Money/Credit/Debt

Highlights Analysis on Indonesia is available below. EM financial markets have diverged from the global growth indicators they have historically correlated with. This raises doubts about the sustainability of this rally. In China, broad bank credit has not accelerated at all, while non-bank credit growth rose sharply in January. The lack of recovery in broad bank credit growth is corroborated by lingering sluggishness in broad money growth. This refutes widespread perception in the global investment community that Chinese banks have re-opened the credit spigots again. Feature The headline news has all been positive for emerging markets over the past two months: The Federal Reserve is going on hold, China is stimulating its economy, the U.S. and China are nearing a trade agreement and risk-on market dynamics are permeating worldwide. Nevertheless, EM stocks have failed to outperform the global equity benchmark (Chart I-1, top panel). Notably, EM relative equity performance rolled over in late December when global share prices bottomed. Chart I-1EM Stocks Have Underperformed DM Ones Since Late December EM Stocks Have Underperformed DM Ones Since Late December EM Stocks Have Underperformed DM Ones Since Late December In absolute terms, EM equities have been attempting to break above their 200-day moving average, but have so far failed to do so decisively (Chart I-1, bottom panel). When a market struggles to break out or outperform amid favorable news flows and buoyant investor sentiment, the odds are that it is facing formidable headwinds under the surface, and is at risk of relapsing. We sense EM currently fits this profile. Needless to say, investor consensus is very bullish on EM, and dominated by the above-mentioned narrative, specifically the Fed turning dovish and China stimulating, which is reminiscent of 2016 when EM staged a cyclical rally. Consequently, investors have rushed to pile into EM stocks and fixed-income. Chart I-2 illustrates that asset managers’ net holdings of EM ETF (EEM) futures have doubled since October 2018. Chart I-2Investor Consensus Is Very Bullish On EM Investor Consensus Is Very Bullish On EM Investor Consensus Is Very Bullish On EM As of mid-February, EMs were by far the most overweight region within global equity portfolios, according to the most recent Bank of America/Merrill Lynch survey. The survey states that net 37% of global equity investors - who participated in the survey - were overweight EM. One of our clients that we met with on the road last week summed it up like this: “Investors have ‘recency bias’.” In other words, investors believe that 2019 will resemble 2016, and in turn have no appetite to bet against Chinese stimulus. We are in accord with this interpretation of investor behavior and the EM/China rally. Yet there are some noteworthy differences between today and 2016. First, in 2016, there was massive stimulus for China’s property market. At the time, the People’s Bank of China (PBoC) monetized the unsold housing stock in Tier-3 and -4 cities via its Pledged Supplementary Lending facility. At present, there is no stimulus for real estate. Second, by early 2016 EM profits had already contracted substantially. EM profits have yet to shrink in the current downtrend. Our thesis is that EM profits will contract this year for reasons we elaborated on in depth in our previous report, Mind The Time Gap. China’s credit and fiscal impulse leads EM/Chinese profits by about 12 months, and the recent improvement in this indicator, if sustained, suggests that a trough in EM/Chinese corporate earnings will only be reached in late 2019 (Chart I-3). Therefore, as EM profits shrink, investors will likely sell EM risk assets. Chart I-3EM Corporate Earnings Are Beginning To Contract EM Corporate Earnings Are Beginning To Contract EM Corporate Earnings Are Beginning To Contract Altogether, these differences with 2016 make us reluctant to chase the current EM rally, and we continue to expect a meaningful reversal in EM risk assets in the months ahead. Monitoring Global Growth We maintain that EM is much more leveraged to global trade and China’s growth than to Fed policy. For a detailed discussion on this matter, please refer to EM: A Replay of 2016 or 2001? report from February 7, 2019. Therefore, the Fed’s dovish turn is not a sufficient reason to buy EM risk assets. To buy EM cyclically, we would need to change our outlook on global trade and Chinese imports. China influences the rest of the world via its imports. A closer look at the indicators that correlate with EM risk assets and commodities do not justify the recent EM rebound. In particular: The import sub-component of China’s NBS manufacturing PMI strongly correlates with EM share prices, excess returns in EM sovereign credit, and industrial metals prices and suggest that investors should fade this rebound (Chart I-4). Chart I-4EM Stocks, EM Credit Markets, As Well As Commodities Prices Are Driven By Chinese Imports EM Stocks, EM Credit Markets, As Well As Commodities Prices Are Driven By Chinese Imports EM Stocks, EM Credit Markets, As Well As Commodities Prices Are Driven By Chinese Imports The Caixin manufacturing PMI for China was up in February, but the NBS manufacturing PMI fell. In turn, manufacturing PMI indexes in Korea, Taiwan, Japan and Singapore are all plunging, with several of them dropping well below the 50 boom-bust mark (Chart I-5). Chart I-5Asian Manufacturing Is Contracting Asian Manufacturing Is Contracting Asian Manufacturing Is Contracting Korean, Taiwanese, Japanese and Singaporean shipments to China were shrinking in January, while their exports to the U.S. were resilient (Chart I-6). This confirms that global trade has been weak due to China, and that there are no signs of its reversal. Chart I-6Asian Exports To China And U.S. Asian Exports To China And U.S Asian Exports To China And U.S Moreover, Korea released its February export data, and its aggregate outbound shipments are contracting (Chart I-7). Chart I-7Korean Exports: Deepening Contraction Korean Exports: Deepening Contraction Korean Exports: Deepening Contraction Further, China’s container freight index – the price to ship containers – has rolled over again after picking-up late last year due to front-loading of shipments to the U.S. which were induced by the U.S. import tariffs. This signals ongoing weakness in global demand, and does not justify the latest rebound in EM financial markets in general and currencies in particular (Chart I-8). Chart I-8Global Trade Is A Risk To EM Currencies Global Trade Is A Risk To EM Currencies Global Trade Is A Risk To EM Currencies Finally, even in the U.S. where manufacturing has been the most resilient globally, the odds point to notable weakness in this sector. Specifically, the continuous underperformance of U.S. high-beta industrial stocks to U.S. overall industrials beckons a further slowdown in American manufacturing (Chart I-9). Chart I-9U.S. Manufacturing Is In A Soft Spot U.S. Manufacturing Is In A Soft Spot U.S. Manufacturing Is In A Soft Spot Bottom Line: Although financial markets are forward-looking, the recent rally has been too fast and has already gone too far. This has created conditions for a material setback as global/China growth will continue to disappoint in the months ahead.  China: Credit Versus Money Growth We have been receiving questions from clients as to whether investors should heed to the message from China’s money or credit data, given they are presently sending contradictory messages (Chart I-10). Chart I-10China: Narrow, Broad Money, And Aggregate Credit China: Narrow, Broad Money, And Aggregate Credit China: Narrow, Broad Money, And Aggregate Credit Even though narrow money (M1) has historically been an excellent indicator for China/EM business cycles, the most recent (January) print – M1 annual growth rate registered a record low – was distorted due to technical/seasonal factors, and should be ignored. Specifically, deposits by enterprises plunged in January and household deposits surged as companies paid out bonuses to employees in late January ahead of the Chinese New Year that began on February 5 (Chart I-11). Provided enterprise demand deposits are in M1 but household demand deposits are a part of M2, M1 was artificially depressed in January. It will rebound in February. Chart I-11China: Technical Reasons For M1 Plunge In January China: Technical Reasons For M1 Plunge In January China: Technical Reasons For M1 Plunge In January Broad money provides a more comprehensive picture of money creation in China. As such, it is more relevant to compare broad money with aggregate credit. To compute aggregate credit, we add outstanding central and local government bonds to Total Social Financing (TSF). Chart I-12 illustrates the latest improvement in aggregate credit is not confirmed by either the PBoC’s broad money measure, M2, or our measure, M3 (M3 = M2 plus other deposits plus banks’ other liabilities excluding bonds). We created this M3 measure of broad money supply because in our opinion, M2 has been underestimating the extent of money creation in China in recent years due to financial engineering. Chart I-12The Recent Uptick In Aggregate Credit Is Not Confirmed By Broad Money The Recent Uptick In Aggregate Credit Is Not Confirmed By Broad Money The Recent Uptick In Aggregate Credit Is Not Confirmed By Broad Money As discussed in Box I-1 on pages 12-13, lending or purchasing of securities by banks simultaneously creates money. Therefore, bank broad credit acceleration should be mirrored in a broad money upturn. Does the lack of revival in broad money mean the latest uptick in aggregate credit data has been driven by non-bank credit? Our analysis suggests yes – non-bank credit is responsible for the strong rise in the aggregate credit numbers in January. We deconstructed aggregate credit into broad bank credit and non-bank credit (Diagram I-1). Chart I-13 illustrates that broad bank credit has not accelerated at all, while non-bank credit growth rose in January. Chart I- Chart I-13China: Recent Credit Acceleration Is Due To Non-Bank Credit China: Recent Credit Acceleration Is Due To Non-Bank Credit China: Recent Credit Acceleration Is Due To Non-Bank Credit The lack of recovery in broad bank credit growth is corroborated by lingering sluggishness in broad money (both M2 and M3) growth (Chart I-14). Chart I-14Broad Bank Credit Is Consistent With Broad Money (As It Should Be) Broad Bank Credit Is Consistent With Broad Money (As It Should Be) Broad Bank Credit Is Consistent With Broad Money (As It Should Be) Consequently, this refutes the widespread perception in the global investment community that Chinese banks have re-opened the credit spigots. Chart I-15demonstrates the annual growth rate of each component of broad bank credit. While mainland banks’ loan growth to enterprises has accelerated, their lending to non-bank financial institutions has continued to shrink.  Chart I-15Broad Bank Credit And Its Components Broad Bank Credit And Its Components Broad Bank Credit And Its Components In sum, broad bank credit and broad money have not revived, and their impulses are rolling over, having failed to break above zero (Chart I-14, bottom panel). Bottom Line: The improvement in aggregate credit growth in January was due to credit provided/bonds purchased by non-banks rather than by banks. This does not tell us whether the credit growth acceleration is sustainable. For a more detailed discussion on the differences between money and credit, please refer to Box I-1 on page 12-13. Investors prefer simple narratives, and have readily embraced the story that China has opened up the credit faucets. Broad bank credit data and broad money supply data do not corroborate this thesis. It may change in the months ahead, but our point is that for the moment there is not yet a simple narrative about China’s credit cycle. Investment Implications Even though China’s aggregate credit impulse ticked up in January, the 2011-‘12 and 2015-‘16 episodes signify that its bottoming can last many months. Critically, EM financial markets have historically lagged turning points in the aggregate credit impulse. These time lags have been anywhere between three to 18 months over the past 10 years. Furthermore, in 2012 there was only a minor rebound in EM share prices – not a cyclical rally – in response to the significant rise in China’s aggregate credit impulse (Chart I-16, top panel). Chart I-16Beware Of The Time Lag Beware Of The Time Lag Beware Of The Time Lag Hence, even if January marked the bottom in the aggregate credit impulse – which is plausible in our opinion – EM risk assets will remain at risk based on historical time lags between the aggregate credit impulse and China-related financial markets.1 BOX 1 Why And When Money Supply Differs From Credit The following elaborates on the key differences between broad money supply and aggregate credit.  1. Why and when do broad money and credit diverge?  When commercial banks provide loans to or buy bonds (or any other asset) from non-banks, they simultaneously create new money supply/deposits. Broad money supply is the sum of all deposits in the banking system, which is why we use the terms money and deposits interchangeably. When non-bank financial institutions – in China's case financial trust and investment corporations, financial leasing companies, auto-financing companies and loan companies – as well as enterprises and households make loans or buy bonds, they do not create money. Hence, money supply/deposits is mostly equal to net cumulative broad bank credit creation. The difference between aggregate credit and money supply is due to lending activities of non-bank entities (see Diagram I-1 on page 9). Lending, purchasing of bonds, or any other forms of financing by non-bank entities does not change money supply. Thus, aggregate credit is more relevant than money supply to forecast business cycle fluctuations. Apart from the fact that banks still play a very large role in aggregate financing in China, there are a few other reasons why one should not ignore broad money and rely solely on aggregate credit: Banks can extend credit, but might choose not to classify it as loans on their balance sheet for regulatory reasons. Chinese banks did this in the past by booking loans as non-standard credit assets. In any case, when a bank lends to a non-bank it creates new deposits/money, and it is hard to conceal deposits/liabilities. In these cases, broad money supply gives a better signal about the true extent of credit growth than statistics on loans. If under regulatory pressures banks reclassify their non-standard credit assets as loans, the amount of loans will expand, even though no new lending occurs. Yet, money supply/deposits will not change. In this case, loan numbers will give a false signal and money supply will be a better indicator for new credit origination by banks and, thereby, for economic activity. The true measure of Chinese bank loans and credit data were probably disguised over the past several years because banks and non-bank financial institutions were involved in financial engineering. However, in the past two years, the regulatory clampdown forced Chinese commercial banks to unwind some of these structures and properly reclassify items on their balance sheets. Both the masking of credit assets and the ensuing reclassification could have distorted loan and credit data. This is why we use broad money supply as a litmus test to gauge banks’ broad credit origination. Given TSF includes bank loans but does not include banks’ non-standard credit assets, we believe TSF understates the amount of credit in the economy. As a result, we have not been able to calculate an accurate aggregate level of non-bank credit. Only since mid-2017, when under the regulatory clampdown, banks have stopped classifying loans as non-standard credit assets, can the annual growth rate of TSF serve as a meaningful statistic. Hence, we estimate the annual growth rate of non-bank credit only starting in 2018 (please refer to Chart I-13 on page 9). 2. Does the central bank (PBoC) create money by injecting liquidity into the system? Barring lending to or buying assets from non-banks – which does not typically occur outside of quantitative easing (QE) programs – central banks do not create broad money or deposits. Central banks create banking system reserves, which are not part of the broad money supply in any country. Money supply/deposits, the ultimate purchasing power for economic agents, is created solely by commercial banks “out of thin air,” as we have discussed and illustrated in our series of reports on money, credit and savings. 3. Why do we use impulses (second derivatives of money/credit) rather than growth rates? Our goal is to forecast a change in economic activity/capital spending/imports/enterprise revenues – i.e., a change in flow variables. Money and credit are stock variables. Therefore, a change (the first derivative) in outstanding money and credit produces flow variables. The latter measures new credit and money origination in a given period. These are comparable with flow variables like spending, income and profits. To gauge changes in flow variables, i.e., the growth rate of spending, one needs to calculate a change in new money and credit origination – i.e., change in their net flow. In brief, to do an apples-to-apples comparison, one needs to use the second derivative (a change in change) in money and credit – i.e., changes in their flows – to predict changes in flow variables such as GDP/capital spending/imports/enterprise revenues.   Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Lin Xiang, Research Analyst linx@bcaresearch.com   Indonesia: It Is Not All About The Fed Indonesian stocks have outperformed their emerging market peers significantly in the past few months as the Federal Reserve has turned dovish and U.S. rate expectations have declined. Although U.S. bond yields do strongly and inversely correlate with Indonesian stocks’ relative performance versus the EM equity benchmark (Chart II-1, top panel), we believe there are other factors – such as Chinese growth and commodities prices – that are also important to this market (Chart II-1, bottom panel). Chart II-1Indonesian Stocks: The Fed Versus Commodities Indonesian Stocks: The Fed Versus Commodities Indonesian Stocks: The Fed Versus Commodities In the next several months, slowing Chinese growth, lower commodities prices, and a renewed sell-off in EM markets will take a toll on Indonesian financial markets. Indonesian exports are contracting which will intensify as commodities prices fall and China’s purchases of coal and base metals drop (Chart II-2, top panel). Chart II-2Indonesia: Exports Are Shrinking Indonesia: Exports Are Plunging Indonesia: Exports Are Plunging Indonesia’s current account deficit is already large and will continue widening as the export contraction deepens (Chart II-2, bottom panel). Remarkably, the nation’s commercial banks have been encouraged to keep the credit taps open as the central bank – Bank Indonesia (BI) – has been injecting enormous amounts of liquidity (excess reserves) into the banking system (Chart II-3, top panel). Given these liquidity injections, bank credit and domestic demand growth have remained more resilient than would otherwise have been the case. Chart II-3The Central Bank Is Injecting Liquidity Indonesia's Central Bank Is Injecting Liquidity Indonesia's Central Bank Is Injecting Liquidity Yet, by injecting such enormous amounts of excess reserves into the system, the central bank has more than negated its previous liquidity tightening, resulting from the sales of its foreign exchange reserves in order to defend the rupiah (Chart II-3, bottom panel). The implications of such policy are that these excess reserves could encourage speculation against the rupiah, especially amid weakening global growth and falling commodities prices. Provided foreigners own large portions of Indonesian stocks and local-currency government bonds, a depreciation in the rupiah will produce a renewed selloff in the nation’s financial markets. A final point on Indonesian commercial banks: their net interest margins have been narrowing sharply (Chart II-4, top panel). Chart II-4Commercial Banks' Profits Will Weaken Commercial Banks' Profits Will Weaken Commercial Banks' Profits Will Weaken Moreover, as global growth slows, non-performing loans (NPLs) on the balance sheets of Indonesian banks will rise. In turn, provisioning for bad loans will also increase, and bank earnings will decline (Chart II-4, bottom panel). These dynamics will be bearish for Indonesian commercial banks, which account for 44% of the overall MSCI Indonesia index. Bottom Line: Continue avoiding/underweighting Indonesian stocks and fixed-income markets. We continue shorting the IDR versus the U.S. dollar. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com Footnotes 1      Please note that this represents the Emerging Markets Strategy team’s view and is different from BCA’s house view on global risk assets and global growth. The key point of contention is the outlook for China’s growth.   Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights It may seem self-evident that most governments are overly indebted, but both theory and evidence suggest otherwise. Higher debt today does not require higher taxes tomorrow if the growth rate of the economy exceeds the interest rate on government bonds. Not only is that currently the case, but it has been the norm for most of history. Unlike private firms or households, governments can choose the interest rate at which they borrow, provided that they issue debt in their own currencies. Ultimately, inflation is the only constraint to how large fiscal deficits can get. Today, most governments would welcome higher inflation. There are increasing signs China is abandoning its deleveraging campaign. Fiscal policy will remain highly accommodative in the U.S. and will turn somewhat more stimulative in Europe. Remain overweight global equities/underweight bonds. We do not have a strong regional equity preference at the moment, but expect to turn more bullish on EM versus DM by the middle of this year. Feature A Fiscal Non-Problem? Debt levels in advanced economies are higher today than they were on the eve of the Global Financial Crisis. Rising private debt accounts for some of this increase, but the lion’s share has occurred in government debt (Chart 1). Chart 1Global Debt Levels Have Risen, Especially In The Public Sector Global Debt Levels Have Risen, Especially In The Public Sector Global Debt Levels Have Risen, Especially In The Public Sector Not surprisingly, rising public debt levels have elicited plenty of consternation. While there has been a lively debate about how fast governments should tighten their belts, few have disputed the seemingly self-evident opinion that some degree of “fiscal consolidation” is warranted. Given this consensus view, one would think that the economic case for public debt levels being too high is airtight. It’s not. Far from it. Debt Sustainability, Quantified Start with the classic condition for debt sustainability, which specifies the primary fiscal balance (i.e., the overall balance excluding interest payments) necessary to maintain a constant debt-to-GDP ratio (See Box 1 for a derivation of this equation).   Image An increase in the economy’s growth rate (g), or a decrease in real interest rates (r), would allow the government to loosen the primary fiscal balance without causing the debt-to-GDP ratio to increase (Chart 2).1 If the government were to ease fiscal policy beyond that point, debt would rise in relation to GDP. But by how much? It is tempting to assume that the debt-to-GDP ratio would then begin to increase exponentially. However, that is only true if the interest rate is higher than the growth rate of the economy. If the opposite were true, the debt-to-GDP ratio would rise initially but then flatten out at a higher level.2 Chart 2 A Fiscal Free Lunch The last point is worth emphasizing. As long as the interest rate is below the economic growth rate, then any primary fiscal balance – even a permanent deficit of 20%, or even 30% of GDP – would be consistent with a stable long-term debt-to-GDP ratio. In such a setting, the government could just indefinitely rollover the existing stock of debt, while issuing enough new debt to cover interest payments. No additional taxes would be necessary. In fact, stabilizing the debt-to-GDP ratio becomes easier the higher it rises. Chart 3 shows this point analytically.  Chart 3   Ah, one might say: If the government issues a lot of debt, then interest rates would rise, and before we know it, we are back in a world where the borrowing rate is above the economy’s growth rate, at which point the debt dynamics go haywire. Now, that sounds like a sensible statement, but it is actually quite misleading. As long as a government is able to issue its own currency, it can always create money to pay for whatever it purchases. If people want to turn around and use that money to buy bonds, they are welcome to do so, but the government is under no obligation to pay them the interest rate that they want. If they do not wish to hold cash, they can always use the cash to buy goods and services or exchange it for foreign currency. As long as a government is able to issue its own currency, it can always create money to pay for whatever it purchases. Wouldn’t that cause inflation and currency devaluation? Yes, it might, and that’s the real constraint: What limits the ability of governments with printing presses to run large deficits is not the inability to finance them. Rather, it is the risk that their citizens will treat their currencies as hot potatoes, rushing to exchange them for goods and services out of fear that rising prices will erode the purchasing power of their cash holdings. When Is Saving Desirable? The reason governments pay interest on bonds is because they want people to save more. However, more savings is not necessarily a good thing. This is obviously the case when an economy is depressed, but it may even be true when an economy is at full employment. Just like someone can work so much that they have no time left over for leisure, or buy a house so big that they spend all their time maintaining it, it is possible for an economy to save too much, leading to an excess of capital accumulation. Under such circumstances, steady-state consumption will be permanently depressed because so much of the economy’s resources are going towards replenishing the depreciation of the economy’s capital stock.  Economists have a name for this condition: “dynamic inefficiency.” What determines whether an economy is dynamically inefficient? As it turns out, the answer is the same as the one that determines whether debt ratios are on an explosive path or not: The difference between the interest rate and the economy’s growth rate. Economies where interest rates are below the growth rate will tend to suffer from excess savings. In that case, government deficits, to the extent that they soak up national savings, may increase national welfare.   r < g Has Been The Norm Today, the U.S. 10-year Treasury yield stands at 2.69%, compared to the OECD’s projection of nominal GDP growth of 3.8% over the next decade. The gap between projected growth and bond yields is even greater in other major economies (Chart 4). Chart 4 Granted, equilibrium real rates are likely to rise over the next few years as spare capacity is absorbed. Structural factors might also push up real rates over time. Most notably, the retirement of baby boomers could significantly curb income growth, leading to a decline in national savings. Chart 5 shows that the ratio of workers-to-consumers globally is in the process of peaking after a three-decade long ascent. Economic growth could also fall if cognitive abilities continue to deteriorate, a worrying trend we discussed in a recent Special Report.3 Chart 5The Global Worker-To-Consumer Ratio Has Peaked The Global Worker-To-Consumer Ratio Has Peaked The Global Worker-To-Consumer Ratio Has Peaked It may take a while before real rates rise above GDP growth. Still, it may take a while before real rates rise above GDP growth. As Olivier Blanchard, the former chief economist at the IMF, noted in his Presidential Address to the American Economics Association earlier this year, periods in U.S. history where GDP growth exceeds interest rates have been the rule rather than the exception (Chart 6).4 The same has been true for most other economies.5 Chart 6GDP Growth Above Interest Rates: Historically, The Rule, Not The Exception GDP Growth Above Interest Rates: Historically, The Rule, Not The Exception GDP Growth Above Interest Rates: Historically, The Rule, Not The Exception What’s Next For Fiscal Policy? Austerity fatigue has set in. In the U.S., fiscally conservative Republicans, if they ever really existed, are a dying breed. Trump’s big budget deficits and his “I love debt” mantra are the waves of the future. For their part, the Democrats are shifting to the left, with the “Green New Deal” proposal being the latest manifestation. The case for fiscal stimulus is stronger in the euro area than for the United States. The European Commission expects the euro area to see a positive fiscal thrust of 0.40% of GDP this year, up from a thrust of 0.05% of GDP last year (Chart 7). This should help support growth. Chart 7The Euro Area Will Benefit From A Modest Amount Of Fiscal Easing This Year The Euro Area Will Benefit From A Modest Amount Of Fiscal Easing This Year The Euro Area Will Benefit From A Modest Amount Of Fiscal Easing This Year Additional fiscal easing would be feasible. This is clearly true in Germany, but even in Italy, the cyclically-adjusted government primary surplus is larger than what is necessary to stabilize the debt ratio.6 Unfortunately, the situation in southern Europe is greatly complicated by the ECB’s inability to act as an unconditional lender of last resort to individual sovereign borrowers. When a government cannot print its own currency, its debt markets can be subject to multiple equilibria. Under such circumstances, a vicious spiral can develop where rising bond yields lead investors to assign a higher default risk, thus leading to even higher yields (Chart 8). Chart 8   Mario Draghi’s now-famous “whatever it takes” pledge has gone a long way towards reassuring bond investors. Nevertheless, given the political constraints the ECB faces, it is doubtful that Italy or other indebted economies in the euro area will be able to pursue large-scale stimulus. Instead, the ECB will keep interest rates at exceptionally low levels. A new round of TLTROs is also looking increasingly likely, which should protect against a rise in bank funding costs and a potential credit crunch. Our European team believes that a TLTRO extension would be particularly helpful to Italian banks.  Even in Italy, the cyclically-adjusted government primary surplus is larger than what is necessary to stabilize the debt ratio. Despite having one of the highest sovereign debt ratios in the world, Japan faces no pressing need to tighten fiscal policy. Instead of raising the sales tax this October, the government should be cutting it. A loosening of fiscal policy would actually improve debt sustainability if, as is likely, a larger budget deficit leads to somewhat higher inflation (and thus, lower real borrowing rates) and, at least temporarily, faster GDP growth. We expect the Abe government to counteract at least part of the sales tax increase with new fiscal measures, and ultimately to abandon plans for further fiscal tightening over the next few years. In the EM space, Brazil, Turkey, and South Africa are among a handful of economies with vulnerable fiscal positions. They all have borrowing rates that exceed the growth rate of the economy, cyclically-adjusted primary budget deficits, and above-average levels of sovereign debt (Chart 9). Chart 9   In contrast, China stands out as having the biggest positive gap between projected GDP growth and sovereign borrowing rates of any major economy. The problem is that the main borrowers have been state-owned companies and local governments, neither of which are backstopped by the state. Not officially, anyway. Unofficially, the government has been extremely reluctant to allow large-scale defaults anywhere in the economy. Despite all the rhetoric about market-based reforms, they are unlikely to start now. Historically, the Chinese government has allowed credit growth to reaccelerate whenever it has fallen towards nominal GDP growth. As we recently argued in a report entitled “China’s Savings Problem,” China needs more debt to sustain aggregate demand.7 Historically, the government has allowed credit growth to reaccelerate whenever it has fallen towards nominal GDP growth (Chart 10). The stronger-than-expected jump in credit origination in January suggests that we are approaching such an inflection point. Chart 10Historically, China Has Scaled Back On Deleveraging When Credit Growth Has Fallen Close To Nominal GDP Growth Historically, China Has Scaled Back On Deleveraging When Credit Growth Has Fallen Close To Nominal GDP Growth Historically, China Has Scaled Back On Deleveraging When Credit Growth Has Fallen Close To Nominal GDP Growth Investment Conclusions The consensus economic view is that deflation is a much harder problem to overcome than inflation. When dealing with inflation, all you have to do is raise interest rates and eventually the economy will cool down. With deflation, however, a central bank could very quickly find itself up against the zero lower bound constraint on interest rates, unable to ease policy any further via conventional means. While this standard argument is correct, it takes a very monetary policy-centric view of macroeconomic policy. When interest rates are low, fiscal policy becomes very potent. Indeed, the whole notion that deflation is a bigger problem than inflation is rather peculiar. Just as it is easier to consume resources than to produce them, it should be easier to get people to spend than to save. People like to spend. And even if they didn’t, governments could go out and buy goods and services directly. Looking out, our bet is that policymakers will increasingly lean towards the ever-more fiscal stimulus. If structural trends end up causing the so-called neutral rate of interest to rise – the rate of interest that is necessary to avoid overheating – policymakers will have no choice but to eventually raise rates and tighten fiscal policy (Box 2). However, they will only do so begrudgingly. The result, at least temporarily, will be higher inflation. Fixed-income investors should maintain below benchmark duration exposure over both a cyclical and structural horizon. Reflationary policies that increase nominal GDP growth will help support equities, at least over the next 12 months. Chart 11 shows that corporate earnings tend to accelerate whenever nominal GDP growth rises. We upgraded global equities to overweight following the December FOMC meeting selloff. While our enthusiasm for stocks has waned with the year-to-date rally, we are sticking with our bullish bias. Chart 11Earnings And Nominal GDP Growth Tend To Move In Lock-Step Earnings And Nominal GDP Growth Tend To Move In Lock-Step Earnings And Nominal GDP Growth Tend To Move In Lock-Step A reacceleration in Chinese credit growth will put a bottom under both Chinese and global growth by the middle of this year. As a countercyclical currency, the dollar will likely come under pressure in the second half of this year. Until then, we expect the greenback to be flat-to-modestly stronger. The combination of faster global growth and a weaker dollar later this year will be manna from heaven for emerging markets. We closed our put on the EEM ETF for a gain of 104% on Jan 3rd, and are now outright long EM equities. I do not have a strong view on the relative performance of EM versus DM at the moment, but expect to shift EM equities to overweight by this summer.8 Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com   Box 1 The Arithmetic Of Debt Sustainability Image   Box 2 Debt Sustainability And Full Employment: The Role Of Fiscal And Monetary Policy Image Policymakers should strive to stabilize the ratio of debt-to-GDP over the long haul, while also ensuring that the economy stays near full employment. The accompanying chart shows the tradeoffs involved. The DD schedule depicts the combination of the primary fiscal balance and the gap between the borrowing rate and GDP growth (r minus g) that is consistent with a stable debt-to-GDP ratio. In line with the debt sustainability equation derived in Box 1, the slope of the DD schedule is simply equal to the debt/GDP ratio. Any point below the DD schedule is one where the debt-to-GDP ratio is rising, while any point above is one where the ratio is falling. The EE schedule depicts the combination of the primary fiscal balance and r - g that keeps the economy at full employment. The schedule is downward-sloping because an increase in the primary fiscal balance implies a tightening of fiscal policy, and hence requires an offsetting decline in interest rates. Any point above the EE schedule is one where the economy is operating at less than full employment. Any point below the EE schedule is one where the economy is operating beyond full employment and hence overheating. Suppose there is a structural shift in the economy that causes the neutral rate of interest – the rate of interest consistent with full employment and stable inflation – to increase. In that case, the EE schedule would shift to the right: For any level of the fiscal primary balance, the economy would need a higher interest rate to avoid overheating. The arrows show three possible “transition paths” to a new equilibrium. Scenario #1 is one where policymakers raise rates quickly but are slow to tighten fiscal policy. This results in a higher debt-to-GDP ratio. Scenario #2 is one where policymakers tighten fiscal policy quickly but are slow to raise rates. This results in a lower debt-to-GDP ratio. Scenario #3 is one where the government drags its feet in both raising rates and tightening fiscal policy. As the economy overheats, real rates actually decline, sending the arrow initially to the left. This effectively allows policymakers to inflate away the debt, leading to a lower debt-to-GDP ratio. Note: In Scenario #2, and especially in Scenario #3, the DD line will become flatter (not shown on the chart to avoid clutter). Consequently, the final equilibrium will be one where real rates are somewhat higher, but the primary fiscal balance is somewhat lower, than in Scenario #1.   Footnotes 1          One can equally define the interest rate and GDP growth rate in nominal terms (see Box 1 for details).  2       Japan is a good example of this point. The primary budget deficit averaged 5% of GDP between 1993 and 2010, a period when government net debt rose from 20% of GDP to 142% of GDP. Since then, Japan’s primary deficit has averaged 5.1% of GDP, but net debt has risen to only 156% of GDP (and has been largely stable for the past two years). 3      Please see Global Investment Strategy Special Report, “The Most Important Trend In The World Has Reversed And Nobody Knows Why,” dated February 1, 2019. 4      Olivier Blanchard, “Public Debt And Low Interest Rates,” Peterson Institute for International Economics and MIT American Economic Association (AEA) Presidential Address, (January 2019). 5      Paolo Mauro, Rafael Romeu, Ariel Binder, and Asad Zaman, “A Modern History Of Fiscal Prudence And Profligacy,” IMF Working Paper, (January 2013). 6      The Italian 10-year bond yield is 2.83% while nominal GDP growth is 2.64%. Multiplying the difference by net debt of 118% of GDP results in a required primary surplus of .22% of GDP that is necessary to stabilize the debt-to-GDP ratio. This is lower than the IMF’s 2018 estimate of cyclically-adjusted government primary surplus of 2.14%. 7      Please see Global Investment Strategy Weekly Report, “China’s Savings Problem,” dated January 25, 2019. 8      Please note that my colleague, Arthur Budaghyan, BCA’s Chief EM strategist, remains bearish on both EM and DM equities and expects EM to underperform DM over the coming months. Strategy & Market Trends MacroQuant Model And Current Subjective Scores Chart 12 Tactical Trades Strategic Recommendations Closed Trades        

Highlights Please note that analysis on India is published below. Even if the recent upturn in the Chinese credit impulse is sustained, there will likely still be a six- to nine-month lag between the impulse’s trough and the bottom in the mainland’s business cycle. EM corporate earnings cycles typically lag Chinese stimulus efforts by about nine months. Therefore, EM profits will be contracting in the first three quarters of 2019. This will short-circuit the current rebound in EM share prices. EM equity valuations are not cheap enough to shield stocks from profit contraction. Feature China’s credit growth was very strong in January. We contend that even if the upturn in the credit impulse proves to be persistent, there will likely be a six- to nine-month lag between its low point and the bottom in the mainland’s business cycle. Chart I-1 demonstrates that the credit impulse leads both nominal manufacturing output growth and the manufacturing PMI’s import subcomponent by roughly nine months. Chinese imports are the most pertinent variable to gauge China’s economic impact on the rest of the world. Chart I-1China: Credit Impulse Leads Business Cycle By Nine Months China: Credit Impulse Leads Business Cycle By Nine Months China: Credit Impulse Leads Business Cycle By Nine Months In the meantime, will financial markets exposed to Chinese growth look through the valley of the ongoing growth deceleration and continue to rally? Or will they experience a major relapse in the coming months? In our opinion, corporate profits will be the key to broader financial market performance. So long as corporate profits do not shrink, investors will likely look beyond weak macro data, and any weakness in stocks will be minor. However, if corporate profits contract in the next nine months, then share prices will plummet anew. EM Profits Are Heading Into Contraction Chart I-2 illustrates that China’s credit impulse leads both EM and Chinese corporate earnings per share (EPS) by at least nine months and that it currently foreshadows EPS contraction in the first three quarters of 2019. Even if the recent upturn in the credit impulse is sustained, EM and Chinese EPS growth will likely bottom only in August – while they are in negative territory. Chart I-2EM EPS Is Beginning To Contract EM EPS Is Beginning To Contract EM EPS Is Beginning To Contract EM corporate earnings growth has already dropped to zero and will turn negative in 2019. Chart I-3A reveals that EPS in U.S. dollar terms are already contracting in six out of 10 sectors – industrials, consumer staples, consumer discretionary, telecom, utilities and health care. Chart I-3AEM EPS By Sector EM EPS By Sector EM EPS By Sector Chart I-3BEM EPS By Sector EM EPS By Sector EM EPS By Sector EPS growth has not yet turned negative for financials, technology, energy and materials (Chart I-3B). Notably, corporate earnings within these four sectors collectively account for 70% of EM total corporate earnings, as shown in Table I-1. Chart I- Over the course of 2019, these sectors’ EPS are also set to shrink: Technology (accounts for 20% of MSCI EM corporate earnings): NAND semiconductor prices have been plunging for some time, and DRAM prices are also beginning to drop (Chart I-4). This reflects broad-based weakness in global trade – global auto sales are shrinking for the first time since the 2008 global financial crisis, global semiconductor sales are relapsing and global mobile phones shipments are falling (Chart I-5). Chart I-4Semiconductor Prices Are Falling Semiconductor Prices Are Falling Semiconductor Prices Are Falling Chart I-5Broad-Based Weakness In Global Trade Broad-Based Weakness In Global Trade Broad-Based Weakness In Global Trade Semiconductors accounted for 77% of Samsung’s operating profits in the first three quarters of 2018, suggesting the potential drop in DRAM prices will be devastating for its profits. Next week we will publish a Special Report on Korea and discuss the outlook for both semiconductors and Korean profits in more detail. In addition, the ongoing contraction in Taiwanese exports of electronics parts confirms downside risks to EM tech earnings (please refer to top panel of Chart I-3B). In brief, the ongoing decline in semiconductor prices will bring about EPS contraction in the EM technology sector. Financials/Banks (financials make up 31% of EM corporate earnings): Banks’ profits often correlate with fluctuations in economic activity, because the latter drive non-performing loan (NPL) cycles (Chart I-6). NPL cycles outside Brazil, Russia and India – where the banking systems have already gone through substantial NPL recognition and provisioning – will deteriorate, and push banks to increase their provisions. The latter will be a major drag on EM banks’ profits. Chart I-6EM Banks EPS And Economic Activity EM Banks EPS And Economic Activity EM Banks EPS And Economic Activity Regarding Chinese banks in particular, if the credit revival in January is sustained, it would strongly suggest that the government is resorting to its old, credit-driven growth playbook. Following 10 years of an enormous credit frenzy and a 20-year capital spending boom, it is currently difficult to find many financially viable projects. Hence, a renewed credit binge will once again be associated with further capital misallocation and more NPLs. Many of these projects will fail to generate sufficient cash flow to service debt. NPLs will thus rise considerably and the need to raise capital will dilute the banks’ existing shareholders. Of course, this will happen with a time lag. Chart I-7 shows that the gap between Chinese banks’ EPS and non-diluted profits has once again widened, and that EPS are beginning to contract. Chart I-7Chinese Banks: Earnings Dilution Chinese Banks: Earnings Dilution Chinese Banks: Earnings Dilution Chinese banks could issue perpetual bonds – discussed in great detail in last week’s report – to recapitalize themselves. Nevertheless, this will be negative for existing shareholders. In a nutshell, despite low multiples, share prices of Chinese banks will drop because more credit expansion amid the lingering credit bubble is negative for existing shareholders. The basis is that it will ultimately lead to their dilution. Chinese banks make up 4.5% of the MSCI’s EM equity market cap and 10% of aggregate EM profits. Hence, their EPS contraction will have a non-trivial impact on overall EM EPS. Resource sectors (energy and materials together make 20% of EM corporate earnings): The ongoing slowdown in China will exert renewed selling pressure in commodities markets. As shown in Chart I-9 on page 8, base metals prices lag the turning points in the Chinese credit impulse by several months and are still at risk of renewed price decline. Hence, profits of firms in the materials sector are at risk. Energy companies’ trailing EPS growth is still positive because the late-2018 carnage in oil prices has not yet filtered through to corporate earnings announcements (Chart I-3B on page 3). More importantly, the recent oil price rebound can be attributed to both Saudi Arabia’s output cuts as well as stronger demand – in the form of a surge in Chinese imports of oil and petroleum products. Chart I-8 illustrates that growth rates of China’s intake of oil and related products approached zero when crude prices were rising but has dramatically accelerated following their plunge. This is consistent with China’s pattern of buying commodities on dips. The point is that the upside in oil prices will be capped by China, which will likely moderate its oil purchases going forward, as crude prices have recently rallied. Chart I-8China And Oil bca.ems_wr_2019_02_21_s1_c8 bca.ems_wr_2019_02_21_s1_c8 Bottom Line: EM profit cycles lag Chinese’s stimulus by about nine months. EM profits will be contracting in the first three quarters of 2019. This will short-circuit the current rebound in EM share prices. China’s Credit Cycles And Financial Markets What has been the relationship between China’s credit cycle and related financial markets over the past 10 years? The time lag between turning points in China’s credit impulse and relevant financial markets can be anywhere from zero to 18 months. Chart I-9 illustrates historical time lags between the Chinese credit impulse on the one hand and EM share prices, base metals prices and the global manufacturing PMI on the other. The time lag has not been consistent over time. Chart I-9Chinese Credit Impulse And Financial Markets: Understanding Time Lags Chinese Credit Impulse And Financial Markets: Understanding Time Lags Chinese Credit Impulse And Financial Markets: Understanding Time Lags In late 2015-early 2016, the rebound in China’s credit impulse led financial markets by six months. At the recent market peak in January 2018, the credit impulse led financial markets and the global manufacturing PMI by about 18 months. In the meantime, in the 2012-13 mini cycle, EM share prices and commodities markets did not rally much, despite the meaningful upturn in China’s credit impulse. Finally, at the 2010-2011 peak, the credit impulse led EM stocks and base metals prices by 12 months. In short, the credit impulse led those financial markets by a few months to as much as a year and a half. Further, not only do time lags to the stimulus vary, but the impact on both economic activity and financial markets varies as well. This is because both economic activity and financial markets are driven by human psychology and behavior; iterations in stimulus, economic activity and financial markets are chaotic and complex in nature and do not follow well-defined patterns. Given the poor state of sentiment among Chinese consumers, business managers and entrepreneurs, more stimulus and more time may be required to turn the mainland’s business cycle this time around. Besides, unlike in previous episodes, there has not been any stimulus for the property market and no tax reductions on auto sales. Finally, although China and the U.S. may strike a deal on trade, it is unlikely to be a comprehensive agreement that is sustainable in the long run. This would be consistent with our Geopolitical Strategy team’s view that China and the U.S. are in a long-term and broad geopolitical confrontation – not a trade war. The trade war and tariffs are just one dimension of this. Hence, Chinese consumers and businesses, as well as the global business community may well look through this potential deal and not significantly alter their cautious behavior, at least for some time. In other words, the genie of geopolitical confrontation is out of the bottle, and the presidents of the U.S. and China are unlikely to succeed in putting it back. Bottom Line: Turning points in China’s credit impulse generally lead financial markets exposed to Chinese growth by several months. Given that the improvement in the credit impulse is both very recent and modest, odds are that China-related plays including EM risk assets will go through a major selloff before putting in a durable bottom.1 EM Equity Valuations In terms of the ability of EM stocks to withstand profit contraction, would cheap valuations not shield share prices from a considerable drop? We do not think EM equities are cheap; their valuations are neutral. Hence, there is no real valuation cushion in EM stocks to help them endure a period of negative EPS growth. We have written frequently about valuations and will touch on the topic only briefly here. Market cap-based multiples indeed appear very low. However, some segments of the EM universe such as Chinese banks and state-owned companies in Russia, Brazil, China and India have had low multiples for years. In other words, they are a value trap and their multiples are low for a reason. We elaborated above why Chinese banks are chronically “cheap”. For many other companies, low multiples are due to structural issues such as the lack of focus on profitability and shareholder value, or the high cyclicality of profits. Many of these stocks have large market caps, which pull down the EM index’s aggregate multiple. To remove market-cap bias, we have calculated 20% trimmed-mean multiples by ranking 50 MSCI EM industry groups (sub-sectors) and cutting off the top and bottom 10%. Then, we calculate the equal-weighted average of the remaining 80% of the sub-sectors. We did this calculation for the following five ratios: trailing P/E, forward P/E, price-to-cash earnings, price-to-book value and price-to-dividend. Then, we combined them into a composite valuation indicator (Chart I-10, top panel). This indicator shows that EM equity valuations are neutral. Chart I-10EM Equity Valuations In Absolute Terms bca.ems_wr_2019_02_21_s1_c10 bca.ems_wr_2019_02_21_s1_c10 In addition, we calculated the median and equal-weighted composite valuation indicators (Chart I-10, middle and bottom panels). They also remove market cap bias and tell the same message: EM stocks are trading close to their fair value. EM equities are also close to their historical average relative to developed markets (DM). Chart I-11 illustrates relative EM versus DM valuation indicators based on 20%-trimmed mean, median and equal-weighted metrics. Chart I-11EM Equity Valuations Versus DM bca.ems_wr_2019_02_21_s1_c11 bca.ems_wr_2019_02_21_s1_c11 In sum, EM valuations are not cheap neither in absolute terms, nor relative to DM. According to both measures, valuations are neutral. Hence, valuations will not prevent share prices from falling as profits begin to contract. This is why we continue to recommend a defensive strategy for absolute-return investors, and we continue to underweight EM versus DM within a global equity portfolio. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com India: Beware Of Rural Growth Lapse Indian share prices are weak and are underperforming the emerging markets benchmark in U.S. dollar terms (Chart II-1, top panel). Small cap stocks are in a full-fledged bear market (Chart II-1, bottom panel). Chart II-1Indian Stocks Are Weak Indian Stocks Are Weak Indian Stocks Are Weak The latest earnings season turned out to be disappointing. Many companies missed their earnings estimates. Chart II-2 shows that net profit margins of listed non-financial companies have turned down and overall EPS growth is weakening. Chart II-2Indian Corporate Profits Are Sluggish Indian Corporate Profits Are Sluggish Indian Corporate Profits Are Sluggish Disappointing corporate earnings are confirmed by macro data as well. Chart II-3A shows that manufacturing production is decelerating and intermediate goods production is contracting. Further, sales of two-wheelers, three-wheelers, passenger and commercial vehicles, as well as tractors, are either slowing or contracting (Chart II-3B). Chart II-3ACyclical Spending Is Decelerating Cyclical Spending Is Decelerating Cyclical Spending Is Decelerating Chart II-3BCyclical Spending Is Decelerating Cyclical Spending Is Decelerating Cyclical Spending Is Decelerating This weakness emanates from rural areas. The basis is that food prices have been falling since the summer of 2018 – and are deflating for the first time since the early 2000s. This is hurting rural incomes. Several indicators confirm considerable weakness in rural income growth and the latter’s underperformance versus urban income and spending: The top panel of Chart II-4 illustrates that our proxy for spending in rural areas relative to urban areas has deteriorated massively along with the decline in Indian food prices. Chart II-4Rural Spending Is Weaker Than Urban One Rural Spending Is Weaker Than Urban One Rural Spending Is Weaker Than Urban One This measure is calculated as revenue growth of four rural-exposed listed companies minus the revenue growth of four urban-exposed listed companies. In both cases, the companies largely operate in the consumer goods space. Credit growth in rural areas has lagged that of urban areas, explaining the underperformance of rural spending (Chart II-4, bottom panel). Corroborating this, stock prices of these urban-exposed companies have outperformed their rural peers substantially (Chart II-5). Chart II-5Urban-Exposed Stocks Have Outperformed Rural Ones Urban-Exposed Stocks Have Outperformed Rural Ones Urban-Exposed Stocks Have Outperformed Rural Ones Such a slump in rural income is posing a challenge to Modi’s re-election in May. His government – which lost three key state elections in late 2018 – is aware of these ominous trends and is acting boldly to revive income growth in rural areas. The government announced an expansionary budget that appeases rural voters. In particular, the budget aims to strengthen farmers’ support schemes, cut taxes for low- and middle-income earners and introduce a pension scheme for social security coverage of unorganized labor. However, there is a significant risk that the authorities’ fiscal and monetary stimulus are too late to lift growth before May’s elections. According to the past relationship between fiscal spending and India’s business cycle, higher government expenditure growth will only begin to have an effect on the economy in the second half of this year – i.e. after the elections are held (Chart II-6). Hence, the BJP could lose its majority, meaning it would either rule in a minority government or be forced to turn over power to the Congress Party and its allies. Chart II-6Government Expenditures To Lift Growth In H2 2019 Government Expenditures To Lift Growth In H2 2019 Government Expenditures To Lift Growth In H2 2019 Beyond the elections, food prices might be approaching their lows. Well-below average rain will likely result in weak agricultural production and, hence, higher food prices in the second half of 2019 (Chart II-7). Chart II-7Below Trend Monsoon = Food Prices Will Likely Rise Below Trend Monsoon = Food Prices Will Likely Rise Below Trend Monsoon = Food Prices Will Likely Rise Therefore, in the second half of 2019, both fiscal easing and higher food prices will revive rural incomes and spending. In the meantime, monetary easing and credit growth acceleration will support demand in urban areas. Overall, Indian financial markets will likely remain in a risk zone until the elections as economic growth and corporate profits will continue to disappoint. If the opposition Congress Party’s alliance wins the election, Indian stocks and the currency will initially sell off. After this point, Indian assets could offer a buying opportunity because growth will likely revive in the second half of 2019. Bottom Line: For now, we continue to recommend an underweight position in Indian equities relative to the EM equity benchmark. Weakening growth, the very low interest rate differential versus U.S. rates and political uncertainty ahead of the general elections, pose risks of renewed rupee depreciation. A weaker rupee will continue to benefit India’s export-oriented software companies. Therefore, we also reiterate our long Indian software / short EM stocks recommendation. Finally, fixed-income investors should stay with the yield curve steepening trade. The central bank could further cut rates in the near term. However, long-term bond yields will not fall substantially and will likely start drifting higher sooner than later. The widening fiscal deficit, expectations of growth revival in the second half of 2019, and eventually higher food prices and inflation expectations, will all lead to a continuous steepening in the local yield curve. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com Footnotes 1      This is the view of BCA’s Emerging Markets Strategy team and it is different from BCA’s house view on China-related assets and the global business cycle. The primary source of the difference is the outlook for China’s growth.   Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Equities can continue to outperform bonds for a few months longer. The pro-cyclical equity sector stance that has worked well since last October can also continue for a few months longer. Overweight pro-cyclical Sweden versus pro-defensive Denmark. The caveat is that these short-term trends are unlikely to persist and will viciously reverse later in the year. European ‘soft’ luxury goods companies are an excellent structural investment opportunity. Take profits on the 75 percent rally in Litecoin and 50 percent rally in Ethereum. Feature Why should European investors care so much about China? The Chart of the Week provides one emphatic answer. For Europe’s $500 billion basic resources sector, the three most important things in the world are: China, China, and China. Through the past decade, the share price performance of the resource behemoths BHP, Anglo American, Rio Tinto, and Glencore have been joined at the hip to China’s short-term credit impulse (Chart I-2 and Chart I-3). Chart of the WeekFor European Basic Resources, The Three Most Important Things In the World Are: China, China, And China For European Basic Resources, The Three Most Important Things In the World Are: China, China, And China For European Basic Resources, The Three Most Important Things In the World Are: China, China, And China Chart I-2BHP, Anglo American, And Rio Tinto Have Been Rallying For Several Months BHP, Anglo American, And Rio Tinto Have Been Rallying For Several Months BHP, Anglo American, And Rio Tinto Have Been Rallying For Several Months Chart I-3BHP Is Joined At The Hip To China's Short-Term Credit Impulse BHP Is Joined At The Hip To China's Short-Term Credit Impulse BHP Is Joined At The Hip To China's Short-Term Credit Impulse But China has a much deeper importance to Europe. According to Mario Draghi, the recent cycle in Europe is ‘made in China’. On the euro area’s domestic fundamentals, Draghi is upbeat, citing “supportive financing conditions, favourable labour market dynamics and rising wage growth”. Yet the economic data have continued to be weaker than expected. Why? Draghi blames a “slowdown in external demand” and specifically, vulnerabilities in emerging markets. He claims that as soon as there is clarity on the exports and the trade sector, much of the euro area’s weakness will wash out.     Federal Reserve Chairman, Jay Powell presented a remarkably similar narrative to justify the recent pause in the Fed’s sequential rate hikes: “The U.S. economy is in a good place… but growth has slowed in some major foreign economies.” If Powell claims that the U.S. domestic economy is in a good place and Draghi points out that the euro area domestic fundamentals are fine, then the explanation for what has happened – and what will happen – can only come from one place: China. Optimistically, Draghi adds: “everything we know says that China’s government is actually taking strong measures to address the slowdown.” The good news is that we can independently corroborate Draghi’s optimism, at least in the near-term (Chart I-4). Chart I-4China's Short-Term Credit Impulse Is Up Sharply, And Commodities Have Rebounded China's Short-Term Credit Impulse Is Up Sharply, And Commodities Have Rebounded China's Short-Term Credit Impulse Is Up Sharply, And Commodities Have Rebounded Why China Matters To Europe Chart I-5 shows the short-term credit impulses in the euro area, U.S., and China through the past twenty years. They are all expressed in dollars to allow an apples for apples comparison between the three major economies. The comparison reveals a fascinating transformation. The dominant short-term impulse – the one with the highest amplitude – charts the shift in global economic power and influence from Europe and the U.S. to China. Chart I-5The Shift In Global Economic Power From Europe And The U.S. To China The Shift In Global Economic Power From Europe And The U.S. To China The Shift In Global Economic Power From Europe And The U.S. To China Before 2008, the short-term impulses in the euro area and the U.S. dominated. But the global financial crisis was a major turning point: the credit stimulus from China dwarfed the responses from the western economies. Then through 2009-12 the impulse oscillations from the three major economies took it in turns to dominate. For example, the 2011-12 global downturn was definitely ‘made in Europe’. However, since 2013 China has taken on the undisputed mantle of dominant impulse. Most recently, last year’s peak to trough decline in China’s short-term impulse amounted to $1 trillion, equivalent to a 1.5 percent drag on global GDP. By comparison, the declines in the euro area and the U.S. amounted to a much more modest $200 billion. Likewise, the recent rebound in the China’s short-term impulse, in dollar terms, has been much larger than the respective rebounds in the euro area and the U.S. Credit Impulses And Speeding Tickets Clients complain that they are confused by the conflicting messages from differently calculated credit impulses. So let’s digress for a moment to present a powerful analogy which should clear the confusion once and for all. Imagine you floored the accelerator pedal of your car (analogous to a huge stimulus). After a hundred metres or so, the stimulus would become very apparent. Your speed over that short sprint would have surged, and possibly have become illegal! But your average speed measured over the previous kilometre would have barely changed. Now imagine a police officer rightfully presents you with a speeding ticket. To protest your innocence, you argue that you couldn’t have floored the accelerator pedal because your average speed over the previous kilometre had barely changed! Clearly, you would never offer such a ludicrous defence for pushing the pedal to the metal. Yet when assessing the impact of an economic stimulus, it is commonplace to make the same mistake.    The crucial point is that a stimulus – like flooring the accelerator pedal of your car – will barely move the needle for a longer-term rate of change, but it will become very apparent in a short-term rate of change. For this reason, financial markets never wait for the long-term rates of change to pick up. They always move up or down on the evolution of short-term rates of change. It follows that the credit impulse calculation that is most relevant is the one that provides the best explanatory power for the cycles that we actually observe in the economic and financial market data. As we described in our Special Report, “The Cobweb Theory And Market Cycles”, both the theory and evidence powerfully identify the 6-month credit impulse as the one with the best explanatory power for the oscillations that we actually observe in the economy and markets.1 For the sceptics, the charts in this report should finally dispel any lingering doubts. China’s 6-month impulse gives a spookily perfect explanation for the industrial commodity inflation cycle, and thereby the share price performance of the basic resources sector, as well as the other classically cyclical sectors (Chart I-6 and Chart I-7). Chart I-6China's Short-Term Impulse Perfectly Explains Industrial Commodity Inflation China's Short-Term Impulse Perfectly Explains Industrial Commodity Inflation China's Short-Term Impulse Perfectly Explains Industrial Commodity Inflation Chart I-7Semiconductors Are A Modern Day Cyclical Semiconductors Are A Modern Day Cyclical Semiconductors Are A Modern Day Cyclical The good news is that China’s short-term impulse has indisputably been in a mini-upswing in recent months, and this is the reason that the classical cyclical sectors have simultaneously rebounded or, at the very least, stabilised. The bad news is that the shelf-life of such mini-upswings averages no more than eight months or so. Intuitively, this is because just as you cannot accelerate your car indefinitely, it is likewise impossible to stimulate credit growth indefinitely. The investment conclusion is that the pro-cyclical equity sector stance that has worked well since last October can continue for a few months longer. This sector stance necessarily impacts regional and country allocation. For example, it is still right to be overweight pro-cyclical Sweden versus pro-defensive Denmark (Chart I-8 and Chart I-9).  Chart I-8Overweight Pro-Cyclical Sweden Versus Denmark... Overweight Pro-Cyclical Sweden Versus Denmark... Overweight Pro-Cyclical Sweden Versus Denmark... Chart I-9...And Versus Norway ...And Versus Norway ...And Versus Norway From an asset allocation perspective, it means that equities can continue to outperform bonds for the time being. But the caveat is that these short-term trends are unlikely to persist, and most likely, they will viciously reverse later in the year. Stay tuned for the signal to switch. Stay Structurally Overweight ‘Soft’ Luxuries A common question we get concerns the European luxury goods sector: is it, just like the basic resources sector, a direct play on China’s growth cycle?  The answer is no. Recently, the connection between the fortunes of ‘soft’ luxury goods brands like LVMH, Hermes, and Kering and China’s growth cycle has been weak (Chart I-10). Broadly, this is also true for ‘hard’ luxury brands – for example, luxury watches – like Richemont (Chart I-11). Chart I-10European 'Soft' Luxuries Are No Longer A China Play... European 'Soft' Luxuries Are No Longer A China Play... European 'Soft' Luxuries Are No Longer A China Play... Chart I-11...Neither Are European 'Hard' Luxuries ...Neither Are European 'Hard' Luxuries ...Neither Are European 'Hard' Luxuries As we highlighted in Buying European Clothes: An Investment Megatrend, the much bigger driver for the ‘soft’ luxury brands is the structural increase in female labour participation rates, and the feminisation of consumer spending. We expect this trend to persist for the next decade.2 Hence, we are happy to buy and hold the European clothes and accessories companies with a dominant or significant exposure to women’s clothes and/or accessories; provided they have a top-end brand (or brands) giving pricing power, and mitigating the very strong deflation in clothes prices. In summary, while European basic resources are a good tactical investment opportunity, European ‘soft’ luxury goods companies are an excellent structural investment opportunity. Fractal Trading System* We are delighted to report that the fractal trading system perfectly identified the sharp recent rebound in cryptocurrencies. Our long Litecoin and Ethereum position has hit its 60 percent profit target with Litecoin up 75 percent and Ethereum up 50 percent since trade initiation on December 19. Additionally, long industrials versus utilities has also hit its profit target. With no new trades this week, the fractal trading system now has five open positions. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-12 Litecoin Is Oversold On A 65-Day Horizon Litecoin Is Oversold On A 65-Day Horizon The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. *  For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com Footnote 1 Please see the European Investment Strategy Special Report “The Cobweb Theory And Market Cycles” January 11, 2018 available at eis.bcaresearch.com  2 Please see the European Investment Strategy Special Report “Buying European Clothes: An Investment Megatrend” December 6, 2018 available at eis.bcaresearch.com Fractal Trading System Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

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

Highlights We would fade fears of an “earnings recession.” EPS growth should increase during the remainder of this year. While high debt burdens around the world may exacerbate deflationary pressures by restraining spending, they may also motivate policymakers to raise inflation in order to reduce the real value of outstanding debt. Ultimately, whether high debt levels turn out to be deflationary or inflationary depends on the extent to which policymakers have both an incentive and the means to increase inflation. The spread of political populism has made governments more inclined to boost nominal incomes by allowing economies to overheat. Central bankers have also become increasingly convinced that they should wait to see “the whites of inflation’s eyes” before tightening monetary policy any further. With inflation expectations still well anchored, it may take at least another 18 months for inflation in the U.S. to break out, and longer still elsewhere. Stay bullish on global stocks for now. However, be prepared to dial back equity exposure late next year, while shifting bond duration to a maximum underweight. Feature Fade Fears Of An “Earnings Recession” We upgraded global stocks in December following the post-FOMC meeting selloff. Our recommendation to go long the MSCI All-Country World Index has gained 9.0% since we initiated it. Although our enthusiasm for stocks has waned somewhat given the recent run-up, we continue to see upside for global bourses over the next 12-to-18 months. Admittedly, earnings growth has come down sharply from a year ago. To some extent, this reflects base effects (U.S. EPS rose by 23% in Q1 of 2018, thanks in part to the tax cuts). However, slower global growth and higher tariffs have also taken their toll. The good news is that the trade war is likely to stay on hiatus over the coming months. We also expect nominal GDP growth in the U.S. and the rest of the world to pick up by the middle of this year. Chart 1 shows that earnings growth tends to move in lock-step with nominal GDP growth. Chart 1Earnings And Nominal GDP Growth Move In Lock-Step Earnings And Nominal GDP Growth Move In Lock-Step Earnings And Nominal GDP Growth Move In Lock-Step Equity prices usually bottom when earnings growth bottoms (Chart 2). Analyst estimates based on IBES data foresee EPS growth troughing in Q1 and then accelerating modestly over the remainder of the year. If this happens, global equities will move higher over the coming months. Chart 2 What’s The Bigger Risk? Deflation Or Inflation? Last week, we argued that the next global economic downturn would probably be sparked by a surge in inflation which forces central banks to raise interest rates more aggressively than they would like.1 Given the absence of inflationary pressures today, and the still-ample spare capacity that exists in many economies, we noted that such an outcome is far from imminent. This implies that the global expansion still has plenty of room to run, thus justifying an overweight stance towards risk assets. One common objection to this thesis posits that deflation, rather than inflation, is the main risk to the global economy. And unlike its inflationary cousin, the next deflationary shock could be lurking just around the corner. Italy serves as a good example of the dangers of high debt levels. While many things can contribute to deflationary pressures, elevated debt levels are often cited as being the most important. An excessive debt burden can lead to a prolonged period of deleveraging. Since borrowers typically spend a larger share of their cash flows than lenders, overall spending could decline, leading to lower prices and wages. High debt levels can also make an economy vulnerable to interest-rate shocks. This is particularly the case when a country is reliant on external debt or issues debt in a currency it does not control. The Italian Lesson Italy serves as a good example of the dangers of high debt levels. Italy entered the euro area with one of the highest public debt ratios in the world. Private debt also soared in anticipation of euro membership as well as during the period leading up to the Global Financial Crisis, almost doubling as a share of GDP between 1998 and 2008 (Chart 3). Chart 3Italy's Debt Inferno Italy's Debt Inferno Italy's Debt Inferno Worries about high indebtedness, poor growth prospects, and contagion from Greece sent the 10-year Italian bond yield to nearly 7.5% on November 9, 2011. Yields tumbled after Mario Draghi pledged to do “whatever it takes” to preserve the common currency, but rose again last April after Italians brought an anti-austerity populist government into power. Today, the Italian government finds itself in the unenviable position of having to devote 3.4% of GDP to interest payments, more than double the euro area average (Chart 4). Domestic investors own less than half of Italian government debt, so most of those interest payments do little to stimulate domestic spending. Chart 4The Italian Government's Interest Payments Are Higher Than Elsewhere In The Euro Area The Italian Government's Interest Payments Are Higher Than Elsewhere In The Euro Area The Italian Government's Interest Payments Are Higher Than Elsewhere In The Euro Area The Inflation Solution When debt reaches elevated levels, faster nominal growth via higher inflation becomes an increasingly appealing solution for reducing debt ratios. A one percentage-point increase in nominal GDP will cut debt-to-GDP by half a percentage point when it stands at 50%, but by three full percentage points when it stands at 300%. Given the attractiveness of inflating away debt burdens, why don’t more governments pursue this strategy? Part of the answer is politics. The long history of hyperinflation in Europe and many other economies has cast a long shadow over how central banks operate. Unanticipated inflation also redistributes wealth from creditors to debtors. While the latter usually outnumber the former, the former typically have more political sway. Means And Opportunities Political will is a necessary condition for generating inflation, but it is not a sufficient one. Policymakers also need to possess the ability to accomplish their goal. What determines whether they will succeed? The answer, to a large extent, is the level of the neutral rate of interest. The neutral rate of interest is the long-term interest rate that is appropriate for the economy. When interest rates are above the neutral rate, growth will tend to fall below trend, while inflation will decline. Conversely, when rates are below their neutral level, the economy will grow at an above-trend pace and inflation will accelerate. Many things can influence the neutral rate of interest. These include: Trend GDP growth: Faster growth will incentivize firms to expand capacity in anticipation of rising demand. This will push up the neutral rate of interest. National savings: Lower taxes and increased government spending will drain national savings, while stimulating aggregate demand. This will push up the neutral rate of interest. Likewise, a decrease in private-sector savings — whether it be the result of easier access to credit or greater optimism about future income growth — will raise the neutral rate. The capital intensity of the economy: Economies that require a lot of physical capital will tend to have a higher neutral rate of interest. By the same token, economies where the capital stock needs to be replenished quickly in order to offset depreciation will have a higher neutral rate of interest.  The exchange rate: A weaker exchange rate will boost net exports. This resulting increase in aggregate demand will translate into a higher neutral rate of interest. With the exception of the currency effect, all of the factors listed above are captured by the canonical Solow growth model which undergraduate economics students usually encounter in their studies (See Appendix 1 for a derivation of the neutral rate of interest in this model). Inflation And The Neutral Rate Economists tend to define the neutral rate in real terms. However, when thinking about inflation, it is useful to consider the neutral rate’s nominal counterpart. Conceptually, the nominal neutral rate of interest can be either negative or positive. When the nominal neutral rate is negative, even a policy rate of zero will be insufficient to allow the economy to overheat. One might call this outcome the “strong form” version of the secular stagnation thesis. In contrast, when the neutral rate is low, but still positive, an interest rate of close to zero will be low enough to allow the economy to overheat, which will eventually generate inflation. One may refer to this as the “weak form” version of the secular stagnation thesis. Political will is a necessary condition for generating inflation, but it is not a sufficient one. The Danger Of Strong-Form Secular Stagnation In situations where the strong form version of secular stagnation prevails, deflationary pressures will feed on themselves. If an economy suffers from a chronic shortfall of aggregate demand, inflation is liable to drift lower. A lower inflation rate will push down the nominal interest rate that is consistent with any given real rate. For example, if the economy requires a real rate of -1% in order to grow at trend and inflation is 2%, a 1% nominal rate will suffice. But if inflation is 0%, then the policy rate would need to be -1%, which may be difficult to achieve. Japan serves as a case study for how this vicious circle can unfold. Following the simultaneous bursting of the property and stock market bubbles in the early 1990s, the Japanese private sector entered a prolonged deleveraging cycle. Inflation drifted steadily lower, ultimately falling into negative territory during the 1997-98 Asian Crisis (Chart 5). High debt levels in Japan were deflationary because the nominal neutral rate of interest was negative. Even if the Bank of Japan wanted to, it was greatly constrained in its ability to raise inflation. Chart 5Japan: A Case Study In Strong-Form Secular Stagnation Japan: A Case Study In Strong-Form Secular Stagnation Japan: A Case Study In Strong-Form Secular Stagnation Europe Is Not Japan… Yet Next to Japan, the euro area comes the closest to meeting the criteria for strong form secular stagnation. The euro area has low trend growth, owing to its slow population growth rate, as well as a banking system that is still focused on deleveraging. There is a silver lining, however: Despite the many woes the euro area has experienced, long-term inflation expectations are still over 100 basis points higher than in Japan (Chart 6). Fiscal policy is also turning somewhat more accommodative. Our base case is that the ECB will be slow to unwind its balance sheet and will only raise rates if the economy is showing more verve. This should be enough to move inflation towards target over the next two years. Chart 6Long-Term Inflation Expectations In The Euro Area Are Still Well Above Japanese Levels Long-Term Inflation Expectations In The Euro Area Are Still Well Above Japanese Levels Long-Term Inflation Expectations In The Euro Area Are Still Well Above Japanese Levels Inflation In The U.S. When inflation does break out early next decade, it will probably happen first in the United States. A large structural budget deficit and the revival of credit growth to the household sector following an intense period of deleveraging have boosted the neutral rate of interest. An overheated labor market is driving up real wages, which will lead to more consumer spending. December’s weaker-than-expected retail sales report will prove to be a fluke. Not only was it influenced by the sharp drop in the stock market and worries about a pending government shutdown (both of which have reversed), but the report itself was probably compromised by delays in the collection of data, which may have pushed some responses into January (historically, the weakest month for retail sales). This interpretation is consistent with strong holiday sales reported by online retailers and solid growth in the Johnson Redbook index of same-store sales. The latter captures over 80% of the sales surveyed by the Department of Commerce in its retail sales report, and featured a 9.3% year-over-year increase in sales in the final week of December, the fastest since the start of this series in 1997 (Chart 7). Chart 7The December Retail Sales Report Was Probably A Fluke The December Retail Sales Report Was Probably A Fluke The December Retail Sales Report Was Probably A Fluke Yes, corporate debt in the U.S. is high, but it is not particularly elevated relative to most other countries (Chart 8). Despite the collapse in equity prices and the spike in credit spreads late last year, U.S. corporations are still eager to expand capacity (Chart 9). This is not an economy teetering on the brink of recession. Chart 8U.S. Corporate Debt Is Not Extreme By Global Standards U.S. Corporate Debt Is Not Extreme By Global Standards U.S. Corporate Debt Is Not Extreme By Global Standards Chart 9U.S. Capex Plans Have Come Off Their Highs, But Remain Solid U.S. Capex Plans Have Come Off Their Highs, But Remain Solid U.S. Capex Plans Have Come Off Their Highs, But Remain Solid Policymakers in the U.S., and in much of the world, have grown more comfortable in letting economies overheat. Whether it be Trump’s unfunded tax cuts or the “Green New Deal” championed by the more liberal members of the Democratic Party, fiscal stimulus is in, austerity is out. Policymakers in the U.S., and in much of the world, have grown more comfortable in letting economies overheat. Even mainstream voices have given their nod of approval. Just this week, former IMF Chief Economist Olivier Blanchard argued that the U.S. could safely increase public debt without endangering economic stability.2 Meanwhile, central banks have increasingly bought into the mantra, famously espoused by Larry Summers, that they should wait to see the “the whites of inflation’s eyes” before tightening monetary policy.3 What this mantra overlooks is that inflation is a highly lagging indicator. By the time you see the whites of a tiger’s eyes, you are already destined to be its dinner. Investment Conclusions The spread of populist economic policies offers a one-two punch to inflation. Not only are populist prescriptions apt to stimulate demand, but that stimulus will raise the neutral rate of interest, thereby giving central banks greater traction to further boost spending by keeping rates below their neutral level. For investors, this implies a dichotomy between the medium-term and longer-term asset market outlook. Easy money policies are a boon to risk assets when they are first introduced, as they typically combine low interest rates with fast nominal GDP growth. But the path to higher rates is lined with lower rates, meaning that the longer central banks keep rates below their neutral level, the more economies will overheat, and the larger the eventual inflation overshoot will be. As growth outside the U.S. begins to accelerate in the second half of 2019, the dollar will come under downward pressure. As such, investors should overweight global equities and high-yield credit for the next 12 months. However, be prepared to dial back equity exposure late next year, while shifting bond duration to a maximum underweight. In terms of regional equity allocation, we continue to see global growth bottoming by the middle of this year. As growth outside the U.S. begins to accelerate in the second half of 2019, the dollar will come under downward pressure. The resulting reflationary impulse will be manna from heaven for the more cyclically-sensitive sectors of the stock market, as well as Europe and EM. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Image   Laura Gu Research Associate Footnotes 1      Please see Global Investment Strategy Weekly Report, “Minsky’s Corollary,” dated February 8, 2019. 2       Olivier Blanchard, “Public Debt and Low Interest Rates,” Peterson Institute for International Economics and MIT American Economic Association (AEA) Presidential Address, (January 2019); Noah Smith, “The U.S. Can Take on a Lot More Debt Within Limits,” Bloomberg Opinion, (February 2019). 3      Lawrence Summers, “Only raise US rates when whites of inflation’s eyes are visible,” Financial Times, (February 2015). Strategy & Market Trends MacroQuant Model And Current Subjective Scores Chart 10 Tactical Trades Strategic Recommendations Closed Trades