Money/Credit/Debt

Highlights A financial market riot point remains likely over the coming few months to force policymakers, including those in China, to address the economic weakness that a full-tariff scenario will entail. The near-term outlook is bearish for China-related assets, but investors should stay cyclically bullish in anticipation of a strong reflationary response. It is not clear whether further monetary easing will occur over the coming year, given that monetary conditions have already eased substantially. But an RRR cut coupled with a benchmark lending rate cut is now a real possibility, and would signal that the monetary policy dial has been turned to “maximum stimulus”. Monthly credit growth needs to be approximately 2.8-3 trillion RMB per month in May and June in order to be consistent with a 2015/2016-magnitude policy response. May’s number may fall short of this, but that would set up June as a make-it or break-it month for credit creation. Chinese credit growth surged in 2012, but economic activity did not significantly accelerate. A repeat of this scenario is a risk to our cyclically bullish stance, but three reasons suggest it is not likely to occur. Investors should stay long USD-CNH over the cyclical horizon despite warnings from Chinese policymakers not to short the RMB. Feature Tensions between China and the U.S. have worsened materially over the past two weeks, in line with our view that an actual trade agreement this year (not just continued negotiations) is much less likely. The Huawei blacklist, stalled negotiations, a sharp escalation in preparatory nationalist rhetoric in China, and President Xi Jinping’s declaration in a Jiangxi province speech that the country is embarking on a new “Long March”1 significantly diminishes the possibility of a deal that addresses the U.S.’ structural concerns. Chart 1A Market Riot Point Is Coming A Market Riot Point Is Coming A Market Riot Point Is Coming This implies that any agreement would require President Trump to capitulate and accept a temporary deal relating simply to the balance of trade between the two countries. It is possible that this occurs over the coming 6-12 months (in time for Trump to attempt a declaration of victory before the 2020 election), but it is not likely to occur before real economic (and thus financial market) pain arrives. This supports our view that a major financial market riot point is likely over the coming few months to force policymakers, including those in China, to address the economic weakness that a full-tariff scenario will entail (Chart 1). Given this, we would not recommend a long position in Chinese stocks, either in absolute terms or relative to the global benchmark, for investors with a time horizon of less than 3 months. However, over a strictly cyclical (i.e. 6-12 month) time horizon, we would recommend staying long/overweight Chinese stocks (in hedged currency terms) on the basis that policymakers will ultimately respond as needed, lest they face an unstable deceleration in economic activity that may become difficult to stop. In this week’s report we address the following three questions facing China-exposed investors over the coming year, before concluding with a brief note about the RMB: Can the PBOC provide more of a reflationary impulse if needed, and if so, how? How can investors tell whether policymakers are stimulating as required from the monthly credit data? What are the odds that China will stimulate aggressively and the economy does not meaningfully reaccelerate? How Can The PBOC Ease Further? We argued in our May 15 Weekly Report that a 2015/2016-magnitude policy response will again be required in order for policymakers to be confident that the upcoming trade shock will be overcome.2 In our view, this response, instead of aggressive and broad-based bank lending, will likely have to come in the form of quasi-fiscal spending, e.g. a significant increase in infrastructure-oriented local government bond issuance (which we include as “credit” in our adjusted total social financing calculation). However, we have received several questions from clients asking about the outlook for monetary policy in a full-tariff scenario, particularly the question of what the PBOC can do to provide even more of a reflationary response. Most investors would simply assume that the PBOC would cut interest rates even further, and this is certainly a possible outcome over the coming year. But even if the PBOC were to cut interest rates, it is not always clear to investors what rate should or will be cut. Confusion surrounding China’s monetary policy landscape has been high ever since the PBOC established an interest rate corridor system in 2015, and a review of what has occurred over the past 2½ years is warranted in order to better understand the implications of future policy decisions. A 2015/2016-magnitude policy response will again be required in order for policymakers to be confident that the upcoming trade shock will be overcome. Chart 2The Simple (But Incomplete) View Of China's New Monetary Regime The Simple (But Incomplete) View Of China's New Monetary Regime The Simple (But Incomplete) View Of China's New Monetary Regime Chart 2 outlines how China’s new monetary regime is officially described by the PBOC. The benchmark lending rate, China’s “old” policy rate that established a base regulated rate for banks to price their loans, was replaced in 2015 with a corridor system. The target rate in this system is the 7-day interbank repo rate, which can be seen in Chart 2 is often at the low end of the corridor. However, we explained in a February 2018 Special Report why Chart 2 is only half of the story.3Charts 3 - 5 show the other half: Chart 3 shows that while the 7-day repo rate rose in late-2016 and 2017, the rise was fairly small (on the order of 60 basis points). By contrast, the 3-month repo rate surged, which appears to have been caused by macro-prudential policy changes aimed at severely curtailing the issuance of wealth management products by non-depository financial institutions. Chart 4 highlights that there is a strong (and leading) relationship between changes in China’s 3-month interbank repo rate and 1) changes in the percentage of loans issued above the benchmark rate and 2) changes in the gap between the weighted-average interest rate and the benchmark rate. Chart 5 shows that China’s weighted average interest rate can be successfully modelled by a regression on the benchmark lending rate and the 3-month interbank repo rate. Chart 3The 3-Month Repo Rate Has Been More Important Than The 7-Day The 3-Month Repo Rate Has Been More Important Than The 7-Day The 3-Month Repo Rate Has Been More Important Than The 7-Day Chart 4A Strong Link Between 3-Month Repo Rates And Economy-Wide Rates A Strong Link Between 3-Month Repo Rates And Economy-Wide Rates A Strong Link Between 3-Month Repo Rates And Economy-Wide Rates       The relationships shown in Charts 3 - 5 are weaker if the 3-month repo rate is replaced with the 7-day rate, highlighting that while the latter is the new de jure policy rate in China, the former has been the de facto policy and market-driven lending rate among banks and non-financial institutions over the past 2½ years. Chart 5The Benchmark Lending And 3-Month Repo Rates Explain Effective Lending Rates The Benchmark Lending And 3-Month Repo Rates Explain Effective Lending Rates The Benchmark Lending And 3-Month Repo Rates Explain Effective Lending Rates Our framework for examining China’s monetary policy environment leads us to conclude that there are three things the PBOC can do to meaningfully ease further, were they to decide to do so: The most impactful action that the PBOC could take is to cut the benchmark lending rate. While banks in China are no longer required to price loans in reference to the benchmark rate, in practice many still do. Roughly 2/3rds of loans in China have been priced at an interest rate above the benchmark over the past year, and Chart 5 noted that the weighted average interest rate is a direct function of the benchmark rate. As such, a cut to the benchmark rate is likely to feed directly into lower lending rates. Chart 3 showed that the substantial spread between the 3-month and 7-day repo rates that prevailed from late-2016 to mid-2018 has all but disappeared, implying that the PBOC cannot lower interest rates much further by dialing back on macro-prudential regulation. Instead, if it wants interbank rates to fall meaningfully, lowering the corridor around the 7-day rate by cutting the floor (the PBOC’s 7-day reverse repo rate) will likely be required. This would be carried out with further reductions to the reserve requirement ratio (RRR). Third, while Chart 5 showed that our model for the weighted average lending rate has done a very good job over the past few years, it is clear that a gap has opened up between the actual rate and that predicted by the model. The most likely explanation of this gap is that it is due to a risk premium applied by banks, possibly in response to the re-orientation of riskier funding demands that had previously been fulfilled by the shadow banking sector to on-balance sheet loans from depository institutions. It is not clear what policy tools are at the PBOC’s disposable to reduce the gap, but doing so has the potential to lower average interest rates by a non-trivial amount. The relative easiness of monetary conditions is the key difference between today and 2012. It is not clear yet which option the PBOC will pursue over the coming year or whether further monetary easing will occur, but an RRR cut coupled with a benchmark lending rate cut is now a real possibility. If it happens, it would be a clear signal for investors that the monetary policy dial has been turned to “maximum stimulus”. Inferring Reluctance Or Capitulation From Monthly Credit Growth The second issue that investors will be wrestling with over the coming few months relates to the question of whether the month-to-month pace of credit growth is consistent with the magnitude of the reflationary response that we believe will be required. To the extent that significantly more monetary easing occurs over the coming year, it is likely to have happened because policymakers were overly reluctant to green-light a renewed and substantial re-acceleration in credit growth and were then forced to fight a destabilizing slowdown in the economy. Chart 6A Strong Credit Response Will Be Required In Response To A Full Tariff Scenario A Strong Credit Response Will Be Required In Response To A Full Tariff Scenario A Strong Credit Response Will Be Required In Response To A Full Tariff Scenario We have used the metric of new credit to GDP as the primary method to judge the relative size of previous credit booms, and have argued that a return to 30% on this measure will likely be required in response to a full 25% tariff scenario (Chart 6). Unfortunately, China’s unique seasonality patterns and the lack of official seasonally adjusted data make it difficult for investors to judge whether incoming credit data is consistent with the required policy response. Previously, we have shown seasonally adjusted measures of credit using a simple application of X12 ARIMA, the statistical seasonal adjustment program used by the U.S. Census Bureau. But Charts 7 and 8 present a different approach. The charts show the average cumulative amount of adjusted total social financing as the calendar year progresses, along with a ±0.5 standard deviation band, based on the 2010 to 2018 period. The thick black line in both charts shows the progress in new credit creation this year, assuming an 8% annual nominal GDP growth rate for the remainder of the year. Chart 7 shows the cumulative progress in credit assuming a 27% new credit to GDP ratio for the year (corresponding to a half-strength credit cycle relative to past episodes), whereas Chart 8 assumes 30%. Chart 7 Chart 8 In our view, these charts are revelatory. First, Chart 7 provides evidence that policymakers have been reluctant to allow credit growth to surge. The chart shows that credit growth ran well above a half-strength credit cycle pace in the first quarter of the year; following this, through either administrative controls or jawboning, policymakers lowered the pace of credit growth in April such that it moved back within the range. By contrast, Chart 8 highlights that the pace of Q1 credit growth was exactly right in a 30% new credit to GDP scenario, and that April fell short. In order to be back within the range by June, Chart 8 suggests that monthly credit growth needs to be on the order of 2.8-3 trillion RMB per month in May and June, just a slightly slower pace than what investors observed in March. It is quite possible that May’s credit number will fall short of 2.8-3 trillion RMB, given that the increase in the second round tariffs only occurred on May 10 and that Chinese policymakers have so far seemed reluctant to pull the trigger. But this also heightens the risk of a serious near-term selloff in the domestic equity market, and would set up June as a make-it or break-it month for credit creation. Stimulus Without A Recovery? Revisiting The 2012 Scenario Chart 9The 2012 Scenario: Strong Credit, But A Modest Improvement In Activity The 2012 Scenario: Strong Credit, But A Modest Improvement In Activity The 2012 Scenario: Strong Credit, But A Modest Improvement In Activity A final question facing investors this year is whether it is possible that the Chinese economy fails to respond to strong efforts by policymakers to stimulate the economy. Chart 9 shows that a similar situation occurred in 2012; while the surge in new credit to GDP did stabilize economic activity and caused a modest uptrend, the economic improvement was much smaller than what the relationship shown in the chart would imply. In our view, there are three reasons to believe that a 2012 scenario will not repeat itself: First, Chart 10 shows that the Q1 rebound in new credit to GDP appears to have halted the decline in investment-relevant Chinese economic activity. There is no basis to suggest that an uptrend in activity has begun, but the fact that the economy has even started to respond to the pickup in credit growth is a positive sign. Second, Chart 11 highlights one important difference between 2012 and today. The chart shows that our leading indicator for China’s economy did not rise as much as new credit to GDP, and that this occurred because monetary conditions remained relatively tight from the beginning of 2012 all the way through to early-2015. This relative tightness in monetary conditions occurred because of fairly elevated interest rates, and due to a persistent rise in the real effective exchange rate. However, the collapse in the weighted average lending rate following the 2015/2016 economic slowdown has eased monetary conditions in a lasting way, suggesting that a similar rise in new credit to GDP should have a strongly positive effect on Chinese economic growth. This also underscores our earlier point: monetary policy has already largely returned to 2015/2016 levels, meaning that it is fiscal/administrative action to boost credit growth that is missing. Third, Chart 12 highlights that the pace of inventory accumulation represents another key difference between the current economic environment and that of 2012. The chart shows that the change in China’s level of industrial inventories relative to exports (both measured in value terms) rose sharply in 2011 and 1H 2012, only to slow significantly over the following year (which may have weighed on the rebound in activity in 2012 and 2013). In contrast, the chart shows that inventories have recently been contracting at their fastest pace relative to exports since 2011, implying that the drag on production from potential destocking may be minimal. Chart 10A (Very) Tentative Sign Of Stabilization A (Very) Tentative Sign Of Stabilization A (Very) Tentative Sign Of Stabilization Chart 11Monetary Conditions Are Considerably Easier Today Monetary Conditions Are Considerably Easier Today Monetary Conditions Are Considerably Easier Today There are, however, two caveats to the above analysis. First, on the inventory front, Chart 12 shows that the level of industrial inventories to exports is fractionally higher than it was in 2012, even though it has declined significantly from its 2017 high. The level of inventories has been rising relative to exports for some time, and thus the “equilibrium” level is not clear. But to the extent that a prolonged trade war with the U.S. requires meaningfully lower inventory levels in China, then destocking may become more of a drag than we expect. Second, Chart 11 shows that while monetary conditions are much easier today than they were in 2012, money growth is much weaker. A weaker-than-expected recovery in Chinese economic activity is much more likely if money growth remains weak, although we cannot reasonably envision an outcome where credit growth surges and growth in the money supply does not. A Brief Note On The RMB We noted in our May 15 Weekly Report4 that a significant rise in new credit to GDP and a meaningful decline in the currency would be required to stabilize China’s economy if the U.S. proceeds with 25% tariffs on all imports from China. Consequently, we recommended that investors hedge the inherent RMB exposure from a long US$ cyclical position in Chinese stocks by opening a long USD-CNH trade, with the expectation that a break above 7 in the coming weeks was likely (Chart 13). Chart 12Inventories Have Been Meaningfully Reduced Inventories Have Been Meaningfully Reduced Inventories Have Been Meaningfully Reduced   Chart 13In A Full Tariff Scenario, A Defense Of 7 Is Only A Near-Term Event In A Full Tariff Scenario, A Defense Of 7 Is Only A Near-Term Event In A Full Tariff Scenario, A Defense Of 7 Is Only A Near-Term Event Recently, Xiao Yuanqi, the spokesman for the China Banking and Insurance Regulatory Commission, was quoted as saying that “those who speculate and short the yuan will [surely] suffer heavy loss[es]”,5 which many investors took to mean that China will defend USD-CNY = 7 at all costs. In our view this may be true in the short-term, but is unlikely to occur over a 6-12 month time horizon in a full 25% tariff scenario. Policymakers have become much more attuned to sharp declines in the currency after the major episode of capital flight that occurred in 2015 and 2016, and are keen to ensure that any movements in the exchange rate are orderly. However, complete currency stability in the face of a major shock to the export sector means that the required rise in the “macro leverage ratio” to stabilize the economy will be even higher, highlighting that an orderly depreciation in the currency is the lesser of two evils. As such, we interpret these recent comments from policymakers as an attempt to prevent a breach in USD-CNY = 7 over the short-term, and an attempt to control the pace of decline over the longer term in a full-tariff scenario. The conclusion for investment strategy is that China-exposed investors should stay long USD-CNH over the cyclical horizon, but should limit the leverage of the position and should expect frequent short-term reversals.   Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com Footnotes 1      Please see Geopolitical Strategy Weekly Report, “Is  Trump Ready For The New Long March?” dated May 24, 2019, available at gps.bcaresearch.com. 2      Please see China Investment Strategy Weekly Report, “Simple Arithmetic,” dated May 15, 2019, available at cis.bcaresearch.com. 3      Please see China Investment Strategy Special Report, “Seven Questions About Chinese Monetary Policy,” dated February 22, 2018, available at cis.bcaresearch.com. 4      Please see China Investment Strategy Weekly Report, “Simple Arithmetic,” dated May 15, 2019, available at cis.bcaresearch.com. 5      Reuters News, “China’s top banking regulator says yuan bears will suffer ‘heavy losses’,” dated May 25, 2019.   Cyclical Investment Stance Equity Sector Recommendations

Highlights So What? Odds of a total breakdown in U.S.-China relations are highly underrated. Why? The key market-relevant geopolitical event is Trump’s large risk appetite. Inflationary pressures resulting from the trade tariffs are not prohibitive for Trump’s trade war. Chinese stimulus will surprise to the upside, but a massive stimulus package will depend on talks collapsing and maximum tariffs. Markets will sell before they recover. We will maintain our current portfolio hedge of Swiss bonds and gold. Feature Chart 1Equities Sell, Safe Havens Rally Equities Sell, Safe Havens Rally Equities Sell, Safe Havens Rally Global equities have sold off and safe-haven assets caught a bid since the near-breakdown in U.S.-China trade negotiations on May 5 (Chart 1). Yet financial markets are still complacent, as the 2.8% drawdown to date on global equities and the S&P 500 does not yet reflect the depth of the geopolitical risk to sentiment and corporate earnings. To understand this risk we need to step away from the ups and downs of the trade negotiations and ask, What have we learned about U.S. policy over the past month and what does it mean for global markets on a cyclical and structural horizon? We have learned that in the lead-up to the 2020 election, President Trump is not seeking to protect his greatest asset – namely, a strong American economy – but rather to solidify his support through new ventures. By imposing the full brunt of sanctions on Iran and hiking the tariff rate on Chinese imports, Trump has made two highly significant decisions that could jeopardize the American voter’s pocketbook, with a full 18 months to go before November 3, 2020. Why has he done this? Because he believes the American economy can take the pain and he will achieve resounding foreign policy successes. These, he hopes, will make his reelection more likely. President Trump’s aggressive posture is a direct threat to the global equity bull market due to (1) higher odds of a negative shock to global trade when global growth is already weak, and (2) higher odds of an oil price shock due to a potential vicious spiral of Middle East conflict. Wreaking Havoc Historically, the United States thrives when the rest of the world is in chaos. This was obviously the case during World War I and II (Chart 2). But it also proved true in the chaotic aftermaths of the Soviet Union’s collapse and the global financial crisis, though the U.S. did suffer along with everyone else during the 2008-09 downturn. American equities have generally outperformed during periods of global chaos (Chart 3). Chart 2America Thrives Amid Global Chaos America Thrives Amid Global Chaos America Thrives Amid Global Chaos Chart 3U.S. Equities Outperform During Global Crises U.S. Equities Outperform During Global Crises U.S. Equities Outperform During Global Crises The reasons for U.S. immunity are well known: the U.S. has a large, insulated, consumer-driven economy; it has immense economic advantages enhanced by its dominance of North America; it has vast and liquid financial markets; and it is the world’s preponderant technological and military power. This position enables Washington to act more aggressively than other capitals in pursuit of the national interest – and to recover more quickly from mistakes. Chart 4U.S. Preponderance Declining U.S. Preponderance Declining U.S. Preponderance Declining It follows that there is an influential idea or myth that the country can or should exploit this advantage, when necessary or desirable, by “wreaking havoc” abroad. The prime example is the preemptive invasion of Iraq. In this way Washington can turn the tables on its opponents and keep them off balance. The Trump administration, regardless of Trump’s intentions, could soon become the epitome of this school of thought. First, it is true that, structurally, American preponderance has been decreasing: despite various crises, there has been sufficient peace and prosperity in the twenty-first century to see the rest of the world’s wealth, trade, and arms grow relative to the United States (Chart 4). With the rise of China and resurgence of Russia, U.S. global leadership is at risk and the Trump administration has adopted unorthodox policies to confront its rivals and try to reverse this process. Second, cyclically, President Trump is stymied at home after his Republican Party lost the House of Representatives in the 2018 midterm election. Scandals and investigations plague his inner circle. Unable to secure funding for his signature campaign promise – the southern border wall – Trump faces the risk of irrelevance. Foreign policy, especially trade policy, thus becomes the clearest avenue for him to try to notch up victories. Trump faces the risk of irrelevance. Foreign policy thus becomes the clearest avenue for him to try to notch up victories. Bottom Line: The key market-relevant event over the past month has been the Trump administration’s demonstration of voracious risk appetite. This is fundamentally a cyclical not tactical risk to the bull market due to tit-for-tat tariffs, sanctions, and provocations with rivals like China and Iran. Pocketbooks Versus Patriotism Trump’s vulnerability becomes clear by looking at our electoral Map 1, which highlights his excruciatingly thin margins of victory in the critical “swing states” in the 2016 election. We emphasize the margin of victory among white voters – which are slightly higher than the margins overall – because the Trump campaign courted the white working class specifically in a calculated strategy to swing the Midwest “Rustbelt” states and win the election. Chart The problem for Trump is that while whites remain the majority of the eligible voting population, it is a declining majority due to demographic change. Demographics is not near-term destiny, but the vanishingly thin margins ensure that Trump cannot assume that he will win reelection without generating even more turnout and support among blue-collar whites in the key states. Chart 5 Job creation and rising incomes are the chief hope. The problem is that Trump’s tax cuts and the red-hot economy in 2018 did not prevent Republicans from getting hit hard in the midterm elections, especially in the Midwest. Moreover today’s resilient economy is not preventing the top two Democratic candidates, former Vice President Joe Biden and independent Vermont Senator Bernie Sanders, from beating Trump in head-to-head polling in the key swing states (Chart 5). Trump’s national approval rating, at about 44%, is nearly as good as it gets, but the indications from the Midwest are worrisome, especially because the economy has slowed. If the economy is not winning the argument on the campaign trail in 2020, Trump will need to have another leg to stand on. In addition to hammering home his attempts to build a wall on the border, Trump will highlight his economic nationalism. Protectionism has won the Rustbelt over the past three elections. As we have since 2016 argued, this now boils down to pressure on China. If Trump’s policies provoke China (or Iran) to take aggressive actions, he will have a pretext to exercise American power in a way that will likely create a rally-around-the-flag effect, at least in the short term. Elections do not normally hinge on foreign policy, but they certainly can. While President Trump may not actually want a war with Iran, he knows that George W. Bush cruised to victory amid the Afghan and Iraqi wars. Or he may have in mind 1964, when Lyndon B. Johnson crushed Barry Goldwater, an offbeat, ideological “movement candidate” (can anyone say Bernie Sanders?) in the face of a hulking communist menace, the Soviet Union. A conflict with China (or Iran) could serve similar purposes in 2020, either distracting the populace from a weakening economy or adding to an election bid centered on a reaccelerating economy. The problem is that a patriotic conflict with China or Iran is an insurance policy that threatens to undermine the health and safety of the very thing being insured: the U.S. economy. Indeed, U.S. stocks did not outperform after the September 11th attacks or during the Bush administration’s wars abroad. In essence, Trump is a gambler and is now going for broke. This constitutes a huge risk to the global economy and financial markets – a risk that was subdued just a month ago due to oil sanction waivers and tariff-free trade talks. Bottom Line: President Trump is courting international chaos because his policy priorities are tied down with gridlock and scandal at home. Aggressive foreign policy is a strategy to rack up policy victories and potentially expand his voter base, but it comes at the risk of higher policy uncertainty and negative economic impacts that could derail this year’s fledgling economic rebound and the long-running bull market. “No Deal” Is More Likely Than A Weak Deal It wasn’t just a tweet that sent volatility higher over the past two weeks. Most likely, President Trump decided to raise tariffs on China at the advice of his trade negotiators, who had become convinced that China was not offering deep enough concessions (“structural changes”) and was playing for time. This was always the greatest risk in the trade talks. China is indeed playing for time, as it has no security guarantee from the United States and therefore cannot embrace structural changes in the way that Japan did during the U.S.-Japanese trade war in the 1980s. Originally, the talks were set to last 90 days with the tariff hike by March 1. Trump was apparently determined not to lose credibility on this threat as China drew out the negotiations. Hence, he piled on the pressure to try to force a conclusion by the June 28-29 G20 summit in Japan, which has been the target date for our trade war probabilities over the past several months (Table 1). We have now adjusted those probabilities to upgrade the risk that talks collapse (50%) and downgrade the odds of a deal to 40% by that date. Table 1U.S.-China Trade War: Probabilities Of A Deal By End Of June 2019 How Trump Became A War President How Trump Became A War President The underlying calculation from the Trump administration is that a cosmetic, short-term deal – along the lines of the NAFTA renegotiation – will be difficult to defend on the campaign trail and hence politically risky. We upgraded the risk that talks collapse (50%) and downgraded the odds of a deal to 40% by end of June. If China agreed arbitrarily to increase imports from the U.S. by 10% by 2020, it would only increase the level of imports above the pre-trade war 2015-18 trend by $23 billion dollars in 2029 (Chart 6, panel 1). It would also have a minimal impact on the trade deficit. The deficit has increased so much in recent years that the impact of a 10% increase in exports by 2020 would merely offset the high point we reached during the trade war, leaving Trump with a mere $800 million per year by 2029 (Chart 6, panel 2). Chart 6 For commodities in particular – where China offered the largest purchases – the negative impact of the trade war has been so great that a 10% increase by 2020 over the status quo would fail to offset the recent damages over a ten-year period. China would have to increase imports by at least 17% to offset the trade war-induced decreases. If commodity imports were 30% higher in 2020 than otherwise, the impact 10 years down the line would amount to a mere $11 billion per year. These gains are smaller, as Chinese negotiators have long argued, than what could be made if the U.S. increased exports of advanced technology products to China. If the U.S. exported as many of these products to China as it does to the EU, as a share of EU GDP, it would amount to a $48 billion increase in exports. For Japan, the equivalent would be an $85 billion increase. Increasing the growth of these exports to China to match the recent trend of such exports globally would nearly double the amount sent to China by 2029, earning the U.S. an additional $60 billion that year (Chart 6, panel 3). The problem, of course, is that the confrontation with China is specifically focused on the latter’s technological acquisition and competition with the United States – it is precisely not about making reductions to the trade deficit at the expense of technological superiority. The tech war is more likely to derail the trade talks than the trade talks are likely to resolve the tech war. It is hugely significant that, at the moment of decision, President Trump sided with U.S. Trade Representative Robert Lighthizer and did not accept a deal focused on marginal improvements to the trade deficit. There was always a strong possibility – we previously put it at a 50% chance – that Trump would accept a short-term deal in order to get a “quick win” and minimize tariff pains ahead of the election, while punting the longer-term structural grievances until his second term when he would be less constrained by the economy. But this possibility has clearly fallen. We now put it at 35%, as shown in Table 1 above. Trump sees a shallow deal as a political liability. The most important takeaway from Table 1, however, is that the odds of a “Grand Compromise” have dropped to a mere 5%. Trump still may settle for a deal to reduce economic risks ahead of the election, but a grand compromise is very hard to get. Bottom Line: Our adjusted trade war probabilities suggest that global equities can fall further on a tactical horizon and that downside risks are grave, given a 50% chance that talks utterly collapse by the end of June. This would include a 30% chance of igniting an intense period of saber-rattling, sanctions, and Cold War-esque tensions that would cause a global flight to quality. Won’t The Trade War Turn Voters Against Trump? No. Chart 7 While geopolitical and political constraints push against a weak deal, the economic constraints of a failure to conclude a deal are not prohibitive. The latest tariff hike doubles the dollar magnitude of the tariffs, and an additional 25% tariff on the remaining $300 billion of imports would more than quadruple the magnitude of the tariffs from the April 2019 level (Chart 7). With all U.S. imports from China affected, price rises will percolate upward through all tradable industries and consumer goods. A few points are worth noting: The domestic value-add of Chinese exports to the U.S. is not as low as consensus holds. China’s manufacturing sector is highly competitive, comparable to the EU and Germany in the degree to which its exports to the U.S. incorporate foreign value (Chart 8). This means that Americans cannot substitute other goods for Chinese goods as easily as one might think. Chart 8 There remains a massive gulf between the nominal output of China’s manufacturing sector and the rest of Asia (Chart 9). Strategically it makes sense for the U.S. to want to decrease China’s share of American imports from Asia and reduce China’s centrality to the production process. But Asia cannot yet substitute for China. In practical terms this requires spreading China’s concentrated production system across the Indonesian archipelago. It is inefficient and will raise costs and import prices. Even in areas where China is lacking – such as technology, institutions, and governance – it still has a productivity advantage over the rest of Asia, pointing yet again to the cost-push inflationary consequences of an abrupt transition forced by tariffs (Chart 10). Chart 9Asia Cannot Replace China ... Yet Asia Cannot Replace China ... Yet Asia Cannot Replace China ... Yet Chart 10China's Productivity Beats Rest Of Asia China's Productivity Beats Rest Of Asia China's Productivity Beats Rest Of Asia Nevertheless, these cost factors are not so great as to force Trump into a weak deal. While the new and proposed tariff expansions will impact consumer goods more than the earlier batches that attempted to spare the consumer, the truth is that Chinese imports do not comprise a large share of the U.S. consumer basket (Chart 11). Chart 11American Shoppers Not Too Exposed To China American Shoppers Not Too Exposed To China American Shoppers Not Too Exposed To China Chart 12Goods Price Inflation Not An Immediate Risk Goods Price Inflation Not An Immediate Risk Goods Price Inflation Not An Immediate Risk Goods prices have been flat in the U.S., albeit in great part because of China, and they have fallen while the consumer price index and the real wage component of the CPI have risen by more than 20% since 2001 (Chart 12). Moreover, it is precisely in consumer goods where the American shopper does have considerable ability to substitute away from China – as opposed to the American corporation, which will have a harder time replacing Chinese-made capital goods quickly (Table 2). Thus, the risk impacts Wall Street differently than Main Street. Table 2Capital Goods Harder To Substitute How Trump Became A War President How Trump Became A War President Further, the median American household’s real income growth is still elevated (Chart 13). This comes on top of the fact that net household worth and the saving rate are both in good shape. President Trump has some leeway in waging his trade war. The risk, of course, is that this income growth is decelerating and Trump has given the tariffs 18 months to cause negative impacts for consumers prior to the election. He is also simultaneously wagering that the U.S.’s newfound energy independence – and his own ability to tap the strategic petroleum reserve – will prevent gasoline prices from spiking (Chart 14). This would occur as a result of any Iranian-backed attacks on oil production and export facilities across the Middle East. Chart 13American Household Still In Good Shape American Household Still In Good Shape American Household Still In Good Shape Chart 14Fuel Prices Already Rising Fuel Prices Already Rising Fuel Prices Already Rising Bottom Line: Inflationary pressures will result from trade tariffs (and Iranian sanctions) but they are not prohibitive for Trump thus far. This is not a recipe for cost-push inflation significant enough to trigger a recession or derail Trump’s reelection odds at present, but it is a risk that will need to be monitored. How Will China Respond? More Stimulus! The immediate ramification of a heightened trade war is deteriorating global trade and sentiment and hence slower global growth that pushes down prices. Indeed, the escalation of the trade war brings sharply into focus two long-running Geopolitical Strategy themes: Sino-American Conflict: U.S. and Chinese exports to each other have already sharply fallen off (Chart 15). Trade is interconnected so this will further depress global and Asia-ex-China exports. Chart 15Trade War Hurts Bilateral Trade ... And All Trade Trade War Hurts Bilateral Trade ... And All Trade Trade War Hurts Bilateral Trade ... And All Trade Chart 16Global Trade Already Rolling Over Global Trade Already Rolling Over Global Trade Already Rolling Over Apex of Globalization: Global trade as a whole is contracting as a result of the global slowdown, which the trade war has exacerbated (Chart 16). The negative impact on China is acute and threatens something akin to the global manufacturing recession of 2015 (Chart 17). Given that the trade war is now piling onto a merely fledgling rebound in Chinese and global growth this year, it is possible that the manufacturing slowdown could even get worse than 2015 and culminate in a global recession in our worst case scenario of a major strategic escalation. Preventing this outcome, China will increase fiscal-and-credit stimulus, which we have argued is likely to overshoot expectations this year due to trade war and the country’s desire to meet 2020 urban income goals (Chart 18). The magnitude should be comparable to the 2015-16 stimulus, unless a global recession is immediately in view, in which case it will be larger. Chart 17A Relapse Would Point Toward 2015-Sized Crisis A Relapse Would Point Toward 2015-Sized Crisis A Relapse Would Point Toward 2015-Sized Crisis It was the Xi administration that undertook the huge 2015-16 expansion of credit, so this magnitude is not out of the question. While Xi has attempted to contain leverage and reduce systemic financial risk, he is ultimately like his predecessors, most notably Jiang Zemin, in the sense that he will aim for social stability above all. Chart 18China Will Keep Stimulating China Will Keep Stimulating China Will Keep Stimulating The pain threshold of today’s policymakers has already been discovered, seeing how President Xi and the Politburo began easing policy in July 2018 after the U.S. implemented the initial Section 301 tariffs. The Chinese leaders were willing to tighten credit controls until this external risk materialized. The fact that the trade war is the proximate cause of heightened stimulus was confirmed in the wake of the Buenos Aires summit, where Xi chose to stimulate the economy further – resulting in a surge of credit in Q1 – as a way of improving China’s leverage vis-à-vis the United States in the 90-day talks. China will increase fiscal-and-credit stimulus … The magnitude should be comparable to the 2015-16 stimulus. In short, Xi and his government will stimulate first and ask questions later. Both fiscal and credit stimulus will be utilized, including traditional fiscal infrastructure spending and permissiveness toward shadow banking. A dramatic renminbi depreciation could occur but would be evidence that talks will fail (Chart 19). Chart 19Currency Agreement: Far From A Plaza Accord Currency Agreement: Far From A Plaza Accord Currency Agreement: Far From A Plaza Accord Stimulus will continue to be tactical, rolled out in piecemeal announcements, at least as long as the trade talks continue and there is a prospect of China’s economy rebounding without drastic measures. Only a total breakdown in negotiations – and collapse into outright Cold War – will prompt a massive stimulus package. Bottom Line: Chinese stimulus will surprise to the upside while talks are going, and it will increase dramatically if talks collapse. This will ultimately support global growth but it will not prevent market riots between a negative policy shock and the point at which markets are totally reassured about the magnitude of stimulus. How Will The Negotiations Proceed? Precariously. The risk of a strategic conflict is much higher than the markets are currently pricing. This is highlighted in Table 1 above, but there are additional reasons to have a high conviction on this point. We can demonstrate this by constructing a simple decision tree that outlines the step-by-step process by which the U.S. and China will proceed in their negotiations after the May 10 tariff rate hike (Diagram 1). To these we attach subjective probabilities that we believe are fair and slightly conservative. The result shows that it is not difficult to conclude that the conditional probability of a long-term, durable trade agreement is a mere 4%, whereas the conditional probability of an uncontained escalation in strategic tensions is as high as 59%! This is a much worse outcome than our actual view as expressed in Table 1. Diagram 1A Simple Decision Tree Says Geopolitical Risks Are Huge How Trump Became A War President How Trump Became A War President A similar exercise – an analysis of competing hypotheses conducted according to analytical techniques used by the U.S. intelligence community – reinforces the point that the most likely scenario is a major escalation in tensions, while the least likely is a “grand compromise” (Appendix). While our final trade war probabilities in Table 1 are not as pessimistic as these exercises suggest, the latter reinforce the point that the market is too sanguine. An increase in tariffs after five months of negotiations, with a threat to impose even more sweeping tariffs with a one-month deadline, is not conducive to Chinese concessions and therefore increases the odds of talks failing and an escalation in strategic conflict unprecedented in U.S.-China relations since the rupture from 1989-91. And this rupture would be considerably worse for the global economy. The Trump administration’s political logic is willing to accept such a conflict on the basis that a foreign policy confrontation can produce a rally-around-the-flag effect whereas a short-term deal that does not address significant technological and national security concerns is a political liability on the campaign trail. Yes, it is important that Presidents Trump and Xi are making verifiable preparations to attend the G20 summit in Japan. But they could cancel their attendance or snub each other at the event. In our view investors should wait for something more substantial to become more optimistic about political risk – such as public commitments to structural changes by China and a complementary tariff rollback schedule by the United States. Bottom Line: The odds of a total breakdown in U.S.-China relations and a Cold War-style escalation of strategic conflict are highly underrated. Markets will sell before they recover. Investment Implications Chart 20China's Nuclear Option Might Fizzle China's Nuclear Option Might Fizzle China's Nuclear Option Might Fizzle Equity markets are exposed to further downside in the short run. Even a minor escalation is not fully priced according to our Global Investment Strategy’s equity market forecasts based on our own geopolitical scenario probabilities (see Table 1 above). Our Chief Global Strategist Peter Berezin would recommend increasing exposure to risk if the S&P 500 falls 5% from current levels, other factors being equal. Cyclically, any trade agreement will fail to bring substantial benefits to the U.S.-China trade and investment outlook over a horizon beyond 12-24 months. The tech industries of the two countries will not benefit greatly from the deal. While multinational corporations exposed to the Asian manufacturing supply chain could suffer earnings downgrades from trade war, China’s stimulus will be a countervailing factor, particularly for commodities and commodity-oriented EMs. Therefore, we will keep our China Play Index and long Indonesia trades in place despite near-term risks. Ironically, U.S. treasuries can rally even when China is reducing its holdings, as global demand rises amid crisis (Chart 20). However, given that bonds have already rallied and we expect Chinese stimulus to come sooner rather than later, we will maintain our current portfolio hedge of Swiss bonds and gold, which is up 2%. We are closing our long small caps trade for a loss of 11.9%.   Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Appendix Image

Feature In what has become a tradition, I met with Ms. Mea following client meetings in Europe last week. Ms. Mea is a long-term BCA client who has been following our Emerging Markets Strategy very closely over the years. It was our fourth meet-up in the past 18 months. Ms. Mea keeps our meetings interesting by always challenging our views and questioning the nuances of our analysis. The timing of our most recent meeting was particularly notable, as we had just received news that the latest U.S.-China trade talks had not produced an agreement. In light of this, Ms. Mea started our conversation with a question on the link between geopolitics and financial markets: Ms. Mea: Why have the U.S. and China failed to reach a trade accord when it is clear that without one, both global financial markets and business sentiment will be hurt? Answer: The U.S. and China are intertwined in a geopolitical confrontation that will endure for decades. Their strategic national interests are not aligned at all. Therefore, any accord on trade and other geopolitical disputes will not be lasting. It is impossible to accurately forecast and time all turns of the negotiation process and the associated event risks. Therefore, an investment process should be informed and guided by a thematic approach. The U.S. and China are intertwined in a geopolitical confrontation that will endure for decades. Our theme has been, and remains, that China and the U.S. are in a long-term geopolitical confrontation that epitomizes a rivalry between an existing and a rising superpower. This suggests that the demands of one side will be unacceptable to the other. That makes any agreement unsustainable over the long run. In brief, there was a structural regime shift in the U.S.-China relationship last year. Yet global equity markets rallied this year on rising expectations of a major trade deal. Notably, most of the gains in EM equities since late December occurred on days when there was positive news on the progress of trade talks. Hence, the EM rally can largely be attributed to expectations of a trade deal. Not surprisingly, the failure to conclude a trade accord has quickly pushed EM share prices back down to their mid-January levels (Chart I-1). As such, the majority of investors who have bought the EM equity index since early this year lost a substantial part of their gains in the recent selloff.  Chart I-1EM Equity Index: Between Support And Resistance EM Equity Index: Between Support And Resistance EM Equity Index: Between Support And Resistance Given that these two nations are embroiled in a long-term geopolitical rivalry, it will be difficult to find solutions on trade and geopolitical disputes that can simultaneously satisfy both sides. Even so, this does not imply that global risk assets will be in freefall forever. Financial markets currently need to price in both (1) a geopolitical risk premium on a structural basis; and (2) the impact of trade tariffs on global business activity on a cyclical basis. Once these two components have been priced in, markets will become less sensitive to the ebbs and flows of tensions between the U.S. and China. Finally, China’s exports to the U.S. constitute only 3.5% of mainland GDP (Chart I-2). This is considerably smaller than capital spending, which makes up 42% of China’s GDP. Further, most of the investment outlays over the past 10 years have not been in productive capacity to supply goods to the American market. On the contrary, the overwhelming share of capital expenditures since 2008 have occurred in domestic segments of the economy rather than export industries. Certainly, the trade confrontation will weigh on consumer and business sentiment in China as well as reduce the flow of U.S. dollars to the Middle Kingdom, warranting RMB depreciation. Still, there are other predicaments unrelated to the U.S. import tariffs that Chinese policymakers are facing. These include the credit, money and property bubbles that we have written about extensively. China’s exports to the U.S. constitute only 3.5% of mainland GDP. Ms. Mea: With no trade deal, the odds appear to be rising that the Chinese authorities will ramp up both credit and fiscal stimulus. Should investors not be looking through the near-term volatility and be buying EM risk assets and China-plays – because this stimulus will produce a cyclical recovery in the mainland economy? Answer: It is a safe bet that the Chinese authorities will encourage more credit creation and ramp up fiscal spending. The difficulty for investors is in gauging two unknowns: What is the lead time between the stimulus and economic growth, and what will be the multiplier effect of these stimuli. Lead time: Chart I-3 portends our aggregate credit and fiscal spending impulse. Based on the past relationship between turning points in this indicator and the business cycle in China, the latter is likely to bottom around August. Chart I-2Structure Of Chinese Economy Structure Of Chinese Economy Structure Of Chinese Economy Chart I-3China: Stimulus Works With A Time Lag China: Stimulus Works With A Time Lag China: Stimulus Works With A Time Lag   Chart I-4China's Stimulus And Financial Markets: 2012 Versus 2016 China's Stimulus And Financial Markets: 2012 Versus 2016 China's Stimulus And Financial Markets: 2012 Versus 2016 Multiplier effect: The impact of stimulus on the economy also depends on the multiplier effect. The latter is contingent on households’ and companies’ willingness to spend. If households and companies hasten the pace of spending, the economy can recover with little stimulus. If they reduce their expenditure growth, the economy may require much more stimulus. The majority of investors and commentators are comparing China’s current stimulus efforts with what occurred in 2016. However, our hunch is that the current Chinese business cycle might actually resemble the 2012-‘13 episode due to similarities in the multiplier effect. The size of credit and fiscal stimulus in 2012 was as large as in 2016. Nevertheless, the business cycle recovery in 2012-‘13 was very muted, as illustrated in Chart I-3 on page 3. Consistently, EM share prices and commodities did not stage a cyclical rally in 2012 as they did in 2016-‘17 (Chart I-4). Ms. Mea: It seems you are implying that differences between the 2012 and 2016 economic and financial markets outcomes are due to the multiplier. How does one appraise the multiplier effect? Answer: In a word, yes. Unfortunately, there is no easy way to forecast consumers’ and businesses’ willingness to spend – particularly in the midst of a clash between the positive effects of stimulus and the negative sentiment stemming from the ongoing U.S.-China confrontation. We have constructed indicators that measure the willingness to spend among households and companies in China. Our proxies for their marginal propensity to spend (MPS) are currently in decline (Chart I-5A and I-5B). Chart I-5AChina: Households' Marginal Propensity To Spend China: Households' Marginal Propensity To Spend China: Households' Marginal Propensity To Spend Chart I-5BChina: Enterprises’ Marginal Propensity To Spend China: Enterprises' Marginal Propensity To Spend China: Enterprises' Marginal Propensity To Spend   MPS does not affect day-to-day expenditures, but rather captures consumer spending on large-ticket items such as housing, cars and durable goods, as well as investment expenditures by companies. Consistently, mainland companies’ MPS leads industrial metal prices by several months (Chart I-5B). Chart I-6 illustrates the critical difference between 2012 and 2016 in terms of the impact of credit and fiscal stimulus. In both episodes, the size of the stimulus was roughly the same, but the manufacturing PMI did not really recover in 2012-’13, gyrating in the 49-51 range. In contrast, it did stage a cyclical recovery in 2016-‘17 (Chart I-6, second panel). In brief, the difference between the 2012 and 2016 episodes was the MPS by companies and households (Chart I-6, third and fourth panels). There are other predicaments unrelated to the U.S. import tariffs that Chinese policymakers are facing. These include the credit, money and property bubbles that we have written about extensively. Provided the not-so-upbeat sentiment among Chinese households and businesses due to their high debt levels and the ongoing trade conflict, the odds are that their MPS will remain weak for now. As a result, the impact of credit and fiscal stimulus on China’s business cycle will be muted for now. As such, more stimulus and longer lead time may be required to engineer a cyclical recovery. Interestingly, the current profiles of both EM and developed equity markets closely resemble their 2012 trajectories – both in terms of direction and magnitude (Chart I-7). Chart I-6China's Stimulus In 2012 And 2016: Beware Of Multiplier Effect China's Stimulus In 2012 And 2016: Beware Of Multiplier Effect China's Stimulus In 2012 And 2016: Beware Of Multiplier Effect Chart I-7Is 2018-2019 Akin ##br##2011-2012? Is 2018-2019 Akin 2011-2012? Is 2018-2019 Akin 2011-2012? Ms. Mea: So, you are suggesting risks to China-related plays and EM financial markets are skewed to the downside. How should one assess how much downside there is, and what should investors look for to gauge turnings points in financial markets? Answer: We continuously assess the investment landscape, not only based on our fundamental analysis of the global/EM/China business cycles but also on various financial market valuations, positioning and technicals. Let’s review where we stand with respect to these metrics.   Equity Valuations: EM stocks are not cheap. Our favored measure of equity valuations is the composite indicator-based 20% trimmed means of the following multiples: trailing and forward P/E, price-to-cash earnings, price-to-book value and price-to-dividend ratios (Chart I-8). On these metrics, EM stocks appear fairly valued. Nevertheless, these valuations should be viewed in the context of structural decline in EM corporate profitability. The measures of return on equity and assets for non-financial companies in EM are on par with their 2008 lows (Chart I-8, middle and bottom panels). When valuations are neutral, the equity market’s direction is dictated by the profit outlook. The latter currently remains negative for EM and Chinese companies (Chart I-9). Chart I-8EM Equities Are Not Cheap bca.ems_wr_2019_05_16_s1_c8 bca.ems_wr_2019_05_16_s1_c8 Chart I-9Downside Profit Surprises In EM And China Downside Profit Surprises In EM And China Downside Profit Surprises In EM And China   Currency Valuations: The U.S. dollar is only moderately (one standard deviation) expensive, according to the real effective exchange rate based on unit labor costs (Chart I-10). The latter is our most favored currency valuation measure. The greenback has been in a major structural bull market since 2011. Secular bull/bear markets do not typically end before valuations reach 1.5-2 standard deviations. We reckon that the cyclical and structural backdrop remains favorable for the dollar, and odds are it will overshoot before a major top sets in. Going forward, most of the dollar’s additional gains will not occur versus the euro or the Japanese yen – which are already modestly undervalued (Chart I-10, middle and bottom panels) – but against other currencies. In particular, commodity currencies of developed economies have not yet cheapened enough (Chart I-11). Typically, a structural bear market in commodities does not end until these commodity currencies become cheap. Hence, the current valuation profile of these commodity currencies is consistent with the notion that the secular bear markets in commodities prices and EM are not yet over. Chart I-10The Euro Is Fairly Valued, The Yen Is Cheap G3 Currency Valuations The Euro Is Fairly Valued, The Yen Is Cheap G3 Currency Valuations The Euro Is Fairly Valued, The Yen Is Cheap G3 Currency Valuations Chart I-11Commodities Currencies ##br##Are Not Cheap Yet Commodities Currencies Are Not Cheap Yet Commodities Currencies Are Not Cheap Yet   Unfortunately, there are no data for unit labor cost-based real effective exchange rates for the majority of EMs. However, it is a safe bet to infer that long- and medium-term cycles in EM currencies coincide with those of DM commodity currencies because they are all pro-cyclical. If DM commodity currencies have not yet bottomed, EM currencies remain vulnerable. Relative to the global equity benchmark, global materials have broken down to new cyclical lows. This could be a harbinger of EM relative equity performance making new lows. Ms. Mea: But the positioning in the U.S. dollar is long. How consistent is this with your view of further dollar strength? Positioning: While investors are long the U.S. dollar versus several DM currencies, they are short the greenback versus EM currencies. Chart I-12 illustrates the aggregate net long positions of both leveraged funds and asset managers in the BRL, MXN, RUB and ZAR. As of May 10 (the last datapoint available), investors were as long these EM high-beta currencies as they were at their cyclical peak in early 2018. As to emerging Asian currencies, ongoing RMB depreciation will drag emerging Asian currencies down. Notably, the Korean won has already broken down from its tapering wedge pattern. Concerning EM equities, investor positioning and sentiment was still very elevated before last week’s market turmoil. Chart I-13 demonstrates the number of net long positions in EM ETFs (EEM) by leveraged funds and asset managers. The last datapoint is also as of May 10. Chart I-12Investors Have Been Long EM Currencies Investors Have Been Long EM Currencies Investors Have Been Long EM Currencies Chart I-13Investors Have Been Bullish On EM Stocks Investors Have Been Bullish On EM Stocks Investors Have Been Bullish On EM Stocks   In short, investor sentiment on EM was bullish and long positions in EM were extended before the U.S.-China trade confrontation escalated again. Tell-tale signs and technicals: Market profiles can sometimes help us gauge whether an asset class is in a bull or bear market, and what the next move is likely to be. We have the following observations: U.S. dollar volatility is close to its record lows (Chart I-14). Following the previous three low-volatility episodes, EM shares prices in dollar terms dropped substantially over the ensuing 18 months – 60% in 1997-1998, 65% in 2007-2008 and 30% in 2014-2015. The rationale is that very low global currency volatility indicates that investors do not foresee a major tectonic macro shift. When this does inevitably occur, currency markets move violently. The RMB depreciation could be a tectonic macro shift that global markets are not prepared for. The absolute and relative performances of EM stocks resemble that of global materials stocks. Global materials are breaking below their long-term moving averages (technical support lines) in absolute terms, raising the odds that the EM equity index will do the same. Relative to the global equity benchmark, global materials have broken down to new cyclical lows. This could be a harbinger of EM relative equity performance making new lows (Chart I-15). Chart I-14U.S. Dollar Volatility And ##br##EM Equity Returns U.S. Dollar Volatility And EM Equity Returns U.S. Dollar Volatility And EM Equity Returns Chart I-15EM And Global Materials: Relative To Global Index EM And Global Materials: Relative To Global Index EM And Global Materials: Relative To Global Index Consistently, industrial metals prices as well as our Risk-on/Safe-Haven Currency Index have potentially formed a head-and-shoulders pattern and may be entering a major down leg (Chart I-16). Further weakness in these variables would be consistent with a risk-off phase in EM financial markets.   Finally, the relative performance of the MSCI China All-Share Index – which includes all onshore- and offshore-listed stocks – has relapsed relative to the global equity benchmark, failing to break above its long-term moving average (Chart I-17). This is a negative tell-tale sign, and often warrants considerable downside. Chart I-16A Head-And-Shoulder Pattern In Global Cyclical Markets? bca.ems_wr_2019_05_16_s1_c16 bca.ems_wr_2019_05_16_s1_c16 Chart I-17China All-Share Index: Absolute And Relative Performance China All-Share Index: Absolute And Relative Performance China All-Share Index: Absolute And Relative Performance   Ms. Mea: It seems to me that the RMB holds the key. What are your thoughts on the Chinese currency? Answer: There are several reasons why the RMB will likely depreciate. First, yuan depreciation is needed to mitigate the impact of U.S. import tariffs on Chinese exporters’ profitability. Authorities could use the RMB depreciation to fight back against U.S. import tariffs – a response that U.S. President Donald Trump will certainly not like. Second, the ongoing cyclical downturn in China and rising deflationary pressures also warrant a cheaper currency. Third, there is a vast overhang of money supply in China: The broad money supply is equivalent to US$30 trillion. More stimulus will only make this oversupply of yuans larger. This, along with the desire of mainland households and businesses to diversify their deposits into foreign currencies/assets, is like “the sword of Damocles” on the yuan’s exchange rate. Finally, the sources of foreign currency that previously offset capital outflows in China are no longer available. The current account surplus has largely evaporated. In addition, the central bank seems to be reluctant to reduce its foreign exchange reserves to fund capital outflows. In fact, at US$3 trillion, its foreign currency reserves are equivalent to only 10% of local currency broad money supply. All in all, we are structurally short the RMB versus the dollar. Chart I-18China, Commodities, & EM: Identical Cycles China, Commodities, & EM: Identical Cycles China, Commodities, & EM: Identical Cycles Ms. Mea: What are the investment implications? Where are we in the EM/China investment cycle? Answer: Our investment themes since early this decade have been that EM share prices and currencies are in a bear market, the U.S. dollar is in a structural bull market, and commodities are in a structural downtrend (Chart I-18). With the exception of 2016-‘17, these themes have played out quite well. These structural moves have not yet been exhausted. At the moment, we do not foresee a 2016-’17-type cyclical rally either. The failure of EM equities to outperform DM stocks and the resilience of the U.S. dollar during the risk-on period since early this year, give us comfort in maintaining a negative stance on EM risk assets. Importantly, a decade-long poor EM performance is likely to end with a bang rather than a whimper, especially when investors by and large remain bullish on EM. On the whole, we recommend trading EM stocks on the short side and underweighting EM equities in a global equity portfolio. Within the EM equity universe, our overweights are Russia, central Europe, Thailand, non-tech Korean stocks, Mexico, Chile, the UAE and Vietnam. Our underweights are Brazil, South Africa, Turkey, Peru, Indonesia, India, and the Philippines. Fixed-income investors should also position for higher volatility and weaker EM currencies, favoring low-beta versus high-beta markets. Russian and Mexican markets are our favored local currency and U.S. dollar bonds. Finally, we continue to recommend shorting a basket of the following EM currencies versus the U.S. dollar: ZAR, CLP, IDR, MYR, PHP and KRW. Our currency overweights are MXN, RUB, SGD and the THB as well as central European currencies. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Looking past the day-to-day noise of trade-related announcements, we view the underlying odds of an actual trade agreement this year to have fallen below 50%. For the purposes of investment strategy, China-exposed investors should now simply assume that the U.S. proceeds with 25% tariffs on all imports from China. Given this, investors should stop focusing strictly on the odds of trade war, and should instead start focusing on the likely net impact of the tariff shock and China’s inevitable policy response. Simulated and empirical estimates of the impact of a 25% increase in tariffs affecting all U.S.-China trade suggest that economic conditions in China are likely to deteriorate to 2015/2016-like levels. This implies that a 2015/2016-style policy response will again be required in order for policymakers to be confident that the shock will be overcome. The preference of policymakers is to prevent another significant episode of releveraging, but the constraints facing policymakers suggest that one is unlikely to be avoided. We see a meaningful chance that this tension will be resolved by a classic market “riot” over the coming 3 months as financial markets force reluctant policymakers to capitulate. We would not recommend a long position in Chinese stocks, either in absolute terms or relative to the global benchmark, for investors with a time horizon of less than 3 months. However, over a strictly cyclical (i.e. 6-12 month) time horizon, we would recommend staying long/overweight on the basis that policymakers will ultimately respond as needed. We recommend investors hedge the inherent RMB exposure from a long US$ cyclical position in Chinese stocks by opening a long USD-CNH trade. Feature U.S. and Chinese negotiators failed last week to secure an agreement deferring the threatened increase in the second round tariff rate.1 The tariffs increased on Thursday at midnight for goods not already in transit to the U.S. (effectively doubling the existing tariffs), which was followed by the inevitable retaliation by China on Monday (scheduled to take effect on June 1). The retaliation, coupled with President Trump’s earlier warning that China should not do so, was taken by investors as a sign that 25% tariffs on all goods imported from China will soon be in place. As we go to press, the S&P 500, Hang Seng China Enterprises Index, and the CSI 300 are down 3.5%, 7%, and 6.9%, respectively, since President Trump’s May 5 tweet (Chart 1). Chart 1Investors Are Starting To Price In 25% Tariffs Affecting All U.S.-China Trade Investors Are Starting To Price In 25% Tariffs Affecting All U.S.-China Trade Investors Are Starting To Price In 25% Tariffs Affecting All U.S.-China Trade Stimulus Minus Shock Holding all else equal, the events of the past two weeks are strictly negative for Chinese economic growth and would thus justify a decisively bearish outlook for Chinese stock prices after the rally that has taken place over the past six months. However, all is not equal, because a substantial deterioration in the export outlook will invariably cause a response from Chinese policymakers. Over the coming few weeks, global investors are likely to remain highly focused on developments and announcements related to the trade conflict. But at this point, our geopolitical team believes that the conclusion of an actual trade agreement this year is now only a 40% probability. This underscores that China-exposed investors should, for the purposes of investment strategy, simply assume that the U.S. proceeds with 25% tariffs on all imports from China, and should broaden their focus to the outcome of a simple formula that describes the potential net outcome of this event. Two simple scenarios concerning this formula are outlined below: Scenario 1 (Bullish): Stimulus – Shock > 0 Scenario 2 (Bearish): Stimulus – Shock ≤ 0 In scenario 1, the impact of China’s reflationary efforts more than offsets the negative shock to aggregate demand from the sharp decline in exports to the U.S. In this scenario, investors should actually have a bullish cyclical outlook for China-related assets, even if the near-term outlook is deeply negative. Scenario 2 denotes a bearish outcome where China’s reflationary response is not larger than the magnitude of the shock, which includes a circumstance where the impacts are exactly offsetting (because of the higher uncertainty, and thus risk premium, that this would entail). “Solving” The Formula In order to “solve” this formula, investors need answers to the following three questions: What is the size and disposition of the likely shock to China’s economy in a full-tariff scenario? What kind of reflationary response is required in order to offset this shock? What are the odds that policymakers will deliver the required response? Simulated and empirical estimates of a 25% increase in tariffs affecting all U.S.-China trade suggest a sizeable economic impact. Charts 2 & 3 provide the IMF’s perspective on the first question. The charts show the simulated impact of a 25% increase in tariffs affecting all U.S.-China trade, and they estimate the near-term impact for China to be -1.25% for real GDP (-0.5% over the long-run) and -3.5% for real exports (-4.5% to -5.5% over the long run). Chart 2 Chart 3   A recent IMF working paper came up with a more benign estimate of the first year impact, but a sizeable second year impact and a similar estimate of the long-term ramifications of tariff increases.2 Using a dataset with wide time and country coverage, the aggregate results of the study imply that Chinese output is only likely to fall about 0.2% in the year following the tariff increase. However, the cumulative shock to output increased sharply to roughly 1.6% in the second year of the tariff increase, with a negative yearly impact to output persisting for 5 years (with an average annual impact of -0.6% over the whole period, somewhat higher than the estimates shown in Charts 2 & 3). At the 90% confidence interval, the author’s estimates show that a tariff increase of this magnitude would imply a -1.7% average impact on output per year in the first two years following the increase. Chart 4The IMF's Shock Estimates Suggest A Serious Hit To China's Economy The IMF's Shock Estimates Suggest A Serious Hit To China's Economy The IMF's Shock Estimates Suggest A Serious Hit To China's Economy In order to answer the second question, investors need to have some sense of the relative magnitude of the estimates noted above. Chart 4 provides some perspective and highlights that the estimates above, were they to materialize, would do two things: Taking Chinese real GDP data at face value, it would cause the largest deceleration in China’s real GDP growth rate since 2012, when the economy slowed significantly and authorities responded forcefully. Based on the most recent data for Chinese real export growth, a 3.5% deceleration in export volume would push its growth rate to its lowest level since the global financial crisis. In practice, we doubt that China’s reported real GDP growth rate accurately reflects what occurred in 2015, and it is very possible that a similar deceleration happened in that year. However, economic similarity to the 2015/2016 episode implies that a similar policy response may also be required, a proposition that is supported by our MSCI China Index earnings recession model. Table 1 shows a set of earnings recession probabilities, based on a model that we presented in two recent reports.3 The scenarios express the odds as a function of new credit to GDP and our calculation of China’s export weighted exchange rate, and assume a substantial decline in the new export orders component of the official manufacturing PMI, and flat momentum in forward earnings. Table 1Our Earnings Recession Model Suggests That A 2015/2016 Style Response Is Needed To Counter This Shock Simple Arithmetic Simple Arithmetic The table clearly highlights that a significant further acceleration in new credit to GDP, coupled with a meaningful decline in the exchange rate, is needed in order to stabilize the earnings outlook. We have previously related stability in the outlook for earnings to stability in the economy itself, given the close correlation between Chinese investment-relevant economic activity and the earnings cycle (Chart 5). Given that new credit to GDP peaked at 31.5% during the 2015/2016 episode, it seems reasonable to conclude that a 2015/2016-style policy response will again be required in order for policymakers to be confident that the shock will be overcome. Policymaker Preferences Vs. Constraints This brings us to our third question: What are the odds that policymakers will deliver the stimulus required to confidently overcome the upcoming shock? It seems reasonable to conclude that a 2015/2016-style policy response will again be required in order for policymakers to be confident that the shock will be overcome. If the answer was only dependent on the preferences of policymakers, the odds would be low. China has relied heavily on credit to stimulate its economy over the past decade, and Chart 6 highlights that this has come at a high cost. The BIS’ estimate of the debt service ratio of China’s private non-financial sector is already extraordinarily high relative to other countries, and another round of meaningful re-leveraging will just make this problem even worse. Chart 5Earnings Stability = Economic ##br##Stability Earnings Stability = Economic Stability Earnings Stability = Economic Stability Chart 6Further Leveraging Will Undoubtedly Make A Big Problem Even Worse Further Leveraging Will Undoubtedly Make A Big Problem Even Worse Further Leveraging Will Undoubtedly Make A Big Problem Even Worse   We documented in detail how this has created the risk of a debt trap for China’s state-owned enterprises in an August Special Report,4 and have presented evidence arguing that China’s policymakers appear to have good economic reasons to try and shift China’s economy away from extremely high rates of investment towards more consumption.5 This implies that restraining credit growth to avoid further leveraging has been a reasonable policy objective during periods of relative economic stability. However, policy decisions cannot be made in a vacuum, and this is true even in the case of China. As such, instead of preferences, investors should be focused on policymaker constraints in judging likely policy actions. Given the potential for second round effects, Chinese policymakers need to calibrate their policy response to ensure a positive net impact of the stimulus minus the shock. In our view, three factors point to the conclusion that Chinese policymakers face serious economic constraints in setting their policy response: Charts 2-4 highlighted that 25% tariffs on all U.S.-China trade would constitute a meaningful shock, but it is also the case that this shock would be coming at a time when Chinese economic momentum is already relatively weak. This suggests that policymakers will have to act quickly and decisively to put a floor under economic activity. Charts 7 & 8 suggest that there are meaningful second round effects on Chinese domestic investment from external sector shocks, which raises the possibility that the impact on Chinese economic activity may be larger than Charts 2-4 suggest. Chart 7 shows that while the contribution to official real GDP growth from net exports is small, Chart 8 shows that past changes in net export contribution are reasonably correlated with subsequent changes in the contribution to growth from gross capital formation. While it is possible that this relationship is not actually causal, taking it at face value implies that the IMF’s estimate of the impact on output could be exceeded if the contribution to growth from net exports declines by 0.4% or more (holding the contribution to growth from final consumption expenditure constant). Since 2018’s change in net export contribution declined by three times this amount (1.2%), the downside risks to domestic investment from effectively quadrupling U.S. import tariffs are clear. China does not have a flexible labor market, and its political system is highly sensitive to significant job losses. Chart 9 shows that the employment situation has already seriously deteriorated in lockstep with actual economic activity, further underscoring the need for policymakers to act urgently. Chart 7 Chart 8 Chart 9The Employment Situation Is Already Deteriorating, And Will Do So Further The Employment Situation Is Already Deteriorating, And Will Do So Further The Employment Situation Is Already Deteriorating, And Will Do So Further We are open to the idea that policymakers may be able to devise a stimulative response of similar reflationary magnitude to the 2015/2016 episode without resorting to a major credit overshoot, but we are currently unable to articulate what it might be. This is an area of ongoing research for BCA’s China Investment Strategy service, but for now we assume that a credit overshoot remains the ultimate line of defense for China’s policymakers that will be deployed if the pursuit of alternative strategies fail to quickly stabilize economic activity. Investment Strategy Conclusions In our view, focusing on policymaker constraints rather than their preferences is much more likely to guide investors towards the right strategy conclusions over a 6-12 month time horizon. However, in the near-term, policy mistakes can occur, and are much more likely to occur if policymakers react to the imposition of constraints rather than anticipate their arrival. Over the coming three months, we see meaningful odds that Chinese policymakers remain reluctant to allow another episode of significant releveraging in the economy. If we are correct in our assessment of the damage that the tariff shock is likely to cause, this would set up a classic market “riot”, where policymakers are forced by financial markets to capitulate and respond forcefully to the seriousness of the economic situation. Further RMB weakness is likely. Investors should hedge their exposure and go long USD-CNH. Chart 10Investors Have A Green Light To Bet On A Lower RMB Investors Have A Green Light To Bet On A Lower RMB Investors Have A Green Light To Bet On A Lower RMB Given this, we would not recommend a long position in Chinese stocks, either in absolute terms or relative to the global benchmark, for investors with a time horizon of less than 3 months. However, over a cyclical (i.e. 6-12 month) time horizon, we would recommend staying long/overweight on the basis that policymakers will ultimately deliver the stimulus required to more than offset the upcoming shock to external demand. This means that our long MSCI China Index, MSCI China A onshore index, and MSCI China Growth index trades relative to the global benchmark are explicitly cyclical in orientation, and may suffer meaningful further losses over the coming few months before ultimately recovering. As a final point, Table 1 highlighted that a meaningful decline in the exchange rate is likely required in order to stabilize the earnings outlook. Chart 10 shows that currency weakness persisted well past the trough in relative Chinese investable equity performance during the 2015/2016 episode, and we would expect a similar result in the current environment given the nature of the shock. As such, we recommend investors hedge the inherent RMB exposure from a long US$ cyclical position in Chinese stocks by opening a long USD-CNH trade today, with high odds of a break above 7 in the coming weeks. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com Footnotes 1 The first, second, third “round” of tariffs reference the $50/$200/$300 billion tranches of imported goods subject to U.S. tariff announcements since last summer. 2 IMF Working Paper WP/19/9, “Macroeconomic Consequences of Tariffs”, by Davide Furceri, Swarnali A. Hannan, Jonathan D. Ostry, and Andrew K. Rose. 3 Please see China Investment Strategy Special Report “Six Questions About Chinese Stocks,” dated January 16, 2019, and Weekly Report “A Gap In The Bridge,” dated January 30, 2019 available at cis.bcaresearch.com. 3 Please see China Investment Strategy Special Report “Chinese Policymakers: Facing A Trade-Off Between Growth And Leveraging,” dated August 29, 2018, available at cis.bcaresearch.com. 4  Please see China Investment Strategy Weekly Report “Is China Making A Policy Mistake?,” dated October 31, 2018, available at cis.bcaresearch.com.   Cyclical Investment Stance Equity Sector Recommendations

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

Highlights The March data brought the first signs of a stabilization in China’s “hard” economic data, albeit from a weak level. The April PMIs disappointed, but they remained in expansionary territory; this is in addition to a continued significant improvement in the trade-related subcomponents of the official survey. Chinese credit growth is unlikely to relapse over the coming year, despite recent investor concerns that Chinese policymakers may dial back their stimulus efforts. The pace of growth may moderate, but halting the uptrend in growth this year would constitute a major policy mistake that we do not expect. Chinese stocks may trend flat-to-down in the very near term as investors await a signed trade deal with the U.S. and further signs of a recovery in activity. Over the next 6-12 months, however, an overweight stance is warranted, barring a major relapse in our leading indicator. Feature Tables 1 and 2 on pages 2 and 3 highlight key developments in China’s economy and its financial markets over the past month. On the growth front, March’s data brought the very first (albeit modest) signs of stabilization in actual Chinese economic activity. While the April manufacturing PMIs released earlier this week disappointed, the trade related components of the official survey continued to improve meaningfully, which implies that an improvement in domestic demand is still early. This conclusion is not particularly surprising given that the first green shoots in the actual data are emerging from a depressed level of activity. Credit growth has only recently picked up, implying that actual activity will strengthen over the coming 6-12 months followed a signed trade deal and a continued (modest) uptrend in credit. Table 1China Macro Data Summary China Macro And Market Review China Macro And Market Review Table 2China Financial Market Performance Summary China Macro And Market Review China Macro And Market Review Within financial markets, the most significant recent development has been that Chinese stocks have sagged somewhat due to concerns that policymakers may meaningfully dial back their stimulus efforts over the coming year. In our view, recent statements from policymakers, as well as the fact that the recovery in activity is only now beginning, underscores that credit growth is unlikely to relapse over the coming year. It may not grow at the breakneck pace observed in the first quarter, but beyond the near-term jitters that this may introduce into the equity market, we do not see it as a threat to an overweight stance towards Chinese stocks over the coming 6-12 months. In reference to Tables 1 and 2, we provide below several detailed observations concerning developments in China’s macro and financial market data: Chart 1 highlights that March brought the first sign of a stabilization in actual Chinese economic activity. When measured on a smoothed basis, the Li Keqiang index itself weakened further in March, but total import growth moved sideways and nominal manufacturing output ticked higher. We noted in our last Macro & Market review that future changes in activity measures were now more likely to reflect actual changes in underlying economic circumstances given that the previously beneficial tariff front-running effect had probably washed out of the data. March’s data confirms this view, and underscores that activity will pickup in the second half of the year. Chart 1The First (Albeit Tentative) Sign Of Economic Stabilization The First (Albeit Tentative) Sign Of Economic Stabilization The First (Albeit Tentative) Sign Of Economic Stabilization Chart 2 shows that the uptrend in our leading indicator for Chinese economic activity is so far modest, but also that it is now at a 2-year high relative to its 12-month moving average. The indicator is being weighed-down by weak money growth (M2 and our definition of M3), even though monetary conditions remain easy and our measures of credit growth picked up sharply in Q1. We doubt that the trend in Chinese money and credit growth can sustainably decouple in a scenario where the latter is sustainably improving, as it would imply that all of the credit improvement was originating from non-bank financial institutions. As such, we expect money growth to catch up to credit growth in the coming months. The annual change in the PBOC’s pledged supplementary lending injection remained in negative territory in March, and both floor space started and sold decelerated modestly further. Construction and sales activity continue to diverge, with the latter still pointing to a further slowdown in the former. We will be updating our Chinese housing outlook in a Special Report next week. April’s Caixin and official manufacturing PMI disappointed, but this overshadowed a continued significant improvement in the new export orders and import components of the official PMI (Chart 3). In our view, this is consistent with a stabilization in the export outlook, but implies that Chinese domestically-oriented manufacturing activity is not yet booming. Nonetheless, a signed trade deal, improving importer/exporter sentiment, and an uptrend in credit growth still implies that activity will pick up meaningfully later in the year. Chart 2Our Leading Indicator Is Now Modestly Trending Higher Our Leading Indicator Is Now Modestly Trending Higher Our Leading Indicator Is Now Modestly Trending Higher Chart 3Trade-Related Components Of The Official PMI Continue To Rise Trade-Related Components Of The Official PMI Continue To Rise Trade-Related Components Of The Official PMI Continue To Rise   Over the past month, Taiwanese and domestic Chinese stocks have been the best performers within “Greater China”, relative to the MSCI Hong Kong index, the MSCI China index, and the Hang Seng China Enterprises index. The latter in particular has lagged other Chinese equity indexes since late-March (Chart 4), and may be due for a catch-up. Over the nearer-term, Chinese stocks, especially the domestic market, have sagged due to concerns that Chinese policymakers may meaningfully dial back their stimulus efforts over the coming year. We discussed this risk in our April 17thWeekly Report,1 and noted that while we expected credit growth to moderate somewhat, a more meaningful slowdown, particularly if coupled with signals from policymakers that a much slower pace of growth is desired, could pose a risk to our overweight equity stance. The April manufacturing PMIs disappointed, but the trade-related components of the official survey continued to improve meaningfully. In our view, recent statements from policymakers, particularly from PBOC Deputy Governor Liu Guoqiang,2 underscores that credit growth is unlikely to relapse over the coming year; it will simply not be growing at the breakneck pace observed in the first quarter. Beyond the near-term jitters that this may introduce into the equity market, we do not see it as a threat to an overweight stance towards Chinese stocks over the coming 6-12 months. Chart 5 highlights that Chinese consumer stocks have been the clear winners since the beginning of the year, particularly in the domestic market. Consumer stocks, including staples, sold off substantially in 2H2018 as investors responded to shockingly weak consumer spending data. Stimulus measures targeted to Chinese households, along with a meaningful improvement in some measures of consumer spending, has helped restore investor confidence in consumer stocks (which had previously been viewed as a bullish “no-brainer” structural trade). Chart 4Is An H-Share Catchup##br## Looming? Is An H-Share Catchup Looming? Is An H-Share Catchup Looming? Chart 5Chinese Consumer Stocks Have Been On Fire Chinese Consumer Stocks Have Been On Fire Chinese Consumer Stocks Have Been On Fire   The sharp rise in the 7-day interbank repo rate in April fed concerns among equity investors that Chinese policymakers might be in the process of paring back their stimulus efforts. However, as Chart 6 shows, China’s 7-day repo rate is extraordinarily volatile, and is affected by a variety of seasonal and technical factors. The chart shows that a 1-month moving average of the 7-day repo rate is broadly in line with the level that has prevailed over the past 9 months. In addition, the 3-month repo rate (which we have argued has been a more informative predictor of China’s monetary policy stance) remains well on the low end of its range over the past year. In short, despite investor concerns, Chinese interbank repo rates are not signaling a change in China’s monetary policy stance. Tighter monetary policy is not in the cards for this year. After having risen noticeably in late-March, Chinese onshore corporate bond spreads have fallen back to the low end of their trading range over the past 8 months. We continue to recommend that domestic investors hold a diversified portfolio of SOE corporate bonds, on the basis that actual bond defaults over the coming 6-12 months are likely to be materially lower than what investors are pricing in even though they are indeed likely to rise. Chart 7 shows that USD-HKD has eased somewhat over the past month from the top end of the band, and now trades closed at 7.845. This modest appreciation in HKD appears to have been catalyzed by a further reduction in the supply of interbank liquidity by the HKMA. While the appreciation in HKD is some modest good news for Hong Kong’s monetary authority, it remains reluctant to reduce liquidity in the system given how extremely weak loan growth is in Hong Kong. This implies that, barring a meaningful upturn in credit, a significant appreciation in HKD is not likely in the cards. Chart 6Interbank Repo Rates Are Not Trending Higher Interbank Repo Rates Are Not Trending Higher Interbank Repo Rates Are Not Trending Higher Chart 7A Modest Appreciation In HKD (Which Is Not Likely To Continue) A Modest Appreciation In HKD (Which Is Not Likely To Continue) A Modest Appreciation In HKD (Which Is Not Likely To Continue)   Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com Footnotes 1      Please see China Investment Strategy Weekly Report “In The Wake Of An Upgrade: An Investment Strategy Post-Mortem,” dated April 17, 2019, available at cis.bcaresearch.com 2      During a PBOC briefing on April 25, Deputy Governor Guoqiang noted that “no one can bear it if policy swings back and forth between tightening and loosening many times a year”. Cyclical Investment Stance Equity Sector Recommendations

Highlights An aging population, a banking sector in poor health, and a private sector focused on building up savings are the key factors undermining euro area growth on a structural basis. A large manufacturing sector makes the euro area vulnerable to EM competition. Unlike the U.S., the region’s tech sector is held back by regulatory burdens, taxes and heavy dependence on bank funding. The euro area growth faces decades of low growth and inflation. Euro area rates will stay depressed, but paradoxically, the euro can still experience structural appreciation. Euro area equities are cheap for a good reason, and banks will continue to weigh on performance. Feature Over the past 10 years, the euro area has gone through a sovereign debt crisis, a double-dip recession, persistent below-target inflation, and most recently, yet another major growth slowdown. Moreover, this economic malaise materialized despite highly stimulative monetary policy, including negative interest rates. The ongoing economic weakness has raised the specter that the euro area is the new Japan. Nearly three decades after the bursting of the Nikkei bubble, the Land of the Rising Sun remains mired in low growth and mild but persistent deflation. Consequently, charts showing that European policy rates or bond yields are tracking Japanese developments with a 17-year lag (Chart II-1) have not only become commonplace, they elicit fears that European growth, interest rates and asset valuations will lag the rest of the world for decades to come. Chart II-1Europe Is Following The Japanese Example Europe Is Following The Japanese Example Europe Is Following The Japanese Example In this piece, we discuss the various forces that explain why the euro area economy has been so weak this decade, and why such low interest rates have had so little impact on growth. We also study what sets the U.S. and euro area apart, and whether or not Europe will follow the trail blazed by Japan nearly 30 years ago. The Three Headwinds Three ills have kept European growth particularly depressed this cycle and are likely to remain significant headwinds into the foreseeable future: demographics, the banking sector’s poor health, and nonfinancial private sector balance sheet cleansing. 1)   Demographics This is the most well understood and acknowledged problem impacting Europe today. Since 2008, the European population has grown by 2%, or only 0.2% a year, with the working age population having peaked around that year. Going forward, the picture will only deteriorate: The UN expects Europe’s population to contract by 12% over the next 27 years, and the working age population to fall by 15%. This also means that the dependency ratio – the number of individuals aged less than 15 and above 65 per 100 working-age people – will approximately double over the coming 40 years. This is a clear parallel with Japan. As Chart II-2 illustrates, Europe’s population, the number of working-age individuals and the dependency ratio are all tracking Japan with a 17-year lag. Like Japan, Europe’s trend growth will thus only deteriorate further. Not only will Europe not be able to add as many workers as the U.S. to its total, but it will need to build even fewer schools, malls, office buildings or units of housing. Consequently, both the supply and demand sides of the economy will lag due to this factor alone. 2)   Banking Sector Health The poor health of the euro area banking sector is well known. BCA’s Global Asset Allocation service published an in-depth analysis of the European banking sector last December.4 The piece demonstrated that European banks have been much slower to recognize non-performing loans, curtail credit and rebuild capital than their U.S. counterparts. U.S. bank loans to the private sector fell by 13% in the two years during the crisis, while in Europe, these same loans have only fallen by 2% since 2008. Euro area banks generally remain burdened with significant non-performing loans as a percentage of regulatory capital. Moreover, net interest margins are also dismal, implying that the income cushion against bad loans is thin. Consequently, outside of France, Finland and Germany, European banks have either not grown their loan books to the private sector or, as is the case with Spain, Portugal, and Ireland, these books are continuously shrinking (Chart II-3). Chart II-2Same Demography In Europe Now Than In Japan Then Same Demography In Europe Now Than In Japan Then Same Demography In Europe Now Than In Japan Then Chart II-3Peripheral Banks Continue To Curtail Credit Peripheral Banks Continue To Curtail Credit Peripheral Banks Continue To Curtail Credit   The poor health of the European banking system is now constraining the supply of new credit to the rest of the economy. This is a much bigger problem than is the case in the U.S. given that in Europe, 72% of corporate funding comes from the banking system while 88% of household liabilities are also funded this way. In the U.S., the share of bank funding for these sectors is 32% and 29%, respectively (Chart II-4). A weak euro area banking system prevents the nonfinancial private sector from growing as robustly as it could. Chart II-4 3)   Nonfinancial Private Sector Balance Sheet Cleanse Another major drag on European growth has been the continued efforts of the European private sector to rebuild its balance sheet. To use the terminology developed by our upcoming conference speaker Richard Koo, the euro area has been in the thralls of a powerful balance sheet recession. Households in the euro area, Japan and the U.S. are all accumulating more financial assets than liabilities. However, only in the U.S. is the nonfinancial corporate sector building more liabilities than it is accumulating assets (Chart II-5). In Japan and Europe, the nonfinancial corporate sector is also a source of savings for the economy. Moreover, in Europe, the government runs a much smaller financial deficit. The current account balance tells this story vividly. A country’s current account is equal to the private sector’s savings minus investment and minus government deficits. As Italy, Spain, and other peripheral economies increased their aggregate savings after 2008, their large current account deficits vanished. Meanwhile, the governments of countries like Germany or the Netherlands, which sported healthy public finances, did not increase their spending in a commensurate way. This adjustment transformed an overall euro area current account deficit of 1.5% in 2008 into a surplus of 3.0% of GDP today, sending some of Europe’s excess savings abroad. This mimics the post-1990 Japanese experience. In the U.S., where the private sector savings did not rise as durably as in Europe, the current account stopped improving meaningfully in 2010 (Chart II-6). Chart II-5European Businesses Are Savers, Like In Japan European Businesses Are Savers, Like In Japan European Businesses Are Savers, Like In Japan Chart II-6The Current Account Dynamics Epitomise The Savings Dynamics The Current Account Dynamics Epitomise The Savings Dynamics The Current Account Dynamics Epitomise The Savings Dynamics   A private sector squarely focused on rebuilding its balance sheet liquidity can lead to a liquidity trap. In this state, monetary policy can become ineffective as spending does not respond to lower interest rates. This is where Europe is currently stuck, explaining why the European Central Bank is finding that inflation and growth are not experiencing much lift, despite seemingly incredibly accommodative monetary conditions. Why Such An Urge To Save? The fact that the household sector is a net saver is not surprising, as this is a normal state of affairs across most economies. But why is the European nonfinancial corporate sector still trying to improve its balance sheet liquidity by accumulating more assets than liabilities? Like Japanese businesses 30 years ago, European firms have large debt loads. Another problem is the lack of capex opportunities in Europe. Why do we make this assertion? The return on assets in Europe has been at rock-bottom levels ever since the introduction of the euro (Chart II-7). In the decade from 1998 to 2008, this was a non-issue. Strong global growth flattered European sales, and easy access to credit meant that via rising leverage euro area-listed nonfinancial corporations were able to generate returns on equity comparable to U.S. firms (Chart II-8, top panel). Once European banks got cold feet and European nonfinancial businesses began focusing on deleveraging, the low level of return on assets became more apparent. Part of the problem is that European profit margins are much closer to Japanese than U.S. levels (Chart II-8, middle panel). Even more damning, asset turnover – how much sales are generated by a unit of assets – has been structurally lower in Europe than in both Japan and the U.S. for multiple decades (Chart II-8, bottom panel). Chart II-7Europe Suffers From A Lower RoA Europe Suffers From A Lower RoA Europe Suffers From A Lower RoA Chart II-8DuPont's Decomposition Shows Why The Euro Area RoA Is Poor DuPont's Decomposition Shows Why The Euro Area RoA Is Poor DuPont's Decomposition Shows Why The Euro Area RoA Is Poor   The first factor weighing on the level of asset utilization and returns in Europe is the elevated level of capital stock. As Chart II-9 illustrates, the capital stock as a share of output in Italy, Spain and France dwarfs that of Japan, China or the U.S. Even Germany’s capital stock, which stands well below that of other large euro area economies, is nearly 100 percentage points of GDP larger than the U.S’s. Europe has too large a pool of assets to make any additional investments profitable, especially in light of its poor demographic profile. Chart II-9 The second factor weighing on European asset utilization and returns is the poorer level of labor productivity. From the 1950s to the early 1980s, European GDP per worker rose relative to the U.S., albeit peaking at 92% of the levels across the Atlantic. Due to falling working hours in Europe relative to the U.S. since the 1980s, relative output per hour continued to rise until the mid-1990s, peaking at 105% of the U.S. level. However, since their respective zeniths, both relative productivity measures have collapsed (Chart II-10, top panel). Chart II-10Another Symptom Of Europe's Misallocation Of Capital In The 2000s Another Symptom Of Europe's Misallocation Of Capital In The 2000s Another Symptom Of Europe's Misallocation Of Capital In The 2000s These collapses are in fact worse than Japan’s performance since its lost decades began. As the second panel of the chart shows, since the early 1990s, Japan’s relative output per hour and per worker have flattened – not declined – at around 65% and 72%, respectively, of U.S. levels. Instead, relative European productivity levels are currently converging toward Japanese levels (Chart II-10, third and fourth panels). The particularly poor level of European asset utilization and productivity principally reflects the duality between the peripheral as well as French economies on one side, and Germany as well as the Netherlands on the other side. The exceptionally large capital stock outside of Germany is a legacy of the years directly after the euro’s introduction. Back then, the ECB kept rates low to help Germany, the then-sick man of Europe. These rates were too low for the rest of Europe, encouraging large capital stock build-ups. Moreover, this capital was misallocated, as demonstrated by the tepid growth of output per hour and output per capita in Europe post 2000. Since funds were poorly allocated, the output-to-capital ratio in the periphery collapsed. In other words, the peripheral capital-stock-to-GDP ratios continued rising because the denominator, GDP, lagged. An additional problem for Europe’s asset utilization has been its large manufacturing sector. Even after declining, 20% of Europe’s GDP still comes from the secondary sector versus less than 12% in the U.S. (Chart II-11). This has two consequences for Europe’s asset utilization relative to the U.S. First, a large manufacturing sector requires a much larger asset base than a large service or tech sector. Second, the manufacturing sector is more exposed to competition from emerging markets than the tech sector, or than the domestically-focused service sector. Chart II-11Europe Is Left Exposed To EM Competition Europe Is Left Exposed To EM Competition Europe Is Left Exposed To EM Competition In other words, not only has the U.S. experienced less capital misallocation than a large swath of the European economy, it has also re-aligned its economy to make it more robust in the face of competition from emerging economies, while Europe mostly has not. Consequently, hurt by foreign competition and unable or unwilling to re-invent itself, Europe has been left with dwindling relative productivity levels and poor degrees of asset utilization and returns. Why Did The U.S. Economy Transition Better than Europe To A Globalized World? There are many reasons why the U.S. has maintained higher RoAs and has been more successful at transitioning away from a manufacturing-led economy than the euro area. First, the level of product and service market regulation in Europe is highly punitive. As Chart II-12 illustrates, like Japan, most euro area countries fare poorly in the World Bank’s Ease of Doing Business survey. In fact, Italy scores even lower than China! Meanwhile, the U.S. ranks near the top, not far from Singapore. This means that starting new businesses, competing, and so on is easier in the U.S. than in Europe, helping foster a greater level of entrepreneurialism. Consequently, established businesses have been able to maintain the status quo longer in Europe than in the U.S., preventing creative destruction from purging the system of bad assets. Chart II-12 Second, most large euro area economies are burdened by heavy taxes. As Chart II-13 shows, while the U.S. public sector extracts taxes equal to 27.1% of GDP, German, Italian and French taxes equal 37.5%, 42.4% and 46.2% of GDP, respectively, well above the OECD average of 34.2%. Such high levels of taxation disincentivize risk-taking. Lower levels of risk taking by individuals further prevented the degree of creative destruction necessary for Europe to better use its capital stock. Chart II-13 Third, and linked to the previous point, government spending equals 34.9% of GDP in the U.S., compared to 48.2% and 56.0% in Italy or France, respectively. A large government has historically stifled innovation and favored the status quo. By no means does this implies that the U.S. system is free of imbalances, but it highlights that compared to two of the three largest European economies, the U.S. public sector has had a less deleterious impact on growth conditions and entrepreneurialism. Moreover, Italy and France have been in deep need of structural reforms that have been lacking. On this front, while the outlook is improving in France under Macron’s presidency, Italy remains mired in immobilism. Europe has too large a pool of assets to make any additional investments profitable, especially in light of its poor demographic profile. Fourth, the financing structure in the U.S. favors investing in new businesses and industries, especially when compared to the euro area. Equities represent 78% of the capital structure of nonfinancial corporations in the U.S. while they represent only 61% in the euro area. Moreover, within debt-financing, capital markets account for 68% of sourced funds in the U.S. compared to 28% in the euro area. In fact, junk bond market capitalization only accounts for 2.2% of GDP in Europe compared to 6.0% in the U.S. This suggests that financing risky ventures – and entrepreneurialism is inherently risky – is tougher in Europe than in the U.S. In fact, as a share of GDP, the European venture capital business is less than a sixth the size of the U.S.’s (Chart II-14), a gap that has existed for more than 30 years. Chart II-14U.S. Financing Allows For Greater Risk Taking U.S. Financing Allows For Greater Risk Taking U.S. Financing Allows For Greater Risk Taking With all these hurdles, it is unsurprising that Europe has taken more time to make its economy more dynamic in the globalized economy of the 21st century. It also explains why Europe might be suffering more from EM competition than the U.S. Interestingly, this last point may be changing as U.S. voters seem to want to move back toward a larger manufacturing sector. This transition is unlikely to happen without more protectionism. This is a topic for another report. Is Europe Doomed To Japanification… Or Worse? It is easy to see why Europe cannot hope to grow as fast as the U.S., and therefore why the ECB will not be able to lift rates as high as the Fed and why bund yields are likely to lag Treasurys for years to come. Europe has a much more dire demographic profile than the U.S. It needs to purge its capital stock and invigorate its economy through reforms, a smaller public sector, and more diversified financing channels. But can the euro area fare better than Japan has over the past 30 years? On three fronts, the euro area looks better than Japan. First, as Chart II-15 shows, the overall European nonfinancial private sector entered its crisis in 2008 with lower leverage than Japan’s in the early 1990s. Additionally, European stocks were much cheaper in 2007 than the Nikkei was in 1989 (Chart II-16, top panel). Even Spanish real estate was more reasonably valued in 2007 than Japanese real estate in the early 1990s (Chart II-16, bottom panel). This combination means that now that the acute part of the crisis is over, the hole in the European private sector’s balance sheet is much smaller than the one Japan needed to plug 30 years ago. Thus, from a balance-sheet perspective, the need to rebuild savings is lower in Europe than Japan, and we could expect the current period of elevated savings to be shorter in the euro area than it has been in Japan. Chart II-15 Chart II-16...And European Assets Were Not As Expensive As Japanese Ones At The Onset Of The Crisis ...And European Assets Were Not As Expensive As Japanese Ones At The Onset Of The Crisis ...And European Assets Were Not As Expensive As Japanese Ones At The Onset Of The Crisis   Second, despite former ECB President Jean-Claude Trichet’s policy mistake of raising interest rates in 2011, the ECB was much quicker to implement extreme easing policy measures than the Bank of Japan was in its day. It took 10 years for the BoJ to cut rates to zero after the Nikkei peaked in December 1989. It took one year for the ECB to do so after stock prices peaked in 2007. It took nine years for the BoJ to expand its balance sheet aggressively, but it took less than two years for the ECB to do so. One of the key benefits of this greater European proactivity has been to keep European inflation expectations much higher than in Japan, curtailing real interest rates in the process. Third, Europe purged economic excesses much more quickly than Japan. The Japanese unemployment rate increased from 2% to 6% between 1990 and 2010. In peripheral Europe, where the worst pre-crisis excesses existed, unemployment rose from 7.5% in 2008 to 18% in 2013 (Chart II-17, top panel). Meanwhile, real wages never adjusted in Japan, but fell 27.0% at their worst in Spain and 32.5% in Greece (Chart II-17, bottom panel). Moreover, the Rajoy reforms in Spain and the Macron reforms in France show that outside of Italy, European governments have been reforming their economies faster than Japan did after the bubble burst in 1990. Chart II-17Bigger Labor Market Purge In Europe Than Japan Bigger Labor Market Purge In Europe Than Japan Bigger Labor Market Purge In Europe Than Japan However, on three fronts Europe is faring worse than Japan. First, up until the last 10 years, Japan benefited from a robust global economy where trade grew strongly. Europe is entering its second decade of low growth in an environment where global economic activity is much weaker, as potential U.S. GDP growth has slowed and China is not growing at a double-digit pace anymore. Moreover, budding protectionism in the U.S. is creating another hurdle for European economic output. Second, the excess capital stock in the European periphery is in fact greater than was the case in Japan in 1990. This suggests that the periphery needs to curtail investments by a greater margin than Japan did. Consequently, peripheral growth will continue to exert downward pressure on aggregate European activity for an extended period. Third, the European fiscal response will not match Japan’s. Investors often decry Japan’s large government debt of 238.2% of GDP as a sign of profligacy. It is not. It is mainly a mirror image of the private sector’s savings surplus. The Japanese government’s ability to run large deficits has prevented a larger fall in output – one that would have equaled the annual savings of the private sector. Without the government’s dissaving, the Japanese private sector would have found its debt load even more onerous to service, and the need to curtail spending would have been even greater as economy-wide cash flows would have been even smaller. Europe does not have a unified fiscal authority that can run such large-scale deficits. Instead, each nation’s government has a limited capacity to accumulate debt as investors worry that overly-indebted governments may very well redenominate what they have borrowed in much weaker currencies than the euro. This risk is made even greater by the fact that there is no euro-area wide deposit insurance scheme. Since Italian and Spanish banks hold large amounts of BTPs and Bonos, respectively, a so-called doom-loop exists that links the health of banks in those countries to the health of their governments, further limiting the public sector’s ability to act as a spender of last resort. This makes the efforts of the private sector in Italy, France, and Spain to increase its savings and bring down its excess capital stock more difficult, and thus, likely to last longer. Even if 10 years after the crisis first emerged, Europe has done more to purge its economy from its pre-crisis excesses than Japan had after its first lost decade, a lack of unified fiscal lever in Europe nullifies this positive. Thus, so long as the European integration efforts remain on the backburner, euro area growth, inflation, and interest rates will continue to look more like Japan’s have over the past 30 years than the U.S. This is likely to cause a big problem once the next recession emerges. Europe will enter that slowdown without any ammunition to reflate growth. Therefore, the next recession is likely to prove very deflationary and test the recent improvement in support for the euro seen across all euro area nations (Chart II-18). If the euro area survives this crisis, and we suspect it will, the probability of a fiscal union will only grow.2 After all, it has been through various crises that Europe has moved closer together, and the rise of a multipolar geopolitical environment dominated by large countries makes this imperative ever more vital. Chart II-18Support For The Euro Is Resilient Support For The Euro Is Resilient Support For The Euro Is Resilient Bottom Line: We expect European growth and inflation to continue to lag well behind the U.S. for years to come if not a full decade. Ultimately, bringing down the expensive capital stock in the European periphery will be a slow process, especially if governments remain tight fisted. Investment Implications First, core euro area interest rates are likely to remain well below U.S. levels. As long as the European private sector pares back investments in order to normalize its capital stock-to-GDP ratio - a phenomenon that will be most pronounced in the periphery and France - European growth and inflation will lag behind the U.S. This also means that as long as European governments remain shy spenders and do not compensate for the lack of spending from the private sector, in the euro area periphery, European banks will suffer from depressed net interest margins and be structural underperformers. Second, the euro is likely to experience a structural upward drift. The euro is trading at a 10.5% discount to its purchasing power parity. Moreover, high private sector savings not only weigh on inflation, they will also push Europe’s net international investment position higher via an accumulated current account surplus. Both these factors are long-term bullish for the euro. Moreover, the fact that the euro area will soon become a net creditor nation, along with a lack of room to stimulate growth via monetary easing in times of recessions, means that the euro could increasingly become a counter-cyclical currency like the yen. So long as the European integration efforts remain on the backburner, euro area growth, inflation, and interest rates will continue to look more like Japan’s have over the past 30 years than the U.S. Third, European equities are trading at a discount to U.S. equities, but we do not think this guarantees long-term outperformance. European equities are cheap because European growth prospects are poor. If Japan is any guide, European stocks may be set to continue underperforming. This is especially true as financials are over-represented in European equity benchmarks, and banks stand at the epicenter of the European economic malaise. Fourth, European stocks will remain slaves to the global business cycle. Since the crisis, European growth has become hypersensitive to global growth, making European equities very responsive to the global business cycle. The same phenomenon happened in post-1990 Japan. In other words, the beta of European stocks is likely to continue to rise. This phenomenon could be exacerbated if the euro indeed does become a counter-cyclical currency, in which case the euro and European equities would become negatively correlated, like the yen and the Nikkei. Finally, the period from 1999 to 2005 showed how ECB policy targeted at supporting Germany resulted in imbalances that boosted real estate and equity returns in the periphery – in Spain and Ireland in particular. Today, the periphery is the worst offender when it comes to poor bank health and private sector balance sheet rebuilding. This means that the ECB is likely to keep monetary conditions too accommodative for Germany, where balance sheets are more robust and where the capital stock is not as excessive. As a result, financial market plays linked to German real estate are likely to continue outperforming other European domestic plays. They therefore warrant an overweight within European portfolios. Mathieu Savary Vice President The Bank Credit Analyst   Footnotes 1 Please see Global Asset Allocation Special Report "Euro Area Banks: Value Play Or Value Trap?" dated December 14, 2018, available at gaa.bcaresearch.com 2 The European Commission Eurobarometer Surveys show that Europeans overwhelmingly see Europe as a peace project and as a way to maintain a voice in a world dominated by huge players like the U.S., China, or Russia, a world where France, Germany, or Italy individually are marginal players. In 2016, the U.K. population did not share this opinion. Moreover, even after what amounts to a depression, the support for the euro continues to rise in Greece, showing the growing commitment of Europeans to the euro, and the resilience of this commitment to economic shocks.

Highlights The recent dovish shift in tone from central banks around the world is here to stay this year, providing support for global growth. As a result, stock prices will benefit from a combination of easy policy and rebounding activity, while safe-haven yields will grind higher. The recent deterioration in profit margins is not due to rising costs but reflects weaknesses in pricing power. Pricing power is pro-cyclical: If global growth improves and the dollar weakens, margins should recover. Overweight financials and energy. We are upgrading European equities to neutral, and placing them on a further upgrade watch. Feature Easy Does It The global monetary environment has eased over the past four months. Some major central banks like the Federal Reserve and the Bank of Canada have backed away from tightening. Others, like the Bank of Japan, the Reserve Bank of Australia, the Reserve Bank of New Zealand and the Swedish Riksbank have provided very dovish forward guidance. And one major policy setting institution – the European Central Bank – has even eased policy outright by announcing a large-scale injection of liquidity in the banking sector through its TLTRO-III operation that will begin in September. This phenomenon is not limited to advanced economies. Important EM central banks are also targeting easier liquidity conditions. The Reserve Bank of India has cut interest rates by 50 basis points; the Monetary Authority of Singapore is now targeting a flat exchange rate; and the Bank of Korea has issued a somewhat dovish forward guidance. Most importantly, Chinese policymakers are once again forcing debt through the system, with total social financing flows amounting to RMB 2.9 trillion last quarter, more than the RMB 2.4 trillion pumped through the economy in the first quarter of 2016. These reflationary efforts will bear fruit. Policy easing, especially when it relies as largely on forward guidance as the current wave does, should result in lower forward interest rates. And as Chart I-1 illustrates, when a large proportion of global forward rates are falling, a rebound in global economic activity typically follows. This time will not be different. Chart I-1Monetary Guardians Are Coming To The Rescue Monetary Guardians Are Coming To The Rescue Monetary Guardians Are Coming To The Rescue The S&P 500 and global equities have already rebounded by 18.9% and 17.2%, respectively since late December. Have markets already fully discounted the growth improvement that lies ahead, leaving them vulnerable to disappointments? Or do global stocks have more upside? While a rest may prove necessary, BCA anticipates that global equity prices have more upside over the coming 12 months. Are Central Banks About To Abandon Their Newfound Dovish Bias? We sincerely doubt it. Reversing the recent tone change soon would only hurt the battered credibility that central banks are fighting so hard to maintain. In the case of the U.S., the most recent FOMC minutes were clear: The Fed does not intend to tighten policy soon, even if growth remains decent. The minutes confirmed the idea we espoused last month, that FOMC members are focused on avoiding a Japan-like outcome for the U.S. where low expected inflation begets low realized inflation. Such an outcome would greatly increase the probability that an entrenched deflationary mindset develops in the U.S. in the next recession. As a result, we anticipate that the Fed will refrain from tightening policy until inflation expectations move back up toward their historical range (Chart I-2). Further justifying the Fed’s new stance, a small rebound in productivity is keeping unit labor costs at bay, despite a pick-up in wages. This is likely to put a lid on core inflation for now (Chart I-3). Chart I-2Inflation Expectations: Too Low For The FOMC's Comfort Inflation Expectations: Too Low For The FOMC's Comfort Inflation Expectations: Too Low For The FOMC's Comfort Chart I-3A Whiff Of Disinflation A Whiff Of Disinflation A Whiff Of Disinflation There is little reason for the ECB to adopt a more hawkish stance either. The euro area PMIs have stabilized but are still flirting with the boom/bust line. Realized core inflation is a paltry 0.8% and the ECB’s own forecast is inconsistent with its definition of price stability, which dictates that the inflation rate should be “below but close to 2% over the medium term.” Our ECB Monitor captures these dynamics, remaining in the neutral zone (Chart I-4).   In China, the case for quickly removing credit accommodation is weak. Property developer stocks have rebounded 41% from their October lows, but sales of residential floor space remain soft, keeping real estate speculation in check. Meanwhile, our proxy for the marginal propensity to consume of Chinese households – based on the ratio of demand deposits to time deposits – continues to deteriorate (Chart I-5). The recent pick up in credit growth should put a floor under those trends, but it will take some time before these variables overheat enough to call for policy tightening. Chart I-4Our ECB Monitor Supports An ECB Standing Still Our ECB Monitor Supports An ECB Standing Still Our ECB Monitor Supports An ECB Standing Still Chart I-5Key Domestic Variables Argue Against Tightening Policy In China Key Domestic Variables Argue Against Tightening Policy In China Key Domestic Variables Argue Against Tightening Policy In China   Bottom Line: The three most important policymakers in the world are not set to suddenly slam on the brake pedal. As a result, the global policy backdrop will remain accommodative for at least two to three quarters. The few economic green shoots observed around the world should therefore blossom into a full-fledge global growth pick-up. From Green Shoots To Green Gardens If central banks adopt an easier bias but global growth is slowing sharply without any end in sight, stock prices are unlikely to find a floor. After all, stock prices represent the discounted value of future cash flows. If those cash flows are expected to decline at a faster pace than the risk-free rate, then stock prices can fall – even if policy is becoming more accommodative. However, if economic activity is stabilizing, easier policy should generate substantial equity gains. Stimulative financial conditions will result in an improvement in global activity indicators, including emerging economies (Chart I-6, top panel). This is very important as emerging markets were at the epicenter of the slowdown in global trade, and because they historically lead global industrial activity (Chart I-6, bottom panel). The few economic green shoots observed around the world should therefore blossom into a full-fledge global growth pick-up. Policy easing in China is of particular significance. Our Chinese activity indicator is still slowing, but BCA’s Li-Keqiang Leading Indicator, which mostly tracks developments in the credit sector, has stabilized (Chart I-7, top panel). The rebound in the credit impulse also points to an acceleration in Chinese nominal manufacturing output (Chart I-7, bottom panel). This should lift Chinese imports, resulting in a positive growth impulse for the rest of the world. Chart I-6The Dance Of FCI And Activity The Dance Of FCI And Activity The Dance Of FCI And Activity Chart I-7Chinese Industrial Activity Will Rebound Soon Chinese Industrial Activity Will Rebound Soon Chinese Industrial Activity Will Rebound Soon   At the moment, the euro area remains weak, but it will become a key beneficiary of improving growth. As the top panel of Chart I-8 illustrates, the Eurozone’s exports to China tend to follow the trend in the Chinese Adjusted Total Social Financing impulse. Moreover, European exports to the rest of the world are set to enjoy a recovery, as highlighted by the upturn in the diffusion index of our Global Leading Economic Indicator (Chart I-8, bottom panel). This external-sector improvement is happening as the euro area domestic credit impulse is rebounding, and as the region’s fiscal thrust increases from roughly zero to 0.4% of GDP. In the U.S., it is unlikely that 2019 growth will top that of 2018, but activity should nonetheless rebound from a lukewarm first quarter. Importantly, the fed funds rate is holding below its equilibrium (Chart I-9). Additionally, household fundamentals remain solid. A tight labor market means that wages have upside and household debt levels and debt servicing costs are all well behaved relative to disposable income (Chart I-10). Moreover, housing dynamics are generally stronger than reported by the press, as mortgage applications for purchases are making cyclical highs and the NAHB Homebuilder confidence index is rebounding (Chart I-11). Offsetting some of these positives, capex intentions – a robust forecaster of actual corporate investments – have rolled over from their heady mid-2018 levels. Even so, they remain consistent with positive capex growth. Also, U.S. fiscal policy is becoming increasingly less growth-friendly starting in mid-2019. Netting it all out, U.S. growth should remain above-trend, at about 2.5%. Chart I-8Europe Will Benefit From Stabilizing Growth Elsewhere Europe Will Benefit From Stabilizing Growth Elsewhere Europe Will Benefit From Stabilizing Growth Elsewhere Chart I-9U.S. Policy Remains Accommodative U.S. Policy Remains Accommodative U.S. Policy Remains Accommodative   Chart I-10U.S. Households Are Doing Alright U.S. Households Are Doing Alright U.S. Households Are Doing Alright Chart I-11Forward-Looking Housing Indicators Point To A Pick-Up Forward-Looking Housing Indicators Point To A Pick-Up Forward-Looking Housing Indicators Point To A Pick-Up Bottom Line: While U.S. growth may be weaker than in 2018, it should not fall below trend. Meanwhile, Chinese credit trends suggest that growth there should clearly pick up in the coming months, which should also lead to stronger activity in Europe. In other words, exactly as central banks have removed policy constraints, global growth is set to re-accelerate. This is a positive backdrop for risk assets over the coming 12 months.   What Does It Mean For Asset Prices? Simply put, a dovish shift in policy along with a tentative stabilization in growth should result in both higher stock prices and rising safe-haven bond yields. First, a rebound in global economic activity means that depressed profit growth expectations could easily be bested (Chart I-12, top panel). Bottom-up estimates point to EPS growth of 3.4% in the U.S. and 5.3% in the rest of the world in 2019, using MSCI data. However, profits are extremely pro-cyclical, and a combination of easy financial conditions and improving growth conditions in the second half of the year should result in better-than-expected earnings. Chart I-12Profit Expectations Are Low Profit Expectations Are Low Profit Expectations Are Low Second, the Fed is extending its pause, as other global central banks are also adopting more accommodative policies. This implies that global real interest rates, both at the short- and long-end of the curve, will remain below equilibrium for longer than would have been the case if policy had remained on its previous path. Consequently, not only do lower real rates decrease the discount factor for stocks, they also imply a longer business cycle expansion. This should result in narrower risk premia for stocks and higher multiples. Since they offer cheaper valuations than those in the U.S., international equities may stand to benefit more from policy-led multiple expansion (Chart I-12, bottom panel). Third, the global duration indicator developed by BCA’s Global Fixed Income Strategy service is forming a bottom.1 This gauge – levered to global growth variables like the Global ZEW growth expectations survey, our Global Leading Economic Indicator and the Global LEI’s diffusion index – has perked up in response to green shoots around the globe. An upturn in global safe-haven yields is imminent (Chart I-13). Additionally, the global Policy Uncertainty Index is currently recording very high readings, congruent with depressed yields (Chart I-14). A benign resolution to the Sino-U.S. trade tensions along with the low likelihood of the implementation of a No-Deal Brexit should push this indicator down, lifting yields in the process. Chart I-13Global Dynamics Argue For Fading The Bond Rally Global Dynamics Argue For Fading The Bond Rally Global Dynamics Argue For Fading The Bond Rally Chart I-14Policy Uncertanity Is At An Apex: Look The Other Way Policy Uncertanity Is At An Apex: Look The Other Way Policy Uncertanity Is At An Apex: Look The Other Way   Fourth, while we expect the Fed to stay on pause for the remainder of 2019 and probably through the lion’s share of 2020 as well, this is a more hawkish forecast than what the market is currently pricing in (Chart I-15). As we argued last month, a fed funds rate that turns out to be higher over the next year than what is currently discounted often results in the underperformance of Treasurys relative to cash. Finally, a rebound in global growth, even if the Fed proves more hawkish than the market anticipates, generally pushes the dollar lower (Chart I-16). Since speculators currently hold large net short bets on the euro, the AUD, the CAD, and so on, the probability is high that this historical pattern will assert itself. The recent period of dollar strength is unlikely to last more than a couple of weeks. A weak dollar, easy policy and rebounding growth should boost commodity prices, especially metals and oil. The latter should benefit most from this set up as the end of the waivers of U.S. sanctions on Iran will constrain the availability of crude in international markets. Chart I-15 Chart I-16The Dollar Last Hurrah Will End Very Soon The Dollar Last Hurrah Will End Very Soon The Dollar Last Hurrah Will End Very Soon   Rebounding global growth should also allow equity prices to be resilient in the face of rising bond yields, up to a point. When yields and inflation expectations are low, multiples and equity prices tend to move in tandem. This is because in an environment where central banks are frightened by deflationary risks, monetary authorities do not lift rates as quickly as nominal activity would warrant. Thus, improving nominal growth lifts the growth component of equity multiples more than it raises yields. In other words, we expect yields and stocks to rise together because low but rising inflation expectations, but not surging real rates, will drive the upside in bond yields. Obviously, this cannot last forever. Once the Fed starts suggesting that rates will rise again, and the entire yield curve moves closer to neutral, higher yields will curtail equity advances. This is a constructive cyclical setup; but the tactical environment is murkier. The problem is that equity prices have already moved up significantly over the past four months. With volatility across asset classes having once again plunged toward historical lows, risk assets display a high degree of vulnerability to disappointing economic data. This means that unless growth rebounds strongly and quickly, stocks could experience a short-term correction in the coming months. While staying overweight equities, it is nonetheless prudent to buy some protection. Investors should also wait on the sidelines to deploy any excess cash. Rebounding global growth should also allow equity prices to be resilient in the face of rising bond yields, up to a point. Bottom Line: The current environment is favorable for risk assets on a cyclical basis. Low real rates will not only continue to nurture the nascent improvement in the global economy. They also imply lower discount rates. Meanwhile, improving economic activity and a decline in policy uncertainty will push safe-haven yields higher. Consequently, it remains sensible to be long stocks and underweight bonds for the remainder of the year, even if the risk of a short-term stock correction has risen. Within fixed-income portfolios, a below-benchmark duration makes sense, especially as oil prices are rising, Sino-U.S. trade negotiations should end in a benign outcome, and a No-Deal Brexit remains unlikely. Margins Are The Greatest Risk At the current juncture, the biggest risk for stocks is that profits fall short of depressed analysts’ estimates for 2019 – not because revenue growth disappoints, but because profit margins contract. Our U.S. Equity Sector Strategy service has recently highlighted that the S&P 500 operating earnings margin stands at 10.1% after having peaked at 12% in Q3 2018 (Chart I-17).2 Despite this decline, margins remain both elevated by historical standards and above their long-term upward-sloping trend. As Chart I-18 illustrates, the decline in margins is not an S&P 500-only phenomenon: It is an economy wide one as well, as the pattern is repeated using national accounts data. Chart I-17Will This Margin Deterioration Continue? Will This Margin Deterioration Continue? Will This Margin Deterioration Continue? Chart I-18Margins: All About Labor Costs Versus Selling Prices Margins: All About Labor Costs Versus Selling Prices Margins: All About Labor Costs Versus Selling Prices   At first glance, the Fed’s current pause may undermine profit margins. As Chart I-19 shows, when the unemployment rate stands below NAIRU, on average, wages grow faster than when the labor market is not at full employment. Since the unemployment gap stands as -0.8% today, we are likely to see continued wage pressures in the U.S. economy. Chart I-19Wages Have Upside Wages Have Upside Wages Have Upside The problem with this story is that productivity has been accelerating – from a -0.3% annual rate in the second quarter of 2016 to 1.8% in the fourth quarter of 2018. Because wage inflation did not experience as large a change, unit labor cost inflation is still growing at 1% annually, as they did in Q2 2016. In fact, real unit labor costs are currently contracting at a 0.4% pace. The pick-up in capex over the past three years suggests that productivity can continue to improve over the coming quarters. Consequently, as has been the case over the past two years, rising wages will only have a limited negative impact on margins. The key source of variance in profit margins has been, and will likely remain over the next year or so, corporate pricing power, which today stands at its lowest level since the deflationary episode of 2015-2016 (Chart I-20). As was the case back then, the slowdown in global growth has played a role, since it has resulted in falling global export prices. Not only do they affect foreign revenues for U.S. businesses, they also impact the price of goods sold at home, and thus have a broad impact on aggregate pricing power. Chart I-20Pricing Power Follows The Global Business Cycle Pricing Power Follows The Global Business Cycle Pricing Power Follows The Global Business Cycle Last year’s dollar strength amplified those headwinds. A strengthening dollar affects profitability through four channels. First, it negatively impacts global growth by tightening financial conditions for foreign borrowers who fund themselves in USD. They are thus more financially constrained when the dollar appreciates. Second, a strong dollar hurts commodity prices and industrial goods prices. Third, a strong dollar negatively impacts the competitiveness of U.S. firms, forcing them to cut their prices to stay competitive. Finally, a strong dollar hurts the translation of overseas earnings back into USDs. As a result, a strong dollar weighs on earnings estimates (Chart I-21).   Chart I-21The Dollar Amplified Margins Problems The Dollar Amplified Margins Problems The Dollar Amplified Margins Problems Since we anticipate global growth to improve and the greenback to buckle, the current pricing power problem faced by corporate America should fade and profit margins should rebound in the second half of 2019. This suggests that for now, declining profit margins remain a risk that needs to be monitored – not a base case to embrace. Our U.S. Equity Sector Strategy service has highlighted that the tech sector has the poorest earnings outlook within the S&P 500. An economic upswing could counteract some of the recent declines in tech margins, but the much more pronounced rise in labor costs in Silicon Valley than in other sectors suggests that tech profits could lag behind other heavyweights like financials and energy. Consequently, BCA recommends a neutral allocation to tech stocks. We instead recommend overweighting financials and the energy sector. Financials will benefit from an easy monetary policy setting that should help credit growth. Moreover, net interest margins are at cycle highs of 3.5%, as banks have prevented interest costs on deposits from rising in line with short rates. Finally, buybacks by financial services firms are rising and will likely battle the tech sector’s buybacks for the pole position this year (Chart I-22).3 Chart I-22Why Are We Neutral On Tech? Why Are We Neutral On Tech? Why Are We Neutral On Tech? Our positive stance on energy stems from undue pessimism surrounding the sector. Bottom-up analysts currently pencil in such a large contraction in earnings for this group that, according to their forecasts, energy will curtail 2019 S&P 500 earnings by 18%. With WTI prices back above $65/bbl, rising per-well productivity and easing financing costs, the hurdle to beat is already low. Moreover, the end of U.S. waivers on Iranian sanctions further supports oil prices. In this context, if global growth rebounds and the dollar depreciates, energy stocks could catch fire. Bottom Line: The biggest risk to our positive stance on equities is that earnings are dragged down by declining margins. While the recent softness in margins is concerning, it does not reflect an increase in labor costs. Instead, it is a consequence of eroding pricing power. Falling pricing power is itself a symptom of the slowdown in global growth and a stronger dollar. As both these ills pass, margins should recover in the second half of 2019. Within equities, we prefer financials and energy, as their earnings prospects outshine tech stocks. Upgrading European Equities To Neutral, And Looking For More For equity investors competing against a global benchmark, there is a simple way to express the view that global growth will rebound, safe-haven yields have upside, the dollar will weaken, and that profit margins are a risk to monitor. It is to abandon underweight allocations to European equities and overweight positions to U.S. stocks. This month, we are upgrading European equities to neutral and downgrading U.S. stocks to neutral. Even after this upgrade, we are putting European equities on a further upgrade watch. First, the euro area is much more sensitive than the U.S. to Chinese growth. This also has implication for equities. As Chart I-23 shows, when the ratio of M1 to M2 money supply in China perks up, as it is currently doing, European stocks end up outperforming their U.S. counterparts. This is because the M1-to-M2 ratio ultimately reflects the growth of demand deposits relative to savings deposits in the Chinese banking sector. It therefore informs how spending is likely to evolve. Currently, China’s reflationary efforts point toward a pickup in spending that should lift European exports, and European profits as well. Chart I-23Monetary Dynamics In China Favor Fading Euro Area Bearishness Monetary Dynamics In China Favor Fading Euro Area Bearishness Monetary Dynamics In China Favor Fading Euro Area Bearishness Second, European exports have upside, and unsurprisingly, the bottoming in the BCA Boom/Bust indicator – which captures global growth dynamics beyond just China – is also flagging the end of European equity underperformance (Chart I-24, top panel). Moreover, if the global reflationary period is sustained, the decline in forward interest rates will reverse. This too is consistent with a period of outperformance for European equities (Chart I-24, bottom panel). Third, our overweight stance on financials relative to tech equates to European equities beating their U.S. counterparts. This simply reflects the fact that financials constitute 17.9% of the MSCI euro area index, while tech stocks account for 9.2%. The same sectors represent 12.9% and 26.8% of the U.S. market, respectively. Not only are European banks trading at 0.6-times book value compared to 1.2-times for U.S. lenders, but European banks stand to benefit more than U.S. banks from rising bond yields as they garner a larger share of their income from lending activity. Fourth, European profit margins are toward the bottom third of their distribution relative to U.S. profit margins. As Chart I-25 shows, European profit margins tend to rise when euro area unit labor costs lag U.S. ones. Since the euro area output gap is not as positive as that of the U.S., it is unlikely that European wages will outpace U.S. wages this year. Also, since European stocks are more heavily weighted toward industrials, materials and energy, the sectors that suffered the greatest loss of pricing power during the global economic slowdown, pricing power in Europe could rebound more strongly than in the U.S. This too should flatter European profit margins relative to the U.S. Chart I-24European Equities To Benefit From Rebounding Global Growth European Equities To Benefit From Rebounding Global Growth European Equities To Benefit From Rebounding Global Growth Chart I-25European Profit Margins Can Experience A Further Cyclical Lift European Profit Margins Can Experience A Further Cyclical Lift European Profit Margins Can Experience A Further Cyclical Lift   Finally, even after adjusting for sectoral composition, European equities trade at a discount to U.S. stocks. On an equal-sector basis, the 12-month forward P/E ratio is 14.2, and the price-to-book ratio is 2.0. For the U.S., the same multiples stand at 20.7 and 4.0, respectively. This means that European stocks are not yet pricing in an improving outlook. Be warned: The positive outlook for European equities relative to the U.S. is a cyclical story. As Section II of this report argues, poor demographics and an excessively large capital stock suggest that European rates of return will continue to lag the U.S. As a result, the return from investing in European stocks is unlikely to beat that of the U.S. beyond 12 to 18 months. Bottom Line: Within a global equity portfolio, we are upgrading the euro area from underweight to neutral at the expense of the U.S., which moves to neutral. We are also putting European equities on a further upgrade watch. Mathieu Savary Vice President The Bank Credit Analyst April 25, 2019 Next Report: May 30, 2019 II. Europe: Here I Am, Stuck In A Liquidity Trap An aging population, a banking sector in poor health, and a private sector focused on building up savings are the key factors undermining euro area growth on a structural basis. A large manufacturing sector makes the euro area vulnerable to EM competition. Unlike the U.S., the region’s tech sector is held back by regulatory burdens, taxes and heavy dependence on bank funding. The euro area growth faces decades of low growth and inflation. Euro area rates will stay depressed, but paradoxically, the euro can still experience structural appreciation. Euro area equities are cheap for a good reason, and banks will continue to weigh on performance. Over the past 10 years, the euro area has gone through a sovereign debt crisis, a double-dip recession, persistent below-target inflation, and most recently, yet another major growth slowdown. Moreover, this economic malaise materialized despite highly stimulative monetary policy, including negative interest rates. The ongoing economic weakness has raised the specter that the euro area is the new Japan. Nearly three decades after the bursting of the Nikkei bubble, the Land of the Rising Sun remains mired in low growth and mild but persistent deflation. Consequently, charts showing that European policy rates or bond yields are tracking Japanese developments with a 17-year lag (Chart II-1) have not only become commonplace, they elicit fears that European growth, interest rates and asset valuations will lag the rest of the world for decades to come. Chart II-1Europe Is Following The Japanese Example Europe Is Following The Japanese Example Europe Is Following The Japanese Example In this piece, we discuss the various forces that explain why the euro area economy has been so weak this decade, and why such low interest rates have had so little impact on growth. We also study what sets the U.S. and euro area apart, and whether or not Europe will follow the trail blazed by Japan nearly 30 years ago. The Three Headwinds Three ills have kept European growth particularly depressed this cycle and are likely to remain significant headwinds into the foreseeable future: demographics, the banking sector’s poor health, and nonfinancial private sector balance sheet cleansing. 1)   Demographics This is the most well understood and acknowledged problem impacting Europe today. Since 2008, the European population has grown by 2%, or only 0.2% a year, with the working age population having peaked around that year. Going forward, the picture will only deteriorate: The UN expects Europe’s population to contract by 12% over the next 27 years, and the working age population to fall by 15%. This also means that the dependency ratio – the number of individuals aged less than 15 and above 65 per 100 working-age people – will approximately double over the coming 40 years. This is a clear parallel with Japan. As Chart II-2 illustrates, Europe’s population, the number of working-age individuals and the dependency ratio are all tracking Japan with a 17-year lag. Like Japan, Europe’s trend growth will thus only deteriorate further. Not only will Europe not be able to add as many workers as the U.S. to its total, but it will need to build even fewer schools, malls, office buildings or units of housing. Consequently, both the supply and demand sides of the economy will lag due to this factor alone. 2)   Banking Sector Health The poor health of the euro area banking sector is well known. BCA’s Global Asset Allocation service published an in-depth analysis of the European banking sector last December.4 The piece demonstrated that European banks have been much slower to recognize non-performing loans, curtail credit and rebuild capital than their U.S. counterparts. U.S. bank loans to the private sector fell by 13% in the two years during the crisis, while in Europe, these same loans have only fallen by 2% since 2008. Euro area banks generally remain burdened with significant non-performing loans as a percentage of regulatory capital. Moreover, net interest margins are also dismal, implying that the income cushion against bad loans is thin. Consequently, outside of France, Finland and Germany, European banks have either not grown their loan books to the private sector or, as is the case with Spain, Portugal, and Ireland, these books are continuously shrinking (Chart II-3). Chart II-2Same Demography In Europe Now Than In Japan Then Same Demography In Europe Now Than In Japan Then Same Demography In Europe Now Than In Japan Then Chart II-3Peripheral Banks Continue To Curtail Credit Peripheral Banks Continue To Curtail Credit Peripheral Banks Continue To Curtail Credit   The poor health of the European banking system is now constraining the supply of new credit to the rest of the economy. This is a much bigger problem than is the case in the U.S. given that in Europe, 72% of corporate funding comes from the banking system while 88% of household liabilities are also funded this way. In the U.S., the share of bank funding for these sectors is 32% and 29%, respectively (Chart II-4). A weak euro area banking system prevents the nonfinancial private sector from growing as robustly as it could. Chart II-4 3)   Nonfinancial Private Sector Balance Sheet Cleanse Another major drag on European growth has been the continued efforts of the European private sector to rebuild its balance sheet. To use the terminology developed by our upcoming conference speaker Richard Koo, the euro area has been in the thralls of a powerful balance sheet recession. Households in the euro area, Japan and the U.S. are all accumulating more financial assets than liabilities. However, only in the U.S. is the nonfinancial corporate sector building more liabilities than it is accumulating assets (Chart II-5). In Japan and Europe, the nonfinancial corporate sector is also a source of savings for the economy. Moreover, in Europe, the government runs a much smaller financial deficit. The current account balance tells this story vividly. A country’s current account is equal to the private sector’s savings minus investment and minus government deficits. As Italy, Spain, and other peripheral economies increased their aggregate savings after 2008, their large current account deficits vanished. Meanwhile, the governments of countries like Germany or the Netherlands, which sported healthy public finances, did not increase their spending in a commensurate way. This adjustment transformed an overall euro area current account deficit of 1.5% in 2008 into a surplus of 3.0% of GDP today, sending some of Europe’s excess savings abroad. This mimics the post-1990 Japanese experience. In the U.S., where the private sector savings did not rise as durably as in Europe, the current account stopped improving meaningfully in 2010 (Chart II-6). Chart II-5European Businesses Are Savers, Like In Japan European Businesses Are Savers, Like In Japan European Businesses Are Savers, Like In Japan Chart II-6The Current Account Dynamics Epitomise The Savings Dynamics The Current Account Dynamics Epitomise The Savings Dynamics The Current Account Dynamics Epitomise The Savings Dynamics   A private sector squarely focused on rebuilding its balance sheet liquidity can lead to a liquidity trap. In this state, monetary policy can become ineffective as spending does not respond to lower interest rates. This is where Europe is currently stuck, explaining why the European Central Bank is finding that inflation and growth are not experiencing much lift, despite seemingly incredibly accommodative monetary conditions. Why Such An Urge To Save? The fact that the household sector is a net saver is not surprising, as this is a normal state of affairs across most economies. But why is the European nonfinancial corporate sector still trying to improve its balance sheet liquidity by accumulating more assets than liabilities? Like Japanese businesses 30 years ago, European firms have large debt loads. Another problem is the lack of capex opportunities in Europe. Why do we make this assertion? The return on assets in Europe has been at rock-bottom levels ever since the introduction of the euro (Chart II-7). In the decade from 1998 to 2008, this was a non-issue. Strong global growth flattered European sales, and easy access to credit meant that via rising leverage euro area-listed nonfinancial corporations were able to generate returns on equity comparable to U.S. firms (Chart II-8, top panel). Once European banks got cold feet and European nonfinancial businesses began focusing on deleveraging, the low level of return on assets became more apparent. Part of the problem is that European profit margins are much closer to Japanese than U.S. levels (Chart II-8, middle panel). Even more damning, asset turnover – how much sales are generated by a unit of assets – has been structurally lower in Europe than in both Japan and the U.S. for multiple decades (Chart II-8, bottom panel). Chart II-7Europe Suffers From A Lower RoA Europe Suffers From A Lower RoA Europe Suffers From A Lower RoA Chart II-8DuPont's Decomposition Shows Why The Euro Area RoA Is Poor DuPont's Decomposition Shows Why The Euro Area RoA Is Poor DuPont's Decomposition Shows Why The Euro Area RoA Is Poor   The first factor weighing on the level of asset utilization and returns in Europe is the elevated level of capital stock. As Chart II-9 illustrates, the capital stock as a share of output in Italy, Spain and France dwarfs that of Japan, China or the U.S. Even Germany’s capital stock, which stands well below that of other large euro area economies, is nearly 100 percentage points of GDP larger than the U.S’s. Europe has too large a pool of assets to make any additional investments profitable, especially in light of its poor demographic profile. Chart II-9 The second factor weighing on European asset utilization and returns is the poorer level of labor productivity. From the 1950s to the early 1980s, European GDP per worker rose relative to the U.S., albeit peaking at 92% of the levels across the Atlantic. Due to falling working hours in Europe relative to the U.S. since the 1980s, relative output per hour continued to rise until the mid-1990s, peaking at 105% of the U.S. level. However, since their respective zeniths, both relative productivity measures have collapsed (Chart II-10, top panel). Chart II-10Another Symptom Of Europe's Misallocation Of Capital In The 2000s Another Symptom Of Europe's Misallocation Of Capital In The 2000s Another Symptom Of Europe's Misallocation Of Capital In The 2000s These collapses are in fact worse than Japan’s performance since its lost decades began. As the second panel of the chart shows, since the early 1990s, Japan’s relative output per hour and per worker have flattened – not declined – at around 65% and 72%, respectively, of U.S. levels. Instead, relative European productivity levels are currently converging toward Japanese levels (Chart II-10, third and fourth panels). The particularly poor level of European asset utilization and productivity principally reflects the duality between the peripheral as well as French economies on one side, and Germany as well as the Netherlands on the other side. The exceptionally large capital stock outside of Germany is a legacy of the years directly after the euro’s introduction. Back then, the ECB kept rates low to help Germany, the then-sick man of Europe. These rates were too low for the rest of Europe, encouraging large capital stock build-ups. Moreover, this capital was misallocated, as demonstrated by the tepid growth of output per hour and output per capita in Europe post 2000. Since funds were poorly allocated, the output-to-capital ratio in the periphery collapsed. In other words, the peripheral capital-stock-to-GDP ratios continued rising because the denominator, GDP, lagged. An additional problem for Europe’s asset utilization has been its large manufacturing sector. Even after declining, 20% of Europe’s GDP still comes from the secondary sector versus less than 12% in the U.S. (Chart II-11). This has two consequences for Europe’s asset utilization relative to the U.S. First, a large manufacturing sector requires a much larger asset base than a large service or tech sector. Second, the manufacturing sector is more exposed to competition from emerging markets than the tech sector, or than the domestically-focused service sector. Chart II-11Europe Is Left Exposed To EM Competition Europe Is Left Exposed To EM Competition Europe Is Left Exposed To EM Competition In other words, not only has the U.S. experienced less capital misallocation than a large swath of the European economy, it has also re-aligned its economy to make it more robust in the face of competition from emerging economies, while Europe mostly has not. Consequently, hurt by foreign competition and unable or unwilling to re-invent itself, Europe has been left with dwindling relative productivity levels and poor degrees of asset utilization and returns. Why Did The U.S. Economy Transition Better than Europe To A Globalized World? There are many reasons why the U.S. has maintained higher RoAs and has been more successful at transitioning away from a manufacturing-led economy than the euro area. Europe has too large a pool of assets to make any additional investments profitable, especially in light of its poor demographic profile. First, the level of product and service market regulation in Europe is highly punitive. As Chart II-12 illustrates, like Japan, most euro area countries fare poorly in the World Bank’s Ease of Doing Business survey. In fact, Italy scores even lower than China! Meanwhile, the U.S. ranks near the top, not far from Singapore. This means that starting new businesses, competing, and so on is easier in the U.S. than in Europe, helping foster a greater level of entrepreneurialism. Consequently, established businesses have been able to maintain the status quo longer in Europe than in the U.S., preventing creative destruction from purging the system of bad assets. Chart II-12 Second, most large euro area economies are burdened by heavy taxes. As Chart II-13 shows, while the U.S. public sector extracts taxes equal to 27.1% of GDP, German, Italian and French taxes equal 37.5%, 42.4% and 46.2% of GDP, respectively, well above the OECD average of 34.2%. Such high levels of taxation disincentivize risk-taking. Lower levels of risk taking by individuals further prevented the degree of creative destruction necessary for Europe to better use its capital stock. Chart II-13 Third, and linked to the previous point, government spending equals 34.9% of GDP in the U.S., compared to 48.2% and 56.0% in Italy or France, respectively. A large government has historically stifled innovation and favored the status quo. By no means does this implies that the U.S. system is free of imbalances, but it highlights that compared to two of the three largest European economies, the U.S. public sector has had a less deleterious impact on growth conditions and entrepreneurialism. Moreover, Italy and France have been in deep need of structural reforms that have been lacking. On this front, while the outlook is improving in France under Macron’s presidency, Italy remains mired in immobilism. Fourth, the financing structure in the U.S. favors investing in new businesses and industries, especially when compared to the euro area. Equities represent 78% of the capital structure of nonfinancial corporations in the U.S. while they represent only 61% in the euro area. Moreover, within debt-financing, capital markets account for 68% of sourced funds in the U.S. compared to 28% in the euro area. In fact, junk bond market capitalization only accounts for 2.2% of GDP in Europe compared to 6.0% in the U.S. This suggests that financing risky ventures – and entrepreneurialism is inherently risky – is tougher in Europe than in the U.S. In fact, as a share of GDP, the European venture capital business is less than a sixth the size of the U.S.’s (Chart II-14), a gap that has existed for more than 30 years. Chart II-14U.S. Financing Allows For Greater Risk Taking U.S. Financing Allows For Greater Risk Taking U.S. Financing Allows For Greater Risk Taking With all these hurdles, it is unsurprising that Europe has taken more time to make its economy more dynamic in the globalized economy of the 21st century. It also explains why Europe might be suffering more from EM competition than the U.S. Interestingly, this last point may be changing as U.S. voters seem to want to move back toward a larger manufacturing sector. This transition is unlikely to happen without more protectionism. This is a topic for another report. Is Europe Doomed To Japanification… Or Worse? It is easy to see why Europe cannot hope to grow as fast as the U.S., and therefore why the ECB will not be able to lift rates as high as the Fed and why bund yields are likely to lag Treasurys for years to come. Europe has a much more dire demographic profile than the U.S. It needs to purge its capital stock and invigorate its economy through reforms, a smaller public sector, and more diversified financing channels. But can the euro area fare better than Japan has over the past 30 years? On three fronts, the euro area looks better than Japan. First, as Chart II-15 shows, the overall European nonfinancial private sector entered its crisis in 2008 with lower leverage than Japan’s in the early 1990s. Additionally, European stocks were much cheaper in 2007 than the Nikkei was in 1989 (Chart II-16, top panel). Even Spanish real estate was more reasonably valued in 2007 than Japanese real estate in the early 1990s (Chart II-16, bottom panel). This combination means that now that the acute part of the crisis is over, the hole in the European private sector’s balance sheet is much smaller than the one Japan needed to plug 30 years ago. Thus, from a balance-sheet perspective, the need to rebuild savings is lower in Europe than Japan, and we could expect the current period of elevated savings to be shorter in the euro area than it has been in Japan. Chart II-15 Chart II-16...And European Assets Were Not As Expensive As Japanese Ones At The Onset Of The Crisis ...And European Assets Were Not As Expensive As Japanese Ones At The Onset Of The Crisis ...And European Assets Were Not As Expensive As Japanese Ones At The Onset Of The Crisis   Second, despite former ECB President Jean-Claude Trichet’s policy mistake of raising interest rates in 2011, the ECB was much quicker to implement extreme easing policy measures than the Bank of Japan was in its day. It took 10 years for the BoJ to cut rates to zero after the Nikkei peaked in December 1989. It took one year for the ECB to do so after stock prices peaked in 2007. It took nine years for the BoJ to expand its balance sheet aggressively, but it took less than two years for the ECB to do so. One of the key benefits of this greater European proactivity has been to keep European inflation expectations much higher than in Japan, curtailing real interest rates in the process. Third, Europe purged economic excesses much more quickly than Japan. The Japanese unemployment rate increased from 2% to 6% between 1990 and 2010. In peripheral Europe, where the worst pre-crisis excesses existed, unemployment rose from 7.5% in 2008 to 18% in 2013 (Chart II-17, top panel). Meanwhile, real wages never adjusted in Japan, but fell 27.0% at their worst in Spain and 32.5% in Greece (Chart II-17, bottom panel). Moreover, the Rajoy reforms in Spain and the Macron reforms in France show that outside of Italy, European governments have been reforming their economies faster than Japan did after the bubble burst in 1990. Chart II-17Bigger Labor Market Purge In Europe Than Japan Bigger Labor Market Purge In Europe Than Japan Bigger Labor Market Purge In Europe Than Japan However, on three fronts Europe is faring worse than Japan. First, up until the last 10 years, Japan benefited from a robust global economy where trade grew strongly. Europe is entering its second decade of low growth in an environment where global economic activity is much weaker, as potential U.S. GDP growth has slowed and China is not growing at a double-digit pace anymore. Moreover, budding protectionism in the U.S. is creating another hurdle for European economic output. Second, the excess capital stock in the European periphery is in fact greater than was the case in Japan in 1990. This suggests that the periphery needs to curtail investments by a greater margin than Japan did. Consequently, peripheral growth will continue to exert downward pressure on aggregate European activity for an extended period. Third, the European fiscal response will not match Japan’s. Investors often decry Japan’s large government debt of 238.2% of GDP as a sign of profligacy. It is not. It is mainly a mirror image of the private sector’s savings surplus. The Japanese government’s ability to run large deficits has prevented a larger fall in output – one that would have equaled the annual savings of the private sector. Without the government’s dissaving, the Japanese private sector would have found its debt load even more onerous to service, and the need to curtail spending would have been even greater as economy-wide cash flows would have been even smaller. Europe does not have a unified fiscal authority that can run such large-scale deficits. Instead, each nation’s government has a limited capacity to accumulate debt as investors worry that overly-indebted governments may very well redenominate what they have borrowed in much weaker currencies than the euro. This risk is made even greater by the fact that there is no euro-area wide deposit insurance scheme. Since Italian and Spanish banks hold large amounts of BTPs and Bonos, respectively, a so-called doom-loop exists that links the health of banks in those countries to the health of their governments, further limiting the public sector’s ability to act as a spender of last resort. This makes the efforts of the private sector in Italy, France, and Spain to increase its savings and bring down its excess capital stock more difficult, and thus, likely to last longer. Even if 10 years after the crisis first emerged, Europe has done more to purge its economy from its pre-crisis excesses than Japan had after its first lost decade, a lack of unified fiscal lever in Europe nullifies this positive. Thus, so long as the European integration efforts remain on the backburner, euro area growth, inflation, and interest rates will continue to look more like Japan’s have over the past 30 years than the U.S. This is likely to cause a big problem once the next recession emerges. Europe will enter that slowdown without any ammunition to reflate growth. Therefore, the next recession is likely to prove very deflationary and test the recent improvement in support for the euro seen across all euro area nations (Chart II-18). If the euro area survives this crisis, and we suspect it will, the probability of a fiscal union will only grow.2 After all, it has been through various crises that Europe has moved closer together, and the rise of a multipolar geopolitical environment dominated by large countries makes this imperative ever more vital. Chart II-18Support For The Euro Is Resilient Support For The Euro Is Resilient Support For The Euro Is Resilient Bottom Line: We expect European growth and inflation to continue to lag well behind the U.S. for years to come if not a full decade. Ultimately, bringing down the expensive capital stock in the European periphery will be a slow process, especially if governments remain tight fisted. Investment Implications First, core euro area interest rates are likely to remain well below U.S. levels. As long as the European private sector pares back investments in order to normalize its capital stock-to-GDP ratio - a phenomenon that will be most pronounced in the periphery and France - European growth and inflation will lag behind the U.S. This also means that as long as European governments remain shy spenders and do not compensate for the lack of spending from the private sector, in the euro area periphery, European banks will suffer from depressed net interest margins and be structural underperformers. Second, the euro is likely to experience a structural upward drift. The euro is trading at a 10.5% discount to its purchasing power parity. Moreover, high private sector savings not only weigh on inflation, they will also push Europe’s net international investment position higher via an accumulated current account surplus. Both these factors are long-term bullish for the euro. Moreover, the fact that the euro area will soon become a net creditor nation, along with a lack of room to stimulate growth via monetary easing in times of recessions, means that the euro could increasingly become a counter-cyclical currency like the yen. So long as the European integration efforts remain on the backburner, euro area growth, inflation, and interest rates will continue to look more like Japan’s have over the past 30 years than the U.S. Third, European equities are trading at a discount to U.S. equities, but we do not think this guarantees long-term outperformance. European equities are cheap because European growth prospects are poor. If Japan is any guide, European stocks may be set to continue underperforming. This is especially true as financials are over-represented in European equity benchmarks, and banks stand at the epicenter of the European economic malaise. Fourth, European stocks will remain slaves to the global business cycle. Since the crisis, European growth has become hypersensitive to global growth, making European equities very responsive to the global business cycle. The same phenomenon happened in post-1990 Japan. In other words, the beta of European stocks is likely to continue to rise. This phenomenon could be exacerbated if the euro indeed does become a counter-cyclical currency, in which case the euro and European equities would become negatively correlated, like the yen and the Nikkei. Finally, the period from 1999 to 2005 showed how ECB policy targeted at supporting Germany resulted in imbalances that boosted real estate and equity returns in the periphery – in Spain and Ireland in particular. Today, the periphery is the worst offender when it comes to poor bank health and private sector balance sheet rebuilding. This means that the ECB is likely to keep monetary conditions too accommodative for Germany, where balance sheets are more robust and where the capital stock is not as excessive. As a result, financial market plays linked to German real estate are likely to continue outperforming other European domestic plays. They therefore warrant an overweight within European portfolios. Mathieu Savary Vice President The Bank Credit Analyst III. Indicators And Reference Charts The S&P 500 is retesting its all-time high made last fall. While our indicators suggest that U.S. equity have additional upside, the violence of the rally since December argues that a period of digestion may first be needed. Our Willingness-to-Pay (WTP) indicator for the U.S. and Japan continues to improve, while for the euro area, it is flat-lining after a tentative rebound. The WTP indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. The current readings in major advanced economies thus suggest that investors are still inclined to add to their stock holdings. Our Revealed Preference Indicator (RPI) is not echoing this message. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. The pick-up in global growth remains too feeble for the RPI to validate the advance in stocks. This is why we worry that a correction is likely until economic activity around the globe confirms the rally in stocks. According to BCA’s composite valuation indicator, an amalgamation of 11 measures, the U.S. stock market remains slightly overvalued from a long-term perspective. Nonetheless, the S&P 500 is not at nosebleed valuation levels anymore. Hence, we are betting that once global growth picks up, stocks will be able to move even higher and any correction will prove temporary. Moreover, our Monetary Indicator remains into stimulative territory. The Fed has reiterated its dovish message and global central banks have all engaged in dovish talks, thus monetary conditions should stay supportive. As a result, our speculation indicator has also now fully moved out of the “speculative activity” zone. Our Composite Technical indicator for stocks had broken down in December, but it has now moved back above its 9-month moving average. This positive cyclical signal reinforces our confidence that any correction in stocks should prove tactical in nature, and that on a nine- to twelve-month basis equities have upside. According to our model, 10-year Treasurys are slightly expensive. However, we should not read too much into this. Essentially, yields are currently within their neutral range. Moreover, our technical indicator flags a similar picture. That being said, since BCA expects that over the next 24 months, the Fed will lift rates more than the OIS curve anticipates, and since the term premium is incredibly low, once green shoots for global growth fully bloom, bonds could suffer a violent selloff. Since our duration indicator has begun to deteriorate, it is probably a good time to begin moving out of safe-haven bonds. On a PPP basis, the U.S. dollar has only gotten more expensive. Additionally, our Composite Technical Indicator is becoming increasingly overbought. This combination suggests that the greenback could experience further downside this year. However, this downside will only materialize once global growth shows greater signs of strength. EQUITIES: Chart III-1U.S. Equity Indicators U.S. Equity Indicators U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation U.S. Stock Market Valuation U.S. Stock Market Valuation Chart III-6U.S. Earnings U.S. Earnings U.S. Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance   FIXED INCOME: Chart III-9U.S. Treasurys And Valuations U.S. Treasurys And Valuations U.S. Treasurys And Valuations Chart III-10Yield Curve Slopes Yield Curve Slopes Yield Curve Slopes Chart III-11Selected U.S. Bond Yields Selected U.S. Bond Yields Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets   CURRENCIES: Chart III-16U.S. Dollar And PPP U.S. Dollar And PPP U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator U.S. Dollar And Indicator U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals U.S. Dollar Fundamentals U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning   ECONOMY: Chart III-28U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot U.S. Macro Snapshot U.S. Macro Snapshot Chart III-30U.S. Growth Outlook U.S. Growth Outlook U.S. Growth Outlook Chart III-31U.S. Cyclical Spending U.S. Cyclical Spending U.S. Cyclical Spending Chart III-32U.S. Labor Market U.S. Labor Market U.S. Labor Market Chart III-33U.S. Consumption U.S. Consumption U.S. Consumption Chart III-34U.S. Housing U.S. Housing U.S. Housing Chart III-35U.S. Debt And Deleveraging U.S. Debt And Deleveraging U.S. Debt And Deleveraging   Chart III-36U.S. Financial Conditions U.S. Financial Conditions U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China   Mathieu Savary Vice President The Bank Credit Analyst Footnotes 1       Please see Global Fixed Income Strategy Weekly Report, “A Sustainable Bottom In Global Bond Yields,” dated April 9, 2019, available at gfis.bcaresearch.com 2       Please see U.S. Equity Strategy Weekly Report, “Have SPX Margins Peaked?” dated March 25, 2019, available at uses.bcaresearch.com 3       Please see U.S. Equity Strategy Weekly Report, “Mixed Signals,” dated April 22, 2019, available at uses.bcaresearch.com 4       Please see Global Asset Allocation Special Report "Euro Area Banks: Value Play Or Value Trap?" dated December 14, 2018, available at gaa.bcaresearch.com 5       The European Commission Eurobarometer Surveys show that Europeans overwhelmingly see Europe as a peace project and as a way to maintain a voice in a world dominated by huge players like the U.S., China, or Russia, a world where France, Germany, or Italy individually are marginal players. In 2016, the U.K. population did not share this opinion. Moreover, even after what amounts to a depression, the support for the euro continues to rise in Greece, showing the growing commitment of Europeans to the euro, and the resilience of this commitment to economic shocks. EQUITIES:FIXED INCOME:CURRENCIES:COMMODITIES:ECONOMY: