Geopolitics
Highlights Overstated geopolitical risks in 2017 are giving way to understated risks in 2018; The reshuffle of China's government raises policy headwinds for global growth and EM assets; U.S. politics will be roiled by a leftward turn and Trump's protectionism and foreign policy; Italian politics, more than German, is the chief threat to European risk assets; Volatility and the USD will rise; shift to neutral on European risk assets; close tactical long on Chinese Big Banks. Feature BCA's Geopolitical Strategy has operated this year on a high conviction view that geopolitical risks would be overstated, thus generating considerable upside for risk assets. Our analysis focused on three particular "red herrings": European populism, U.S. politics, and Brexit.1 Meanwhile we identified North Korea as a genuine geopolitical risk, though not one that would cause us to change our "risk on" outlook. We therefore take issue - and perhaps offense - with the contemporary narrative that "geopolitics did not matter" in a year when the S&P 500 rose by 15% and VIX plumbed historic lows (Chart 1). Stocks rose and the VIX stayed muted precisely because geopolitical risks were overstated earlier in the year. Investors who correctly assessed the balance of geopolitical risks and opportunities would have known to "buy in May and enjoy your day."2 At the same time that we encouraged investors to load up on risk this year, we cautioned that 2018 would be a challenging year.3 Three themes are now coming into focus as 2017 draws to a close: Politics has become a headwind to growth in China as Beijing intensifies deleveraging and structural reforms; U.S. fiscal and monetary policy favor the USD, which will reignite trade protectionism from Washington D.C.; Italian elections may reignite Euro Area breakup risk. In this report, we update our view on these three risks. Data out of China are particularly concerning: broad money (M3) growth has decelerated sharply with negative implications for the economy (Chart 2).4 M3 is at last ticking up but the consequences of its steep drop have not yet translated to the economy. Our message to clients since 2016 has been that the nineteenth Party Congress would mark a turning point in President Xi Jinping's tenure, that he would see his political capital replenished, and that Beijing's pain threshold would therefore rise appreciably in 2018. Hence we do not expect any new stimulus to be quick in coming or very large. Chart 1Buy In May And Enjoy Your Day Chart 2China's Money Impulse Spells Slowdown What happens in China will not stay in China. Signs of cracks are emerging in the buoyant global growth narrative (Chart 3), with potentially serious consequences for emerging markets (EM) (Chart 4).5 Chart 3Signs Of Cracks Forming Chart 4EM Manufacturing: Rolling Over China: Ramping Up For The New Year Crackdown The aftermath of the Communist Party's nineteenth National Party Congress is unfolding largely as we expected: with a reboot of President Xi Jinping's reform agenda. Chinese economic data are starting to reflect the consequences of tighter policy since late last year (Chart 5), and BCA's China Investment Strategy has shown consumer-oriented sectors outperforming industrials and materials since the party congress, as the reform drive would have one expect.6 China's policymakers have already allowed the monetary impulse - the rate of growth in the supply of money - to slow to the lowest levels in recent memory. This bodes ill for Chinese imports and base metal prices (Chart 6), as BCA's Emerging Market Strategy has emphasized.7 Chart 5Expect More Disappointments From China Chart 6Chinese Imports And Base Metals At Risk It is true that policymakers will re-stimulate the economy when they reach their pain threshold, but with Xi Jinping's political capital replenished and the party and state unified under him, we expect that threshold to have moved higher than financial markets expect. Yes, the government will try to prevent its policies from being highly disruptive and destabilizing - as with the People's Bank of China injecting liquidity to ease rapidly rising bond yields (Chart 7) - but the bottom line is that it is pressing forward with tightening. How can we be so sure that this policy trajectory is set? The initiatives in the early stages of implementation after the congress confirm our view that the central government is hardening the line on several key economic-political fronts: Financial regulatory overhaul: People's Bank Governor Zhou Xiaochuan has made a series of dire comments about China's financial risks and the danger that it is reaching a "Minsky Moment," or accumulation of risks that will end in a catastrophe.8 Zhou's likeliest replacements are both financial reformers, and one of them, Guo Shuqing, is the hawkish regulator who has led the crackdown on shadow lending this year (Chart 8). Moreover, whoever heads the central bank will have the benefit of new financial oversight capabilities. The Financial Stability and Development Commission (FSDC), a new entity charged with coordinating the country's various financial regulatory agencies, has just held its first meeting. Its inaugural chairman, Vice-Premier Ma Kai, is likely to retire soon, but rumors are swirling that his replacement will be Liu He, President Xi's top economic thinker and a reformist, who wrote an ominous article about excessive leverage in the People's Daily in May 2016 and has now made it onto the Politburo. If Liu He takes charge, given his very close relationship with Xi, the FSDC will be irresistible. If not, the FSDC will still be effective, judging by the fact that Ma Kai's replacement will likely be someone, like Ma, who sits on both the Politburo and State Council. Chart 7China's Bond Yields Rising Sharply Chart 8Shadow Banking Has Peaked Local government crackdown: Local government officials in two cities in Inner Mongolia have canceled urban metro projects due to excessive debt, reportedly under orders from the central government. Other cities in other provinces have suggested that approvals for such projects are being delayed.9 In other words, the central government is no longer endlessly accommodating debt-financed local government projects, even projects that support priority goals like urbanization and interior development. This news, so soon after the party congress, is likely to be the tip of the iceberg, which suggests that local government spending cannot be assumed to shake off its weakening trend anytime soon (Chart 9). Top officials pointed out local government leverage as a systemic risk, along with shadow banking, at the National Financial Work Conference in July, and both the outgoing finance minister and the outgoing central bank chief have called for reining in local governments. The latter's comments were formally endorsed by being included in the Communist Party's official "party congress study guide," suggesting that they are more than just the parting advice of a soon-to-be retiree. Property tightening: China's real estate sector, which provides 22% of investment in the country, is feeling the squeeze from financial tightening and targeted measures to drive out speculation since October 2016 (Chart 10). More, not less, of a squeeze is expected in both the short and long term. In the short term, inspections of commercial housing for corruption and speculative excesses could exert an additional dampening effect. In the medium and long term, the Xi administration plans to roll out a nationwide property tax, according to Huang Qifan, an economic policymaker tied to the legislature, "in the near future, not ... 10-20 years. It could happen in the next several years."10 The tax was delayed in 2016 amid economic turmoil. A national property tax would be an important fiscal reform that would tamp down on the asset bubble, rebalance the growth model, and enable the government to redistribute wealth from multiple homeowners to lower income groups. Chart 9Local Government Spending Is Weak Chart 10Property Tightening Continues Industrial restructuring: Environmental curbs on outdated and excess industrial capacity are continuing. Although China aggressively cut overcapacity in coal, steel and other sub-sectors over the past twelve months, it continues to face larger overcapacity than other economies (Chart 11), particularly in glass, cement, chemical fertilizers, electricity generation and home construction. It is also possible that SOE restructuring will become more aggressive. Currently, SOEs listed on the Shanghai exchange are rallying relative to the A-share market, as they have tended to do when the Communist Party reaffirms its backing of the state sector (Chart 12). However, announcements of SOE reforms in this administration have also triggered phases of under-performance. SOEs targeted for reforms face greater scrutiny of their finances and operations.11 Moreover, any SOE is vulnerable to the new wave of the anti-corruption campaign.12 National Supervision Commission: The new anti-corruption czar, Zhao Leji, will be a very influential figure if he is even to hold a candle to his predecessor, Wang Qishan. Zhao is to oversee the creation of a nationwide anti-corruption system that targets not only the Communist Party, as before, but every public official. The new commission will have branches at each level of administration (city, province, central government) and will combine the various existing anti-corruption agencies under one head. The purpose is not merely to root out political enemies (as administration critics, with some justice, would argue) but also to improve the effectiveness of policy implementation and address public grievances that threaten to undermine the regime. The latest environmental curbs have shown that employing anti-corruption teams to help enforce broader economic policy can be highly effective. Xi and Zhao Leji look set to extend this practice to state ministries, including financial regulators.13 It is not clear whether they will succeed in rebuilding the regime's legitimacy in public eyes, but in the short term an initiative like this should send a chilling effect throughout the state bureaucracy, similar to that which occurred among local government party chiefs in 2014 after the initial anti-corruption campaign was launched.14 Chart 11Overcapacity Still A Problem For China Chart 12SOEs Preserved, But Face Reforms In short, preparations are under way for Xi's second five-year term in office. (Perhaps not his last term, as the party congress also made clear.)15 New agencies and personnel suggest that the administration is embarking on an intensification of policy tightening. Tougher policy is viewed as necessary, not optional: top leadership has repeatedly stated that a lack of action on systemic threats will lead to regime-threatening crises down the road.16 Chart 13China's Impact On Global Growth How will this agenda impact the rest of the world? Our colleagues at China Investment Strategy hold that China may step up reforms but will not do so in a way that will negatively impact China's imports or key assets like base metal prices.17 However, from a political perspective, we view the combination of Xi's political capital with the new financial and anti-corruption commissions as likely to increase policy effectiveness to an extent that causes banks to lend less eagerly and local governments and SOEs to err on the side of less borrowing and spending. This will reduce demand for imports and commodities and will also raise the tail-risk of excessive tightening. China's contribution to global growth had fallen over the years, but has recently rebounded on the back of stimulus in 2015-16 (Chart 13). As such, it will not take much of a drag on import growth in 2018 to have a global impact. The most exposed commodity exporters to China (outside of oil) are Brazil, Chile and Peru (with Indonesia and South Africa also at risk), while the most exposed exporters of capital goods are Taiwan and South Korea, followed by Southeast Asia (the Philippines, Malaysia, Vietnam and Thailand). Looking at the China-exposed countries whose stocks rallied the most while China stimulated in 2016, the prime candidates for a negative impact in 2018 will be Brazil and Peru, and less so Hungary and Thailand. Bottom Line: The Xi administration is rebooting its reform agenda and has a higher tolerance for pain than the market yet realizes. Centralization, deleveraging and industrial restructuring have been deemed necessary to secure the long-term stability of the regime. China's policy risks are understated and the next wave of stimulus will not be as rapidly forthcoming as financial markets expect. U.S.: Trouble In (GOP) Paradise Markets have rallied throughout the year despite a lack of policy initiatives from the U.S. Congress. Judging by the performance of highly taxed S&P 500 equities, the rally this year has not been about the prospects of tax reform (Chart 14).18 Rather, markets have responded to strong earnings data and a lack of policy initiatives. Wait, what? Yes, markets have rallied because nothing has been accomplished. Investors just want President Trump and the Republican-held Congress to maintain a pro-business regulatory stance (Chart 15) and not do anything anti-corporate. Doing nothing is just fine. Chart 14Market Has Doubted Tax Reform Chart 15Market Has Cheered De-Regulation Here Come The Socialists Dems The Democratic Party leads the 2018 generic Congressional vote polling by 10.8%, up from 5.9% in May (Chart 16). The generic ballot polling is notoriously unreliable as most U.S. electoral districts are politically designed to be safe seats - "gerrymandered" - and as such are unlikely to respond to nation-wide polling (Chart 17). However, Republican support has fallen and Democratic candidates have performed extremely well this year. Chart 16U.S. Public Leans Democratic Chart 17Electoral System Reduces Competition First, candidates for governor in Virginia and New Jersey have outperformed their polling in November elections. Second, in the four special elections this summer, Democrats narrowed Republican leads by 18%. If the electoral results from Table 1 are replicated in 2018, Republicans could face a massacre in the House of Representatives. In addition, Republicans are suddenly vulnerable in Alabama, where the anti-establishment Senate candidate, and Breitbart-endorsee, Roy Moore is struggling with accusations of pedophilia (Chart 18). Table 12017 Special Elections Are Ominous For The GOP Chart 18Republican Senate Majority May Lose A Seat Why should investors fear a Democratic takeover of the House of Representatives? Yes, the odds of impeachment proceedings against President Trump would rise, but we are on record saying that investors should fade any impeachment risk to assets.19 The greater risk is that the Democratic Party has turned firmly to the left with its new manifesto, "A Better Deal." A strong performance by unusually left-of-center Democratic candidates could spook financial markets that have been lulled into complacency by the lack of genuine populism from the (thus far) pluto-populist president. Protectionism While most investors are focused on the ongoing NAFTA negotiations - which we addressed in last week's Special Report20 - we would draw attention again to the shift towards protectionism by the Republicans in the Senate. Normally a bastion of pro-business free-traders, the Senate has turned to the left on free trade. Senator John Cornyn (R, Texas) has introduced a bill to make significant reforms to the process by which the United States reviews foreign investments for national security, led by the Committee on Foreign Investment in the United States (CFIUS). Two further bills, one in the House and another in the Senate, would also significantly tighten access to the U.S. by foreign investors. China is foremost in their sights. In early 2018, investors will also be greeted by two significant decisions. First, on tariffs: Trump will have to decide on January 12 and February 3 whether to impose tariffs on solar panels and washing machines, respectively, under Section 201 of the U.S. Trade Act of 1974. The International Trade Commission has already determined that imports of these goods can cause material injury to U.S. industries, so Trump merely has to decide whether to impose tariffs (likely from 35% to 50%), import quotas (which have never received limits from courts), or bilaterally negotiated export limitations from trade partners.21 The consequences would go beyond the current, country-specific tariffs on these items, setting a precedent that would expose a wide range of similar imports to punitive action, and more broadly would signal to the world that the U.S.'s protectionist turn under Trump is real.22 Second, the White House has allegedly completed a comprehensive review of China policy under way since June.23 The review is said to focus on economic rather than strategic matters and to call for the use of punitive measures to insist that China alter tactics long complained about by the United States, including intellectual property theft, export subsidies, and forced tech transfer from joint ventures in China. Already the U.S. is investigating China for intellectual property theft under Section 301 of the 1974 Trade Act, with results that could prompt tariffs no later than August 2018.24 As if on cue, Wang Yang, a new inductee on China's Politburo Standing Committee and a prominent reformer, wrote an editorial in the People's Daily declaring that China should protect intellectual property, not require tech transfers, and give foreign firms equal treatment under the "Made in China 2025" plan.25 China has made similar promises and the U.S. has made similar threats many times before, so decisions in the coming months will be telling. Ultimately we fear that President Trump may feel compelled to ratchet up protectionism in 2018 for two reasons. First, Americans within his populist base will grow restless as they do the math on the tax legislation and realize that their champion is not quite the populist they voted for. Trump will need to re-convince them of his protectionist credentials and independence from Washington elites and the policy status quo. Second, if our view on Chinese slowdown and American fiscal thrust is correct, the USD bull market should restart in 2018. This would hurt U.S. export competitiveness, expand the trade deficit, and motivate U.S. companies to invest abroad, a paradox of President Trump's tax and fiscal policy. The White House may, therefore, be compelled to reach for mercantilist solutions to an FX problem. Foreign Policy The final reason to worry is a "Lame Duck" presidency. Far more predictable presidents sought relevancy abroad late in their mandate. For example, President George H. W. Bush committed troops to Somalia on his way out of the White House. President Bill Clinton bombed Yugoslavia. Given Trump's dismal approval polling and a potentially historic "wave" election for the Democrats in November, President Trump could similarly shift focus to geopolitics. If that shift includes confronting regional powers like China (and/or North Korea), or Iran, risk premiums may rise. In the meantime, we expect tax cuts to pass. The going is getting tougher in the Senate. The decision to include the repeal of the Obamacare individual mandate - designed to cut another $300 billion in government spending over the next ten years - will make it more difficult to secure 51 Senate votes. We maintain our view that the final legislation may need until Q1 to pass. Between now and then, legislators may need a failure or two in order to realize that the clock is ticking toward the midterms. Bottom Line: Markets have cheered lack of action from the Congress. However, the going will get tougher in 2018 as investors fret about protectionism, President Trump's itch to remain relevant, and a potential takeover of the House by the most left-of-center Democratic Party in a generation. Europe: Germany Is A Passing Risk, Focus On Italy The collapse of coalition talks in Germany is not a structural concern for Europe. The breakdown in the negotiations occurred because of the immigration debate, in which the right-of-center Christian Social Union (CSU) and the Free Democratic Party (FDP) struck out a different position from the ruling Christian Democratic Union (CDU) and the liberal Green Party. Of course, the disagreement is not about immigration today, given that inflows of asylum seekers this year has been well below past flows (Chart 19A). Rather, the fundamental disagreement is over how the CDU and its leader Angela Merkel handled the 2015 migration crisis and how it will be handled in the future. Chart 19ANo Immigration Crisis Today Chart 19BGermans Love Europe For investors, what matters is that there is no substantive disagreement over the EU, European integration, or Germany's role in it. The mildly euroskeptic FDP did not draw any red lines. The reason is obvious: the German euroskeptic constituency is small, shrinking, and largely already captured by the Alternative for Germany (AfD) anti-establishment party (Chart 19B). Germans are objectively the most europhile people in Europe. Going forward, a new election would cause further political uncertainty. On the margin, it could cause business confidence to stall. However, Germany runs a 14 billion euro budget surplus and is not expected to launch any structural reforms or fundamental economic changes. As such, if the formation of a government is delayed by three-to-six months, the economic implications will be fleeting. In fact, the result of a new election could be a Grand Coalition between the CDU and Socialists, which would be positive for European integration. However, as we have argued before, hopes for a significant restart of integration have probably run ahead of reality.26 For us, Italy is the immediate concern. Italy passed a new electoral law in late October, setting the stage for the election due by May 2018. The consensus in the news media is that the president will call elections in January, with the vote taking place sometime in March.27 The consensus is that the new law will make it more difficult for the populist Five Star Movement (M5S) to win a majority of seats in the Italian Parliament. In addition, it will give a lift to the parties with strong regional ties - such as the governing Democratic Party (PD) and Lega Nord. Chart 20Italy Set For A Hung Parliament The nuances of the new law are largely irrelevant, however, given the close polling of the three electoral blocs. The most likely outcome will be a hung parliament (Chart 20). Nonetheless, we can still learn something from the law: the Italian establishment parties are cooperating to subvert the electoral chances of M5S. The ruling PD and the center-right Forza Italia of former Prime Minister Silvio Berlusconi are working together to design an electoral system that favors the pre-election norm of coalition-building and parties with strong regional representation. Neither of these factors fits M5S's profile. This suggests that the two centrist blocs will be able to put together an establishment coalition following the election. On one hand, this will give stability to the Euro Area for at least the duration of that government. On the other hand, the underlying data continues to point to structural euroskepticism in Italy. Unlike their European peers, Italians seem to be flirting with overt euroskepticism. When it comes to support for the common currency, Italians are clear outliers, with support levels around 55% (Chart 21). Similarly, over 40% of Italians appears to be confident in the country's future outside the EU (Chart 22). These are ominous signs for the future. Still, both M5S and the mildly euroskeptic Lega Nord have tempered their demands for an exit from the common currency union. The official stance of the M5S is that the exit from the Euro Area is only "option B," that is, an option if the bloc is not reformed. Meanwhile, Lega Nord is on record opposing a referendum on membership in the currency union because it is illegal.28 Chart 21Italians Stand Out For Distrust Of Euro Chart 22Italians Not Enthusiastic About EU The stance of Italy's euroskeptics will change as soon as it is convenient. The country's establishment is likely making a mistake by contemplating a grand coalition alliance. Unless such a government develops a serious plan for painful structural reforms - it will not - it will likely waste its mandate and fall at the first sign of recession or crisis. At that point, the only alternative will be the M5S, which will stand alone in opposition to such an ineffective government. Investors can therefore breathe a sigh of relief in the medium term. Italy will likely not be a source of risk-off in 2018 or even 2019, although it is still the main risk in Europe for next year and bears monitoring. However, in the long term, we maintain that Italy will be a catalyst for a serious global risk-off episode within the next five years. We remain optimistic that such a crisis will ultimately strengthen Italy's commitment to the Euro Area, as we outlined in a recent Special Report.29 But that is a low conviction view that will require constant monitoring. Could there be another scenario? Several clients have asked us if an Emmanuel Macron could emerge in Italy? Our answer is that there already was an Emmanuel Macron: Matteo Renzi, the former prime minister and current PD leader, was Macron before Macron. And yet he failed to enact significant structural and constitutional reforms. Yet two potential candidates may be ready to swoop in from the "radical center" position that Renzi and Macron characterize. The first is ECB President Mario Draghi. He is widely respected in Italy and is seen as someone who not only allayed the Euro Area sovereign debt crisis, but also stood up to German monetarist demands in doing so. The second is Fiat-Chrysler CEO Sergio Marchionne, one of the world's most recognizable business leaders and a media star inside and outside Italy. If the centrist coalition begins to fray by the end of 2019, both of these individuals may be available to launch a star-studded campaign to "save Italy." Bottom Line: We remain cautiously optimistic about the upcoming Italian elections. While our baseline case is that Italian elections will produce a weak and ineffective government, though crucially not a euroskeptic one, nevertheless risks abound and require monitoring. Investment Implications There are a lot of unknowns heading into 2018. What will become of U.S. tax cuts? How deep will the policy-induced slowdown become in China? What will President Trump do if he becomes the earliest "Lame Duck" president in recent U.S. history? Will he embark on military or protectionist adventures abroad? Asset implications are unclear, but we offer several broad takeaways. First, the VIX will not stay low in 2018. Second, the USD should rally. Both should happen because investors are far too complacent about the Fed's pace of hikes and because of potential global growth disappointments as Beijing tinkers with the financial and industrial sectors. Chart 23AEuro Area Versus U.S. Growth: Don't Ignore China (I) Chart 23BEuro Area Versus U.S. Growth: Don't Ignore China (II) Third, it is time to close our recommendation to be overweight European risk assets. European equities have a higher beta to global growth due to the continent's link to Chinese demand. As our colleague Mathieu Savary has pointed out, when Chinese investment slows, Europe feels it more acutely than the U.S. (Chart 23). Chart 24U.S. Dollar Rebound = EM Pullback We are also closing our tactical long position on China's big banks versus its small-to-medium-sized banks. This position has been stopped out at a loss of 5%, despite the riskier profile of the latter banks and the fact that their non-performing loans are rising. Faced with these challenges, Beijing decided to open the door to foreign investment and too ease regulations on these banks so that they can lend to small cap companies as part of the reform drive. These actions inspired a rally relative to the Big Banks that worked against our trade. As financial tightening will continue, however, we expect this rally to be short-lived, and for big banks to benefit from state backing. Our highest conviction view is that it is time to short emerging markets. Our two core views - that politics will become a tailwind to growth in the U.S. and a headwind to growth in China - should create a policy mix that will act as a headwind to EM (Chart 24). The year 2017 may therefore turn out to have been an anomaly. Emerging markets outperformed as China aggressively stimulated in 2016 and as both the U.S. dollar and bond yields declined. This mix of global fiscal and liquidity conditions proved to be a boon for EM, giving it a liquidity-driven year to remember. That year is now coming to an end. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Overstated In 2017," dated April 5, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Buy In May And Enjoy Your Day," dated April 26, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," dated April 12, 2017, available at gps.bcaresearch.com. 4 China's official broad money (M2) measure has also sharply decelerated, as have all measures of China's money. We prefer BCA's Emerging Market Strategy's broader M3 measure. The official M2 has underestimated the amount of new money in China because banks and shadow banks have done extensive off balance sheet lending. The M3 measure includes bank liabilities excluded from M2, it is calculated by taking the total of non-financial institution and household deposits, plus other financial corporation deposits, and other liabilities. Please see BCA Emerging Market Strategy, "Ms. Mea Challenges The EMS View," dated October 19, 2017, available at ems.bcaresearch.com. 5 Please see BCA Foreign Exchange Strategy Weekly Report, "Temporary Short-Term Risks," dated November 10, 2017, available at fes.bcaresearch.com and BCA Emerging Markets Strategy Weekly Report, "EM: Cracks Are Appearing," dated November 15, 2017, available at ems.bcaresearch.com. 6 Please see BCA China Investment Strategy Weekly Report, "Messages From The Market, Post-Party Congress," dated November 16, 2017, available at cis.bcaresearch.com. 7 Please see BCA Emerging Markets Strategy Special Report, "China's 'De-Capacity' Reforms: Where Steel & Coal Prices Are Headed," dated November 22, 2017, available at ems.bcaresearch.com. 8 Zhou's comments should not be interpreted merely as a farewell speech of a retiring central bank governor, since they echo the general policy shift in the administration since December 2016's Central Economic Work Conference, and April 2016's Politburo meeting, toward tackling financial risk. For Zhou's comments, please see "China's central bank chief lays out plans to avert future financial crisis," South China Morning Post, November 4, 2017, available at www.scmp.com. 9 Xianyang in Shaanxi, and Wuhan in Hubei. Please see Wu Hongyuran and Han Wei, "Another City Halts Subway Projects Amid Financing Concerns," Caixin, November 13, 2017, available at www.caixinglobal.com. 10 Please see Kevin Yao, "China central bank adviser expects less forceful deleveraging in 2018," Reuters, November 15, 2017, available at www.reuters.com. 11 The latest official announcement claims that an additional 31 SOEs will be listed for restructuring. Please see "More SOEs to be included in reform plan," People's Daily, November 16, 2017, available at en.people.cn. 12 We fully expect SOEs to be subjected to rigorous treatment from the National Supervision Commission. Note that the crackdown on overseas investment earlier this year merely touches the tip of the iceberg in terms of the SOE corruption that could be revealed by probes. See, for example, the following report on the National Audit Office's public notice on SOE fraud and irregularities, "20 Central Enterprises Overseas Investment Audit Revealed A Lot Of Problems," Pengpai News (Shanghai), June 26, 2017, available at news.163.com. 13 Please see BCA Geopolitical Strategy Special Report, "How To Read Xi Jinping's Party Congress Speech," dated October 18, 2017, available at gps.bcaresearch.com. 14 Please see BCA China Investment Strategy Weekly Report, "Policy Mistakes And Silver Linings," dated October 7, 2015, and "Legacies Of 2014," dated December 17, 2014, available at cis.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Special Report, "China: Party Congress Ends ... So What?" dated November 1, 2017, available at gps.bcaresearch.com. 16 Xi Jinping has called financial security an important part of national security and declared that "safeguarding financial security is a strategic and fundamental task in the economic and social development of our country." Please see Wang Yanfei, "Leaders aim to fend off financial risks," China Daily, April 26, 2017, available at www.chinadailyasia.com. For Zhao Leji's post-congress comments on this topic in the People's Daily, please see "China faces historic corruption battle, new graft buster says," The Guardian, November 11, 2017, available at www.theguardian.com. 17 See footnote 6. 18 More anecdotally, a clear majority of our clients disagrees with our bullish prospects of tax cuts. 19 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 20 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "NAFTA - Populism Vs. Pluto-Populism," dated November 10, 2017, available at gps.bcaresearch.com. 21 Please see Chad P. Bown, "Donald Trump Now Has The Excuse He Needs To Open The Floodgates Of Protectionism," Peterson Institute of International Economics, October 9, 2017, available at piie.com. 22 Other measures could follow thereafter. For instance, the Commerce Department will issue its final report on steel and aluminum in January and Trump could decide to take punitive actions on these goods under Section 232 of the 1962 Trade Expansion Act. Please see Ana Swanson, "Democrats Pressure Trump to Fulfill Promise to Impose Steel Tariffs," New York Times, October 26, 2017, available at www.nytimes.com. 23 The review itself began in June, around the time when Trump's and Xi's initial "100-day plan" to improve trade relations expired. The report that the review is completed is from Lingling Wei et al, "Beyond Trump-Xi Bond, White House Looks to Toughen China Policy," Fox Business News, November 19, 2017, available at www.foxbusiness.com. See also Adam Behsudi et al, "White House conducting wide-ranging review of China policy," Politico, September 28, 2017, available at www.politico.com. 24 The U.S. Trade Representative Robert Lighthizer is supposed to finish his investigation into intellectual property under Section 301 of the 1974 Trade Act within a year of August 18, 2017. Please see Gary M. Hnath and Jing Zhang, "Trump Administration Initiates Section 301 Investigation of China's Acts, Policies and Practices Related to Technology Transfer, Intellectual Property and Innovation," dated August 25, 2017, available at www.lexology.com. 25 Please see "Chinese vice premier pledges fair treatment of foreign firms as China opens up," Reuters, November 10, 2017, available at www.reuters.com. 26 Please see BCA Geopolitical Strategy Weekly Report, "Stick To The Macro(n) Picture," dated May 10, 2017, available at gps.bcaresearch.com. 27 Just in time to get a new government in place ahead of the World Cup! Oh wait... Too soon? 28 Which is an odd position to take given their supposed anti-establishment orientation. For example, the U.K. referendum on EU membership was non-binding, and yet it took place and had relatively binding political consequences. 29 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy Part II: Italy In Purgatorio," dated June 21, 2017, available at gps.bcaresearch.com.
Highlights The cyclical bull market in stocks will last until the end of next year. That said, global equities have become increasingly vulnerable to a correction, so fast-money investors should consider putting on a tactical hedge spanning the next few weeks. The passage of tax legislation in the U.S. will face many hurdles, and this is likely to ruffle markets in the near term. We ultimately expect Congress to pass a bill early next year. While lower corporate tax rates will be a boon for Wall Street, the gains to Main Street will be a lot more muted. A higher after-tax rate of return on equity will encourage capital inflows into the U.S. This will bid up the value of the dollar, depressing exports in the process. Over the long haul, a larger budget deficit will soak up private-sector savings that could otherwise have been used to finance investment spending. This will lead to less capital accumulation, and eventually a lower standard of living. Feature Rising Odds Of A Stock Market Correction We remain cyclically bullish on global equities based on the expectation that global growth will stay strong over the next 12 months, which should support corporate earnings. Nevertheless, the recent price action in credit markets is disconcerting. Yesterday's relief rally notwithstanding, junk bonds have been selling off in recent weeks, as have EM credit and currencies (Chart 1). We have found that credit trends generally lead the stock market. This raises the risk of an equity correction. The fact that the bull/bear ratio has reached a 30-year high in the weekly Investors Intelligence Sentiment survey (Chart 2), and that the most recent BofA Merrill Lynch Survey shows that a record share of fund managers are overweight risk assets, only add to our worries. Chart 1Junk Bond Selloff Raises ##br##Risks Of An Equity Correction Chart 2Equity Bullish Sentiment:##br## Getting Stretched Doubts about the ability of Republicans in Congress to push through tax cuts further muddle the picture. We continue to expect a tax bill to be signed into law early next year, but the intention of President Trump and Senator Majority Leader Mitch McConnell to include a provision in the bill to rescind the individual mandate to purchase health insurance could greatly complicate this task. Moreover, as we discuss in greater detail below, the economic benefits of the tax legislation are likely to be muted, even if equity prices do rise on the back of lower corporate tax rates. This will make selling the merits of the tax plan to the American people all the more difficult. With all this in mind, we are putting on a short S&P 500 trade recommendation. We are targeting a gain of 5% and putting in a stop-loss of 2%. We will close this trade before the end of the year, so this should be seen as a purely tactical decision appropriate for fast-money investors only. Fiscal Policy Was Tightened Too Early ... Global bond yields plummeted during the Great Recession, but then quickly recovered. The U.S. 10-year Treasury yield hit 3.95% in June 2009, while the German bund yield reached 3.72% that same month. Today, output gaps are much smaller globally than they were seven years ago, yet bond yields are substantially lower (Chart 3). Chart 3ASmaller Output Gaps... Chart 3B...But Lower Bond Yields Many theories have been offered to account for this seemingly paradoxical turn of events. Was it QE? Maybe the Phillips curve broke down? Perhaps investors have steadily revised down their estimate of the neutral rate of interest? One can make compelling arguments in support of all these explanations. However, there is one reason that has received relatively little attention: fiscal policy. Chart 4 shows that fiscal policy was tightened by an average of 4.1% of GDP in the G20 economies between 2010 and 2015. This happened despite the fact that unemployment was still quite high. One could make a half-plausible case that fiscal austerity was necessary in southern Europe, where one country after another was being attacked by the bond vigilantes (although even there, the failure of the ECB to act as a lender of last resort to European sovereigns greatly exacerbated the problem). It is harder to justify the shift towards austerity in countries such as the U.S. and the U.K. which were able to issue debt in their own currencies; or to explain why Germany felt the need to tighten fiscal policy when its structural primary balance was already in surplus. In Japan's case, the 2.9% of GDP in fiscal tightening that occurred between 2013 and the 2015 was a key reason why Abenomics failed to push the country out of deflation. Faced with the reality of what was happening on the fiscal front, central banks had no choice but to step in. They did so by slashing interest rates, in some cases pushing them into negative territory. They also engaged in massive asset purchases. The tsunami of easy money helped to keep economies afloat. But in many countries, slower government debt growth was replaced by faster private-sector debt growth (Chart 5). Debt continued to rise. It just did so in a different form. Chart 4Fiscal Belt-Tightening##br## In 2010-2015 Chart 5Private Debt Growth Picked Up##br## Amid Slowing Government Debt Growth ... And Is Now Being Eased Too Late The good news is that governments are abandoning their obsession with fiscal austerity. The bad news is that they are doing it at a time when fiscal easing is no longer warranted. Standard economic theory suggests that governments should run budget deficits when unemployment is high, and surpluses when it is low. In the U.S., the unemployment rate stands at 4.1%, 0.6 percentage points below the Fed's estimate of NAIRU. And yet, President Trump and the Republicans in Congress are pushing for massive tax cuts which, according to the CBO, would add $1.7 trillion to federal debt over the next ten years, while pushing up the debt-to-GDP ratio by an extra six percentage points to 97% (Chart 6). Limited Supply-Side Benefits Proponents of the legislation argue that lower tax rates will spur growth by so much that they will pay for themselves. This is highly unlikely. Chart 7 shows that major tax cuts in the past have always led to a rising debt-to-GDP ratio, whereas tax hikes have led to a deceleration, or even outright decline, in the debt ratio. Even the much lauded 1981 Reagan tax cuts had to be partially rolled back in 1982 after the budget deficit widened sharply. Chart 6More Red Ink Chart 7Do Tax Cuts Pay For Themselves? The growth-enhancing effects of lower tax rates are likely to be smaller at present than they were in the early 1980s. The Reagan tax cuts were introduced when the economy was in the doldrums and government debt levels were much lower than they are today. Cross-border ownership of foreign assets has also increased tremendously since the Reagan era. Foreigners now own more than $10 trillion of U.S. equities, or close to 35% of the total, up from 10% in the early 1980s (Chart 8). This implies that a corporate tax cut would not only represent a massive windfall for foreigners - a bizarre outcome for a self-professed nationalist president - but would mean that a smaller share of capital gains taxes will make their way into the coffers of the U.S. Treasury. Personal income tax cuts are also likely to generate much less bang for the buck. Most empirical studies suggest that lower personal tax rates increase labor supply largely by boosting female labor participation.1 The prime-age female labor participation rate in the U.S. today is 11 points higher than it was in 1980, which limits the scope for further gains. Moreover, when Ronald Reagan cut taxes in 1981, the top personal tax rate stood at 70% (Chart 9). At such a high rate, a one percentage-point cut in the top rate increases take-home pay by 3.3% (1/30). Today, the top rate stands at 39.6%, so a one-point cut would raise after-tax income by only 1.6% (1/60.4). Thus, the incentive effect from cutting the top marginal tax rate is only half of what it was back then. And, of course, the lower the tax rate, the less incremental revenue the government gets from every additional dollar of income. A reasonable estimate is that the revenue offset from tax cuts today would be only one-quarter of whatever modest amount it was in the early 1980s. Chart 8Growing Share Of U.S. Equities##br## Is Held By Foreigners Chart 9Lower Bang For The Buck From##br## Cutting Individual Tax Rates Tax Cuts Versus Tax Reform This is not to say that tax reform is undesirable. Statutory corporate tax rates in the U.S. are quite high, but effective rates are very low, given the myriad deductions and tax-sheltering strategies (Chart 10). The combination of base-broadening and lower statutory rates would make the economy more efficient. In this respect, the set of reforms unveiled by Paul Ryan earlier this year actually had a lot going for it. Unfortunately, the half-measures in both the House and Senate bills run the risk of making the current system even worse. For example, the proposed transition from the current system where U.S. companies are taxed on their worldwide profits to one where they are taxed only on the profits they earn in the U.S. is likely to increase the incentive to use accounting gimmicks to shift more taxable income to low-tax jurisdictions abroad.2 The new "pass through" tax rate of 25% would also provide passive business owners, who are currently subject to the top marginal tax rate, with a massive tax break. Chart 10Statutory Vs. Effective Corporate Tax Rates: Please Mind The Gap In theory, full business investment expensing is a good idea, but the economic impact is likely to be modest. Companies pay less tax upfront when they can write off the value of capital expenditures immediately, but incur higher taxes in the future due to the absence of any further depreciation expenses. When interest rates are low, as they are today, the present value gain from shifting tax liabilities around in this way is bound to be small. This, along with the fact that companies can already write off a large share of capital purchases under current law in the first few years after they are made, will limit the benefits of the proposal. The full expensing of capital purchases also expires after five years under the Republican plan. This could cause companies to pull forward capital spending simply to game the tax code. Such a policy could be justified if the economy were depressed, but that is not the case today. The Tax Foundation, a free-market think tank that a number of left-leaning economists have accused of overstating the benefits of tax cuts, estimates that temporary expensing would raise the level of real GDP by only 0.18% after a decade, compared to 1.6% in the case of permanent expensing.3 From Populism To Pluto-Populism Chart 11This Is Not Populism Martin Wolf has aptly referred to Donald Trump as a "pluto-populist" - someone who talks like a champion of the poor and middle class to his adoring supporters, but actually pushes for policies that mainly benefit the wealthiest Americans.4 Many of the proposals in the Republican tax bills - including the abolition of the Alternative Minimum Tax, the phase-out of the estate tax, and the aforementioned reduction in the business pass-through tax - would further skew the distribution of income towards the rich (Chart 11). Indeed, the benefits for the wealthy grow over time under the proposed plans, even as those for the middle class dissipate, eventually reaching the point where the average middle-class household ends up paying more taxes under the House plan than they do now (Chart 12).5 And no, one cannot say that this outcome is simply the inevitable consequence of the fact that the rich pay most of the taxes. Once regressive taxes such as the payroll tax and state and local taxes are included in the tally, the rich pay about the same share of their income in taxes as the middle class (Chart 13). To make matters worse, the Republican tax bill would trigger $25 billion in Medicare cuts and $111 billion in cuts to other government programs under current PAYGO rules. More pain for middle-class voters. Donald Trump was quick to throw Ed Gillespie under the bus after he failed to win the governor's race in Virginia, tweeting that Gillespie "did not embrace me or what I stand for." But the truth is Trump has not embraced Trumpism either. We were widely scorned in the early days of the primary season for saying that Trump would secure the Republican nomination, and mocked again in 2016 for predicting that he would win the presidential election. At this point, however, the odds are high that the Republicans will lose the House next November and Trump will fail to get re-elected in 2020. Chart 12Middle-Class Tax Cuts Will Morph Into Tax Hikes Chart 13U.S. Taxation Not Very Progressive Investment Conclusions U.S. equities are overbought and ripe for a correction. As is almost always the case, lower stock prices in the U.S. will negatively impact global bourses. Fortunately, the selloff is likely to be short-lived, with strong global growth and rising earnings powering stocks into 2018. The passage of tax legislation in the U.S. will face many hurdles, and this is likely to ruffle markets in the near term. Nevertheless, we expect Congress to pass a bill early next year. While lower corporate tax rates will be a boon for Wall Street, the gains to Main Street will be a lot more muted. A higher after-tax rate of return on equity will encourage capital inflows into the U.S. This will bid up the value of the dollar, depressing exports in the process. Over the long haul, a wider budget deficit will soak up private-sector savings that could otherwise have been used to finance investment spending. This will lead to less capital accumulation, and eventually a lower standard of living. Chart 14Inflation Higher In Countries Lacking Independent Central Banks Higher government debt levels will also increase the temptation to inflate away debt. As we discussed a few weeks ago, rising political polarization is affecting every facet of society, with the NFL just being the latest example.6 It is hard to believe that the Fed will remain above the fray. History suggests that the loss of central bank independence is often associated with higher inflation (Chart 14). Such may be America's fate as well. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Robert K. Triest, "The Effect Of Income Taxation On Labor Supply In The United States," The Journal of Human Resources, Special Issue on Taxation and Labor Supply in Industrial Countries, 25:3 (Summer 1990); and Costas Meghir and David Phillips, "Labour Supply And Taxes," IZA Discussion Paper No. 3405 (March 2008). 2 Both the House and Senate versions of the tax bill have a number of provisions to limit the ability of corporations to shift profits abroad, but at present, it is unclear how effective these measures will be. 3 Please see "Economic and Budgetary Impact of Temporary Expensing," Tax Foundation, dated October 4, 2017. 4 Martin Wolf, "Donald Trump Embodies How Great Republics Meet Their End," Financial Times, March 1, 2016. 5 This mainly occurs because the "Family Flexibility Credit" expires after 2022. The expanded Child Tax Credit is also not indexed to inflation under the House plan, implying that its value to tax filers will go down over time. In addition, the repeal of the individual mandate would cause fewer lower-income earners to buy health insurance, leading them to forego the tax subsidies that they would otherwise receive. 6 Please see , "Three Demographic Megatrends," dated October 27, 2017. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades