Mega Themes

Highlights U.S. inflation is on a structural uptrend. Monetary and fiscal policy, populism, and demographics will tend to push inflation higher over the coming decade. How can investors protect portfolios against inflation risk? We look at periods of rising inflation to determine which assets were the best inflation hedge. We find that the level of inflation is very important in determining which assets work best. When inflation is rising and high, or very high, the best inflation hedges at the asset class level are commodities and U.S. TIPS. When inflation is very high, gold is the best commodity to hold and defensive sectors will minimize losses in an equity portfolio. However, hedges have a cost. Allocating a large percentage of a portfolio to inflation hedges will be a drag on returns. Investors should opt for a low allocation to hedges now, and increase to a medium level when inflation rises further. Feature Some 38 years have passed since the last time the U.S. suffered from double-digit inflation. The Federal Reserve reform of 1979, championed by Paul Volcker, changed the way the Fed approached monetary policy by putting a focus on controlling money growth.1 The reform gave way to almost four decades of relatively controlled inflation, which persists today. But times are changing. While most of today’s investors have never experienced anything other than periods of tame inflation, BCA expects that rising inflation will be a major driving force of asset returns over the coming decade.2 The main reasons behind this view are the following: 1. A rethink in the monetary policy framework: At its most recent meeting, the FOMC openly discussed the idea of a price-level target, implying that it would be open to the economy running hot to compensate for the past 10 years of below-target inflation (Chart II-1.1A, top panel). Chart II-1.1AStructural Forces Point To Higher Inflation In The Coming Decade (I) Structural Forces Point To Higher Inflation In The Coming Decade (I) Structural Forces Point To Higher Inflation In The Coming Decade (I) Chart II-1.1BStructural Forces Point To Higher Inflation In The Coming Decade (I) Structural Forces Point To Higher Inflation In The Coming Decade (I) Structural Forces Point To Higher Inflation In The Coming Decade (I)   2. Procyclical fiscal policy: The U.S. is conducting expansionary fiscal policy while the economy is at near-full employment (Chart II-1.1A, middle panel). The last time this happened in the U.S., during the 1960s, high inflation followed, as the fiscal boost made the economy run substantially above capacity. 3. Waning Fed independence: President Trump has openly questioned the hiking campaign undertaken by the Fed. Moreover, he has tried to nominate Fed governors with dovish tendencies. Historically around the world, a lack of central bank independence has often led to higher inflation rates (Chart II-1.1A, bottom panel). 4. Peak in globalization: Globalization accelerated significantly in the 1990s and 2000s, flooding the global economy with cheap labor (Chart II-1.1B, top panel). However, we believe that globalization has peaked. Instead, populism and protectionism will be the dominant paradigms for years to come, reducing the cheap pool of workers and goods previously available. 5. Demographics: The population in the U.S. is set to age in coming years (Chart II-1.1B, middle panel). As the percentage of U.S. retirees increases, the number of spenders relative to savers will begin to rise (Chart II-1.1B, bottom panel). Higher spending and lower savings in the economy should create upward pressure on inflation. If our view is correct, how should investors allocate their money? We attempt to answer this question by evaluating the performance of five major asset classes during periods when inflation was rising. Furthermore, we look into sub-asset class performance to determine how investors should position themselves within each asset class to take advantage of an inflationary environment. In our asset-class analysis, we use a data sample starting in 1973 and we limit ourselves to five publicly traded assets that have adequate history: global equities, U.S. Treasuries, U.S. real estate (REITs), U.S. inflation-linked bonds,3 and commodities. We compare asset classes according to their Sharpe ratios: average annualized excess returns divided by annualized volatilities.4  BCA expects that rising inflation will be a major driving force of asset returns over the coming decade. In our sub-asset class analysis, we analyze global equity sectors, international vs U.S. equities, and individual commodities. In some of the sections in our sub-asset class analysis, our sample is slightly reduced due to lack of historical data. Moreover, since in some instances all sectors have negative returns, we compare sub-asset classes according to their excess returns only. We base our analysis on the U.S. Consumer Price Index, given that most of the assets in our sample are U.S. based. We opt for this measure because it tends to track the living expenses for most U.S. citizens and it is the preferred measure to index defined-benefit payments. Finally, we decompose the periods of rising inflation into four quartiles in order to examine whether the level of inflation has any impact on the performance of each asset. Chart II-1.2 and Table II-1.1 show the different ranges we use for our analysis as well as a description of the typical economic and monetary policy environments in each of them. Chart II-1 Chart II- Summary Of Results Table II-1.2 shows the summary of our results. For a detailed explanation on how each asset class and sub-asset class behaves as inflation rises, please see the Asset Class section and the Sub-Asset Class section below. Chart II- Which assets perform best when inflation is rising? Rising inflation affects assets very differently, and is especially dependent on how high inflation is. Global equities performed positively when inflation was rising and low or mild, but they were one of the worst-performing assets when inflation was rising and high or very high. Importantly, equities underperformed U.S. Treasuries in periods of both high and very high inflation. Commodities and U.S. TIPS were the best performers when inflation was high or very high. U.S. REITs were not a good inflation hedge. Which global equity sectors perform best when inflation is rising? Energy and materials outperformed when inflation was high. Every single sector had negative excess returns when inflation was very high, but defensive sectors such as utilities, healthcare, and telecommunications5 minimized losses. Which commodities perform best when inflation is rising? With the exception of energy, most commodities had subpar excess returns when inflation was in the first two quartiles. Industrial metals outperformed when inflation was high. Gold and silver outperformed when inflation was very high. Additionally, gold had consistent returns and low volatility. What is the cost of inflation hedging? Chart II-1 To answer this question, we construct four portfolios with different levels of inflation hedging: 1. Benchmark (no inflation hedging): 60% equities/40% bonds. 2. Low Inflation Hedging: 50% equities/40% bonds/5% TIPS/5% commodities 3. Medium Inflation Hedging: 40% equities/30% bonds/15% TIPS/15 % commodities 4. Pure Inflation Hedging: 50% TIPS/50% commodities. While increased inflation hedging provides better performance when inflation is high and rising, these hedges are costly to hold when inflation is at lower ranges or when it is falling (Chart II-1.3, panels 1 & 2). However, adding moderate inflation hedging (low or medium) to a portfolio achieved the right balance between cost and protection, and ultimately improved risk-adjusted returns over the whole sample (Chart II-1.3, panel 3). What about absolute returns? The benchmark outperformed over the whole sample. However, the low and medium inflation hedging did not lag far behind, while avoiding the big drawdowns of high inflation periods (Chart II-1.3, panel 4). Investment Implications High inflation may return to the U.S. over the next decade. Therefore, inflation hedging should be a key consideration when constructing a portfolio. Based on our results, our recommendations are the following: 1. At the asset-class level, investors should allocate to commodities and U.S. TIPS to hedge inflation. 2.  However, these hedges are costly to hold as they will create a drag on returns in periods when inflation is not high or very high. Therefore, a low allocation to inflation hedges is warranted now. 3.   Inflation will probably start to pick up in the 2020s. A medium allocation to inflation hedges will then be appropriate. 4.   When inflation is high (3.3%-4.9%), investors should overweight energy and materials in their equity portfolios. Likewise, they should overweight industrial metals and energy within a commodity portfolio. 5.   When inflation is very high (4.9% or more), investors should overweight defensive sectors in their equity portfolio to minimize losses. Moreover, investors should overweight gold within a commodity portfolio. At the asset-class level, investors should allocate to commodities and U.S. TIPS to hedge inflation. Asset Classes Global Equities Chart II-2 The relationship between equity returns and rising inflation depends on how high inflation is, with outstanding performance when inflation is rising but low or mild, and poor performance as it gets higher (Chart II-2.1, top panel). This relationship can be explained by the interaction between interest rates, inflation, earnings, and valuations: Earnings growth was usually slightly negative when inflation was recovering from low levels. However, given that interest rates were very low in this environment and growth expectations were high, multiple expansion boosted equity returns (Chart II-2.1, bottom panel). When inflation was mild, the Fed typically started to raise rates, resulting in a declining multiple. However, equities had the best performance in this range thanks to very high earnings growth – a result of the economy growing strongly due to a healthy level of inflation. When inflation climbed into the high or very high range, earnings growth was usually positive but beginning to slow, as high inflation weighed on growth. Meanwhile the multiple started to decline rapidly due to rising interest rates and declining growth expectations. With the exception of the mild inflation range, the return profile of equities during inflationary periods was similar to its normal profile: negative skew and excess kurtosis (Table II-2.1). However, the consistency of returns decreased at higher levels of inflation, with only 45% of months with positive returns when inflation was rising and in its highest quartile. Chart II- U.S. Treasuries Chart II-2 U.S. Treasuries reacted in a similar fashion to equities when inflation was rising (Chart II-2.2). However, while Treasuries underperformed equities when inflation was low or mild, they actually outperformed equities when inflation was high or very high. This was in part due to the fact that at higher inflation ranges, U.S. Treasuries offer a higher coupon return when rates are high, at least partially counteracting losses from falling prices. The steady stream of cash flows from the coupons helped Treasuries achieve positive returns roughly two-thirds of the time at the highest levels of inflation (Table II-2.2). However, this consistency in returns came at a cost: very high inflation resulted in negative skew and high excess kurtosis. Therefore, while Treasuries provided frequent positive returns when inflation was very high, they were prone to violent selloffs. Chart II- U.S. REITs Chart II-2 While REITs had high risk-adjusted returns when inflation was rising but mild, much like equities they had subpar performance in every other quartile and particularly poor performance when inflation was high or very high (Chart II-2.3). These results confirm our previous research showing that REITs performance is very similar to that of equities.6 The return consistency for REITs was generally poor in inflationary periods, with the second-lowest percentage of positive return of any asset class (Table II-2.3). Moreover, REIT returns had excess kurtosis and negative skew throughout all inflation quartiles. Chart II- Commodity Futures Chart II-2 Commodities performed positively in every quartile, and did particularly well when inflation was mild (Chart II-2.4, top panel). However, total return and price return were very different due to the behavior of the roll and collateral return: Total risk-adjusted returns were lower than spot risk-adjusted returns when inflation was low and rising. This happened because during these periods, commodity supply was high relative to demand, as the economy was recovering from a deflationary shock. Thus, there was an incentive for producers to conserve inventories, making the futures curve upward-sloping (contango). Thus, roll return was negative (Chart II-2.4, bottom panel). When inflation was in the upper two quartiles, total risk-adjusted returns were much higher than risk-adjusted spot returns. This was because high inflation was the product of supply shocks. These supply shocks resulted in a downward-sloping futures curve (backwardation), which, in turn, resulted in a positive roll return. Additionally, high rates during these regimes contributed to a high collateral return. Commodities provided good return consistency during inflationary periods, with roughly 60% of positive return months in the upper two inflation quartiles (Table II-2.4). The skew of returns was neutral or positive in the top two quartiles. This means that although volatility was high for commodities, extreme return movements were normally positive. Chart II- U.S. Inflation-Protected Bonds Chart II-2 While inflation-protected bonds provided meager returns when inflation was rising but in the mild range, they provided excellent performance at the highest levels of inflation (Chart II-2.5). Moreover, this high Sharpe ratio was not just simply the result of low volatility, since U.S. TIPS had excess returns of 4.6% when inflation was high and 5.7% when inflation was very high.7 The return profile of inflation-protected bonds during inflationary periods was also attractive in our testing period. Average skew was positive, while kurtosis was relatively low (Table II-2.5). The percentage of positive months across all quartiles was also the highest of all asset classes, with a particularly high share of positive returns in the periods of highest inflation. Chart II- Sub-Asset Classes Global Equity Sectors Chart II-3 For the sector analysis, we looked at information technology, financials, energy, materials, utilities, healthcare, and telecommunications. We excluded industrials, consumer discretionary, and consumer staples given that they do not have adequate back data. Once again, we separate rising inflation periods into four quartiles, arriving at the following results: When inflation was low, information technology had the best excess returns while utilities had the worst (Chart II-3.1, panel 1). This matches our observations at the asset class level, as IT is highly responsive to changes in the valuation multiple. When inflation was mild, energy had the best performance, followed by information technology (Chart II-3.1, panel 2). Meanwhile, financials had the worst performance, as rates were normally rising in these periods. When inflation was high, sectors highly correlated with commodity prices such as energy and materials outperformed. Meanwhile, IT was the worst performer (Chart II-3.1, panel 3). When inflation was very high, every sector had negative excess returns. Overall, investing in energy minimized losses (Chart II-3.1, panel 4). However, this performance was in part attributable to the oil spikes of the 1970s. Alternatively, defensive sectors such as utilities, telecommunications, and healthcare also minimized losses. International vs U.S. Equities Chart II-3 How do equities outside of the U.S. behave when inflation is rising? While the high share of U.S. equities in the global index causes U.S. equities to be the main driver of global stock prices, is it possible to improve returns in inflationary environments by overweighting international equities? The answer once again depends on the level of inflation. When inflation was rising but low, U.S. stocks outperformed global ex-U.S. equities in both common currency and local currency terms (Chart II-3.2, panel 1). This was in part due to the inherent tech bias in U.S. stocks. Additionally, the low level of inflation was often accompanied by slowing global growth in our sample, helping the U.S. dollar. When inflation was mild, U.S. stocks once again outperformed international stocks in both local and common currency terms, though to a lesser degree (Chart II-3.2, panel 2). The dollar was roughly flat in this environment. U.S. stocks started to have negative excess returns when inflation was high (Chart II-3.2, panel 3). On the other hand international equities had positive excess returns in dollar terms, partly because of their energy and material bias and partly because the dollar was generally weak in this period. U.S. equities outperformed global ex-U.S. equities by a small margin when inflation was very high, given that defensive sectors such as telecommunication were over-represented in the U.S. index (Chart II-3.2, panel 4). The dollar was roughly flat in this period. Individual Commodities Chart II-3 Our analysis above confirmed that commodities were one of the best assets to hold when inflation was rising. However, which commodity performed best?8 Total return for every commodity was lower than spot return when inflation was low (Chart II-3.3, panel 1). This was due to the upward-sloping term structure of the futures curve (contango), resulting in a negative roll yield. In this range, energy had the best performance, followed by industrial metals. Precious metals had negative excess returns. When inflation was mild, energy had the best performance of any commodity by far (Chart II-3.3, panel 2). Precious and industrial metals had low but positive excess returns in this period. When inflation was high, industrial metals had the highest excess returns, followed by energy (Chart II-3.3, panel 3). We omit energy for the last quartile since there is not enough data available. Overall, when inflation was very high, both gold and silver had the highest excess returns (Chart II-3.3, panel 4). However, gold’s return volatility was much lower, while it also had positive returns 64% of the time compared to 52% for silver. Other Assets U.S. Direct Real Estate Our asset-class analysis confirmed that public real estate (REITs) as an asset class offered poor risk-adjusted returns during inflationary periods. But how did direct real estate perform? We analyzed direct real estate separately from all other assets because of a couple of issues: Our return dataset is available only on a quarterly basis, versus a monthly basis for the rest of the assets in our sample. Even when annualized, volatility is not directly comparable when using data with different frequencies. The NCREIF Real Estate Index that we used is a broad aggregate, which is not investable. Individual property prices might differ from this aggregate. Finally, real estate returns are measured on an appraisal basis. Appraisal-based indices are not reflective of real transactions. Moreover, prices tend to be sticky. To attenuate this issue we unsmoothed the capital returns by removing return autocorrelation. Overall, the Sharpe ratio of direct real estate was solid throughout the first three quartiles of rising inflation (Chart II-4.1, top panel). There is not enough data available for the fourth quartile. However, judging by the performance of U.S. housing in the 1970s from OECD, risk-adjusted returns when inflation was very high was likely positive (Chart II-4.1, bottom panel). Chart II-4 Chart II-4   Cash Cash (investing in a 3-month U.S. Treasury bill) outperformed inflation over our sample (Chart II-4.2, top panel). Moreover, cash provided positive real returns when inflation was mild, or high, or when it was decreasing (Chart II-4.2, bottom panel). However, cash was not a good inflation hedge at the highest inflation quartile, with an average annualized real loss of almost 2%. Juan Manuel Correa Ossa Senior Analyst Global Asset Allocation Footnotes 1       Please see Carl E. Walsh, “October 6, 1979,” FRSBF Economic Letter, 2004:35, (December 3, 2004). 2       Please see Global Investment Strategy Special Report, “1970s-Style Inflation: Could it Happen Again? (Part 1), ” dated August 10, 2018, and “1970s-Style Inflation: Could it Happen Again? (Part 2),” dated August 24, 2018, available at gis.bcaresearch.com. 3       We use a synthetic TIPS series for data prior to 1997. For details on the methodology, please see: Kothari, S.P. and Shanken, Jay A., “Asset Allocation with Inflation-Protected Bonds,” Financial Analysts Journal, Vol. 60, No. 1, pp. 54-70, January/February 2004. 4       Excess returns are defined as asset return relative to a 3-month Treasury bill. 5       Sector classification does not take into account GICS changes prior to December 2018.  6       Please see Global Asset Allocation Strategy Special Report "REITS Vs Direct: How To Get Exposure To Real Estate," dated September 15, 2016, available at gaa.bcaresearch.com. 7       It is important to note that the synthetic TIPS series does not completely match actual TIPS series for the periods where they overlap. Specifically, volatility is significantly higher in the synthetic series. Thus, results should be taken as approximations. 8       We decompose the returns into the same 4 quartiles to answer this question. However, due to lower data availability, we start our sample in 1978 instead of 1973. Moreover, our sample for energy is smaller beginning in 1983. This mainly reduces the amount of data available at the upper quartile.

Highlights Treasury yields have tumbled despite a solid U.S. economy: The 10-year Treasury bond yielded just under 3% when we started beating the below-benchmark-duration drum last summer; now it’s hovering around 2.3%. The golden rule of bond investing argues against positioning for further declines, … : The returns to duration strategies hinge on the difference between actual and expected moves in the fed funds rate. With the money market looking for two cuts over the next twelve months, the fed funds rate is more likely to surprise to the upside than the downside. … but could a lack of borrowing keep yields low?: If debt-fueled spending has gone out of fashion in the U.S., global savings could overwhelm investment, and rates might have to fall further to bring them back into balance. Feature The ride has gotten bumpier as the trade tensions between the U.S. and China have heated up, but our recommendations have held up well since last summer. Equal-weighting equities, underweighting bonds and overweighting cash helped preserve capital during the fourth-quarter selloff, while our early and late January upgrades of equities (while downgrading cash) and spread product (while further downgrading Treasuries), respectively, have proven to be beneficial.1 On a total return basis, the S&P 500 is up over 12% since our upgrade, and the Barclays Bloomberg Corporate and High Yield Indexes have generated excess returns over Treasuries of around 175 and 75 basis points (“bps”), respectively, despite ceding much of their previous leads.2 Even the TIPS ETF (TIP) has held its own with the equivalent-duration nominal-Treasury ETF (IEF). The below-benchmark duration call has eroded some of the overall outperformance, however, and there has been some debate within BCA about whether or not we should change the view. We still do not believe the monetary policy outlook merits a duration-view change. We remain constructive on the outlook for global growth, despite the escalation in tensions between U.S. and Chinese trade negotiators, and therefore do not see a fundamental reason to expect lower real rates. The idea that soft credit growth could hold rates down is interesting, but one would have to believe the spendthrift U.S. leopard really has changed its spots to position a portfolio in line with it. Fed Policy Chart 1Caution: Falling Rate Expectations Caution: Falling Rate Expectations Caution: Falling Rate Expectations As of Thursday’s close, the money market was pricing in a 100% chance of a 25-bps rate cut by Thanksgiving, a 100% chance of a 50-bps rate cut by this time next year, and a 45% chance of a third cut by Thanksgiving 2020 (Chart 1, bottom panel). The FOMC has paused its rate-hiking campaign, to be sure, but the idea that it will soon embark on a rate-cutting campaign seems like a stretch. The minutes from the FOMC’s April 30th-May 1st meeting, released last week, painted a picture of a fundamentally solid economy. The balance between hawks and doves remained roughly equal, with “a few participants” calling for a coming need to firm policy, given the swiftness with which inflation pressures can build in a tight labor market, while “a few other participants” noted that the unemployment rate is not the be-all and end-all measure of resource utilization. From an investment strategy perspective, we think our U.S. Bond Strategy service’s golden rule provides the best insight. Below-benchmark-duration positioning will outperform if the Fed cuts less (or hikes more) over the next twelve months than markets expect; above-benchmark-duration will win if the Fed cuts more (or hikes less) than markets expect. Some strategists within BCA have raised the possibility that market expectations could force the Fed’s hand. The reason that the Fed is especially loath to disappoint markets in what might be called the forward-guidance era of central banking, but we think there’s an important distinction between taking care not to surprise markets and surrendering one’s free will to them, as parents of young children can attest. Bottom Line: We think the money markets are significantly overestimating the possibility that the Fed will soon cut the fed funds rate, increasing the potential returns from below-benchmark-duration positioning. The Rates Checklist Table 1Rates View Checklist Is America Not Borrowing Enough? Is America Not Borrowing Enough? We developed our rates checklist3 to provide a list of real-time measures that bear on our rates view. Of the eleven items on the list, only three have met our threshold for reassessing our bearish rates call at any point over the last eight months, so we have stayed the course (Table 1). The checked boxes indicate that the evidence has been moving against us, though we would argue that the stingy 10-year Treasury yield has gotten overly carried away with discounting that evidence (Chart 1, top panel).  Policy Perceptions The spread between our monetary policy expectations and the markets’ remains wide, so the prospective returns from our Fed call remain ample, and the first box remains unchecked. Thanks to last week’s two-day, 11-bps decline in the 10-year Treasury yield, we have again checked the inverted yield curve box, which first inverted for five days near the end of March, and has inverted for four days so far in May. Our empirical study of the inverted curve’s recession-signaling properties used month-end closes for the 10-year Treasury yield and the 3-month Treasury Bill rate, and found that an inverted curve had called the seven recessions that have occurred over the last 50 years with just one false positive (Chart 2). Now that the curve has inverted over a couple of daily stretches, clients have asked us just what constitutes bona fide inversion. Chart 2Accurate Yield Curve Signals Tend To Last Accurate Yield Curve Signals Tend To Last Accurate Yield Curve Signals Tend To Last Per the curve’s moves over the last 50 years, we would say inversion doesn’t issue an actionable signal until it persists for at least a few months (Table 2). 1998’s false alarm encompassed just seven days between late September and early October, and covered just one month end. The intuition behind the inverted yield curve’s predictive power is that the bond market sniffs out economic weakness before the Fed officially changes course. Recognizing that the Fed will have to begin cutting rates soon, bond investors buy longer-maturity instruments to reap the biggest rewards. Investors shouldn’t overreact to tentative inversions of the yield curve. Table 2Yield Curve Inversions Is America Not Borrowing Enough? Is America Not Borrowing Enough? We have argued that the next recession will not occur until the Fed has hiked the fed funds rate to a level above the equilibrium fed funds rate. Since we cannot observe the equilibrium rate in real time, we have looked to interest-rate-sensitive segments of the economy to gauge if higher rates are beginning to bite. Housing is on the front line of interest-rate sensitivity, and it remains quite affordable relative to history, suggesting that monetary policy has not yet become restrictive. Every time the inverted curve preceded a recession, the affordability index was below its long-run mean or rapidly making its way there (mid-1973); when the yield curve briefly inverted in September 1998, homes remained more affordable than average (Chart 3). Chart 3If Higher Rates Aren't Squeezing The Economy, The Yield Curve May Be Crying Wolf If Higher Rates Aren't Squeezing The Economy, The Yield Curve May Be Crying Wolf If Higher Rates Aren't Squeezing The Economy, The Yield Curve May Be Crying Wolf Inflation We concede that realized inflation measures (Chart 4), and inflation expectations as proxied by the difference in TIPS and nominal Treasury yields (Chart 5), have lost momentum since last summer. Washington’s unexpected grant of six-month waivers for importing Iranian oil caused crude prices to plunge, taking headline inflation measures and inflation expectations down with them (Chart 6). Given our Commodity And Energy Strategy team’s view that oil prices will extend their rebound across the rest of this year and into next, we expect that they will again move higher. Chart 4Consumer Price Indexes, ... Consumer Price Indexes, ... Consumer Price Indexes, ... chart 5... And Inflation Breakevens, ... ... And Inflation Breakevens, ... ... And Inflation Breakevens, ... Chart 6... Are Joined At The Hip With Oil Prices ... Are Joined At The Hip With Oil Prices ... Are Joined At The Hip With Oil Prices The Labor Market And Imbalances At Home And Abroad The labor market remains tight, so none of the labor market indicators argue for easier monetary policy and lower rates across the term structure. As far as the instability indicators go, there is as yet no sign of unsustainable activity in the economy’s key cyclical sectors. The Fed has stopped emphasizing the idea that financial sector imbalances alone might justify tighter policy, but anecdotal reports about lending standards suggest that potential vulnerabilities remain. There has not yet been an outbreak of major international distress that could deter the Fed from tightening policy, but worsening trade tensions and continued dollar strength would seem to make it slightly more likely. Bottom Line: We have checked a few boxes on our rates checklist, but the available evidence does not support adopting a more constructive view on rates. Hey, Big Spender The American consumer has long been a punching bag for Austrian School adherents and other moralists. As much as they scorn American households for living beyond their means, U.S. consumption has long played a symbiotic role in the global economy. As the engine powering the world’s largest economy, it makes an essential contribution to global aggregate demand, and provides an outlet for export powerhouses like China and Germany. An economy can only run a current account surplus provided that there are other economies running current account deficits capable of offsetting it. Measured inflation and inflation expectations were beginning to get some traction before oil collapsed upon the issuance of Iranian import waivers. In a recent blog post, former BCA Editor-in-Chief Francis Scotland posited that interest rates may not go anywhere as long as American households embrace their nascent post-crisis frugality. Using U.S. household demand as a proxy for global aggregate demand, Francis argues that if households don’t borrow and spend the way they did throughout the pre-crisis postwar era, global aggregate demand will suffer unless another profligate spender emerges to pick up the slack. Add China to the mix, and global savings could swamp global investment. Against that backdrop, savings and investment would only realign if rates fell. Newly frugal U.S. households may be helping to cap interest rates, but it’s too early to declare the end of the Debt Supercycle. Broadening the scope to include all public- and private-sector U.S. borrowing, the nominal 10-year Treasury yield has taken some cues from growth in aggregate borrowing (Chart 7). The relationship with real yields is not as strong (Chart 8), but if borrowing has some relationship to inflation, as under the guns-and-butter fiscal policy of the late sixties, nominal yields might well be a better measure. We can easily go along with the supply-and-demand intuition behind the observed relationship: when there’s stronger demand for credit, rates have to rise to entice savings and discourage investment to bring them back into balance, and vice versa. Chart 7Nominal Treasury Yields Have Been Tightly Linked With The Pace Of Loan Growth, ... Nominal Treasury Yields Have Been Tightly Linked With The Pace Of Loan Growth, ... Nominal Treasury Yields Have Been Tightly Linked With The Pace Of Loan Growth, ... Chart 8... And Real Yields Have Broadly Followed The Pattern As Well ... And Real Yields Have Broadly Followed The Pattern As Well ... And Real Yields Have Broadly Followed The Pattern As Well Government borrowing filled the void left by retrenching households and corporations in the immediate aftermath of the crisis. Household and corporate loan demand has been choppy since, however, and growth in aggregate borrowing has bumped around its mid-1950s lows throughout the expansion. We are not ready to declare that Americans have turned over a new, parsimonious leaf. The federal budget deficit soared following the passage of the stimulus package, and the CBO projects that it will continue to widen. Household debt growth is at its pre-crisis lows, but it has been accelerating ever since 2010 (Chart 9), and with debt service as a share of disposable income at its lowest level in at least 40 years, households have plenty of capacity to borrow. Chart 9Don't Count Consumers Out Just Yet Don't Count Consumers Out Just Yet Don't Count Consumers Out Just Yet Bottom Line: Interest rates have moved directionally with aggregate loan growth across the postwar era. Tepid loan demand growth may well keep a lid on rates, but we are not convinced that the Debt Supercycle has really breathed its last. Investment Implications Now that the 10-year Treasury yield has drifted back down to 2.3%, we believe the distribution of potential rate outcomes a year from now is skewed to the upside. We are thereby sticking with our recommendation that investors underweight Treasuries and maintain below-benchmark-duration positioning in all fixed-income portfolios. Even if there is not a clear catalyst on the immediate horizon for higher rates, we do not think that either the U.S. or the global economy is so fragile that investors should position for further rate declines. Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com Footnotes 1 Please see the January 7 and January 28, 2019 U.S. Investment Strategy Weekly Reports, “What Now?” and “Double Breaker,” available at usis.bcaresearch.com. 2 All return data calculated as of the Thursday, May 23rd close. 3 Please see the September 17, 2018 U.S. Investment Strategy Weekly Report, “What Would It Take To Change Our Bearish Rates View?” available at usis.bcaresearch.com.

Highlights The view that the world will sink into a deflationary “ice age” hinges on the assumption that policymakers will make a colossal mistake by failing to do what is in their own best interest. Contrary to popular belief, governments always have a tool to increase inflation, even when an economy has fallen into a liquidity trap: It’s called sustained fiscal stimulus. Japan could have avoided its deflationary epoch if the authorities had eased fiscal policy more aggressively. Ironically, bigger budget deficits probably would have caused the government debt-to-GDP ratio to rise less than it did. The U.S. and China are unlikely to repeat Japan’s mistake. Actually, looking ahead, Japan may not repeat Japan’s mistake. The euro area is a tougher call given the region’s political and institutional constraints; but even there, a reflationary outcome is more likely than not. An intensification of the trade war will cause government bond yields to fall a bit further in the near term. However, yields are likely to be higher one year from now. Global equities will follow the same path as bond yields: Down in the near term, but up over a 12-month horizon. Feature I feel more confident than ever that the next phase of the Ice Age will soon be upon us. Much of the thesis has come from learning the hard deflationary lessons from Japan. Most commenters now accept the Japanification of mainland Europe has occurred, but they just cannot conceive that the same thing might happen with the US. My biggest conviction call is that US 10y bond yields will converge with Japanese and German yields in the next recession at around minus 1% (and US 30y yields will fall to zero or below) and that markets will panic as outright deflation takes an icy grip. -  Albert Edwards, Société Générale (May 2019) Fire Or Ice? If you were to ask most central bankers today whether it is better to err on the side of too much or too little inflation, chances are they would say the former. Their rationale would surely be as follows: If inflation rises to uncomfortably high levels, they can simply raise interest rates in order to cool the economy. In contrast, if inflation gets too low, and interest rates are already close to zero, monetary policy loses potency. It is better to have more control over the economy than less. This reasoning is correct on its own terms, but if one stands back and thinks about it, it is rather perverse to argue that deflation, which generally stems from a lack of aggregate demand, should be more difficult to overcome than inflation, which is usually the result of too much demand. After all, people like to spend money. Getting someone to work and produce should, in principle, be more difficult than getting them to consume. Inflation should be a bigger problem than deflation. So why do so many economists think otherwise? The Paradox Of Thrift There actually is a very good reason for this bias, one which John Maynard Keynes articulated more than 80 years ago. Keynes observed that when unemployment is rising, people are likely to try to save more due to fear of losing their jobs. Since one person’s spending is another’s income, this could create a vicious cycle where falling spending leads to lower aggregate income, and so on. Unfortunately, it is hard to save if you do not have a job. Thus, the decision by all individuals to save more could result, ironically, in a decline in aggregate savings.1 Keynes called this the paradox of thrift. At the heart of the paradox of thrift lies a deep-seated coordination problem. During an economic downturn, everyone would be better off if everyone else spent more money. However, since the spending of any one person only has a negligible effect on aggregate demand, no one has an incentive to spend more than is absolutely necessary. Keynes’ seminal insight was that a government could overcome this coordination problem by acting as a spender of last resort. Keynes argued that if the private sector decides to save more, the public sector should save less by running a bigger budget deficit. The result would be the preservation of full employment. Debt And Deliverance A common objection to the idea that governments should run bigger budget deficits to compensate for inadequate private-sector demand is that this will cause public-sector debt levels to swell to the point that a fiscal crisis becomes inevitable. The solution to Japan’s problem is obvious: The government should just keep easing fiscal policy until long-term inflation expectations reach the BoJ’s target. For countries such as Italy, this is a legitimate concern. If a country does not have a central bank that can serve as a buyer of last resort of government debt, it can end up facing a pernicious feedback loop where rising bond yields increase the likelihood of default, leading to even higher bond yields. These countries can, and often do, face speculative attacks on their bond markets (Chart 1). Chart 1 For countries that issue debt in their own currencies, this concern does not exist. This is because their governments can print money to pay for goods and services. Since the cost to the government of printing a $100 bill is negligible, the government can always conjure up demand out of thin air. Of course, there is a risk that the government will manufacture too much demand and inflation will rise. But if the goal is to prevent deflation, this is a feature not a bug. Once demand increases enough, the government can just pull the plug on further fiscal stimulus, and everyone can live happily ever after. Japan’s Experience Chart 2The 1990s Japanese Example The 1990s Japanese Example The 1990s Japanese Example Didn’t Japan try this approach and fail? No. Japan suffered the mother of all financial shocks in the early 1990s when the real estate and stock market bubbles simultaneously burst. This happened just as the working-age population was peaking, which made businesses even less eager to expand domestic capacity. The result of all this was a massive increase in excess private-sector savings. The government did loosen fiscal policy, but not by enough. Consequently, deflation eventually set in. As inflation expectations fell, real rates rose (Chart 2). Rising real rates put upward pressure on the yen and increased the government’s real debt financing costs. To make matters worse, falling prices made it more difficult for private-sector borrowers to pay back their loans. This further depressed spending. Ironically, had the Japanese government eased fiscal policy more aggressively to begin with, it probably would have been able to trim deficits later on. Nominal GDP would have also increased more briskly. As a consequence, the government debt-to-GDP ratio would have ended up rising less than it did. Today, Japan remains mired in a deflationary mindset. Twenty-year CPI swaps, a proxy for long-term inflation expectations, are trading at 0.3%, nowhere close to the Bank of Japan’s 2% target. Interest rates are stuck near zero, reflecting the fact that the economy continues to suffer from excess savings. Japan Needs Fiscal Stimulus, Not Austerity The solution to Japan’s problem is obvious: The government should just keep easing fiscal policy until long-term inflation expectations reach the BoJ’s target. Given Japan’s pathetically low fertility rate, a sensible strategy would be to offer subsidized housing and baby bonuses to any couple that has three or more children. It is impossible to know how big a budget deficit will be required to reset inflation expectations to a higher level. If people believe that the government is serious about easing fiscal policy by enough to get inflation up to target, real rates will collapse, the yen will fall, and private demand will rise. In the end, the government may not need to raise the budget deficit that much. Even if the Japanese government did have to increase the budget deficit substantially, this would not endanger the economy. As long as the interest rate at which the government borrows is below the growth rate of the economy, any budget deficit, no matter how large, will produce a stable debt-to-GDP ratio in the long run (Chart 3).2 Since there would be no need to ease fiscal policy by so much that the Bank of Japan is forced to lift interest rates above the economy’s growth rate, there is little risk that the debt-to-GDP ratio will end up on an unsustainable trajectory. Chart 3 Chart 4Japanese Excess Savings Are Starting To Recede Japanese Excess Savings Are Starting To Recede Japanese Excess Savings Are Starting To Recede Will the Japanese government heed this advice? While Q1 GDP growth surprised on the upside, this was mainly because of a strong contribution from net exports and inventories. Final domestic demand remains underwhelming. Stronger global growth will help Japan later this year, but we think there is still a 50/50 chance the planned VAT hike will be postponed. Looking ahead, the exodus of Japanese workers from the labor market into retirement will reduce private-sector savings. The household savings rate has already fallen from nearly 20% in the early 1980s to around 4% in recent years. The ratio of job openings-to-applicants has risen to a 45-year high (Chart 4). Falling private-sector savings will raise the neutral rate of interest, thus giving the BoJ more traction over monetary policy. Japan’s deflationary ice age may be coming to an end. Stimulus With Chinese Characteristics Like Japan, China has struggled to consume enough of what it produces. In the days when China had a massive current account surplus, it could export that excess savings abroad. It cannot do that anymore, so the government has consciously chosen to spur fixed-investment spending in order to prop up employment. Since a lot of investment is financed through credit, debt levels have risen (Chart 5). Much of China’s debt-financed investment spending has been undertaken by local governments and state-owned enterprises. This has made credit and fiscal policy virtually indistinguishable. While the general government fiscal deficit stands at a moderate 4.1% of GDP, the augmented deficit, which includes a variety of off-balance sheet expenditures, has swollen to 10.7% of GDP, up more than six percentage points since 2010 (Chart 6). Chart 5China: From Exporting Savings To Investing Domestically And Building Up Debt China: From Exporting Savings To Investing Domestically And Building Up Debt China: From Exporting Savings To Investing Domestically And Building Up Debt Chart 6 As we discussed a few weeks ago in a report entitled “Chinese Debt: A Contrarian View”, there is little preventing the Chinese government from further ramping up credit/fiscal stimulus.3 The fact that the trade negotiations are on the ropes only strengthens the case for additional easing. The government knows full well that it will gain negotiating leverage over the U.S. if the Chinese economy is humming along despite higher tariffs on Chinese imports. Regardless of whether it is right-wing populism or left-wing populism that triumphs in the end, the outcome is likely to be the same: higher inflation. Europe: Turning Japanese? Judging from the fact that German bund yields have fallen to Japanese levels, one might conclude that the Japanification of Europe is complete. There is, however, at least one key macro difference between the two regions: While long-term inflation expectations in the euro area have declined, they are still well above Japanese levels (Chart 7). As a result, real yields are quite a bit lower in core Europe, which gives countries such as Germany and France some cushion of support. Chart 7Despite Similar Nominal Bond Yields, Real Rates Are Still Much Lower In Germany Than Japan Despite Similar Nominal Bond Yields, Real Rates Are Still Much Lower in Germany Than Japan Despite Similar Nominal Bond Yields, Real Rates Are Still Much Lower in Germany Than Japan Chart 8Italian Bond Yields Are Still Worryingly High Italian Bond Yields Are Still Worryingly High Italian Bond Yields Are Still Worryingly High Bond yields remain elevated in Italy, though still below the levels seen last October, and far below their peak during the euro crisis in 2011 (Chart 8). Short of the creation of a pan-euro area fiscal union, Italy’s best hope is that Germany takes steps to reflate its own economy. The conventional wisdom is that the German psyche, ever focused on fiscal discipline, would never permit that to happen. This view, however, forgets that Germany had no trouble violating the Maastricht Treaty’s deficit cap of 3% of GDP in the early 2000s. Germany today sees little need to significantly loosen fiscal policy because years of wage repression, and more recently, a weak euro, have caused its current account surplus to swell to 9% of GDP. However, the country’s ability to push out its excess production to the rest of the world may become more limited in the future. The gap in unit labor costs between Germany and other euro area members has narrowed steadily in recent years. This development has coincided with a decline in Germany’s trade surplus with the rest of the euro area (Chart 9). If the common currency starts to appreciate and wage growth in Germany continues to outpace the rest of the region, the German government may have no choice but to loosen the fiscal screws. Chart 9Germany's Competitive Advantage Against The Rest Of The Euro Area Is Declining Germany's Competitive Advantage Against The Rest Of The Euro Area Is Declining Germany's Competitive Advantage Against The Rest Of The Euro Area Is Declining Chart 10U.S.: Federal Discretionary Spending Has Been Gaining Steam U.S.: Federal Discretionary Spending Has Been Gaining Steam U.S.: Federal Discretionary Spending Has Been Gaining Steam   U.S.: Ice Age Vs. Green New Deal While Trump’s tax cuts have gotten a lot of attention, an equally important development in recent years has been the rapid acceleration in federal government spending. From a contraction of 7% in 2013, real discretionary outlays are set to grow by 3% in 2019 (Chart 10). There is little reason to think that the U.S. budget deficit will shrink anytime soon. Taxes may go back up if the Democrats take control of the White House and sweep Congress next year. However, even in that scenario, any increase in tax rates is likely to be neutralized by higher social welfare spending – yes, including partial implementation of the green new deal. Meanwhile, government outlays on Social Security and health care programs such as Medicaid are on track to rise by 5.4% of GDP over the next thirty years (Chart 11). Chart 11 So far, an overstimulated U.S. economy has not produced much in the way of inflation. But with the unemployment rate down to a 49-year low, that could change over the next few years. Recent communications from FOMC members suggest a growing tolerance for a modest inflation overshoot of the 2% target. An outright increase in the Fed’s inflation target is unlikely in the near term, but could become a viable option if realized inflation moves above the Fed’s current comfort zone of 2%-to-2.5% for long enough. If that were to happen, raising the inflation target could turn out to be politically more expedient than engineering a deep recession in an effort to bring inflation back down. It will also help alleviate the rising real debt burden that will ensue from high deficits. We expect global bond yields to reach a series of “higher highs and higher lows” over the coming years. The Fed is already facing political pressure from the Trump administration to keep rates low. Politics in the U.S. and in many other countries is moving in a more populist direction. Regardless of whether it is right-wing populism or left-wing populism that triumphs in the end, the outcome is likely to be the same: higher inflation. Historically, there is a clear inverse correlation between central bank independence and inflation (Chart 12). Chart 12 Investment Conclusions On the question of whether we are heading for a deflationary ice age or a period of inflationary global warming, we would put higher odds on the latter. Many of the structural factors that have produced lower inflation over the last few decades are in retreat. Globalization has stalled, and may even reverse course if the trade war intensifies (Chart 13). The ratio of workers-to-consumers globally is starting to shrink as the post-war generation leaves the labor force (Chart 14). Central bank autonomy is under attack, while fiscal policy is turning more expansionary. Chart 13The Age Of Globalization Is Over The Age of Globalization Is Over The Age of Globalization Is Over Chart 14The Worker-To-Consumer Ratio Has Peaked Globally The Worker-To-Consumer Ratio Has Peaked Globally The Worker-To-Consumer Ratio Has Peaked Globally To believe that politicians will not dial up fiscal stimulus in the face of a chronic shortfall of aggregate demand is to believe that they will act incompetently. Not incompetent in the low-IQ sort of way. Incompetent in the sense that they will act against their own self-interest. Voters want more employment. In the age of populism, it seems unlikely that politicians with ready access to the printing press will fail to deliver what the people want. We declared “The End Of The 35-Year Bond Bull Market” on July 5, 2016. As luck would have it, this was the very same day that the U.S. 10-year Treasury yield hit an all-time low of 1.37%. We expect global bond yields to reach a series of “higher highs and higher lows” over the coming years. Right now, we are witnessing a countertrend rally in bond prices. Yields could fall a bit further in the coming weeks if the trade war heats up. However, yields will be higher in 12 months’ time, provided that China and the U.S. begrudgingly reach a trade truce and global growth reaccelerates, as we expect. Global equities are likely to follow the same pattern as bond yields. Trade tensions could push stocks down about 5% from current levels (we are presently positioned for this by being tactically short the S&P 500 against an underlying structural overweight position). However, equities will move to fresh highs over a 12-month horizon as global growth picks up. The recent stock market correction caused our long European bank trade to be stopped out for a loss of 7%. We will re-enter the trade once we conclude that global equities have found a bottom. The dollar will probably strengthen a bit more in the near term, but as a countercyclical currency, the greenback will weaken in the second half of this year. This will provide a good opportunity to go overweight EM and European stocks in common-currency terms.   Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com   Footnotes 1      Another way to see this point is to recall that business spending normally declines when the economy weakens. Investment spending tends to move in lockstep with national savings (indeed, at the global level, the two must be exactly equal to each other). Thus, if consumer spending falls in response to the decision by households to try to save more, and this leads to lower investment, it will also lead to lower aggregate savings. 2      Please see Global Investment Strategy Weekly Report, “Is There Really Too Much Government Debt In The World?” dated February 22, 2019. 3      Please see Global Investment Strategy Weekly Report, “Chinese Debt: A Contrarian View,” dated April 19, 2019.   Strategy & Market Trends MacroQuant Model And Current Subjective Scores Chart 15 Tactical Trades Strategic Recommendations Closed Trades

We are strongly committed to our 2 percent inflation objective and to achieving it on a sustained and symmetric basis. – Jerome Powell, May 1, 2019 St Louis Fed President James Bullard, a voting member of the central bank’s policy committee, said he “certainly would be open to a cut” should inflation continue to fall short of expectations after the summer. – Financial Times, May 3, 2019 The Federal Reserve’s preferred measure of prices (the core personal consumption deflator) rose by 1.6% in the year to March, a shortfall from the 2% inflation target. Moreover, the 10-year-moving average of core inflation has remained persistently below the 2% level over the past 17 years (Chart 1). Recent comments from some policymakers and market analysts highlight growing concerns about this shortfall. Personally, I see little to worry about. Chart 1Core Inflation: Not Quite At 2% Core Inflation: Not Quite At 2% Core Inflation: Not Quite At 2% For investors, high and rising inflation is a terrible thing, as is its even more evil twin, a high and accelerating pace of deflation. The Holy Grail for investors and policymakers alike is for actual inflation and inflation expectations to remain both low and stable. It seems to me that this has been achieved, with resulting huge benefits to the economy and financial markets. It matters little that inflation has fallen slightly short of the arbitrary 2% target. If inflation was problematically low, what might we expect to see? Importantly, companies would be complaining about a tough pricing environment and pressure on profits. Yet, S&P 500 profit margins are close to an all-time high (Chart 2). And that is providing powerful support to the stock market, with the S&P 500 also close to its highs. If there were building deflationary pressures in the economy, then it also would be reasonable to expect spreading signs of economic distress. While not every indicator is flashing green, the overall economy is doing just fine. Healthy employment growth, rising real wages and strong profits are more consistent with a nascent inflation problem than with deflation. According to the National Federation of Independent Business survey, small companies’ main problem is the quality of labor, not concerns about demand. Excessively low inflation is a problem for debtors, but loan delinquency rates – albeit a lagging indicator – are well contained. The Fed makes a big deal about the importance of keeping inflation expectations anchored – i.e. stable at a low level. There does not appear to be any major problem on this front. For example, the New York Fed’s survey of consumers shows median expected inflation of 2.9% in three years’ time (Chart 3). The University of Michigan Survey of Consumers shows expected inflation of 2.3% over the next 5-10 years. The gap between nominal and real 10-year Treasury yields – a proxy for financial market inflation expectations – is lower (currently 1.88%), but that measure moves around a lot and is highly correlated with oil prices. No measures of expected inflation are in free-fall or dangerously low. Chart 2No Signs Of Pricing Distress No Signs of Pricing Distress No Signs of Pricing Distress Chart 3Inflation Expectations Are Contained Inflation Expectations Are Contained Inflation Expectations Are Contained   What If? Suppose that the Fed had been prescient enough to realize 10 years ago that, despite its best efforts, core inflation would average only 1.6% rather than the desired 2% over the coming decade. Presumably, the Fed would have taken even more extreme actions than actually occurred, implying a bigger expansion of its balance sheet. It is unclear whether it would have been any more successful in pushing up actual inflation. But we can be sure that it would have further inflated asset prices and encouraged even more leverage in the corporate sector. Increased financial imbalances in the economy – asset price overshoots and greater leverage – would not have been an attractive trade-off to pushing up inflation by an average 40 basis points. The core problem is that monetary policy is ill-equipped to deal with the forces that have held back economic growth. A combination of demographics, high debt and slower productivity growth have limited the U.S. economy’s potential. Thus, I have a lot of sympathy for Larry Summer’s secular stagnation thesis. Yes, that implies that the real equilibrium interest rate is very low and, therefore, that monetary policy needs to be accommodative. But it also implies that force-feeding the system with easy money is more likely to lead to asset bubbles and financial distortions than to increased consumer price inflation. What About Policy Ammo For The Next Downturn? One of the main arguments for getting inflation up is to give the Fed more scope to ease policy in the next recession. In the past, the Fed has cut the funds rate by an average of around 500 basis points during recessions. Going into the next downturn with inflation and thus interest rates close to current levels means it would not take long for the funds rate reach the constraints of the zero bound. However, this also would be the case if core inflation was at or modestly above the 2% target. That is why some commentators (e.g. Olivier Blanchard and Larry Summers) have argued for an inflation target of 4% during good times in order to allow for a large fall in interest rates when times turn bad. As long as inflation is in moderate single digits, its stability probably is more important than its level. In other words, if inflation was at 4% and was expected by all economic and financial agents to remain at that level for the foreseeable future, then the economy should not perform any worse than if inflation had stabilized at 2% - and it might even perform better. However, central banks have long had the view that the higher the inflation rate, the less stable it would be. And the same logic would apply to the downside if there was deflation. For example, once inflation rises from 2% to 4%, then it could easily move from 4% to 6% etc. Given the challenges of fine-tuning monetary policy, that view has merit. Raising the inflation target is all very well, but if central banks are having trouble getting the rate to 2%, how on earth would they get it to 4%. And the same point applies if the Fed were to shift from targeting the inflation rate to targeting the level of prices or of nominal GDP. If boosting the Fed’s balance sheet from less than $1 trillion to $4.5 trillion did not get inflation to 2%, what would it take to get inflation to 4%? It is always possible to increase inflation. For example, the government could give all households a check for $10,000 that had to be spent on domestically-produced goods and services. Furthermore, assume the checks were valid only for one year and the fiscal costs were directly financed by the Fed. This would undoubtedly unleash a powerful consumer boom and a spike in inflation. And the government could keep repeating the exercise until a sustained inflation upturn took hold. But that is an unrealistic scenario except in the event of an Armageddon economic situation. And it hardly would fit in with keeping inflation stable at a modestly higher pace. A recession is very likely within the next couple of years and monetary policy will indeed face major constraints on its actions. We undoubtedly would see renewed quantitative easing on a heroic scale with an expanded range of assets purchased by the central bank. And advocates of Modern Monetary Theory may well have their wishes granted with direct monetary financing of fiscal deficits. But, as already noted, policymakers would face these policy challenges regardless of whether inflation was modestly below or above the 2% target. Be Careful What You Wish For The Fed spent three decades squeezing inflation out of the system. In the 1970s and 1980s, high inflation expectations were deeply embedded in the behavior of consumers, companies and investors. It was a long and at times painful process to change that psychology. With inflation expectations now in the range of 2% to 3%, the Fed can claim success. Why would they want to risk undoing that achievement? Letting the economy run hot to try and offset sub-2% inflation with a period of above-2% inflation would be a dangerous strategy. History shows us that central banks have both limited understanding of the inflation process and limited control over the economy. If policymakers were successful in raising inflation, they run the risk that expectations would no longer be anchored. Moreover, the Fed would have a massive problem in communicating the logic of a pro-inflation strategy. Having spent so long in selling the message that low and stable inflation is the best way to maximize long-run economic growth, it likely would create considerable confusion to then say that a period of higher inflation was acceptable. Investors and businesses would face huge uncertainty about the magnitude and duration of an inflation overshoot and about whether the Fed could even control the process. The Fed’s credibility undoubtedly would suffer. It is true that policymakers know how to bring inflation back under control – they simply have to tighten policy. But that introduces increased instability into the economy and financial markets. Rather than be obsessed about hitting the 2% target, policymakers should be happy that they have met the requirements of the Federal Reserve Act: “to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” The Policy Outlook And Market Implications The Fed was right to stop raising interest rates. The economy does not appear to be on the verge of overheating and there are enough risks to the outlook to warrant a cautious wait-and-see approach to policy. Yet, I am somewhat troubled by the dovish tone of some Fed officials. Thank goodness President Trump’s recent choices for Fed Board positions are now out of the picture. If I am worried now, I can only imagine how much worse I would have felt with Stephen Moore and Herman Cain on the Board. With no recession on the horizon and the labor markets extremely tight, I fully expect to see inflation gather steam later this year. But I suspect that the Fed will be slow to react. And then the timing of the 2020 elections will become a factor. The FOMC is not particularly sensitive to political considerations, but this is no ordinary President. The Fed would have to be very sure of itself before it started raising rates again in the midst of the election cycle. The bottom line is that we are setting up for a monetary policy error with the Fed falling behind the inflation curve later this year or in early 2020. This will be positive for risk assets in the short run, but poses a big threat down the road. Notwithstanding our concerns about the near-term market impact of current U.S.-China trade tensions, our strategy is thus to remain overweight equities and corporate credit until we see signs that financial conditions are about to significantly tighten.   Martin H. Barnes, Senior Vice President Economic Advisor mbarnes@bcaresearch.com

Highlights Even if higher tariffs are imposed tonight, there is a good chance that China and the U.S. will reach a temporary trade truce over the coming weeks. Contrary to President Trump’s assertion, U.S. companies and consumers have borne all of the costs of the tariffs. With the next U.S. presidential campaign less than one year away, the self-described “master negotiator” will actually need to prove that he can negotiate a trade deal. If trade talks do collapse, the Chinese will ramp up credit/fiscal stimulus “MMT style,” thus providing a cushion under global growth and risk assets. In fact, there is a very high probability that the Chinese will overreact to the risks to growth, much like they did in 2009 and 2016. Investors should remain overweight global equities for the next 12 months, while positioning for a modestly weaker U.S. dollar and somewhat higher global bond yields. Feature Tariff Man Strikes Again Hopes for a quick end to the trade war were dashed last Sunday. President Trump threatened to hike tariffs on $200 billion of Chinese goods and begin proceedings to tax the remaining $325 billion of imports currently not subject to tariffs. Although details remain sketchy, U.S. Trade Representative Robert Lighthizer apparently informed the president that the Chinese were backtracking on prior commitments to change laws dealing with issues such as market access, forced technology transfers, and IP theft.1 This infuriated Trump. Trump’s announcement came just as Vice Premier Liu He and a 100-person Chinese trade delegation were set to depart for Washington. As BCA’s Chief Geopolitical Strategist Matt Gertken has noted, the relationship between the two sides was deteriorating even before Trump fired his latest salvo.2 The Chinese government was incensed by the U.S. request that Canada detain and extradite a senior official at Huawei, a top Chinese telecom firm. For its part, the Trump Administration was irked by China’s questionable enforcement of Iranian oil imports, the escalation of Chinese military drills around Taiwan, and the perception that China had not done enough to keep North Korea in check following the failed summit with Kim Jong-Un in Hanoi. It would be naïve to expect these ongoing geopolitical issues to fade anytime soon. The world is shifting from a unipolar to a multipolar one (Chart 1). In an environment where there are overlapping spheres of influence, geopolitical tensions will rise. Chart 1The Era Of Unipolarity Is Over The Era Of Unipolarity Is Over The Era Of Unipolarity Is Over That said, stocks still managed to advance during the first four decades of the post-war era even though the U.S. and the Soviet Union were at each other’s throats. What investors need today is some reassurance that the current trade spat will not degenerate into a full-out trade war that undermines global commerce. Ultimately, we think they will get this reassurance for the same reason that the Soviets and Americans never ended up lobbing missiles at each other: It would have been a lose-lose proposition to do so. Yet, the path from here to there will be a bumpy one. Investors should expect heightened volatility over the coming weeks. As It Turns Out, Trade Wars Are Neither Good Nor Easy To Win There was never any doubt that Wall Street would suffer from a trade war. What was less clear at the outset was the impact that higher tariffs would have on Main Street. Despite President Trump’s claim that the tariffs paid to the U.S. Treasury were “mostly borne by China,” the evidence suggests that close to 100% of the tariffs were, in fact, borne by U.S. companies and consumers. What investors need today is some reassurance that the current trade spat will not degenerate into a full-out trade war that undermines global commerce. A recent NBER paper compared the prices of Chinese imports that were subject to tariffs and similar goods that were not.3 Had Chinese producers been forced to bear the cost of the tariffs, one would have expected pre-tariff import prices to decline. In fact, they didn’t. The tariffs were simply absorbed by U.S. importers in the form of lower profit margins and by U.S. consumers in the form of higher selling prices. This does not mean that Chinese producers escaped unscathed. The paper showed that imports of tariffed goods dropped sharply as U.S. demand shifted away from China and towards domestically-produced goods and imports from other countries. Chart 2Support For Protectionism Rises When Unemployment Is High Support For Protectionism Rises When Unemployment Is High Support For Protectionism Rises When Unemployment Is High One might think that the decision to divert spending from Chinese goods to, say, Korean goods would be irrelevant for U.S. welfare. However, a simple thought experiment reveals that this is not the case. Suppose that a 10% tariff raises the price of an imported good from $100 to $110. If the consumer buys this good from China, the consumer will lose $10 while the U.S. government will gain $10, implying no loss in welfare. However, suppose the consumer buys the same good, tariff-free, from Korea for $105. Then the consumer loses $5 while the government gets no additional revenue, implying a net loss in national welfare of $5. Things get trickier when we consider the case where the consumer buys an identical domestically-produced good for say, $107, in order to avoid the tariff. If the economy is suffering from high unemployment, the additional demand will boost GDP by $107. The consumer who bought the domestically-produced good will be worse off by $7, but wages and profits will rise by $107, leaving a net gain of $100 for the economy. When unemployment is high, beggar-thy-neighbor policies make more sense. This is a key reason why support for protectionism tends to rise when unemployment increases (Chart 2). Today, however, the U.S. unemployment rate is at a 49-year low. To the extent that tariffs shift demand towards locally sourced goods, this is likely to require that workers and capital be diverted from other uses. When this occurs, there is no change in overall GDP. Within the context of the example above, all that would happen is that consumers would lose $7, reducing national welfare by the same amount. In fact, it is even worse than that. The example above does not include the impact on welfare from any resources that would need to be squandered from having to shift workers and capital equipment from sectors of the economy that lose from higher tariffs to those that gain from them. Nor does the example include the adverse impact on national welfare from any retaliatory policies. Ironically, while the evidence suggests that U.S. tariffs did not have much effect on Chinese import prices, it does appear that Chinese tariffs had an effect on U.S. export prices. Agricultural prices are highly sensitive to market conditions. Chart 3 shows that grain and soybean prices fell noticeably in 2018 on days when trade tensions intensified. This pattern has continued into the present. It is not surprising that Senators Chuck Grassley and Joni Ernst, along with other senior Iowa politicians, penned a letter to President Trump imploring him to reach a trade deal in order to help the state’s farming communities.4 Chart 3 China’s Secret Weapon: MMT To be fair, the arguments above do not account for the strategic possibility that the threat of punitive tariffs forces the Chinese to open their markets and refrain from corporate espionage and IP theft. If Trump is able to wrangle these concessions from the Chinese, then he could remove the tariffs, creating an environment more favorable to American corporate interests. The problem is that China will resist conceding so much ground. True, a trade war would hurt Chinese exporters much more than it would hurt U.S. firms. However, China is no longer as dependent on trade as it once was. Chinese exports to the U.S. account for only 3.6% of GDP, down from 7.3% of GDP in 2006 (Chart 4). China also has plenty of tools to support the economy in the event of a trade war. Chief among these is credit/fiscal stimulus. As we discussed three weeks ago, investors are underestimating China’s ability to ramp up credit growth in order to support spending throughout the economy.5 High levels of household savings have kept interest rates below the growth rate of the economy (Chart 5). When GDP growth exceeds the interest rate at which the government can borrow, even a persistently large budget deficit will produce a stable debt-to-GDP ratio in the long run. Chart 4China Is No Longer As Dependent On Trade With The U.S. As It Once Was China Is No Longer As Dependent On Trade With The U.S. As It Once Was China Is No Longer As Dependent On Trade With The U.S. As It Once Was Chart 5China: High Levels Of Household Savings Have Kept Interest Rates Below The Growth Rate Of The Economy China: High Levels Of Household Savings Have Kept Interest Rates Below The Growth Rate Of The Economy China: High Levels Of Household Savings Have Kept Interest Rates Below The Growth Rate Of The Economy   The standard counterargument is that governments cannot control the interest rate at which they borrow. This means that they run the risk of experiencing a vicious circle where high debt levels cause bond yields to rise, making it more difficult for the government to service its debt. This could lead to even higher bond yields and, eventually, default. However, this argument applies only to countries that do not issue their own currencies. Since a sovereign government can always print cash to pay for the goods and services, it can never run out of money. Chinese exports to the U.S. account for only 3.6% of GDP, down from 7.3% of GDP in 2006. The main reason a sovereign central bank would wish to raise rates is to prevent the economy from overheating. If a rising fiscal deficit is the consequence of a decline in private-sector spending (which is something that would likely happen during a trade war), there is no risk of overheating, and hence, there is no need to raise interest rates. We are not big fans of Modern Monetary Theory, but at least on this point, the MMT crowd is right while most analysts are wrong. Investment Conclusions It is impossible to say with any confidence what the next few days will bring on the trade front. If the Trump Administration’s allegation that the Chinese backtracked on prior commitments turns out to be true, it is possible that some of them will be reinstated, thus allowing the negotiations to resume. This could prompt Trump to offer a “grace period” to the Chinese of one or two weeks later tonight before scheduled tariff hikes are set to occur. If tariffs do go up, what should investors do? The answer depends on how much stocks fall in response to the news. If global equities were to decline by more than five percent, our inclination would be to get more bullish. There are two reasons for this. First, the failure to reach a deal this week does not mean that the talks will irrevocably break down. The point of Trump’s tariffs was never to raise revenue. It was to force the Chinese into a trade agreement that served America’s interests. With less than a year to go before the presidential campaign kicks into high gear, the self-described “master negotiator” needs to prove to the American public that he can actually negotiate a trade deal. This means some sort of an agreement is more likely than not. Second, as noted above, China will respond aggressively with fresh stimulus if the U.S. slaps tariffs on its exports. This will help cushion global growth and risk assets. Infrastructure spending tends to be more commodity intensive than manufacturing production. Thus, even if the Chinese government exactly offsets the loss of manufacturing exports with additional infrastructure spending, the net effect on global growth will probably be positive. China will respond aggressively with fresh stimulus if the U.S. slaps tariffs on its exports. In reality, there is a very high probability that the Chinese will do more than that. As the 2009 and 2016 episodes illustrate, when faced with a clear downside shock to growth, the government calibrates the policy response based on the worst-case scenario. Not only would a bout of hyperstimulus provide downside protection to the Chinese economy against a growth shock, it would also give the government more negotiating leverage with Trump. After all, it is much easier to brush away threats of punitive tariffs if you have an economy that is humming along. Investors should remain overweight global equities for the next 12 months, while positioning for a modestly weaker U.S. dollar and somewhat higher global bond yields. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Footnotes 1      David Lawder, Jeff Mason, and Michael Martina, “Exclusive: China backtracked on almost all aspects of U.S. trade deal – sources,” Reuters, May 8, 2019. 2      Please see Geopolitical Strategy Special Alert, “U.S. And China Get Cold Feet,” dated May 6, 2019. 3      Mary Amiti, Stephen J. Redding, and David E. Weinstein, “The Impact of the 2018 Trade War on U.S. Prices and Welfare,” NBER Working Paper No. 25672, (March 2019). 4      “Young, Ernst Lead Iowa Delegation in Letter Urging President Not to Impose Tariffs,” Joni Ernst United States Senator For Iowa, March 7, 2018. 5      Please see Global Investment Strategy Weekly Report, “Chinese Debt: A Contrarian View,” dated April 19, 2019. Strategy & Market Trends MacroQuant Model And Current Subjective Scores Chart 6 Tactical Trades Strategic Recommendations Closed Trades

Highlights Odds are that the recently improved access to financing will allow property developers to boost construction volumes modestly in the coming months. Yet, the outlook for new credit origination and government tolerance of another credit binge is highly uncertain. For now, the completion of previously launched projects will help construction-adjacent industries in the short run. However, these activities will consume real estate developers’ cash augmenting both their liquidity needs and financial vulnerability. That is a basis to underweight the Chinese real estate sectors within both the Chinese MSCI investable universe and the onshore A-share indexes. Feature The emergent divergence among Chinese property sales, starts and completions constitutes an exceptionally bizarre phenomenon. The gaps between these three indicators are currently unprecedented (Chart I-1). Understanding these divergences is critical to correctly gauging the outlook for the Chinese real estate market. This report aims to assess the growth outlook of these three variables. Odds are that these gaps will narrow going forward. Over the next three to six months, the Chinese property market is likely to be characterized by a contraction in floor space sold, a considerable relapse in floor space starts, and a rebound in floor space completions (Chart I-2). Chart I-1An Unprecedented Divergence… The Unprecedented Divergence The Unprecedented Divergence Chart I-2…But A Convergence Looms Convergence Ahead Convergence Ahead   In terms of the strength of construction activity in the Chinese property market, the real estate developers’ access to funding has been and remains the key. Over the next three to six months, the Chinese property market is likely to be characterized by a contraction in floor space sold, a considerable relapse in floor space starts, and a rebound in floor space completions. For now, we reckon the improved access to financing in recent months should help property developers to boost construction volumes modestly in the coming months (Chart I-3). Chart I-3Construction Activity Will Modestly Improve In The Coming Few Months Further Credit Easing Will Likely Lead To Rising Construction Activity Further Credit Easing Will Likely Lead To Rising Construction Activity That said, the current round of credit stimulus has probably been front-loaded in the first quarter, and property developers’ access to funding will begin to deteriorate again going forward. This will weigh on their ability to raise construction volumes materially. Understanding The Construction Cycle In China Floor space sold, starts and completions generally move in tandem. Specifically, strong sales lead rising starts, which then with a time lag result in increased completions. However, over the past 15 months, the growth rate of property starts has accelerated to over 20%, while sales have mildly contracted and floor space completions have been shrinking dramatically (Chart I-2). The key reason for these divergences has been the considerable financing difficulties facing property developers. Tighter monetary policy and credit beginning in late 2016 severely impaired developers’ ability to raise funds. This made Chinese real estate developers desperate for any source of possible revenue or financing. Launching new projects aggressively last year – i.e., more property starts – allowed real estate developers to pre-sell and get cash at a time when credit was tight.  Property developers were also aiming to conserve cash flow amid tight credit. After investing 25% of the total investment required for a property project (excluding the value of the land), they received a presale permit from the authorities. The permits allowed them to sell housing units in advance. Home-buyers had to pay at least 30% of the total property value at the time they signed the presale contract. This way, developers were able to obtain both deposits and advance payments1 (Chart I-4). This was a welcome addition to scarce financing last year. After this phase, property developers then slowed their investment in construction, installation and equipment purchases – because these would consume precious, limited cash. This depressed construction activity has resulted in a material contraction in floor space completed (Chart I-5). Chart I-4Developers’ Funding Has Improved Due To Deposits & Advanced Payments Rising Funding From Deposits And Advance Payments Rising Funding From Deposits And Advance Payments Chart I-5   Bottom Line: Launching new projects and pre-selling housing units while shrinking construction enabled Chinese real estate developers to stay afloat last year amid tight access to credit. What Does This Mean? There are two important implications related to this unprecedented divergence among property sales, starts and completions. The first is that raising funds via launching property starts along with shrinking completions has resulted in a significant increase in Chinese property developers’ liabilities. This is a form of borrowing money for property developers, and it has been occurring on top of very poor financial health. Specifically, Chinese real estate developers’ debt-to-equity ratio is currently above 4, and continues to surge (Chart I-6). Further, in 2018, 54 out of 131 Chinese property developers had negative free cash flow. This scheme of raising funding via new launches along with postponing building and completions is becoming unsustainable. The divergence between surging property starts and contracting completions suggests that real estate developers have raised funds through selling more uncompleted buildings instead of completed properties (Chart I-7, top panel). Chart I-6Chinese Property Developers Are Very Leveraged Chinese Property Developers Are Very Leveraged Chinese Property Developers Are Very Leveraged Chart I-7A Big Increase In Sales Of Uncompleted Buildings A Big Increase In Sales Of Uncompleted Buildings A Big Increase In Sales Of Uncompleted Buildings   Specifically, some 87% of total residential floor space sold in the past 12 months has been sold in advance, much higher than the approximate 77% total recorded in the years prior to 2018 (Chart I-7, bottom panel). The second important implication is that property developers’ ability to raise financing will determine the strength of property construction activities in China going forward. Chinese real estate developers are facing massive funding requirements this year. Developers need considerable amounts of funding this year to speed up their construction activities on delayed projects (launched but not completed ones). It generally takes about two years for real estate developers to complete a construction project and deliver the presold properties. Developers had already slowed their construction progress last year. They must accelerate the pace this year to ensure deliveries are made on time. Developers also need to roll over or repay significant amounts of debt coming due in 2019. On the whole, they have issued nearly RMB3.9 trillion of bonds so far, with most in the three- to five-year duration. Chart I-3 on page 2 shows that further improvements in credit flows in the economy will likely lead to ameliorating construction activity. Credit easing has allowed developers to raise funds through bank loans, bond issuances (both domestic and overseas) and other forms of borrowing (Chart I-8). Property developers’ ability to raise financing will determine the strength of property construction activities in China going forward. As a result, real estate investment in construction, installation and equipment purchases have all ameliorated in recent months (Chart I-9). This reflects a true pickup in real estate construction activities since the beginning of this year. Chart I-8Marginal Credit ##br##Easing Marginal Credit Easing Marginal Credit Easing Chart I-9   However, whether or not this latest improvement develops into full-fledged recovery is contingent on credit flows in the economy in general, and property developers’ access to financing in particular. If the overflow of credit decelerates after the massive binge that took place in the first quarter, it will weigh on construction activity. If the first-quarter credit binge persists, Chinese property developers will likely be able to raise sufficient funds to speed up property completions and roll over their maturing debt this year. In this scenario, construction activity will gather speed, facilitating a recovery in the overall economy.  At the current juncture, it is impossible to make a definite conclusion. The outlook for new credit flows and government tolerance of another credit binge is highly uncertain. On the one hand, the Politburo last month reiterated that China will push forward structural deleveraging and prevent speculation in the property market. Preliminary credit flow numbers for April appear to be very weak, not confirming blockbuster credit in the first quarter. Besides, the banking regulator has renewed pressure on banks to recognize non-performing loans and provision for them.2 This will curb banks’ ability to originate new loans and buy corporate bonds. On the other hand, an escalation of tensions between China and the U.S. and the uncertainty it is instilling in the economy and financial markets could lead the authorities to keep the credit taps open for longer, allowing credit to flow into the broader economy. Bottom Line: Real estate developers are extremely leveraged and lack cash to complete launched projects. Hence, property developers’ ability to raise financing holds the key in terms of the strength of property construction activities in China. Further easing in credit will likely lead to rebounding property completions and rising construction activity, and vice versa. What About Chinese Property Demand? Easy credit may alleviate the financing stress facing Chinese real estate developers and lift construction activity temporarily. However, the most important and sustainable source of funding for real estate developers is property sales. Chart I-10 shows that funding from property sales, including deposits, advance payments and mortgages assumed by property buyers, contributes nearly half of the sources of funds raised in that year. Chart I-10 Self-raised funds are the second-largest component of the source of funds, with a share of 34%. One major component of self-raised funds – retained earnings – are also closely related to property sales. The other major component is equity and bond issuance. Bank loans and foreign investment (including direct equity injections, sales of bonds and equity, and borrowing from foreign banks) together account for only about 15%. Even though there has been some credit easing for Chinese real estate developers, the bad news is that property sales are still in a structural downtrend. Chart I-11Slower PSL Injections Will Negatively Impact Property Demand Diminishing PSL Scheme Will Be Negative To Property Demand Diminishing PSL Scheme Will Be Negative To Property Demand As discussed in our previous reports,3 China’s property market is currently facing structural impediments. Low affordability, slowing rural-to-urban migration, demographic changes, the promotion of the housing rental market and the government’s continuing emphasis on clamping down speculation are together generating strong structural headwinds for property demand in China. Importantly, surging property demand between late 2015 and 2017 was mainly driven by the Chinese central bank’s direct lending to the real estate sector, which is not sustainable. Our calculations indicate that about 20% of floor space sold (in volume terms) in 2017 was due to the Pledged Summary Lending (PSL) facility designed for slum area reconstruction.4 Indeed, the central bank’s PSL injections have already decelerated considerably since last year (Chart I-11). This has resulted in contracting overall property sales. Late last month, the authorities significantly cut their slum-area reconstruction target by more than one-half – from 6.4 million units last year to 2.85 million units this year. This suggests the amount of PSL injections will decline correspondingly (Chart I-12). Chart I-12 Besides the diminishing PSL scheme, some other factors are also signaling a dismal outlook for Chinese property demand. A deep and long contraction in property demand in rich provinces indicates demand saturation (Chart I-13). Sales outside eastern provinces track PSL injections very closely, as per Chart I-11, and are facing headwinds. Chinese households are more leveraged than U.S. ones, with the former’s debt-to-disposable income ratio having surpassed that of the latter (Chart I-14). Chart I-13Demand Is Saturated In China’s (Richer) Eastern Provinces Demand Saturation In Rich Eastern Provinces Demand Saturation In Rich Eastern Provinces Chart I-14China’s Household Debt Burden Is Very Elevated Escalated Household Debt In China Escalated Household Debt In China   Chart I- In addition, mortgage rates in China have not dropped much, despite monetary policy easing in the past 12 months. Recent data shows the average mortgage rate paid by first-time homebuyers has fallen from 5.71% last November to 5.56% this March, a still-high number. With respect to the ability to service mortgage payments, on a 90-square-meter house with a 30% down payment, our calculations show that annual interest costs account for about 27% of average household disposable income levels (Table I-1). Overall, poor affordability for Chinese homebuyers will constrain property demand in the coming years. Finally, the government is quite determined to implement its property tax in a few years. Local governments’ financing needs will become more acute as revenue from land sales decline substantially. China’s property market is on the way to becoming the market dominated by second-hand properties instead of new buildings – similar to many developed countries. Critically, the progress in establishing property tax laws in China seems to be accelerating. There have been more high-level meetings and discussions about the property tax law, and these meetings/discussions are becoming more detailed and concrete. Bottom Line: Chinese housing demand will be in a structural downtrend, weighing on construction activity beyond any near-term rebound. Investment Implications Based on the above findings, we draw the following investment strategy conclusions: It is reasonable to expect a slight pickup in real estate construction activity in China over the next few months. This will be marginally positive for construction-related commodities demand. Consequently, construction-related commodities markets (steel, cement, and glass) may be supported in the near term (Chart I-15). However, over the longer term, we remain fundamentally negative on construction activity within China’s property markets, as property sales will be in a structural downtrend. BCA’s Emerging Market Strategy service recommends equity investors underweight Chinese property developers within the Chinese equity indexes (Chart I-16). Chart I-15Construction-Related Commodities May Marginally Benefit From A Pickup In Activity Contraction Commodities Prices May Marginally Benefit Contraction Commodities Prices May Marginally Benefit Chart I-16Underweight Real Estate Stocks Relative To The Domestic And Investable Benchmarks Underweight Real Estate Stocks Within Respective Chinese Investable Universes Underweight Real Estate Stocks Within Respective Chinese Investable Universes   The completion of previously launched projects will help construction-related industries. Yet, these activities will consume real estate developers’ cash augmenting their liquidity needs and amplifying their financial vulnerability. This is a basis for our recommendation to underweight property stocks, especially following their significant outperformance in the past six months.  Further, property stocks respond to marginal changes in financing conditions rather than housing sales or construction activities. The basis is that they are extremely leveraged, and access to funding is key. In the coming months, if credit conditions tighten at a time when real estate developers must commit cash to complete previously launched projects, their cash flow will deteriorate. This will be reflected in their share prices, which will underperform the Chinese broader onshore and offshore indexes. This is likely to occur regardless of the absolute performance of Chinese stocks. Ellen JingYuan He, Associate Vice President ellenj@bcaresearch.com Footnotes 1      Chinese real estate developers could also slow the construction activity after completing 50% of a property project, which allows them to receive at least 60% of the presold property value from house buyers. 2      https://www.bloomberg.com/news/articles/2019-05-06/china-is-said-to-imp… 3      Please see Emerging Markets Strategy Special Report “China Real Estate: A Never-Bursting Bubble?” dated April 6, 2018 and China Investment Strategy Special Report “China’s Property Market: Where Will It Go From Here?” dated September 13, 2018. 4      Please see China Investment Strategy Special Report “China’s Property Market: Where Will It Go From Here?” dated September 13, 2018. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Feature For a decade, mainstream economics has prescribed remedies for sluggish growth in the euro area on the basis of three articles of blind faith. First, that the ailment arises from structural impediments to growth; second, that in response to an ailing economy, ultra-loose monetary policy is always and everywhere effective; and third, that ‘Keynesian’ government stimuluses are at best a necessary evil and at worst a recipe for disaster. As a result, European policymakers have expended much time and energy attempting structural reforms, experimenting with ultra-loose monetary policy, while shirking government borrowing and spending. But have policymakers misdiagnosed the ailment? Chart of the WeekItaly’s Private Sector Is Paying Back Debt Italy's Private Sector Is Paying Back Debt Italy's Private Sector Is Paying Back Debt Why The Focus On Public Deficits And Debt Might Be Misplaced We frown upon government deficits. They are associated with crowding out and misallocation of resources. But when the private sector is running a financial surplus, the exact opposite is true. Government borrowing and spending causes no crowding out because the government is simply utilising the private sector’s surplus savings and debt repayments. And importantly, this deficit spending prevents a deflationary shrinkage of the broad money supply. Most people are aware of the size of government deficits. Few people are aware of the size of private sector surpluses; and the leakage from the national income stream that they create. By not making this connection, people might believe that government deficits are profligate. But if the private sector as a whole has a financial surplus, it makes sense for the government to borrow to support economic growth. In a similar vein, an economy’s debt sustainability depends on its total indebtedness, not on its public indebtedness or its private indebtedness in isolation. Debt becomes unsustainable when the marginal extra euro of debt results in misallocation of resources and mal-investment. At this point, the extra debt adds nothing to growth or, worse, it subtracts from growth. This is also the point at which lenders tend to be unwilling to provide the marginal loan. Therefore, debt reaches its sustainable limit when the economy has exhausted all productive uses for it. Deficit spending can prevent a deflationary shrinkage of the broad money supply. It does not matter whether these productive uses are funded with private debt or with public debt. For example, successful economies require investment in high-quality healthcare and education. Some economies fund this with private debt, while others fund it with public debt. This means that if productive private indebtedness is low, there is more scope for productive public indebtedness. Many people believe that Italy has one of the world’s most indebted economies. But this belief is wrong. Although Italy’s public indebtedness is high, Italy’s private indebtedness is one of the lowest in the world, making Italy’s total indebtedness less than that of France and the U.K., and broadly equal to that of the U.S. (Chart I-2-I-5). Crucially, Italy’s extremely low private indebtedness means that it could afford relatively high public indebtedness before reaching the limit of debt sustainability. Chart I-2Italy: Total Debt = 250% Of GDP Italy: Total Debt = 250% Of GDP Italy: Total Debt = 250% Of GDP Chart I-3France: Total Debt = 315% Of GDP France: Total Debt = 315% Of GDP France: Total Debt = 315% Of GDP Chart I-4U.K.: Total Debt = 280% Of GDP U.K.: Total Debt = 280% Of GDP U.K.: Total Debt = 280% Of GDP Chart I-5U.S: Total Debt = 250% Of GDP U.S: Total Debt = 250% Of GDP U.S: Total Debt = 250% Of GDP   Italy And Japan: Compare And Contrast In a normal world, the task of ensuring that private sector savings are borrowed and spent falls on the banks, which take in the savings and debt repayments and lend them out to others in the private sector who can make the best use of the funds. But if a dysfunctional banking system fails this task, the savings generated by the private sector will find no borrowers. The unrecycled funds become a leakage from the national income stream generating a persistent deflationary headwind for the economy. Welcome to Italy! Since 2008, the stock of loans to Italian households and firms has been stagnant while in real terms it has fallen (Chart of the Week). The upshot is that the real money supply has shrunk despite low private sector indebtedness, low interest rates and massive injections of ECB liquidity into the banking system. Japan’s public sector levering has been counterbalancing its private sector de-levering. After the 2008 global financial crisis Italian banks’ balance sheets were left unrepaired and undercapitalized. For an individual bank whose solvency is impaired, the right thing to do is shrink its loan book relative to its equity capital. But when the entire banking system is doing this simultaneously, the economy falls into a massive fallacy of composition: what is right for an individual bank becomes very deflationary when all banks are doing it together. Under these circumstances, an agent outside the fallacy of composition – namely, the government – must counter this deflationary headwind by borrowing and spending the un-recycled private sector savings. Welcome to Japan! The Japanese government has been doing precisely this for the past 25 years. Many people fret about the Japanese government’s persistent deficits and its ballooning public debt. What these people do not realise is that these persistent deficits are simply counterbalancing private sector de-levering. Hence, Japan’s all-important total (public plus private) indebtedness as a share of GDP has not been rising (Chart I-6). In Italy, the banking system has been dysfunctional for over a decade, preventing the private sector from borrowing (Chart I-7). Under these circumstances, the Italian government could borrow the private sector’s excess savings and debt repayments and put them to highly productive use, just like in Japan. Chart I-6Japan’s Persistent Deficits Have Been Counterbalancing Private Sector De-levering Japan's Persistent Deficits Have Been Counterbalancing Private Sector De-levering Japan's Persistent Deficits Have Been Counterbalancing Private Sector De-levering Chart I-7The Italian Banking System Has Been Dysfunctional The Italian Banking System Has Been Dysfunctional The Italian Banking System Has Been Dysfunctional Japan and Italy have quite similar demographics, but there is also a big difference. Despite the Japanese government’s persistent deficit and ballooning debt, the 10-year Japanese government bond seems not the slightest bit concerned and is yielding zero. Whereas in Italy, where the government finances are close to structural balance, the merest hint of a Keynesian stimulus sent the 10-year BTP yield rocketing towards 4 percent. Why? The answer is that Italy does not have its own central bank. The Japanese government bond yield is a direct function of the BoJ’s expected monetary policy. But the Italian BTP yield has two components: the ECB’s expected monetary policy plus a risk-premium for currency redenomination in the event that Italy left the euro. Italy’s problem is that even if modest deficit spending was the right policy, it would take time to prove. Meanwhile, bond vigilantes shoot first and ask questions later. The euro debt crisis was essentially a fear of currency redenomination which resulted from bond vigilantes running amok. When bond markets refuse to lend to sovereigns at a rational interest rate, maturing debt has to be refinanced at a penalising interest rate, causing an undeserved deterioration in the government’s finances. Thereby, the fear of redenomination could become a self-fulfilling prophecy. In Italy, the banking system has been dysfunctional for over a decade. The bottom line is that every economy has its own ‘tipping-point’ interest rate, at which its debt financing can flip from stability to instability. But we believe this interest rate is low everywhere. Modern Monetary Theory Simplified Modern Monetary Theory (MMT) is a hot topic of the moment. Our view is that its breakthrough is to establish the ‘appropriate’ public sector deficits in the context of private sector surpluses, and it simplifies to this question: In highly indebted economies, what is the interest rate needed to keep total (public plus private) indebtedness as a share of GDP stable, and prevent a deflationary shrinkage of the broad money supply? The answer differs slightly from economy to economy because private sector indebtedness is modestly rising in some places, stable in a few, while declining in others (Chart I-8).  But crucially, at a global level, total indebtedness is stabilising with the global bond yield within a historically depressed sideways channel (Chart I-9). Chart I-8Private Sector Indebtedness Is Not Rising As A Whole Private Sector Indebtedness Is Not Rising As A Whole Private Sector Indebtedness Is Not Rising As A Whole Chart I-9The Global Long Bond Yield Has Been In A Sideways Channel The Global Long Bond Yield Has Been In A Sideways Channel The Global Long Bond Yield Has Been In A Sideways Channel Admittedly, the global bond yield is now at the bottom of this channel. This means that from a tactical perspective, we can expect 10-year yields to go up about 50 bps before hitting the top of the channel. However, from a structural perspective, the interest rate needed to stabilise total indebtedness as a share of GDP now appears to be extremely low. And this means that structurally low bond yields are here to stay. Finally, I am excited to report that two of the main commentators on MMT – Richard Koo and Stephanie Kelton – are keynote speakers at our annual conference on September 26-27 in New York City. Suffice to say it will be an event not to be missed! Fractal Trading System* There are no new trades this week, leaving five open positions. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 Short the 10-Year OAT Short the 10-Year OAT The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. *  For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com Dhaval Joshi, Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields   Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Highlights So what? The U.S.-China deal is not shaping up as well as the consensus holds. Why? The odds of reaching a deal by June are rising, but no higher than 50%. Unemployment is a constraint on the Chinese side but stimulus reduces urgency. Structural concessions on currency and foreign investment are limited in scope. Strategic concessions are limited to North Korea; Taiwan risks are rising. Stay overweight U.S. and Chinese equities on a relative basis at least until the deal is signed.   Feature Once again investors are faced with a stream of headlines suggesting that a U.S.-China trade deal is all but finished, only to find critical caveats buried on page six. For instance, President Donald Trump and President Xi Jinping have not yet scheduled a summit to sign a trade agreement, though Trump insists a summit is necessary. Chief U.S. negotiator Robert Lighthizer says that he is “hoping but not necessarily hopeful.”1 There is still room for U.S. and Chinese bourses to outperform on a relative basis while negotiations continue. Still, the news flow is encouraging. Trump has said “we’ve agreed to far more than we have left to agree to,” while Xi Jinping has called for an “early conclusion of negotiations.” The other negotiators are also making positive sounds, with Vice Premier Liu He saying that a “new consensus” has been reached on a text of the trade agreement. National Economic Council Director Larry Kudlow says that key structural issues are on the table and that negotiations are continuing by videoconference after two successful rounds of direct talks in Beijing and Washington. Even the notorious China hawk, Peter Navarro, Director of the U.S. National Trade Council, has begrudgingly admitted that the two sides are in the final stage of the talks, saying, “the last mile of the marathon is actually the longest and the hardest.”2 Readers know that we take a pessimistic view of U.S.-China relations over the long run. We were skeptical about the possibility of a tariff truce on December 1. However, the signs are stacking up in favor of a deal. While we would not be surprised if talks extended to the June 28-29 G20 summit in Osaka, Japan, President Trump has suggested that a summit could come as early as May 5-19. Chart 1Still Some Room To Run Still Some Room To Run Still Some Room To Run Judging by the performance of U.S. and Chinese equities relative to the rest of the world since the first tariffs were imposed on June 14, 2018, there is still room for these two bourses to outperform on a relative basis while negotiations continue. Relative to global equities excluding China and U.S., Chinese stocks have retraced 78% of the ground they lost, while U.S. stocks have not surpassed the high points reached at the peak of the global economic divergence in 2018 (Chart 1). Once a deal is reached, will investors that bought equities on the rumor sell the news? We would buy, though equity leadership should rotate away from the U.S. and China depending on the timing and external conditions discussed below. As a House we are overweight global equities on a 12-month horizon. Xi Is Not Mao China’s economic stimulus is a key swing factor for global growth and the corporate earnings outlook this year. Our China Investment Strategy has highlighted that the BCA Activity Indicator has now fully registered the negative impact of trade tariffs as well as the broader slowdown (Chart 2). Chart 2Slowdown Fully Priced In Slowdown Fully Priced In Slowdown Fully Priced In Previously it was more buoyant than our leading indicator suggested it should be, largely because companies placed orders throughout the second half of 2018 to front-run Trump’s tariffs and this artificially boosted China’s exports and manufacturing activity. Now that this front-running is over, any improvement or deterioration in underlying monetary conditions, money supply, and lending should be reflected in the BCA Activity Indicator itself. Hence a stout credit number for March will cause an uptick that will confirm that China’s economy is recovering. We expect this to occur because, to be blunt, President Xi Jinping is not truly a modern-day Chairman Mao Zedong. While he has revived aspects of Maoism, he has responded pragmatically, rather than ideologically, to the Communist Party’s Number one political constraint: the tradeoff between productivity and employment. When Xi consolidated power in 2017, he launched a deleveraging campaign and doubled down on various structural reforms in order to make progress in rebalancing China’s economy. The result was renewed weakness in the labor market as the stimulus measures of 2015-16 wore off (Chart 3). Labor “incidents,” or protests, particularly those sparked by the relocation of workers from closed factories, began to rise again (Chart 4). Significantly, the number of bankruptcies also increased, demonstrating that the government was willing to tolerate some economic pain in order to make the allocation of capital more efficient (Chart 5). Chart 3A Key Constraint On Xi Jinping A Key Constraint On Xi Jinping A Key Constraint On Xi Jinping Chart 4Labor Incidents On The Rise Labor Incidents On The Rise Labor Incidents On The Rise Chart 5 China’s policymakers pursued these reforms while believing that President Trump’s threat of a trade war was largely bluster. But when Trump proceeded to impose tariffs, confidence collapsed and China’s private sector found itself sandwiched between stricter government at home and an impending squeeze of demand abroad. The labor and business indicators in Charts 3-5 suffered further deterioration in 2018 as animal spirits evaporated across the economy. President Xi’s response could have been to close China’s doors to trade and to the West and undertake an even more aggressive purge of “capitalist roaders.” The possibility is inherent in his cult of personality, aggressive anti-corruption campaign, and cyber-security state apparatus. This would have meant a dramatic reckoning with the country's economic and financial imbalances, but it would have given the hardliners in the Communist Party an opportunity to establish absolute control and national “self-sufficiency.” Instead, Xi entered into talks with Trump and launched supply-side, tax-and-tape-cutting measures to stimulate private economic activity, and boosted fiscal spending. He chose reflation rather than revolution. Chinese stimulus does not make a trade deal more likely in itself, as it gives President Xi more leverage in negotiations. But without a trade deal, private sector sentiment and animal spirits will remain depressed and stimulus measures will eventually falter. So it makes sense that Xi wants a deal. China will be the center of two market-positive outcomes in the near term: more domestic reflation and less conflict with the United States. To put this into context: if China’s credit impulse turns positive it will push the overall fiscal-and-credit impulse higher than 2% of GDP (Chart 6), foreshadowing a rebound in Chinese imports and global growth and enabling China’s own corporate earnings to recover. Our China Investment Strategy estimates that if the past three months’ rate of credit growth continues, while manufacturing sentiment improves on a trade deal and the renminbi remains flat, then the probability of an earnings recession on the MSCI China Index falls from 92% to 21%, as shown in Chart 7. From a policy perspective this looks conservative, as the actual rate of credit growth will probably be faster than that of the past three months. Chart 6Credit Will Add To Fiscal Boost Credit Will Add To Fiscal Boost Credit Will Add To Fiscal Boost Chart 7Earnings Unlikely To Contract Earnings Unlikely To Contract Earnings Unlikely To Contract Of course, President Trump has even more acute political constraints than President Xi urging him toward a deal. A deterioration in the U.S. manufacturing sector is a serious liability, especially in the Midwestern battleground states (Chart 8), and Trump has apparently calculated that a tailored infusion of Chinese cash and promises is a better reelection strategy than a continuation of trade war amid a slowdown.   Chart 8A Key Constraint On Donald Trump A Key Constraint On Donald Trump A Key Constraint On Donald Trump The implication of all of the above is that China will be the center of two market-positive outcomes in the near term: more domestic reflation and less conflict with the United States. The former is not yet consensus, while the latter is lacking in specifics. Yet both are beneficial for Chinese equities on an absolute and relative basis. And once there is a concluded trade deal and clarity over stimulus, emerging markets can also outperform their developed market counterparts. Note that we do not expect China to launch a massive 2008-09-style stimulus unless the tariff war reignites. Such an outcome would only be bullish for some EMs, since beneath the initial surge in Chinese imports would lie the disruption of the global supply chain and broader de-globalization. Bottom Line: Unemployment is a key political constraint suggesting both that China’s stimulus will surprise to the upside and that a trade deal is forthcoming. We are reducing the odds of an extension of trade talks beyond June from 35% to 20%, leaving a 50% chance for some kind of trade deal to emerge by the end of that month (Table 1). Table 1Updated Trade War Probabilities (April 2019) U.S.-China Conflict: The End Of The Beginning U.S.-China Conflict: The End Of The Beginning Trump Is Not Nixon If Xi is not Mao, then Trump is not Nixon. Despite a likely trade deal, we are not on the verge of a historic 1972-esque “grand compromise” that will usher in a new era of U.S.-China engagement. This should temper enthusiasm regarding the long-term durability of the trade truce, highlighting that China’s credit data is the more important factor for the 12-month horizon, though the trade issue is an impediment that needs to be removed for a sustainable rally. China may be increasingly willing to embrace structural concessions, but the depth of the structural change should be doubted until the details of the trade deal prove otherwise. For example, at the moment there is still no agreement on tariff levels. And there can be no “enforcement mechanism” to satisfy the U.S. side other than the perpetual threat of tariffs, which erodes trust and discourages Chinese implementation of structural changes. Two structural issues highlight the conundrum: currency and foreign investment. First, while the details of the currency agreement are unknown, the U.S. will definitely not get anything comparable to what it got from Japan after the Plaza Accord in 1985. The Japanese were a subordinate ally to the U.S. in the midst of the Cold War; they did not negotiate with the suspicion that the U.S. secretly wanted to destroy their economy. China has neither the security guarantee nor the economic trust. The implication is that the CNY-USD may rise by about 10% or so from current levels (Chart 9), as opposed to the 54% that the JPY-USD witnessed from 1985-88. The upside for the U.S. is that Trump may get some yuan appreciation, while the upside for China is that limited appreciation means no excessively deflationary impact. Chart 9Currency Agreement: Far From A Plaza Accord Currency Agreement: Far From A Plaza Accord Currency Agreement: Far From A Plaza Accord Second, China’s new foreign investment law, which received a rubber stamp from the legislature in March, is not an unqualified success for American negotiators. We have illustrated this in Table 2 by denoting white flags for aspects of the law that are genuine concessions and red flags for aspects that will raise new suspicions about China’s foreign investment framework. It is a mixed bag. Moreover, the law itself has no power and will depend entirely on the central government’s dedication to imposing strict adherence down through the local layers of government, where forced technology transfer actually takes place. Table 2New Foreign Investment Law: A Mixed Bag U.S.-China Conflict: The End Of The Beginning U.S.-China Conflict: The End Of The Beginning American negotiators will also want bilateral agreements on tech transfer and intellectual property protection since otherwise they will not receive any particular benefit from a law that applies equally to all foreign investors (e.g. Europeans). But it is not yet clear that they will get anything more concrete. The upside for the U.S. is that it will have some means of redress for forced tech transfer and intellectual property theft, while the upside for China is that foreign direct investment should improve. The strategic conflicts between the U.S. and China are even less likely to be dealt with than the economic issues. How can we be sure? Peer Competition: The U.S.-China détente under Nixon occurred at a time when a vast asymmetry between U.S. and Chinese national power existed, whereas today China’s power increasingly rivals that of the U.S., making it easier for China to write its own rules for global interactions and to resist U.S. pressure (Chart 10). Unilateralism: Trump did not leverage American alliances and partnerships across the world to create a “coalition of the willing” to confront China over its mercantilist trade and investment practices. There is some cooperation but it has been inconsistent and tentative, even on deep national security concerns like Huawei’s involvement in 5G networks and the Internet of Things. Had the U.S. created such a coalition and then set out to prosecute its claims, the threat to China’s economy would have been so immense that much greater structural changes could be expected than is the case today (Chart 11). Chart 10The Era Of U.S.-China Detente Is Over The Era Of U.S.-China Detente Is Over The Era Of U.S.-China Detente Is Over Chart 11Trump Eschewed A Coalition Of The Willing Trump Eschewed A Coalition Of The Willing Trump Eschewed A Coalition Of The Willing Core Interests: The trade talks only nominally address dangerous conflicts in China’s near abroad. China’s enforcement of sanctions on North Korea has produced limited results so far but we ultimately expect diplomacy to bear fruit (Chart 12). However, Taiwan is more rather than less likely to be the site of conflict. This is not because of pro-independence sentiment, which is actually on decline in public opinion relative to pro-unification sentiment (Chart 12, second panel). It is because the lame duck Tsai Ing-wen administration may attempt to secure last-minute benefits from the U.S., while an unexpected primary election challenge could lead to the nomination of Lai Ching-te (William Lai), a more outspoken pro-independence candidate, on April 24. Either could provoke Beijing. There is zero chance that any trade deal in the coming months will reduce the threat of reunification of Taiwan by force. Underlying distrust will remain. Chart 12Geopolitical Risk Down In Korea But Up In Taiwan Geopolitical Risk Down In Korea But Up In Taiwan Geopolitical Risk Down In Korea But Up In Taiwan Furthermore, the South China Sea is not a “red herring” but a potential “black swan,” as it is connected to Taiwan’s security and more broadly to U.S. alliance security. After all, 96%-97% of Taiwan’s, South Korea’s, and Japan’s oil imports flow through these sea lanes. Critical supplies become vulnerable if China expands its military’s capabilities there (Diagram 1). The U.S. and China will likely be just as provocative as before in this area after they sign a deal. Technology: The tech conflict is more likely to limit the trade deal than vice versa. The sanctions and embargoes on Chinese companies like ZTE, Fujian Jinghua, and Huawei have operated on a separate track from the trade talks, and it is not at all clear that the U.S. will embrace Huawei as part of any final deal. The initial actions of the newly beefed-up Committee on Foreign Investment in the United States (CFIUS) send warning signals. CFIUS is largely a vehicle for U.S. oversight of China (Table 3) and, if anything, that country-specific focus is intensifying. For instance, the U.S. has deemed Chinese ownership of a gay and lesbian hook-up app, Grindr, to pose an excessive national security risk.3 This is not a high bar for intervention and it suggests that any trade deal will fail to improve China’s investment options in the U.S. tech sector. Diagram 1South China Sea As Traffic Roundabout U.S.-China Conflict: The End Of The Beginning U.S.-China Conflict: The End Of The Beginning Table 3CFIUS Is Mostly About China U.S.-China Conflict: The End Of The Beginning U.S.-China Conflict: The End Of The Beginning The takeaway is that while both sides want a deal over the short term, it will not mark the end of the trade war. It is more likely the end of the beginning of a cold war. As long as China’s economy and industrial capabilities continue to grow relative to the United States, its geographic periphery remains a cauldron of geopolitical risks, and its technological advancement remains rapid, the competition will continue. Bottom Line: There is no substantial evidence from the current trade talks that underlying strategic conflicts will be resolved. This implies that the U.S. and China will shift their focus to these conflicts in the weeks and months after any trade deal. That process will be a nuisance to global equity markets expecting a clean deal; Chinese and American tech stocks in particular will remain exposed to tail risks. The status of Chinese tech companies is a critical risk, as a deal for the U.S. to admit Huawei would be a game-changer. Investment Conclusions Ironically, an early resolution of the trade war – in April or May – offers less of a benefit for Chinese equities and other risk assets than a later resolution in June or thereafter. While we expect to have greater clarity on China’s stimulus magnitude from the March data, it is still possible that stimulus will remain mixed or disappointing. Stimulus measures may also be toned down after a deal is approved, which means that an earlier deal would reduce the total stimulus by the end of 2019. The Trump administration will use the new flexibility gained from a China deal to toughen its policies in other areas, potentially with negative market consequences. The decision to designate the Iranian Revolutionary Guard Corps (IRGC) as a foreign terrorist organization is an important example. This decision is squarely within the Trump administration’s policy of pressuring Iran, which is a high-risk policy with substantial market-relevance. Trump may have made the decision in order to save face while planning to renew waivers on Iranian oil sanctions on May 4 – we would be extremely surprised if he did not renew. Sanctioning the IRGC involves a string of consequences but it is not a direct attack on oil supply that could produce an oil shock dangerous to Trump’s re-election prospects in 2020 (Chart 13). Of course, Iran will retaliate to the IRGC blacklisting – and one way it could do so would be through oil production in various places, including Iraq. The result would be oil volatility and higher prices. Chart 13 Further, an early deal could encourage Trump to instigate a trade war with Europe. Trump’s four-to-six week time frame for the conclusion of talks with China is conspicuously close to the tentative May 18 deadline by which he is required to determine whether to impose tariffs on foreign auto and auto part imports (Chart 14). Such tariffs would be pursuant to the Section 232 investigation that likely found such imports a threat to national security. We have argued that a U.S.-China deal raises the risk of tariffs on European cars to 35%, with Japanese and Korean cars less at risk, progressively. The EU is ready to retaliate so this would be a drawn-out trade conflict. Chart 14 Chart 15   By contrast, we are less concerned about the market impact of Trump’s recent threats to close the border with Mexico or include Mexico in car tariffs (Chart 15). True, Trump could close the border and generate a temporary drag on trade and the border economy. However, the Republicans have limited patience for the economic blowback of an extended border closure, and Trump cannot afford to jeopardize passage of his USMCA trade deal as long as he has alternative ways of looking tough on the border. Geopolitical Strategy would view the U.S. and China as good overweights relative to global equities and within their respective developed and emerging market contexts. What about a later resolution of the trade deal, in June or later in the summer? This would remove some risks. By that time, the Iran decision and possibly the car tariff decision will be past and there will be greater clarity on the magnitude of China’s stimulus. More extensive negotiations could also suggest that the ensuing trade deal will resolve deeper disagreements – unless the talks drag on without consequence amid signs of declining trust. Given the risk of trade war with Europe, oil volatility, and uncertainties about China’s stimulus, Geopolitical Strategy would view the U.S. and China as good overweights relative to global equities and within their respective developed and emerging market contexts. When and if the above political hurdles are cleared, the emphasis can shift to other bourses. Geopolitical Strategy’s preferred emerging market plays are EM energy producers and EM Asian states like Thailand and Indonesia.   Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1 See Ailsa Chang, “U.S. Trade Representative Robert Lighthizer Discusses Ongoing Trade Talks With China,” National Public Radio, March 25, 2019, www.npr.org. 2 For the above quotations see Andrew Mayeda, Xiaoqing Pi, and Margaret Talev, “Kudlow Sees No Letup in China Talks as Both Sides Cite Progress,” Bloomberg, April 4, 2019, www.bloomberg.com. 3 See David E. Sanger, “Grindr Is Owned by a Chinese Firm, and the U.S. Is Trying to Force It to Sell,” March 28, 2019, www.nytimes.com.

Highlights Many on the left have embraced Modern Monetary Theory because it seemingly provides a politically expedient way to increase social welfare spending without raising taxes. Money-financed budget deficits can be justified when an economy is stuck in a liquidity trap, but can be extremely inflationary once full employment is reached. Investors should regard MMT as simply an extreme example of the increasingly permissive attitude that policymakers are adopting towards inflation and larger budget deficits. The path to high rates is lined with low rates, meaning that an extended period of accommodative monetary policy is usually necessary to stoke inflation. Investors should maintain a bullish bias towards global equities for now, but be prepared to turn bearish late next year as inflation begins to accelerate in the United States. An earlier turn to a more defensive posture on stocks may be necessary if Bernie Sanders, or some other far-left candidate, emerges as the likely victor in the next presidential election. Feature Print Some Money And Feel The Bern You know that an economic theory has reached the big leagues of policy debate when the Fed Chair is asked about it during his congressional testimony. This is exactly what happened on February 26, 2019, when Senator David Perdue questioned Jay Powell about his views on Modern Monetary Theory, or simply MMT as it is often called. Rather ironically given its name, MMT plays down the influence of monetary policy over the economy. Its adherents argue that Congress, and not the Fed, should be responsible for maintaining full employment. MMT proponents abhor the idea of a “balanced budget.” They contend that worries about sovereign debt levels are overblown. The U.S. government can always print money to finance itself. Fiscal deficits matter, but only to the extent that excessive deficits can cause inflation. The theory’s backers are a bit cagey about exactly how much inflation they are willing to tolerate or what they would do if, as in the 1970s, inflation and unemployment both rose together. Whether one thinks MMT is crackpot economics is not the point. What matters is that its supporters are growing in number. They include Stephanie Kelton, Bernie Sanders’ former economic advisor, and one of the speakers at BCA’s forthcoming annual New York Investment Conference. In my personal opinion, Sanders stands a very good chance of winning the 2020 presidential election. This makes MMT about as market-relevant as anything out there. In the following Q&A, we discuss the details of MMT and what it means for investors: Q: How does Modern Monetary Theory differ from standard Keynesian economics? A: MMT is almost indistinguishable from Keynesian economics when an economy is stuck in a liquidity trap, an environment where even interest rates of zero are not enough to revive demand. What really separates the two schools of thought is that MMT proponents tend to see liquidity trap conditions as the normal state of affairs, whereas most Keynesians see them as the exception to the rule. Q: Who’s right? The Keynesians or the MMTers? A: That remains to be seen. Near-zero rates have been the norm for most of the last decade, and much longer in Japan. This is a key reason why MMT has grown in popularity. The future may be different, however. Output gaps are shrinking and some of the structural forces which have held down rates over the last decade may fade. For example, the ratio of workers-to-consumers has peaked around the world, which may result in a decline in global savings (Chart 1). This could push up interest rates. Chart 1The Worker-To-Consumer Ratio Has Peaked Globally The Worker-To-Consumer Ratio Has Peaked Globally The Worker-To-Consumer Ratio Has Peaked Globally Q: Does the tendency of MMT backers to see the world as chronically ensnarled in a liquidity trap explain why they seem to consistently argue for bigger budget deficits? A: It does. If an economy needs negative interest rates to reach full employment, but actual rates are constrained by the zero-lower bound, anything which incrementally adds to aggregate demand will not result in higher rates. This means that increased government spending will not crowd out private investment – indeed, quite to the contrary, bigger budget deficits will “crowd in” private spending by boosting employment. The standard MMT prescription is to run a budget deficit that is large enough, but no larger, to maintain full employment. In effect, this means taking any excess private-sector savings – that is, savings which cannot be transformed into private investment or exported abroad via a current account surplus – and having the government absorb them with its own dissavings. Q: So MMT supporters are assuming that the government is competent and agile enough to tighten and loosen fiscal policy at exactly the right time? Good luck with that. A: Yes, that is a common problem with most left-wing theories: They assume that the government should not be trusted with anything unless it is run by fellow leftists, in which case it should be trusted with everything. To make the fiscal response timelier, MMT supporters have proposed creating a government job guarantee. The basic idea is that the government would hire more workers when the private sector is hunkering down, while shedding workers when the private sector is expanding. In theory, automatic fiscal stabilizers of this sort could help dampen the business cycle. The consensus among MMT backers in the U.S. is that a $15 wage would be high enough to offer a tolerable standard of living without enticing many people to opt for government work when suitable private-sector employment is available. MMT supporters are assuming that the government is competent and agile enough to tighten and loosen fiscal policy at exactly the right time. Unfortunately, as is often the case with such ideas, the devil is in the details. For example, does the $15 wage include potentially generous government benefits? What will the government do if someone shows up for work but decides to just loaf around? What about low-skilled workers who would be more productive in the private sector but are instead diverted into government make-work projects? Inquiring minds want to know. Q: And the price tag could be huge! Wouldn’t an extended period of large budget deficits – even if justified by economic circumstances – cause debt levels to spiral out of control? A: A prolonged period of large budget deficits would most certainly lead to a significant increase in the government debt burden. However, if the interest rate on government borrowing is lower than the growth rate of the economy, as MMT supporters tend to assume, the debt-to-GDP ratio will eventually stabilize.1 In such a setting, the government could just roll over the existing stock of debt indefinitely, while issuing enough new debt to cover interest payments. No additional taxes would be necessary. Chart 2 shows this point analytically. Chart 2 Right now, projected GDP growth is higher than 10-year government borrowing rates for most countries (Chart 3). That’s the good news. The bad news is that there is no guarantee that this will remain the case indefinitely. If interest rates ever rose above GDP growth for an extended period of time, debt dynamics would quickly become unsustainable. MMTers argue that the government can borrow at any rate it wants because they see the currency as a public monopoly.  Chart 3 Q: Isn’t it crazy to assume that interest rates will always stay below GDP growth? A: Not according to MMTers. They argue that the government can borrow at any rate it wants. This is because they see the currency as a public monopoly. As long as a government is able to issue its own currency, it can create money to pay for whatever it purchases, and by definition, money pays no interest. This means that the interest rate can always be held below the growth rate of the economy. The only reason policymakers may wish to raise interest rates is if inflation is getting out of hand. However, even then, most MMT adherents would prefer that the government tighten fiscal policy either by hiking taxes on the rich or cutting spending programs they don’t like (the military is usually high on their list). Raising rates is widely seen by MMT supporters as simply providing a handout to bondholders. Q: It sounds like MMT basically cuts the Fed and other central banks out of the loop. A: That’s right. MMTers contend that monetary policy has little impact on the economy. In fact, many MMT advocates believe that higher rates raise aggregate demand by putting more income into bondholders’ pockets. It’s a very odd argument. Yes, corporate investment tends to respond more to animal spirits than to changes in interest rates. However, there is little doubt that rates affect housing, the currency, and asset prices (and all three, in turn, affect animal spirits). It is almost as if the 1982 recession – an episode where the Volcker Fed took interest rates to 19% – never happened. Q: An odd argument, but perhaps not a surprising one? A: That’s where the “Magic Money Tree” moniker comes in. When an economy is suffering from high unemployment, there really is a free lunch: Putting more people to work can increase someone’s spending without decreasing someone else’s. However, when an economy is at full employment, scarcity becomes relevant again. If a government wants to spend more, it has to convince the private sector to spend less, which it normally does by raising interest rates. MMTers like to throw out the old chestnut about how budget deficits endow the private sector with financial assets such as cash or government bonds. But if additional government spending leads to higher inflation, an increase in the volume of financial assets will simply result in the erosion of the value of existing financial assets. There may be times when more government spending is beneficial even in a full-employment economy, such as funding for basic scientific research or public infrastructure. However, there may also be times when increased government spending is wasteful and comes at the expense of valuable private-sector investment. MMT does not distinguish between the two cases because its adherents seem to deny that any such trade-off exists. Q: It sounds like MMTers want to have their cake and eat it too. A: Exactly. The political appeal of MMT is that it seemingly promises European-style welfare spending without Europe’s level of taxes. Just print more money! Let us ignore the fact that the Fed actually pays interest on bank reserves. Under the current rules, increasing the monetary base would not be costless for the government if that money ended up back at the Fed in the form of excess reserves, as it surely would. The bigger problem is that a large increase in government spending, which is not matched by much higher taxes, will quickly cause the economy to overheat. At that point, policymakers would either need to rapidly tighten fiscal policy, aggressively hike interest rates, or face hyperinflation and a plunging currency. Q: That seems like an obvious point. Why don’t MMTers see it? A: It gets back to what we discussed at the outset – MMTers regard the world as being chronically stuck in a liquidity trap. The prevailing view among MMTers is that there is still a lot of spare capacity globally, including in the United States, where the unemployment rate has fallen below official estimates of NAIRU (the Non-Accelerating Inflation Rate of Unemployment). MMT supporters tend to be skeptical of these NAIRU estimates, believing them to be biased upwards. MMTers see the world as being chronically stuck in a liquidity trap. The prevailing view among MMTers is that there is still a lot of spare capacity in the world. To be fair, the methodology used by the OECD and many other statistical agencies to calculate the full employment rate, which effectively just smooths out past values of the actual unemployment rate, has probably understated the degree of labor market slack in a few countries (Chart 4). Chart 4AThe Unemployment Rate Versus NAIRU (I) The Unemployment Rate Versus NAIRU (I) The Unemployment Rate Versus NAIRU (I) Chart 4BThe Unemployment Rate Versus NAIRU (II) The Unemployment Rate Versus NAIRU (II) The Unemployment Rate Versus NAIRU (II) That said, we doubt that NAIRU is overstated in the United States. Both the Fed and the OECD peg NAIRU at 4.3%, slightly below the CBO’s estimate of 4.6%. As it is, the current CBO estimate is nearly one percentage point below the post-1960 average (Chart 5). Back in the 1960s and 1970s, most economists thought NAIRU was lower than it actually turned out to be (Chart 6). This caused the Fed to keep rates below where they should have been. Chart 5U.S. NAIRU Is Estimated To Be The Lowest On Record U.S. NAIRU Is Estimated To Be The Lowest On Record U.S. NAIRU Is Estimated To Be The Lowest On Record Chart 6The Fed Continuously Overstated The Magnitude Of Economic Slack In The 1970s The Fed Continuously Overstated The Magnitude Of Economic Slack In The 1970s The Fed Continuously Overstated The Magnitude Of Economic Slack In The 1970s Q: Let’s bring this back to market strategy. What does the increasing popularity of MMT mean for investors? A: Investors should regard MMT as simply an extreme example of the increasingly permissive attitude that policymakers are adopting towards inflation. The idea that central banks should raise rates preemptively to avoid overheating is slowly giving way to the belief that they should wait to see the “whites of inflation’s eyes” before tightening monetary policy. Meanwhile, on the fiscal side, austerity is out, and big deficits are in. None of this should be all that surprising. Attitudes towards inflation move in generational cycles. The generation that grew up during the 1930s was highly sensitized towards deflation risk. As a result, policymakers focused on increasing employment, even at the expense of higher inflation. In contrast, the generation that came of age in the 1970s favored policies that clamped down on inflation. For today’s generation, the stagflation of the seventies is a distant memory. “Maximum employment” is the name of the game again. It often takes several years for an overheated economy to produce inflation. This is particularly true when the Phillips curve is quite flat, as appears to be the case today. To the extent that the Fed raises rates over the next 12 months, it will be in response to better-than-expected growth. The stock market should be able to do well in that environment. However, as we get into late-2020 or early-2021, inflation may begin to move materially higher, forcing the Fed to crank up the pace of rate hikes. At that point, equity prices will drop and a maximum short duration stance towards government bonds will be warranted. Q: Just in time for Bernie Sanders’ inauguration! You predicted Trump would win, but Crazy Bernie? Come on, seriously? A: My guess is that Trump was the only Republican candidate who could have beaten Hillary Clinton in 2016, while Clinton was the only Democratic candidate who could have lost to Trump. Had it been Bernie versus Trump, Trump would have lost. Given how close the election turned out to be, Sanders would have probably prevailed.   This is not just idle speculation. During the tail end of the 2016 primary season, head-to-head polls showed Sanders leading Trump by about 10 points, compared to a 3-point lead for Clinton (Chart 7). The final results would have been more favorable for Trump, but given how close the election turned out to be, Sanders would have probably prevailed. Chart 7 A strong economy will help Trump this time around. However, demographic trends continue to move against Republicans. Trump also made a strategic mistake during his first two years in office by focusing on Republican pet issues like corporate tax cuts and gutting Obamacare, rather than securing funding for the border wall, which was his signature campaign promise. For its part, the Democrat establishment will try to stymie Sanders again, but having recently watered down the “superdelegate” rules, it will be in a much weaker position to do so than last time. Q: Yikes, President Bernie doesn’t sound good for stocks! A: In our client conversations on “tail risks” facing the markets, Bernie Sanders almost never comes up. Admittedly, a lot can change in the next 12 months, including the possibility that Joe Biden will enter the race. Biden is more moderate than Sanders and has broad-based appeal. This means that it is still too early to make any significant changes to portfolio strategy. However, if Bernie Sanders, or some other far-left candidate, begins to do well in the polls, markets may start to get antsy later this year.     Peter Berezin Chief Global Investment Strategist peterb@bcaresearch.com       1      Please see Global Investment Strategy Weekly Report, “Is There Really Too Much Government Debt In The World?” dated February 22, 2019.     Strategy & Market Trends MacroQuant Model And Current Subjective Scores Chart 8 Tactical Trades Strategic Recommendations Closed Trades

Developed economies are challenged by two powerful and related demographic trends: declining growth in working-age populations, and a rapidly-aging population structure. Working-age populations are in absolute decline in Japan and much of Europe and growth is slowing sharply in the U.S. An offsetting acceleration in productivity growth is unlikely, implying a marked deceleration in economic growth potential. The combination of slower growth in the number of taxpayers and rising numbers of retirees is toxic for government finances. Future generations face sharply rising debt burdens and increased taxes to pay for entitlements. The correlation between aging and asset prices is inconclusive but common sense suggests it is more likely to be bearish than bullish. Population growth remains rapid throughout most of the developing world, China being a notable exception. It is especially strong in Africa, a region that has historically faced economic mismanagement and thus poor economic prospects for most of its inhabitants. Migration from the emerging to developed world is a logical solution to global demographic trends, but faces a backlash in many countries for both economic and cultural reasons. These tensions are likely to increase. Making accurate economic and market forecasts is daunting because there are so many moving parts and unanticipated events are inevitable. Quantitative models are destined to fail because of the unpredictability of human behavior and random shocks. Demographic forecasts are a lot easier, at least over the short-to-medium term. If you want to know how many 70-year olds there will be in 10 years’ time, then count how many 60-year olds there are today and adjust by the mortality rate for that age group. Demographic trends are very incremental from year to year and their impact is swamped by economic, political and financial events. Thus, it rarely makes sense to blame demographics for cyclical swings in the economy or markets. In some respects, demographics can be likened to glaciers. You will quickly get bored standing by a glacier to watch it move. But, over long time periods, glaciers cover enormous distances and can completely reshape the landscape. Similarly, over the timespan of one or more generations, demographics can have powerful effects on economies and societies. Some important demographic trends have been going on for long enough that their effects are visible. The most common concern about global demographics has tended to be overpopulation and pressure on resources and the environment. And this is hardly new. In 1798, Thomas Malthus published his “Essay on The Principles of Population” in which he argued that population growth would outstrip food supply, leading to a very miserable outcome. Of course, what he missed was the revolution in agricultural techniques that meant food supply kept up with population growth. In 1972, a group of experts calling themselves The Club of Rome published a report titled “The Limits to Growth” which argued that a rising world population would outstrip the supply of natural resources, putting a limit to economic growth. Again, that report underestimated the ability of technology to solve the problem of scarcity, although many still believe the essence of the report has yet to be proved wrong. Phenomena such as climate change and rising numbers of animal species facing extinction are seen as supporting the thesis that the world’s population is putting unsustainable demands on the planet. Rather than get into that debate, this report will focus on three particular big-picture problems associated with demographic trends: Declining working-age populations in most major industrialized economies during the next several decades. Population aging throughout the developed world. Continued rapid population growth in many of the world’s poorest and most troubled countries. According to the UN’s latest projections, the world’s population will increase from around 7.5 billion today to almost 10 billion by 2050.1 The population growth rate peaked in the 1970s and is expected to slow sharply over the next several decades (Chart II-1). Despite slower percentage growth rates, the population keeps going up steadily because one percent of the 1970 global population was about 3.7 million, while one percent of the current population is about 7.5 million. Image But here is an important point: virtually all future growth in the global population will come from the developing world (Chart II-2). The population of the developed world is expected to be broadly flat over the period to 2050, and this has some significant economic implications. Image Let’s first look at why population growth has stagnated in the developed world. Population growth is a function of three things: the birth rate, the death rate and net migration. Obviously, if there are more births than deaths then there will be a natural increase in the population and net migration will either add or subtract to that. Over time, there have been major changes in some of these drivers. In the developed world, a stable population requires that, on average, there are 2.1 children born for every woman. The fact that it is not exactly 2 accounts for infant mortality and because there are slightly more males than females born. The replacement-level fertility rate needs to be higher than 2.1 in the developing world because of higher infant mortality rates. After WWII, the fertility rate throughout most of the developed world was well above 2.1 as soldiers returned home and the baby boom generation was born. But, by the end of the 1970s, the rate had dropped below the replacement level in most countries and currently is a lowly 1.5 in Japan, Germany and Italy (Table II-1). It has stayed higher in the U.S. but even there it has dipped below the critical 2.1 level. This trend has reflected lot of factors including more widespread use of birth control and more women entering the labor force. Image In the developed world, the birth rate is expected to drop below the death rate in the next ten years (Chart II-3). That means there will be a natural decrease in the population. In the case of Japan, Germany, Italy and Portugal that change already occurred between 2005 and 2010. In the U.S., the UN expects birth rates to stay just above death rates in the period to 2050, but the gap narrows sharply. Births exceed deaths throughout most of the developing world meaning that populations continue to grow. Notable exceptions to this are Eastern Europe where populations are already in sharp decline and China, where deaths begin to exceed births in the 2030s. Image Although life expectancy is rising, death rates in the developed world will rise simply because the rapidly growing number of old people more than offsets the impact of longer lifespans. Of course, the population of a country can also be boosted by immigration, and that has been true for much of the developed world. In Canada and most of Europe, net migration already is the dominant source of overall population growth and it will become so in the U.S. in the coming decades, based on current trends (Chart II-4). Image This is the background to the first key issue addressed in this report: the declining trend in the growth of the working-age population in the developed world. Slowing Growth In Working-Age Populations An economy’s growth potential depends on only two things: the number of people working and their productivity. If the labor force grows at 1% a year and productivity also increases by 1%, then the economy’s trend growth rate is 2%. In the short-run, the economy may grow faster or slower than that, depending on issues like fiscal and monetary policy, oil prices etc. Over the long run, growth is constrained by people and productivity. The potential labor force is generally regarded to be the people aged 15 to 64. The growth trend in this age segment has slowed sharply in recent years in the major economies and is set to weaken further in the years ahead (Chart II-5). The problem is most severe in Japan and Europe where the working-age population is already declining. In the case of the U.S., growth in this age cohort slows from an average 1.5% a year in the 1960s and 1970s to a projected pace of less than 0.5% in the coming decades. Image While this generally is not a problem faced by the developing world, a notable exception is China, now reaping the consequences of its one-child policy. Its working-age population is set to decline steadily in the years ahead. Thus, it is inevitable that Chinese growth also will slow in the absence of an acceleration of productivity growth The slowing trend in the working-age population could be offset if we could get more 15-64 year olds to join the labor force, or get more older people to stay working. In the U.S., almost 85% of male 15-64 year olds were either employed or were wanting a job in the mid-1990s. This has since dropped to below 80% - a marked divergence from the trend in most other countries (Chart II-6). And the female participation rate in the U.S. also is below that of other countries. Image The reason for the decline in U.S. labor participation rates for prime-aged adults is unclear. Explanations include increased levels of people in full-time education, in prison, or claiming disability. A breakdown of male participation rates by age shows particularly sharp drops in the 15-19 and 20-24 age groups, though the key 20-54 age category also is far below earlier peaks (Chart II-7). The U.S. participation rate has recently picked up but it seems doubtful that it will return to earlier highs. Image Other solutions to the problem would be getting more people aged 65 and above to stay in the labor force, and/or faster growth in productivity. The former probably will require changes to the retirement age and we will return to that issue shortly. There always are hopes for faster productivity growth, but recent data have remained disappointing for most developed economies (Chart II-8). New technologies hold out some hope but this is a contentious topic. Image On a positive note, the shrinking growth of the working-age population may be easier to live with in a world of robotization and artificial intelligence where machines are expected to take over many jobs. That would support a more optimistic view of productivity but it remains to be seen how powerful the impact will be. Another important problem related to the slowing growth of the working-age population relates to fiscal burdens. In 1980, the level of government debt per taxpayer (ages 20-64) was around $58,000 in the U.S. in today’s money and this is on track for $104,000 by 2020 (Chart II-9). But this pales in comparison to Japan where it rises from $9,000 to $170,000 over the same period. Canada looks more favorable, rising from $23,000 in 1980 to $68,000 in 2020. These burdens will keep rising beyond 2020 until governments start running budget surpluses. Our children and grandchildren will bear the burden of this and won’t thank us for allowing the debt to build up in the first place. Image There will be a large transfer of privately-held assets from the baby boomers to the next generation, but the ownership of this wealth is heavily skewed. According to one study, the top 1% owned 40% of U.S. wealth in 2016, while the bottom 90% owned 20%.2 And it seems likely that this pool of wealth will erode over time, providing a smaller cushion to the following generation. This leads in to the next topic – aging populations. Aging Populations In The Developed World The inevitable result of the combination of increased life expectancy and declining birth rates has been a marked aging of populations throughout the developed world. Between 2000 and 2050, the developed world will see the number of those aged 65 and over more than double while the numbers in other age groups are projected to show little change (Chart II-10). Image As long as the growing numbers of those aged 65 and above are in decent health, then life is quite good. Fifty years ago in the U.S., poverty rates were very high for those of retirement age compared to the young (i.e. under 18). But that has changed as the baby boomer generation made sure that they voted for increased entitlement programs. Now poverty rates for the 65+ group are far below those of the young (Chart II-11). At the same time, real incomes for those 65 and older have significantly outperformed those of younger age groups. Image A major problem is that aging baby boomers are expensive because of the cost of pensions and medical care. As would be expected, health care costs rise dramatically with age. For those aged 44 and under, health care costs in the U.S. averaged around $2,000 per person in 2015. For those 65 and over, it was more than $11,000 per person. And per capita spending doubles between the ages of 70 and 90. So here we have the problem: a growing number of expensive older people supported by a shrinking number of taxpayers. This is illustrated by the ratio of the number of people between 20 and 64 divided by those 65 and older. In other words, the number of taxpayers supporting each retiree (Chart II-12). Image In 1980, there were five taxpayers for every retiree in the U.S., four in W. Europe and seven in Japan. These ratios have since dropped sharply, and in the next few decades will be down to 2.5 in the U.S., 1.8 in Europe and 1.3 in Japan. For each young Japanese taxpayer, it will be like having the cost of a retiree deducted from their paycheck. Throughout the developed world, the baby boomers’ children and grandchildren face a growing burden of entitlements. Some of the statistics related to Japan’s demographics are dramatic. In the first half of the 1980s there were more than twice as many births as deaths (Chart II-13). They become equal around ten years ago and in another ten years deaths are projected to exceed births by around three million a year. In 1990, the number of people aged four and under was more than double the number aged 80 and above. Now the situation is reversed with those aged 80 years and above more than double those four and under. That is why sales of adult diapers reportedly exceed those of baby diapers – very depressing!3 Image What’s the solution to aging populations? An obvious one is for people to retire later. When pension systems were set up, life expectancy at birth was below the age pensions were granted - typically around 65. In other words, not many people were expected to live long enough to get a government pension. And the lucky ones who did live long enough were not expected to be around to receive a pension for more than a few years. By 1950, those males who had reached the age of 65 were expected, on average, to live another 11 to 13 years in the major developed countries (Table II-2). This rose to 16-18 years by 2000 and is expected to reach 22-23 years by 2050. Governments have made a huge error in failing to raise the retirement age as life expectancy increased. Pension systems were never designed to allow people to receive government pensions for more than 20 years. Image Some countries have raised the retirement age for pensions, but progress on this front is painfully slow. Other solutions would be to raise pension contributions or to means-test benefits. Not surprisingly, governments are reluctant to take such unpopular actions. At some point, they will have no choice, but that awaits pressures from the financial markets. Currently, not many people aged over 65 remain in the workforce. The participation rate for men is less than 10% in Europe and less than 25% in the U.S. And it is a lot lower for women (Chart II-14). The rate in Japan is much higher reflecting the fact that it is at the leading edge of aging. Participation rates are moving higher in Europe and the U.S. and further increases are likely in the years ahead if Japan’s experience is anything to go by. Image Having people staying in the workforce for longer will help offset the decline in prime-age workers, but there is a downside. While it is a contentious topic, many studies point to a negative correlation between age and productivity after the age of 50. As we age, there is some decline in cognitive abilities and older people may be less willing or able to adapt to new technologies and working practices. These would only be partly offset by the benefits of experience that comes with age. Therefore, an aging workforce is not one where one would expect productivity growth to accelerate, other things being equal. An IMF study concluded that a 1% increase in the labor force share of the 55-64 age cohort in Europe could reduce the growth in total factor productivity by 0.2% a year over the next 20 years.4 Another study published by the NBER paper estimated that aging will reduce the U.S. economic growth rate by 1.2% a year this decade and 0.6% a year next decade.5 Other studies are less gloomy but it would be hard to argue that aging is actually good for productivity. Another aging-related issue is the implications for asset prices. It is generally believed that aging will be bad for asset prices as people move from their high-saving years to a period where they will be liquidating assets to supplement their incomes. This is supported by a loose correlation between the percentage of the labor force between 35 and 64 (the higher-saving years) and stock market capitalization as a percent of GDP (Chart II-15). However, other studies cast doubts on this relationship.6 Image One might think real estate is even more vulnerable than stocks to aging. However, in late 1988, two high-profile economists (Greg Mankiw and David Weil) published a report arguing that real house prices would fall substantially over the next two decades as the baby boom generation aged.7 That forecast was catastrophically wrong. Of course, that does not mean that the more dramatic aging occurring over the next couple of decades will not have a major negative impact on home prices. Numerous studies have been carried out on the relationship between demographics and asset prices and the conclusions are all over the place.8 Time and space constraints prevent a more in-depth discussion of this topic. Nonetheless, common sense would suggest that aging is more likely to be bearish than bullish for asset prices. Thus far, we have addressed two demographic challenges facing the developed world: slowing growth in the number of working-age people and a marked aging of the population. Much of the developing world has the opposite issue: continued rapid population growth and large numbers of young people. This is my third topic. Rapid Population Growth In The Developing World We already noted that nearly all future growth in global population will occur in the developing world, China being a notable exception. With birth rates remaining far above death rates, emerging countries will not have the aging problem of the developed world and this has some positives and negatives. On the positive side, a rapidly-growing young population creates the potential for strong economic growth – the opposite of the situation in advanced economies. But this assumes that the institutional and political framework is conducive to growth. Unfortunately, the history of many developing countries is that corrupt and incompetent governments prevent economies from ever reaching their potential. This means there will be a growing pool of young people likely facing a dim economic future. In some cases, these young people could be an excellent recruiting ground for extremist groups. It is unfortunate that there is particularly rapid population growth in some of the most troubled countries in the world. The Institute for Economics and Peace ranks countries by whether they are safe or dangerous.9 According to their ranking, the eight most dangerous countries in the world will see their population grow at a much faster pace than the developing world as a whole (Chart II-16). Image Some individual country comparisons are striking. The UN’s projections show that Nigeria’s population will exceed that of the U.S. by 2050, The Democratic Republic of Congo’s population will match that of Japan by 2030 and by 2050 will be 80% larger (Chart II-17A and B). Similarly, Afghanistan will overtake Italy in the 2040s. Most incredibly, Africa’s overall population surpassed that of the whole of Europe in the second half of the 1990s and is projected to be 3.5 times larger by 2050. That suggests that the numbers seeking to migrate from Africa to Europe will increase dramatically in the next couple of decades. Controlling these flows will become an increasing challenge for countries in Southern Europe. Image Image Migration is the logical solution to declining working-age populations in the developed world and expanding young populations in the developing world. However, there currently is a backlash against immigration in many developed countries. Anti-immigration political parties are gaining strength in many European countries and immigration was a major factor influencing the Brexit vote in the U.K. And it is a hot-button political issue in the U.S. Concerns about immigration are twofold: competition for employment and potential cultural change. Employment fears have coincided with a long period of severely depressed wages for low-skill workers in many developed economies and immigration is an easy target for blame. Meanwhile, the cultural challenge of absorbing large numbers of immigrants clearly has fueled increased nationalist sentiment in a number of countries. In the U.S., projections by the Bureau of the Census show that the non-Hispanic white population will fall below 50% of the total by 2045. That has implications for voting patterns and lies behind some of the concerns about high levels of immigration. There is no simple solution to this controversial issue and an in-depth discussion is beyond the scope of this article. Conclusions We have only touched on some aspects of demographic trends. It is a huge topic and has many other implications. For example, the political and cultural views of each generation are shaped by the environment they grow up in and this changes over time. This year, the number of millennials (those born from the early 1980s to the mid-1990s) in the U.S. is expected to surpass those of baby boomers and that will have important political and social implications. Again, that is beyond the scope of this report. The demographic trends we have discussed will pose serious challenges to policymakers. In the developed world, the baby boom generation has accumulated huge amounts of government debt, partly to fund generous entitlement programs and did not have enough children to ease the burdens on future generations. The young have good reason to feel frustrated by the actions of their elders (see cartoon). Image In the developing world, the challenge will be to provide economic opportunities for a growing pool of young people. The biggest problems will be in Africa, a continent where economic success stories have been few and far between in the past. Failure to deal with this will have troubling implications for geopolitical stability. Martin H. Barnes Senior Vice President Economic Advisor   Footnotes 1       Most of the data referred to in this report comes from the medium variant projections from the United Nation’s World Population Prospects report, 2017 revision. There is an excellent online database tool that allows users to access numerous demographic series for every country and region in the world. This can be found at https://population.un.org/wpp/DataQuery/ 2       Edward N. Wolff, Household Wealth Trends in the United States, 1962 to 2016. NBER Working Paper 24085, November 2017. Available at: https://www.nber.org/papers/w24085. 3       This is not a joke: https://www.businessinsider.com/signs-japan-demographic-time-bomb-2017-3 4       The Impact of Workforce Aging on European Productivity. IMF Working Paper, December 2016. Available at: https://www.imf.org/en/Publications/WP/Issues/2016/12/31/The-Impact-of-Workforce-Aging-on-European-Productivity-44450 5       The Effect of Population Aging on Economic Growth, the Labor Force and Productivity. NBER Working Paper 22452, July 2016. Available at https://www.nber.org/papers/w22452.pdf 6              For example, see “Will Grandpa Sink The Stock Market?”, The Bank Credit Analyst, September 2014. 7       The Baby Boom, The Bay Bust, and the Housing Market. NBER Working Paper 2794. Available at: https://www.nber.org/papers/w2794 8       For those interested in this topic, we recommend the following paper: Demographics and Asset Markets: A Survey of the Literature. Available at: https://pdfs.semanticscholar.org/912a/5d6d196c3405e37b3a50d797cbf65a27ba44.pdf 9       Global Peace Index, 2018. Available at: http://visionofhumanity.org/app/uploads/2018/06/Global-Peace-Index-2018-2.pdf. According to this index, the eight least-safe countries are (starting with the most dangerous): Syria, Afghanistan, South Sudan, Iraq, Somalia, Yemen, Libya, and Democratic Republic of the Congo.