BCA The Bank Credit Analyst 2015

Monthly forecast and analysis of the
January 2015 - Vol. 66 - No. 7 global economy and financial markets
SPECIAL YEAR END ISSUE
OUTLOOK 2015
www.bcaresearch.com
BCA RESEARCH
Carlos Palma AFP PROFUTURO January 2015 THE BANK CREDIT ANALYST
224477
1
THE
BANK CREDIT ANALYST
Monthly forecast and analysis of the
January 2015 - Vol. 66 - No. 7 U.S. economy and financial markets
SPECIAL YEAR END ISSUE:
OUTLOOK 2015
The Debt Supercycle R.I.P. Now What? 3
Conclusions 54
2 THE BANK CREDIT ANALYST January 2015 BCA RESEARCH

OUTLOOK 2015:
The Debt Supercycle R.I.P. Now What?
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 report is an edited transcript
of our recent conversation.
Mr. X: Once again, it is a pleasure to Before we start talking about the future,
meet with you to discuss the economic and we should review your key recommenda-
financial market outlook. It has been a tions from last year. It is always interesting
reasonable year for my investments, but I to see what went right and what went
can’t shake off the nagging feeling that the wrong.
performance of financial markets is de-
tached from reality. Underlying economic BCA: We are not surprised that you re-
and financial conditions continue to look main uncomfortable with the outlook,
very unbalanced and weak in most ma- and you are not alone in feeling this way.
jor economies, with easy money being the Outside of the U.S., the economic news
main thing propping up asset prices. This has remained mostly bleak, and current
obviously can go on for a long time, but it policy actions are not likely to lead to
is not a stable source of support because ex- a significant improvement. The reli-
treme monetary policies are a symptom of ance on monetary policy alone to boost
deep problems, not something to celebrate. growth has been misguided given the
structural nature of many of the global
I must sound like a broken record because economy’s problems and the inability
I have been expressing concerns about im- of low interest rates to trigger increased
balances and policy actions for some years, private-sector leverage in the wake of the
even though the bad outcome that I have biggest credit bust since the 1930s.
feared has not come to pass. Nevertheless,
fundamentals do matter and I remain We would not argue with your desire to
reluctant to embrace risky assets simply on shift to a more risk-averse investment
the assumption that I will be bailed out by stance and we moved from an over-
what I regard as irresponsible central bank weight to a neutral position in U.S. eq-
policies. Moreover, I fear that recent vola- uities a couple of months ago. Markets
tility in the markets is a warning sign of face increased challenges in the coming
looming trouble. I am tempted to shift to a year and we will get into the details
very risk-averse investment stance but will shortly. Meanwhile, as you requested,
try to keep an open mind until we have let’s look back at how things played out
completed our discussion. over the past year. At our meeting a year
ago, we predicted that:
BCA RESEARCH January 2015 THE BANK CREDIT ANALYST 3

 The environment that delivered  Abenomics is giving a temporary
strong returns from the major equity boost to Japan’s economy, largely
markets in 2013 – i.e., solid cor- through a weaker yen, and this will
porate earnings, low inflation and continue to be the case for 2014.
easy money – is likely to persist in A longer-run improvement in eco-
2014. Although many markets are nomic performance will depend on
no longer cheap, the conditions for structural reforms and skepticism is
an overshoot are in place. We recom- warranted on that front.
mend maintaining modestly over-
 China’s economy is likely to grow
weight positions in equities.
at a 7%-to-8% pace over the next
 There are many lingering economic couple of years. We are encouraged
and financial imbalances in the glob- by the new government’s focus on
al economy, but none pose an im- structural reforms to improve the
mediate danger to growth. A broad- economy’s growth potential.
based improvement in growth is in
 Government bonds in the major
prospect for 2014, ending several
economies remain unattractive from
years of economic disappointments.
a long-run valuation perspective
Inflation will stay tame, ensuring
with real yields more likely to rise
that central bank policy stays highly
than fall over the next few years.
accommodative in the developed
Fixed-income investments should
economies, even as the Fed backs
continue to focus on corporate
away from QE.
bonds, especially high yield.
 The U.S. economy should grow
 Within developed equity markets,
by 3%-to-3½% over the next year,
the non-core euro area and Japan of-
aided by a marked reduction in fiscal
fer better value than the U.S. How-
drag. A gradual healing in business
ever, the credit environment will be
confidence will lead to faster growth
a headwind for the euro area and
in capital spending. Housing will
we do not have a strong conviction
continue to recover although the
about whether stocks in the euro
pace of price gains will slow.
area will outperform those of the
 Diminishing fiscal drag also is help- U.S. in 2014. Both markets should
ing the troubled euro economies to comfortably beat cash and govern-
climb out of recession and modest ment bonds.
growth should be sustained in 2014.
 For other developed equities, we rec-
However, tight credit conditions will
ommend being overweight in Japan,
remain a headwind and growth risks
neutral on the U.K., and under-
are tilted to the downside. Defla-
weight Canada and Australia.
tionary pressures will persist, espe-
cially in the periphery.

 Emerging markets are still vulner-  Alternative investments help to di-
able and are likely to underperform versify portfolios but hedge funds
their developed counterparts. There should continue to underperform
has been a worrying deterioration in equities as long as the bull market in
profitability, an early return of for- the latter persists. Commercial real
eign capital is not in prospect, and estate has some interesting oppor-
valuations are not as attractive as tunities in second-tier markets, but
they appear. trophy markets such as London and
New York offer poor value.
 From a sector perspective, we fa-
vor plays on economic growth and  Our key geopolitical theme is the
would avoid sectors that do poorly same as last year: risks, as they affect
when bond yields rise. And we markets, will stay focused on East
would emphasize plays on capital Asia, not the Middle East. The U.S.
spending rather than consumption. remains the global power, but China
We recommend overweighting In- is closing the gap. More generally,
dustrials, technology and financials, there continues to be a rotation of
and underweighting utilities and political risk out of developed mar-
telecommunications services. kets and into the EM.
 Commodities should enjoy a bounce It always is rather nerve-wracking to ex-
on the back of stronger global amine year-ago forecasts, because things
growth but the secular bull market never work out exactly as expected. The
has ended and we do not advocate overall macro environment was broadly
exposure from a long-run perspec- as we predicted, with continued moder-
tive. We are not bullish on gold ate growth and low inflation, but there
given that prices are still high in real were some surprises with respect to mar-
terms and rising real interest rates ket moves.
will be a dampener on bullion. Oil
As far as growth is concerned, the euro
prices should hold firm in 2014.
area economy crawled out of recession
 The problem with currencies is that in 2014, the U.S. economy contin-
no country wants an appreciating ued to expand, and China performed
exchange rate in the current eco- as expected with growth holding be-
nomic environment. On balance, tween 7% and 8%. The main growth
the U.S. dollar and yen are most disappointments were in some euro
likely to drift lower while the euro area countries, Japan and commodity-
gains modestly. The Chinese cur- producing emerging economies, such
rency should strengthen and com- as Brazil and Russia, with the result
modity currencies should enjoy a being that overall global activity did
temporary bounce. not improve as much as we had hoped.

TABLE 1
IMF Economic Forecasts
OCTOBER 2013
OCTOBER 2014 FORECASTS
FORECASTS
2013 2014 2015 2014 2015
ANNUAL % GROWTH IN REAL GDP:
ADVANCED ECONOMIES 1.4 1.8 2.3 2.0 2.5

U.S. 2.2 2.2 3.1 2.6 3.4
EUROPE -0.4 0.8 1.3 1.3 1.6
JAPAN 1.5 0.9 0.8 1.2 1.1
EMERGING ECONOMIES 4.7 4.4 5.0 5.1 5.3
CHINA 7.7 7.4 7.1 7.3 7.0
WORLD 3.3 3.3 3.8 3.6 4.0
G7 INFLATION RATE (%) 1.3 1.7 1.8 1.8 1.8
SOURCE: IMF WORLD ECONOMIC OUTLOOK.
The IMF revised down its 2014 global The solid performance of bonds was
growth estimate from 3.6% a year ago obviously a surprise to many investors,
to 3.3% in its latest projections, leaving with only 5% of the participants at our
calendar year growth no higher than September 2013 New York Investment
in 2013 (Table 1). Against this back- Conference voting for government or
ground, inflation has remained very corporate bonds as their favorite asset
subdued, as we had expected, with de- for the coming year. We did switch to
flation concerns in the euro area. a neutral duration position in mid-year
and our recommendation for a curve-
Turning to the markets, we were not flattening strategy by shorting the 5-year
keen on government bonds when we and going long the 30-year delivered
met 12 months ago because we expected good returns.
yields to move higher over the com-
ing few years. In the event, our long- The U.S. had the best performing major
standing view of global excess savings equity market in 2014, by a long margin
and underlying deflationary pressures (Table 2). We expressed ambivalence
continued to have a powerful impact, between U.S. and euro area equities, but
causing yields to fall further during clearly we should have stuck with the
the year. In the U.S., Treasuries even former. Our overweight recommenda-
outperformed corporate bonds over tion on Japan did not pan out, with
the course of the year. And the most Abenomics failing to deliver the hoped-
impressive performance came from euro for improvement in economic growth.
area bonds, with 10-year German bund Emerging markets did poorly as we had
yields dropping to an all-time low of al- predicted, albeit with marked divergences
most 60 basis points.

TABLE 2
Market Performance
2013 2014
MSCI INDEX - TOTAL % RETURNS*
ALL COUNTRY INDEX 23.4 2.1

U.S. 32.6 10.7
CANADA 6.4 -1.6
EURO AREA 30.0 -8.6
U.K. 20.7 -8.3
JAPAN 27.3 -5.6
EMERGING ASIA 2.3 1.2
EMERGING LATIN AMERICA -13.2 -15.9
10-YEAR GOVERNMENT BOND % RETURNS*
U.S. -8.7 10.7

GERMANY -4.0 14.7
JAPAN 1.2 4.3
U.S. CORPORATE BOND % RETURNS
INVESTMENT-GRADE -1.5 6.9

HIGH-YIELD 7.4 0.3
BRENT OIL PRICE ($/BARREL)** 111.6 59.8

GOLD PRICE ($/OZ.)** 1204.5 1195.8
TRADE-WEIGHTED DOLLAR** 81.4 91.9
* U.S. DOLLAR TERMS. 2014 DATA REFERS TO YTD TO DECEMBER 17.
** END-YEAR LEVELS.
in individual country performance. anticipate oil prices falling as much

At the sector level, our overweight in as they have in recent months. Hope-
technology worked out well, as did our fully, you took our advice to stay away
underweight in telecommunications ser- from gold. On currencies, the euro was
vices. But, industrials and financials did weaker than we had predicted, even
not live up to our year-ago expectations, though the ECB’s balance sheet con-
the former held back by the continued tinued to shrink relative to that of the
lackluster performance of capital spend- Fed. Markets are pricing in very ag-
ing. Fortunately, we moved to a more de- gressive monetary expansion from the
fensive sector stance around mid-year. ECB in the coming year while perhaps
being too optimistic on the pace of
Although we said a year ago that Fed tightening.
commodity prices could bounce, we
abandoned that view early in the year, Finally, our geopolitical assessment that
focusing instead on our more bear- Middle East turmoil would have little
ish secular outlook. But, we did not market significance was correct. Although

distressing from a human suffering Some Thoughts On
perspective, the escalating problems in Oil Market Developments
Syria and Iraq did not impact oil prices.
BCA: There are indeed a lot of crosscur-
Meanwhile, we warned that there was
rents related to the oil price drop so it is
potential for more unrest in other emerg-
not a simple one-sided story. The speed
ing market (EM) countries, including
and magnitude of the price drop was
Ukraine. This supported our negative
bound to create problems for companies
view on EM equities and bonds.
and countries dependent on oil pro-
Overall, our main error was in underes- duction, and this has fed through into
timating the scale of investor confidence related prices for debt, equities and cur-
in the U.S., reflected in the continued rencies. However, at the simplest level,
outperformance of Wall Street and a ris- lower oil prices are good for consumers
ing dollar in the second half of the year. and bad for producers, and because the
Certainly, the U.S. economy has per- former outnumber the latter, they are a
formed much better than that of Japan net positive for global growth. Put an-
and Europe this year, but it has been other way, the world is characterized by
far from stellar. This raises the question a surfeit of savings and inadequate ag-
of whether the U.S. will remain the gregate demand, and global consumers
best out of a bad bunch in 2015. But have a lower propensity to save than oil
the bigger issue is whether the global producers.
economy will be able to break out of
Price declines can reflect a positive sup-
its low-growth trap. The obstacles are
ply shock or weak demand, and the cur-
significant, with the most important
rent oil situation is due to a bit of both.
one being the powerful headwinds from
The U.S. shale oil boom has clearly
credit. Or to frame this in a BCA way:
contributed to a reduced call on OPEC
can we expect more vigorous economic
production at a time when weak global
growth in a post-Debt Supercycle world?
growth has curbed energy consumption.
Mr. X: I am glad you asked that question And OPEC’s reluctance to cut output
and I can’t wait to hear your answer. But inevitably has led to oversupply, driv-
before we get into that, I must first ask ing down prices. Even if the drop in oil
about your perspective on recent develop- prices was caused entirely by weak eco-
ments in the oil market. The sharp drop nomic growth, it would still be a posi-
in oil prices seems to have created a lot of tive development because it represents a
confusion as to whether it is a positive or kind of tax cut for consumers – exactly
negative development for the markets and what is required when growth is in need
economy. I have always assumed that high of a boost.
prices are bad and low prices are good for
Lower oil prices will feed through into
the overall economy, but in a world on the
lower inflation and that means more
verge of deflation, I recognize that it might
countries will slip into deflation. But
be more complicated.

unless prices keep dropping, the impact total private nonresidential investment
should be temporary. Currently, the and has accounted for just 18% of the
Brent oil price is down more than 40% growth in capital spending during the
on the year, but if prices simply hold at past five years. That is significant, but
current levels, the year-on-year change not a game changer and the recent
obviously will move back to zero in 12 drop in oil prices will take the edge off
months’ time. Meanwhile, the drop in capital spending on shale development.
inflation will maintain the pressure on
central banks to keep a highly-accom- On the trade side, the volume of oil im-
modative monetary stance. ports has dropped by three million bar-
rels a day (or 25%) in the past five years,
There are three other issues to consider: saving about $80 billion a year at current
prices. Nonetheless, the trade deficit con-
 The impact on the U.S. shale oil sector. tinues to run at a still-high annual rate
 The impact on geopolitics. of $700 billion, equivalent to around
4% of GDP. In other words, shale oil has
 The threat of increased financial helped, but has not eliminated the trade
stress. deficit as a lingering problem.
The U.S. shale oil sector: There is no Overall, the shale oil boom has not been
doubt that the shale boom has been important enough to make a huge dif-
positive for the U.S. economy. Domestic ference to the performance of the U.S.
oil production has more than doubled economy. The industry has been very
in the past six years, making the U.S. good at finding ways to boost produc-
the second-largest producer of crude in tivity and lower its cost structure, but
the world, after Saudi Arabia. The ben- close to half of shale production may be
efits have included a lower trade deficit, unprofitable below $60/bbl (Chart 1).
lower oil prices for consumers, and in- That is a moving target as the technol-
creased output and employment in oil- ogy improves and more resources flow
related sectors. But, we need to put it in into developing low-cost fields, but the
perspective. decline in prices is bound to take a toll
Employment in the oil and gas extrac- on production. On the other hand, any
tion sector increased by 37% in the negative impact on the economy will be
five years to November 2014, but this more than offset by the boost to con-
only represented an additional 58,000 sumer spending power.
jobs, accounting for a negligible 0.6% Geopolitics: There are various theories
of the increase in total employment being touted to explain why Saudi Ara-
over the period. The oil boom created bia has resisted calls from other OPEC
jobs in other industries as well, but the members to cut production and stabi-
overall impact has been small. Mean- lize prices. Two popular ones are that
while, capital spending for oil and it reflects U.S. prodding to hurt Russia
gas extraction represents only 10% of and Iran, or that it is an attempt to

CHART 1
U.S. Shale Production Sensitivity To The Oil Price
EAGLE FORD BAKKEN
WTI BREAKEVEN COST (2013 DOLLARS PER BARREL)
180
PERMIAN OTHER TIGHT OIL
160
140
120
80% OF RESOURCES IN THIS RANGE
100
80
60
40
20
© BCA Research 2015
3 6 9 12 15 18 21 24 27 30 33 36 39 42 45 48
RESOURCES IN BILLIONS OF BARRELS
SOURCE: RYSTAD ENERGY, APPEARING IN HUNT, HAROLD (OCTOBER 2014), “HOW OIL DRIVES THE HOUSTON ECONOMY – AND THE ECONOMY DRIVES
REAL ESTATE,” REAL ESTATE CENTER AT TEXAS A&M, COLLEGE STATION, TEXAS, PP. 88-89.
undermine the viability of U.S. shale not really pose a long-term threat. There
and other competitors such as Canada’s are limits to how much further U.S.
tar sands. output will rise and the production life
of shale wells is likely to decay quite rap-
Saudi Arabia generally takes a long- idly. A bigger threat to Saudi dominance
term strategic approach to oil prices. comes from Iraq and Iran, with the
Being almost totally dependent on oil added problem that these are Shia states.
revenues for economic growth, the gov- Thus, there probably is some truth to
ernment has always wanted to ensure the view that Saudi Arabia is quite con-
that oil remains a fuel of choice for the tent to have low prices damage these two
foreseeable future. Overly-high prices producer and political competitors.
are problematic because they encourage
a shift toward alternative energy and Low oil prices undoubtedly increase do-
the development of oil supplies in the mestic political risks in oil-producing
rest of the world. But, overly-low prices countries. Somewhat perversely, that
raise the risk of domestic instability if could then lead to supply disruptions in
the government does not have enough the most vulnerable countries such as Ven-
revenues to disperse largesse to its rap- ezuela and Nigeria, leading to a rebound
idly-growing population. It is a tough in prices. You already have some sign of
balance to get right. that with recent problems in Libya. The
oversupply in the oil market could evapo-
While rising U.S. oil production has rate quickly with some disruptions in
stolen market share from OPEC, it does OPEC and cutbacks in U.S. shale activity.

CHART 2 CHART 3
Russia Under Pressure Where Next For Oil Prices?
US$/ US$/ US$/ US$/
Rub RUBLE VERSUS U.S. DOLLAR (INVERTED) (LS) Bbl Bbl Bbl
BRENT OIL PRICE (RS) BRENT OIL PRICE
140 140
120
FUTURES CURVE
30
110
120 120
100
40 100 100
90
80 80 80
50
70
60 60
60 60
40 40
% % © BCA Research 2015
RUSSIA REPO RATE
2006 2008 2010 2012 2014 2016 2018 2020
16 16
14 14 so will not come as a surprise. Russia

also is under severe pressure with the
12 12
currency dropping by more than 50%
10 10
in the past six months as it followed the
oil price lower (Chart 2). Even a sharp
8 8 hike in the central bank repo rate has
not relieved the pressure on the cur-
6 6

rency. The next step may well be capital
controls but a debt default is not in the
2013 2014
cards. The country has a large cushion of
foreign exchange reserves, estimated at
Financial Stress: The high-yield bond
more than $200 billion, excluding about
sector already has been roiled by a huge
$170 billion in assets held by the two
blow-out in spreads in the energy sec-
big sovereign wealth funds.
tor, reflecting fears of increased defaults.
Meanwhile, currencies of some oil- Mr. X: Presumably, the extent of the prob-
producing countries have fallen sharply lems posed by lower oil prices depends on
for the same reason. However, unless the where they settle. How low do you expect
price continues to collapse, oil develop- them to go?
ments should not pose a systemic threat
to the financial system. BCA: Oil prices have a tendency to
overshoot in both directions, making it
Venezuela is the country most vulner- hard to predict exactly where prices will
able to a default, but that already is bottom. The forward curve for Brent has
priced in the credit default swap market, prices edging higher from current levels,

but remaining below $70 until January CHART 4
2017 and below $80 until May 2022 What Deleveraging?
% %
(Chart 3). Those levels seem too low giv- 210 WORLD TOTAL DEBT EXCLUDING FINANCIALS 210
en the impact that lower prices will have (PERCENT OF GDP)
on marginal non-OPEC production. It

200 200
would not be a surprise to see prices fall
further into the $50s within the next few
months, but that would set the scene 190 190
for a sharper rebound than suggested

by the futures market. However, absent 180 180
some geopolitical shock, it could take a

very long time for prices to return to the 170 170
highs of the past couple of years.

Mr. X: O.K., I promise not to hold you to 2002 2004 2006 2008 2010 2012
a specific oil price forecast and I know you SOURCE: GENEVA REPORT ON THE WORLD ECONOMY, SEPTEMBER 2014.
may adjust your views during the course of

the year. But the bottom line is that you see
low prices as a net economic positive and I BCA: Our view that the Debt Supercycle
agree with that view. Now let’s go back to is over is not inconsistent with an ongo-
the discussion of one of my favorite topics: ing rise in the ratio of debt-to-GDP, at
The Debt Supercycle least for a while. Our Debt Supercycle
thesis is a story about how policymakers
were always able to limit the economic
The End Of The
and financial damage of recessions and
Debt Supercycle other shocks by easing policy enough to
Mr. X: You raised the issue of whether trigger a new private-sector leverage cycle
growth can revive following the demise of (see Box 1 on page 13 for a brief over-
the Debt Supercycle. Rapid debt growth view of the Debt Supercycle thesis). The
played such an important role in support- imperative was always to try and rekindle
ing demand in most economies over the growth rather than accept the pain that
past several decades that it is not clear to would result if the markets were allowed
me how economic growth can recover if the to wash out the financial excesses, even if
addiction to credit has indeed been broken. policy actions were likely to create even
However, I would first question your view bigger excesses and problems down the
that the Debt Supercycle has ended. I draw road. The credit-driven U.S. housing
your attention to a chart in the recent bubble was a classic example of the Debt
Geneva Report on the World Economy, Supercycle in action, as it was encour-
“Deleveraging? What Deleveraging?” that aged by the Federal Reserve’s aggressive
shows the ratio of global debt-to-global response to the bursting of the technol-
GDP has continued to increase to a new ogy bubble in 2000. However, something
high (Chart 4). profound has occurred in the current

Box 1: A Primer On The Debt Supercycle
The Debt Supercycle is a description of the long-term decline in U.S. balance-sheet

liquidity and rise in indebtedness during the post-WWII period. Economic expan-
sions have always been associated with a buildup of leverage. However, prior to the
introduction of automatic stabilizers such as the welfare state and deposit insurance,
balance-sheet excesses tended to be fully unwound during economic downturns,
albeit at the cost of severe declines in activity.
The pain of the Great Depression led governments to intervene to smooth out the
business cycle, and their actions were given legitimacy by the economic theories of
John Maynard Keynes. Fiscal and monetary reflation, together with the introduc-
tion of automatic stabilizers such as unemployment insurance, were successful in
preventing the frequent depressions that plagued the pre-WWII economy, but the
downside was that balance-sheet imbalances and financial excesses built up during
each expansion phase were never fully unwound.
Periodic “cyclical” corrections to the buildup of debt and illiquidity occurred dur-
ing recessions, but these were never enough to reverse the long-run trend. Although
liquidity was rebuilt during a recession, it did not return to its previous cyclical
high. Meanwhile, the liquidity rundown during the next expansion phase estab-
lished new lows.
These trends led to growing illiquidity, and vulnerability in the financial markets.
The greater the degree of illiquidity in the economy, the greater is the threat of de-
flation. Thus, the bigger that balance-sheet excesses become, the more painful the
corrective process would be. So, the stakes became higher in each cycle, putting
ever-increasing pressure on the authorities to reflate demand, by whatever means
were available. The Supercycle process was driven over time by the building tension
between rising underlying deflationary risks in the economy, and the ability of poli-
cymakers to create inflation.
The Supercycle reached an important inflection point in the recent economic and
financial meltdown, with the authorities reaching the limit of their ability to get
consumers to take on more leverage. This forced the government to leverage itself
up instead, representing the Debt Supercycle’s final inning.

CHART 5 CHART 6
Japan: A Long Slow Deleveraging Is Hard
Climb Out From Debt Without Growth
% Of % Of US$ US$
GDP JAPAN GDP Bn Bn
NONFINANCIAL CORPORATE SECTOR DEBT 160 U.S. 160
PRIVATE* DEBT
150 150
140 140
140 140
120 120
130 130
120 120 100 100
US$ US$
Bn Bn
110 110
100 NOMINAL GDP 100
90 90
100 100
© BCA Research 2015 80 80
1980 1985 1990 1995 2000 2005 2010 70 70
SOURCE: BANK FOR INTERNATIONAL SETTLEMENTS.

60 60
cycle as even zero short-term interest rates % Of % Of

have not been able to engineer a major GDP
240
PRIVATE* DEBT / GDP GDP
240
credit upturn.
200 200
There are three principal reasons why
the global debt-to-GDP ratio has con- 160 160
tinued to move higher in the past few
years: 120 120
 It is incredibly difficult for borrowers 1920 1924 1928 1932
to deleverage when income growth * HOUSEHOLD, FARM, AND BUSINESS DEBT.

NOTE: VERTICAL LINE REPRESENTS PEAK IN NOMINAL GDP.
is sluggish, as it has been throughout

this recovery.
It is hard to deleverage in a slow-growth
 In the developed world, much of
world because the very act of trying to
the continued rise in debt reflects
reduce debt burdens can create negative
increased borrowing by govern-
feedback loops on economic activity,
ments rather than the private sector.
further depressing incomes. This was
This reflects weak economic growth
highlighted by the experience of Japan
rather than loose fiscal policy per se.
where it took more than two decades
 Debt growth until recently had been to get the corporate debt-to-GDP ratio
strong in a number of emerging back to the pre-bubble levels of the early
economies that enjoyed strong capital 1980s, and that of the U.S. in the 1930s
inflows. However, that period is over. (Charts 5 and 6).

CHART 7 CHART 8
A Worrying Trend U.S. Households Have
In Money Velocity Deleveraged, But…
% %
U.S. HOUSEHOLD DEBT
108 108 (PERCENT OF DISPOSABLE INCOME
G7
140 TIME TREND (1960 - 2004)
...still 140
MONEY VELOCITY*
high
104 104
120 120
100 100
100 100
96 96
80 80
92 92
500 MORTGAGE APPLICATIONS: 500

PURCHASE INDEX*
88 88
400 No 400
recovery
84 84 300 300
2006 2008 2010 2012 2014

200 200
* GDP DIVIDED BY BROAD MONEY. SERIES REBASED TO JAN. 2008 = 100.
BROAD MONEY BASED ON M3 MONEY SUPPLY, EXCEPT FOR U.S. WHICH
IS BASED ON M2 MONEY SUPPLY.
100 100
% HOUSEHOLD DEBT-SERVICE PAYMENTS %
Irving Fisher’s seminal Debt-Deflation (PERCENT OF DISPOSABLE INCOME)
13 13
theory, published in 1933, remains the
best description of how attempts to 12 12
unwind excessive debt can lead to a de-

11 11
structive self-feeding cycle of declining
economic activity and even higher debt 10 10
burdens.1 And a key indicator of the © BCA Research 2015
problem is a collapse in money’s velocity 1990 1995 2000 2005 2010
of circulation – exactly what is happen- * SHOWN SMOOTHED EXCEPT FOR LATEST DATAPOINT.
SOURCE: MORTGAGE BANKERS ASSOCIATION.
ing now in the developed economies

(Chart 7). We are not suggesting that
we are headed into another depression. sector via mortgage delinquencies, with
The point is that there are powerful the debt-to-income ratio back to its end-
headwinds against the authorities’ at- 2002 level and to its pre-bubble trend
tempts to restart a credit cycle. line (Chart 8). Moreover, the decline in
interest rates has brought down the cost
As far as progress in unwinding debt
of servicing this debt to very low levels.
excesses is concerned, there has been
However, debt levels are still high by
some deleveraging in the U.S. household
historical standards and there is no rea-
son to assume that the debt-to-income
1
Irving Fisher, “The Debt-Deflation Theory of trendline will continue to slope upward
Great Depressions”, Econometrica, 1:4 (1933). as it did in the past.

CHART 9 underestimate the speculative forces
U.S. Small Businesses Have that are unleashed by extreme mon-
Little Interest In Borrowing etary stimulus. However, this is a
% %
42 42 small niche area, and overall consumer

U.S. borrowing remains subdued. Business-
PERCENT OF COMPANIES
40
BORROWING REGULARLY*
40 sector borrowing has indeed increased,
but much of it is to finance equity
38 38
buybacks. Small businesses – the ones
36 36
that are most reliant on banks – con-
tinue to have little interest in bor-
34 34 rowing, according to surveys by the
National Federation of Independent
32 32
Business (Chart 9).
30 30
We are not suggesting that private debt
© BCA Research 2015 will be stagnant. The outlook for eco-
2004 2006 2008 2010 2012 2014 nomic growth would be very bleak in-
* PERCENT OF BORROWERS WHO REPORTED BORROWING AT LEAST EVERY
3 MONTHS. SHOWN SMOOTHED.
SOURCE: NATIONAL FEDERATION OF INDEPENDENT BUSINESS.
deed if there was absolutely no increase
in private credit because few people can
The failure of the mortgage applications afford to buy homes and autos for cash.
purchase index to recover from its reces- The point is that we are not likely to
sion low, despite the collapse in borrow- return to an extended period where debt
ing costs and drop in home prices, is a growth exceeds that of income. That is
stunning sign of a turning point in the what we mean when we say the Debt
Debt Supercycle for U.S. consumers. Supercycle is over.
Thus, it would be premature to assume
that deleveraging in the U.S. household Mr. X: Well, let’s talk about government
sector has run its course and the debt- debt. You say it is a reflection of weak eco-
income ratio is likely to drift lower over nomic activity rather than policymakers
the medium term. deliberately running easy fiscal policies.
Yet the end result is the same: public-sector
Mr. X: But I have read that subprime debt burdens continue to climb and must
auto loans are a new area of growth in the pose an eventual threat to economic and/or
U.S., and business borrowing also has been financial stability.
quite strong. This suggests that attitudes to-
ward debt may not have changed as much BCA: It was inevitable that budget defi-
as you are suggesting. cits would soar during the downturn
because of both automatic stabilizers
BCA: It is rather discouraging to see and stimulus measures to boost de-
increased subprime lending so soon mand. And it is true that deficits remain
after the biggest credit meltdown discouragingly high in most countries.
since the 1930s, and we should never Cyclical forces are still exerting upward

pressure on deficits because economies we can say is that the debt arithmetic
are running below potential. The struc- will continue to deteriorate if there is a
tural primary government deficit2 in the primary deficit and the interest rate on
advanced economies was only 1.6% of the debt is above nominal GDP growth.
GDP in 2014 compared to a peak of Economies stuck in that position, if they
5.3% in 2010. And assuming that cur- already have a large debt overhang, are
rent policies continue, the IMF assumes vulnerable to an eventual debt crisis. In
this deficit will be largely eliminated by Chart 10 we show which countries cur-
2018. The headline deficit in the ad- rently are in a difficult situation, accord-
vanced economies is forecast to still be ing to IMF data.
2.4% of GDP in 2019, but that entirely
reflects the burden of interest payments. Japan stands out as a country that looks
to be in a dangerous fiscal situation. The
As long as governments run deficits then IMF forecasts that the primary govern-
debt will continue to accumulate. And ment deficit will average more than 4%
this does raise the issue of the dangers of GDP over the period 2014-19, far
this may pose down the road. Gov- above the interest rate-growth differen-
ernment financing is a kind of Ponzi tial of -1.2%. Thus, gross government
scheme whereby the proceeds from new debt is expected to hold above 240% of
debt are used to pay off previous lenders. GDP over the period, far above long-
Like all Ponzi schemes, it unravels when run sustainable levels. Yet, Japan has
the volume of required new borrow- had little trouble in financing its deficits
ing exceeds the willingness or ability of because it has not had to rely on foreign
investors to lend. A crisis then ensues as investors and there has been a large cap-
interest rates soar, which puts even more tive pool of domestic buyers. And more
pressure on government finances. But recently, the Bank of Japan has been a
there is one important caveat: unlike pri- huge purchaser of JGBs. If there was a
vate Ponzi schemes, governments have deficit financing crisis down the road,
the advantage that central banks can act the BoJ could simply purchase all the
as buyers of last resort. net issuance and hang on to these bonds
indefinitely. The absence of a large num-
A lot of research has been done to try ber of foreign JGB holders would make
and determine if there is a particular gov- this even easier to do.
ernment debt-to-GDP ratio that marks a
danger point for economic and financial The point is that governments have op-
stability. Although some work suggests tions to deal with deficit-financing prob-
that a ratio of 70%-to-90% is problem- lems. The traditional solutions are rapid
atic, the results are not convincing. What economic growth, inflation, or default.
Growth is obviously the ideal remedy
2
but hard to achieve in today’s economy,
This is the budget balance (excluding interest
payments) that would exist if economies were and default is a last resort. That leaves
operating at their potential level. inflation as an attractive way out, but

CHART 10
Government Debt Vulnerability
2.5
Primary deficit Primary surplus

2.0
and interest rate and interest rate ITALY
above growth above growth
INTEREST RATE - GDP GROWTH DIFFERENTIAL (%)
1.5
1.0 SPAIN
BELGIUM PORTUGAL
0.5
IRELAND
AUSTRIA
NETHERLANDS
0.0
Primary deficit DENMARK

AUSTRALIA SWITZERLAND
and interest rate FINLAND FRANCE

NEW ZEALAND
-0.5
below growth CANADA
U.K.
GERMANY GREECE
-1.0 G20 ADVANCED Primary surplus

JAPAN and interest rate
-1.5
below growth
U.S.
SWEDEN © BCA Research 2015
-2.0
-5 -4 -3 -2 -1 0 1 2 3 4 5
PRIMARY
PRIMARY DEFICIT-TO-GDP
BALANCE (%)
AS A % OF GDP
NOTE: BASED ON IMF DATA.
again, that is not easy to achieve in a BCA: China did unleash a remarkable
low-growth world. A fourth option is credit boom with its 2008-09 stimulus
financial repression: keeping interest rates measures – another example of the Debt
artificially low and perhaps forcing finan- Supercycle at work. However, policy
cial institutions to hold more government changed course about a year ago when
debt. That may seem to be an attractive policymakers decided to try and squeeze
way for governments to try and head off the excesses out of the system. Monetary
a fiscally-induced crisis. However, such policy has been among the tightest in
policies would not end well because, ul- the world with very high real interest
timately, they would lead to capital con- rates and a rising exchange rate, and
trols, inflation and economic decay. money and credit growth has started
to decelerate (Chart 11). The resulting
Mr. X: This discussion does not encourage slowdown in economic activity has been
me to hold government bonds. With regard enough to force the authorities to relax
to other debt risks, what about the emerg- the pressure by cutting interest rates, but
ing world, especially China? Credit growth policy is still tight by global standards.
has been especially rapid there and the lack
of good data makes it difficult to assess the
full scale of the risks.

CHART 11 CHART 12
Chinese Monetary Policy Is Tight An Accident Waiting To Happen?
% %
REAL HOUSE PRICES*
200 200
10 10
8 8 U.S.
180 AUSTRALIA 180
6 CHINA: 6 CANADA
REAL* AVERAGE LENDING
4 RATE AT BANKS 4 160 160
2 2
140 140
0 0
REAL EFFECTIVE EXCHANGE RATE INDEX** 120 120
130 130
126 126 100 100
122 122 % %
HOUSEHOLD DEBT
(PERCENT OF DISPOSABLE INCOME)
118 118
160 160
114 114
M1 MONEY SUPPLY (LS)

Ann% BANK LOANS*** (RS) Ann% 140 140
Chg Chg
14 18
12 17
120 120
10
16
8
15
6
14 100 100
4
2 13
© BCA Research 2015 © BCA Research 2015
2011 2012 2013 2014 2000 2002 2004 2006 2008 2010 2012 2014
* DEFLATED BY PRODUCER PRICES. * REBASED TO JAN. 2000 = 100. OECD DATA.
** SOURCE: J.P. MORGAN CHASE & CO.
*** RMB LOANS BY ALL FINANCIAL INSTITUTIONS.
The Chinese authorities face a tricky bal- to get out of hand following strong capi-
ancing act: keeping policy tight enough tal inflows. Among the worst offenders
to cool excesses but not so tight as to were the so-called fragile five3 and the
cause a hard landing for the economy. problems were exposed as capital flowed
We cannot rule out the possibility of a back out when markets began to con-
policy mistake whereby conditions are template an eventual rise in U.S. interest
kept too tight for too long. However, be- rates. The result was a sharp slowdown
cause the banks are largely state-owned, in economic activity, and this was com-
there is little risk of a credit seizure as pounded by weak commodity prices.
occurred in the U.S. and Europe. This, in turn, led to a pendulum swing
away from credit excesses to restraint.
Another group of emerging economies
also allowed domestic credit conditions
3
Brazil, Turkey, India, South Africa, and Indonesia.
BCA RESEARCH January 2015 THE BANK CREDIT ANALYST

Going back to the developed world, global economy can break out of its cur-
Canada and Australia are two countries rent low-growth trap. There are several
where private credit growth has re- problems facing the global economy:
mained relatively buoyant. Both avoided
 With most consumers no longer
a bank and real estate downturn in
2007-09, so house prices have contin- willing or necessarily able to take on
ued to rise and banks have continued to more debt, spending is constrained
lend. Consumer debt-to-income ratios by the growth in incomes. But real
are far above the level that caused prob- wages in the major developed econo-
lems in the U.S., and the authorities mies are either declining or growing
are not unaware of the potential risks very slowly, and this does not seem
(Chart 12). There has not been any sub- likely to change anytime soon.
prime lending and most homeowners  There is a distinct lack of business-
have considerable equity, but close at- sector animal spirits – even in coun-
tention to the situation is warranted. tries where profits have been buoy-
Overall, it is hard to find many coun- ant and corporate balance sheets
tries where credit is still being embraced are strong. In the U.S., companies
by borrowers and lenders. It does not seem more interested in buying
mean that credit growth is imploding back shares or engaging in mergers
around the world, but the environment and acquisitions than in new capital
represents a sea change from that of the spending. And European companies
previous few decades. do not even have the benefit of de-
cent profit growth.
Is There Life After Debt?  China has ended its rapid growth
Mr. X: I had always assumed that the end phase, hurting those economies that
of the Debt Supercycle would be a cataclys- had benefited the most from the
mic event with the global economy going country’s strong import demand.
through terrible withdrawals as it was  Fiscal policy is still a headwind to
forced to give up on its addiction to debt. growth as governments focus on
Yet, although a deep economic and finan- reducing structural budget deficits.
cial crisis was required to break the addic- And a swing toward fiscal stimulus
tion, the after-effects do not seem to be as is unlikely given political realities in
traumatic as I had feared. Is this as bad as the major economies.
it is going to get?
 Deflation remains a threat, espe-
BCA: Maybe it is not as bad as you had cially in the euro area. While lower
feared, but it is hardly painless. The prices may be welcomed by con-
recovery from the deepest downturn sumers, it implies higher real debt
since the 1930s has been the weakest on burdens and lower top-line growth
record and it is still not clear how the for companies.

The above points do not mean that the We know that you have long held the
global economy cannot or will not grow, view that inflation must be the inevi-
but the odds favor activity continuing at table consequence of such extreme mon-
a disappointingly slow pace, rather than etary easing. And history is on your side
breaking out into a rapid phase that because large budget deficits financed
would signal a more normal expansion. by printing money inevitably have led
to inflation in the past. However, to-
Mr. X: You seem to be suggesting a con- day’s “money printing” has not led to
tinuation of the same kind of economic en- the kind of expansion in money growth
vironment we have had for the past two or that creates the conditions for inflation.
three years. On the one hand, that has not One of the consequences of moving into
been bad for most asset markets, but on the a post-Debt Supercycle environment is
other, growth has not been vigorous enough that the monetary transmission process
to significantly reduce financial imbalances via the credit channel is blocked. If both
or allow a shift away from policies that I lenders and borrowers are acting with
fear will ultimately prove to be very desta- restraint, then the expansion of base
bilizing. Is a world of slow growth some- money by central banks does not lead to
thing that can be sustained indefinitely? a parallel increase in broad money. This
BCA: It is indeed a strange kind of is highlighted by declines in the velocity
world. Markets celebrate central banks’ of circulation and in money multipliers
aggressively easy policies even though (Chart 13).
such actions are a response to a very We should add that the rise in the euro
disappointing growth environment. It area money multiplier since the end of
is sustainable as long as growth stays 2012 is misleading in that it does not
strong enough for corporate earnings to reflect a rise in broad money growth.
hold up and for the major economies Because banks were quick to repay the
to stay out of deflation. Our base case ECB loans taken out when the LTRO
is that growth will be strong enough to scheme was introduced, base money
do that in the U.S., but risks are on the contracted sharply. Thus, the rise in the
downside in the euro area and Japan, as money multiplier actually reflects a de
has been signaled by the decline in bond facto tightening rather than an easing in
yields. the region’s monetary conditions.
The long-term implications of current If broad money growth starts to acceler-
monetary policies are quite uncertain. ate, then it would signal that inflation
There are no historical precedents for risks are increasing. But, presumably,
all the major regions embarking on this would only occur in the context of
large-scale quantitative easing, and that stronger economic growth and in that
makes it difficult to assess how it might case, central banks would be free to
all play out. tighten policy. Central banks will not

CHART 13 BCA: It will only become a problem
The Credit Channel Is Blocked if the expansion in central bank assets
MONEY MULTIPLIER* leaks into a generalized rapid expansion
U.S.
JAPAN
in liquidity in the economy. At the mo-
100
EURO AREA
100
ment, that seems a distant threat. Per-
haps you should be just as worried about
80 80 the opposite risk – that central banks err
by trying to reduce their balance sheets
60 60
at an inappropriate time – i.e., when the
economies are not yet strong enough to
cope with such a move.
40 40
Shrinking central bank balance sheets

would require selling bonds back to the
private sector, presumably pushing up
MONEY VELOCITY** yields in the process. This would only
100 100 be warranted if economies were starting
to overheat. Most likely, balance-sheet
95 95
assets will be allowed to run off natu-
rally as the bonds mature, and this will
90 90
take several years. But as we mentioned
earlier, Japan could eventually take the
85 85
more drastic action of simply converting
the bonds held by the BoJ into perpetual
80 80
securities, which effectively would trans-
late into outright debt monetization.
2008 2010 2012 2014 Even that would only occur in extreme
* BROAD MONEY DIVIDED BY BASE MONEY.
** GDP DIVIDED BY BROAD MONEY.
NOTE: ALL SERIES REBASED TO JAN. 2008 = 100. BROAD MONEY BASED ON
circumstances if Japan were to slide back
M3 MONEY SUPPLY, EXCEPT FOR U.S. WHICH IS BASED ON M2 MONEY SUPPLY.
into a deep deflation.
raise interest rates until they are abso- We don’t want you to think we are com-
lutely sure that any growth improve- placent about the outlook, but inflation
ment is sustainable, suggesting they will seems a low priority threat in a low-
err on the side of being late rather than growth world. If the Fed and ECB also
early. Therefore, an increase in inflation were to go for outright debt monetiza-
is possible at some point, but it should tion then it would be a different story.
be temporary. For that to happen, a bad deflation
would have to occur first.
Mr. X: I understand that the cyclical
threat of higher inflation is limited, but The global economy’s biggest problem
surely these bloated central bank balance is insufficient aggregate demand rather
sheets eventually will pose a problem? than excessive demand and looming

inflation. And, relying on monetary CHART 14
policy to solve the problem is a second- A Collapse In U.S. Government
best approach in a post-Debt Supercycle Infrastructure Spending
US$ US$
world. Monetary policy can push up Bn U.S. REAL GROSS GOVERNMENT INVESTMENT:
STRUCTURES
Bn
asset prices and move exchange rates,

but such moves do not create sustain- 320 320
able prosperity. In a liquidity trap, fiscal

policy is more effective than monetary 300 300
policy.
Mr. X: I have trouble with that policy pre- 280 280
scription given how much government debt

already has risen over the past six years. I 260 260
would much rather see governments reduce

the barriers to private-sector growth than 240 240
engage in increased public spending. © BCA Research 2015
2006 2008 2010 2012 2014

BCA: In an ideal world, governments
would hack away at the many rules and
regulations that hamper innovation around. Real U.S. government spending
and business formation/expansion. And on structures has dropped by more than
there is tremendous scope to make tax 20% in the past five years (Chart 14).
systems fairer and more growth-friendly There is much infrastructure spending
by, for example, eliminating tax breaks that will have to be done in the coming
and lowering marginal rates. The prob- decade just to deal with normal wear
lem is that these distortions and rules and tear. There is a strong case for bring-
typically were put there in the first place ing that spending forward and locking
at the behest of powerful special interests in generationally low interest rates. And,
and that makes things hard to change. unlike the bridges to nowhere, this type
of spending could have reasonable rates
Given that we don’t live in an ideal of return. Even the IMF is making the
world, there is a strong case for having case for doing this, a reversal of its tradi-
more infrastructure spending by govern- tional call for fiscal restraint as the solu-
ments. This immediately conjures up tion to economic problems.
images of Japan’s infamous “bridges to
nowhere” – government infrastructure The problem is that there is little politi-
spending that yielded no real payoff. But cal appetite for increased fiscal activism
it need not be like that. in the developed world. In the U.S.,
the Republicans are in control of Con-
Larry Summers has quipped that anyone gress and have no sympathy for more
flying into New York’s JFK airport then discretionary government spending,
driving into Manhattan can see desper- except perhaps on defense. And in the
ately-needed infrastructure spending all euro area, Germany remains firmly

committed to maintaining strict con- CHART 15
trols on the size of budget deficits. Ja- A Less Favorable
pan has been forced to delay the second Picture For U.S. Profits
Ann%
U.S.
of its planned two-stage hike in the Chg
CORPORATE OVERSEAS PROFITS* (LS)
national sales tax, but a major round of 40 NOMINAL TRADE-WEIGHTED

DOLLAR** (INVERTED) (RS)
fiscal stimulus is not in the cards. 30
78
This leaves monetary policy as the only 20

82
game in town. And even though it has
10
limited impact, central banks will keep
pushing. So we can expect interest rates 0
86
in most countries to stay low for a long

-10
time, and the ECB and BoJ will go fur- 90
ther down the QE road. In the U.S., the -20
strong employment report for Novem-

ber has increased the pressure on the Fed CORPORATE DOMESTIC PROFIT MARGINS*
to raise rates, but we are skeptical that .18 .18

recent strong growth will persist. Thus,
even though the Fed may raise rates in .16 .16
mid-2015, the pace of subsequent hikes Peaking

will be very slow. .14 .14
Mr. X: I assume this means more asset .12 .12

bubbles and excesses will be created?
.10 .10
BCA: That does seem like a safe assump-
tion, albeit with a caveat. Monetary .08 .08
policy may be conducive to further gains
in equity prices, but the environment is 2006 2008 2010 2012 2014
* BASED ON CORPORATE PROFITS WITH INVENTORY VALUATION
likely to be more volatile than in the past AND CAPITAL CONSUMPTION ADJUSTMENT.
** SOURCE: J.P. MORGAN CHASE & CO.
couple of years – especially for the U.S.

are not a problem in Japan or most of
market. It was relatively easy for the Fed
Europe, but of course the outlook for
to push Wall Street higher from a start-
economic growth and thus corporate
ing point of attractive valuations and
revenues remains challenging there.
when corporate earnings had a number
of tailwinds. Conditions are now much Easy money will always lead to excesses
less favorable: the market is already ex- somewhere, but it is not easy to tell in
pensive by most measures, the strong advance where it will show up. Gold is a
dollar will undermine overseas earnings, good candidate for a bubble when mone-
and domestic margins are looking toppy tary conditions are highly accommodative,
(Chart 15). So the path higher for eq- but that does not apply when the world is
uity prices will be rockier. Valuations more deflationary than inflationary.

Let’s try and sum up this part of our growth is a retreat from open markets
discussion. There is life after debt, but it and open trade. Globalization has long
is difficult to generate sustained above- been contentious because, despite being
trend economic growth. The credit- good for overall global growth, it creates
fueled expansion during the previous lots of losers. As long as the destruction
decades in a sense stole growth from the is “creative”, then there should not be
future and now it is payback time. If the any lasting problem because losses in de-
authorities could have their way, they clining industries are offset by growth in
would trigger a new credit boom, even new areas. For example, the U.S. contin-
bigger than the last one. It was how the ued to do well even as it lost many man-
Debt Supercycle always worked: push ufacturing jobs to Japan in the 1970s
up growth today even if it means greater and 1980s. The question now is whether
problems tomorrow. But they can’t get enough jobs can be created in new areas
their way, because we finally seemed to to absorb those being lost. And the issue
have maxed out the ability and willing- is exacerbated by technological innova-
ness of lenders and borrowers to play tion which is squeezing out labor in a
along. growing number of sectors.
Mr. X: I cannot believe that governments The growth of globalization over the
or voters will be satisfied with the outcome past few decades was well illustrated by
you are suggesting. Could this lead to other a rising share of trade relative to GDP,
policy shifts that we have not discussed? and by increased flows of foreign direct
investment (FDI), portfolio investment,
BCA: That is a very good question, and and labor migration. Since the financial
leads into some of the potential negative crisis, there has been a clear flattening
implications of a low-growth world. out or even a decline in these trends
(Chart 16). In a world of slow domes-
Potential Consequences tic growth, there is more resistance to
Of A Low-Growth World competition from foreign goods and
BCA: Rapid economic growth is the labor. The U.K. is under pressure to re-
magic elixir to deal with almost every strict immigration from other European
economic problem. Strong income Union countries, Switzerland has curbed
growth makes it easy to service high immigration, and U.S. immigration has
debt levels and governments have the re- fallen off in recent years.
sources to ensure that all tiers of society
A retreat from globalization would be
receive some benefits of rising prosperity.
bad for productivity, profits and overall
And generally, one would expect popular
growth. At the moment, there are no overt
support for free-market policies. The op-
calls for protectionism in the major econ-
posite is true when growth is low.
omies, but this could change the longer
One potential threat that concerns us that growth remains subpar. The issue is
as a result of persistent disappointing on our radar screen for close monitoring.

CHART 16
A Retreat From Globalization
1.6 RATIO OF WORLD TRADE-TO-GDP* 1.6
1.4 1.4
1.2 1.2
1.0 1.0
% Of % Of
GDP U.S. FOREIGN DIRECT INVESTMENT FLOWS GDP
4 OUTFLOWS 4
INFLOWS
3 3
2 2
1 1
Thous Thous
250 INFLOW OF FOREIGN-BORN WORKERS** 250

U.S.
U.K.
JAPAN
200 200
150 150
100 100
50 50
1990 1994 1998 2002 2006 2010 2014

* SOURCE: IMF.
** SOURCE: OECD.

While some workers may welcome a kinds of challenges. But you have not said
retreat from globalization and reduced whether this is your most likely scenario.
competition from low-wage countries,
weak economic growth threatens to BCA: It is certainly not inevitable, but
make inequality worse. In a low-growth something has to change for it to be
world, the unskilled fare worse than avoided. Positive developments would
those with skills and higher education. be the adoption of pro-growth reforms
Meanwhile, easy monetary policy is con- in those countries with numerous bu-
ducive to asset bubbles, again benefiting reaucratic obstacles to new business
those who are better off. The danger formation and entrepreneurship. And
would be that at some point, inequality we are especially thinking of many euro
becomes a big enough issue to trigger a area countries in this regard. At the same
political response. time, increased willingness to engage in
selective government-funded infrastruc-
The best way to reduce inequality is, ture projects would help.
of course, to bring up those at the bot-
tom. But there is no simple way to do Unfortunately, we fear that it may take
that in a demand-constrained world, more pain before we see a marked shift
especially if governments are unwilling in policy. In other words, things may
or unable to embrace fiscal activism. The have to get worse before they can get
risk then would be populist pressures to better. As we said before, we do not
bring down those at the top via more project another depression, but over the
punitive taxation of income and capital. next few years, growth seems more likely
That would make the economic growth to disappoint than to deliver positive
outlook even worse, but would allow surprises.
politicians to claim they were doing Mr. X: This is all quite depressing. Perhaps
something about the problem. we should move on to the specifics of your
A final danger of being in a low-growth forecasts, starting with the economic out-
world is that it can become increasingly look.
entrenched. Companies have less incen-
tive to invest when they are gloomy The Economic Outlook
about the future, undermining the size Mr. X: It makes sense to start with the
and quality of the capital stock, with U.S. In contrast to the gloomy tone of our
negative consequences for long-run discussion so far, the news out of the U.S.
productivity. And productivity is the economy has been quite good with real
key to long-term prosperity. So the dan- GDP growing at annualized rates of 4.6%
ger is that low growth begets more low and 3.9% in the second and third quarters
growth. of 2014, respectively. And, as you noted,
the November employment report was very
Mr. X: I don’t need much convincing that
strong. Many forecasters expect real GDP to
an extended period of low growth poses all

rise by around 3% over the next couple of CHART 17
years. Is that in line with your expectations? The U.S. Economy: Decent,
But Not Great
Ann% Ann%
BCA: We are less optimistic. It is hardly Chg Chg
a surprise that we have had a couple of 12 U.S. S&P/CASE-SHILLER 12

good growth quarters recently given all HOME PRICES
20-CITY COMPOSITE
the positive forces at work. The stock 8 8
market and house prices have been 4 4

strong over the past year, and fiscal
policy has become less of a headwind to 0 0
growth. The pace of house price appre-

-4 -4
ciation has already slowed and we doubt
that the equity market will provide the Ann%
REAL DISPOSABLE INCOME
Ann%
same scale of support in 2015. Also, Chg Chg
6 6
while employment has improved, real
incomes are still only growing at a 2%- 4 4
2½% annual rate because real hourly 2 2
earnings are still increasing by less than

0 0
1% a year (Chart 17). And capital goods
orders remain disappointing, with the -2 -2
core measure (non-defense, excluding -4 -4
aircraft) showing average year-on-year

Ann% REAL AVERAGE HOURLY EARNINGS* Ann%
growth of only 6½% in the past six Chg Chg
months. Finally, the rise in the dollar will 1.0 1.0
have a negative impact on trade and on .5 .5
profits. 0 0
There are some positives for private -.5 -.5
demand. The retail gasoline price has -1.0 -1.0

dropped by around 30% in the past six
-1.5 -1.5
months, saving consumers about $110
million at an annual rate, or 0.8% of to- Ann% Ann%
tal disposable incomes. And the benefits Chg CAPITAL GOODS ORDERS: Chg
NONDEFENSE EXCLUDING AIRCRAFT
will be much greater for those with low
incomes, the group that has the high- 12 12
est propensity to spend. For someone 8 8
on median weekly earnings ($41,000

4 4
a year) and consuming the average
amount of gasoline, the oil price savings 0 0
in the past six months are equivalent to

-4 -4
a wage increase of 1.6% over the course © BCA Research 2015
of a year. And the gasoline price has not 2011 2012 2013
* TOTAL PRIVATE NONFARM, ALL EMPLOYEES.
2014
bottomed yet.
We should also see a modest pickup in CHART 18
wage growth, although there will be an A Grim Euro Area Performance
offset in lower corporate margins. Fi- REAL GDP
U.S.
nally, there does remain a case for faster 112 EURO AREA 112
growth in capital spending, given an ag-

110 110
ing capital stock and the need to boost
productivity. However, as we discussed 108 108
earlier, it requires an act of faith that

106 106
companies actually will follow through
with increased spending. 104 104
In sum, the U.S. is in better shape than 102 102
most other developed economies, but the

performance is hardly anything to get ex- 100 100
cited about. The drop in oil prices could REAL GDP
keep growth above trend in the first half GERMANY

FRANCE
of 2015, but it should then drop back 110 EURO AREA PERIPHERY* 110
into the 2%-to-2½% range, which is be- 108 108

low the consensus expectation.
106 106
Mr. X: The U.S. economy is at least grow-

ing which is more than can be said for 104 104
many European economies. Problems in 102 102
the euro area in recent years were associ-

ated with the peripheral countries that 100 100
recklessly used credit and/or lost ground on 98 © BCA Research 2015 98
competitiveness. But even German growth 2009 2010 2011 2012 2013 2014
has slowed a lot in the past year, and defla- * GDP-WEIGHTED AVERAGE OF GREECE, IRELAND, ITALY, PORTUGAL, AND SPAIN;
BASED ON IMF DATA.
tion has become a bigger concern through- NOTE: ALL SERIES REBASED TO 2009 Q2 = 100.
out the region. Is there any prospect for a

decent revival in euro area growth in the 0.7% in the euro area (Chart 18). It
coming one or two years? is hard to call that a recovery at all. Of
course, this aggregate masks major differ-
BCA: It truly has been a miserable recov-
ences between countries with average an-
ery in the region. The 2007-09 down-
nualized growth since 2009 Q2 of 2% in
turn was deeper than in the U.S. and real
Germany, 1% in France, -0.4% in Italy
euro area GDP went back into recession
and Spain, and -4.2% in Greece.
in the second half of 2011, declining
for seven consecutive quarters. Both the Let’s start with the good news. The
U.S. and euro area bottomed in 2009 worst-affected peripheral economies bot-
Q2 and since then, annualized growth tomed in the first half of 2014 as the fis-
has averaged 2.3% in the U.S., but only cal noose loosened. In fact, fiscal policy

ceased to be a headwind to euro area CHART 19
growth in 2014, after subtracting 1.3% Less Deleveraging In The Euro Area
% %
from growth in 2013. Of course, the im- EURO AREA
CREDIT TO PRIVATE SECTOR
plication is that the underlying euro area ANNUAL PERCENT CHANGE
growth picture was even worse than it 2

3-MONTH RATE OF CHANGE,
ANNUALIZED
2
appeared on the surface. But we should

not give up yet on the positive news.
0 0
As you know, the region’s banks have

been under tremendous pressure to
-2 -2
boost capital ratios and clean up their
balance sheets. This meant fierce delever-
aging, with a negative impact on credit -4 -4
availability and thus, economic activity.

This phase has passed its worst in terms EUR
Bn
EUR
Bn
of the impact on growth. As with fiscal NET LENDING TO
HOUSEHOLD AND BUSINESS SECTORS*
policy, economic growth is impacted 20 20
by the second derivative of credit flows

– in other words, it is the pace of de-
10 10
leveraging that matters. On that basis,
things have improved with a slowing
pace of the decline in bank lending to 0 0
the private sector (Chart 19). Adjusted

for sales and securitization, net loans to -10 -10
households and nonfinancial corpora-

tions recently have edged into positive © BCA Research 2015
territory. 2010 2012 2014

* SHOWN SMOOTHED. LOANS ADJUSTED FOR SALES
AND SECURITIZATIONS.
Finally, the drop in both oil prices and SOURCE: ECB.
bond yields is positive for demand. Fur-

ther QE by the ECB also could push
down the euro, helping export growth, risk averse given the economy’s recent
but that is more uncertain. We can get performance, arguing against much of a
into that shortly when we discuss cur- revival in hiring or capital spending. At
rencies. the same time, consumers are faced with
high unemployment (Germany/Aus-
That probably is it for the good news. tria excluded) and stagnant real wages
On the negative side, even if credit be- (Chart 20). Even in Germany, hourly
comes more available, we doubt that earnings rose only 1.7% in the year to
there will be much demand for bor- 2014 Q2, despite an unemployment rate
rowing. Businesses will remain very of only 5%.

CHART 20 CHART 21
It’s Tough For Euro Area Consumers Germany Falters
% % Ann% Ann%
Chg Chg
GERMANY
12.0 EURO AREA 12.0 30 30
FOREIGN MANUFACTURING
UNEMPLOYMENT RATE
ORDERS*
11.5 11.5
20 20
11.0 11.0
10 10
10.5 10.5
0 0
10.0 10.0
Ann% Ann%
9.5 9.5 Chg Chg
RETAIL SALES VOLUME*
2 2
Ann % Ann %
Chg Chg
1 1
.8 REAL HOURLY WAGES* .8

0 0
-1 -1
.4 .4
-2 -2
0 0
MANUFACTURING PMI*:
-.4 -.4 GERMANY
60 60
-.8 -.8
© BCA Research 2015 55 55
2010 2011 2012 2013 2014

50 50
* DEFLATED BY CONSUMER PRICE INDEX; BASED ON OECD DATA.
45 45
As you mentioned, it is particularly wor-

rying that the German economy has suf-
fered a marked deterioration in growth, 4
MANUFACTURING PMI**
GERMANY MINUS EURO AREA 4
after having held up well during most
3 3
of the recovery. The growth in export
orders has slowed sharply, retail sales 2 2
growth is mediocre, and the purchasing 1 1
managers’ composite index (PMI) has 0 0

declined. Notably, the gap between the
-1 -1
PMIs of Germany and the overall euro © BCA Research 2015
area has shrunk dramatically this year 2010 2011 2012 2013 2014
(Chart 21). The Bundesbank recently * SHOWN SMOOTHED.

** SOURCE: MARKIT.

slashed its 2015 growth forecast for the CHART 22
German economy to a mere 0.8%. Deflation Ahead?
Ann% Ann%
Chg Chg
The bottom line is that the euro area CONSUMER PRICE INFLATION:
EURO AREA
seems likely to be stuck in its low- 4 GERMANY 4
EURO AREA PERIPHERY*
growth environment for the foreseeable
future. 3 3
Mr. X: Does that mean the euro area will

slip into deflation? 2 2
BCA: Probably. The inflation rate for

1 1
the region is already down to 0.3% with
a range of +1.2% (Finland) to -1.8%
(Greece) across the 18 member countries 0 0

(Chart 22). The decline in oil prices
almost guarantees that the headline in- 2010 2012 2014
flation rate will drop into negative terri-

* GDP-WEIGHTED AVERAGE OF GREECE, IRELAND, ITALY, PORTUGAL, AND SPAIN.
tory for the overall region in the months

ahead. The core inflation rate, currently years ago. But the reflationary moves
at 0.7%, may not fall below zero, but were not without cost, a key one being a
it is sure to remain far below the ECB’s marked deterioration in fiscal finances.
desired level of 2% for a very long time. Leading indicators point to a slowdown
There are good reasons to believe that in growth, and the country’s weak pro-
the euro area is following in Japan’s ductivity performance is an ongoing
footsteps of an extended period of low concern (Chart 23).
growth and deflation. This means real
GDP growth of 1% or less over the next High house prices are a problem in the
couple of years. South-east of the country, but this is
more of a structural than cyclical prob-
Mr. X: What about the U.K.? Staying out lem, reflecting constraints on new sup-
of the euro area has proved to be a very ply and an ongoing influx of foreign
wise decision, judging by the economy’s capital. London remains a preferred
relative performance. But it has its own bolthole for overseas money fleeing do-
set of problems with continued large bud- mestic problems.
get deficits, sky-high house prices in the
London area, and considerable political The politics have certainly become more
uncertainty. complicated and messy. The various fis-
cal promises made to Scotland ahead of
BCA: The U.K., along with the U.S., the referendum on independence have
has been among the better-performing led other regions to ask for similar treat-
developing economies, partly reflecting ment. Meanwhile, relations between the
the aggressive policy actions taken a few U.K. and the EU are strained, and the

CHART 23 anti-Europe and anti-immigration UK
The U.K. Economy Is Losing Steam Independence Party has received enough
Ann%
U.K.
Chg
4
popular support to influence political
4
LEADING ECONOMIC debate in the country. We doubt that
INDICATOR* (LS)
3 INDUSTRIAL 2 the U.K. will vote to leave the EU if a
PRODUCTION (RS)
2 referendum on the issue is held in 2017,
1
0
but uncertainty could rattle business
confidence and the markets.
0 -2
-1
Overall, the U.K. will remain one of the
-4
better-performing economies in Europe,
PMI**
but it cannot be immune to develop-
65 MANUFACTURING
SERVICES
65
ments in the rest of the world. The Bank
of England will stay a lot more hawkish
60 60
than the ECB, so there is a low risk of
inflation.
55 55
Mr. X: We talked about the risk that the

50 50 euro area could follow a Japan-style path.
But what about Japan itself? Abenomics
45 45 has been a huge disappointment thus far,
Ann% Ann% but the authorities have upped the ante
Chg
HOUSE PRICES***
Chg
with more aggressive action from the BoJ.
8 8 Are there any reasons for more optimism?
BCA: We have not been long-term
4 4
bulls on Japan because of its structural
0 0
problems of terrible demographics and
a grim fiscal picture. And the ability of
-4 -4
Japan to make deep reforms along the
lines of the “third arrow” of Abenomics
Ann% PRODUCTIVITY: Ann% was always in doubt. Yet, we thought
Chg OUTPUT PER WORKER Chg
1.5 (WHOLE ECONOMY) 1.5 that the economy might do better in
1.0 1.0
2014 on the back of monetary refla-
.5 .5
tion and a drop in the yen. We were too
optimistic in that the lower yen has not
0 0
led to any significant improvement in
-.5 -.5
exports, and the sales tax hike did more
-1.0 -1.0
damage than expected (Chart 24).
-1.5 -1.5
It will be hard for the economy to pull
2011 2012 2013 2014
* SHOWN AS A DEVIATION FROM TREND. SOURCE: CONFERENCE BOARD.
out of its low-growth trap without a
** SOURCE: MARKIT/CIPS.
*** SOURCE: HALIFAX.

CHART 24 marked improvement in real wages. The
Japan Hits A Bump drop in oil prices will help, but what
Ann%
JAPAN Chg is needed is a pickup in nominal wage
120 LEADING COMPOSITE INDEX* (LS)
INDUSTRIAL PRODUCTION (RS) 15 growth, and that may be slow to appear,
116
10
despite the wishes of Prime Minister
112 Shinzo Abe. The bottom line is that
5
108 Japan will struggle to improve over the
104
0
next year, and that is consistent with the
-5 IMF forecasts we showed in Table 1 on
100
-10 page 6.
96
Ann% Ann%
Mr. X: Before we leave the developed
Chg NOMINAL AVERAGE MONTHLY CASH EARNINGS
REAL EARNINGS
Chg world, I have to ask about Canada – es-
2 2
pecially as that is where we are meeting.
1 1 How damaging is the recent drop in oil
0 0 and commodity prices to the economy?
-1 -1
BCA: It certainly is not good news for
-2 -2 the western side of the country. Tar
-3 -3
sands oil production is not really eco-
nomic at prices below $60 a barrel, and
Ann% CORE PRIVATE MACHINERY ORDERS** Ann% that industry has been an important
Chg
20
Chg
20
source of growth for Alberta. But Can-
ada is a two-sided economy. The manu-
facturing part of the economy – largely
10 10
in the east – is benefiting from a drop in
the currency and lower input costs. In
0 0
net terms, it probably is a wash.
-10 -10
At the end of the day, Canada’s GDP
tends to move very closely with that of
REAL EFFECTIVE EXCHANGE RATE*** (LS)
EXPORT VOLUMES**** (RS) the U.S., even though the two economies
104
90
have a different structure (Chart 25).
100 So if the U.S. economy grows at a 2%-
to-2½% pace, then that is a reasonable
80
96
assumption for Canada as well. But, the
92
country does have some additional risks,
70
beyond its exposure to resource prices.
88 As we mentioned earlier, house prices
60
relative to income are among the highest
84
2011 2012 2013 2014

in the developed world and the ratio of
* SOURCE: CABINET OFFICE.
** EXCLUDING VOLATILE ORDERS (SHIPS AND ELECTRIC POWER COMPANIES).
household debt-to-income also is
*** SOURCE: J.P. MORGAN CHASE & CO.
**** SHOWN SMOOTHED.

CHART 25 India’s new government has pledged a
Can You Tell Them Apart? number of reforms to boost the coun-
Ann% Ann%
Chg Chg try’s economic performance, but it
remains to be seen whether this will be
4 4
successful. The country is plagued by
under-saving, under-investment, a cur-
2 2 rent account deficit, and by excessive
and growth-sapping regulations and bu-
0 0
reaucracy. We are skeptical that enough
will change to dramatically improve
near-term growth prospects.
-2 REAL GDP -2
CANADA
U.S.
Turning to China, we continue to be-
lieve that a hard landing can be avoided.
-4 -4
© BCA Research 2015 However, it is clear that growth will
1990 1995 2000 2005 2010 be slower than we previously expected
over the next couple of years, not least
extremely elevated. This does not mean because Chinese exports face a more
that there will be a destructive crash, but challenging global environment. Real
it is a source of vulnerability. estate excesses continue to unwind with
construction and prices both falling
Mr. X: Let’s move on to the emerging
(Chart 26). At the same time, retail sales
world, especially the so-called BRICs.
volume and total fixed investment are
Brazil and Russia have moved from star
still growing at a double-digit pace.
to basket-case status and China remains
a source of great concern to me. You have As noted earlier, the fact that Chinese
been correct in predicting that China banks are largely state-owned does pro-
would avoid a hard landing, but the jury is vide protection against the destructive
still out on whether they can unwind their financial consequences of a real estate
credit-driven real estate bubble without a bust. The government will backstop the
lot more economic and financial pain. major banks in the event of a serious
problem with bad loans. And the fiscal
BCA: The economic outlook for all
position does give room for maneuver
commodity-dependent countries has
with a general government deficit of
taken a marked turn for the worse as a
only 1% of GDP and gross debt only
result of the sharp deterioration in their
around 40% of GDP, according to IMF
terms of trade, and Russia has faced
data (Chart 27).
the additional pressures of economic
sanctions from the West. Russia faces a We are not unaware or complacent about
deep recession as does Brazil. Absent a the many challenges China faces in the
rebound in resource prices, these econo- years ahead, including the need to shift
mies face a very difficult time. toward a more consumption-oriented

CHART 26 CHART 27
China: Slowing, But Not Collapsing No Problems With China’s
Ann%
Chg
Ann%
Chg
Government Finances
% %
35 CHINA 35 CHINA GENERAL GOVERNMENT
1 1
FLOOR SPACE OVERALL BALANCE*
30 UNDER CONSTRUCTION OF 30 (PERCENT OF GDP)
COMMODITY BUILDINGS*
0 0
25 25
20 20
-1 -1
15 15
-2 -2
Ann% RESIDENTIAL FLOOR SPACE SOLD** Ann%

Chg Chg
40 40
% %
30 30 42 42
GROSS GOVERNMENT DEBT*
20 20
40 (PERCENT OF GDP) 40
10 10
38 38
0 0
-10 -10 36 36
34 34
Ann% PROPERTY PRICES*** Ann%
Chg BEIJING Chg
32 32
SHANGHAI
SHENZHEN Bn Bn
20 20
US$ FOREIGN US$
EXCHANGE RESERVES
10 10
3200 3200
0 0
2400 2400
-10 -10
1600 1600
Ann% Ann% 800 800

Chg Chg
15 REAL RETAIL SALES** 15
14 14 2000 2002 2004 2006 2008 2010 2012 2014

* SOURCE: IMF WORLD ECONOMIC OUTLOOK, OCTOBER 2014.
13 13
12 12 growth model, to put in place a stable

11 11
source of tax revenue for local govern-
ments, to clean up and privatize the
Ann%
FIXED ASSET INVESTMENT
Ann% banking sector, and to root out corrup-
Chg
26
Chg
26
tion and improve governance and the
rule of law. These are not trivial issues
22 22
and will take a long time to resolve. In
18 18 the meantime, growth should remain
14 14 around 7%, although we do not rule out
10 © BCA Research 2015 10
a dip below this level for a while. The
2011 2012 2013 2014
central bank’s recent reduction in interest
* PROPERTY PURCHASED AND/OR
rates indicates that the authorities will be
RENTED AT PRICES DETERMINED BY THE MARKET. SHOWN SMOOTHED.
** SHOWN SMOOTHED.
*** SOURCE: CENTALINE; PRICE INDEX COVERS PRIMARY
responsive to a further slowing in growth.
AND SECONDARY RESIDENTIAL, OFFICE AND RETAIL MARKETS.

Overall, the emerging market universe the most recent drop in nominal yields
is not likely to see the growth improve- relates to a plunge in inflation expecta-
ment expected by the IMF. As we tions rather than a further decline in real
showed in Table 1 on page 6, in the yields (Chart 28).
October World Economic Outlook, the
IMF projected that emerging economy The low level of real yields is a reflection
growth will increase from 4.4% in 2014 of an ongoing problem that we discussed
to 5% in 2015. However, the recent last year – an excess of desired global
drop in oil and commodity prices has savings relative to perceived investment
undermined that forecast. The IMF had opportunities. At the end of the day, sav-
assumed that the Brent price will average ings must always equal investment and
$104 a barrel in 2015 and that is far too it clearly requires an extremely low level
optimistic. EM growth in 2015 is cer- of interest rates to achieve this balance.
tain to slow from the 2014 pace. Given the economic picture that we just
talked about, it does not appear as if
this situation will change anytime soon.
Bond Market Prospects
Therefore, yields are likely to stay at un-
Mr. X: I was hoping that you would cheer usually low levels for a while longer, and
me up about the economic outlook, but we cannot rule out further declines if
you are just as gloomy as me. And it seems global growth disappoints.
that markets – well, at least bond inves-
tors – share our mutual concerns. I am Overall, we recommend sticking with
stunned by how much yields have fallen a neutral duration position in fixed in-
in some countries and am now struggling come. Although we look for yields to
to know what to do with my bond invest- rise over the next few years, the near-
ments. I like the protection that bonds give term picture is benign. To copy Fed lan-
me against downside economic risks, but I guage, our bond view will remain “data
don’t see any value at current low yields. dependent” and we will shift to a more
cautious stance if growth shows signs of
BCA: As we noted earlier, the majority exceeding our expectations. With the
of investors also were caught off base by U.S. economy growing at a close-to-
this year’s continued solid performance trend pace, it will require an upturn in
from bonds. By standard measures, growth prospects outside the U.S. for
government bond yields throughout the bond yields to have any sustainable up-
developed world offer poor value. Real side.
yields are negative in Europe, outside
of the periphery, and negligible in most Mr. X: What are your thoughts on yields
other countries. Even nominal 2-year in the euro area periphery? I find it ex-
government bond yields are negative traordinary that Ireland, Italy and Spain
in some European countries. This is can all borrow for 10 years at a lower rate
not a normal state of affairs. However, than the U.S.

CHART 28
Unusually Low Bond Yields
% % % %
U.S. 5 5
U.S.
2 2
4 4
1 1 3 3
2 2
0 0
1 1
-1 -1
0 0
-2 -2
5-YEAR
GOVERNMENT BOND YIELD 5-YEAR, 5-YEAR FORWARD
GOVERNMENT BOND YIELD
% CPI SWAP RATE % % %
CPI SWAP RATE
GOVERNMENT BOND YIELD
MINUS CPI SWAP RATE GOVERNMENT BOND YIELD
MINUS CPI SWAP RATE
4 4
GERMANY
2 2
GERMANY
3 3
1 1
2 2
0 0 1 1
0 0
-1 -1
-1 -1
% U.K. % % %
U.K.
5 5
3 3
4 4
2 2
3 3
1 1
2 2
0 0
1 1
-1 -1
0 0
-2 -2
© BCA Research 2015 -1 © BCA Research 2015 -1
2011 2012 2013 2014 2011 2012 2013 2014

BCA: It does seem strange at first sight, BCA: That is a tricky question to an-
but you should not forget that these swer. From a valuation perspective, none
economies are considerably weaker than of the major bond markets are attractive.
the U.S. and they are either in or close Chart 29 shows a value ranking based
to deflation. Moreover, the market is on current 10-year real yields relative
expecting further QE from the ECB, to their historical average, expressed in
while the Fed has ended its program and standard deviations. You can see that
expects to be raising short-term interest the core euro area countries have the
rates within the next six-to-nine months. most overvalued markets but even the
In contrast, the ECB may not be able to U.S. is expensive, with the real yield 1.5
raise rates for several years. standard deviations below its historical
average.
Peripheral bonds trade as a spread over
the bund curve, which has been flat- Given the current environment of
tened by market expectations that the weak growth and QE by the ECB and
real short-term policy rate will be nega- BoJ, valuation is not going to be a reli-
tive at least until the end of the decade. able predictor of the near-term direc-
Given the prospective expansion in the tion of yields. Euro area yields may be
ECB’s balance sheet, this helps to ex- overshooting, but that will persist for a
plain why peripheral bond yields can be while. Thus, we would not be surprised
sustained below U.S. yields. to see euro area bonds continue to
outperform Treasuries for several more
Clearly, a lot will depend on economic months. At some point in the first half
trends. If the euro area economy contin- of 2015, it probably will be appropriate
ues to disappoint then the ECB will step to overweight Treasuries relative to euro
up its actions, including purchases of area bonds. It is all a matter of timing,
sovereign bonds. While some argue that and that will reflect economic develop-
the ECB does not have the authority for ments.
such a move, that view is not consistent
with statements from ECB officials. If Currently, U.S. Treasuries are priced for
the euro area looks to be going back into the Fed to start raising rates in October.
recession, then you should not underes- That is later than the majority of FOMC
timate the policy response. Thus, while members currently expect. If the U.S.
peripheral spreads are low, they could economy does grow above trend in the
tighten even further in response to ad- first half, then it will greatly increase
ditional QE. the odds of a June rate hike, leaving the
Treasury market vulnerable as it reprices
Mr. X: In relative terms, the U.S. is now a the timing of Fed moves. However, that
high-yield country and I would expect this could create a buying opportunity, as
to attract a lot of foreign buying. Would I slowing growth in the second half calms
be better off in U.S. Treasuries or euro area Fed rate fears.
bonds on a currency-hedged basis?

CHART 29
Valuation Ranking* Of Government Bond Yields
1.5
Better
1 value
NETHERLANDS
SWITZERLAND
AUSTRALIA
GERMANY
DENMARK
0.5
BELGIUM
AUSTRIA
FINLAND
IRELAND
CANADA
SWEDEN
NORWAY
FRANCE
MEDIAN
KOREA
JAPAN
SPAIN
ITALY
U.K.
U.S.
0
PORTUGAL
GREECE
NEW ZEALAND
-0.5
-1
-1.5
-2
-2.5
-3
* RANKING IS BASED ON HOW FAR CURRENT REAL YIELDS ARE FROM THEIR HISTORICAL AVERAGE, EXPRESSED IN NUMBER OF STANDARD DEVIATIONS.
Mr. X: You have long recommended over- remain strong. The drop in oil prices
weighting spread product relative to gov- caused particular problems for energy
ernment bonds, and that strategy worked sector bonds but other sectors have fared
well until last June. What is your view better. Nevertheless, we are not assum-
now? ing a renewed compression in corporate
spreads, and the excess return will be
BCA: The backup in U.S. corporate restricted to the yield pickup relative to
yield spreads during the past year has Treasuries. For high yield, that currently
boosted value, so we do still prefer cor- is a yield gain of more than 200 basis
porates to government bonds. As long as points, even after adjusting for expected
the economy continues to grow at a pace net defaults over the next year.
above 2%, then the corporate default
rate should stay at a low level. Our Cor- We did not recommend emerging
porate Health Monitor has deteriorated market bonds a year ago and we have
in the past year, reflecting increased not changed that view. The economic
corporate leverage (Chart 30). Much of and currency fundamentals for emerg-
the increased debt was used to buy back ing market bonds are unattractive and
equity, but corporate finances generally although spreads have increased, this

CHART 30 CHART 31
Defaults In U.S. Corporate Avoid EM Corporate Credit
BPs
Bonds Remain Low EMERGING MARKETS
2 U.S. CORPORATE HEALTH MONITOR* 2 CURRENCIES* VS U.S. DOLLAR (LS)
102 100
SOVEREIGN SPREADS** (INVERTED) (RS)
1 1
101
DETERIORATING HEALTH 150
0 0
100
-1 -1 200
99
-2 IMPROVING HEALTH -2
98 250
% 12-MONTH TRAILING DEFAULT RATE** % 97

300
14 14
2010 2011 2012 2013 2014 BPs
10 10 2 0
CORPORATE HEALTH INDICATOR*** (LS)
CORPORATE SPREADS**** (INVERTED) (RS)
6 6 200
2 2 400
CORPORATE BREAKEVEN SPREAD**:

BPs INVESTMENT-GRADE INDEX BPs
0 600
PRE-CRISIS AVERAGE
100 100
800
80 80
-1
60 60 1000
40 40 2002 2004 2006 2008 2010 2012 2014

* EQUITY MARKET-CAP WEIGHTED; REBASED TO 2010 = 100;
SOURCE: MSCI INC. (SEE COPYRIGHT DECLARATION)
20 20 ** EQUITY MARKET-CAP WEIGHTED INCLUDING 13 EMERGING ECONOMIES;
SOURCE: J.P. MORGAN CHASE & CO.
*** USING STANDARDIZED RATIOS;
DEFAULT-ADJUSTED HIGH-YIELD SPREAD*** ABOVE 0 MEANS GOOD HEALTH; BELOW 0 MEANS POOR HEALTH.
**** CEMBI BROAD CORPORATE SPREADS; SOURCE: J.P. MORGAN CHASE & CO.
PRE-CRISIS AVERAGE
BPs BPs
1000 1000
800 800
does not fully compensate for the risks.
Weaker EM currencies will raise the cost
600 600
of debt servicing, while deteriorating
400 400 corporate health warns of a widening in
200 200
EM corporate spreads (Chart 31).
0 © BCA Research 2015 0 Mr. X: Let me see if I have this straight.

2006 2008 2010 2012 2014
Bonds are expensive and yields should rise
* COMPOSITE OF 6 KEY FINANCIAL RATIOS FOR THE NON-FINANCIAL
CORPORATE SECTOR.
over the medium term. But, given weak
** SOURCE: MOODY'S INVESTORS SERVICE.
*** OPTION-ADJUSTED SPREAD LESS PROJECTED DEFAULT LOSSES. growth, low inflation and QE policies, you

don’t expect much change in the near run, Chart 32 shows the valuation ranking of
hence your stance of keeping benchmark developed market nonfinancial stocks,
duration. And it is still a bit too soon to measured by the gap between the cur-
overweight U.S. Treasuries, despite their rel- rent cyclically-adjusted price-earnings
atively high yields. And I will do better with ratio (CAPE) and its historical average,
corporate bonds than with governments. again expressed in standard deviations.
Japan comes out as the cheapest market
BCA: Yes, that captures our view nicely. on this basis, but current valuations are
It’s not very exciting, but that’s hardly a flattered by the fact that the historical
surprise given current yield levels. The CAPE was very high for a long time.
caveat is that if economic growth sur- Nonetheless, Japan is still one of the
prises on the upside over the next year, more attractive markets from a valuation
then bonds will be vulnerable to a very perspective, as is the U.K. and some of
nasty sell-off. We will, of course, refine
PORTUGAL
the peripheral euro area markets.

our view over the course of the year in
JAPAN
line with economic developments. Markets generally move for a reason,

and investors have focused on the U.S.
Equity Market Prospects because its economy and thus earnings
have been superior to elsewhere, and
Mr. X: Moving on to the equity market,
until recently, the Fed has been the most
we talked a year ago about how there was
aggressively easy central bank. As we
a strong bullish consensus on euro area
have discussed, the U.S. economy still
stocks, but my inclination was to stay with
looks the best of a bad bunch, but the
the U.S. and you did not try to dissuade
earnings outlook is becoming more chal-
me from that view. That was a good deci-
lenging. Moreover, often it is changes at
sion, but now it is more difficult because
the margin that matter, and even a mod-
U.S. stocks have already moved up more
est downgrading of U.S. expectations
than I expected. Does it now make more
relative to those of Europe and Japan
sense to shift out of the U.S. into the areas
might be enough to swing sentiment.
that have lagged over the past year?
Relative monetary policy also should be
BCA: The outperformance of the U.S.
more in favor of Europe and Japan, with
market has been very impressive, but it
central banks in these regions still em-
has indeed taken its toll on relative valu-
bracing QE. And if the ECB does not
ations. The S&P is trading at 17-times
engage in more aggressive QE it will be
trailing operating earnings, and almost
because the euro area economy is doing
27-times cyclically-adjusted reported
much better, and that also should sup-
earnings. These are above the 60-year
port the relative outperformance of the
historical averages by around 6.5% and
region’s equities. So to answer to your
14%, respectively. In contrast, virtually
question, some diversification out of the
every other developed market is trading
U.S. is appropriate.
below its historical valuation.

CHART 32
Valuation Ranking Of Developed Equity Markets
1.4
Better DEVELOPED MARKET NONFINANCIAL EQUITY VALUATIONS

1.2 value (RELATIVE TO EACH COUNTRY’S HISTORY)*
1.0
0.8
0.6
NETHERLANDS
SWITZERLAND
SWEDEN
0.4
NEW ZEALAND
NORWAY
AUSTRALIA
PORTUGAL
GERMANY
AUSTRIA
0.2 FINLAND
CANADA
FRANCE
MEDIAN
IRELAND
JAPAN
SPAIN
ITALY
U.K.
U.S.
0.0
-0.2

-0.4
* RANKING IS BASED ON HOW FAR CURRENT CYCLICALLY-ADJUSTED PRICE-EARNINGS RATIO IS FROM THE HISTORICAL AVERAGE, EXPRESSED IN NUMBER OF
STANDARD DEVIATIONS.
Mr. X: Let’s talk about Japan. This has combination of easy money and excel-
been such a horrible market for such a long lent corporate earnings. Japan also has
time that I am reluctant to invest there. had easy money, but earnings have
You show that valuations are decent but is underperformed those of the U.S.
that a good enough reason to buy Japanese Nonetheless, earnings in Japan are
stocks? benefiting from the drop in the yen,
while those in the U.S. will be ham-
BCA: Japan has indeed been a heart- pered by the firmer dollar. Thus, rela-
breaker of a market and valuations have tive earnings performance will be more
not been a good guide to performance favorable for Japan for a while, even as
in recent years. It is important to note the economy continues to lag.
that a drop in the yen has been a par-
ticular problem for overseas investors. In We already have noted that Japan has
fact, in local-currency terms, Japan has serious structural challenges, and we
outperformed the world index during doubt that Abenomics will make a huge
the past two years (Chart 33). difference to the long-run outlook. But
that does not rule out a period of equity
The U.S. has been such a good mar- market outperformance, and we are
ket because it enjoyed the unbeatable comfortable with a tactical overweight in

CHART 33 The Fed will tighten only when it is sure
Japan’s Relative Performance: that the economy is on a sound foot-
Currency Matters ing. In that respect, equities should not
JAPAN RELATIVE TO WORLD:
STOCK PRICES
be harmed by rising rates – at least, not
130 130
IN LOCAL-CURRENCY TERMS until they get to a restrictive level. And
IN COMMON-CURRENCY TERMS
that is two or three years away. Equities
120 120 will be in greater trouble if the Fed is
not able to raise rates in the next couple
of years because that would suggest the
110 110
economy has not recovered, with bearish
implications for earnings.
100 100
U.S. equity prices may move modestly
higher in 2015, but Wall Street will
90 90
not remain the top performing major
© BCA Research 2015 market. That argues for no more than a
2013 2014 benchmark weighting.
NOTE: BOTH SERIES ARE REBASED TO JAN. 2013 = 100;
BASED ON MSCI INC. DATA (SEE COPYRIGHT DECLARATION).
Mr. X: Emerging equity markets have
continued to underperform, as you had
Japan. The currency has some downside expected. What should I look for to know
risks, but the good news is that this can when it is time to buy? And among the
be hedged at minimal cost. various markets, which ones do you like
the most and the least? And what about
Mr. X: I would like to delve into U.S.
developed commodity-oriented markets
equities in a bit more detail. You have
such as Canada?
referred to a more difficult earnings envi-
ronment and relatively poor valuations. BCA: Our current assessment is that
Are you actually expecting the market to EM equity underperformance is not
decline over the coming year? over yet. The odds are that things will
likely get worse before a buying oppor-
BCA: A correction is long overdue,
tunity arises. The rationale for keeping
but there is no indication of a looming
low exposure toward EM risk assets is
bear market. Major declines typically
based on three factors: valuation, eco-
are associated with tight money and/or
nomic growth and commodity prices.
major earnings declines and neither is in
prospect over the next 12 months. It is Valuation: EM stocks are still not
quite possible that the market will suffer cheap. While the market cap-weighted
a “rate hike tantrum” at some point next price-earnings ratio (PER) is around
year as the timing of the Fed’s first inter- 13, the equal sector-weighted PER is
est rate increase approaches, but that a much higher 18. In comparison, the
should be a temporary affair, much like equal sector-weighted PER for U.S.
the bond market’s 2013 “taper tantrum”. stocks is 19. Thus, adjusted for sector

CHART 34 CHART 35
EM Valuations Are Not Cheap EM Profit Growth To Slow
Ann% Ann%
EMERGING MARKETS Chg EMERGING MARKETS: Chg
PRICE-TO-EARNINGS RATIO*: EARNINGS-PER-SHARE* (LS)
EQUAL SECTOR-WEIGHTED** M1 GROWTH** (RS)
MARKET-CAP WEIGHTED 25
24 24
50
20
20 20
25
15
16 16
0
10
12 12
-25 5
EQUAL SECTOR-WEIGHTED © BCA Research 2015

PRICE-TO-EARNINGS RATIO*:
EMERGING MARKETS 2000 2002 2004 2006 2008 2010 2012 2014
U.S. * CALCULATED AS STOCK PRICES DIVIDED BY PRICE-TO-EARNINGS RATIO;
24 24 SHOWN AS A 6-MONTH MOVING AVERAGE IN LOCAL CURRENCY TERMS.
SOURCE: MSCI INC. (SEE COPYRIGHT DECLARATION)
** EQUITY MARKET-CAP WEIGHTED AGGREGATE OF 20 EM ECONOMIES,
SHOWN ADVANCED.
20 20
consumer staples trade at a PER of 27 and
a price-to-book value ratio of 3.7. In short,
16 16
everything that has decent fundamentals
is expensive and segments that have low
multiples are “cheap” for a reason. We are
12 12 waiting for equal sector- weighted mul-
© BCA Research 2015 tiples to drop below their historical mean
2004 2006 2008 2010 2012 2014 before a buying opportunity transpires.
* SOURCE: MSCI INC. (SEE COPYRIGHT DECLARTAION)
** CALCULATED AS A SIMPLE AVERAGE OF 10 EM SECTORS;
TRUNCATED AT 24. Economic growth: Risks to EM econom-
ic growth are skewed to the downside.
biases, the discount of EM equities to Importantly, money and credit growth
U.S. stocks is only 5% (Chart 34). are decelerating and this has bearish im-
The large discrepancy between market plications for profits (Chart 35). And
cap-weighted and equal sector-weighted the earlier credit excesses in a number of
multiples reflects the fact that, in some developing economies suggest that the
countries, energy stocks, banks and slowdown in money and credit growth
state-owned companies trade at very low has further to run. This is all part of the
multiples. This is for a reason and these death of the Debt Supercycle that we
stocks represent value traps. talked about earlier. It will take consider-
able monetary and fiscal easing by EM in
Outside of the low PER sectors, equity val- general, and China in particular, before
uations are rather expensive. For example, credit and business cycles regain traction.

Commodity Prices: EM bull and bear CHART 36
markets go hand-in-hand with com- EM, Canada And Australia:
modity cycles. To be bullish on EM Commodities Are Key
risk assets, one needs to be bullish on 1400
EMERGING MARKETS STOCK PRICES* (LS)
CRB** RAW INDUSTRIALS (RS)
commodities. At this point, we do not 1200 600
foresee a major bottom in commodity

1000
prices, and without it, a sustainable rally 500
800
in EM stocks is unlikely. 400
600
The positive correlation between EM 400

300
stocks and commodities is due to two

factors: First, many EM countries are CANADIAN STOCK PRICES* (LS)
CRB** RAW INDUSTRIALS (RS)
commodity producers. Second, non- 2000 600
commodity producers’ stocks and cur-
rencies (for example, emerging Asia) 1600 500
positively correlate with commodities be- 1200 400

cause resource prices, to some extent, are
an indicator of global economic activity. 800 300
As regards to country allocation, our AUSTRALIAN STOCK PRICES* (LS)
favored equity markets currently are CRB** RAW INDUSTRIALS (RS)
Taiwan, China, Korean technology and 1000 600
domestic sectors, Malaysia, Singapore, 800 500

central Europe and Mexico. Our major
underweights are Brazil, Colombia, Tur- 600 400
key, South Africa, Thailand and Indone- 400 300

sia. © BCA Research 2015
2004 2006 2008 2010 2012 2014

You also asked about Canada and Aus- * IN U.S. DOLLAR TERMS, SOURCE; MSCI INC. (SEE COPYRIGHT DECLARATION).
tralia. Again, it is largely down to the ** COMMODITY RESEARCH BUREAU, INC.
trend in commodity prices (Chart 36).

And because we are not very bullish on
that front, we recommend that you con- BCA: We continue to recommend a
tinue to stay away from these markets. defensive sector stance given the delicate
The declines in the Canadian and Aus- state of the global economy. This means
tralian dollars will help profits of export- focusing on areas such as consumer
ers so there might be some opportunities staples, utilities, health care and selected
in manufacturing, but the investment financials, and avoiding consumer dis-
opportunities in this sector are limited cretionary, materials and industrials. The
in these countries. search-for-yield theme is likely to remain
in place during 2015, sustaining investor
Mr. X: Before we leave the equity market, interest in companies with dependable
please tell me your latest thoughts on sec- dividends.
tor strategy.
CHART 37 CHART 38
Stick With Defensive Stocks Waiting For Financials To Do
Ann%
Chg GLOBAL Better, Bearish On Materials
INDUSTRIAL PRODUCTION* (LS) %
15
STOCK PRICES: CYCLICALS** 1.2 U.S.
RELATIVE TO DEFENSIVES*** (RS) S&P FINANCIALS
RELATIVE TO S&P 500 (LS) 5
10 3-MONTH T-BILL RATE (RS)
.30
1.1
4
5
.25
1.0 3
0
.20
2
-5 .9
.15 1
-10
.8
2008 2010 2012 2014

GLOBAL STOCK PRICES: MATERIALS* (LS)
* SOURCE: NETHERLANDS BUREAU FOR ECONOMIC POLICY ANALYSIS. CRB** RAW INDUSTRIALS (RS)
** AVERAGE OF ENERGY, MATERIALS, CONSUMER DISCRETIONARY,
AND INDUSTRIALS. 320
*** AVERAGE OF CONSUMER STAPLES, TELECOMMUNICATION SERVICES,
UTILITIES, AND HEALTH CARE. 600
NOTE: ALL STOCK PRICES IN U.S. DOLLAR TERMS, MSCI INC. DATA (SEE
COPYRIGHT DECLARATION).
280
500
240
Global defensive stocks have outper-
formed cyclicals in recent years, reflect- 200
ing persistent disappointments with 400
global growth (Chart 37). It is too soon 160
to bet against this trend, especially as

300
the firm dollar will put pressure on U.S. 120 © BCA Research 2015
earnings. 2008 2010 2012 2014

* IN U.S. DOLLAR TERMS, MSCI INC. DATA (SEE COPYRIGHT DECLARATION).
With regard to financials, we would em- ** COMMODITY RESEARCH BUREAU, INC.
phasize the U.S. over the euro area. This

reflects a better-capitalized banking sec- an uptrend given the pressure to boost
tor, a more advanced deleveraging cycle, productivity and competitiveness. More-
and the fact that the Fed will be ahead over, many of the large-cap IT stocks are
of the ECB in raising rates, to the ben- cash rich and now pay decent dividends.
efit of interest margins. Low rates have
not been good for the sector’s relative Not surprisingly, the materials sec-
performance, and it should do better in tor has moved broadly in line with the
anticipation of rate hikes (Chart 38, top trend in commodity prices (Chart 38,
panel). We also would stay with an over- second panel). Despite the chance for a
weight in technology, but not the over- counter-trend bounce, we recommend
hyped social media stocks. Corporate staying away from these stocks given
spending on technology will remain in our gloomy view on the prospects for

CHART 39
The Long-Run Trend In Real Commodity Prices
REAL* RAW INDUSTRIALS PRICES (In US$ Terms)

TREND**
TREND +/- TWO STANDARD DEVIATIONS
5.0 5.0
4.5 4.5
4.0 4.0
3.5 3.5
3.0 3.0
1800 1820 1840 1860 1880 1900 1920 1940 1960 1980 2000
* ADJUSTED BY U.S. GDP DEFLATOR.
** TIME-TREND FROM 1800 TO PRESENT.
resource prices. We currently are neu- is overdone. Everyone has turned bearish
tral on energy stocks, waiting for a final on oil and other commodities: would this
washout in oil prices. be a good time to take a contrary view?
Of course, our sector views will evolve BCA: There always is the potential for
over the course of the year to reflect reversals after big market moves and
market moves and economic develop- yes, commodities could have a bounce
ments. For the moment, the key point after recent sharp declines. However,
is that we are avoiding taking aggressive we would view any such moves as tem-
positions in favor of a conservative and porary fluctuations within an ongoing
defensive posture. secular bear market – at least with regard
to metals and gold. We have already
Commodities And Currencies talked about oil where the story is more
complicated because we have to factor in
Mr. X: A year ago, you were bearish on
geopolitics and game theory among the
the underlying trend in commodity prices
various producers.
and you do not seem to have changed
that view. But prices have fallen a lot As we have noted many times in the
recently and I am wondering if the move past, commodity prices have fallen in

real terms over the long run, reflect- CHART 40
ing the impact of technology in boost- Real Industrial Commodity
ing supply and reducing consumption Prices Are Still Elevated
(Chart 39). The rise in real prices in the REAL CRB* METALS
decade to 2013 pushed them to the top 120 120
of their historical range and now we are 100 100
shifting back into the trend path.

80 80
Commodity demand from the emerging

60 60
world will no doubt grow strongly over
the next several years in line with urban- 40 40
ization and industrialization. However,

technology should ensure adequate sup-
plies to meet this demand. The recent 120 REAL OIL PRICES 120
10-year commodity bull market fol- 100 100

lowed a long period when prices were
very depressed and the sector had been 80 80
starved of new investment. This set the 60 60

scene for a strong rise in prices as EM
demand soared – especially from China. 40 40
But that catch-up phase has ended. 20 20

Current prices for industrial commodi-
ties are not particularly low by histori-
cal standards and there is no reason to 160 REAL CRB* FOODSTUFFS 160
expect supply shortfalls to drive prices 140 140
higher, at least in the next year or so 120 120
(Chart 40). 100 100
80 80
Mr. X: We can’t end our discussion of
commodities without talking about gold. I 60 60
should have taken your advice from a year 40 40
ago and stayed away from gold, but I con-

tinued to view it as a good hedge against REAL GOLD PRICES
extreme monetary policies and even defla- 100 100
tionary risks. That has not been a successful

80 80
strategy thus far, but I am not inclined to
give up now. 60 60
BCA: We have met with you for enough 40 40
years to know that it always is difficult 20 20

to persuade you with a negative view © BCA Research 2015
of gold. However, we still believe that 1970 1980 1990 2000 2010
* SOURCE: COMMODITY RESEARCH BUREAU, INC.
NOTE: ALL SERIES DEFLATED BY CONSUMER PRICE INDEX, REBASED TO JAN. 1980 = 100.

CHART 41 is not likely to do so now, absent a ma-
Gold Has Not Been A Good jor shock to the financial system. Most
Long-Term Investment likely the gold price will drift sideways
to a bit lower against a backdrop of low
1400 1400
inflation and a firm dollar.
GOLD RELATIVE TO TOTAL RETURNS
S&P 500
30-YEAR TREASURY BOND Mr. X: Perhaps you are right, but owning
1000 1000
some gold still seems a sensible hedge to me,
especially in a world where prospective re-
turns from other assets are not very attractive.
600 600 BCA: It is certainly true that the oppor-
tunity cost of owning gold is negligible
when interest rates are so low, and gold
200 200 is a hedge against a re-emergence of a
© BCA Research 2015 euro area crisis. Having around 5% of
1970 1980 1990 2000 2010
your portfolio in gold will not do you
NOTE: ALL SERIES REBASED TO MAR. 1968 = 100. any harm, but we would not advocate
greater exposure than that.
this remains an asset to avoid. There
have only been two periods since WWII Mr. X: Commodities clearly have been
when it was very advantageous to over- undermined by the dollar’s strength. Will
weight gold: the decade of the 1970s the currency stay strong? I understand the
and the decade between 2003 and 2013 reasons to be bullish on the dollar: the U.S.
(Chart 41). In the 46 years since the economy is likely to remain much stronger
gold price has freely floated, bullion has than Europe and Japan, the Fed will raise
underperformed the total return from rates before the ECB and BoJ, and, as was
U.S. stocks and long-term Treasuries by mentioned earlier, the U.S. is a high-yield
63% and 14%, respectively. country for those seeking income. It all
makes for a compelling argument, but the
The fact that gold prices have declined strength of the consensus trouble me. What
during the past two years, even as cen- are your thoughts?
tral banks stepped up their QE, was an
important signal that something had BCA: We share your concerns about
changed in market dynamics. Gold was the strong bullish consensus on the dol-
certainly a prime candidate – perhaps lar. Traders are more bullish toward the
the best candidate – to move into a dollar than at any time since the peak
bubble as a result of hyper-easy mon- of the tech bubble in the late 1990s
etary policies. Yet, although the bullion (Chart 42). Meanwhile, there is cor-
price did rise, it never went into the responding pessimism toward the yen
manic phase that characterizes the most and the euro.
powerful period of asset bubbles. And it

CHART 42 CHART 43
Traders’ Sentiment On Currencies Balance Of Payments Flows
% %
Are Euro-Friendly
% Of % Of
BULLISH CONSENSUS ON:
GDP BASIC BALANCE* GDP
90 U.S. DOLLAR 90 4 EURO AREA 4
U.S.
70 70
2 2
50 50
0 0
30 30
% % -2 -2
YEN
70 70 -4 -4
50 50
-6 -6
30 30 2006 2008 2010 2012 2014

* CURRENT ACCOUNT PLUS NET PORTFOLIO AND FOREIGN DIRECT INVESTMENT.
% EURO %
90 90
of the current account and net long-

70 70 term capital flows) is more relevant.
50 50
Although there has been much excite-
ment about the U.S. shale boom and
30 30
its impact on oil imports, the U.S.
continues to run a very large deficit on
2006 2008 2010 2012 2014
its basic balance. In contrast, the euro
SOURCE: MARKETVANE.NET
area is running a very large surplus.
This means that the U.S. has to rely on
short-term capital flows to balance its
The reasons for dollar optimism that you accounts, while the euro area is a large
mentioned are all valid, so we would capital exporter.
not want to take a strong opposing view
just for the sake of being contrary. But, The challenge in forecasting currencies is
there are some negatives to consider. that none look particularly attractive on
For example, the gap between the U.S. the basis of domestic fundamentals. And
and euro area balance of payments is ex- in a demand-deficient world, no coun-
tremely large and is in favor of the euro try really wants a strong exchange rate.
(Chart 43). Current account balances From a valuation perspective, the dollar
are not very helpful in predicting cur- is a bit expensive, the yen is cheap and
rencies, but the basic balance (the sum the euro is broadly neutral (Chart 44).

CHART 44 on the euro. This is because of both ex-
Real Effective Exchange Rates pected policy moves and relative balance
160
REAL EFFECTIVE EXCHANGE RATE
U.S.
160 of payments positions.
140 JAPAN 140
120
EURO AREA
120
Mr. X: Emerging market currencies have
been quite weak over the past year, with
100 100
the Russian ruble having a complete melt-
80 80
down. How do you see developments with
60 60
these currencies?
U.K.
CANADA
120
SWITZERLAND
120
BCA: Russia’s situation has been rather
unique, affected by both the oil price
100 100 collapse and economic sanctions. That
remains a currency to stay away from,
80 80
© BCA Research 2015 even though it is massively oversold
from a technical perspective. Given our
2000 2004 2008 2012
NOTE: ALL SERIES REBASED TO JAN. 2000 = 100.
pessimistic view on commodity prices,
we also would not recommend positions
SOURCE: J.P. MORGAN CHASE & CO.
in other resource-oriented currencies

such as the Brazilian real, or the South
However, even more than in other mar-
African rand.
kets, currencies can overshoot fair values
for extended periods of time. If the dollar holds firm as we expect,
then those currencies with a formal or
Currencies have been heavily influenced
loose peg will do well. That includes the
by the actual and expected actions of
Hong Kong and Singapore dollars and
central banks. The dollar benefits from
the Chinese renminbi. Other Asian cur-
the view that the Fed will be ahead of
rencies such as the Korean won are likely
the others in raising rates, while the yen
to get caught up in trying to stay com-
is undermined by the new aggressive
petitive against a weak yen. In a world of
stance of the BoJ. The euro situation is
competitive devaluations, emerging mar-
more complex. The ECB states that it is
ket currencies will tend to depreciate.
committed to more QE, but the internal
politics of the central bank are an ob- Mr. X: Are there any other potential cur-
stacle to action. Thus, there is a risk of rency developments I should be aware of?
disappointment on what the ECB is able
to achieve. BCA: The outlook for sterling is worth
a quick mention. The currency has
On balance, we would still side with the appreciated by more than 10% on a
view that the dollar will move higher trade-weighted basis since early 2013,
over the next 12 months, but we do not supported by positive economic growth
expect a large gain. On the other side, surprises. However, signs of renewed soft-
it is easier to be bearish on the yen than ness, an ongoing large current account

deficit and some looming political uncer- the world in an absolute sense, but it is
tainty point to significant downside risks in relative decline, with regional powers
for sterling. looking to carve out their spheres of in-
fluence. The keystone theme of our geo-
Lastly, the Canadian and Australian dol- political views is therefore multipolarity,
lars remain vulnerable to ongoing weak- or the absence of a hegemon willing
ness in commodity prices. Most of the and able to enforce global coordination.
downward adjustment in these curren- Multipolarity is theoretically and empir-
cies probably is over, but it will be diffi- ically known to increase the probability
cult for them to gain ground for as long of inter-state conflict, as more states pur-
as resource prices are under pressure. sue an independent foreign policy.
Geopolitical Risks As you note, not all crises affect global
Mr. X: We have not yet talked about the investors. Russia is indeed constrained
geopolitical environment and there is a lot by its military, economic and domestic
going on there that concerns me. None of variables. The Islamic State (IS) militants
the past year’s geopolitical turbulence seems in Iraq have also proven to be largely
to have affected the markets, but maybe we inconsequential to Iraq oil production,
can put that down to a mix of complacency and thus also remain largely investment
and the more powerful force of easy money. irrelevant. However, the combination
Things do not seem to be calming down of crises contributes to morose global
on the geopolitical front and I wonder if investment sentiment and provides a
investors should be paying more attention tailwind to safe-haven assets such as the
to these issues. I have no hope that the U.S. dollar and Treasuries. We expect
Middle East will ever be completely calm this to continue in 2015.
in my lifetime, yet the region appears to be Another major concern for investors in
becoming increasingly fragmented. Russia’s 2015 will be mounting domestic po-
more aggressive stance also is troublesome. litical risk in emerging markets. Weak
I realize that economic realities are a con- growth, currency depreciation, and term
straint on Russia’s military spending, but of trade shocks will have political reper-
the more it is pushed into a corner, perhaps cussions. Protests that engulfed Brazil
the more antagonistic it becomes toward and Turkey in 2013/14 were caused by
the West. What geopolitical developments grievances that were never really resolved
are you most focused on? and the economic backdrop has deterio-
BCA: The crises you refer to are all con- rated further. Furthermore, many EM
nected via an important shift in the countries lack the social shock absorbers
post-Cold War environment. For the of developed economies, such as a wel-
first time in almost 80 years, the global fare state and good governance. There-
distribution of power is becoming frag- fore, investors should not draw parallels
mented, and thus multipolar. The U.S. between current EM problems and Eu-
remains the most powerful country in rope’s lack of social unrest following its
debt crisis.
Speaking of Europe, political uncertain- continues to be the most serious and
ty will increase in early 2015 with po- market-relevant risk facing investors.
tential Greek elections and, later in the However, we expect all the relevant par-
year, with Spanish elections and a pos- ties to take a step back in 2015. China
sible early election in Italy. Despite the and Japan will be focused on domestic
uptick in risk, the current backdrop is politics and economics, while the U.S.
different from early on in the euro area takes a pause from its ‘pivot to Asia’ to
debt crisis. First, a number of left-wing deal with crises in the Middle East and
parties, such as Greece’s SYRIZA and Russia. On a secular trend, the U.S. is
Spain’s Podemos, have moderated their shifting its focus to Asia. In fact, the as-
euroskeptic stance in light of continued sertiveness of Russia and chaos in Iraq
high support for the currency union in are both second derivatives of American
the peripheral economies. Second, the geopolitical deleveraging from Europe
ECB is today on record as being will- and the Middle East, respectively. As
ing to do “whatever it takes” to save the such, we remain pessimistic about Sino-
euro, whereas in 2011/2012, it had not American relations over the long term.
yet made any strong commitments. Eu-
ropean politics will not be calm, but ma- Conclusions
jor market-moving upsets are not likely.
Mr. X: We have covered a lot of ground
On a positive note, we do not expect and, as always, I have appreciated the
U.S. political developments to cause any opportunity to get into some of the detail
major problems for investors. Relations behind your views. It seems that we are
between the Democrats and Republicans not very apart in our thinking for the next
remain fractious but much of the politi- year or so: the economic outlook is at best
cal rhetoric is just noise. Meanwhile, uninspiring, and this will ensure that in-
there are real openings in 2015 for both flation stays low and monetary policy stays
a modest immigration deal and a reve- accommodative. The longer-run end game
nue-neutral corporate tax deal. remains a source of uncertainty and I sense
that I am much more bearish than you.
Mr. X: You have not mentioned one of
the big geopolitical themes that you em- I started out by saying that I was predis-
phasized a year ago – increased tension posed to moving to a more risk-averse in-
in South-East Asia. Does this mean you vestment stance, and nothing that we have
no longer are worried about developments discussed has dissuaded me from that view.
there? My portfolio has done much better than I
ever expected during the past several years
BCA: We continue to worry about and I see no harm in taking money off the
the secular increase in geopolitical risk table and locking in profits.
in East Asia. Over the long term, an
accidental skirmish or military cri- BCA: The old adage that “nobody ever
sis between great powers in East Asia went broke taking profits” seems quite

TABLE 3
Market Returns For The Coming Decade
COMPOUND % RETURNS PER ANNUM
THE PAST: THE FUTURE: PORTFOLIO

1983-2013 2014-2024 WEIGHT
U.S. EQUITIES 11.1 4.5 45
OTHER DEVELOPED EQUITIES 9.7 7.0 15
EM EQUITIES 14.0 9.0 5
10-YEAR TREASURIES 8.2 2.1 25
CORPORATE BONDS 9.4 3.3 10
TOTAL PORTFOLIO* 10.1 4.4 100
INFLATION 2.8 2.0
TOTAL PORTFOLIO REAL RETURN 7.1 2.1
* BASED ON WEIGHTS AND FINAL COLUMN.
appropriate and we agree that this is You can see that, using the asset weights
a time to be more defensive. We are in the final column, a balanced portfo-
recommending a neutral rather than lio is likely to deliver average returns of
underweight position in equities because only 4.4% a year over the next 10 years,
we do not see any of the classic signs of and that is before inflation and taxes. Of
a looming bear market. A market cor- course, this is an average and some years
rection is long overdue – especially in will be better, and some a lot worse. The
the U.S. – so there is a case for being problem is the current starting point
underweight from a tactical perspective. with very low bond yields and unattract-
However, corrections are very difficult to ive equity valuations – most notably in
predict. the U.S. In contrast, in the early 1980s,
bond yields were extremely high and
An important point to emphasize is that equities were cheap, so that was a great
long-run portfolio returns are likely to starting point for assets to deliver ex-
be very modest from current levels. In traordinarily large returns over the sub-
Table 3, we show our estimates of the sequent 30 years.
average annual returns that you should
expect from various assets over the com- In sum, we have very modest expecta-
ing decade. The bond returns are easy to tions for what markets will be able to
predict – they are simply the current 10- deliver over the medium term, even
year yield. The projected equity returns without factoring in a bearish economic
are based on our assumptions about outcome. If equities do better than the
trend growth in earnings, a mean rever- numbers in the table in the coming year,
sion of multiples and the current divi- it will be because easy money pushes up
dend yield. We deliberately have used multiples. And we cannot rule that out
very middle-of-the-road assumptions as because valuations do have room to rise
we are not trying to bias the results to- further. But, that would effectively be
wards a bearish or bullish view. stealing from future returns unless one

was to assume a structural upward shift slow in 2015. The demise of the
in the equilibrium price-earnings ratio. Debt Supercycle has blunted the
And we see no justification for that. impact of monetary policy and there
is opposition to using fiscal policy
It clearly is a challenging time for inves- to boost growth. Economic activity
tors. Bonds are hard to like when yields will be constrained by the growth in
are so low, so equities inevitably remain real incomes, which is likely to stay
the asset of choice. But the upside in modest.
prices is limited in the U.S. market, and
there are still profound economic risks  The pace of U.S. economic growth
in Europe and Japan. will remain above trend for a couple
of quarters before dropping back
Mr. X: We should stop now before you into the 2%-2½% range in the sec-
make me even more depressed. Let’s finish ond half of 2015. A firm dollar and
as we usually do with a brief summary of smaller gains from home and equity
your main economic and financial views. prices will offset the benefits from
BCA: With pleasure. The key points are lower oil prices.
as follows:  The euro area will remain stuck
 The drop in oil prices is a net posi- with low economic growth for the
tive for the global economy. In a world foreseeable future and a period of
plagued by deficient aggregate demand, deflation is probable. Growth in the
resources are shifting from high savers region is likely to average 1% or less
(oil producers) to lower savers (con- over the next couple of years.
sumers). Low oil prices pose a threat  Japan’s economic growth remains
to political stability in some producing constrained by falling real wages and
countries and will negatively impact Abenomics is not expected to change
non-OPEC supply. This sets the scene this. The weak response of exports to
for prices to rebound by more over the a lower yen is a further bearish sign.
next couple of years than what is priced A marked improvement in growth is
in the forward markets. not in the cards.
 Borrowers and lenders remain under  The Chinese authorities are attempt-
pressure to deleverage in most econ- ing the delicate task of squeezing out
omies and regions. For the first time credit excesses while avoiding a ma-
in decades, easy money has been un- jor growth slowdown. While there is
able to trigger a new credit cycle and risk of a policy mistake, we do not
effectively, this means the death of expect a hard landing.
the Debt Supercycle.
 Inflation will stay very low through-
 Despite the stimulus from lower oil out the developed world over the
costs, the pace of global economic coming year and central banks will
growth will remain disappointingly maintain a highly-accommodative
policy stance. The Fed is on track to  Commodities are in a secular bear
raise rates in mid-2015, but slowing market so any bounce in prices will
growth in the second half will limit be short-lived. Monetary conditions
the pace of subsequent hikes. The appear favorable for gold, but bul-
ECB will step up its QE, possibly to lion missed its chance to move into a
include purchases of sovereign bonds. full-scale bubble.
 Government bonds are expensive in  There are compelling reasons to
most countries but the forces keep- expect the dollar to move higher in
ing yields down – excess global sav- 2015, but the strong bullish con-
ings and low inflation – will persist sensus is a concern. There is more
in 2015. We recommend neutral du- downside for the yen than for the
ration, with curve strategy geared to- euro. Avoid commodity-related cur-
ward a flattening. Corporate bonds rencies.
are preferred to governments as we
 The geopolitical risks will be con-
do not expect a rise in default rates.
centrated in emerging economies,
Continue to avoid EM bonds.
although elections in Europe will
 Stick with a benchmark weight- also generate some uncertainty for
ing in equities. Although monetary investors. Russia’s ability to cause
policy will remain supportive, the problems will be constrained by
profit outlook will be more challeng- economic pressures. Geopolitics will
ing – especially in the U.S., where a support safe-haven assets such the
firm dollar will undermine overseas U.S. dollar and Treasuries.
earnings. Relative valuations and
 A cautious investment strategy is ap-
monetary conditions warrant a di-
propriate, especially given that long-
versification away from the U.S. and
run asset returns will be very modest
toward Europe. Japan also offers a
from current levels. We estimate that
tactical opportunity.
a balanced portfolio for a U.S.-based
 It is too soon to move back into EM investor will deliver average returns
equities given deteriorating economic of only 4.4% a year over the next
growth and earnings, poor valuations decade, before inflation and taxes.
and weak commodity prices. Our Let us take this opportunity to wish you
favored markets are China, Taiwan, and all of our clients a very peaceful,
Mexico, Singapore, Malaysia, central healthy and prosperous New Year.
Europe and domestic sectors in Korea.
 We recommend staying with a de-
fensive sector strategy, focusing on The Editors
consumer staples, health care, utili-
December 18, 2014
ties and selected financials.

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Monthly forecast and analysis of the

January 2015 - Vol. 66 - No. 7 global economy and financial markets

SPECIAL YEAR END ISSUE

SPECIAL YEAR END ISSUE:

2 THE BANK CREDIT ANALYST January 2015 BCA RESEARCH

BCA RESEARCH January 2015 THE BANK CREDIT ANALYST 3

4 THE BANK CREDIT ANALYST January 2015 BCA RESEARCH

BCA RESEARCH January 2015 THE BANK CREDIT ANALYST 5

2013 2014 2015 2014 2015

ANNUAL % GROWTH IN REAL GDP:

ADVANCED ECONOMIES 1.4 1.8 2.3 2.0 2.5

6 THE BANK CREDIT ANALYST January 2015 BCA RESEARCH

MSCI INDEX - TOTAL % RETURNS*

ALL COUNTRY INDEX 23.4 2.1

10-YEAR GOVERNMENT BOND % RETURNS*

U.S. -8.7 10.7

U.S. CORPORATE BOND % RETURNS

INVESTMENT-GRADE -1.5 6.9

BRENT OIL PRICE ($/BARREL)** 111.6 59.8

in individual country performance. anticipate oil prices falling as much

BCA RESEARCH January 2015 THE BANK CREDIT ANALYST 7

8 THE BANK CREDIT ANALYST January 2015 BCA RESEARCH

BCA RESEARCH January 2015 THE BANK CREDIT ANALYST 9

10 THE BANK CREDIT ANALYST January 2015 BCA RESEARCH

2006 2008 2010 2012 2014 2016 2018 2020

14 14 so will not come as a surprise. Russia

© BCA Research 2015

BCA RESEARCH January 2015 THE BANK CREDIT ANALYST 11

on marginal non-OPEC production. It

for a sharper rebound than suggested

some geopolitical shock, it could take a

highs of the past couple of years.

may adjust your views during the course of

12 THE BANK CREDIT ANALYST January 2015 BCA RESEARCH

The Debt Supercycle is a description of the long-term decline in U.S. balance-sheet

BCA RESEARCH January 2015 THE BANK CREDIT ANALYST 13

120 120 100 100

© BCA Research 2015 80 80

1980 1985 1990 1995 2000 2005 2010 70 70

SOURCE: BANK FOR INTERNATIONAL SETTLEMENTS.

cycle as even zero short-term interest rates % Of % Of

 It is incredibly difficult for borrowers 1920 1924 1928 1932

to deleverage when income growth * HOUSEHOLD, FARM, AND BUSINESS DEBT.

is sluggish, as it has been throughout

14 THE BANK CREDIT ANALYST January 2015 BCA RESEARCH

500 MORTGAGE APPLICATIONS: 500

2006 2008 2010 2012 2014

% HOUSEHOLD DEBT-SERVICE PAYMENTS %

Irving Fisher’s seminal Debt-Deflation (PERCENT OF DISPOSABLE INCOME)

unwind excessive debt can lead to a de-

burdens.1 And a key indicator of the © BCA Research 2015

problem is a collapse in money’s velocity 1990 1995 2000 2005 2010

ing now in the developed economies

BCA RESEARCH January 2015 THE BANK CREDIT ANALYST 15

42 42 small niche area, and overall consumer

16 THE BANK CREDIT ANALYST January 2015 BCA RESEARCH

BCA RESEARCH January 2015 THE BANK CREDIT ANALYST 17

Primary deficit Primary surplus

Primary deficit DENMARK