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Quantitative & Strategy

PEERING INTO 2020 AND BEYOND

February 18, 2019

EXECUTIVE SUMMARY

In the past year, we have been fortunate to be right on the major turning points in the U.S.

equity market. We were steadfastly bullish in early 2018 after the correction (see A Correction,

Not A Bear). We turned cautious in early August because of the early technical warning,

which was accompanied by deterioration in top-down data (see A Major Market Top Ahead).

Finally, we turned bullish on stocks in mid-January 2019 (see Ursus Interruptus).

As we gaze into the crystal ball for 2020 and beyond, we are both bullish and bearish, but

on different time frames. Our base-case scenario is as follows:

Short-term growth scare (next 1–4 months)

Recovery (remainder of 2019)

Two themes for 2020:

1. Resumption of Sino-American Cold War 2.0

2. Prepare for the Modern Monetary Theory (MMT) experiment

We expect the resumption of the Sino-American Cold War 2.0 in 2020 will be bearish for

equity prices, but a likely experiment with MMT will provide a bullish fiscal boost to the

economy. As to how the two factors play out, we advise investors to be data dependent.

Cam Hui, CFA cam@pennockideahub.com

Table of Contents

Peering Into 2020 and Beyond ............. 2

The Near-Term Growth Scare .............. 3

No 2019 Recessionary Bear .................... 6

Cold War 2.0 ......................................... 10

The Great MMT Experiment .................. 11

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February 18, 2019

Quantitative & Strategy

Peering Into 2020 and Beyond

In the past year, we have been fortunate to be right on the major turning points in the U.S.

equity market. We were steadfastly bullish in early 2018 after the correction (see A Correction,

Not A Bear). We turned cautious in early August because of the early technical warning, which

was accompanied by deterioration in top-down data (see A Major Market Top Ahead). Finally,

we turned bullish on stocks in mid-January 2019 (see Ursus Interruptus).

Exhibit 1: Our Market Calls in the Past Year

Source: Stockcharts

As we gaze into the crystal ball for 2020 and beyond, we are both bullish and bearish, but on

different time frames. Our base-case scenario is as follows:

Short-term growth scare (next 1–4 months)

Recovery (remainder of 2019)

Two themes for 2020:

3. Resumption of Sino-American Cold War 2.0

4. Prepare for the Modern Monetary Theory (MMT) experiment

Cam Hui, CFA | cam@pennockideahub.com Page 3

February 18, 2019

Quantitative & Strategy

The Near-Term Growth Scare

We have been writing about a possible near-term growth scare, and there is no point repeating

myself (see Here Comes The Growth Scare). The most visible sign of a growth slowdown is the

continual downward revisions of forward 12-month EPS, indicating a loss of fundamental

momentum, and the above-average rate of negative guidance for Q1 earnings.

Exhibit 2: Earnings Estimates Are Falling

Source: FactSet Information Systems

In addition, the deterioration in initial claims is concerning, as initial claims have historically

been inversely correlated with stock prices. However, there may be an anomaly in the data

because of a possible spike that attributable to the federal government shutdown.

Exhibit 3: Initial Jobless Claims Are Inversely Correlated with the S&P 500

Source: FRED, Federal Reserve Bank of St. Louis

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February 18, 2019

Quantitative & Strategy

Another worrisome sign of weakness is the diving NFIB small business optimism.

Exhibit 4: Small Business Optimism Is Diving

Source: National Federation of Independent Business

Global bond yields are also plunging, which is a real-time market signal of slowing growth.

Exhibit 5: Global Bond Yields Are Plunging

Source: Reuters

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Quantitative & Strategy

New Deal democrat, who monitors high frequency economic figures and categories them into

coincident, short leading, and long leading indicators, indicated this week that the short-term

outlook is deteriorating, though with an important caveat:

The big news this week is that the short-term forecast has turned sharply negative, while the coincident

nowcast also turned negative. The long-term forecast remains essentially neutral.

A special note of caution this week: In the past several weeks a whole variety of both weekly and monthly

indicators in several time frames have abruptly cratered. Part of that may be due to the “polar vortex”

giving rise to 30-year low temperatures in part of the country, but I suspect that the effects of the government

shutdown have been more pronounced than almost everybody thought. A similar pattern happened during

the 2011 “debt ceiling debacle.” If so, the coincident indicators in particular should begin to bounce in the

next several weeks.

Cam Hui, CFA | cam@pennockideahub.com Page 6

February 18, 2019

Quantitative & Strategy

No 2019 Recessionary Bear

Should stock prices retreat and test the December lows on a growth scare, we believe such an

event would represent a gift from the market gods. We had pointed out that the equity

valuations in December 2018 were discounting a mild recession (see Ursus Interruptus), which

represents a contrarian buying opportunity, unless you believed that a catastrophic global

meltdown was about to happen.

Today, the Fed has become much more accommodative, and it has signaled that rate hikes are

on hold until mid-year. A recent CNBC interview with Fed governor Lael Brainard revealed an

even more dovish tilt. The Fed is now more attuned to downside risk from abroad [emphasis

added]:

STEVE LIESMAN: How does it fit in with your general view of the economy? Did you believe

the economy is decelerating? Is that part of that framework that you have?

LAEL BRAINARD: So I think going into this year we would have expected a solid growth

figure, but a slower growth figure than the very strong growth we were getting last year. But downside

risks have definitely increased relative to that modal outlook of continued solid growth.

STEVE LIESMAN: Let's talk about some of those risks that are out there. First overall

question: do you see an elevated risk of recession this year or next?

LAEL BRAINARD: I would certainly say there are a variety of downside risks. And, of course,

I'm very attend I have to all the recession indicators that people look at, including the slope of the

yield curve. But in terms of the other kinds of downside risks, foreign growth has slowed. It was first very apparent in China, but now we're seeing those

numbers coming in below expectations in Europe. Policy uncertainty still high

whether, you know, we look at trade conflict with China or whether we look at Brexit, and financial conditions have tightened, so I want to take those on board as I think about the year ahead.

In addition, the market had been concerned about the Fed’s program of steadily shrinking its

balance sheet, which represents a form of monetary tightening. Brainard stated that she is in

favour of ending the program of balance sheet normalization later this year:

So I think on the balance sheet, it's really important to distinguish between the overall technical

factors and monetary policy. With regard to just the general size of our balance sheet, ultimately,

you know, we said last time that we're going to stay in an ample reserve system. My own view is that balance sheet normalization process should probably come to an end later this year. We know that liquidity demand on the part of financial institutions is much

higher than it was pre-crisis so we want to make sure that there's an ample supply of reserves to

guard against volatility.

The Powell Put is firmly in place.

In addition, there is sentiment support in place that will put a floor on stock prices. Simply put,

the slow-moving institutions are bearish, which is contrarian bullish. Callum Thomas reported

that the State Street Confidence Index, which measures the equity allocation of fund managers

by the State Street custodian bank, is at an extreme, indicating high levels of defensiveness.

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February 18, 2019

Quantitative & Strategy

Exhibit 6: North American Institutions Are Highly Defensive

Source: Topdown Charts, State Street

The latest BAML Global Fund Manager Survey confirms these observations. Equity allocations

are at the lowest level since September 2016, despite rising stock prices. This indicates that

managers are increasingly defensive and they are actively selling their equity positions.

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Quantitative & Strategy

Exhibit 7: Global Equity Allocation Is Low

Source: BAML Global Fund Manager Survey

The defensive posture can also be seen in cash allocations, which have risen to levels not seen

since 2009.

Exhibit 8: Cash Allocations Are High

Source: BAML Global Fund Manager Survey

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Quantitative & Strategy

Analysis from Goldman Sachs shows that past equity bears with recessions tend to continue to

fall, while bear markets without recessions tend to recover quickly. We believe the current

episode falls into the latter category, and if history is any guide, expect a pullback over the next

few months, followed by a recovery.

Exhibit 9: Bear Markets with and without Recessions

Source: Goldman Sachs Global Investment Research

Once the market moves past any growth scare and realizes that recession risk is only a mirage,

the market should stage a relief rally, which we believe should last until year-end.

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February 18, 2019

Quantitative & Strategy

Cold War 2.0

The year 2020 is another story altogether. While my crystal ball starts to get cloudy beyond six

months, there are two themes that investors should consider in 2020. The first is the resumption

of the Sino-American Cold War 2.0.

The friction between America and China is not just restricted to trade. We wrote in early 2018

that the U.S. had branded China a strategic competitor in its National Security Strategy 2017

(see Sleepwalking Towards a Possible Trade War). Regardless of what understanding both sides may

come to before the March 1 deadline, those tensions are not going away.

Leland Miller of China Beige Book summarized the most likely scenario in a recent CNBC

appearance.

The short time frame of 90 days between the G20 summit and March 1 prevents

meaningful negotiation between the parties on comprehensive structural reform.

The only way a deal that can be done if a Trump-Xi meeting can be finalized.

Both sides want a deal, so there will be a deal, but it will be a superficial one at best.

The provisions of a deal will include commitment to reduce the trade deficit, and

shallow efforts on IP protection, but those provisions can be reversed easily if relations

deteriorate.

Robert Lighthizer recognizes that Trump wants a deal; and his mandate is to strike the

best deal he can. Therefore his primary focus has turned to enforcement. The intent

of the latest round of negotiations is set up a process to document possible non-

compliance by China so that they can retaliate with higher tariffs in the future.

In a separate CNBC appearance, Miller stated that there is a growing consensus on both sides

of the aisle in Washington that China is becoming a problem for America. As the U.S.

approaches the 2020 election, he expects that both Trump and the Democratic nominee to

posture and demonstrate how tough he or she is on China. This outcome will not be bullish

for U.S.-China relations, the global trade outlook or equity prices.

Look for a resumption of Cold War 2.0 in 2020, not just in trade, but in other dimensions as

well.

Cam Hui, CFA | cam@pennockideahub.com Page 11

February 18, 2019

Quantitative & Strategy

The Great MMT Experiment

The dominant event of 2020 for the stock market will be the election. While there will be a

huge gulf between Trump and the Democratic nominee, there will be some commonalities.

Donald Trump is a self-professed "debt guy". The ambitious provisions of the Democrats'

Green New Deal (GND) suggests that Modern Monetary Theory (MMT) will become a major

topic of conversation in 2020. Whoever wins, MMT is likely gain greater traction and become

a serious theory for government finance in the post-electoral landscape.

What is MMT?

Kevin Muir at The Macro Tourist had a terrific layman’s explanation:

MMT’ers believe that government’s red ink is someone else’s black ink. Sure, the government owes

dollars, but they have a monopoly of creating those dollars, and not only that, the creation of more

and more dollars is essential to the functioning of the economy.

Here are the policy implications of accepting MMT:

governments cannot go bankrupt as long as it doesn’t borrow in another currency

it can issue more dollars through a simple keystroke in the ledger (much like the Fed did

in the Great Financial Crisis)

it can always make all payments

the government can always afford to buy anything for sale

the government can always afford to get people jobs and pay wages

government only faces two different kinds of limitations; political restraint and full

employment (which causes inflation)

The government can keep spending until they begin to crowd out the private sector and

compete for resources.

And in fact, Stephanie Kelton [a leading academic proponent of MMT] argues it is immoral to not

utilize this power to fix problems in our society. From an interview she gave,

“if you think you can’t repair crumbling infrastructure or feed hungry kids, unless and until you

find some money somewhere, it’s actually pretty cruel because you leave people who are struggling

in a position where there are still struggling and they are hurting, and they are not properly taken

care of…”

This may sound like sacrilege to Austrian economists, but MMT adherents believe the

government can keep on spending, and printing money with inflation being the only constraint

on its actions. Before descending down the rabbit hole of whether the MMT effects are benign,

like Japan, or hyper-inflationary, like Zimbabwe, here is some perspective. FT Alphaville

published an insightful article detailing how the US financed its deficit during the Second World

War. Ultimately, how an initiative is financed is a political question [emphasis added]:

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Quantitative & Strategy

In a resolution this week, in interviews and even in an oped for The Financial Times, Democrats

have either hinted or said outright that they would pay to fight climate change by borrowing — the

same way the country paid to fight fascists. It's not an absurd comparison. During the war, the U.S.

borrowed more than 100 per cent of its gross domestic product and did not subsequently collapse.

Also, though: finance in the U.S. was different in the 1940s.

The Federal Reserve explicitly supported the goals of the war, and expanded its balance

sheet to keep Treasury yields down.

Domestic institutional investors were trapped in the U.S., with few options for assets other

than Treasuries. There weren’t really any foreign investors.

Within a decade after the war, two runs of inflation — the first of which reached 20 per

cent — got the U.S. debt to GDP ratio down to 50 per cent.

We have always been underwhelmed by the argument “you can’t do x, because x is politically

infeasible.” You argue a policy on its merits, then you convince the people you need to convince. And

shocks can redefine “feasible”, the way hurricanes and wildfires have in the U.S.

But: to borrow at the scale of the Second World War is not just a political question for Congress. It’s a political question for the Fed, which during the war provided quantitative warfighting to keep yields down on Treasuries. It’s a political question for U.S. capital at home, which has spent the last 40 years

getting used to buying assets wherever it wants in the world. And it’s a question for foreign capital in U.S. markets, which didn't exist during the war, and may not feel compliant now.

Twenty per cent inflation in 2030 wouldn't hurt, either. But it'd be, you know, a political adjustment.

The U.S. raised taxes on capital from 44 to 60 per cent during the Second World War. Labour

taxes doubled, from 9 to 18 per cent. The numbers come from a 1997 paper by Lee Ohanian for

the American Economic Review. The U.S. financed just over 40 per cent of the war through direct

taxes, comparable to what the Union did during the Civil War. It was a far greater percentage than

during the Revolutionary War, the War of 1812 or the First World War:

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Quantitative & Strategy

Exhibit 10: How the U.S. Financed Wars

Source: FT Alphaville

The Fed co-operated to keep rates down, with a technique otherwise known as financial

repression:

We don’t have a historical record of what happens to Treasury yields as debt climbs above 100 per

cent of GDP, because the Fed was part of the war effort. In 1942, the Fed began intervening in

Treasury auctions, keeping 90-day bills at 3/8 of a per cent, with a ceiling for all debt on 2.5 per

cent.

After the war, inflation eroded the debt away:

In a paper for the National Bureau of Economic Research in 2009, Joshua Aizenman of the

University of California, Santa Cruz and Nancy Marion of Dartmouth College point out that

within 10 years of the end of the war, two bouts of inflation dropped U.S. debt by 40 per cent. (They

also note that the U.S., unlike other countries, tends to extend the maturity of its debt when it borrows

more. Maturity peaked at 113 months in 1947. It reached a low of 31 months in 1976, and is now

back at 69 months.)

But developed-economy central banks can't create inflation now even when they're desperate to. So a

29-year nonmarketable bond at 2 3/4 per cent, like the one Treasury offered as a swap in 1951,

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Quantitative & Strategy

might not be the same good deal for Treasury anymore. Maybe it can’t be inflated away. Again: we

just don’t know.

Here is the key conclusion [emphasis added]:

Democrats have proposed to finance a new program the way the U.S. financed the Second World

War. They are correct that when Americans really want something, they find a way to pay for it. But

a lot of things — including the entire structure and movement of U.S. and global capital —were

very, very different during the war. There’s consequently no guarantee what worked in the past will

work again today.

Today, the U.S. has a dovish and compliant Federal Reserve. The President is a self-professed

“debt guy” who is not afraid to stimulate the economy by running deficits. His likely opponent

in 2020 will likely come from the left wing of the party who is sympathetic to similar ideas

about government finance. What they differ on are the government’s priorities.

This is a perfect political environment to experiment with MMT. At best, MMT represents a

new theory that turns macro-economics and government finance upside down. At worst,

Stephanie Kelton, who is the academic face of MMT, is the Left’s version of Arthur Laffer.

Whoever wins, expect a round of reflationary fiscal stimulus in 2021. The result will be bullish

for growth and equity prices.

We leave the theorists to argue how the piper will be paid. The answer to that question is well

beyond our pay grade.

In conclusion, as we peer into 2020, we expect the competition between the U.S. and China to

heat up again into a new Cold War 2.0. This development will be bearish for equity prices.

On the other hand, we are likely to see an experiment with MMT in the post-electoral landscape

in 2021. Should such a scenario unfold, it would provide a fiscal boost to the economy and

equity prices.

We suggest that investors prepare for these themes to become more dominant in the future. It

is impossible to forecast the magnitude of these effects, as our crystal ball gets very cloudy

when we look that far ahead, but our best advice is to be aware, and stay data dependent.

Cam Hui, CFA | cam@pennockideahub.com Page 15

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Quantitative & Strategy

Disclaimer

I, Cam Hui, certify that the views expressed in this commentary accurately reflect my personal views about the subject company (ies). I am

confident in my investment analysis skills, and I may buy or already own shares in those companies under discussion. I prepare and edit

every report published under my name. I depend on my colleagues for constructive criticism on my research methods and conclusions but

final responsibility is my own.

I also certify that I have not and will not be receiving direct or indirect compensation from the subject company(ies) in exchange for publishing

this commentary.

This investment analysis excludes any target price, and is not a recommendation to buy or sell a stock. It is intended to provide a means for

the author to share his experience and perspective exclusively for the benefit of the clients of Pennock Idea Hub (PIH). My articles may

contain statements and projections that are forward-looking in nature, and therefore subject to numerous risks, uncertainties, and

assumptions. The author does not assume any liability whatsoever for any direct or consequential loss arising from or relating to any use of

the information contained in this note.

This information contained in this commentary has been compiled from sources believed to be reliable but no representation or warranty,

express or implied, is made by the author or any other person as to its fairness, accuracy, completeness or correctness.

This article does not constitute an offer or solicitation in any jurisdiction.

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