Policy

Highlights Structurally, EM corporate leverage is elevated and the interest coverage ratio is low. Cyclically, China/EM growth slowdown will lead to corporate spread widening. Rising U.S. dollar corporate bond yields in EM herald lower share prices. The recent underperformance in Mexican financial markets versus their EM peers is not sustainable. We reiterate our overweight position in Mexico. In Indonesia, the central bank is attempting to fight the Impossible Trinity, a battle that by definition cannot be won. Investors should keep underweighting this market. Feature This report focuses on the corporate health of emerging market (EM) companies, as well as the outlook for corporate bonds. We review the key drivers behind credit spreads and provide an up-to-date snapshot of overall corporate health. We also illustrate the travails in China's offshore corporate bond market, which are of high importance to the broad EM outlook. With respect to scope of coverage and data comparability, please refer to Box 1. BOX 1 Data Relevance And Its Application As there is no aggregate financial dataset for EM corporate bond issuers, we use corporate financial data provided by Worldscope for the EM equity universe - the constituents of the MSCI EM equity index. While from an individual country perspective this makes a difference, from an EM sector perspective the differences are not substantial. Excluding the technology sector, it is often the case that the same companies have both publicly traded stocks and bonds. This is especially true in sectors such as basic materials, energy, industrials, telecom, utilities and financials. This is why, in this report, we focus our attention on sectors rather than countries, and why we examine the EM companies' financial health excluding technology and banks. Banks' relevant financial ratios vary greatly from those of non-banks. For the technology sector, the largest tech names in the equity space have minimal bonds outstanding, so using financial data from the equity space for credit analysis is inappropriate. In short, the analysis below on corporate health is pertinent to both equity and corporate bond investors. However, its emphasis is on creditworthiness and ability to service debt, which is more attuned to credit investors. Drivers Of EM Credit Spreads Cyclical swings in EM corporate and sovereign credit spreads are driven by changes in borrowers' revenues, cash flow and profits. Hence, the business cycle is one of the important drivers of corporate creditworthiness. When global and EM growth accelerate, revenue and free cash flow improve, causing credit spreads to narrow (Chart I-1). The EM business cycle drives EM sovereign spreads too (Chart I-2). Chart I-1EM Corporates: Cash Flow From Operations And Credit Spreads bca.ems_sr_2018_11_22_s1_c1 bca.ems_sr_2018_11_22_s1_c1 Chart I-2EM Sovereign Spreads Move In Tandem With Business Cycle EM Sovereign Spreads Move In Tandem With Business Cycle EM Sovereign Spreads Move In Tandem With Business Cycle This is why we spend a lot of time gauging the global business cycle outlook and cover this topic extensively in our reports. For now, the growth outlook for China/EM and global trade remains gloomy: Chart I-3China Is A Major Risk For EM Profits China Is A Major Risk For EM Profits China Is A Major Risk For EM Profits China's credit and fiscal spending impulse projects further weakness in the mainland's business cycle and EM corporate earnings (Chart I-3). China's slowdown is no longer limited to the industrial sector - household spending growth has downshifted considerably since early this year, as we discussed in last week's report.1 Weakening sales of consumer goods and autos in China are one of the primary reasons behind the ongoing slump in the global technology and semiconductor sectors. Consistently, plunging growth in Taiwanese electronics exports points to both weaker global trade and EM tech earnings in the months ahead (Chart I-4). In short, even though we have excluded technology from our analysis of corporate financial health, hardware tech companies' profits remain at risk. The latter is not relevant for EM corporate bond investors, but it is critical for the EM equity space. Chart I-4Taiwanese Shipments Foreshadow A Relapse In EM Tech Earnings Taiwanese Shipments Foreshadow A Relapse In EM Tech Earnings Taiwanese Shipments Foreshadow A Relapse In EM Tech Earnings Other pertinent financial market indicators for EM credit spreads are commodities prices, EM exchange rates and EM local rates. The basis is as follows: (1) Energy and materials make up 25% of the J.P. CEMBI EM corporate bond index, and commodities prices drive their revenues and in turn credit spread fluctuations (Chart I-5, top panel); (2) Outside the resource sector, corporate bond issuers by and large do not feature exporters, and their capacity to service foreign currency debt is greatly affected by exchange rate movements (Chart I-5, bottom panel); (3) Financials make up 30% of the J.P. CEMBI EM corporate bond index, and their credit spreads are greatly influenced by domestic interest rates and banking system health (Chart I-6). We exclude financials from our corporate health analysis because their financial ratios differ vastly from those of non-financials. Chart I-5Drivers Of Credit Spreads: Commodities And Currencies Drivers Of Credit Spreads: Commodities And Currencies Drivers Of Credit Spreads: Commodities And Currencies Chart I-6EM Bank Credit Spreads Will Widen If Local Bond Yields Rise EM Bank Credit Spreads Will Widen If Local Bond Yields Rise EM Bank Credit Spreads Will Widen If Local Bond Yields Rise Overall, we expect global trade to weaken, commodities prices to drop further and EM currencies to depreciate. The latter will push up local interest rates. In turn, several EM banking systems remain saddled with bad assets from previous credit booms that have not been recognized, and banks have not been recapitalized. These factors point to a widening in bank credit spreads. All in all, EM corporate and sovereign spreads will widen further. A Snapshot Of EM Corporate Health The following financial ratios - which are calculated for EM companies excluding technology and financials - do not justify currently tight corporate spread. Leverage measured as net debt (total debt minus cash assets) divided either by EBITDA or cash flow from operation2 (CFO) remains elevated (Chart I-7, top panel). Among 9 sectors, only energy, basic materials and consumer discretionary have seen their leverage fall over the past two years. Chart I-7EM Corporate Health: Leverage And Interest Coverage Ratios EM Corporate Health: Leverage And Interest Coverage Ratios EM Corporate Health: Leverage And Interest Coverage Ratios Interest coverage ratios computed as EBITDA- or CFO- to- interest expense are well below their 2007 and 2011 levels (Chart I-7, middle panel). These figures corroborate that neither EM corporate indebtedness nor companies' ability to service debt using cash from operations is back to levels that prevailed before the global financial crisis in 2008 when EM financial markets were in a secular uptrend. Crucially, this is inconsistent with presently still-tight EM corporate spreads (Chart I-7, bottom panel). This mispricing, in our opinion, reflects the global search for yield that was induced by the crowding out of investors from DM bond markets by global central banks' QE programs. A contraction in corporate profits and cash flows from operation - for the reasons discussed above - will cause issuers' credit matrixes to deteriorate. With respect to cross-sectional analysis, Table I-1 presents interest coverage ratios (computed as an average of EBITDA- and CFO-to-interest expense ratios) for mainstream countries and all sectors. The cells in red present pockets of distress where the interest coverage ratio is below 3. The cells in blue illustrate segments where moderate financial stress is present: these are sectors with an interest coverage ratio of above 3 but below 5.5. Table I-1Interest Coverage Ratios EM Corporate Health And Credit Spreads EM Corporate Health And Credit Spreads On a positive note, the rally in commodities and cutbacks in capex have allowed energy and basic materials companies to drastically improve their leverage and interest coverage ratios in the past 2 years. However, even though their present financial health is great, their cash flow from operations is set to deteriorate again as commodities prices continue to relapse. The key motive behind our negative view on credit markets in Latin America, Russia, the Middle East and Africa - which is de facto the EM universe excluding emerging Asia - is because with the exception of Turkey, they are very exposed to commodities prices. As commodities prices drop and these nations' currencies depreciate, their sovereign and corporate credit spreads will widen. We are not implying that these issuers are facing default risks. Simply, lower revenues from commodities and higher debt servicing costs due to currency depreciation warrant a re-pricing of risk. Within credit portfolios, we recommend favoring defensive low-beta credit, excluding banks, versus riskier high-beta ones. We are underweight EM banks within the EM equity space and recommend the same strategy for the EM credit universe. Based on the matrix in Table I-1, credit portfolios should overweight consumer services, tech, energy and basic materials and underweight industrials, utilities and healthcare. China's Corporate Health And Credit Market There has been little deleveraging among Chinese companies. On the contrary, the country's massive credit and fiscal stimulus in 2016 bailed out many indebted companies, lifting corporate debt levels and augmenting the misallocation of capital. In particular: Chart I-8China's Corporate Debt Is Enormous China's Corporate Debt Is Enormous China's Corporate Debt Is Enormous China's corporate debt remains enormous, at $19.5 trillion, or RMB 140 trillion. It is the highest in the history of any country (Chart I-8). Some 95% of corporate debt is in local currency terms. My colleague Jonathan LaBerge from China Investment Strategy has calculated that Chinese state-owned enterprises' adjusted return on assets, has fallen below the cost of capital (Chart I-9). This indicates that these companies have for now exhausted profitable investment opportunities and should arguably scale back on their investment expenditures. Further borrowing and investing by these enterprises will augment the amount of bad assets held by Chinese banks and reduce the country's overall productivity and hence, potential growth. Yet, denying these debtors financing will result in a major slump in capex, and probably labor market weakness. Chart I-9Chinese SOEs: Capital Misallocation Chinese SOEs: Capital Misallocation Chinese SOEs: Capital Misallocation Chart I-10Leverage And Interest Coverage For Chinese Companies Leverage And Interest Coverage For Chinese Companies Leverage And Interest Coverage For Chinese Companies Dissecting sectoral data, indebtedness is elevated for industrials, utilities and property developers. Consistently, the interest coverage ratio is extremely low for industrials, utilities and property developers (Chart I-10). Financial health of Chinese materials has improved tremendously due to de-capacity reforms - the shutdown of excess capacity that has boosted both steel and coal prices. Interestingly, this has occurred at the expense of utilities and some other heavy consumers of steel and coal. Notably, steel and coal prices are beginning to relapse (Chart I-11). For reasons discussed in our previous report,3 these commodities prices will drop further and will hurt producers' cash flow and profits, causing their creditworthiness to deteriorate. Chart I-11Steel And Thermal Coal Prices Steel And Thermal Coal Prices Steel And Thermal Coal Prices Offshore corporate bond yields and spreads are surging, foreshadowing rising borrowing costs and reduced availability of financing (Chart I-12A). The problem is especially acute for property developers (Chart I-12B). In a nutshell, Chinese corporate U.S. dollar bond yields are at their highest levels of the past five-six years. The same is true for emerging Asian corporate bond issuers. Chart I-12AChinese Offshore Aggregate Corporate Bonds Chinese Offshore Aggregate Corporate Bonds Chinese Offshore Aggregate Corporate Bonds Chart I-12BChinese Offshore Property Developers Chinese Offshore Property Developers Chinese Offshore Property Developers Not only do Chinese corporate bonds now account for 32.5% of EM and 56% of emerging Asian corporate bond indexes, but investment expenditures by Chinese companies are also critical to companies elsewhere in Asia and globally. Chinese gross fixed capital formation accounts for 6% and 5.4% of global GDP in nominal and real terms, respectively. By contrast, these numbers are 4.6% and 4.3% for the U.S. We have deliberated at great length on why China's growth will likely continue to downshift, despite the policy stimulus, and we will not repeat our arguments today.4 The financial health of Chinese companies will worsen due to dwindling sales and cash generation. This, along with less credit/financing available onshore and offshore, will erode their capacity to undertake large investment expenditures. Consequently, capital expenditures in general and construction in particular will suffer substantially. This is the main rationale behind our negative view on resources, raw materials and industrials worldwide. Investment Observations And Conclusions Apart from Turkey and Argentina, there has been no liquidation and capitulation in EM assets in general and the credit space in particular. It would be unusual if this extended selloff ends without capitulation. EM credit markets appear technically vulnerable. In particular, the excess returns on EM sovereign and corporate bonds are splintering below their 200-day moving averages (Chart I-13). Odds are there will be more downside. Chart I-13A Bad Signal A Bad Signal A Bad Signal Rising U.S. dollar corporate bond yields in both EM overall and in emerging Asia herald lower share prices (Chart I-14). So long as the drop in U.S. Treasury yields is offset by widening EM credit spreads, EM corporate bond yields will continue to rise and EM share prices will sell off. However, as and when EM corporate (or sovereign) yields start falling, irrespective of whether because of declining U.S. Treasury yields or narrowing EM credit spreads, EM equity prices will rally. EM sovereign and corporate bond yields are an imperative indicator to watch for equity investors. Chart I-14Rising Corporate Yields = Lower Share Prices Rising Corporate Yields = Lower Share Prices Rising Corporate Yields = Lower Share Prices We continue to recommend defensive positioning in EM sovereign and corporate bonds. In terms of asset allocation, EM dollar-denominated sovereign and corporate bonds should not be compared with EM local currency bonds or equities or U.S. Treasurys.5 These are credit instruments, and they should be a part of a credit portfolio with U.S. and European corporate bonds. Credit portfolios should presently be underweight EM sovereign and corporate bonds relative to U.S. corporate bonds (Chart I-15A & Chart I-15B). Chart I-15AEM Sovereign Credit Versus U.S. Credit: Relative Excess Returns EM Credit Versus U.S. Credit: Relative Excess Returns EM Credit Versus U.S. Credit: Relative Excess Returns Chart I-15BEM Corporate Credit Versus U.S. Credit: Relative Excess Returns EM Credit Versus U.S. Credit: Relative Excess Returns EM Credit Versus U.S. Credit: Relative Excess Returns Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Andrija Vesic, Research Analyst andrijav@bcaresearch.com Mexico: Is The Underperformance Overdone? Despite having a sound macroeconomic backdrop,6 Mexican financial markets have lately substantially underperformed their emerging market peers due in large part to domestic politics. Odds are that Mexican risk assets will continue to sell off in absolute terms, especially given the broad turmoil in the EM universe, which we expect to continue. That said, the recent underperformance of Mexican markets versus their EM peers is overdone, and odds are that Mexican stocks, local bonds and sovereign credit will outperform their EM peers over the coming six to 12 months: First, the Mexican authorities have been pursuing orthodox macro policies, including very tight monetary and fiscal policies. The central bank hiked its policy rate again last week in the face of a currency relapse, and the fiscal stance has been tight. Currently, the real policy rate is 4% and the 10-year local currency government bond yield is 5.5%, both deflated by core consumer price inflation (Chart II-1, top and middle panel). Real rates are very high by historical standards and are now above most other EMs. Chart II-1Mexico: Tight Monetary And Fiscal Policies Mexico: Tight Monetary And Fiscal Policies Mexico: Tight Monetary And Fiscal Policies The government's non-interest expenditures deflated by core consumer price inflation have been contracting (Chart II-1, bottom panel). Such a tight monetary and fiscal policy mix will not change considerably with AMLO taking the office and it should benefit the currency. We expect the peso to start outperforming its EM peers on a total-return basis. Second, the Mexican peso is very cheap - close to one standard deviation below fair value, according to the unit labor cost-based real effective exchange rate (Chart II-2). The latter is our favorite currency valuation measure. Chart II-2The Mexican Peso Is Cheap The Mexican Peso Is Cheap The Mexican Peso Is Cheap Third, economic growth is improving, as the effects from monetary and fiscal tightening are diminishing (Chart II-3). This should at the margin support Mexican financial markets versus their EM peers where growth is slowing. Chart II-3Mexico: A Moderate Cyclical Recovery Mexico: A Moderate Cyclical Recovery Mexico: A Moderate Cyclical Recovery Fourth, Mexico's business cycle is much more leveraged to the U.S. economy than to China's. In line with our view that U.S. growth will fare better than China's growth, the Mexican economy will likely outperform other EMs that are more leveraged to China. Finally, an important rationale behind our recommendation to maintain an overweight stance on Mexico is that Mexican risk assets are defensive plays within the broad EM universe. In other words, whenever there is broad EM turbulence and an ensuing flight to quality, Mexican risk assets tend to outperform their EM peers. This is even more likely to happen now that Mexican sovereign spreads are already elevated and local currency government bonds offer a very attractive yield relative to other EMs (Chart II-4). Chart II-4Mexican Domestic And U.S. Dollar Bonds Offer Value Mexican Domestic And U.S. Dollar Bonds Offer Value Mexican Domestic And U.S. Dollar Bonds Offer Value Still, a few words are warranted on the recent domestic political developments. Our view is that the latest measures announced by the incoming administration regarding the new airport and banking fees are more indicative of a strategy to test the markets before the AMLO administration takes office, rather than declaring war against both markets and investors. It is noteworthy how fast the AMLO government came out after each of these announcements to calm investors. This suggests to us that fears of Mexico taking an irreversible sharp political turn to the left are overblown. AMLO is likely to be pragmatic and deliberate in the way he pushes forward his policies. In a nutshell, our bias is that these announcements represent an attempt by the AMLO administration to promote competition and reduce rent-seeking activities in the economy. This can be negative for shareholders of incumbent large companies, as it will hurt corporate profits of oligopolies. However, in the long term these polices will be positive for overall economic growth as they will reduce the cost of doing business, appease structural inflation and boost the nation's competitiveness. From a structural perspective, these policies are positive for the currency and local bonds. One way to play this theme is to favor small-cap over large-cap companies. Given the oligopolistic structure of some industries, Mexican large-cap companies are much more likely to be hurt by the incoming administration's open competition policies than small-cap companies. As such, small-caps will likely outperform large-caps in Mexico over at least the next six to 12 months (Chart II-5). Moreover, small-caps are currently trading at a significant discount compared to large-caps, with the former trading at multiples that are half of the latter. Chart II-5Mexico: Small-Caps Will Outperform Large-Caps Mexico: Small-Caps Will Outperform Large-Caps Mexico: Small-Caps Will Outperform Large-Caps Investment Conclusion Dedicated EM investors should overweight Mexican equities, local currency bonds and sovereign credit within their respective universes. Concerning the exchange rate, we are maintaining our long MXN / short ZAR position. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Indonesia: Defying The Impossible Trinity? Indonesian stocks are attempting to rally and have lately outperformed the EM equity benchmark. The outlook for this bourse remains negative and we recommend investors to fade this rally and outperformance. Critically, Indonesian domestic interbank rates and corporate U.S. dollar bond yields are rising. Historically, this is a negative signal for share prices (Chart III-1, rates and yields are shown inverted). Chart III-1Rising Rates/Yields = Falling Stocks Rising Rates/Yields = Falling Stocks Rising Rates/Yields = Falling Stocks Weakening rupiah and rising interest rates are forcing the central bank (BI) into a policy dilemma: Should it defend the currency and allow interest rates to rise further or should it cap interest rates and let the currency find a market equilibrium? It appears the BI is trying to do both - to stop the currency from depreciating, while also capping or bringing down interbank rates simultaneously. This defies the Impossible Trinity thesis which stipulates that a central bank of a country with an open capital account has to choose between controlling either the exchange rate or interest rates. On the surface, it would seem that the BI has been focused on targeting a stable rupiah. The monetary authorities have sold foreign exchange reserves (Chart III-2, top panel), and raised the key policy rate. Chart III-2Aggressive Monetary Policy Tightening... Aggressive Monetary Policy Tightening... Aggressive Monetary Policy Tightening... Selling of foreign exchange reserves is a form of tightening as it drains the banking system's excess reserves at the central bank. Shrinking interbank liquidity, however, pushes up interbank rates and borrowing costs (Chart III-2, bottom panel). Higher borrowings costs not only make the currency more appealing to investors, but they also curb domestic demand and, thereby, improve the current account balance. This is an ultimate mechanism of how policy tightening leads to exchange rate stability. Yet the full picture of BI's policies is a lot murkier. While on the one hand, the central bank has sold its foreign exchange reserves and hiked policy rates to defend the rupiah, it has also offset some of the tightening by injecting local currency reserves into the banking system. Chart III-3 shows that the BI purchased/redeemed back central bank certificates from commercial banks, which has led to a sharp increase in commercial banks' excess reserves. Chart III-3... And Liquidity Injections By Central Bank ... And Liquidity Injections By Central Bank ... And Liquidity Injections By Central Bank Central bank liquidity injections are akin to monetary easing aimed at capping or even bringing down interbank rates. Hence, they come as a contradiction to the central bank's restrictive policies. If the BI chooses to stabilize the rupiah, then interbank rates and borrowing costs in general will have to rise and the economy will take a hit. Corporate earnings will then contract which will be bearish for the equity market. If the central bank opts to cap interbank rates, it has to inject as much liquidity (excess reserves) into the banking system as required. In this scenario, the currency could depreciate triggering capital flight and selloffs in equity and local bond markets. The BI can continue the muddle-through policy - offsetting or sterilizing its foreign exchange interventions by turning the backdoor liquidity taps on. These injections of local currency liquidity into the banking system could encourage speculation against the rupiah and allow banks to lend more, maintaining robust imports and a large current account deficit. It is not certain, but if the market perceives that interest rates are lower than warranted, the currency could very well depreciate amid this policy mix. In this scenario, the result could be a mix of gradual currency depreciation and somewhat higher interest rates. Financial markets will still do poorly in dollar terms. Overall, odds are high that the rupiah will resume its depreciation and interest rates will move higher. Indonesia's balance of payment dynamics remain a risk to the exchange rate. The current account deficit is still large and exports are heading south (Chart III-4). Chart III-4Current Account Deficit Is Large Current Account Deficit Is Large Current Account Deficit Is Large First, Chart III-5 illustrates that the sharp slowdown in the average manufacturing PMIs of Japan, Korea, Taiwan and Germany are pointing to an imminent contraction in Indonesian export volumes. Chart III-5Exports Are Heading South Exports Are Heading South Exports Are Heading South Second, thermal coal prices seem to be breaking down. Chart III-6 shows that the stock price of Adaro - a large Indonesian coal producing company - has already fallen by 45% in U.S. dollar terms since January, and is heralding a dismal outlook for coal prices. Chart III-6Coal Prices Are To Break Down Coal Prices Are To Break Down Coal Prices Are To Break Down Lower coal prices will shrink Indonesia's coal export revenues. The latter accounts for 12% of total Indonesian exports. In terms of the outlook for banks, which is a key equity sector, their share prices have been surprisingly resilient. Rising interest rates, however, will cause their NPLs to move higher hurting banks' profits, and pulling their share prices down (Chart III-7). Chart III-7Bank Stocks Are At Risk Bank Stocks Are At Risk Bank Stocks Are At Risk Finally, overall Indonesian equity valuations are still not attractive either in absolute terms or relative to the EM benchmark. Meanwhile, foreigners own 32% of the equity market and 37% of local currency bonds. As the rupiah slides, foreigners will rush to the exits, amplifying the currency depreciation. Bottom Line: The path of least resistance for the rupiah is down. Continue underweighting Indonesian equities and bonds and continue shorting the rupiah versus the U.S. dollar. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com Footnotes 1 Please see Emerging Markets Strategy Weekly Report, "On Domino Effects And Portfolio Outflows," dated November 15, 2018, available at ems.bcaresearch.com. 2 Cash flow from operations represents net cash flow from operating activities & excludes net cash flow financing and investing activities. 3 Please see China Investment Strategy Special Report, "Revisiting China's De-Capacity Reforms," dated October 17, 2018, available at cis.bcaresearch.com. 4 Please see Emerging Markets Strategy Weekly Report, "China: Stimulus, Deleveraging And Growth," dated October 25, 2018, available at ems.bcaresearch.com. 5 Please see Emering Markets Strategy Weekly Report, "Strategic Asset Allocation For Emerging Markets," dated May 7 2013, available at ems.bcaresearch.com. 6 Please see Emerging Markets Strategy Special Report, "A Mexican Standoff - Markets Vs. AMLO," dated June 28 2018, available at ems.bcaresearch.com. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights So What? A collapse in Venezuelan oil production could cause Brent prices to average $92/bbl next year. Why? Venezuelan oil output is in freefall. Years of mismanagement constrain its production potential, severely denting government revenues. External debt is sky-high. Venezuela faces challenges in repaying its obligations. China and Russia are unlikely to provide the large-scale subsidies necessary to stabilize the regime over a long period. The United States is unlikely to lift sanctions anytime soon. Rather they may expand them. Feature "PDVSA is red, red from top to bottom." - Former Energy Minister Rafael Ramí­rez "It has been an interesting activity, working without payment." - Sergio Requensa, President of the Corporation of Intermediary Industries, on volunteer groups trying to boost oil output. Global oil prices have fallen by 28.5% since their peak on October 4. While the world awaits OPEC 2.0's meeting on December 6 in Vienna, it is important to remember that global spare capacity is low while serious supply risks loom in many corners of the world. One such risk is the deterioration of Venezuela's economic, political and social situation, which has already precipitated steady declines in oil production (Chart 1). The odds of halting or reversing this trend are razor thin. The Nicolás Maduro government has managed to hobble along, but there is no firm basis for projecting a stabilization either of the regime or oil output. Although it is possible that Venezuela will secure enough ad hoc funding to survive another year, we have no solid grounds for arguing that it will. Chart 1On A Downward Spiral On A Downward Spiral On A Downward Spiral In our dominant scenario of steadily declining Venezuelan output, we forecast Brent to average $82/bbl in 2019. The event of a complete collapse could push Brent prices as high as $92/bbl next year (Chart 2). Chart 2A Production Collapse Would Trigger A Price Spike A Production Collapse Would Trigger A Price Spike A Production Collapse Would Trigger A Price Spike Venezuelan Production In Freefall While Venezuelan authorities have stopped reporting official economic data, declining oil production offers clear evidence of a deepening crisis. Venezuela is a founding member of OPEC and was once one of the most prosperous Latin American countries. Decades of gross mismanagement have pushed the country into crisis. Estimated to hold the world's largest crude oil reserves (Chart 3), Venezuela's potential role in global oil markets is massive. Its oilfields have, in the past, accounted for 4% of global oil supply, but have dwindled down to 1% so far this year (Chart 4). Nevertheless, Venezuela's role should not be underestimated. Price risks could be to the upside - on the back of a collapse in output - or to the downside in the unlikely event of production restoration. For now, we project monthly declines will average 35k b/d over the coming year, ending at 681k b/d by the end of 2019. Chart 3Venezuala's Potential Is Unrivaled... Venezuela: What Cannot Go On Forever Will Stop Venezuela: What Cannot Go On Forever Will Stop Chart 4...But Not Captured By Its Dwindling Production Venezuela: What Cannot Go On Forever Will Stop Venezuela: What Cannot Go On Forever Will Stop Continued deterioration in supply comes on the back of decades of economic mismanagement at the hands of former President Hugo Chávez and his United Socialist Party of Venezuela. The failed 2002 coup attempt and related labor strikes at Petróleos de Venezuela, S.A. (PDVSA) - the state-owned oil and gas company - led to the firing of thousands of employees and their replacement with Chávez loyalists, Chavistas. This event politicized the country's economic engine, catalyzing a steady loss in capital and technical expertise. Furthermore, regulations imposed on the energy sector are unfavorable to international investors. For example, the 2001 Hydrocarbons Law stipulated a massive rise in royalties paid by foreign companies - increasing from a range of 1%-17% to 20%-30%. Today, taxes per barrel in Venezuela are the highest among the major producers and form the largest cost component per barrel of oil and gas (Chart 5). Chart 5High Tax Rate Is Unattractive Venezuela: What Cannot Go On Forever Will Stop Venezuela: What Cannot Go On Forever Will Stop Other damaging state actions include: A law requiring PDVSA to hold at least 60% equity in joint ventures with foreign firms investing in the Venezuelan oil sector; The nationalization of the Orinoco Belt - a highly fertile region home to the world's largest petroleum deposits; Government expropriation of foreign assets; Payment failures to international oil service companies. These events ultimately culminated in today's production freefall, which has continued despite the rebound in oil prices after 2015. Needless to say, falling revenues are deadly for petro states. Caracas relies on oil sales for 95% of the government's revenue. Falling rig counts are an ominous sign (Chart 6). Chart 6An Ominous Sign An Ominous Sign An Ominous Sign To make matters worse, export figures actually understate the dire economic situation. The U.S. EIA estimates that roughly half of Venezuela's oil exports are not generating cash! The Venezuelan government has mortgaged much of its production in exchange for loans from China and Russia in recent years. Under these loans-for-oil schemes, the government secured emergency funding to keep its ailing economy afloat, but sacrificed the long-term ability to ensure its own liquidity. This arrangement also includes shipments to the Vadinar refinery in India, which is owned by Russia's Rosneft (Chart 7). Chart 7U.S. Exports Are Main Source Of Revenue U.S. Exports Are Main Source Of Revenue U.S. Exports Are Main Source Of Revenue This leaves exports to the U.S. as the main source of revenue for the Venezuelan government. The result is a Catch-22: With fewer oil barrels to go around, Venezuela can either satisfy its foreign creditors to keep open the possibility of future lines of credit, or it can sell to the U.S. in return for badly needed cash. For the moment, Venezuela is opting for cash. Despite having been cut by ~20% since last year, exports to the U.S. appear to have hit a floor. According to EIA data, after coming in at 13.21mm bbl in February, they have rebounded slightly averaging 19mm bbl/month since June. This is occurring despite ongoing production declines. This is ultimately unsustainable, as the evidence of mismanagement goes beyond production facilities: A breakdown in domestic refining facilities has necessitated an increase in Venezuela's imports of U.S. crude. The lighter oil is needed as a diluent - to blend with Venezuela's heavy crude, facilitating transportation. This is forcing Venezuela's economy to divert scarce hard currency to these imports. In fact, imports have picked up even amid declining oil production and the deepening economic crisis. Earlier this year, PDVSA's Caribbean assets fell under risk of being handed over to ConocoPhillips as compensation for Chavez's 2007 nationalization of Conoco's facilities. These Caribbean assets include storage facilities, refineries, and export terminals on the islands of Bonaire, Curacao, St. Eustatius, and Aruba. Terminals there account for 17% of the company's exports - mainly destined for Asia (Table 1). To prevent this transfer, Venezuela has agreed to pay the American company $2 billion in compensation, $345 million of which has been paid. If these payments cannot be met, the Caribbean assets will be in jeopardy once again - and Conoco is by no means the only company preparing lawsuits to claim assets in the event of further defaults. Table 1Caribbean Assets At Risk Of Seizure Venezuela: What Cannot Go On Forever Will Stop Venezuela: What Cannot Go On Forever Will Stop Similarly, CITGO - PDVSA's U.S. refiner and crown jewel - is at risk to being handed over to creditors. A loss of control of CITGO would disrupt one of the most reliable sources of cash for Venezuela. While U.S. sanctions prevent CITGO from sending dividends to Venezuela, it is so far still allowed to purchase Venezuelan crude. CITGO's assets include three U.S. refineries with a total capacity of 750k b/d. To complicate matters, several creditors are claiming stakes in the refiner: Crystallex International, a Canadian mining company whose Venezuelan assets were nationalized in 2011, is making claims on CITGO. In August, a U.S. federal judge ruled in favor of Crystallex, giving it permission to seize shares of PDV Holding Inc., which owns CITGO. However, the judge also issued a temporary stay on Crystallex - which is planning to auction the shares - until an appeal is decided. If the appeal is in favor of Crystallex it will encourage additional asset grabs by aggrieved foreign companies. PDVSA has offered bond investors a 51% claim on CITGO to push back maturing payments to 2020. The remaining 49% of CITGO was put up as collateral for a $1.5 billion loan from Rosneft. The risk - which intensifies with each missed payment - is that as Venezuela defaults on its debts, more of its facilities will be seized, further reducing its production, refining, and export potential. This would ultimately accelerate the total collapse of Venezuelan output. Bottom Line: Venezuelan oil production is steadily crumbling. Almost two decades of mismanagement have preceded this outcome and, as such, it cannot be reversed easily. We expect monthly declines to average 35k b/d, with the probability of a complete collapse in output rising with each passing day. A Macroeconomic Mess Venezuelans today are paying the price for the unsustainable external debt amassed over the past decade (Chart 8). Estimates of external debt place it around a staggering $150-$200 billion! Sovereign and PDVSA bonds due next year are estimated to be about $9 billion (Chart 9). This does not even account for payments due from other forms of debt (Table 2). Chart 8Debt Levels Are Unsustainable Debt Levels Are Unsustainable Debt Levels Are Unsustainable Chart 9It's Payback Time Venezuela: What Cannot Go On Forever Will Stop Venezuela: What Cannot Go On Forever Will Stop Table 2Yikes! Venezuela: What Cannot Go On Forever Will Stop Venezuela: What Cannot Go On Forever Will Stop Total reserves leave little room for optimism (Chart 10). They now stand at less than $10 billion, down from $43 billion less than a decade ago. Chart 10Reserves Cannot Lend Support Reserves Cannot Lend Support Reserves Cannot Lend Support In projecting the country's ability to make payments in 2019, we looked at several oil-price and production scenarios. All scenarios point to default, as shown in Table 3. Even in the optimistic scenario in which production is flat (which is highly unlikely given that it has been declining at an average monthly rate of 47k b/d so far this year), the country needs $14.8 billion in foreign exchange reserves to cover rising PDVSA expenses plus debt-service costs and its total import bill. This will put Venezuela $6 billion in the red. Table 3All Roads Lead To Default Venezuela: What Cannot Go On Forever Will Stop Venezuela: What Cannot Go On Forever Will Stop This forecast would become even more somber if we were to include payments due on other forms of debt (e.g. private bonds, loans, etc), for which there is no published repayment schedule. Stability is entirely out of reach for the Venezuelan government alone. Maduro's recovery plan announced earlier this year will do nothing to combat the root of the crisis. For instance, the launch of a cryptocurrency - the "petro" - that is backed by five billion barrels of oil reserves, to which the bolivar will be pegged, is not a viable solution.1 In fact, Venezuela's policy options are extremely limited. Only a massive show of support from China and Russia can realistically bring about a substantial improvement. This would require a commitment to pay: (1) debt servicing and import costs; (2) the operating costs of PDVSA and the funds needed to preserve CITGO and other critical assets; (3) the funding of new investment required to revive the oil sector. Over the past decade, China and Russia have provided loans worth ~ $60 billion and ~ $20 billion, respectively. Of these loans, an estimated $28.1 billion and $9.1 billion remain outstanding for China and Russia, respectively.2 Venezuela has paid off not quite half of its debts to these powerful patrons. The last Chinese loan was in 2016. China stopped the credit tap throughout 2017 and most of 2018 amid Venezuelan instability. While China expressed its intention to extend a $5 billion loan in September, this amount is small by comparison with the double-digit billions of loans and direct investment that China provided annually from 2009-15. It would not cover Venezuela's shortfall of funding in our three scenarios even if it were devoted entirely to paying immediate obligations. Moreover, the Chinese loan has not been finalized.3 Thus, China's diplomatic "return" to Venezuela suggests that Beijing is not willing to provide the large-scale subsidies necessary to stabilize the regime over a long period. Indeed, China's state oil firm Sinopec has joined other foreign companies in suing Venezuela for unpaid debts!4 Moreover, Chinese and Russian funds are hardly likely to exceed the large amount invested over the past decade - and those amounts did not prevent Venezuela from falling into its current crisis. Russia is no longer capable of fully financing a satellite state in the way the Soviet Union financed Cuba in the twentieth century. It is hoping that China will foot most of the bill. While China is probably able to do so in cash terms, it is so far unwilling to pay the strategic price of setting up a Soviet-style power struggle with the United States in violation of the Monroe Doctrine.5 Indeed, plowing tens of billions of additional dollars into Venezuela may be unwise if the U.S. reverts back to its tried and tested strategy of directly intervening in the domestic affairs of Latin American countries. Venezuela, being in South America and on the Atlantic coast, is too far away for China to secure in the event of a showdown with the United States. As such, Beijing must understand that any investment in Venezuela could one day become stranded capital in a traditionally American sphere of influence. In fact, China is concentrated on building its own sphere of influence in Asia. While Venezuela is nominally part of the expansive Belt and Road Initiative, the latter is ultimately directed at making China's outward investment more coherent and expanding influence on the Eurasian continent. Neither of these aims is all that favorable for Venezuela. While China certainly wants privileged access to Venezuelan oil, it does not "need" Venezuelan crude for supply security in the way that is often implied. It frequently re-sells the oil on global markets. Nevertheless, Russia and China can offer debt restructuring and relief. Out of the $9 billion outstanding that is owed to Russia, Moscow has agreed to restructure $3.15 billion to be paid over ten years. Other such restructuring deals could be forthcoming (although, notably, China did not agree to a restructuring when Maduro visited in September). Restructuring will not work with U.S. bondholders. The U.S. imposed sanctions on August 24, 2017 seem to prevent U.S. holders of Venezuelan bonds from participating in such arrangements. The U.S. Office of Foreign Assets Control is unlikely to lift sanctions anytime soon.6 More likely, the United States will expand sanctions, as U.S. National Security Advisor John Bolton indicated in a speech in Miami on November 2. There he dubbed Venezuela, Cuba, and Nicaragua the "troika of tyranny" in the western hemisphere. Possible sanctions include: First, the Trump administration has moved to restrict purchases of Venezuelan gold, as the government has been increasing exports to Turkey (and likely China).7 Trump is considering putting Venezuela on the list of state sponsors of terrorism, which will cut off aid and loans. Second, the financial sanctions announced in 2017 could be expanded to cover existing debts, the trading of government and PDVSA bonds on secondary markets, and CITGO's newly issued debt - all areas that the Department of Treasury has so far exempted. Third, sanctions on tanker insurance could impede Venezuela's ability to transport its oil to international destinations. Venezuela does not have the tanker capacity to ship its own oil. Fourth, in the most extreme case, restrictions on U.S. imports of crude oil could punish the Maduro administration. The U.S. is reluctant to exacerbate the humanitarian crisis and deal with its second-round effects. But it could ultimately use its leverage as importer to insist that its companies are compensated, one way or another, for Venezuelan defaults. Technically alternative buyers could absorb Venezuela's heavy crude, but the loss of the U.S.'s cash-generating imports would pile more pressure onto an already wobbling regime. Bottom Line: Venezuela has been relying on ad hoc funding to survive thus far. Loans in exchange for oil are now eating up its revenues. President Maduro's recovery plan does not address the root causes of the ongoing macroeconomic mess. All scenarios point to insolvency. A Regime Change Is In Order Hyperinflation and the absence of basic necessities have left Venezuelans pessimistic about their country's future (Chart 11). This is not surprising: A staggering 87% of households are estimated to be below the national poverty line, most of whom are in extreme poverty. GDP per capita is half the level it was only a decade ago (Chart 12). These are the ingredients of a revolutionary brew. Chart 11The Outlook Isn't Rosy The Outlook Isn't Rosy The Outlook Isn't Rosy Chart 12Purchasing Power Has Been Slashed By Half Purchasing Power Has Been Slashed By Half Purchasing Power Has Been Slashed By Half The deepening humanitarian and economic crisis is causing one of the largest outflows of emigrants in recent years. According to the United Nations, 2.6 million Venezuelans live abroad and 1.9 million of them have left since 2015 (Chart 13). Chart 13Venezuelans Are Fleeing Venezuela: What Cannot Go On Forever Will Stop Venezuela: What Cannot Go On Forever Will Stop The crisis has naturally translated into a massive shift in public opinion against the regime (Chart 14). Maduro's reelection for a second term in May occurred in an environment in which the opposition boycotted the elections and voter turnout was reported at just 46.1%, hardly half of the 80% rate in 2013. Venezuelans have also lost faith in the armed forces and police, which have buttressed the current regime (Chart 15). Chart 14Maduro Lacks Support Maduro Lacks Support Maduro Lacks Support Chart 15Loss Of Faith In Security Institutions Loss Of Faith In Security Institutions Loss Of Faith In Security Institutions Opposition parties do not have the power to force a transition to a new government, but under today's extreme circumstances they are not as divided as they were in the past. They all support regime change, domestic resistance, and international pressure. All have refused to participate in any dialogue unless it is to discuss the terms of Maduro's resignation. This means that a fracture within the regime, or an external factor like U.S. action, could tip the balance. Could a military coup provide the way out of the current morass? Ultimately, yes, in the sense that the military is the ultimate arbiter of Venezuelan society over the course of history. But short-term investors should not hold their breath. The Maduro regime has managed to survive as long as it has by ceding ever more power to the army, meaning that, in a sense, the coup has already occurred. Food distribution and oil production are now directly under the control of the military. Once the regime becomes completely fiscally defunct, military leaders may pin the blame on Maduro and reshape or expunge the Socialist Party. The timing, however, is nearly impossible to predict other than to emphasize that the current situation is unsustainable and we do not believe that Beijing will ride to the rescue. One foreboding sign is that Maduro has authorized hikes to domestic gasoline prices, which are heavily subsidized. A hike of this nature prompted the Caracazo social unrest in 1989, which helped motivate the attempted coups of 1992. Another option may be direct U.S. action. While the U.S. has been reluctant to intervene in Latin America since the short-lived, albeit successful, 1989 intervention in Panama, President Trump did raise the idea of a "military option" in August 2017.8 While Trump's comments were largely ignored, and subsequently opposed by the Pentagon itself, the reorientation of U.S. policy towards confronting China may convince the U.S. defense and intelligence establishment to view Venezuela through the prism of a new Cold War. As such, and especially if the humanitarian crisis grows, investors should not completely dismiss the possibility of a U.S. military-backed coup in Venezuela.9 Bottom Line: Opposition parties are not as divided as they were in the past, in a sign that the current regime is failing to maintain control. Given the unsustainability of the economic situation and the military's ever-growing role, odds are in favor of an army takeover at some point. The relevant takeaway for investors is that things will have to get worse before that occurs - adding pressure on global oil supply and leading to additional debt defaults. Investment Implications Declining Venezuelan oil production will continue weighing on global supply. We model monthly production declines of 35kb/d as the dominant scenario in our supply-demand balances. On this basis, we expect Brent to average $82/bbl in 2019 and WTI to trade $6/bbl below that. A complete collapse in Venezuelan production next year could push prices much higher - up to $92/bbl and $86/bbl for Brent and WTI, respectively. While an eventual production collapse is inevitable, Venezuela may be able to hobble along for another year through ad hoc funding. Thus, a premium will be priced into global oil markets in 2019 on the back of falling Venezuelan production - and the risk of its collapse. Roukaya Ibrahim, Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Pavel Bilyk, Research Associate pavelb@bcaresearch.com Juan Egaña, Research Associate juane@bcaresearch.com Footnotes 1 The U.S. is already considering sanctions targeting the cryptocurrency. Please see Franco Ordonez, "Top lawmakers in Congress push tough new measures against Venezuela," September 24, 2018, available at www.mcclatchydc.com. For the text of an earlier proposal please see "Venezuela Humanitarian Relief, Reconstruction, and Rule of Law Act of 2018," introduced into the Senate by Senator Robert Menendez (D, NJ) on the foreign relations committee, S. 3486 at www.congress.gov. 2 Please see "Venezuela: Deuda externa per capita del sector público," Prodavinci, available at especiales.prodavinci.com. 3 Please see "China y Rusia desconfían del régimen chavista y aumentan la supervisión de sus inversiones en Caracas," PD América, October 31, 2018, available at www.periodistadigital.com. 4 Please see Jonathan Wheatley, "Sinopec settles with Venezuela's PDVSA, ending 5-year dispute," Financial Times, December 12, 2017, available at www.ft.com. 5 The Monroe Doctrine was reinforced specifically in relation to Venezuela by the "Roosevelt Corollary" in 1902-03. Recently the United States has reasserted the Monroe Doctrine in the face of a widespread perception that China has gained strategic ground on the continent, namely in Venezuela. Please see Vice President Mike Pence, "Remarks by Vice President Pence on the Administration's Policy Toward China," the White House, October 4, 2018, available at www.whitehouse.gov. 6 On the contrary, sanctions are expanding. Please see U.S. Treasury Department, "Treasury Targets Venezuelan President Maduro's Inner Circle and Proceeds of Corruption in the United States," September 25, 2018, available at home.treasury.gov. 7 Please see the White House, "Executive Order Blocking Property of Additional Persons Contributing to the Situation in Venezuela," November 1, 2018, available at www.whitehouse.gov. 8 Please see Jeremy Diamond, "Trump asked advisers about invading Venezuela in 2017," CNN, July 5, 2018; and Dan Merica, "Trump says he won't rule out military option in Venezuela," CNN, August 11, 2017, both available at www.cnn.com. 9 Even the Secretary General of the Organization of American States, Luis Almagro, has refused to rule out any options, including military intervention. Pro-Maduro commentators have claimed that the U.S., along with Colombia and other enemies of the regime, supported the apparent attempt to assassinate Maduro by drones in August this year. Please see "Venezuela President Maduro survives 'drone assassination attempt,'" BBC, August 5, 2018, available at www.bbc.com. The New York Times has also reported that the Trump administration sent officials to "listen" to rebel Venezuelan military officers proposing a coup attempt. Please see Ernesto Londono and Nicholas Casey, "Trump Administration Discussed Coup Plans With Rebel Venezuelan Officers," NYT, September 8, 2018, available at www.nytimes.com. We Read (And Liked)... The Great Leveler: Violence And The History Of Inequality From The Stone Age To The Twenty-First Century Professor Walter Scheidel's opus - The Great Leveler - introduces the "Four Horsemen" of equality: warfare, revolution, state collapse, and pandemics.10 These four factors, he argues, explain all significant levelling of wealth and income throughout history. And by history, Scheidel really means all of human history. The thesis behind The Great Leveler is that only through the "aid" of the Four Horsemen has wealth ever been distributed more evenly in human societies. In every grand passage in history, one of the four terrible afflictions has tipped the scales away from capital and landholders and in favor of laborers. Otherwise, when there is not war, revolution, state collapse, or pandemics, capital and landholders acquire sufficient wealth and political capital to stave off any attempts at leveling. Scheidel's focus on World War I and II is particularly interesting. He controversially argues that the prosperity and equality that prevailed in the western world after these wars was to a great extent the product of government measures imposed in order to win the conflict. These included nationalization, direct intervention in production, fiscal policy, and inflationary monetary policy. Mass mobilization necessary to wage and win a total war left western societies, and Japan, "levelled" by the time the wars ended. BCA Research was honored to have Professor Scheidel attend our annual Investment Conference in Toronto this September. In the talk, he warned the room full of investors to "be careful what you wish for," since the suppression of inequality has "only ever brought forth sorrow." Furthermore, Scheidel rejected the hypothesis that wealth and income inequality bring about their own demise. They usually grow unchecked until one of the Four Horsemen appears exogenously. The takeaway from Scheidel's work is that income and wealth inequality are, according to the scales of human history, essentially part of human existence. As such, one should neither fret too much about them nor worry that they will lead to serious efforts to curb them. There are two weaknesses in this argument. First, the book is primarily a treatise on medieval history. The vast amount of empirical evidence that Scheidel has carefully collected occurred before societies became democratic, and specifically before universal suffrage. While Scheidel focuses on the effects of the world wars in the twentieth century as the causes of modern leveling, he barely mentions the role played by the spread of the electoral franchise during and after the conflicts. And it is true that democracy has not prevented the rise of income inequality in much of the developed world since the 1980s - that is, since the laissez-faire revolution. However, the end to that story is yet to be written. Which brings us to the second weakness: Scheidel dismisses GINI coefficient data on income inequality. It does not support his thesis. For example, his tables show that the "market GINI" of many western European countries is as high as that in the United States. However, after accounting for redistributive effects, it is in many cases significantly lower. Instead, Scheidel focuses on the wealth accruing to the top 1%. But again, continental European countries have experienced much lower concentration of wealth than the laissez-faire economies of the U.K. and the United States. Yes, there is growth in concentration even in the social democracies of Europe, but it is at a much slower pace than in the countries that have been the most committed adherents of the Reagan-Thatcher revolution. The greatest failing of Scheidel's thesis is that it lacks nuance when it comes to the modern era. Its parsimony over the course of human history is astounding and commendable - it is what makes this a true magnum opus of social science. However, the real world is rarely as parsimonious. The facts are quite different from the theory. Chart 1 shows that the wealth accruing to the top 10% of income distribution in France was higher in the 1950-1970 era than in the U.S., and much higher than in the United Kingdom. Then, the supply-side revolution took hold in the Anglo-Saxon world, while France pursued policies that sought to reverse the causes of the May 1968 social angst. The shift in wealth distribution was jarring. Chart 1No Horsemen Here, Just Social Democracy No Horsemen Here, Just Social Democracy No Horsemen Here, Just Social Democracy From this one example we can draw two conclusions. First, Scheidel is wrong when he says that the march of income inequality is inevitable. It clearly has not been in western Europe in recent memory. Second, Scheidel is also wrong when he argues that the march of income inequality is irreversible. France was once a right-of-center country ruled by elites who saw revenues accrue to their capital and wealth holdings. Then, all hell broke loose in the country, with teenage Baby Boomers joining up with common workers in a (relatively) bloodless socialist revolution. Rather than adopt laissez-faire capitalism with vigor, French policymakers adopted wealth and income taxes that reversed the rising share of income accruing to the top 10%. Only today, after decades of a deliberately orchestrated and significant leveling, are policymakers in France looking in a different direction. Scheidel claims that his book is pessimistic, but that of course depends on the audience. Our audiences tend to be made up of investors, i.e. of savers. As such, Scheidel's thesis is in fact joyous! A historical opus that proves, without a doubt, that income inequality is irreversible short of apocalypse!? Sounds too good to be true! It is. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 10 Princeton: Princeton University Press, 2017, 504 pages.

Highlights The October credit and housing market data present a gloomy picture for Chinese domestic demand. Trade remains buoyant, but exports are set to decline materially over the coming months. Many investors are focused too much on external demand and not enough on Chinese domestic demand. China's old economy has been deteriorating for two years, and it is unlikely that exchange rate depreciation alone will reverse this trend. A review of the drivers of credit growth during China's last mini-cycle upswing underscore that the country's monetary transmission mechanism is impaired. This suggests that investors are exposed to fiscal and regulatory policy inertia, as well as time lags once policymakers decide to aggressively stimulate. Chinese stocks may present an excellent buying opportunity over the coming year, but that point has not yet been reached. Stay neutral for now. Feature China's October trade data (released earlier this month) was a frustrating one for investors, as it revealed that market participants will have to wait even further for clarity on the magnitude and duration of the upcoming shock to exports. The strong October trade data has even led to some market participants questioning whether export growth will decelerate at all, a view that we strongly disagree with. It is true that there is no direct reason to expect that the impact of U.S. import tariffs will affect China's non-U.S. exports. But Chart 1 shows that Chinese exports to the U.S. are currently running above the pace that would be predicted by the overall trend in U.S. non-oil imports, a circumstance that is highly unlikely to continue in the face of mutual tariff imposition. Negative export "alpha" would imply a growth rate materially below the dotted line in Chart 1. As such, even though Chinese exports to the U.S. account for only 20% of total exports, the impact of an eventual "reversion to fundamentals" is likely to substantially effect the overall trend in Chinese export growth. Chart 1Export Frontrunning To The U.S. Continues Export Frontrunning To The U.S. Continues Export Frontrunning To The U.S. Continues Given the integrated nature of global trade, persistently strong export growth is also very likely supporting imports. Chart 2 shows that import growth has been closely correlated with domestic industrial activity since 2010, but is now running approximately 10-12 % above would normally be expected. This implies that China's overall trade momentum will weaken considerably over the coming months, which is likely to reverberate through key trade linkages in emerging markets and commodity-producing developed markets. Chart 2Current Import Growth Appears Unsustainable Current Import Growth Appears Unsustainable Current Import Growth Appears Unsustainable October's credit data was also highly significant, as it validated the view that we espoused in our recent report.1 We noted in response to the September credit release that a surge in the 3-month rate of change of adjusted total social financing (TSF) was driven by front-loaded fiscal spending that would not last. Chart 3 shows that special local government bond issuance in October fell by 650 bn RMB relative to the prior month, suggesting that (net) new fiscal stimulus will be required in order for local government bond issuance to materially boost overall credit growth. Chart 3September Was Not The Start Of A New Trend In LG Bond Issuance September Was Not The Start Of A New Trend In LG Bond Issuance September Was Not The Start Of A New Trend In LG Bond Issuance Finally last week's housing data release highlighted that residential sales and construction momentum is faltering (Chart 4), which was likely triggered in part by prior reductions in the PBOC's pledged supplementary lending (PSL) program. We noted in a September Special Report that the pullback in the PSL would negatively impact the housing market on a cyclical basis,2 and October's data certainly supports this view. Chart 4The Housing Market Slowed In October The Housing Market Slowed In October The Housing Market Slowed In October Don't Pin Any Hopes On A Trade "Ceasefire" Against this gloomy economic backdrop market participants have actually been incrementally positive about China over the past few weeks, in anticipation of a possible détente with the U.S. Last week's flurry of optimism about an apparently meaningful resumption in trade talks were somewhat diminished by comments from President Xi and Vice President Pence at the APEC summit over the weekend, but our geopolitical strategists believe that the odds of a short-term "tariff ceasefire" occurring at the G20 summit later this month are genuinely non-trivial (possibly as high as 30-40%). We define a "ceasefire" in this case as a commitment to refrain from any further protectionist action during a renewed period of negotiations, not an immediate and substantive deal that ends the trade war. We agree that any positive actions on the trade front are likely to lead to a short-term boost to Chinese stock prices (and global risk assets more generally). But the key question for investors is whether this will lead to a durable rally lasting several months. In our opinion, three factors argue against this view: A ceasefire probably will not lead to an agreement: There is no indication that either the U.S. or China has changed their positions concerning the dispute, with China reportedly having simply restated their previous offer in advance of the G20 summit. On the U.S. side, attempts to restart negotiations may reflect the desire to give China "one last chance" before moving to impose tariffs on all Chinese imports, which the administration may be planning as a rhetorical counter to any domestic pushback from rising consumer goods prices (the "Walmart effect"). A ceasefire will not roll back tariffs already in place: It is unlikely that the U.S. would impose tariffs on all remaining imports from China (the "third round") while negotiations are taking place. But a near-term shock to Chinese exports is still likely, because the existing tariffs on the first and second round would not be rolled back until a deal is successfully negotiated. It is even possible (albeit unlikely) that the administration will move ahead with the planned increase in the second round tariff to 25% at the end of the year despite the presence of negotiations. A ceasefire alone will not reverse the ongoing slowdown in Chinese domestic demand: The trade war between the U.S. and China is occurring against a backdrop of weaker Chinese domestic demand, a point that we have highlighted numerous times over the past year. As shown in Chart 2 above, the growth momentum of China's old economy peaked well before the trade war began, and a temporary "stay of execution" on the trade front is unlikely to change the downtrend in domestic activity. This last point is important, as it appears that many global investors are focused almost exclusively on China's negative external demand outlook and not nearly enough on weak domestic demand. Chart 5 vividly illustrates this point, by contrasting our new Market-Based China Growth Indicator with our leading indicator for the Li Keqiang Index. Our market-based China Growth Indicator is very similar to the highly informative China Play Index created by BCA's Foreign Exchange Strategy service to hedge against a possible countertrend correction in the U.S. dollar,3 but it is somewhat broader, has four asset class subcomponents, and has been built on a deviation from trend basis (see Box 1 for a description). Chart 5The Market Has Lagged The Macro Data Over The Past Three Years The Market Has Lagged The Macro Data Over The Past Three Years The Market Has Lagged The Macro Data Over The Past Three Years Box 1 Introducing The BCA Market-Based China Growth Indicator Chart A1 presents the BCA Market-Based China Growth Indicator, along with its four asset class subcomponents: currencies, commodities, equities, and rates/fixed-income. The purpose of the indicator is to act as a broad proxy of investor expectations for Chinese growth, and to illustrate which asset classes are providing the strongest/weakest growth signals. Chart A1Investors Are Incrementally Positive, But Rates Caution Against Over Optimism Investors Are Incrementally Positive, But Rates Caution Against Over Optimism Investors Are Incrementally Positive, But Rates Caution Against Over Optimism Table A1 presents a list of the series included in each of the asset class subcomponents, all of which were tested to ensure that they were coincident or lead the Bloomberg Li Keqiang index. The indicator is made up of an equally-weighted average of the four asset class subcomponents, and each series is equally-weighted within its respective subcomponent (meaning that the 17 series do not have equal weights in the overall indicator). Table A1Components Of The BCA Market-Based China Growth Indicator Trade Is Not China's Only Problem Trade Is Not China's Only Problem Chart A1 highlights that the commodity and equity subcomponents are currently providing the most positive signals, whereas the currency component is in line with the overall indicator. The rates component, which provided the earliest warning sign this cycle that Chinese growth was likely to decelerate, remains the weakest element of the indicator and has not been rising over the past few weeks (in contrast to the other components). The chart shows that price signals from China-related assets generally followed or even anticipated our LKI leading indicator prior to 2015, but that the reverse has been true over the past three years. The gap between the two indicators became extreme earlier in the year, and only closed once investors began to react to the emergence of the trade war. But the key point from the chart is that trade is not China's only problem, as our LKI leading indicator shows that Chinese monetary conditions, money, and credit growth have been deteriorating for the better part of the past two years. Monetary Policy: Pushing On A String? One bullish China narrative that currently prevails in the marketplace is that the odds of "big bang" stimulus rise materially in lockstep with any further deterioration in the macro data. Most recently, several China analysts have speculated that the PBOC will soon cut its benchmark policy rate, which would be an unmistakable sign that the monetary policy dial has been turned towards "maximum reflation". Ultimately, we agree with the view that investors hold a put option issued by the Chinese government, but we have strenuously argued that the strike price is considerably lower than many think. On top of this, investors face another risk, namely a circumstance where the exercise price of the China put is even lower than the government intends it to be. This situation could arise if the PBOC decides to fire its bazooka, but the resulting decline in interest rates does not materially boost credit growth. Such a scenario prevailed in the U.S. several years following the global financial crisis, when many investors characterized the Fed's efforts to boost (or at least stabilize) credit growth as "pushing on a string". Chart 6 illustrates that this actually occurred in China during its last mini-cycle upswing, raising the odds of a repeat incident that results in a meaningful lag between the approval of big bang stimulus and its reflationary effect on financial markets. The chart shows the annual change in total social financing as a share of 4-quarter trailing GDP, including and excluding local government bond issuance (both measures exclude equity financing). Chart 6No Major Acceleration In "Standard" Credit Growth In 2015-2016... No Major Acceleration In "Standard" Credit Growth In 2015-2016... No Major Acceleration In "Standard" Credit Growth In 2015-2016... While adjusted TSF excluding local government bonds technically accelerated as a share of GDP from 2015 to late last year, the rise was tepid at best (in contrast to the 2012/2013 episode). It is clear from the chart that most of the acceleration in overall credit during the 2015/2016 period came from a surge in local government bond issuance, not from "standard" credit. This is an important observation, given that interest rates declined significantly over the period (Chart 7). Chart 7...Despite A Substantial Easing In Monetary Policy ...Despite A Substantial Easing In Monetary Policy ...Despite A Substantial Easing In Monetary Policy From a theoretical perspective, an atypical divergence between interest rates and credit growth can occur either because of abnormal loan demand or loan supply. Chart 8 suggests that it was the latter in China in 2015/2016: loan demand reportedly rose for small/micro, medium, and large enterprises (particularly among small/micro), but the trend in loan approval barely budged (unlike in 2011/2012 when it rebounded sharply). In short, Chart 8 provides support for the view that Chinese banks did not meaningfully ease lending standards during the 2015/2016 episode, despite a substantial easing in monetary policy and (ultimately) a substantial improvement in economic conditions. Chart 8Loan Demand Responded To Lower Rates, But Lending Standards Did Not Loan Demand Responded To Lower Rates, But Lending Standards Did Not Loan Demand Responded To Lower Rates, But Lending Standards Did Not Chart 9 highlights that this almost certainly occurred because of a sharp deterioration in reported bank asset quality that began in 2014. The chart shows that both the non-performing loan and special mention loan ratios rose significantly during this period, the sum of which has only modestly declined. We highlighted the potential for NPL recognition to weigh on credit growth in our two-part joint Special Report with BCA's Geopolitical Strategy service,4 as long as the ongoing financial regulatory crackdown is even half-heartedly implemented. While Chart 8 shows that loan approval modestly ticked higher in Q3, it provides no evidence of stealth easing in financial regulation. Chart 9Banks Did Not Rush To Lend Because Of Deep Concerns Over Asset Quality Banks Did Not Rush To Lend Because Of Deep Concerns Over Asset Quality Banks Did Not Rush To Lend Because Of Deep Concerns Over Asset Quality The key conclusion for investors from these observations is as follows: while China can certainly decide to stimulate aggressively in response to too-weak economic conditions, an impaired monetary transmission mechanism implies that there may be a lag, possibly a substantial one, between the decision to stimulate and its reflationary impact on financial markets. This is of crucial importance to investors aiming to maximize risk-adjusted returns over a 6-12 month time horizon, and weighs heavily on our recommendations. Investment Strategy Recommendations Chart 10 shows our Li Keqiang leading indicator within its component range, a chart that remains at the core of our efforts to predict China's business cycle. The indicator has been built in such a way that a decision of policymakers to push for more local government bond issuance (like in 2015/2016), or an improvement in the efficacy of China's monetary transmission mechanism, are likely to be captured by one or more of its components. Chart 10Only A Narrow Pickup In Our LKI Leading Indicator Only A Narrow Pickup In Our LKI Leading Indicator Only A Narrow Pickup In Our LKI Leading Indicator As we noted in our November 7 Weekly Report,5 the rise in the indicator has been driven by its two monetary conditions components, which have in turn mostly been driven by the substantial weakness in the RMB over the past four months. Given that the ultimate impact of the U.S. tariffs on Chinese exports remains obscured by trade frontrunning, it is unclear if China's exchange rate depreciation will be sufficiently reflationary even to counter the upcoming export shock, let alone reverse the ongoing domestic demand slowdown. As a result, investors should be closely watching for signs of a pickup in money & credit growth, which for now remain absent. Put differently, macrofundamental support for the equity market is lacking. Despite this, Chart 11 highlights that both Chinese A-shares and the investable market are deeply oversold, which in combination with expectations of further monetary stimulus and the potential for a tariff ceasefire have many investors chafing at the bit to go long either market (or both!) over a 6-12 month time horizon. Chart 11Chinese Stocks Are Quite Oversold... Chinese Stocks Are Quite Oversold... Chinese Stocks Are Quite Oversold... Our advice is simply to wait. A trade ceasefire is unlikely to generate more than a short-term boost to stock prices, and our indicators provide the best bet to monitor whether an impaired banking system is responding to any further easing in monetary policy. Finally, while we agree that stocks have priced in a meaningful decline in earnings, that earnings adjustment process has yet to even begin. Chart 12 illustrates the point where Chinese stocks bottomed in relation to the last major decline in earnings, suggesting that stocks need both a valuation discount and earnings clarity before putting in a durable bottom. The latter is missing and may stay missing for several months, highlighting that an outright long position remains premature. Stay tuned! Chart 12...But We Have Yet To Even Begin The Earnings Adjustment Process ...But We Have Yet To Even Begin The Earnings Adjustment Process ...But We Have Yet To Even Begin The Earnings Adjustment Process Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com Footnotes 1 Pease see China Investment Strategy Weekly Report "Is China Making A Policy Mistake?", dated October 31, 2018, available at cis.bcaresearch.com. 2 Pease see China Investment Strategy Special Reports "China's Property Market: Where Will It Go From Here?", dated September 13, 2018, available at cis.bcaresearch.com. 3 Pease see BCA Foreign Exchange Strategy Weekly Report "The Dollar And Risk Assets Are Beholden To China's Stimulus", dated August 3, 2018, available at fes.bcaresearch.com. 4 Pease see China Investment Strategy Special Reports "China: How Stimulating Is The Stimulus?", dated August 8, 2018, and "China: How Stimulating Is The Stimulus? Part Two", dated August 15, 2018, available at cis.bcaresearch.com. 5 Pease see China Investment Strategy Weekly Report "Checking In On The Data", dated November 7, 2018, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights Global Yields: Global bond yields appear to be settling into a new trading range, with the downside limited by tight labor markets but the upside capped by slowing global growth momentum. 2014/15 Redux?: The domestic U.S. economy is much stronger today compared to the 2014/15 period when slowing global growth and a rapidly rising U.S. dollar prompted selloffs in global credit markets and, eventually, a dovish shift by the Fed. U.S. financial conditions need to tighten more before the Fed can signal a pause. New Zealand: The RBNZ will continue to maintain a dovish policy stance over at least the next year, amid softening economic growth and underwhelming domestic inflation. Stay long 5-year New Zealand government bonds versus both U.S. Treasuries (hedged into USD) and German sovereign debt (hedged into EUR). Feature Dear Client, There will be no Global Fixed Income Strategy report published next Tuesday, November 27th. Instead, you will be receiving a Special Report this Thursday, November 22nd. The report - authored by BCA's Chief Emerging Markets strategist, Arthur Budaghyan - will discuss the outlook for Emerging Market hard currency debt. Best regards, Rob Robis Chief Strategist On the surface, it appears that uncertainty is increasing in global fixed income markets. Government bond yields have dipped over the past couple of weeks, most notably in the U.S. where the benchmark 10-year Treasury yield is back down to 3.05% as we go to press. Corporate credit spreads have also been drifting wider, especially in the U.S. where there is growing concern that economic momentum has peaked, at least temporarily. The problem for bond markets is that while global growth momentum has clearly slowed, it has not been by enough to alleviate inflation pressures coming from tight labor markets. This story is clearly most visible in the U.S., but also in the majority of major developed market economies. Central bankers are sticking to their guns and focusing on their belief in the Phillips Curve model to forecast inflation. Until there are signs that more turbulent financial markets are feeding into actual weaker economic growth, bond yields will not be able to fall by enough to help bail out flailing equities and corporate credit. There are now 83% of OECD countries with an unemployment rate below the estimated full employment NAIRU. As expected with such a backdrop, our Central Bank Monitors are calling for tighter monetary policy across the developed economies. This is also showing up in an unusual divergence between rising global real bond yields and falling global leading economic indicators (Chart of the Week). Chart of the WeekYields Are Less Responsive To Slowing Growth Yields Are Less Responsive To Slowing Growth Yields Are Less Responsive To Slowing Growth By most conventional measures, monetary policy settings are not restrictive across the major economies. Actual policy interest rates remain below conventional measures of equilibrium like a Taylor Rule, while government bond yields - adjusted for inflation expectations - are less than trend real GDP growth (Chart 2). Those gaps are smallest in the U.S., where the Fed has been raising interest rates for the past three years, but remain wide in other countries. Chart 2Global Interest Rates Are Still Below Equilibrium Levels The Bond Market Is Not Your Friend The Bond Market Is Not Your Friend If global growth is merely shifting from above-trend (falling unemployment) to trend (stable unemployment), then central bankers will not be able to move back to a more dovish posture that could trigger a major fall in bond yields. Trading ranges are more likely to result in such an environment, where yields struggle to break higher because of shaky risk assets but cannot break lower because of low unemployment. We are likely in one of those ranges now, measured by a 3-3.25% range on the 10-year U.S. Treasury. Without a friendly boost from falling bond yields, we continue to recommend a cautious stance on global spread product, while maintaining an overall below-benchmark stance on global duration exposure. Will It Be 2014/15 All Over Again? Watch The USD & China Two months ago, we published a comparison of the current macro backdrop to that of the 2014/15 period.1 Back then, the Fed was forced to alter its plans to deliver a series of rate hikes after the end of its quantitative easing program, thanks to a sharply rising U.S. dollar that triggered major financial market selloffs and, eventually, slower U.S. growth. We concluded that such an outcome could occur again in the next few months, but it would take a much larger tightening of financial conditions to get the Fed to stand down this time given tighter U.S. labor markets and stronger U.S. inflation pressures. The way we presented that comparison between today and four years ago was though "cycle-on-cycle" charts, showing financial and economic data today overlapped with data from that 2014/15 period. The two episodes were indexed to the trough in the U.S. dollar in May 2014 and February 2018. This week, we update a few of those charts, but also add a few new indicators to assess if there has been enough financial and economic damage to trigger a shift to a more dovish Fed. U.S. Economy: The domestic U.S. economy appears healthier today versus the 2014/15 period, judging by the more robust readings from the NFIB Small Business Optimism index and the high level of job openings from the JOLTS data (Chart 3). Yet there are similarities seen in the latest decline in the Conference Board survey of U.S. CEO confidence, and the sharp fall in the ISM Manufacturing New Orders index. We suspect that this divergence in business optimism reflects U.S.-China trade tensions, which should have a greater impact on larger corporations that sell globally compared to smaller companies with a more domestic customer base. Chart 3U.S. Growth Today Vs. 2014/15: Stronger Domestic Economy U.S. Growth Today Vs. 2014/15: Stronger Domestic Economy U.S. Growth Today Vs. 2014/15: Stronger Domestic Economy U.S. Inflation: U.S. core CPI inflation is much faster now than at the similar point in the 2014/15 cycle, as is the growth in Average Hourly Earnings (Chart 4). This is due to the much lower unemployment rate today in the U.S., which is putting more upward pressure on domestically-generated prices and wages. Yet while the ISM Prices Paid index is also at a higher level today than 2014/15, the upward momentum has peaked and the latest decline in commodity prices is following an ominously similar path to four years ago (bottom panel). Chart 4U.S. Inflation Today Vs. 2014/15: Faster Core/Wage Inflation U.S. Inflation Today Vs. 2014/15: Faster Core/Wage Inflation U.S. Inflation Today Vs. 2014/15: Faster Core/Wage Inflation Emerging Markets (EM): EM economic growth has been decelerating at a similar pace to 2014/15, with the aggregate EM (ex-China) PMI produced by our EM strategists now sitting right at the boom/bust 50 line (Chart 5). China's economic growth appears to be holding up better today when looking at the more elevated Li Keqiang index. A possible reason for that is the much larger and faster easing of Chinese monetary conditions today compared to 2014/15, thanks to the sharp weakening of the yuan. Chart 5EM Growth Today Vs. 2014/15: China Drag Is Smaller (For Now) EM Growth Today Vs. 2014/15: China Drag Is Smaller (For Now) EM Growth Today Vs. 2014/15: China Drag Is Smaller (For Now) Global Financial Markets: Here, the current cycle is sticking very close to the 2014/15 script when looking at the rising U.S. trade-weighted dollar, widening spreads for U.S. investment grade (IG) corporate bonds and EM USD-denominated sovereign debt, and the tightening of U.S. financial conditions (Chart 6). Although it should be noted that the trade-weighted dollar would have to rise another 10% from current levels, and U.S. IG spreads would have to widen another 60bps, to generate similar moves compared to 2014/15. Chart 6Financial Markets Today Vs. 2014/15: Following A Similar Script Financial Markets Today Vs. 2014/15: Following A Similar Script Financial Markets Today Vs. 2014/15: Following A Similar Script U.S. Treasury Yields: Nominal U.S. Treasury yields are at much higher levels today than four years ago, an obvious consequence of the Fed's tightening cycle and more elevated U.S. inflation expectations (Chart 7). Yet the amount of tightening discounted over the next 12-months in the U.S. Overnight Index Swap (OIS) is similar to 2014/15, as is our estimate of the market-implied level of the terminal real fed funds rate (around 0.5%).2 One major difference: there is a large net short position in the Treasury market today, while positioning was fairly neutral during 2014/15 (bottom panel). Chart 7U.S. Treasuries Today Vs. 2014/15: Higher Yields But Similar Fed Pricing U.S. Treasuries Today Vs. 2014/15: Higher Yields But Similar Fed Pricing U.S. Treasuries Today Vs. 2014/15: Higher Yields But Similar Fed Pricing Summing it all up, the broader range of evidence we present here confirms our conclusion from two months ago. There needs to be a much larger tightening of U.S. financial conditions before the Fed can signal a pause on its planned rate hikes, because of a much healthier domestic U.S. economy and a more entrenched acceleration of inflation (especially wage growth). If China's economy can continue to outperform the 2014/15 path - still a big "if" given U.S.-China trade uncertainties and with Chinese policymakers less willing to reflate the domestic credit bubble to boost growth - then the odds of U.S. growth converging down to non-U.S. growth will be reduced. We will continue to monitor these charts and relationships in future Weekly Reports but, for now, we see nothing yet to change our bearish views on U.S. Treasuries and our cautious view on U.S. corporate credit. Bottom Line: The domestic U.S. economy is much stronger today compared to the 2014/15 period when slowing global growth and a rapidly rising U.S. dollar prompted selloffs in global credit markets and, eventually, a dovish shift by the Fed. U.S. financial conditions need to tighten more before the Fed can signal a pause. New Zealand Update: Fade The Recent Bump In Yields We have been structurally positive on New Zealand (NZ) government bonds for some time, dating back to mid-2017. Our view was based on an assessment that the Reserve Bank of New Zealand (RBNZ) would be unable to make any upward change in policy rates due to sub-par economic growth and inflation that would struggle to meet the RBNZ's target of 2% (the midpoint of the 1-3% target band). So far, that scenario has fully played out, and NZ government bonds have significantly outperformed their global peers as a result (Chart 8). Chart 8Sticking With Our Successful Long NZ Trades Sticking With Our Successful Long NZ Trades Sticking With Our Successful Long NZ Trades Our preferred trades, which are part of our Tactical Overlay shown on page 14, have been yield spread trades for NZ government bonds versus U.S. and German equivalents.3 Specifically, we have been recommending long positions in 5-year NZ bonds vs. 5-year U.S. Treasuries and 5-year German government debt. The trades have performed well, but have given back some of the gains in recent weeks. This has mostly come via a surge in NZ yields (+29bps higher since the recent low on September 7th) that has driven yield spreads wider versus the U.S. and Germany (+23bps and +34bps, respectively, since September 7th). These increases are likely to prove unsustainable, given the sluggish momentum in NZ growth and inflation. The latest read on year-over-year real GDP growth came in at below-potential pace of 2.8% in the 2nd quarter of 2018. The manufacturing and services purchasing managers' indices (PMIs) have both fallen sharply throughout 2018, although the latest data points suggest some stabilization above the 50 level on the PMIs (Chart 9). Similar trends can be seen in the RBNZ surveys of business confidence and capacity utilization, which both remain near the post-2008 lows but may also be stabilizing. Chart 9Sub-Par Growth In New Zealand Sub-Par Growth In New Zealand Sub-Par Growth In New Zealand In the November Monetary Policy Statement (MPS) that was released after the RBNZ meeting earlier this month, a cautious view on growth was outlined.4 The pickup in Q2 GDP growth was dismissed as driven by temporary factors, and policymakers expressed concern that deteriorating business confidence could be signaling a more prolonged period of slowing domestic demand. The central bank did also highlight growth risks coming from slowing exports if U.S.-China trade tensions intensify. It is difficult to find an obvious trigger for faster NZ growth at the moment. Both consumer spending and residential investment were fueled by rising immigration and population growth from 2013 to 2017, but those trends have since begun to reverse. The RBNZ projects net monthly immigration to NZ to slow to levels last seen in 2014 and in line with the current growth rate of consumer spending around 3% (Chart 10). Business investment growth has already stalled (middle panel), while the RBNZ'S Business Outlook surveys indicate a negative outlook for export growth (bottom panel). Chart 10Where Will NZ Growth Come From? Where Will NZ Growth Come From? Where Will NZ Growth Come From? Against this sluggish growth backdrop, the RBNZ must continue to run an accommodative monetary policy to support growth. This can be done given the persistent undershooting of NZ inflation versus the RBNZ target. Headline CPI inflation did accelerate to 1.9% in Q3, but core inflation at 1.2% continued to languish near the bottom end of the RBNZ target range. The gap between the two inflation measures can be attributed to previous increases in global energy prices, which caused a blip up in the tradeables portion of the NZ CPI (Chart 11). Yet the recent decline in oil prices, combined with a bounce in the NZ dollar, suggests that the bump in tradeables inflation is likely to reverse in Q4 (middle panel). Non-tradeables inflation, which is driven by domestic factors such as wage growth, has remained stable at just over 2%, even with the NZ unemployment rate at a 10-year low of 4.5% that is below the OECD's NAIRU estimate. Chart 11Stubbornly Low NZ Inflation Stubbornly Low NZ Inflation Stubbornly Low NZ Inflation With an obvious trigger from higher inflation, the RBNZ will be forced to maintain a highly accommodative policy stance. This is especially true given the RBNZ's mandate, which now includes maximizing sustainable employment alongside keeping inflation between 1-3%. We think that means the RBNZ is more likely to tolerate a move to the upper end of that inflation band if the growth outlook was less certain, as is currently the case. Our RBNZ Monitor sits close to the zero line, indicating no pressure to either hike or cut interest rates. In the November MPS, the RBNZ stuck to its forecast that the Official Cash Rate (OCR) would remain unchanged at 1.75% until mid-2020, consistent with the signal from our RBNZ Monitor. The market is differing on this, with the NZ OIS curve currently discounting almost one full 25bp rate hike by the end of 2019, and a faster pace of hikes after that (Chart 12). Chart 12Market-Priced RBNZ Hikes Will Not Happen Market-Priced RBNZ Hikes Will Not Happen Market-Priced RBNZ Hikes Will Not Happen We continue to recommending fading any pricing of RBNZ rate hikes over the next 6-12 months. Given our still bearish views on U.S. Treasuries, we are maintaining our recommended long NZ 5-year/short U.S. 5-year position (on a currency-hedged basis into U.S. dollars). We have been running our long NZ/short Germany position on an UN-hedged basis - atypical for the Global Fixed Income Strategy service, where our views are almost always currency-hedged into U.S. dollars - since the trade's inception last year, based on a currency view that was more bearish on the euro than the New Zealand dollar. The NZD/EUR cross instead fell substantially, which more than fully eroded the gains on the bond side of the trade until the recent 7.5% pop in that exchange rate. After that move, the return on our unhedged trade is nearly back to flat. We are using that as an opportunity to switch our NZ/Germany trade to a more typical currency-hedged basis, moving the exposure into euros from New Zealand dollars. Bottom Line: The RBNZ will continue to maintain a dovish policy stance over at least the next year, amid softening economic growth and underwhelming domestic inflation. Stay long 5-year New Zealand government bonds versus both U.S. Treasuries (hedged into USD) and German sovereign debt (hedged into EUR). Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "EM Contagion? Or Just QT On The Q.T.?", dated September 11th 2018, available at gfis.bcarsearch.com. 2 This is calculated by subtracting the 5-year U.S. CPI swap rate, 5-years forward, from the 5-year U.S. OIS rate, 5-years forward. 3 We freely admit that a position held for over one full year should not be described as "tactical", as the name of our overlay portfolio suggests. Yet we have seen no reason to close these trades early given our market views on NZ. 4 The full Monetary Policy Statement can be found here: https://www.rbnz.govt.nz/-/media/ReserveBank/Files/Publications/Monetary%20policy%20statements/2018/mpsnov2018.pdf Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index The Bond Market Is Not Your Friend The Bond Market Is Not Your Friend Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Duration: The Fed will need to see further significant tightening in broad indexes of financial conditions before backing away from its +25 bps per quarter rate hike pace. With only 54 bps of rate hikes priced into the curve for the next 12 months, investors should maintain below-benchmark portfolio duration. Credit Spreads: A likely deceleration in U.S. economic growth during the next few quarters is a near-term risk for credit spreads, while waning demand for C&I loans could signal that the market's default outlook is too benign. We see a high risk of spread widening during the next few months, and would advocate only a neutral allocation to spread product on a 6-12 month horizon. TIPS: Breakeven inflation rates remain low because investors are much less fearful of high inflation than in the past. This will change over time as inflation continues to print near the Fed's target and expectations slowly shift to price more two-way risk into the inflation market. Remain overweight TIPS versus nominal Treasuries on a 6-12 month investment horizon. Feature More Pain Required Fed Chairman Jerome Powell spoke at the Dallas Fed last week, amidst some expectation that he might try to assuage financial market concerns about the pace of monetary tightening. Instead, the Chairman struck a balanced tone that the market took as slightly dovish. A rate hike next month remains fully discounted, but investors are now split on whether the Fed will move again in March (Chart 1). The April 2019 fed funds futures contract implies a funds rate of 2.525% by next April, just barely above the lower-end of the 2.5% - 2.75% target band consistent with two more rate hikes. Chart 1Markets Doubt The Gradual Pace Of Hikes Markets Doubt The Gradual Pace Of Hikes Markets Doubt The Gradual Pace Of Hikes Chairman Powell's remarks did not alter our view of the Fed's reaction function, which we expect will result in continued quarterly rate hikes until a preponderance of evidence is consistent with a significant slow-down in U.S. economic activity. As we discussed in last week's report, it is highly likely that the combination of a waning fiscal impulse and a stronger U.S. dollar will cause U.S. growth to slow during the next few quarters.1 What remains uncertain is whether the slow-down will be severe enough for the Fed to pause its +25 bps per quarter tightening cycle. With only 54 bps of rate hikes priced into the yield curve for the next 12 months, we are inclined to maintain below-benchmark portfolio duration on a 6-12 month investment horizon. However, we do not anticipate a significant move higher in yields during the next few months. We also think credit spreads can widen further in the near-term as growth slows, and we recommend only a neutral allocation to spread product versus Treasuries on a 6-12 month horizon, given the less attractive risk/reward trade-off in corporate credit. Another reason to get defensive on credit spreads before increasing portfolio duration is that further spread widening and tighter financial conditions are likely a necessary pre-condition for the Fed to slow its pace of rate hikes. Chairman Powell noted last week that financial conditions are an important input to the Fed's assessment of future economic growth, and also stressed that the Fed takes a broad view of financial conditions - encompassing not just the stock market but also the level of rates, credit spreads and other factors. With that in mind, we observe that there has been very little tightening in broad indexes of financial conditions during the past few months. In fact, the Chicago Fed's National Financial Conditions Index shows that financial conditions remain far more accommodative than when the Fed started hiking rates in December 2015 (Chart 2). Chart 2More Pain Needed For The Fed To Pause More Pain Needed For The Fed To Pause More Pain Needed For The Fed To Pause We conclude that much more financial market pain will be required before the Fed takes a dovish turn. As such, we are inclined to get more defensive with respect to credit, but to remain bearish on rates for now. Last week's release of the Fed's Senior Loan Officer Survey provided one more negative datapoint for corporate credit. While banks continue to ease standards on commercial & industrial loans, respondents reported that demand for such loans waned during the past three months (Chart 3). If the demand slow-down continues, then lending standards will eventually start to tighten and we will see more corporate defaults. For now, the slow-down in loan demand is a tentative signal that could be reversed next quarter, but it bears close monitoring as a potential warning that we are moving into the late stages of the credit cycle. Stay tuned. Chart 3Tighter Lending Standards Ahead? Tighter Lending Standards Ahead? Tighter Lending Standards Ahead? Bottom Line: U.S. economic growth will decelerate from a high level during the next few quarters, but the Fed will need to see further significant tightening in broad indexes of financial conditions before backing away from its +25 bps per quarter rate hike pace. Investors should get more defensive on credit spreads, but maintain below-benchmark duration. Stick With TIPS We have been recommending overweight positions in TIPS versus nominal Treasuries for some time, targeting a range of 2.3% to 2.5% for both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates. This range is consistent with prior periods when core inflation was well-anchored around the Fed's target.2 This recommendation suffered a set-back last week when long-maturity breakevens finally capitulated to the trend in other financial market indicators that have been pointing to weakness in global demand for several months (Chart 4). In fact, for most of this year falling commodity prices and a strengthening dollar have been signaling that global demand is on the decline. But until last week, TIPS breakevens had mostly bucked the trend. Chart 4Held Down By Global Demand Held Down By Global Demand Held Down By Global Demand The reason is that long-maturity TIPS breakeven inflation rates remain under the influence of two competing forces. Signals of waning global demand on the one hand, and rapidly rising U.S. inflation on the other. Last December, the 12-month rate of change in core PCE inflation stood at 1.64%. As of September it stands at 1.97%, within a hair of the Fed's 2% target. Likewise, year-over-year core CPI inflation has increased from 1.76% as of last December to 2.15% as of October. Survey measures of realized and expected price changes have similarly strengthened (Chart 5). Chart 5Pulled Up By U.S. Inflation Pulled Up By U.S. Inflation Pulled Up By U.S. Inflation The combination of strong U.S. inflation and waning global growth has left long-dated breakevens relatively trendless for most of the year. And although we think year-over-year U.S. core inflation will flatten-off during the next few months (see Box), we would remain overweight TIPS versus nominal Treasuries on a 6-12 month investment horizon. BOX Core Inflation: Grappling With Base Effects Year-over-year core CPI inflation was 2.15% in October, down slightly from 2.17% in September. Meanwhile, our Base Effects Indicator ticked up from 3 to 4 but it remains below the critical 5.5 level (Chart 6). Chart 6Expect Year-Over-Year Core CPI To Flatten-Off Expect Year-Over-Year Core CPI To Flatten-Off Expect Year-Over-Year Core CPI To Flatten-Off In our Weekly Report from September 4, 2018, we showed that when our Base Effects Indicator - an indicator derived from near-term rates of change in core CPI - is below 5.5, 12-month core inflation is much more likely to fall than rise during the next six months. While pipeline inflation measures and the tightness of the labor market both suggest that the uptrend in core inflation will remain intact, we expect that year-over-year core inflation will flatten-off during the next six months, at levels close to the Fed's target. Our view is that as long as inflation remains sufficiently close to the Fed's target, over time, investors will start to price two-way risk back into the inflation market. It simply takes time for expectations to fully adapt to the new economic reality. Expectations Are Slow To Adapt To illustrate why we remain optimistic that TIPS breakevens have further upside, we created what we call our Adaptive Expectations Model of the 10-year breakeven rate (Chart 7). The model combines both forward-looking and backward-looking measures of inflation, and is premised on the idea that investors are slow to fully adapt their expectations to a changing environment. Chart 7Adaptive Expectations Model Adaptive Expectations Model Adaptive Expectations Model For example, even though core inflation is now close to the Fed's target on a 12-month rate of change basis, investors remain scarred by the past decade when it was stubbornly low. The long period of low inflation makes it much more difficult for investors to believe that the regime is finally shifting. Our Adaptive Expectations Model includes three variables: The 120-month rate of change in core CPI inflation (annualized) The 12-month rate of change in headline CPI inflation The New York Fed's Underlying Inflation Gauge (full data set measure) The 120-month rate of change is included to capture the impact from investors' long memories when it comes to inflation. The 12-month rate of change is included to capture the more recent trend in prices and the New York Fed's Underlying Inflation Gauge is included to provide a forward-looking measure of inflationary pressures in the economy. Notice in Table 1 that the 120-month rate of change in core CPI carries much greater importance in our model than the other two variables. Table 1Adaptive Expectations Model Regression Output (2003 To Present) Adaptive Expectations In The TIPS Market Adaptive Expectations In The TIPS Market Turning back to Chart 7, we see that the current 10-year TIPS breakeven inflation rate is more or less in line with our model's fair value. We also see that two of the model's three variables (12-month headline CPI and the Underlying Inflation Gauge) have returned to pre-crisis levels. It is only the 120-month rate of change in core CPI that is preventing breakevens from reaching our target range. In other words, even though inflation is more or less back to target levels, investors still doubt whether we have transitioned out of the prior low-inflation regime. The Fear Of High Inflation Is Missing Digging further into the data, we see that the real difference between today and the pre-crisis period is that investors are now much less worried about significantly higher inflation. A break-down of individual responses from the Survey of Professional Forecasters shows that, as in 2004, most forecasters think inflation will average between 2.01% and 2.5% during the next 10 years. But today, only 7% of forecasters think inflation will average above 2.51%. In 2004, 32% of forecasters thought inflation would average above 2.51% over the next 10 years (Chart 8). Chart 8High Inflation Is Less Of A Worry Adaptive Expectations In The TIPS Market Adaptive Expectations In The TIPS Market This assessment of likely inflation outcomes is backed-up by the economic data. The St. Louis Fed's Price Pressures Measure is a macro model designed to output the probability that inflation falls into different ranges over the next year.3 Here again, we see that the probability of inflation being between 1.5% and 2.5% is similar to its pre-crisis level, but the probability of inflation exceeding 2.5% is much lower (Chart 9). Chart 9Price Pressures Price Pressures Price Pressures Even looking at only the post-crisis period shows that it is the upper-tail of the inflation expectations distribution that is lagging. The Fed's Survey of Primary Dealers has been asking respondents to place probabilities on different long-run inflation outcomes since 2011. Chart 10 shows how the most recent responses - from September - compare to the post-2011 range. It shows that respondents are more certain than at any time since 2011 that inflation will be between 2.01% and 2.5% on average during the next 10 years, but are also more doubtful that inflation will be 2.51% or higher. Chart 10Primary Dealer Inflation Expectations Adaptive Expectations In The TIPS Market Adaptive Expectations In The TIPS Market Bottom Line: Even though 12-month inflation has more or less returned to the Fed's target, long-maturity TIPS breakeven inflation rates remain below levels that have been historically consistent with that target. Breakevens remain low because investors are much less fearful of elevated inflation (> 2.5%) than in the past. This will change over time as inflation continues to print near the Fed's target and expectations slowly adapt to the new regime. Remain overweight TIPS versus nominal Treasuries on a 6-12 month horizon. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy Weekly Report, "The Sweet Spot On The Yield Curve", dated November 13, 2018, available at usbs.bcaresearch.com 2 For details on how we arrive at that range please see U.S. Bond Strategy Weekly Report, "The Two-Stage Bear Market In Bonds", dated February 20, 2018, available at usbs.bcaresearch.com 3 https://research.stlouisfed.org/publications/economic-synopses/2015/11/06/introducing-the-st-louis-fed-price-pressures-measure/   Fixed Income Sector Performance Recommended Portfolio Specification

Dear Client, Barring any major market developments, we will not be sending you a report next week. Instead, I will be working with my colleagues on BCA's Annual Outlook, which will be published on Monday, November 26. The outlook will feature a wide-ranging discussion with Mr. X and his daughter Ms. X on the key themes that we see shaping global markets in 2019. Best regards, Peter Berezin, Chief Global Strategist Highlights The stock market correction has further to run. We would turn more bullish if global equities were to drop another 8% from current levels. A mundane economic identity - savings minus investment equals the current account balance - provides deep market insight into the workings of the global economy. The U.S. economy is suffering from a shortage of savings, which will push up interest rates and the value of the dollar. In contrast, China has a surfeit of savings. Rectifying this will require a weaker yuan. The political impasse between the EU and Italy over next year's budget will be resolved. However, the fact that Italy lacks a readily available outlet for its excess private-sector savings could spell doom for the euro area down the road. Feature The Correction Ain't Over Our MacroQuant model continues to signal downside risks for global equities over the coming weeks (Chart 1). The model is flagging a deterioration in a variety of leading economic indicators, both in the U.S. and abroad, which tends to be bearish for stocks (Chart 2). Global financial conditions have also tightened since the summer due to the rise in government bond yields, higher credit spreads, and a firmer dollar. Chart 1MacroQuant* Model Suggests Caution Is Still Warranted S-I=CA In The U.S., China, And Italy S-I=CA In The U.S., China, And Italy Chart 2Global Growth Indicators Are Deteriorating Global Growth Indicators Are Deteriorating Global Growth Indicators Are Deteriorating Sentiment remains reasonably upbeat, a bearish contrarian indicator. The November Bank of America Merrill Lynch Global Fund Manager Survey revealed that a net 31% of managers were still overweight global stocks. Past major bottoms in 2008, 2011, 2012, and 2016 all saw equity allocations fall into underweight territory. Strikingly, EM allocations rose in November, with a net 13% of fund managers overweight the asset class. This is in stark contrast to 2015 when a net 30% of fund managers were underweight EM stocks. We do not expect the correction which began in October to morph into a full-fledged bear market. Nevertheless, the near-term path of least resistance for stocks remains to the downside. We would only upgrade global equities to overweight if the MSCI All-Country World index were to fall another 8% from current levels, consistent with a price of $64 on the ACWI ETF. At that level, the forward P/E on the index would be back to 2013 levels (Chart 3). Chart 3A Valuation Reset A Valuation Reset A Valuation Reset A Key Macro Identity One of the first identities undergraduate economics students learn is S-I=CA: The difference between what a country saves and invests is equal to its current account balance.1 While it is easy to dismiss this identity as yet another abstract concept that only egghead economists would find interesting, it has real-world implications for investors of all stripes. To see this, it is useful to expand the identity a bit. Total savings is just the sum of private-sector and public-sector savings. Thus, we can write: Private-sector savings = fixed asset investment + government budget deficit + current account balance In other words, the savings that the private sector generates must either be recycled into investment, soaked up by the government through a budget deficit, or exported abroad via a current account surplus. This relationship always holds ex post. But what happens if it does not hold ex ante? Then "something" must adjust to make the relationship hold. In a normal environment, this "something" is interest rates. If there is a shortfall of private-sector savings - that is, if the right-hand side of the equation above exceeds the left-hand side - an increase in rates can restore the identity by encouraging private savings, discouraging investment, and potentially making it more difficult for the government to pursue an expansionary fiscal policy. Higher rates will also produce a stronger currency, leading to a deterioration in the current account balance. The exact opposite will happen if there is an excess of private-sector savings. What happens if there is excessive savings but the central bank cannot lower interest rates either because it lacks monetary independence - i.e., when a country has a currency peg - or because monetary policy is constrained by the zero lower bound on nominal short-term rates? In that case, employment will decline. One cannot save if one does not have a job that generates income. In practice, this can lead to a vicious circle where falling employment causes households to try to save more for precautionary reasons, while discouraging companies from investing in new capacity. The resulting increase in desired savings is likely to lead to further declines in employment. Keynes referred to this outcome as the paradox of thrift: A situation where one person's desire to save more leads to a collective decline in savings because aggregate income shrinks. Let's turn to what all this means for investors today. The U.S.: Trump's Fiscal Policy Is Inconsistent With His Trade Goals The IMF estimates that the U.S. cyclically-adjusted budget deficit will reach 5.6% of GDP next year. The results of the midterm elections are unlikely to change this outcome. While the takeover of the House of Representatives by the Democrats will preclude Congress from passing another round of tax cuts, our geopolitical strategists believe that there is a better than 50% chance that a bipartisan deal will be reached to increase infrastructure spending.2 They point out that Nancy Pelosi mentioned infrastructure five times during her election night address, without mentioning impeachment once. Recent data on U.S. capital spending has been on the soft side (Chart 4). Core capital goods orders have decelerated and capex intention surveys have come off their highs. Residential investment has also been weak, as reflected in declining housing starts and building permits. Chart 4Both Residential And Nonresidential Investment Have Softened Both Residential And Nonresidential Investment Have Softened Both Residential And Nonresidential Investment Have Softened We would tend to fade the weakness in capital spending (Chart 5). The ISM industrial capacity utilization rate is near cycle highs. Rising wages will incentivize firms to substitute labor with capital, leading to more investment spending. The downside risk to home building is also limited, given that residential investment stands at only 3.9% of GDP, well below the high of 6.7% reached in 2005. If anything, the U.S. is not churning out enough fixed capital, as evidenced by the fact that the average age of the capital stock has risen swiftly over the past decade. As my colleague Doug Peta likes to say, you don't get hurt falling out of a basement window. Chart 5Running Out Of Spare Capacity Running Out Of Spare Capacity Running Out Of Spare Capacity Meanwhile, the personal savings rate stands at over 6%, significantly higher than what one would expect based on its typical relationship with household net worth (Chart 6). Chart 6U.S. Household Savings Rate Is High Relative To Wealth S-I=CA In The U.S., China, And Italy S-I=CA In The U.S., China, And Italy The identity described at the outset of this report implies that the trade balance will necessarily deteriorate if the savings rate falls, investment rises, and the budget deficit remains elevated. If President Trump strikes a trade deal with China, he will have no one to blame for a larger U.S. trade deficit. Hence, he has little incentive to make a deal. Protectionism remains popular in the U.S. Midwest, the battleground on which the next presidential election will be fought. Democrat Sherrod Brown won the Ohio Senate race by 6.4% - a state that Trump carried by 8.1% - on a highly protectionist platform. Trump simply cannot afford to go soft on one of his signature issues. China: What To Do With Excess Savings? The slowdown in Chinese growth this year has been concentrated in domestic demand (Chart 7). Exports have held up well. In fact, Chinese exports to the U.S. are up 13% in dollar terms in the first ten months of the year compared with the same period last year. Chart 7China's Domestic Economy Is Weakening China's Domestic Economy Is Weakening China's Domestic Economy Is Weakening Unfortunately, judging from the steep drop in the export component of the Chinese manufacturing PMI, exports are likely to come under increasing pressure over the coming months (Chart 8). This makes it all the more important for the Chinese authorities to prop up domestic growth. Chart 8China's Export Outlook Is Dire China's Export Outlook Is Dire China's Export Outlook Is Dire China has historically stimulated its economy through debt-financed fixed-investment spending (Chart 9). This made eminent sense when China needed more factories, infrastructure, and modern housing. However, now that China has all this in spades, it is looking for different stimulus options. Chart 9China: Debt And Capital Accumulation Have Gone Hand In Hand China: Debt And Capital Accumulation Have Gone Hand In Hand China: Debt And Capital Accumulation Have Gone Hand In Hand Our formula reveals what those other options must be. If China wants to reduce investment spending to a more sustainable level, it must either boost consumption, increase the fiscal deficit, or raise net exports. Given a hostile export backdrop, it is therefore no surprise that the Chinese government has been cutting taxes, increasing social transfer payments, and letting the currency slide. The problem is that none of these other forms of stimulus are beneficial to the rest of the world, and in some cases, they may be quite detrimental. The rest of the world relies on Chinese investment, not Chinese consumption. Raw materials and capital goods comprise 80% of Chinese imports. China represents close to half of the world's demand for aluminum, copper, zinc, nickel, and steel (Chart 10). Whether it be services or manufactured goods, what Chinese households consume is generally produced in China. Chart 10China Is The Predominant Source Of Global Demand For Metals China Is The Predominant Source Of Global Demand For Metals China Is The Predominant Source Of Global Demand For Metals A weaker yuan will make the Chinese economy more competitive, but at the expense of other emerging markets. A weaker yuan will also raise the price of imported goods, leading to a lower volume of imports. The implication is that both the magnitude and composition of China's stimulus may disappoint. This week's much weaker-than-expected credit and money data - new CNY loans clocked in at RMB 697 billion in October, well below consensus expectations of RMB 905 billion - validates this view. Italy: Getting To "Yes" Is The Easy Part The showdown between Italy's populist leaders and the EU continues. The Lega-Five Star coalition government promised big tax cuts and generous increases in social spending. It is loath to backtrack on its campaign pledges so soon after the election. As long as there is no contagion from Italy to the rest of Europe, the EU has no incentive to back off. While it will never admit it, the EU establishment would love nothing more than to humiliate the Italians in order to dissuade voters across Europe from electing populist politicians. In the end, we expect the Italian government to give in to the EU's demands. Business confidence has plunged (Chart 11). The economy is again teetering on the brink of recession. Italy's banking system would be technically insolvent if the ten-year BTP yield were to rise above 4% based on a mark-to-market accounting of Italian bank holdings of government debt. Chart 11Italy: Is The Economy Heading For Another Dip? Italy: Is The Economy Heading For Another Dip? Italy: Is The Economy Heading For Another Dip? A political resolution to the ongoing crisis would provide short-term relief. However, it may not solve Italy's problems - indeed, it could exacerbate them. Italy's working-age population is shrinking (Chart 12). This has made companies reluctant to expand capacity. Meanwhile, households are busily saving for retirement. Their motivation to save more would only be amplified by the cuts to pension benefits that the previous caretaker government promised and that the EU is insisting be implemented. The overall private-sector financial balance - the difference between what the private sector saves and invests - reached a surplus of 5.1% of GDP in 2017 (Chart 13). Chart 12The Italian Workforce Is Shrinking S-I=CA In The U.S., China, And Italy S-I=CA In The U.S., China, And Italy Chart 13Italy: Private Sector Saves Too Much And Spends Too Little Italy: Private Sector Saves Too Much And Spends Too Little Italy: Private Sector Saves Too Much And Spends Too Little Our formula shows that counterbalancing this private-sector surplus will require a persistent government fiscal deficit or current account surplus. Italy's primary budget balance - its overall budget balance excluding interest payments - hit 1.7% of GDP in 2017 (Chart 14). This primary surplus is necessary to cover the 3.6% of GDP in interest payments that the government has to make, a number that will only rise if the ECB raises rates (hence, our high-conviction view that the ECB will have to keep rates low for years to come). Chart 14Italy Needs A Primary Budget Surplus Italy Needs A Primary Budget Surplus Italy Needs A Primary Budget Surplus Italy runs a modest current account surplus of 2% of GDP. However, its current account balance would be far smaller, and perhaps even negative, if the economy were operating at full employment since stronger domestic demand would suck in more imports. Italy would love to copy Germany, a country which habitually over-saves but exports its excess savings to the rest of the world through a gargantuan 8% of GDP current account surplus. Alas, achieving a larger current account surplus would require either a currency depreciation or productivity-enhancing structural reforms. The former is impossible as long as Italy is a member of the euro area, while the latter has proven to be wishful thinking for as long as people have talked about it. We do not expect Italy to default on its debt or jettison the euro in the near term. But when the next synchronized global downturn arrives - probably in about two years or so - all hell could break loose. Concluding Thoughts An economy facing a shortfall in savings is one where desired spending exceeds income. When the economy has spare capacity, such a savings shortfall is a good thing; it means more demand, more employment, and ultimately, more income. However, once spare capacity is soaked up, a shortage of savings will lead to higher inflation. The U.S. finds itself in the latter situation today. The output gap is fully closed, but growth remains above trend. As we have discussed in past reports, the Fed is likely to raise rates more than the market expects.3 This will lead to higher Treasury yields and a stronger dollar. With that in mind, we are raising our end-year target on our long DXY trade recommendation from 98 to 100, implying another 3% increase from current levels. In the absence of offsetting Chinese stimulus, a stronger dollar will put further pressure on emerging markets. EM equities will likely bottom in the first half of next year once the dollar peaks and global growth stabilizes. Until then, investors should overweight DM stocks relative to their EM peers. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 National savings, S, is equal to Y-C-G, where Y is national income and C and G are household and government consumption, respectively. Substituting this identity into the standard Y=C+I+G+X-M equation yields S-I=X-M. National income includes net foreign earnings. In this case, the trade balance, X-M, is equal to the current account balance. 2 Please see Geopolitical Strategy Special Report, "The 2020 U.S. Election: A "Way Too Soon" Forecast," dated November 7, 2018. 3 Please see Global Investment Strategy Weekly Report, "Bond Bears Maul Goldilocks," dated October 12, 2018; and "The Next U.S. Recession: Waiting For Godot?" dated October 5, 2018. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades