Geopolitics

Highlights So What? India is overcoming the economic constraints to its strategic rise.  Why? India faces rising political risk once again as public opinion puts Modi’s tenure in power at risk. However, India will continue to improve its economy, as outside pressures will force it to act coherently as a nation. Stay on the sidelines for now but remain constructive over the long run. Feature “An enemy of my enemy is my friend.” This is to paraphrase Kautilya, a philosopher of the Mauryan Empire, circa 200 BC. Kautilya was the Indian Machiavelli and wrote the Arthashastra to give hard-nosed political advice to rulers who wanted to know how kingdoms and states really behave rather than how they ought to behave.1   The quotation is no less true today than it was in ancient times. It explains why risks are rising to our view that Prime Minister Narendra Modi will remain in power after the election in April or May. This reinforces our underweight position on Indian risk assets over a 12-month time horizon. The quotation also explains why China’s growing influence in South Asia will drive India to continue reforming its economy and befriend the United States, thus supporting an optimistic view of India’s economic and investment potential in the long run (Chart 1). Chart 1 What Is India’s Grand Strategy? India’s geopolitical predicament stems from the fact that it is a relatively rational geographic unit, but one whose political unity is extremely difficult to maintain. Almost every side of the subcontinent is demarcated by forbidding geology: the Himalayas, the Bay of Bengal, the Arabian Sea, the thick jungles of Burma. Even the northwest, the traditional route of invaders, hosts vast obstacles like the Hindu Kush and Thar Desert. Any kingdom that takes shape can soon dream of expanding its borders to a natural stopping place (Map 1). Chart Yet formidable obstacles stand between the cradles of Indian civilization – the Indus and Ganges Rivers – and the river ways and coastal outlets of the south. The Vindhya-Satpura mountains, the Deccan plateau, and the eastern and western Ghats make it extremely difficult for a northern power to govern the various cultures of the southern cone.  This geography ensures that empires are always trying and failing to unify the subcontinent into a coherent whole. As a result, India rarely projects power beyond it. When it does, the projection is short-lived.2    Historically India has seen the rise of five major empires that dominated the subcontinent: the Mauryans, the Guptas, the Mughals, the British, and the modern Republic of India (Chart 2). The Mughals and many other invaders periodically streamed in from the northwest – most often from modern-day Afghanistan and northern Pakistan, but also from Iran and southern Pakistan. Meanwhile several European empires invaded from the sea and established coastal settlements. The British East India Company settled in Bengal and then drove west and south, cutting off the French who had settled on the southeastern shores.   Chart 2 The modern Republic of India, founded in 1947 after Mahatma Gandhi and his followers harassed the British into leaving, feared that the United States would follow in Britain’s footsteps, being the world’s preeminent naval power. The Indians also distrusted the U.S.’s constructive relations with China and Pakistan that aimed to “contain” the Soviet Union. The Soviets, by contrast, could apply great pressure on Pakistan’s flank in Afghanistan and thus proved useful to India. They could also sell India weapons and capital goods as founding Prime Minister Jawaharlal Nehru pursued a socialist path of economic development.  The collapse of the Soviet Union coincided with a balance-of-payments crisis in India in 1991 that resulted in the abandonment of the old command-style economy and the adoption of modern capitalism under the reforms of Narasimha Rao. India also supported the U.S.’s intervention in the region after September 11, 2001 as a way of maintaining pressure on Pakistan’s back door. From this brief history we can glean a few solid points about India’s grand strategy: An Indian empire must establish control along the Indus or Ganges rivers, or both; An Indian empire must assimilate or drive out foreign rulers and unify the north and south; An Indian empire must strive to become the kingmaker across the subcontinent, through influence if not conquest; An Indian empire must fend off an invasion from the sea. The result of Rao’s reforms, India’s achievement of nuclear status in 1998, and nearly three decades of economic growth have been an India that is clearly an emerging “great power.” According to our Geopolitical Power Index, India is today on the cusp of supplanting Russia as the world’s third most powerful state (Chart 3). It surpassed the U.K., its former colonial master, in 1993. Chart 3India On Cusp Of Overtaking Russia In Comprehensive National Power India On Cusp Of Overtaking Russia In Comprehensive National Power India On Cusp Of Overtaking Russia In Comprehensive National Power Like China in East Asia, India is modernizing its vast army, developing a blue-water navy, and carving out a sphere of influence in South Asia (Chart 4). Also like China, India’s ambitions of regional hegemony are frustrated by its neighbors. India’s rivalry with Pakistan is foundational and existential – it is as if China faced Taiwan with nuclear weapons. Chart 4India's Military Clout Quietly Rising India's Military Clout Quietly Rising India's Military Clout Quietly Rising Today the fragile world order that prevailed in the wake of the Cold War is under severe strain. China’s grand regional ambitions are provoking a harsh reaction from the United States, which is setting up a new “containment policy” to limit China’s technological advance. The U.S. is withdrawing military forces from the Middle East and South Asia as it becomes energy self-sufficient and looking to counter-balance China with its free hand. Meanwhile China’s influence on the subcontinent is growing – already it is a rival to India as a trade partner for India’s South Asian neighbors (Chart 5). The Sino-Indian rivalry has often been overstated – the Himalayas are more than a hindrance. But China’s Belt and Road Initiative (BRI) means that this logic is increasingly out of date. Historically, India faced overland invasions from the northwest and maritime invasions from the northeast. The Belt and Road – of which Pakistan is probably the most comprehensive beneficiary – potentially threatens India from both directions sometime in the future. Chart 5China Encroaching In India's Sphere Of Influence China Encroaching In India's Sphere Of Influence China Encroaching In India's Sphere Of Influence Of course the U.S. and India still face tensions between each other – foremost being the impending withdrawal from Afghanistan and the U.S. “maximum pressure” policy towards Iran (Chart 6). There are also trade tensions with the Trump administration and a broader problem of inconsistent U.S. outreach to India. Nevertheless the logic of “the enemy of my enemy is my friend” suggests that over the long run the U.S. will grow warmer with India as a regional counterweight to China, while India will wish to become less isolationist and cultivate its relationship with the U.S. as a counter both to Pakistan and China. Simply put, China is making historic advances into India’s neighborhood in South Asia and the Indian Ocean basin. Chart 6A Good Sign For U.S.-India Ties: Cooperation On Iran A Good Sign For U.S.-India Ties: Cooperation On Iran A Good Sign For U.S.-India Ties: Cooperation On Iran This logic also suggests that India will be driven to continue reforming its economic structure so as to preserve internal unity and South Asian influence. If its economy languishes, it will lose preponderance within its neighborhood and become vulnerable to foreign aggression. Bottom Line: India and the U.S. are likely to see an ever-strengthening strategic partnership. They will overcome hurdles to the relationship because of their mutual need to counter China’s regional ascendancy. India’s Economic Hang-Up India has been ineffective in establishing an international presence because it has only reluctantly and haltingly reformed its economy. Today India’s middle class – measured by the share of adults with total wealth from  $10,000 to $100,000 – is less than 10%, comparable to the Philippines and Thailand. China’s is now above 50%, according to Credit Suisse’s Global Wealth Report (Chart 7).    Chart 7 This weakness stems in great part from policy decisions, namely the dogged pursuit of socialism through the latter stages of the Cold War. The same ruling ideology that prized independence also prized self-sufficiency, doubling down on import-substitution and thus missing the chance to industrialize with the export-oriented Asian Tigers in the 1970s or China in the 1980s. The result of insufficient measures to limit the state, curtail monopolies, contain inflation, and promote trade and private enterprise has been a chronic shortfall of national savings (Chart 8), which are needed to invest in capital projects and boost productivity (Chart 9).3   Chart 8India Lacks National Savings India Lacks National Savings India Lacks National Savings Chart 9India's Lagging Productivity India's Lagging Productivity India's Lagging Productivity Many of these historic hang-ups have begun to change, however, first under the reforms of the 1990s-2000s and more recently under the government of Prime Minister Narendra Modi since 2014. As a result, there are a number of “truisms” about India’s economy that are no longer true. For instance, while India’s government is said to be small and weak due to its federal structure – which empowers the states – the truth is that its government is not notably smaller than that of other comparable emerging markets (Chart 10). There is no doubt that it is harder for India’s leaders to drive their agenda than it is for Russia’s and China’s leaders, but this is due to the type of government rather than the size. India inherited liberal democracy and rule of law from the British and its own revolutionary leaders built on this foundation, providing relative stability despite its patchwork of languages, ethnicities, and castes. Democratic checks and balances have led to better governance. Chart 10India's Government Neither Small Nor Weak India's Government Neither Small Nor Weak India's Government Neither Small Nor Weak The contrast has had clear effects on demography. India has a strong demographic foundation and hence a large internal market and robust labor force growth. China, by contrast, is suffering from the distortive effects of the “One Child Policy” on its working age population. As a result India’s population will increasingly provide the global labor force as China’s workers become scarcer and rise in cost (Chart 11) and as trade conflicts between China and the West drive investors to relocate supply chains. Chart 11 This is also a risk to India, of course, if job creation lags. But that is where other economic improvements come in. Cumulatively, Modi’s policies have improved the trajectory of a capital formation relative to consumption, which will increase productivity, potential growth, and job creation (Chart 12). Chart 12Modi Corrected India's Investment Trajectory Modi Corrected India's Investment Trajectory Modi Corrected India's Investment Trajectory On openness to trade, India has largely closed the gap with China and other comparable EMs like Indonesia (Chart 13). And while India has long been highly restrictive toward foreign investment, it is much less so than China (Chart 14), and a slew of policies to ease restrictions has resulted in a surge in foreign direct investment that only recently came off the boil (Chart 15). Chart 13India Not So Closed To Trade Anymore India Not So Closed To Trade Anymore India Not So Closed To Trade Anymore Chart 14 Chart 15Modi Opened India To Foreign Investment Modi Opened India To Foreign Investment Modi Opened India To Foreign Investment Further, while India remains broadly under-invested and has not managed to rebalance its overall economy toward manufacturing, it has created some bright spots within the manufacturing sector, such as autos (Chart 16).4 Modi’s government has significantly improved other conditions that will encourage private investment: the ease of doing business, global competitiveness, infrastructure effectiveness, and human capital (Chart 17). Chart 16Cars A Bright Spot In Indian Manufacturing Cars A Bright Spot In Indian Manufacturing Cars A Bright Spot In Indian Manufacturing Chart 17 Bottom Line: India’s grand strategy has historically suffered because internal unity and regional influence could not be achieved with a floundering economy. Over recent decades, however, India’s reforms have accumulated into substantial improvements – and the Modi administration has made some key improvements. But Will Modi Survive? Our baseline case for the general election due in April or May is that Modi and his ruling Bharatiya Janata Party (BJP), along with their allies in the National Democratic Alliance (NDA), will remain in power, if narrowly. However, in recent weeks the public opinion polling has taken a turn for the worse for Modi (Chart 18), raising the odds of a hung parliament or opposition victory. Modi still remains well ahead of Rahul Gandhi, the dynastic leader of the opposition Indian National Congress and its United Progressive Alliance (UPA), in terms of popularity (Chart 19). But in some polling he is barely holding onto a double-digit lead. Meanwhile Gandhi’s sudden viability as a candidate is a significant change from only a year ago. Chart 18 Chart 19 Nevertheless the range of seat projections for the lower house of parliament, the Lok Sabha, is very wide and suggests that Modi’s coalition could still win a majority, as long as the opposition’s current rally breaks (Chart 20).   Chart 20 A critical election dynamic points back to Kautilya’s ancient advice. Recently, two major parties in Uttar Pradesh – the key bellwether state – have joined forces to avoid stealing each other’s votes and thus help the opposition take seats. If this scheme works, then the NDA could be outmatched at the polls.5 For investors, however, the key takeaway is that Modi’s reform agenda is past its peak and policy uncertainty can only rise from here: Modi’s seats will certainly shrink from the landslide of 2014 – the BJP is likely to lose its single-party majority, weakening Modi and his party members on their reform agenda. The support of their NDA allies will have to be bought with favorable policy tradeoffs (Chart 21); Chart 21 The high tide of Modi’s movement has already come and gone in the state governments, where the BJP recently lost Madhya Pradesh, Rajasthan, and Chhattisgarh, among others (Map 2). It is possible to lose these states and still win the general election, as largely occurred in 2004 and 2009, but state governments are a decisive factor in implementing federal policies and Modi’s influence is now clearly on the wane; Chart Estimates of the NDA’s future gains in the Rajya Sabha, the upper house, suggest that even if Modi stays in power, he will never obtain a majority there (Diagram 1) – meaning that lower house bills other than supply bills will be subject to a veto; Diagram 1Modi Unlikely To Gain Majority In Upper House … Ever India's Geopolitics: What Investors Need To Know India's Geopolitics: What Investors Need To Know Modi is unlikely to have enough seats in the two houses to have the option of driving key legislation through a joint session of parliament. This is a rare occurrence but it would be a valuable ace up the sleeve. Modi’s reform movement has already seen high tide. He will struggle to institute reforms if he is weakened in parliament and the states. This is even truer if a hung parliament occurs, or if the UPA ekes out a slim majority. In essence, the next Indian government will likely be hobbled if Modi’s polling and performance do not recover from here – and even then he will not reclaim the political capital of his first term in office. It would be a mistake, however, to believe that reforms cannot get done without Modi. Prime Minister Rao came from the Congress Party, after all. Moreover, it is possible for India to undertake major reforms with a weak coalition or minority government. This was the backdrop of the critical pro-market reforms of the 1990s. But this implies that there would need to be a market riot to induce additional reform momentum, as was the case at that time, and India is not at a comparable crisis point today.  Bottom Line: Modi’s reform momentum is over. The next government will be weaker and less able to drive major pro-productivity reforms. But eventually reform momentum will recover, driven by the geopolitical forces outlined above. Does Modi Matter? What is the basis for Modi’s loss of momentum? The gist of the problem is that Modi’s reforms were structural and therefore entailed substantial economic and social costs. As a result, Modi has lost support. The good news is that Modi’s achievements thus far will continue to yield benefits for India. To highlight a few: The creation of a single market by means of the Goods and Services Tax (GST) is a significant reform that will ensure a strong legacy for Modi in the long run. However, the new tax obviously does not get voters enthused. The new Bankruptcy Law has helped to cleanse economic inefficiencies. But it has resulted in layoffs and financial deleveraging, weighing on credit growth and the broader economy. Demonetization, the sudden replacement of key denominations of money in circulation, has helped to formalize gray and black parts of the economy. But it was executed in a hugely disruptive manner and various scandals have arisen in the wake of it, hurting the ruling party. Controlling the fiscal deficit has been a federal government objective that has had some success. However, Modi and the state governments are more recently boosting spending ahead of the election to avoid what otherwise would be a negative fiscal thrust this year. This is a factor that should play to Modi’s advantage, although it has not so far. It also highlights the difficulty of fiscal consolidation over the long run (Chart 22). Chart 22Election Cycle Fiscal Easing Is The Norm Election Cycle Fiscal Easing Is The Norm Election Cycle Fiscal Easing Is The Norm More concerning, both for Modi and for India, is the unemployment rate. Even the official unemployment rate is rising despite the fast clip of economic growth and the pro-growth reforms (Chart 23). A leaked government statistical report suggests that unemployment has indeed gone up and labor participation has fallen more than the government is willing to admit. Chart 23Even Official Unemployment Is Rising Even Official Unemployment Is Rising Even Official Unemployment Is Rising The jury is still out on the extent of the current growth slowdown. Some estimates suggest that the output gap is closed, others say slightly negative. While there has been a soft patch in wage growth – particularly among the important 40% of the population that still works on the farm (Chart 24) – the latest data show improvement. Unit labor costs are ebullient and suggest that employee compensation is rising (Chart 25). The reality could make all the difference for Modi’s coalition at the ballot box. Chart 24Rural Wages Improving... But Is It Enough? Rural Wages Improving... But Is It Enough? Rural Wages Improving... But Is It Enough? Chart 25Will Workers Reward Modi? Will Workers Reward Modi? Will Workers Reward Modi? More importantly, if India cannot keep unemployment down amidst significant labor force growth, then Modi will only become the near-term casualty of a more profound problematic trend. Another long-term concern is Modi’s political pressure on the Reserve Bank of India. This has resulted in the replacement of two orthodox and credible central bankers under Modi’s watch. The result is a noticeably dovish policy shift, as confirmed by the cut of the repo rate to 6.25% (from 6.5%) on February 7. This cut and later cuts may be supported by global growth fears but will raise suspicions of political influence. Any damage to the central bank’s credibility will have lasting negative effects since the election result cannot reverse it (at least not fully). It will feed inflation expectations marginally and insofar as it does it will worsen the conditions for sustainable private sector capital investment. However, inflation is currently low and other reforms – such as the RBI’s adoption of inflation-targeting and ample domestic grain production – will help to offset any new monetary policy risk. Bottom Line: Modi’s reform legacy is mostly positive for India structurally, although the erosion of central bank independence is a critical exception. Investment Implications In the short run, cooperation among Modi’s political opponents poses a risk of removing him from power and short-circuiting his reform agenda. In the long run, cooperation between China and India’s South Asian neighbors poses a risk of undermining India’s grand strategy, driving it into the arms of the United States. In both cases Kautilya’s ancient wisdom is on display.   In the first case, a Modi defeat would be negative for India’s policy continuity, currency, and risk assets. The upside to our baseline view of a Modi victory is not high, however, unless Modi and the BJP surprise to the upside and win a substantial majority. This is unlikely unless the polling changes. In the second case, the geopolitical environment will pressure India to continue reforming and improving its economy so as to maintain internal stability, influence its neighbors, and ward off unwanted foreign influence. With China’s Belt and Road putting pressure on India’s strategic interests, leaders in New Delhi will have a continual motivation to focus on improving the economy as well as seeking alliances. This is the only way to ensure India retains its influence within its neighborhood.  For now, investors should steer clear of the Indian currency and risk assets in absolute terms because Modi’s reforms are priced in; election cycle dynamics are undermining monetary and fiscal policy; and the risk of sharp policy discontinuity is rising. On a relative basis, India may also underperform EM in the short term while oil prices rise: oil prices and India’s equity performance relative to EM are negatively correlated.6 Beyond that, however, India is a structural opportunity. Capital investment in China, which has powered much of the structural bull market in commodities and EM assets over the past two decades, is declining, while India’s is improving (Chart 26). Capex is the key to improving India’s productivity and keeping inflation in check even as the demographic dividend pushes up growth rates. Although many EM economies will suffer from a slowdown in Chinese capex, India is not overly exposed to China or global trade, and it is further along than other EMs in its process of bank deleveraging, which opens the prospect of a new credit cycle that will improve its investment outlook (Chart 27).    Chart 26China Capex Down, India Capex Up China Capex Down, India Capex Up China Capex Down, India Capex Up Chart 27Deleveraging Enables A New Credit Cycle Deleveraging Enables A New Credit Cycle Deleveraging Enables A New Credit Cycle   Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1      Kajari Kamal, “Kautilya’s Arthashastra: Indian Strategic Culture and Grand Strategic Preferences,” Journal of Defence Studies 12:3 (2018), pp. 27-54, available at idsa.in 2      The medieval Chola Kingdom sailed across the Bay of Bengal and as far as Malacca in 1025. Please see  Manjeet Singh Pardesi, “Deducing India’s Grand Strategy of Regional Hegemony from Historical and Conceptual Perspectives,” Institute of Defense and Strategic Studies, Working Paper 76 (April 2005), available at www.rsis.edu. For an in-depth study of India’s strategic history, see Graham P. Chapman, The Geopolitics of South Asia: From Early Empires to the Nuclear Age (Burlington, VT: Ashgate, 2009). 3      Please see BCA Emerging Market Strategy Special Report, “Capital Rationing Is Deterring Growth,” February 28, 2012, and “India’s Inflation: How Serious Is The Problem?” January 26, 2010, available at www.bcaresearch.com. 4      Please see BCA Commodity and Energy Strategy Weekly Report, “India’s Commodity Demand, With Or Without Modi,” February 7, 2019, available at ces.bcaresearch.com. 5      Please see Milan Vaishnav and Jamie Hintson, “As Uttar Pradesh Goes, So Goes India,” Carnegie Endowment for International Peace, February 5, 2019, available at carnegieendowment.org. 6      Please see BCA Emerging Markets Strategy Weekly Report, “EM: Sustained Decoupling, Or Domino Effect?”June 14, 2018, available at ems.bcaresearch.com.  

Highlights So What? The late-cycle rally faces non-trivial political hurdles. Why? The rally is based on a too-sanguine view of the Fed, China, and the trade war. Other issues – like Brexit and the U.S. border showdown – are also problematic. Venezuela still has the potential to push oil prices sharply upwards. Feature All is well. Global equities are on the path of recovery, as should be the case at the end of an economic cycle. The U.S. S&P 500 has gained 16% since the bottom on December 24, with healthy technicals suggesting a breakout is ahead (Chart 1). The S&P 500 may be entering one of its typical late-cycle rallies, which tend to be the second best-performing decile of a bull market (Chart 2).1 Meanwhile, emerging market equities and currencies are outperforming developed market peers (Chart 3), a reversal from 2018 Chart 1Late Cycle Rally Ahead? Late Cycle Rally Ahead? Late Cycle Rally Ahead?   Chart 2 Chart 3...As Does Current Global Outperformance ...As Does Current Global Outperformance ...As Does Current Global Outperformance Typically, global risk assets outperform American risk assets at the end of an economic cycle. While institutional investors can use these rallies to lighten the load ahead of a recession, most investors cannot afford to miss such a rally. As such, BCA (and others) are calling for investors to play what is expected to be a yearlong rally in global risk assets and the S&P 500. Our view at BCA Geopolitical Strategy is more cautious, perhaps because it is informed by a methodological bias rooted in geopolitics. We believe that the reversal in U.S. outperformance relative to global risk assets rests on three pillars: The Federal Reserve remains dovish throughout 2019; China begins a major reflationary effort;  The U.S.-China tariff truce results in a trade deal. In addition, a consensus is emerging that a “no deal” Brexit will not occur, that U.S. polarization cannot get worse, and that President Trump eschews foreign interventionism. While we hold a nuanced view on each of these assertions, the mix is far less bullish than investors may think. We see a witches’ brew of factors that is murky at best and bearish at worst. The Three Pillars Of The Bullish View Before we turn to geopolitics, let us examine the three pillars underpinning the bullish view. Our colleague Peter Berezin, BCA’s Chief Global Strategist, remains bullish on the U.S. economy and expects the Fed to resume hiking rates by mid-year.2 The Conference Board’s Leading Credit Index remains in expansionary territory (Chart 4). While business capex intention surveys have come off their highs, they still point to robust spending plans over the next few quarters (Chart 5). Chart 4Little Sign Of A Looming Credit Crunch Little Sign Of A Looming Credit Crunch Little Sign Of A Looming Credit Crunch Chart 5Capex Plans Still Solid Capex Plans Still Solid Capex Plans Still Solid It is no surprise that the BCA Fed Monitor continues to suggest that “tighter monetary policy is required” (Chart 6). This is a far cry from 2016, when our indicator was in deeply “tightening” territory and the Fed paused for 12 months. If we compare 2019 to 2016, it is difficult to see how the market expectation of 4.72 bps of rate cuts will occur over the next 12 months (Chart 7). Of the three components that make up the BCA Fed Monitor, only the financial conditions have fallen into “easing required” territory (Chart 8), and they are already shifting back to “tightening required” territory with the stock market rally underway (Chart 9). Chart 6A Hawkish Fed Is Needed A Hawkish Fed Is Needed A Hawkish Fed Is Needed Chart 7 Chart 8BCA Fed Monitor Calls For Tighter Policy BCA Fed Monitor Calls For Tighter Policy BCA Fed Monitor Calls For Tighter Policy Chart 9Financial Conditions Starting To Ease Financial Conditions Starting To Ease Financial Conditions Starting To Ease In addition, in 2016 the Fed was not contracting its balance sheet. Today it is doing so, although the pace has moderated. As such, the Fed’s rate hike pause is occurring amidst an ongoing effort to normalize monetary policy and to transfer rate risks back to the private sector. By chance, this is also occurring at a time when the Treasury Department must issue more debt to cover a larger deficit, a process that could significantly pull U.S. rates higher and, by extension, yields on assets further down the risk curve. This would be a particular problem for global risk assets given the exposure of several EM economies to dollar-denominated debt.  The bottom line for investors is that a rate hike pause is not a pause in the overall hawkish policy of the U.S. Fed, which acts as a global central bank. The fall in the amount of dollars available for the international financial system acts as a brake on growth. Over the past 10 years, each time money supply growth fell below the loan uptake of the U.S. corporate sector, BCA’s Global Industrial Activity Nowcast, BCA’s Global Leading Economic Indicator, Korean exports, and global export prices all deteriorated considerably (Chart 10). Chart 10Deteriorating Excess Liquidity Hurts Global Growth Deteriorating Excess Liquidity Hurts Global Growth Deteriorating Excess Liquidity Hurts Global Growth Our muted view on Chinese reflation is unnecessary to repeat here. There is no doubt that Chinese policymakers are stimulating the economy, but the question is whether they are willing to pull the credit lever as aggressively as they have done in the past (Chart 11).So far, all of the evidence we have reviewed point to a cautious effort to stabilize growth, not reflate the entire planetary economy as Beijing did in 2016. If our BCA House View on the Fed is correct, a tepid Chinese effort to stimulate the domestic economy will fall short of lighting the flame of a global risk rally in 2019. Chart 11Compare Any Stimulus To Previous Efforts Compare Any Stimulus To Previous Efforts Compare Any Stimulus To Previous Efforts The BCA China Play Index, which in the past has tracked EM vs. DM equity outperformance, is sending mixed signals today (Chart 12). Enthusiasm for global risk assets has not been confirmed by the most China-sensitive plays. Chart 12Mixed Signals From China-Sensitive Plays Mixed Signals From China-Sensitive Plays Mixed Signals From China-Sensitive Plays Finally, there is the trade truce that should produce a trade deal. The logic is clear: President Trump sets aside the political constraints working against a deal and focuses on ensuring that he wins 2020 by avoiding a recession. The near bear market in the S&P 500 was a game changer that focused the White House on averting any further downside to markets and the economy from the trade war. But if the current rally proves that the selloff in December was a temporary pullback, the White House may be emboldened to play hard-to-get with China. After all, the electorate is generally supportive of getting tough on China (Chart 13) and there is no demand from either Trump voters or Democrats for a quick deal. The Fed pause and lower oil prices also give Trump some space to push negotiations a bit harder. Chart 13 Already there are leaks from the negotiations that the U.S. is asking for a lot from China, which could prolong the talks. This includes genuine structural changes to the economic relationship that would address long-standing U.S. concerns of forced technology transfers, intellectual property theft, and foreign investor access to the Chinese domestic market. It also includes U.S. demands that these changes be verifiable and enforceable. China is likely to balk at some of the U.S. demands, particularly if the U.S. is indeed pushing for regular reviews of China’s progress, a condition that implicitly creates a hierarchy between the two economies and would thus represent a loss of face for Beijing.3 Table 1 presents our latest expectations of where the U.S. and China will be on March 1. We assign only 10% each to “black and white” outcomes, a “Grand Compromise” and “No deal, with major escalation.” The remaining 80% is divided between “mushy” outcomes, including a 25% probability that negotiations simply continue. Table 1Updated U.S.-China Trade War Probabilities Witches' Brew: How Geopolitical Risks May Short-Circuit The Late-Cycle Rally Witches' Brew: How Geopolitical Risks May Short-Circuit The Late-Cycle Rally How would the market react to such uncertain outcomes? We think that almost anything other than a “Grand Compromise” would be greeted with limited relief, if not outright market correction. A vaguely positive meeting between Presidents Trump and Xi, and a memorandum of understanding, would not remove long-term risks in the relationship, especially if the parallel “tech war” is not resolved. On top of the ongoing U.S.-China negotiations, there is one remaining trade issue that investors should keep in mind: auto tariffs. The Section 232 investigation into whether auto imports are a national security threat is ongoing and U.S. authorities are expected to present their conclusions on February 17. We fear that the Trump administration could still stage a surprise and impose tariffs on auto imports. This is because the just-concluded NAFTA deal likely raised the cost of vehicle production within the trade bloc, necessitating import tariffs in order for the deal to make sense from President Trump’s set of political priorities. An extended truce with China could provide the opportunity. The Trump administration may not have the stomach for a long-term trade war with Europe, but the timing of this decision could upset the market’s perception of Trump’s commitment to free trade once again. Bottom Line: The conventional narrative is that global markets are experiencing a late-cycle rally, one that is worth playing given its usual duration and amplitude. This view rests on three pillars: that the Fed has backed off from tightening, that China is stimulating in earnest, and that the trade deal will produce a definitive outcome. We fear that all three pillars are shaky. First, the Fed is not easing. Its balance sheet contraction process, which is ongoing, is a form of tightening. And the U.S. economy remains healthy. As such, the expectation of a 12-month Fed pause is overly optimistic. Second, China is stimulating, but only tepidly. Third, “black and white,” definitive outcomes are unlikely in the U.S.-China negotiations. In fact, more protectionism could be around the corner if U.S.-China tech issues continue to flare or if the U.S. announces the conclusion of its investigation into auto imports. Geopolitical Factors To Monitor Aside from shaky pillars, markets will also have to contend with several uncertain geopolitical processes this year. While we are not necessarily bearish on each one, we are concerned that the collective investment community is overly bullish. Take Brexit. We agree with the conventional view that the chances of a no-deal Brexit outcome are below 10%. Political betting markets have only priced in an actual exit on March 29, which is in ink in British legislation, at just above 30% (Chart 14). Chart 14Online Betters Expect A Brexit Delay Online Betters Expect A Brexit Delay Online Betters Expect A Brexit Delay The problem is not with the conventional view but with its timing. While Prime Minister Theresa May will ultimately be forced to extend the Article 50 deadline, it may take a lot of brinkmanship and eleventh hour negotiations to do so. Getting from here – collective bullishness – to there – an actual extension of Article 50 – may require a downturn in GBP/USD or other U.K. assets. Furthermore, several scenarios could produce a downturn in GBP/USD (Diagram 1). For example, the Labour Party remains neck-and-neck with the Tories in the polls, despite being led by the most left-leaning leader since the 1970s. Although a new election that produces a Labour government would likely reduce the odds of Brexit eventually occurring, it would raise the odds of Corbyn pursuing unorthodox economic policy while also trying to negotiate his own version of Brexit with the EU. Diagram 1Brexit: The Path To Salvation Remains Fraught With Dangers Witches' Brew: How Geopolitical Risks May Short-Circuit The Late-Cycle Rally Witches' Brew: How Geopolitical Risks May Short-Circuit The Late-Cycle Rally The point is that it is tough to recommend that investors close their eyes and buy GBP/USD, no matter how cheap the currency may look, unless one has a very long time horizon and a high threshold for pain. The second issue where we take a more nuanced position is the ongoing U.S. executive-legislative standoff over the border. The government shutdown is only on pause until February 15. The House Democrats are demanding that a solution be found by Friday, February 8 if it is to be voted on in time. Meanwhile President Trump’s popularity is in the doldrums (Chart 15). His supporters note that President Reagan was even less popular at this point in his term, but that is because unemployment hit 10.4% in January 1983 (Chart 16). The grave risk for President Trump is that he is as unpopular as Reagan, even though unemployment is at 4% and the U.S. economy is on fire. Chart 15President Trump Is Unpopular... President Trump Is Unpopular... President Trump Is Unpopular... Chart 16...And It Can't Be Blamed On Unemployment ...And It Can't Be Blamed On Unemployment ...And It Can't Be Blamed On Unemployment As such, the real risk is not another shutdown, but rather political dysfunction in Congress that imperils the legislative process. The current two-year budget deal, which raised spending levels in January 2018, is set to expire when the FY2019 ends. Democrats and Trump have to come to an agreement to avert the “stimulus cliff” expected in 2020 (Chart 17). If they cannot conclude the border issue and the FY2019 appropriations, then Trump may declare a national emergency (or act unilaterally in other ways) and spark a new conflict with the courts. He could also threaten not to raise the debt ceiling in spring or summer. This is not an atmosphere in which a FY2020 deal looks very easy. Chart 17Stimulus Cliff Ahead Stimulus Cliff Ahead Stimulus Cliff Ahead Ultimately, we expect Democrats to succumb to the pressure from their voters for more spending. But a total failure to cooperate is a risk. Furthermore, the greatest political risk in the U.S. is that the 2020 election will not be contested on the same issues as in 2016: trade and immigration. Instead, income inequality is rearing its head, as Democratic candidates jostle for attention and as they test various messages on focus groups. If income inequality catches fire as the issue of 2020, we will know it soon. And it may begin to impact the markets as Democrats begin to campaign on, for instance, reversing President Trump’s income tax cuts. While the market may ignore headline election risks for some time, we do not think that non-financial corporates can do the same. Any hint that President Trump’s pro-business policies will be reversed could send shivers down the spines of CEOs and negatively impact capex intentions, hurting the real economy well before the next election. Finally, there is the issue of foreign policy. President Trump has abandoned his maximum pressure tactic on Iran and has begun withdrawing the remaining troops in the Middle East. These trends are likely to continue in 2019 as President Trump focuses on China and lesser issues like Venezuela. There is one important area of alignment between him and the defense and intelligence community, notwithstanding recent scuffles: less focus on the Middle East means more focus on Asia and specifically China. However, President Trump is facing a dilemma. Despite an extraordinary economic performance, his popularity remains in the doldrums. When faced with similar situations in the past, presidents far more orthodox than Trump have sought relevance abroad, by means of military interventions. A convenient opportunity has presented itself in Venezuela, where a revolution against Chavismo could give the U.S. an opening to intervene. On paper, we see how such a scenario could look appealing for a quick, and relatively painless, intervention. The problem is that it could also get messy and, in the analysis of BCA’s Commodity & Energy Strategy, raise oil prices to nearly $100 per barrel by mid-year if a total loss of Venezuelan production ensues (Chart 18). This is a non-negligible risk. Chart 18A Venezuela Collapse Could Send Brent Crude Prices Toward $100/Bbl A Venezuela Collapse Could Send Brent Crude Prices Toward $100/Bbl A Venezuela Collapse Could Send Brent Crude Prices Toward $100/Bbl Bottom Line: Geopolitical risks still abound. We are not alarmist. However, there is little reason to believe that Brexit, U.S. polarization, U.S.-China tensions, or a potential U.S. intervention in Venezuela will end painlessly for the market. An unpopular U.S. president is seeking to remain relevant and a global populist wave is continuing to create unorthodox and anti-establishment policy prescriptions. Given that the current rally is supported by three shaky pillars, any one of these geopolitical risks could catalyze a relapse, the history of late-cycle rallies be damned.   Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1      Please see BCA U.S. Investment Strategy Weekly Report, “Late-Cycle Blues,” dated October 29, 2018, available at usis.bcaresearch.com. 2      Please see BCA Global Investment Strategy Weekly Report, “Patient Jay,” dated January 18, 2019, available at gis.bcaresearch.com. 3      Please see Reuters, “Exclusive: U.S. demands regular review of China trade reform,” dated January 18, 2019, available at reuters.com.   Geopolitical Calendar

Highlights 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. Feature 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 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. Chart 1 In subsequent work, Clark and 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 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 2).1 Chart 2 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 3). Chart 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.2 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 4). Chart 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 1 and Chart 5). IQ even predicts trader performance!3 Table 1What IQ Predicts (Results From Meta-Analyses) The Most Important Trend In The World Has Reversed And Nobody Knows Why The Most Important Trend In The World Has Reversed And Nobody Knows Why   Chart 5 Like most physiological traits, IQ is highly heritable.4 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.5 This makes IQ almost as heritable as height (Chart 6). Chart 6 Although there is a great deal of variation among individuals, on average, more intelligent people earn higher incomes (Chart 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.” Chart 7 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 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. Chart 8 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.6 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 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.7 Chart 9 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.8 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 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.9 Similar results have been documented in France, the Netherlands, Germany, Denmark, and most recently, Norway. Chart 10 The Norwegian results, published last year, are particularly noteworthy.10 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 11). For the first time in recorded history, Norwegian kids today are not scoring as well as their parents. Chart 11 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.11 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 fruit have been picked. Educational attainment has slowed dramatically in most of the world (Chart 12). Economist James Heckman estimates that U.S. high-school graduation rates, properly measured, peaked over 40 years ago.12 Chart 12 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.”13 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.14 All sorts of weird and concerning physiological changes are occurring. Sperm counts have fallen by nearly 60% since the early 1970s.15 Testosterone levels in young men are dropping. Among girls, the age of first menarche has declined by two years over the past century.16 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 13). The fraction of young adults that made suicide plans nearly doubled.17 More than 20% of U.S. women over the age of 40 are on antidepressants.18 Five percent of U.S. children are receiving ADHD medication.19 Chart 13 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.20 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.21 Measures to reduce inbreeding are also likely to boost IQ scores.22 Yet, we should not underestimate the importance of falling cognitive skills in developed economies. Chart 14 shows that there is a clear positive correlation between student score on math and science and per capita incomes. Chart 14 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 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). Chart 15 Falling IQs could result in slower productivity growth, which could further strain fiscal balances. Lower IQs are also associated with decreased future orientation.23 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 16). Chart 16Equity Multiples Tend To Fall When Real Rates Rise And Productivity Growth Declines Equity Multiples Tend To Fall When Real Rates Rise And Productivity Growth Declines Equity Multiples Tend To Fall When Real Rates Rise And Productivity Growth Declines 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.”24 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.25 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 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.26 Other companies are following suit.27 Chart 17 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.28 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 2). Table 2A Poisoned Chalice? Genetic Screening Can Raise IQ The Most Important Trend In The World Has Reversed And Nobody Knows Why The Most Important Trend In The World Has Reversed And Nobody Knows Why China has been investing heavily in genetic technologies. As Geoffrey Miller has argued, China’s infatuation with eugenics spans into the modern day.29 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.30 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 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. Chart 18 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.   Peter Berezin, Chief Global Strategist Global Investment Strategy  peterb@bcaresearch.com     Box 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 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 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. Image   Image Source: Gregory Clark and Neil Cummins, "Nature Versus Nurture in Social Outcomes. A Lineage Study of 263,000 English Individuals, 1750-2017," Luxembourg Institute of Socio-Economic Research.   Footnotes 1      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. 2      Gregory Cochran and Henry Harpending, "The 10,000 Year Explosion: How Civilization Accelerated Human Evolution," Basic Books, (2009). 3      Mark Grinblatt, Matti Keloharju, and Juhani T. Linnainmaa, “IQ, Trading Behavior, and Performance,” Journal of Financial Economics, 104:2, (May 2012): 339-362. 4      Thomas Bouchard, “Genetic Influence On Human Psychological Traits - A Survey,” Current Directions in Psychological Science 13:4, (August 2004): 148-151. 5      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. 6       "Cache Cab: Taxi Drivers' Brains Grow to Navigate London's Streets," Scientific American, (December 2011). 7       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. 8       “Anthropologists Find American Heads Are Getting Larger,” ScienceDaily, (May 2012). 9       “British Teenagers Have Lower IQs Than Their Counterparts Did 30 Years Ago,” The Telegraph, (February 2009). 10     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. 11     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. 12     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. 13     “Turning Around Chronically Low-Performing Schools,” The Institute of Education Sciences (IES), (May 2008). 14     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. 15     "Sperm Counts In The West Plunge By 60% In 40 Years As ‘Modern Life’ Damages Men’s Health," Independent, (July 2017). 16     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. 17     “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). 18     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). 19     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. 20     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. 21     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). 22     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. 23     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. 24     James Flynn, “IQ decline and Piaget: Does the rot start at the top?” Lifetime Achievement Award Address, 18th Annual meeting of ISIR, (July 2017). 25     For a good discussion of these issues, please see Richard J. Haier, “The Neuroscience of Intelligence,” Cambridge Fundamentals of Neuroscience in Psychology, (December 2016). 26     “The Future of In-Vitro Fertilization and Gene Editing,” Psychology Today, (December 2018). 27     “DNA Tests For IQ Are Coming, But It Might Not Be Smart To Take One,” MIT Technology Review, (April 2018). 28     Michael Lynch, “Rate, Molecular Spectrum, And Consequences Of Human Mutation,” Proceedings of the National Academy of Sciences 107:3, (January 2010): 961-968. 29     Geoffrey Miller, “What *Should* We Be Worried About?” Edge, (2013). 30     Mingrui Wang, John Fuerst, and Jianjun Ren, “Evidence Of Dysgenic Fertility In China,” Intelligence 57, (April 2016): 15-24. Strategy & Market Trends MacroQuant Model And Current Subjective Scores Image Tactical Trades Strategic Recommendations Closed Trades

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. Chart II-1Richer Men Had More Surviving Children In Medieval England The Most Important Trend In The World Has Reversed And Nobody Knows Why The Most Important Trend In The World Has Reversed And Nobody Knows Why 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).1 Chart II-2High-Status Men In China Produced More Descendants In The 18th And 19th Centuries The Most Important Trend In The World Has Reversed And Nobody Knows Why The Most Important Trend In The World Has Reversed And Nobody Knows Why 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). Chart II-3Human Evolution Has Accelerated 100-Fold Over The Past 10,000 Years The Most Important Trend In The World Has Reversed And Nobody Knows Why The Most Important Trend In The World Has Reversed And Nobody Knows Why 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.2 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). Chart II-4Long-Term Decline In Homicide Rates The Most Important Trend In The World Has Reversed And Nobody Knows Why The Most Important Trend In The World Has Reversed And Nobody Knows Why 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!3 Table II-1What IQ Predicts (Results From Meta-Analyses) The Most Important Trend In The World Has Reversed And Nobody Knows Why The Most Important Trend In The World Has Reversed And Nobody Knows Why   Chart II-5IQ Tests Don’t Just Measure How Well You Can Do On An IQ Test The Most Important Trend In The World Has Reversed And Nobody Knows Why The Most Important Trend In The World Has Reversed And Nobody Knows Why Like most physiological traits, IQ is highly heritable.4 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.5 This makes IQ almost as heritable as height (Chart II-6). Chart II-6The Inheritance You Cannot Renounce The Most Important Trend In The World Has Reversed And Nobody Knows Why The Most Important Trend In The World Has Reversed And Nobody Knows Why 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.” Chart II-7IQ Tends To Be Positively Correlated With Income And Wealth The Most Important Trend In The World Has Reversed And Nobody Knows Why The Most Important Trend In The World Has Reversed And Nobody Knows Why 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. Chart II-8The Flynn Effect: It Was Nice While It Lasted The Most Important Trend In The World Has Reversed And Nobody Knows Why The Most Important Trend In The World Has Reversed And Nobody Knows Why 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.6 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.7 Chart II-9IQ And Disease Burden The Most Important Trend In The World Has Reversed And Nobody Knows Why The Most Important Trend In The World Has Reversed And Nobody Knows Why 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.8 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.9 Similar results have been documented in France, the Netherlands, Germany, Denmark, and most recently, Norway. Chart II-10Math And Science Skills Are Slipping In The OECD The Most Important Trend In The World Has Reversed And Nobody Knows Why The Most Important Trend In The World Has Reversed And Nobody Knows Why The Norwegian results, published last year, are particularly noteworthy.10 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. Chart II-11Norwegian IQs Have Been Falling For Those Born Since The Mid-1970s The Most Important Trend In The World Has Reversed And Nobody Knows Why The Most Important Trend In The World Has Reversed And Nobody Knows Why 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.11 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.12 Chart II-12The Contribution To Economic Growth From Rising Human Capital Is Falling The Most Important Trend In The World Has Reversed And Nobody Knows Why The Most Important Trend In The World Has Reversed And Nobody Knows Why 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.”13 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.14 All sorts of weird and concerning physiological changes are occurring. Sperm counts have fallen by nearly 60% since the early 1970s.15 Testosterone levels in young men are dropping. Among girls, the age of first menarche has declined by two years over the past century.16 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.17 More than 20% of U.S. women over the age of 40 are on antidepressants.18 Five percent of U.S. children are receiving ADHD medication.19 Chart II-13A Disturbing Deterioration In Mental Health The Most Important Trend In The World Has Reversed And Nobody Knows Why The Most Important Trend In The World Has Reversed And Nobody Knows Why 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.20 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.21 Measures to reduce inbreeding are also likely to boost IQ scores.22 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. Chart II-14Positive Correlation Between Student Scores On Math And Science And Per Capita Income The Most Important Trend In The World Has Reversed And Nobody Knows Why The Most Important Trend In The World Has Reversed And Nobody Knows Why 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). Chart II-15Having A Compass In Your Head Makes You A Better Inventor The Most Important Trend In The World Has Reversed And Nobody Knows Why The Most Important Trend In The World Has Reversed And Nobody Knows Why Falling IQs could result in slower productivity growth, which could further strain fiscal balances. Lower IQs are also associated with decreased future orientation.23 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). Chart II-16Equity Multiples Tend To Fall When Real Rates Rise And Productivity Growth Declines The Most Important Trend In The World Has Reversed And Nobody Knows Why The Most Important Trend In The World Has Reversed And Nobody Knows Why 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.”24 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.25 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.26 Other companies are following suit.27 Chart II-17Sequencing Costs Have Plummeted The Most Important Trend In The World Has Reversed And Nobody Knows Why The Most Important Trend In The World Has Reversed And Nobody Knows Why 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.28 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). Table II-2A Poisoned Chalice? Genetic Screening Can Raise IQ The Most Important Trend In The World Has Reversed And Nobody Knows Why The Most Important Trend In The World Has Reversed And Nobody Knows Why China has been investing heavily in genetic technologies. As Geoffrey Miller has argued, China’s infatuation with eugenics spans into the modern day.29 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.30 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. Chart II-18China’s Labor Pool Is Shrinking The Most Important Trend In The World Has Reversed And Nobody Knows Why The Most Important Trend In The World Has Reversed And Nobody Knows Why 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. BOX CHART II-1Comparative Father-Son And Brother Correlations By Status The Most Important Trend In The World Has Reversed And Nobody Knows Why The Most Important Trend In The World Has Reversed And Nobody Knows Why   BOX CHART II-2Wealth Correlations By Genetic Distance The Most Important Trend In The World Has Reversed And Nobody Knows Why The Most Important Trend In The World Has Reversed And Nobody Knows Why 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   Footnotes 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.

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 Policy Uncertainty Has Spiked Watch Policy Uncertainty Policy Uncertainty Has Spiked Watch Policy Uncertainty 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 U.S. Private Sector: A New Saver The U.S. Private Sector Is A Net Saver U.S. Private Sector: A New Saver The U.S. Private Sector Is A Net Saver Chart I-3U.S. Cyclical Spending Not Extended U.S. Cyclical Spending Not Extended U.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 Some Tentative Signs Some 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 U.S. Wage Pressure Is Percolating U.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 Global Leading Indicators Still Deteriorating Global Growth Is Still Moderating... Global Leading Indicators Still Deteriorating Global Growth Is Still Moderating... 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... China: No Property Market Stimulus... China: 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 ...And No Credit Impulse ...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 The Fallout From Trade The 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 China's Woes Are Infecting Europe China'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 Japan Hit By The Chinese Cold As Well Japan 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 Brexit Result May Be Overturned Brexit 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 U.S. Corporate Health U.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 Euro Area Corporate Health Euro 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 Fed Patience To Narrow Spreads Fed 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... Value Restored In IG Corporates... Value 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 ...And In HY Too ...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 Forward Rates Far Too Low Forward 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. The Most Important Trend In The World Has Reversed And Nobody Knows Why The Most Important Trend In The World Has Reversed And Nobody Knows Why 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 Most Important Trend In The World Has Reversed And Nobody Knows Why The Most Important Trend In The World Has Reversed And Nobody Knows Why 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). The Most Important Trend In The World Has Reversed And Nobody Knows Why The Most Important Trend In The World Has Reversed And Nobody Knows Why 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). The Most Important Trend In The World Has Reversed And Nobody Knows Why The Most Important Trend In The World Has Reversed And Nobody Knows Why 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 The Most Important Trend In The World Has Reversed And Nobody Knows Why The Most Important Trend In The World Has Reversed And Nobody Knows Why   The Most Important Trend In The World Has Reversed And Nobody Knows Why The Most Important Trend In The World Has Reversed And Nobody Knows Why 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). The Most Important Trend In The World Has Reversed And Nobody Knows Why The Most Important Trend In The World Has Reversed And Nobody Knows Why 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.” The Most Important Trend In The World Has Reversed And Nobody Knows Why The Most Important Trend In The World Has Reversed And Nobody Knows Why 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. The Most Important Trend In The World Has Reversed And Nobody Knows Why The Most Important Trend In The World Has Reversed And Nobody Knows Why 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 The Most Important Trend In The World Has Reversed And Nobody Knows Why The Most Important Trend In The World Has Reversed And Nobody Knows Why 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 Most Important Trend In The World Has Reversed And Nobody Knows Why The Most Important Trend In The World Has Reversed And Nobody Knows Why 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. The Most Important Trend In The World Has Reversed And Nobody Knows Why The Most Important Trend In The World Has Reversed And Nobody Knows Why 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 The Most Important Trend In The World Has Reversed And Nobody Knows Why The Most Important Trend In The World Has Reversed And Nobody Knows Why 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 The Most Important Trend In The World Has Reversed And Nobody Knows Why The Most Important Trend In The World Has Reversed And Nobody Knows Why 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. The Most Important Trend In The World Has Reversed And Nobody Knows Why The Most Important Trend In The World Has Reversed And Nobody Knows Why 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). The Most Important Trend In The World Has Reversed And Nobody Knows Why The Most Important Trend In The World Has Reversed And Nobody Knows Why 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). The Most Important Trend In The World Has Reversed And Nobody Knows Why The Most Important Trend In The World Has Reversed And Nobody Knows Why 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 The Most Important Trend In The World Has Reversed And Nobody Knows Why The Most Important Trend In The World Has Reversed And Nobody Knows Why 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). The Most Important Trend In The World Has Reversed And Nobody Knows Why The Most Important Trend In The World Has Reversed And Nobody Knows Why 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 Most Important Trend In The World Has Reversed And Nobody Knows Why The Most Important Trend In The World Has Reversed And Nobody Knows Why 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. Image   Image 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 U.S. Equity Indicators U.S. Equity Indicators   Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator   Chart III-5U.S. Stock Market Valuation U.S. Stock Market Valuation U.S. Stock Market Valuation Chart III-6U.S. Earnings U.S. Earnings U.S. Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations U.S. Treasurys And Valuations U.S. Treasurys And Valuations Chart III-10Yield Curve Slopes Yield Curve Slopes Yield Curve Slopes Chart III-11Selected U.S. Bond Yields Selected U.S. Bond Yields Selected U.S. Bond Yields   Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP U.S. Dollar And PPP U.S. Dollar And PPP   Chart III-17U.S. Dollar And Indicator U.S. Dollar And Indicator U.S. Dollar And Indicator   Chart III-18U.S. Dollar Fundamentals U.S. Dollar Fundamentals U.S. Dollar Fundamentals   Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators   Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop   Chart III-29U.S. Macro Snapshot U.S. Macro Snapshot U.S. Macro Snapshot   Chart III-30U.S. Growth Outlook U.S. Growth Outlook U.S. Growth Outlook Chart III-31U.S. Cyclical Spending U.S. Cyclical Spending U.S. Cyclical Spending Chart III-32U.S. Labor Market U.S. Labor Market U.S. Labor Market Chart III-33U.S. Consumption U.S. Consumption U.S. Consumption Chart III-34U.S. Housing U.S. Housing U.S. Housing Chart III-35U.S. Debt And Deleveraging U.S. Debt And Deleveraging U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions U.S. Financial Conditions U.S. Financial Conditions   Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global 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. Chart 1 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! France Was Once Less Socialist Than America! France 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. Chart 3 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. Chart 4 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). Chart 5 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? Are We Even Mid-Cycle Yet? Are We Even Mid-Cycle Yet?   Chart 7Corporate Debt Load Is Not Excessive Corporate Debt Load Is Not Excessive Corporate 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 Budget Deficits Will Be Very High In The Next Recession Budget 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. Chart 9 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? Why Ocasio-Cortez Will Get What She Wants Why Ocasio-Cortez Will Get What She Wants 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.