Europe

Highlights So What? The yellow vest movement has not soured our optimistic view on France – if anything, it tells us it is time to turn more bullish. Why? The constraints on Macron pursuing reforms are overstated; he has no choice but to double-down.  France has multiple tailwinds: strong demographic trends, comparative advantages in exports, and an increasingly pro-business market environment.  Also … The roadmap for the European Union to change structurally is set, though it will need political will to materialize. Feature “La réforme oui, la chienlit non!” Charles De Gaulle, May 1968 “France is only herself when she leads fights that are bigger than herself.” Emmanuel Macron, August 2018 “When France sneezes the rest of Europe catches cold.” Prince Clemens von Metternich, 1848   In May 2017, the election of 39-year-old Emmanuel Macron brought an end to the seemingly unstoppable tide of populist nationalism in the developed world. As it turned out, the median voter in France was not as angry as the median voter in the U.K. and the U.S.  The reforms implemented since the French election have hardly made headlines outside of domestic media. The struggles of Italy, akin to la commedia dell’arte, and the jousting between London and Brussels, have drawn more attention. More recently, the yellow vest protests have reaffirmed the usual stereotypes about France. Behind the headlines, however, one cannot ignore the market relevance of what is happening in France. Thought to be condemned to stagnation by the rigidity of its labor market and the size of its state, the country is now looking to undo the malaise of the past two decades. The only surprise about the protests is that they did not occur sooner in Macron’s term. In this Special Report, we assess the ongoing yellow vest protests, review the reforms conducted since 2017, and give Macron favorable chances of reforming France further. We also highlight structural tailwinds that will support the French economy in the long run. Finally, we briefly go over the European Union’s roadmap for reforms. How Relevant Are The Yellow Vest Protests? Where there are reforms, there are protests. Or, as an astute client once told us: Buy when blood is in the streets. Had there been no protest against President Macron’s reforms, it would have signaled they lacked teeth. Protests were inevitable as soon as Macron set in motion his ambitious pro-growth and pro-business reform agenda. The yellow vest movement is not a coherent force led by a clear leadership. The demands of the group are many: lower taxes, better services, less of the current reforms (specifically in education), and more of other reforms. But despite this lack of clarity, the protesters have convinced most of the public that the reform agenda should pause, or at least slow down (Chart 1). Chart 1 What started on social media as a protest against the fuel tax in rural areas has evolved into a movement against President Macron. This transition occurred in part because a large segment of the population believes that Macron’s reforms have mainly benefited the wealthy. In fact, 77% of respondents in a recent poll view him as the “president of the rich.” The modification of the “wealth tax” – which mostly shifts the focus toward real estate assets instead of financial assets – was highly criticized for favoring the wealthiest households. It resonated strongly with the perception that past governments helped the wealthiest households to accumulate more wealth at the expense of the middle class. But it is not clear how intense or durable this popular sentiment will be, given that this type of inequality is not extreme in France and has not been rising (Chart 2). Chart 2What Income Inequality? What Income Inequality? What Income Inequality? Public support for the protests has hovered around 70% for several weeks since they started in November 2018, but is now coming down (Chart 3). There are now more respondents who think that the protests should stop than those who believe they should continue (Chart 4). As a sign of things to come, a demonstration against the yellow vests and in support of Macron and his government – held by the “red scarves” – managed to gather more people on the streets of Paris than the regionally based yellow vests have done in the capital city.1 Chart 3 Chart 4 Who are the yellow vests? The profile is shown in Diagram 1. They are mostly rural, mostly hold a high school degree (or less), and overwhelmingly support anti-establishment political leaders Marine Le Pen (right-wing leader of the National Rally) or Jean-Luc Mélenchon (left-wing leader of La France Insoumise). This suggests that the movement has failed to cross the ideological aisle and win converts from the center. Diagram 1The Profile Of A 'Yellow Vest' Protester France: La Marche A Suivre? France: La Marche A Suivre? How many French people are actually protesting? Although there was a slight pickup in protests at the beginning of January, nationwide numbers are not high. In fact, they are far from what they were back in November and therefore would have to get much larger for markets to become concerned anew (Chart 5). If we are to compare these protests to those in 1995 or 2010, the numbers pale in comparison (Table 1). For instance, the protest of December 1995 brought a million people onto the streets while the demonstrations against the Woerth pension reform in 2010 lasted for seven months and gathered close to nine million protesters across eight different events (Chart 6). Chart 5   Table 1In A Glorious History Of Protests, 'Yellow Vests' Are A Footnote France: La Marche A Suivre? France: La Marche A Suivre? Chart 6   Instead we would compare the yellow vest protests to the 15-month long Spanish Indignados in 2011, which gathered between six and eight million protesters overall, and the U.S. Occupy Wall Street protests that same year. The two movements were similarly disorganized and combined disparate and often contradictory demands. In both cases, the governments largely ignored the protesters. In the Spanish case, the right-of-center government of Mariano Rajoy plowed ahead with painful, pro-market reforms that have significantly improved Spain’s competitiveness. Thus the yellow vests should not have a major impact on Macron’s reform agenda. Although they have dragged his approval rating to historic lows (Chart 7), there is no constitutional procedure for the French president to lose power. The president’s mandate runs until 2022 and he has a solid 53% of the seats in the Assemblée Nationale. In other words, despite the consensus view – including among voters (Chart 8) – that he will not be able to implement the reforms he had planned, he still has the political power to push forward new initiatives. Chart 7...Although Macron Wishes He Was Sarkozy! ...Although Macron Wishes He Was Sarkozy! ...Although Macron Wishes He Was Sarkozy! Chart 8 Nevertheless, Macron will certainly have to adjust course to calm the protesters. For example, the recent increase in the minimum wage that the government announced in response to the demonstrations was not supposed to be implemented until later in the presidential term. The reforms brought forward in response to the protest are highlighted in Table 2. This should help reduce the movement’s fervor or otherwise its support. Table 2Macron’s Reforms: The Scorecard France: La Marche A Suivre? France: La Marche A Suivre? More importantly, Table 2 provides a list of the main reforms that have been implemented, proposed, or are yet to be completed since the election. The pace and breadth of these reforms come close to a revolution by the standards of the past forty years.2 What really matters is how these reforms tackle the following three key issues: the size of the state, the cost of financing such a large state, and the inflexible labor market. Macron is making progress on the latter two.  Labor reforms, effective since the beginning of 2018, simplify a complex labor code to allow for more negotiations at the company level, leaving unions outside the process. They also establish ceilings on damages awarded by labor courts, which represent a real burden on small and medium-sized French companies. The objective is to better align firm-level wage and productivity developments and encourage hiring on open-ended contracts. Education and vocational reforms aim at reducing the slack in the economy by reallocating skills. The youth unemployment rate, and the percentage of the youth population not in education, employment, or training, are both high (Chart 9). This is very relevant for the labor market given that the lack of skilled labor is the most important barrier to hiring (Chart 10), more so than regulation or employment costs. Chart 9Stagnant Youth Employment Figures... Stagnant Youth Employment Figures... Stagnant Youth Employment Figures... Chart 10...Are A Product Of Skill Deficiencies And Economic Uncertainty ...Are A Product Of Skill Deficiencies And Economic Uncertainty ...Are A Product Of Skill Deficiencies And Economic Uncertainty The administration’s weak spot is the large size of the state, which is undeniably at the root of the French malaise. At 55% of GDP, total government spending makes the French state the largest amongst developed economies (Chart 11). Although cutbacks have been announced, they have not materialized yet. These would include bringing the defense budget back to 2% of GDP, decreasing the number of deputies in the National Assembly by 30%, and cutting 120,000 jobs in the public sector. Chart 11 On the bright side, polls show that the French people understand the need to pare back the state. Indeed, 71% are in favor of the announced 100 billion euro cuts in government spending by 2022. Even Marine Le Pen campaigned on the promise of cutting the size of the public sector. Despite having a relatively good opinion of government employees, the majority of respondents approve of increasing work hours and job cuts for redundant government employees (Chart 12). Chart 12 The fundamental problem of a large public sector is that it has to be financed by taxing the private sector. This has fallen on the shoulders of businesses. However, under Macron, the corporate tax rate is set to decline progressively from 33.33% to 25% by 2022 – a cut of 8.3% in the corporate tax rate over four years (Chart 13). Chart 13Respite Coming For The Private Sector Respite Coming For The Private Sector Respite Coming For The Private Sector Bottom Line: The yellow vest protests were to be expected – they are the natural consequence of Emmanuel Macron’s push to reform the French economy and state. However, when compared to previous efforts to derail government reforms, the numbers simply do not stack up. Their disunited and broad objectives are likely to limit the effectiveness of the movement going forward. The global media’s focus on the protests ignores the structural reforms that Paris has already passed. This is a mistake as the reforms have been significant thus far, though much remains to be done. What To Expect Going Forward? Macron stands in what we call the “danger zone” of the J-Curve of structural reform (Diagram 2). Cutting the size of the state might be what he needs to get out of that zone over the course of his term. Diagram 2In The Danger Zone Of The J-Curve France: La Marche A Suivre? France: La Marche A Suivre? Unlike the last two presidents, Macron’s term has begun with a whirlwind. If he stops now, it is highly unlikely that he will recover his support levels. As such, there is no strategic reason why he would reverse course. His popularity is already in the doldrums. His only chance at another term is to plow ahead and campaign in 2022 on his accomplishments. He just needs to ensure that he will not plow into a rock. As expected, Macron has not made any mention of changing course on his most business-friendly reforms, which we see as a signal to investors that despite the recent chaos, the plan remains the same. Pension reforms, however, will likely be postponed given the ongoing protests. Macron hoped to introduce a universal, unified pension system by the middle of 2019 to replace an overly complex and fragmented system in which 42 different types of pension coexist, each one with its own calculation rules. Though protests (both yellow vest and otherwise) have been unimpressive by historical standards (Table 1), it might be too risky for the government to push the pension reform so close to these events. Bottom Line: Macron has turned France into one of the fastest-reforming countries in Europe. Do not read too much into the lows in approval rating and the protests. Macron has no choice but to own the reform agenda and try to campaign on it in 2022. France Is Not Hopelessly Condemned To Stagnation No country elicits investor doom and gloom like France. It is like the adage that Brazil has been turned on its head: France is the country of the past and always will be. However, we think that such pessimism ignores three important structural tailwinds.  Demographics From 2015 to 2050, the age distribution will remain broadly unchanged (Chart 14). The same cannot be said of Italy or Germany, where low fertility rates and ageing populations will permanently shift the demographic picture. Indeed, France has the highest fertility rate amongst advanced economies and less than 20% of the population is older than 65 (Chart 15). And France is far from relying on net migration to keep its population growing; migration represented only 27% of total population growth between 2013 and 2017, lower than in the U.S., the U.K. and Germany even if we were to exclude the migration crisis (Chart 16). Chart 14   Chart 15France Has Healthy Demographics… Positive Demographic Trends Positive Demographic Trends Chart 16 Whenever one mentions France’s positive demographics, criticism emerges that the high fertility rate is merely the result of migrants having lots of kids. This is not entirely correct. While data is scarce due to nineteenth century laws prohibiting censuses based on race or religious belief, data from neighboring European states shows that the birth rate among migrants and citizens of migrant descent essentially declines to that of the native population by the second generation, which in France remains at the replacement level.3 Solid population growth will be a boon to the French economy. A stable dependency ratio – the ratio of working-age to very old or very young people – should limit the burden on government budgets. Further, France will avoid the downward pressure on aggregate household savings associated with an ageing population, the negative implications of a smaller pool of funds available to the private sector, and the resulting inflationary pressures. We also expect the structural rise in European elderly labor force participation to finally take effect in France. The aftermath of the Great Recession and the burden of having to provide for unemployed youth should spur French retirees to work longer. At 3.1%, France is still some way behind Germany at 7% and the average of 6% for European countries (Chart 17). Chart 17Time For Pépère To Get Back To Work Time For Pépère To Get Back To Work Time For Pépère To Get Back To Work Together, these forces imply a higher long-term French potential growth. Based on demographic divergence alone, the European Commission expects French nominal GDP to overtake German nominal GDP by 2040. The French Savoir-Faire France has lost competitiveness in the global marketplace. French export performance has suffered from decades of rigidities and high unit-labor costs while some of France’s peers, such as Germany, benefited greatly from an early implementation of labor reforms (Chart 18). While pro-growth and pro-market reforms ought to reverse some of these trends, France can still rely on a manufacturing savoir-faire that gives it a strong foothold in high value-added sectors of manufacturing, such as in transportation, defense, and aeronautics. Chart 18The Hartz Reforms Gap The Hartz Reforms Gap The Hartz Reforms Gap Table 3 lists the 10 largest export sectors as a share of total exports for France and Germany. These two economies share five similar categories of exports amongst their largest exports, representing respectively 23.8% and 24.3% of their total exports. However, France displays a substantially higher revealed comparative advantage (RCA) in its flagship sectors.4 In other words, the level of specialization of these sectors relative to the world average is higher in France than in Germany. Going forward, it is precisely this level of specialization in the high value-added sectors that will support the French manufacturing industry. Table 3France Vs. Germany: Closer Than You Think France: La Marche A Suivre? France: La Marche A Suivre? We also view the bullish trends for defense spending and arms trade, and the burgeoning EM demand for transportation goods, as important tailwinds for French manufacturing. France is the world’s fourth-largest global defense exporter and will benefit from shifting geopolitical equilibriums caused by multipolarity. France is also well positioned in the transportation sector where its exports to EM countries represent 20% of its overall transportation exports – a share that more than doubled in the past 15 years (Chart 19). While this trend is currently declining with the end of Chinese industrialization, we expect that it will resume over the next several decades as more EM and FM economies grow. Chart 19EM: A Growth Market For France EM: A Growth Market For France EM: A Growth Market For France France Is Much More Business-Friendly Than You Think A surge in the number of businesses created followed the election of the French president. Last year, more than 520,000 new businesses were created (Chart 20). Chart 20The New 'Start-Up Nation' The New "Start-Up Nation" The New "Start-Up Nation" The ease of doing business has improved on various metrics and the economy-wide regulatory and market environment should continue on this trend, as measured by the OECD product market regulation indicator (Chart 21). For instance, it takes only three and a half days to set up a business in France and no more than five steps, which is much easier than in most European countries. Chart 21 France also ranks 10th on the Global Entrepreneurship Index – a measure of the health of entrepreneurship ecosystems in 137 countries. It appears prepared for more tech start-ups as it ranks amongst the top countries on the Technological Readiness Index. Overall, France is now a much more attractive destination for investments (Chart 22). It appears that Brexit uncertainty is also driving some long-term capital investments. Between 2016 and 2017, the number of FDI projects in France jumped by 31% and Paris has become the most attractive European city for foreign direct investments (Chart 23). Chart 22 Chart 23Paris: The City Of (Love) FDI Paris: The City Of (Love) FDI Paris: The City Of (Love) FDI Cyclical View Despite the end of QE, markets do not expect the ECB to start hiking rates in the next 12 months – the expected change in ECB policy rate as discounted by the Overnight Index Swap curve is only 7 bps. This means the private sector will keep benefiting from extremely low lending rates, nearing 2%. Bank loans to the private sector will continue growing at a solid pace (Chart 24). Chart 24Banks Are Itching To Lend Banks Are Itching To Lend Banks Are Itching To Lend A lower unemployment rate and accelerating wage growth are positive for both consumer spending and residential investment. Average monthly earnings have strongly rebounded in the past five quarters (Chart 25). These two trends could put a floor under deteriorating household confidence and support consumer spending (Chart 26). Should household confidence rebound, consumers might spend more and stimulate the economy given their high savings rate. Chart 25Consumers Are Primed To Consume Consumers Are Primed To Consume Consumers Are Primed To Consume Chart 26But Protests Have Dented Confidence But Protests Have Dented Confidence But Protests Have Dented Confidence How does this dynamic translate in economic growth? Despite the setback experienced by the euro area – due to weaker external demand, or “vulnerabilities in emerging markets” to use the European Central Bank’s (ECB) own words – and the negative economic impact of the yellow vests, French real GDP grew by 1% (annualized) in the fourth quarter. The concessions made by Macron to answer the protests will bring the budget deficit close to 3.2% of GDP – from an earlier projection of 2.8%. The fiscal thrust will contribute positively to GDP growth (Chart 27), though 2020 may witness a larger fiscal drag.  Chart 27Macron Has Given Up On Austerity Macron Has Given Up On Austerity Macron Has Given Up On Austerity Bottom Line: The overall fundamentals of the economy are not as bad as the pessimists say. Cyclical and structural tailwinds will support the French economy going forward and should be reinforced by reforms. Can Europe Be Set En Marche Too? Macron’s presidency offers the European Union a window of opportunity to change structurally. He is already perceived as the “default leader” of Europe and might be the answer to the EU’s desperate need for strong leadership. What we have so far looks like a roadmap for a roadmap, but some progress could materialize this year. The European Stability Mechanism (ESM) – the European instrument for economic crisis prevention – is supposed to be granted new powers. At the Euro Summit in December, the ministers agreed on the terms of reference of the common backstop to the euro zone bank resolution fund (SRF), which would allow the ESM to lend to the SRF should a crisis or number of crises suck away all its funds. It would be ready from 2024 to come up with loans for bank resolution. While this may appear to be too late to make a difference in the next recession, we would remind clients that all dates are malleable in the European context. The possibility of the ESM playing a role in a potential sovereign debt restructuring in the future, like a sort of “European IMF,” was also discussed. However, some – including the ESM’s leadership – argue that such an expanded role will necessitate a greater injection of capital, which obviously Berlin must accept. Second, the stalled Banking Union project requires Berlin’s intimate involvement. In fact, Germany remains practically the only member state against the European Deposit Insurance Scheme (EDIS). This deposit insurance union would go a long way toward stabilizing the Euro Area amid future financial crises. However, a high-level working group should report by June 2019. As such, with Merkel sidelined and Macron taking leadership of the reform process, there could be movement on the EDIS by mid-year. Bottom Line: As Merkel exits the stage, France is likely to seize the opportunity to take the leading role from the Germans. By delivering the reforms he promised during his campaign and thus performing effectively at home, Macron hopes to obtain the legitimacy to set the EU en marche as well. Some material progress could be achieved as early as June this year. Stay tuned.   Jeremie Peloso, Research Analyst jeremiep@bcaresearch.com Footnotes 1      According to the government, 10,500 “red scarves” marched in Paris on January 27, 2018. 2      Sans the guillotine! 3      Rojas, Bernardi, and Schmid, “First and second births among immigrants and their descendants in Switzerland,” Demographic Research 38:11 (2018), pp. 247-286, available at https://www.demographic-research.org/Volumes/Vol38/11/Ariane Pailhé, “The convergence of second-generation immigrants’ fertility patterns in France: The role of sociocultural distance between parents’ and host country,” Demographic Research 36:45 (2017), pp. 1361-1398, available at https://www.demographic-research.org/Volumes/Vol36/45/Kulu et al., “Fertility by Birth Order among the Descendants of Immigrants in Selected European Countries,” Population And Development Review 43:1 (2017), pp. 31-60, available at https://doi.org/10.1111/padr.12037  4      A country displays a revealed comparative advantage in a given product if it exports more than its “fair” share, that is, a share that is equal to the share of total world trade that the product represents.  

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

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

Highlights Equities can continue to outperform bonds for a few months longer. The pro-cyclical equity sector stance that has worked well since last October can also continue for a few months longer. Overweight pro-cyclical Sweden versus pro-defensive Denmark. The caveat is that these short-term trends are unlikely to persist and will viciously reverse later in the year. European ‘soft’ luxury goods companies are an excellent structural investment opportunity. Take profits on the 75 percent rally in Litecoin and 50 percent rally in Ethereum. Feature Why should European investors care so much about China? The Chart of the Week provides one emphatic answer. For Europe’s $500 billion basic resources sector, the three most important things in the world are: China, China, and China. Through the past decade, the share price performance of the resource behemoths BHP, Anglo American, Rio Tinto, and Glencore have been joined at the hip to China’s short-term credit impulse (Chart I-2 and Chart I-3). Chart of the WeekFor European Basic Resources, The Three Most Important Things In the World Are: China, China, And China For European Basic Resources, The Three Most Important Things In the World Are: China, China, And China For European Basic Resources, The Three Most Important Things In the World Are: China, China, And China Chart I-2BHP, Anglo American, And Rio Tinto Have Been Rallying For Several Months BHP, Anglo American, And Rio Tinto Have Been Rallying For Several Months BHP, Anglo American, And Rio Tinto Have Been Rallying For Several Months Chart I-3BHP Is Joined At The Hip To China's Short-Term Credit Impulse BHP Is Joined At The Hip To China's Short-Term Credit Impulse BHP Is Joined At The Hip To China's Short-Term Credit Impulse But China has a much deeper importance to Europe. According to Mario Draghi, the recent cycle in Europe is ‘made in China’. On the euro area’s domestic fundamentals, Draghi is upbeat, citing “supportive financing conditions, favourable labour market dynamics and rising wage growth”. Yet the economic data have continued to be weaker than expected. Why? Draghi blames a “slowdown in external demand” and specifically, vulnerabilities in emerging markets. He claims that as soon as there is clarity on the exports and the trade sector, much of the euro area’s weakness will wash out.     Federal Reserve Chairman, Jay Powell presented a remarkably similar narrative to justify the recent pause in the Fed’s sequential rate hikes: “The U.S. economy is in a good place… but growth has slowed in some major foreign economies.” If Powell claims that the U.S. domestic economy is in a good place and Draghi points out that the euro area domestic fundamentals are fine, then the explanation for what has happened – and what will happen – can only come from one place: China. Optimistically, Draghi adds: “everything we know says that China’s government is actually taking strong measures to address the slowdown.” The good news is that we can independently corroborate Draghi’s optimism, at least in the near-term (Chart I-4). Chart I-4China's Short-Term Credit Impulse Is Up Sharply, And Commodities Have Rebounded China's Short-Term Credit Impulse Is Up Sharply, And Commodities Have Rebounded China's Short-Term Credit Impulse Is Up Sharply, And Commodities Have Rebounded Why China Matters To Europe Chart I-5 shows the short-term credit impulses in the euro area, U.S., and China through the past twenty years. They are all expressed in dollars to allow an apples for apples comparison between the three major economies. The comparison reveals a fascinating transformation. The dominant short-term impulse – the one with the highest amplitude – charts the shift in global economic power and influence from Europe and the U.S. to China. Chart I-5The Shift In Global Economic Power From Europe And The U.S. To China The Shift In Global Economic Power From Europe And The U.S. To China The Shift In Global Economic Power From Europe And The U.S. To China Before 2008, the short-term impulses in the euro area and the U.S. dominated. But the global financial crisis was a major turning point: the credit stimulus from China dwarfed the responses from the western economies. Then through 2009-12 the impulse oscillations from the three major economies took it in turns to dominate. For example, the 2011-12 global downturn was definitely ‘made in Europe’. However, since 2013 China has taken on the undisputed mantle of dominant impulse. Most recently, last year’s peak to trough decline in China’s short-term impulse amounted to $1 trillion, equivalent to a 1.5 percent drag on global GDP. By comparison, the declines in the euro area and the U.S. amounted to a much more modest $200 billion. Likewise, the recent rebound in the China’s short-term impulse, in dollar terms, has been much larger than the respective rebounds in the euro area and the U.S. Credit Impulses And Speeding Tickets Clients complain that they are confused by the conflicting messages from differently calculated credit impulses. So let’s digress for a moment to present a powerful analogy which should clear the confusion once and for all. Imagine you floored the accelerator pedal of your car (analogous to a huge stimulus). After a hundred metres or so, the stimulus would become very apparent. Your speed over that short sprint would have surged, and possibly have become illegal! But your average speed measured over the previous kilometre would have barely changed. Now imagine a police officer rightfully presents you with a speeding ticket. To protest your innocence, you argue that you couldn’t have floored the accelerator pedal because your average speed over the previous kilometre had barely changed! Clearly, you would never offer such a ludicrous defence for pushing the pedal to the metal. Yet when assessing the impact of an economic stimulus, it is commonplace to make the same mistake.    The crucial point is that a stimulus – like flooring the accelerator pedal of your car – will barely move the needle for a longer-term rate of change, but it will become very apparent in a short-term rate of change. For this reason, financial markets never wait for the long-term rates of change to pick up. They always move up or down on the evolution of short-term rates of change. It follows that the credit impulse calculation that is most relevant is the one that provides the best explanatory power for the cycles that we actually observe in the economic and financial market data. As we described in our Special Report, “The Cobweb Theory And Market Cycles”, both the theory and evidence powerfully identify the 6-month credit impulse as the one with the best explanatory power for the oscillations that we actually observe in the economy and markets.1 For the sceptics, the charts in this report should finally dispel any lingering doubts. China’s 6-month impulse gives a spookily perfect explanation for the industrial commodity inflation cycle, and thereby the share price performance of the basic resources sector, as well as the other classically cyclical sectors (Chart I-6 and Chart I-7). Chart I-6China's Short-Term Impulse Perfectly Explains Industrial Commodity Inflation China's Short-Term Impulse Perfectly Explains Industrial Commodity Inflation China's Short-Term Impulse Perfectly Explains Industrial Commodity Inflation Chart I-7Semiconductors Are A Modern Day Cyclical Semiconductors Are A Modern Day Cyclical Semiconductors Are A Modern Day Cyclical The good news is that China’s short-term impulse has indisputably been in a mini-upswing in recent months, and this is the reason that the classical cyclical sectors have simultaneously rebounded or, at the very least, stabilised. The bad news is that the shelf-life of such mini-upswings averages no more than eight months or so. Intuitively, this is because just as you cannot accelerate your car indefinitely, it is likewise impossible to stimulate credit growth indefinitely. The investment conclusion is that the pro-cyclical equity sector stance that has worked well since last October can continue for a few months longer. This sector stance necessarily impacts regional and country allocation. For example, it is still right to be overweight pro-cyclical Sweden versus pro-defensive Denmark (Chart I-8 and Chart I-9).  Chart I-8Overweight Pro-Cyclical Sweden Versus Denmark... Overweight Pro-Cyclical Sweden Versus Denmark... Overweight Pro-Cyclical Sweden Versus Denmark... Chart I-9...And Versus Norway ...And Versus Norway ...And Versus Norway From an asset allocation perspective, it means that equities can continue to outperform bonds for the time being. But the caveat is that these short-term trends are unlikely to persist, and most likely, they will viciously reverse later in the year. Stay tuned for the signal to switch. Stay Structurally Overweight ‘Soft’ Luxuries A common question we get concerns the European luxury goods sector: is it, just like the basic resources sector, a direct play on China’s growth cycle?  The answer is no. Recently, the connection between the fortunes of ‘soft’ luxury goods brands like LVMH, Hermes, and Kering and China’s growth cycle has been weak (Chart I-10). Broadly, this is also true for ‘hard’ luxury brands – for example, luxury watches – like Richemont (Chart I-11). Chart I-10European 'Soft' Luxuries Are No Longer A China Play... European 'Soft' Luxuries Are No Longer A China Play... European 'Soft' Luxuries Are No Longer A China Play... Chart I-11...Neither Are European 'Hard' Luxuries ...Neither Are European 'Hard' Luxuries ...Neither Are European 'Hard' Luxuries As we highlighted in Buying European Clothes: An Investment Megatrend, the much bigger driver for the ‘soft’ luxury brands is the structural increase in female labour participation rates, and the feminisation of consumer spending. We expect this trend to persist for the next decade.2 Hence, we are happy to buy and hold the European clothes and accessories companies with a dominant or significant exposure to women’s clothes and/or accessories; provided they have a top-end brand (or brands) giving pricing power, and mitigating the very strong deflation in clothes prices. In summary, while European basic resources are a good tactical investment opportunity, European ‘soft’ luxury goods companies are an excellent structural investment opportunity. Fractal Trading System* We are delighted to report that the fractal trading system perfectly identified the sharp recent rebound in cryptocurrencies. Our long Litecoin and Ethereum position has hit its 60 percent profit target with Litecoin up 75 percent and Ethereum up 50 percent since trade initiation on December 19. Additionally, long industrials versus utilities has also hit its profit target. With no new trades this week, the fractal trading system now has five open positions. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-12 Litecoin Is Oversold On A 65-Day Horizon Litecoin Is Oversold On A 65-Day Horizon The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. *  For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com Footnote 1 Please see the European Investment Strategy Special Report “The Cobweb Theory And Market Cycles” January 11, 2018 available at eis.bcaresearch.com  2 Please see the European Investment Strategy Special Report “Buying European Clothes: An Investment Megatrend” December 6, 2018 available at eis.bcaresearch.com Fractal Trading System Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations