Monetary

Special Report

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

Special Report

Highlights European Growth: Europe’s economy is slowing, while core inflation remains subdued. The ECB must now contemplate the need for a monetary policy ease so soon after ending its bond buying program. Likely ECB Options: The ECB will likely have no choice but to initiate a new round of LTROs – likely to be announced in either April or May – to prevent an unwanted tightening of credit conditions at a time of slowing economic growth. Fixed Income Implications: Stay below-benchmark on euro area duration, with inflation expectations likely to rebound alongside a more dovish ECB and rising global oil prices. Stay underweight Italian government bonds and neutral overall euro area corporate credit exposure, however, until there are more decisive signs that growth is stabilizing. Feature Back in December, the European Central Bank (ECB) - confident that the euro zone economy was healthy enough to allow the slow process of policy normalization to begin - ended its Asset Purchase Program and signaled that rate hikes could commence as soon as late 2019. Just two months later, the central bank is faced with an unexpectedly persistent and broad-based growth slump. Markets now expect no change in short-term interest rates until well into 2020. By most conventional measures, the ECB is running a very accommodative monetary stance, with a €4.7 trillion balance sheet and negative interest rates (both in nominal and inflation-adjusted terms). On a rate-of-change basis, however, policy has become incrementally less stimulative, with the balance sheet no longer expanding and real interest rates unchanged from levels of a year ago (Chart 1). An additional potential tightening of liquidity conditions is on the horizon with the ECB’s long-term funding operations for euro zone banks (LTROs and TLTROs) set to begin rolling off next year. Chart 1The ECB Needs To Ease Policy Somehow Our ECB Monitor indicates that fresh monetary easing will soon be required if the current downtrend in growth persists. Given the persistent fragilities within the European banking system, not only in Italy but increasingly in core countries like Germany, a combination of slowing economic momentum and tightening monetary liquidity is a potentially toxic brew. Weaker growth raises the specter of a rise in non-performing loans held by banks that also have significant sovereign debt exposures (the so-called “Doom Loop”). In this Special Report, we consider the policy options that the ECB could realistically deliver in the coming months - given the state of the economy, inflation and banking system – with the associated investment implications for European fixed income markets. Our conclusion: the ECB will be forced to take a dovish turn as an insurance policy against tighter credit conditions and weak growth. Eurozone Economy: Broad-Based Mediocrity The ECB has categorized the current downturn, which has pushed real GDP growth in the Eurozone to a below-trend pace of 1.7% and triggered a technical recession in Italy, as simply the product of a bunch of idiosyncratic country-specific shocks (a cut in Germany auto production due to changing emissions standards, Italy-EU fiscal policy debates that raised the cost of capital in Italy, and political unrest in France damaging consumer spending). The biggest shock, however, has been exogenous. Trade policy uncertainty and a weakening Chinese economy have both been a major drag on growth for euro zone countries that rely heavily on exports, in general, and Chinese import demand, in particular. The “one-off shocks” narrative is incorrect because the slowdown has been broad-based. The majority of countries within the euro zone are suffering slowing GDP growth, falling leading economic indicators and decelerating headline inflation, according to our diffusion indices for each (Chart 2). The previous three times such a synchronized slowdown unfolded (2001, 2009 and 2012), the ECB responded with a full-blown rate cutting cycle. Inflation trends today, however, make it a bit more difficult for the ECB to consider any such possible shift in a more dovish direction. Chart 2ECB Typically Eases After A Broad-Based Economic Downturn The overall unemployment rate for the region is 7.8%, well below the OECD’s estimate of the full employment NAIRU1 rate. In contrast to our diffusion indicators for the economy, the majority of euro area countries (83%) have unemployment rates lower than NAIRU (Chart 3). The previous two times labor markets were so tight in the euro area, wage inflation reached 4%, core inflation climbed beyond 2.5% and the ECB pushed policy interest rates to between 4-5%. Today, a large majority of countries are witnessing faster wage growth and core inflation, but the overall level of both is still relatively low (2.5% and 1%, respectively). Chart 3ECB Policy Is Already Very Easy So from the point of view of the state of overall growth and inflation, the ECB is in a difficult position. Euro area growth has slowed, but not by enough to ease the nascent inflation pressures in labor markets. The story gets more complex when looking at growth and inflation at the individual country level. For the four largest economies in the region – Germany, France, Italy and Spain – the latter two remain a source of concern. Unemployment in both Spain and Italy remains in double-digits, with headline and core inflation rates at 1% or lower (Chart 4). Italy’s manufacturing PMI is now at 47.6 and Spain’s is now at 49.9, both below the 50 level indicating an expanding economy. Chart 4Italy & Spain Are Becoming An Issue (Again) Credit growth exhibits a similar pattern. Total bank lending is contracting on a year-over-year basis in Italy (-4.3%) and Spain (-2.1%), while still growing at a positive, albeit decelerating, rate in Germany (+1.5%) and France (+5.3%). The most recent ECB Bank Lending Survey for the fourth quarter of 2018 showed that lending standards were becoming more stringent in Italy and Spain than in Germany or France (Chart 5). In Italy, where the growth downturn has been deeper and borrowing costs have gone up due to the Italian populist government’s repudiation of EU deficit limits, banks are actually tightening lending standards. Chart 5Credit Conditions Tightening At The Margin The last thing the ECB wants to see now is a sustained credit contraction in the large economies where growth and banking systems are the most fragile – most notably, Italy. Bottom Line: Europe’s economy is slowing, while core inflation remains subdued. Weakness is more pronounced in the Peripheral countries compared to the Core, especially Italy. The ECB must now contemplate the need for a monetary policy ease so soon after ending its bond buying program. Italy’s Banks Are Still A Huge Headache For The ECB European banks have struggled to generate acceptable profits in recent years against a backdrop of sluggish economic growth, negative interest rates and increased regulatory capital requirements. Bank equity values remain near post-2008 crisis lows, with Italian bank stocks severely underperforming their competitors within the euro zone (Chart 6). Credit spreads for Italian banks are also far more elevated than those of their euro area peers, a reflection of the higher yields and wider spreads on Italian government bonds (which, given Italy’s BBB sovereign credit rating, means that the floor on Italian yields and credit spreads is higher than those of other euro zone countries with better credit ratings). Chart 6Italy's Fiscal Problems Impacting The Banks Even given the economic fragility in Italy, Italian banks remain reasonably well-capitalized. According to the data from the European Banking Authority (EBA), Italian banks have a Common Equity Tier 1 (CET1) capital ratio of 13.8%, well above the minimum levels required by Basel III bank regulations and close to the overall euro area CET1 ratio of 14.7% (Chart 7). The problem for Italian banks, however, remains the high level of non-performing loans (NPLs). EBA data shows that Italian banks have an NPL ratio of 9.4%, nearly three times the total euro area NPL ratio of 3.4%. While this is a substantial improvement from the near-20% NPL ratio seen after the 2011 European debt crisis, the absolute level of NPLs remains high. The other major risk for Italian banks is their large holdings of Italian sovereign bonds, which raises the risk of mark-to-market losses hitting the banks’ capital position as government bond yields rise (i.e. the “Doom Loop”). The ECB’s bond purchases have helped to reduce the share of Italian sovereign debt held by Italy’s banks from 25% to around 19% over the past five years (Chart 8). Yet with Italy’s sovereign credit rating now BBB – on the cusp of junk – Italian bank balance sheets remain heavily exposed to sovereign debt risk. The ECB has tried to mitigate the impact of its extraordinary monetary stimulus on the profitability of Europe’s banks by offering longer-term loans (against acceptable collateral) at low interest rates. These programs, known as Long-Term Refinancing Operations (LTROs), have mostly been used by banks in Italy and Spain, which have taken up a combined 56% of all outstanding LTROs (Chart 9). Chart 956% Of ECB LTROs Have Gone To Italy & Spain The most recent LTRO operation launched in 2016 was a Targeted LTRO (TLTRO) that tied the extension of ECB funding directly to the amount of new loans made by any bank that received the funding. Those TLTROs were offered at the ECB’s Marginal Deposit Rate of -0.4%, effectively providing a 40bps subsidy for new bank lending. The impact on loan growth from the TLTROs was far greater in Italy and Spain, where the share of total bank lending funded by LTROs in each country is now 10% compared to 4% for all euro area bank loans (Chart 10). Chart 10LTROs Funding 10% Of Bank Lending In Italy & Spain The TLTROs extended in 2016 had a maturity of four years, which means that the loans will begin to mature next year.2 If the ECB lets these operations expire without any offering of a new program, then banks that have used that cheap liquidity will be faced with one of two choices: replace that funding with bank debt at much higher market interest rates, or reduce the size of their loan books (i.e. delever their balance sheets). For Italy’s banks, replacing all of that cheap TLTRO funding with expensive bank debt is highly unlikely. According to the Bank of Italy’s latest Financial Stability Report, bank debt represents as large a share of overall Italy bank funding as the TLTROs (around 10%), but the growth rate of that debt has been contracting at a -15% to -20% rate over the past couple of years (Table 1).3 This is how rising Italian sovereign bond yields translate into higher bank debt yields and market funding costs, restricting lending activity. Table 1Italian Banks Have Slashed Expensive Debt Market Funding Already, Italian banks have been cutting back on lending to the most risky borrowers, according to Bank of Italy data (Chart 11). The growth rates of loans deemed “risky” and “vulnerable” contracted at a faster pace in 2018 than during 2015-17, while loans extended to “solvent” and “safe” borrowers grew more quickly in 2018 than the prior three years. These trends are likely to continue with credit standards now being tightened by Italian banks according to the ECB Bank Lending Survey. An additional factor for the banks to consider is the upcoming implementation of the Basel III regulatory requirement that banks must maintain a minimum amount of funding with a maturity greater than one year (the Net Stable Funding Ratio, or NSFR). Even though the current round of TLTROs do not begin to expire until June 2020, they will turn into “short-term” funding as of June of this year when it comes to banks calculating their NSFR. That ratio is not yet binding, but banks will likely seek to plan ahead for their long-term funding and will seek guidance from the ECB. So the ECB is now faced with the prospect of letting the TLTROs begin to expire next year, placing 4% of total euro area bank lending and 10% of Italian and Spanish bank lending at risk. Given the current fragile state of growth in the euro area, especially in Italy, the central bank would be taking a huge gamble by risking an even deeper downturn through banks shrinking their loan books. The easiest way to prevent that outcome – more LTROs. Bottom Line: The ECB will likely have no choice but to initiate a new round of LTROs – likely to be announced in April or May - to prevent an unwanted tightening of credit conditions amid slowing economic growth. The ECB’s Likely Next Move? New LTROs With More Dovish Forward Guidance The ECB Governing Council meets this week. There will be a new set of economic projections prepared for this meeting, and the ECB has typically chosen to make changes to its monetary policies alongside shifts in its economic forecasts. ECB President Mario Draghi has already noted that the growth risks in the euro zone are now tilted to the downside. Even noted monetary hawks like German Bundesbank President Jans Weidmann and Dutch Central Bank President Klaas Knot – both candidates to replace Draghi when his term expires in October – have toned down their calls for monetary tightening given the weak growth in their own economies. We expect the ECB to follow a dovish script at the March ECB meeting, along these lines: Downgrade the ECB’s growth forecasts Delay the date when inflation is projected to return back to 2% target Extend forward guidance on the first rate hike out to “mid-2020 or later” (which only validates current market pricing) A pessimistic assessment of the outlook for bank lending based on elevated bank funding costs impairing the transmission of ECB’s “highly accommodative” monetary policy A discussion about the need for a new LTRO program to replace the ones that start expiring in 2020 Step 4 in that script could be delayed until the April or May ECB meetings, to allow for more time to see how the economic data unfolds. Almost all of the current downturn in real GDP growth can be attributed to the plunge in net exports – the contribution to growth from domestic demand has been stable over the past year (Chart 12). Thus, the ECB will likely want to see if the current indications of a U.S.-China trade deal, combined with more stimulus from China’s policymakers, puts a floor under the downturn in euro area trade activity. Chart 12ECB Growth Forecasts Require A Rebound In Exports Step 5 in our March ECB meeting script can also be delayed to April or May, but the ECB is not likely to wait longer than that and run the risk of letting the current slowing of euro area credit growth turn into a full-blown contraction due to the end of cheap funding (Chart 13). Chart 13Tightening Lending Standards: Trigger For A New LTRO? There has also been some speculation that the ECB could satisfy both the hawks and doves on the Governing Council by announcing a hike in the ECB Overnight Deposit rate at the same time as a new LTRO program. The Overnight Deposit rate represents the floor of the ECB’s policy interest rate corridor, with the Marginal Lending rate representing the ceiling and the Main Refinancing rate acting as the midpoint of the corridor. Yet with the ECB maintaining such a large balance sheet, with €1.2 trillion in excess reserves, the effective short-term interest rate (1-week EONIA) has traded near the Overnight Deposit Rate floor. Thus, lifting only the Overnight Deposit Rate, which is -0.4% and has been blamed for damaging the earnings of euro area banks, would effectively be the same as a traditional hike in the ECB’s main interest rate tool, the Main Refinancing Rate (Chart 14). Chart 14The ECB Cannot Bottom Line: Offering a new LTRO, but perhaps for only a shorter time period than the expiring TLTROs (i.e. two years instead of four), seems to be the best solution for the ECB. This will prevent a potential liquidity-driven bank credit crunch in the most vulnerable parts of the European economy – Italy and Spain. Fixed Income Investment Implications Of Our ECB View 1. Duration: the benchmark 10-year German Bund yield had fallen as low as 0.09% in the most recent global bond rally, largely driven by a collapse in inflation expectations. The ECB’s likely dovish guidance on rate hikes will prevent any meaningful rise in real Bund yields. Inflation expectations, however, do have a lot more upside if BCA’s bullish oil forecast is realized – especially so if the ECB also takes a more dovish turn (Chart 15). Stay below-benchmark on euro zone duration, and stay long inflation-linked instruments like CPI swaps. Chart 15Stay Below-Benchmark On European Duration Exposure 2. Italian Sovereign Debt: A new LTRO program, combined with more dovish forward guidance, should help prevent the current Italian growth downturn from intensifying. However, a weak economy will sustain pressure on Italian sovereign spreads. Stay underweight for now, but look to upgrade when growth stabilizes (Chart 16). Chart 16Stay Cautious On Euro Area Spread Product Until Growth Bottoms 3. Euro Area Corporates: A more dovish ECB will help stabilize corporate credit spreads in the euro area, but like Italian sovereign debt, signs of more stable growth are required before spreads can meaningfully compress. Stay neutral for now.   Robert Robis, CFA, Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Non-accelerating inflation rate of unemployment. 2 The loans were offered in four allotments in June 2016, September 2016, December 2016 and March 2017. Hence, the loans will mature in June 2020, September 2020, December 2020 and March 2021. 3 The November 2018 Bank of Italy Financial Stability Report can be found here: https://www.bancaditalia.it/pubblicazioni/rapporto-stabilita/2018-2/index.html Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Feature Recommendations Two Key Questions For Asset Allocators Stocks have rallied this year – MSCI ACWI is up 17% from its late December low – despite the fact that economic growth outside the U.S. has continued to deteriorate. The PMI in Germany has fallen to 47.6, in Japan to 48.5, and the average in Emerging Markets to 49.5 (Chart 1). Chart 1PMIs Ex-U.S. Still Falling U.S. growth remains robust, though recent data have showed some signs of weakness. The Citigroup Economic Surprise Index has fallen sharply, capex indicators have slipped, and December retail sales were terrible (Chart 2). The New York Fed NowCast for Q1 is now pointing at only 1.2% real GDP growth. Most of the slippage, however, was caused by the six-week government shutdown, and should be reversed in Q2. And the retail sales number appears “rogue”, perhaps caused by irregular data-collection methods during the shutdown, since other retail data do not support it (Chart 2, panel 3). The tightening of financial conditions in the last months of 2018 – which has now partly reversed – may have added to the slowdown (Chart 3). BCA’s view is that U.S. GDP growth is likely to come in well above 2% in 2019, slower than last year’s 2.9% but still above trend. Chart 2Should We Worry About U.S. Growth Too? Chart 3Financial Conditions Now Easing Our recommendation, therefore, is to continue to overweight equities (particularly U.S. equities), which should be supported by decent earnings growth (our top-down model points to 12% EPS growth for the S&P500 this year, compared to a bottom-up consensus forecast of only 5%), reasonable valuations, and sentiment that appears still to be damaged by the Q4 sell-off (Chart 4). Chart 4Environment Still Positive For U.S. Equities Two key questions will determine which asset allocation will be optimal this year. First, how long will the Fed stay “patient” and keep rates on hold? The futures market has almost completely priced out the possibility of any rate hikes in 2019, and even assigns a 15% probability of a cut (Chart 5). We still see upside risk to inflation, with core PCE likely to print above the Fed’s target of 2% by mid-year, partly because of the year-on-year base effect (in January 2018, monthly inflation was especially high), but also because underlying inflation pressures remain (Chart 6). Chart 5Is The Fed Really Going To Cut Rates? Chart 6Inflation Pressures Haven't Gone Away The market has misunderstood two of the Fed’s recent messages. Its mooted plan to end balance-sheet reduction by year-end is not intended as part of monetary policy. It is simply that bank excess reserves will have reached USD1-1.2 trillion, the level required to operate monetary policy using current tools, rather than those used before 2007 when reserves were zero (Chart 7). Second, recent discussions about changing the Fed’s inflation target from 2% a year to a price-level target will probably become effective only when the effective lower bound is hit in the next recession and, anyway, no decision will be taken until mid-2020. Chart 7Excess Reserves Will Be At Equilibrium Soon The market has taken this talk as dovish. We read recent comments by Fed Chairman Jay Powell to mean that if, by June, the economy is robust, risk assets are still rebounding, and inflation is ticking up, the Fed will continue to hike, maybe two or three times by year-end. This implies long-term bond yields will rise too. Equities may wobble initially but, as long as the Fed is hiking because growth is solid and not because of an inflation scare, this should not undermine the 12-month case for equity outperformance. The second key question is whether China has now abandoned its focus on deleveraging and switched to a 2016-style liquidity-driven stimulus. Certainly, the January total social financing number pointed in that direction, with new credit creation of almost 5 trillion RMB ($750 billion) and the first signs of an easing of restrictions on shadow banking (Chart 8). But the jury is still out on whether this is the massive reflation the market has been waiting for. Premier Li Keqiang criticized the increase, saying, “the increase in total social financing appears rather large…it may also bring new potential risks”. A PBOC official commented that the big increase was “due to seasonal factors” and emphasized that China was not embarking on “flood irrigation-style” stimulus. The recent more positive noises on the U.S./China trade war may also alleviate the pressure on China to stimulate. Chart 8First Signs Of Chinese Reflation? If and when Chinese growth does rebound, this will have major implications for asset allocation. It would signal a bottoming of the global cycle, which would favor stocks in Emerging Markets, Europe and Japan. It would push up commodity prices, and imply a weaker dollar. For now, we are not positioning ourselves like this, since global growth remains weak. Nonetheless, the first signs of a bottoming are appearing with, for example, the diffusion index of the global Leading Economic Index (which often leads the LEI itself) turning up (Chart 9). We may shift in this direction mid-year, and are now making some minor changes to our recommendations (see below) to hedge against this risk. But for the moment we prefer U.S. equities, expect further USD appreciation, and remain cautious on EM. Chart 9Is The LEI Close To Bottoming? Equities: We prefer U.S. equities given their better growth, reasonable valuations, and depressed sentiment (despite their outperformance year-to-date). But we are watching for an opportunity to increase our weighting in Europe, where growth still looks poor but may rebound in H2 due to fiscal stimulus, improving wage growth, a dovish turn by the ECB, and an eventual recovery in exports to China (Chart 10). We still see problems in EM, since earnings growth expectations need to be revised down further and stock prices have risen prematurely on expectations of a Chinese recovery (Chart 11). But we reduce the size of our underweight bet, to hedge against Chinese credit growth continuing to accelerate. We are also raising our recommendation for the industrials sector (with its large weight in capital goods companies dependent on exports to China) to overweight for the same reason.  We fund this by cutting consumer staples to underweight. We also raise our weighting on the energy sector, given our positive view on oil prices (see below). This gives our sector weightings a slightly more cyclical tilt, in line with our macro view. Chart 10Some Good News In Europe Too Chart 11EM Has Further Downside Fixed Income: It has been a conundrum this year why equities have risen and credit spreads tightened significantly, but the 10-year Treasury yield remains stuck below 2.7%. One explanation is that inflation expectations have been dampened by the crude oil price and if, as we forecast, oil continues to recover, the inflation component of the yield will rise (Chart 12). U.S. yields have also been dragged down by weak growth in other developed markets, where bond yields have therefore fallen. The spread between U.S. and German and Japanese yields reached record high levels in late 2018 (Chart 13). The term premium also is deeply into negative territory because many investors remain highly bearish and have hedged this view by buying Treasuries. If our view of robust U.S. growth, rising inflation, and more Fed hikes is correct, we would see 10-year Treasury yields rising towards 3.5% over the next 12 months. Accordingly, we are underweight global government bonds. We raised credit to neutral last month, but continue to have some qualms about this asset class, and prefer equities as a way of taking exposure to further upside for risk assets. Besides high leverage among U.S. corporates, we are worried about the deterioration in the quality of the credit market, since duration has been extended, covenants weakened, and the average credit rating fallen (Chart 14). Chart 12Inflation Expectations Driven By Oil Chart 13U.S. Yields Pulled Down By Europe And Japan Chart 14Deterioration In Credit Market Fundamentals Currencies: We see some more upside in the U.S. dollar over the next few months, given U.S. growth and monetary policy relative to the euro area and Japan (Chart 15). This may reverse, however, if global cyclical growth rebounds in the second half. The dollar is particularly vulnerable if macro conditions change, since it looks around 10% overvalued relative to other major DM currencies, and speculative positions are predominantly long dollar (Chart 16). Chart 15Relative Rates Support USD Chart 16But Dollar Vulnerable To Macro Shifts Commodities: With demand likely to grow steadily this year, but supply under pressure because of production cuts by OPEC and Canada, lower U.S. shale oil output, and disruptions in Venezuela and elsewhere, our energy strategists see drawdowns in inventories throughout the year (Chart 17). They forecast Brent to average $75 a barrel during 2019 (compared to $66 now), with WTI $5 a barrel lower. Industrial commodities continue to be driven by China which means, given our view expressed above, that we may see further weakness short-term, with a possible rebound in H2 (Chart 18). Chart 17Oil Supply/Demand Is Tight Chart 18When Will Metal Prices Bottom?   Garry Evans Chief Global Asset Allocation Strategist garry@bcaresearch.com   GAA Asset Allocation  

Special Report

Highlights Korean stocks are facing downside risks over the next several months. Exports will continue to contract on falling semiconductor prices and retrenching global demand. Growth deceleration and low inflation will lead the central bank to cut rates in 2019. Within an EM equity portfolio, we are downgrading Korean tech stocks from overweight to neutral but remain overweight the non-tech sector. We are booking gains on our strategic long positions in EM tech versus both the broader EM equity benchmark and materials. The KRW/USD exchange rate is at a critical technical juncture. Investors should wait to buy on a breakout and/or sell on a breakdown of the tapering wedge pattern. Feature   Decelerating and lately contracting South Korean exports have been a major drag on the economy and stock market (Chart I-1). The country is heavily reliant on manufacturing, with exports of goods contributing to nearly half of real GDP. Chart I-1Korean Stocks: Unsustainable Rebound? Although exports are currently shrinking, Korean domestic stock prices still rebounded. The rebound has mostly been driven by the information technology (tech) sector (Chart I-2). Is this recent rally justified by underlying fundamentals? Will share prices continue to rise in 2019? Our inclination is ‘no’ to both questions. There are still dark clouds on the horizon for both Korea’s business cycle and stock market. We are downgrading Korean tech stocks to neutral from overweight within a dedicated EM equity portfolio. However, we are maintaining our overweight in non-tech stocks relative to the EM equity benchmark. Lingering Risks In The Semiconductor Industry Korea’s dependence on the semiconductor sector has risen considerably in the past several years: Semiconductor exports have risen from under 10% to slightly above 20% of total goods exports (Chart I-3). As such, the outlook for semiconductor exports is a critical factor for future economic growth. Chart I-3Korea: Increasing Reliance On The Semiconductor Sector Table 1 lists the top 10 major exported goods from Korea, together contributing about 72% of total exports. Semiconductors are by far the largest component. Last year, overseas sales of semiconductors alone contributed to some 90% of growth in Korean exports, and about one-third of the country’s nominal GDP growth. Notably, Korea produces the largest quantity of DRAM and NAND memory chips in the world. Last year, Korean semiconductor companies accounted for about 70% of global DRAM and 50% of NAND flash global sales revenue. In 2019 Korean semiconductor exports will likely contract due to further deflation in DRAM and NAND memory prices (Chart I-4). Chart I-4Memory Prices Are Plunging The 2016-2017 surge in DRAM and NAND flash prices was due to supply shortages relative to demand. Last year, NAND prices plunged and DRAM prices began to fall as their supply-demand balances shifted to oversupply. This year, the glut will worsen. Demand Global demand for DRAM and NAND memory is slowing. Memory demand from the global smartphone sector – one important end-user market for DRAM and NAND memory chips – is contracting. According to the International Data Corporation (IDC), the global mobile phone sector is the biggest end-market for both DRAM and NAND memory chips, with nearly 40% market share in each. As major markets like China and advanced economies have entered the saturation phase of mobile-phone demand, global smartphone shipments are likely to decline further in 2019 (Chart I-5, top panel). Chart I-5Global Memory Demand Is Slowing DRAMeXchange1 expects global smartphone production volume for 2019 to fall by 3.3% from last year. In addition, the significant surge in bitcoin prices greatly boosted cryptocurrency mining activity in 2016-‘17 as miners quickly expanded their computing power. This contributed to strong DRAM demand and in turn higher semiconductor prices between June 2016 and May 2018. With the bust of bitcoin prices, this demand has vanished, which will further weigh on prices (Chart I-5, bottom panel). Supply High semiconductor prices in 2016-2017 boosted global production capacity expansion of DRAM and NAND memory chips. Based on data compiled by the IDC, global DRAM and NAND flash capacity expanded by 5.7% and 4.3% respectively in 2018 from a year earlier. As most of the global new capacity was added in the second half of 2018, the output of DRAM and NAND in 2019 will be higher than last year. Moreover, DRAM capacity will grow an additional 4% this year. Because of rising supply and slowing demand, both DRAM and NAND markets are in excess supply and have high inventories. DRAMeXchange forecasts that average DRAM prices will drop by at least another 20% in 2019, while NAND flash prices will fall another 10% from current levels. DRAM and NAND flash memory are the largest components of Korean tech producers. Yet they also sell many other tech products such as analog integrated circuits, LCD drivers, discrete circuits, sensors, actuators, and so on. Apart from the negative impact of declining global DRAM and NAND flash prices, the country’s semiconductor exports will also suffer from slowing demand in China in 2019. China, the biggest importer of Korean semiconductor products, has already shown waning demand. Its imports of electronic integrated circuits and micro-assemblies have contracted over the past two months in both value and volume terms (Chart I-6, top and middle panels). This mirrors a similar contraction in Korean semiconductor exports over the same period (Chart I-6, bottom panel). Chart I-6Weakening Chinese Semiconductor Demand Bottom Line: Korean semiconductor producers will likely face a contraction in their sales in 2019 due to weakening demand and deflating semiconductor prices. Diminishing Competitive Advantage Korea has been losing its competitive edge in key sectors like automobiles and smartphones. Even though the country remains highly competitive in the global semiconductor industry, it is beginning to show early signs of losing competitiveness there too. Improving competitiveness among other producers as well as a slowing pace of technological improvement and rising production costs are major reasons underlying Korea’s diminishing global competitiveness. Automobiles Korean auto manufacturers have lost market share in the global auto market. In China, the world’s biggest auto market, Korean brands’ market share has declined significantly in the past four years, losing out to both Japanese and German brands (Chart I-7, top three panels). Chart I-7Korea: Losing Market Shares In China's Auto Market Korean car companies have established auto manufacturing plants in China over the past decade. As a result, all Korean cars sold in China are produced within China, and automobile exports to China from Korea have fallen to zero (Chart I-7, bottom panel). Due to Korean auto manufacturers’ diminishing competitive advantage, Korean automobile production and exports peaked in 2012 in terms of volumes, and have been on a downtrend over the past seven years (Chart I-8, top panel). Chart I-8Further Decline In Korean Auto Output And Exports Is Possible While demand for Korean cars in the EU remains resilient, sales volumes in the U.S., China and the rest of world have been on a downward trajectory (Chart I-8, bottom three panels). Smartphones In the global smartphone market, Korea’s major smartphone-producing company – Samsung – has been in fierce competition with Chinese brands, and it seems to be losing the battle. Chart I-9 shows that while Samsung’s smartphone sales declined 8% year-on-year last year, smartphone sales from major Chinese smartphone producers (Huawei, Xiaomi, Oppo and Vivo) continued to grow at a pace of 20%. Chart I-9Korea: Losing Market Shares In Global Smartphone Market From 2012 to 2018, China’s share of global smartphone shipments rose from 6% to 39%. By comparison, Samsung’s share declined from 30% to 21% over the same period. Semiconductors Korean semiconductor companies – notably Samsung and SK Hynix – will likely remain the biggest producers in the memory market, given their advanced technology. However, there are still signs that Korean semiconductor companies will face increasing challenges in protecting their market share. Based on IDC data, Korean semiconductor companies’ share of global DRAM capacity will inch lower to 65% in 2019 from 65.4% in 2017, while their share of NAND capacity will decline to 53.8% from 57.5% during the same period. Meanwhile, China is focusing on boosting its self-sufficiency in terms of semiconductor production. At the moment there is still a three- to four-year technological gap between China and Korea in DRAM and NAND mass production, though the gap is likely to narrow. In the meantime, the U.S. will continue to create obstacles to prevent the rise of the Chinese semiconductor sector. However, these factors will only delay – not avert – the sector’s development and growth. We believe China will remain firmly committed to develop its semiconductor sector, particularly memory products, irrespective of the cost of investment necessary to do so. Similar to what has transpired in both automobile and smartphone production (Chart I-10), China will slowly increase its penetration in the semiconductor market with increasing capacity and a narrower technology gap over the next five to 10 years. After all, the world’s biggest semiconductor demand is in China. Chart I-10China: A Rising Star In Global Auto And Smartphone Market Significant increase in labor costs = falling export competitiveness for all sectors Korean President Moon Jae-in’s flagship economic policy, “income-led growth,” has resulted in dramatic increases in minimum wages since he took office in 2017, further damaging Korea’s competitiveness. The nation’s minimum wage was hiked by 7.3% in 2017, 16.4% in 2018 and will rise by another 11% to 8,350 KRW or $7.40 an hour, in 2019. As the president remains committed to meeting his campaign pledge of lifting the minimum wage to 10,000 KRW an hour, or about $8.90, this would require a further 20% increase in the next year or two. In addition, the government has also limited the maximum workweek to 52 hours since last July for businesses with more than 300 workers. Last month, the Cabinet further approved a revision bill whereby workers are eligible to receive an additional eight hours of wages every weekend for 40 hours of work that week. The new wage regulations have become a substantial burden on employers in all industries. The impact is more severe on small- and medium-sized enterprises (SMEs). According a recent survey, about 30% of SMEs have been unable to pay workers due to the state-set minimum wage. It is also affecting large manufacturers. According to a joint statement released in late December by the Korea Automobile Manufacturers Association and the Korea Auto Industries Cooperative Association, local automakers’ annual labor cost burdens will increase by at least 700 billion won (US$630 million) a year. As for auto parts manufacturers, a skyrocketing financial burden due to the new policy may threaten their survival. In addition, despite the KORUS FTA agreement reached between Korea and the U.S. last September, Korean auto manufacturers still fear they will be subject to new tariffs in 2019. On February 17, the U.S. Commerce Department submitted a report about imposing tariffs on imported automobiles and auto parts to U.S. President Donald Trump, who will make a decision by May 18. Our Geopolitical Strategy Service (GPS) team believes the odds of U.S. administration imposing auto tariffs on imported cars from Korea are small as this will be against the KORUS FTA agreement.2 Our GPS team also believes Japan is less likely to suffer a tariff than the EU, and even if Japan suffers a tariff along with the EU, Japan will negotiate a waiver more quickly than the EU. In both cases, Korea is likely to sell more cars in the U.S., but it will continue to face strong competition from Japan. Bottom Line: In addition to weakening global demand, a deterioration in Korea’s competitive advantage, due in large part to improving competitiveness among other producers and rising domestic wages, will negatively affect Korean exports. What About Domestic Demand? Record fiscal spending in 2019 will boost public sector consumption considerably, offsetting weakening consumption in the private sector. As the new wage policy will likely result in more layoffs and additional shuttering of businesses, domestic retail sales growth will remain under pressure (Chart I-11). Hence, an unintended consequence of the government’s higher income policy will be weaker aggregate income and consumer spending growth. Chart I-11KOREA The New Wage Policy May Trigger More Layoffs And Weaken Retail Sales Manufacturing and service sector jobs, including wholesale and retail trade and hotels and restaurants, account for 17% and 23% of total employment, respectively. Of all sectors, these two lost the most employees in January from a year ago. Meanwhile, due to the government’s deregulation of loans in 2014, Korean household debt has increased at a much faster pace than nominal income growth (Chart 12, top panel). As a result, Korea’s household debt has rapidly risen to 86% of its GDP as of the end of the third quarter of last year, from 72% four years ago – (Chart I-12, bottom panel). Elevated household debt at a time of rising layoffs will increase consumer anxiety and weigh on household spending. Chart I-12High Household Debt Will Weigh On Spending In order to combat an economic downturn, the government last month approved a record 467 trillion won ($418 billion, 26.5% of the country’s 2018 GDP) budget for 2019, up 9.5% from last year. The last time the budget increased by such a big scale was in 2009, when spending rose 10.7% in the wake of the global financial crisis. In addition, the government will front-load spending – with 61% of the budget to be spent in the first half of 2019. Household spending and government expenditures account for 48% and 15% of real GDP, respectively, while exports equal about 50% of real GDP. Hence, the increase in fiscal spending will not entirely offset the contraction in exports and slowdown in consumer spending. This entails a considerable slowdown in economic growth in 2019. Bet On Monetary Easing With growth disappointing and both headline and core inflation well below 2% (Chart I-13), the central bank will cut rates in 2019. Chart I-13Bet On A Rate Cut So far, economic growth has decelerated in the past 10 months, and recent data shows no signs of recovery. The country’s manufacturing sector is in contraction, with manufacturing PMI holding below the 50 boom-bust line in January (Chart I-14). Meanwhile, South Korea's unemployment rate rose to a nine-year high in January, with most of the job losses in the manufacturing and construction sectors. Chart I-14Manufacturing Sector: Still In Contraction Saramin, a South Korean job search portal, surveyed 906 firms in South Korea last month, 77% of which expressed unwillingness to hire new employees due to higher labor costs and negative business sentiment. Retail sales volume growth recently tumbled to 2-3%, pointing to faltering domestic demand (Chart I-11 above, bottom panel). The fixed-income market is not pricing in a rate cut in 2019. Therefore, investors should consider betting on lower interest rates. Shrinking exports and rate cuts will likely undermine the Korean won. Bottom Line: Economic deceleration and low inflation will lead the central bank to cut interest rates in 2019. Investment Implications The following are our investment recommendations: Downgrade the Korean tech sector from overweight to neutral within the EM space. We are reluctant to downgrade to underweight because many other emerging markets and sectors within the EM universe have poorer structural fundamentals than Korean tech. The tech sector accounts for 38% of the MSCI Korea Index, and 27% of the KOSPI in terms of market value. The stock with the largest weight in the MSCI Korea equity index is Samsung Electronics, with a share of 25%, followed by SK Hynix, with a ~5% share. Both are very sensitive to semiconductor prices. Specifically, semiconductor sales accounted for 31% of Samsung’s revenue, but contributed 77% of Samsung’s operating profit last year (Table I-2). Falling prices reduce producers’ profits by more than falling volumes.3 Hence, profits of semiconductor producers in Korea and globally will shrink in 2019. This will lead to a substantial selloff in Korean tech stocks (Chart I-15). Chart I-15Falling Memory Prices Will Trigger A Sell-Off In Korean Tech Stocks Meanwhile, China accounts for 33% of Samsung’s revenue, making it the largest market (Chart I-16). The ongoing economic slump in China’s domestic demand implies weaker demand for Korean shipments to China, which account for 28% of its exports and 14% of its GDP. ​​​​​​​ We are booking gains on our strategic long position in the Korean tech sector versus the EM benchmark index first instituted on January 27, 2010. This trade resulted in a 136% gain (Chart I-17, top panel). Chart I-16Taking Profits On Our Overweight Tech Positions Consistently, we are also taking profits on our long EM tech / short EM materials stocks trade, a strategic recommendation initiated on February 23, 2010 that has yielded a 186% gain (Chart I-17, second panel). The basis for this strategic position was our broader theme for the decade of being long what Chinese consumers buy and short plays on Chinese construction, which we initiated on June 8, 2010.4 Stay overweight non-tech equities within the EM space. The fiscal stimulus will have a considerable positive impact on the economy. Besides, Korean non-tech stocks have been weak relative to the EM equity benchmark, and in a renewed EM selloff they could act as a low-beta play (Chart I-17, bottom panel). We initiated our long Korean non-tech sector versus the EM benchmark index on May 31, 2018, which has so far been flat. The KRW/USD exchange rate is at a critical technical juncture. Investors should wait and buy on a breakout or sell on a breakdown of the tapering wedge pattern. The KRW/USD has been in a tight trading range over the past eight months (Chart I-18) and is approaching a major breaking point – i.e., any move will be significant, which we expect will largely depend on the movement of the RMB/USD. Chart I-18Tapering Wedge Patterns The natural path for the RMB would have been depreciation versus the U.S. dollar. However, China may opt for a flat exchange rate versus the U.S. dollar given its promises to the U.S. within the framework of forthcoming trade agreements. We have been shorting the KRW versus an equally weighted basket of USD and yen since February 14, 2018. We continue to hold this trade for the time being. Investors should augment their positions if the KRW/USD breaks down or close this trade and go long the won if the KRW/USD breaks out of its tapering wedge pattern. With respect to fixed income, we continue to receive Korean 10-year swap rates as we expect interest rates to fall meaningfully. Local investors should overweight bonds versus stocks.   Ellen JingYuan He, Associate Vice President Emerging Markets Strategy ellenj@bcaresearch.com     Footnotes 1 DRAMeXchange, the memory and storage division of a technology research firm TrendForce, has been conducting research on DRAM and NAND Flash since its creation in 2000. 2 Please see the Geopolitical Strategy Weekly Report, "Trump's Demands On China", published April 4, 2018. Available at gps.bcaresearch.com. 3 Please see the Emerging Markets Strategy Weekly Report “Corporate Profits: Recession Is Bad, Deflation Is Worse”, dated January 28, 2016, available at www.bcaresearch.com 4 Please see the Emerging Markets Strategy Special Report “How To Play Emerging Market Growth In The Coming Decade”, dated June 8, 2010, available at www.bcaresearch.com. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Fed: With financial conditions easing and core inflation more likely to rise than fall, the majority of Fed officials will feel justified lifting rates again in the second half of this year. The best way to position for the resumption of rate hikes is to sell the 5-year or 7-year part of the Treasury curve and buy a duration-matched barbell consisting of the short and long ends of the curve. These sorts of positions currently offer positive carry, meaning you get paid as you wait for the market to price rate hikes back in. Corporate Spreads: Maintain an overweight allocation to corporate bonds (both investment grade and high-yield) with the exception of the Aaa credit tier. But be prepared to reduce exposure when spreads reach our target levels. Economy: Tracking estimates for 2018 Q4 and 2019 Q1 real GDP have fallen significantly during the past two weeks. The decline in tracking estimates is heavily influenced by an abnormal December retail sales report. That impact will reverse in 2019. Feature The Federal Reserve’s “on hold” strategy is now well known and has been completely discounted in the market. In fact, the overnight index swap curve is priced for 9 bps of rate cuts during the next 12 months and 21 bps of cuts during the next 24 months (Chart 1). Chart 1Primary Dealers Still Looking For Hikes At this point, the only thing that’s unclear is how the Fed will respond to the economic data going forward. Will it be eager to re-start rate hikes at the first sign of calm? Or perhaps the Fed is leaning toward a strategy where the next move will be a rate cut in the face of flagging economic growth? Survey Says Unfortunately, last month’s FOMC meeting was not accompanied by an updated Summary of Economic Projections. We therefore don’t know how policymakers have revised their rate hike expectations since December. However, the New York Fed’s Survey of Primary Dealers was updated in January, and it shows that the median primary dealer still expects two rate hikes this year. The only change between the December and January surveys is that the median primary dealer now expects one of the 2019 rate hikes in June and the other in December. In the December survey, both 2019 rate hikes were anticipated before the end of June (Chart 1). Typically, the median primary dealer and the median FOMC participant have very similar views on the future interest rate trajectory. Counting The Minutes The next stop on our search for clarity is the minutes from the January FOMC meeting, which were released last week. The January minutes provide a lot of insight into the thought processes of different FOMC participants. Unfortunately, they also reveal a serious lack of cohesion amongst the group. All in all, the document might confuse more than it clarifies. A few key excerpts from the document drive this point home. Referring to “global economic and financial developments”: Many participants observed that if uncertainty abated, the Committee would need to reassess the characterization of monetary policy as “patient” and might then use different language. This suggests that many Fed participants view the pause in rate hikes as a result of slower non-U.S. growth and tighter financial conditions. They also suggest that if global growth improves and financial conditions ease it would be appropriate to abandon a “patient” stance. … several […] participants argued that rate increases might prove necessary only if inflation outcomes were higher than in their baseline outlook. This second statement is much more dovish than the first. It suggests that several participants think that even improving global growth and an easing of financial conditions would not be sufficient to re-start rate hikes. They would also need to see inflation come in stronger than expected. Several other participants indicated that, if the economy evolved as they expected, they would view it as appropriate to raise the target range for the federal funds rate later this year. Finally, this last statement reveals that several other participants disagree with the view that an unexpected rise in inflation is a pre-condition for further rate hikes. What can we make of all this mess? The first thing that seems clear is that all Fed members view easier financial conditions as a pre-condition for further rate hikes. In this regard, we are already well on our way. Financial conditions have eased considerably since the start of the year, with the stock-to-bond total return ratio up sharply and credit spreads, the VIX and the dollar all off their highs (Chart 2). Chart 2Financial Conditions Are Easing Second, all FOMC participants need more confidence that inflation will return to target before re-starting rate hikes, but this bar seems higher for some than for others. Year-over-year core and trimmed mean CPI are currently running at 2.15% and 2.19%, respectively. This is slightly below the 2.4% level that is consistent with the Fed’s inflation target (Chart 3).1 The minutes suggest that some FOMC participants would be comfortable re-starting rate hikes as long as core inflation moves higher in the next few months and approaches the Fed’s target from below. Some others, however, may need to see an overshoot of the Fed’s inflation target before recommending rate hikes. Chart 3Core Inflation Needs To Move Higher Depressed inflation expectations, as seen in the TIPS market or the Michigan Consumer Sentiment survey, are a related issue (Chart 3, bottom 2 panels). The Fed will probably want to see upward movement in both of these measures before resuming rate hikes. In fact, New York Fed President John Williams warned last week that the “persistent undershoot of the Fed’s [inflation] target risks undermining the 2 percent inflation anchor.” He added that “the risk of the inflation expectations anchor slipping toward shore calls for a reassessment of the dominant inflation targeting framework.”2 Williams has long been an advocate for a monetary policy framework where the Fed targets an overshoot of its inflation target in the future to “make up” for undershooting its target in the past, i.e. some form of price level targeting. The Fed is currently conducting a year-long investigation into whether it should switch to this sort of regime and we learned last week that the Fed will announce the results of its investigation in the first half of 2020. Our own sense is that the Fed will eventually adopt some sort of “history dependent” inflation target as a way to avoid continuously bumping up against the zero-lower bound on interest rates. But this change will not occur this year and maybe not even next year. Of course, the more immediate concern for bond investors is whether inflation pressures will be meaningful enough in the next few months for the Fed to resume rate hikes in 2019. We expect they will be. We have previously shown that base effects alone will pressure year-over-year core CPI higher as we head toward mid-year.3 Meanwhile, other signs also point toward rising core inflation (Chart 4): Chart 4Inflation Pressures Building The New York Fed’s Underlying Inflation Gauge is running close to 3% (Chart 4, top panel). The ISM Manufacturing PMI is off its highs, but is still consistent with rising year-over-year core CPI (Chart 4, panel 2). Our CPI Diffusion Index is deep in positive territory, pointing to further near-term upside in the core measure (Chart 4, bottom panel). Bottom Line: With financial conditions easing and core inflation more likely to rise than fall, the majority of Fed officials will feel justified lifting rates again this year. January’s FOMC minutes imply that several Fed members want to see an overshoot of the inflation target before advocating for the resumption of rate hikes, but until the Fed changes its inflation targeting regime they will likely be out-voted. The Best Way To Trade The Fed We continue to recommend a below-benchmark duration bias in U.S. bond portfolios, on the view that rate hikes will exceed depressed market expectations on a 12-month horizon. However, this is not the most attractive way to position for the resumption of Fed rate hikes. The best way to trade the Fed in the current environment is by initiating a duration-neutral yield curve trade where you buy a barbell consisting of the long and short ends of the curve, and sell the 5-year or 7-year maturity. In a prior report we demonstrated that the 5-year and 7-year Treasury yields are most sensitive to changes in our 12-month fed funds discounter.4 That is, when the market starts to price-in more Fed rate hikes, the 5-year and 7-year Treasury yields increase more than other maturities. Similarly, the 5-year and 7-year yields fall the most when our discounter declines. Clearly, this means that if you are short the 5-year/7-year part of the curve versus the wings, you will make money as rate hikes are priced back into the market. Usually the problem with implementing such a trade is that it has negative carry. That is, the 5-year or 7-year bullet typically offers a greater yield than what you would earn on a duration-matched 2/10 or 2/30 barbell. If you don’t time the trade properly, you end up losing money waiting for Fed rate hike expectations to move. However, this is not a problem at the moment. In fact, duration-matched barbells are now positive carry propositions relative to 5-year and 7-year bullets (Chart 5). Chart 5 Barbell Yields Greater Than Bullet Yields In other words, if you think rate hikes will resume at some point, you are currently getting paid to wait for the market to catch on. The only way to lose money in this sort of trade is if our 12-month fed funds discounter falls further from its current -9 bps level. We view that as an unlikely scenario. Bottom Line: The best way to position for the resumption of Fed rate hikes is to sell the 5-year or 7-year part of the Treasury curve, and buy a barbell consisting of the long and short ends of the curve. We currently recommend being short the 7-year and long the 2/30 barbell. This trade has positive carry, meaning that you will earn money as you wait for rate hikes to get priced back in.  Corporate Spread Targets As we have discussed in prior reports, we think the Fed’s pause opens up a window where corporate bond spreads have room to tighten during the next few months.5 However, we also acknowledge that the window for outperformance is limited. Once financial conditions ease and the Fed resumes rate hikes, the environment will quickly become more difficult for corporate bonds. For this reason, in last week’s report we presented Chart 6. The diamonds in Chart 6 show where corporate 12-month breakeven spreads are today relative to past “Phase 2” periods, which are environments similar to today when the yield curve is quite flat but still positively sloped.6 We argued that we would be quick to reduce corporate bond exposure when the breakeven spreads reach the historical median for Phase 2 periods, i.e. when the diamonds fall to the 50% line in Chart 6. However, we acknowledge that this is not a helpful guide for investors who don’t have timely access to our valuation metrics. So this week we present Charts 7A and 7B. These charts estimate the option-adjusted spread (OAS) levels for each credit tier of the Bloomberg Barclays corporate bond indexes that would be consistent with the 50% line in Chart 6. To make these estimates we need to assume that the average duration of each index remains constant. The results show the following spread targets: For Aa we target 55 bps. The current OAS is 61 bps. For A we target 84 bps. The current OAS is 94 bps. For Baa we target 128 bps. The current OAS is 161 bps. For Ba we target 186 bps. The current OAS is 236 bps. For B we target 298 bps. The current OAS is 391 bps. For Caa we target 571 bps. The current OAS is 813 bps. We do not recommend an overweight allocation to Aaa-rated corporate bonds, where spreads are already expensive relative to past Phase 2 periods (Chart 7A, top panel). Chart 7aInvestment Grade Spread Targets Chart 7BHigh-Yield Spread Targets   Bottom Line: Maintain an overweight allocation to corporate bonds (both investment grade and high-yield) with the exception of the Aaa credit tier. But be prepared to reduce exposure when spreads reach our target levels. Economic Update We will finally receive GDP data for the fourth quarter of 2018 on Thursday, and investors should ready themselves for a weak number. In fact, the most recent tracking estimates from the New York Fed have real GDP coming in at 2.35% in Q4 and a mere 1.20% in 2019 Q1 (Chart 8). Chart 8Poor GDP Tracking Estimates ... It will come as no surprise that the trend in GDP growth is vital to our interest rate call. In fact, we showed in a recent report that when year-over-year nominal GDP growth falls below the 10-year Treasury yield it is often a good signal that monetary policy has turned restrictive and that interest rates have peaked for the cycle.7 With that in mind, if we add 1.2% expected real growth in Q1 to the 1.7% average growth rate of the GDP deflator (Chart 8, bottom panel), we can roughly estimate nominal GDP growth of 2.9% in Q1. This remains above the current 10-year Treasury yield, suggesting that monetary conditions would still be accommodative, but just barely. However, we expect the Q1 tracking forecast to improve as new data come in. According to the New York Fed’s model, the weak December retail sales report trimmed 0.41% from its Q1 growth forecast and this report increasingly looks like an aberration. In contrast to the retail sales number, the Johnson Redbook index of same-store sales is growing at a rate close to 5%, and indexes of consumer confidence remain elevated (Chart 9). Chart 9...Driven By Abnormal Retail Sales Even the Fed staff’s economic report, as presented in the January FOMC minutes, suggests that December should have been a good month for consumer spending: The release of the retail sales report for December was delayed, but available indicators – such as credit card and debit card transaction data and light motor vehicle sales – suggested that household spending growth remained strong in December. Bottom Line: However, we expect the Q1 tracking forecast to improve as new data come in. According to the New York it seems likely that the partial government shutdown influenced the collection of the December retail sales data and led to an abnormal print. Since the retail sales data feed directly into GDP, the impact will be felt in the next GDP report. But the impact will prove fleeting.   Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Footnotes 1 The Fed’s target is for 2% PCE inflation. CPI tends to run about 0.4% above PCE. 12-month core PCE is currently 1.88%, but data only go to November. This is why we refer to CPI in this report, which has data through January. 2 https://www.newyorkfed.org/newsevents/speeches/2019/wil190222 3 Please see U.S. Bond Strategy Weekly Report, “Caught Offside”, dated February 12, 2019, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, “Don’t Position For Curve Inversion”, dated January 22, 2019, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, “Buy Corporate Credit”, dated January 15, 2019, available at usbs.bcaresearch.com 6 For more detail on the different phases of the economic cycle please see U.S. Bond Strategy Special Report, “2019 Key Views: Implications For U.S. Fixed Income”, dated December 11, 2018, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, “Running Room”, dated January 29, 2019, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Special Report

Highlights The Phillips curve, which encouraged economic policymakers of the sixties and early seventies to believe in a mechanical tradeoff between inflation and unemployment, fell into disrepute once stagflation strangled the U.S. economy. We do not view the idea that there is an inverse relationship between the unemployment rate and wage gains as controversial. This weak form of the Phillips curve simply formalizes the interplay between supply and demand in the labor market. We have found, however, that any reference to the Phillips curve has the potential to provoke strong reactions from investors. The criticism that the link between compensation gains and consumer prices is questionable has merit. Over the last 30 years, changes in compensation have exhibited a sporadic correlation with changes in consumer prices. Even if the empirical evidence between labor market tightness and inflation is somewhat wobbly, the Fed remains squarely in the Phillips curve camp, and its take on the relationship is the only one that matters for monetary policy. The investment implication is that labor market strength will prove self-limiting. An unemployment rate bound for 3.5% or lower will pull the Fed back off the sidelines, ultimately bringing down the curtain on the expansion and the equity bull market. Feature The stagflation of the seventies was a near-death experience for the Phillips curve and its proposition that unemployment and inflation are inversely related. As both Milton Friedman and Edmund Phelps had predicted, the trade-off could not survive beyond the short term because workers would adjust their expectations as they caught on to the pattern, demanding wages that kept pace with inflation even when unemployment was high. Duly modified, the Phillips curve’s appeal was rekindled, and the Phelps-Phillips expectations-augmented version has gone mostly unchallenged within the economics profession ever since. The Fed and other policymakers may have given up on the notion that they could manage their economies via a mechanical tradeoff between inflation and unemployment, but the inverse relationship remains a pillar of their macroeconomic models. We don’t find the idea that the unemployment rate and wage inflation are inversely related the least bit controversial, as it fully accords with the laws of supply and demand. Unemployment’s link to consumer price inflation is uncertain, however, and even the narrow unemployment/wages form of the Phillips curve relationship we favor often invites controversy. Discussing upward wage pressures within the context of consumer price inflation and the Fed’s reaction function can elicit spirited resistance. As one client put it in a January meeting, “it is unbecoming for BCA to subscribe to these sorts of cost-plus notions of inflation.” This Special Report examines the record in an effort to determine the influence the Phillips curve thesis will have on policy and markets going forward. It asks the following questions along the way: What is the Phillips curve? Where does inflation come from? Is there a relationship between wage inflation and price inflation? Where does the Fed stand? What impact will a falling unemployment rate have on the economy and financial markets? A Brief History Of The Phillips Curve The Phillips curve arose from a study of the unemployment rate and wages in the U.K. from the mid-nineteenth to the mid-twentieth centuries. William Phillips discovered a consistent inverse relationship between the unemployment rate and changes in wages: high unemployment was associated with muted wage gains, and low unemployment was associated with robust wage gains. He posited that the unemployment rate revealed the level of tightness in the labor market, and the extent to which employers had to compete to attract workers. Other researchers extended the relationship from wage inflation to price-level inflation and suggested that policy makers could use the tradeoff between unemployment and inflation to fine-tune the course of the economy. The stagflation of the seventies blew up the notion of a mechanical tradeoff, but a modified form of the inverse relationship between unemployment and wage gains resides at the heart of mainstream macroeconomic forecasting models. Those models have become more sophisticated, and now include the concept of a natural rate of unemployment, but the inverse relationship between unemployment and inflation remains at their core. Investor skepticism aside, the Phillips curve is deeply embedded in orthodox economic narratives relating inflation and unemployment. As New York Fed President Williams put it last Friday in the first line of a speech discussing the issues raised in a new Phillips curve paper, “The Phillips curve is the connective tissue between the Federal Reserve’s dual mandate goals of maximum employment and price stability.1” Where Does Inflation Come From? Thousands of dissertations have grappled with this subject without providing a definitive solution, but there are two broad explanations we find most compelling. The first is that inflation responds to the level of slack in the economy. That’s to say that inflation is a by-product of the relative balance between aggregate supply and aggregate demand. When the output gap is wide (demand falls well short of the economy’s capacity), inflation is unlikely to find a footing. When the output gap is closed (demand and capacity are in balance) or negative (demand exceeds capacity), inflation will gain traction unless imported capacity bridges the gap. For the second, we combine the idea that inflation expectations play a central role with Milton Friedman’s always-and-everywhere admonition. The stable inflation of the last couple of decades has coincided with stable inflation expectations. The causation mostly appears to run from (trailing) inflation to expectations (Chart 1), but expectations surely influence economic actors’ price negotiations and open the door to a monetary influence. Inflation expectations are likely to be well anchored under a central bank that convinces households and businesses of its commitment to price stability. When the monetary authority lacks inflation credibility, inflation expectations may become unmoored and impel economic actors to insist upon higher wages and selling prices to keep pace with a rising price level. Chart 1Seeing The Future In The Recent Past The expectations-augmented Phillips curve makes it clear that inflation is a function of inflation expectations just as surely as it is a function of the unemployment rate. The more firmly expectations are anchored, the more unemployment has to drift from its natural rate (NAIRU, or u-star (u*)) to move the inflation needle. In other words, when expectations are as well-anchored as they have been since the crisis, wages will be so unresponsive to changes in the unemployment rate that the Phillips curve will appear to be broken. Believing that inflation will permanently remain at 2% or lower, workers feel no urgency to press for larger wage/salary increases. The Empirical Record – Unemployment And Wages The seventies played havoc with the Phillips curve, but over the last twenty-five years, the inverse relationship between changes in the unemployment rate and wage gains has held up very well once the unemployment rate has reached threshold levels at or near u-star. When there is ample slack in the labor market, wages are nearly insensitive to changes in the unemployment rate. When the unemployment rate moves from 10% to 9%, 9% to 8%, or 8% to 7%, there are multiple qualified candidates for every job opening and employers have no reason to bid wages higher (Chart 2, top panel). Below 5%, roughly around u*, employers have to compete for workers and wage gains are very sensitive to moves in the unemployment rate (Chart 2, bottom panel). Chart 3 illustrates the threshold concept, segmenting the last 30 years of observations by their relationship to the unemployment gap. Observations for which the unemployment gap is greater than or equal to 2% are shown in gray; their best-fit line with wage gains is nearly flat. Positive, but small, unemployment-gap observations are shown in orange; their best-fit line is steeper and indicates a more robust correlation with moves in wages. Negative unemployment-gap observations are colored blue; they have the steepest best-fit line and exhibit the tightest correlation with changes in wages. A skeptic might seek more convincing evidence, but period-to-period noise in the data limits the amount of variation in wages explained by the unemployment rate (just under 40% over the last 30 years). Noting that the unemployment gap tends to persist in negative and positive territory for extended periods, we measured the annualized rate of wage gains for negative-gap and positive-gap phases. The results were robust, with wage gains in negative-gap phases consistently topping gains in positive-gap phases (Chart 4). Both groups exhibited remarkably consistent growth rates – the three complete negative-gap phases featured wage gains of 3.8%, 3.8% and 3.9%, while the three positive-gap phases had wage growth of 2.7%, 2.5% and 2.4%. At 3%, the current negative-gap phase has already separated itself from the last three decades’ positive-gap phases, though the 3.8% level is still a ways away. Chart 4Mind The Gap The Empirical Record – Wage Inflation And Price Inflation If businesses were omniscient, omnipotent and able to adjust selling prices in real time – something like Amazon, in another words – they might seek to preserve their profit margins by instantaneously raising prices to offset wage gains. Wage inflation and price inflation would then move together in lockstep without any lags. Businesses do not have unlimited power or unlimited knowledge, however, and neither do workers. There are information and expectation lags, and price-making/price-taking status is fluid. The empirical record over the 50-plus years covered by the average hourly earnings series shows that the wage-price relationship is constantly shifting. Under a cost-push inflation framework, tightness in the labor market shows up in consumer prices after employees negotiate raises, and employers subsequently raise prices to recoup lost profits. In a demand-pull model, businesses perceiving signs of excess demand take the opportunity to raise prices, spurring employees to demand raises to preserve their purchasing power. There is room for both models, as BCA’s analysis of wage/price dynamics over the years has shown that leadership between prices and wages regularly shifts. For the purposes of this report, it is sufficient to note that the wage/price skeptics have a point. A decade-by-decade review of year-on-year gains in average hourly earnings (“AHE”) and core CPI shows that correlations between AHE and consumer prices regularly make big swings. The ‘60s, ‘80s and ‘00s were pretty good to Phillips curve adherents (Chart 5), but the ‘70s, ‘90s and the current decade mocked them, featuring repeated instances of outright decoupling (Chart 6). The bottom line is that the direction of causation between wages and consumer price inflation, as well as the sensitivity of the relationship, is fluid. The empirical record does not support the idea that wage inflation translates to overall inflation in a consistent and timely fashion. Chart 5Moving In Lockstep One Decade... Chart 6... Decoupling The Next The Fed’s Reaction Function Wage gains exhibit little sensitivity to changes in the unemployment rate when there is a lot of slack in the labor market. Even at lower levels of unemployment, inflation expectations can temper wages’ sensitivity to the unemployment rate. There is assuredly an inverse relationship between wages and unemployment, nonetheless, and wage gains are especially sensitive when the unemployment gap is negative. The jury is out on the relationship between unemployment and inflation, however. The direction of causation is not constant and the response lags between the series can be quite long. Inflation expectations play a sizable role, and are capable of smothering wage gains in times of low unemployment if they’re well-anchored, or goosing them even in times of high unemployment if they’re spiraling upward. Believing in the Phillips curve relationship requires a lot of assumptions, and if the theory were brand-new today, it might have a hard time surviving peer review. Markets don’t take their cues from peer-reviewed journals, however. When it comes to interest rates and the entire gamut of financial assets impacted by monetary policy, the Fed has the last word. What it believes about the Phillips curve is much more important than whether or not its conclusions have iron-clad empirical support. It has long been BCA’s view, informed by our contacts within the Fed, the former central bankers who sat on our Research Advisory Board, the Bank of Canada veterans who have worked at BCA, and careful observation of the Fed’s own comments and research, that the Fed maintains a Phillips curve view of the world. The Fed has plenty of company in this regard. Nearly all central banks are Phillips curve believers; in the absence of a mainstream alternative model of inflation, they all have to fall back on the expectations-augmented hypothesis. Investors and economics enthusiasts can rail against the Phillips curve’s empirical shortcomings, and posit that globalization, robotics/AI, Amazon and the gig economy have rendered it null and void. Those theories have not been confirmed by the data,2 however, and until the profession unites behind an alternative narrative, the Phillips curve will continue to heavily influence monetary policy. New York Fed President Williams clearly subscribes to the tell-‘em-what-you’re-gonna-tell-‘em/tell-‘em/tell-‘em-what-you-just-told-‘em method of constructing speeches. One need look no further than his remarks last Friday, when discussing a paper co-authored by former Fed governor Frederic Mishkin, for his view. “[T]he Phillips curve is very much alive in very tight labor markets,” he said near the beginning of his remarks. “[T]he Phillips curve is alive and kicking,” he said more than halfway through. “In summary, the Phillips curve is alive and well,” he said in conclusion, in case anyone in the audience had been napping. The bottom line for an investor today is that the Fed’s reaction function ensures that labor market strength will ultimately prove to be self-limiting. Assuming that Baby Boomer retirements will stifle further gains in the labor force participation rate, the unemployment rate is likely to ratchet lower across 2019.3 As it dips further and further below NAIRU, the Fed can be counted upon to remove accommodation, ultimately triggering a recession (Chart 7). Chart 7Expansions End When Unemployment Rises Investment Implications As the Fed’s pause allows the economy to regather momentum, hiring and wage growth should be well supported. The accompanying decline in the unemployment rate will drive the Fed to revive its tightening campaign. The irony is the longer the Fed grants the economy, and investors, a respite by holding its fire, the more accommodation it will have to remove to stamp out inflation pressures. It will take until 2020 for the Fed to complete its tightening campaign, but we expect the terminal fed funds rate in this cycle will be at least 3.25 to 3.5%, far above the OIS curves’ projection that fed funds will end 2020 at 2.25%. Such a wide disparity between our expectations and market expectations leaves considerable room for the Treasury curve to shift out along all maturities. We expect the curve will ultimately invert, but the process will follow a bear-flattening course, and long maturities will suffer the worst capital losses. We therefore advocate underweighting Treasuries in all fixed-income portfolios, while maintaining below-benchmark duration in all bond sleeves. We expect that Fed tightening will bring the curtain down on the equity bull market before the recession officially begins (Chart 8). Until it does, however, we expect the Fed’s forbearance to help the economy generate evident momentum, pushing risk-asset values higher. We continue to recommend that investors overweight equities and spread product for now, but the clock is ticking. Watch the unemployment gap for the cue to position portfolios more defensively. Chart 8Inducing A Recession Is Tantamount To Inducing A Bear Market Doug Peta, CFA, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com     Footnotes 1      Williams, John C., “Discussion of ‘Prospects for Inflation in a High Pressure Economy: Is the Phillips Curve Dead or Is It Just Hibernating?’” Remarks at the U.S. Monetary Policy Forum, New York City, February 22, 2019. https://www.newyorkfed.org/newsevents/speeches/2019/wil190222 2      Please see the September 2017 Bank Credit Analyst Special Report, “Did Amazon Kill the Phillips Curve?” available at bcaresearch.com. 3      Holding the participation rate constant, the U.S. economy has to create 110,000 jobs a month to keep the unemployment rate at a steady state. Please see the Atlanta Fed’s online jobs calculator at https://www.frbatlanta.org/chcs/calculator.aspx.

Highlights A sooner-than-anticipated end to the Federal Reserve’s balance-sheet runoff should give a welcome boost to international liquidity conditions. Moreover, reflationary efforts in China, cautious global central banks, and easing global financial conditions all point to a rebound in economic surprises. This will support pro-cyclical versus defensive currencies and argues against a strong USD. At this point, it is too early to tell how long a pro-cyclical FX stance will be warranted. Sell NZD/CAD. Feature Since the turn of the year, this publication has argued that a correction in the dollar was increasingly likely, and that the main beneficiaries of this move should be the more pro-cyclical currencies. Because U.S. domestic fundamentals remain much stronger than the rest of the G10’s, our preference has been to favor commodity currencies versus the yen instead of playing dollar weakness outright. This theme remains in place for now. However, we are increasingly concerned about the dollar and think the outperformance of commodity currencies could last longer than originally expected. Essentially, an end to the Federal Reserve’s balance-sheet runoff, more cautious central banks, and easier global financial conditions could set the stage for a significant rebound in commodity currencies. U.S. Excess Reserves Vs. Commodity Currencies Whether it is from Governor Lael Brainard, Cleveland Fed President Loretta Mester, or the FOMC minutes, the message is clear: The days of the Fed’s balance sheet runoff are numbered. Ryan Swift, BCA’s Chief U.S. Bond Strategist, has written at length that the Fed’s balance sheet attrition has had a limited direct impact on U.S. growth. However, Ryan and the FOMC members both agree that a smaller balance sheet impacts the ability of the Fed to control the level of the fed funds rate.1 With less excess reserves in the banking system, the New York Fed has to intervene more often to keep the policy rate below its ceiling. This might seem like a very technical point, but it is an important one for many FX markets. Prior to the financial crisis, expanding excess reserves on U.S. commercial banks would coincide with improving dollar-based liquidity. Moreover, since 2011, reserves even lead our financial liquidity index (Chart I-1). Since there is 14 trillion of USD-denominated foreign-currency debt around the world, these fluctuations in U.S. excess reserves, and thus global liquidity, can have an impact on the price of assets most levered to global growth conditions. Chart I-1U.S. Excess Reserves Contribute To The Global Liquidity Backdrop Chart I-2 illustrates that commodity currencies are indeed very responsive to changes in U.S. excess reserves, particularly when these pro-cyclical currencies are compared to counter-cyclical ones like the JPY. Meanwhile, the trade-weighted dollar tends to move in the opposite direction of excess reserves, reflecting the dollar’s countercyclical nature (Chart I-3). This relationship, however, is not as tight as the one between commodity currencies and the reserves. Chart I-2Improving Growth In Excess Reserves Leads To Stronger Commodity Currencies... Chart I-3...And To A Weaker Greenback A corollary to the growing consensus within the FOMC to end the balance-sheet runoff sooner than later is that the contraction in excess reserves will end. A bottoming in the rate of change of the reserves is consistent with a rebound in commodity currencies, especially against the yen, and with a correction in the dollar. Gold prices are very sensitive to global liquidity conditions. Today, not only is the yellow metal moving closer to the US$1350-US$1370 zone that marked its previous highs in 2016, 2017, and 2018, but also, the gold rally is broadening, as exemplified by the advance / decline line of gold prices versus nine currencies, which is making new highs (Chart I-4, top panel). This indicates that the precious metal could punch above this resistance level. Gold is probably sniffing out an improvement in global liquidity conditions. Since rising gold prices tend to lead EM high-yield bond prices higher (Chart I-4, bottom panel), investors need to monitor this move closely. Chart I-4A Broadening Gold Rally Is Consistent With Easing Liquidity Conditions Bottom Line: The growing chorus among FOMC members singing the praises of the end of the Fed’s balance-sheet runoff points toward a significant slowdown in U.S. excess reserves attrition. While this may not be a significant development for U.S. domestic economic variables, it should help liquidity conditions outside the U.S. While this could weigh on the greenback, the probability is higher that it will help commodity currencies in the short run, especially against the yen. Global Policy And Commodity Currencies In China, new total social financing hit CNY 4.6 trillion in January, well above the normal seasonal strength. Accordingly, the Chinese fiscal and credit impulse is starting to improve (Chart I-5). While this rebound is currently embryonic, our Geopolitical Strategy team has argued that a massive increase in Chinese credit this January would indicate a change in Beijing’s economic priorities.2 The Chinese government may be trying to limit the downside to growth, and reflation may expand. This would result in a further pick-up in the credit impulse. Chart I-5The Chinese Credit Impulse May Be Bottoming Easing EM financial conditions – courtesy of rebounding EM high-yield bond prices – and rising Chinese credit flows should ultimately lead to improving growth conditions across EM. As a result, our diffusion index of EM economic activity – which tallies improvements across 23 EM economic variables – should bounce from currently very depressed levels. Such a recovery is normally associated with a weaker trade-weighted dollar, a stronger euro, rising commodity prices and rising commodity currencies – both against the USD and the JPY (Chart I-6). Chart I-6IF EM Growth Conditions Improve, This Will Have A Profound Impact On the FX Market We can expand this line of thinking to the global economy. Our Leading Economic Indicator Diffusion Index, which compares the number of countries with a rising LEI versus those with a falling LEI, already rebounded five months ago. Historically, this signals an upcoming rebound in the BCA global LEI. Additionally, other major central banks are also sounding an increasingly cautious tone. This should accentuate the easing in global financial conditions that began in late December, creating another support for global growth. However, global investors remain very pessimistic on global growth, as exemplified by this week’s very poor global growth expectations computed from the German ZEW survey (Chart I-7). This dichotomy between depressed growth expectations and burgeoning green shoots suggests that risk asset prices have room to rally further in the coming quarter or two. Chart I-7Investors Remain Pessimistic About Growth, Yet Green Shoots Are Popping Up These dynamics are positive for commodity currencies and negative for the dollar. This cycle, the pattern has been for the trade-weighted dollar to correct and hypersensitive pro-cyclical currencies like the AUD and the NZD to perk up only after our Global LEI diffusion index has trough, and around the same time as risk asset prices rebound (Chart I-8). Chart I-8Thinking About Growth, Asset Prices, The Dollar, And Commodity Currencies Treasury yields will most likely also be forced higher by improving risk asset prices and economic activity, especially as bond market flows suggest T-notes currently are a coiled spring. The U.S. Treasury International Capital System data released at the end of last week was very revealing. The press emphasized the large-scale selling of Treasurys from the Cayman Islands – interpreted as selling by hedge funds. Missing from the picture was the enormous buying from these same players over the past 12 months, which corresponded with falling yields and a rallying trade-weighted dollar (Chart I-9). It was a sign of growing fear that pushed up the price of bonds. Chart I-9Hedge Funds Have Room To Liquidate Their Treasury Holdings If, as we expect, global growth beats dismal expectations and risk assets rebound further, the countercyclical dollar should correct. This will further ease global financial conditions and justifying even more a wholesale liquidation of stale bond holdings by hedge funds and further pushing the Fed toward resuming its hiking campaign faster than the market is currently anticipating. This combination is highly bond bearish. Unsurprisingly, this means that the yen, which normally trades closely in line with U.S. Treasury yields, is likely to weaken. Hence, USD/JPY and EUR/JPY could experience significant upside over the coming months (Chart I-10). Chart I-10A Bond Bearish Backdrop Is Also Bad For The Yen Bottom Line: Global growth conditions are evolving away from a dollar-bullish, commodity currency-bearish backdrop. Not only is the dollar-based liquidity set to improve, but China is also releasing the proverbial brake. Additionally, a generally more cautious tone among global central banks will contribute to easing global financial conditions. These developments are likely to result in a period of positive global economic surprises – and an environment where the greenback weakens and where pro-cyclical currencies outperform. But For How Long? It remains a question mark as to how long this pro-growth cycle will last. Parts of the dynamics described above are very self-defeating. If global growth conditions and asset prices rebound strongly, the Fed will be in a better position to increase rates once again. This could quickly curtail the improvement in global financial conditions and favor a strong dollar. Additionally, it is not clear how far Beijing will go in terms of pushing reflation through the Chinese economy. Chinese policymakers are worried about too-pronounced a slowdown but are equally worried about too much debt in their economy, and do not want to repeat the debt binge witnessed in 2010 and 2016. Therefore, they may be much quicker to lift their foot off the gas pedal. This conflicting attitude is best illustrated by recent opposing remarks made by Chinese policymakers. On the one hand, Premier Li-Keqiang expressed concerns regarding the January credit surge, suggesting that some Chinese policymakers are already trying to dampen expectations that stimulus will be substantial. On the other hand, the PBoC sounded utterly unconcerned.  Moreover, as our Emerging Markets Strategy service highlights, EM earnings are likely to continue to suffer from the lagged effect of China’s previous tightening. This creates the risk that even if global growth rebounds, EM stock prices, EM FX and all related plays do not follow. This would maintain the dollar-bullish environment and hurt pro-cyclical commodity currencies while supporting the yen. Despite these risks, it is nonetheless too early to tell how short-lived this period of dollar softness and commodity currency strength will be.  After all, the dollar is a momentum currency. If the dollar weakness gathers steam, a virtuous cycle could emerge: improving global growth begets a weaker dollar, a weaker dollar begets easier global financial conditions, easier global financial conditions beget stronger growth, and so on.          Gold prices may hold the key to cut this Gordian knot. If gold cannot maintain its recent gains, then the pro-cyclical positioning will not be valid for more than three months. However, if gold prices can remain at elevated levels or even rally further, then this pro-cyclical positioning will stay appropriate for at least six to nine months. What is clear is that for now, buying risk in the FX space makes sense. Bottom Line: At this point, too many crosscurrents are at play to evaluate confidently the length of any rally in pro-cyclical currencies relative to defensive ones. Since easier financial conditions ultimately force the Fed to resume hiking and since it is far from clear how committed to reflation Chinese policymakers are, our base case remains that this move will last a quarter or so. However, the fact that a falling dollar further eases global financial conditions, fomenting greater global growth in the process, suggests that a virtuous circle that create additional dollar downside can also emerge. Gold may provide early signals as to when investors should once again adopt a defensive posture. Sell NZD/CAD Something exceptional happened three months ago. For the second time in 25 years, Canadian policy rates fell in line with New Zealand’s. As Chart I-11 shows, this last happened from 1998 to 1999, when NZD/CAD subsequently depreciated 26%. However, today Canada’s and New Zealand’s current accounts are roughly in line while back then New Zealand had a substantially larger deficit, such a decline is unlikely to repeat itself. Nonetheless, we posit that NZD/CAD possesses ample downside. Chart I-11Bad News For NZD/CAD First, like in 1998-‘99, the real trade-weighted NZD exhibits a larger premium to its fair value than the real trade-weighted CAD (Chart I-12). In fact, the relative premium of the NZD to the CAD is roughly comparable as it was back then. Moreover, our Intermediate-Term Timing Model for NZD/CAD reinforces this message as it suggests that short-term valuations are also stretched (Chart I-13). Chart I-12NZD/CAD Is Pricey... Chart I-13...And Our Short-Term Valuation Metric Agrees Second, the New Zealand economy is currently weaker than that of Canada. Relative consumer confidence and business confidence have been in a downward trend for three years. Historically, while NZD/CAD can deviate from such dynamics, ultimately this cross tends to revert toward relative growth trends. The recent collapse in New Zealand’s economic surprises relative to Canada’s suggests that the timing for such a reversion is increasingly ripe, as there is currently scope for investors to discount a more hawkish Bank of Canada than Reserve Bank of New Zealand. Indeed, 1-year/1-year forward yields in Canada have fallen much more relative to the BoC overnight rate than similar forwards have fallen relative to the RBNZ policy rate. Third, New Zealand real bond yields have collapsed relative to Canada’s. As Chart I-14 illustrates, NZD/CAD tends to follow real yield differentials. So far, NZD/CAD has been less-weak than the real-yield gap would imply, but from late 2003 to early 2005 this cross also managed to defy gravity for an extended time, only to ultimately succumb to the inevitable. Chart I-14Falling Real Yield Spreads Will Weigh On NZD/CAD Fourth, as the top panel of Chart I-15 illustrates, the performance of kiwi stocks relative to Canadian equities tend to lead NZD/CAD, especially at tops. While tentative, the ratio of New Zealand to Canadian stocks seems to have peaked in early 2016. Supporting this judgment, kiwi profits have fallen relative to their Canadian counterparts and relative net earnings revisions are following a similar path – a move normally associated with a weaker NZD/CAD (Chart I-15, bottom panel). Chart I-15Relative Stock Market Dynamics Look Poor Fifth, terms of trades are becoming a growing headwind for NZD/CAD (Chart I-16). The price of agricultural commodities relative to energy products drives this pair, reflecting the comparative advantages of the two countries. BCA’s Commodity & Energy service is currently much more positive on the outlook for the energy complex than the agricultural complex. NZD/CAD is a perfect instrument to implement this view, especially now that the NZD suffers from a very rare negative carry against the CAD. Chart I-16A Negative Tems-Of-Trade Shock For NZD/CAD Bottom Line: NZD/CAD is set to experience an important fall. The NZD currently suffers from a very rare negative carry against the CAD. The last time this happened, a large depreciation ensued. Moreover, valuations and economic trends argue in favor of shorting this pair. Finally, relative bond yields, equity dynamics and term-of-trade outlooks also point to a lower NZD/CAD. Sell at 0.900, with a stop at 0.927 for a target of 0.800.     Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy Weekly Report, titled “Caught Offside”, dated February 12, 2019, and the U.S. Bond Strategy Weekly Report, titled “The Great Unwind”, dated September 19, 2017, available at usbs.bcaresearch.com 2 Please see Geopolitical Strategy Special Report titled “China: Stimulating Amid The Trade Talks,” dated February 20, 2019 available at gps.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. has been mixed: Capacity Utilization underperformed expectations, coming in at 78.2%. However, Michigan Consumer Sentiment outperformed expectations, coming in at 95.5. Finally, the NAHB Housing Market Index also surprised to the upside, coming in at 62. The DXY has fallen by 0.2% this week. We remain bullish on the U.S. dollar on a cyclical basis, given that the Fed will end up hiking rates more than expected. However, the current easing of monetary conditions by Chinese authorities should tactically hurt the dollar and help commodity currencies. Moreover, the fact that the Fed announced that it might bring about an end to the balance sheet runoff sooner than expected will further help global liquidity conditions. The real question now is how long the coming dollar correction will last? Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Global Liquidity Trends Support The Dollar, But... - January 25, 2019 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area has been mixed: The annual growth in construction output underperformed expectations, coming in at 0.7%. The current account balance also surprised to the downside, coming in at 33 billion euros. However, the Zew Survey – Economic sentiment, though negative, surprised to the upside, coming in at -16.6. EUR/USD has risen by 0.4% this week. We remain bearish on EUR/USD on a cyclical basis; given that, we expect real rates to rise much faster in the U.S. than in the euro area. This is because we think that the U.S. economy  will remain stronger than Europe’s, a consequence of the fact that the former has experienced a significant private sector deleveraging since 2008 while the latter has not. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 2019 Key Views: The Xs And The Currency Market - December 7, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: Machinery orders yearly growth outperformed to the upside, coming in at 0.9%. Hurt by a very sharp contraction in shipments to China, the yearly growth of Japanese exports also surprised to the downside, coming in at -8.4%. However, imports yearly growth outperformed to the upside, coming in at -0.6%. USD/JPY has risen by 0.2% this week. We are bearish towards the yen on a tactical basis as the current upturn in liquidity conditions should hurt safe haven currencies. Moreover, reflationary efforts by Chinese Authorities should provide a boon to risk assets and make low yield currencies like the yen even less attractive. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Yen Fireworks - January 4, 2019 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been strong: Retail sales and retail sales ex-fuel yearly growth both outperformed expectations, coming in at 4.2% and 4.1%. Moreover, the yearly growth of average hourly earnings excluding bonus also surprised positively, coming in at 3.4%. GBP/USD has risen by 0.9% this week. We expect that a soft Brexit deal remains the most probable outcome out of Westminster. Thus, this factor, along with how cheap the pound is, make us bullish on the pound on a long-term basis. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Deadlock In Westminster - January 18, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia has been mixed: The wage price index yearly growth underperformed expectations, coming in at 0.5%. However, the employment change surprised to the upside, coming in at 39.1 thousand in January. The participation rate also surprised positively, coming in at 65.7%. AUD/USD has fallen 0.7% this week. We are positive on the AUD on a tactical basis. Global monetary conditions have eased thanks to the rising Chinese credit and more cautious global central banks. Moreover, the announcement that the Fed is looking to halt its balance sheet reduction sooner than expected has provided further relief. However, the fundamentals of Australia remain poor, and thus long-term investors should continue to avoid this currency, Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 CAD And AUD: Jumping Higher To Plunge Deeper - February 1, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 The recent data in New Zealand has been mixed: The business PMI in January fell to 53.1. However, the input of the producer price index on a quarter-over-quarter basis surprised to the upside, coming in at 1.6%. NZD/USD depreciated by 0.7% this week. While NZD/USD might have some upside in the short term, we remain bearish on the NZD/USD on a cyclical basis. Both the short-term and long-term interest rates in New Zealand are lower than in the U.S., while the real trade-weighted NZD is trading at 7% premium to its fair value. Thus, the kiwi is relatively overvalued which means that any tactical upside of NZD won’t have legs.  Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Updating Our Intermediate Timing Models - November 2, 2018 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 The recent data in Canada has been neutral: The December new housing price index stays unchanged at 0%, on both month-over-month and year-over-year basis. The CAD has risen by 0.2% against USD this week. As BCA anticipates oil prices to strengthen more, we also expect the CAD to outperform the AUD and the NZD over the next few months. However, we remain bearish on CAD/USD on a structural basis. The unhealthy housing market in Canada could be a potential risk to the Canadian financial industry and the economy as a whole. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 CAD And AUD: Jumping Higher To Plunge Deeper - February 1, 2019 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 The recent data in Switzerland has been positive: The December exports increased to 19,682 million, while the imports increased to 16,639 million. The trade balance in December thus increased to 3,043 million, surprised to the upside. EUR/CHF has been flat this week. We are bullish on EUR/CHF on a cyclical basis. Easy global financial conditions should hurt safe haven currencies like the franc. Moreover, we believe that the SNB will continue to play a heavily dovish bias in order to counteract the fall in inflation caused by the surge in the franc last year. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Waiting For A Real Deal - December 7, 2018 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway has been positive: January trade balance increased to 28.8 million, from previous 25 billion. USD/NOK was flat this week. In general, we are overweight the krone, since we believe the pickup in oil prices will help the Norwegian economy, ultimately boosting the performance of NOK against the EUR,  the SEK, the AUD and the NZD. Moreover, the NOK is undervalued and currently trading at a large discount to its fair value, which could further lift the performance of the NOK on a cyclical basis. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Global Liquidity Trends Support The Dollar, But... - January 25, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden has been negative: January unemployment rate has increased to 6.5%. Moreover, the monthly inflation rate comes in at -1%, surprising to the downside. USD/SEK rallied by more than 1% this week. We remain bearish on EUR/SEK since the SEK is currently trading at a discount to its long-term fair value. Moreover, there are many signs pointing to a Swedish economy rebound. The negative rate in the country and easy financial conditions could stimulate the domestic demand and if global growth perks up, the weak inflation readings will prove transitory. The Riksbank has already abandoned it pledge to suppress the krona and it will move this year to lift rates again. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Global Liquidity Trends Support The Dollar, But... - January 25, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Special Report

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