Fiscal

Special Report

Highlights Many on the left have embraced Modern Monetary Theory because it seemingly provides a politically expedient way to increase social welfare spending without raising taxes. Money-financed budget deficits can be justified when an economy is stuck in a liquidity trap, but can be extremely inflationary once full employment is reached. Investors should regard MMT as simply an extreme example of the increasingly permissive attitude that policymakers are adopting towards inflation and larger budget deficits. The path to high rates is lined with low rates, meaning that an extended period of accommodative monetary policy is usually necessary to stoke inflation. Investors should maintain a bullish bias towards global equities for now, but be prepared to turn bearish late next year as inflation begins to accelerate in the United States. An earlier turn to a more defensive posture on stocks may be necessary if Bernie Sanders, or some other far-left candidate, emerges as the likely victor in the next presidential election. Feature Print Some Money And Feel The Bern You know that an economic theory has reached the big leagues of policy debate when the Fed Chair is asked about it during his congressional testimony. This is exactly what happened on February 26, 2019, when Senator David Perdue questioned Jay Powell about his views on Modern Monetary Theory, or simply MMT as it is often called. Rather ironically given its name, MMT plays down the influence of monetary policy over the economy. Its adherents argue that Congress, and not the Fed, should be responsible for maintaining full employment. MMT proponents abhor the idea of a “balanced budget.” They contend that worries about sovereign debt levels are overblown. The U.S. government can always print money to finance itself. Fiscal deficits matter, but only to the extent that excessive deficits can cause inflation. The theory’s backers are a bit cagey about exactly how much inflation they are willing to tolerate or what they would do if, as in the 1970s, inflation and unemployment both rose together. Whether one thinks MMT is crackpot economics is not the point. What matters is that its supporters are growing in number. They include Stephanie Kelton, Bernie Sanders’ former economic advisor, and one of the speakers at BCA’s forthcoming annual New York Investment Conference. In my personal opinion, Sanders stands a very good chance of winning the 2020 presidential election. This makes MMT about as market-relevant as anything out there. In the following Q&A, we discuss the details of MMT and what it means for investors: Q: How does Modern Monetary Theory differ from standard Keynesian economics? A: MMT is almost indistinguishable from Keynesian economics when an economy is stuck in a liquidity trap, an environment where even interest rates of zero are not enough to revive demand. What really separates the two schools of thought is that MMT proponents tend to see liquidity trap conditions as the normal state of affairs, whereas most Keynesians see them as the exception to the rule. Q: Who’s right? The Keynesians or the MMTers? A: That remains to be seen. Near-zero rates have been the norm for most of the last decade, and much longer in Japan. This is a key reason why MMT has grown in popularity. The future may be different, however. Output gaps are shrinking and some of the structural forces which have held down rates over the last decade may fade. For example, the ratio of workers-to-consumers has peaked around the world, which may result in a decline in global savings (Chart 1). This could push up interest rates. Chart 1The Worker-To-Consumer Ratio Has Peaked Globally Q: Does the tendency of MMT backers to see the world as chronically ensnarled in a liquidity trap explain why they seem to consistently argue for bigger budget deficits? A: It does. If an economy needs negative interest rates to reach full employment, but actual rates are constrained by the zero-lower bound, anything which incrementally adds to aggregate demand will not result in higher rates. This means that increased government spending will not crowd out private investment – indeed, quite to the contrary, bigger budget deficits will “crowd in” private spending by boosting employment. The standard MMT prescription is to run a budget deficit that is large enough, but no larger, to maintain full employment. In effect, this means taking any excess private-sector savings – that is, savings which cannot be transformed into private investment or exported abroad via a current account surplus – and having the government absorb them with its own dissavings. Q: So MMT supporters are assuming that the government is competent and agile enough to tighten and loosen fiscal policy at exactly the right time? Good luck with that. A: Yes, that is a common problem with most left-wing theories: They assume that the government should not be trusted with anything unless it is run by fellow leftists, in which case it should be trusted with everything. To make the fiscal response timelier, MMT supporters have proposed creating a government job guarantee. The basic idea is that the government would hire more workers when the private sector is hunkering down, while shedding workers when the private sector is expanding. In theory, automatic fiscal stabilizers of this sort could help dampen the business cycle. The consensus among MMT backers in the U.S. is that a $15 wage would be high enough to offer a tolerable standard of living without enticing many people to opt for government work when suitable private-sector employment is available. MMT supporters are assuming that the government is competent and agile enough to tighten and loosen fiscal policy at exactly the right time. Unfortunately, as is often the case with such ideas, the devil is in the details. For example, does the $15 wage include potentially generous government benefits? What will the government do if someone shows up for work but decides to just loaf around? What about low-skilled workers who would be more productive in the private sector but are instead diverted into government make-work projects? Inquiring minds want to know. Q: And the price tag could be huge! Wouldn’t an extended period of large budget deficits – even if justified by economic circumstances – cause debt levels to spiral out of control? A: A prolonged period of large budget deficits would most certainly lead to a significant increase in the government debt burden. However, if the interest rate on government borrowing is lower than the growth rate of the economy, as MMT supporters tend to assume, the debt-to-GDP ratio will eventually stabilize.1 In such a setting, the government could just roll over the existing stock of debt indefinitely, while issuing enough new debt to cover interest payments. No additional taxes would be necessary. Chart 2 shows this point analytically. Right now, projected GDP growth is higher than 10-year government borrowing rates for most countries (Chart 3). That’s the good news. The bad news is that there is no guarantee that this will remain the case indefinitely. If interest rates ever rose above GDP growth for an extended period of time, debt dynamics would quickly become unsustainable. MMTers argue that the government can borrow at any rate it wants because they see the currency as a public monopoly.  Q: Isn’t it crazy to assume that interest rates will always stay below GDP growth? A: Not according to MMTers. They argue that the government can borrow at any rate it wants. This is because they see the currency as a public monopoly. As long as a government is able to issue its own currency, it can create money to pay for whatever it purchases, and by definition, money pays no interest. This means that the interest rate can always be held below the growth rate of the economy. The only reason policymakers may wish to raise interest rates is if inflation is getting out of hand. However, even then, most MMT adherents would prefer that the government tighten fiscal policy either by hiking taxes on the rich or cutting spending programs they don’t like (the military is usually high on their list). Raising rates is widely seen by MMT supporters as simply providing a handout to bondholders. Q: It sounds like MMT basically cuts the Fed and other central banks out of the loop. A: That’s right. MMTers contend that monetary policy has little impact on the economy. In fact, many MMT advocates believe that higher rates raise aggregate demand by putting more income into bondholders’ pockets. It’s a very odd argument. Yes, corporate investment tends to respond more to animal spirits than to changes in interest rates. However, there is little doubt that rates affect housing, the currency, and asset prices (and all three, in turn, affect animal spirits). It is almost as if the 1982 recession – an episode where the Volcker Fed took interest rates to 19% – never happened. Q: An odd argument, but perhaps not a surprising one? A: That’s where the “Magic Money Tree” moniker comes in. When an economy is suffering from high unemployment, there really is a free lunch: Putting more people to work can increase someone’s spending without decreasing someone else’s. However, when an economy is at full employment, scarcity becomes relevant again. If a government wants to spend more, it has to convince the private sector to spend less, which it normally does by raising interest rates. MMTers like to throw out the old chestnut about how budget deficits endow the private sector with financial assets such as cash or government bonds. But if additional government spending leads to higher inflation, an increase in the volume of financial assets will simply result in the erosion of the value of existing financial assets. There may be times when more government spending is beneficial even in a full-employment economy, such as funding for basic scientific research or public infrastructure. However, there may also be times when increased government spending is wasteful and comes at the expense of valuable private-sector investment. MMT does not distinguish between the two cases because its adherents seem to deny that any such trade-off exists. Q: It sounds like MMTers want to have their cake and eat it too. A: Exactly. The political appeal of MMT is that it seemingly promises European-style welfare spending without Europe’s level of taxes. Just print more money! Let us ignore the fact that the Fed actually pays interest on bank reserves. Under the current rules, increasing the monetary base would not be costless for the government if that money ended up back at the Fed in the form of excess reserves, as it surely would. The bigger problem is that a large increase in government spending, which is not matched by much higher taxes, will quickly cause the economy to overheat. At that point, policymakers would either need to rapidly tighten fiscal policy, aggressively hike interest rates, or face hyperinflation and a plunging currency. Q: That seems like an obvious point. Why don’t MMTers see it? A: It gets back to what we discussed at the outset – MMTers regard the world as being chronically stuck in a liquidity trap. The prevailing view among MMTers is that there is still a lot of spare capacity globally, including in the United States, where the unemployment rate has fallen below official estimates of NAIRU (the Non-Accelerating Inflation Rate of Unemployment). MMT supporters tend to be skeptical of these NAIRU estimates, believing them to be biased upwards. MMTers see the world as being chronically stuck in a liquidity trap. The prevailing view among MMTers is that there is still a lot of spare capacity in the world. To be fair, the methodology used by the OECD and many other statistical agencies to calculate the full employment rate, which effectively just smooths out past values of the actual unemployment rate, has probably understated the degree of labor market slack in a few countries (Chart 4). Chart 4AThe Unemployment Rate Versus NAIRU (I) Chart 4BThe Unemployment Rate Versus NAIRU (II) That said, we doubt that NAIRU is overstated in the United States. Both the Fed and the OECD peg NAIRU at 4.3%, slightly below the CBO’s estimate of 4.6%. As it is, the current CBO estimate is nearly one percentage point below the post-1960 average (Chart 5). Back in the 1960s and 1970s, most economists thought NAIRU was lower than it actually turned out to be (Chart 6). This caused the Fed to keep rates below where they should have been. Chart 5U.S. NAIRU Is Estimated To Be The Lowest On Record Chart 6The Fed Continuously Overstated The Magnitude Of Economic Slack In The 1970s Q: Let’s bring this back to market strategy. What does the increasing popularity of MMT mean for investors? A: Investors should regard MMT as simply an extreme example of the increasingly permissive attitude that policymakers are adopting towards inflation. The idea that central banks should raise rates preemptively to avoid overheating is slowly giving way to the belief that they should wait to see the “whites of inflation’s eyes” before tightening monetary policy. Meanwhile, on the fiscal side, austerity is out, and big deficits are in. None of this should be all that surprising. Attitudes towards inflation move in generational cycles. The generation that grew up during the 1930s was highly sensitized towards deflation risk. As a result, policymakers focused on increasing employment, even at the expense of higher inflation. In contrast, the generation that came of age in the 1970s favored policies that clamped down on inflation. For today’s generation, the stagflation of the seventies is a distant memory. “Maximum employment” is the name of the game again. It often takes several years for an overheated economy to produce inflation. This is particularly true when the Phillips curve is quite flat, as appears to be the case today. To the extent that the Fed raises rates over the next 12 months, it will be in response to better-than-expected growth. The stock market should be able to do well in that environment. However, as we get into late-2020 or early-2021, inflation may begin to move materially higher, forcing the Fed to crank up the pace of rate hikes. At that point, equity prices will drop and a maximum short duration stance towards government bonds will be warranted. Q: Just in time for Bernie Sanders’ inauguration! You predicted Trump would win, but Crazy Bernie? Come on, seriously? A: My guess is that Trump was the only Republican candidate who could have beaten Hillary Clinton in 2016, while Clinton was the only Democratic candidate who could have lost to Trump. Had it been Bernie versus Trump, Trump would have lost. Given how close the election turned out to be, Sanders would have probably prevailed.   This is not just idle speculation. During the tail end of the 2016 primary season, head-to-head polls showed Sanders leading Trump by about 10 points, compared to a 3-point lead for Clinton (Chart 7). The final results would have been more favorable for Trump, but given how close the election turned out to be, Sanders would have probably prevailed. A strong economy will help Trump this time around. However, demographic trends continue to move against Republicans. Trump also made a strategic mistake during his first two years in office by focusing on Republican pet issues like corporate tax cuts and gutting Obamacare, rather than securing funding for the border wall, which was his signature campaign promise. For its part, the Democrat establishment will try to stymie Sanders again, but having recently watered down the “superdelegate” rules, it will be in a much weaker position to do so than last time. Q: Yikes, President Bernie doesn’t sound good for stocks! A: In our client conversations on “tail risks” facing the markets, Bernie Sanders almost never comes up. Admittedly, a lot can change in the next 12 months, including the possibility that Joe Biden will enter the race. Biden is more moderate than Sanders and has broad-based appeal. This means that it is still too early to make any significant changes to portfolio strategy. However, if Bernie Sanders, or some other far-left candidate, begins to do well in the polls, markets may start to get antsy later this year.     Peter Berezin Chief Global Investment Strategist peterb@bcaresearch.com       1      Please see Global Investment Strategy Weekly Report, “Is There Really Too Much Government Debt In The World?” dated February 22, 2019.     Strategy & Market Trends MacroQuant Model And Current Subjective Scores Tactical Trades Strategic Recommendations Closed Trades

Special Report

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). 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? 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 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 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).   Table 1In A Glorious History Of Protests, 'Yellow Vests' Are A Footnote   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! 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 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... Chart 10...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. 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). 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 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 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 15France Has Healthy Demographics… 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 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 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 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 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 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. 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 23Paris: 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 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 Chart 26But 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 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 It may seem self-evident that most governments are overly indebted, but both theory and evidence suggest otherwise. Higher debt today does not require higher taxes tomorrow if the growth rate of the economy exceeds the interest rate on government bonds. Not only is that currently the case, but it has been the norm for most of history. Unlike private firms or households, governments can choose the interest rate at which they borrow, provided that they issue debt in their own currencies. Ultimately, inflation is the only constraint to how large fiscal deficits can get. Today, most governments would welcome higher inflation. There are increasing signs China is abandoning its deleveraging campaign. Fiscal policy will remain highly accommodative in the U.S. and will turn somewhat more stimulative in Europe. Remain overweight global equities/underweight bonds. We do not have a strong regional equity preference at the moment, but expect to turn more bullish on EM versus DM by the middle of this year. Feature A Fiscal Non-Problem? Debt levels in advanced economies are higher today than they were on the eve of the Global Financial Crisis. Rising private debt accounts for some of this increase, but the lion’s share has occurred in government debt (Chart 1). Chart 1Global Debt Levels Have Risen, Especially In The Public Sector Not surprisingly, rising public debt levels have elicited plenty of consternation. While there has been a lively debate about how fast governments should tighten their belts, few have disputed the seemingly self-evident opinion that some degree of “fiscal consolidation” is warranted. Given this consensus view, one would think that the economic case for public debt levels being too high is airtight. It’s not. Far from it. Debt Sustainability, Quantified Start with the classic condition for debt sustainability, which specifies the primary fiscal balance (i.e., the overall balance excluding interest payments) necessary to maintain a constant debt-to-GDP ratio (See Box 1 for a derivation of this equation).   An increase in the economy’s growth rate (g), or a decrease in real interest rates (r), would allow the government to loosen the primary fiscal balance without causing the debt-to-GDP ratio to increase (Chart 2).1 If the government were to ease fiscal policy beyond that point, debt would rise in relation to GDP. But by how much? It is tempting to assume that the debt-to-GDP ratio would then begin to increase exponentially. However, that is only true if the interest rate is higher than the growth rate of the economy. If the opposite were true, the debt-to-GDP ratio would rise initially but then flatten out at a higher level.2 A Fiscal Free Lunch The last point is worth emphasizing. As long as the interest rate is below the economic growth rate, then any primary fiscal balance – even a permanent deficit of 20%, or even 30% of GDP – would be consistent with a stable long-term debt-to-GDP ratio. In such a setting, the government could just indefinitely rollover the existing stock of debt, while issuing enough new debt to cover interest payments. No additional taxes would be necessary. In fact, stabilizing the debt-to-GDP ratio becomes easier the higher it rises. Chart 3 shows this point analytically.    Ah, one might say: If the government issues a lot of debt, then interest rates would rise, and before we know it, we are back in a world where the borrowing rate is above the economy’s growth rate, at which point the debt dynamics go haywire. Now, that sounds like a sensible statement, but it is actually quite misleading. As long as a government is able to issue its own currency, it can always create money to pay for whatever it purchases. If people want to turn around and use that money to buy bonds, they are welcome to do so, but the government is under no obligation to pay them the interest rate that they want. If they do not wish to hold cash, they can always use the cash to buy goods and services or exchange it for foreign currency. As long as a government is able to issue its own currency, it can always create money to pay for whatever it purchases. Wouldn’t that cause inflation and currency devaluation? Yes, it might, and that’s the real constraint: What limits the ability of governments with printing presses to run large deficits is not the inability to finance them. Rather, it is the risk that their citizens will treat their currencies as hot potatoes, rushing to exchange them for goods and services out of fear that rising prices will erode the purchasing power of their cash holdings. When Is Saving Desirable? The reason governments pay interest on bonds is because they want people to save more. However, more savings is not necessarily a good thing. This is obviously the case when an economy is depressed, but it may even be true when an economy is at full employment. Just like someone can work so much that they have no time left over for leisure, or buy a house so big that they spend all their time maintaining it, it is possible for an economy to save too much, leading to an excess of capital accumulation. Under such circumstances, steady-state consumption will be permanently depressed because so much of the economy’s resources are going towards replenishing the depreciation of the economy’s capital stock.  Economists have a name for this condition: “dynamic inefficiency.” What determines whether an economy is dynamically inefficient? As it turns out, the answer is the same as the one that determines whether debt ratios are on an explosive path or not: The difference between the interest rate and the economy’s growth rate. Economies where interest rates are below the growth rate will tend to suffer from excess savings. In that case, government deficits, to the extent that they soak up national savings, may increase national welfare.   r < g Has Been The Norm Today, the U.S. 10-year Treasury yield stands at 2.69%, compared to the OECD’s projection of nominal GDP growth of 3.8% over the next decade. The gap between projected growth and bond yields is even greater in other major economies (Chart 4). Granted, equilibrium real rates are likely to rise over the next few years as spare capacity is absorbed. Structural factors might also push up real rates over time. Most notably, the retirement of baby boomers could significantly curb income growth, leading to a decline in national savings. Chart 5 shows that the ratio of workers-to-consumers globally is in the process of peaking after a three-decade long ascent. Economic growth could also fall if cognitive abilities continue to deteriorate, a worrying trend we discussed in a recent Special Report.3 Chart 5The Global Worker-To-Consumer Ratio Has Peaked It may take a while before real rates rise above GDP growth. Still, it may take a while before real rates rise above GDP growth. As Olivier Blanchard, the former chief economist at the IMF, noted in his Presidential Address to the American Economics Association earlier this year, periods in U.S. history where GDP growth exceeds interest rates have been the rule rather than the exception (Chart 6).4 The same has been true for most other economies.5 Chart 6GDP Growth Above Interest Rates: Historically, The Rule, Not The Exception What’s Next For Fiscal Policy? Austerity fatigue has set in. In the U.S., fiscally conservative Republicans, if they ever really existed, are a dying breed. Trump’s big budget deficits and his “I love debt” mantra are the waves of the future. For their part, the Democrats are shifting to the left, with the “Green New Deal” proposal being the latest manifestation. The case for fiscal stimulus is stronger in the euro area than for the United States. The European Commission expects the euro area to see a positive fiscal thrust of 0.40% of GDP this year, up from a thrust of 0.05% of GDP last year (Chart 7). This should help support growth. Chart 7The Euro Area Will Benefit From A Modest Amount Of Fiscal Easing This Year Additional fiscal easing would be feasible. This is clearly true in Germany, but even in Italy, the cyclically-adjusted government primary surplus is larger than what is necessary to stabilize the debt ratio.6 Unfortunately, the situation in southern Europe is greatly complicated by the ECB’s inability to act as an unconditional lender of last resort to individual sovereign borrowers. When a government cannot print its own currency, its debt markets can be subject to multiple equilibria. Under such circumstances, a vicious spiral can develop where rising bond yields lead investors to assign a higher default risk, thus leading to even higher yields (Chart 8).   Mario Draghi’s now-famous “whatever it takes” pledge has gone a long way towards reassuring bond investors. Nevertheless, given the political constraints the ECB faces, it is doubtful that Italy or other indebted economies in the euro area will be able to pursue large-scale stimulus. Instead, the ECB will keep interest rates at exceptionally low levels. A new round of TLTROs is also looking increasingly likely, which should protect against a rise in bank funding costs and a potential credit crunch. Our European team believes that a TLTRO extension would be particularly helpful to Italian banks.  Even in Italy, the cyclically-adjusted government primary surplus is larger than what is necessary to stabilize the debt ratio. Despite having one of the highest sovereign debt ratios in the world, Japan faces no pressing need to tighten fiscal policy. Instead of raising the sales tax this October, the government should be cutting it. A loosening of fiscal policy would actually improve debt sustainability if, as is likely, a larger budget deficit leads to somewhat higher inflation (and thus, lower real borrowing rates) and, at least temporarily, faster GDP growth. We expect the Abe government to counteract at least part of the sales tax increase with new fiscal measures, and ultimately to abandon plans for further fiscal tightening over the next few years. In the EM space, Brazil, Turkey, and South Africa are among a handful of economies with vulnerable fiscal positions. They all have borrowing rates that exceed the growth rate of the economy, cyclically-adjusted primary budget deficits, and above-average levels of sovereign debt (Chart 9).   In contrast, China stands out as having the biggest positive gap between projected GDP growth and sovereign borrowing rates of any major economy. The problem is that the main borrowers have been state-owned companies and local governments, neither of which are backstopped by the state. Not officially, anyway. Unofficially, the government has been extremely reluctant to allow large-scale defaults anywhere in the economy. Despite all the rhetoric about market-based reforms, they are unlikely to start now. Historically, the Chinese government has allowed credit growth to reaccelerate whenever it has fallen towards nominal GDP growth. As we recently argued in a report entitled “China’s Savings Problem,” China needs more debt to sustain aggregate demand.7 Historically, the government has allowed credit growth to reaccelerate whenever it has fallen towards nominal GDP growth (Chart 10). The stronger-than-expected jump in credit origination in January suggests that we are approaching such an inflection point. Chart 10Historically, China Has Scaled Back On Deleveraging When Credit Growth Has Fallen Close To Nominal GDP Growth Investment Conclusions The consensus economic view is that deflation is a much harder problem to overcome than inflation. When dealing with inflation, all you have to do is raise interest rates and eventually the economy will cool down. With deflation, however, a central bank could very quickly find itself up against the zero lower bound constraint on interest rates, unable to ease policy any further via conventional means. While this standard argument is correct, it takes a very monetary policy-centric view of macroeconomic policy. When interest rates are low, fiscal policy becomes very potent. Indeed, the whole notion that deflation is a bigger problem than inflation is rather peculiar. Just as it is easier to consume resources than to produce them, it should be easier to get people to spend than to save. People like to spend. And even if they didn’t, governments could go out and buy goods and services directly. Looking out, our bet is that policymakers will increasingly lean towards the ever-more fiscal stimulus. If structural trends end up causing the so-called neutral rate of interest to rise – the rate of interest that is necessary to avoid overheating – policymakers will have no choice but to eventually raise rates and tighten fiscal policy (Box 2). However, they will only do so begrudgingly. The result, at least temporarily, will be higher inflation. Fixed-income investors should maintain below benchmark duration exposure over both a cyclical and structural horizon. Reflationary policies that increase nominal GDP growth will help support equities, at least over the next 12 months. Chart 11 shows that corporate earnings tend to accelerate whenever nominal GDP growth rises. We upgraded global equities to overweight following the December FOMC meeting selloff. While our enthusiasm for stocks has waned with the year-to-date rally, we are sticking with our bullish bias. Chart 11Earnings And Nominal GDP Growth Tend To Move In Lock-Step A reacceleration in Chinese credit growth will put a bottom under both Chinese and global growth by the middle of this year. As a countercyclical currency, the dollar will likely come under pressure in the second half of this year. Until then, we expect the greenback to be flat-to-modestly stronger. The combination of faster global growth and a weaker dollar later this year will be manna from heaven for emerging markets. We closed our put on the EEM ETF for a gain of 104% on Jan 3rd, and are now outright long EM equities. I do not have a strong view on the relative performance of EM versus DM at the moment, but expect to shift EM equities to overweight by this summer.8 Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com   Box 1 The Arithmetic Of Debt Sustainability   Box 2 Debt Sustainability And Full Employment: The Role Of Fiscal And Monetary Policy Policymakers should strive to stabilize the ratio of debt-to-GDP over the long haul, while also ensuring that the economy stays near full employment. The accompanying chart shows the tradeoffs involved. The DD schedule depicts the combination of the primary fiscal balance and the gap between the borrowing rate and GDP growth (r minus g) that is consistent with a stable debt-to-GDP ratio. In line with the debt sustainability equation derived in Box 1, the slope of the DD schedule is simply equal to the debt/GDP ratio. Any point below the DD schedule is one where the debt-to-GDP ratio is rising, while any point above is one where the ratio is falling. The EE schedule depicts the combination of the primary fiscal balance and r - g that keeps the economy at full employment. The schedule is downward-sloping because an increase in the primary fiscal balance implies a tightening of fiscal policy, and hence requires an offsetting decline in interest rates. Any point above the EE schedule is one where the economy is operating at less than full employment. Any point below the EE schedule is one where the economy is operating beyond full employment and hence overheating. Suppose there is a structural shift in the economy that causes the neutral rate of interest – the rate of interest consistent with full employment and stable inflation – to increase. In that case, the EE schedule would shift to the right: For any level of the fiscal primary balance, the economy would need a higher interest rate to avoid overheating. The arrows show three possible “transition paths” to a new equilibrium. Scenario #1 is one where policymakers raise rates quickly but are slow to tighten fiscal policy. This results in a higher debt-to-GDP ratio. Scenario #2 is one where policymakers tighten fiscal policy quickly but are slow to raise rates. This results in a lower debt-to-GDP ratio. Scenario #3 is one where the government drags its feet in both raising rates and tightening fiscal policy. As the economy overheats, real rates actually decline, sending the arrow initially to the left. This effectively allows policymakers to inflate away the debt, leading to a lower debt-to-GDP ratio. Note: In Scenario #2, and especially in Scenario #3, the DD line will become flatter (not shown on the chart to avoid clutter). Consequently, the final equilibrium will be one where real rates are somewhat higher, but the primary fiscal balance is somewhat lower, than in Scenario #1.   Footnotes 1          One can equally define the interest rate and GDP growth rate in nominal terms (see Box 1 for details).  2       Japan is a good example of this point. The primary budget deficit averaged 5% of GDP between 1993 and 2010, a period when government net debt rose from 20% of GDP to 142% of GDP. Since then, Japan’s primary deficit has averaged 5.1% of GDP, but net debt has risen to only 156% of GDP (and has been largely stable for the past two years). 3      Please see Global Investment Strategy Special Report, “The Most Important Trend In The World Has Reversed And Nobody Knows Why,” dated February 1, 2019. 4      Olivier Blanchard, “Public Debt And Low Interest Rates,” Peterson Institute for International Economics and MIT American Economic Association (AEA) Presidential Address, (January 2019). 5      Paolo Mauro, Rafael Romeu, Ariel Binder, and Asad Zaman, “A Modern History Of Fiscal Prudence And Profligacy,” IMF Working Paper, (January 2013). 6      The Italian 10-year bond yield is 2.83% while nominal GDP growth is 2.64%. Multiplying the difference by net debt of 118% of GDP results in a required primary surplus of .22% of GDP that is necessary to stabilize the debt-to-GDP ratio. This is lower than the IMF’s 2018 estimate of cyclically-adjusted government primary surplus of 2.14%. 7      Please see Global Investment Strategy Weekly Report, “China’s Savings Problem,” dated January 25, 2019. 8      Please note that my colleague, Arthur Budaghyan, BCA’s Chief EM strategist, remains bearish on both EM and DM equities and expects EM to underperform DM over the coming months. Strategy & Market Trends MacroQuant Model And Current Subjective Scores Tactical Trades Strategic Recommendations Closed Trades        

Special Report

Highlights So What? China’s January credit data suggest that stimulus is here. Why? January credit growth was a blowout number. Trade uncertainty is likely to be prolonged with an extension of talks. Equity bourses in South Korea and Russia are the most likely to benefit from Chinese stimulus. Industrial metals such as copper will also benefit – with a delay. Feature New credit data for China in January improves the chances that Beijing’s stimulus measures will overshoot this year, causing China’s economy to bottom in 2019 and jumpstart global growth. In our annual outlook for this year we argued that while China was stimulating the economy, the magnitude of stimulus would be the decisive factor for the global macro environment in 2019. We argued that the type of stimulus would remain primarily fiscal – tax cuts for households and small and medium-sized enterprises – and hence that it would be modest as fiscal easing would merely offset relatively weak credit growth. This view stemmed from our assessment of the Xi Jinping administration, highlighted in April 2017, as an “elitist” (not populist) administration. Its policy priorities are to discipline the Chinese economy, and in particular to contain systemic financial risk, which President Xi has cited as a national security threat. This view is not wrong, but the latest data clearly show that Xi has decided to pause these painful efforts at limiting leverage and rebalancing China’s economy. Witness January’s decisive uptick in both total social financing (total private credit) and local government bond issuance (Chart 1). Chart 1Higher Risk Of An Overshoot A massive spike in new credit is the single most important criterion in our “Checklist For A Stimulus Overshoot.” Thus, from a policy perspective, we are now at higher risk of an overshoot (Table 1). Not only credit as a whole but also informal lending saw a surge in January, implying that the government is relenting in its crackdown on the shadow banks. The approval of local government bond issuance for early in the year – and the People’s Bank of China’s announcement of a “Central Bank Bills Swap” program – reinforce this policy shift.1 Table 1Checklist For A Chinese Stimulus Overshoot In 2019   A stimulus overshoot is positive for Chinese demand in the short run but negative for potential GDP in the long run. A “traditional” credit surge of this nature cannot be surgically targeted at SMEs or households. It will go to state-owned enterprises, privileged corporations, property developers, and the like, which have always had the advantage in China’s financial system. SOEs have taken a much larger share of new loans than private companies in recent years,2 and the only silver lining of this trend was the possibility that tighter credit controls would discipline the SOEs. That silver lining is now fading, barring some new and surprising development on the reform front. China needs to create 26 trillion renminbi in new credit over the course of the year to avoid a corporate earnings contraction. These January numbers put China on track to do just that (Chart 2), assuming that President Xi and U.S. President Donald Trump agree to a short-term, framework trade deal this year. Chart 2On Track To Avoid An Earnings Contraction Of course, a few caveats are in order. First, January’s credit number is only one data point and credit growth is always abnormally strong in the first month of the year. Early in the year, banks seek to expand their assets rapidly in a bid to get as much market share as possible before administrative credit quotas kick in. Because of Chinese New Year, it is best to combine January and February data to get a sense of the rate of credit expansion in the first part of the year. To do that, investors will have to wait for mid-March when the February data is out. This year’s January numbers are very strong relative to previous Januaries (Chart 3) and the context is more accommodative than the 2017 January credit surge, when authorities were beginning to tighten rather than ease macroprudential policy. Still a rapid rate of credit expansion will have to be sustained in the coming months in order to meet the 26 trillion RMB requirement highlighted above. Second, there is some risk that China’s households and private businesses will not respond as positively today as in the past. The intensification of Communist Party control over the society and economy, President Xi’s cancellation of term limits, and the strategic confrontation with the United States have created a bearish sentiment in the private sector. Our Emerging Markets Strategy would point out that if the propensity to consume, and money velocity,3 do not accelerate, then a surge in new credit may fail to ignite a reacceleration in China (Chart 4). Chart 4Chinese Are Holding On To Their Money Still, what we now know is that Xi Jinping and his top economic adviser, Vice Premier Liu He, are not initiating the “assault phase of reform” that their predecessors initiated in the late 1990s in order to cleanse China’s economy of bad loans and zombie companies. Instead, they are likely reestablishing the “Socialist Put” in order to reverse the current deceleration, demonstrate China’s continued economic might and face down the United States’ threat of tariffs. Bottom Line: China’s stimulus measures are increasingly likely to overshoot, with positive implications for both Chinese and global growth. China is still facing a corporate earnings recession, but the odds of averting it are increasing.    Trade Deadline More Likely To Be Extended What of the trade war? First, we would warn clients that China’s annual credit origination is a much bigger factor for the global economy than China’s exports to the United States (Chart 5). The trade war can escalate from here and yet, if China’s stimulus works as it has in the past, the results will be manageable for China’s economy save for Chinese companies expressly exposed to the U.S. economy through exports. In reality, both the U.S. and China are now effectively stimulating their economies and in this sense global trade as a whole will benefit regardless of bilateral tariffs. Chart 5Watch China Credit, Not So Much The Trade War But it is possible that just as global equity markets ignored China’s economic slowdown and only sold off when the tariffs were levied (Chart 6), they may not continue to rally much on China’s credit data. Given the already considerable rally in global risk assets since October, markets may not be satisfied merely with one or two months of solid credit data out of China without a clear resolution to the trade conflict. After all, if a collapse in U.S.-China trade talks portends a new Cold War, then institutional investors may be justified in taking a wait-and-see approach despite China’s credit cycle upswing. Chart 6Will Equities Ignore China Data (Again)? In the past, we have highlighted that the U.S. and China are not economically prohibited from engaging in a trade war – the export exposure is too small – and China’s new stimulus reinforces this point. However, President Trump is concerned about causing a sell-off in the tech sector and hence the broad equity market which could translate into a bear market and raise the probability of a recession occurring prior to November 2020. Meanwhile, in China, given Beijing’s reported trade concessions, there is apparently a desire to pacify the relationship and discourage U.S. unilateral tariffs and sanctions that could become seriously destabilizing for the Chinese economy and society. The need to have a happy 2021 centenary celebration for the Communist Party may factor into policymakers’ thinking. The latest news flow is mildly positive for the odds of getting a framework deal sometime this year. President Trump visited the Chinese negotiators in Washington, D.C. while President Xi reciprocated with the American negotiators in Beijing. Trump has signaled that an extension of the March 1 deadline is possible, and a two-month extension is being bandied about in the press. China’s National People’s Congress is likely to pass a new Foreign Investment Law that ostensibly guarantees many of the American demands on forced tech transfer, intellectual property theft, and discriminatory treatment of U.S. companies (Table 2). Even the second Trump summit with Kim Jong Un, this time in Vietnam, should be seen as a mild positive for U.S.-China negotiations. Table 2New Foreign Investment Law Would Be A Positive For U.S.-China Negotiations However, Presidents Trump and Xi have yet to schedule a new summit, which is probably necessary for a final deal. And there are murmurs from the press suggesting that China’s new law and other concessions are not going to satisfy the U.S. negotiators on the critical point of “structural changes” and a verification process. This leaves us inclined to change our trade war probabilities to increase the odds of an extension (Table 3). The improvement in U.S. financial conditions and China’s stimulus, if anything, make it more likely that negotiations will be extended, as both sides feel their economic and financial constraints less acutely. Table 3Updated Trade War Probabilities Bottom Line: Global and Chinese risk assets should rally on China’s credit uptick, but the lack of resolution of the trade war could continue to inhibit animal spirits – and the odds of a March 1 resolution are declining. Who Are The Equity Winners Of China’s Stimulus? China’s strong January credit number is supportive of global equity markets. That much is obvious. But which equity markets will benefit the most? In what follows we examine the relationship between Chinese credit and MSCI equity returns of various countries. We find that Malaysian, Australian, South Korean, and Indonesian equities are the most highly correlated with Chinese credit growth and are thus most likely to benefit from the recent upturn (Chart 7). On the other hand, France and Italy stand out as countries whose bourses are more insulated. Out of the markets that are positively correlated, South Korea and Russia stand out as relatively cheap (Chart 8). Thus we expect these equities to do especially well. By contrast, while Indonesia and the Philippines are highly leveraged to China, these markets are currently relatively expensive. BCA’s Emerging Markets Strategy is currently overweight Korean and Russian equities within the EM space, neutral Turkey (although recently upgraded from underweight), and underweight Indonesia and the Philippines. In addition to credit stimulus, we expect Chinese household consumption to also gain support going forward. This will likely be driven by policy stimulus targeting the consumer specifically and is best exemplified by the recently announced tax cuts (Chart 9), which we expect to trickle down to greater consumer demand and growth in retail sales. Our base case calls for 8%-10% growth in household consumption over the coming 12 months, up from the current 3.5%. However, consumer sentiment in China is weak. BCA’s Emerging Markets Strategy’s proxy for household marginal propensity to spend ticked up recently, after falling since early last year (see Chart 4 above). A resumption in the decline would highlight that households are increasingly unwilling to spend, which would translate into weaker retail sales despite policy efforts to boost consumption. Such a scenario – in which credit growth accelerates without a substantial uptick in consumer spending – is plausible, given that it occurred between mid-2015 and mid-2016 (Chart 10). In any case, whether Chinese stimulus comes in the form of the traditional credit channel, or instead in the form of fiscal stimulus to household consumption, the same equity markets will generally benefit the most (Chart 11). Chart 10...But Flattish Retail Sales Are Also A Possibility Indeed, global equity markets react the same way regardless of the type of stimulus implemented. For instance, MSCI returns for the Philippines, Sweden, Malaysia, Indonesia, and Turkey are more closely correlated to both Chinese credit growth and retail sales growth compared to Italy, Japan, and France.  The same conclusion is reached when we look at the correlations between Chinese credit growth or consumption growth and individual MSCI sectors such as industrials and consumer discretionary (Chart 12). The relatively stronger correlation between Chinese credit growth and equity returns – as opposed to Chinese retail sales and equity returns – can be put down to the nature of Chinese imports. While industrial goods account for the bulk of China’s purchases of foreign goods, consumer goods excluding autos make up only 15% of China’s imports (Table 4). However, as Chart 12 illustrates, the relationship between China’s retail sales growth and global equities is much tighter in the case of the consumer discretionary sector, whether the latter is compared to global industrials sectors or the overall MSCI index. Table 4Import Composition Of Chinese Imports Equity market exposure to China is not always in line with the extent of each country’s trade exposure to China (Chart 13). There are some clear exceptions – most notably Mexico, which has the highest correlation coefficient with Chinese credit and consumption variables since 2010. However, this is likely due to idiosyncratic factors.4 Correlation does not imply causation, and we cannot conclude with certainty that Mexican equities will outperform amid China’s new round of stimulus. Nevertheless, given that Mexico is a very deeply liquid market that benefits amid EM bull markets, this may not be entirely coincidental. The correlations between global equity markets and Chinese credit peak two months after the stimulus measures are first implemented (Chart 14). This is more or less in line with adjusted total social financing’s correlation versus industrial metals. However BCA’s Commodity & Energy Strategy has shown that copper’s correlations versus other measures of Chinese money and credit peak after roughly three quarters (Chart 15).5 This is evident in both the 2012 and 2015-16 stimulus episodes in which the bottom in copper prices lagged the bottom in China’s credit growth. Thus we may witness a rebound in equity markets on the back of China’s credit splurge before we see an improvement in annual returns on copper prices.  Chart 15Copper Rallies Lag China Credit Stimulus Bottom Line: South Korean and Russian equities are best positioned to benefit from the positive surprise in China’s credit data. France and Italy are the worst positioned. Copper prices will rebound with a delay.  Investment Implications BCA’s Geopolitical Strategy recommends that investors stay long Chinese equities ex-tech relative to the emerging market benchmark. This is a tactical call initiated in August 2018 that is now becoming a cyclical call on the basis of the credit upswing. We also remain long the “China Play Index,” a basket of China-sensitive assets, and long China’s “Big Five” banks relative to other banks. A rebound in China’s credit data and stronger global growth will support copper demand. Prices are still 15% below the mid-2018 peak and are poised to benefit in this environment, especially given that global inventories are already falling. BCA’s Geopolitical Strategy recommends that investors go long copper. Meanwhile, BCA’s China Investment Strategy recommends (for now) staying only tactically overweight Chinese equities relative to the global benchmark, pending higher conviction that the pace of credit growth will be strong enough to overwhelm the negative ramifications of a continued deceleration in actual activity over the coming few months on sentiment and 12-month forward earnings expectations. Over the long run, Geopolitical Strategy would look to underweight Chinese equities, as we are not optimistic about China’s productivity and potential GDP. This is because of the negative structural consequences of continuing the Socialist Put (i.e., bad loans, zombie companies, trade protectionism).  We would expect CNY/USD to remain relatively buoyant in the context of both trade negotiations with the U.S. and fiscal-and-credit stimulus. The trade talks can hardly succeed if CNY/USD is falling. Depending on whether and how soon China’s stimulus results in a durable economic bottom, global growth could stabilize and the USD could see a substantial countertrend selloff.   Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Roukaya Ibrahim, Editor/Strategist roukayai@bcaresearch.com   Footnotes 1          Please see Emerging Markets Strategy Special Report titled “China: Prepping A Bazooka?” dated February 14, 2019 available at ems.bcaresearch.com 2      Please see Nicholas Lardy, “The State Strikes Back: The End Of Economic Reform In China?” Peterson Institute For International Economics, January 29, 2019, available at piie.com. 3          Please see Emerging Markets Strategy Weekly Report titled “Dissecting China’s Stimulus,” dated January 17, 2019 available at ems.bcaresearch.com 4       The 2012 election of President Enrique Peña Nieto caused Mexican equities to outperform their EM counterparts. Similarly in 2015-16, U.S. outperformance relative to EM also supported Mexico relative to EM because Mexico’s economy is highly leveraged to its northern neighbor. In both periods Mexico’s outperformance was not caused by – but instead coincided with – Chinese credit stimulus. These idiosyncratic events biased the correlation between Mexico’s equity markets and Chinese credit growth to the upside. 5      Please see Commodity & Energy Strategy Weekly Report titled “Trade Wars, China Credit Policy Will Roil Global Copper Markets,” dated June 21, 2018, available at ces.bcaresearch.com.                  

Bank Credit Analyst

Highlights Global equity markets have managed to recoup some of last year’s plunge since we upgraded stocks to overweight in late December. The equity rally has been tentative, however, and so far feels more like a technical bounce from oversold levels than a resumption of the bull market. One driving factor behind last year’s market swoon was that policy uncertainty spiked at a time when the last pillar of global growth, the U.S., was showing signs of cracking. Investors thus welcomed the Fed’s signal that it would pause in March. Nonetheless, shrinkage in the Fed’s balance sheet is proving to be troublesome. Quantitative tightening does not necessarily imply permanently higher risk premia, but it will be a source of volatility. There are hopeful but tentative signs that a U.S. slowdown is not the precursor to a recession. The hit to GDP from the U.S. government shutdown will be reversed next quarter. The FOMC has also signaled that policymakers are attuned to the economic risks associated with tightening financial conditions, and that the calm inflation backdrop provides room to maneuver. The FOMC will stand pat in March, but should restart rate hikes in June as the economic soft patch ends. We still see only a modest risk of a U.S. recession this year. In contrast, our outlook for growth outside the U.S. remains downbeat for at least the first half of the year. Among the advanced economies, Japan and Europe are being the most affected by the Chinese economic slowdown and global trade tensions. This means that monetary policy divergence will continue to be a tailwind for the dollar. China continues to stimulate at the margin, but efforts so far have been insufficient to put a floor under growth. The contraction in Chinese exports has just begun. It is still too early to upgrade EM assets or base metals. Despite the cloud still surrounding Brexit, sterling is beginning to look attractive as a long-term punt. Our decision to upgrade corporate bonds to overweight this month, similar to our reasoning for upgrading equities in December, is based on improved value and a sense that investor pessimism had become excessive. Just as the selloff in risk assets was overdone, so too was the rally in government bonds. It is highly unlikely that the Fed is done tightening, as is currently discounted in the money market curve. A resumption of Fed rate hikes around mid-year means that the 10-year Treasury yield will move back above 3% by year end. Feature Global equity markets have managed to recoup some of last year’s plunge since we upgraded the asset class back to overweight in the latter half of December. A decline in the VIX and high-yield bond spreads are also positive signs that global risk appetite is recovering, following an overdone investor ‘panic attack’ last quarter. The equity rally has been tentative, however, and so far feels more like a simple technical bounce from oversold levels than a resumption of the bull market. One problem is that policy uncertainty has spiked at a time when the last pillar of global growth, the U.S., is showing signs of cracking (Chart I-1). Investors are skittish while they await a clear de-escalation of U.S./China trade tensions, an end to the U.S. economic soft patch, an end to the U.S. government shutdown, and signs that global growth is bottoming (especially in China). There has only been some modestly positive news on a couple of these issues. Chart I-1Policy Uncertainty Has Spiked Another factor that appeared to play a role in last quarter’s market swoon is the fear that the end of asset purchases by the European Central Bank and the normalization of the Fed’s balance sheet necessarily imply a structural de-rating for all risk assets. A related worry is that the de-rating might intensify the global economic slowdown, resulting in a self-reinforcing negative feedback loop. Does QT Imply Lower Multiples? The question of balance sheet normalization is a difficult one because there is widespread disagreement on how, or even whether, quantitative easing (QE) works. We have always maintained that QE was not about creating a wave of central bank liquidity that flowed into asset prices. Central banks did not “print money” – they created bank reserves. These reserves did not result in a major acceleration in broader measures of money growth, including M1 and M2, largely because there was little demand for loans and because banks tightened lending standards. In other words, the credit channel of monetary policy was broken. The implication is that investors should not worry that quantitative tightening (QT) implies a withdrawal of central bank liquidity that must mechanically come from the sale of risk assets. Rather, we believe that QE operates mostly through the portfolio balance effect. There are two ways to think about this channel. First, the central bank forced investors to move into riskier assets by purchasing large amounts of “safe” assets, such as government bonds. Investors had little choice but to redeploy the capital into other riskier areas, pushing up asset prices. The second perspective is that central bank purchases of government bonds depressed both the yield curve and bond volatility. Volatility fell because investors could forecast the policy rate with certainty – it would be glued to zero (or negative) for the foreseeable future in most of the advanced economies. This is akin to strong forward guidance that flattened the yield curve. Aggressive monetary stimulus, such as QE, also helped to reduce the perceived risk that the economy would succumb to secular stagnation or fall back into recession. Reduced bond volatility, lower bond yields, and less economic risk all increased the attractiveness of the riskier asset classes. These explanations represent two sides of the same coin. Either way, QE boosted a broad array of asset prices. If this is true, then unwinding QE must be bearish for risk assets, all else equal. In the case of the U.S., the fed funds rate is much more difficult to forecast than was the case when the Fed was buying bonds. Higher yields and bond volatility imply a lower equilibrium multiple in the equity market and wider equilibrium corporate bond spreads. Nonetheless, all else is not equal. If interest rates and bond volatility are rising in the context of healthy economic and profit growth, then it is likely that the perceived risk of secular stagnation is falling. It would be a sign that the economy has finally put the financial crisis firmly in the rear-view mirror. It could be the case that the upgrade in economic confidence overwhelms the negative impact of the reverse portfolio balance effect related to quantitative tightening, allowing risk assets to rise. No one can prove this thesis one way or the other and we are not making the case that unwinding the Fed’s balance sheet will necessarily go smoothly, especially since interest rates are rising at the same time. The problem is that both investors and the Fed are trying to figure out where the neutral fed funds rate lies. If the so-called level of R-star is still very low, then the Fed might have already made a policy mistake by raising rates too far. We discussed in last month’s Overview the market implications of four scenarios for the level of R-star and the Fed’s success in correctly guessing it. If the economy holds up and the economic soft patch ends in the coming months as we expect, then investors will revise their estimate of the neutral rate higher and risk assets will rally even as bond yields rise. The Doom Loop One risk to our base-case scenario is the so-called financial conditions “doom loop”. Irrespective of whether or not QT is playing a role, the doom loop scenario involves a shock to investor confidence that leads to a tightening in financial conditions and market liquidity as stock prices fall and credit spreads widen. More onerous financial conditions, in turn, undermine economic activity, which then feeds back into even tighter financial conditions. One could make the argument that risk assets are even more exposed to this type of negative feedback loop today than in past monetary tightening cycles because of program trading, the Fed’s balance sheet shrinkage and investors’ lingering shell shock from the Great Recession and financial crisis. Nonetheless, there are a few mitigating factors to consider. We believe that a doom loop is more likely to unfold when economic growth becomes very sensitive to changes in financial conditions. This normally happens when economic and financial imbalances are elevated. On a positive note, unlike in the lead-up to the last two recessions, the U.S. private sector is a net saver whose income outstrips spending by 2.1% of GDP (Chart I-2). The highly cyclical parts of the U.S. economy are not stretched to the upside as a share of GDP, reducing the risk that overspending in one part of the economy will required a deep contraction to correct the imbalance (Chart I-3). Chart I-2U.S. Private Sector: A New Saver Chart I-3U.S. Cyclical Spending Not Extended In terms of financial excesses, the good news is that the U.S. household sector is in its best shape in decades. Our main concern is debt accumulation in the corporate sector. We reviewed the related risks in a Special Report published in the November 2018 issue.1 We concluded that corporate leverage will not cause the next U.S. recession, because high levels of debt will only become a problem when profits begin to contract (i.e. when the economic downturn is already underway). Nonetheless, when a recession does occur, corporate spreads will widen by more than in the past for any given degree of economic contraction (see below). ‘Fed Put’ Still In Play Another factor that tempers the risk of a doom loop is that the so-called ‘Fed Put’ is still operating. The December FOMC Minutes and comments by various FOMC members communicated to investors that the Fed is attuned to the economic risks associated with tightening financial conditions, and that the calm inflation backdrop provides policymakers with room to maneuver. Chair Powell even said he was willing to adjust the Fed’s balance sheet run-off if necessary. One important reason for policymakers’ willingness to be flexible is that the fed funds rate is still not far from the zero-lower-bound, making it potentially more difficult for the FOMC to respond adequately in the event of a recession this year because the fed funds rate can only be cut by 250 basis points. Several U.S. data releases have been delayed due the government shutdown, but what has been released has been mixed. The downdraft in the January reading of the manufacturing ISM was eye-opening, highlighting that the global manufacturing slowdown has reached U.S. shores. The good news is that the non-manufacturing ISM and the small business survey, although off their peaks, remain consistent with solid underlying growth. The December U.S. payroll report revealed that wage growth continued to accelerate on the back of gangbusters job creation at the end of the year. There have also been some recent hints that the soft patch in capital spending and housing is ending (Chart I-4). Existing home sales fell sharply in December, but extremely low inventories suggest that it is more of a supply than a demand problem. The impressive bounce in home mortgage applications for purchases is a hopeful sign. U.S. commercial and industrial loan growth is also accelerating. Chart I-4Some Tentative Signs These tentative signs that the economic soft patch is close to an end will not be enough to get the FOMC to tighten in March, after so many members have gone out of their way to signal a pause in recent weeks. Nonetheless, we believe the economy will remain strong enough for the Fed to resume hiking in June. The U.S. government shutdown will complicate interpreting incoming economic data. Ultimately, while its impact on Q1 real GDP growth will be non-trivial, it will be reversed the following quarter and we do not expect any permanent damage to be done. U.S. inflation should edge higher by mid-year, supporting our view that the Fed will resume tightening in June. The decline in oil prices will continue to feed into a lower headline inflation rate in the coming months, but that does not mean that the core rate will fall. Indeed, core CPI has increased by roughly 0.2% in each of the past three months, translating into an annualized rate of approximately 2.4%. Base effects will depress annual core inflation in February but, thereafter, this effect will begin to reverse. The acceleration in wage growth according to measures such as average hourly earnings and the Employment Cost Index highlights that underlying inflationary pressures continue to percolate (Chart I-5). The implication is that the Treasury bond market is overly complacent in discounting that the fed funds rate has peaked for the cycle. Chart I-5U.S. Wage Pressure Is Percolating Looking further ahead, our base case remains that the next U.S. recession will not occur until 2020, and will be the result of tighter fiscal policy and further Fed tightening that takes short-term rates a step too far. No Bottom Yet For Global Growth Our outlook for growth outside the U.S. remains downbeat for at least the first half of the year. Our global economic indicators still show no sign of a turnaround, except for a bottoming in the diffusion index based on BCA’s Global Leading Economic Indicator (Chart I-6). The global ZEW economic sentiment index continued to fall in January, while business and consumer confidence readings in the advanced economies eroded heading into year end. Chart I-6Global Leading Indicators Still Deteriorating A better global growth dynamic awaits more serious policy stimulus in China. Real GDP growth decelerated further to 6.4% year-over-year in the last quarter of 2018. This is no disaster, but the point is that there are still no signs of stabilization. The Chinese authorities continue to tweak the policy dials at the margin, most recently providing some tax cuts and a liquidity injection into the banking system. Nonetheless, the central government has so far abstained from stimulating the property market due to existing speculative excesses. This is very different from the previous two policy easing episodes, including 2015/16 (Chart I-7). Chart I-7China: No Property Market Stimulus... The stimulus undertaken so far has been insufficient in terms of putting a floor under growth according to our 12-month Credit Impulse (Chart I-8). It is a hopeful sign that broad money growth is trying to bottom, but this does not guarantee that the credit impulse is about to turn. The latter is required to confirm that Chinese import demand will accelerate, providing a lift to EM exporters, EM asset prices and commodity prices. Without a positive credit impulse, China’s investment and construction activity will continue to moderate, leading to lower imports of machinery and raw materials. Chart I-8...And No Credit Impulse The economic situation in China is likely to get worse before it gets better. Dismal trade figures in December confirmed that the trade war is beginning to bite. The period of export ‘front-running’ related to higher U.S. tariffs is over as total exports fell by 4.4% year-over-year. Last year’s collapse in export orders indicates that the woes are just beginning. In turn, moderating production related to the Chinese export sector will bleed into domestic consumption and imports, suggesting that it is too early to expect a durable rally in EM assets or commodity prices. Lackluster Chinese demand and growing trade concerns have weighted on global business confidence, contributing to the pullback in capital goods orders, manufacturing PMIs and industrial production in the advanced economies (Chart I-9). Even the average service sector PMI and consumer confidence index in the advanced economies have fallen in recent months, although both remain at a high level. Chart I-9The Fallout From Trade Europe and Japan, in particular, are feeling the pinch. German GDP only grew 1.5% in 2018, implying that Q4 GDP growth was in the vicinity of just 0.2% QoQ. Meanwhile, European industrial production contracted by 3.3% year-over-year in December. The German Ifo and ZEW surveys do not point to any significant improvements in this trend. A few idiosyncratic factors explain some of this poor performance, including new emissions testing standards that have weighted on the German auto industry, a tightening in financial conditions in Italy, and the ‘gilets jaunes’ protests in France. Nonetheless, the euro area slowdown cannot be fully explained by one-off factors. The economy is highly sensitive to global trade fluctuations given that 18% of the euro area’s gross value added is generated in the manufacturing sector. Hence, China’s poor economic health has been painful for Europe, and the trend in Chinese credit does not bode well for the near term (Chart I-10). The European Central Bank (ECB) is likely to stay on the defensive as a result, especially as euro area core inflation, which has been stuck near 1% for three years, is unlikely to pick up if growth remains on the back foot. The ECB stuck with the view that the economic soft patch is temporary after the January policy meeting, but policymakers will consider providing more stimulus in March if the economy does not pick up (using forward guidance or a new TLTRO). This will weigh on the euro. Chart I-10China's Woes Are Infecting Europe Japan is suffering from similar ills. Exports are no longer growing, and foreign machinery and factory orders are contracting at a 4.1% and 4.3% pace, respectively. This weakness is not mimicked in domestic growth, but the disproportionate contribution of the external sector to Japan’s overall economic health means that this country is also falling victim to the malaise witnessed in China and emerging markets, the destination of 19% and 45% of Japanese shipments, respectively (Chart I-11). Collapsing oil prices and a firming trade-weighted yen have amplified this deflationary backdrop. It is therefore far too early to bet that the Bank of Japan will tighten the monetary dials. Chart I-11Japan Hit By The Chinese Cold As Well If we are correct that the U.S. economic soft patch will soon end, then the dollar will once again look to be the best of a bad lot. Interest rate expectations will move in favor of the dollar. We expect the dollar to rise by about 6% this year on a trade-weighted basis, appreciating most strongly against the AUD and SEK. As for sterling, it is beginning to look attractive as a long-term punt. Brexit Deadlock We are a month closer to the end-March deadline and a Brexit deal seems even farther out of reach. It could play out in one of three ways: (1) a “no deal” where the U.K. leaves the EU with no alternative in place; (2) a “soft Brexit” involving an agreement to form a permanent customs union or some sort of “Norway plus” arrangement; or (3) a decision to reverse the results of the original referendum and stay in the EU. There is no support for the “no deal” option in Parliament, which means that it won’t happen. We do not have a strong view on which of the latter two scenarios will occur. The odds of another referendum are rising and the polls are swinging away from any sort of Brexit, suggesting that the original referendum result may be over-turned via another referendum (Chart I-12). Nonetheless, for investors, it does not matter much whether it is scenario 2 or 3; either outcome would be welcomed by markets. Overweight sterling positions are attractive as a long-term play, although it could be some time before the final solution emerges. Chart I-12Brexit Result May Be Overturned Upgrade Corporate Bonds To Overweight Given the recent global economic dynamics, it is perhaps surprising that U.S. corporate financial health actually improved in 2018 according to our Corporate Health Monitors (CHM). We highlighted in the aforementioned Special Report the risks facing U.S. corporate bonds when the economic expansion ends. High levels of corporate leverage mean that the interest coverage ratio for the median corporation in the Barclays-Bloomberg index will plunge to near or below all-time historic lows. The potential for a large wave of fallen angels implies that downgrade activity will be particularly painful for corporate bond investors. The surge in lower-quality issuance has led to a downward trend in the average credit rating and has significantly raised the size of the BBB-rated bonds relative to the IG index and relative to the broader universe of corporate bonds. Moreover, poor market liquidity and covenant erosion will intensify pressure for corporate spreads to widen when the bear market arrives. Rapid debt accumulation is reflected in our bottom-up Corporate Health Monitors (CHM) for the U.S. investment-grade and high-yield sectors (Chart I-13). The CHMs are constructed from six financial ratios that the rating agencies use when rating individual companies. The companies in our bottom-up sample were chosen so as to mimic the sector and quality distribution in the Bloomberg-Barclay’s corporate bond index. Chart I-13U.S. Corporate Health The debt-to-book-value of equity ratio for both the U.S. IG and HY sample of companies has risen to nose-bleed levels, although the ratio appears to have flattened off for the latter. Despite rising leverage, the HY CHM has shifted into “improved health” territory and the IG CHM is on the verge of doing the same. Last year’s upturn in the profitability measures, such as the return on capital, overwhelmed the deteriorating leverage trend. In Europe, where we distinguish between domestic and foreign issuers, rising leverage has been concentrated among the latter until recently (Chart I-14). In any event, the CHM for both types of issuers is close to the neutral zone. Chart I-14Euro Area Corporate Health Improving U.S. corporate health on its own would not justify increasing exposure to corporate bonds within balanced portfolios or moving down in quality. Profit growth is likely to moderate this year, especially in Europe, such that last year’s improvement in corporate health is likely to reverse. And, as previously discussed, the economic cycle is well advanced and this sector is particularly vulnerable to a recession. Nonetheless, value has improved enough to warrant a tactical upgrade to overweight within fixed-income portfolios, at a time when the FOMC has signaled a pause and the next recession is at least a year away. Implied volatility should continue to moderate and spreads should narrow, similar to dynamics in 2016, the last time that the Fed signaled patience following a period of market turmoil (Chart I-15). Chart I-15Fed Patience To Narrow Spreads Spreads have already narrowed from the peak in late December, but 12-month breakeven spreads for most credit tiers are all still close to or above their historical means, except for AA-rated issues (Chart I-16). For example, the 12-month breakeven spread2 for the Baa credit tier is 46%. This means that the spread has been tighter than its current level 46% of the time since 1988 and wider than its current level 54% of the time. Historically, spreads tend to hover within the tight-end of their historical range during this phase of the credit cycle, and only cheapen significantly when the yield curve inverts and the default rate moves higher. Chart I-16Value Restored In IG Corporates... For U.S. high yield, our estimate of the spread adjusted for expected defaults has risen to 237 bps (Chart I-17). This implies that investors are discounting a 2019 default rate of 3.2%, in line with Moody's forecast. Since we do not foresee recession this year, high-yield bonds are not expensive enough to be avoided within a portfolio. Chart I-17...And In HY Too Value has also improved in the European corporate bond market, but our global fixed-income team still recommends favoring the U.S. market for global credit investors. Leverage is higher in the U.S., especially relative to domestic issuers in Europe, but the U.S. economic and profit outlook for 2019 is better. Conclusions Our decision to upgrade corporate bonds this month, similar to our reasoning for upgrading equities to overweight in December, is based on improved value and a sense that investor pessimism had become excessive. For the equity market, the S&P 12-month forward P/E is an attractive 15.4 as we go to press, and bottom-up estimates for 2019 EPS have been slashed to a very reasonable 8%. Just as the selloff in risk assets late last year was overdone, so too was the rally in government bonds. It is highly unlikely that the Fed is done tightening. A resumption of Fed rate hikes, probably in June, means that the 10-year Treasury yield will move back above 3% by year end. Across the major countries, market expectations for yields 5-10 years from now are close to current levels, which is extremely complacent (Chart I-18). Investors should keep duration short of benchmark. Chart I-18Forward Rates Far Too Low Our shift to overweight in both equities and corporate bonds is tactical in nature. We fully expect to move back to neutral and then to underweight later this year or into 2020, as the peak in U.S. GDP draws nearer. Timing will be difficult as always, which means that investors should be prepared to trim risk exposure earlier than implied by our base-case economic timeline.  The tactical upgrade does not imply that we have become more sanguine on the economic and geopolitical risks for 2019. We do not believe that quantitative tightening or U.S. corporate leverage will truncate the U.S. expansion prematurely. Nonetheless, there is a plethora of other risks to keep us up at night. These include a Fed policy mistake, a hard economic landing in China, a full-blown financial crisis in Italy and an escalation in U.S./China trade tensions. The last one has diminished marginally in probability. We have a sense that the recent equity market downdraft unnerved President Trump, such that he now has a diminished appetite for upsetting investors with talk of an escalating trade war ahead of next year’s election. Outside of these well-known risks, our geopolitical team has recently published its “Black Swans” report for 2019. These are deemed to be risks that are off of most investors’ radar screens, but that would have profound implications if they were to occur: It is premature to expect armed conflict over Taiwan, but an outbreak of serious tensions between China and Taiwan is possible as Sino-American strategic distrust continues to build. Russia and Ukraine may have a shared incentive to renew hostilities this year. Saudi Arabia has received a “blank cheque” from Donald Trump, and thus it may continue to be provocative. This could boost the geopolitical risk premium in oil prices. Tensions are building in the Balkans. A renewed conflict on Europe’s doorstep could be the next great geopolitical crisis. A “Lame Duck” Trump could stage a military intervention in Venezuela. We encourage interested readers to see our Special Report for details.3 As for emerging market assets and base metals, we continue to shy away until we receive confirmation that China is aggressively stimulating. We expect better news on this front by mid-year, but watch our China Credit Impulse indicator for timing. In contrast, investors should be overweight oil and related assets now because our commodity specialists still see the price of Brent rising above US$80/bbl sometime this year. Recent political turmoil in Venezuela buttresses our bullish oil view. Finally, this month’s fascinating Special Report, penned by BCA’s Chief Global Strategist, Peter Berezin, examines the long-term implications of the peaking in the average IQ in the advanced economies. Average intelligence is falling for both demographic and environment reasons. The impact will be far from benign, potentially leading to lower productivity growth, lower equity multiples, larger budget deficits and higher equilibrium bond yields. The report begins on page 20. Mark McClellan Senior Vice President The Bank Credit Analyst Mathieu Savary Vice President Foreign Exchange Strategy January 31, 2019 Next Report: February 28, 2019   II. The Most Important Trend In The World Has Reversed And Nobody Knows Why After rising for thousands of years, human intelligence has begun to decline in developed economies. This can be seen in falling IQ scores and a decline in math and science test scores. Environmental factors appear to account for the bulk of this decline, but no one knows what these factors are. If left unchecked, falling intelligence will severely undermine productivity growth. This could lead to lower equity multiples, larger budget deficits, and ultimately, much higher government bond yields. Technological advances, particularly in the genetic realm, promise to radically raise IQs. In a complete abandonment of its one-child policy, China will combine these controversial technologies with pro-natal measures in order to boost sagging birth rates. The coming Eugenic Wars will be one of the most important economic and geopolitical developments of the 21st century. Part 1: What The Tame Fox Says In 1959, a Soviet scientist named Dmitry Belyaev embarked on an ambitious experiment: to domesticate the silver fox. A geneticist by training, Belyaev wanted to replicate the process by which animals such as cats and dogs came to live side-by-side with humans. It was a risky endeavor. The Soviets had essentially banned the study of Mendelian genetics in favor of the blank slate ideology that is popular in progressive circles today. Belyaev persevered. Working under the guise of studying vulpine physiology, he selected foxes based on only one trait – tamability. Less than 10% of foxes made it to the subsequent generation, with the other 90% being sent off to fur farms. By the fourth generation, the changes were undeniable. Rather than fleeing humans, the foxes sought out their attention with no prompting whatsoever. They even wagged their tails and whined and whimpered like dogs do. The tame foxes also displayed physical changes. Their ears flopped over. Their snouts became shorter and their tails stood upright. "By intense selective breeding, we have compressed into a few decades an ancient process that originally unfolded over thousands of years," wrote Lyudmila Trut, who began as Belyaev’s assistant and took over the project when her boss died in 1985.  Genetically Capitalist? Evolution can broadly proceed in two ways. The first way is through random mutations. This form of evolution, which scientists sometimes refer to as genetic drift, can take thousands of years to yield any discernable changes. The second way is through natural selection, a process that exploits existing variations in genetic traits. As the Russian fox experiment illustrates, evolution driven by selective pressures (either natural or artificial) can occur fairly quickly. Did selective pressures manifest themselves in human evolution in the lead up to the Industrial Revolution? Did humans, in some sense, domesticate themselves? In his book, A Farewell To Alms, economic historian Gregory Clark argued in the affirmative. Clark documented that members of skilled professions in Medieval England had twice as many surviving children as unskilled workers (Chart II-1). Indeed, the fledgling middle class of the time had even more surviving children than the aristocracy, who were often out fighting wars. As a result, the wages of craftsmen declined by a third relative to laborers between 1200 and 1800, implying that the supply of skilled labor was growing more quickly than the demand for skilled workers over this period. In subsequent work, Clark and Neil Cummins argued that the spread of bourgeois values across pre-industrial England was more consistent with a model of genetic transmission than a cultural one (see Box II-1 for details). Similar developments occurred in other parts of the world. For example, in China, the gateway into the bureaucracy for a thousand years was the highly competitive imperial exam. Xi Song, Cameron Campbell, and James Lee showed that high-status men had more surviving children during the eighteenth- and nineteenth-centuries (Chart II-2).4 The 10,000 Year Explosion Stephen Jay Gould famously said that “There’s been no biological change in humans in 40,000 or 50,000 years. Everything we call culture and civilization we’ve built with the same body and brain.” Gould was wrong. Data from the International HapMap Project show that human evolution accelerated by 100-fold starting around 10,000 years ago (Chart II-3). In their book The 10,000 Year Explosion: How Civilization Accelerated Human Evolution, Gregory Cochran and the late Henry Harpending explained why evolution sped up so rapidly.5 The advent of agriculture led to a surge in population levels. This, in turn, increased the absolute number of potentially beneficial genetic mutations that could be subject to selection effects. Farming and the rise of city states also completely reshaped the environment in which people lived. Basic biology teaches us that environmental dislocations of this kind tend to generate selective pressures that cause evolution to accelerate. John Hawks, professor of anthropology and genetics at the University of Wisconsin-Madison, put it best: “We are more different genetically from people living 5,000 years ago than they were different from Neanderthals.” Many of the changes to our genomes relate to diet and diseases. The various genetic resistances that people have built up to malaria are all less than 10,000 years old. Mutations to the LCT gene, which confers lactose tolerance into adulthood, occurred independently in three different geographical locations: one in East Asia, one in the Middle East, and one in Africa. The Middle Eastern variant was probably responsible for the rapid enlargement of the Indo-European language group, which now stretches from India to Ireland. The African variant likely facilitated the Bantu expansion, which started near the present-day border of Nigeria and Cameroon, and then spread out across almost all of sub-Saharan Africa. Evolution Of The Human Brain About half of the genes in the human genome regulate some aspect of brain function. Given the rapid acceleration in evolution, it would be rather surprising if our own brains had not been affected. And indeed, there is plenty of evidence that they were. The frontal lobe of the brain has increased in size over the past 10,000 years. This is the part of the brain that regulates such things as language, memory, and long-term planning. Testosterone levels have also declined. That may explain the steady reduction in violent crime rates (Chart II-4). We know that certain genes that are associated with higher intelligence have been under recent selective pressure. For example, the gene that leads to torsion dystonia – a debilitating movement disorder – appears to have increased in frequency. Why would a gene that causes a known disease become more widespread? The answer is that individuals who have this particular mutation tend to have IQs that are around 10-to 20-points above the population average. Why IQ Matters IQ has a long and contentious history. Yet, despite numerous efforts to jettison the concept, it has endured for one simple reason: It has more predictive power than virtually anything else in the psychological realm. A simple 30-minute IQ test can help predict future educational attainment, job performance, income, health, criminality, and fertility choices (Table II-1 and Chart II-5). IQ even predicts trader performance!6   Like most physiological traits, IQ is highly heritable.7 The genetic contribution to IQ increases from 20% in early childhood to as high as 80% by one’s late teens and remains at that level well into adulthood.8 This makes IQ almost as heritable as height (Chart II-6). Although there is a great deal of variation among individuals, on average, more intelligent people earn higher incomes (Chart II-7). If the same relationship existed in the pre-industrial era, as seems likely, then human intelligence probably increased in a way that facilitated the economic explosion that we associate with the Industrial Revolution. The stunning implication is that the emergence of the modern era was a question of “when, not if.” Part 2: The Flynn Effect By the late-19th century, it had become clear that the rich were no longer having as many children as the poor. This realization, together with the growing popularity of Darwin’s theories, helped galvanize the eugenics movement. Contrary to popular belief, this movement was not a product of the far-right. In fact, the most vocal proponents of eugenics were among the progressive left. John Maynard Keynes, for example, served as the Director of the British Eugenics Society between 1937 and 1944. Yet, a funny thing happened on the road to idiocracy: The concerns of eugenicists did not come to pass. Rather than becoming dimmer, people became smarter. This phenomenon is now known as the Flynn Effect, named after James Flynn, a psychologist who was among the first to document it. Chart II-8 shows the evolution of IQ scores in a sample of countries between 1940 and 1990. The average country recorded IQ gains of three points per decade over this period, a remarkably large increase over such a relatively short period of time. Explaining The Flynn Effect The Flynn Effect must have been entirely driven by environmental factors since genetic factors – namely the tendency of less-educated people to have more children, and to have them at an earlier age – would have reduced average IQs over the past two hundred years. But how could environmental factors have played the dominant role in light of the strong role of genes discussed above? The answer was proposed by geneticist Richard Lewontin in the 1970s. Lewontin suggested imagining a genetically-diverse sack of seed corn randomly distributed between two large identical fields. One field had fertilizer added to it while the other did not. Genetic variation would explain all of the differences in the height of corn stalks within each field, while environmental factors (the addition of fertilizer) would explain all of the difference in the average height of corn stalks between the two fields. This logic explains why genes can account for the bulk of the variation in IQs within any demographic group, while environmental effects may explain most of the variation across groups, as well as why average scores have changed over time. And what environmental effects are these? The truth is that no one really knows. Plenty of theories have been advanced, but so far there is still little consensus on the matter. Bigger, Healthier Brains It has long been known that learning increases the amount of grey matter in the brain. For example, a recent study showed that the hippocampi of London taxi drivers tend to be larger due to the need for drivers to memorize and navigate complex routes.9 The emergence of modern societies likely kicked off a virtuous circle where the need to solve increasingly complex tasks forced people to hone their learning skills, leading to higher IQs and further technological progress. The introduction of universal primary education amplified this virtuous circle. Better health undoubtedly helped as well. Early childhood diseases reduce IQ by diverting the body’s resources away from mental development towards fighting off infections. There is a strong correlation between measured IQ and disease burden across countries (Chart II-9). A number of studies have documented a strong relationship between the timing of malaria eradication in the U.S. and other parts of the world and subsequent observed gains in childhood IQs.10 Brain size and IQ are positively correlated. Forensic evidence from the U.S. suggests that the average volume of adult human skulls has increased by 7% since the late 1800s, or roughly the size of a tennis ball.11 Part 3: The End Of A 10,000 Year Trend The problem with environmental effects is that they eventually run into diminishing returns. This appears to have happened with the Flynn Effect. In fact, not only does the recent evidence suggest that the Flynn Effect has ended, but the data suggest that IQs are starting to decline. Chart II-10 shows that average math and science test scores fell in the OECD’s Program For International Scholastic Achievement (PISA) between 2009 and 2015, the latest year of the examination. The drop in math and science test scores has been mirrored in falling IQ scores. Flynn observed a decade ago that IQs of British teenagers were slipping.12 Similar results have been documented in France, the Netherlands, Germany, Denmark, and most recently, Norway. The Norwegian results, published last year, are particularly noteworthy.13 Bernt Bratsberg and Ole Rogeberg examined three-decades worth of data on IQ tests of Norwegian military conscripts. Military duty has been mandatory for almost all men in Norway since 1814, which means that the study’s authors were able to collect comprehensive data on most Norwegian men and their fathers.  Their paper clearly shows that IQ peaked with the generation born in the mid-1970s and declined by about five points, or one-third of a standard deviation, for the one born in 1990 (Chart II-11). For the first time in recorded history, Norwegian kids today are not scoring as well as their parents. A Mystery What caused the sudden reversal of the Flynn Effect in Norway and most other developed economies? Nobody knows. We can, however, offer three possible theories: New Technologies For much of human history, rising intelligence and technological innovation were complementary processes, meaning that the smartest people were the ones who could best exploit the new technologies that were coming their way. Moreover, as noted above, even those who were less gifted benefited from the mental stimulation that a technologically advanced society provided. It remains to be seen how future technological advances such as generalized AI will affect human intelligence, but recent technological advances seem to have had a dumbing down effect.14 For example, the GPS has obviated the need for people to navigate unfamiliar locations, thus blunting the development of their visuospatial skills. Modern word processors have made spelling skills less important. Having all the information in the world just a click away is a wonderful thing, but it has reduced the need for our brains to retain and codify what we learn. Meanwhile, the constant bombardment of information to which we are subject has made it difficult to concentrate on anything for long. How many youth today can read a report of this length without checking their Facebook feed multiple times? My guess is not many. Diminishing Returns To Education The ability to take young bright minds, who would have otherwise spent their lives doing menial labor, and provide them with an education was probably the greatest tailwind to growth that the 20th century enjoyed. There is undoubtedly still scope to continue this process, but the low-hanging fruits have been picked. Educational attainment has slowed dramatically in most of the world (Chart II-12). Economist James Heckman estimates that U.S. high-school graduation rates, properly measured, peaked over 40 years ago.15 Despite billions of dollars spent, efforts to improve school performance have generally fallen flat. A recent high-level report by the U.S. Department of Education concluded that “The panel did not find any empirical studies that reached the rigor necessary to determine that specific turnaround practices produce significantly better academic outcomes.”16 This gets to a point that most parents already know, which is that when people talk about “bad schools," they are really talking about “bad students.” Deteriorating Health Better health probably contributed to the Flynn Effect. But is it possible to have too much of a good thing? More calories are welcome when people are starving, but today’s calorie-rich, nutrient-poor diets have led to a surge in obesity rates. A clean environment reduces the spread of germs, but it also makes children hypersensitive to foreign substances. Following German reunification, researchers observed that allergies were much more common among West German children than their Eastern peers, presumably because of the West’s more salubrious environment.17 All sorts of weird and concerning physiological changes are occurring. Sperm counts have fallen by nearly 60% since the early 1970s.18 Testosterone levels in young men are dropping. Among girls, the age of first menarche has declined by two years over the past century.19 Are chemical agents in the environment responsible? If they are, what impact are they having on cognitive development? Nobody knows. Reported mental illness is also on the rise. The share of U.S. teenagers with a reported major depressive episode over the prior year surged by over 60% between 2010 and 2017 (Chart II-13). The fraction of young adults that made suicide plans nearly doubled.20 More than 20% of U.S. women over the age of 40 are on antidepressants.21 Five percent of U.S. children are receiving ADHD medication.22 Implications For Economic Growth And Asset Markets So far, the reversal of the Flynn Effect has been largely confined to the developed economies. Test scores are still rising in the developing world, albeit from fairly low levels. For example, two recent studies have documented significant IQ gains in Kenya and Brazil.23 In the poorest countries, opportunities for improving health abound. Even small steps such as fortifying salt with iodine (which costs about five cents per person per year) have been shown to boost IQ by nearly one standard deviation.24 Measures to reduce inbreeding are also likely to boost IQ scores.25 Yet, we should not underestimate the importance of falling cognitive skills in developed economies. Chart II-14 shows that there is a clear positive correlation between student score on math and science and per capita incomes. Most technological innovation still takes place in developed economies. There is an extremely tight relationship between visuospatial IQ and the likelihood of becoming an inventor (Chart II-15). Since IQ is distributed along a bell curve, a 0.1 standard deviation drop in IQs across the entire distribution will result in an 8% decline in the share of people with IQs over 100, a 14% decline in those with IQs over 115, and a 21% decline in those with an IQ over 130 (by convention, each standard deviation on an IQ test is worth 15 points). Falling IQs could result in slower productivity growth, which could further strain fiscal balances. Lower IQs are also associated with decreased future orientation.26 People who live for the moment tend to save less. A decline in savings would push up real rates, leading to less capital accumulation. History suggests that a deceleration in productivity growth and higher real rates will put downward pressure on equity multiples (Chart II-16). Part 4: Generation E For 200 years, the environmentally-driven Flynn Effect disguised the underlying genetically-driven decline in IQs that began not long after the dawn of the Industrial Revolution. Flynn has acknowledged this himself, noting at the 2017 International Society For Intelligence Research Conference that “I have no doubt that there has been some deterioration of genetic quality for intelligence since the late Victorian times.”27 Now that the Flynn Effect has reversed, both genes and the environment are working together to reduce cognitive abilities in developed economies. This means that the most important trend in the world – a trend that allowed the human population to increase during the Malthusian era and later allowed output-per-worker to soar following the Industrial Revolution – has broken down. Yet, there may be another twist in the story – one that began just a few months ago: the first members of Generation E were born. E Is For Edited ... Or Eugenics Lulu and Nana will be like most other children, but with one key difference: They will be the first humans ever to have their genomes edited through a procedure know as CRISPR-Cas9. Rogue Chinese scientist He Jiankui deactivated their CCR5 gene, which the HIV virus uses as a gateway into the body. His actions were rightfully condemned around the world for endangering the twins’ health by using a procedure that has not yet been fully vetted in animal studies, let alone in human trials (Lulu and Nana’s father is HIV+ but it is debatable whether the children were at an elevated risk of infection). He Jiankui remains under house arrest at the university where he worked. But whatever his fate, the dam has been broken. For better or for worse, the era of personal eugenics has arrived. The Return Of The Silver Fox It is easier to delete a gene than to add one. It is even more difficult to swap out a large number of genes in a way that achieves a predictable outcome. Thus, the successful manipulation of highly polygenic traits such as intelligence — traits that are linked to hundreds of different genes – may still be decades away.28 Predicting a trait is much simpler than modifying it, however. The cost of sequencing a human genome has fallen by more than 99% since 2001 (Chart II-17). Start-up company Genomic Prediction has already developed a test for fertilized embryos for IVF users that predicts height within a few centimetres and IQ with a correlation of 0.3-to-0.4, roughly as accurate as standardized tests such as the SAT or ACT.29 Other companies are following suit.30 Some will recoil in horror at the prospect of selecting prospective children in this manner. They will argue that such technologies, beyond being simply immoral, will widen social inequality between those who can afford them and those who cannot. Others will counter that screening embryos for certain traits is not that dissimilar to what people already do with prospective romantic partners. They will also point out that mass usage of these technologies will drive down prices to the point that even poor people will be able to access them, thus giving low IQ parents the chance to have high IQ kids. They might also note that such technologies may be the only way to reverse the ongoing accumulation of deleterious mutations within the human germline that has been the unintended by-product of the proliferation of life-saving medicines.31 We will not wade into this thorny debate, other than to note that there will be huge incentives for people to avail themselves of these technologies. The Coming Eugenic Wars And not just individuals either – governments too. While the initial impact of eugenic technologies will be small, the effects will compound over time. Carl Shulman and Nick Bostrom estimate that genetic screening could boost average IQs by up to 65 points in five generations (Table II-2). China has been investing heavily in genetic technologies. As Geoffrey Miller has argued, China’s infatuation with eugenics spans into the modern day.32 Like most other countries, fertility in China is negatively correlated with IQ. Mingrui Wang, John Fuerst, and Jianjun Ren estimate that China is currently losing nearly one-third of a point in generalized intelligence per decade, with the loss having accelerated rapidly between the 1960s and mid-1980s.33 The decline in the genetic component of Chinese IQs is coming at a time when the population itself is about to shrink. According to the UN’s baseline forecast, China will lose 450 million working-age people by the end of the century (Chart II-18). Meanwhile, the country is saddled with debt, the result of an economic model that has, for decades, recycled copious household savings into debt-financed fixed-investment spending in an effort to shore up domestic demand. The authorities may be tempted to tackle all three problems simultaneously by adopting generous pro-natal measures – call it the “at least one-child policy”– which increasingly harnesses emerging eugenic technologies. The resulting baby boom would strengthen domestic demand, thus making the economy less dependent on exports, while ensuring China’s long-term geopolitical viability. The Eugenic Wars are coming, and they will be unlike anything the world has seen before. BOX II-1 The Diffusion Of Bourgeois Values: Culture Or Genes? Higher-income people had more surviving children in the centuries leading up to the Industrial Revolution. Real per capita income was broadly stable during this period. This implies that there must have been downward social mobility, with sons, on average, being less wealthy than their fathers. This downward mobility, in turn, spread the characteristics of higher-income people across the broad swathe of society. What were these characteristics? Cultural values that emphasized thrift, diligence, and literacy were undoubtedly part of what was passed on to future generations. But surprisingly, it also appears that genetic transmission played an important, and perhaps pivotal, role. Models of genetic transmission make very concrete predictions about the correlations in economic status that one would expect to see among relatives. Biological brothers share 50% of their genes, as do fathers and sons. Likewise, first cousins share 25% of their genes, the same as grandfathers and sons. These facts yield two testable predictions: The first is that the correlation coefficient on status measures such as wealth, occupation, and education should be the same for relatives that share the same fraction of genes such as sibling pairs and father-son pairs. Box Chart II-1 shows that this is borne out by the data. The second prediction is that the correlation between status and genetic distance should follow a linear trend so that, for example, the correlation in wealth among brothers is twice that of first cousins and four times that of second cousins. Box Chart II-2 shows that this is also borne out by the data.   Other evidence supports the importance of genes in the transmission of status across generations. The correlation in measures such as wealth, education, and occupation is much higher among identical twins than fraternal twins. Adopted children turn out to be more similar to their biological parents on these measures when they reach adulthood than their adopted parents, even when the children have never met their biological parents. The parent-child correlation also remains the same regardless of family size, suggesting that spreading the same resources over more children may not harm life outcomes to any discernible degree, at least on the measures listed above. Peter Berezin Chief Global Strategist Global Investment Strategy III. Indicators And Reference Charts Our tactical equity upgrade to overweight last month has still not been confirmed by most of our proprietary indicators. Our Willingness-to-Pay (WTP) indicator for the U.S. is falling fast. It is also eroding for Europe, although it has ticked higher in Japan. The WTP indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. Investors have clearly moved funds away from the U.S. equity market and there is no sign yet that this is reversing. Our Revealed Preference Indicator (RPI) for stocks continued to issue a ‘sell’ signal in January. 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 signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. While the RPI is still cautious, value has improved significantly according to BCA’s composite valuation indicator. It is a composite of 11 different valuation measures. This indicator almost reached the fair value line in December. Moreover, our Monetary Indicator has suddenly shifted out of negative territory for stocks, rising to the neutral line in December. Calming words from the Fed has improved the monetary backdrop by removing expected rate hikes from the money market curve. Given the improvement in both value and the monetary backdrop, the RPI could generate a ‘buy’ signal next month. Our Composite Technical indicator for stocks broke down last month, providing a clear ‘sell’ signal, and has not yet delivered a ‘buy’. However, sentiment is now washed out and earnings expectations have been revised heavily downward. These signals are bullish from a contrary perspective.  The 10-year Treasury yield is in the neutral range according to our valuation model. Bonds are not overbought, despite the rally in December, because they were still working off oversold conditions. Contrary to the bond valuation model, the 10-year term premium moved further into negative territory in January, suggesting that yields are unsustainably low. Our bond-bearish bias is consistent with the view that the Fed rate hike cycle is not over. The U.S. dollar is somewhat overbought and very expensive on a PPP basis. Nonetheless, we believe it will become more expensive in the first half of 2019, before its structural downtrend resumes in broad trade-weighted terms. 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 Components Chart 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 Mark McClellan Senior Vice President The Bank Credit Analyst   Footnotes 1       Please see The Bank Credit Analyst Special Report "The Long Shadow Of The Financial Crisis," dated October 25, 2018, available at bca.bcaresearch.com 2       The amount of spread widening required for corporate returns to break-even with duration-matched U.S. Treasuries on a one-year horizon. 3       Please see Geopolitical Strategy Special Report "Five Black Swans In 2019," dated January 16, 2019, available at gps.bcaresearch.com 4       Xi Song, Cameron Campbell, and James Lee, "Descent Line Growth and Extinction From A Multigenerational Perspective, Extended Abstract," American Sociological Review 80:3, (April 21, 2015): 574-602. 5       Gregory Cochran and Henry Harpending, "The 10,000 Year Explosion: How Civilization Accelerated Human Evolution," Basic Books, (2009). 6       Mark Grinblatt, Matti Keloharju, and Juhani T. Linnainmaa, “IQ, Trading Behavior, and Performance,” Journal of Financial Economics, 104:2, (May 2012): 339-362. 7       Thomas Bouchard, "Genetic Influence On Human Psychological Traits - A Survey," Current Directions in Psychological Science 13:4, (August 2004): 148-151. 8      The tendency for the genetic contribution to IQ to increase until early adulthood and then to remain at high levels until old age is known as the Wilson Effect. There is no consensus on what causes it, but it probably reflects a number of factors: 1) It may take some children longer than normal to reach full intellectual maturity. Testing their IQs at a young age will result in scores that are lower than those expected based on their parents’ IQs. The opposite is true for children whose IQs increase relatively quickly in young age, but possibly top out earlier; 2) Environmental effects are probably more important in young age when a child’s brain is still quite malleable; 3) Self-reinforcing gene-environment interactions tend to increase with age. Children do not have much control over their environment, but as they get older, they will seek out activities that are more in keeping with their genetic predispositions. For example, a studious child may pursue a career that reinforces their love of learning. 9       "Cache Cab: Taxi Drivers' Brains Grow to Navigate London's Streets," Scientific American, (December 2011). 10       Atheendar Venkataramani, "Early Life Exposure to Malaria and Cognition in Adulthood: Evidence from Mexico," Journal of Health Economics 31:5, (July 2012): 767-780; Hoyt Bleakley, "Health, Human Capital and Development," Annual Review of Economics 2, (March 2010): 283-310; Hoyt Bleakley, "Malaria Eradication in the Americas: A Retrospective Analysis of Childhood Exposure," American Economic Journal: Applied Economics 2, (April 2010): 1-45. 11       "Anthropologists Find American Heads Are Getting Larger," ScienceDaily, (May 2012). 12       "British Teenagers Have Lower IQs Than Their Counterparts Did 30 Years Ago," The Telegraph, (February 2009). 13     Bernt Bratsberg and Ole Rogeberg, "Flynn Effect And Its Reversal Are Both Environmentally Caused," Proceedings of the National Academy of Sciences 115:26, (June 2018): 6674-6678. 14     On the face of it, artificial intelligence would appear to be a substitute for human intelligence. Many applications of AI would undoubtedly have this feature, especially those that allow computers to perform complex mental tasks that humans now must do. However, there are several ways that AI may eventually come to complement human intelligence. First, and most obviously, AI could be used to augment human capabilities either directly by hardwiring it into our brains, or indirectly through the development of drugs or genetic techniques which improve cognition. Second, looking further out, the benefits of highly intelligent AI systems would be limited if humans did not possess the requisite intelligence to understand certain concepts that are currently beyond our mental reach. No matter how well intentioned, trying to explain string theory to a mouse is not going to succeed. There are probably a multitude of ideas that AI could reveal that we simply cannot comprehend at current levels of human intelligence. 15     James Heckman and Paul La Fontaine, "The American High School Graduation Rate: Trends and Levels," The Review of Economics and Statistics 92:2, (May 2010): 244–262. 16     "Turning Around Chronically Low-Performing Schools," The Institute of Education Sciences (IES), (May 2008). 17     E. von Mutius, F.D. Martinez, C. Fritzsch, T. Nicolai, G. Roell, and H. H. Thiemann, "Prevalence Of Asthma And Atopy In Two Areas Of West Germany And East Germany," American Journal of Respiratory and Critical Care Medicine 149:2, (February 1994): 358-64. 18     "Sperm Counts In The West Plunge By 60% In 40 Years As ‘Modern Life’ Damages Men’s Health," Independent, (July 2017). 19     Kaspar Sørensen, Annette Mouritsen, Lise Aksglaede, Casper P. Hagen, Signe Sloth Mogensen, and Anders Juul, "Recent Secular Trends in Pubertal Timing: Implications for Evaluation and Diagnosis of Precocious Puberty," Hormone Research in Paediatrics 77:3, (May 2012): 137-145. 20     “Results from the 2017 National Survey On Drug Use And Health: Detailed Tables,” Substance Abuse and Mental Health Services Administration, Center for Behavioral Health Statistics and Quality, Rockville (Maryland), (September, 2018). 21     Laura A. Pratt, Debra J. Brody, and Qiuping Gu, "Antidepressant Use Among Persons Aged 12 and Over: United States, 2011–2014," NCHS Data Brief No. 283, Centers for Disease Control and Prevention, (August 2017). 22     Some, but not all, of the increase in reported rates of mental illness may be due to more aggressive diagnosis by health practitioners. For example, a recent study revealed that children born in August were 30% more likely to receive an ADHD diagnosis than those born in September, simply because they were less mature compared to other kids in the first few years of elementary school. See: Timothy J. Layton, Michael L. Barnett, Tanner R. Hicks, and Anupam B. Jena, "Attention Deficit-Hyperactivity Disorder and Month of School Enrollment," New England Journal of Medicine 379:22, (November 2018): 2122-2130. 23     Tamara C. Daley, Shannon E. Whaley, Marian D. Sigman, Michael P. Espinosa, and Charlotte Neumann, "IQ On The Rise: The Flynn Effect In Rural Kenyan Children," Psychological Science 14:3, (June 2003): 215-9; Jakob Pietschnig and Martin Voracek, "One Century of Global IQ Gains: A Formal Meta-Analysis of the Flynn Effect (1909-2013)," Perspectives on Psychological Science 10:3, (May 2015): 282-306. 24     N. Bleichrodt and M. P. Born, “Meta-Analysis of Research on Iodine and Its Relationship to Cognitive Development,” In: ed. J. B. Stanbury, "The Damaged Brain of Iodine Deficiency," Cognizant Communication Corporation, New York, (1994): 195-200; "Iodine status worldwide: WHO Global Database on Iodine Deficiency," World Health Organization, Geneva, (2004). 25     Mohd Fareed and Mohammad Afzal, "Estimating the Inbreeding Depression on Cognitive Behavior: A Population Based Study of Child Cohort," PLOS ONE 9:12, (October 2015): e109585. 26     H. de Wit, J. D. Flory, A. Acheson, M. McCloskey, and S. B. Manuck, "IQ And Nonplanning Impulsivity Are Independently Associated With Delay Discounting In Middle-Aged Adults," Personality and Individual Differences 42:1, (January 2007): 111-121; W. Mischel and R. Metzner, "Preference For Delayed Reward As A Function Of Age, Intelligence, And Length Of Delay Interval," Journal of Abnormal and Social Psychology 64:6, (July 1962): 425-31. 27     James Flynn, “IQ decline and Piaget: Does the rot start at the top?” Lifetime Achievement Award Address, 18th Annual meeting of ISIR, (July 2017). 28     For a good discussion of these issues, please see Richard J. Haier, “The Neuroscience of Intelligence,” Cambridge Fundamentals of Neuroscience in Psychology, (December 2016). 29     "The Future of In-Vitro Fertilization and Gene Editing," Psychology Today, (December 2018). 30     "DNA Tests For IQ Are Coming, But It Might Not Be Smart To Take One," MIT Technology Review, (April 2018). 31     Michael Lynch, "Rate, Molecular Spectrum, And Consequences Of Human Mutation," Proceedings of the National Academy of Sciences 107:3, (January 2010): 961-968. 32     Geoffrey Miller, "What *Should* We Be Worried About?" Edge, (2013). 33     Mingrui Wang, John Fuerst, and Jianjun Ren, "Evidence Of Dysgenic Fertility In China," Intelligence 57, (April 2016): 15-24. EQUITIES:FIXED INCOME:CURRENCIES:COMMODITIES:ECONOMY:

Highlights So What? A 70% tax on Americans with income over $10 million is not far-fetched. Why? The median U.S. voter wants higher taxes on the wealthy; Both populism and geopolitics make it impossible to cut spending; The next recession, no matter how shallow, will elicit unconventional policy. Feature The New Year has brought a chill to the investment community. No, it is not the weather, but rather a proposal by U.S. Congresswoman Alexandria Ocasio-Cortez (AOC) to create a new top-income bracket, starting at $10,000,000, that would be taxed at 70%. The reaction to the self-described Democratic Socialist has been swift. Her strategy of soaking the rich would not work, would cause an exodus of job-creators out of the U.S., and would slow down the pace of growth. A CNBC headline screamed: “The super rich at Davos are scared of Alexandria Ocasio-Cortez’s proposal to hike taxes on the wealthy.”1 In these pages, we are not going to discuss the merits of the proposal, although it would not raise enough revenue to fund the Democrats’ other policy proposals. Instead, we are going to forecast that Representative Ocasio-Cortez will get what she wants. Within our investment horizon. Probably following the next recession, which is nigh. However, how she gets what she wants will ultimately matter more than what the tax rate is on every dollar over $10,000,000 of income. The Median American Voter Since before the 2016 U.S. election and the Brexit vote, we have argued that the Median Voter is moving to the Left, particularly in the laissez-faire economies of the U.S. and the U.K. These two Anglo-Saxon economies swerved most enthusiastically to the right of the economic spectrum during the 1980 supply-side revolutions. They embraced both neo-liberal economic policy and globalization. While these reforms allowed them to outperform their less enthusiastically capitalist peers on a number of measures of economic performance, they also produced higher income inequality and a slower pace of social mobility (Chart 1). Over time, and particularly following the 2008 Great Recession, this pernicious mix of factors produced a surge in populism. There has been plenty of evidence that our view is on track. Take for example the performance of the über-left leaning Labour Party in the U.K.’s 2017 election or the breakdown of the Washington Consensus on global trade. Still, many clients have resisted our thesis. This is because President Trump did manage to push a sweeping supply-side tax cut through Congress in 2017. Given that we forecast that Republicans would get their way on tax cuts, our clients were left wondering how our thesis of a shift to the left could coexist with a Reagan-esque lowering of tax rates? The answer is that the move of the Median Voter to the left is a structural geopolitical view. A tax cut policy in 2017 was a tactical/cyclical view that deviated from the long-term trend. Trump was a candidate who promised faster economic growth while the Republican Party was a political machine that sought a low tax regime as a matter of policy and ideology. We expected the GOP, and House leader Paul Ryan, to use the Trump presidency as a way to get one last tax cut while they had control. However, since the tax cuts were passed, much has gone awry for America’s center-right party. First, the Democrats campaigned enthusiastically against the tax cuts in the midterm elections. On the other side of the aisle, Republican members of Congress quickly found out that they got no applause from constituents for their signature piece of legislation. The tax cut therefore disappeared from GOP messaging ahead of the November 2018 election. Steve Bannon, Trump’s political strategist, had apparently predicted this outcome when he cautioned against cutting tax rates for the top income bracket. He suggested a hike on taxes for the wealthy to boost Trump’s populist credentials. (Bannon’s proposal was for a 44% rate on those who earn income over $5,000,000, mathematically on the path towards Ocasio-Cortez’s end-point!).2 Second, the Republicans went on to lose their majority in the House. Granted, presidents usually lose their first midterm. However, with unemployment at 3.7% last November and the economy clocking in at a 3% clip, the GOP had a clear upper hand on economic messaging. And yet it did not avert major losses. The commentary from the right is that the Democrats are going to dig their own grave with their increasingly “Socialist” talk. But will they? We present three reasons that suggest that Ocasio-Cortez (and, ironically, Steve Bannon) are going to get what they want. Income taxes in America will rise over the next decade. Reason #1: The Median Voter Wants Higher Taxes On The Wealthy There is nothing sacred in politics. A society’s volonté générale swings like a pendulum between thesis and antithesis. The idea that Americans embody the laissez-faire spirit, while the French are socialists, is simply a product of linear extrapolation based on the timeline of a single generation.3  Chart 2 suggests a different story. As recently as the early 1970s, the U.S. and France were like peas in a pod when it came to income distribution, while the U.K. – the epicenter of the supply-side revolution — was the most redistributive Western economy. Chart 2France Was Once Less Socialist Than America! Today, Americans are much more in line with AOC than with Paul Ryan, which is why only one of the two has a job in the U.S. Congress. Ryan knew when to take his winnings and go home. According to a poll published merely weeks after AOC’s proposal, 59% of Americans support the 70% marginal tax rate. Democrats support the idea at a 71% clip, which suggests that Ocasio-Cortez is not on the fringes of the party. Independents support it at 60% and even 45% of registered Republicans support the idea. One could argue that the much-cited poll above is merely a flash in the pan, that it signifies nothing. We disagree for two reasons. First, if 60% of Americans – including 45% of Republicans – support a 70% tax rate now, when the economy is firing on all cylinders, GDP growth is above potential, and unemployment is at 3.9%, what will they support 12-36 months from now, when the inevitable recession hits? Or when America’s indebted corporations begin to deleverage by shedding jobs because they took on massive debts in order to buy back equities and return value to shareholders (which, completely coincidentally, includes senior management)? Second, there is evidence that a majority of Americans has thought that “upper-income people” have not been paying their fair share for some time now. A Gallup poll run since the early 1990s shows that the sentiment for higher taxes on upper-income individuals is off its lows in 2010 (Chart 3). We are still far from the early 1990s highs, but the trajectory of the public opinion is clearly going in the Left’s direction and has always hovered around the 60% mark. Bottom Line: It seems like ages ago that Grover Norquist, the anti-tax advocate, dominated the hallways of Congress, prodding legislators into pledging to “oppose any and all efforts to increase the marginal tax rate for individuals and businesses.” As recently as the 2012 election, 238 out of 242 House Republicans and 41 out of 47 Senate Republicans signed Norquist’s “Taxpayer Protection Pledge.” We subscribe to the theory that the median voter is the price maker in the political marketplace, the politician is the price taker. Trump and Ocasio-Cortez are merely vessels for the expression of the volonté générale, the median voter’s policy preference. And that preference runs counter to Norquist’s activism and the GOP’s tax cut policy in 2017. Reason #2: History Is On Ocasio-Cortez’s Side Chart 4 has already made the rounds, suggesting that Ocasio-Cortez is not making a ludicrous proposal given that the U.S. already had much higher marginal tax rates on top incomes in the past. Critics accuse her of simplifying history without considering context. This is an important point. First, defense spending as a percent of GDP was at 37.5% in 1945 and still at an elevated 7.4% in 1965, twenty years later. The U.S. exited World War II and then almost immediately stumbled into two major conflicts, one on the Korean Peninsula and one in Vietnam. Meanwhile, the Cold War competition with the Soviet Union created an existential threat that had to be resisted on land, sea, and space, justifying higher tax rates. Second, while the U.S. did indeed cut its top marginal rates throughout the second half of the century, so did everyone else! Chart 5 shows that the rest of the Western world was largely in lock-step with the U.S. In fact, it was the U.S. that came down to French levels of taxation (!!!) throughout 1960s and 1970s (again, remember Chart 2). As such, Chart 4 by itself is not a reason to excuse higher marginal rates. Of course we are completely disinterested in the merits of the policy. We are merely trying to forecast it. And Chart 4 does help us do so for two reasons. First, the key achievement of the Tax Cuts And Jobs Act of 2017 was the corporate tax cut to 21%. There is some bipartisan support for this policy, at least in the center of the Democratic Party (President Obama tried to cut the corporate tax rate from 35% to 28% in 2012). The last time corporate tax rates were this low, however, the top marginal income tax rate was at 79%. As such, we think that a bipartisan consensus could emerge on keeping corporate tax cuts at or below the OECD average of 24%, but at the cost of higher marginal tax rates for high-income earners. Second, it has been a key structural view of BCA’s Geopolitical Strategy, since inception, that the defining geopolitical feature of the twenty-first century will be the Sino-American conflict. If we are right on this issue, then perhaps an “existential conflict” to justify higher taxes on elites is already here. In other words, it is a fact that global challenges have required the U.S. to tax households and corporations at a higher rate in the past. It is also a fact that the U.S. faces greater global challenges today, specifically with China and Russia, than at anytime since the Cold War. Thus, while AOC may not be motivated by geopolitics, she may represent one aspect of a growing public policy consensus nonetheless. Simply put, with the U.S. facing both populism and geopolitical multipolarity, there is simply no political option for cutting either defense or non-defense spending. The only question is whether the U.S. will simultaneously shore up its ability to service its debts and maintain a reliable currency. AOC may find unlikely allies as geopolitical competition heats up. Reason #3: Policymakers Will Overreact To The Next Recession  President Trump was elected in November 2016, with the recession having ended 88 months prior, with the unemployment rate down 5.6%, and the economy on the path to recovery. But his economic populist message resonated with a lot of voters who did not participate in that recovery. Our concern is that the next recession is close at hand. BCA’s House View is that the next recession will be relatively shallow in the U.S., in part because there aren’t any obvious bubbles. For one, cyclical spending as a percent of GDP is at mid-cycle levels (Chart 6). Corporate debt is elevated, but not by international standards (Chart 7). U.S. banks are in a much sounder position than in 2007. So, from a macroeconomic perspective, the next recession is nothing to fear. Chart 6Are We Even Mid-Cycle Yet?   Chart 7Corporate Debt Load Is Not Excessive Policymakers, however, don’t care about macroeconomics. They care about the policy preferences of the Median Voter. And if that Median Voter elected an anti-establishment populist during relatively good times, who will he or she support when unemployment is high? Whoever is running the U.S. when the next recession happens, they will not wait around to find out. Unorthodox monetary, fiscal, and yes tax policy will overshoot norms and conventions regardless of how shallow the recession is. All bets are off at that point since policymakers will have a “recency bias” due to the trauma of 2008. While the recession may be shallow, the budget deficit will likely be at an elevated level. The U.S. is currently engaged in the first pro-cyclical economic stimulus since the late 1960s (Chart 8). This means that the recession will likely hit with the budget deficit already at around 5%-6% of GDP, compared to just 3%-4% when the last recession occurred. Given that the last four recessions raised the U.S. budget deficit by an average of 5% of GDP, it is safe to say that the U.S. budget deficit may rise to 2010 levels after the next downturn, regardless of how shallow the recession is. Chart 8Budget Deficits Will Be Very High In The Next Recession As with the  Great Recession, the public will demand that the government deals with the deficit. Unlike in the post-2008 environment, however, we think that the Median Voter will abandon the Norquist and Tea Party thesis of cutting spending and adopt the view that higher income brackets should see their taxes increased. That said, extremely high marginal rates at $10,000,000 will impact very few individuals and thus have a negligible revenue impact. What about higher marginal rates across the board? Chart 9 illustrates the evolution of marginal tax rates, using 2012 dollars for income brackets, across decades. The 1950s, 1960s, and 1970s saw multiple tax brackets, all with progressively higher marginal tax rates. In the 1970s, the 70% tax rate started at $460,000 in 2012 dollars, but a 50% rate began at $100,000 in 2012 dollars. The question for investors is whether Ocasio-Cortez’s proposal is merely a branding exercise. A 70% tax rate that begins at $10,000,000 – Option 1 on Diagram 1 – is largely irrelevant, macroeconomically and politically. But if that is an end point of a curve, that is something that investors will want to know. This is because policymakers could draw those curves either by cutting lower-class and middle-class marginal rates – such as in Option 2 – or by simply replicating the 1970s curve, such as in Option 3. The impact of new taxes on the part of society with a higher marginal propensity to consume is an important consideration for policymakers recovering from a recession. Diagram 1Is Ocasio-Cortez’s Proposal An End Point Of A Curve Or Just A Branding Exercise? At the moment, investors are probably not overly concerned about these issues. Options 2 and 3 look unlikely in the current political environment. But, again, they have been acceptable policy options in the past and could be revived if the Democratic Party decides to make income inequality the central issue of the 2020 election. Which makes the 2020 election the most significant U.S. election in a generation. Will Trump-style populism succeed or will Democratic Socialism emerge in the United States? At the moment, most of our clients would likely guess that trade and immigration – policy issues from 2016 – will dominate the debate again in 2020. This is likely incorrect linear extrapolation. Rarely do the same issues carry over from one election to another. As such, a left-leaning presidential candidate could push the Trump administration on its tax reform package and the continued growing income inequality, despite a falling unemployment rate. Throw in a potential recession and you have a witch’s brew. Not only would the rhetoric alarm the markets, but so would the electoral math. Democrats have a solid House majority while Republicans are clinging to a small Senate majority in a year when the electoral math clearly works in Democrats’ favor (20 out of 33 Senate seats up for reelection are held by the GOP). We are not ready to give a high conviction forecast on the presidential election – other than to say that a recession will virtually ensure Trump’s loss – but we do have a high conviction that whoever wins the White House in 2020 will also carry the Senate. As such, a Democratic sweep of both the White House and Congress is a possible scenario. At that point, the Options from Diagram 1 will no longer be an academic question. Finally, even if Trump emerges victorious, he may still have to agree with a Democratic Congress to modify his tax cuts in order to pay for his border wall, immigration reform, and a national infrastructure package. In that case, the median voter would have established the long-term bottom of U.S. tax rates even without a change in political parties. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com   Footnotes 1      Please see CNBC Markets, “The super rich at Davos are scared of Alexandria Ocasio-Cortez’s proposal to hike taxes on the wealthy,” dated January 22, 2018, available at cnbc.com. 2       Please see “Steve Bannon’s Plan to Raise Taxes on the Rich? Not Happening,” Fortune, dated July 31, 2017, available at fortune.com. 3      Also known as stereotyping.