unity within his coalition having accomplished its greatest shared goal. Thus if the bill passes yet fails to boost his approval rating, or immediately prompts him to pursue less market-friendly policies or to lose major parties from his coalition, then it is a red flag suggesting that he is a one-trick pony and will not get other major reforms done in his term. Law And Order: Bolsonaro was elected on a ticket of restoring order. The crime rate has fallen since the beginning of the year and voters will be looking for this to be sustained (Chart I-4). The fall in the crime rate and the net approval of the security environment in Brazil are positive for Bolsonaro’s credibility. However, it is not clear that his policies are directly responsible for this improvement, which means the trend could change. If crime goes up, he loses political capital to do other things. Moreover the public may not approve of his approach. As indicated by Chart I-3 above, while the population is divided over the right to possess weapons in the home, there is clear disapproval of the right to possess weapons on the street. Pursuit of an unpopular solution could diminish his support on law and order. Chart I-4A Rise In Crime Would Hurt Bolsonaro Chart I-5Moro Key For Bolsonaro Anti-Corruption Drive Corruption: The third panel of Chart I-4 also reveals that combating corruption is a key area of perceived success by the Bolsonaro administration to date. Bolsonaro won the office partly because he was seen as a clean leader during a time of pervasive corruption. His administration is also fortified by the presence of Minister of Justice Sergio Moro, who played a leading role in prosecuting corrupt figures in the Lava Jato operation. Moro is by far the most popular minister in cabinet today (Chart I-5). A decline in Moro’s popularity would be an indication that Brazilians are not satisfied with the administration’s progress on the anti-corruption front. As such it would flag declining political capital. If Moro departs the administration for any reason, that would also hurt Bolsonaro's credibility on this critical issue. Bolsonaro’s approval rating to date is very low relative to previous presidents and falling (Chart I-6). The only way this can change is if he gets credit for the pension reform and then prioritizes policies that are broadly popular rather than ideological. As mentioned, the change in the wake of pension reform will be critical to observe: polls show that the public gives the federal government and President Bolsonaro personally the most credit for improvements in Brazil (Chart I-7), but it is not clear that he will be greatly rewarded for cutting pensions. Chart I-6Will Pension Reform Passage Save Bolsonaro? Chart I-7All Credit Goes To The Bolsonaro Administration   The legislative effort has succeeded largely due to House Speaker Rodrigo Maia, a clutch player in congress. The economic liberal Maia has set aside personal differences with the leadership to shepherd economic reforms through congress. This has involved a pragmatic approach that sidelines the president’s controversial social policies and focuses on getting pro-market bills passed. Chart I-8A Weak Starting Point For PSL The political news flow from Brazil this year has been preoccupied with the rift between the legislative and executive branches. At first glance, congress looks impossible to navigate. As is typical in Brazil, congress is extremely fractured. Bolsonaro’s PSL holds only 10% of seats that belong to the 25 parties in the lower house, and only 5% of the seats that belong to the 17 parties in the upper house (Chart I-8). This is comparable to the first Cardoso administration – so it is not impossible to grow this legislative base – but it is a weak starting point. On top of that, Bolsonaro has held true to his campaign promise to shun so-called “old politics” – the granting of cabinet positions or “pork” based on congressional patronage. This reinforces his anti-corruption pillar but makes it hard to grease the wheels of legislation. The passage of the pension reform proposal through Brazil’s Chamber of Deputies shows that congress can be navigated, but it highlights Maia’s critical role. This relationship could break down after pension reform, which would reduce the government’s ability to accomplish additional reforms that require legislative approval. Maia’s third two-year term will expire at the end of next year. He technically cannot be elected for a successive term (although this rule has already been broken). This raises the threat that his successor may not be as pro-market or as successful in managing the lower house. In fact, the coming 12 to 18 months create a window of opportunity for the administration and legislature to pass bills before the 2020 local elections and the 2022 general election begin to interfere. Since the pension cuts will be back-loaded – delayed until subsequent years – voters will not immediately feel the pain of the social security changes, which will reduce the chances of a major popular backlash during this window. Provided Maia’s pragmatism continues to prevail, the government can use the pension reform to launch into another major reform initiative. Economy minister Paulo Guedes, another key pro-market player, has highlighted privatization and tax reforms as the next big issues on his agenda. The upcoming 12-18 months offer a window of opportunity for further reforms. Bottom Line: Tensions between the executive and legislative branches of government have not prevented pension reforms from passing because Bolsonaro had a fresh mandate, full political capital, and a broad consensus on the policy itself. Going forward a great deal of political capital will have been spent while consensus will have to be built for the next policy priority. House Speaker Rodrigo Maia is a clutch player, pragmatically enabling the passage of bills through congress, so his cooperation is essential. The upcoming 12-18 months offer a window of opportunity for further reforms, most notably privatization and tax reform. An Executive Way Forward On Privatization The administration’s privatization plan is overly ambitious but there is an executive path forward while the government enters a long slog in the legislature. Guedes has indicated that he wants to sell all of Brazil’s state owned enterprises to the private sector. In value terms, the government hopes to raise 1.3 trillion reals ($323 billion) in the process, about 20% of total public debt. Brazil has 418 SOEs controlled directly or indirectly by the state, both at the state and municipal levels. Of the 134 federal companies, 46 are under direct control, while the remaining 88 are under indirect control – subsidiaries of major SOEs such as Petrobras, Eletrobras, Banco do Brasil, Caixa, and BNDES. With Brazil’s public debt at 86% of GDP, profit from these sales would go toward paying down the debt and hopefully also raising GDP through gains from increased competition and efficiency. The program would also reduce the government’s interest payments – that account for 25% of government spending and 5% of GDP. Salim Mattar – Special Secretary of Privatization, Divestment and Market — argues that the interest saved will allow the government to divert funds to education and health, buoying Brazil’s human capital over the long term. The privatization of inefficient and loss-generating SOEs is positive for both the near-term and long-term outlook, but the government’s plan is completely unrealistic. Even Mattar’s significantly lower projected gains – up to 800 billion reals ($214 billion) – are likely unattainable. Although the government will easily meet its target of raising $20 billion this year,2 these sales represent the low-hanging fruit – they are the asset sales that face no or low resistance from the public and congress. On August 21, the Bolsonaro government released a list of 17 state-owned companies that it intends to privatize (Table I-1). From among the largest SOEs, – Petrobras, Eletrobras, BNDES, Banco do Brasil, and Caixa Economica Federal – only Eletrobras is on the list. The rest of the major SOEs will face greater hurdles as they have been identified as “strategic” and face greater resistance from the public (Chart I-9). In fact, although government officials expressed confidence that Eletrobras will be privatized in 2020, Senate President Davi Alcolumbre indicated that the process faces significant resistance in the senate. As such we would expect the legislature to tackle companies that are not as controversial. Table I-1Government Privatization List What is more, while congressional approval is required for the sale of SOEs, a supreme court ruling earlier this year allows the government to sell subsidiaries of its companies without approval from congress. Thus while major state companies such as Petrobras or Eletrobras are unlikely to be privatized (certainly not wholly), the government will attempt to move forward by selling non-core assets of non-strategic companies, and taking other measures to improve efficiency of operations. Chart I-9These "Strategic" SOEs Face Privatization Resistance Chart I-10Privatization Will Reduce Debt Burden Putting aside the administration’s plan to accelerate the program next year, if we project $20 billion worth of privatizations per year for the remainder of Bolsonaro’s term, the total $80 billion in total sales will bring Brazil’s debt-to-GDP ratio down to 81% from 85% (Chart I-10). Bottom Line: Although the sale of the largest “strategic” state-owned companies will not happen, the administration’s privatization program can succeed by diverting congressional efforts to non-strategic companies. The administration can also move alone on non-core assets. This is a net positive for overall productivity, competitiveness, and fiscal sustainability although it is not huge in magnitude. Less Optimism On Tax And Tariff Reform In addition to the outsized economic role of the state, Brazil has been suffering from inefficiencies due to the relatively elevated tax burden and overly complicated system (Chart I-11). This has reduced its ranking in the World Bank’s Doing Business rankings which assigns it the seventh worst spot in paying taxes (Chart I-12). The nearly six thousand laws governing taxes in Brazil likely hold back the country’s FDI potential and encourages tax evasion. Chart I-11Brazilians Suffer From Outsized Tax Burden … Chart I-12… Contributing To An Unattractive Business Environment Given Brazil’s poor fiscal standing and large debt load, there is no room to reduce taxes. Rather, reform efforts are centered around simplifying the tax code in order to improve the investment environment. A complete overhaul requires the approval of three-fifths of congress. Pension reform shows this is theoretically possible, but the process will be lengthy and unlikely to occur before the second half of next year. There are currently four main proposals being considered. All aim to simplify the tax system by combining all current taxes imposed on consumption into a single tax. The proposal most advanced in the legislative process enjoys the support of Maia and has already been deemed lawful by a lower house committee. It recommends applying the single tax rate uniformly across all states. Bolsonaro’s administration is also designing its own reform proposals, but has yet to release details. As revealed by the firing of special secretary to Brazil’s federal revenue service Marcos Cintra on September 11, the cabinet is in conflict over the reintroduction of a financial transactions tax, such as the CPMF which expired in 2007. Chart I-3 above illustrates that the tax is generally unpopular, causing Bolsonaro to be staunchly against the tax, while Guedes has indicated that it should be part of the reform. The proposal is expected to be put to lawmakers in a congressional committee responsible for drafting the bill by October 8 before being introduced to the lower house. However, given that the financial transactions tax is unpopular and a point of contention in the administration, the timeline will likely be delayed. Moreover the legislative approval process will be lengthy. While Bezerra Coelho does not expect tax reform to be approved until the second half of 2020, this is an optimistic assessment. Given the complexity of overhauling the tax system, we expect a one-year process at minimum and therefore doubt that approval will come in 2020. Instead modifications to the current system may be easier to enact and implement. Guedes has also signaled the need for a reduction in Brazil’s extremely elevated import tariffs which have been erected amid a policy of import substitution (Chart I-13). With most tariffs in the range of 10% and 35%, Guedes has stated that the government plans to reduce tariffs by 10 percentage points during Bolsonaro’s four year term by cutting the rate by one percentage point in the first year, two in the second, three in the third, and four in the fourth. This can be done by executive action and does not require legislation. What about Bolsonaro's trade liberalization push? On the campaign trail, Bolsonaro expressed his intention to step back from Mercosur and instead prioritize bilateral trade with rich countries such as the United States. However, given the importance of the bloc to Brazilian trade, the reality is that Bolsonaro cannot afford to neglect these countries (Chart I-14). The recently agreed EU-Mercosur trade deal, 20 years in the making, could create opportunities for Brazil over the long-run, but it is being held up by European countries as appetite for free trade deals becomes politically problematic across the world. Chart I-13Elevated Tariff Rate Hurts Brazil's Competitiveness Chart I-14Trade Surplus With Mercosur Is Reliable While greater integration with global trade will increase Brazil’s market access – a positive for exports – it also results in increased competition and a threat to existing companies that are unable to compete at an international level over the near term. Thus it is not immediately clear whether trade liberalization will generate net gains for Brazil’s economy in the short term. If Bolsonaro and Guedes do not move immediately, they will have to pause these efforts in the 2021 lead up to the 2022 election. Moreover the Mercosur agreement, as well as Brazil’s general bilateral trade with Argentina, are at risk if opposition leader Alberto Fernandez wins the presidential election on October 27. A return to protectionist policies by Argentina could harm Brazilian exports and threaten progress on the Mercosur trade bloc. There is more reason to be optimistic about privatization than about tax reform or trade liberalization. Bottom Line: There is more reason to be optimistic about privatization efforts than about the passage of a major overhaul to Brazil’s tax system or the integration of Brazil with global markets. Nevertheless, ongoing efforts should sustain an improvement in “animal spirits” in the short term and create some potential for structural improvements over the long term. The Economy: A Stall Speed Risk Chart I-15A Slow Grinding Recovery The Brazilian economy is en route to recovery, albeit a slow one. The level of economic activity is still well below its pre-recession level but is grinding slowly back (Chart I-15). The key economic risk is stall speed. Like an aircraft, if the pace of growth falls below stall speed, gravity forces will overwhelm, and the economy will descend into a recession. In the case of Brazil, gravity forces refer to indebtedness – public debt, household debt servicing costs and corporate foreign currency debt. The path of least resistance for the business cycle is up and bullishness on Brazil is pervasive in the global investment community. Nevertheless, the economy remains very fragile. At the current juncture, while acknowledging that odds for the positive outlook to pan out are reasonably high, we would like to emphasize that gravity forces remain acute in Brazil. While odds for the positive outlook to pan out are high, gravity forces remain reasonably acute. Weakening narrow money growth fore shadows a weaker pace of nominal and real economic activity (Chart I-16). Brazilian households have increasingly relied on credit cards and revolving credit lines to finance their consumption in recent years. These types of credit carry high interest rates. Consequently, at 21% of disposable income, household debt servicing remains very elevated despite a large reduction in bond yields and policy rates (Chart I-17). Chart I-16Is Growth About To Stall? Chart I-17Household Servicing Costs Remain Elevated Private banks have experienced a modest uptick in non-performing loans (NPLs) (Chart I-18). This may incentivize private banks to moderate credit growth. With public banks deleveraging or shrinking their balance sheets, any moderation in private bank lending could stall the pace of growth in the economy. Interestingly, all-time low bond yields and the Selic rate have not yet translated into a meaningful recovery in real estate prices and new construction launches remain anemic (Chart I-19). Chart I-18Private Banks NPLs And Credit Growth Chart I-19Weak Property Market Despite Low Interest Rates   Fiscal policy is straightjacketed by the spending cap rule, which indexes government spending to the rate of inflation of the previous year. Nominal fiscal spending will grow only 4.3% this year and will expand by a mere 3.4% in 2020. Foreign debt obligations (FDO) – the sum of short-term claims, interest payments and amortization over the next 12 months – stand at $180 billion, equivalent to 78% of Brazil’s annual exports (Chart I-20).  The current account deficit will continue widening if domestic demand and, consequently, imports recover. Foreign funding requirements – FDO plus the current account balance – are substantial, standing at $250 billion (Chart I-21). If portfolio flows to EM are disturbed, Brazil will feel the pain. Chart I-20Foreign Debt Obligation Are Elevated Chart I-21Brazil Has Large Funding Gap... Chart I-22...With Exports Contracting With export growth contracting by double digits on both a value and volume basis (Chart I-22), the demand vesus supply of dollars in Brazil will likely keep the greenback well bid versus the Brazilian real. The nation’s pension bill is a very positive and much-needed step in the structural reform process. However, in its current form, it is insufficient to make public debt dynamics sustainable – i.e., halt the rise in the government debt-to-GDP ratio. Bottom Line: The path of least resistance for the business cycle is up. However, the economy remains very fragile. A negative external or domestic shock could cause the Brazilian economy to stall speed. Barring such negative shocks, the economy will continue its recovery. Have Financial Markets Reached Escape Velocity? Financial markets are vulnerable to the risk of stall speed on both the structural reforms and economic growth fronts. This is especially true now that equity and bond prices have risen substantially. If the pace of structural reforms or the economy fall victim to stall speed, financial markets will tumble. On the contrary, if the reform agenda progresses and economic growth accelerates, financial markets will reach escape velocity and sustain their bull markets. Apart from the outlook for both structural reforms and the business cycle, the largest risks to Brazil’s financial markets are as follows: BCA’s Emerging Markets Strategy team expects base metals and energy prices to decline further, weighing on EM currencies. The main culprit is weakening Chinese demand. This scenario entails non-negligible odds of Brazilian real depreciation because the latter has historically been positively correlated with commodity prices (Chart I-23). Brazil has become a net exporter of oil, so lower crude prices are negative for the currency. Importantly, the real is not cheap based on the real effective exchange rate (Chart I-24). Chart I-23Commodity Prices Hold The Key Chart I-24Real Valuations Are Not Yet Attractive The gap between local currency and U.S. dollar bond yields has narrowed to a record low. This along with the large overhang of corporate foreign currency debt, as discussed above, is already encouraging debt swap - corporates borrow in reals to repay their foreign currency debt. These capital outflows from residents will continue weighing on the exchange rate. A widening current account deficit has historically foreshadowed lower share prices in U.S. dollar terms (Chart I-25). Finally, local bond yields, and sovereign and corporate spreads have plummeted despite currency depreciation. Such resilience by fixed-income markets to currency depreciation is historically unprecedented. It remains to be seen if yields and credit spreads can remain low if the currency breaks down. Bottom Line: Barring stall speed in structural reforms and economic growth, downside in Brazilian asset prices is limited. However, near-term volatility is likely as the nation’s financial markets are overbought and investor sentiment is very bullish. Besides, equity prices in dollar terms have not broken above important technical resistance levels, as shown in Chart I-26. Hence, we can say the bull market in the Bovespa in dollar terms has not yet reached escape velocity. Chart I-25The Current Account Is A Risk To Share Prices Chart I-26The Bovespa In Dollar Terms Has Not Reached Escape Velocity Investment Recommendations Weighing the pros and cons, we recommend upgrading Brazil from underweight to neutral for dedicated EM equity, credit and domestic bond portfolios. Given the potential risks discussed above, we are looking for a better entry point to upgrade Brazil to overweight. We upgraded Brazil to overweight on October 9, 2018 following the first round of presidential elections but downgraded it on April 4, 2019 when volatility began rising. In retrospect, that was the wrong decision. Volatility could rise but there is a basis for giving the administration the benefit of the doubt as long as it remains committed to pro-market reforms. Chart I-27Real Estate Stocks Offer An Opportunity For long-term absolute return investors the key risk is the exchange rate. Hence, these investors should adopt a positive long-term bias for local currency returns but hedge currency risk periodically. Currently, global financial markets are in a juncture where the dollar will likely move higher and the Brazilian real will depreciate. Hence, investors already invested in Brazil should hedge exchange rate risk. Within the Brazilian equity universe, BCA’s Emerging Markets Strategy service favors real estate because low nominal and real interest rates are bullish for the property sector. The latter was devastated during the recession and has not yet recovered (Chart I-27). Consequently, for long-term investors, we continue recommending Brazilian real estate plays/assets on dips. Footnotes   1      "Stall speed" is the velocity below which an aircraft will descend, or 'stall', regardless of its angle of attack. If an aircraft's airspeed is greater than the stall speed then the pilot can increase the aircraft's angle of attack to achieve additional lift. 2      So far in 2019 the government has already sold off $12.3 billion worth of assets from Petrobras, $4.9 billion in shares held in various companies, and gained $1.9 billion from leases on airports, railways and ports.

Highlights President Trump’s support among Republicans and lack of smoking gun evidence will prevent his removal from office. Trade risk will increase if Trump’s approval benefits from impeachment proceedings and the U.S. economy is resilient. Political risk on the European mainland is falling. However, watch out for Russia and Turkey, and short 10-year versus 2-year gilts. A new election in Spain may not resolve the political deadlock. Book gains on our Hong Kong Hang Seng short. Feature Impeachment proceedings against U.S. President Donald Trump, the brazen Iranian attack on Saudi Arabia, the persistence of trade war risk, and additional weak data from China and Europe all suggest that investors should remain risk averse for now. Specifically, Trump’s impeachment could drive him to seek distractions abroad – abandoning the tactical retreat from aggressive foreign and trade policy that had only just begun. Geopolitical risk outside of the hot spots is falling, especially in Europe. The risk of a no-deal Brexit has collapsed in line with our expectations. Italy and Germany have pleased markets by providing some fiscal stimulus sans populism. In France, President Emmanuel Macron’s popularity is recovering. And – as we discuss in this report – Spain’s election will not add any significant fear factor. In what follows we introduce a new GeoRisk Indicator, review the signal from all of our indicators over the past month, and then focus on Spain. Fear U.S. Politics, Not Impeachment The House Democrats’ decision to impeach Trump gives investors another reason to remain cautious on risk assets. Why not be bullish? It is true that impeachment without smoking gun evidence increases Trump’s chances of reelection, which is market positive relative to a Democratic victory. President Trump is virtually invulnerable to Democratic impeachment measures as long as Republicans continue to support him at a 91% rate (Chart 1). Senators will not defect in these circumstances, so Trump will not be removed from office. Trump is invulnerable to impeachment measures as long as GOP support remains high. Moreover the transcript of his phone conversation with Ukrainian President Volodymyr Zelenskiy did not produce a bombshell: there is no explicit quid pro quo in which President Trump suggests he will withhold military aid to Ukraine in exchange for an investigation into former Vice President Joe Biden’s and his son Hunter’s doings involving Ukraine. Any wrongdoing is therefore debatable, pending further evidence. This includes evidence beyond the “whistleblower’s complaint,” which suggests that the Trump team attempted to stifle the transcript of the aforementioned phone call. The point is that the grassroots GOP and Senate are the final arbiters of the debate. The problem is that scandal and impeachment will still likely feed equity market volatility (Chart 2). The House Democrats could turn up new evidence now that they are fully focused on impeachment and hearing from whistleblowers in the intelligence community. Chart 1GOP Not Yet Willing To Impeach Trump Impeachment also has a negative market impact via the Democratic Party’s primary election. Elizabeth Warren has not dislodged Biden in the early Democratic Primary yet. Chart 2Impeachment Proceedings Likely To Raise Vol If she does, it will have a sizable negative impact on equity markets, as President Trump will still be only slightly favored to win reelection. Under any circumstances, this election will be extremely close, it has significant implications for fiscal policy and regulation, and therefore it will create a lot of uncertainty between now and November 2020. The whistleblower episode has if anything aggravated this uncertainty. As mentioned at the top of the report, if impeachment proceedings ever gain any traction they could drive Trump to seek distractions abroad – abandoning the tactical retreat from aggressive foreign and trade policy that had only just begun. Finally, Trump’s reelection, while more market-friendly than the alternative and likely to trigger a relief rally, is not as bullish as meets the eye. Trump’s policies in the second term will not be as favorable to corporates as in the first term. Unshackled by electoral concerns yet still facing a Democratic House, Trump will not be able to cut taxes but he will be likely to conduct his foreign and trade policy even more aggressively. This is not a market-positive outlook, regardless of whether it is beneficial to U.S. interests over the long run. Bottom Line: President Trump’s approval among Republican voters is the critical data point. Unless they abandon faith, the senate will not turn, and Trump’s support may even go up. But this is not a reason to turn bullish. The coming year will inevitably see a horror show of American political dysfunction that will lead to volatility and potentially escalating conflicts abroad. Introducing … Our Sino-American Trade Risk Indicator This week we introduce a new GeoRisk Indicator for the U.S.-China trade war (Chart 3). The indicator is based on the outperformance of overall developed market equities relative to those same equities that have high exposure to China, and on China’s private credit growth (“total social financing”). As our chart commentary shows, the indicator corresponds with the course of events throughout the trade war. It also correlates fairly well with alternative measures of trade risk, such as the count of key terms in news reports. Chart 3Trade Risk Will Go Up From Here As we go to press, our indicator suggests that trade-war related risk is increasing. Over the past month Trump has staged a tactical retreat on foreign and trade policy in order to control economic risks ahead of the election. Our indicator suggests this is now priced. The problem is that Trump’s re-election risk enables China to drive a harder bargain, which is tentatively confirmed by China’s detainment of a FedEx employee (signaling it can trouble U.S. companies) and its cancellation of a tour of farms in Montana and Nebraska. These were not major events but they suggest China smells Trump’s hesitation and is going on the offensive in the negotiations. Principal negotiators are meeting in early October for a highly significant round of talks. If these result in substantive statements of progress – and evidence that the near-finished draft text from April is being completed – they could set up a summit between Presidents Xi Jinping and Donald Trump in November at the APEC summit in Santiago, Chile. At this point we would need to upgrade our 40% chance that a deal is concluded by November 2020. If the talks do not conclude with positive public outcomes then investors should not take it lightly. The Q4 negotiations are possibly the last attempt at a deal prior to the U.S. election. If there is no word of a Trump-Xi summit, it will confirm our pessimistic outlook on the end game. U.S.-China trade talks are unlikely to produce a durable agreement. Ultimately we do not believe that the U.S.-China trade talks will produce a conclusive and durable agreement that substantially removes trade war risk and uncertainty. This is especially the case if financial market and economic pressure – amid global monetary policy easing – is not pressing enough to force policymakers to compromise. But we will watch closely for any signs that Trump’s tactical retreat is surviving the impeachment proceedings and eliciting reciprocation from China, as this would point to a more sanguine outlook. Bottom Line: As long as the president’s approval rating benefits from the Democratic Party’s impeachment proceedings, and the U.S. economy is resilient, as we expect, Trump can avoid any capitulation to a shallow deal with China. Trade risk could go up from here. By the same token, impeachment proceedings could eventually force Trump to change tactics yet again and stake out a much more aggressive posture in foreign affairs. If impeachment gains traction, or a bear market develops, he could become more aggressive than at any stage in his presidency – and this aggression could be directed at China (or Iran, North Korea, Venezuela, or another country). The risk to our view is that China accepts Trump’s trade position in order to win a reprieve for its economy and the two sides agree to a deal at the APEC summit. European Risk Falls, While Russian And Turkish Risk Can Hardly Fall Further Elsewhere our measures of geopolitical risk indicate a decrease in tensions for a number of developed and emerging markets (see Appendix). In Germany, risk can rise a bit from current levels but is mostly contained – this is not the case in the United Kingdom beyond the very short run. In Russia and Turkey, risk can hardly fall further. Take, for starters, Germany, where political risk declined after Chancellor Angela Merkel’s ruling coalition agreed to a 50 billion euro fiscal spending package to battle climate change. This agreement confirms our assessment that while German politics are fundamentally stable, the administration will be reactive rather than proactive in applying stimulus. Europe will have to wait for a global crisis, or a new German government, for a true “game changer” in German fiscal policy. Perhaps the Green Party, which is surging in polls and as such drove Merkel into this climate spending, will enable such a development. But it is too early to say. Meanwhile Merkel’s lame duck years and external factors will prevent political risk from subsiding completely. We see the odds of U.S. car tariffs at no higher than 30%, at least as long as Sino-American tensions persist. By contrast, the United Kingdom’s political risks are not contained despite a marked improvement this month. The Supreme Court’s decision on September 25 to nullify Prime Minister Boris Johnson’s prorogation of parliament drove another nail into the coffin of his threat to pull the country out of the EU without a deal. This was a gambit to extract concessions from the EU that has utterly flopped.1 Since it was the most credible threat of a no-deal exit that is likely to be mounted, its failure should mark a step down in political risk for the U.K. and its neighbors. However, paradoxically, our GeoRisk indicator failed to corroborate the pound’s steep slide throughout the summer and now, as no-deal is closed off, it has stopped falling. The reason is that the pound’s rate of depreciation remained relatively flat over the summer, while U.K. manufacturing PMI – one of the explanatory variables in our indicator – dropped off much faster as global manufacturing plummeted. As a result, our indicator registered this as a decrease in political risk. The world feared recession more than it feared a no-deal Brexit – and this turned out to be the right call by the market. But the situation will reverse if global growth improves and new British elections are scheduled, since the latter could well revive the no-deal exit risk, especially if the Tories are returned with thin majority under a coalition. The truth is that the Brexit saga is far from over and the U.K. faces an election, a possible left-wing government, and ultimately resilient populism once it becomes clear that neither leaving nor staying in the EU will resolve the middle class’s angst. Our long GBP-USD recommendation is necessarily tactical and we will turn sellers at $1.30. In emerging markets, Russia and Turkey have seen political risk fall so low that it is hard to see it falling any further without some political development causing an increase. Based on our latest assessment, Turkey is almost assured to see a spike in risk in the near future. This could happen because of the formation of a domestic political alliance against President Recep Erdogan or because of the increase in external risks centering on the fragile U.S.-Turkey deal on Syria. Tensions with Iran could also produce oil price shocks that weaken the economy and embolden the opposition. As for Russia, our base case is that Russia will continue to focus internal domestic problems to the neglect of foreign objectives, which helps geopolitical risk stay low. With U.S. politics in turmoil and a possible conflict with Iran on the horizon, Moscow has no reason to attract hostile attention to itself. Nevertheless Moscow has proved unpredictable and aggressive throughout the Putin era, it has no real loyalty to Trump yet could fall victim to the Democrats’ wrath, and it has an incentive to fan the flames in the Middle East and Asia Pacific. So to expect geopolitical risk to fall much further is to tempt the fates. Bottom Line: European political risk is falling, but Merkel’s lame duck status and trade war make German risk likely to rise from here despite stable political fundamentals. The United Kingdom still faces generationally elevated political risk despite the happy conclusion of the no-deal risk this summer. Go short 10-year versus 2-year gilts. Russia should remain quiet for now, but Turkey is almost guaranteed to experience a rise in political risk. Spain: Election Could Surprise But Risks Are Low Spanish voters will head to the polls on November 10 for the fourth time in four years after political leaders failed to reach a deal to form a permanent government. The Spanish Socialist Workers’ Party (PSOE) has served as a caretaker government after winning 123 out of 350 seats in the snap election in April. A new Spanish election will not resolve the current political deadlock. Prime Minister and PSOE leader Pedro Sanchez failed to be confirmed in July, and has since attempted to make a governing deal with the left-wing, anti-establishment party Podemos. However, PSOE is not looking for a full coalition but merely external support to continue governing in the minority. Hence it is only offering Podemos non-ministerial agencies (rather than high-level cabinet positions) in negotiations, leaving Podemos and other parties ready for an election. The outcome of the upcoming election may not differ much from the April election. The Spanish voter is not demanding change. Unemployment and underemployment have been decreasing, and wage growth has been positive since 2014 (Chart 4). In opinion polls, support for the various parties has not shifted significantly (Chart 5, top panel). PSOE is still leading by a considerable gap. Chart 4Spanish Voter Is Not Demanding Change However, the election will increase uncertainty at an inconvenient time, and it could produce surprises. PSOE’s support has slightly decreased since late July, when negotiations with Podemos started falling apart. Chart 5Not Much Change In Polls... Even if PSOE and Podemos form a governing pact, their combined popular support is not significantly higher than the combined support for the three main conservative parties. These are the Popular Party, Ciudadanos, and Vox (Chart 5, bottom panel) – which recently showed they can work together by making a governing deal to rule the regional government in Madrid. Chart 6…But Lower Turnout Could Hurt The Left The Socialist Party hopes to capture borderline voters from Ciudadanos, namely those who are skeptical towards the party’s right-wing populist shift and hardening stance regarding Catalonia. However, even capturing as many as half of Ciudadanos’ voters would place PSOE support at ~37% – far short of what is needed to form a single-party majority government. Another factor that can hurt PSOE is voter turnout. Spanish voters have been less and less interested in supporting any party at all since the April election. A decrease in turnout would hurt left-wing parties the most, given that voters blame Podemos and PSOE more than PP and Ciudadanos for the failure to form a government (Chart 6). The most likely outcomes are the status quo, or a PSOE-Podemos alliance. But a conservative victory cannot be ruled out. In the former two cases, the implication is slightly more positive fiscal accommodation that is beneficial in the short-term, but at the risk of a loss of reform momentum that has long-term negative implications. To put this into context, Spanish politics remains domestic-oriented, not a threat to European integration. Voters in Spain are some of the most Europhile on the continent, both in terms of the currency and EU membership (Chart 7). Spain is a primary beneficiary of EU budget allocations, along with Italy. Even Spain’s extreme right-wing party Vox is not considered to be “hard euroskeptic.” Within Spain, however, political polarization is a problem. Inequality and social immobility are a concern, if not as extreme as in Italy, the U.K., or the United States. Moreover the Catalan separatist crisis is divisive. While a new Catalonian election is not scheduled until 2022, the pro-independence coalition of the Republican Left of Catalonia and Catalonia Yes has been gaining momentum in the polls, and Ciudadanos’s support plummeted since the party hardened its stance on Catalonia earlier this year (Chart 8). Catalonia is by no means going independent – support for independence in the region peaked in 2013 – but it remains a driving factor in Spanish politics. Chart 7Spaniards Love Europe Chart 8Catalonia Is A Divisive Issue In the very short term, election paralysis introduces fiscal policy crosswinds. On one hand, regional governments may be forced to cut spending. The regions were expecting to receive EUR 5 billion more than last year, which was promised to be spent in part on healthcare and education. Until a stable (or at least caretaker) government can approve a 2019 budget, the regions will base their 2019 budgets on last year’s numbers, meaning they will have to cut any projected increases in spending. Yet on the other hand, the budget deficit will widen as taxes fail to be collected. In late 2018 Spain approved increases in pensions, civil servants’ salaries, and minimum wage by decree, but any corresponding revenue increases that were to be implemented in the 2019 budget will fail to materialize until government is in place, putting upward pressure on the deficit. Beyond the election the trend should be slightly greater fiscal thrust due to the continental slowdown. Spain has some fiscal room to play with – its budget deficit is projected to decrease to 2% in 2019 and 1.1% in 2020.2 The more conservative estimate by the European Commission forecasts the 2019 and 2020 deficits to be 2.3% and 2%, respectively (Chart 9). This means that Spain can provide roughly 10-15 billion euros worth of additional stimulus in 2020 without so much as hinting at triggering Excessive Deficit Procedures, a welcome change after nearly a decade of austerity. The risk is that Spain’s structural reform momentum could be lost with negative long-term consequences. In 2012 Spain undertook painful labor and pension reforms that underpinned its impressive economic recovery. The economy continues to grow faster than the average among its peers, unemployment has fallen by 12% in the past six years, and export competitiveness has had one of the sharpest recoveries in Europe since 2008 (Chart 10). This recovery has now begun to slow down, and the current political deadlock means that reforms could be rolled back farther than the market prefers. Chart 9Spain Has Some Fiscal Room This is more likely to be avoided if a surprise occurs and the conservatives come back into power, although that would also mean less accommodative near-term policies. Chart 10Recovery Starting To Slow Bottom Line: Our geopolitical risk indicator is signaling subdued levels of risk for Spain. This is fitting as the election may not change anything and at any rate the country will remain in an uneasy equilibrium. Politics are fundamentally more stable than in the populist-afflicted developed countries – the U.S., U.K., and Italy. However, an outcome that produces a left-wing government will lead to greater short-term fiscal accommodation at the expense of Spain’s recent outstanding progress on structural reforms. Housekeeping We are booking gains on our Hong Kong Hang Seng short. Unrest is not yet over, but is about to peak as we approach October 1, the National Day of the People’s Republic of China, and Beijing will look to avoid an aggressive intervention.   Ekaterina Shtrevensky, Research Analyst ekaterinas@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 The Supreme Court deemed Johnson’s government’s prorogation of parliament an unlawful frustration of parliament’s role as sovereign lawgiver and government overseer without reasonable justification. The court was larger than usual, with 11 judges, and they ruled unanimously against the prorogation. We had expected the vote at least to be narrow – given the historic uses of prorogation, the fact that parliament still had time to act prior to October 31 Brexit Day, and the prime minister’s historical authority over foreign affairs and treaties. But the Supreme Court has risen to fill the power vacuum created by parliament’s paralysis amid the Brexit saga; it has “quashed” what might have become a neo-Stuart precedent that prime ministers can curtail parliament’s role at important junctures. The pragmatic, near-term consequence is the reduction in the political and economic risks of a no-deal exit; but the long-term consequence may be the rise of the judiciary to greater prominence within Britain’s ever-evolving constitutional system. 2 Please see “Stability Programme Update 2019-2022, Kingdom of Spain,” available at www.ec.europa.eu. U.K.: GeoRisk Indicator France: GeoRisk Indicator Germany: GeoRisk Indicator Spain: GeoRisk Indicator Italy: GeoRisk Indicator Russia: GeoRisk Indicator Turkey: GeoRisk Indicator Brazil: GeoRisk Indicator Taiwan: GeoRisk Indicator Korea: GeoRisk Indicator What's On The Geopolitical Radar? Section III: Geopolitical Calendar

Highlights We are upgrading Indian stocks from underweight to neutral within an EM equity portfolio. Nevertheless, the outlook for the absolute performance of Indian share prices remains downbeat. Odds are that local bond yields will rise due to a widening budget deficit. Higher bond yields and still depressed growth will overwhelm the one-off positive effect of corporate tax cuts on equity prices. Feature The unexpected extraordinary measure was adopted because growth in the Indian economy has downshifted drastically. The Indian government resorted to an unexpected large corporate income tax cut last week. The government reduced the effective corporate tax rate from 35% to around 25%. What are the investment implications of this dramatic policy change? Why The Extraordinary Measure? The unexpected extraordinary measure was adopted because growth in the Indian economy has downshifted drastically: Household discretionary spending is shrinking (Chart I-1). Measures of capital spending by enterprises are extremely weak, and in many cases are also contracting (Chart I-2). Chart I-1India: Household Discretionary Spending Is Contracting Chart I-2India: Capital Spending Is In The Doldrums Earnings per share for the top 500 listed Indian companies are down 8% from a year ago in local currency terms (Chart I-3). Core measures of inflation are low (Chart I-4). Chart I-3Indian Corporate Earnings Are Contracting Chart I-4Inflation Is Extremely Subdued The central bank has been cutting interest rates, but borrowing costs in real terms remain elevated. The reason is that inflation has dropped, pushing lending rates higher in real (inflation-adjusted) terms (Chart I-5). Besides, corporate borrowing costs (local currency BBB corporate bond yields) are above nominal GDP growth (Chart I-6). This implies that borrowing costs are not at levels conducive for capital expenditure outlays among businesses. The government’s decision to cut corporate income taxes drastically is the right policy decision in the current environment. Policymakers are hoping businesses will in turn invest and a virtuous economic cycle will unfold. Chart I-5Real Rates Are High And Rising Chart I-6Borrowing Rates Are High Relative To Nominal Growth Chart I-7Commercial Bank Lending: Public Vs. Private Finally, lenders are still licking their wounds from non-performing loans. Public banks have undergone retrenchment, non-bank finance companies are currently shrinking their balance sheets and private banks could be the next in line to reduce their pace of credit origination (Chart I-7). Realizing that gradual reduction in the central bank’s policy rates is unlikely to boost growth in the near term, authorities have resorted to fiscal policy to stimulate. India is an underinvested country and capital spending holds the key to its long-term growth potential. Therefore, the government’s decision to cut corporate income taxes drastically is the right policy decision in the current environment. Policymakers are hoping businesses will in turn invest and a virtuous economic cycle will unfold.  A pertinent question for investors, however, is whether these policy measures will put a floor under share prices now or if a better buying opportunity lies ahead. Local Bond Yields Hold The Key To Stock Prices If government and corporate local bond yields rise materially in response to this fiscal stimulus, share prices will struggle. Chart I-8High Borrowing Costs Are Negative For Stock Prices If domestic bond yields rise materially in response to this fiscal stimulus, share prices will struggle. In contrast, if local bond yields remain close to current levels, equity prices will fare well, especially relative to the EM benchmark (Chart I-8). Critically, stock prices are much more sensitive to interest rates and long-term growth expectations than to next year’s profits or dividends.1 The reduction in corporate taxes is a one-off event that will boost earnings and possibly dividends next year, but only next year. If interest rates rise or expectations of long-term nominal growth moderate, a one-off rise in corporate profits will not be sufficient to justify higher equity valuations. On the contrary, higher interest rates or lower nominal growth expectations will overwhelm the positive effect of one-off rise in corporate profits next year. As a result, the fair value of equities will drop, not rise. Bottom Line: Local currency bond yields and long-term growth expectations are much more important for equity valuations than the one-off rise in corporate earnings. The Outlook For Domestic Bonds Why would local bond yields spike amid lingering weak growth and very low inflation? The primary reason is a sharply widening fiscal deficit, instigating a need to increase issuance of government bonds. The central government’s overall fiscal deficit was 3.7% of GDP prior to the latest corporate tax cut. Combined with state governments, the aggregate fiscal deficit is around 6% of GDP. Going forward, the central budget deficit will considerably exceed the government’s 3.3% of GDP forecast for this fiscal year. On top of the corporate tax reductions, government revenue growth has been plunging and will continue to drop until at least the end of the current fiscal year – March 2020 – due to very sluggish nominal growth. Chart I-9India: Money Creation Versus The Fiscal Deficit If broad money creation by commercial banks falls short of the aggregate fiscal deficit (which is equivalent to net government bond issuance), bond yields will come under upward pressure. Chart I-9 shows that as the aggregate fiscal deficit surges, the incremental increase in broad money supply might not be sufficient to absorb the widening deficit.  Barring banks’ large purchases of bonds, this would entail that there is less financing available for both the public and private sectors. This would push bond yields higher. There are rising odds that new bond issuance is unlikely to be easily absorbed by the market. At 28% of deposits, banks’ holdings of government bonds are already well above the statutory minimum of 18.75%. Foreigners’ holdings of government bonds have also surged since 2014. Foreign investors’ appetite for Indian government bonds will likely be sluggish in the coming months for the following reasons: A sharply rising public debt-to-GDP ratio from its current elevated level of 67%. EM currency depreciation will likely trigger foreign capital outflows from EM fixed-income markets, which will erode international demand for Indian local currency bonds. Banks account for 42% of government bond holdings, insurance companies 23%, and mutual funds and foreigners 3% each. Altogether, they presently account for 71% of outstanding government bonds. Hence, banks hold the key to financing both public and private sectors. Chart I-10RBI Ownership Of Government Bonds A risk to the scenario of higher bond yields is if Indian’s central bank further accelerates its ongoing purchases of government bonds (Chart I-10). In such a case, bond yields will be capped. However, this entails quantitative easing or monetization of public debt. The latter will lead to currency depreciation and trigger capital flight. Bottom Line: Odds are that Indian government bond yields will drift higher. This will push up local currency corporate bond yields and in turn weigh on equity valuations. Investment Conclusions The outlook for the absolute performance of Indian share prices remains downbeat (Chart I-11, top panel). Nevertheless, we are using the underperformance of the past several months to upgrade this bourse from underweight to neutral within an EM equity portfolio (Chart I-11, bottom panel). Odds of equity outperformance versus the EM benchmark have risen because of the corporate tax cuts but are not high enough to justify an overweight allocation. Chart I-11Indian Stock Prices: Profiles Of Absolute And Relative Performance Chart I-12Our Long Indian Software / Short EM Stocks Position As is the case with other EM currencies, the rupee is vulnerable to a pullback in the coming months. Historically, foreign investors in India have cumulatively pumped $148 billion into equity and investment funds. Hence, accruing disappointments by foreign investors concerning India’s growth trajectory and fiscal deficits could trigger a period of outflows. A weaker currency and our theme of favoring DM growth plays versus EM continue warranting a long Indian software stocks / short overall EM equity index position. We have initiated this position on December 21, 2016 and it has produced sizable gains (Chart I-12). Fixed-income investors should continue betting on yield curve steepening by receiving 1-year / paying 10-year swap rates.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Ayman Kawtharani, Editor/Strategist ayman@bcaresearch.com   Footnotes 1      The reason is that both interest rates and earnings long-term growth rate are present in the denominator of any cash flow discount model (Stock Price = Expected Dividends / (Interest rate – Earnings long-term growth rate)). Hence, they have the potential to affect share prices exponentially while dividends/profits are present in the numerator so their impact on equity prices is linear. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Bank Credit Analyst

Highlights U.S. growth will soon rebound thanks to robust drivers of domestic activity, and strengthening money and credit trends. The U.S. Federal Reserve will maintain an easing bias and will expand its balance sheet again. A growing Fed balance sheet will catalyze an underlying improvement in global liquidity conditions and boost the global economy. Brexit, China and Iran are key risks. The dollar will depreciate, bond yields will rise further and silver will outperform gold. Equities will surpass bonds on both cyclical and structural investment horizons. Financials and energy are more attractive than tech and healthcare. Thus, Europe is becoming increasingly appealing relative to the U.S. Feature Global equities are only 5% below their January 2018 all-time highs and the S&P 500 is close to breaking out above its July 2019 record. Meanwhile, yields are rebounding and value stocks are crushing momentum plays. Are these trends durable? Global growth is the key. If economic activity around the world can stabilize and ultimately improve, then stocks will break out and bond prices will suffer in the coming year. Otherwise, these recent financial market developments will undo themselves. Even if current activity remains weak, the outlook for global growth is looking up, despite trade wars, Brexit, Middle East tensions and problems in the interbank market. Therefore, we continue to favor stocks over bonds, because the backup in yields has further to go. If the dollar weakens, our pro-risk stance will only strengthen. U.S. Growth Drivers Are Healthy Chart I-1Recession Indicators Are Flashing A Yellow Flag The U.S. is near the end of a potent mid-cycle slowdown, but a recession will be avoided. Current conditions support an improvement in U.S. activity next year, even if key recessionary indicators, such as the yield curve and the annual rate of change of the Leading Economic Indicator, are still sending muddy signals (Chart I-1). U.S. growth will intensify because of five fundamental factors that will ultimately push the LEI higher and force the yield curve to re-steepen: A budding housing rebound, robust household spending, a stabilizing manufacturing sector, limited inflationary pressures, and a pick-up in money and credit trends. Housing The housing market has stabilized, buoyed by strong household formation, decent affordability, passing of the shock created by the cap in state and local tax deductions, and a 110-basis point collapse in mortgage yields since November 2018. Housing market indicators are finally catching up with leading variables, such as mortgage applications. In the past nine months, the NAHB housing market index has recovered nearly two-thirds of its decline since December 2018. Building permits and housing starts are at their highest levels since 2007, despite a significant fall last year. Even existing home sales have increased by 11% since December and are tracking the stimulation offered by lower borrowing costs (Chart I-2). Chart I-2The Housing Recovery Is Real Residential investment should soon boost economic activity after curtailing the level of GDP by 1% over the past six quarters. Moreover, rebounding housing activity implies that policy is not constraining growth. The real estate sector is historically the most sensitive to monetary conditions. Households Are Still Doing Well Core U.S. real retail sales continue to grow at a more than 4% annual pace and the Atlanta Fed GDPNow model forecasts a healthy 3.1% annual rise in consumer spending in the third quarter. This resilience is particularly impressive in the face of economic uncertainty and an ISM Manufacturing index below the 50 boom-bust line. Strong balance sheets are crucial to households. After 12-years of deleveraging, household debt has contracted by 37 percentage points to 99% of disposable income. Consequently, debt-servicing costs only represent 10% of disposable income, the lowest level in more than 45 years. Moreover, the household savings rate is a healthy 7.9% of after-tax income, which is particularly high in the context of the highest net worth ever and the lowest debt-to-asset ratio since 1985. Household income creates an additional support to consumption. Real disposable income is expanding at a 3% annual rate, despite slowing job creation. A tight labor market explains this apparent paradox. The employment-to-population ratio for prime-age workers is our favorite measure of labor market slack, and it has escalated to 79.7%, a level consistent with the 2.9% pace of annual growth in wages and salary (Chart I-3). The UAW strike at GM, the quits-rate at an 18-year high, and the difficulties small firms face to find qualified workers, all suggest that wages (and thus, consumption) will remain well underpinned (Chart I-3, bottom panel). Improving Manufacturing Outlook Manufacturing activity is set to rebound, despite the weakness in the ISM Manufacturing index. Recent industrial production numbers have already improved. Monthly IP expanded at a 0.6% monthly pace in August, but as recently as April, it was shrinking at a -0.6% rate. U.S. monetary conditions will continue to support asset prices and worldwide economic activity for the coming 18 months or so. The car sector will soon bottom. Weak auto production has been a primary diver of the recent global manufacturing slowdown. The automotive component of GDP contracted at a stunning 29.1% annual rate in the second quarter. However, U.S. light-vehicle sales are essentially flat. This dichotomy implies that the automobile sector’s inventories are contracting briskly (Chart I-4). Chart I-3A Tight Labor Market Supports Consumption Chart I-4Will Auto Production Rebound Soon?   Capex should also recover. Last quarter, investment in structures and equipment subtracted from GDP growth. Before this, capex intentions had fallen significantly, now, the Philly Fed’s capital expenditure component is trying to stabilize. Capex must stop falling if global manufacturing is to strengthen. Limited Inflationary Pressures Inflationary pressures remain muted in the U.S., which supports growth in two ways. First, muted inflation allows the Fed to maintain accommodative monetary conditions. In the absence of crippling debt-servicing costs, easy policy guarantees a continued expansion. Secondly, low inflation keeps real income growth higher and increases the welfare of households. At 2.4%, core CPI is perky, but will soon roll over. Core goods prices have been driving fluctuations in aggregate core prices in the past three years, while service sector inflation has been stable at 2.7% during this period. Goods inflation will soon weaken for the following reasons: Chart I-5The Trade War Is Masking The Economy's Deflationary Tendencies Soft global economic activity will drive down global inflation. Inflation lags real activity and proxies for the global economy, such as Singapore’s GDP, point to weaker core CPI in the OECD (Chart I-5). This weakness will act as a drag on U.S. inflation because U.S. goods prices have a large international component. U.S. import prices peaked 15 months ago and they normally lead goods inflation by roughly a year and a half. The strength in the broad trade-weighted dollar, which has climbed by nearly 15% in the past 18 months to an all-time high, will hurt goods prices. U.S. capacity utilization declined through 2019 and remains well below the 80% level that historically causes core goods prices to overheat. The White House’s tariffs on China are boosting inflation but this effect will prove transitory. The tariffs are pushing up inflation for goods touched by the levies, while unaffected goods are experiencing deflation (Chart I-5, bottom panel). Given that tariffs have a one-off impact and that inflation expectations are hovering near record lows, inflation for tariffed-goods will converge toward the underlying trend in non-tariffed goods. Stronger Money And Credit Trends Money and credit trends indicate that the recent slump will not translate into a recession. Moreover, improving U.S. private-sector liquidity conditions argues that the mid-cycle slowdown is ending. Chart I-6Liquidity Indicators Point To A Growth Rebound U.S. broad money is recovering. After falling to 0.9% last November, U.S. real M2 growth is expanding at a 3% annual rate, a pace in keeping with the end of mid-cycle slowdowns. Moreover, money is also accelerating relative to credit issuance, which historically has pointed to quicker industrial activity. Similarly, our U.S. financial liquidity index is rapidly escalating, a development that normally precedes turning points in the ISM manufacturing (Chart I-6) index. Credit activity is also picking up. Corporate bond issuance is firming and, according to the Fed’s Senior Loan Officer Survey, demand for loans is rebounding across the board. The yield collapse is boosting credit growth across the G-10. Gold is outperforming bonds, which confirms that a mid-cycle slowdown occurred. If inflation is not a problem, then the yellow metal always underperforms bonds ahead of recessions. However, before mid-cycle slumps, gold consistently outperforms bonds (Chart I-7). Chart I-7Bonds Outperform Gold Ahead Of Recession More Fed Easing Imminent U.S. monetary conditions will continue to support asset prices and worldwide economic activity for the coming 18 months or so. The Fed will ease policy further and is a long way from tightening. Last week, the Federal Open Market Committee (FOMC) curtailed the fed funds target rate by 25 basis points to 2%. Additionally, while the median projection shows that Fed members expect no more rate cuts for at least the next 18 months, the reality is more subtle. Among 17 FOMC members, 7 expect to cut the fed funds rate by another 25 basis points by year end, and 8 foresee a lower policy rate in late 2020. The greenback is very expensive and will decline as global liquidity conditions improve. We are still on track for three 25-basis-point rate cuts this year. The Fed remains highly data dependent and is particularly sensitive to depressed inflation expectations. This means the Fed is acutely aware of the danger created by a sudden tightening in financial conditions. If by year-end the market has not moved away from discounting another cut in 2019, the FOMC will likely deliver this easing. Otherwise, financial conditions could suddenly tighten, which would hurt inflation expectations and the economic outlook. If global growth does not recover in early 2020, the Fed would probably cut rates an additional time in the first quarter, which would validate the current 12-month pricing in the OIS curve. Chart I-8Not Enough Excess Reserves The Fed will again increase the size of its balance sheet. Interbank markets have boxed the FOMC into adding welcomed stimulus to the global economy. Allowing commercial bank excess reserves to grow anew will have a greater positive impact for global growth compared with rate cuts alone. Last month, we highlighted the risks to the repo market created by the combination of the dwindling of excess reserves, the bloated securities inventory of primary dealers financed via repo transactions, and the growth in the issuance of Treasurys.1 These risks materialized last week, when the Secured Overnight Financing Rate (SOFR) suddenly spiked above 5% (Chart I-8). To calm the market, the Fed injected $75 billion each day last week starting Tuesday to bring repo rates closer to the Interest Rate on Excess Reserves (IOER). But this is not a long-term solution. Chart I-9Higher Excess Reserves Will Hurt The Dollar And Boost Global Growth Paradoxically, the crystallization of the repo market tensions is good news for the global economy because it will force the Fed to again expand its balance sheet as soon as next month. The supply of funds to the repo market needs to increase permanently, which means that banks’ excess reserves must re-expand. As we showed last month, higher excess reserves will hurt the U.S. dollar, lift EM exchange rates and boost global PMIs (Chart I-9). Higher excess reserves ease global liquidity conditions. The money injected will find its way to the rest of the world. The dollar trades 25% above its long-term, fair-value estimate of purchasing power parity. Therefore, a growing fiscal deficit indirectly financed by a larger Fed balance sheet will lead to a larger U.S. current account deficit, which in turn, will lift global FX reserves. As a result, the Fed’s custodial holdings of securities on behalf of other central banks will rise. Thus, global dollar-based liquidity will stop contracting relative to the stock of U.S. dollar-denominated foreign currency debt it supports (Chart I-10). Higher excess reserves will also ease global financial conditions. By boosting dollar-based liquidity, a larger Fed balance sheet will dampen offshore dollar interest rates. Moreover, rising excess reserves depreciate the greenback, which further cuts the cost of credit for foreign entities borrowing in U.S. dollars. This phenomenon is especially significant for EM. Therefore, we should see an easing of EM financial conditions, which are heavily dependent on EM exchange rates. Historically, looser EM financial conditions lead to stronger global growth (Chart I-11). Chart I-10High-Powered Liquidity Set To Improve Chart I-11Easier EM FCI Should Lead To Faster Growth   Risks: The U.K., China And Iran While the outlook generally points to a rebound in global growth, which will create a positive environment for risk assets, the situations in the U.K., China, and Iran should be closely monitored. The U.K. Brexit remains a potential danger for the world even though our base case calls for a benign outcome. U.K. Prime Minister Boris Johnson’s gambit to push for a No-Deal Brexit to force the EU to make concessions could result in a miscalculation. Such a turn of events would plunge a European economy – already damaged by weak global trade – into recession. The dollar would strengthen and global financial conditions would tighten. Global growth would take another hit. Chart I-12U.K.: No Clear Winner Ahead Of A Potential Election Following this week’s Supreme Court unanimous ruling against Johnson’s decision to prorogue Parliament, No-Deal carries a less than 10% probability. Johnson lacks a majority in a Parliament staunchly against a hard Brexit and he is unable to call an election prior to the October 31st deadline to leave the EU. Therefore, a delay is the most likely outcome, which will allow the EU and the U.K. to reach a deal on the Irish backstop that Parliament can then ratify. Ultimately, the U.K. needs another election to break the current logjam, which could materialize in November or December. However, the Remain vote is split between Labour, Lib Dems, and the SNP, but the Brexit vote is not nearly as divided. (Chart I-12). Hence, Brexit will remain a risk lurking in the background even if it does not morph into a full-blown assault on global growth. China Chart I-13Chinese Stimulus Remains Too Tepid To Move The Needle China’s economic activity continues to soften. In August, industrial production and fixed-asset investment decelerated to 4.4% and 5.5%, respectively. Moreover, total social financing growth slowed on an annual basis and overall Chinese credit flows decreased as a share of GDP (Chart I-13). Chinese policy reflation remains too tepid to undo the drag created by trade uncertainty and the weakness in the marginal propensity to spend (Chart I-13, bottom panel). Sino-U.S. trade tensions have significantly decreased in recent months, but they will remain an important source of uncertainty for China and the world. China and the U.S. will again hold high-level talks next month, U.S. President Donald Trump has again postponed some of the tariff increases, and China is again buying mid-Western soybeans and pork. But last Friday’s cancelation of U.S. farm visits by Chinese officials reminds us that the situation is very fluid. Ultimately, China and the U.S. are long-term geopolitical rivals. Trump may be constrained by the 2020 election, but China could still drive a hard bargain. Hence, it is prudent to expect a stop-and-go pattern in the negotiations. Chart I-14Deflation Unleashes A Vicious Circle Of Higher Real Borrowing Costs A weak China will sow the seeds of its own recovery. In addition to the negative effect on capex intentions and credit demand of trade uncertainty, Beijing faces deteriorating employment and producer price inflation of -0.8% (Chart I-14, top panel). As PPI inflation becomes more negative, heavily indebted corporate borrowers face rising real interest rates (Chart I-14, bottom panel). This higher cost of debt weakens an already vulnerable economy, unleashing a vicious circle. Chinese policymakers are unlikely to tolerate this situation for much longer. The cumulative 400-basis point cuts in the reserve requirement ratio since April 2018 are steps in the right direction, but are not yet enough. The dovish change to the Politburo’s and State Council’s language indicates that greater stimulus is forthcoming. Thus, credit expansion, local government special bonds issuance and fiscal stimulus will become even more prevalent in the final quarter of 2019. This policy should noticeably goose economic activity in 2020, which will help global growth accelerate. Iran Tensions are re-flaring and a spike in oil prices would threaten the fragile global economy. However, this remains a risk, not a central case. In the July issue of The Bank Credit Analyst, we warned that tensions with Iran were the greatest visible risk to global growth and risk assets.2 This danger came into focus last week with the drone attacks on the Khurais oil field and Abqaiq oil processing facility in Saudi Arabia, which curtailed global oil supply by an unprecedented 5.7 million bbl/day, or 5.5% of global demand. Unsurprisingly, Brent prices quickly surged by 12% to $68/bbl. Chart I-15Higher Energy Efficiency Makes The World More Robust A durable spike in oil prices would push the global economy into a recession, especially while the global economy is already on weak footing. Chief U.S. Equity Strategist Anastasios Avgeriou reminded his clients3 that according to a seminal 2011 paper by Prof. James D. Hamilton, a doubling of oil prices preceded all but one of the post-war recessions.4 However, an oil-induced recession would likely be shallow because the oil intensity of the global economy has significantly declined in the past 30 years (Chart I-15). Moreover, global fiscal authorities would respond forcefully to an economic contraction, which would also limit the impact of the shock. There is a low likelihood that oil will double by year-end. It would require Brent prices to surge to $100/bbl. Saudi Arabia has already stated that production will return to pre-crisis levels in the coming days and not a single shipment will be missed. This promise implies further inventory drawdowns. Aramco also expects to achieve maximum output by late November. Moreover, higher oil prices will encourage further activity in the U.S. shale patch. Consequently, oil prices are unlikely to surge by another $35/bbl in the next three months. However, Brent prices could climb to $75/bbl next year, because while oil demand is set to recover, investors must also embed a greater risk premium against Saudi supply disruptions. A military conflict with Iran is a tail risk, but if it were to materialize, crude prices would surge by $35/bbl or more in an instant. According to Matt Gertken, BCA’s Chief Geopolitical strategist, the appetite for such a conflict is low in the U.S.5 President Trump has isolationist instincts and does not want to be mired in another conflict. Investment Implications The Dollar The dollar has significant downside. The greenback is very expensive and will decline as global liquidity conditions improve (Chart I-16). These dynamics reflect the countercyclical nature of the dollar and also lead to strong greenback momentum, both on the way up and down. The dollar would weaken in response to improving global growth and liquidity conditions, the lower dollar would ease global financial conditions, further stimulating the global economy. A virtuous circle could then emerge. Chart I-16Increasing Financial Liquidity Will Hurt The Greenback Repatriation flows will also move from a tailwind to a headwind for the greenback. Prompted by both rising risk aversion and the Trump tax cuts, U.S. economic agents have repatriated $461 billion in the past 18 months. This has created powerful support for the USD (Chart I-17). The effect of the tax cut is vanishing and rising global growth will incentivize U.S. households and firms to buy foreign assets more levered to the global business cycle. In the process, they will sell the dollar. Chart I-17Repatriation Will Not Support The Dollar For Much Longer The euro will continue to behave as the anti-dollar, a consequence of the pair’s plentiful market liquidity. Moreover, the euro trades at a 17% discount to its purchasing power parity equilibrium. After last week’s rate cut and QE announcement, the European Central Bank has no more room to ease. Instead, the recent fall in peripheral bond spreads is loosening European financial conditions, which is boosting European growth prospects. This makes the euro more attractive. Bonds And Precious Metals Safe-haven yields will have significant upside in the coming 12 to 18 months. As we highlighted last month, bonds are so expensive, overbought and over-owned that they suffer from an extremely elevated probability of negative cyclical returns (Chart I-18, left and right panels). Moreover, excess reserves will once again grow when the Fed re-starts to expand its balance sheet. Higher excess reserves lead to a steeper yield curve slope (Chart I-19). Short rates have limited downside, therefore, the curve can only steepen via higher 10-year yields. Chart I-18AValuation And Technicals Point Toward Higher Yields In 12 Months (I) Chart I-18BValuation And Technicals Point Toward Higher Yields In 12 Months (II)   Chart I-19Fed Purchases Will Steepen The Curve Short-term dynamics are more complex. Treasury yields have climbed by 21 basis points since their September 3rd low, mostly on the back of decreasing trade tensions. In previous mid-cycle slowdowns, bond price tops only emerged after the ISM bottomed. We are not there yet. We expect substantial short-term volatility in yields in view of the unpredictable Sino-U.S. negotiations and the current lack of pick-up in global growth. During this transition process, cyclical investors should use bond rallies such as the current one to build below-benchmark duration positions in their fixed-income portfolios. Within precious metals, we continue to prefer silver to gold. We have favored precious metals since late June,6 but higher bond yields are negative for gold. However, central banks are maintaining a dovish bias aimed at lifting inflation breakevens back to their historical norm of 2.3% to 2.5%. This process increases the chance that the economy will overheat late next year. For the next 12 months, rising inflation expectations, not higher real rates, will push up bond yields. Combined with a weaker dollar, this configuration is mildly bullish for gold. Silver has a higher beta and more industrial uses than gold, which will allow for a period of outperformance if global growth increases. In this context, the silver-to-gold ratio, which stands at its 6th percentile since 1970, is an attractive mean-reversion play (Chart I-20). Chart I-20The Silver-Gold Ratio Is A Bargain Equities Investors should continue to favor stocks relative to bonds in the next year. Equities perform well up to six months before a recession starts (Table I-1). Moreover, our monetary and technical indicators are upbeat (see Section III). Additionally, sentiment surveys do not show rampant investor complacency (see Section III), which limits risks from a contrarian perspective. Meanwhile, yields have upside, which implies an outperformance of stocks versus bonds. Table I-1The S&P 500 Doesn’t Peak Until Six Months Before A Recession The short-term picture is more complex. P/E ratio expansion powered 90% of the S&P 500’s gains since it bottomed in December 24, 2018, and according to our model, U.S. operating earnings will contract for at least eight more months (Chart I-21). Thus, if yields mount through the rest of the year, multiples will likely contract. The S&P 500 is set to continue to churn over that time frame. Chart I-21U.S. Profits Still Have Downside In this context, strategy dictates investors focus on internal stock market dynamics. Namely, investors should favor financials and energy at the expense of tech and healthcare for the following reasons: Rising bond yields lift financials’ net interest margins. They also hurt multiples for tech stocks, which carry a large percentage of their intrinsic value in long-term cash flows and their terminal value. Thus, rising yields correlate with an outperformance of financials relative to tech (Chart I-22). Moreover, financials’ valuations and technicals are very depressed relative to tech, while comparative earnings estimates are equally morose (Chart I-23). Finally, our U.S. Equity Strategy team expects buybacks by financials to increase significantly.7 Chart I-22If Yields Rise, Financials Will Beat Tech Chart I-23Valuations, Technicals And Sentiment Favor Financials Over Tech     Rising yields also hurts healthcare stocks. Additionally, the rising popularity of Democratic progressives like Senator Elizabeth Warren requires investors embed a risk premium in the price of healthcare stocks (Chart I-24). The progressives want to nationalize healthcare insurance and compress healthcare profit margins, from drugs to hospitals. Chart I-24The Rise Of The Progressives Requires A Risk Premium In Health Care Stocks We have used energy stocks as a hedge against rising tensions in the Middle East. Now, our U.S. Equity Strategy colleagues have become more positive on this sector. Energy valuations and technicals are very attractive relative to the S&P 500 (Chart I-25).8 Energy stocks will outperform if global growth recovers and lifts global bond yields These sectoral recommendations argue investors should soon begin to favor European relative to U.S. stocks. Financials and energy are overrepresented in European equities while tech and healthcare are large overweight’s in the U.S. (Table I-2). Moreover, European activity is more sensitive to global economic momentum than the U.S. Thus, when global yields rally and the world economy stabilizes, European stocks will outperform their U.S. counterparts (Chart I-26). Additionally, European banks trade at 0.6-times book value which makes them the ultimate value play, one highly geared to easier European financial conditions and higher yields. Chart I-25Energy Is A Compelling Buy Table I-2Overweighting Europe Is Consistent With Our Sectoral RecommendationsChart I-26Europe Will Soon Outperform The U.S. Chart I-27Long-Term Investors Should Favor Stocks Over Bonds These sectoral biases are also consistent with value stocks outperforming growth equities. However, as Xiaoli Tang from BCA’s Global Asset Allocation service argues in Section II, the value-versus-growth question is a complex one that needs to be differentiated across geographies and equity size. Finally, long-term investors should also favor stocks over bonds. According to BCA Chief Global Strategist Peter Berezin, global stocks at their current valuations offer an expected 10-year real return of 4.2%. By historical standards, these are not elevated returns, but they are still much more generous than government bonds. Based on their dividend yields, U.S., Japanese and European equities need to fall by 18%, 28% and 40% before underperforming bonds on a 10-year basis, respectively.9 This is a large margin of safety (Chart I-27). We prefer foreign stocks with their more attractive valuations and local-currency expected returns. Additionally, the dollar is expensive and will weaken in a 5- to 10-year investment horizon. Mathieu Savary Vice President The Bank Credit Analyst September 26, 2019 Next Report: October 31, 2019   II. Value? Growth? It Really Depends! Investors should pay particular attention to definition and methodology when evaluating value versus growth strategies, both academically and in practice. Value investors should focus on non-U.S. markets, especially the emerging market small-cap universe. Growth investors should focus on large caps, especially the U.S. large-cap universe. Small-cap investors should focus on value. Large- and mid-cap investors should not be making bets between value and growth strategically. Tactical style rotation should be done only when valuation spreads reach extreme levels.  GAA remains neutral on value versus growth, but prefers to use sector positioning (cyclicals versus defensives, financials versus tech and health care) and country positioning (euro area versus U.S.) to implement style tilts. Investing by way of style is as old as investing itself. Value versus growth has been one of the most frequently asked questions among our clients of late, particularly given the sharp style reversal in recent weeks. In this report, we attempt to answer some of the most often-asked questions on value versus growth. We have arranged these questions into five separate sections: First, we look at 93 years of history of the Fama-French value and growth portfolios to see how value, growth, and size have interacted over time, because academics have mostly used the Fama-French framework. Second, we look at how comparable U.S. style indices are, including the S&P, the Russell and the MSCI, since practitioners mostly use these commercial indices as their benchmarks. Third, we investigate if international markets share the same value-growth performance cycles as the U.S., using the MSCI suite of value-growth indices (since MSCI is the only index provider that produces value-growth indices for each market under its global coverage). Fourth, we investigate if pure exposure to value and growth can actually improve the value-growth performance spread by comparing the pure style indices from the S&P and the Russell to their standard counterparts. Finally, we present the GAA approach to style tilts in a section on our investment conclusions. 1. Is It True That Value Outperforms Growth In The Long Run? There has been overwhelming academic evidence supporting the existence of the value premium.10 Academically, the “value premium”, also known as the HML (high minus low) factor premium, or the value outperformance, is defined as the return differential between the cheapest stocks and the most expensive. Even though Fama and French used book-to-price as the sole valuation criterion,11 many researchers have combined book-to-price with other valuation measures such as earnings-to-price, sales-to-price, dividend yield,12 and so on.  There is also academic evidence suggesting that “value outperformance is almost non-existent among large-cap stocks.”13 What is more, in 2014 Fama and French caused a huge stir by publishing “A Five-Factor Asset Pricing Model” working paper demonstrating that “HML is a redundant factor” because “the average HML return is captured by the exposure of the HML to other factors” (such as size, profitability, and investment pattern) based on U.S. data from 1963 to 2013.14 Asset owners and allocators should pay special attention when selecting benchmarks for value and growth. For non-quant practitioners, especially the long-only investors, value and growth are two separate investment styles, even though the style classification shares the same principle as the academic “value factor.” Their definitions vary, as evidenced by how S&P Dow Jones, FTSE Russell, and MSCI define their value and growth indexes (see next section on page 7). In general, value stocks are cheap, with lower-than-average earnings growth potential, while growth stocks have higher-than-average earnings growth potential but are very expensive. The indices published by commercial index providers do not have very long histories, however. Fortunately, Fama and French also provide value-growth-size portfolios on their publicly available website.15 Table II-1 shows that for 93 years, from July 1926 to June 2019, U.S. value portfolios in both large-cap and small-cap buckets based on the well-known Fama-French approach have returned more than their growth counterparts, no matter whether the portfolios are equal-weighted or market-cap-weighted. Most strikingly, equal-weighted small-cap value outperformed its growth counterpart by over 10% a year in absolute terms, and has more than doubled the risk-adjusted return compared to its growth counterpart. Table II-1Fama-French Value-Growth-Size Portfolio Performance* Some media reports have claimed that value stocks are “less volatile” because they are on average “larger and better-established companies.”16 This may be true for some specific time periods. For the 93 years covered by Fama and French, however, this common belief is not supported. In fact, value portfolios in both the large- and small-cap universes have consistently had higher volatility than growth portfolios, no matter how the components are weighted. The excess returns, however, have more than offset the higher volatilities in three out of four pairs, with the exception being market cap-weighted large-cap growth, which has a slightly higher risk-adjusted return due to much lower volatility than its value counterpart. From a very long-term perspective, the value outperformance does come from taking higher risk. Further investigation shows that the superior long-run outperformance of value relative to growth came mostly in the first 80 years of Fama and French’s 93-year sample. In more recent years since 2007, however, value has underperformed growth significantly in three out of the four Fama-French value-growth pairs, with the equal-weighted small-cap value-growth pair being the sole exception, as shown in Table II-2. Even though the equal-weighted small-cap value has still outperformed its growth counterpart in the most recent period, the hit ratio drops to 54% compared to 76% in the first 80 years, while the magnitude of average calendar-year outperformance drops to a meager 1.3%, compared to 12.5% in the first 80 years. Table II-2The Fight Between Value And Growth* Statistical analysis is sensitive to the time period chosen. How have value and growth been performing over time? Chart II-1 shows the long-term dynamics among value, growth, and size. The following conclusions are clear: Chart II-1Fama-French Value-Growth-Size Peformance Dynamics* Value investors should favor small caps over large caps, while growth investors should do the opposite, favoring large caps over small caps, albeit with much less potential success (Chart II-1, panel 1). Small-cap investors should favor value stocks over growth stocks (panel 2). Value outperformance in the large-cap space (panel 3) is much weaker than in the small-cap space (panel 2). Fama and French define small and large caps based on the median market cap of all NYSE stocks on CRSP (Center for Research In Security Prices), then use the NYSE median size to split NYSE, AMEX and NASDAQ (after 1972) into a small-cap group and a large-cap group. The value and growth split is based on book-to-price, with stocks in the lowest 30% classified as growth, and the highest 30% as value. Interestingly, small-cap value and small-cap growth account for only a very small portion of the entire universe, as shown in Charts II-2A and II-2B. Value stocks’ average market cap is about half of that of growth stocks, in both the large- and small-cap universes (panel 3 in Charts II-2A and II-2B). Again, this does not support some media claims that value stocks are larger and better-established companies. However, it does add further support to the claim that all investors should favor small-cap value stocks. Unfortunately, “small-cap value” is a very small universe. As of June 2019, the CRSP total U.S. equity market cap was $26.2 trillion, with small-cap value accounting for only 1.5% (about $383 billion); even large-cap value comprises only a relatively small weight, 13% (US$3.5 trillion). Chart II-2ASmall-Cap Value-Growth Portfolios* Chart II-2BLarge-Cap Value-Growth Portfolios*   The U.S. market is dominated by large-cap growth stocks with a heavy weight of 56% (US$14.7 trillion, as of June 2019). This is encouraging because academic research does show that the value premium among large caps is weak. But the large-cap value weakness mostly started from 2007, after 80 years of strength relative to large-cap growth (Chart II-1, panel 3). The Fama-French approach is widely used in academic research, partly due to its long history from 1926. For non-quant practitioners, especially long-only investors, however, commercial indexes from FTSE Russell, S&P Dow Jones, and MSCI are more often used as performance benchmarks. In this report, we study a series of commercial value-growth indexes in the U.S. and globally to shed light on value-growth dynamics, and how asset allocators can incorporate them into their decision-making processes. 2. Not All U.S. Style Indexes Are Created Equal Three major index providers have style indices. They are FTSE Russell (which launched the industry’s first set of value-growth indexes in 1987), S&P Dow Jones, and MSCI. MSCI is the only provider that has a full suite of value-growth indices for all individual markets under coverage. While all three provide “standard” style indices that include the full component of the parent index, the FTSE Russell and the S&P Dow Jones also provide “pure” style indices. There are two major differences between “standard” and “pure” style indices: 1) the standard indices are market-cap weighted, while the “pure” indices are weighted based on style score. 2) Standard value and standard growth have overlapping components, while pure value and pure growth do not share any common components. We prefer to use sector and country positioning to implement style tilts tactically. Other than book-to-price, the value variable used by the Fama-French approach, the three providers have added different variables in the determination of value and growth, as shown in Table II-3. This also reflects the evolution of the industry’s understanding on value and growth. For example, when MSCI first launched its style index in 1997, it used only book-to-price, but changed its approach in May 2003 to the current “multi-factor two-dimension” framework. Table II-3Value-Growth Index Criteria Because of the differences in index construction methodology, value-growth indices for the U.S. have behaved differently. The S&P 500, the Russell 1000, and the MSCI standard (large and mid-cap) indices are widely followed institutional benchmarks, with back-tested history dating to the 1970s. Chart II-3 shows the relative value/growth performance dynamics from the three index providers, together with that from Fama and French (market value-weighted, to be consistent with the approach from the index providers). One can observe the following: Chart II-3Which Value/Growth? None of the three pairs looks exactly like Fama-French’s market-cap value-weighted value/growth. This raises the question of how historical analysis based on the long history of Fama-French value/growth portfolios can be applied to the commercial indices. In the first cycle from 1975 to February 2000, all three index pairs made a round trip, with flat performance between value and growth. Also, even though the S&P 500 and Russell 1000 were more closely correlated with one another than with the MSCI, the three were quite similar. In the current cycle that began in February 2000, however, Russell value/growth has rebounded much more strongly than the other two. But in the down period that started in 2007, the three indices performed in line with each other, as shown in Table II-4. Table II-4U.S. Style Index Performance* In addition, the difference between S&P and Russell does not just lie between the S&P 500 and the Russell 1000. It actually exists in every market-cap segment, as shown in Chart II-4. Unfortunately, MSCI does not provide history from 1975 for the detailed cap segments. In the current cycle since February 2000, S&P value rebounded the least between 2000 and 2006. Why? Chart II-4Know Your Benchmark Further investigation reveals some interesting observations, as shown in Chart II-5. Chart II-5Value/Growth: Russell Vs. S&P At the aggregate level, the S&P 1500, the Russell 3000 and their respective style indices have performed largely in line with one another in the most recent cycle starting from February 2000 (Chart II-5, panel 4), reflecting the industry trend of index convergence. In different market cap segments, however, the divergence is still prominent, especially in the small-cap space (panel 1). The S&P 600 has consistently outperformed the Russell 2000 in both the value and growth categories. In addition to different style factors, this consistency also reflects different universes, size distribution, and sector exposure, as explained in an earlier GAA Special Report on small caps.17 Managers with Russell 2000 as their performance benchmark could simply beat it by doing a total-return-performance swap between the Russell 2000 and the S&P 600. Bottom Line: Asset owners and allocators should pay special attention when selecting benchmarks for value and growth.  3. How Have Value And Growth Performed Globally? MSCI is the only index provider that also produces value-growth indices for each equity market under its global coverage, using the same methodology. Unfortunately, only the “standard” (i.e., large- and mid-cap) universe has a long history, dating from December 1974. Charts II-6A and II-6B show the value/growth dynamics in major DM and EM markets. The relative performance of MSCI DM value versus growth shares a similar pattern to that of the U.S. in the latest cycle since 2000, but looks very different in the period before 2000 (Chart II-6A). The ratio of EM large- and mid-cap value versus growth did not peak until February 2012, about five years after the peak of its DM peer (Chart II-6B, panel 1). On the other hand, EM small-cap value has resumed its outperformance versus growth since early 2016 after having peaked around the same time as its large-cap counterpart. Chart II-6AIs Value Dead In DM? Chart II-6BIs Value Dead In EM?   The global value/growth dynamics also show that the “value outperforming growth” effect is more prominent in the small-cap space. But why has small value also underperformed small growth in most DM markets? Our explanation is that the EM universe is much less efficient than the DM universe because there are not many quant funds dedicated to the EM small-cap space – in addition to the fact that, in general, EM small caps are much smaller than those in DM markets. This is also in line with our finding that, in general, factor premia are more prominent in the EM universe.18 Bottom Line: Value premium is more prominent in non-U.S. markets, especially the EM small-cap universe. 4. Do Pure Style Indices Improve Performance? Both S&P Dow Jones and FTSE Russell provide pure-value and pure-growth indices. Unlike the standard value-growth indices, which target about 50% of the parent market cap, the pure-style indices include only stocks with the strongest value and growth characteristics. There is no overlap between the two. In theory, the pure-style indices should outperform the standard-style indices because of their concentrated exposure to style factors. How do they do in reality? Table II-5 shows that in terms of absolute return, this is indeed the case for 14 out of the 18 pairs of indices from S&P and Russell for the period between 1998 and 2019. However, the higher returns from greater exposure to style factors have largely come from much higher volatility in 17 out of the 18 pairs. Pure style has higher volatility than standard style in general, the only exception being the Russell mid-cap value space. As such, on a risk-adjusted basis, pure style is not necessarily better. Table II-5Purer Is Not Necessarily Better Charts II-7A and II-7B show the different performance dynamics for the S&P and Russell families of style indices. For the S&P indices, pure growth has outperformed standard growth for the entire period in all three market-cap segments, but only the S&P 500 pure value outperformed its standard counterpart. Therefore, more concentrated exposure to style characteristics has improved the value-growth spread only in the large-cap space, but it has actually worsened the value-growth spread in the mid- and small-cap universes (Chart II-7A). Chart II-7AS&P Pure Styles* Chart II-7BRussell Pure Styles*   For the Russell indices, it’s clear that there were a lot more tech stocks in its pure-growth indices leading up to the 2000 tech bubble, because pure growth shot up significantly more than the standard growth before the bubble burst, and also crashed more severely following it. Overall, only in the small-cap space did the value-growth spread improve by the more concentrated exposure to style factors. However, this improvement was not because of the outperformance of the pure-style relative to the standard indices. In fact, both pure value and pure growth in the small-cap universe underperformed their standard counterparts, but pure growth performed even worse (Chart II-7B and Table II-5). 5. Investment Conclusions Value and growth can mean very different things and behave very differently. Investors should pay special attention to the definitions and methodologies when evaluating style indices or strategies, both academically and in practice. Depending on an investor’s mandate, the following is recommended: Value investors should focus on non-U.S. markets, especially the emerging market small-cap universe. Growth investors should focus on large caps, especially the U.S. large-cap space. Small-cap investors should focus on value. Large-and mid-cap investors should not make bets between value and growth strategically. Tactical style rotation should be done only when valuation spreads reach extreme levels. Price-to-book is the only common variable used in the determination of value and growth by academics and practitioners. Its track record as a systematic return predictor has been poor, as shown in panel 2 of Charts II-8A and II-8B. Another factor we have a long history for is dividend yield. Its predictive power is even worse than that of price-to-book (panel 3). Chart II-8AValuation Is A Poor Timing Tool In The U.S. Chart II-8BValuation Is A Poor Timing Tool Globally   Many factors have been used in conjunction with price-to-book by both academics and practitioners to time the rotation between value and growth. However, the results have been mixed. Regression models that correctly predicted in the past may not work in the future. For example, a regression model based on valuation spread and earnings-growth spread using data from January 1982 to October 1999 successfully predicted the rebound of value outperformance starting in early 2000,19 but the universal suffering of value funds over the past several years implies that this model may have given many false signals. Chart II-9 demonstrates how difficult it is to use regression models as a timing tool for value and growth rotation. A simple regression is conducted between value and growth return differentials (subsequent 60-month returns) and relative price-to-book. For data from December 1974 to July 2019, the r-squared for the MSCI world is 0.38 and for the U.S. it is 0.09. In hindsight, both models predicted the value outperformance starting in early 2000. However, the gaps between actual value and fitted value started to open, long before 2000. By late 1998, the gaps were already wider than the previous cycle lows, yet they continued to widen as value continued to underperform growth until February 2000. Chart II-9How Good Is The Fit? What should investors currently do, based on these models? The gaps are large, but not as large as in early 2000. At which point should investors start to shift into value given its more than 12 years of underperformance? We have often written that we prefer to use sector and country positioning to implement style tilts.20, 21  This preference has not changed. Value and growth indices have sector tilts that change over time. Currently, the S&P Dow Jones large- and mid-cap value indices have a clear overweight in financials but an underweight in tech and health care compared to their growth counterparts (Table II-6). Table II-6Sector Bets In Value And Growth Indices* Chart II-10Prefer Sector And Country Positioning To Style We have been neutral on value and growth, but would likely change this view if we change our country equity allocation between the U.S. and the euro area, and our equity sector allocation between cyclicals and defensives as well as between financials and information technology (Chart II-10). Xiaoli Tang Associate Vice President Global Asset Allocation III. Indicators And Reference Charts The S&P 500 will continue to churn this year. U.S. stocks have rebounded sharply through the month of September, yet, sentiment is neutral. Nonetheless, for now, stocks are likely to find it hard to meaningfully break above their July highs. Short-term momentum oscillators are overbought and U.S. profits still have downside. Because this year’s equity rally has been nearly entirely driven by multiples, this leaves equities vulnerable to any back-up in yields. As yields have not priced in any pick-up in growth, potential positive economic surprises are more likely to lift yields than stock prices. However, if growth disappoints, weak rates will cushion to blow to expected earnings. In line with this picture, our Revealed Preference Indicator (RPI) continues to shun stocks. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive readings from the policy and valuation measures. Conversely, if strong market momentum is not supported by valuations and policy, investors should lean against the market trend. Global growth remains the biggest problem for stocks. Until the global economy finds a floor, the outlook for profits will be poor and our RPI will argue against buying equities. The outlook for next year remains constructive for stocks. Our Willingness-to-Pay (WTP) indicator for the U.S. and Japan is markedly improving. However, it continues to deteriorate in Europe. The WTP indicator tracks flows, and thus provides information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. Global yields remain very depressed at highly stimulatory levels. Moreover, money growth has picked up around the world, and global central banks are cutting rates and expanding their balance sheets again. As a result, our Monetary Indicator remains at its most accommodative level since early 2015. Furthermore, our Composite Technical Indicator might not be improving anymore but it is still very much in constructive territory. Therefore, unlike four years ago, equities are more likely to avoid the headwind created by their overvaluation, especially as our BCA Composite Valuation index continues to improve.  10-year Treasurys may have cheapened a bit since last month, but they remain very expensive. Moreover, when current overvaluation levels are met by our technical indicator being as massively overbought as it is today, safe-haven bonds experience significant price declines over the following 12 months. That being said, the timing of a backup in yields is uncertain. If previous mid-cycle slowdowns are any guide, yields might need to wait for a bottom in the global manufacturing PMIs before rising freely. Nonetheless, the current setup argues against adding to long-duration bets. On a PPP basis, the U.S. dollar is only growing more expensive and the U.S. current account is deteriorating anew. For now, weak global manufacturing activity has helped the dollar stay well bid. However, our Composite Technical Indicator has lost momentum and has formed a negative divergence with the Greenback’s level. This means that the dollar is highly vulnerable to any stabilization in growth. In fact, we would argue that the USD might prove to be the best variable to evaluate whether global growth is forming a durable bottom or not.   EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation Chart III-6U.S. Earnings   Chart III-7Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance   FIXED INCOME: Chart III-9U.S. Treasurys And Valuations Chart III-10Yield Curve Slopes Chart III-11Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets   CURRENCIES: Chart III-16U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning   ECONOMY: Chart III-28U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot Chart III-30U.S. Growth Outlook Chart III-31U.S. Cyclical Spending Chart III-32U.S. Labor Market Chart III-33U.S. Consumption Chart III-34U.S. Housing Chart III-35U.S. Debt And Deleveraging   Chart III-36U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China   Mathieu Savary Vice President The Bank Credit Analyst Footnotes 1       Please see The Bank Credit Analyst Section I, “September 2019,” dated August 29, 2019, available at bca.bcaresearch.com 2       Please see The Bank Credit Analyst Section I, “July 2019,” dated June 27, 2019, available at bca.bcaresearch.com 3       Please see U.S. Equity Strategy Weekly Report, “The Oil Factor,” dated September 23, 2019, available at uses.bcaresearch.com 4              J. D. Hamilton, "Historical Oil Shocks," NBER Working Paper No. 16790. 5       Please see Geopolitical Strategy Special Report "Policy Risk, Uncertainty Cloud Oil Price Forecast," dated September 19, 2019, available at gps.bcaresearch.com 6       Please see The Bank Credit Analyst Section I, “July 2019,” dated June 27, 2019, available at bca.bcaresearch.com 7       Please see U.S. Equity Strategy Weekly Report, “The Great Rotation,” dated September 16, 2019, available at uses.bcaresearch.com 8       Please see U.S. Equity Strategy Weekly Report, “The Oil Factor,” dated September 23, 2019, available at uses.bcaresearch.com 9       Please see Global Investment Strategy Special Report, “TINA To The Rescue?,” dated August 23, 2019, available at gis.bcaresearch.com 10     Antti Ilmanen, Ronen Israel, Tobias J. Moskowitz, Ashwin Thapar, Franklin Wang, “Factor Premia and Factor Timing: A Century of Evidence,” AQR Working Paper, July 2, 2019. 11     Eugene F. Fama and Kenneth R. French, “Common risk factors in the return on stocks and bonds,” Journal of Financial Economics, 33 (1993). 12     Clifford Asness, Andrea Frazzini, Ronen Israel and Tobias Moskowitz, “Fact, Fiction, and Value Investing,” The Journal of Portfolio Management, Vol. 42 No.1, Fall 2015. 13     Ronen Israel and Tobias J. Moskowitz, “The Role of Shorting, Firm Size and Time on Market Anomalies,” Journal of Financial Economics, Vol 108, Issue 2, May 2013 14      Eugene F. Fama and Kenneth R. French, “A Five-Factor Asset Pricing Model,” Working Paper, University of Chicago, September 2014. 15             Fama-French value-growth-size portfolios. 16     Mark P. Cussen, “Value or growth Stocks: Which are Better?” Investopedia, Jun 25, 2019. 17     Please see Global Asset Allocation Special Report titled “Small Cap Outperformance: Fact or Myth?” dated April 7, 2017, available at gaa.bcaresearch.com. 18     Please see Global Asset Allocation Special Report titled, “Is Smart Beta A Useful Tool In Global Asset Allocation?” dated July 8, 2016, available at gaa.bcaresearch.com. 19    Clifford S. Asness, Jacques A Friedman, Robert J. Krail and John M Liew, “Style Timing: Value versus Growth,” The Journal of Portfolio Management, Spring 2000. 20     Please see Global Asset Allocation Quarterly Portfolio Outlook, “Quarterly - March 2016,” dated March 31, 2016, and available at gaa. bcaresearch.com. 21     Please see Global Asset Allocation Quarterly Portfolio Outlook, “Quarterly - April 2019,” dated April 1, 2019 available at gaa.bcaresearch.com.