The Bank Credit Analyst

THE BANK CREDIT ANALYST

Monthly forecast and analysis of the December 2017 - Vol. 69 - No. 6 global economy and financial markets

SPECIAL YEAR END ISSUE OUTLOOK 2018 Policy And The Markets: On A Collision Course

www.bcaresearch.com THE BANK CREDIT ANALYST

Monthly forecast and analysis of the December 2017 - Vol. 69 - No. 6 global economy and financial markets

SPECIAL YEAR END ISSUE OUTLOOK 2018

Policy And The Markets: On A Collision Course 2 Conclusions 49 OUTLOOK 2018: Policy And The Markets: On A Collision Course Mr. X is a long-time BCA client who visits our offices toward the end of each year to discuss the economic and financial market outlook. This year, Mr. X introduced us to his daughter, who we shall identify as Ms. X. She has many years of experience as a portfolio manager, initially in a wealth management firm, and subsequently in two major hedge funds. In 2017, she joined her father to help him run the family office portfolio. She took an active role in our recent discussion and this report is an edited transcript of our conversation.

Mr. X: As always, it is a great pleasure to happen, I would worry about the potential sit down with you to discuss the economic for a sudden 1987-style crash. I remember and investment outlook. And I am thrilled that event well and it was an unpleasant to bring my daughter to the meeting. She experience. My inclination is to move right and I do not always agree on the market now to an underweight equity position. outlook and appropriate investment strategy, but even in her first year working Ms. X: Let me add that I am delighted with me she has added tremendous value to finally attend the annual BCA to our decisions and performance. As you meeting with my father. Over the years, know, I have a very conservative bias in he has talked to me at length about your my approach and this means I sometimes discussions, making me very jealous that miss out on opportunities. My daughter is I was not there. He and I do frequently more willing than me to take risks, so we disagree about the outlook so it will be make a good team. good to have BCA’s independent and objective perspective. I am happy that our investment portfolio has performed well over the past year, As my father noted, I do not always share but am puzzled by the high level of his cautious bias. When I joined the family investor complacency. I can’t understand firm in early 2017, I persuaded him to why investors do not share my concerns raise our equity exposure and that was the about by sky-high valuations, a volatile right decision. I have been in the business geopolitical environment and the long enough to know that it is dangerous considerable potential for financial to get more bullish as the market rises instability. Over the years, you have and I agree there probably is too much made me appreciate the power of easy complacency. However, I do not see an money to create financial bubbles and early end to the conditions that are driving also that market overshoots can last for a the bull market and I am inclined to stay surprisingly long time. Thus, I am fully overweight equities for a while longer. aware that we could easily have another Thus, the big debate between us is whether year of strong gains, but were that to or not we should now book profits from the

2 THE BANK CREDIT ANALYST December 2017 BCA RESEARCH past year’s strong performance and move CHART 1 to an underweight stance in risk assets. An Impressive Bull Market Hopefully, this meeting will help us make 600 600 MSCI ALL COUNTRY INDEX* the right decision. BCA: First of all, we are delighted to see 500 500 you both and look forward to getting to know Ms. X in the years to come. It is not a surprise that you are debating 400 400 whether to cut exposure to risk assets because that question is on the mind A great bull market, of many of our clients. We share your fueled by... 300 300 surprise about complacency – investors have been seduced by the relentless upward drift of prices since early 2016. The global equity index has not suffered any setback above 2% during 28 ACW EARNINGS 28 the past year, and that has to be close to a record (Chart 1). The conditions that have underpinned this remarkable 26 26 performance are indeed still in place but we expect that to change during the coming year. Thus, if equity prices 24 24 continue to rise, it would make sense to ...decent reduce exposure to risk assets to a neutral earnings... position over the next few months. A 22 22 blow-off phase with a final spike in prices cannot be ruled out, but trying to catch those moves is a very high-risk ACW P/E RATIO* strategy. We are not yet recommending 20 20 underweight positions in risk assets, but if our economic and policy views pan out, we likely will shift in that direction 18 18 in the second half of 2018. 16 16 Ms. X: It seems that you are siding with ...and rising my father in terms of wanting to scale 14 multiples 14 back exposure to risk assets. That would be premature in my view and I look forward to discussing this in more detail. But first, 12 © BCA Research 2017 12 I would be interested in reviewing your 2011 2012 2013 2014 2015 2016 2017 * SHOWN IN LOCAL CURRENCY TERMS. SOURCE: MSCI INC. forecasts from last year. (SEE COPYRIGHT DECLARATION).

BCA RESEARCH December 2017 THE BANK CREDIT ANALYST 3 BCA: Of course. A year ago, our key expands alongside increased demand conclusions were that: and it will be critical to monitor business capital spending.  A number of important regime shifts will impact the economic  Lingering structural problems will and investment outlook over the prevent any growth acceleration next few years. These include the outside the U.S. The euro area and end of the era of falling inflation emerging economies are still in the and interest rates, a move away midst of a deleveraging cycle and from fiscal conservatism, a policy demographics remain a headwind for pushback against globalization, and Japan. Not many countries will follow a rise in the labor share of income the U.S. example of fiscal stimulus. at the expense of profit margins. Nevertheless, for the first time since Together with an earlier regime shift the recovery began, global growth when the Debt Supercycle ended, forecasts are likely avoid a downgrade these trends are consistent with very over the next couple of years. modest returns from financial assets  China remains an unbalanced and over the next decade. fragile economy but the authorities  The failure of low interest rates to have enough policy flexibility to trigger a vigorous rebound in private avoid a hard landing, at least over credit growth is consistent with our the year or two. The longer-run end-of-Debt Supercycle thesis. The outlook is more bearish unless the end point for dealing with high debt government moves away from its levels may ultimately be sharply stop-go policy approach and pursues higher inflation, but only after more supply-side reforms. the next downturn triggers a new  Inflation has bottomed in the U.S., deflationary scare. but the upturn will be gradual in  The potential for trade restrictions 2017 and it will stay subdued in the by the incoming U.S. administration euro area and Japan. Divergences in poses a threat to the outlook, but the monetary policy between the U.S. odds of a global trade war are low. and other developed economies will continue to build in 2017 as the Fed  Time lags in implementing policy tightens and other central banks stay mean that the fiscal plans of on hold. Unlike a year ago, the Fed’s President-elect Trump will boost U.S. rate expectations look reasonable. growth in 2018 more than 2017. This raises the risk of an overheated  Bond yields in the U.S. may fall economy in 2018 leading to a in the near run after their recent monetary squeeze and recession in sharp rise, but the cyclical trend is 2019. The key issue will be whether up against a backdrop of monetary the supply side of the economy tightening, fiscal stimulus and rising

4 THE BANK CREDIT ANALYST December 2017 BCA RESEARCH inflation. Yields in the euro area will planned production cuts by OPEC be held down by ongoing QE, while and some other producers will the 10-year yield will stay capped at ensure that inventories will have to zero in Japan. The secular bull mar- be drawn down in the second half ket in bonds is over although yields of 2017. Non-oil commodity prices could retest their recent lows in the will stay in a trading range after next downturn. healthy gains in 2016, but the long- run outlook is still bearish.  The search for yield will remain an important investment theme,  The dollar bull market should stay but rich valuations dictate only a intact over the coming year with neutral weighting in investment- the trade-weighted index rising by grade corporate bonds and a modest around 5%. Relative policy stances underweight in high-yielders. and economic trends should all stay supportive of the dollar. The  The U.S. equity market is modestly outlook for the yen is especially overvalued but the conditions are gloomy. A stabilization in resource ripe for an overshoot in 2017 given prices will keep commodity prices in optimism about a boost to profits a range. We remain bearish on EM from the new administration’s currencies. policies. Earnings expectations are far too high and ignore the  The biggest geopolitical risks relate likelihood that rising labor costs to U.S.-China relations, especially will squeeze margins. Nevertheless, given President-elect Trump’s that need not preclude equity prices inclination to engage in China- moving higher. There is a good bashing. Meanwhile, the defeat of chance of a sell-off in early 2017 and ISIS could create a power vacuum that would be a buying opportunity. in the Middle East that could draw Turkey into a disastrous conflict  Valuations are better in Japan and with the Kurds and Iran/Russia. several European markets than in The coming year is important for the U.S. and relative monetary con- elections in Europe but we do not ditions also favor these markets. We expect any serious threat to the EU expect the U.S. to underperform in or single currency to emerge. 2017. We expect emerging markets to underperform developed markets. The most important prediction that we got right was our view that conditions  The oil price should average around were ripe for an overshoot in equity $55 a barrel over the next one or prices. The MSCI all-country index has two years, with some risk to the delivered an impressive total return of upside. Although shale production around 20% in dollar terms since the should increase, the cutbacks in end of 2016, one of the best calendar oil industry capital spending and year performances of the current

BCA RESEARCH December 2017 THE BANK CREDIT ANALYST 5 TABLE 1 Market Performance

LOCAL U.S. DOLLAR

CURRENCY TERMS

2016 2017* 2016 2017* MSCI INDEX - TOTAL RETURNS* ALL COUNTRY INDEX 9.7 17.1 8.5 20.3 U.S. 11.6 17.4 11.6 17.4 CANADA 21.2 7.4 25.5 12.4 EURO AREA 6.0 12.6 2.2 25.7 U.K. 19.2 7.0 0.0 14.3 JAPAN -0.4 16.9 2.7 21.5 EMERGING ASIA 7.3 36.3 6.5 41.8 EMERGING LATIN AMERICA 24.0 18.8 31.5 21.9 10-YEAR GOVERNMENT BOND RETURNS* U.S. 0.2 2.9 0.2 2.9 GERMANY 4.3 -1.4 0.5 10.0 JAPAN 2.1 0.0 5.3 3.9 U.S. CORPORATE BOND RETURNS INVESTMENT GRADE 6.1 5.4 6.1 5.4 HIGH YIELD 17.1 6.6 17.1 6.6

BRENT OIL PRICE ($ BARREL)** 56.7 62.0 GOLD PRICE ($ OZ)** 1146 1284 TRADE-WEIGHTED DOLLAR** 128.2 117.5

* 2017 DATA REFERS TO YTD TO NOVEMBER 17. SOURCE: MSCI INC. (SEE COPYRIGHT DECLARATION). ** END-YEAR LEVELS.

cycle (Table 1). So it was good that With regard to the overall economic your daughter persuaded you to keep environment, we were correct in a healthy equity exposure. It is all forecasting a modest improvement in the more impressive that the market 2017 global economic activity and powered ahead in the face of all the that growth would not fall short of the concerns that you noted earlier. Our IMF’s predictions for the first time in preference for European markets over the current expansion. However, one the U.S. worked out well in common big surprise, not only for us, but also for currency terms, but only because the policymakers, was that inflation drifted dollar declined. Emerging markets did lower in the major economies. Latest much better than we expected, with data show the core inflation rate for the significant outperformance relative to G7 economies is running at only 1.4%, their developed counterparts. down from 1.6% at the end of 2016. We will return to this critical issue later

6 THE BANK CREDIT ANALYST December 2017 BCA RESEARCH as the trend in inflation outlook will be Nevertheless, there are many lingering a key determinant of the market outlook risks to the outlook and market for the coming year and beyond. complacency is a much bigger concern now than it was a year ago. Regionally, the Euro area and Japanese economies registered the biggest upside Mr. X: As you just noted, a key theme of surprises relative to our forecast and your Outlook last year was “Shifting Re- those of the IMF (Table 2). That goes gimes” such as the end of disinflation and a long way to explaining why the U.S. fiscal conservatism, a retreat from global- dollar was weaker than we expected. ization, and the start of a rebalancing in In addition, the dollar was not helped income shares away from profits toward by a market downgrading of the scale labor. And of course, you talked about the and timing of U.S. fiscal stimulus. End of the Debt Supercycle a few years ago. Nonetheless, it is worth noting that the Do you still have confidence that these re- dollar has merely unwound the 2016 gime shifts are underway? Trump rally and recently has shown BCA: some renewed strength. Absolutely! These are all trends that we expect to play out over a num- A year ago, there were major concerns ber of years and thus can’t be judged by about potential political turmoil from short-term developments. There have important elections in Europe, the risk been particularly important shifts in the of U.S.-led trade wars and a credit bust- policy environment. The 2007-09 eco- up in China. We downplayed these nomic and financial meltdown led cen- issues as near-term threats to the markets tral banks to fight deflation rather than and that turned out to be appropriate. inflation and we would not bet against

TABLE 2 IMF Economic Forecasts

OCTOBER 2017 OCTOBER 2016 FORECASTS FORECASTS 2016 2017 2018 2017 2018 ANNUAL % GROWTH IN REAL GDP

ADVANCED ECONOMIES 1.7 2.2 2.0 1.8 1.8

U.S. 1.5 2.2 2.3 2.2 2.1

EUROPE 2.0 2.3 2.1 1.7 1.8

JAPAN 1.0 1.5 0.7 0.6 0.5

EMERGING ECONOMIES 4.3 4.6 4.9 4.6 4.8

CHINA 6.7 6.8 6.5 6.2 6.0

WORLD 3.2 3.6 3.7 3.4 3.6

G7 INFLATION RATE 0.8 1.7 1.7 1.8 2.0

SOURCE: IMF WORLD ECONOMIC OUTLOOK.

BCA RESEARCH December 2017 THE BANK CREDIT ANALYST 7 them in this battle. Inflation has been environment than has existed in recent lower than expected, but there has been years. Central banks have been in panic a clear turning point. On fiscal policy, mode since the 2007-09 downturn with governments have largely given up on an unprecedented period of negative real austerity against a background of a dis- interest rates in the advanced economies, appointingly slow economic recovery coupled with an extraordinary expansion in recent years and rising populist pres- of central bank balance sheets (Chart 3). sures (Chart 2). The U.S. budget deficit Initially, the fear was for another Great could rise particularly sharply over the Depression and as that threat receded, next few years. In the U.S., the relative the focus switched to getting inflation income shares going to profits and labor back to the 2% target favored by most have started to shift direction, but there developed countries. is a long way to go. Finally, the same forces driving government to loosen fis- In a post-Debt Supercycle world, nega- cal purse strings have also undermined tive real rates have failed to trigger the support for globalization with the U.S. typical rebound in credit demand that even threatening to abandon NAFTA. was so characteristic of the pre-down- The ratio of global trade to output has turn era. Central banks have expanded trended sideways for several years and is base money in the form of bank reserves, unlikely to turn higher any time soon. but this has not translated into mark- All these trends are part of our Regime edly faster growth in broad money or Shift thesis. nominal GDP. This is highlighted by the collapse in money multipliers (the ratio The remarkable macro backdrop of low of broad to base money) and in veloc- inflation, easy money and healthy profits ity (the ratio of GDP to broad money). has been incredibly positive for financial This has been a double whammy: there markets in recent years. You would have is less broad money generated for each to be an extreme optimist to believe that dollar of base money and less GDP for such an environment will persist. Our every dollar of broad money (Chart 4). big concern for the coming year is that we are setting up for a collision between Historically, monetary policy acted pri- the markets and looming changes in marily through the credit channel with economic policy. lower rates making households and companies more willing to borrow, and lend- The Coming Collision Between ers more willing to supply funds. In the post-Debt Supercycle world, the credit Policy And The Markets channel has become partly blocked, BCA: As you mentioned earlier, we forcing policymakers to rely more on the attach enormous importance to the role other channels of monetary transmis- of easy money in supporting asset prices sion, the main one being boosting asset and it is hard to imagine that we could prices. However, there is a limit to how have had a more stimulative monetary far this can go because the end result is

8 THE BANK CREDIT ANALYST December 2017 BCA RESEARCH CHART 2 Regime Shifts % Of % Of GDP GDP FISCAL THRUST*

1 Stimulus 1

0 0

Restraint

-1 -1

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 % Of % Of GDP U.S. CORPORATE SECTOR: GDP EMPLOYEE COMPENSATION (LS) GROSS OPERATING SURPLUS (RS) 66 36

62 32

30 58

54 26

1952 1962 1972 1982 1992 2002 2012

RATIO OF GLOBAL EXPORTS TO OUTPUT

1.0 1.0

.9 .9

.8 .8

.7 .7

.6 .6

1990 1995 2000 2005 2010 2015

* G20 ADVANCED ECONOMIES ANNUAL CHANGE IN CYCLICALLY ADJUSTED PRIMARY BUDGET DEFICIT. SOURCE:IMF FISCAL MONITOR TABLE A-3.

BCA RESEARCH December 2017 THE BANK CREDIT ANALYST 9 CHART 3 CHART 4 An Extraordinary Period Monetary Policy: Of Easy Money Pushing On A String %% G7 REAL INTEREST RATES MONEY MULTIPLIER* U.S. EURO AREA JAPAN 2 2 100 100

1 1 80 80

0 0 60 60

-1 -1

40 40

-2 -2

% Of CENTRAL BANK ASSETS (AS PERCENT OF GDP): % Of MONEY VELOCITY** GDP U.S. GDP U.S. 80 EURO AREA 80 EURO AREA JAPAN JAPAN 60 60 100 100 U.K.

40 40 95 95

20 20 90 90

85 85

80 80

75 75 © BCA Research 2017 © BCA Research 2017

2006 2008 2010 2012 2014 2016 2018 2008 2010 2012 2014 2016 * BROAD MONEY DIVIDED BY BASE MONEY. ** GDP DIVIDED BY BROAD MONEY. NOTE: ALL SERIES REBASED TO JAN. 2007 = 100.

massively overvalued assets and building gap closed in 2015 having been as high financial excesses. The Fed and many as 2% of potential GDP in 2013. The other central banks now realize that this IMF estimates that the economy was strategy cannot be pushed much further. operating slightly above potential in 2017 with a further rise forecast in 2018 The economic recovery in the U.S. (Chart 5). According to IMF estimates, and other developed economies has the median output gap for 20 advanced been the weakest of the post-WWII economies will shift from -0.1% in period. But potential growth rates also 2017 to +0.3% in 2018 (i.e. they will be have slowed which means that spare operating above potential). This makes capacity has gradually been absorbed. it hard to justify the maintenance of According to the IMF, the U.S. output hyper-stimulative monetary policies.

10 THE BANK CREDIT ANALYST December 2017 BCA RESEARCH CHART 5 Ms. X: This is another area where my No More Output Gaps % Of % Of father and I disagree. I view the world as OUTPUT GAP* Pot. Pot. U.S. GDP GDP essentially deflationary. We all know that technological innovations have opened up 0 0 competition in a lot of markets, driving -1 -1 down prices. Two obvious examples are Uber and Airbnb, but these are just the -2 For All Panels -2 FORECASTS* tip of the iceberg. Amazon’s purchase of -3 -3 Whole Foods is another example of how increased competitive pressures will con- % Of % Of Pot. Pot. tinue to sweep through previously relatively GDP EURO AREA GDP stable industries. And such changes have 0 0 an important impact on employee psychol- ogy and thus bargaining power. These -1 -1 days, people are glad to just keep their jobs

-2 -2 and this means companies hold the upper hand when it comes to wage negotiations. So I don’t see a pickup in inflation being a % Of % Of Pot. Pot. threat to the markets any time soon. GDP MEDIAN OF 20 ECONOMIES GDP 0 0 Mr. X: I have a different perspective. First of all, I do not even believe the official inflation data because most of the -1 -1 things I buy have risen a lot in price over the past couple of years. Secondly, given the © BCA Research 2017 -2 -2 extremely stimulative stance of monetary

2010 2011 2012 2013 2014 2015 2016 2017 2018 policy in recent years, a pickup in inflation * SOURCE: IMF WORLD ECONOMIC OUTLOOK, OCTOBER 2017. would not surprise me at all. So I am sympathetic to the BCA view. But, even if the data is correct, why have inflation The low U.S. inflation rate is giving the forecasts proved so wrong and what Fed the luxury of moving cautiously and underpins your view that it will increase that is keeping the markets buoyant. In- in the coming year? deed, the markets don’t even believe the BCA: There is an interesting discon- Fed will be able to raise rates as much nect between the official data and the they expect. The most recent FOMC pro- inflation views of many consumers and jections show a median federal funds rate economic/statistics experts. According to of 2.1% by the end of 2018 but the mar- the Conference Board, U.S. consumers’ kets are discounting a move to only 1.8%. one-year ahead inflation expectations The markets probably have this wrong have persistently exceeded the published because inflation is likely to wake up from data and the latest reading is close to 5% its slumber in the second half of the year.

BCA RESEARCH December 2017 THE BANK CREDIT ANALYST 11 (Chart 6). That ties in with your per- CHART 6 Differing Perspectives Of Inflation ception. Consumer surveys by the New Ann% Ann% York Fed and University of Michigan Chg U.S.: Chg CORE CONSUMER PRICE INFLATION* have year-ahead inflation expectations 3 3 at a more reasonable 2.5%. At the same time, many “experts” believe the official data is overstated because it fails to take 2 2 enough account of technological changes and new lower-priced goods and services. The markets also have a moder- 1 1 ately optimistic view with the five-year %% CPI swap rate at 2%. This is optimistic 3-YEAR CPI SWAP RATE

because it is consistent with inflation 3 3 below the Fed’s 2% target, if one allows for an inflation risk premium built in to 2 2

the swap price. 1 1

We are prepared to take the inflation 0 0 data broadly at face value. Low inflation is consistent with an ongoing tough -1 -1 competitive environment in most %% sectors, boosted by the disruptive impact CONSUMER ONE-YEAR INFLATION EXPECTATIONS of technological changes that Ms. X (CONFERENCE BOARD) described. The inflation rate for core goods (ex-food and energy) has been in 7 7

negative territory for several years while 6 6 that for services ex-shelter is at the low end of its historical range (Chart 7). 5 5

There is no simple explanation of why 4 4 inflation has fallen short of forecasts. %% Economic theory assumes that price CONSUMER ONE-YEAR INFLATION EXPECTATIONS (UNIVERSITY OF MICHIGAN) pressures build as an economy moves 5 5 closer to full employment and the

U.S. is at that point. This raises several 4 4 possibilities: 3 3  There is more slack in the economy than suggested by the low unem- 2 2 ployment rate. © BCA Research 2017

 2005 2007 2009 2011 2013 2015 2017 The lags are unusually long in the * EXCLUDES FOOD AND ENERGY. current cycle.

12 THE BANK CREDIT ANALYST December 2017 BCA RESEARCH CHART 7 CHART 8 Not Much Inflation Here Inflationary Pressures Are Turning Ann% Ann% % Ann% U.S. Chg U.S.: Chg Chg UNEMPLOYMENT GAP* (LS) CORE GOODS CPI* ATLANTA FED WAGE TRACKER** (RS) SERVICES INFLATION EX. SHELTER 4.5 3 3 6 4.0

4 3.5 2 2 3.0 2 2.5

1 1 0 2.0

Ann% NON-OIL IMPORT PRICES (LS) Chg TRADE-WEIGHTED DOLLAR*** (INVERTED, RS) 0 0 8 90

100 4 -1 -1 © BCA Research 2017 110 0 2010 2011 2012 2013 2014 2015 2016 2017 2018 * EXCLUDES FOOD AND ENERGY. 120 -4

130

$/Bbl $/Bbl  Technological disruption is having a BRENT CRUDE OIL PRICE

greater impact than expected. 120 120 The link between economic slack and inflationary pressures is typically cap- 80 80 tured by the Phillips Curve which

shows the relationship between the un- 40 40 employment rate and inflation. In the © BCA Research 2017 U.S., the current unemployment rate 2005 2007 2009 2011 2013 2015 2017 * UNEMPLOYMENT RATE MINUS NAIRU, SOURCE: CBO. ** SOURCE: FEDERAL RESERVE BANK OF ATLANTA. of 4.1% is believed to be very close to a *** SOUCE: JPMORGAN CHASE & CO. full-employment level. Yet, inflation recently has trended lower and while wage growth is in an uptrend, it has remained historical evidence still suggests that softer than expected (Chart 8). once the labor market becomes tight, inflation eventually does accelerate. A We agree with Ms. X that employee broad range of data indicates that the bargaining power has been undermined U.S. labor market is indeed tight and over the years by globalization and the Atlanta Fed’s wage tracker is in an technological change and by the impact uptrend, albeit modestly. of the 2007-09 economic downturn. That would certainly explain a weakened Two other factors consistent with an relationship between the unemployment end to disinflation are the lagged effects rate and wage growth, but does not of dollar weakness and a firming in oil completely negate the theory. The prices. Non-oil prices have now moved

BCA RESEARCH December 2017 THE BANK CREDIT ANALYST 13 decisively out of deflationary territory and hopefully boost the supply side while oil prices in 2017 have averaged of the economy without undermining more than 20% above year-ago levels. revenues. However, the economy does not need stimulus from net tax As far as the impact of technology giveaways given that it is operating is concerned, there is no doubt that close to potential. That would simply innovations like Uber and Airbnb are boost demand relative to supply, create deflationary. However, our analysis overheating, and give the Fed more suggests that the growth in online reason to get aggressive. spending has not had a major impact on the inflation numbers. E-commerce still The Republican’s initial tax plan has some represents a small fraction of total U.S. good elements of reform such as cut- consumer spending, depressing overall ting back the personal mortgage interest consumer inflation by only 0.1 to 0.2 deduction, eliminating some other de- percentage points. The deceleration of ductions and making it less attractive for inflation since the global financial crisis companies to shift operations overseas. has been in areas largely unaffected by However, many of these proposals are online sales, such as energy and rent. unlikely to survive the lobbying efforts Moreover, today’s creative destruction in of special interest groups. The net result the retail sector is no more deflationary probably will be tax giveaways without than the earlier shift to ‘big box’ stores. much actual reform. Importantly, there is not a strong case for personal tax cuts We are not looking for a dramatic given that a married worker on the aver- acceleration in either wage growth or age wage and with two children paid an inflation - just enough to convince average income tax rate of only 14% in the Fed that it needs to carry on with 2016, according to OECD calculations. its plan to raise interest rates. And the pressure to do this will increase if the There inevitably will be contentious Administration is able to deliver on its negotiations in Congress but we assume planned tax cuts. that the Republicans will eventually come together to pass some tax cuts Ms. X: You make it sound as if cutting by early next year. The combination of taxes would be a bad thing. Surely easier fiscal policy and Fed rate hikes the U.S. would benefit from the will be bullish for the dollar and this will Administration’s tax plan? A reduction in contribute to tighter overall financial the corporate tax rate would be very bullish conditions. That is why we see a coming for equities. collision between economic policy and BCA: The U.S. tax system is desperately the markets. in need of reform via eliminating The narrative for the so-called Trump loopholes and distortions and using rally in markets was based on the as- the savings to lower marginal rates. sumption that the Administration’s plat- That would make it more efficient form of increased spending, tax cuts and

14 THE BANK CREDIT ANALYST December 2017 BCA RESEARCH reduced regulations would be bullish for not really need a big fiscal boost. And the economy and thus risk assets. That that certainly applies to the current was always a misplaced notion. The per- environment. fect environment for markets has been moderate economic growth, low infla- The other area of potential policy error is tion and easy money. The Trump agenda on trade. Having already pulled the U.S. would be appropriate for an economy out of the Trans-Pacific Partnership, that had a lot of spare capacity and the Trump Administration is taking a needed a big boost in demand. It is less hardline attitude toward a renegotiation suited for an economy with little spare of NAFTA. This could even end up with capacity. Reduced regulations and lower the deal being scrapped and that would corporate tax rates are good for the sup- add another element of risk to the North ply side of the economy and could boost American economies. the potential growth rate. However, if a Ms. X: Your scenario assumes that the Fed key move is large personal tax cuts then will be quite hawkish. However, every- the boost to demand will dominate. thing I have read about Jerome Powell, the Mr. X: It seems that you are making the new Fed chair, suggests that he will err on case for a serious policy error in the U.S. the side of caution when it comes to raising in the coming year – both on fiscal and rates. So monetary policy may not collide monetary policy. I can’t argue against that with markets at all over the coming year. because everything that has happened BCA: It is certainly true that Powell over the past few years tells me that does not have any particular bias when policymakers don’t have a good grip on it comes to the conduct of monetary either the economy or the implications of policy. That would not have been the their actions. I never believed that printing case if either John Taylor or Kevin money and creating financial bubbles was Warsh had been given the job – they a sensible approach to an over-indebted both have a hawkish bias. Powell is not economy. I always expected it to end badly. an economist so will likely follow a BCA: Major tightening cycles frequently middle path and be heavily influenced end in recession because monetary by the Fed’s staff forecasts and by the policy is a very blunt tool. Central opinions of other FOMC members. banks would like to raise rates by just There are still several vacancies on the enough to cool things down but that Fed’s Board so much will depend on is hard to achieve. The problem with who is appointed to those positions. fiscal policy is that implementation lags The latest FOMC forecasts are for mean that it often is pro-cyclical. In growth and inflation of only 2% in other words, there is pressure for fiscal 2018 and these numbers seem too low. stimulus in a downturn, but by the Meanwhile, the prediction that unem- time legislation is passed, the economy ployment will still be at 4.1% at end- typically has already recovered and does 2018 is too high. We expect projections

BCA RESEARCH December 2017 THE BANK CREDIT ANALYST 15 of growth and inflation to be revised up CHART 9 Financial Leverage Has Risen and unemployment to be revised down. US$ US$ That will embolden the Fed to keep rais- Bn U.S. Bn MARGIN DEBT (LS) ing rates. So, even with Powell at the 600 WILSHIRE 5000 (RS) 26000 helm, monetary policy is set to get tighter than the market currently expects. 500 22000 Ms. X: So far, we have talked mainly about the U.S. What about other central 400 banks? I can’t believe that inflation will be 18000 much of a problem in the euro area or in

Japan any time soon. Does that not mean 300 that the overall global monetary environ- 14000 ment will stay favorable for risk assets? 200 © BCA Research 2017 BCA: The Fed is at the leading edge of 2010 2011 2012 2013 2014 2015 2016 2017 2018 the shift away from extreme monetary ease by hiking interest rates and starting the process of balance sheet reduction. But the Bank of Canada also has raised hidden until they blow up. We know rates and the ECB has announced that that companies have taken on a lot it will cut its asset purchases in half of debt, largely to fund financial beginning January 2018, as a first step transactions such as share buybacks in normalizing policy. Even the Bank of and merger and acquisitions activity. England has raised rates despite Brexit- That is unlikely to be the direct cause related downside risks for the economy. of a financial accident but might well The BoJ will keep an accommodative become a problem in the next downturn. stance for the foreseeable future. It typically is increased leverage within the financial sector itself that poses the You are correct that financial conditions greatest risk and that is very opaque. will be tightening more in the U.S. The banking system is much better than in other developed economies. capitalized than before the 2007-09 Moreover, equity valuations are more downturn so the risks lie elsewhere. stretched in the U.S. than elsewhere leaving that market especially As would be expected, margin debt has vulnerable. Yet, market correlations are climbed higher with the equity market, such that any sell-off in U.S. risk assets and is at a historically high level relative Chart 9 is likely to become a global affair. to market capitalization ( ). We don’t have good data on the degree of Another key issue relates to the potential leverage among non-bank financial for financial shocks. Long periods of institutions such as hedge funds but that extreme monetary ease always fuel is where leverage surprises are likely to excesses and sometimes these remain occur. And the level of interest rates that

16 THE BANK CREDIT ANALYST December 2017 BCA RESEARCH causes financial stress is almost certainly As we have discussed in the past, there to be a lot lower than in the past. is not an inconsistency between our End of Debt Supercycle thesis and the Mr. X: That is the perfect lead-in to my continued high levels of debt in most perennial concern – the high level of debt countries. As noted earlier, record-low in the major economies. I realize high debt interest rates have not triggered the kind levels are not a problem when interest rates of private credit resurgence that occurred are close to zero, but that will change if in the pre-crisis period. For example, your view on the Fed is correct. household borrowing has remained far Ms. X: I would just add that this is one below historical levels as a percent of in- area where I share my father’s concerns, come in the U.S., despite low borrowing but with an important caveat. costs (Chart 11). At the same time, it is I wholeheartedly agree that high debt levels not a surprise that debt-to-income ratios pose a threat to economic and financial are high given the modest growth in stability, but I see this as a long-term nominal incomes in most countries. issue. Even with rising interest rates, debt Debt growth is not benign everywhere. servicing costs will stay low for at least the In the developed world, Canada’s debt next year. It seems to me that rates will growth is worryingly high, both in the have to rise a lot before debt levels in the household and corporate sectors. As is major economies pose a serious threat to also the case with Australia, Canada’s the system. Even if the Fed tightens policy overheated housing market has fueled in line with its plans, real short rates rapid growth in mortgage debt. These will still stay low by historical standards. are accidents waiting to happen when This will not only keep debt financing borrowing costs increase. In the manageable but will also sustain the search emerging word, China has yet to see the for yield and support equity prices. end of its Debt Supercycle. Fortunately, BCA: We would be disappointed if with most banks under state control, the you both had not raised the issue of authorities should be able to contain any debt. Debt levels do indeed remain very systemic risks, at least in the near run. elevated among advanced and emerging With regard to timing, we agree that Chart 10 economies ( ). The growth in debt levels are not likely to pose an private debt remains far below pre-crisis economic or financial problem in next levels in the advanced countries, but this year. It is right to point out that debt- has been offset by the continued high servicing costs are very low by historical level of government borrowing. As a standards and it will take time for rising result, the total debt-to-GDP ratio has rates to have an impact given that a stayed close to a peak. And both private lot of debt is locked in at low rates. and public debt ratios have climbed to For example, in the U.S., the ratio of new highs in the emerging economies, household debt-servicing to income with China leading the charge. and the non-financial business sector’s

BCA RESEARCH December 2017 THE BANK CREDIT ANALYST 17 CHART 10 Debt Levels Remain Elevated Ann% Ann% Ann% Ann% Chg Chg Chg EMERGING ECONOMIES: Chg ADVANCED ECONOMIES:

PRIVATE DEBT GROWTH* PRIVATE DEBT GROWTH* 20 20 30 30

20 20 10 10

10 10 0 0

0 0

%%%% PRIVATE DEBT PRIVATE DEBT AS A PERCENT OF GDP* 140 AS A PERCENT OF GDP* 140 180 180

120 120 170 170

100 100 160 160

150 150 80 80

%%%% GOVERNMENT DEBT GOVERNMENT DEBT AS A PERCENT OF GDP* AS A PERCENT OF GDP* 110 110 45 45 100 100

90 90 40 40

80 80 35 35 70 70

%%%% TOTAL DEBT 280 AS A PERCENT OF GDP* 280 TOTAL DEBT AS A PERCENT OF GDP* 180 180

260 260 160 160

240 240 140 140

220 220 120 120

2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018

* SOURCE: BIS. * SOURCE: BIS.

18 THE BANK CREDIT ANALYST December 2017 BCA RESEARCH CHART 11 CHART 12 Low Rates Have Not Triggered Borrowing Costs Are Benign %% A Borrowing Surge In U.S. U.S. %% U.S.: 14 HOUSEHOLD DEBT SERVICE RATIO* 14 BORROWING FOR HOME MORTGAGES AS A PERCENT OF DISPOSABLE INCOME(LS) 20 30-YEAR FIXED MORTGAGE RATE (RS) 10

13 13

10 8 12 12

11 11 0 6

10 10

-10 4 %%

1990 1995 2000 2005 2010 2015 18 18

16 16 ratio of interest payments to EBITD are at relatively benign levels (Chart 12). 14 14 However, changes occur at the margin and the example of the Bernanke taper 12 12 tantrum highlighted investor sensitivity to even modest changes in the monetary 10 10 environment. 8 © BCA Research 2017 8

You may well be right Ms. X that risk 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 assets will continue to climb higher in * DEBT SERVICING COSTS AS A % OF INCOME. the face of a tighter financial conditions. But given elevated valuations, we lean to grow out of it, to write it off, or to toward a cautious rather than aggressive try and inflate it away. The first option approach to strategy. We would rather obviously would be best – to have fast leave some money on the table than risk enough growth in real incomes that being caught in a sudden downdraft. allowed debtors to start paying down Other investors, including yourself, their debt. Unfortunately, that is the might prefer to wait for clearer signals least likely prospect given adverse demo- that a turning point is imminent. graphic trends throughout the developed world and disappointing productivity Returning to the issue of indebted- growth (Chart 13). ness, the end-game for high debt levels continues to be a topic of intense inter- Writing the debt off – i.e. defaulting – is est. There really are only three options: a desperate measure that would be the

BCA RESEARCH December 2017 THE BANK CREDIT ANALYST 19 CHART 13 by converting them to perpetuals – It's Hard To Grow Out Of Debt securities that are never redeemed. With These Structural Headwinds Avg % Avg % Year Year If the first two options are not viable, GROWTH OF WORKING AGE POPULATION* (15-64)

For All Panels then inflation becomes the preferred so- 2.0 U.S. 2.0 JAPAN lution to over-indebtedness. To make a EUROPE big impact, inflation would need to rise 1.5 1.5 far above the 2% level currently favored 1.0 1.0 by central banks, and it would have to stay elevated for quite some time. Cen- .5 .5 tral banks are not yet ready to allow such

0 0 an environment, but that could change after the next economic downturn. -.5 -.5 Central banks have made it clear that

Ann% 1970 1980 1990 2000 2010 2020 2030 Ann% they are prepared to pursue radical Chg Chg policies in order to prevent deflation. GDP PER HOUR WORKED** 5 5 This sets the scene for increasingly aggressive actions after the next recession 4 4 and the end result could be a period of

3 3 significantly higher inflation. Mr. X: I don’t disagree with that view 2 2 which is why I always like to hold some

1 1 physical gold in my portfolio. It is interesting that you are worried about a looming 0 0 setback for risk assets because you are posi- © BCA Research 2017 tive on the near-run economic outlook. 1975 1980 1985 1990 1995 2000 2005 2010 2015 That is contrary to the typical view that * SOURCE: UNITED NATIONS. ** SHOWN AS A 3-YEAR MOVING AVERAGE. SOURCE: THE CONFERENCE BOARD. sees a decent economy as supporting higher equity prices. Let’s spend a bit more time on your view of the economic outlook. very last resort after all other approaches had failed. In this case, we are talking Ms. X: Before we do that, I would just mainly about government debt, because emphasize that it is far too early to worry private debt always has to be written about debt end games and the potential off when borrowers become bankrupt. for sharply rising inflation. I don’t disagree Japan is the one developed country that monetary policy could be forced to where government debt probably will embrace massive reflation during the next be written off eventually. Given that downturn and perhaps that will make me the Bank of Japan owns around 45% change my view of the inflation outlook. of outstanding government debt, But the sequencing is important because those holdings can be neutralized we would first have to deal with a recession

20 THE BANK CREDIT ANALYST December 2017 BCA RESEARCH that could be a very deflationary episode. CHART 14 And before the next recession we could Global Activity On An Uptrend have period of continued decent growth, GLOBAL: LEADING ECONOMIC INDICATOR* (LS) which would be positive for risk assets. MANUFACTURING PMI** (RS) 54 So I agree that the near-term view of the .6 economic outlook is important. 53 .4 52 The Economic Outlook .2 BCA: This recovery cycle has been 51 characterized by a series of shocks and 0 50 headwinds that constrained growth in various regions. In no particular 49 order, these included fiscal austerity, -.2

the euro crisis, a brief U.S. government 2013 2014 2015 2016 2017 shutdown, the Japanese earthquake, MAJOR ADVANCED ECONOMIES: and a spike in oil prices above $100. As 2 CONSUMER CONFIDENCE*** 2 BUSINESS CONFIDENCE*** we discussed a year ago, in the absence

of any new shocks, we expected global 1 1 growth to improve and that is what occurred in 2017. 0 0 A broad range of indicators shows that -1 -1 activity has picked up steam in most

areas. Purchasing managers’ indexes are -2 -2

in an uptrend, business and consumer © BCA Research 2017 confidence are at cyclical highs and leading indicators have turned up 2000 2002 2004 2006 2008 2010 2012 2014 2016 * INCLUDES 40 COUNTRIES, SHOWN AS DEVIATION FROM TREND, BASED ON BCA CALCULATIONS (Chart 14). This is hardly a surprise ** SOURCE: J.P. MORGAN / MARKIT ECONOMICS. *** STANDARDIZED. BASED ON BCA CALCULATIONS. given easy monetary conditions and a more relaxed fiscal stance almost everywhere. markets. But there are two alternative sce- The outlook for 2018 is positive and the narios, both quite optimistic for risk assets. IMF’s projections for growth is probably On the one hand, a cut in the corporate too low (see Table 2). So, for the second tax rate could trigger a further improve- year in a row, the next set of updates due ment in business confidence and thus ac- in the spring are likely to be revised up. celeration in capital spending. This would boost the supply side of the economy and Ms. X: Let’s talk about the U.S. economy. mean that faster growth need not lead to You are concerned that tax cuts could con- higher inflation. It would be the perfect tribute to overheating, tighter monetary world of a low inflation boom. At the policy and an eventual collision with the other extreme, if political gridlock prevents

BCA RESEARCH December 2017 THE BANK CREDIT ANALYST 21 any meaningful tax cuts, we will be left CHART 15 Trends In U.S. Growth with the status quo of moderate growth Ann% Ann% Chg U.S. Chg and low inflation that has been very posi- REAL CONSUMER SPENDING tive for markets during the past several years. 4 4

Mr. X: You can always rely on my daugh- 3 3 ter to emphasize the potential for optimistic outcomes. I would suggest another 2 2 entirely different scenario. The cycle is very mature and I fear it would not take much 1 1 to tip the economy into recession, even if Ann% REAL RESIDENTIAL INVESTMENT Ann% we get some tax relief. So I am more con- Chg Chg cerned with near-term downside risks to 15 15 the U.S. economy. A recession in the com- 10 10 ing year would be catastrophic for the stock

market in my view. 5 5

BCA: Before we get to the outlook, let’s 0 0 agree on where we are right now. As we already noted, the U.S. economy cur- -5 -5

Ann% Ann% rently is operating very close to its po- REAL NON-RESIDENTIAL FIXED INVESTMENT tential level. The Congressional Budget Chg Chg Office estimates potential growth to be only 1.6% a year at present, which ex- 10 10 plains why the unemployment rate has

dropped even though growth has aver- 5 5 aged a modest 2% pace in recent years.

The consumer sector has generally 0 0 been a source of stability with real

spending growing at a 2¾% pace over Ann% REAL GOVERNMENT SPENDING Ann% the past several years (Chart 15). And, Chg Chg encouragingly, business investment 2 2 has recently picked up from its earlier disappointing level. On the negative 0 0 side, the recovery in housing has lost steam and government spending has -2 -2 been a source of drag. © BCA Research 2017 Looking ahead, the pattern of growth may change a bit. With regard to 2011 2012 2013 2014 2015 2016 2017

22 THE BANK CREDIT ANALYST December 2017 BCA RESEARCH consumer spending, the pace of CHART 16 employment growth is more likely to Personal Saving At A Recovery Low slow than accelerate given the tight % Of % Of Disp U.S. Disp market and growing lack of available Inc PERSONAL SAVING RATE* Inc skilled employees. According to the National Federation of Independent Business survey, 88% of small companies 8 8 hiring or trying to hire reported “few or no qualified applicants for the positions they were trying to fill”. Companies in manufacturing and construction say that 6 6 the difficulty in finding qualified workers is their single biggest problem, beating

taxes and regulations. 4 4 In addition, we should not assume that © BCA Research 2017 the personal saving rate will keep falling 2011 2012 2013 2014 2015 2016 2017 given that it has hit a recovery low of * SHOWN AS 3-MONTH MOVING AVERAGE. Chart 16 3.1% ( ). On the other hand, Last, but not least, government spending wage growth should continue to firm will face countervailing forces. The Ad- and there is the prospect of tax cuts. ministration plans to increase spending Overall, this suggests that consumer on defense and infrastructure but there spending should continue to grow by at could be some offsetting cutbacks in least a 2% pace in 2018. other areas. Overall, government spend- Survey data suggests that business in- ing should make a positive contribution vestment spending should remain strong to 2018 after being a drag in 2017. in the coming year, even without any Putting all this together, the U.S. econ- additional boost from corporate tax cuts. omy should manage to sustain a growth Meanwhile, rebuilding and renovations rate of around 2.5% in 2018, putting in the wake of Hurricanes Harvey and GDP further above its potential level. Irma should provide a short-term boost And it could rise above that if tax cuts to housing investment and a more last- are at the higher end of the range. ing improvement will occur if the mil- lennial generation finally moves out of You suggested three alternative scenarios their parents’ basements. On that note, to our base case: a supply-side boom, it is encouraging that the 10-year slide continued moderate growth and a near- in the homeownership rate appears to term recession. A supply-side revival that have run its course (Chart 17). And leads to strong growth and continued although housing affordability is down low inflation would be extremely from its peak, it remains at an attractive bullish, but we are skeptical about level from a historical perspective. that possibility. The revival in capital

BCA RESEARCH December 2017 THE BANK CREDIT ANALYST 23 CHART 17 spending is good news, but this will A Weak Housing Recovery Mn Mn take time to feed into faster productivity U.S. 2.5 2.5 growth. Overall, any tax cuts will have a HOUSING STARTS* greater impact on demand than supply, 2.0 2.0 putting even greater pressure on an already tight labor market. 1.5 1.5 The second scenario of a continuation 1.0 1.0 of the recent status quo is more possible, especially if we end up with a very .5 .5 watered-down tax package. However, growth would actually have to drop be- HOUSING AFFORDABILITY INDEX** low 2% in order to prevent GDP from 220 220 rising above potential. We will closely monitor leading indicators for signs that 180 180 growth is about to lose momentum. The bearish scenario of a near-term reces- 140 140 sion cannot be completely discounted, but there currently is no compelling evi- 100 100 dence of such a development. Recessions can arrive with little warning if there is S&P CASE-SHILLER 10-CITY HOME PRICE INDEX*** an unanticipated shock, but that is rare. Historically, a flat or inverted yield curve 220 220 has provided a warning sign ahead of most recessions and the curve currently is 180 180 still positively sloped (Chart 18). Another leading indicator is when cyclical spend- 140 140 ing1 falls as a share of GDP, reflecting the increased sensitivity of those items to changes in financial conditions. Cyclical %%HOMEOWNERSHIP RATE spending is still at a historically low level relative to GDP and we expect this to rise 68 68 rather than fall over the coming quarters. While a near-term recession does not 66 66 seem likely, the odds will change during the course of 2018. By late year, there is 64 64 a good chance that the yield curve will be © BCA Research 2017

2000 2002 2004 2006 2008 2010 2012 2014 2016 1 This comprises consumer spending on durables, * SHOWN AS A 3-MONTH MOVING AVERAGE. ** SOURCE: NATIONAL ASSOCIATION OF REALTORS. housing and business investment in equipment *** SOURCE: S&P CASE-SHILLER. and software.

24 THE BANK CREDIT ANALYST December 2017 BCA RESEARCH CHART 18 No Recession Signals For The U.S. …Yet BPs BPs 3-MONTH / 10-YEAR TREASURY YIELD CURVE*

400 400

200 200

0 0

-200 -200

Ann% Ann% Chg Chg LEADING ECONOMIC INDICATOR**

10 10

0 0

-10 -10

-20 -20

% of CYCLICAL SPENDING*** % of GDP GDP

22 22

20 20

18 18

16 16 © BCA Research 2017

1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015

* YIELD CURVE IS DEFINED AS THE 10-YEAR TREASURY YIELD MINUS 3-MONTH TREASURY BILL YIELD ** SOURCE: THE CONFERENCE BOARD ***SUM OF PERSONAL CONSUMPTION EXPENDITURE FOR TOTAL DURABLE GOODS, RESIDENTIAL INVESTMENT, NONRESIDENTIAL INVESTMENT FOR EQUIPMENT AND SOFTWARE NOTE: SHADING DENOTES NBER-DESIGNATED RECESSIONS

BCA RESEARCH December 2017 THE BANK CREDIT ANALYST 25 flat or inverted, giving a warning signal for CHART 19 a recession in 2019. Our base case view is No Clear Winner On Growth

for a U.S. recession to start in the second REAL GDP PER HEAD*: U.S. half of 2019, making the current expan- 106 EURO AREA 106 sion the longest on record. At this stage, it JAPAN is too early to predict whether it would be

a mild recession along the lines of 1990- 104 104 91 and 2000-01 or a deeper downturn. Mr. X: I hope that you are right that a U.S. recession is more than a year away. I am not 102 102 entirely convinced but will keep an open mind, and my daughter will no doubt keep

me fully informed of any positive trends. 100 100 © BCA Research 2017 Ms. X: You can be sure of that. Although I 2013 2014 2015 2016 2017 lean toward the optimistic side on the U.S. * REBASED TO Q1 2013 = 100. economy, I have been rather surprised at how well the euro area economy has done drag (the change in the structural prima- in the past year. Latest data show that the ry deficit) was equivalent to around 10% euro area’s real GDP increased by 2.5% in of GDP in Greece and Portugal and 7% the year to 2017 Q3 compared to 2.3% of GDP in Ireland and Spain. There was for the U.S. Can that be sustained? little fiscal tightening in the subsequent three years, allowing those economies to BCA: The relative performance of the recover lost ground. Meanwhile, Ger- euro area economy has been even better many’s economy has continued to power if you allow for the fact that the region’s ahead, benefiting from much easier -fi population growth is 0.5% a year below nancial conditions than the economy has that of the U.S. So the economic growth warranted. That has been the inevitable gap is even greater on a per capita basis. consequence of a one size fits all mone- The euro area economy performed tary policy that has had to accommodate poorly during their sovereign debt crisis the weakest members of the region. years of 2011-13, but the subsequent improvement has meant that the region’s The French and Italian economies have real per capita GDP has matched that disappointed, but there are hopes that of the U.S. over the past four years. And the new French government will pursue even Japan’s GDP has not lagged much pro-growth policies. And Italy should behind on a per capita basis (Chart 19). also pick up given signs that it is finally starting to deal with its fragile banking The recovery in the euro area has been system. Both Spain and Italy faced a broadly based but the big change was the sharp rise in non-performing bank loans end of a fiscal squeeze in the periphery during the great recession, but Italy countries. Between 2010 and 2013, fiscal lagged Spain in dealing with the problem

26 THE BANK CREDIT ANALYST December 2017 BCA RESEARCH CHART 20 and we do not anticipate any major A Turning Point For Italian Banks? %%changes in fiscal policy. If, as we fear, NON PERFORMING LOANS AS % OF TOTAL LOANS: the U.S. moves into recession in 2019, SPAIN ITALY there will be negative fallout for Europe,

12 12 largely via the impact on financial markets. However, in relative terms, the euro area should outperform the U.S.

8 8 during the next downturn. Mr. X: A year ago, you said that Brexit posed downside risks for the U.K. economy. 4 4 For a while, that seemed too pessimistic as the economy performed quite well, but recent data show things have taken a

ITALIAN BANK STOCK PRICES* turn for the worse. How do you see things playing out with this issue? 3000 3000 BCA: It was apparent a year ago that the U.K. government had no concrete plans to deal with Brexit and little has changed 2000 2000 since then. The negotiations with the EU are not going particularly well and the odds of a “hard” exit have risen. This 1000 1000 means withdrawing from the EU without any agreement on a new regime for trade,

© BCA Research 2017 labor movements or financial transactions. A growing number of firms are taking the 2000 2002 2004 2006 2008 2010 2012 2014 2016 * SOURCE: THOMSON / REUTERS; SHOWN IN LOCAL CURRENCY TERMS. precaution of shifting some operations from the U.K. to other EU countries. (Chart 20). That goes a long way to explaining why the Italian economic As you noted, there are signs that Brexit recovery has been so poor relative to is starting to undermine the U.K. econ- Spain. With Italian banks raising capital omy. For example, London house prices and writing off non-performing loans have turned down and the leading eco- Chart 21 more aggressively, the Italian economy nomic index has softened ( ). should start to improve, finally catching The poor performance of U.K. consum- up with the rest of the region. er service and real estate equities relative to those of Germany suggest investors Overall, the euro area economy should are becoming more wary of the U.K. manage to sustain growth above the outlook. Of course, a lot will depend on 2.1% forecast by the IMF for 2018. the nature of any deal between the U.K. Overall financial conditions are likely to and the EU and that remains a source of stay favorable for at least another year great uncertainty.

BCA RESEARCH December 2017 THE BANK CREDIT ANALYST 27 CHART 21 once the country is freed from the stifling Brexit Effects Show Up £000's £000's bureaucratic constraints of EU member- LONDON AVERAGE HOUSE PRICE* 600 600 ship. The U.K. has a more dynamic economy than most EU members and it will be

500 500 able to attract plenty of overseas capital if the government pursues appropriate policies

400 400 toward taxes and regulations. It will take a few years to find out who is correct about

300 300 this. In the meantime, given the uncertainties, I am inclined to have limited exposure U.K. LEADING ECONOMIC INDICATOR** to sterling and the U.K. equity market.

110 110 Let’s now talk about China, another country facing complex challenges. This is a top- 105 105 ic where my father and I again have a lot

100 100 of debates. As you might guess, I have been on the more optimistic side while he has 95 95 sided with those who have feared a hard U.K. vs. GERMANY CONSUMER SERVICES EQUITIES landing. And I know that similar debates REAL ESTATE EQUITIES have occurred in BCA. 30 30 BCA: It is not a surprise that there are lots 25 25 of debates about the China outlook. The country’s impressive economic growth has 20 20 been accompanied by an unprecedented 15 15 © BCA Research 2017 build-up of debt and supply excesses in several sectors. The large imbalances 2005 2007 2009 2011 2013 2015 2017

* SOURCE: LSL ACADATA would have led to a collapse by now in ** SOURCE: U.K. CONFERENCE BOARD any other economy. However, China has benefited from the heavy state involve- At the moment, there are no real ment in the economy and, in particular, grounds for optimism. The U.K. holds the banking sector. The big question is few cards in the bargaining process and whether the government has enough con- the country’s strong antipathy toward trol over economic developments to avoid the free movement of people within the an economic and financial crisis. The EU will be a big obstacle to an amicable good news is that China’s government separation agreement. debt is relatively low, giving them the fiscal flexibility to write-off bad debts from Ms. X: I think the U.K. made the right zombie state-owned enterprises (SOEs). decision to leave the EU and am more optimistic than you about the outlook. There The problems of excessive leverage and may be some short-term disruption but the over-capacity are particularly acute in long-term outlook for the U.K. will be good SOEs that still comprise a large share of

28 THE BANK CREDIT ANALYST December 2017 BCA RESEARCH economic activity. The government is well CHART 22 aware of the need to reform SOEs and China: Debt-Fueled Growth To Continue various measures have been announced, %% but progress has been relatively limited thus far. The IMF projects that the ratio 7.5 CHINA: 7.5 of total non-financial debt to GDP will REAL GDP GROWTH* remain in an uptrend over the next several FORECASTS* years, rising from 236% in 2016 to 298% 7.0 7.0 by 2022 (Chart 22). Yet, growth is ex-

pected to slow only modestly over the pe- 6.5 6.5 riod. Of course, one would not expect the IMF to build a crisis into their forecast. 6.0 6.0 Some investors have been concerned that a peak in China’s mini-cycle of the past two years may herald a return to the % Of % Of GDP GDP economic conditions that prevailed in NON-FINANCIAL SECTOR DEBT* FORECASTS* 2015, when the industrial sector grew 300 300 at a slower pace than during the acute phase of the global financial crisis. These conditions occurred due to the combination of excessively tight monetary 250 250 conditions and weak global growth. While China’s export growth may slow over the coming year, monetary policy 200 200 remains accommodative. Monetary © BCA Research 2017 conditions appear to have peaked early 2014 2016 2018 2020 2022 this year but are still considerably easier * SOURCE: IMF ARTICLE IV REPORT ON CHINA. than in mid-2015. Shifts in the monetary conditions index have done a good power and he will go to great lengths to job of leading economic activity and ensure that his reign is not sullied with they paint a reasonably positive picture an economic crisis. The longer-term (Chart 23). The industrial sector has outlook will depend on how far the gov- finally moved out of deflation, with ernment goes with reforms and delever- producer prices rising 6.9% in the year aging and we are keeping an open mind ended October. This has been accompa- at this point. In sum, for the moment, nied by a solid revival in profits. we are siding with Ms. X on this issue. On balance, we assume that the Chinese Mr. X: I have been too bearish on China economy will be able to muddle through for the past several years, but I still worry for the foreseeable future. President Xi about the downside risks given the massive Jinping has strengthened his grip on imbalances and excesses. I can’t think of

BCA RESEARCH December 2017 THE BANK CREDIT ANALYST 29 CHART 23 CHART 24 China Leaves Emerging Economy Growth: Deflation Behind The Boom Years Are Over %% CHINA: MEDIAN GROWTH OF 23 EMERGING ECONOMIES* LI KEQIANG INDEX* (LS) MONETARY CONDITIONS INDEX** (ADV, RS) 120 6 6 12

110 10

100 4 4 8

6 2 2 80

4 70

2 0 0 60

4 index (Chart 24). This recovered to 3% 20 in 2017 according to IMF estimates, but that is still far below the average 5% 0 10 pace of the period 2000-07. It is always dangerous to generalize about -4 0 the emerging world because the group

* SHOWN AS A 3-MONTH MOVING AVERAGE. the largest countries – Brazil and Russia – ** SOURCE: BLOOMBERG FINANCE L.P., ADVANCED BY 5 MONTHS, SMOOTHED. went through particularly bad downturns in the past couple of years and those any example of a country achieving a soft economies are now in a modest recovery. landing after such a massive rise in debt. I In contrast, India has continued to grow will give you and my daughter the benefit at a healthy albeit slowing pace, while of the doubt, but am not totally convinced Korea and the ASEAN region have not that you will be right. BCA has been suffered much of a slowdown. cautious on emerging economies in general: has that changed? If, as seems likely, Chinese growth holds above a 6% pace over the next year, then BCA: The emerging world went through those countries with strong links to Chi- a tough time in 2015-16 with median na should do fine. And it also points to growth of only 2.6% for the 23 con- reasonably steady commodity prices, sup- stituent countries of the MSCI EM porting resource-dependent economies.

30 THE BANK CREDIT ANALYST December 2017 BCA RESEARCH Longer-run, there are reasons to be cau- CHART 25 Bonds Yields Offer Little Appeal tious about many emerging economies, %% U.S.: particularly if the U.S. goes into recession 5 10-YEAR TREASURY YIELD 5 2019, as we fear. That would be associ- DIVIDEND YIELD ated with renewed weakness in commod- 4 4 ity prices, and capital flight from those economies with high external debt such 3 3 as Turkey and South Africa. As we stated 2 2 a year ago, the heady days of emerging economy growth are in the past. %%EURO AREA: 10-YEAR GOVERNMENT Mr. X: It seems that both my daughter BOND YIELD and I can find some areas of agreement 6 DIVIDEND YIELD 6 with your views about the economic 4 4 outlook. You share her expectation that the global growth outlook will stay healthy 2 2 over the coming year, but you worry about a U.S.-led recession in 2019, something 0 0 that I certainly sympathize with. But we %%REAL 10-YEAR TREASURY YIELD*: U.S. differ on timing: I fear the downturn could EURO AREA occur even sooner and I know my daughter 2 2 believes in a longer-lasting upturn. Let’s 1 1 now move onto what this all means for financial markets, starting with bonds. 0 0

-1 -1 Bond Market Prospects © BCA Research 2017 Ms. X: I expect this to be a short discussion 2006 2008 2010 2012 2014 2016 2018 * NOMINAL YIELD MINUS CPI SWAP RATE. as I can see little attraction in bonds at current yields. Even though I expect inflation to stay muted, bonds offer no into bonds against a backdrop of higher prospect of capital gains in the year ahead yields and a likely bear market in equi- and even the running yield offers little ties. For the moment, we recommend advantage over the equity dividend yield. underweight bond exposure. BCA: As you know, we have believed for It is hard to like government bonds some time that the secular bull market when the yield on 10-year U.S. Treasur- in bonds has ended. We expect yields ies is less than 50 basis points above the to be under upward pressure in most dividend yield of the S&P 500 while the major markets during 2018 and thus euro area bond yield is 260 basis points share your view that equities offer bet- below divided yields (Chart 25). Real ter return prospects. By late 2018, it yields, using the 10-year CPI swap rate might well be appropriate to switch back as a measure of inflation expectations,

BCA RESEARCH December 2017 THE BANK CREDIT ANALYST 31 CHART 26 Valuation Ranking Of Developed Bond Markets 2 Better value

0 GREECE SPAIN ITALY PORTUGAL

-1 U.K. U.S. NEW ZEALAND KOREA JAPAN FINLAND MEDIAN IRELAND AUSTRALIA FRANCE SWITZERLAND SWEDEN

-2 CANADA NORWAY DENMARK BELGIUM NETHERLANDS GERMANY AUSTRIA © BCA Research 2017 -3

* RANKING IS BASED ON HOW FAR CURRENT REAL YIELD ARE FROM THEIR HISTORICAL AVERAGE, EXPRESSED IN NUMBER OF STANDARD DEVIATIONS.

are less than 20 basis points in the U.S. Greece where there needs to be a risk and a negative 113 basis points in the premium in case the country is forced to euro area. Even if we did not expect leave the single currency at some point. inflation to rise, it would be difficult This is less of a risk for Portugal, making to recommend an overweight position it a more interesting market. Real yields in any developed country government in New Zealand are broadly in line with bonds. their historical average, also making it one of the more attractive markets. One measure of valuation is to compare the level of real yields to their historical Mr. X: Given your expectation of higher average, adjusted by the standard inflation, would you recommend inflation- deviation of the gap. On this basis, the protected Treasuries? most overvalued markets are the core BCA: euro area countries, where real yields are Yes, in the sense that they should 1.5 to 2 standard deviations below their outperform conventional Treasuries. The historical average (Chart 26). There are 10-year TIPS are discounting average only two developed bond markets where inflation of 1.85% and we would expect real 10-year government yields currently this to be revised up during the coming are above their historical average: Greece year. However, the caveat is that absolute and Portugal. This is warranted in returns will still be mediocre.

32 THE BANK CREDIT ANALYST December 2017 BCA RESEARCH Ms. X: You showed earlier that corporate CHART 27 bonds had a reasonable year in 2017, Not Much Value In U.S. Corporates albeit falling far short of the returns from BPs BPs equities. A year ago, you recommended EX-POST DEFAULT-ADJUSTED SPREAD*: BCA ESTIMATE only neutral weighting in investment- 800 800 grade bonds and an underweight in high yield. But you became more optimistic 400 400 toward both early in 2017, shifting to an overweight position. Are you thinking of scaling back exposure once again, given the 0 0 tight level of spreads? Ann% 12-MONTH EXCESS RETURNS** Ann% Chg BCA EXCESS RETURN PROXY*** Chg BCA: Yes, we were cautious on U.S. For All Panels corporates a year ago because valuation HIGH-YIELD 40 CORPORATES 40 was insufficient to compensate for the deterioration in corporate balance sheet health. Nonetheless, value improved 0 0 enough early in 2017 to warrant an up- grade to overweight given our construc- -40 -40 tive macro and default rate outlook. %% 12-MONTH TRAILING DEFAULT RATE**** MOODY'S BASELINE FORECAST 15 DEFAULT LOSS***** 15 The cyclical sweet spot for carry trades BCA FORECAST****** should continue to support spread product for a while longer. Moreover, 10 10 value is better than it appears at first 5 5 glance. The dotted line in Chart 27

shows the expected 12-month option- 0 0 adjusted spread for U.S. junk bonds © BCA Research 2017 1995 2000 2005 2010 2015 after adjusting for our base case forecast * OPTION-ADJUSTED SPREAD LESS DEFAULT LOSSES, SOURCE: BLOOMBERG BARCLAYS INDICES ** SOURCE: BLOOMBERG BARCLAYS INDICES for net default losses. At 260 basis *** CALCULATED AS: (DEFAULT ADJUSTED SPREAD ADVANCED 12 MONTHS) - DURATION × (12-MONTH CHANGE IN OAS), PROJECTION ASSUMES THE LATTER TWO ARE FLAT points, this excess spread is in line with **** SOURCE: MOODY'S INVESTORS SERVICE ***** CALCULATED AS: DEFAULT RATE × (1 - RECOVERY RATE) ******BASED ON MOODY'S BASELINE DEFAULT RATE FORECAST & BCA the historical average. RECOVERY RATE FORECAST NOTE: SHADING DENOTES PERIODS OF RISING DEFAULT RATE In the absence of any further spread narrowing, speculative-grade bonds excess returns of 5%. Of course, if would return 230 basis points more spreads widen, then corporates will than Treasurys in 2018. If high-yield underperform. spreads were to tighten by another 150 basis points, then valuations would If financial conditions tighten in 2018 be at a historical extreme, and that as we expect then it will be appropriate seems unwarranted. An optimistic to lower exposure to corporates. In the scenario would have another 100 basis meantime, you should favor U.S. and point spread tightening, delivering U.K. corporate bonds to issues in the

BCA RESEARCH December 2017 THE BANK CREDIT ANALYST 33 Eurozone because ECB tapering is likely CHART 28 to spark some spread widening in that Emerging Market Bonds Are Expensive market. BPs BPs EM YIELD-TO-MATURITY* SOVEREIGN VS. CORPORATES** Mr. X: What about EM hard-currency -50 -50 bonds? -100 -100 BCA: The global economic background is indeed positive for EM assets. -150 -150 However, EM debt is expensive relative -200 -200 to DM investment-grade bonds which, historically, has heralded a period of -250 -250 underperformance (Chart 28). We BPs YIELD-TO-MATURITY*: BPs expect that relative growth dynamics will EMERGING MARKET CORPORATES** VS. GLOBAL CORPORATE AGGREGATE be more supportive of U.S. corporates 600 600 because EM growth will lag. Any commodity price weakness and/or a 500 500 stronger U.S. dollar would also weigh on EM bonds and currencies. 400 400 Mr. X: We have not been excited about the bond market outlook for some time and 300 300 nothing you have said changes my mind. I BPs EM SOVEREIGN CDS*** BPs am inclined to keep our bond exposure to the bare minimum. 400 400 Ms. X: I agree. So let’s talk about the stock

market which is much more interesting. 300 300 As I mentioned before, I am inclined to remain fully invested in equities for a

while longer, while my father wants to 200 200 start cutting exposure.

Ann% U.S. INVESTMENT GRADE VS. EM CORPORATES*: BPs Chg TOTAL RETURN DIFFERENTIAL* (LS) Equity Market Outlook OPTION-ADJUSTED SPREAD* (ADVANCED, RS) 10 -100 BCA: This is one of those times when it is important to draw a distinction 5

between one’s forecast of where markets 0 -200 are likely to go and the appropriate investment strategy. We fully agree -5

-300 that the conditions that have driven -10 this impressive equity bull market are © BCA Research 2017

likely to stay in place for much of the 2013 2014 2015 2016 2017 2018 * SOURCE: BLOOMBERG BARCLAYS INDICES. next year. Interest rates in the U.S. and ** MARKET CAP WEIGHTED AVERAGE OF INVESTMENT GRADE AND HIGH-YIELD CORPORATES. *** SOURCE: MARKIT EM CDX INDEX. 34 THE BANK CREDIT ANALYST December 2017 BCA RESEARCH some other countries are headed higher, CHART 29 but they will remain at historically low Reasons For Caution levels for some time. Meanwhile, in the On U.S. Stocks

absence of recession, corporate earnings 40 S&P 500 CYCLICALLY-ADJUSTED P/E RATIO 40 still have upside, albeit not as much as analysts project. However, we have a Market is 30 expensive... 30 conservative streak at BCA that makes us reluctant to chase markets into the stratosphere. 20 20

For long-term investors, our 10 10

recommended strategy is to gradually ANALYSTS' LONG-RUN EARNINGS GROWTH FORECAST* lower equity exposure to neutral. 18 18 However, those who are trying to ...overly optimistic 16 16 maximize short-term returns should stay earning expectations... overweight and wait for clearer signs 14 14 that tighter financial conditions are 12 12

starting to bite on economic activity. 10 10 Getting down to specifics, here are the %%BCA COMPOSITE SENTIMENT INDICATOR** trends that give us cause for concern and ...and investor they are all highlighted in Chart 29. 60 complacency 60

Valuation: Relative to both earnings 50 50 and book value, the U.S. equity market is more expensive than at any time 40 40 since the late 1990s tech bubble. The price-earnings ratio (PER) for the S&P 30 © BCA Research 2017 30 500 is around 30% above its 60-year 2000 2004 2008 2012 2016 * SOURCE: IBES. average on the basis of both trailing ** BASED ON ADVISOR, INDIVIDUAL INVESTOR AND TRADER SENTIMENT. operating earnings and a 10-year average of earnings. The market is not expensive growth. However, current expectations on a relative yield basis because interest are ridiculously high. According to IBES rates are so low, but that will change data, analysts expect long-run earnings as rates inevitably move higher. Other growth of around 14% a year in both developed markets are not as overvalued the U.S. and Europe. Even allowing as the U.S., but neither are they cheap. for analysts’ normal optimistic bias, the sharp upward revision to growth expec- Earnings expectations: The perfor- tations over the past year makes no sense mance of corporate earnings throughout and is bound to be disappointed. this cycle – particularly in the U.S. - has been extremely impressive give the Investor complacency: We all know weaker-than-normal pace of economic that the VIX index is at a historical low,

BCA RESEARCH December 2017 THE BANK CREDIT ANALYST 35 CHART 30 Bear Markets And Recessions Usually Overlap

8 U.S. S&P 500* 8

7 7

6 6

5 5

4 © BCA Research 2017 4

1970 1975 1980 1985 1990 1995 2000 2005 2010 2015

* SHOWN IN LOG SCALE. NOTE: GREY SHADING INDICATES NBER-DESIGNATED RECESSIONS.

indicating that investors see little need the rally could persist all year. Of course, to protect themselves against market the timing of a recession and market is turmoil. Our composite sentiment uncertain. So it boils down to potential indicator for the U.S. is at a high upside gains over the next year versus extreme, further evidence of investor the downside risks, plus your confidence complacency. These are classic contrarian in being able to time the top. signs of a vulnerable market. We are not yet ready to recommend that Most bear markets are associated with you shift to an underweight position recessions, with the stock market in equities. A prudent course of action typically leading the economy by 6 would be to move to a broadly neutral to 12 months (Chart 30). The lead position over the next few months, but in 2007 was an unusually short three we realize that Ms. X has a higher risk months. As discussed earlier, we do not tolerance than Mr. X so we will leave anticipate a U.S. recession before 2019. you to fight over that decision. The tim- If a recession were to start in mid-2019, ing of when we move to an underweight it would imply the U.S. market would will depend on our various economic, be at risk from the middle of 2018, but monetary and market indicators and

36 THE BANK CREDIT ANALYST December 2017 BCA RESEARCH CHART 31 Valuation Ranking Of Developed Equity Markets 1.00 Better value

0.50 AUSTRALIA NETHERLANDS FRANCE 0.00 ITALY SPAIN JAPAN U.K. CANADA SWEDEN FINLAND AUSTRIA GERMANY MEDIAN PORTUGAL

-0.50 U.S. NORWAY SWITZERLAND

-1.00

* RANKING IS BASED ON HOW FAR CURRENT CYCLICALLY-ADJUSTED PRICE-EARNINGS RATIO IS FROM THE HISTORICAL AVERAGE, EXPRESSED IN NUMBER OF STANDARD DEVIATIONS.

our assessment of the risks. It could well to these markets. At the same time, happen in the second half of the year. profit margins are less vulnerable outside the U.S. and, as you noted, valuations Mr. X: My daughter was more right than are less of a problem. me regarding our equity strategy during the past year, so maybe I should give her In Chart 31, we show a valuation rank- the benefit of the doubt and wait for ing of developed equity markets, based clearer signs of a market top. Thus far, you on the deviation of cyclically-adjusted have focused on the U.S. market. Last year PERs from their historical averages. The you preferred developed markets outside the chart is not meant to measure the extent U.S. on the grounds of relative valuations to which Portugal is cheap relative to and relative monetary conditions. Is that the U.S., but it indicates that Portugal is still your stance? trading at a PER far below its historical average while that of the U.S. is above. BCA: Yes it is. The economic cycle You can see that the “cheaper” markets and thus the monetary cycle is far less tend to be outside the U.S. Japan’s read- advanced in Europe and Japan than in ing is flattered by the fact that its histori- the U.S. This will provide extra support cal valuation was extremely high during

BCA RESEARCH December 2017 THE BANK CREDIT ANALYST 37 CHART 32 When The U.S. Market Sneezes, The World Catches A Cold

MSCI PRICE INDEX: U.S.* WORLD EXCLUDING U.S.*

7 7

6 6

5 5

4 4

1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 * SHOWN IN LOG SCALE NOTE: GREY SHADING INDICATES BEAR MARKETS

the bubble years of the 1980s, but it still improvement in global growth and further is a relatively attractive market. potential upside in developed equity prices? From a cyclical standpoint, we are still BCA: The emerging world did extremely recommending overweight positions in well over many years when global trade European and Japanese stocks relative was expanding rapidly, China was to the U.S., on a currency-hedged basis. booming, commodity prices were in a Nevertheless, market correlations are powerful bull market and capital inflows such that a sell-off in the U.S. will be were strong. Those trends fostered a transmitted around the world (Chart 32). rapid expansion in credit-fueled growth across the EM universe and meant Ms. X: I would like to turn the focus to that there was little pressure to pursue emerging equity markets. You have been structural reforms. However, the 2007- cautious on these for several years and that 09 economic and financial crisis marked worked out extremely well until 2017. I a major turning point in the supports to note from your regular EM reports that EM outperformance. you have not changed your stance. Why are you staying bearish given that you see an

38 THE BANK CREDIT ANALYST December 2017 BCA RESEARCH As we noted earlier, the era of rapid CHART 33 globalization has ended, marking an Drivers Of EM Performance EMERGING MARKETS VS. GLOBAL 12-MONTH important regime shift. Meanwhile, 160 FORWARD P/E* (LS) 600 China’s growth rate has moderated and BLOOMBERG COMMODITY INDEX** (RS) 140 500 the secular bull market in commodities ended several years ago. We do not view 120 400 the past year’s rebound in commodities 100 300 as the start of a major new uptrend. Many emerging equity markets remain 80 200 highly leveraged to the Chinese Ann% EM VS. DM STOCK PRICES IN US$*** (LS) Ann% economy and to commodity prices Chg CHINESE RELATIVE TO DM**** IMPORT Chg VOLUMES (RS) (Chart 33). Although we expect the 30 Chinese economy to hold up, growth 40 20 is becoming less commodity intensive. 20

Finally, the rise in U.S. interest rates is 10 0 a problem for those countries that have taken on a marked increase in foreign -20 0 currency debt. This will be made even Ann% EMERGING MARKETS: Ann% worse if the dollar appreciates. Chg NARROW MONEY GROWTH***** (LS) Chg EPS IN US$****** (RS) 80 20 Obviously, the very term “emerging” 60

16 implies that this group of countries has a 40 lot of upside potential. However, the key 20 to success is pursuing market-friendly 12 0 reforms, rooting out corruption and 8 investing in productive assets. Many © BCA Research 2017 -20 countries pay only lip service to these 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 * REBASED TO JANUARY 2000 = 100; SOURCE: IBES. issues. India is a case in point where ** SOURCE: BLOOMBERG FINANCE L.P. *** SOURCE: MSCI Inc. (SEE COPYRIGHT DECLARATION). **** SOURCE: NETHERLANDS BUREAU FOR ECONOMIC POLICY ANALYSIS there is growing skepticism about the SHOWN AS A 12-MONTH MOVING AVERAGE. ***** SHOWN AS A 3-MONTH MOVING AVERAGE; ADVANCED BY 9-MONTHS; EQUITY MARKET-CAP WEIGHTED OF 19 EMERGING ECONOMIES. Modi government’s ability to deliver on ****** SOURCE: IBES. major reforms. The overall EM index does not ap- equities will continue to rise as long as pear expensive, with the PER trading the bull market in developed markets broadly in line with its historical average persists, but we expect them to underper- (Chart 34). However, as we have noted form on a relative basis. in the past, the picture is less compel- Mr. X: ling when the PER is calculated using One last question on equities from equally-weighted sectors. The financials me: do you have any high conviction calls and materials components are trading at on sectors? historically low multiples, dragging down BCA: A key theme of our sector view is the overall index PER. Emerging market that cyclical stocks should outperform

BCA RESEARCH December 2017 THE BANK CREDIT ANALYST 39 CHART 34 are financials and energy. The former Emerging Markets Fundamentals should benefit from rising rates and a EMERGING MARKETS: steeper yield curve while the latter will P/E RATIO* EQUAL SECTOR-WEIGHTED benefit from firm oil prices. P/E RATIO** 25 25 If, as we fear, a recession takes hold in 2019, then obviously that would 20 20 warrant a major shift back into defensive stocks. For the moment, the positive

15 15 growth outlook will dominate sector performance.

10 10 Ms. X: I agree that the bull market in equities, particularly in the U.S., is very

%%mature and there are worrying signs of

EMERGING MARKETS: complacency. However, the final stages NON-FINANCIAL RETURN 18 ON EQUITY*** 18 of a market cycle can sometimes be very rewarding and I would hate to miss out 16 16 on what could be an exciting blow-off phase in 2018. As I mentioned earlier, my 14 14 inclination is to stay heavily invested in equities for a while longer and I have con- 12 12 fidence that BCA will give me enough of a warning when risks become unacceptably 10 10 high. Of course, I will have to persuade my

2006 2008 2010 2012 2014 2016 2018 Mr. X: You can say that again, but we * SOURCE: MSCI Inc. (SEE COPYRIGHT DECLARATION). ** CALCULATED AS A SIMPLE AVERAGE OF 10 EM SECTORS. *** SOURCE: DATASTREAM; FOR MSCI EQUITY UNIVERSE; BCA CALCULATION. won’t bother our BCA friends with that conversation now. It’s time to shift the focus to commodities and currencies and I would defensives given the mature stage of the start by commending you on your oil call. economic cycle. We are seeing the typi- You were far out of consensus a year ago cal late-cycle improvement in capital when you said the risks to crude prices were spending and that will benefit industri- in the upside and you stuck to your guns als, and we recommend an overweight even as the market weakened in the first stance in that sector. Technology also half. We made a lot of money following is a beneficiary of higher capex but of your energy recommendations. What is course those stocks have already risen a your latest thinking? lot, pushing valuations to extreme levels. Thus, that sector warrants only a neutral weighting. Our two other overweights

40 THE BANK CREDIT ANALYST December 2017 BCA RESEARCH Commodities And Currencies CHART 35 Oil Market Trends BCA: We had a lot of conviction in $/Bbl $/Bbl BRENT CRUDE OIL PRICE our analysis that the oil market would 120 120 tighten during 2017 against a backdrop of rising demand and OPEC produc- 100 100 tion cuts, and that view turned out to be 80 80

correct. As we entered the year, the big 60 60 reason to be bearish on oil prices was the 40 40 bloated level of inventories. We forecast

that inventories would drop to their five- Ann% Ann% Chg OIL PRODUCTION* Chg year average by late 2017, and although OIL CONSUMPTION*

that turned out to be a bit too optimis- 3 3 tic, the market tightened by enough to push prices higher (Chart 35). 2 2

The forces that have pushed prices 1 1 up will remain in force over the next year. Specifically, our economic view MMb MMb implies that demand will continue to OECD INVENTORIES**: BCA ESTIMATE expand, and we expect OPEC 2.0 – the 5-YEAR AVERAGE producer coalition of OPEC and non- 3000 2010-2014 AVERAGE 3000 OPEC states, led by Saudi Arabia and Russia - to extend its 1.8 million b/d 2800 2800 production cuts to at least end-June. On

that basis, OECD inventories should 2600 © BCA Research 2017 2600 fall below their five-year average by the end of 2018. We recently raised our 2012 2013 2014 2015 2016 2017 2018 * ANNUAL GROWTH OF 12-MONTH MOVING AVERAGE. 2018 oil price target to an average of ** SOURCE: U.S. EIA; BCA RESEARCH. $65 in 2018. Of course, the spot market is already close to that level, but the BCA: futures curve is backwardated and that Our modeling indicates that is likely to change. We continue to see U.S. shale output will increase from upside risks to prices, not least because 5.1 mb/d to 6.0 mb/d over the next of potential production shortfalls from year, in response to higher prices. This Venezuela, Nigeria, Iraq and Libya. is significant, but will not be enough to materially change the global oil demand/ Mr. X: The big disruptor in the oil market supply balance. Longer run, the expan- in recent years was the dramatic expansion sion of U.S. shale output will certainly in U.S. shale production. Given the rise in be enough to prevent any sustained price prices, could we not see a rapid rebound in rise, assuming no large-scale production shale output that, once again, undermines losses elsewhere. A recent report by the prices? International Energy Agency projected

BCA RESEARCH December 2017 THE BANK CREDIT ANALYST 41 that the U.S. is destined to become the CHART 36 China Drives Metals Prices global leader in oil and gas production Ann%80% Chg for decades to come, accounting for LME BASE METAL INDEX* 60% 60 ACTUAL 80% of the rise in global oil and gas MODEL 40% supply between 2010 and 2025. 40 20%20

Ms. X: You have suggested that China’s 0%0

economic growth is becoming less commod- -20%-20

ity intensive. Also, you have shown in the -40%-40 past that real commodity prices tend to fall -60% over time, largely because of technological

innovations. What does all this imply for 1/1/2010 5/1/2010 9/1/2010 1/1/2011 5/1/2011 9/1/2011 1/1/2012 5/1/2012 9/1/2012 1/1/2013 5/1/2013 9/1/2013 1/1/2014 5/1/2014 9/1/2014 1/1/2015 5/1/2015 9/1/2015 1/1/2016 5/1/2016 9/1/2016 1/1/2017 5/1/2017

base metals prices over the coming year? 100%% 90%90 BASE METAL PRODUCTION AS % OF WORLD** BCA: The base metals story will 80%80 CHINA REST OF WORLD continue to be highly dependent on 70%70 60%60

developments in China. While the 50%50 government is attempting to engineer a 40%40 shift toward less commodity-intensive 30%30 growth, it also wants to reduce excess 20%20 10%10 capacity in commodity-producing 0%

sectors such as coal and steel. Base 60%% BASE METAL CONSUMPTION AS % OF WORLD** metals are likely to move sideways CHINA U.S. EU OTHER until we get a clearer reading on the 50%50 nature and speed of economic reforms. 40%40

We model base metals as a function 30%30 of China's PMIs and this supports 20%20 our broadly neutral stance on these commodities (Chart 36). 10%10

0% Mr. X: As usual, I must end our 100%% BASE METAL CONSUMPTION AS % OF WORLD** commodity discussion by asking about 90%90 gold. Last year, you agreed that an 80%80 uncertain geopolitical environment 70%70 60%60 CHINA coupled with continued low interest rates 50%50 should support bullion prices, and that was 40%40 the case with a respectable 12% gain since 30%30 the end of 2016. You also suggested that 20%20 10%10 © BCA Research 2017 I should not have more than 5% of my 0% portfolio in gold which is less than I am 1/1/2000 9/1/2001 7/1/2002 5/1/2003 3/1/2004 1/1/2005 9/1/2006 7/1/2007 5/1/2008 3/1/2009 1/1/2010 9/1/2011 7/1/2012 5/1/2013 3/1/2014 1/1/2015 9/1/2016 7/1/2017 inclined to own. It still looks like a gold- 11/1/2000 11/1/2005 11/1/2010 11/1/2015 * AS A FUNCTION OF CHINESE PMI, EM IMPORT VOLUME AND EM CURRENCIES. friendly environment to me. ** SUM OF LAST 12 MONTHS. SOURCE: WORLD BUREAU OF METAL STATISTICS.

42 THE BANK CREDIT ANALYST December 2017 BCA RESEARCH CHART 37 Gold At A Key Level

GOLD PRICE 200-DAY MOVING AVERAGE 1400 1400

1350 1350

1300 1300

1250 1250

1200 1200

1150 1150

1100 1100

1050 1050

2014 2015 2016 2017

Ms. X: Let me just add that this is one Gold appears to be at an important area where my father and I agree. I do point from a technical perspective not consider myself to be a gold bug, (Chart 37). It currently is perched just but I think bullion does provide a good above its 200-day average and a key hedge against shocks in a very uncertain trend line. A decisive drop below these economic and political world. I would also levels would be bearish. At the same be inclined to hold more than 5% of our time, there is overhead resistance at portfolio in gold. around 1350-1360 and prices would have to break above that level to indicate BCA: There will be opposing forces on a bullish breakout. Traders’ sentiment gold during the coming year. On the is at a broadly neutral level, consistent positive side, it is safe to assume that with no clear conviction about which geopolitical uncertainties will persist way prices will break. and may even intensify, and there also is the potential for an increase in inflation There is no science behind our expectations that would support bullion. recommendation of keeping gold On the negative side, rising interest rates exposure below 5%. That just seems are not normally good for gold and there appropriate for an asset that delivers likely will be an added headwind from a no income and where the risk/reward firmer U.S. dollar. balance is fairly balanced.

BCA RESEARCH December 2017 THE BANK CREDIT ANALYST 43 Ms. X: You referred to the likelihood of a CHART 38 firmer dollar as a depressant on the gold Too Much Pessimism On The Dollar price. You also were bullish on the dollar a year ago, but that did not work out too 100 DXY INDEX* 100 well. How confident are you that your forecast will fare better in 2018?

BCA: We did anticipate that the 90 90 dollar would experience a correction at the beginning of 2017, but we

underestimated how profound this move 80 80 would be. A combination of factors explains this miscalculation.

It first began with positioning. We should %% NET SPECULATIVE POSITIONS** AS DEVIATION have paid more attention to that fact that FROM 5-YEAR AVERAGE (% OF OPEN INTEREST) investors were massively bullish and long the dollar at the end of 2016, making the market vulnerable to disappointments. 50 50 And disappointment did come with U.S. inflation weakening and accelerating in

the euro area. Additionally, there were 0 0 positive political surprises in Europe, especially the presidential victory of Emman- uel Macron in France. In the U.S., the -50 -50 government’s failure to repeal Obamacare © BCA Research 2017 forced investors to lower expectations 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

about fiscal stimulus. As a result, while * SOURCE: BLOOMBERG / NYMEX. investors were able to price in an earlier ** SOURCE: CFTC. first hike by the ECB, they cut down the number of rate hikes they anticipated out pressures to build. This will give the Fed of the Fed over the next 24 months. the leeway to implement its planned rate hikes, and thus beat what is currently In terms of the current environment, priced in the market. This development positioning could not be more different should support the dollar in 2018. because investors are aggressively short- ing the dollar (Chart 38). The hurdle Ms. X: A bullish view on the U.S. dol- for the dollar to deliver positive surprises lar necessarily implies a negative view on is thus much lower than a year ago. the euro. However, the European economy Also, we remain confident that tax cuts seems to have a lot of momentum, and will be passed in the U.S. by early 2018. inflation has picked up, while U.S. prices As we discussed earlier, U.S. GDP will have been decelerating. To me, this suggests remain above potential, causing inflation that the ECB also could surprise by being

44 THE BANK CREDIT ANALYST December 2017 BCA RESEARCH more hawkish than anticipated, arguing CHART 39 Too Much Optimism On The Euro against any major weakness in the euro. EUR/ EUR/ USD USD BCA: The European economy has in- EUR/USD deed done better than generally expected 1.5 1.5 in the past year. Also, geopolitical risks were overstated by market participants 1.4 1.4 at the beginning of 2017, leaving less reason to hide in the dollar. However, 1.3 1.3 the good news in Europe is now well known and largely discounted in the 1.2 1.2 market. Investors are very long the euro, by both buying EUR/USD and short- 1.1 1.1 ing the dollar index (Chart 39). In that sense, the euro today is where the dollar

stood at the end of 2016. LONG EUR PLUS SHORT DXY SPECULATIVE POSITIONS* Valuations show a similar picture. 2 2 The euro might appear cheap on a long- term basis, but not so much so that its purchasing power parity estimate 1 1 – which only works at extremes and

over long-time periods – screams a buy. 0 0 Moreover, the euro has moved out of line with historical interest rate parity relationships, warning that the currency -1 -1 is at risk if the economy disappoints. Overall, we expect EUR/USD to trade EUR MINUS DXY: around 1.10 in 2018. Long-run, the RELATIVE SHORT SPECULATIVE POSITIONS* picture is different because a U.S. 2 2 recession in 2019 would trigger renewed broad-based weakness in the dollar. 1 1 Mr. X: I have been perplexed by the yen’s firmness in the past year, with the currency still above its end-2016 level versus the 0 0 dollar. I expected a lot more weakness with the central bank capping bond yields -1 -1 at zero and more or less monetizing the © BCA Research 2017 government deficit. A year ago you also predicted a weak yen. Will it finally drop 2010 2012 2014 2016 2018 * NON-COMMERCIAL; EXPRESSED AS A % OF OPEN INTEREST; in 2018? STANDARDIZED SINCE 2000; SOURCE: CFTC.

BCA RESEARCH December 2017 THE BANK CREDIT ANALYST 45 BCA: We were not completely wrong CHART 40 on the yen as it has weakened over the Bond Yield Differentials past year on a trade-weighted basis Drive The Yen and currently is about 2% below its 95 95 end-2016 level. But it has risen slightly

against the U.S. dollar. In the past 90 90 couple of years, the yen/dollar rate has been highly correlated with real bond yield differentials (Chart 40). These did 85 85 not move against the yen as much as

we expected because U.S. yields drifted 80 NOMINAL TRADE-WEIGHTED YEN* 80 lower and there was no major change in relative inflation expectations. 75 75 The real yield gap is likely to move in USD/ % the dollar’s favor over the next year, JPY USD/JPY (INVERTED, LS) 10-YEAR REAL RATES**:JAPAN MINUS U.S. (RS) putting some downward pressure on .5 the yen. Meanwhile, the Bank of Japan 100 will continue to pursue a hyper-easy monetary stance, in contrast to the Fed’s 0

normalization policy. However, it is not 110

all negative: the yen is cheap on a long- -.5 term basis, and Japan is an international

net creditor to the tune of more than 120 60% of GDP. Investors are also quite -1.0 short the yen as it remains a key fund- ing currency for carry trades. Thus, it © BCA Research 2017 will continue to benefit each time global 2015 2016 2017 * REBASED TO 2010=100; SOURCE:J.P.MORGAN CHASE & CO. markets are gripped with bouts of vola- ** NOMINAL YIELD MINUS CPI SWAPS tility. It remains a good portfolio hedge. Ms. X: Are any other currency views worth well. At this stage, it is hard to know noting? what kind of deal, if any, will emerge regarding Brexit so we would hedge BCA: The outlook for sterling obviously exposure to sterling. will be tied to the Brexit negotiations. Having fallen sharply after the Brexit Our optimism toward the oil price is vote, sterling looks cheap relative to its consistent with a firm Canadian dollar, history. This has allowed it to hold in but developments in the NAFTA a broad trading range over the past 18 negotiations represent a significant risk. months, even though the negotiations At the moment, we are overweight the with the EU have not been going Canadian dollar, but that could change

46 THE BANK CREDIT ANALYST December 2017 BCA RESEARCH if the NAFTA talks end badly. We still CHART 41 can’t get enthusiastic about emerging Bitcoin Looks Like Other Bubbles market currencies even though some BTC BTC now offer reasonable value after falling USD USD

sharply over the past few years. 7000 7000

Mr. X: We can’t leave currencies without 6000 USD PER BITCOIN* 6000 MANIA INDEX** talking about Bitcoin and cryptocurrencies 5000 5000 in general. I like the idea of a currency that cannot be printed at will by 4000 4000 governments. There are too many examples 3000 3000 of currency debasement under a fiat money system and the actions of central banks in 2000 2000

recent years have only served to increase my 1000 1000 mistrust of the current monetary system. But I can’t profess to fully understand how 0 © BCA Research 2017 0 these cryptocurrencies work and that makes 2012 2014 2016 2018 2020 * SOURCE: THOMSON REUTERS. ** THE MANIA INDEX IS BASED ON THE PATH OF PREVIOUS BUBBLES me nervous about investing in them. What INCLUDING THE NIKKEI, NASDAQ, SILVER, NICKEL AND TAIWAN EQUITIES. are your thoughts? BCA: You are right to be nervous. There have been numerous cases of This does not mean that Bitcoin prices hackers stealing Bitcoins and other cannot rise further, but the price trend cryptocurrencies. Also, while there is is following the path of other manias a limit to the number of Bitcoins that making it a highly speculative play can be issued, there is no constraint on (Chart 41). If you want more detail the number of possible cryptocurrencies about our thoughts on this complex that can be created. Thus, currency topic then you can read the report we 2 debasement is still possible if developers published last September. continue creating currencies that are Ms. X: I don’t fear bubbles and manias as only cosmetically different from the ones much as my father and have made a lot already in existence. Moreover, we doubt of money during such episodes in the past. that governments will sit idly by and But I am inclined to agree that Bitcoin allow these upstart digital currencies to is best avoided. The topic of manic events become increasingly prevalent. presents a nice segue into the geopolitical The U.S. Treasury derives $70 billion environment which seems as volatile as ever. a year in seigniorage revenue from its ability to issue currency which it can then redeem for goods and services. At 2 Please see ‘Bitcoin’s Macro Impact’, BCA Global some point, governments could simply Investment Strategy Special Report, September 15, criminalize the use of cryptocurrencies. 2017.

BCA RESEARCH December 2017 THE BANK CREDIT ANALYST 47 Geopolitics Three other issues that could become Ms. X: Which geopolitical events do you market-relevant are the ongoing North think will have the biggest impact on the Korean nuclear crisis, trade protection- markets over the coming year? ism, and tensions between the Trump administration and Iran. The first two BCA: Domestic politics in the U.S. and are connected because a calming of ten- China will be very much in focus in sions with North Korea would give the 2018. In the U.S., as we discussed, the U.S. greater maneuvering room against Republicans will pass tax cuts but it is China. The ongoing economic détente unclear whether this will help the GOP between the U.S. and China is merely in the November midterm elections. At a function of President Trump needing this point, all of our data and modeling President Xi’s cooperation on pressuring suggests that Democrats have a good North Korea. But if President Trump chance of picking up the House of no longer needs China’s help with Kim Representatives, setting a stage for epic Jong-Un, he may be encouraged to go battles with President Trump about after China on trade. everything under the sun. As for Iran, it is not yet clear if the In China, we are watching carefully administration is serious about for any sign that Beijing is willing to ratcheting up tensions or whether it is stomach economic pain in the pursuit playing domestic politics. We suspect of economic reforms. The two reforms it is the latter implying that the market that would matter the most are increased impact of any brinkmanship will be financial regulation and more aggressive minor. But our conviction view is low. purging of excess capacity in the in- Mr. X: We seem to be getting mixed dustrial sector. The 19th Party Congress messages regarding populist pressures in marked a serious reduction in politi- Europe. The far right did not do as well as cal constraints impeding President Xi’s expected in the Netherlands or France, but domestic agenda. This means he could did well in Austria. Also, Merkel is under launch ambitious reforms, akin to what some pressure in Germany. President Jiang Zemin did in the late 1990s. While this is a low-conviction BCA: We don’t see much in the way of view, and requires constant monitoring mixed messages, at least when it comes of the news and data flow out of China, to support for European integration. In it would be a considerable risk to global Austria, the populists learned a valuable growth. Reforms would be good for lesson from the defeats of their peers in China’s long-term outlook, but could the Netherlands and France: stay clear of put a significant damper on short-term the euro. Thus the Freedom Party com- growth. The jury is out, but the next mitted itself to calling a referendum on several months will be crucial. Austria’s EU membership if Turkey was invited to join the bloc. As the probability of that is literally zero, the right-wing

48 THE BANK CREDIT ANALYST December 2017 BCA RESEARCH in Austria signaled to the wider public We likely have seen the peak in “credible that it was not anti-establishment on the threat” display this summer between issue of European integration. In Ger- the U.S. and North Korea. The next many, the Alternative for Germany only two-to-three months could revisit gained 12.6%, but it too focused on an those highs as North Korea responds to anti-immigration platform. President Trump’s visit to the region, as well as to the deployment of the three The bottom line for investors is that U.S. aircraft carriers off the coast of the the European anti-establishment right Korean Peninsula. However, we believe is falling over itself to de-emphasize its that we have entered the period of Euroskepticism and focus instead on “negotiations.” anti-immigration policies. For investors, the former is far more relevant than the It is too early to tell how the North latter, meaning that the market relevance Korean crisis will end. We do not see of European politics has declined. a full out war between either of the main actors. We also do not see North One potential risk in 2018 is the Italian Korea ever giving up its nuclear arsenal, election, likely to be held by the end of although limiting its ballistic technology the first quarter. However, as with Aus- and toning down its “fire and brimstone’ tria, the anti-establishment parties have rhetoric is a must. The bottom line is all moved away from overt Euroskepti- that this issue will remain a source of cism. At some point over the next five concern and uncertainty for a while years, Italy will be a source of market longer. risk, but in this electoral cycle and not with economic growth improving. Conclusions Ms. X: The tensions between the U.S. and Mr. X: This seems a good place to end our North Korea, fueled by two unpredictable discussion. We have covered a lot of ground leaders, have me very concerned. I and your views have reinforced my belief worry that name-calling may slide into that it would make good sense to start something more serious. How serious is the lowering the risk in our portfolio. I know threat? that such a policy could leave money on the BCA: The U.S.-Iran nuclear table as there is a reasonable chance that negotiations are a good analog for the equity prices may rise further. But that is a North Korean crisis. The U.S. had to risk I am prepared to take. establish a “credible threat” of war in Ms. X: I foresee some interesting order to move Iran towards negotiations. discussions with my father when we As such, the Obama administration get back to our office. At the risk of ramped up the war rhetoric – using sounding reckless, I remain inclined to Israel as a proxy – in 2011-2012. The stay overweight equities for a while longer. negotiations with Iran did not end until I am sympathetic to the view that the mid-2015, almost four years later. era of hyper-easy money is ending and at

BCA RESEARCH December 2017 THE BANK CREDIT ANALYST 49 TABLE 3 10-Year Asset Return Projections

COMPOUND % RETURNS P.A.

THE PAST THE FUTURE PORTFOLIO 1982-2017 2018-2028 WEIGHT

U.S. EQUITIES 11.4 2.6 40

OTHER DEVELOPED EQUITIES 9.4 4.8 20

EM EQUITIES 12.9 6.5 5

10-YEAR TREASURIES 7.5 2.4 25

CORPORATE BONDS 9.3 3.5 10

TOTAL PORTFOLIO* 9.9 3.3 100

INFLATION 2.7 2.0

TOTAL PORTFOLIO REAL RETURN 7.0 1.3

* BASED ON WEIGHTS IN FINAL COLUMN.

some point that may cause a problem for we estimated a year ago, reflecting the risk assets. However, timing is important current more adverse starting point for because, in my experience, the final stages valuations. There is a negligible equity of a bull market can deliver strong gains. risk premium on offer, implying that stock prices have to fall at some point to BCA: Good luck with those discussions! establish higher prospective returns. We have similar debates within BCA between those who want to maximize The return calculations for equities short-run returns and those who take a assume profit margins decline modestly longer-term view. Historically, BCA has over the period and that multiples mean had a conservative bias toward invest- revert to their historical average. These ment strategy and the bulk of evidence assumptions may turn out to be too suggests that this is one of these times pessimistic if there is no redistribution when long-run investors should focus of income shares from the corporate on preservation of capital rather than sector back to labor and/or PERs stay stretching for gains. Our thinking also at historically high levels. In that case, is influenced by our view that long-run equities obviously would do better than returns will be very poor from current our estimates. market levels. In terms of the outlook for the com- Our estimates indicate that a balanced ing year, a lot will depend on the pace portfolio will deliver average returns of of economic growth. We are assuming only 3.3% a year over the coming de- that growth is strong enough to encour- cade, or 1.3% after inflation (Table 3). age central banks to keep moving away That is down from the 4% and 1.9% from hyper-easy policies, setting up for nominal and real annual returns that a collision with markets. If growth slows

50 THE BANK CREDIT ANALYST December 2017 BCA RESEARCH enough that recession fears spike, then economic and policy views, there is a that also would be bad for risk assets. good chance that we will move to an Sustaining the bull market requires a underweight position in risk assets goldilocks growth outcome of not too during the second half of 2018. hot and not too cold. That is possible,  but we would not make it our base case The U.S. economy is already operat- scenario. ing above potential and thus does not need any boost from easier fiscal Ms. X: You have left us with much to policy. Any major tax cuts risk over- think about and I am so glad to have heating the economy, encouraging finally attended one of these meetings. the Federal Reserve to hike interest My father has always looked forward to rates and boosting the odds of a re- these discussions every year and I am very cession in 2019. This is at odds with happy to be joining him. Many thanks for the popular view that tax cuts will be taking the time to talk to us. Before we go, good for the equity market. A U.S. it would be helpful to have a recap of your move to scrap NAFTA would add to key views. downside risks. BCA: That will be our pleasure. The key  For the second year in a row, the points are as follows: IMF forecasts of economic growth for the coming year are likely to  The environment of easy money, low prove too pessimistic. The end inflation and healthy profit growth of fiscal austerity has allowed the that has been so bullish for risk as- euro area economy to gather steam sets will start to change during the and this should be sustained in coming year. Financial conditions, 2018. However, the slow progress especially in the U.S., will gradu- in negotiating a Brexit deal with ally tighten as decent growth leads the EU poses a threat to the U.K. to building inflation pressures, en- economy. couraging central banks to withdraw stimulus. With U.S. equities at an  China’s economy is saddled with overvalued extreme and investor sen- excessive debt and excess capacity timent overly optimistic, this will set in a number of areas. Any other the scene for an eventual collision economy would have collapsed between policy and the markets. by now, but the government has enough control over banking and  The conditions underpinning the other sectors to prevent a crisis. bull market will erode only slowly Growth should hold above 6% in which means that risk asset prices the next year or two, although much should continue to rise for at least will depend on how aggressively the next six months. However, long- President Xi pursues painful run investors should start shifting reforms. to a neutral exposure. Given our

BCA RESEARCH December 2017 THE BANK CREDIT ANALYST 51  The market is too optimistic in as- with risks to the upside. We expect suming that the Fed will not raise base metals prices to trade broadly interest rates by as much as indicated sideways but will remain highly in their “dots” projections. There is dependent on developments in a good chance that the U.S. yield China. Modest positions in gold are curve will become flat or inverted by warranted. late 2018.  Relative economic and policy trends  Bonds are not an attractive will favor a firm dollar in 2018. investment at current yields. Only Unlike at the start of 2017, investors Greece and Portugal currently have are significantly short the dollar 10-year government bond real which is bullish from a contrary yields above their historical average. perspective. Sterling is quite cheap Corporate bonds should outperform but Brexit poses downside risks. governments, but a tightening in  financial conditions will put these at The key market-relevant geopolitical risk in the second half of 2018. events to monitor will be fiscal policy and mid-term elections in the  The euro area and Japanese equity U.S., and reform policies in China. markets should outperform the U.S. With the former, the Democrats over the next year reflecting their have a good chance of winning better valuations and more favorable back control of the House of financial conditions. Developed Representatives, creating a scenario markets should outperform the of complete policy gridlock. emerging market index.  A balanced portfolio is likely to  Historically, the U.S. equity market generate average returns of only has led recessions by between 3 and 3.3% a year in nominal terms over 12 months. If, as we fear, a U.S. the next decade. This compares to recession starts in the second half of average returns of around 10% a 2019, then the stock market would year between 1982 and 2017. be at risk from the middle of 2018. Let us take this opportunity to wish you  The improving trend in capital and all of our clients a very peaceful, spending should favor industrial healthy and prosperous New Year. stocks. Our other two overweight sectors are energy and financials.  The oil price will be well supported The Editors by strong demand and output restraint by OPEC and Russia. November 20, 2017 The Brent price should average $65 a barrel over the coming year,

52 THE BANK CREDIT ANALYST December 2017 BCA RESEARCH BCA RESEARCH INC.

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