Developed Countries

  Overweight Rail stocks in general, and Union Pacific (UNP) in particular, got a major lift yesterday when UNP announced a plan to implement the principles of Precision Scheduled Railroading (PSR) in its push to improve customer deliveries and profitability. Recall that PSR was developed by Hunter Harrison first at CN Rail, then CP Rail and finally at CSX where its implementation took industry profit laggards to profit leadership. Though his recent passing was untimely, the 9% year-over-year improvement in CSX’s Q2/18 operating ratio is a testament to the success of Mr. Harrison’s strategy. The timing for a renewed approach at UNP could scarcely be better. Both demand and pricing are soaring (second and third panels) and the resulting congestion is threatening profitability. We expect the ongoing supportive macro backdrop, combined with operating improvements such as these, to sustain the operating margin improvement trend of the past two years (bottom panel). Stay overweight, despite the 20% in relative return since inception. The ticker symbols for the stocks in this index are: BLBG: S5RAIL - UNP, CSX, NSC, KSU.  

Highlights The latest round of tariffs on U.S. imports from China confirms that the Trump administration's confrontation with China goes beyond the mid-term elections. Desynchronization between the U.S. and China/EM growth foreshadows dollar appreciation. The latter is the right medicine for the global economy for now. A stronger dollar is required to redistribute growth and inflation away from the U.S. and towards the rest of the world. China needs a weaker currency to offset deflationary pressures stemming from domestic deleveraging and trade tariffs. For EM ex-China, the dollar rally is painful, but it is the right medicine in the long run. It will bring about the unraveling of excesses within their economies. Feature The global economy presently finds itself between two strong and opposing crosscurrents: robust growth and mounting inflationary pressures in the U.S. on the one hand, and weakening Chinese growth on the other. Desynchronization between China/EM and the U.S. has been our theme since April 2017.1 Although this theme has become evident and to a certain degree priced into the markets, we believe it is not yet time to abandon it. Before exploring this analysis in greater depth, we will address the issue of whether strong U.S. demand will reverse the slowdown in the global trade cycle, and update our thoughts on the trade wars. Global Trade And Trade Wars Our leading indicators for global trade do not herald a reversal in the global exports slowdown. Chart I-1 demonstrates that the ratio of risk-on versus safe-haven currencies2 leads global export volumes by several months, and it does not yet flag any improvement. Chart I-1Risk-On / Safe-Haven Currency Ratio As An Indicator Of Global Trade In addition, Taiwanese exports of electronic products lead the global trade cycles by a couple of months, and they are currently pointing to further deceleration in world exports (Chart I-2). It seems extremely robust U.S. domestic demand growth has not prevented a slowdown in global trade in general and EM exports in particular. The reason for this is that many developing countries' shipments to China are larger than their exports to the U.S., as illustrated in Table I-1. Chart I-2Taiwanese Electronics Exports##br## Slightly Lead Global Exports Table I-1Many Emerging Economies##br## Sell More To China Than To The U.S. The latest decision by the U.S. administration to impose a 10% tariff on $200 billion of imports from China and increase this rate to 25% starting January 1, 2019 confirms that the Trump administration's confrontation with China goes beyond the mid-term elections. The true intention of the U.S. is to contain China's geopolitical rise to preserve its global hegemony. These episodes of import tariffs will likely mark the beginning of a much longer and drawn-out geopolitical confrontation. Our colleagues at BCA's Geopolitical Strategy service have been noting for several years that a U.S.-China confrontation is unavoidable.3 In this vein, it is not clear to us why global growth-sensitive and China-leveraged plays in financial markets have rallied in recent days on the new tariff announcement. We can think of two reasons: (1) markets expect China to stimulate domestic demand aggressively to counter tariffs; and (2) gradually rising U.S. import tariffs will boost global trade in the near term, as companies front load their production and shipments before the 25% tariff rate takes hold. On the first point, there has so far been no major new fiscal stimulus announced in China. We detailed fiscal numbers in our August 23 report,4 and there have been no changes since. As to liquidity easing - which has been material - our assessment is that it is likely to be overwhelmed by ongoing regulatory tightening on banks and shadow banking. In short, lingering credit excesses and regulatory tightening will hamper the monetary transmission mechanism from lower interest rates to faster credit growth. So far, money growth in China remains very weak (Chart I-3). Chart I-3China's Narrow Money And EM Stocks On the second point, we cannot rule out a moderate and temporary improvement in global trade due to various technical factors. Yet, any rally rooted in this will prove to be short-lived and fleeting. Bottom Line: Escalating tariffs on U.S. imports from China will reinforce the tectonic macro shifts that have been in place since early this year: it will lift U.S. inflation slightly and weigh on Chinese growth. Rising U.S. Inflation U.S. core inflation is accelerating and moving above the Federal Reserve's soft target of 2%. This will substantially narrow the Fed's maneuvering room to respond to the turmoil in EM and weakening growth outside the U.S. Chart I-4 demonstrates that an equally weighted average of various core consumer inflation measures for the U.S. has been markedly accelerating. The components of this core inflation aggregate are presented in Chart I-5 and include: trimmed mean CPI, trimmed mean PCE, market-based core PCE and median CPI. Besides, the U.S. labor market is super tight, and employee compensation growth will continue to rise. This will put downward pressure on corporate profit margins and will push businesses to consider passing on their rising costs to consumers. Provided wage growth will continue accelerating and the job market and confidence both remain strong, odds are that companies will be able to raise their selling prices. Chart I-4U.S. Inflation Is Rising... Chart I-5...Based On Various Core Measures Weakening Chinese Growth Growth continues to weaken in China. In particular: The aggregate freight index (transport by railway, highway, waterway, and aviation) is sluggish and the measure of Air China's freight continues to downshift (Chart I-6). The strength in China's residential property market since 2015 has partially been due to the central bank providing very cheap financing directly to housing via its Pledged Supplementary Lending (PSL) scheme. We have argued in the past that this represents nothing less than monetization of excess housing inventories directly by the People's Bank of China.5 This has boosted property prices and sales, supporting the economy over the past two years. Having met the objective of reducing housing inventories, the PBoC has lately reduced the amount of PSL. Provided changes in PSL flows have led both housing prices and sales volumes, it is reasonable to expect a relapse in new sales in the next six months or so (Chart I-7). Chart I-6China: A Slowdown In Freight Indicators Chart I-7China: Housing Sales To Roll Over Soon Our main theme in China has been and remains shrinking construction activity - both infrastructure and property building. This is the primary rationale for our negative view on commodities prices as well as weakness in mainland aggregate imports. Chart I-8 illustrates property construction activity is already contracting. Headline fixed asset investment in real estate has been held up by booming land purchases, yet equipment purchases as well as construction and installation have been shrinking (Chart I-8). Capital expenditures for all industries, including construction and installation, purchase of equipment and instruments - but excluding land values - are also very weak (Chart I-9). Chart I-8China: Property Investment##br## Excluding Land Is Contracting Chart I-9China: Overall Capex##br## Is Very Weak   Interestingly, our proxy for marginal propensity to spend6 by Chinese companies leads global industrial metals prices, and continues pointing to more downside (Chart I-10). With respect to oil, Chinese oil import growth has downshifted considerably (Chart I-11) implying that global oil prices have been mostly propped up by supply concerns. Chart I-10Chinese Companies' Propensity##br## To Spend And Metal Prices Chart I-11China: A Slowdown##br## In Oil Imports Currency Markets As A Rebalancing Mechanism Pressures from growth desynchronization between the U.S. and China and trade wars continue to build. Left unchecked, these imbalances will enlarge and culminate into a bust. A release valve is needed to diffuse these accumulating pressures. Currency and bond markets often act as such - they move to rebalance the global economy and amend economic excesses. Odds are that exchange rates will continue to act as a rebalancing conduit. A stronger dollar is the right medicine for the global economy at the moment. A stronger dollar is required to redistribute growth away from the U.S. and towards the rest of the world. In particular, dollar appreciation is needed to cap budding U.S. inflationary pressures. China needs a weaker currency to offset deflationary pressures stemming from domestic deleveraging and trade tariffs. In turn, a stronger greenback will cause capital outflows from EM and compel the unraveling of excesses within the developing economies. While the result will be painful growth retrenchment for EM in the medium term, cheapened currencies and deleveraging (an unwinding of credit excesses) will ultimately create a foundation for stronger and healthier growth in the years ahead. As to the question of why the dollar would rally in the face of widening twin deficits, we have the following remarks. In a world where growth and inflation are scarce (i.e., in a deflationary milieu), a wider current account deficit and higher inflation - signs of robust domestic demand - will attract capital, ultimately lifting a country's currency. By contrast, in a world of strong growth and intensifying inflationary pressures, twin deficits and higher inflation will cause a country's currency to depreciate. Our assessment is that the global economic backdrop is still more deflationary than inflationary, despite intensifying inflationary pressures in the U.S. Therefore, twin deficits and inflation in the U.S. will be at a premium. That and the fact that the Federal Reserve is willing to continue tightening are conducive for dollar appreciation. As we have argued in previous reports, the U.S. dollar is not cheap,7 but it is not particularly expensive either. In fact, odds are it will get much more expensive before topping out. Bottom Line: Beyond any possible short-term countertrend moves, the path of least resistance for the U.S. dollar is up, and for the RMB and EM currencies, down. As these adjustments within the currency markets endure, EM risk assets will stay under selling pressure and underperform their developed market counterparts.   Indonesia: At The Whims Of Foreign Portfolio Flows 20 September 2018   The Indonesian currency has reached a two- decade low, and equities and bonds have sold off considerably. Is it time to turn positive on the nation's financial markets? Our bias remains that this selloff is not over and stocks, bonds as well as the currency have more downside. The basis is that Indonesia's balance of payments (BoP) will continue to deteriorate. Indonesia has been very reliant on volatile foreign portfolio flows to fund its current account deficit (Chart II-1). Not surprisingly, a reversal in foreign portfolio inflows to emerging markets (EM) has hurt this country's financial markets. We expect international capital flows to EM to be lackluster, which will continue to weigh on Indonesia's capital account. In the meantime, Indonesia's current account deficit is likely to widen in the months ahead. First, export revenues will begin rolling over on the back of lower copper and palm oil prices. Together, these commodities account for 13% of Indonesian exports. Second, the ongoing slowdown in China may eventually weigh on thermal coal prices. This commodity makes up another 12% of exports. Third, Indonesian imports remain very robust. Overall, a widening current account/trade deficit is typically negative for both share prices and the rupiah (Chart II-2). Chart II-1Indonesia: Foreign ##br##Portfolio Flows Are Key Chart II-2Deteriorating Trade Balance ##br##Is Bearish For Equities To prevent further currency depreciation, the government announced it will curb certain imports by raising tariffs.While this policy may succeed in limiting imports, it will also raise inflation by pushing prices of imported goods higher. This will allow inefficient domestic producers to stay in business. Higher inflation is fundamentally negative for the currency and local bonds. The above dynamics are making Indonesia's macro outlook increasingly toxic because Bank Indonesia (BI) will probably need to tighten monetary policy further in order to stabilize the rupiah and restrain inflation. Crucially, the BI's objective is to maintain rupiah stability in order to keep inflation tame. Further, Perry Warjiyo, the current governor of BI, has highlighted his preference for setting decisive and preemptive policies. Indonesia's central bank has already raised interest rates, and more hikes are likely if the currency continues depreciating - as we expect. On top of rate hikes, the BI will continue to deplete its foreign exchange reserves to defend the rupiah. Chart II-3 shows that foreign exchange reserve selling by the BI is shrinking local banking system liquidity (commercial bank reserves at the central bank) and lifting domestic interbank rates. In turn, higher local rates will cause bank loan growth to slow, hurting domestic demand. The latter will be very negative for profit growth and share prices because the Indonesian stock market is heavily dominated by banks and other domestic plays. The outlook for Indonesian banks is crucial for the performance of the Indonesian bourse, given they account for 42% of total MSCI market cap. Unfortunately, banks still rest on shaky foundations: Chart II-3Selling FX Reserves = Higher Interbank Rates Chart II-4Net Interest Margins Will Keep Compressing Not only will demand for loans slump as borrowing costs rise, but banks' net interest margins will also continue to compress (Chart II-4). Weaker growth and higher interest rates will also lead to a considerable rise in non-performing loans (NPLs), and cause banks' provisioning levels to spike. Higher provisions will hurt their earnings (Chart II-5). Notably, banks have boosted their profits substantially in the past two years by reducing their provisions. This process is set to reverse very soon. Finally, a word on overall equity valuations is warranted. Despite the correction that has taken place, this bourse is not yet trading at compelling valuation levels neither in absolute nor in relative terms (Chart II-6). Chart II-5Downside Ahead For Banks' Shares Chart II-6Indonesian Bourse Isn't Cheap Bottom Line: The rupiah will remain under selling pressure. This in turn will create a toxic macro mix of higher inflation, rising borrowing costs and weaker domestic demand. We recommend investors keep an underweight position in Indonesian stocks as well as local and sovereign bonds within their respective EM dedicated portfolios. We are also maintaining our short positions in the rupiah versus the U.S. dollar and on 5-year local currency bonds. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Ayman Kawtharani, Associate Editor ayman@bcaresearch.com Footnotes 1 Please see Emerging Markets Strategy Weekly Report, "Toward A Desynchonized World?" dated April 26, 2017, the link is available at ems.bcaresearch.com. 2 Relative total return (carry included) of four equally weighted EM (ZAR, RUB, BRL and CLP) and three DM (AUD, NZD and CAD) commodities currencies versus an equally weighted average of two safe-haven currencies - the Japanese yen and Swiss franc. 3 Please see Geopolitical Strategy Weekly Report, "We Are All Geopolitical Strategists Now," dated March 28, 2018, the link is available at gps.bcaresearch.com. 4 Please see Emerging Markets Strategy Weekly Report, "EM: Do Not Catch A Falling Knife," dated August 23, 2018, the link is available at ems.bcaresearch.com. 5 Please see Emerging Markets Strategy Special Report, "China Real Estate: A Never-Bursting Bubble?" dated April 6, 2018, the link is available at ems.bcaresearch.com. 6 Calculated as a ratio of corporate demand deposits to time deposits. Rising demand deposits relative to time (savings) deposits entail that companies are gearing up to spend /invest money and vice versa. 7 Please see Emerging Markets Strategy Special Report, "The Dollar: Will The U.S. Invoke A "Nuclear" Option?" dated August 30, 2018, the link is available at ems.bcaresearch.com. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Prediction 1: A major financial downturn will trigger the next major economic downturn, and not the other way round. Prediction 2: The straw that will break the back of a fragile financial system will be the global long bond yield rising by 60 bps within a short space of time. But for those who can fine tune, the global long bond yield must rise a further 30-50 bps before reaching the tipping point for the global risk-asset edifice. Take short-term profits in the overweight position in 30-year government bonds. Take short-term profits in the underweight position in basic materials. Take short-term profits in the underweight positions in Italy (MIB) and Spain (IBEX) and overweight position in Denmark (OMX). Feature The twenty-first century has witnessed three major downturns: the first started in 2000; the second started in 2007 culminating in the Lehman crisis a year later; and the third started in 2011 (Chart of the Week). Today, we are going to stick our necks out and make two predictions about the century's fourth major downturn. Chart of the WeekThree Episodes When Equities Underperformed Bonds By 20 Percent Or More A major financial downturn will trigger the fourth major economic downturn. The straw that will break the back of a fragile financial system will be the global long bond yield rising by 60 bps within a short space of time. Where The Consensus Is Very Wrong As investment strategists, our primary focus should be the financial markets rather than the economy. On this basis, we define a major downturn in terms of the markets: an episode in which equities underperform bonds by more than 20 percent over a period of more than six months.1 All the same, our market based definition of a major downturn perfectly captures the three occasions that the European economy went into recession or stagnation (Chart I-2). Does this mean that the economic downturns triggered the financial market downturns? No, quite the reverse. The onset of the three major financial downturns clearly preceded the onset of the three major economic downturns. Chart I-2Three Episodes When The Euro Area Economy ##br##Contracted Or Stagnated On reflection, this is hardly surprising. The twenty-first century's major economic downturns have all resulted from financial market distortions and fragilities: the bubble valuations of the technology, media and telecom sectors in 2000 (Chart I-3); the mispricing of U.S. mortgages and credit in 2007 (Chart I-4); and the mispricing of euro area sovereign credit risk in 2011 (Chart I-5). Therefore, it makes perfect sense that the downturns in financial markets should precede the downturns in the economy, even when both are measured in real time. Chart I-3The Major Downturns Stemmed From##br## Financial Market Distortions: The Dot Com ##br##Bubble In 1999/2000... Chart I-4...The Mispricing Of U.S. ##br##Mortgages And Credit##br## In 2007/2008... Chart I-5...And The Mispricing Of Euro Area ##br##Sovereign Credit Risk##br## In 2010/2011 Today, the consensus overwhelmingly believes that an economic downturn will cause the next major downturn in financial markets. But history has taught us time and time again that the causality is much more likely to run the other way. Why not learn the lesson? So here's our first prediction: a major financial downturn will trigger the fourth major economic downturn, and not the other way round. This prediction raises some obvious questions: what could be the major fragility in financial markets, and what could fracture it? A Sharp Rise In Bond Yields Triggered The Last Three Major Downturns Look carefully at the financial market downturns that started in 2000, 2007 and 2011, and you will see another striking similarity. In each episode, the global long bond yield rose by 60 bps or more in the months that preceded the onset of the financial market downturn: April 1999 through January 2000 (Chart I-6); March through July 2007 (Chart I-7); and October 2010 through April 2011 (Chart I-8). This strongly suggests that the spike in the bond yield was the trigger for the subsequent major downturn in financial markets. Chart I-6A Sharply Rising Bond Yield Triggered ##br##The Major Downturn Of 2000 Chart I-7A Sharply Rising Bond Yield Triggered##br## The Major Downturn Of 2007 And 2008 Chart I-8A Sharply Rising Bond Yield Triggered ##br##The Major Downturn Of 2011 A sharp rise in bond yields is usually the straw that breaks the back of financial market fragilities, in (at least) one of three ways: it flushes out those actors that are reliant on cheap liquidity; it pressures interest rate sensitive sectors in the economy; and it weighs on the valuations of other assets such as equities, especially if those valuations are already extremely elevated. Which segues us neatly to the current fragility in the global financial system. As we wrote last week, the post-2008 global experiment with quantitative easing, and zero and negative interest rate policy has boosted the valuations of all risk-assets across all geographies across all asset-classes. And the total value of those global risk-assets is $400 trillion, equal to about five times the size of the global economy.2 We have also consistently highlighted that not only do the rich valuations of $400 trillion of risk-assets depend (inversely) on bond yields, but that this relationship is an exponential function.3 So here's our second prediction: the straw that will break the back of a fragile financial system will be the global long bond yield rising by 60 bps within a short space of time - just as it did in 2000, 2007 and 2011. But Bond Yields Haven't Gone Up Far Enough... Yet Now comes some bullish news, at least for those who can play shorter-term moves in the market. The global long bond yield has been trapped within a tight channel and is only 20 bps up from its recent low in April (Chart I-9). Therefore, it has the scope to rise a further 30-50 bps before reaching the tipping point for the global risk-asset edifice and unleashing a 'risk-off' phase. Chart I-9In 2018, The Bond Yield Has Not Risen Sharply...Yet For those who want to fine tune their investment strategy, the journey up to that turning point would define a phase when many of this year's cyclical sector underperformances would end or even switch to a phase of modest outperformances. Bear in mind that the cyclical sector underperformances this year have been substantial: European banks have underperformed healthcare by 35 percent; global basic materials have underperformed the market by 10 percent; emerging market equities have underperformed developed market equities by 15 percent. So it is prudent to take some short-term profits, especially as these trends are likely to end, at least in the near term. Hence, three weeks ago we closed our underweight banks versus healthcare position, booking a tidy profit of 23 percent. Today, we are closing our underweight position in basic materials versus the market, booking a profit of 6 percent. In a similar vein, we are taking the modest profits in our overweight position in 30-year government bonds. Sector allocation has unavoidable implications for stock market allocation - because the mainstream stock market indexes all have dominant sector skews which determine their relative performances (Chart I-10). Chart I-10Italy Vs. Denmark = Banks Vs. Healthcare On this basis, closing our underweight banks versus healthcare removes the justification for being underweight bank-dominant Italy (MIB) and Spain (IBEX) and the justification for being overweight healthcare-dominant Denmark (OMX). These three positions now move to neutral. While we consider our next shift, our European stock market allocation is temporarily reduced to just five positions. Overweight: France, Ireland, Switzerland. Underweight: Sweden, Norway. Finally, just to say that there will be no report next week as I will be attending our annual Investment Conference which is in Toronto this year. I look forward to seeing some of you there. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Based on the relative performance of the MSCI All Country World Index versus the JP Morgan Global Government Bond Index, both in local currency terms. 2 Please see the European Investment Strategy Weekly Report 'Trapped: Have Equities Trapped Bonds?' September 13 2018 available at eis.bcaresearch.com. 3 Please see the European Investment Strategy Weekly Report 'The Rule Of 4 For Equities And Bonds' August 2 2018 available at eis.bcaresearch.com. Fractal Trading Model* This week, we note that the very strong recent outperformance of U.S. telecoms versus U.S. autos is technically extended, reaching a fractal dimension that has previously signalled the start of a countertrend move. Hence, the recommended trade is short U.S. telecoms, long U.S. autos. Set a profit target of 9% with a symmetrical stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-11 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations

Highlights Recent estimates by ship trackers put the loss of Iranian exports at close to 1mm b/d as of mid-September vs April levels. This loss is higher (and sooner) than our previous baseline expectation, and prompts us to raise our estimate of lost Iranian oil exports to 1.25mm b/d by November, when U.S. sanctions kick in. Venezuela still is close to collapse, but may avoid a complete meltdown with Chinese companies stepping in to safeguard the $50 billion loaned to the country's oil industry.1 We expect production to fall below 1mm b/d next year - to less than half its end-2016 level. With Fed policy likely to continue tightening into 2019 as oil prices surge, the odds of an equity bear market and recession arriving in 2H19 - vs our 2H20 House view - also increase. Our dominant scenario now includes a supply shock and higher prices in 1Q19, which is followed by a U.S. SPR release and price-induced demand destruction (Chart of the Week). As a result, we are raising the odds of Brent prices reaching or exceeding $100/bbl by as early as 1Q19, and lifting our 2019 forecast to $95/bbl. Energy: Overweight. U.S. refining capacity utilization remains close to 19-year highs. At 97.1% of operable capacity, it is within a whisker of the four-week-moving-average highs of 97.3% recorded in August, driven by strong product demand ex U.S. Base Metals: Neutral. The U.S. Treasury granted permission to Rusal's existing customers to continue signing new contracts with the aluminum producer. The announcement stopped short of a full removal of sanctions, which are set to come into effect on October 23. Precious Metals: Neutral. The strong trade-weighted USD continues to hold gold prices on either side of $1,200/oz. We remain long as a portfolio hedge. Ags/Softs: Underweight. The USDA's Crop Production report forecasts record yields for corn and soybeans - 181.3 and 52.8 bushels/acre, respectively - which continues to weigh on prices. The bean harvest is expected to be a record. Feature Chart of the WeekBCA Ensemble Forecast Lifts Brent To $95/bbl, As Market Tightens With the loss of Iranian exports occurring faster and sooner than expected, and Venezuela remaining on the brink of collapse, senior energy officials from the U.S., Russia and the Kingdom of Saudi Arabia (KSA) are going to great lengths to reassure their domestic consumers everything - particularly on the supply side - is under control. We are inclined to believe their comfort level re global oil supply is inversely proportional to the amount of reassurance they provide their domestic audiences. The more they meet and talk - particularly to the media - the more concerned they are. And right now, they're pretty concerned. Rick Perry, the U.S. Energy Secretary, held a presser in Moscow following his meeting with Alexander Novak, Russia's Energy Minister, saying the U.S., KSA and Russia can lift output over the next 18 months to compensate for the loss of exports from Iran, Venezuela, and other unplanned outages.2 That might be true, but the market's already tightening far faster and far sooner than many analysts expected. Covering a supply shortfall in 18 months does nothing for the market over the next few months, particularly with demand remaining robust (Chart 2) and OECD inventories falling (Chart 3). Since 2017, our factor model shows Brent prices have been supported by two factors acting simultaneously together: Chart 2Fundamentals Support Strong Prices Chart 3Inventory Draws Will Accelerate Strong compliance of OPEC 2.0 members to the coalition's production-cutting agreement, which reduced the OPEC Supply-and-Inventory factor's role, and The pickup in global oil demand, particularly in EM economies, which pushed our Global Demand factor up. These effects were partly counterbalanced by the rise in our non-OPEC Supply factor - driven by strong growth in U.S. shale-oil output - which became the largest negative contributor to price movements. Global demand's been strengthening since the end of 1H17 on the back of stellar EM income growth. This remains the fundamental backdrop to global oil for now. While our base case remains relatively supportive for oil prices, we are raising the odds of a price spike resulting from a supply shock as early as 1Q19 on the back of larger- and faster-than-expected Iranian export losses, and continued declines in Venezuelan production. Should this occur, we believe it would trigger a U.S. SPR release, and produce demand destruction at a rate that could be faster than historical experience would suggest (Table 1). This further tightens balances, and leads us to raise our 2019 forecast for Brent crude oil to $95/bbl on average, up from $80/bbl last month, with WTI trading $6/bbl below that (Chart 4). This forecast is highly conditional, given our assumptions re supply-side variables, a U.S. SPR release, and demand destruction estimates. Table 1BCA Global Oil Supply - Demand Balances (MMb/d) (Base Case Balances) Chart 4BCA's Oil Balances Tighter Oil Balances Tighten As Supply Contracts In our monthly balances update, we are incorporating a sharply accelerated loss of Iranian export barrels to the market, which already is evident. Bloomberg this week reported its tanker-tracking service registered a decline in Iranian exports of close to 1mm b/d between April, when sanctions were announced, and mid-September.3 At this rate, the assessment by Platts Analytics last week that as much as 1.4mm b/d of Iranian exports could be lost by the time U.S. sanctions kick in November 4 appears more likely.4 However, to be conservative, we are building in a loss of 1.25mm b/d in our balances, and have it developing over the July - November period in increments of 250k b/d, instead of the November - February interval we assumed in last month's balances. We will monitor this situation and revise our estimates as new information arrives. Also on the supply side, we are assuming the U.S. SPR releases 500k b/d starting a month after Brent prices go over $90/bbl in March 2019. This is in line with the SPR's enabling legislation, which limits drawdowns to 30mm b/d over a 60-day period, after the President authorizes such action to meet a severe energy supply interruption. Lastly, we continue to carry supply constraints arising from the lack of sufficient take-away capacity to get all of the crude produced in the Permian Basin to refining markets in our models. To wit: We continue to expect 1.2mm b/d of supply growth from the U.S. shales, driven largely by Permian production, vs an earlier expectation of 1.4mm b/d of growth. We expect the Permian to be de-bottlenecked by 4Q19. We expect the Big 3 producers Secretary Perry expects to fill supply gaps in 18 months - the U.S., Russia, and KSA - to produce 10.83mm, 11.4mm and 10.4mm b/d in 2H18, and 11.79mm, 11.43mm and 10.4mm b/d next year, respectively. They will get some help from OPEC's Gulf Arab producers - i.e., the core OPEC producers (Chart 5) - but, supply will continue to fall/stagnate in most of the rest of the world, particularly in offshore producers (Chart 6). Chart 5While Core OPEC Can Increase Supply... Chart 6... 'The Other Guys' Output Stagnates We also note the EIA and IEA have lowered their supply-growth estimates this month. The EIA this month reduced expected U.S. crude production growth by 210k b/d in 2019, and the IEA lowered its estimate of offshore production growth in Brazil from 260k b/d to just 30k b/d this year. These are non-trivial adjustments in a market that was tight prior to the downgrade in supply growth. Still, there are significant marginal disagreements on the supply side among the major data supporters (the EIA, IEA and OPEC), which can be seen in Table 2. Table 2Comparison Of Major Balances Estimates Demand Destruction Likely As Prices Spike In 1Q19 We expect the rate of growth in EM incomes and trade - a proxy for income - to slow slightly this year vs 2017, on the back of a strengthening USD. This will reduce the rate of growth in EM imports and the rate of growth in EM commodity demand, at the margin. However, y/y growth in EM incomes is expected to remain positive over the next 12 months in our baseline scenario, which will keep the level of commodity demand - particularly for oil and industrial metals - robust. This will drive global demand growth of ~ 1.6mm b/d this year, roughly unchanged from last month. Higher prices risk slowing next year's growth. This is where it gets tricky. An oil-supply shock occurring when global demand is strong most likely will produce a price spike, as we've been arguing for the past several weeks.5 This price spike, coupled with continued monetary-policy tightening by the Fed, raises the likelihood of demand destruction globally. Higher oil prices and a stronger USD act as a double-whammy on EM oil demand. The problem we have now is gauging the elasticity of oil demand, particularly in EM. Oil markets are fundamentally different now than at any point in the modern era - roughly beginning in the early 1960s with the ascendance of OPEC - because many big oil-importing EM economies removed or relaxed subsidies following the prices collapse of 2014 - 2016. Prominent among these states are China and India. OPEC states also took advantage of the price collapse to relax or remove subsidies, e.g., KSA.6 The price shock we anticipate, therefore, will be the first in the modern era in which EM consumers - the principal driver of oil demand in the world, accounting for roughly 70% of the demand growth we expect - are exposed directly to higher prices. How quickly they will respond to higher prices is unknown. For this reason, we're introducing what we consider a reasonable first approximation of how EM demand might respond to higher prices and a stronger USD into the scenarios we include in our ensemble forecast (Chart 7). As a first approximation - subject to at least monthly adjustment, as more data become available - we are modeling a 100k b/d loss of demand for every $10/bbl increase in crude oil prices.7 We will continue to iterate on this as new information becomes available. Chart 7Ensemble Scenarios Reflect New Risks Bottom Line: We've raised the odds of a supply shock in the oil markets that takes Brent prices to or through $100/bbl by 1Q19. Should this occur, we expect it will be met by a U.S. SPR release of 500k b/d a month after prices breach $90/bbl. This price spike will set off a round of demand destruction, which we expect will be quicker than history would suggest, given many large EM oil-consuming states have relaxed or eliminated fuel subsidies, leaving their consumers exposed to the price shock. This will be exacerbated by a stronger USD going forward, as the Fed likely looks through the price spike and continues with its policy-rate normalization. In this scenario, a U.S. recession could arrive in 2H19 vs our House view of 2H20 or later. In addition, we would expect an equity bear market to ensue sooner than presently anticipated. We recommend using Brent call spreads to express the view consistent with our research. At tonight's close, we will go long April, May and June 2019 calls struck at $85/bbl and short $90/bbl calls. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 Please see "Venezuela hands China more oil presence, but no mention of new funds," published by reuters.com September 14, 2018. 2 U.S. Energy Secretary Rick Perry made this claim at a press conference after meeting with Russian Energy Minister Alexander Novak last Friday. Please see "Big Three oil states can offset fall in Iran supplies: Perry," published by reuters.com September 14, 2018. 3 Please see "Saudi Arabia Is Comfortable With Brent Oil Above $80," published by bloomberg.com September 18, 2018. 4 Please see "OPEC crude oil production rises to 32.89 mil b/d in Aug as cuts unwind: Platts survey" published by SP Platts Global September 6, 2018. 5 Please see "Oil-Supply Shock, Rising U.S. Rates Favor Gold As A Portfolio Hedge," published by BCA Research's Commodity & Energy Strategy Weekly Report on September 13, 2018. It is available at ces.bcaresearch.com. For a discussion of the effect of a stronger USD on global oil demand, please see "Trade, Dollars, Oil & Metals ... Assessing Downside Risk," published by the Commodity & Energy Strategy August 23, 2018. 6 Please see the Special Focus in the World Bank's January 2018 Global Economic Prospects entitled "With The Benefit of Hindsight: The Impact of the 2014 - 16 Oil Price Collapse," beginning on p. 49. 7 In this simulation, we employ an iterative one-step-ahead forecasting methodology that reduces demand by 100k b/d for every $10/bbl increase in prices. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2017 Summary of Trades Closed in 2018

Highlights In this Weekly Report, we present our semi-annual chartbook of the BCA Central Bank Monitors. The message now conveyed by the Monitors is that divergences between the cyclical pressures faced by the individual central banks are growing larger. This is occurring within some countries, where the growth and inflation indicators are trending in opposite directions. This is also visible across countries, with not every Monitor calling for rate hikes - a significant shift from the coordinated backdrop seen in 2017 (Chart of the Week). Chart of the WeekFrom Convergence To Divergence In The BCA Central Bank Monitors The combined message from the Monitors is that the slower pace of global growth seen in 2018 has not been enough put a serious dent in inflation pressures stemming from a dearth of spare capacity in most major countries. Perhaps that changes if a full-blown U.S.-China trade war develops, or if the tensions in emerging markets spill over more broadly into global financial conditions, but that remains to be seen. Add it all up, and a below-benchmark stance on overall global duration exposure remains appropriate. Feature An Overview Of The BCA Central Bank Monitors Chart 2CB Monitor Divergence = Bond Yield Divergence The BCA Central Bank Monitors are composite indicators designed to measure the cyclical growth and inflation pressures that can influence future monetary policy decisions. The economic data series used to construct the Monitors are not the same for every country, but the list of indicators generally measure the same things (i.e. manufacturing cycles, domestic demand strength, commodity prices, labor market conditions, exchange rates, etc). The data series are standardized and combined to form the Monitors. Readings above the zero line for each Monitor indicate pressures for central banks to raise interest rates, and vice versa. Through the nexus between growth, inflation, and market expectations of future interest rate changes, the Monitors do exhibit broad correlations to government bond yields in the Developed Markets (Chart 2). Our current recommended country allocation for global government bonds reflects the trends seen in the Central Bank Monitors - underweighting countries were the Monitors are most elevated (the U.S., Canada) in favor of regions where the Monitors are lower (Australia, Japan, euro area, New Zealand). In each BCA Central Bank Monitor Chartbook, we include a new chart for each country that we have not shown previously. In this edition, we show the Monitors plotted against the relative returns for each country versus the overall Bloomberg Barclays Global Treasury index (shown inversely in the charts so that a rising line means underperformance versus the benchmark index). Fed Monitor: Still On A Gradual Rate Hike Path Our Fed Monitor remains in the "tight money required" zone, signalling that the cyclical backdrop justifies additional Fed rate hikes (Chart 3A). Resilient U.S. growth, a dearth of spare capacity and an acceleration of both wage growth and core inflation are all consistent with a U.S. economy starting to overheat and requiring tighter monetary policy (Chart 3B). Chart 3AU.S.: Fed Monitor Chart 3BU.S. Inflation On The Rise The growth and inflation components of the Fed Monitor have both accelerated since our last Central Bank Monitor Chartbook was published back in April. Most notably, the inflation component has blasted through the zero line to the highest level since 2008 (Chart 3C). The financial conditions component has retreated from very elevated (i.e. growth-supportive) levels, mostly due to the stronger U.S. dollar but also because of wider corporate credit spreads seen since the start of 2018. Importantly, the financial conditions component has not tightened enough to offset the impact on the Monitor from faster growth and inflation. Chart 3CAll Fed Monitor Components Now Above Zero Recent comments from senior Fed officials (Chair Jay Powell and Governor Lael Brainard) have indicated that the Fed is less confident in its own estimates of the full-employment NAIRU or the appropriate neutral level of the funds rate. Our read on this is that the Fed will instead continue to raise the funds rate at a gradual 25bp per quarter pace until there are signs that U.S. monetary policy has become tight (i.e. an inverted yield curve, wider credit spreads, softer U.S. economic data). Until then, the message sent by the Fed Monitor is to remain underweight U.S. Treasuries with below-benchmark duration, as market pricing of expectations for both the funds rate and inflation remain too low (Chart 3D). Chart 3DU.S. Treasury Underperformance Will Continue - Stay Underweight BoE Monitor: Brexit Uncertainty Trumps Inflation Pressures The BoE Monitor remains in the "tighter money required" zone as it has since late 2015 (Chart 4A). Despite that persistent signal, the BoE has kept monetary policy at highly accommodative levels, only raising the base rate 50bps over the past year. The BoE Monetary Policy Committee remains torn between signs that inflation risks are tilted to the upside and the downside risks to U.K. growth from an uncertain Brexit outcome. The U.K. unemployment rate is well below NAIRU with an output gap that is now estimated to be closed (Chart 4B). Yet realized inflation has peaked, with core inflation drifting back below 2%. Wages are finally starting to grow in real terms, which the BoE cites as an important factor underpinning consumer spending, but the pace remains modest. Chart 4AU.K.: BoE Monitor Chart 4BNo Spare Capacity, Yet Has Inflation Peaked? Looking at the breakdown of our BoE Monitor, both the growth and inflation sub-components of the indicator have recently reaccelerated (Chart 4C). Yet U.K. leading economic indicators continue to decline and dampened business confidence measures reflect the heightened uncertainty over the future relationship between the U.K. and the European Union. Chart 4CBoth Growth & Inflation Components Are Boosting The BoE Monitor The performance of U.K. Gilts has diverged from the Monitor since the 2016 Brexit vote (Chart 4D), as the BoE has been more worried about Brexit than inflation and has stayed accommodative. Stay overweight U.K. Gilts within global government bond portfolios, even with the more bearish signal implied by our BoE Monitor, given the weakening trend in leading economic indicators and persistent Brexit uncertainty. Chart 4DBrexit Uncertainty Preventing More BoE Hikes - Stay Overweight Gilts ECB Monitor: No Pressure To Hike Rates Quickly Post-QE Our European Central Bank (ECB) Monitor has fallen sharply since we last published this Chartbook back in April, and it now sits below the zero line (Chart 5A). The growth deceleration in the first half of the year from the rapid pace seen in 2017 is the main reason for this move, as inflation pressures have not subsided (Chart 5B). Chart 5AEuro Area: ECB Monitor Chart 5BEuro Area At Full Capacity ECB President Mario Draghi noted last week that the plan remains in place to end the net new buying phase of the ECB's Asset Purchase Program at the end of 2018. Policymakers' have grown more confident that their inflation forecasts will be met as most measures of euro area wage growth (and headline inflation) have accelerated to 2% over the past year. It remains to be seen if those expectations are too optimistic, as the growth component of our ECB Monitor remains well below the zero line, while the inflation component is no longer rising (Chart 5C). Chart 5CGrowth Component Dragging Down The ECB Monitor For now, we recommend a neutral stance on core euro area government bonds with an underweight posture on Peripheral sovereign debt as a way to manage these conflicting trends. The overall performance of euro area bonds versus global benchmarks has followed the pace of the ECB's bond-buying since 2015, and not the pressures suggested by our ECB Monitor (Chart 5D), suggesting a bearish stance as the bond buying ends. Yet from a more bullish perspective, the mixed message on growth and lack of immediate pressures on core inflation (still at 1%) imply that the ECB will not deviate from its current dovish forward guidance of no interest rate hikes until at least September 2019. Chart 5DECB Will Not Hike Rates Quickly After QE Ends - Stay Neutral Core European Bonds BoJ Monitor: Too Soon To Consider Policy Changes Our Bank of Japan (BoJ) Monitor has stayed just barely in the "tighter money required" zone since last October, due mostly to growing inflation pressures (Chart 6A). Yet with the Japanese labor market now as tight as it has been in decades, headline and core CPI inflation are only at 0.9% and 0.3% respectively, well below the BoJ's 2% target (Chart 6B). Chart 6AJapan: BoJ Monitor Chart 6BInflation Pressures Slowly Building In Japan Japanese firms appear to finally be reacting to the tightness of the labor market, however, as wage growth has accelerated in recent months. The pick-up in wages has helped boost inflation expectations, both of which are part of the inflation component of the BoJ Monitor that is now at the highest level since 2008 (Chart 6C). However, the growth component just rolled over and now sits at the zero line, as the Japanese economy has lost some momentum. Chart 6CInflation Boosting BoJ Monitor We continue to recommend an overweight stance on JGBs, based on our view that the BoJ will maintain hyper-easy monetary policy settings - especially compared to the rest of the developed markets - until there is much higher realized inflation in Japan. JGBs have indeed been outperforming over the past year, even with the less dovish signal sent by the BoJ Monitor (Chart 6D). Yet the absolute level of the Monitor remains around zero, suggesting that no policy changes should be expected. That means no upward adjustment of the BoJ's 0% yield target on 10-year JGBs or major further reductions in the annual pace of BoJ JGB buying (even though the central bank is hitting capacity constraints as it now owns close to ½ of all outstanding JGBs). Chart 6DBoJ In No Hurry To Turn Hawkish - Stay Overweight JGBs BoC Monitor: Rate Hikes - More To Come The Bank of Canada (BoC) Monitor has stayed in "tighter money required" since the beginning of 2017 and is now well above the zero line (Chart 7A). The BoC has been following our BoC Monitor, hiking rates by a cumulative 100bps since July 2017. Chart 7ACanada: BoC Monitor Chart 7BAn Overheating Canadian Economy? The BoC has been responding to the growing inflation pressure in Canada. There is no evidence that spare economic capacity exists, while realized inflation is near the upper bound of BoC's target range of 1-3% (Chart 7B). There is a growing divergence between the growth and inflation subcomponents of the BoC Monitor, with the latter decelerating over the past several months. That was due to a combination of slowing Chinese import demand and the imposition of trade tariffs on Canada by the Trump administration (Chart 7C). Yet the domestic economy remains in good shape, with the overall indicator from the BoC's Business Outlook Survey at the highest level since 2010. Chart 7CInflation Component Boosting BoC Monitor We continue to recommend an underweight stance on Canadian government bonds, as the relative performance has broadly followed the path of the BoC Monitor over the past three years (Chart 7D). The BoC tends to follow the policy actions of the Fed with a short lag, thus our bearishness on Canadian government bonds is related to our more hawkish views on the Fed. Yet the surge in Canadian inflation, at a time when the economy has no spare capacity, suggests that there are good domestic reasons to expect more rate hikes from the BoC over the next year than what is currently discounted by markets. Chart 7DBoC Not Done Yet - Stay Underweight Canadian Bonds RBA Monitor: Easier Policy Needed The Reserve Bank of Australia (RBA) monitor has rapidly fallen below the zero line for the first time since 2016, and now indicates that easier monetary policy is required (Chart 8A). This stands out from the more stable trajectory of the rest of the BCA Central Bank Monitors. Unlike most other developed countries, there is still excess capacity in the Australian economy. Australia's output gap has not closed while the current unemployment rate is just at the OECD's NAIRU estimate of 5.3%. Headline and core inflation are at the low end of the RBA's 2-3% target and struggling to gain much upward momentum (Chart 8B). Chart 8AAustralia: RBA Monitor Chart 8BMinimal Inflation Pressure In Australia While both the growth and inflation components of the RBA Monitor have fallen, the biggest decline has come from the inflation side (Chart 8C). The sluggishness of Australia's economy is due to the slow growth of consumer spending and a big deceleration in exports related to softer Chinese demand. On inflation, excess labor market slack, with an underemployment rate close to 8.5%, is the main factor explaining soft wage growth and overall sluggish inflation. Chart 8CInflation Component Weighing On RBA Monitor Our highest conviction country allocation call this year has been to overweight Australian Government bonds, and we see no need to change that given the bullish signal from our RBA Monitor (Chart 8D). It would likely take a rise in unemployment, a renewed decline in realized inflation or a big external shock for the RBA to actually cut rates as our Monitor suggests, but the signal is still bullish for Australian debt on a relative basis. Chart 8DRBA A Long Way From A Hike - Stay Overweight Australian Government Bonds RBNZ Monitor: Policy On Hold For A While Longer The Reserve Bank of New Zealand (RBNZ) Monitor is currently just above the zero line, indicating that tighter monetary policy is required (although just barely) (Chart 9A). This is consistent with the mixed messages in the New Zealand economic data. For example, there is no spare capacity in the economy according to estimates of the output and employment gaps, yet both headline and core inflation have decelerated to the lower end of the RBNZ's 1-3% target band (Chart 9B). Chart 9ANew Zealand: RBNZ Monitor Chart 9BNo Spare Capacity In NZ, But No Inflation Either Looking at the components of the RBNZ Monitor, the growth factors have continued to plunge whereas the inflation factors have been increasing (from below zero) since the start of 2018 (Chart 9C). New Zealand's economic growth has slowed because of softer consumer spending and weaker housing activity, the latter of which is related to lower net immigration. Yet business confidence is falling, both the manufacturing and services PMIs have also declined, and export growth has cooled thanks to weaker growth from China and Australia. Meanwhile, the uptick in the inflation components has not yet translated into any broader improvement in realized inflation that would cause the RBNZ to take a more hawkish turn. Chart 9CConflicting Trends Within The RBNZ Monitor We continue to recommend an overweight stance on New Zealand Government Bonds, in line with the bullish signal sent by our RBNZ Monitor (Chart 9D). The RBNZ has already provided forward guidance indicating that the Overnight Cash Rate (OCR) will stay unchanged until 2020, and it will take some time before there is evidence that the recent hook down in inflation is nothing more than a temporary blip. Chart 9DRBNZ To Remain On Hold - Stay Long New Zealand Bonds Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, CFA, Research Analyst ray@bcaresearch.com Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights The Trump administration's decision to effectively tariff the second round of imports at 25% materially raises the odds of another significant uptick in Chinese financial market volatility. Even if China ramps up its stimulus efforts in response, the lesson of the 2014-2016 episode is that investors are likely to wait for earnings clarity before buying stocks aggressively. Stay neutral China, at best, relative to global stocks, and overweight low-beta sectors within the investable equity universe. We have a contrarian view about Chinese corporate bonds, and recommend holding a long but diversified position over the coming 6-12 months. Feature Chart 1The RMB Is Acting As A "Panic Barometer" ##br##For Domestic Stocks The Trump administration finally announced its decision this week on the second round of tariffs on Chinese imports, essentially applying a 25% rate. While the rate will initially start at 10%, it will rise to 25% by the end of the year, and the administration has threatened to immediately seek public consultation on tariffs on all remaining imports from China if the country retaliates against the second round (which was announced yesterday). With news reports having suggested that China would reject new trade talks merely if the second round moves forward, the prospect of a breakthrough in negotiations seems dim, at best. We have highlighted in past reports that the RMB has acted as a panic barometer for domestic equities (Chart 1), as evidenced by the recent spike in the correlation between the two. During this period, the percent decline in CNY-USD seems to have closely followed the magnitude of proposed tariffs as a percent of Chinese exports to the U.S., as would be implied in a simple open economy model with flexible exchange rates. Based on this framework, Chart 2 suggests that the RMB may come under considerable further market pressure, even if investors only assume a 10% rate on the third round of tariffs. A break above the psychologically-important level of 7 for USD-CNY appears likely barring a major intervention from the PBOC, suggesting that a meaningful uptick in Chinese financial market volatility is forthcoming. Chart 2USDCNY = 7 Is Likely To Be Breached Barring Strong Action From The PBOC Stimulus To The Rescue? Given that Chinese policymakers have signaled their willingness to stimulate in response to a negative external environment, some investors have argued that China is actually about to enter a mini-cycle upswing. For now, two points suggest that this conclusion is premature: A 10% tariff rate on all remaining imports from China would imply close to $90 billion in tariffs collected, once the second round rate rises to 25%. As noted above, a simple equilibrium exchange rate framework would imply material further weakness in the RMB to counter protectionism of this magnitude. Besides heralding a further selloff in Chinese stocks, this could lead to competitive currency devaluation amongst China's largest trading partners, a "beggar-thy-neighbor" policy that tends to exacerbate rather than alleviate shocks to aggregate demand. As we have noted numerous times over the past year, China's old economy was slowing in the lead up to the U.S./China trade war, and it is not yet clear whether the announced stimulus will generate enough "lift" to convince investors that the low in economic activity is behind them. Chart 3 shows that the August rise in adjusted total social financing as a share of GDP was extremely muted, and that there is no sign yet of a pickup in government spending. Even if China ramps up its stimulus efforts in response to this week's decision from the Trump administration, Chart 4 highlights an important point for investors: there was a considerable lag between a policy response and the low in stock prices during the 2014-2016 episode (a lag that may re-occur today). The chart shows that despite an ongoing depreciation in the RMB and a rebound in our BCA leading indicator for the Li Keqiang index, Chinese stock prices continued to decline for several months. This gap was caused by a lagged decline in earnings, and underscores that investors may ignore the current efforts by policymakers to stabilize the economy until clarity on the stability of earnings presents itself. Chart 3No Sign Yet Of##br## Major Stimulus Chart 4History Suggests Investors Need Both ##br##Stimulus And Earnings Clarity And for now, several signs point to potentially material downside risk for earnings: While the now considerably larger shock from U.S. tariffs has yet to impact the Chinese economy, trailing earnings growth has already peaked and has recently fallen below its trend (Chart 5, panel 1). Despite the recent deceleration in trailing earnings growth and the sharp decline in stock prices, analysts' 12-month forward growth estimates remain quite elevated (Chart 5, panel 2). This suggests that forward earnings could be vulnerable to a decline above and beyond what occurs to trailing earnings, as a full 1/3rd of the increase in the former since late-2015 has been due to very significant shift in growth expectations. The rise in trailing earnings over the past few years appears to be stretched, based the trend in profit margins (Chart 6). The chart highlights that 12-month trailing earnings have well surpassed sales since late-2016, causing margins to rise to their highest level on record and raising the risk of a significant mean-reversion in response to a meaningful economic shock. Net earnings revisions have done a good job at predicting inflection points in forward earnings growth over the past decade, and have recently fallen into negative territory (Chart 7). Chart 5Lofty Earnings Growth Expectations ##br##Are A Risk To Stocks Chart 6The Earnings Recovery Has Been Partly ##br##Reliant On A Margin Expansion Chart 7Earnings Revisions Herald ##br##Slowing Earnings Momentum It is true that some of the above-average levels for profit margins and 12-month forward growth expectations can be explained by the substantial rise in the share of the tech sector in the MSCI China index, whose constituents are significantly more profitable than ex-tech stocks, may have better longer-term growth prospects, and may be more immunized from the trade war with the U.S. Still, Chart 8 illustrates the high earnings hurdle rate for tech stocks over the coming year. Bottom-up analysts continue to expect tech stocks to grow their earnings more than 20% over the next 12 months, despite: Chart 8Are Chinese Tech Stocks Going To Be##br## Able To Grow Earnings 20+%? A poor economic outlook that is likely to impact consumer spending (even if households "outperform" the business sector), and The fact that tech sector net earnings revisions have fallen deeply into negative territory (panel 2). How should investors allocate capital within China in the middle of a trade war with the U.S? First, despite the fact that Chinese stocks have already fallen significantly from their early-January high, it is clearly too early to bottom fish either domestic or investable stocks. Stay neutral China, at best, relative to global stocks. Second, investors should certainly favor low-beta sectors within the Chinese equity universe. Currently, our low-beta equity portfolio includes industrials, telecom services health care, utilities, and consumer staples, but we update the portfolio weights at the end of every month. Third, as discussed below, investors should ignore the very bearish narrative towards Chinese corporate bonds, and hold a long but diversified position over the coming 6-12 months. Bottom Line: The Trump administration's decision to effectively tariff the second round of imports at 25% materially raises the odds of another significant uptick in Chinese financial market volatility. Even if China ramps up its stimulus efforts in response, the lesson of the 2014-2016 episode is that investors are likely to wait for earnings clarity before buying stocks aggressively. Stay neutral China, at best, relative to global stocks, and overweight low-beta sectors within the investable equity universe. Chinese Corporate Bonds: A Contrarian Long Our analysis of the earnings risk facing equities suggests that it is probably still too early to buy Chinese stocks, but in our (contrarian) view there is still one pro-cyclical asset that investors should favor: Chinese corporate bonds. Headlines about defaults in China's corporate bond market continue to appear in the financial press, with concerns most recently focused on low recovery rates of defaulted issues.1 We last wrote about Chinese corporate bonds in June,2 and took a contrarian (i.e. optimistic) stance towards the market. In the meantime, our long China onshore corporate bond trade has continued to gain ground, and an analysis of the inferred credit rating of the market actually strengthens our conviction to stay long. One key element of the bearish narrative towards Chinese corporate bonds is the fact that investment-grade issues in the market are trading like junk. Table 1 highlights that this is largely true: the table presents the spread-inferred credit rating of the four major rating categories of the ChinaBond Corporate Bond Index, and shows that AAA bonds are trading on the border of equivalent maturity investment- and speculative-grade bonds in the U.S. Bonds rates AA+/AA/AA- in China are trading between lower-B and high-CAA, which is firmly in speculative-grade territory. However, in our view market participants are making a mistake when they assume that de-facto junk ratings on Chinese corporate bonds will translate into U.S. junk-style default rates on bonds over the coming 6-12 months (or, frankly, beyond). Chart 9 presents an estimate of the market-implied default rate for the four rating categories shown in Table 1, and suggests that investors are pricing in roughly a 1% default rate for AAA-rated corporate bonds and a 4-5% default rate for AA+/AA/AA-. Table 1Chinese Corporate Bonds Are Trading##br## Like Speculative-Grade Issues Chart 9Allowing Market-Implied Default Rates##br## To Occur Would Be A Huge Policy Error There are two important factors to consider when gauging the validity of these expectations: Based on Moody's most recent Annual Default Study, the market's current expectations for Chinese corporate bond defaults are actually above the average historical one-year default rates for their inferred credit ratings. Average default rates almost never actually occur over a given 12-month period. Chart 10 highlights that default rates in the U.S. have a binary distribution that is almost entirely determined by whether the economy is in recession (not just slowing down). The late-1980s and the post-2015 environment have been exceptions to this rule, which in large part can be explained by industry-specific events (namely, a surge of energy-sector defaults due to a collapse in the price of oil). But the key point is that investors are likely to overestimate the actual default rate over a given 12 month period when assuming an average historical rate, unless the economy shifts from an expansion to an outright recession over the period. From our perspective, the combination of the market's default expectations and the fact that China is easing suggests an outright long position in Chinese corporate bonds is warranted over the coming year. In our judgement, there is simply no way that policymakers can allow default rates on the order of what is being priced in to occur, as it would constitute an enormous policy mistake that would risk destabilizing the financial system at a time when officials are attempting to counter the looming shock to the export sector. In fact, we doubt that China's typical policy of gradualism when liberalizing its economy and financial markets would allow default rates to rise from 0% to 5% over a year in any economic environment, particularly the current one. As a final point, Chart 11 highlights why a significant rise in the default rate is required in order for investors to lose money on Chinese corporate bonds. The chart shows the 12-month breakeven spread for the ChinaBond AA- Corporate Bond index, unadjusted for default. The breakeven spread represents the rise in yields that would be required for investors to lose money over a 12-month horizon (i.e. the yield change that exactly erases the income return from the position), assuming no defaults. Chart 10"Average" Default Rates ##br##Do Not Really Occur Chart 11A 2% Rise In Yields From Tighter Policy Is Not##br## Going To Occur Over The Coming Year The chart shows that AA- bond yields would have to rise approximately 215 bps over the coming year before investors suffer a negative total return, which would be an enormous rise that has a near-zero probability of occurring due of tighter monetary policy. As such, defaults (or the pricing of default risk) remains the only real credible source of potential capital loss from these bonds over the coming year. Our bet, with high conviction, is that holders of Chinese corporate bonds hold a put option that will prevent this from occurring. Bottom Line: Fade investor concerns about rising defaults, and stay long Chinese corporate bonds over the coming 6-12 months. We acknowledge that idiosyncratic risk is likely to be elevated for this asset class, and we recommend that investors take a diversified, portfolio approach when investing in China's corporate bond market. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 For example, please see "In China, Less Than 20% Defaulted Bonds Have Been Paid Back" by Bloomberg News, August 27, 2018 2 Pease see China Investment Strategy Weekly Report "A Shaky Ladder", dated June 13, 2018, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations