Money/Credit/Debt

Highlights Mutual Funds & ETFs: The liquidity mismatch between easily tradeable mutual fund shares and the less liquid underlying corporate bonds makes it possible for negative feedback loops to emerge between fund flows and corporate bond spreads. The growing presence of open-ended mutual funds and ETFs in the corporate bond market should be seen as a risk that could exacerbate future periods of spread widening, leading to worse economic outcomes. BBB Securities: The large amount of outstanding BBB debt could lead to fire sales from corporate bond holders with investment grade-only mandates when the debt is downgraded to junk. However, in contrast to the negative feedback loop that can be generated by mutual fund flows, the evidence shows that the negative price pressure from fallen angel fire sales is fleeting. Leveraged Loans: The rapid surge in leveraged loans has been partially offset by reduced high-yield issuance, helping mitigate a potentially destabilizing rise in all riskier corporate debt. At the same time, bank exposure is focused on the safest CLO tranches, limiting the potential systemic risks from bank losses. Feature In April, we published a Special Report that investigated whether corporate debt poses a risk to the U.S. economy.1 That report focused on what economic theory and empirical evidence say about the relationship between corporate debt and future economic growth. We arrived at the following conclusions: The empirical evidence decisively shows that private (household + business) debt helps predict future economic outcomes. Some evidence shows that household debt is more important than corporate debt in this regard. In contrast to mainstream economic theory, the level of private debt-to-GDP does not help predict future economic outcomes. Rather, it is rapid private debt growth that is linked to more severe economic downturns. Ebullient credit market sentiment is also shown to predict weak economic growth. Tight credit spreads should be viewed as a warning sign, similar to rapid private debt growth. In this follow-up Special Report, we consider three credit market developments that are unique to this cycle: The large ownership stake of open-ended mutual funds and ETFs in the U.S. corporate bond market. The elevated amount of BBB-rated debt outstanding relative to other credit tiers. The rapid issuance of leveraged loans. All three of these developments could mediate the relationship between corporate debt and economic growth, potentially increasing risks to the economy. We consider each factor in turn. 1. Fund Flows One unique feature of the current cycle is that open-ended mutual funds and ETFs own a much larger share of outstanding corporate bonds than in the past. Back in 1990, insurance companies and pension funds were the largest holders of corporate debt, controlling 54% of the market. Meanwhile, open-ended funds owned a paltry 3%. Since then, fund ownership has surged to 16%, mostly at the expense of financial institutions, insurance companies and pensions. Foreign holdings of U.S. corporate bonds have also increased during this period, from 13% of the market to 28% (Charts 1 & 2). Chart 1 Chart 2Mutual Funds Now An Important Market Player Mutual Funds Now An Important Market Player Mutual Funds Now An Important Market Player Why Does Fund Ownership Matter? We focus on fund ownership of corporate bonds because it has been theorized that flows into and out of open-ended mutual funds can have a similar impact on market prices as leverage, amplifying price moves in either direction. As described in a 2014 paper by Feroli, Kashyap, Shoenholtz, and Shin:2 [W]hen asset flows for certain fixed income securities are high, prices persistently rise and a feedback loop emerges. High flows lead to rising prices, which attract more flows, which further raises prices. Obviously, the proposed feedback loop also works in reverse: Outflows cause prices to decline, and lower prices lead to further outflows. This sort of feedback loop is unique to mutual funds. Insurance companies and pension funds, for example, do not experience investor capital flight in response to a near-term price drop. This makes the larger presence of mutual funds in the corporate bond market potentially destabilizing. Fund ownership has surged to 16%, from a paltry 3% back in 1990. Why Do Fund Flows Behave This Way? Mutual fund shares are much more liquid than the corporate debt securities they hold. As described in a 2017 paper by Goldstein, Jiang and Ng:3 When [mutual] fund investors redeem their shares, they get the net asset value as of the day of redemption. The fund then has to conduct costly liquidation that hurts the value of the shares for investors who keep their money in the fund. Hence, the expected redemption by some investors increases the incentives for others to redeem. In other words, during times of stress, mutual fund investors have an incentive to withdraw their money before other fund shareholders get the chance. Otherwise, they could be stuck holding a basket of illiquid corporate bonds. This bank-run like behavior is well documented for corporate and municipal bond funds, though it appears not to exist for funds that traffic in more liquid instruments, such as Treasuries and equities. In fact, when Goldstein et al looked at how flows into and out of individual corporate bond and equity funds respond to past fund performance, they found that the Flow-Performance curve for an individual corporate bond fund exhibits a pronounced concave shape. Meanwhile, the same curve for an individual equity fund is convex (Chart 3). This means that corporate bond mutual fund shareholders are quick to redeem their shares in response to poor fund performance, while equity fund shareholders are more inclined to stand pat. On the flipside, positive fund performance leads to large equity fund inflows, but doesn’t attract capital to corporate bond funds to the same extent. The above results apply to individual funds, but Goldstein et al also performed the same analysis for corporate bond funds in the aggregate. That is, rather than measuring whether investors sold a particular corporate bond mutual fund in response to its poor performance, they measured whether investors exited the corporate bond mutual fund space altogether in response to poor corporate bond performance. Interestingly, they found a very similar result (Chart 4). Investors are inclined to exit the corporate bond space entirely following periods of poor performance. Meanwhile, they found no relationship between aggregate equity fund flows and performance. Investors might switch between different equity funds in response to recent performance trends, but they don’t exit the asset class altogether. Chart 3 Chart 4   These results provide a clear indication for why the large presence of corporate bond mutual funds might be destabilizing. Corporate bond fund investors are quick to flee the space during periods of poor performance. For more liquid securities, such as equities and Treasuries, a large mutual fund presence in the market is not a concern, since flows do not respond as aggressively to price shocks. Empirical Evidence For The Flow-Performance Feedback Loop The evidence presented above shows that fund flows respond to performance, but for the theorized feedback loop between fund flows and corporate bond prices to exist, we also need evidence that fund flows impact corporate bond performance. In that regard, a 2019 Banque de France working paper examines the impact of aggregate flows into French corporate bond funds on the yields of the underlying securities.4 It finds that not only do flows impact yields contemporaneously, but also that outflows have a larger influence on yields than inflows. Using a different methodology, a 2015 paper by Hoseinzade finds no material impact of fund flows on underlying corporate bond yields, but for an interesting reason.5 The paper confirms that corporate bond fund shareholders demonstrate bank-run like behavior in response to poor performance, but also argues that “bond fund managers hold a significant level of liquid assets, allowing them to manage redemptions without excessively liquidating corporate bonds.” Chart 5Funds Deploy Cash Before Selling Bonds Funds Deploy Cash Before Selling Bonds Funds Deploy Cash Before Selling Bonds It’s true that corporate bond mutual funds often hold significant allocations to cash and U.S. Treasuries, and Hoseinzade shows that fund managers tend to discharge their most liquid holdings first, before attempting to sell corporate bonds. This result lines up with our casual observation. Chart 5 shows the aggregate liquid asset (cash and Treasury) holdings of corporate bond mutual funds. It is apparent that they tend to fall during periods of spread widening. We also note that corporate bond mutual funds, in aggregate, currently hold about 6% of their assets in liquid securities. This buffer can probably withstand a sizeable shock, but liquid assets fell from similar levels into negative territory during each of the past two recessions. One other factor that could help break the feedback loop between fund flows and prices is the institutional ownership of corporate bond mutual funds. Goldstein et al find that mutual funds mostly owned by institutional investors exhibit less of a feedback loop between flows and performance. That is, large institutional investors are less likely to redeem their shares in response to a bout of poor performance. While we don’t have data on corporate bond mutual fund ownership specifically, Federal Reserve data reveal that insurance companies and pension funds own a significantly larger proportion of outstanding mutual fund shares than in the 1990s, though less than they did in the mid-2000s (Chart 6). Note that Chart 6 shows data for all mutual funds, including equity funds, Treasury funds, etc… Chart 6Institutional Ownership Of Mutual Funds Institutional Ownership Of Mutual Funds Institutional Ownership Of Mutual Funds We conclude that there is enough evidence of a feedback loop between fund flows and corporate bond prices that we should be wary of the growing presence of open-ended mutual funds and ETFs in the corporate bond space. Cash holdings and institutional ownership can help mitigate negative flow/performance feedback loops to some extent, but probably shouldn’t be counted on in the event of a severe shock. What’s The Economic Impact? In our corporate debt Special Report from April, we postulated that changes in corporate bond spreads might, themselves, cause an economic downturn, rather than simply reflect one. The mechanism is summarized nicely by Lopez-Salido, Stein and Zakrajsek (2016):6 [a] sentiment-driven widening of credit spreads amounts to a reduction in the supply of credit, especially to lower credit-quality firms. It is this reduction in credit supply that exerts a negative influence on economic activity. With that in mind, in the current environment it seems very possible that an initially sentiment-driven credit spread widening could be exacerbated by outflows from corporate bond mutual funds. A larger shock to credit spreads leads to a larger reduction in credit supply and a more severe economic impact. Aggregate liquid asset holdings of corporate bond mutual funds tend to fall during periods of spread widening. Bottom Line: The liquidity mismatch between easily tradeable mutual fund shares and the less liquid underlying corporate bonds makes it possible for negative feedback loops to emerge between fund flows and corporate bond spreads. The growing presence of open-ended mutual funds and ETFs in the corporate bond market should be seen as a risk that could exacerbate future periods of spread widening, leading to worse economic outcomes. 2: BBB Debt Outstanding Chart 7The Large Amount Of BBB Debt The Large Amount Of BBB Debt The Large Amount Of BBB Debt It has been widely reported that an unusually large amount of outstanding corporate bonds are rated BBB, the lowest credit rating that is still considered investment grade. In fact, the par value of BBB-rated securities now makes up 50% of the Bloomberg Barclays Investment Grade index, up from 21% in 1990 (Chart 7). The amount of outstanding BBB securities is more than double the par value of the Bloomberg Barclays High-Yield index, and BBBs represent 41% of the total combined par value of the investment grade and high-yield indexes. The reason to be wary about the large amount of outstanding BBB debt is that when the credit cycle turns and ratings downgrades start to occur, a larger than normal amount of debt will be downgraded from investment grade into high-yield. When that happens, any investors with an investment grade-only mandate will be forced to sell. The concern is that such forced selling could set off a negative feedback loop very similar to the one discussed in the first section. An added layer of risk comes from the fact that in addition to investment grade-only mutual funds, insurance companies and pension funds – who still control 35% of the corporate bond market (see Chart 2 on page 3) – are often burdened with larger capital costs for high-yield debt. This means that a very large pool of investors could be impacted by a spate of BBB downgrades. In terms of the potential market impact, a 2010 paper by Ellul, Jotikasthira and Lundblad investigated fire sales of downgraded corporate bonds induced by regulatory constraints.7 The authors found that insurance companies often engage in the forced selling of bonds that have been recently downgraded into high-yield. Further, the downgraded bonds experience negative near-term price pressure from the fire sale, but that pressure tends to reverse after a few months. The finding that the negative price pressure is fleeting is important. In contrast to the negative feedback loop that can be generated by mutual fund flows, BBB securities can only be downgraded to high-yield once. In other words, once the initial fire sale of fallen angel debt takes place, there is no mechanism to force the downward price pressure to continue.8 Bottom Line: The large amount of outstanding BBB debt could lead to fire sales from corporate bond holders with investment grade-only mandates when the debt is downgraded to junk. However, in contrast to the negative feedback loop that can be generated by mutual fund flows, the evidence shows that the negative price pressure from fallen angel fire sales is fleeting. 3. Leveraged Loans The rapid growth of leveraged loans – lending made to below investment-grade borrowers - over the past couple of years has caught the attention of global central banks and financial regulators. That concern is understandable, as it would be a dereliction of duty for any policymaker or regulator who lived through the 2008 financial crisis to not consider the potential risks to financial stability and future economic growth from a surge in lower quality lending. This is especially true given the increase in the number of securitized instruments linked to leveraged loans – collateralized loan obligations, or CLOs – which evokes memories of the toxic subprime mortgage products that helped trigger the 2008 crisis. Although as the Fed’s Vice Chair for Supervision, Randal Quarles, recently noted, the financial media has been overplaying the leveraged loan story in such a way that it felt like “the Earth must be getting hit by an asteroid.” The BoE estimates that the CLOs would have to suffer a loss more than twice as severe as seen during the 2008 financial crisis for the AAA-rated piece of CLOs issued in 2018 to incur losses. The leveraged loan and CLO markets can be opaque. However, based on the information we do have from credible sources like central banks, the IMF and the BIS, some conclusions can be made about the potential economic risks from the rapid build-up of U.S. leveraged loans: Leveraged loan expansion has been partially offset by high-yield contraction. Chart 8More Leveraged Loans, Less Junk Bonds More Leveraged Loans, Less Junk Bonds More Leveraged Loans, Less Junk Bonds Based on estimates from the BIS and IMF, there are around $1.4 trillion in U.S. leveraged loans outstanding, which is greater than the $1.2 trillion U.S. high-yield bond market (Chart 8). That is an all-time high in the dollar amount of leveraged loans, as well as for the share of all lower-rated corporate debt accounted for by loans. The annual growth rate of U.S. leveraged loans is now a whopping 29% - the fastest pace seen since 2007. Yet the growth of the total amount of leveraged loans plus high-yield bonds is a much lower 12%. While that is still a large number, it is below the peak growth rates seen during the past fifteen years. This is because the amount of high-yield bonds outstanding has been modestly contracting since 2015. Much of that run-up in leveraged loan growth has been to satiate the demand for loans created by private equity funds and, more importantly, CLOs. The strong risk appetite from investors resulted in a notable deterioration in lending standards, with loans coming out at higher leverage multiples (debt/EBITDA) and with reduced investor covenant protection. Yet since lower-rated companies were not ramping up high-yield bond issuance at the same time, the economic stability risks from a rapid run-up in total riskier borrowing are lower, on the margin. The ownership structure of leveraged loans (and CLOs) is diverse enough to not create systemic problems. Chart 9 To date, the Bank of England (BoE) has compiled the most detailed estimates of the ownership breakdown of both leveraged loans and CLOs.9 In Chart 9, we have recreated a chart from the BoE’s July 2019 Financial Stability Report, which colorfully shows the ownership of global leveraged loans and CLOs. The way to read the chart is that each square represents a 1% share of the estimated $3.2 trillion of global leveraged loans and CLOs. The split in the chart is 75% loans and 25% CLOs (CLO ownership is shown on the right side of the thick dotted line). The biggest category of leveraged loan investor is what the BoE titled “U.S. and other global banks”, a group that represents 38% of total loans and CLOs. European banks own 12%, U.K. banks own 3% and Japanese banks own 3% (entirely through CLOs), thus bringing the global bank exposure to 56% of all leveraged loan instruments. While that sounds like a large number, the majority of that is in the form of revolving credit facilities – effectively, overdraft facilities to lower-rated borrowers. Revolving credit facilities are typically less risky than leveraged loans, because credit facilities have greater covenant protection and even more seniority in terms of creditor claims on borrower assets. The BoE estimates that 40% of all global leveraged loans and CLOs are owned by non-bank investors. This includes pension funds, insurance companies and investment funds (mutual funds and ETFs). Chart 9 shows how much more diverse the investor base is for CLOs than for other leveraged loans. It suggests that any future potential losses from CLOs will be distributed more evenly within the financial system, rather than being concentrated in the banks. Chart 10Leveraged Loan Losses Are Typically Lowered Compared To Junk Leveraged Loan Losses Are Typically Lowered Compared To Junk Leveraged Loan Losses Are Typically Lowered Compared To Junk Even within the bank holdings of CLOs, the systemic risks are lessened. The BoE noted that the increased amount of subordination (i.e. lower-rated tranches) of more recent CLO deals helps protect the senior tranches from losses. According to the BoE, the AAA-rated piece of a representative sample of CLOs issued in 2018 was 63%; this compares to 70% for CLOs issued in 2006.10 Furthermore, the central bank estimates that the CLOs would have to suffer a loss more than twice as severe as seen during the 2008 financial crisis for the AAA-rated piece of CLOs issued in 2018 to incur losses. That would be an extraordinary outcome, given how 2008 generated losses on leveraged loans that were over twice as bad as the previous worst year in 2002 (Chart 10). Potential losses from AAA tranches are important from a financial stability perspective. The BoE estimates that 40% of all CLOs are owned by global banks (including a large 13% share from yield-chasing Japanese banks). These banks tend to focus on safer AAA-rated CLO tranches. The demand for leveraged loan products is volatile, but that might actually be a good thing for economic stability. The surge in leveraged loans over the past two years has not only been related to demand from private equity funds and CLOs. U.S. retail investors have also been big buyers of mutual funds and ETFs linked to the leveraged loan market, as a way to seek out higher credit returns against a backdrop of Fed rate hikes. Chart 11Fed Rate Expectations Drive The Demand For Loans Vs Bonds Fed Rate Expectations Drive The Demand For Loans Vs Bonds Fed Rate Expectations Drive The Demand For Loans Vs Bonds Leveraged loans are floating rate instruments. Thus, they are more desirable than fixed-rate high-yield corporate debt when short-term interest rates are rising. This is seen in Chart 11, where we show net flows into the largest U.S. junk bond and leveraged loan ETFs. These flows are plotted with the JP Morgan survey of bond investor duration positioning (top panel) and our Fed Funds Discounter that measures the market-implied expected change in the fed funds rate over the next year (bottom panel). The conclusion is obvious – there was very strong retail demand for floating-rate leveraged loans over fixed-rate junk bonds during 2016-18 when expected rate hikes justified defensive duration positioning. In 2019, the tables have turned. The Fed is more dovish, rate cuts are now expected, investors have been adding duration exposure, and demand for leveraged loan funds has plunged while high-yield bond funds have been seeing inflows. The exodus from all leveraged loan funds has been historically large, with Lipper reporting that there were 33 straight weeks of outflows to July 3, 2019, for a total of $32 billion.11 Already, that reduced demand for leveraged loans has translated into sharply reduced issuance of new U.S. CLOs, which was 73% lower in the first half of 2019 versus the same period in 2018 (Chart 12). At the same time, high-yield bond issuance was up 20% in the first six months of 2019 versus 2018. The reduced demand for leveraged loans has also shifted the balance of power back to lenders, as the share of U.S. leveraged loans that have been issued with limited covenant protection (“cov-lite”) has plunged from 72% in 2018 to around 40% (Chart 13). Chart 12Lower-Rated Issuance Is "Self-Regulating" Lower-Rated Issuance Is "Self-Regulating" Lower-Rated Issuance Is "Self-Regulating" Chart 13Reduced Covenant-Lite Issuance So Far In 2019 Reduced Covenant-Lite Issuance So Far In 2019 Reduced Covenant-Lite Issuance So Far In 2019     This is a critical point on the potential stability risks from leveraged loans – the market for those loans is “self-regulating”, based on final demand from investors who “toggle” between floating rate and fixed rate credit instruments. This helps limit the growth in overall corporate indebtedness, helping to put off the date when credit booms turn into future credit busts. Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Robert Robis, CFA, Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1      Please see U.S. Bond Strategy / Global Fixed Income Strategy Special Report, “The Risk From U.S. Corporate Debt: Theory And Evidence”, dated April 23, 2019, available at usbs.bcaresearch.com 2     https://www.nowpublishers.com/article/DownloadEBook/9781680834864?format=pdf 3     http://finance.wharton.upenn.edu/~itayg/Files/bondfunds-published.pdf 4     https://ideas.repec.org/p/bfr/banfra/706.html 5     https://pdfs.semanticscholar.org/5a60feab84a7d10de084abfce414b5888d5586e2.pdf 6     https://www.nber.org/papers/w21879 7     https://pdfs.semanticscholar.org/55a4/8602b17bc7e7f8428695ab6a3ef2c87756ab.pdf 8      Corporate bonds that are downgraded from investment grade to high-yield are called fallen angels. 9      The Financial Stability Board, the international body that monitors and makes recommendations on the global financial system, is due to publish a comprehensive analysis of the ownership structure of the leveraged loan market in the autumn of 2019. 10     For a more detailed description of this analysis, see pages 28 & 29 of the Bank of England’s July 2019 Financial Stability report, which can be found here: https://www.bankofengland.co.uk/financial-stability-report/2019/july-20… 11     https://www.spglobal.com/marketintelligence/en/news-insights/latest-news-headlines/leveraged-loan-news/leveraged-loan-fund-withdrawal-streak-hits-record-33-weeks-totaling-32b  

Dear Client, In lieu of next week’s regular report, we will be bringing you a Special Report featuring a no-holds-barred debate over the economic and financial market outlook among three of BCA’s more bullish strategists (Doug Peta, Rob Robis, and yours truly) and three of the more bearish ones (Anastasios Avgeriou, Arthur Budaghyan, and Dhaval Joshi). Best regards, Peter Berezin, Chief Global Strategist Highlights Slowdowns are much more likely to turn into recessions when significant economic and financial imbalances are present. The U.S. does not currently suffer from any of the three major imbalances that have historically heralded recessions – rapid private-sector debt growth; excessive spending in cyclical sectors such as housing, consumer durables, and business capex; or accelerating inflation. Imbalances are larger abroad, but not to the extent that they will trigger a global recession. The combination of ongoing Chinese stimulus and the lagged effect from lower bond yields will lift global growth during the coming months. The inventory cycle, which is likely to subtract at least one full percentage point from U.S. growth in Q2, will also turn from being a headwind to a tailwind. Stay overweight global equities relative to government bonds over the next 12 months. A rebound in global growth will push down the U.S. dollar later this year, creating an opportunity to increase exposure to European and EM equities. Feature Global Growth At A Critical Juncture The global economy has clearly slowed since early 2018 (Chart 1). So far, much of the weakness has been confined to the manufacturing sector. However, the service sector has softened as well (Chart 2). Chart 1The Global Economy Has Slowed... The Global Economy Has Slowed... The Global Economy Has Slowed... Chart 2...Mostly Due To Another Manufacturing Downturn ...Mostly Due To Another Manufacturing Downturn ...Mostly Due To Another Manufacturing Downturn     Regionally, the U.S. has held up somewhat better than most other economies. Nevertheless, the ISM manufacturing and nonmanufacturing indices have both declined, with the former now flirting with the 50 line. All recessions begin as slowdowns but not all slowdowns end in recessions. As we discuss below, slowdowns are much more likely to morph into recessions when financial and economic imbalances are elevated. We confine our empirical analysis to the U.S., but discuss the global context later in the report. Three Key Recessionary Imbalances Three imbalances, in particular, have often been present at the outset of U.S. recessions (Chart 3): Chart 3What Makes A Slowdown Degenerate Into A Recession: Imbalances What Makes A Slowdown Degenerate Into A Recession: Imbalances What Makes A Slowdown Degenerate Into A Recession: Imbalances Rapid private-sector debt growth: Rising debt lifts aggregate demand.1 Fast debt growth is also often associated with bad lending decisions, which makes economies more vulnerable to adverse shocks. An unsustainably high level of cyclical spending: Cyclical spending includes business and residential investment, as well as spending on consumer durable goods. If spending on these categories is elevated, there is more scope for it to decline when the economy turns down. High and rising inflation. When inflation rises above the Fed’s comfort zone, the central bank normally needs to raise rates into restrictive territory.  Fast debt growth is also often associated with bad lending decisions, which makes economies more vulnerable to adverse shocks. Table 1 shows every episode since 1960 when the U.S. economy has slowed significantly. To keep things simple, we define a slowdown as a 10-point drop in the ISM manufacturing index from its recent high. Table 1Episodes Of Significant Economic Slowdown When Do Slowdowns Turn Into Recessions? When Do Slowdowns Turn Into Recessions? Of the 15 slowdowns that we examined, seven culminated in recessions. An average of 2.1 of the three imbalances listed above were visible prior to recessions. However, an average of only 0.9 imbalances were present when a recession failed to materialize. This supports our claim that slowdowns are more likely to turn into recessions when significant imbalances are present. The good news for the U.S. is that it currently does not register any of three imbalances that have typically preceded recessions. Equities reacted very differently in the two cases. When a recession did occur following the start of a slowdown, the S&P 500 declined by an average of 3.6% over the subsequent 12 months. When the slowdown failed to turn into a recession, the S&P rose by an average of 18.3%. In the latter case, the recovery in stocks usually coincided with a swift rebound in the ISM index. The U.S. Is Currently 0 For 3 On The Imbalance Front The good news for the U.S. is that it currently does not register any of three imbalances that have typically preceded recessions. Chart 4Reasons Not To Panic About U.S. Corporate Debt (I) Reasons Not To Panic About U.S. Corporate Debt (I) Reasons Not To Panic About U.S. Corporate Debt (I) Private-Sector Debt While U.S. private nonfinancial debt has edged up slightly as a share of GDP since 2015, it remains well below its 2008 peak. In fact, the current business expansion is the only one in the post-war era where private-sector debt has failed to rise above its previous cycle high. A recent Bank of England study examined 130 recessions across 26 countries. It found private debt growth matters much more for recession risk than the level of debt.2 Granted, the composition of debt also matters: While household debt in the U.S. has fallen over the past decade, corporate debt has risen. As a share of GDP, corporate debt is now at the highest level in the post-war era. That said, despite its recent ascent, the ratio of corporate debt-to-GDP is less than two percentage points higher than it was in 2008. One drawback of comparing debt to GDP is that the former is a stock variable while the latter is a flow variable. A more sensible “apples-to-apples” approach is to look at corporate debt in relation to assets rather than GDP. If one does that, one sees that the ratio of U.S. corporate debt-to-assets is below its post-1980 average and only slightly above its post-1950 average. The interest coverage ratio, which compares the profits that companies earn for every dollar of interest that they pay, is above its historic norm (Chart 4). Corporate sector free cash flow – the difference between profits and spending on such things as labor and capital goods – remains in surplus. Every recession during the past 50 years has begun when the free cash flow balance was in deficit (Chart 5). In contrast to mortgages, which are generally held by leveraged institutions such as banks, most corporate debt is held by entities such as insurance companies, pension funds, mutual funds, and ETFs. Banks hold only 18% of corporate debt, down from 40% in 1980 (Chart 6). Thus, while high corporate debt levels could exacerbate the next recession, they are unlikely to engender it.  Chart 5Reasons Not To Panic About U.S. Corporate Debt (II) Reasons Not To Panic About U.S. Corporate Debt (II) Reasons Not To Panic About U.S. Corporate Debt (II) Chart 6Banks Have Reduced Their Exposure To The Corporate Sector Banks Have Reduced Their Exposure To The Corporate Sector Banks Have Reduced Their Exposure To The Corporate Sector   Cyclical Spending Unlike a restaurant meal or a vacation, a house, office tower, factory, or automobile will usually retain some value for a while after it is purchased. If spending on cyclical items rises to a high level for an extended period of time, a glut will form, requiring a period of lower production. By contrast, if spending on these items is subdued for a long time, pent-up demand will accumulate, requiring a period of higher production.  Recessions can result from either economic overheating or financial market overheating. As a share of GDP, cyclical spending is still far below the peaks observed during past expansions. Just as importantly, today’s low level of cyclical spending follows ten years of even lower spending. As a result, the average age of the U.S. capital stock has increased across almost all categories since 2008 (Chart 7). Most notably, the average age of U.S. homes has risen by nearly five years since 2006, the sharpest increase since the Great Depression. Despite the rebound in residential investment from its recessionary lows, the current level of homebuilding still falls short of what is necessary to keep up with household formation. As a consequence, the vacancy rate has fallen to multi-decade lows (Chart 8). Chart 7The Capital Stock Is Aging The Capital Stock Is Aging The Capital Stock Is Aging Chart 8There Is No Glut Of U.S. Homes There Is No Glut Of U.S. Homes There Is No Glut Of U.S. Homes   Inflation Recessions can result from either economic overheating or financial market overheating. Economic overheating was the dominant driver of recessions between the late 1960s to early 1980s. Rising inflation preceded the recessions of 1969-70, 1973-75, as well as the back-to-back recessions in 1980-82. Chart 9The 1990 Recession: A Bit Of Everything The 1990 Recession: A Bit Of Everything The 1990 Recession: A Bit Of Everything Overheating also contributed to the 1990 recession. After peaking in 1982, the unemployment rate fell to 5% in 1989, about one percent below its equilibrium level at the time. Core inflation began to accelerate, reaching 5.5% by August 1990. The Fed initially responded to the overheating economy by hiking interest rates. The fed funds rate rose from 6.6% in March 1988 to a high of 9.8% by May 1989. By the summer of 1990, the economy had already slowed significantly. Commercial real estate, still reeling from the effects of the Savings and Loan crisis, weakened sharply. Defense outlays continued to contract following the collapse of the Soviet Union. The final straw was Saddam Hussein’s invasion of Kuwait, which caused oil prices to surge and consumer confidence to plunge (Chart 9). In contrast to earlier downturns, the last two recessions were more the byproduct of financial excesses: The 2007-09 recession stemmed from the housing crash and the financial crisis it generated; the 2001 recession followed the dotcom bust, which precipitated a steep decline in capital spending. What will the next U.S. recession look like? Given the absence of major financial imbalances, the odds are high that the next recession will be a “retro recession,” featuring classic economic overheating. The fact that the Fed has adopted a risk-based approach to monetary policy, which puts great weight on avoiding a deflationary outcome, only raises the likelihood that inflation will eventually move higher. The good news is that this is unlikely to happen anytime soon. While wage growth has picked up, productivity growth has risen even more. As a result, unit labor costs – the ratio of wages-to-productivity – have actually decelerated over the past 18 months. Unit labor cost inflation tends to lead core inflation by up to one year (Chart 10). Given the absence of major financial imbalances, the odds are high that the next recession will be a “retro recession,” featuring classic economic overheating. As we discussed in our latest Strategy Outlook, the Fed will probably not bring rates into restrictive territory until early 2022. This gives the economy plenty of breathing space.3 The Global Dimension The discussion above has focused on the United States. To some extent, this is unavoidable. Not only is the U.S. still the world’s largest economy, but it remains at the heart of the global financial system. U.S. equities account for over half of global stock market capitalization, up from a third in the early 1990s (Chart 11). The dollar continues to be the preeminent reserve currency. As a result, U.S. financial markets drive overseas markets much more than the other way around. Chart 10No Imminent Threat Of A Wage-Price Inflationary Spiral No Imminent Threat Of A Wage-Price Inflationary Spiral No Imminent Threat Of A Wage-Price Inflationary Spiral Chart 11The U.S. Stock Market Capitalization Is More Than Half Of Global The U.S. Stock Market Capitalization Is More Than Half Of Global The U.S. Stock Market Capitalization Is More Than Half Of Global   Chart 12 This does not mean that the rest of the world is irrelevant. The global supply chain now dominates international trade. More than half of all cross-border trade is in intermediate goods (Chart 12). Irrespective of the financial and economic imbalances discussed above, a full-blown trade war would upend the global economy, sending the U.S. and the rest of the world into recession. President Trump’s re-election prospects would plummet if U.S. unemployment rose and the stock market plunged. This is the main reason for thinking that the trade talks will ultimately produce some sort of détente. Nevertheless, a severe deterioration of trade relations remains the biggest risk to our bullish view on risk assets. The fact that financial and economic imbalances are generally larger overseas means that the rest of the world is more vulnerable to adverse shocks. Unlike in the United States, private debt has risen sharply as a share of GDP in several key economies over the past decade (Chart 13). Government debt is also a problem in countries such as Italy that do not have central banks which can function as reliable lenders of last resort. Chart 13 Chart 14Economies With Frothy Housing Markets Risk Having Deeper Downturns Economies With Frothy Housing Markets Risk Having Deeper Downturns Economies With Frothy Housing Markets Risk Having Deeper Downturns Cyclical spending is fairly elevated in a number of countries. Notably, residential investment stands at near record highs as a share of GDP in Canada, Australia, and New Zealand (Chart 14). Home prices are also quite frothy there. When the global economy falls into recession in two-to-three years, these economies will take it on the chin. Investment Conclusions Notwithstanding the risks noted above, we continue to maintain a bullish outlook on global equities and spread product over the next 12 months. To paraphrase Wayne Gretzky, one should invest on the basis of where the economic data is going, not where it is.4 While global growth remains anemic today, the combination of Chinese stimulus and the lagged effect from lower bond yields will boost activity during the coming months. The inventory cycle, which is likely to subtract at least one full percentage point from U.S. growth in Q2, will also turn from being a headwind to a tailwind. Global equities are not super cheap, but they are not particularly expensive either. The MSCI All-Country World Index trades at 15.3-times forward earnings. Given the ultra-low level of global bond yields, this generates an equity risk premium (ERP) that is well above its historical average (Chart 15). From an asset allocation perspective, one should favor stocks over bonds when the ERP is high. Chart 15AEquity Risk Premia Remain Elevated (I) Equity Risk Premia Remain Elevated (I) Equity Risk Premia Remain Elevated (I) Chart 15BEquity Risk Premia Remain Elevated (II) Equity Risk Premia Remain Elevated (II) Equity Risk Premia Remain Elevated (II)   The ERP is especially elevated outside the United States. This is partly because non-U.S. stocks trade at a meager 13.3-times forward earnings, but it also reflects the fact that bond yields are lower overseas. The fact that financial and economic imbalances are generally larger overseas means that the rest of the world is more vulnerable to adverse shocks. As global growth accelerates, the dollar will start to weaken (Chart 16). EM and European equities usually outperform the global benchmark in that environment (Chart 17). We expect to upgrade stocks in these regions later this summer. Chart 16The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency Chart 17EM And Euro Area Equities Outperform When Global Growth Improves EM And Euro Area Equities Outperform When Global Growth Improves EM And Euro Area Equities Outperform When Global Growth Improves   Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com   Footnotes 1      Recall that GDP is a flow variable (how much production takes place every period), whereas credit is a stock variable (how much debt there is outstanding). By definition, a flow is a change in a stock. Thus, credit growth affects GDP and the change in credit growth affects GDP growth. 2      Jonathan Bridges, Chris Jackson, and Daisy McGregor, "Down in the slumps: the role of credit in five decades of recessions," Bank Of England Staff Working Paper No. 659, (April 2017). 3      Please see Global Investment Strategy Strategy Outlook, "Third Quarter 2019 Strategy Outlook: The Long Hurrah," dated June 28, 2019. 4      According to Wayne Gretzky, his father, Walter, once advised him to “skate to where the puck is going, not to where it is.”   Strategy & Market Trends MacroQuant Model And Current Subjective Scores Chart 18 Tactical Trades Strategic Recommendations Closed Trades

NOTE: There will be no report on Wednesday, July 17 due to our regular summer break. Highlights Chinese policymakers as well as the People’s Bank of China (PBoC) have historically been reactive, meaning they have typically waited for economic pain to become entrenched before accelerating reflationary measures. The agreement reached at the June G20 Summit to renew trade negotiations with the U.S., while temporary, takes the pressure off the immediate need to further stimulate the economy. While China has the ability to juice the economy, the pain threshold has been raised higher during this cycle, and the country’s leadership has been reluctant to let go of its financial deleveraging campaign. This approach has resulted in a “half measure” stimulus over the past 12 months. The outlook for Chinese stocks is negative over the next three months, as a flip-flop policy approach will increase market volatility.  However, over a cyclical (i.e. six- to 12-month) time horizon, we are maintaining a bullish stance toward Chinese stocks in hedged currency terms. Feature Last week marked the first anniversary of the imposition of tariffs on imports from China by the U.S. – an event that has clearly had a lasting and meaningful impact on global economic activity. Last week was also the first anniversary of a significant monetary easing measure: China’s 3-month interbank repo rate fell 90 basis points on July 3, 2018, 3 days before the first tranche of import tariffs took effect. This decline was just under half of what would ultimately occur (the 3-month repo rate fell from 4.5% in early July to 2.4% in early August), and was taken as a sign by many investors that the PBoC had shifted to a maximum reflationary stance (Chart 1). Chart 1Indecisively Falling Interbank Rate Indecisively Falling Interbank Rate Indecisively Falling Interbank Rate However, several facts underscore that either the PBoC did not, in retrospect, move completely toward a pro-growth stance, or that China’s monetary transmission mechanism is seriously impaired. In our view, it is a combination of both: Despite evidence suggesting it should, the PBoC did not cut its benchmark lending rate. The repo rate declined in the third quarter last year on the back of increased liquidity supply in the interbank market. The weighted average lending rate also fell, but not massively, and not by as much as our model had predicted (Chart 2). A pickup in credit expansion has significantly lagged easing. Excluding local government bonds, the general pickup in credit has been modest. Based on this measure of Total Social Financing, new credit to GDP still remains lower today than at any point during the 2015-2016 downturn (Chart 3). Chart 2Lending Rate: Not Much Easing Lending Rate: Not Much Easing Lending Rate: Not Much Easing Chart 3No Strong Re-Leveraging No Strong Re-leveraging No Strong Re-leveraging With the conclusion of the G20 Summit temporarily halting the trade war escalation and implementation of additional tariffs, these observations raise important questions: Will the PBoC be proactive in easing policy? What does this mean for investors over the coming year? The PBoC Will Be Reactive Rather Than Proactive Chart 4Shadow-Banking Crackdown Continues Shadow-Banking Crackdown Continues Shadow-Banking Crackdown Continues In our view, the PBoC’s policy actions last year can at best be described as half-measures, despite the fact that the central bank was quick to reduce interbank interest rates in last July by cutting the reserve requirement ratio (RRR). The reason is that the PBoC clearly maintained macro-prudential/administrative restrictions on shadow banking activity, despite significantly easing liquidity in the interbank market. Chart 4 shows that shadow-banking credit as a share of total adjusted social financing continued to decelerate rapidly throughout 2018. It now accounts for a mere 12% of the stock of total adjusted social financing, by far the lowest point since 2009. This underscores that the PBoC and policymakers more generally have a deep-seated desire to avoid (further) inflating China’s substantial money and credit excesses – a dynamic that we have discussed in previous reports.1 Looking forward, there are three reasons why the PBoC’s reactive nature is unlikely to change in the near term, in addition to policymakers’ concerns about financial system’s excesses. First, the PBoC has historically been a reactive central bank, in a way that goes beyond the now-typical “data dependent” approach of its developed-market peers. Chart 5 provides a close look at China’s previous economic growth cycles and their corresponding credit expansions. The chart highlights that Chinese policymakers tend to stay behind the curve when it comes to monetary easing: In the previous three growth cycles, the first sign of monetary easing (defined as an RRR and/or benchmark lending rate cut) lagged the peak of nominal GDP growth by an average of four quarters. Rate cuts took place not when economic growth peaked, but once economic activity had already weakened considerably (Chart 6). Chart 5Chinese Policymakers Tend To Stay 'Behind The Curve' Chinese Policymakers Tend To Stay 'Behind The Curve' Chinese Policymakers Tend To Stay 'Behind The Curve' Chart 6More 'Pain' Needed For Massive Easing More 'Pain' Needed for Massive Easing More 'Pain' Needed for Massive Easing The same pattern has applied to other monetary easing tools that the PBoC has deployed in the past, including the Medium Lending Facility (MLF), the Targeted Medium-term Lending Facility (TMLF), the standing Lending Facility (SLF), and the Pledged Supplementary Lending program (PSL) – all of which only took shape after the economy had already shown across-the-board weakness. It will take more widespread and entrenched economic weakness for the PBoC to meaningfully ease further. The local government debt-to-bond swap program was also launched well into the 2015 growth downturn. When widespread and sustained weakness in activity emerged, Chinese policymakers responded by “throwing the kitchen sink” at the economy – by moving forward with multiple rate cuts and often creating new forms of easing in an attempt to catalyze a quick rebound. Since the PBoC has already implemented a series of easing measures, we believe it will take more widespread and entrenched weakness in the real economy for the PBoC to meaningfully ease further. Chart 7Chinese Currency Is Under Pressure Chinese Currency Is Under Pressure Chinese Currency Is Under Pressure Second, the PBoC is likely to be reactive because of the potentially negative effects that proactive rate cuts could cause on sentiment towards the RMB. Chart 7 highlights the close historical correlation between the RRR, interest rate differentials and the USD/CNY. USD/CNY was trading at 7.8 the last time the weighted average RRR was at 11%, which was back in 2007. At the current juncture, interest rate differentials already point to a weaker currency. The PBoC has signaled that USD/CNY at 7 is no longer a line in the sand that must be defended, meaning this level is not a hard constraint that would prevent the central bank from cutting either the RRR or the benchmark lending rates if warranted. In fact, a measured depreciation in the RMB would help mitigate some of the blow from increased tariffs. Nevertheless, in an environment where the currency has already weakened significantly, cutting the RRR or the benchmark lending rates quickly or by a large amount could create self-reinforcing expectations of further depreciation. China has implemented a better counter-cyclical mechanism to defend the RMB than it had in 2015-‘16,2 but the potential for capital outflows remains a serious concern.3 Third, the Trump-Xi meeting at the June G20 Summit in Osaka temporarily averted a further escalation of the trade war and additional tariffs. The agreement to continue trade negotiations lacks tangible progress from either side, and thus the “truce” is likely to be short-lived. Chart 8Markets So Far Unimpressed By Stimulus Markets So Far Unimpressed By Stimulus Markets So Far Unimpressed By Stimulus However, as we pointed out in last week’s report,4 the existence of talks is likely to take some pressure off Chinese policymakers’ immediate need to floor the reflation accelerator. Readouts from recent PBoC leadership meetings indicate that speculative excesses in the financial system remain a top concern for Chinese policymakers. China’s onshore market, after rallying by 2% following the good news from the G20 meeting, has given back all its gain (Chart 8). Given that the onshore equity market is extremely sensitive to China’s credit growth, the short-lived rally since the G20 meeting suggests markets have been unimpressed by the authorities’ reflationary efforts so far. Bottom Line: Chinese policymakers have not fully abandoned their financial deleveraging campaign, which President Xi Jinping initiated two years ago. This implies China’s central bank is likely to maintain its reactive approach in further easing monetary policy, and will likely try to avoid going “all-in” on stimulus for as long as possible. The Reduced Effectiveness Of Monetary Policy The events of the past year have also demonstrated that the effectiveness of Chinese monetary policy has declined relative to past economic cycles. This, in conjunction with the reluctant/reactive nature of the monetary authorities, has clear implications for investors over the coming year. When there is lack of clarity in policy interpretation, Chinese banks tend to stay on the sidelines. Chart 9A Long Delayed Credit Response To Monetary Easing A Long Delayed Credit Response To Monetary Easing A Long Delayed Credit Response To Monetary Easing The PBoC has cut the RRR five times since the second quarter of last year, which has freed up a total of 3.35 trillion yuan of liquidity for the banking system5 and has helped spur significant easing in overall monetary conditions. Yet, as we noted earlier, overall credit growth did not pick up until January of this year, lagging the first rate cut by three quarters (Chart 9). Prior to the economic slowdown in 2015-2016, credit growth used to respond to cuts in the RRR almost immediately. In other words, when banking system liquidity was ample, banks historically lent without hesitation. Post-2015, however, this relationship has changed. The PBoC has increasingly been having trouble channeling new liquidity into actual financing for the real economy. A sharp deterioration in reported bank asset quality that began in 2014 is likely part of the explanation,6 but we suspect that more recent extreme policy contradiction – in particular, repeated flip-flopping among authorities between their desire to support growth and their focus on financial stability – has caused economic agents to wait on the sidelines. While monetary conditions eased and the government urged banks to lend (particularly to the private sector) in the second half of 2018, the “prudent” stance coming from Chinese top leaders was little changed, and tight regulations on financial institutions remained in place. This combination did not give banks the confidence to lend. This changed in the first quarter of this year, when new credit creation-to-GDP surged from 23.6% to 25.6%. The surge occurred shortly after the late-December Central Economic Work Conference (CEWC), which sent a clear message that the central government’s policy focus had shifted to “stabilizing aggregate demand.” Incredibly, the tone shifted again in February, when Premier Li Keqiang and the PBoC publicly disputed whether the January credit spike represented “flood irrigation-style” stimulus, something Premier Li made clear was to be avoided.7 Charts 10 and 11 highlight how these shifts impacted credit growth: The first quarter was clearly on track for a 2015-2016-magnitude outcome, whereas April and May saw the path of credit growth return back to a moderate re-leveraging scenario. Chart 10 Chart 11 To get back on track for a 2015-2016 magnitude reflation, we will need to see June’s credit creation at or above 5 trillion yuan – equivalent to January’s credit numbers (Chart 12). Chart 12'Credit Binge' In June Unlikely Credit Binge' in June Unlikely Credit Binge' in June Unlikely As we go to press, the number for June’s total social financing has not been officially released yet. But the official reading from the total local government bond issuance in June (including both general bond and special-purpose bond issuance), a key component of our adjusted total social financing series, came in at 900 billion yuan. This is three times more than local government bonds issued in May and twice the size of January’s. Nevertheless, January’s bank lending, particularly short-term lending, was unusually large; an episode highly criticized by Chinese leadership as we mentioned above. As PBoC stated in its defense to this criticism, January is “traditionally the biggest month of the year for bank loans due to seasonal factors”. Therefore, without a clear shift in policy signal from China’s top leadership, we do not expect June’s bank lending number to be a repeat of January’s. Instead, June’s total credit impulse will likely put the cumulative progress in credit growth closer to our 27% of nominal GDP assumption (assuming an 8% nominal GDP growth for the remainder of 2019). This would fall into our “half-strength” credit cycle scenario relative to past reflationary episodes. Bottom Line: Ultimately, we do not doubt that Chinese policymakers will be able to engineer a significant re-acceleration in economic activity should they choose to do so. But in order for policymakers to achieve this goal, policy ambiguity and inconsistency will have to be meaningfully reduced.  Investment Implications Over a cyclical time horizon, we recommend staying long/overweight Chinese stocks in hedged currency terms. From our perspective, neither policymakers’ bias towards reluctance nor the reduced effectiveness of monetary policy convincingly argue against our bullish stance towards Chinese stocks over a cyclical (i.e. six- to twelve-month) time horizon, but the tactical implications are clearly negative. Over a cyclical horizon, one of two scenarios is likely to unfold: Either downside risk brought on by current tariffs and weakness in domestic demand is contained enough such that Chinese economic activity does not materially decelerate, or the trade dispute escalates into a full-tariff scenario of 25% on all U.S. imports from China that dramatically impacts Chinese growth. In the first scenario, policymakers will likely to continue providing half-measured responses, and unconstrained “across-the-board” easing will not occur. But Chart 13 highlights that Chinese stocks, particularly the investable market, are priced for a much worse economic outcome, suggesting Chinese relative equity performance would trend higher in these circumstances. Chart 13Chinese Stocks Priced In For A Worse Economic Outlook Chinese Stocks Priced In For A Worse Economic Outlook Chinese Stocks Priced In For A Worse Economic Outlook Chart 14Bullish On A Cyclical Horizon, Bearish In The Near Term Bullish On A Cyclical Horizon, Bearish In The Near Term Bullish On A Cyclical Horizon, Bearish In The Near Term In the second scenario, Chinese business and consumer sentiment is likely to collapse and policymakers will be facing high odds of a substantial slowdown in economic activity. This will create the political will necessary for unconstrained “across-the-board” easing, similar to what occurred in 2015-2016. The sharp re-acceleration in economic activity that would result from broad-based stimulus would clearly be positive for listed Chinese earnings per share (Chart 14), meaning the cyclical outlook for Chinese stocks would likely be even more positive than in the first scenario. However, the near-term equity market outlook of the second scenario would be extremely negative, as a financial market meltdown in of itself would likely be required to build the political will necessary to ultimately ease. Bottom Line: For investors with a time horizon of less than three months, we would not recommend a long position in Chinese stocks, neither in absolute terms nor relative to the global benchmark. However, over a strictly cyclical (i.e. six- to 12-month) time horizon, we recommend staying long/overweight Chinese stocks in hedged currency terms.   Jing Sima China Strategist JingS@bcaresearch.com   Footnotes   1      Please see Geopolitical Strategy Special Report, “China: How Stimulating is The Stimulus?”, dated August 8, 2018, available at cis.bcaresearch.com 2      A series of countercyclical measures China implemented in 2016-2017 includes: tightening controls on capital outflows, reducing offshore RMB liquidity supply, raising offshore RMB borrowing costs, and setting a firmer daily reference point for the RMB’s trading band. 3      Please see China Investment Strategy Special Report, “Monitoring Chinese Capital Outflows”, dated March 20, 2019, available at cis.bcaresearch.com 4      Please see China Investment Strategy Weekly Report, “China Macro and Market Review”, dated July 4, 2019, available at cis.bcaresearch.com 5      According to PBoC announcements. 6      Please see China Investment Strategy Weekly Report, “Trade Is Not China’s Only Problem”, dated November 21, 2018, available at cis.bcaresearch.com 7      Please see “Chinese Premier In Rare Spat With Central Bank”, Financial Times. Cyclical Investment Stance Equity Sector Recommendations

Highlights The EM equity and currency rebounds should be faded. When corporate profits are contracting, lower interest rates typically do not preclude equity prices from dropping. This is the case in EM and China. Our leading indicators for the Chinese business cycle continue to point to intensifying profit contraction in both China and EM. The ratio of global broad money supply to the current value of securities worldwide is at an all-time low. This casts doubt on the “too much money chasing too few assets” hypothesis. Feature Chart I-1EM Share Prices: Decision Time EM Share Prices: Decision Time EM Share Prices: Decision Time EM share prices are at a critical juncture (Chart I-1). Their ability to hold their recent lows and break above their April highs will signify that a sustainable cyclical rally is in the making. Failure to punch through April’s highs will pose a major breakdown risk. In brief, EM is facing a make-it-or-break-it moment. Fundamentally, the outlook for EM risk assets and currencies largely hinges on economic growth in general and corporate profits in particular. In our June 20 report, we illustrated that the primary drivers of EM risk assets and currencies have historically been their business cycles and profit growth – not U.S. interest rates. Falling interest rates are positive for share prices when profits are expanding, even if at a slower rate. However, when corporate profits are contracting, lower interest rates typically do not preclude equity prices from dropping. Hence, lower global interest rates in of themselves are not a sufficient condition to foster a sustainable cyclical EM rally. As to EM corporate profits, the rate of their contraction will continue deepening. Since early this year, we have been arguing that expectations of recovery in the Chinese economy and global trade are unwarranted. That is why BCA’s Emerging Markets Strategy team contends that EM risk assets and currencies, as well as China-plays, face the risk of a breakdown. This differs from BCA’s house view, which is positive on global risk assets in general. Global And Chinese Business Cycles: No Recovery So Far Chart I-2Chinese A-Share EPS Is Heading Into Contraction Chinese A-Share EPS Is Heading Into Contraction Chinese A-Share EPS Is Heading Into Contraction The rebound in EM risk assets and currencies since last December has occurred despite no improvement in both China’s business cycle and global trade, and despite the deepening contraction in EM corporate profits. Since early this year, we have been arguing that expectations of recovery in the Chinese economy and global trade are unwarranted. So far, our baseline economic view has played out – mainland growth has been rather weak, and global trade has contracted. Yet EM financial markets have done better than we had anticipated. China’s domestic industrial new orders lead Chinese A-share earnings per share growth rate by about nine months and point to intensifying profit slump into early 2020 (Chart I-2). Furthermore, China’s adjusted narrow money(M1+)1 growth leads Chinese investable stocks earnings per share (EPS) by about nine months, and is also pointing to further compression (Chart I-3). Finally, Korea’s exports are shrinking, as are EM EPS (Chart I-4, top panel). Chart I-3Chinese Investable Companies' EPS Is Already Shrinking Chinese Investable Companies' EPS Is Already Shrinking Chinese Investable Companies' EPS Is Already Shrinking Chart I-4Korean Exports And EM EPS Korean Exports And EM EPS Korean Exports And EM EPS   Notably, both Korean exports values and EM EPS in U.S. dollars terms are on par with their early  2011 levels (Chart I-4, bottom panel). This indicates that neither Korean exports nor EM EPS have expanded sustainably over the past eight years. Chart I-5Global Stocks Did Not Lead Global PMI Historically Global Stocks Did Not Lead Global Manufacturing PMI Historically Global Stocks Did Not Lead Global Manufacturing PMI Historically Is it possible that the current gap between global share prices and global manufacturing is due to the fact that financial markets are forward-looking and lead business cycles? Historical evidence suggests that global share prices have not led the global manufacturing PMI, as exhibited in Chart I-5. In fact, global share prices have actually been coincident with the global manufacturing PMI not only throughout this decade but before that as well. The de-coupling between share prices and the manufacturing PMI is currently also present in EM, albeit in a less-striking form. Chart I-6 illustrates that the EM manufacturing PMI has slipped below 50 line, yet share prices have recently rebounded and sovereign spreads have tightened. In a nutshell, the divergence between global share prices and the global manufacturing PMI is unprecedented. This cannot be explained by falling global bond yields either. The latter were falling in the previous business cycle downtrends (2011-12 and 2015), yet share prices did not deviate from the global manufacturing PMI during those episodes (Chart I-5). Chart I-6EM PMI And EM Risk Assets EM PMI And EM Risk Assets EM PMI And EM Risk Assets Chart I-7The Rest Of World's Exports To China Will Continue Shrinking The Rest Of Worlds' Exports To China Will Continue Shrinking The Rest Of Worlds' Exports To China Will Continue Shrinking It seems that the global equity and credit markets expect an imminent recovery in the global business cycle in general and in China in particular. As we elaborated in the previous reports, the current global manufacturing recession stems primarily from China. Our leading indicators of the mainland business cycle suggest that more growth disappointments are likely before China’s growth and other economies’ shipments to the mainland hits a bottom (Chart I-7). For example, Korea’s exports to China in June were still dropping by 24% from a year ago. The primary reason for the lack of revival in growth is that China’s stimulus efforts have so far not been large enough, and the marginal propensity to spend among households and companies is diminishing, offsetting the positive effect of the stimulus, as we have discussed in previous reports. Will the recent G20 trade truce between the U.S. and China boost business confidence worldwide and in China? In our view, it is unlikely to produce a quick and meaningful recovery in business confidence among multinational companies and Chinese businesses. Corporate managers have probably come to realize that the U.S.-China row is not about import tariffs but rather geopolitical confrontation between the existing hegemon and a rising superpower. Hence, there is no easy solution that will satisfy both parties. An acceptable resolution for China will be unacceptable for the U.S., and vice versa. Hence, it will be hard to find a formula that gratifies both sides politically and economically. Overall, we reckon there are low odds in the next six months of an agreement between the U.S. and China that removes tariffs, addresses structural issues and satiates both nations. Korea’s exports are shrinking, as are EM EPS. Finally, even though the S&P 500 is hovering around its previous highs, under-the-surface dynamics have been less upbeat. Specifically, the equal-weighted share price index of U.S. high-beta stocks in cyclical sectors such as industrials, technology and consumer discretionary versus the S&P 500 has been tame and has not yet broken above its 200-day moving average (Chart I-8, top panel). The same holds true for the relative performance of an equal-weighted stock index of global cyclical sectors such as industrials, materials and semiconductors against the overall global equity benchmark (Chart I-8, bottom panel). Conversely, despite its recent setback, the U.S. dollar has technically not yet broken down (Chart I-9, top panel). In fact, our composite momentum indicator for the broad trade-weighted dollar has troughed at zero – a sign that downside is limited and another up-leg will likely emerge soon (Chart I-9, bottom panel). Chart I-8Cyclical Stocks Have Been Underperforming bca.ems_wr_2019_07_04_s1_c8 bca.ems_wr_2019_07_04_s1_c8 Chart I-9The U.S. Dollar Has Technically Not Broken Down The U.S. Dollar Has Technically Not Broken Down The U.S. Dollar Has Technically Not Broken Down   Bottom Line: The EM equity and currency rebounds should be faded. As EM currencies depreciate, sovereign and corporate credit spreads will likely widen. Asset allocators should continue underweighting EM equities and credit markets relative to their DM peers. Too Much Money Chasing Too Few Assets? Many investors identify “liquidity” as the main reason why global equity and credit markets have done so well this year, despite the relapsing global business cycle. Yet there are as many definitions of “liquidity” as there are investors. Many commentators use the term “liquidity” to denote balance sheet expansion by global central banks. As part of their quantitative easing programs, central banks in the U.S., U.K., Japan, the euro area, Switzerland and Sweden have expanded their balance sheets enormously. In line with their asset expansion, their liabilities – the monetary base, consisting primarily of commercial banks’ excess reserves – have also mushroomed. Nevertheless, broad money supply has grown only modestly in these economies.2 The principal reason behind this phenomenon has been a collapse in the money multiplier due to both banks’ unwillingness to boost lending proportionally to their swelling excess reserves, and a persistent lack of demand for credit among households and businesses. This computation casts doubt on the “too much money chasing too few assets” hypothesis. Broad money supply includes all types of deposits at commercial banks and cash in circulation. Crucially, it does not include commercial banks’ excess reserves at central banks. This differentiation between broad money and excess reserves at central banks is vital because excess reserves are not used to purchase goods, services or assets/securities. Hence, a true measure of purchasing power for assets, goods and services is broad money supply. Consistently, the pertinent liquidity ratio for financial markets can be computed by dividing global broad money supply by the value of all securities outstanding excluding those owned by central banks. The top panel of Chart I-10 depicts the ratio of the sum of broad money supply in 12 economies3 - excluding China - to the market value of investable global equities and bonds. The latter is calculated as the market cap of the Datastream World Equity Index plus the market value of the Barclays Aggregate Bond Index, excluding securities owned by central banks (Chart I-11). Bonds include both government and corporate issues. Chart I-10Comparing Global Broad Money And Market Value Of Outstanding Securities Comparing Global Broad Money And Market Value Of Outstanding Securities Comparing Global Broad Money And Market Value Of Outstanding Securities Chart I-11Broad Money, Securities Absorbed By QEs And Value Of Outstanding Securities Broad Money, Securities Absorbed By QE And Value Of Outstanding Securities Broad Money, Securities Absorbed By QE And Value Of Outstanding Securities   We exclude China from this calculation because its money supply (deposits) is not internationally “mobile” – i.e., due to capital controls, Chinese residents cannot convert their renminbi deposits to other currencies, or use them to purchase international securities. Likewise, we exclude Chinese on-shore equity and bond markets from the calculation because they are not easily accessible to all foreign investors. This broad money supply-to-asset values ratio can be regarded as a rough proxy for available liquidity for financial markets.4 Our interpretation is that a lower ratio means investors have lower cash balances relative to the value of financial assets they hold, and vice versa. Interestingly, the ratio of global broad money to the current value of securities worldwide is at an all-time low (Chart I-10, top panel). Hence, this computation casts doubt on the “too much money chasing too few assets” hypothesis. By flipping this ratio, we compute the ratio of market value of all investable securities (excluding the ones owned by central banks) to broad money supply (Chart I-10, bottom panel). It is at all-time high entailing that the market value of globally investable publically-traded securities has expanded much more than global broad money supply/deposits. Bottom Line: We recognize that this is a simplistic macro exercise, and a more comprehensive methodology is required to compute global cash balances that are available to purchase securities worldwide. However, at minimum the above casts doubt on the hypothesis that “too much money is chasing too few assets”. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes 1      M1+ is calculated as M1 plus household demand deposits and deposits at third-party payment platforms. 2      Note that when a central bank purchases securities from commercial banks, this operation originates excess reserves, but not a new deposit at commercial banks. However, when a central bank acquires securities from a non-bank entity, such as a pension fund or an insurance company, this transaction creates both excess reserves and a bank deposit that did not exist before. Hence, QE programs have created some deposits but less so than excess reserves. 3      Economies included into this aggregate are the U.S., the euro area, the UK, Japan, Canada, Australia, Switzerland, Sweden, Korea, Taiwan, Hong Kong and Singapore. 4      This calculation does not strip out transactional demand for money, i.e., how much money is required to finance regular  economic activity. Given transactional demand for money is not stable, it is hard to estimate and adjust for it.   Equity Recommendations Fixed-Income, Credit And Currency Recommendations Chart I-

Analysis on Thailand is available below. Feature Last week we were on the road meeting with some of our U.S. clients. This week’s report presents some of the key topics of our discussions in a Q&A format. Question: You have been downplaying the potentially positive impact of lower bond yields in advanced economies on EM risk assets. Why do you think lower bond yields in developed markets (DM) and potential rate cuts by DM central banks won’t suffice to lift EM markets on a sustainable basis? Answer: Falling interest rates are positive for share prices when profits are growing, even at a slower rate. When corporate profits are contracting, lower interest rates typically do not preclude equity prices from dropping. Presently, EM and Chinese corporate earnings are shrinking rapidly (Chart I-1). This is the primary reason why we believe DM monetary easing will not help EM share prices much. Furthermore, EM exchange rates follow relative EPS cycles in local currency terms (Chart I-2). In short, EM currencies are driven by relative corporate profitability between EM and the U.S. – not by interest rate differentials. Chart I-1EM & China EPS Are Contracting EM & China EPS Are Contracting EM & China EPS Are Contracting Chart I-2Relative EPS And Exchange Rate Relative EPS And Exchange Rate Relative EPS And Exchange Rate   The contraction in EM and China EPS has not been caused by higher interest rates and slump in DM domestic demand. Rather, the EM/China profit contraction has been due to China’s economic slowdown spilling over to the rest of EM. Crucially, there is no empirical evidence that interest rate cuts and QEs in DM preclude EM selloffs when EM/Chinese growth is slumping. Specifically: Chart I-3A and I-3B illustrate that neither the level of G4 central banks’ assets nor their annual rate of change correlates with EM share prices or EM local bonds’ total returns in U.S. dollar terms. Hence, QEs have not always guaranteed positive returns for EM financial markets. Chart I-3APace Of QE And EM Performance Pace Of QE And EM Performance Pace Of QE And EM Performance Chart I-3BPace Of QE And EM Performance Pace Of QE And EM Performance Pace Of QE And EM Performance Chart I-4U.S. Treasury Yields And EM Performance U.S. Treasury Yields And EM Performance U.S. Treasury Yields And EM Performance Chart I-4 demonstrates the correlation between U.S. 5-year Treasurys yields on the one hand and EM spot exchange rates, EM sovereign credit spreads and EM share prices on the other. There has been no stable relationship – at times it has been positive, and at other times negative. We are not implying that DM interest rates have no bearing on EM financial markets. Our point is that lower interest rates and QEs in DM do not constitute sufficient conditions for EM financial markets to rally. Even though DM monetary policy has not been the driving force of cyclical fluctuations in EM financial markets, it has had a structural impact. QEs and lower bond yields in DM have prompted an expanded search for yield and have produced substantial compression in risk premia worldwide. For example, Chart I-5 demonstrates that excess returns on EM corporate bonds have historically been correlated with the global manufacturing cycle, but the correlation has diminished in recent years. The widening gap between the two lines is due to investors’ search for yield. Investors have bought and continue to hold securities of “zombie” companies and countries that have low productivity and poor fundamentals. In short, QEs have undermined the efficiency of global capital allocation. This is marginally adverse for productivity in the global economy in the long run. Question: But doesn’t DM monetary policy influence DM demand, which in turn affects EM corporate profits? Answer: DM monetary policy influences DM domestic demand, but there is little correlation between DM domestic demand and EM corporate profits. For example, U.S. import volumes have been growing at a decent pace, yet EM corporate profits have shrunk (Chart I-6). Indeed, robust growth in U.S. imports did not preclude EM EPS contraction in 2012, 2014-‘15 and 2018-‘19, as shown in this chart. Chart I-5Fundamentals Have Become Less Important Due To QE Programs Fundamentals Have Become Less Important Due To QE Programs Fundamentals Have Become Less Important Due To QE Programs Chart I-6EM EPS And U.S. Imports EM EPS And U.S. Imports EM EPS And U.S. Imports   Chart I-7 reveals additional evidence of the diminished impact of U.S. growth on Asian exports. Korean, Taiwanese, Japanese and Singaporean exports to the U.S. are growing at 7% rate, while their shipments to China are contracting at an 11% rate from a year ago as of May. As a result, these countries’ overall exports are shrinking because they ship to China considerably more than they do to the U.S. We are not implying that DM interest rates have no bearing on EM financial markets. Our point is that lower interest rates and QEs in DM do not constitute sufficient conditions for EM financial markets to rally. The current global slowdown did not originate in the U.S. or Europe. Rather, it originated in China and has spilt across the world, affecting the economies that sell to China the most. The deceleration in global trade can be tracked to Chinese imports contraction (Chart I-8). Chart I-7Asia's Exports To China And U.S. Asia's Exports To China And U.S. Asia's Exports To China And U.S. Chart I-8Chinese Imports And Global Trade Chinese Imports And Global Trade Chinese Imports And Global Trade   U.S. manufacturing is the least exposed to China, which is the main reason why it was the last shoe to drop in the global manufacturing recession. Question: So, what drives EM business cycles if it is not DM growth and DM interest rates? Chart I-9China's Credit & Fiscal Impulse And EM EPS China's Credit & Fiscal Impulse And EM EPS China's Credit & Fiscal Impulse And EM EPS Answer: The key and dominant driver of EM risk assets – stocks, credit markets and currencies – has been the global trade and EM/China growth cycles. There is a much stronger correlation between EM financial markets and the global business cycle in general, and Chinese imports in particular than with DM interest rates. In turn, Chinese imports are driven by its capital spending cycle. 85% of the mainland’s good imports are composed of industrial goods and devices, machinery, chemicals, various commodities and autos. Only 15% are non-auto consumer goods. Meanwhile, the credit/money cycles drive capital spending. That is why China’s credit and fiscal spending impulse leads EM corporate profits (Chart I-9). This is also why we spend a significant amount of time analyzing and discussing China's credit cycle. Question: Why has the policy stimulus in China not revived growth in its economy and its suppliers around the world? Answer: Our aggregate credit and fiscal spending impulse bottomed in January of this year, but its recovery has so far been timid. In the past, this indicator led China’s business cycle and the global manufacturing PMI by an average of about nine months (Chart I-10, top panel) and EM corporate profits by 12 months (Chart I-9). According to this pattern, the bottom in global manufacturing should occur in August of this year. However, global share prices have not led global manufacturing PMI during this decade; they have instead been coincident (Chart I-10, bottom panel). Hence, there was no historical justification for global share prices to rally since early January - well ahead of a potential bottom in the global manufacturing PMI in August. The current global slowdown did not originate in the U.S. or Europe. Rather, it originated in China and has spilt across the world, affecting the economies that sell to China the most. That said, due to the U.S.-China confrontation and other structural reasons currently prevailing in China – including high levels of indebtedness and more regulatory scrutiny over shadow banking as well as local government debt – a recovery in mainland household and corporate spending is likely to be delayed. Crucially, as we have documented in previous reports, the marginal propensity to spend for consumers and companies continues to fall (Chart I-11). This is the opposite of what occurred in early 2016. Chart I-10Chinese Stimulus, Global Manufacturing And Global Stocks Chinese Stimulus, Global Manufacturing And Global Stocks Chinese Stimulus, Global Manufacturing And Global Stocks Chart I-11China: What Is Different From 2016 China: What Is Different From 2016 China: What Is Different From 2016   Overall, a revival in China’s growth will likely take longer to unfold and EM risk assets will likely sell off anew before bottoming. Chart I-12Global Slowdown Is Not Yet Over Global Slowdown Is Not Yet Over Global Slowdown Is Not Yet Over Chart I-13Global Semiconductor Demand Is Shrinking Global Semiconductor Demand Is Shrinking Global Semiconductor Demand Is Shrinking Question: Apart from China’s credit and fiscal spending impulse and marginal propensity to spend among households and companies, what other indicators are you monitoring to gauge a bottom in the global manufacturing cycle? Answer: Among many variables and indicators we continuously monitor, there are a few we have been paying particular attention to: The difference between global narrow (M1) and broad money growth correlates well with global corporate earnings (Chart I-12). The rationale for this indicator is that it is akin to the marginal propensity to spend: When demand deposits (M1) outpace time/savings deposits, it is indicative that households and companies are getting ready to spend on large-ticket items or kick off capital spending, and vice versa. Presently, this narrow-to-broad money growth differential continues to point to lower global growth. Last week we published a report on the global semiconductor industry, arguing that upstream demand for semiconductors is withering as sales of servers, smartphones, PCs and autos are all shrinking globally (Chart I-13). With consumption of these goods contracting, demand for semiconductors remains lackluster, and semiconductor prices are still deflating (Chart I-14). Hence, semiconductor prices can be used as an indicator of final demand dynamics in many important segments of the global economy. China’s Container Freight Index – the price to ship containers – is also currently lackluster, reflecting weak global trade dynamics (Chart I-15, top panel). Chart I-14Semiconductor Prices Are Still Deflating Semiconductor Prices Are Still Deflating Semiconductor Prices Are Still Deflating Chart I-15Global Shipments Are Very Weak Global Shipments Are Very Weak Global Shipments Are Very Weak Global Shipments Are Very Weak Global Shipments Are Very Weak   In the U.S., both total intermodal carloads and railroad carloads excluding petroleum and coal are tanking, reflecting subsiding growth (Chart I-15, middle and bottom panel). In turn, Chinese imports continue to contract. This is the primary channel in terms of how the Middle Kingdom affects the rest of the world economy. From the rest of the world’s perspective, China is in recession because their shipments to the mainland are shrinking. In China and Taiwan, the seasonally adjusted manufacturing PMI new orders have rolled over after the temporary pick up early this year (Chart I-16). Finally, we are monitoring our Reflation Indicator and Risk-On/Safe-Haven Currency Ratio (Chart I-17). Both are market-based indicators and are very sensitive to global growth conditions – especially to the dynamics in commodities markets – making them very pertinent to EM investors. Chart I-16Manufacturing PMI: New Orders Seasonally-Adjusted Manufacturing PMI: New Orders Seasonally-Adjusted Manufacturing PMI: New Orders Seasonally-Adjusted Chart I-17Market-Based Indicators Market-Based Indicators Market-Based Indicators   As with any marked price-based signals, both are very volatile. Even though both indicators have rebounded in recent days, only a major trend reversal matters for macro investors. Technically speaking, the profile of both indicators is consistent with a breakdown rather than a breakout. Question: You have highlighted that EM corporate EPS is contracting. How widespread is the profit contraction, and how long will it persist? Answer: EM corporate EPS contraction is widespread across almost all sectors. Chart I-18A and I-18B illustrate EPS growth in U.S. dollar terms for all sectors. EPS growth is negative for most sectors, close to zero for three (technology, financials and materials) and still positive for the energy sector. However, technology, materials and energy EPS are heading into contraction, given the drop in semiconductor, industrial metals and oil prices, respectively. Chart I-18ASynchronized EM EPS Contraction Synchronized EM EPS Contraction Synchronized EM EPS Contraction Chart I-18BSynchronized EM EPS Contraction Synchronized EM EPS Contraction Synchronized EM EPS Contraction   Consequently, all EM equity sectors will soon be experiencing synchronized profit contraction. EM corporate EPS contraction is widespread across almost all sectors. Our credit and fiscal spending impulse for China leads EM EPS growth by about 12 months, and it currently entails that the profit contraction will continue to deepen all the way through December (Chart I-9 on page 6). It would be surprising if EM share prices stage a major rally amid a hastening decline in corporate EPS (please refer to Chart I-1 on page 1). Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Thailand: A Defensive Play Within EM The Thai parliament has elected to keep the ex-military general Prayuth Chan-ocha as the country’s prime minister. This will instill political stability for now, which is positive for investor confidence. In absolute terms, Thai financial markets are leveraged to global trade and will, therefore, sell off if our negative views on the latter and EM risk assets play out. Chart II-1Thailand's Current Account Is In Surplus Thailand's Current Account Is In Surplus Thailand's Current Account Is In Surplus Relative to their EM peers, Thai equities, credit, currency and domestic bonds will continue outperforming: The Thai current account balance remains in large surplus, which provides a large cushion for the Thai baht amid the slowdown in global growth (Chart II-1). Critically, Thailand is less exposed to China and is more leveraged to the U.S. and Europe than its EM peers. Thailand’s shipments to China account for 12% of the former’s total exports, while exports to the U.S. and EU together account for 21%. Both U.S. and European imports are holding up better than those of China. Thailand also has the lowest foreign debt obligations (FDO) among EM countries. FDOs measure the sum of short-term claims, interest payments and amortization over the next 12 months. The country’s current FDOs stand at 8% relative to its exports of goods and services and 12% relative to the central bank’s foreign exchange reserves. The rest of EM countries have much higher ratios. In addition, foreign ownership of local currency bonds is amongst the lowest in the region (18%). As a result, currency depreciation will not trigger major portfolio outflows and a self-reinforcing downtrend in Thai financial markets. Thailand also has the lowest foreign debt obligations (FDO) among EM countries. Chart II-2Thailand: Moderate Growth In Private Consumption Thailand: Moderate Growth In Consumption Thailand: Moderate Growth In Consumption Thailand’s private consumption is growing reasonably well (Chart II-2, top panel). Likewise, passenger and commercial vehicle sales are rising and so is household credit (Chart II-2, bottom two panels). The Thailand MSCI index carries a large weight in domestic and defensive stocks such as transportation, utilities, telecommunication, and consumer staples. These sectors will benefit from moderate consumption growth. In fact, Thai equity outperformance versus EM has been justified by its non-financial companies’ EBITDA outpacing that of EM non-financials (Chart II-3). This trend remains intact. Concerning banks, Thailand’s commercial banks suffer from credit excesses, as do many of their EM peers. However, Thai commercial banks have been responsible in terms of recognizing NPLs and have been properly provisioning for them (Chart II-4). This is contrary to many other EM banks. This means that share prices of Thai commercial banks will outperform their EM counterparts. Finally, although the Thai bourse is more expensive than its EM counterparts, relative equity valuation will likely get even more stretched before a major reversal occurs. Given our cautious view on overall EM, we continue to prefer this richly valued and defensive bourse to the more cyclical, albeit cheaper, but fundamentally vulnerable EM peers. Chart II-3Equity Outperformance Has Been Justified By Earnings Equity Outperformance Has Been Justified By Earnings Equity Outperformance Has Been Justified By Earnings Chart II-4Thai Commercial Banks Are Well Provisioned Thai Commercial Banks Are Well Provisioned Thai Commercial Banks Are Well Provisioned Bottom Line: Investors should keep an overweight position in Thai equities, currency, domestic bonds and credit markets. Ayman Kawtharani, Editor/Strategist ayman@bcaresearch.com Footnotes   Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights A resurfacing of trade tensions could weigh on risk sentiment in the near term. A somewhat less dovish tone from the FOMC this month could further rattle risk assets. While we would not exclude the possibility of an “insurance cut,” the Fed is probably uncomfortable with the amount of easing that markets now expect. That being said, a trade truce is still more likely than not, and while the Fed will resist cutting rates this year, it will not raise them either. The neutral rate of interest in the U.S. is higher than widely believed, which means that monetary policy will remain accommodative. That’s good news for global equities. Investors should maintain a somewhat cautious stance over the next month or so. However, they should overweight stocks, while underweighting bonds, over a 12-month horizon. The equity bull market will only end when U.S. inflation rises to a level that forces the Fed to pick up the pace of rate hikes. That is unlikely to occur until late-2020 at the earliest. Feature Stocks Bounce Back We turned positive on global equities in late December after a six-month period on the sidelines. While we have remained structurally bullish over the course of this year, we initiated a tactical hedge to short the S&P 500 on May 10th following what we regarded as an overly complacent reaction by investors to President Trump’s decision to increase tariffs on Chinese imports. Our reasoning at the time was that a period of market pressure would likely be necessary to forge an agreement between the two sides. Our thesis was looking prescient for a while. However, the rebound in stocks since last week has brought the S&P 500 close to the level where we initiated the trade. Is it time to drop the hedge? Not yet. First, market internals do not inspire much confidence. Even though the S&P 500 is just below its year-to-date (and all-time) high, the Russell 2000 is 5.1% below its May highs, and 11.8% below where it was last August (Chart 1). The S&P mid cap and small cap indexes are 6.8% and 16.2%, respectively, below their highs reached last August. Such weak breadth is disconcerting. Chart 1U.S. Stocks: Not As Strong As They Appear U.S. Stocks: Not As Strong As They Appear U.S. Stocks: Not As Strong As They Appear Second, President Trump’s decision to suspend raising the tariffs on Mexican imports may have had less to do with his desire to seek a more conciliatory tone, and more to do with pressure from Congressional Republicans. Various news reports suggested that Mitch McConnell and other Republican leaders opposed the action, and threatened to revoke the President’s authority to unilaterally impose tariffs.1 In the end, the deal with Mexico contained many of the same measures that the Mexicans had already agreed to implement months earlier. Our geopolitical team remains skeptical of a grand bargain in trade talks with China.2 In the United States, protectionist sentiment is politically more popular towards China than it is towards other countries (Chart 2). A breakthrough is still probable, but again, it may take a stock market selloff to produce a trade truce. Chart 2 Chart 2   Third, we have become increasingly concerned that the market has gotten ahead of itself in pricing in Fed easing. While we would not rule out the possibility that the Fed takes out an “insurance cut” to guard against downside risks to the economy, the 80 basis points of easing that the market has priced in over the next 12 months seems excessive to us. Chart 3Financial Conditions Have Not Tightened Much Financial Conditions Have Not Tightened Much Financial Conditions Have Not Tightened Much Unlike late last year, U.S. financial conditions have tightened only modestly over the past nine weeks (Chart 3). The economy is also performing reasonably well. According to the Atlanta Fed GDPNow model, real final sales to domestic purchasers3 are set to grow by 2.5% in the second quarter, up from 1.5% in Q1 (Chart 4). Real personal consumption expenditures are on track to rise by 3.2%. Gasoline futures have tumbled, which will support discretionary spending over the next few quarters (Chart 5).   Chart 4 Chart 5Lower Gasoline Prices Should Bode Well For Discretionary Spending Lower Gasoline Prices Should Bode Well For Discretionary Spending Lower Gasoline Prices Should Bode Well For Discretionary Spending Granted, the labor market has cooled down. Payrolls increased by only 75K in May. However, the Council of Economic Advisers estimated that flooding in the Midwest shaved 40K from payrolls. And even with this adverse impact, the three-month average for payroll growth still stands at 151K, well above the 90K-to-100K or so that is needed to keep up with labor force growth. Meanwhile, initial unemployment claims remain muted and the employment component of the nonmanufacturing ISM hit a seven-month high in May. Chart 6Trimmed Mean PCE Inflation Back To 2% Trimmed Mean PCE Inflation Back To 2% Trimmed Mean PCE Inflation Back To 2% Inflation expectations are on the low side, but actual inflation is proving to be reasonably sturdy. The core PCE index rose by 0.25% month-over-month in April. Trimmed mean PCE inflation increased above 2% on a year-over-year basis for the first time in seven years (Chart 6). According to a recent Fed study, the trimmed mean calculation is superior to the core PCE index as a summary measure of underlying inflationary trends.4 Ultimately, the fact that the U.S. economy is holding up well is a positive sign for equity returns over the next 12 months. In the short term, however, it does create the risk that the Fed will sound less dovish than investors are anticipating, leading to a temporary selloff in stocks. Hence our view: near-term cautious, longer-term bullish. Who Determines Interest Rates? Central banks decide where rates will go in the short run, but it is the economy that determines where interest rates will go in the long run. The neutral rate of interest is the rate that corresponds to full employment and stable inflation. One can also think of it as the rate that aligns the level of aggregate demand with the maximum potential output the economy is capable of achieving without overheating. Both the Fed dots and the widely-used Laubach Williams model suggest that rates are close to neutral. But are they really? If a central bank keeps rates below their neutral level for too long, inflation will eventually break out, forcing the central bank to raise rates. Conversely, if a central bank raises rates above their neutral level, growth will slow, inflation will decline, and the central bank will be forced to cut rates. The problem is that changes in monetary policy typically affect the economy with a lag of 12-to-18 months. Inflation is also a highly lagging indicator. It usually peaks well after a recession has begun and troughs long after the recovery is under way (Chart 7). Thus, central banks have to make an educated guess as to where the neutral rate lies and try to steer the economy towards that rate in a way that achieves a soft landing. Needless to say, this is easier said than done. Chart 7 Today, both the Fed dots and the widely-used Laubach Williams model suggest that rates are close to neutral (Chart 8). Chart 8The Fed Thinks Rates Are Close To Neutral The Fed Thinks Rates Are Close To Neutral The Fed Thinks Rates Are Close To Neutral But are they really? That’s the million dollar question. Not only will the answer determine the medium-term path of interest rates, it will also determine how long the current U.S. economic expansion will last. Recessions rarely occur when monetary policy is accommodative, and equity bear markets almost never happen outside of recessionary periods (Chart 9). Thus, if rates are currently well below neutral, investors should maintain a bullish equity tilt. Chart 9Recessions And Bear Markets Usually Overlap Recessions And Bear Markets Usually Overlap Recessions And Bear Markets Usually Overlap Chart 10U.S.: Federal Fiscal Policy Has Been Expansionary U.S.: Federal Fiscal Policy Has Been Expansionary U.S.: Federal Fiscal Policy Has Been Expansionary Where Is Neutral? The neutral rate of interest is a function of many variables, most of which are not in the Laubach Williams model. Let us consider a few: Fiscal Policy A larger budget deficit boosts aggregate demand, while higher interest rates lower demand. Thus, once an economy has achieved full employment, an easing of fiscal policy must be counterbalanced by an increase in interest rates, which is another way of saying that looser fiscal policy raises the neutral rate of interest. The U.S. cyclically-adjusted budget deficit has risen by about 3% of GDP since 2015. Both tax cuts and increased federal discretionary spending have contributed to the deterioration in the fiscal balance (Chart 10). Standard “Taylor Rule” equations suggest that a 1% of GDP increase in aggregate demand will raise the appropriate level of the fed funds rate by 0.5-to-1 percentage points.5 This implies that easier fiscal policy has lifted the neutral rate of interest by 1.5-to-3 percentage points over the past five years. Labor Market Developments A tight labor market tends to increase the share of national income accruing to workers (Chart 11). Workers generally spend more of every dollar of income than businesses. Thus, a shift of income from businesses to workers raises the neutral rate of interest. The fact that a tight labor market usually generates the biggest gains for workers at the bottom of the income distribution – who have the highest marginal propensity to spend – further amplifies the positive effect on aggregate spending. Chart 11Workers Garner A Larger Piece Of The Income Pie When The Labor Market Is Tight Workers Garner A Larger Piece Of The Income Pie When The Labor Market Is Tight Workers Garner A Larger Piece Of The Income Pie When The Labor Market Is Tight Chart 12 The labor share of income has rebounded since reaching a record low in 2014. The lowest-paid workers have also seen the largest wage increases during the past 12 months (Chart 12). Neither of these nascent developments have come close to unwinding the beating that labor has suffered in relation to capital over the past four decades, but if the unemployment rate keeps falling, workers are going to start gaining the upper hand. Thus, one would expect the neutral rate of interest to rise further as the labor market continues to tighten. Credit Growth The Great Recession ushered in a painful deleveraging cycle. Household debt fell from 86% of GDP in 2009 to 70% of GDP in 2012. The household debt-to-GDP ratio has edged slightly lower since then due to continued declines in mortgage debt and home equity lines of credit. A return to the rapid pace of credit growth seen before the financial crisis is unlikely. Nevertheless, a modest releveraging of household balance sheets would not be surprising. Some categories such as student and auto loans have seen fairly robust debt growth (Chart 13). Housing-related debt could also stage a modest comeback due to rising home prices and buoyant consumer confidence. Conceptually, the rate of credit growth determines the level of aggregate demand.6 Thus, if household credit growth picks up at the margin, this would push up the neutral rate of interest. Corporate debt levels also have scope to rise further. Net corporate debt is only modestly higher than it was in the late 1980s, a period when the fed funds rate averaged nearly 10% (Chart 14). Chart 13U.S. Housing Deleveraging Has Slowed U.S. Housing Deleveraging Has Slowed U.S. Housing Deleveraging Has Slowed Chart 14U.S. Corporate Debt (I): No Cause For Alarm U.S. Corporate Debt (I): No Cause For Alarm U.S. Corporate Debt (I): No Cause For Alarm   Thanks to low interest rates and rapid asset accumulation, the economy-wide interest coverage ratio is above, while the ratio of debt-to-assets is below, their respective long-term averages (Chart 15). The corporate sector financial balance – the difference between what businesses earn and spend – is still in surplus. Almost every recession in the post-war era has begun when the corporate sector financial balance was in deficit (Chart 16). Chart 15U.S. Corporate Debt (II): No Cause For Alarm U.S. Corporate Debt (II): No Cause For Alarm U.S. Corporate Debt (II): No Cause For Alarm Chart 16U.S. Corporate Debt (III): No Cause For Alarm U.S. Corporate Debt (III): No Cause For Alarm U.S. Corporate Debt (III): No Cause For Alarm     The Value Of The U.S. Dollar A stronger dollar reduces net exports. This drains demand from the economy, which lowers the neutral rate of interest. The real broad trade-weighted dollar index has risen 10% since 2014. According to the New York Fed’s econometric model, this would be expected to reduce the level of real GDP by 0.5% in the first year and by a further 0.2% in the second year, for a cumulative decline of 0.7%, equivalent to a decrease in the neutral rate of 0.35%-to-0.7%. The New York Fed model assumes an “all things equal” environment. All things have not been quite equal, however. The U.S. has benefited from a modest improvement in its terms of trade7 over the past five years (Chart 17). The shale boom has also significantly cut into oil imports. As a result, the trade deficit has fallen from 5.9% of GDP in 2005 to 2.9% of GDP at present. Chart 17The Dollar Has Appreciated Since 2014 The Dollar Has Appreciated Since 2014 The Dollar Has Appreciated Since 2014 Chart 18The Savings Rate Has (A Lot Of) Room To Drop, Judging From The Historical Relationship With Wealth The Savings Rate Has (A Lot Of) Room To Drop, Judging From The Historical Relationship With Wealth The Savings Rate Has (A Lot Of) Room To Drop, Judging From The Historical Relationship With Wealth Asset Prices An increase in asset values – whether they be equities, bonds, or homes – makes people and businesses feel wealthier, which leads to more consumption and investment spending. As such, higher asset prices raise the neutral rate of interest. Today, U.S. household net worth stands near a record high as a percent of disposable income (Chart 18). The personal savings rate, in contrast, still stands at an elevated 6.4%. If the savings rate falls over the coming months, this would further boost aggregate demand. Demographics Slower labor force growth has led to a decline in trend GDP growth in the U.S. and most other economies. Slower economic growth tends to reduce the neutral rate of interest. The Bureau of Labor Statistics expects labor force growth to be broadly stable over the next 5-to-10 years, with immigration compensating for the withdrawal of baby boomers from employment (Chart 19). Chart 19 Chart 20Savings Over The Life Cycle Savings Over The Life Cycle Savings Over The Life Cycle In the current political climate, there is quite a bit of uncertainty over how many immigrants will settle in the United States. On the one hand, less immigration would reduce labor force growth, thus lowering the neutral rate. On the other hand, a decline in immigration would lead to an even tighter labor market, thus potentially raising the neutral rate. An additional question is how population aging, which will continue even if immigration remains elevated, will affect the neutral rate. Older people work less, but consume more than younger people, once health care spending is accounted for (Chart 20). If overall national output falls in relation to consumption, national savings will go down. This will raise the neutral rate of interest. The Shift To A Capital-Lite Economy Firms increasingly need less physical capital to carry out their activities. Larry Summers has labeled this the “demassification” of the economy. Lower investment spending would translate into a lower neutral rate. While plausible, it is not clear how important this phenomenon is. Companies may need less physical capital, but they need more human capital. Instead of more lending to businesses to finance purchases of machinery, we get additional lending to students. If our thesis that the neutral rate of interest is higher than widely believed turns out to be correct, this means that the Fed will eventually need to start hiking rates again. The question is when. The share of R&D and other intangibles in business investment has risen from around 14% in the 1960s to 33% today (Chart 21). Importantly, the depreciation rate for intangible investment is much higher than for other forms of capital spending. As intangible investment has increased, the overall depreciation rate for the economy has risen (Chart 22). Conceptually, an increase in the depreciation rate should lead to a higher neutral rate of interest.8 Chart 21A Larger Share Of Business Investment Is Intangible... A Larger Share Of Business Investment Is Intangible... A Larger Share Of Business Investment Is Intangible... Chart 22...And That Puts Upward Pressure On The Depreciation Rate ...And That Puts Upward Pressure On The Depreciation Rate ...And That Puts Upward Pressure On The Depreciation Rate   Watch Housing And Business Capex The discussion above suggests that the neutral rate of interest is probably higher than widely believed. That said, there is significant uncertainty around any estimate of the neutral rate. As such, we recommend that investors track the more interest-rate sensitive sectors of the economy to gauge whether monetary policy is becoming restrictive. Housing, and to a lesser extent, business capital expenditures are the key indicators to watch. As a long-lived asset, housing is very sensitive to mortgage rates. Chart 23 shows that changes in mortgage rates tend to lead residential investment and home sales by about six months. Chart 23Housing Is Interest-Rate Sensitive Housing Is Interest-Rate Sensitive Housing Is Interest-Rate Sensitive If the decline in mortgage rates since last fall fails to spur housing, this would support the claim that monetary policy turned restrictive last year. Fortunately, the jump in homebuilder confidence, the outperformance of homebuilder stocks, and the surge in mortgage applications for purchases all suggest that the housing sector remains on firm ground (Chart 24). Despite the broad-based weakness in the global manufacturing sector, U.S. capex intentions remain reasonably buoyant (Chart 25). This week’s release of the May NFIB small business survey, which showed that the share of firms citing “now is a good time to expand” jumped five points to a seven-month high, provides further evidence in support of this view. Chart 24Some Positives For U.S. Housing Some Positives For U.S. Housing Some Positives For U.S. Housing Chart 25U.S. Capex Intentions Remain Solid U.S. Capex Intentions Remain Solid U.S. Capex Intentions Remain Solid   A Two-Stage Fed Cycle Chart 26Inflation Expectations Are Not Where The Fed Wants Them To Be Inflation Expectations Are Not Where The Fed Wants Them To Be Inflation Expectations Are Not Where The Fed Wants Them To Be If our thesis that the neutral rate of interest is higher than widely believed turns out to be correct, this means that the Fed will eventually need to start hiking rates again. The question is when. Right now, the Fed has the luxury of time on its side. Even though some measures of core inflation such as the trimmed mean calculation discussed above have reached the Fed’s 2% target, this follows a prolonged period of below-target inflation. A few years of above-trend inflation would hardly be the worst thing in the world. The Fed’s failure to reach its inflation target has pushed long-term inflation expectations below the central bank’s comfort zone (Chart 26). Given the asymmetric risks created by the zero lower bound on interest rates - if inflation rises too fast, the Fed can always hike rates; but if inflation falls too much, it may be impossible to ease monetary policy by enough to avert a recession - the Fed can afford to remain patient. Thus, while the Fed is unlikely to cut rates as much as investors currently expect, it is also unlikely to raise them this year. Thanks to a cyclical revival in productivity growth, unit labor cost inflation has actually declined over the past 12 months (Chart 27). However, as we get into late next year and 2021, circumstances may change. If an increasingly tight jobs market continues to push up wage growth, unit labor costs will start to reaccelerate. Cost-push inflation will kick in. At that point, the Fed may have no choice but to pick up the pace of monetary tightening. All this suggests that Fed policy will evolve in two stages: an initial stage lasting for the next 12-to-18 months where the Fed is doing little-to-no tightening (and could even cut rates if the trade war heats up), followed by a second stage where the central bank is scrambling to raise rates to cool an overheated economy. U.S. Treasury yields are likely to rise modestly during the first stage in response to stronger-than-expected economic growth. We see the 10-year yield clawing its way back to the high-2% range by early next year. Yields could rise more precipitously, to around 4%, in the second stage once inflation begins to move decisively higher. The dollar is unlikely to strengthen during the first stage. Indeed, our baseline forecast calls for a period of modest dollar weakness stretching into late next year driven by a reacceleration in European and Chinese/EM growth. The sharp rebound in Chinese real estate equipment purchases from -18% on a six-month basis late last year to +30% in April suggests that the government’s stimulus efforts are working (Chart 28). Chart 27No Imminent Threat Of A Wage-Price Inflationary Spiral No Imminent Threat Of A Wage-Price Inflationary Spiral No Imminent Threat Of A Wage-Price Inflationary Spiral Chart 28China: A Sign That Stimulus Is Finding Its Way Into The Economy China: A Sign That Stimulus Is Finding Its Way Into The Economy China: A Sign That Stimulus Is Finding Its Way Into The Economy   The greenback will likely appreciate, perhaps significantly so, once the Fed picks up the pace of rate hikes in late 2020. The accompanying tightening in global financial conditions is likely to sow the seeds for a worldwide downturn in 2021. The combination of faster global growth and a weaker dollar will support global equities over the next 12 months. European and EM bourses will benefit the most. Investors should begin derisking in the second half of next year. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com   Footnotes 1      Patricia Zengerle, “U.S. Lawmakers Seek To Block Trump On Tariffs,” Reuters, June 5, 2019. 2      Please see Geopolitical Strategy Weekly Report, “Is Trump Ready For The New Long March?” dated May 24, 2019. 3      Final sales to domestic purchasers is equal to gross domestic product (GDP) excluding net exports of goods and services, less the change in private inventories. 4      Jim Dolmas and Evan F. Koenig, “Two Measures Of Core Inflation: A Comparison,” Federal Reserve Bank Of Dallas, Working Paper 1903, February 25, 2019. 5      Depending on which specification of the Taylor Rule one uses, a one percent of GDP increase in aggregate demand will increase the neutral rate of interest by half a point (John Taylor’s original specification) or by a full point (Janet Yellen’s preferred specification). John B. Taylor's 1993 specification is based on the following equation: rt = 2 + pt + 0.5(pt - 2) + 0.5yt. Janet Yellen's preferred specification is based on the following equation: rt = 2 + pt+ 0.5(pt - 2) + 1.0yt. Please note: For both specifications above, rt is the federal funds rate; pt is core PCE expressed as a year-over-year percent change; and yt is the output gap (as approximated using the unemployment gap and Okun's law). For further discussion, please see Janet L. Yellen, "The Economic Outlook And Monetary Policy," April 11, 2012. 6      Recall that GDP is a flow variable (how much production takes place every period), whereas credit is a stock variable (how much debt there is outstanding). By definition, a flow is a change in a stock. Thus, credit growth affects GDP and the change in credit growth affects GDP growth. 7      Ratio (multiplied by 100) of the price index for exports of goods and services to the price index for imports of goods and services. 8      The higher the depreciation rate, the more investment is necessary to maintain the existing capital stock. More investment demand for any given level of savings implies a higher interest rate. One can see this in the Solow growth model, which posits that the neutral rate of interest (r*) should be equal to: Image Where a is the output elasticity of capital, s is the savings rate, n is labor force growth, g is the growth in total factor productivity, and d is the depreciation rate. The equation implies that the neutral rate of interest will increase if capital intensity increases, the savings rate declines, the rate of labor force growth picks up, technological progress accelerates, or the depreciation rate increases.     Strategy & Market Trends MacroQuant Model And Current Subjective Scores Chart 29 Tactical Trades Strategic Recommendations Closed Trades

Dear Client, Credit in China has expanded at an exponential pace, with the country’s debt-to-GDP ratio climbing from 143% to more than 250% over the last decade. The speed and scale of China’s debt surge dwarfs Japan and the U.S.’ respective credit binges in the 1980’s and 2000’s, each of which ultimately led to financial market meltdowns. Why should China’s experience be any different? Given that China has pursued a different economic model whereby the banking sector is largely state-sponsored and the currency is tightly managed by the central bank, the answer to this pressing question for global markets is the subject of spirited debate at BCA and within the investment community at large. Clients are already aware that my colleagues, Peter Berezin and Arthur Budaghyan, disagree on the macro and market ramifications of China’s decade-long credit boom. The aim of this report is to provide visibility on the root sources of the view divergence, not to reconcile the gaps. We hope these insights will help shape your own conviction about this important topic. Caroline Miller Global Strategy Feature   Caroline: Arthur, your cautious outlook towards emerging markets in general and China’s prospects in particular stems from your belief that China’s economy is dangerously addicted to credit as a growth driver. Please explain why you dismiss the more sanguine view that China’s elevated debt burden is a function of an equally unusually high household savings rate. Arthur: It is simple: When people use the word “savings,” they typically and intuitively refer to bank deposits or securities investments; but this is incorrect. Chart 1 (Arthur)No Empirical Evidence That Deposits = 'Savings' No Empirical Evidence That Deposits = 'Savings' No Empirical Evidence That Deposits = 'Savings' Money supply/deposits in the banking system have no relationship with the savings rate of a nation in general or households in particular (Chart 1). When households save, they do not change the amount of money supply and deposits. Hence, households’ decision to save neither alters liquidity in the banking system nor helps banks to originate loans. In fact, banks do not intermediate deposits into loans or savings into credit.1 The terms “savings” in economics does not denote an increase in the stock of money and deposits. The term “savings” in economics means the amount of goods and services produced but not consumed. When an economy produces a steel bar, it is registered as national “savings.” We cannot consume (say, eat or expense) a steel bar. Therefore, once a steel bar or any equipment is produced, economic statistics will count it as “savings.” Besides, the sole utilization of a steel bar is in capital goods and construction, and hence, it cannot be consumed. Once a steel bar is produced, both national savings and investment will rise. That is how the “savings” = “investment” identity is derived. Chart 2 (Arthur)Chinese Households Are More Leveraged Than U.S. Ones Chinese Households Are More Leveraged Than U.S. Ones Chinese Households Are More Leveraged Than U.S. Ones It would avoid confusion and help everyone if economists were to call it “excess production” not “excess savings.” Banks do not need “excess production” – i.e., national “savings” – to create loans. Critically, the enormous amount of bank deposits in China is not due to household “savings” but is originated by banks “out of thin air.” In fact, Chinese households are now more leveraged than U.S. ones (Chart 2). Chart 3 The surge of credit and money supply in China during the past 10 years has been due to animal spirits running wild among lenders and borrowers on the mainland, not its households’ “savings.” In short, the root of China’s credit bubble is not any different from Japan’s (in the 1980s), or the U.S.’ (in the 2000s) and so on. Peter: Yes, banks can create deposits “out of thin air,” as Arthur says. However, people must be willing to hold those deposits. The amount of deposits that households and businesses wish to hold reflects many things, including the interest rate paid on deposits and the overall wealth of the society. The interest rate is a function of savings. The more people save, the lower interest rates will be. And the lower interest rates are, the more demand for credit there will be (Chart 3). It’s like asking what determines how many apples are consumed. Is it how many apple trees farmers want to plant or how many apples people want to eat? The answer is both. Prices adjust so that supply equals demand. How about national wealth? To a large extent, wealth represents the accumulation of tangible capital – factories, plant and machinery, homes and office buildings: the sort of stuff that banks can use as collateral for lending. And what determines how much tangible capital a country possesses? The answer is past savings, of the exact sort Arthur is referring to: the excess of production over consumption. So this form of “economic” savings also plays an important indirect role in determining the level of bank deposits. Chart 4 (Peter)China: From Exporting Savings To Investing Domestically And Building Up Debt China: From Exporting Savings To Investing Domestically And Building Up Debt China: From Exporting Savings To Investing Domestically And Building Up Debt I think the main problem with Arthur’s argument is that he is observing an accounting identity, which is that total bank assets (mostly loans) must equal liabilities (mostly deposits and capital) in equilibrium, without fully appreciating the economic forces – savings being one of them – that produce this equilibrium. In any case, the whole question of whether deposits create savings or savings create deposits misses the point. China’s fundamental problem is that it does not consume enough of what it produces. In the days when China had a massive current account surplus, it could export its excess savings abroad (Chart 4). It can’t do that anymore, so the government has consciously chosen to spur investment spending in order to prop up employment. Since a lot of investment spending is financed through credit, debt levels have risen. It really is just that simple.   Arthur: First, neither the stock nor the flow of credit and deposits has any relevance to (1) the economic term “savings;” (2) a country’s capital stock; or (3) national wealth, contrary to what Peter claims. China’s broad money supply (M2) now stands at 190 trillion yuan, equivalent to US$28 trillion (Chart 5, top panel). It is equal to the size of broad money supply in the U.S. and the euro area combined (US$14 trillion each). Yet, China’s nominal GDP is only two-thirds the size of the U.S. Does the level of China’s wealth and capital stock justify it having broad money supply (US$28 trillion) equivalent to the U.S. and the euro area combined? Chart 5 (Arthur)“Helicopter” Money In China “Helicopter” Money In China “Helicopter” Money In China Second, are Chinese households and companies willing to hold all RMB deposits that banks have created “out of thin air”? The answer: not really. Without capital controls, a notable portion of these deposits would have rushed into the foreign exchange markets and caused currency depreciation. Another sign of growing reluctance to hold the yuan is that households have been swapping their RMB deposits for real assets (property) at astronomical valuations. There is a bubble in China but people are looking for reasons to justify why it is different this time. Caroline: OK, let’s get away from the term “savings,” and agree that China continues to generate a chronic surplus of production of goods and services relative to consumption, and that how China chooses to intermediate that surplus is the most market-relevant issue. Arthur, you have used the terms “money bubble” and “helicopter money” in relation to China. This implies that banks are unconstrained in their ability to make loans. Just because savings don’t equal deposits, and banks can create deposits when they make loans doesn’t mean there is no relationship between the flow of credit and the stock of deposits. Arthur: Money supply and deposits expand only when banks originate a loan or buy an asset from a non-bank. In short, both credit and money/deposits are created by commercial banks “out of thin air.” This is true for any country.2 Consider a loan transaction by a German commercial bank. When it grants a €100 loan to a borrower, two accounting entries occur on its balance sheet. On the assets side, the amount of loans, and therefore total assets, increases by €100. Simultaneously, on the liabilities side, this accounting entry creates €100 of new deposits “out of thin air” (Figure 1). Hence, new purchasing power of €100 has been created via a simple accounting entry, which otherwise would not exist. Chart Critically, no one needed to save for this loan and money to be originated. The bank does not transfer someone else’s deposits to the borrower; it creates a new deposit when it lends. Banks also create deposits/money “out of thin air” when they buy securities from non-banks. In China, fiscal stimulus is largely financed by commercial banks – banks purchase more than 80% of government-issued bonds. This also leads to money creation. In short, when banks originate too much credit – as they have in China – they generate a money bubble. The money bubble is the mirror image of a credit bubble. Chinese banks have created 141 trillion yuan (US$21 trillion) of new money since 2009, compared with $8.25 trillion created in the U.S., euro area, and Japan combined over the same period (Chart 5, bottom panel). This is why I refer to it as “helicopter” money. Caroline: If banks need capital and liquidity to make loans, and deposits are one potential source of funds, don't these capital and liquidity constraints drive banks’ willingness and ability to lend, creating a link between the two variables? Arthur: Let me explain how mainland banks were able to circumvent those regulatory lending constraints. In 2009, they expanded their credit assets by about 30%. Even though a non-trivial portion of those loans were not paid back, banks did not recognize NPLs and instead booked large profits. By retaining a portion of those earnings, they boosted their equity, say, by 20%. As a result, the next year they were able to expand their credit assets by another 20% and so on. If banks lend and do not recognize bad loans, they can increase their equity and continue lending. With respect to liquidity, deposits are not liquidity for banks; excess reserves at the central bank are true liquidity for them. The reason why banks need to attract deposits is not to appropriate the deposits themselves, but to gain access to the excess reserves that come with them. When a person shifts her deposit from Bank A to Bank B, the former transfers a similar amount of excess reserves (liquidity) to the latter. When expanding their credit assets aggressively, banks can: (1) create more loans per one unit of excess reserves/liquidity, i.e., expand the money multiplier; and (2) borrow excess reserves/liquidity from the central bank or other banks. Chinese banks have used both channels to expand their balance sheets over the past 10 years (Chart 6). Chart 6 (Arthur)Broad Money Can Expand Without Growing Banks' Excess Reserves At The Central Bank Broad Money Can Expand Without Growing Banks' Excess Reserves At The Central Bank Broad Money Can Expand Without Growing Banks' Excess Reserves At The Central Bank Crucially, commercial banks create deposits, but they cannot create excess reserves (liquidity).3 The latter are issued only by central banks “out of thin air.” So, neither deposits nor excess reserves have any relevance to household or national “savings.” Caroline: Peter, Arthur argues that Chinese credit policy has been unconstrained by the traditional metrics of capital adequacy that prevail in capitalist, free-market economies. In other words, there is no connection between the availability of funds to lend via deposits in the banking system, and the pace of credit creation. Rather, the central bank has controlled the terms and volume of lending via regulation and fiat reserve provisioning. You’ve argued that credit creation has served the greater good of propping up employment via investment spending. Moreover, you posit that countries with a surplus of production over consumption will invariably experience high levels of credit creation. Our colleague, Martin Barnes, has analyzed national savings rates (as a proxy for over-production) relative to debt-GDP ratios in other countries. The relationship doesn’t look that strong elsewhere (Chart 7). Please elaborate on why you see credit growth as an inevitable policy response to the dearth of aggregate demand we observe in China? Chart 7 Peter: I would not say that countries with a surplus of production over consumption will invariably experience high levels of credit creation. For example, if most business investment is financed through retained earnings, you can have a lot of investment with little new debt. Debt can also result from activities not directly linked to the intermediation of savings. For instance, if you take out a mortgage to buy some land, your consumption and savings need not change, even though debt will be created. I think Arthur and I agree on this point. Thus, I am not saying that debt is always and everywhere the result of savings. I am simply pushing back against Arthur’s extremist position that debt never has anything to do with savings. Caroline: So what determines the level of debt in an economy in your view, Peter? Peter: In general, debt levels will rise if there are large imbalances between income and spending within society and/or if there are significant differences in the mix of assets people wish to hold. Think about the U.S. in the pre-financial crisis period. First, there was a surge in income inequality beginning in the early 1980s. For all intents and purposes, rich households with excess savings ended up lending their surplus income to poor households struggling to pay their bills. Overall savings did not rise, but debt levels still increased. That’s one reason why Martin’s chart doesn’t show a strong correlation between the aggregate savings rate and debt-to-GDP. Sometimes you need to look beneath the aggregate numbers to see the savings intermediation taking place. Unlike in the U.S., even poor Chinese households are net savers (Chart 8). Thus, the aggregate savings rate in China is very high4 (Chart 9). Much of these savings are funnelled to finance investment in the corporate and public sectors. This fuels debt growth. Chart 8 Chart 9 (Peter)Chinese Households Have More Savings Than The U.S., Europe And Japan Combined Chinese Household Savings Are More Than The U.S., Europe And Japan Combined Chinese Household Savings Are More Than The U.S., Europe And Japan Combined The second thing that happened in the U.S. starting in 2000 was a massive housing boom. If you bought a second home with credit, you ended up with one more asset (the house) but one more liability (the mortgage). The person who sold you the home ended up losing one asset (the house) but gaining another asset (a bigger bank deposit). The net result was both higher debt and higher bank deposits. Lending to finance asset purchases has also been a big source of debt growth in China, as it was in the U.S. before the crisis. The U.S. mortgage boom ended in tears, and so the question that we should be asking is whether the Chinese debt boom will end the same way. Arthur: We agreed not to use the term “savings,” yet Peter again refers to “savings” being funnelled into credit. As I explained above, banks do not funnel “savings” (i.e., “excess production”) into credit. China, Japan, and Germany have high “savings” rates because they produce a lot of steel, chemicals, autos, and machinery that literally cannot be consumed and, thus, are recorded as “savings.” The U.S. produces too many services that are consumed/expensed and, hence, not recorded as “savings.” That is why the U.S. has a lower “savings” rate. Chart 10 (Arthur)The Myth Of Deficient Demand In China The Myth Of Deficient Demand In China The Myth Of Deficient Demand In China Economic textbook discussions on “savings” and “investment” are relevant for a barter economy where banks do not exist. When this framework is applied to modern economies with banks, it generates a lot of confusion.5 Caroline: OK, so Peter argues that an imbalance between spending and income CAN be a marker for high debt levels. Arthur, please explain why you see no relationship between China’s chronic shortfall in demand and authorities’ explicit decision to support growth via credit creation. Arthur: First, China does not have deficient demand – consumer spending and capital expenditures have been growing at 10% and 9.4%, respectively, in real terms annually compounded for the past 10 years (Chart 10). The mainland economy has been suffering from excess production, not a lack of demand. China has invested a lot (Chart 11) and ended up with too much capacity to produce steel, cement, chemicals and other materials as well as machinery and industrial goods. So, China has an excess production of goods relative to firms’ and households’ underlying demand. In a market economy, these producers would become non-profitable, halt their investments, and shut down some capacity. Chart 11 (Arthur)China Has Been Over-Investing On An Unprecedented Scale China Has Been Over-Investing On An Unprecedented Scale China Has Been Over-Investing On An Unprecedented Scale In China, to keep the producers of these unwanted goods operating, the government has allowed and encouraged banks to originate loans creating new purchasing power literally “out of thin air” to purchase these goods. This has created a credit/money bubble. In a socialist system, banks do not ask debtors to repay loans and government officials are heavily involved in resource and capital allocation. China’s credit system and a growing chunk of its economy have been operating like a typical socialist system. Socialism leads to lower productivity growth for well-known reasons. With labor force growth set to turn negative, productivity is going to be the sole source of China’s potential growth rate. If the nation continues expanding this money/credit bubble to prop up zombie enterprises, its potential growth rate will fall considerably. As the potential growth rate drops, recurring stimulus will create nominal but not real growth. In short, the outcome will be stagflation. Caroline: The theoretical macro frameworks that you have both outlined make for interesting thought experiments, and spirited intellectual debate. However, investors are most concerned about the sustainability of China’s explosive credit growth, implications for the country’s growth rate, and the return on invested capital. Arthur, given your perspective on how Chinese credit policy has been designed and implemented, please outline the contours of how and when you see the music stopping, and the debt mountain crumbling. Arthur: Not every credit bubble will burst like the U.S. one did in 2008. For example, in the case of the Japanese credit bubble, there was no acute crisis. The bubble deflated gradually for about 20 years. In the cases of the U.S. (2008), Japan (1990), the euro area (2008-2014), Spain (2008-2014) and every other credit bubble, a common adjustment was a contraction in bank loans in nominal terms (Chart 12). Chart 12 (Arthur)All Credit Booms Have Been Followed By Contracting Bank Loans (I) All Credit Booms Have Been Followed By Contracting Bank Loans All Credit Booms Have Been Followed By Contracting Bank Loans Chart 12 (Arthur)All Credit Booms Have Been Followed By Contracting Bank Loans (II) All Credit Booms Have Been Followed By Contracting Bank Loans All Credit Booms Have Been Followed By Contracting Bank Loans Why do banks stop lending? The reason is that banks’ shareholders absorb the largest losses from credit booms. Given that banks are levered at least 20-to-1 at the peak of a typical credit boom, every $1 of non-performing loans leads to a $20 drop in their equity value. Bank shareholders halt the flow of credit to protect their wealth. Chart 13 (Arthur)China: Deleveraging Has Not Yet Begun China: Deleveraging Has Not Yet Begun China: Deleveraging Has Not Yet Begun Chart 14 In fact, credit in China is still growing at a double-digit rate, above nominal GDP growth (Chart 13). Hence, aggregate deleveraging in China has not yet begun. If banks do not curtail credit origination, the music will not stop. However, uninterrupted credit growth happens only in a socialist system where banks subsidize the economy at the expense of their shareholders. But even then, there is no free lunch. Credit origination by banks also expands the money supply as discussed above. An expanding money bubble will heighten devaluation pressure on the yuan in the long run. The enormous amount of money supply/deposits – the money bubble – in China is like “the sword of Damocles” hanging over the nation’s currency. Chinese households and businesses are becoming reluctant to hold this ballooning supply of local currency. Continuous “helicopter” money will only increase their desire to diversify their RMB deposits into foreign currencies and assets. Yet, there is an insufficient supply of foreign currency to accommodate this conversion. The nation’s current account surplus has almost vanished while the central bank carries US$3 trillion in foreign exchange reserve representing only 11% of the yuan deposits and cash in circulation (Chart 14). It is inconceivable that China can open its capital account in the foreseeable future. “Helicopter” money also discourages innovation and breeds capital misallocation, which reduces productivity growth. A combination of slowing productivity growth, and thus potential GDP, and strong money growth ultimately lead to stagflation – the dynamics endemic to socialist systems. Peter: Arthur’s answer implicitly assumes that private investment would increase if the government removed credit/fiscal stimulus. But where is the evidence for that? We had just established that the Chinese economy suffers from a lack of aggregate demand. Public-sector spending, to the extent that it increases employment and incomes, crowds in private-sector investment rather than crowding it out. Ask yourself what would have happened if China didn’t build that “bridge to nowhere.” Would those displaced construction workers have found more productive work elsewhere or would they have remained idle? The answer is almost certainly the latter. After all, the reason the Chinese government built the bridge in the first place was to increase employment in an economy that habitually struggles to consume enough of what is produces. Arthur talks about the “misallocation” of resources. But doesn’t an unemployed worker also represent a misallocation of resources? In my view, it certainly does – and one that is much more threatening to social stability than an underutilized bridge or road. If you understand the point above, you will also understand why Arthur’s comparison between Chinese banks and say, U.S. banks is misplaced. The Chinese government is the main shareholder in Chinese banks. The government cares more about social stability than anything else. There is no way it would let credit growth plunge. Moreover, as the main shareholder, the government has a strong incentive to raise the share price of Chinese banks. After all, it is difficult to have a reserve currency that rivals the U.S. dollar, as China aspires to have, if your largest banks trade like penny stocks. My guess is that the Chinese government will shut down a few small banks to “show” that it is concerned about moral hazard, but then turn around and allow the larger banks to sell their troubled loans to state-owned asset management companies on very favourable terms (similar to what happened in the early 2000s). Once investors get wind that this is about to happen, Chinese bank shares will rally like crazy. Caroline: Isn’t shuffling debt from one sector of the economy to another akin to a shell game? Wouldn’t rampant debt growth eventually cause investors to lose confidence in the currency? Peter: China has a problem with the composition of its debt, not with its total value. Debt is a problem when the borrower can’t or won’t repay the loan. Chart 15 (Peter)China Is On Course To Lose More Than 400 Million Workers China On Course To Lose More Than 400 Million Workers China On Course To Lose More Than 400 Million Workers I completely agree that there is too much shadow bank lending in China. There is also too much borrowing by state-owned enterprises. Ideally, the Chinese government would move all this quasi-public spending onto its own balance sheet. It would significantly raise social spending to discourage precautionary household savings. It would also adopt generous pro-natal policies — free childcare, education, government paid parental leave, and the like. The fact that the Chinese working-age population is set to shrink by 400 million by the end of the century is a huge problem (Chart 15). If the central government borrowed and spent more, state-owned companies and local governments would not have to borrow or spend as much. Banks could then increase their holding of high-quality central government bonds. Debt sustainability is only a problem if the interest rate the government faces exceeds the growth rate of the economy.6 That is manifestly not the case in China (Chart 16). And why are interest rates so low in relation to growth? Because Chinese households save so much! We simply can’t ignore the role of savings in the discussion. Chart 16 (Peter)China: High Levels Of Household Savings Have Kept Interest Rates Below The Growth Rate Of The Economy China: High Levels Of Household Savings Have Kept Interest Rates Below The Growth Rate Of The Economy China: High Levels Of Household Savings Have Kept Interest Rates Below The Growth Rate Of The Economy As far as the currency is concerned, if debt growth rose so much that the economy overheated and inflation soared, then yes, the yuan would plunge. But that’s not what we are talking about here. We are talking about bringing debt growth to a level that generates just enough demand to achieve something resembling full employment. No one is calling for raising debt growth beyond that point. Curbing debt growth in a demand-deficient economy, as Arthur seems to be recommending, would cause unemployment to rise. Investors would then bet that the Chinese government would try to boost net exports by engineering a currency devaluation. Capital outflows would intensify. Far from creating the conditions for a weaker yuan, fiscal/credit stimulus obviates the need for a currency depreciation. Caroline: Peter, even if we accept your argument that the counterfactual of curbing credit growth in a demand-deficient economy would be a more deflationary outcome than sustaining the government-sponsored credit growth engine, how is building bridges to nowhere a positive sum for investors? Even if this strategy maintains social stability in the interests of the CCP’s regime preservation, won’t investors eventually recoil at the retreat to socialism that Arthur outlines, reducing the appeal of holding the yuan, even if, as you both seem to agree, no apocalyptic debt crisis is at hand? In other words, isn’t two times nothing still nothing? Peter: First of all, many of these infrastructure projects may turn out to be quite useful down the road, pardon the pun. Per capita vehicle ownership in China is only one one-fifth of what it is in the United States, and one-fourth of what it is in Japan (Chart 17). A sparsely used expressway today may be a clogged one tomorrow. Chart 17 (Peter)The Automobile Ownership Rate Is Still Quite Low In China The Automobile Ownership Rate Is Still Quite Low In China The Automobile Ownership Rate Is Still Quite Low In China Would China really be better off if it had fewer infrastructure projects and more big screen TVs? An economy where people are always buying stuff they don’t need, with money they don’t have, to impress people they don’t like, is hardly a recipe for success. I am not sure what these references to socialism are supposed to accomplish. You want to see a real retreat to socialism? Try creating millions of unemployed workers with no jobs and no hope. All sorts of pundits decried Franklin Roosevelt’s New Deal as creeping socialism. The truth is that the New Deal took the wind out of the sails of the fledgling U.S. communist movement at the time. Arthur: I believe that Peter is confusing the structural and cyclical needs for stimulus. When an economy is in a recession – banks are shrinking their balance sheets and property prices are deflating – the authorities must undertake fiscal and credit stimulus. Chart 18 (Arthur)What Will Productivity Growth Look Like If Public Officials Allocate 55%-60% Of GDP? What Will Productivity Growth Look Like If Public Officials Allocate 55%-60% Of GDP? What Will Productivity Growth Look Like If Public Officials Allocate 55%-60% Of GDP? Credit and fiscal stimulus made sense in China in early 2009 when growth plunged. However, over the past 10 years, we have witnessed credit and property market booms of gigantic proportions. Does this economy warrant continuous stimulus? What will productivity growth look like if government bureaucrats continuously allocate 55-60% of GDP each year (Chart 18)? Caroline: Arthur and Peter, you can both argue with one another about the semantic economic definition of the term ‘savings’, the implications of chronic excess production (relative to consumption), and the root drivers of credit growth in China long past the expiry of every BCA client’s investment horizon. Clients benefit from understanding your distinct perspectives only to the extent that they inform your outlook for markets. Will each of you now please outline how you see high levels of credit in China’s economy impacting the following over a cyclical (6-12 month) and structural (3-5 year) horizon: Global growth Commodity prices China-geared financial assets Peter: Regardless of what one thinks about the root causes of China’s high debt levels, it seems certain to me that the Chinese are going to pick up the pace of credit/fiscal stimulus over the next six months in response to slowing growth and trade war uncertainties. If anything, the incentive to open the credit spigots this time around is greater than in the past because the Chinese government wants to have a fast-growing economy to gain leverage over trade negotiations with the U.S. Chart 19 (Peter)Stronger Chinese Credit Growth Bodes Well For Commodity Prices Stronger Chinese Credit Growth Bodes Well For Commodity Prices Stronger Chinese Credit Growth Bodes Well For Commodity Prices Chart 20 (Peter)The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency Stronger Chinese growth will boost growth in the rest of the world. Commodity prices will rise (Chart 19). As a counter-cyclical currency, the U.S. dollar will likely peak over the next month or so and then weaken in the back half of 2019 and into 2020 (Chart 20). The combination of stronger Chinese growth, higher commodity prices, and a weaker dollar will be manna from heaven for emerging markets. If a trade truce between China and the U.S. is reached, investors should move quickly to overweight EM equities. European stocks should also benefit. Looking further out, China’s economy will slow in absolute terms. In relative terms, however, Chinese growth will remain near the top of the global rankings. China has one of the most educated workforces in the world (Chart 21). Assuming that output-per-hour reaches South Korean levels by the middle of the century, Chinese real GDP would need to expand by about 6% per year over the next decade (Chart 22). That’s a lot of growth – growth that will eventually help China outgrow its debt burden. Chart 21 Chart 22 (Peter)China Has More Catching Up To Do China Has More Catching Up To Do China Has More Catching Up To Do Keep in mind that credit growth of 1% when the debt-to-GDP ratio is 300% yields 3% of GDP in credit stimulus, compared with only 1% of stimulus when the debt-to-GDP ratio is 100%. That does not mean that more debt is intrinsically a good thing, but it does mean that China will eventually be able to slow debt growth even if excess savings remains a problem. Structurally, Chinese and EM equities will likely outperform their developed market peers over a 3-to-5 year horizon. The P/E ratio for EM stocks is currently 4.7 percentage points below that of developed markets, which is below its long-term average (Chart 23). While EM EPS growth has lagged DM earnings growth over the past eight years, the long-term trend still favors EM (Chart 24). EM currencies will appreciate over this period, with the RMB leading the way. Chart 23 (Peter)EM Stocks: Valuations Are Attractive EM Stocks: Valuations Are Attractive EM Stocks: Valuations Are Attractive Chart 24 (Peter)Earnings Growth In EM Has Outpaced That Of DM Over The Long Haul Earnings Growth In EM Has Outpaced That Of DM Over The Long Haul Earnings Growth In EM Has Outpaced That Of DM Over The Long Haul Arthur: China is facing a historic choice between two scenarios. Medium- and long-term macro outcomes will impact markets differently in each case. Table 1 shows my cyclical and structural investment recommendations for each scenario. Table 1 (Arthur)Arthur’s Recommended Investment Strategy For China-Geared Financial Assets China’s Credit Cycle: A Spirited Debate China’s Credit Cycle: A Spirited Debate Allowing Markets to Play A Bigger Role = Lower credit growth (deleveraging), corporate restructuring, and weaker growth (Chart 25). This is bearish for growth and financial markets in the medium term but it will make Chinese stocks and the currency structural (long-term) buys. Credit/Money Boom Persists (Socialist Put) = Secular Stagnation, Inflation and Currency Depreciation: The structural outlook is downbeat but there are mini-cycles that investors could play (Chart 26). Cyclically, China-geared financial assets still remain at risk. However, lower asset prices and more stimulus in China could put a floor under asset prices later this year. Timing these mini-cycles is critical. A buy-and-hold strategy for Chinese assets will not be appropriate in this scenario. In short, capitalism is bad but socialism is worse. I hope China will pursue the first path. Chart 25 Chart 26 Caroline: Thank you both for clarifying your perspectives. Over a multi-year horizon, markets will render the ultimate judgement on whether China’s credit boom has represented a reckless misallocation of capital, or a rational policy response to an imbalance between domestic spending and income. In the meantime, we will monitor the complexion of Chinese stimulus and evidence of its global growth multiplier effect over the coming weeks and months. These will be the key variables to watch as we determine when and at what level to upgrade BCA’s cyclical outlook for China-geared assets. Can’t wait for that debate. Footnotes 1 For a detailed discussion of these issues, please see Emerging Markets Strategy Special Reports, “Misconceptions About China's Credit Excesses,” dated October 26, 2016 and “The True Meaning Of China's Great 'Savings' Wall,” dated December 20, 2017. 2 For a detailed discussion of these issues, please see Emerging Markets Strategy Special Reports, “Misconceptions About China's Credit Excesses,” dated October 26, 2016 and “The True Meaning Of China's Great 'Savings' Wall,” dated December 20, 2017. 3 For a detailed discussion of these issues, please see Emerging Markets Strategy Special Report, “China's Money Creation Redux And The RMB,” dated November 23, 2016. 4 For a discussion on the reasons behind China’s high savings rate, please see Global Investment Strategy Weekly Report, “China’s Savings Problem,” dated January 25, 2019. 5 For a detailed discussion of these issues, please see Emerging Markets Strategy Special Report, “Is Investment Constrained By Savings? Tales Of China And Brazil,” dated March 22, 2018. 6 For a detailed discussion of these issues, please see Global Investment Strategy Weekly Report, “Is There Really Too Much Government Debt In The World?” dated February 22, 2019 and “Chinese Debt: A Contrarian View,” dated April 19, 2019.

Dear Client, Credit in China has expanded at an exponential pace, with the country’s debt-to-GDP ratio climbing from 143% to more than 250% over the last decade. The speed and scale of China’s debt surge dwarfs Japan and the U.S.’ respective credit binges in the 1980’s and 2000’s, each of which ultimately led to financial market meltdowns. Why should China’s experience be any different? Given that China has pursued a different economic model whereby the banking sector is largely state-sponsored and the currency is tightly managed by the central bank, the answer to this pressing question for global markets is the subject of spirited debate at BCA and within the investment community at large. Clients are already aware that my colleagues, Peter Berezin and Arthur Budaghyan, disagree on the macro and market ramifications of China’s decade-long credit boom. The aim of this report is to provide visibility on the root sources of the view divergence, not to reconcile the gaps. We hope these insights will help shape your own conviction about this important topic. Caroline Miller Global Strategy Feature   Caroline: Arthur, your cautious outlook towards emerging markets in general and China’s prospects in particular stems from your belief that China’s economy is dangerously addicted to credit as a growth driver. Please explain why you dismiss the more sanguine view that China’s elevated debt burden is a function of an equally unusually high household savings rate. Arthur: It is simple: When people use the word “savings,” they typically and intuitively refer to bank deposits or securities investments; but this is incorrect. Chart 1 (Arthur)No Empirical Evidence That Deposits = 'Savings' No Empirical Evidence That Deposits = 'Savings' No Empirical Evidence That Deposits = 'Savings' Money supply/deposits in the banking system have no relationship with the savings rate of a nation in general or households in particular (Chart 1). When households save, they do not change the amount of money supply and deposits. Hence, households’ decision to save neither alters liquidity in the banking system nor helps banks to originate loans. In fact, banks do not intermediate deposits into loans or savings into credit.1 The terms “savings” in economics does not denote an increase in the stock of money and deposits. The term “savings” in economics means the amount of goods and services produced but not consumed. When an economy produces a steel bar, it is registered as national “savings.” We cannot consume (say, eat or expense) a steel bar. Therefore, once a steel bar or any equipment is produced, economic statistics will count it as “savings.” Besides, the sole utilization of a steel bar is in capital goods and construction, and hence, it cannot be consumed. Once a steel bar is produced, both national savings and investment will rise. That is how the “savings” = “investment” identity is derived. Chart 2 (Arthur)Chinese Households Are More Leveraged Than U.S. Ones Chinese Households Are More Leveraged Than U.S. Ones Chinese Households Are More Leveraged Than U.S. Ones It would avoid confusion and help everyone if economists were to call it “excess production” not “excess savings.” Banks do not need “excess production” – i.e., national “savings” – to create loans. Critically, the enormous amount of bank deposits in China is not due to household “savings” but is originated by banks “out of thin air.” In fact, Chinese households are now more leveraged than U.S. ones (Chart 2). Chart 3 The surge of credit and money supply in China during the past 10 years has been due to animal spirits running wild among lenders and borrowers on the mainland, not its households’ “savings.” In short, the root of China’s credit bubble is not any different from Japan’s (in the 1980s), or the U.S.’ (in the 2000s) and so on. Peter: Yes, banks can create deposits “out of thin air,” as Arthur says. However, people must be willing to hold those deposits. The amount of deposits that households and businesses wish to hold reflects many things, including the interest rate paid on deposits and the overall wealth of the society. The interest rate is a function of savings. The more people save, the lower interest rates will be. And the lower interest rates are, the more demand for credit there will be (Chart 3). It’s like asking what determines how many apples are consumed. Is it how many apple trees farmers want to plant or how many apples people want to eat? The answer is both. Prices adjust so that supply equals demand. How about national wealth? To a large extent, wealth represents the accumulation of tangible capital – factories, plant and machinery, homes and office buildings: the sort of stuff that banks can use as collateral for lending. And what determines how much tangible capital a country possesses? The answer is past savings, of the exact sort Arthur is referring to: the excess of production over consumption. So this form of “economic” savings also plays an important indirect role in determining the level of bank deposits. Chart 4 (Peter)China: From Exporting Savings To Investing Domestically And Building Up Debt China: From Exporting Savings To Investing Domestically And Building Up Debt China: From Exporting Savings To Investing Domestically And Building Up Debt I think the main problem with Arthur’s argument is that he is observing an accounting identity, which is that total bank assets (mostly loans) must equal liabilities (mostly deposits and capital) in equilibrium, without fully appreciating the economic forces – savings being one of them – that produce this equilibrium. In any case, the whole question of whether deposits create savings or savings create deposits misses the point. China’s fundamental problem is that it does not consume enough of what it produces. In the days when China had a massive current account surplus, it could export its excess savings abroad (Chart 4). It can’t do that anymore, so the government has consciously chosen to spur investment spending in order to prop up employment. Since a lot of investment spending is financed through credit, debt levels have risen. It really is just that simple.   Arthur: First, neither the stock nor the flow of credit and deposits has any relevance to (1) the economic term “savings;” (2) a country’s capital stock; or (3) national wealth, contrary to what Peter claims. China’s broad money supply (M2) now stands at 190 trillion yuan, equivalent to US$28 trillion (Chart 5, top panel). It is equal to the size of broad money supply in the U.S. and the euro area combined (US$14 trillion each). Yet, China’s nominal GDP is only two-thirds the size of the U.S. Does the level of China’s wealth and capital stock justify it having broad money supply (US$28 trillion) equivalent to the U.S. and the euro area combined? Chart 5 (Arthur)“Helicopter” Money In China “Helicopter” Money In China “Helicopter” Money In China Second, are Chinese households and companies willing to hold all RMB deposits that banks have created “out of thin air”? The answer: not really. Without capital controls, a notable portion of these deposits would have rushed into the foreign exchange markets and caused currency depreciation. Another sign of growing reluctance to hold the yuan is that households have been swapping their RMB deposits for real assets (property) at astronomical valuations. There is a bubble in China but people are looking for reasons to justify why it is different this time. Caroline: OK, let’s get away from the term “savings,” and agree that China continues to generate a chronic surplus of production of goods and services relative to consumption, and that how China chooses to intermediate that surplus is the most market-relevant issue. Arthur, you have used the terms “money bubble” and “helicopter money” in relation to China. This implies that banks are unconstrained in their ability to make loans. Just because savings don’t equal deposits, and banks can create deposits when they make loans doesn’t mean there is no relationship between the flow of credit and the stock of deposits. Arthur: Money supply and deposits expand only when banks originate a loan or buy an asset from a non-bank. In short, both credit and money/deposits are created by commercial banks “out of thin air.” This is true for any country.2 Consider a loan transaction by a German commercial bank. When it grants a €100 loan to a borrower, two accounting entries occur on its balance sheet. On the assets side, the amount of loans, and therefore total assets, increases by €100. Simultaneously, on the liabilities side, this accounting entry creates €100 of new deposits “out of thin air” (Figure 1). Hence, new purchasing power of €100 has been created via a simple accounting entry, which otherwise would not exist. Chart Critically, no one needed to save for this loan and money to be originated. The bank does not transfer someone else’s deposits to the borrower; it creates a new deposit when it lends. Banks also create deposits/money “out of thin air” when they buy securities from non-banks. In China, fiscal stimulus is largely financed by commercial banks – banks purchase more than 80% of government-issued bonds. This also leads to money creation. In short, when banks originate too much credit – as they have in China – they generate a money bubble. The money bubble is the mirror image of a credit bubble. Chinese banks have created 141 trillion yuan (US$21 trillion) of new money since 2009, compared with $8.25 trillion created in the U.S., euro area, and Japan combined over the same period (Chart 5, bottom panel). This is why I refer to it as “helicopter” money. Caroline: If banks need capital and liquidity to make loans, and deposits are one potential source of funds, don't these capital and liquidity constraints drive banks’ willingness and ability to lend, creating a link between the two variables? Arthur: Let me explain how mainland banks were able to circumvent those regulatory lending constraints. In 2009, they expanded their credit assets by about 30%. Even though a non-trivial portion of those loans were not paid back, banks did not recognize NPLs and instead booked large profits. By retaining a portion of those earnings, they boosted their equity, say, by 20%. As a result, the next year they were able to expand their credit assets by another 20% and so on. If banks lend and do not recognize bad loans, they can increase their equity and continue lending. With respect to liquidity, deposits are not liquidity for banks; excess reserves at the central bank are true liquidity for them. The reason why banks need to attract deposits is not to appropriate the deposits themselves, but to gain access to the excess reserves that come with them. When a person shifts her deposit from Bank A to Bank B, the former transfers a similar amount of excess reserves (liquidity) to the latter. When expanding their credit assets aggressively, banks can: (1) create more loans per one unit of excess reserves/liquidity, i.e., expand the money multiplier; and (2) borrow excess reserves/liquidity from the central bank or other banks. Chinese banks have used both channels to expand their balance sheets over the past 10 years (Chart 6). Chart 6 (Arthur)Broad Money Can Expand Without Growing Banks' Excess Reserves At The Central Bank Broad Money Can Expand Without Growing Banks' Excess Reserves At The Central Bank Broad Money Can Expand Without Growing Banks' Excess Reserves At The Central Bank Crucially, commercial banks create deposits, but they cannot create excess reserves (liquidity).3 The latter are issued only by central banks “out of thin air.” So, neither deposits nor excess reserves have any relevance to household or national “savings.” Caroline: Peter, Arthur argues that Chinese credit policy has been unconstrained by the traditional metrics of capital adequacy that prevail in capitalist, free-market economies. In other words, there is no connection between the availability of funds to lend via deposits in the banking system, and the pace of credit creation. Rather, the central bank has controlled the terms and volume of lending via regulation and fiat reserve provisioning. You’ve argued that credit creation has served the greater good of propping up employment via investment spending. Moreover, you posit that countries with a surplus of production over consumption will invariably experience high levels of credit creation. Our colleague, Martin Barnes, has analyzed national savings rates (as a proxy for over-production) relative to debt-GDP ratios in other countries. The relationship doesn’t look that strong elsewhere (Chart 7). Please elaborate on why you see credit growth as an inevitable policy response to the dearth of aggregate demand we observe in China? Chart 7 Peter: I would not say that countries with a surplus of production over consumption will invariably experience high levels of credit creation. For example, if most business investment is financed through retained earnings, you can have a lot of investment with little new debt. Debt can also result from activities not directly linked to the intermediation of savings. For instance, if you take out a mortgage to buy some land, your consumption and savings need not change, even though debt will be created. I think Arthur and I agree on this point. Thus, I am not saying that debt is always and everywhere the result of savings. I am simply pushing back against Arthur’s extremist position that debt never has anything to do with savings. Caroline: So what determines the level of debt in an economy in your view, Peter? Peter: In general, debt levels will rise if there are large imbalances between income and spending within society and/or if there are significant differences in the mix of assets people wish to hold. Think about the U.S. in the pre-financial crisis period. First, there was a surge in income inequality beginning in the early 1980s. For all intents and purposes, rich households with excess savings ended up lending their surplus income to poor households struggling to pay their bills. Overall savings did not rise, but debt levels still increased. That’s one reason why Martin’s chart doesn’t show a strong correlation between the aggregate savings rate and debt-to-GDP. Sometimes you need to look beneath the aggregate numbers to see the savings intermediation taking place. Unlike in the U.S., even poor Chinese households are net savers (Chart 8). Thus, the aggregate savings rate in China is very high4 (Chart 9). Much of these savings are funnelled to finance investment in the corporate and public sectors. This fuels debt growth. Chart 8 Chart 9 (Peter)Chinese Households Have More Savings Than The U.S., Europe And Japan Combined Chinese Household Savings Are More Than The U.S., Europe And Japan Combined Chinese Household Savings Are More Than The U.S., Europe And Japan Combined The second thing that happened in the U.S. starting in 2000 was a massive housing boom. If you bought a second home with credit, you ended up with one more asset (the house) but one more liability (the mortgage). The person who sold you the home ended up losing one asset (the house) but gaining another asset (a bigger bank deposit). The net result was both higher debt and higher bank deposits. Lending to finance asset purchases has also been a big source of debt growth in China, as it was in the U.S. before the crisis. The U.S. mortgage boom ended in tears, and so the question that we should be asking is whether the Chinese debt boom will end the same way. Arthur: We agreed not to use the term “savings,” yet Peter again refers to “savings” being funnelled into credit. As I explained above, banks do not funnel “savings” (i.e., “excess production”) into credit. China, Japan, and Germany have high “savings” rates because they produce a lot of steel, chemicals, autos, and machinery that literally cannot be consumed and, thus, are recorded as “savings.” The U.S. produces too many services that are consumed/expensed and, hence, not recorded as “savings.” That is why the U.S. has a lower “savings” rate. Chart 10 (Arthur)The Myth Of Deficient Demand In China The Myth Of Deficient Demand In China The Myth Of Deficient Demand In China Economic textbook discussions on “savings” and “investment” are relevant for a barter economy where banks do not exist. When this framework is applied to modern economies with banks, it generates a lot of confusion.5 Caroline: OK, so Peter argues that an imbalance between spending and income CAN be a marker for high debt levels. Arthur, please explain why you see no relationship between China’s chronic shortfall in demand and authorities’ explicit decision to support growth via credit creation. Arthur: First, China does not have deficient demand – consumer spending and capital expenditures have been growing at 10% and 9.4%, respectively, in real terms annually compounded for the past 10 years (Chart 10). The mainland economy has been suffering from excess production, not a lack of demand. China has invested a lot (Chart 11) and ended up with too much capacity to produce steel, cement, chemicals and other materials as well as machinery and industrial goods. So, China has an excess production of goods relative to firms’ and households’ underlying demand. In a market economy, these producers would become non-profitable, halt their investments, and shut down some capacity. Chart 11 (Arthur)China Has Been Over-Investing On An Unprecedented Scale China Has Been Over-Investing On An Unprecedented Scale China Has Been Over-Investing On An Unprecedented Scale In China, to keep the producers of these unwanted goods operating, the government has allowed and encouraged banks to originate loans creating new purchasing power literally “out of thin air” to purchase these goods. This has created a credit/money bubble. In a socialist system, banks do not ask debtors to repay loans and government officials are heavily involved in resource and capital allocation. China’s credit system and a growing chunk of its economy have been operating like a typical socialist system. Socialism leads to lower productivity growth for well-known reasons. With labor force growth set to turn negative, productivity is going to be the sole source of China’s potential growth rate. If the nation continues expanding this money/credit bubble to prop up zombie enterprises, its potential growth rate will fall considerably. As the potential growth rate drops, recurring stimulus will create nominal but not real growth. In short, the outcome will be stagflation. Caroline: The theoretical macro frameworks that you have both outlined make for interesting thought experiments, and spirited intellectual debate. However, investors are most concerned about the sustainability of China’s explosive credit growth, implications for the country’s growth rate, and the return on invested capital. Arthur, given your perspective on how Chinese credit policy has been designed and implemented, please outline the contours of how and when you see the music stopping, and the debt mountain crumbling. Arthur: Not every credit bubble will burst like the U.S. one did in 2008. For example, in the case of the Japanese credit bubble, there was no acute crisis. The bubble deflated gradually for about 20 years. In the cases of the U.S. (2008), Japan (1990), the euro area (2008-2014), Spain (2008-2014) and every other credit bubble, a common adjustment was a contraction in bank loans in nominal terms (Chart 12). Chart 12 (Arthur)All Credit Booms Have Been Followed By Contracting Bank Loans (I) All Credit Booms Have Been Followed By Contracting Bank Loans All Credit Booms Have Been Followed By Contracting Bank Loans Chart 12 (Arthur)All Credit Booms Have Been Followed By Contracting Bank Loans (II) All Credit Booms Have Been Followed By Contracting Bank Loans All Credit Booms Have Been Followed By Contracting Bank Loans Why do banks stop lending? The reason is that banks’ shareholders absorb the largest losses from credit booms. Given that banks are levered at least 20-to-1 at the peak of a typical credit boom, every $1 of non-performing loans leads to a $20 drop in their equity value. Bank shareholders halt the flow of credit to protect their wealth. Chart 13 (Arthur)China: Deleveraging Has Not Yet Begun China: Deleveraging Has Not Yet Begun China: Deleveraging Has Not Yet Begun Chart 14 In fact, credit in China is still growing at a double-digit rate, above nominal GDP growth (Chart 13). Hence, aggregate deleveraging in China has not yet begun. If banks do not curtail credit origination, the music will not stop. However, uninterrupted credit growth happens only in a socialist system where banks subsidize the economy at the expense of their shareholders. But even then, there is no free lunch. Credit origination by banks also expands the money supply as discussed above. An expanding money bubble will heighten devaluation pressure on the yuan in the long run. The enormous amount of money supply/deposits – the money bubble – in China is like “the sword of Damocles” hanging over the nation’s currency. Chinese households and businesses are becoming reluctant to hold this ballooning supply of local currency. Continuous “helicopter” money will only increase their desire to diversify their RMB deposits into foreign currencies and assets. Yet, there is an insufficient supply of foreign currency to accommodate this conversion. The nation’s current account surplus has almost vanished while the central bank carries US$3 trillion in foreign exchange reserve representing only 11% of the yuan deposits and cash in circulation (Chart 14). It is inconceivable that China can open its capital account in the foreseeable future. “Helicopter” money also discourages innovation and breeds capital misallocation, which reduces productivity growth. A combination of slowing productivity growth, and thus potential GDP, and strong money growth ultimately lead to stagflation – the dynamics endemic to socialist systems. Peter: Arthur’s answer implicitly assumes that private investment would increase if the government removed credit/fiscal stimulus. But where is the evidence for that? We had just established that the Chinese economy suffers from a lack of aggregate demand. Public-sector spending, to the extent that it increases employment and incomes, crowds in private-sector investment rather than crowding it out. Ask yourself what would have happened if China didn’t build that “bridge to nowhere.” Would those displaced construction workers have found more productive work elsewhere or would they have remained idle? The answer is almost certainly the latter. After all, the reason the Chinese government built the bridge in the first place was to increase employment in an economy that habitually struggles to consume enough of what is produces. Arthur talks about the “misallocation” of resources. But doesn’t an unemployed worker also represent a misallocation of resources? In my view, it certainly does – and one that is much more threatening to social stability than an underutilized bridge or road. If you understand the point above, you will also understand why Arthur’s comparison between Chinese banks and say, U.S. banks is misplaced. The Chinese government is the main shareholder in Chinese banks. The government cares more about social stability than anything else. There is no way it would let credit growth plunge. Moreover, as the main shareholder, the government has a strong incentive to raise the share price of Chinese banks. After all, it is difficult to have a reserve currency that rivals the U.S. dollar, as China aspires to have, if your largest banks trade like penny stocks. My guess is that the Chinese government will shut down a few small banks to “show” that it is concerned about moral hazard, but then turn around and allow the larger banks to sell their troubled loans to state-owned asset management companies on very favourable terms (similar to what happened in the early 2000s). Once investors get wind that this is about to happen, Chinese bank shares will rally like crazy. Caroline: Isn’t shuffling debt from one sector of the economy to another akin to a shell game? Wouldn’t rampant debt growth eventually cause investors to lose confidence in the currency? Peter: China has a problem with the composition of its debt, not with its total value. Debt is a problem when the borrower can’t or won’t repay the loan. Chart 15 (Peter)China Is On Course To Lose More Than 400 Million Workers China On Course To Lose More Than 400 Million Workers China On Course To Lose More Than 400 Million Workers I completely agree that there is too much shadow bank lending in China. There is also too much borrowing by state-owned enterprises. Ideally, the Chinese government would move all this quasi-public spending onto its own balance sheet. It would significantly raise social spending to discourage precautionary household savings. It would also adopt generous pro-natal policies — free childcare, education, government paid parental leave, and the like. The fact that the Chinese working-age population is set to shrink by 400 million by the end of the century is a huge problem (Chart 15). If the central government borrowed and spent more, state-owned companies and local governments would not have to borrow or spend as much. Banks could then increase their holding of high-quality central government bonds. Debt sustainability is only a problem if the interest rate the government faces exceeds the growth rate of the economy.6 That is manifestly not the case in China (Chart 16). And why are interest rates so low in relation to growth? Because Chinese households save so much! We simply can’t ignore the role of savings in the discussion. Chart 16 (Peter)China: High Levels Of Household Savings Have Kept Interest Rates Below The Growth Rate Of The Economy China: High Levels Of Household Savings Have Kept Interest Rates Below The Growth Rate Of The Economy China: High Levels Of Household Savings Have Kept Interest Rates Below The Growth Rate Of The Economy As far as the currency is concerned, if debt growth rose so much that the economy overheated and inflation soared, then yes, the yuan would plunge. But that’s not what we are talking about here. We are talking about bringing debt growth to a level that generates just enough demand to achieve something resembling full employment. No one is calling for raising debt growth beyond that point. Curbing debt growth in a demand-deficient economy, as Arthur seems to be recommending, would cause unemployment to rise. Investors would then bet that the Chinese government would try to boost net exports by engineering a currency devaluation. Capital outflows would intensify. Far from creating the conditions for a weaker yuan, fiscal/credit stimulus obviates the need for a currency depreciation. Caroline: Peter, even if we accept your argument that the counterfactual of curbing credit growth in a demand-deficient economy would be a more deflationary outcome than sustaining the government-sponsored credit growth engine, how is building bridges to nowhere a positive sum for investors? Even if this strategy maintains social stability in the interests of the CCP’s regime preservation, won’t investors eventually recoil at the retreat to socialism that Arthur outlines, reducing the appeal of holding the yuan, even if, as you both seem to agree, no apocalyptic debt crisis is at hand? In other words, isn’t two times nothing still nothing? Peter: First of all, many of these infrastructure projects may turn out to be quite useful down the road, pardon the pun. Per capita vehicle ownership in China is only one one-fifth of what it is in the United States, and one-fourth of what it is in Japan (Chart 17). A sparsely used expressway today may be a clogged one tomorrow. Chart 17 (Peter)The Automobile Ownership Rate Is Still Quite Low In China The Automobile Ownership Rate Is Still Quite Low In China The Automobile Ownership Rate Is Still Quite Low In China Would China really be better off if it had fewer infrastructure projects and more big screen TVs? An economy where people are always buying stuff they don’t need, with money they don’t have, to impress people they don’t like, is hardly a recipe for success. I am not sure what these references to socialism are supposed to accomplish. You want to see a real retreat to socialism? Try creating millions of unemployed workers with no jobs and no hope. All sorts of pundits decried Franklin Roosevelt’s New Deal as creeping socialism. The truth is that the New Deal took the wind out of the sails of the fledgling U.S. communist movement at the time. Arthur: I believe that Peter is confusing the structural and cyclical needs for stimulus. When an economy is in a recession – banks are shrinking their balance sheets and property prices are deflating – the authorities must undertake fiscal and credit stimulus. Chart 18 (Arthur)What Will Productivity Growth Look Like If Public Officials Allocate 55%-60% Of GDP? What Will Productivity Growth Look Like If Public Officials Allocate 55%-60% Of GDP? What Will Productivity Growth Look Like If Public Officials Allocate 55%-60% Of GDP? Credit and fiscal stimulus made sense in China in early 2009 when growth plunged. However, over the past 10 years, we have witnessed credit and property market booms of gigantic proportions. Does this economy warrant continuous stimulus? What will productivity growth look like if government bureaucrats continuously allocate 55-60% of GDP each year (Chart 18)? Caroline: Arthur and Peter, you can both argue with one another about the semantic economic definition of the term ‘savings’, the implications of chronic excess production (relative to consumption), and the root drivers of credit growth in China long past the expiry of every BCA client’s investment horizon. Clients benefit from understanding your distinct perspectives only to the extent that they inform your outlook for markets. Will each of you now please outline how you see high levels of credit in China’s economy impacting the following over a cyclical (6-12 month) and structural (3-5 year) horizon: Global growth Commodity prices China-geared financial assets Peter: Regardless of what one thinks about the root causes of China’s high debt levels, it seems certain to me that the Chinese are going to pick up the pace of credit/fiscal stimulus over the next six months in response to slowing growth and trade war uncertainties. If anything, the incentive to open the credit spigots this time around is greater than in the past because the Chinese government wants to have a fast-growing economy to gain leverage over trade negotiations with the U.S. Chart 19 (Peter)Stronger Chinese Credit Growth Bodes Well For Commodity Prices Stronger Chinese Credit Growth Bodes Well For Commodity Prices Stronger Chinese Credit Growth Bodes Well For Commodity Prices Chart 20 (Peter)The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency Stronger Chinese growth will boost growth in the rest of the world. Commodity prices will rise (Chart 19). As a counter-cyclical currency, the U.S. dollar will likely peak over the next month or so and then weaken in the back half of 2019 and into 2020 (Chart 20). The combination of stronger Chinese growth, higher commodity prices, and a weaker dollar will be manna from heaven for emerging markets. If a trade truce between China and the U.S. is reached, investors should move quickly to overweight EM equities. European stocks should also benefit. Looking further out, China’s economy will slow in absolute terms. In relative terms, however, Chinese growth will remain near the top of the global rankings. China has one of the most educated workforces in the world (Chart 21). Assuming that output-per-hour reaches South Korean levels by the middle of the century, Chinese real GDP would need to expand by about 6% per year over the next decade (Chart 22). That’s a lot of growth – growth that will eventually help China outgrow its debt burden. Chart 21 Chart 22 (Peter)China Has More Catching Up To Do China Has More Catching Up To Do China Has More Catching Up To Do Keep in mind that credit growth of 1% when the debt-to-GDP ratio is 300% yields 3% of GDP in credit stimulus, compared with only 1% of stimulus when the debt-to-GDP ratio is 100%. That does not mean that more debt is intrinsically a good thing, but it does mean that China will eventually be able to slow debt growth even if excess savings remains a problem. Structurally, Chinese and EM equities will likely outperform their developed market peers over a 3-to-5 year horizon. The P/E ratio for EM stocks is currently 4.7 percentage points below that of developed markets, which is below its long-term average (Chart 23). While EM EPS growth has lagged DM earnings growth over the past eight years, the long-term trend still favors EM (Chart 24). EM currencies will appreciate over this period, with the RMB leading the way. Chart 23 (Peter)EM Stocks: Valuations Are Attractive EM Stocks: Valuations Are Attractive EM Stocks: Valuations Are Attractive Chart 24 (Peter)Earnings Growth In EM Has Outpaced That Of DM Over The Long Haul Earnings Growth In EM Has Outpaced That Of DM Over The Long Haul Earnings Growth In EM Has Outpaced That Of DM Over The Long Haul Arthur: China is facing a historic choice between two scenarios. Medium- and long-term macro outcomes will impact markets differently in each case. Table 1 shows my cyclical and structural investment recommendations for each scenario. Table 1 (Arthur)Arthur’s Recommended Investment Strategy For China-Geared Financial Assets China’s Credit Cycle: A Spirited Debate China’s Credit Cycle: A Spirited Debate Allowing Markets to Play A Bigger Role = Lower credit growth (deleveraging), corporate restructuring, and weaker growth (Chart 25). This is bearish for growth and financial markets in the medium term but it will make Chinese stocks and the currency structural (long-term) buys. Credit/Money Boom Persists (Socialist Put) = Secular Stagnation, Inflation and Currency Depreciation: The structural outlook is downbeat but there are mini-cycles that investors could play (Chart 26). Cyclically, China-geared financial assets still remain at risk. However, lower asset prices and more stimulus in China could put a floor under asset prices later this year. Timing these mini-cycles is critical. A buy-and-hold strategy for Chinese assets will not be appropriate in this scenario. In short, capitalism is bad but socialism is worse. I hope China will pursue the first path. Chart 25 Chart 26 Caroline: Thank you both for clarifying your perspectives. Over a multi-year horizon, markets will render the ultimate judgement on whether China’s credit boom has represented a reckless misallocation of capital, or a rational policy response to an imbalance between domestic spending and income. In the meantime, we will monitor the complexion of Chinese stimulus and evidence of its global growth multiplier effect over the coming weeks and months. These will be the key variables to watch as we determine when and at what level to upgrade BCA’s cyclical outlook for China-geared assets. Can’t wait for that debate. Footnotes 1 For a detailed discussion of these issues, please see Emerging Markets Strategy Special Reports, “Misconceptions About China's Credit Excesses,” dated October 26, 2016 and “The True Meaning Of China's Great 'Savings' Wall,” dated December 20, 2017. 2 For a detailed discussion of these issues, please see Emerging Markets Strategy Special Reports, “Misconceptions About China's Credit Excesses,” dated October 26, 2016 and “The True Meaning Of China's Great 'Savings' Wall,” dated December 20, 2017. 3 For a detailed discussion of these issues, please see Emerging Markets Strategy Special Report, “China's Money Creation Redux And The RMB,” dated November 23, 2016. 4 For a discussion on the reasons behind China’s high savings rate, please see Global Investment Strategy Weekly Report, “China’s Savings Problem,” dated January 25, 2019. 5 For a detailed discussion of these issues, please see Emerging Markets Strategy Special Report, “Is Investment Constrained By Savings? Tales Of China And Brazil,” dated March 22, 2018. 6 For a detailed discussion of these issues, please see Global Investment Strategy Weekly Report, “Is There Really Too Much Government Debt In The World?” dated February 22, 2019 and “Chinese Debt: A Contrarian View,” dated April 19, 2019.   Strategy & Market Trends MacroQuant Model And Current Subjective Scores Image   Tactical Trades Strategic Recommendations Closed Trades

Feature Markets have turned jittery in the past month. Global growth data have deteriorated further (Chart 1), with Korean exports, the German manufacturing PMI, and even U.S. industrial production weak. Moreover, trade negotiations between the U.S. and China appear to have broken down, with China threatening to retaliate against U.S. sanctions on Huawei by blocking sales of rare earths, and refusing to negotiate further unless the U.S. eases tariffs. BCA’s Geopolitical Strategists now give only a 40% probability of a trade deal by the time of the G20 summit at the end of June (Table 1). As a result, BCA alerted clients on 10 May to the risk of a further short-term 5% correction in global equities.1 Recommended Allocation Monthly Portfolio Update: China To The Rescue? Monthly Portfolio Update: China To The Rescue? Chart 1Worrying Signs? Worrying Signs? Worrying Signs? Table 1Chances Of A Trade Deal Fading Fast Monthly Portfolio Update: China To The Rescue? Monthly Portfolio Update: China To The Rescue? What is essentially behind the global slowdown, especially outside the U.S., is that both China and the U.S. last year were tightening monetary policy – China by slowing credit growth, the U.S. via Fed hikes. The U.S. economy was robust enough to withstand this, but economies in Europe, Asia, and Emerging Markets were not (Chart 2). The question now is whether the Chinese authorities and the Fed will come to the rescue and add stimulus that will cause a recovery in global growth. China has already triggered a rebound in credit growth since January (Chart 3). Chart 2U.S. Holding Up Better Than Elsewhere U.S. Holding Up Better Than Elsewhere U.S. Holding Up Better Than Elsewhere Chart 3China Stimulus Has Only Just Begun China Stimulus Has Only Just Begun China Stimulus Has Only Just Begun This has not come through clearly in Chinese – and other countries’ – activity data yet, partly because there is usually a lag of 3-12 months before this happens, and partly because Chinese authorities seemingly eased back somewhat on the gas pedal in April given rising expectations of a trade deal. But, judging by previous episodes such as 2009 and 2016, the Chinese will stimulate now based on the worst-case scenario. The risk is more that they overdo the stimulus than that they fail to do enough. Yes, China is worried about its excess debt situation. But this year they will prioritize growth – not least because of some sensitive anniversaries in the months ahead (for example, the 70th anniversary of the People’s Republic on October 1), and because the government is falling behind on its promise to double per capita real income between 2010 and 2020 (Chart 4). Chart 4Chinese Communist Party Needs To Prioritize Growth Chinese Communist Party Needs To Prioritize Growth Chinese Communist Party Needs To Prioritize Growth Chart 5U.S. Consumers Look In Fine State U.S. Consumers Look In Fine State U.S. Consumers Look In Fine State     In the U.S., consumption is likely to continue to buoy the economy. Wages are growing 3.2% a year and set to accelerate further, and consumer confidence is close to a 50-year high (Chart 5). It is easy to exaggerate the impact of even an all-out trade war. For China, exports to the U.S. are only 3.4% of GDP. A hit to this could easily be offset by stimulus leading to greater capital expenditure. For the U.S, most academic studies show that the impact of tariffs will largely be passed on to the consumer via higher prices.2 But even if the U.S. imposes 25% tariffs on all Chinese exports and all is passed on to the consumer with no substitutions for goods from other countries the impact, about $130 billion, would represent only 1% of total U.S. consumption. The question now is whether the Chinese authorities and the Fed will come to the rescue and add stimulus that will cause a recovery in global growth. But if China will bail out the global economy, we are not so convinced that the Fed will cut rates any time soon. The market has priced in two Fed rate cuts over the next 12 months (Chart 6). But we agree with comments from Fed officials that recent softness in inflation is transitory. For example, financial services inflation (mostly comprising financial advisor fees, linked to assets under management, and therefore very sensitive to the stock market) alone has deducted 0.4 percentage points from core PCE inflation over the past six months (Chart 7). The trimmed mean PCE (which cuts out other volatile items besides energy and food, which are excluded from the commonly used core PCE measure) is close to 2% and continues to drift up. Chart 6Will The Fed Really Cut Twice In 12 Months? Will The Fed Really Cut Twice In 12 Months? Will The Fed Really Cut Twice In 12 Months? Chart 7Soft Inflation Probably Is Transitory Soft Inflation Probably Is Transitory Soft Inflation Probably Is Transitory     Fed policy remains mildly accommodative: the current Fed Funds Rate is still two hikes below the neutral rate, as defined by the median terminal-rate dot in the FOMC’s Summary of Economic Projections (Chart 8). The market may be trying to push the Fed into cutting rates and could be disappointed if it does not. For now, we tend to agree with the Fed’s view that policy is about correct (Chart 9) but, if global growth does recover before the end of the year, one hike would be justified in early 2020 – before the upcoming Presidential election in November 2020 makes it less comfortable for the Fed to move. Chart 8Fed Policy Is Still Accommodative Fed Policy Is Still Accommodative Fed Policy Is Still Accommodative Chart 9Fed Doesn't Need To Move For Now Fed Doesn't Need To Move For Now Fed Doesn't Need To Move For Now     In this macro environment, we see global bond yields bottoming not far below their current (very depressed) levels, and equities eking out reasonable gains over the next 12 months. The risk of a global recession over the next year or so is not high, in our opinion. We, therefore, continue to recommend an overweight on global equities and underweight on bonds over the cyclical horizon.  We see global bond yields bottoming not far below their current (very depressed) levels, and equities eking out reasonable gains over the next 12 months. Fixed Income: Government bond yields have fallen sharply over the past eight months (by 110 basis points for the U.S. 10-year, for example) because of 1) falling inflation expectations, caused mostly by a weak oil price, 2) expectations of Fed rate cuts, 3) especially weak growth in Europe, which pulled German yields down to -20 basis points in May, and 4) global risk aversion which pushed asset allocators into government bonds, and lowered the term premium to near record low levels (Chart 10). If Brent crude rises to $80 a barrel this year as we forecast, the Fed does not cut rates, and European growth rebounds because of Chinese stimulus, we find it highly improbable that yields will fall much further. Ultimately, the global risk-free rate is driven by global growth (Chart 11). Investors are already positioned very aggressively for a further fall in yields (Chart 12). We would expect the U.S. 10-year yield to move back towards 3% over the next 12 months. We remain moderately positive on credit, which should also benefit from a growth rebound: U.S. high-yield spreads are still around 70 basis points for Ba-rated bonds, and 110 basis points for B-rated ones, above the levels at which they typically bottom in expansions; investment-grade bonds, though, have less room for spread contraction (Chart 13). Chart 10Term Premium Near Record Low Term Premium Near Record Low Term Premium Near Record Low Chart 11Global Rebound Would Push Up Yields Global Rebound Would Push Up Yields Global Rebound Would Push Up Yields   Chart 12Investors Very Long Duration Investors Very Long Duration Investors Very Long Duration Chart 13Credit Spreads Can Tighten Further Credit Spreads Can Tighten Further Credit Spreads Can Tighten Further     Equities:  We remain overweight U.S. equities, partly as a hedge against our overweight on the equity asset class, since the U.S. remains a relatively low beta market. Our call for the second half will be 1) when will Chinese stimulus start to boost growth disproportionately for commodity and capital-goods exporters, and 2) does that justify a shift out of the U.S. (which may be somewhat hurt short term by the Trade War) and into euro zone and Emerging Markets equities. Given the structural headwinds in both (the chronically weak banking system and political issues in Europe; high debt and lack of structural reforms in EM), we want clear evidence that the Chinese stimulus is working before making this call. We are likely to remain more cautious on Japan, even though it is a clear beneficiary of Chinese growth, because of the risk presented by the rise in the consumption tax in October: after previous such hikes, consumption not only slumped immediately afterwards but remained depressed (Chart 14). Chart 14Japan's Sales Tax Hike Is A Worry Japan's Sales Tax Hike Is A Worry Japan's Sales Tax Hike Is A Worry Chart 15Dollar Is A Counter-Cyclical Currency Dollar Is A Counter-Cyclical Currency Dollar Is A Counter-Cyclical Currency   Currencies:  Again, China is the key. The dollar is a counter-cyclical currency, and a pickup in global growth would weaken it (Chart 15). Any further easing by the ECB – for example, significantly easier terms on the next Targeted Longer-Term Refinancing Operations (TLTRO) – might actually be positive for the euro since it would augur stronger growth in the euro area. Moreover, long dollar is a clear consensus view, with very skewed market positioning (Chart 16). Also, on a fundamental basis, compared to Purchasing Power Parity, the dollar is around 15% overvalued versus the euro and 11% versus the yen. Chart 16 Chart 17Industrial Metals Driven By China Too Industrial Metals Driven By China Too Industrial Metals Driven By China Too Commodities: Industrial metals prices have generally been weak in recent months with copper, for example, falling by 10% since mid-April. It will require a sustained rebound in Chinese infrastructure spending to push prices back up (Chart 17). Oil continues to be driven by supply-side factors, not demand. With OPEC discipline holding, Iran sanctions about to be reimposed, political turmoil in Libya and Venezuela, BCA’s energy strategists continue to see inventories drawing down this year, and therefore forecast Brent crude to reach $80 during 2019 (Chart 18). Chart 18Oil Supply Remains Tight Oil Supply Remains Tight Oil Supply Remains Tight Garry Evans Chief Global Asset Allocation Strategist garry@bcaresearch.com Footnotes 1       Please see Global Investment Strategy, Special Report, “Stay Cyclically Overweight Global Equities, But Hedge Near-Term Downside Risks From An Escalation Of A Trade War,” dated May 10, 2019, available at gis.bcaresearch.com 2      Please see, for example, Mary Amiti, Sebastian Heise, and Noah Kwicklis, “The Impact of Import Tariffs on U.S. Domestic Prices,” Federal Reserve Bank of New York Liberty Street Economics, dated 4 January 2019. Recommended Asset Allocation