BCA - Gis So 2014 12 12 PDF

GLOBAL INVESTMENT STRATEGY
STRATEGY OUTLOOK
First Quarter 2015
December 12, 2014
Periodical Dear client,
In this Issue: Today we are sending you our Strategy Outlook – First Quarter 2015. Please note that this
FF I. Macro Theme:
will be our last publication for 2014. We will resume our regular publishing schedule on
Coping With An
Over-Saving World.... 4 Friday, January 9th, 2015. In the interim, you will receive the monthly results of our Tactical
Asset Allocation Model and Market Indicators, to be published on December 30th, 2014.
FF II. Financial Markets:
Déja Vu................... 19 Finally, on behalf of the Global Investment Strategy team, I thank you for your continued
support over the years and wish you a happy holiday season and a prosperous New Year.
Best regards,
Chen Zhao, Managing Editor
Highlights
FF The world economy will continue to demonstrate a highly uneven pattern, reflective of
different policy settings as well as structural forces: For the U.S., the story for 2015 will
be re-normalization. For Japan, it will be monetary reflation. For the euro zone, defla-
tion will be the dominant story, while for China it will be policy relaxation. Regardless,
whether and when the Federal Reserve will end its zero interest rate policy will once
again become the focus of attention among investors and financial markets next year.
FF As for the markets, investors should continue to use the experience of the second half
of the 1990s as a road map for what may happen in global financial markets. Namely,
U.S. equities have the potential to be inflated further, turning the bull market into
a bubble. Global bond yields could be compressed even lower by global excessive
savings and deflation. The dollar will remain king and the EM equity index as well as
Editorial Board commodities will be the underdogs. There could be isolated and sporadic crises in
the EM space.
Chen Zhao
Managing Editor
FF As for investment strategy, we continue to overweight the U.S. stock market and Japa-
Mathieu Savary
Editor/Strategist nese equities (hedged), we maintain a benchmark weight on European markets and
Chester Ntonifor underweight EM as a whole and commodity plays. Within the EM universe, we remain
Editor/Strategist overweight Asia versus Latam. Finally, into the New Year, a technical pullback in the
Laura Lin dollar is possible, but the dollar bull market is far from over. Similarly, oil may soon
Senior Analyst
find a floor but the cyclical prospects for a speedy recovery are poor.
editor@bcaresearch.com • TEL 514.499.9550 • www.bcaresearch.com Copyright © 2015 BCA Research Inc. All Rights Reserved. Refer to last page. 1
BCA RESEARCH INC. GLOBAL INVESTMENT STRATEGY - STRATEGY OUTLOOK DECEMBER 12, 2014
Discover KEY THEMES AND INVESTMENT POSITIONS

what you Our macro theme for the final quarter of 2014 was “Unlevered Expansion”. We argued that the
can do lack of re-leveraging in the developed world economy would undercut strength in demand, while
with BCA deleveraging would continue to create over-savings around the world. As a result, monetary reflation
would be necessary to sustain growth momentum. Meanwhile, monetary policy cycles between the
Analytics. U.S. and the rest of the world should continue to diverge.
On financial markets, we continued to use the second half of the 1990s as our roadmap for global
financial markets, where the U.S. stock market should outperform the rest of the world. That road-
map dictated our equity allocation for the fourth quarter: overweight U.S. equities, underweight
commodity plays and neutral on Japan and Europe, hedged.
For fixed income, we recommended benchmark duration on U.S. Treasurys, speculating that a
continued rally could compress bond yields further. Our strongest conviction trades were to be long
30-year / short 10-year Treasurys and to buy 10-year Treasurys / sell 10-year bunds, unhedged.
Our currency strategy was straightforward: if we were reliving the second half of the 1990s, then
the primary trend for the U.S. dollar was up. Correspondingly, we were bearish the euro, the yen
and commodity currencies.
All of these predictions panned out rather nicely, with our speculative trades very timely and hugely
profitable, especially on the dollar/euro, gold and Chinese shares. The one exception was having
bought European banks a tad too early.
OPEN SPECULATIVE INVESTMENTS

Long Dividend Aristocrats / Short Nasdaq: Low nominal growth and prolonged zero rates should
inflate assets with high yields much more than those with aggressive growth expectations. The
position is flat since inception.
Long Indian / Short Indonesian stocks (unhedged): A bear market in commodities should benefit
consumers (India) vis-à-vis producers (Indonesia). Meanwhile, a cheap Rupee, a closing current
account deficit and falling rates make India more attractive than Indonesia. This trade is 1.5% in
the money.
Long Chinese A-Shares: Chinese equities, especially bank shares, are dirt cheap after several years
of underperformance. The position is up 27.1% since May (Chart 1).
Long U.S. 10-Year Treasurys / Short German 10-Year Bunds (unhedged): The current 150-basis-
point U.S. Treasury/German bund spread historically marks a multi-decade top. Meanwhile EUR/
USD weakness will also benefit this position. The trade is up 6.2% since August.
Long U.S. Dollar (DXY) Index: The Fed has ended QE, while the European Central Bank (ECB) and
the Bank of Japan (BoJ) are ramping up their respective balance sheets. With a 71.2% weight in
both the euro and yen, the DXY should benefit. The position is currently netting 1.6%.
Long USD/JPY: Our calculations suggest that for the BoJ to sustain a 2% inflation rate, the trade-
weighted yen must weaken 10-15% every year. This trade is up 6.2% since November.
Short Gold: We have been successfully play- CHART 1
ing the gold bear market since 2012 and our Chinese A-Share Market
current sell-stop was triggered this week at
CHINESE SHANGHAI A-SHARE INDEX
US$1,225/oz. The position is currently flat.
3000 3000
CLOSED SPECULATIVE
INVESTMENTS 2800 2800
Best Trade Was:

2600 2600
Short Gold: So long as the U.S. dollar remains
in a bull market, the primary trend for gold is GIS
bought on
down. Our previous two attempts to short gold 2400 2400
May 23,
this year netted us a 6% profit. We were more 2014
successful this time around, locking in gains
of 10.5%. 2200 2200
© BCA Research 2015

Worst Trade Was:
2013 2014
Long European Banks: This recommendation
was based on expectations that the ECB would
buy packaged loans directly from banks. Unfortunately the pace of ECB asset purchases has been
painfully slow, suggesting the central bank may be taking a “wait-and-see” approach. For risk man-
agement purposes, we closed the position with a 6% loss.
Discover I. MACRO THEMES: COPING WITH AN OVER-SAVING WORLD

what you
can do
S ix years into recovery, the decisive attribute CHART 2
with BCA of the global economy is still private sector Low Inflation And Deflation
Ann% Ann%
GLOBAL EXPORT PRICES* (LS)
Analytics. savings far exceeding its ex-ante, investment Chg
CHINESE PRODUCER
Chg
15 6
demand. As a result, there have been clear ten- (EX-FACTORY) PRICES (RS)
dencies of price declines and sub-trend growth 10 4

in many parts of the world. Tradable goods
5 2
prices have been falling, inflation expectations
have crashed almost everywhere and the euro 0 0
zone economy is on the precipice of outright
-5 -2
deflation (Chart 2). Core inflation rates have
dropped to very low levels in most of the G7
Ann% Ann%
countries and China. Chg EURO AREA CONSUMER PRICES** Chg
3.0 3.0
The over-saving problem has continued to take 2.5 2.5

a toll on global growth. Europe is in a prolonged
2.0 2.0
deflationary stagnation, China is growing at its
slowest pace since 2009 and the Japanese 1.5 1.5
economy has struggled with periodic contrac- 1.0 1.0

tions. Many emerging market (EM) countries are
.5 .5
dealing with the double whammy of a strength- © BCA Research 2015
ening dollar and falling commodity prices. The 10 12 14
U.S. economy has been the only bright spot * SOURCE: NETHERLANDS BUREAU FOR ECONOMIC POLICY ANALYSIS.
** SHOWN SMOOTHED.
where growth is expected to accelerate next

year, but U.S. policymakers may be facing a
highly unusual situation in terms of setting economic policy.
Next year, the world economy will continue to demonstrate a highly uneven pattern, reflective of different
policy settings as well as structural forces. The dominant economic themes will also be very different
among nations: For the U.S. economy, the story for 2015 will be re-normalization. For Japan, it will
be re-inflating its economy. For the euro zone, deflation will be the dominant story, while for China it
will be policy stimulation. Regardless, whether and when the Federal Reserve will end its zero inter-
est rate policy will once again become the focus of attention among investors and financial markets.
The Oversaving Problem

Classical economics has long rested on the belief that free market capitalism is always at full em-
ployment equilibrium, because supply and demand are constantly balanced out by price fluctua-
tions. Although the classical school has acknowledged that demand can fall short of supply from
time to time, it has always assumed that such a deficiency is transitory in nature: when prices fall
long enough, demand and supply always adjust, pushing the economy back to full-employment
equilibrium.
The Great Depression of the 1930s proved that some basic assumptions of the classical school
about the market system were naively wrong. The downward spiral in prices and output in the ‘30s
showed that the self-equilibrating power of a free market economy could be very limited. It was John
Maynard Keynes who first discovered that the equilibrium of a market economy does not always
involve full employment.
In Keynes’ world, aggregate expenditures of an economy are often equilibrated with aggregate pro-
duction at an output level that is less than the full employment rate. Under these conditions, price
levels tend to fall and output often contracts unless aggregate demand is lifted by the government,
often via an increase in spending but also by cutting taxes.
It is easy to confuse the national account identity with economic equilibrium. In an accounting
sense, aggregate demand always equals aggregate production, or put another way, savings always
equals investment. Nevertheless, these identities are ex post equations that have always embedded
necessary price or output adjustments.
Economic equilibrium, however, deals with ex ante adjustments. For instance, should desired invest-
ment fall short of desired savings (or should desired aggregate spending fall short of aggregate income),
nominal output needs to fall in order to keep the accounting identity, or ex post, of national account
intact.
The typical symptom of aggregate supply exceeding demand, or savings exceeding investment, is
a fall in nominal GDP, which consists of prices and various outputs. In reality, aggregate demand
includes many components and offsets which tend to balance out demand with supply. This is why
nominal contraction does not usually occur unless a recession is really bad. In post-war U.S. history,
there have been 12 recessions, and only five of them saw nominal contractions, with the worst one
occurring in 2008. Most of the time, the over-saving problem manifests itself by a clear tendency
of very low and slowing nominal growth.
It is a subject of debate as to whether or not the natural tendency of free market capitalism is over-
supply, and therefore deflationary. I belong to the camp that believes it is. In a capitalist society,
all factors of production are paid according to their marginal outputs; for society as a whole it is
difficult or even impossible to generate excessive demand. On the contrary, a socialist system is
always inflationary because workers are often paid more than their marginal value, therefore leading
to excessive demand and rising prices all the time.
Lawrence Summers, the ex-Treasury Secretary under former President Bill Clinton, has postulated
that aggregate demand has chronically fallen short of aggregate supply since the 1990s, leading to
an ever-decreasing equilibrium interest rate. He has further speculated that the real interest rate that
Discover is required to equilibrate aggregate demand CHART 3
with aggregate supply has already fallen into Capital Stock-To-GDP Ratio
what you % Of % Of
can do negative territory since as early as the 1990s. GDP

U.S. NON-FINANCIAL CORPORATE
GDP
with BCA Nevertheless, he does not go into great detail CAPITAL STOCK*
36 36
laying out why the Western world in general
Analytics.
has faced a chronic deficient-demand problem.
34 34
Sources Of Over-Saving
32 32
As I see it, there are several key reasons why the
world economy in general and the developed
30 30
countries in particular are currently facing an
over-savings problem. Some of these reasons
are cyclical in nature, others structural. 28 28
First of all, there has been a steady but very

26 26
pronounced fall in capital stock over the
nominal GDP ratio. Chart 3 depicts this ratio in © BCA Research 2015
the U.S. It is clear that the ratio has dropped 80 85 90 95 2000 05 10 15

significantly for close to three decades. The * SHOWN AS NON-FINANCIAL CORPORATE BUSINESS EQUIPMENT.
same phenomenon is also evident in Europe

and Japan, though the starting points of the
decline are different from country to country.
This ratio is inversely correlated with the capital efficiency of an economy – it measures the aver-
age value of output that is generated by one unit of capital investment. Clearly, a secular fall in the
ratio suggests that for the same unit of output an incrementally lower amount of capital investment
is required.
Rising capital efficiency has many profound economic implications. It means an economy’s
ability to absorb its savings has clearly weakened, giving rise to a potential over-saving problem.
It also suggests that to produce one unit of corporate profit, incrementally less capital outlay is
required, therefore reducing amortization costs and simultaneously increasing the earning power
of the existing capital stock.
There have not been many empirical studies on why the efficiency of capital has been on the rise
since 1984. A reasonable guess is that technological advances and innovation have made the capital
stock progressively more efficient at producing output. It could also have something to do with the
post-industrialization structure, where output growth relies more on human capital than physical
capital. Regardless, this is an important factor that has reduced investment demand, therefore
creating over-saving tendencies. This is secular.
Second, neo-classical economics believes that CHART 4
the wage rate is always determined by the value Falling Wage Share And
Rising Labor Productivity
of the marginal output of labor. In reality, this % Of % Of
GDP U.S. GDP
may not hold true, especially in recent decades.
WAGES AND SALARY DISBURSEMENTS
There has been a great loss of income share 47 47
for workers throughout the developed world,
but the marginal output of labor has soared
46 46
(Chart 4).
In other words, wage growth has not kept 45 45
pace with net gains in output per hour worked

(bottom panel, Chart 4). In aggregate terms, 44 44
this simply says that wage growth has fallen
behind productivity growth. There are many
43 43
deep reasons why labor income and therefore
consumption have lagged GDP growth, but we
should remember that corporate profits, which NON-FINANCIAL CORPORATE SECTOR:
OUTPUT-PER-MAN-HOUR*
have gained income shares in GDP consistently
COMPENSATION DEFLATED BY
since the 1980s, are a key part of gross national CONSUMER PRICES*
180 180
savings by definition.
Global competition and globalization of produc- 160 160

tion have led to the destruction of low-skilled
Mostly went
jobs in the developed world, severely restraining to corporate
140 profits 140
wage rates and income growth for workers. It is
estimated that China has gained approximately
50 million manufacturing jobs between 2002 120 120
and 2014, while the U.S., the euro area and

Japan have lost around 20 million jobs since
100 100
the mid-1990s. Given that there is no evidence © BCA Research 2015
the trend is about to reverse, the relative loss of 85 90 95 2000 05 10 15
income share of workers and the corresponding * SHOWN SMOOTHED AND REBASED TO Q1 1983 = 100.
gain in corporate profits (or corporate savings)

in the developed world should also be regarded as a secular phenomenon.
Some have noted that the increase in income inequality may also be contributing to the over-saving
problem. The argument goes something like this: With income inequality increasing, high-income
earners will receive a disproportionately larger share of the income pie, but this group also has a
significantly higher saving rate than lower-income groups. As a result, the spending power of the
vast majority of the lower- to middle-income groups is restrained, while the high-income group
boosts the savings rate.
Discover This explanation sounds plausible, but actu- CHART 5
ally lacks supporting evidence. There was no G7: Excessive Savings And Under-Investment
what you % Of % Of
can do evidence that the household saving rate rose GDP GDP
with BCA consistently in the 1990s and 2000s, when in-

come inequality dramatically increased. In fact,
Analytics. 18 18
the opposite is true, i.e. the household savings
rate has fallen sharply during that period. G7*
17 17
GROSS PRIVATE FIXED
In addition, it is not obvious at all that the CAPITAL FORMATION**
16 16
countries with more equal income distribution
tend to have more robust spending growth than
those with less income equality. For instance, % Of GROSS PRIVATE SAVINGS** % Of
GDP MINUS GROSS PRIVATE GDP
Europe and Japan both have much lower Gini
FIXED CAPITAL FORMATION
coefficients than the U.S., and yet the U.S. 10 10
economy has arguably fared better than both

Europe and Japan – either before or after the 8 8
2008 Great Recession. Therefore, this line of

argument is probably more motivated by politi- 6 6
cal needs than reflective of economic reality.

4 © BCA Research 2015
4
Finally, the 2008 Great Recession has brought
2000 02 04 06 08 10 12 14
about many profound shifts in the global * GDP-WEIGHTED AVERAGE OF U.S., EURO AREA, JAPAN, U.K. AND CANADA.
economy, and the legacies of these changes ** BASED ON DATA FROM OECD, IMF AND DOMESTIC SOURCES.
still linger. Deleveraging has swept across the

world since 2009, leading to a sharp rise in the gross savings rate as businesses and individuals in
every country try to save more in order to pay down their debt.
The biggest change has taken place in capital investment. There was a dramatic fall in capex in
most G7 nations during 2008 and it never recovered (Chart 5). This has opened up a huge gap
between gross domestic savings and capital investment. For instance, in 2006, excess savings in
the G7 stood at 4.5% of GDP. Today it is at 9%, or equivalent to roughly three trillion dollars.
Taking China into the equation, the over-saving problem becomes even starker. The Chinese gross
national savings rate stands at 52% of GDP, while private sector investment only accounts for 40%.
Authorities there have aggressively restricted capital spending as over-capacity has emerged as a
major problem in China’s many industries, but the gross national saving rate has stayed stubbornly
high (Chart 6). This means that China’s non-government sector has excess savings worth about 10%
of GDP, which translates into US$1.1 trillion a year.
All of this excess savings has been a key source of economic weakness, price destruction and a lack
of vitality in the global recovery process.
Discover Remedy And Sub-Optimal Policy CHART 6

China: Rising Excessive Savings
what you When faced with an over-saving problem, there And Falling Capex Rate
can do is a steady policy remedy: the government sec-
% Of
GDP CHINESE
% Of
GDP
with BCA tor should do everything in its power to dissave GROSS PRIVATE FIXED CAPITAL
FORMATION PROXY
Analytics. in order to lift aggregate demand. The extent to GROSS PRIVATE SAVINGS*
which the public sector dissaves should match 52 52
the extent to which private sector excess sav-
ings surges. Putting it simply, the bigger the
shortfall in aggregate demand, the more aggres-
48 48
sive public sector dissaving should be.
Moreover, it makes no difference whether the

dissaving is financed by borrowing from the
44 44
private sector or from the central bank. After all,
such fiscal action simply represents a transfer
of savings and dissaving among different seg-
ments of the economy. The purpose of public 40 40
sector dissaving is to simply fill up the shortfall © BCA Research 2015
in aggregate demand in order to prevent nomi- 96 2000 04 08 12

nal output from contracting. * SOURCE: IMF AND BCA CALCULATIONS.
A key reason why the 1930s Great Depression turned into a downward spiral of price declines and
output contraction was that the government sector sat still – only to watch the sharp surge in private
sector savings continue to destroy aggregate demand. By the same token, the very reason that the
2008 Great Recession did not turn into a systemic collapse and sparked a downward spiral in prices
and output was that most G7 governments dramatically lifted public sector spending, therefore boost-
ing aggregate demand (Chart 7). This action prevented a protracted period of nominal contraction.
The unfortunate reality is that most countries have reversed their policies abruptly since 2010, de-
spite the fact that over-saving, deflation and under-investment have continued to plague the world
economy. Most countries have pursued draconian fiscal austerity since then with the aim of reining
in budgetary deficits and reducing debt.
This policy orientation has greatly weakened the world economic recovery and unduly increased
systemic risk. Fiscal austerity has been directly responsible for repeated recessions in Europe and
the U.K. Even in the U.S., where fiscal austerity is comparably less severe than in other G7 coun-
tries, overall GDP growth has been trimmed by 1% per year since mid-2009 by the public sector`s
retrenchment (Chart 8).
These dramatic wrong turns in fiscal policy since 2010 have forced monetary authorities to take
additional action in an effort to offset the negative impact of fiscal policy. Nevertheless, monetary
policy is sub-optimal in dealing with a supply CHART 7
glut and its resulting liquidity trap. This is sim- Budget Deficits During
The 2008 Great Recession
ply because unlike fiscal policy, which directly % Of % Of
GDP U.S. GDP
forms aggregate demand, monetary policy does
-2 -2
not enter into the demand function – it can only
impact aggregate demand indirectly, usually -4 -4
via interest rates and foreign exchange rates.
Nevertheless, with policy rates having already -6 -6
fallen to zero, the impact of monetary policy is

-8 -8
obviously much diminished. CYCLICALLY ADJUSTED
-10 GOVERNMENT BALANCE* -10
Nobody wants to minimize the positive impact
of monetary policy here. In fact, the Fed has
% Of % Of
been extremely aggressive in reflating the U.S GDP
EURO AREA
GDP
economy by launching a series of QE programs.

These programs have played a marginally posi- -2 -2
tive role in bringing down the long end of the

yield curve and the dollar, therefore helping the -4 -4
housing sector and exporters.
-6 -6
Nevertheless, it is also true that these aggres-
sive QE programs have failed to propel the U.S.
economy back to its potential growth rate. Had
% Of % Of
the Congress not forced “fiscal sequestration” GDP
JAPAN**
GDP
on the economy, U.S. economic growth likely
would have been much stronger. By the same -2 -2
token, with the fiscal drag behind us, there are
grounds for some optimism that the growth can -4 -4
accelerate.
-6 -6
Chart 9 shows the clear negative correlation

-8 -8
between GDP growth and fiscal drag in vari-
ous countries, suggesting that fiscal policy has
85 90 95 2000 05 10 15
almost been the sole factor behind economic
* SOURCE: OECD.
performance in the post-crash world. Greece has ** SHOWN SMOOTHED EXCEPT FOR THE LATEST DATA POINT.
experienced the worst fiscal contraction, and its

GDP has collapsed. At the other end of the spectrum stands Sweden, where there has been literally
no fiscal austerity implemented. There, average growth has been among the best two of all the indus-
trialized countries. Most other economies have fallen somewhere between these two extreme cases.
From this chart, it is clear that Europe has been facing the worst fiscal austerity, which explains why
most European countries have registered prolonged growth stagnation. The policy mistake here is
Discover obvious: through fiscal austerity, the European CHART 8
government sector has been adding even more U.S. Economy: Private-Sector Versus
what you Public-Sector Growth
can do savings to an economic system that is already
U.S. (IN REAL TERMS)
awash in a savings glut. The net result can only
with BCA GDP EXCLUDING GOVERNMENT SPENDING*
be nominal output contraction. GOVERNMENT SPENDING*
Analytics. 115 115
Japan is another case in point. While the cen-

terpiece of Abenomics is monetary reflation, the 110 Average annual 110
VAT hike introduced this past year has been a growth 3.1%
step in the wrong direction. There is no need
105 105
for fiscal consolidation in Japan, where excess
savings from the private sector are massive.
The only way to prevent nominal contraction is 100 100
public dissaving on a continued massive scale. Average annual
Any small step in the reverse direction could growth -1.2%
95 95
easily tip the balance back into recession, as
it did in 1997 and has done again in recent © BCA Research 2015
months (Chart 10).
10 11 12 13 14
* SHOWN REBASED TO Q2 2009 = 100.
CHART 9
Economic Growth Versus Fiscal Policy
3
SWEDEN GERMANY
2 JAPAN
ANNUALIZED 4-YEAR REAL GDP PER CAPITA GROWTH (%)
NEW ZEALAND
CANADA UNITED STATES
1 AUSTRIA
SWITZERLAND DENMARK
FRANCE
AUSTRALIA CZECH REPUBLIC
BELGIUM UNITED KINGDOM
0
NORWAY NETHERLANDS
PORTUGAL
-1 IRELAND
ITALY
SPAIN
-2
-3
R² = 0.835
-4
-5
GREECE
-6
-5 0 5 10 15 20 25
4-YEAR CHANGE IN STRUCTURAL GOVERNMENT BALANCE (% OF GDP)
NOTE: BASED ON IMF DATA.
There are complicated reasons why most Western governments have gotten their fiscal policy wrong.
Ideology stands in the way. Government debt and deficits are demonized, and most people are
brainwashed into believing that government spending is often wasteful and therefore a bad idea.
There is no question that public expenditures are always less efficient than private sector invest-
ment, but there are times when the private sector stops spending. At this point, public spending,
though less optimal, becomes imperative to save the economic system.
In the meantime, it is always politically appealing for politicians and governments to talk about thrift
and fiscal discipline, and the public opinion has taken it as a given that any government running a
balanced budget is a good one, while deficits and debt are economic evils that any government should
avoid. Under normal circumstances, these value judgments may be correct, but at times of over-saving, a
liquidity trap and deficient demand, the policy implications of these value judgments can be disastrous.
So What?
1) U.S.: Renormalization
In a world of over-saving, both fiscal and monetary policy will continue to dictate the economic
performance of different countries. The U.S. is the only country that is close to getting the policy
CHART 10A CHART 10B

Japan: Public-Sector Dissaving Japanese Tax Hikes Versus
Mirrors Private-Sector Excessive Savings Domestic Demand
% Of % Of Ann% Ann%
GDP GDP Chg VAT hike Chg
JAPANESE VAT hike
(CUMULATIVE SINCE 1980)
GOVERNMENT DEFICITS*
2 2
PRIVATE SAVINGS MINUS
200 PRIVATE INVESTMENTS 200
CURRENT ACCOUNT
BALANCE*
1 1
100 100
0 0
0 0 -1 -1
JAPANESE
REAL PERSONAL
CONSUMPTION*
-2 -2
-100 -100
© BCA Research 2015 © BCA Research 2015
80 85 90 95 2000 05 10 15 95 2000 05 10 15
* SOURCE: OECD. * SHOWN SMOOTHED EXCEPT FOR THE LATEST DATA POINT.
Discover combination roughly right: the fiscal auster- CHART 11
ity of 2012-2013, though unnecessary, was U.S. Economy Is Set To Accelerate

what you Ann% %
can do both briefer and milder than in the rest of the Chg U.S.
REAL GDP (LS) 65
with BCA world, Europe in particular. Monetary stimulus, ISM COMPOSITE*
meanwhile, has been the most aggressive. As a (Advanced, RS)
Analytics. 4
60
result, the U.S. economic recovery has played
out much better than in the rest of the world. On
2 55
a scale of A to F, I would give the U.S. a “B+”.
As far as the U.S. economy’s performance 0 50
is concerned, the story for next year will be

“renormalization”. With the fiscal drag now -2 45
behind us, the economy will likely accelerate

anew. There are many indications suggesting -4
40
better growth ahead:
RATIO OF JOB OPENINGS TO

FF The ISM is perking up, which usually indi-
UNEMPLOYED INDIVIDUALS
cates stronger sales and better GDP growth 2009 - 2012 TREND
.8 .8
ahead (Chart 11);
.7 .7
FF There is a clear quickening in job creation.
The job opening/job applicant ratio has .6 .6
Lift-off!
spiked up sharply, while the NFIB survey
.5 .5
suggests more firms are ready to increase
worker compensation (bottom panel,
.4 .4
Chart 11);
.3 .3
FF Job growth has been strong. Initial unem-
ployment claims suggest a continued rise .2 .2
in non-farm payrolls growth; furthermore, © BCA Research 2015
falling energy costs are another boost for 02 04 06 08 10 12 14 16

corporate profits and consumer spending; * SOURCE: INSTITUTE FOR SUPPLY MANAGEMENT.
FF Private-sector credit is growing and the

money multiplier is beginning to rebound, though from extremely depressed levels.
Bottom Line: Although an over-saving problem continues to plague the U.S. economy, the fiscal drag is
gone and both monetary and fiscal policy will become pro-growth. The economy is healing and growth
is more likely to accelerate than relapse. Inflation will head lower thanks to lower energy costs and
still-weak pricing power. In other words, the U.S. economy should look more “normal” next year than
at any time since 2008.
2) Euro Zone: Price Deflation CHART 12

Euro Area Current Account Surplus
For the euro zone, the story for next year will % Of % Of
GDP GDP
be deflation. Fiscal policy has been wrong and EURO AREA
CURRENT ACCOUNT BALANCE
monetary policy has been lagging. The private
sector’s excess savings are still running at 3% 2 2
of GDP, but the public sector has been cutting
down its deficit aggressively. Domestic spending
has collapsed, resulting in a surge in the current
1 1
account surplus (Chart 12).
Had the European Central Bank followed in the

Fed’s footsteps by launching large scale QE, 0 0
economic conditions may have been margin-

ally better. At a minimum, the ECB could have
driven down the euro and further compressed -1 -1
sovereign spreads to encourage more credit

expansion. In reality, the ECB has been much
more hesitant in providing the policy offset to
2000 02 04 06 08 10 12 14
severe fiscal austerity. This means that repeated
output contraction and price deflation are the
only adjustment paths. The euro zone’s policy combination at best deserves an “F”, or Fail, as there
is no such ranking for “Catastrophe”.
Although the ECB is expected to augment its QE program next year, it will come too late and most
likely be too little to reverse the deflationary tendencies in the euro zone economy. Our bet is that
the euro zone will slip into price declines in 2015, regardless of what the monetary authorities do.
Chart 13 shows that the inflation diffusion index has broken down, which suggests that euro zone
CPI inflation should drop to close to -1% at the headline level.
3) China: Policy Relaxation
As far as China is concerned, the over-saving problem is as acute as ever. This is evidenced by the
fact that economic growth is sub-trend and manufactured goods prices have been falling for three
years in a row. It is important to note that as a developing country, China should not be suffering from
a chronic over-saving problem – presumably China’s potential growth rate is higher, and therefore
the internal rate of return on capital is also higher than in the developed world. This should have
allowed the economy to absorb most of its domestic savings by capital investment.
In fact, China has sustained over two decades of a capital investment boom, which not only absorbed
much of the country’s domestic savings, but also attracted huge amounts of foreign direct capital
inflows. However, since 2010, economic policy has changed course. Worried by debt accumula-
Discover CHART 13 CHART 14

Euro Area: Heading For Deflation China: Monetary Stance And Inflation
what you Ann% % Ann% Ann%
can do Chg Chg CHINESE Chg
4 REAL GDP MINUS REAL* LENDING RATE
with BCA 70
25 25
Analytics. 20
Shaded area represents
20
real lending rate being
3 60 too high
15 15
50 10 Mean 10
2 1990 - Present
5 5
40
1 0 0
30
-5 -5
0 EURO AREA
HEADLINE CPI (LS) 20 Ann% Ann%
INFLATION DIFFUSION Chg Chg
INDEX* (RS) CONSUMER PRICES
25 25
2000 02 04 06 08 10 12 14
* PERCENTAGE OF CPI COMPONENTS WHICH ARE RISING. SHOWN SMOOTHED
EXCEPT LAST DATA POINT.
20 20
tion and over-investment, the government has 15 15
decided to sharply tighten both monetary and

fiscal policy in an effort to discourage capex 10 10
and reduce leverage.

5 5
So far the Chinese government’s policy has

backfired. The combination of weakening capex 0 0
and a high national savings rate implies that © BCA Research 2015
the saving glut has become increasingly acute. 90 94 98 02 06 10 14
Not surprisingly, business activity has turned * DEFLATED BY PRODUCER (EX-FACTORY) PRICE INFLATION.
sluggish since 2010, with GDP growth subse-

quently slipping to a sub-trend pace. The PPI
has begun to deflate since 2011 and growth in the GDP deflator has dropped to 1%.
China’s policy combination probably deserves a “C”, or a pass. Tight monetary and fiscal policy is
obviously a wrong move for any economy with lots of excess savings. Nevertheless, Chinese policy-
makers have been flexible and are willing to adjust policy quickly according to changing economic
circumstances.
The People’s Bank of China has begun to cut rates and Beijing has also started to pump in more
stimulus in the form of various infrastructure-related investment. It is important to emphasize that
China is not in a liquidity trap, and real interest rates remain very high. For instance, the real lend-
ing rate stands above 8%, which is higher than real GDP growth (Chart 14). It is rather easy for
the central bank to stimulate the economy.
We expect more monetary easing to be delivered next year, along with a series of mini-fiscal stimulus
packages aimed at shoring up growth. The Economic Work Conference of the ruling Communist
Party Central Committee has issued a rather dovish statement this week, signaling that promoting
growth will become the top policy priority in 2015.
4) Japan: Continued Reflation

Japanese economic policy should turn even more reflationary in 2015. The VAT hike back in April
was obviously a wrong move, and the Abe government, if re-elected, will likely postpone the next
installment of the planned tax hike or abandon it outright. As a result, the so-called three arrows
of Abenomics have boiled down to one big arrow: Monetary reflation.
Japan has been in a liquidity trap for more than two decades, and as such, monetary policy can
only have an impact on the economy mainly through a decline in the country’s foreign exchange
rate. Therefore, it is almost a foregone conclusion that in order to reach its 2% inflation target, the
Bank of Japan needs to manage a continued down-drift in the Japanese yen.
CHART 15
The Yen Versus Inflation Target
Ann% Ann%
JAPANESE
Chg Chg
TRADE-WEIGHTED YEN*
REGRESSION ON CPI INFLATION EXCLUDING TAXES, ASSUMING INFLATION HITS 2% BY DECEMBER 2015
30 30
20 20
10 10
0 0
-10 -10
-20 -20
96 98 2000 02 04 06 08 10 12 14 16
* SOURCE: J.P. MORGAN CHASE & CO.
Discover Chart 15 suggests that the yen needs to drop CHART 16

U.S. Taylor Rule-Determined Equilibrium
what you 15% a year in order to sustain a 2% inflation % %
can do rate, unless private sector demand is revived

25 U.S. 25
with BCA and excess savings subside. So far, the changes
FED FUNDS RATE TARGET
Analytics. in the economy are primarily concentrated on TAYLOR RULE*
nominal variables, while the real variables re- 20 20

main sluggish. Therefore, it is safe to bet that
the Japanese authorities will have to sustain the
15 15
intensity of their reflation campaign next year in
order to break the back of deflation. I think that
the Japanese economic policy deserves a “B”. 10 10
Gap is
closing
Fed Policy: To Tighten Or 5 5
Not To Tighten?
With the U.S. economy moving back to a more 0 0
normal state, the issue of whether and when

the Fed will raise rates will come back to the
75 80 85 90 95 2000 05 10 15
forefront of investment markets. Currently, the
* BASED ON UNEMPLOYMENT GAP, THE INFLATION GAP AND THE EFFECTIVE
market anticipates the first rate hike in June of FED FUNDS RATE.
next year, but the “terminal value” of the fed

funds rate has been cut to 2.5% from 4% at the beginning of the year. In other words, the market
anticipates that the path of rate hikes will be decisively flatter than before.
Will the Fed raise interest rates next year? When viewed in isolation, the case for the Fed to normal-
ize monetary policy is getting stronger alongside an improving economy. For instance, the Taylor
rule-determined short rate has already bounced back to zero, suggesting that the next move should
be a rise in nominal rates (Chart 16). However, the U.S. economy does not operate in isolation, and
when viewed in a global context the case for Fed tightening has substantially weakened.
The current economic climate is very similar to that of the second half of the 1990s, when defla-
tionary pressures and economic fallout in the rest of the world severely constrained what the Fed
could do, even though the U.S. economy was booming at the time. Going forward, several key forces
could substantially delay the first rate hike.
First, a soaring U.S. dollar on the back of a stagnant and deflating Europe has been acting as a de
facto tightening in America’s monetary conditions. A further spike in the dollar could siphon away
growth from the U.S. economy and compress the inflation rate to even lower levels.
Second, falling oil prices will lead to lower inflation, both at the core and headline levels, but will
also boost consumer spending. In other words, lower oil can be thought of as a deflationary growth
booster, which could even make the Phillips Curve negatively sloped. How the Fed should respond
to this bizarre situation is unknown, but common sense suggests that growth per se should not be
a reason for monetary tightening. Growth becomes a problem only if it creates inflation.
Finally, Fed Chair Janet Yellen has mentioned many times before that the central bank faces
asymmetric policy risks. Most central banks know how to deal with rising inflation, but they may
not necessarily have enough tools to deal with deflation and a liquidity trap. From a risk-reward
viewpoint, the Fed may choose to be a little behind the recovery curve, just to make sure that the
economy is not getting back onto its previous stop-go path.
Bottom Line: Investors must take a non-dogmatic approach to assessing Fed policy. In order to
forecast Fed policy six or seven months out, too many assumptions have to be made on the dollar,
inflation and the world economy. The problem is that all of these variables are dynamic and non-
stationary. As things stand now, the dollar should strengthen and inflation should weaken – both of
which tend to weaken the case for a rate hike next year. However, if the euro zone economy starts to
grow again or if the Chinese economy quickly accelerates to 8% or more, the landscape for monetary
policy could be very different, and the corresponding calculation may also change.
Discover II. FINANCIAL MARKETS: DÉJA VU

what you
I n January, I invoked the experience of the CHART 17
can do second half of the 1990s as the key refer- Financial Market:
with BCA ence point or road map for what might happen
Today Versus The Second Half Of 90’s
Analytics. in global financial markets. The rationale was
400 2010-NOW 400
that there are many economic and financial 1990s MODEL*
market parallels between today and the second

half of the 1990s: 300 U.S. S&P 500 300
FF Back then, the U.S. economy was signifi-

cantly stronger than the rest of the world. 200 200
Today, a similar phenomenon is being
repeated.
100 100
FF Back then, the Fed was the only cen-
tral bank to start hiking rates, while the
Bundesbank and the Bank of Japan were
160 U.S. 10-YEAR GOVERNMENT 160
either cutting rates or holding rates steady.
BOND TOTAL RETURN INDEX
Monetary cycles between the U.S. and the
rest of world clearly diverged. This is being
140 140
repeated today.
FF Back in 1997, Japan was the first major

120 120
industrialized economy to fall into price
deflation. Excess savings from Japan del-
uged world financial markets, dragging 100 100
down bond yields everywhere. Today, it is
the euro zone’s turn to deflate. Bund yields
are rapidly converging to JGB yields. U.S. TRADE-WEIGHTED DOLLAR**
130 130
FF Back in the 1990s, a strong U.S. dollar domi-
nated world financial markets. It compressed
120 120
inflation in the U.S., undercut the Fed’s
tightening efforts and caused U.S. bond
yields to melt, which in turn fuelled an in- 110 110
vestment boom. Stocks soared into a massive

bubble, which did not top out until 2000. 100 100
Commodities, oil and emerging markets were

crashed by a surging dollar. Chart 17 sums
up the similarities in financial markets. * INTERVAL OF ESTIMATION 2010-2014. BASED ON A REGRESSION VERSUS
THE 1990s ROADMAP.
** SOURCE: J.P. MORGAN CHASE & CO.
Drawing on these past experiences, we concluded CHART 18
that for 2014, the U.S. stock market could U.S. Stocks: The Bullish Case
Ann%
U.S.
continue to rule the world, the dollar would Chg
S&P 500 SALES (LS)
65
strengthen on diverging monetary policy between 15 ISM* COMPOSITE INDEX (Advanced, RS)
the Fed and the rest of the world and bond 60

10
yields would drop. In the meantime, we took a
55
very bearish view on commodities and gold, and 5
recommended being long S&P 500 and short oil 50

0
as a strategic position in October 2013. 45
-5
Events that have transpired during the past six 40
months suggest our predictions have turned out -10 35

to be correct: the dollar continues to strengthen
on diverging monetary policy between the Fed Ann% S&P 500 OPERATING EARNINGS PER SHARE Ann%
and the rest of the world. Bond yields have come Chg MODEL ESTIMATE** Chg
way down. The U.S. stock market has made a

series of new highs but oil prices have collapsed. 80 80
Going forward, the question is, with U.S. equity

multiples having expanded, bond yields having 40 40
dropped and the dollar near five-year highs, what
is next?
0 0
Outlook For 2015: -40 -40

An Unstable Bull Market
02 04 06 08 10 12 14
We do not believe that the basic macroeconom- Ann% Ann%
Chg S&P 500 OPERATING EXPENSES PER SHARE Chg
ic backdrop has changed very much from last FORECAST BASED ON CRUDE OIL PRICES***
15 15
quarter. In other words, the U.S. economy will
continue to lead the rest of the world, and the
10 10
Fed will continue to be ahead of other central
banks in terms of monetary renormalization. 5 5
The only difference here is that China is joining

0 0
Europe and Japan in easing monetary policy,
which should be regarded as a welcome move
-5 -5
by stock markets around the world.
-10 © BCA Research 2015 -10
As far as the U.S. stock market is concerned,
92 96 2000 04 08 12
there are two sets of factors that need to be * INSTITUTE FOR SUPPLY MANAGEMENT.
** BASED ON THE CHANGE IN QUALITY SPREADS, NEW ORDERS AND THE
considered. On one hand, corporate earnings GAP BETWEEN PRODUCTIVITY GROWTH AND PERSONAL INCOME
GROWTH PER CAPITA.
will rebound alongside a strengthening economy. *** BASED ON WEST TEXAS INTERMEDIATE OIL PRICES. INTERVAL OF
ESTIMATION: 1991-2008.
Discover The current ISM is consistent with sales growth of close to 10% for the S&P 500 companies, and our
what you model suggests a 20% pickup in earnings growth 12 months out (Chart 18). On the other hand, stocks
can do have run up sharply since the end of 2012, arguably having already discounted these positive signs.
with BCA Pessimists would say that stocks are already fully priced, if not bordering on overvaluation. There-
Analytics. fore, they are vulnerable to any development that is deemed “less good” by the market. In this
vein, there are plenty of potential worries that can spook the market, including possible monetary
tightening by the Fed, a dollar overshoot that undercuts profit expectations for the U.S. corporate
sector, and a possible renewed fallout in the euro zone economy.
The rebuttal from the more optimistic camp could be that falling oil prices are turning the “sweet
spot” for equities even sweeter: lower oil will bring down inflation but jack up profit growth by re-
ducing input costs (bottom panel, Chart 18). In such an environment, low rates could prevail much
longer, stimulating equity multiple expansion. In addition, China could reflate more aggressively,
and global growth could be a tad stronger next year.
In my view, the bull market in U.S. equities is far from reaching its major top. Fed policy remains ultra
stimulative and real short rates remain deeply in negative territory regardless of what the Fed will do next
year. In addition, the real bond yield is far below economic growth and if history is any guide, stocks
outperform bonds over 80% of the time whenever these conditions prevail (Chart 19). Therefore, it
may seem too early for investors to position themselves for the arrival of a major bear market in stocks.
CHART 19
U.S.: Equity / Bond Ratio Versus Yield / Growth Differentials
U.S.
900 STOCK-TO-BOND RATIO 900
550 550
350 350
Shaded areas represent periods when real
230 bond yields fall below GDP growth 230
% REAL GDP GROWTH MINUS %

REAL* 10-YEAR GOVERNMENT BOND YIELD
4 4
2 2
0 0
-2 -2
-4 -4
-6 © BCA Research 2015

-6
65 70 75 80 85 90 95 2000 05 10 15
* DEFLATED BY 10-YEAR CPI SWAP POST-2005. DEFLATED BY EXPONENTIAL MOVING AVERAGE OF ANNUAL CPI PRE-2005.
Nevertheless, we should also be mindful that CHART 20
the risk-reward profile for stocks has deterio- VIX Versus Stocks In The 2nd Half
Of The 1990s
rated sharply as prices have continued to move
higher. Fed policy is always a contentious issue U.S.
S&P 500 (LS)
that causes emotional swings in stock prices. In
VIX VOLATILITY INDEX* (RS)
1400 30
the meantime, market expectations of earnings
growth are already high and therefore vulner-
able to downside risks. 1200
25
The most likely outcome is that the bull market
in U.S. stocks will enter into an unstable stage, 1000
where price gyrations will be much bigger than
20
before. It is entirely possible that the VIX begins
to rise concurrently with rising share prices 800
– alas, a replay of the phenomenon between

1996 and 1999 when both stocks and VIX rose 15
600
simultaneously (Chart 20).
Bottom Line: The U.S. economy is still in an
expansionary phase with low and falling infla- 94 96 98
* SOURCE: CHICAGO BOARD OPTIONS EXCHANGE. SHOWN SMOOTHED.
tion. This is inherently bullish for stocks. The
market also faces big uncertainties – Fed policy
and the soggy state of the world economy. Hence, rising stocks along with a rising VIX is a possible
outcome.
Equity Allocation Strategy

In terms of regional allocation, we are sticking to our strategic layout: overweight the U.S. equity
market and the Japanese equity index, hedged, underweight commodity plays and the EM index,
and stay at a benchmark weight in European stocks. For EM-designated funds, we strongly recom-
mend being long Asia versus Latin America.
The case for overweighting American stocks has not changed: a stronger economy, better profit
outlook, less fiscal drag and falling bond yields. The Fed has a pro-growth track record and falling
oil is a net positive for the U.S. economy.
The reasons to overweight Japan include: very aggressive reflation by the BoJ, a delay of another
tax hike, very small or no fiscal drag, the stimulative impact of a falling yen and a possible wave of
returning cash to shareholders, either through share buybacks or via higher dividends.
The Japanese corporate sector has stashed up nearly US$2 trillion in cash, which is even higher
than that of the U.S. corporate sector. Chart 21 suggests that accumulated cash is worth even
Discover more than the total market capitalization of the CHART 21
Japanese stock market, while the equivalent Japan’s Corporate Sector:

what you Cash Accumulation Is Excessive
can do ratio for the U.S. is 10.6%. % %
with BCA This unusually large cash accumulation is the 160 160
Analytics. result of Japan’s corporate deleveraging process
over the decades. It also reflects very limited
investment opportunities facing Japanese com- 120 120
panies. Regardless, with the Japanese corpo-

rate leverage ratio having already collapsed,
cash levels look extremely excessive. 80 80
The corporate sector has been under increasing NONFINANCIAL CORPORATIONS

pressure to return cash to shareholders, and the CASH AND LIQUID ASSETS
40 AS A PERCENTAGE OF MARKET CAPITALIZATION* 40
Abe government, once re-elected, may also take JAPAN
action to address the excessive cash problem. U.S.
Regardless, odds are increasing that there could

be a move toward higher dividends or increas- 0 0
ing share buybacks next year. If so, the stock © BCA Research 2015
market will receive a large boost. 98 2000 02 04 06 08 10 12 14

* BASED ON MSCI INC. DATA (SEE COPYRIGHT DECLARATION).
We removed our underweight position in euro

zone stocks at the end of October, and since then we have kept a benchmark weight for the region.
The reasons for this move include: the euro zone stock market has underperformed the benchmark
for a long time, and the ECB may be on the verge of more aggressive QE in the New Year. In addi-
tion, most euro zone stocks are cheap by standard valuation yardsticks.
We fully understand that this recommendation is not without risk. The ECB has been notoriously
slow in its reflation efforts, and policymakers are often long on rhetoric but short on action. It is
not certain at all whether the ECB will shock and awe the market by launching an American style
QE program next year.
Should the ECB deliver, the euro zone stock market could rise on a falling euro. Hence, investors
may want to consider hedging euro exposure for their euro zone equities. By the same token, if the
central bank disappoints, European stocks will underperform. Therefore, investors must be flexible
in adjusting their strategy.
Why should investors continue to underweight EM stocks, even though the asset class has been
underperforming for over four years? There are three reasons: First, a big chunk of the EM index is
commodity plays, and commodities are in a bear market.
Second, banks and financials account for almost 50% of the index, and monetary policy in most EM
countries is way too tight. Chart 22 shows that the yield curve for the BRICS countries is inverted.
Finally, EM currencies are still too expensive, CHART 22

EM: Money Is Too Tight,
despite the recent fall in several commodity
Currency Is Too Expensive
currencies (bottom panel, Chart 22). Bp Bp
How likely is it that EM markets experience a BRICS* YIELD CURVE**

160 160
repeat of the kind of financial crisis that oc-
curred in the late 1990s? Low-grade, isolated
120 120
crises are possible, and in fact unfolding. The
Russian ruble has fallen over 40% as oil prices
have dropped and economic sanctions have 80 80
started to bite (Chart 23). Venezuela is in de

facto default as the country has asked China to 40 40
renegotiate its crude supply contract.
0 0
Nevertheless, I doubt we will have a full-blown
EM crisis similar to the second half of the
1990s. There is no currency peg today. In the
08 10 12 14
1990s, the EM crisis was precipitated by a EMERGING MARKET*** REAL EFFECTIVE
EXCHANGE RATE****
currency collapse. Today, we do not have the MEAN FOR THE PERIOD
same crisis-triggering mechanisms for most EM 130
SIGMA BANDS
130
countries. Of course, countries with too much
foreign-currency debt will be stressed. Turkey
is vulnerable. 120 120
Finally, why should EM-dedicated investors

overweight Asia versus Latin America? There is 110 110
really only one reason: Last decade, the Latin

American markets massively outperformed their
100 100
Asian counterparts on the back of a booming
commodities market, because the former is a © BCA Research 2015
commodities producer while the latter is an

98 02 06 10 14
end user. With commodity prices falling, the
* BRAZIL, RUSSIA, INDIA, CHINA AND SOUTH AFRICA.
trend has been reversed. From a mean reversion *** 10-YEAR VERSUS 2-YEAR SWAP RATES; GDP-WEIGHTED.
*** INCLUDES PERU, BRAZIL, CHILE, CHINA, HONG KONG, HUNGARY, INDIA,
viewpoint, Asia’s rise relative to Latin America INDONESIA, KOREA, MALAYSIA, MEXICO, PHILIPPINES, POLAND,
SINGAPORE, SOUTH AFRICA, TAIWAN, THAILAND AND TURKEY.
has further to go (Chart 24). **** EQUALLY-WEIGHTED AVERAGE. BASED ON DATA FROM J.P. MORGAN
CHASE & CO.
Global Bonds: Still In A Bull Market

Although nominal bond yields are low everywhere, the secular bull market in bond prices may not
be over very soon. A large part of the world economy is experiencing extremely low inflation or defla-
tion, and it is not clear at all when global short rates will begin to rise.
Discover CHART 23 CHART 24

Russian Ruble: Long Asian / Short Latam Is
what you Already In A Crisis A Mean Reversion Play
can do USD/
RUB USD / RUB EXCHANGE RATE (Inverted)
USD/
RUB EMERGING ASIAN RELATIVE TO
with BCA LATIN AMERICAN EQUITIES*
100 100
Analytics. 10 10
20 20
80 80
30 30
60 60
A mean reversion
40 40
50 50
40 40
© BCA Research 2015 © BCA Research 2015
98 02 06 10 14 2000 02 04 06 08 10 12 14
* SHOWN IN U.S. DOLLAR TERMS AND REBASED TO JAN. 2000 = 100.
SOURCE: MSCI INC. (SEE COPYRIGHT DECLARATION).
Back in July, this publication speculated that 10-year U.S. Treasury yields could fall to 2%.1 This
prediction turned out to be correct as 10-year Treasury yields briefly broke below 2% during the
October turmoil. Going forward, investors should continue to resist the temptation to go short bonds,
even though 10-year bond yields have already fallen to less than 2.2%.
Several factors could continue to support bond prices:
A strengthening U.S. dollar could compress bond yields. The “rule of thumb” is that for every 10%
move in the U.S. dollar, it usually requires about a 1% move in bond yields to compensate for the
currency market move. Should the trade-weighted dollar gain an additional 7-10% next year, yields
on 10-year Treasurys could fall to 1.5%.
Meanwhile, although now below 2.2%, the U.S. bond market does not show pronounced signs of
overvaluation. Chart 25 shows that the market is only slightly overvalued. Typically, a major setback
in bond prices does not occur until the market is very overvalued.
Finally, as we alluded to earlier, the 10-/2-year yield curve is flattening sharply due to a strong price rally
in the long end of the curve. In recent history, the curve has always flattened prior to the Fed raising
rates, but for different reasons (Chart 26).
1
Please see the Global Investment Strategy Weekly Report titled “Two Percent?”, dated July 18, 2014 available at gis.bcaresearch.com
Back in the second half of the 1990s, there CHART 25
was a massive bull flattening on the back of a U.S. Treasury Yields Versus Fair Value
% %
strengthening dollar. Between 2003 and 2007,
however, there was a bear flattening as the Fed Undervalued
was too aggressive in lifting rates.
20 20
I think we will experience another bull flattening

going forward similar to the one experienced in
the second half of the 1990s, primarily because 0 0
of a strong dollar, deflation in the rest of the

world and a much-reduced “terminal value” of
the Fed funds rate. -20 -20
Bunds Versus JGBs: Trading Places U.S. 10-YEAR GOVERNMENT

BOND YIELD DEVIATION FROM
We initiated a long position in German bunds -40 FAIR VALUE -40
versus JGBs in July 2013, when bund yields

stood at 1.7% while yields on JGBs were 0.9%. © BCA Research 2015
Overvalued
This recommendation has produced more than
95 2000 05 10 15
20% in profits, but I think there is more money
to be made.
CHART 26
U.S.: Yield Curve Versus Fed Policy
Bp %
U.S.
10- / 2-YEAR YIELD CURVE SLOPE (LS)
10
FED FUNDS TARGET RATE (RS)
250
200 8
150
6
100
50
2
0
92 96 2000 04 08 12
Discover The rationale and story here are straightforward: CHART 27
the Japanese authorities are trying very hard Some Warning Signals For The
what you High-Yield Market
can do to fight deflation, and the large fall in the yen USD/ USD/
Shr Bbl
with BCA may begin to inflate the Japanese economy. 42
Although far from certain, it seems that Japan
Analytics. 100
is slowly exiting deflation. Should Japan be able
41
to manage a 0.5% inflation rate and 1% real
90
GDP growth, equilibrium JGB yields should be
1.5%. They are currently 0.4%. 40
80
U.S.
On the other hand, policymakers in the euro SPDR BARCLAYS HIGH YIELD
70
zone are still dragging their feet. Fiscal policy 39 BOND ETF (LS)
CRUDE OIL PRICES* (RS)
is wrong and the ECB is behind the curve. It
60
looks inevitable that mild price declines will
14
occur in the common-currency regime. Should Bp Bp
mild price declines, say -0.5%, take hold, and HIGH-YIELD CORPORATE
assuming the euro zone can grow its economy at BOND SPREAD**
1600 1600
1%, equilibrium bond yields should be around
0.5%. Today, bund yields stand at 0.7%.
1200 1200
Bottom Line: Although bunds are close their fair
value, JGB yields seem to low. We are sticking
800 800
to our strategic position.
?
400 400
Corporate High-Yield Bonds:
No Value Left CORPORATE HEALTH MONITOR
In our last Strategy Outlook, we made the case Deteriorating
that there was no value left in the corporate high Health

1 1
yield market. We still hold this view. Recent
evidence suggests that this asset class has
parted ways from the equity market: while the 0 0
S&P 500 has made a series of record highs,

high yield spreads have actually widened. There -1 -1
are three reasons that this market may continue
Improving
to disappoint investors: Health
-2 -2
First, value is poor. The expected return after
88 92 96 2000 04 08 12
adjusting for the corporate default rate is 5.2%, * WEST TEXAS INTERMEDIATE.
which leaves almost no cushion for any nega- ** BASED ON BARCLAYS DATA.
tive shock.
Second, the high-yield market is weighted CHART 28
heavily in oil companies and energy plays, a Relative Balance Sheets Versus
Foreign Exchange Rates
key reason why it has recently been tightly cor- USD/ Ann%
JPY USD / JPY EXCHANGE RATE (Inverted, LS) Chg
related with falling oil prices (Chart 27). BALANCE SHEET: FED MINUS BoJ (RS)
60 PROJECTIONS (RS)
20
Finally, for years, the corporate sector has
aggressively bought back shares by issuing
10
debt, leading to a rapid change in its capital 80
structure. Perhaps the debt-equity swap has
reached a point where credit risk begins to rise. 0
BCA’s Corporate Health Monitor clearly signals

100
a deterioration in corporate health, which cor- -10
responds to a pickup in junk spreads.
-20
Bottom Line: Be cautious on the high yield 120
market.
EUR/ EUR / USD EXCHANGE RATE (LS) Ann%
USD BALANCE SHEET: FED MINUS ECB (RS) Chg
Currencies: The Dollar Remains King PROJECTIONS (RS)
1.5
The global currency markets will continue to be
80
dominated by a strong dollar. Our projection is
for the USD/JPY to reach 130, and for EUR/
USD to reach 1.15 next year. Nevertheless, 1.4
40
there are a few points worth mentioning.
First, the dollar is overbought, setting the stage 0

1.3
for counter trend moves. Chart 28 suggests that
both JPY and EUR have fallen to levels not too
-40
far off from what is implied by the announced
1.2
balance sheet expansions by both the BoJ and
ECB.
10 12 14 16
If there is no new initiative, neither EUR nor
JPY can fall much further from here. However, it is very likely that both the ECB and BoJ will in-
crease the intensity of their respective QE programs. Therefore, new lows in both EUR and JPY are
expected next year.
Second, the currency market usually follows a rotational pattern. The first leg of the dollar bull
market has been driven primarily by a falling yen. Although the yen’s decline is not over, the next
up-leg in the dollar could be mainly driven by the euro.
Discover Worsening economic conditions could propel CHART 29
policymakers in the euro zone to reflate more, BRICS Yield Curve Versus EM Currency
what you Bp
can do but there is a “currency breakup” risk which

with BCA may still cause a euro rout. It is astonishing
2.5
that the short end of the German yield curve
Analytics. 120
is in negative territory, as are short-term Swiss 2.4
yields.
2.3
Why would any creditor ever be willing to pay 80
Germany or Switzerland for holding their debt?

2.2
The only reason is concern that he or she may
lose money by holding any other debt in the 40
2.1
case of a euro breakup. In other words, nega-
tive nominal yields on German or Swiss paper
2.0
are a de facto “breakup premium” reflective of EMERGING MARKET
0
EXCHANGE RATES* (LS)
the lingering concern over the euro’s integrity. BRICS** 10- / 2-YEAR YIELD CURVE
1.9
Should economic conditions worsen or should SLOPE*** (Advanced, RS)
deflation indeed prevail, the euro could still
fall hard on the increasing perceived risk of a 08 10 12 14
* MARKET-CAP WEIGHTED. BASED ON DATA FROM MSCI INC. (SEE
euro breakup. COPYRIGHT DECLARATION).
** BRAZIL, RUSSIA, INDIA, CHINA AND SOUTH AFRICA.
*** 10-YEAR VERSUS 2-YEAR SWAP RATES; GDP-WEIGHTED.
Finally, the trade-weighted U.S. dollar should
receive a boost from the continued fall in many
EM currencies. Commodity currencies will drop more, in tandem with commodity prices. This is
a classic terms-of-trade adjustment. The USD/CAD could rise to 1.20, while the AUD/USD could
decline to 0.75 in 2015.
In the meantime, China needs to ease policy and cut rates to stimulate growth. This would reverse
the appreciating trend of the Chinese RMB, which has persisted for over nine years. Chart 29 shows
that a flattened or inverted yield curve in the BRIC region often leads to a weakening currency market.
Bottom Line: Most EM currencies are still expensive, and a much cheapened foreign exchange rate
is a pre-condition for economic growth in the EM universe to accelerate. We have been long the JPY/
USD and the USD/EUR via relative bond positions and the DXY. We are happy with these positions
and are looking to sell the CAD and AUD on any price rebounds.
Chen Zhao, Managing Editor

chenz@bcaresearch.com
BCA RESEARCH INC. GLOBAL INVESTMENT STRATEGY STRATEGY OUTLOOK DECEMBER 12, 2014
Strategy & Market Trends*

EQUITY PRICES / WORLD BOND SHORT CURRENCY
BENCHMARKS** YIELDS RATES VS. US$
U.S. UP DOWN FLAT
CANADA DOWN DOWN FLAT DOWN
JAPAN UP FLAT FLAT DOWN
AUSTRALIA DOWN FLAT FLAT DOWN
U.K. FLAT FLAT FLAT UP
EURO AREA FLAT DOWN FLAT DOWN
EMERGING ASIA FLAT FLAT FLAT FLAT
LATIN AMERICA DOWN DOWN DOWN DOWN
* EXPECTATIONS FOR THE COMING SIX WEEKS TO THREE MONTHS BASED ON A COMBINATION OF OUR ASSET ALLOCATION MODEL, ANALYSIS AND INTUITION.
**EQUITY PRICES RELATIVE TO WORLD BENCHMARK EXPRESSED IN LOCAL CURRENCIES.
BCA RESEARCH INC. GLOBAL INVESTMENT STRATEGY STRATEGY OUTLOOK DECEMBER 12, 2014
Tactical Trades
The purpose of this section is to provide investment ideas independent of our asset allocation model or direct market forecasts.
Once recommended, we will monitor the investment recommendation until we close it out.
INITIATION RETURN-TO-
TRADE INCEPTION LEVEL STOP COMMENTS
DATE DATE
LONG S&P DIVIDEND
0.3370 OCT 24/14 0.1% 0.3200
ARISTOCRATS / SHORT NASDAQ
LONG INDIAN STOCKS / SHORT
5.2900 OCT 24/14 1.5% 5.000 SENSEX INDEX / JCI INDEX. UNHEDGED.
INDONESIAN STOCKS
LONG CHINA A-SHARE INDEX* 2451.04 MAY 23/14 27.1% 2750.00
LONG 10-YEAR U.S. TREASURYS /

134 BPs AUG 15/14 6.2% 160 BPs ADJUSTED FOR CURRENCY RETURN.
SHORT 10 YEAR GERMAN BUNDS
LONG U.S. DOLLAR (DXY INDEX) 86.915 OCT 31/14 1.6% 84.500
LONG U.S. DOLLAR /

111.94 OCT 31/14 5.8% 115.00
SHORT JAPANESE YEN
SHORT GOLD 1225.00 DEC 10/14 0.0% 1325.00
NOTE: STOPS ARE BASED ON DAILY CLOSING LEVELS. PLEASE NOTE THAT ALL CURRENCY TRADE CALCULATIONS INCLUDE COST OF CARRY.
* LONG CHINESE BANKS FROM MAY 23, 2014 UNTIL OCTOBER 17, 2014.
This table summarizes our longer-term strategic recommendations. Some of these positions may not necessarily be consistent
with our “Tactical Trades”.
Strategic Recommendations
INCEPTION INITIATION RETURN AS OF CURRENT
POSITION COMMENTS
LEVEL DATE LAST WEEK RETURN
EQUITY RECOMMENDATIONS
UNDERWEIGHT COMMODITY PLAYS1 100 NOV 2013 13.3% 16.7%

LONG THE S&P 500 / SHORT OIL 100 OCT 2013 72.3% 88.2%
FIXED INCOME RECOMMENDATIONS
LONG U.S. 30-YEAR / SHORT U.S. 10-YEAR GOV’T BONDS 96.0 BP FEB 2014 10.7% 13.3%
OVERWEIGHT AUSTRALIA (ADD CURRENCY HEDGE) 2
100 JAN 2009 43.4% 50.5%
OVERWEIGHT NEW ZEALAND (ADD CURRENCY HEDGE) 2
100 JAN 2009 48.6% 49.8%
LONG ITALIAN 10-YEAR GOV’T BONDS 5.878% AUG 2012 44.0% 44.5%
LONG GERMAN 10-YEAR GOV’T BONDS / SHORT JAPANESE
100 JULY 2013 21.7% 20.9%
10-YEAR GOV’T BONDS
CURRENCY RECOMMENDATIONS
LONG AUSTRALIAN DOLLAR /

1.0815 APR 2014 -0.9% -2.6%
SHORT NEW ZEALAND DOLLAR
1
EQUALLY-WEIGHTED BASKET OF CANADA, AUSTRALIA AND LATIN AMERICA.
2
CURRENCY HEDGE ADDED AS OF SEPTEMBER 26, 2014.
NOTE: RETURNS RELATIVE TO BENCHMARK. MSCI WORLD FOR EQUITY RECOMMENDATIONS UNLESS OTHERWISE SPECIFIED. CUSTOM BENCHMARK FOR FIXED-INCOME RECOMMENDATIONS BASED
ON GDP-WEIGHTED G10 GOVERNMENT BOND PERFORMANCE.
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GLOBAL INVESTMENT STRATEGY

Discover KEY THEMES AND INVESTMENT POSITIONS

OPEN SPECULATIVE INVESTMENTS

Short Gold: We have been successfully play- CHART 1

Best Trade Was:

© BCA Research 2015

Discover I. MACRO THEMES: COPING WITH AN OVER-SAVING WORLD

dencies of price declines and sub-trend growth 10 4

The over-saving problem has continued to take 2.5 2.5

economy has struggled with periodic contrac- 1.0 1.0

ening dollar and falling commodity prices. The 10 12 14

where growth is expected to accelerate next

The Oversaving Problem

Discover is required to equilibrate aggregate demand CHART 3

can do negative territory since as early as the 1990s. GDP

First of all, there has been a steady but very

the U.S. It is clear that the ratio has dropped 80 85 90 95 2000 05 10 15

same phenomenon is also evident in Europe

Second, neo-classical economics believes that CHART 4

In other words, wage growth has not kept 45 45

pace with net gains in output per hour worked

Global competition and globalization of produc- 160 160

and 2014, while the U.S., the euro area and

the trend is about to reverse, the relative loss of 85 90 95 2000 05 10 15

gain in corporate profits (or corporate savings)

Discover This explanation sounds plausible, but actu- CHART 5

with BCA consistently in the 1990s and 2000s, when in-

economy has arguably fared better than both

2008 Great Recession. Therefore, this line of

cal needs than reflective of economic reality.

still linger. Deleveraging has swept across the

Discover Remedy And Sub-Optimal Policy CHART 6

Moreover, it makes no difference whether the

sector dissaving is to simply fill up the shortfall © BCA Research 2015

in aggregate demand in order to prevent nomi- 96 2000 04 08 12

policy is sub-optimal in dealing with a supply CHART 7

fallen to zero, the impact of monetary policy is

economy by launching a series of QE programs.

tive role in bringing down the long end of the

Chart 9 shows the clear negative correlation

experienced the worst fiscal contraction, and its

Discover obvious: through fiscal austerity, the European CHART 8

Japan is another case in point. While the cen-

NOTE: BASED ON IMF DATA.

CHART 10A CHART 10B

© BCA Research 2015 © BCA Research 2015

Discover combination roughly right: the fiscal auster- CHART 11

ity of 2012-2013, though unnecessary, was U.S. Economy Is Set To Accelerate

As far as the U.S. economy’s performance 0 50

is concerned, the story for next year will be

behind us, the economy will likely accelerate

better growth ahead:

RATIO OF JOB OPENINGS TO

in non-farm payrolls growth; furthermore, © BCA Research 2015

falling energy costs are another boost for 02 04 06 08 10 12 14 16

FF Private-sector credit is growing and the

2) Euro Zone: Price Deflation CHART 12

Had the European Central Bank followed in the

economic conditions may have been margin-

sovereign spreads to encourage more credit

3) China: Policy Relaxation

Discover CHART 13 CHART 14

tion and over-investment, the government has 15 15