Colombia

Highlights An analysis on Colombia is available below. If EM share prices hold at current levels, a major rally will likely unfold. If they are unable to hold, a substantial breakdown will likely ensue. The direction of EM US dollar and local currency bond yields will be the key to whether EM share prices break down or not. We expect continuous EM currency depreciation that will likely trigger foreign capital outflows from both EM credit markets and domestic bonds. This leads us to reiterate our short position in EM stocks. We are booking profits on the long implied EM equity volatility and the short Colombian peso/long Russian ruble positions. Feature The Federal Reserve’s intra-meeting rate cut this week might temporarily boost EM risk assets and currencies. However, it is also possible that investors might begin questioning the ability of policymakers in general and the Fed in particular to continuously boost risk assets. In recent years, investors have been operating under the implicit assumption that policymakers in the US, China and Europe have complete control over financial markets and global growth, and will not allow things to get out of hand. Investors have been ignoring contracting global ex-US profits as well as exceedingly high US equity multiples and extremely low corporate spreads worldwide. In the past 12 months, investors have been ignoring contracting global ex-US profits (Chart I-1) as well as exceedingly high US equity multiples. This has been occurring because of the infamous ‘policymakers put’ on risk assets. As doubts about policymakers’ ability to defend global growth and financial markets from COVID-19 heighten, investors will likely throw in the towel and trim risk exposure. A sudden stop in capital flows into EM is a distinct possibility. The Last Line Of Defense EM share prices are at a critical juncture (Chart I-2). If they hold at current levels, a major rally will likely unfold. If they are unable to hold at current levels, a substantial breakdown will likely ensue. Chart I-1Profitless Rally In 2019 Makes Stocks Vulnerable Chart I-2EM Share Prices Are At A Critical Juncture   What should investors be looking at to determine whether EM share prices will find a bottom close to current levels, or whether another major down-leg is in the cards? In our opinion, the direction of EM sovereign and corporate US dollar bond yields as well as EM local currency government bond yields will be the key to whether EM share prices break down or not. Chart I-3 illustrates that EM equity prices move in tandem with EM corporate US dollar bond yields as well as EM local currency bond yields (bond yields are shown inverted on both panels). Falling EM fixed income yields have helped EM share prices tremendously in the past year. Chart I-3EM Equities Drop When EM US Dollar & Domestic Bond Yields Are Rising EM corporate US dollar bond yields can rise under the following circumstances: (1) when US Treasury yields are ascending more than corporate credit spreads are tightening; (2) when EM credit spreads are widening more than Treasury yields are falling; or (3) when both US government bond yields and EM credit spreads are increasing simultaneously. Provided the backdrop of weaker growth is bullish for US government bonds, presently EM corporate US dollar bond yields can only rise if their credit spreads widen by more than the drop in Treasury yields. In short, the destiny of EM equities currently rests with EM corporate spreads. EM corporate and sovereign credit spreads are breaking above a major technical resistance (Chart I-4). The direction of these credit spreads is contingent on EM exchange rates and commodities prices as demonstrated in Chart I-5. Credit spreads are shown inverted in both panels of this chart. Chart I-4A Breakout In EM Sovereign And Corporate Credit Spreads? Chart I-5Falling EM Currencies And Commodities Herald Wider EM Credit Spreads   EM exchange rates are also crucial for foreign investors’ in EM domestic bonds. The top panel of Chart I-6 demonstrates that even though the total return on the JP Morgan EM GBI domestic bond index has been surging in local currency terms, the same measure in US dollar terms is still below its 2012 level. The gap is due to EM exchange rates. EM local currency bond yields are at all-time lows (Chart I-6, bottom panel), reflecting very subdued nominal income growth and low inflation in many developing economies (Chart I-7). Chart I-6EM Currencies Are Key To EM Domestic Bonds Total Returns Chart I-7Inflation Is Undershooting In EM Ex-China   Hence, low EM domestic bond yields are justified by their fundamentals. Yet foreign investors are very large players in EM local bonds, and their willingness to hold these instruments is contingent on EM exchange rates’ outlook. The sensitivity of international capital flows into EM US dollar and local currency bonds to EM exchange rates has diminished in recent years because of global investors’ unrelenting search for yield. As QE policies by DM central banks have removed some $9 trillion in high-quality securities from circulation, the volume of fixed-income securities available in the markets has shrunk. This has led to unrelenting capital inflows into EM fixed-income markets, despite lingering weakness in their exchange rates. Nonetheless, sensitivity of fund flows into EM fixed-income markets to EM exchange rates has diminished but has not yet outright vanished. If EM currencies depreciate further, odds are that there will be a sudden stop in capital flows into EM fixed-income markets. Outside of some basket cases, we do not expect the majority of EM governments or corporations to default on their debt. Yet, we foresee further meaningful EM currency depreciation which will simply raise the cost of servicing foreign currency debt. It would be natural for sovereign and corporate credit spreads to widen as they begin pricing in diminished creditworthiness among EM debtors in foreign currency terms.     Bottom Line: Unlike EM equities, EM fixed-income markets are a crowded trade and are overbought. Hence, any selloff in these markets could trigger an exodus of capital pushing up their yields. Rising yields will in turn push EM equities over the cliff. EM Currencies: More Downside We expect EM currencies to continue depreciating. EM ex-China currencies’ total return index (including carry) versus the US dollar is breaking down (Chart I-8, top panel). This is occurring despite the plunge in US interest rates. Notably, as illustrated in the bottom panel of Chart I-8, EM ex-China currencies have not been correlated with US bond yields. The breakdown in correlation between EM exchange rates and US interest rates is not new. This means that the Fed's easing will not prevent EM currency depreciation. EM currencies correlate with commodities prices generally and industrial metals prices in particular (Chart I-9, top panel). The latter has formed a head-and-shoulders pattern and has broken down (Chart I-9, bottom panel). The path of least resistance for industrial metal prices is down. Chart I-8More downside In EM Ex-China Currencies Chart I-9A Breakdown In Commodities Points To A Relapse In EM Currencies Chart I-10Chinese Imports Are Key To EM Currencies EM currencies’ cyclical fluctuations occur in-sync with global trade and Chinese imports (Chart I-10). Both will stay very weak for now. Finally, China is stimulating, and we believe the pace of stimulus will accelerate. However, the measures announced by the authorities so far are insufficient to project a rapid and lasting growth recovery. In particular, the most prominent measure announced in China is the PBoC’s special re-lending quota of RMB 300 billion to enterprises fighting the coronavirus outbreak. However, this amount should be put into perspective. In 2019, private and public net credit flows were RMB 23.8 trillion, and net new broad money (M2) creation was RMB 16 trillion. Thus, this re-lending quota will boost aggregate public and private credit flow by only 1.2% and broad money flow by mere 2%. This is simply not sufficient to meaningfully boost growth in China. Notably, daily, commodities prices in China do not yet confirm any growth recovery (Chart I-11). Barring an irrigation-type of credit and fiscal stimulus, the mainland economy will disappoint. Bottom Line: The selloff in EM exchange rates will persist. As discussed above, this will likely lead to outflows from both EM credit markets and domestic bonds. Reading Markets’ Tea Leaves It is impossible to forecast the pace and scope of the spread of COVID-19 as well as the precautionary actions taken by consumers and businesses around the world. In brief, it is unfeasible to assess the COVID-19’s impact on the global economy. The direction of EM sovereign and corporate US dollar bond yields as well as EM local currency government bond yields will be the key to whether EM share prices break down or not. Rather than throwing darts with our eyes closed, we examine profiles of various financial markets with the goal of detecting subtle messages that financial markets often send: Aggregate EM small-cap and Chinese investable small-cap stocks seem to be breaking down (Chart I-12). Chart I-11Daily Commodities Prices In China: No Sign Of Revival Chart I-12Investable Small Cap Stocks Seem To Be Breaking Down   The technical profiles of various EM currencies versus the US dollar on a total return basis (including the carry) are consistent with a genuine bear market (Chart I-13). Hence, their weakness has further to go. Global industrial stocks’ relative performance against the global equity benchmark has broken below its previous technical support (Chart I-14). This is a bad omen for global growth. Chart I-13EM Currencies Are In A Genuine Bear Market Chart I-14A Breakdown In Global Industrials Relative Performance   Finally, Korean tech stocks as well as the Nikkei index seem to have formed a major top (Chart I-15). This technical configuration suggests that their relapse will very likely last longer and go further. Chart I-15A Major Top in Korean And Japanese Stocks? All these signposts relay a downbeat message on global growth and, consequently, EM risk assets and currencies. A pertinent question to ask is whether the currently extremely high level of the VIX is a contrarian signal to buy stocks? Investors often buy the VIX to hedge their underlying equity portfolios from short-term downside. However, when and as they begin to view the equity selloff as enduring, they close their long VIX positions and simultaneously sell stocks. In brief, the VIX’s current elevated levels are likely to be a sign that many investors are still long stocks. When investors trim their equity holdings, they will likely also liquidate their long VIX positions. Thereby, share prices could drop alongside a falling VIX. Therefore, we are using the recent surge in equity volatility to close our long position in implied EM equity volatility. Even though risks to EM share prices are still skewed to the downside, their selloff may not be accompanied by substantially higher EM equity volatility. However, we continue to recommend betting on higher implied volatility in EM currencies. The latter still remains very low. Investment Conclusions We reinstated our short position on the EM equity index on January 30, and this trade remains intact. For global equity portfolios, we continue to recommend underweighting EM versus DM. Within the EM equity universe, our overweights are Korea, Thailand, Russia, central Europe, Mexico, Vietnam, Pakistan and the UAE. Our underweights are Indonesia, the Philippines, South Africa, Turkey and Colombia. We are contemplating downgrading Brazilian equities from neutral to underweight. The change is primarily driven by our downbeat view on banks (Chart I-16). This is in addition to our existing bearish view on commodities. We will publish a Special Report on Brazilian banks in the coming weeks. Barring an irrigation-type of credit and fiscal stimulus, the mainland economy will disappoint. Among the EM equity sectors, we continue to recommend a long EM consumer staples/short banks trade (Chart I-17, top panel) as well as a short both EM and Chinese banks versus their US peers positions (Chart I-17, middle and bottom panels). Chart I-16Brazilian Bank Stocks Are Breaking Down? Chart I-17Our Favored EM Equity Sector Bets   We continue to recommend a short position in a basket of the following currencies versus the US dollar: BRL, CLP, ZAR, PHP, IDR and KRW. We are also structurally bearish on the RMB. Today we are booking profits on the short Colombian peso / long Russian ruble trade (please refer to section on Colombia on pages 13-17). With respect to EM local currency bonds and EM sovereign credit, our overweights are Mexico, Russia, Colombia, Thailand, Malaysia and Korea. Our underweights are South Africa, Turkey, Indonesia, and the Philippines. The remaining markets warrant a neutral allocation. As always, the list of recommendations is available at end of each week’s report and on our web page. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Colombia: Upgrade Domestic Bonds; Take Profits On Short Peso Trade Chart II-1Oil Makes A Huge Difference To Colombia's Current Account Today we recommend upgrading local currency bonds and booking profits on the short Colombian peso / long Russian ruble trade. The reason is tight fiscal and monetary policies are positive for bonds and the currency. Although we are structurally bullish on Colombia’s economy, we remain underweight this bourse relative the EM equity benchmark. The primary reason is the high sensitivity of Colombia’s balance of payments to oil prices. In particular, oil accounts for a large share (40%) of Colombia’s exports. As of Q4 2019, the current account deficit was $14 billion or 4% of GDP with oil, and $25 billion or 7.5% of GDP excluding oil (Chart II-1). In short, each dollar drop in oil prices substantially widens the nation’s current account deficit and weighs on the exchange rate. Besides, the current hawkish monetary stance and overly tight fiscal policy will produce a growth downtrend. The Colombian economy has reached a top in its business cycle: The flattening yield curve is foreshadowing a major economic slowdown (Chart II-2, top panel). Our proxy for the marginal propensity to spend for businesses and households leads the business cycle by about six months and is presently indicating that growth will roll over soon (Chart II-2, bottom panel). Moreover, the corporate loan impulse has already relapsed, weighing on companies’ capital expenditures (Chart II-3).  Chart II-2The Business Cycle Has Peaked Chart II-3Investment Expenditures Heading South   The government considerably tightened fiscal policy in the past year and will continue to do so in 2020. The primary fiscal balance has surged to above 1% of GDP as primary fiscal expenditures have stagnated in nominal terms and shrunk in real terms last year (Chart II-4). In regards to monetary policy, the prime lending rate is 12% in nominal and 8.5-9% in real (inflation-adjusted) terms. Such high borrowing costs are restrictive as evidenced by several business cycle indicators that are in a full-fledged downtrend: manufacturing production, imports of consumer and capital goods, vehicle sales and housing starts (Chart II-5). Chart II-4Hawkish Fiscal Policy Chart II-5The Economy Is In The Doldrums Chart II-6Consumer Spending Has Been Supported By Borrowing Overall, economic growth has been held up solely by very robust household spending, which accounts for 65% of GDP. Critically, consumer borrowing has financed such buoyant consumer expenditures (Chart II-6). However, the pace of household borrowing is unsustainable with consumer lending rates at 18%. Moreover, nominal and real (deflated by core CPI) wage growth are decelerating markedly and hiring will slow down in line with reduced capital spending.  Besides, disinflationary dynamics in this country will be amplified due to the massive influx of immigration from Venezuela in the past two years. Currently, the number of immigrants from the neighboring country stands at 1.4 million people, or 5% of Colombia’s labor force. Such an enormous increase in labor supply introduces deflationary pressures in the Colombian economy by depressing wage growth. Therefore, despite the depreciating currency, core measures of inflation will likely drop to the lower end of the central bank’s target range in next 18-24 months. Investment Recommendations The economy is heading into a cyclical slump but monetary and fiscal policies will remain restrictive. Such a backdrop is bullish for the domestic bond market and structurally, albeit not cyclically, positive for the currency. We have been recommending fixed-income investors to bet on a yield curve flattening by receiving 10-year and paying 1-year swap rates. This trade has returned 77 basis points since its initiation on January 17, 2019. Given the central bank will stay behind the curve, this strategy remains intact. Today we recommend upgrading Colombian local currency bonds from neutral to overweight. Further currency depreciation and an exodus by foreign investors remain a risk. However, on a relative basis – versus its EM peers – this market is attractive. The share of foreign ownership of local currency government bonds in Colombia is 25%, smaller than in many other EMs. Additionally, Colombian bond yields are 80 basis points above the J.P. Morgan EM GBI domestic bonds benchmark and its currency is one standard deviation below its fair value (Chart II-7). We are also overweighting Colombian sovereign credit within an EM credit portfolio. Fiscal policy is very tight and government debt is at a manageable 50% of GDP. The government considerably tightened fiscal policy in the past year and will continue to do so in 2020. Continue to underweight Colombian equities relative to the emerging markets benchmark. We will be looking for a final capitulation in the oil market to upgrade this bourse. Finally, we are booking profits on our short COP versus RUB trade, which has returned a 19% gain since May 31, 2018 (Chart II-8). As mentioned earlier, the peso has already cheapened a lot according to the real effective exchange rate based on unit labor costs (Chart II-7). Meanwhile, Colombia’s macro policy mix is positive for the currency. Chart II-7The Colombian Peso Has Depreciated Substantially Chart II-8Taking Profits On Our Short COP / Long RUB Trade   In contrast, Russia is relaxing its fiscal policy – which is marginally negative for the ruble – and the currency has become a crowded trade. Juan Egaña Research Associate juane@bcaresearch.com Footnotes   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Analyses on the Philippines, Colombia and Argentina are available below. Highlights Global growth conditions, especially outside the U.S., remain bond friendly. Nevertheless, U.S. bonds are overbought and technical factors might exert upward pressure on them in the near term. Our ubiquitous premise remains that EM currencies and EM risk assets are primarily driven by cycles in global trade and the Chinese economy rather than U.S. growth and interest rates. There are no signs of investor capitulation that mark a major bottom in EM risk assets. Feature Given the recent plunge in bond yields around the world, we are devoting this week’s report to discussing the implications of low U.S. bond yields on EM risk assets. Our key takeaway is that lower U.S. bond yields are not a reason to be long EM risk assets and currencies. Low Bond Yields: Reflective Or Stimulative? With respect to ultra-low bond yield, investors and commentators generally subscribe to one of the following two arguments: Bond yields are reflective – i.e. they are indicative of an upcoming economic calamity and thereby signal a bearish outlook for equity and credit markets; The current low levels of bond yields signify a dovish monetary policy stance and hence are bullish for global risk assets. In our opinion, it is not a certainty that the bond market always has perfect foresight of the economic outlook. At the same time, falling global bond yields and easing central banks do not automatically ensure a pickup in global economic activity. Hence, low bond yields do not justify a bullish stance on global stocks and credit markets. Like any other financial market, bonds are driven by time-varying forces. In certain times, bond yields signal a correct trajectory for growth, inflation and monetary policy. At other times, bond prices are driven by investor sentiment and momentum-chasing trading strategies. In times where the latter is occurring, the bond market can send the wrong signal on growth and inflation, as well as misprice the future path of interest rates. U.S. bond yields are presently correct in signaling that global growth continues to decelerate. This is corroborated by many other indicators that we have been publishing.  Presently, we have the following observations and reflections on U.S. bond yields: U.S. bond yields are presently correct in signaling that global growth continues to decelerate. This is corroborated by many other indicators that we have been publishing. However, this does not imply that U.S. bond yields will be a reliable leading indicator at the bottom of this business cycle. The basis is that U.S. bond yields did not lead at the top of the cycle. On the contrary, U.S. bond yields lagged the global business cycles by a considerable margin in both 2015-‘16 and in 2018-’19, when the growth slowdown emanated from China/EM. Chart I-1 illustrates that Chinese nominal manufacturing output and import volume growth rolled over in December 2017, yet U.S. bond yields rolled over in October 2018. In recent years, U.S. bond yields have also lagged the global manufacturing PMI index by about six to nine months (Chart I-2, top panel). Chart I-1China’s Business Cycle Led U.S. Bond Yields Chart I-2Global Manufacturing And EM Stocks Led U.S. Bond Yields   Remarkably, EM financial markets have been leading U.S. bond yields in recent years, not the other way around (Chart I-2, bottom panel). For some time we have held the view that the ongoing growth slump in China would culminate into a global manufacturing and trade recession that would be negative for the rest of the world, especially for EM, Japan, commodities producers, and Germany. This theme has been the main reason for our negative view on global stocks, especially cyclicals, as well as our positive stance on safe-haven bonds and bullish view on the dollar.  Understanding the origins of this global manufacturing and trade downtrend is critical to gauging the evolution of the business cycle. China is the epicenter of this global trade and manufacturing recession. In turn, the root cause of the mainland’s growth slump is money/credit tightening that has occurred in China in both 2017 and early 2018. ​​​​Money and credit growth remain lackluster in the Middle Kingdom, despite ongoing fiscal and monetary policy easing (Chart I-3). Notably, domestic credit growth and its impulse have been muted, especially when issuance of government bonds is excluded (Chart I-4). The aggregate credit and fiscal stimulus have so far been insufficient to engineer a recovery. Chart I-3China: Fiscal Deficit And Broad Money Growth Chart I-4China: Private Sector Credit Growth Is Weak Federal Reserve’s policy tightening was not the reason behind the current worldwide manufacturing recession. U.S. domestic demand has not been the source of the ongoing global manufacturing and trade recession. U.S. final domestic demand was robust until Q4 2018 and has so far downshifted only modestly (Chart I-5, top panel). Corroborating this, U.S. manufacturing was the last shoe to drop in the global manufacturing recession (Chart I-5, bottom panel). Accordingly, the Federal Reserve’s policy tightening was not the reason behind the current worldwide manufacturing recession. It follows that lower U.S. interest rates might not be essential to instigate a global economic recovery. Critically, the latest plunge in EM currencies and widening in EM credit spreads has occurred amid falling U.S. bond yields and Fed easing. Chart I-5U.S. Economy And Bond Yields Have Lagged In This Cycle Chart I-6U.S. Bond Yields And EM: No Stable Correlation We have long argued against the consensus view that EM equities, credit markets and currencies are much more sensitive to U.S. interest rates than to the global business cycle. Chart I-6 reveals that there has been no stable correlation between U.S. bond yields and EM credit spreads and currencies. Therefore, a bottom in EM currencies and risk assets will occur when global trade and Chinese demand ameliorate rather than as a result of Fed policy. An important question is whether low bond yields are going to support global share prices. Our hunch is that it is not likely.1  First, if U.S. bond yields had not dropped by as much as they have, global equity prices would be lower. In short, reduced long-term interest rate expectations have led investors to pay higher multiples, especially for non-cyclical and growth stocks. The U.S. equity rally since early this year has been due to multiples expansion, especially among non-cyclical and growth stocks. Chart I-7Global Ex-U.S. Share Prices: No Bull Market Here The latter has allowed the S&P 500 to reach new highs recently at a time when global ex-U.S. share prices are not far from their December lows (Chart I-7). Second, falling interest rates are positive for share prices when profits are growing, even if at a slower rate. When corporate profits are contracting, lower interest rates typically do not preclude equity prices from dropping. Going forward, U.S. equities remain at risk due to a potential profit contraction. We do not foresee a recession in U.S. household spending. However, America’s corporate earnings will be under pressure from a stronger dollar and shrinking profit margins due to rising unit labor costs (Chart I-8), notwithstanding the manufacturing recession that is taking hold. Chart I-8U.S. Corporate Profits Are At Risk From Margins One popular narrative attributes exceptionally low bond yields to excess savings over investments. Yet this is not always accurate. Box I-1 below explains why bond yields have little relation to savings and investments in any economy. Chart I-9U.S. Bonds Are High-Yielders Among DM Finally, some investors wonder if the low/negative bond yields in DM ex-U.S. could push U.S. Treasury yields lower. Our take is that it is possible. The spread of U.S. Treasury yields over DM ex-U.S. is very wide, which could entice foreign fixed-income investors to purchase Uncle Sam’s bonds (Chart I-9). ​​​​​​What is preventing foreign fixed-income investors from piling into Treasuries is exchange rate risk. If for whatever reason a consensus emerges among global fixed-income investors that the greenback is not going to depreciate in the next 12-18 months, there could be a stampede of foreign investors into U.S. Treasuries, pushing yields considerably lower. In our opinion, the odds are that the broad trade-weighted dollar will stay firm for now and could make new cycle highs. In such a scenario, investor expectations of U.S. currency depreciation will diminish. This could trigger a stampede of foreign fixed-income investors into U.S. bonds. This is not a forecast but a consideration that bond investors should take into account. Bottom Line: Global growth conditions, especially outside the U.S., remain bond friendly. Nevertheless, bonds are overbought and technical factors discussed in Box I-1 below might exert upward pressure on U.S. bond yields in the near term. Implications For EM  We explore three scenarios for the direction of U.S. bond yields in the coming weeks and months and the corresponding potential dynamics for EM risk assets and currencies. Scenario 1: U.S. bond yields continue to fall as the global trade and manufacturing recession endures, suppressing global growth. Outcome: EM currencies will depreciate and EM risk assets will suffer more. Scenario 2: U.S. Treasury yields increase because U.S. domestic demand firms up, even if the global trade contraction persists.  Outcome: EM currencies will weaken and EM risk assets will sell off further. Scenario 3: U.S. bond yields rise because the global manufacturing recession abates and a recovery in China leads to a global trade revival. Outcome: EM currencies will appreciate and risk assets will rally considerably. Please note that Scenario 3 is not our baseline scenario. The ubiquitous premise in these deliberations is that EM currencies and EM risk assets are primarily driven by cycles in global trade and the Chinese economy rather than U.S. growth and interest rates. EM currencies and EM risk assets are primarily driven by cycles in global trade and the Chinese economy rather than U.S. growth and interest rates. Chart I-10Stay With Short EM Equities / Long 30-Year U.S. Bonds Strategy To capitalize on our view of weaker global growth emanating from China/EM, we have been recommending the following strategy: short EM stocks / long U.S. 30-year Treasuries. This recommendation has panned out nicely, delivering a 21.5% gain since its initiation on April 10, 2017 (Chart I-10). Barring Scenario 3 above, this trade has more upside. EM Financial Markets: No Capitulation So Far Major bottoms in financial markets typically occur after investor capitulation has already taken place. Having reviewed various financial market variables, we conclude that signposts of capitulation in EM risk assets and global equities are absent: The S&P 500 SKEW index is very low. This index reflects the probability that investors are assigning to downside risk in share prices. The SKEW index is currently at one of its lowest readings of the past 30 years (since its existence), which suggests that investors are not hedging themselves against large price swings (Chart I-11). This usually occurs prior to a heightened period of volatility. Chart I-11Are U.S. Equity Investors Complacent? The volatility measures for EM and commodity currencies are still very subdued (Chart I-12). The same is true for EM equity volatility (Chart I-12, bottom panel). Even though EM and commodities currencies as well as EM share prices have fallen substantially, the price of buying insurance is still low – meaning investors are still not particularly worried. This habitually is a sign of complacency. Chart I-12Cyclical Risk Markets: Implied Volatility Remains Low Chart I-13No Capitulation Among EM Equity And Currency Investors Finally, Chart I-13 shows that asset managers’ and leveraged funds’ net long positions in EM equity index futures and high-beta liquid currencies futures were still elevated as of August 15. Bottom Line: There are no signs of investor capitulation that often mark a major bottom in risk assets.   BOX 1 Do Bond Yields Equilibrate Savings And Investment? Mainstream economic theory regards bond yields as the interest rate that balances desired savings and desired investment. According to mainstream theory, when desired savings rise relative to desired investment, bond yields drop. The latter induces less savings and more investment equilibrating the system. Conversely, when desired investment increases relative to desired savings, bond yields climb, discouraging investment and incentivizing more savings. The fundamental shortcoming of this economic model stems from the misrepresentation of banking. When a commercial bank buys any security from a non-bank, it originates a new deposit “out of thin air.” The bank does not allocate someone’s deposit into bonds. Diagram I-1 below exhibits this point. When a U.S. bank purchases a dollar-denominated bond from a pension fund, it does not use someone’s deposit to do so. Rather, a new deposit in the U.S. banking system (often at another bank) is created “out of thin air” as a result of the transaction. The amount of bonds commercial banks can purchase is limited only by regulatory norms, liquidity provision by the central bank as well as its management’s willingness to do so. Nobody needs to save for a bank to buy a bond or make a loan.  We have written in past reports on money, credit and savings that deposits in the banking system have no relationship with national or household savings. When an individual or company saves, the amount of deposits in the banking system does not change. All in all, banks do not intermediate savings/deposits into credit/loans. They create new deposits “out of thin air” when they originate a loan to or buy any security from a non-bank. Provided that banks do not utilize national savings or existing deposits to acquire bonds, fluctuations in bond yields do not reflect changes in national savings. Holding everything else constant, bond yields could drop if commercial banks buy bonds en masse. The opposite also holds true. Chart I-14 demonstrates that U.S. commercial banks have been augmenting their purchases of various types of bonds. This partially explains why bond yields have plunged (bond yields shown inverted on this chart). If U.S. banks’ bonds purchases mean revert, as they often do, U.S. bond yields could rise. Chart I-14Are U.S. Banks' Purchases Of Bonds Driving Bond Yields? This along with more bond issuance by the U.S. Treasury to refill its Treasury’s General Account at the Fed as well as the existing overbought conditions in government bonds could produce a pick-up in yields. Such a rebound in bond yields would be technical and would not signal fundamental changes in the U.S. or global business cycles, or in the savings-investment balance.  Closing Some Positions Long Latin American / short emerging Asian equity indexes. This position has generated a 6% loss since its initiation on October 11, 2018 and we have low confidence that it will generate positive returns going forward. Long Chinese small cap / short EM small-cap stocks. Our bet has been that Chinese private sector companies trading in Hong Kong and represented in the MSCI small-cap index will perform better than the average EM small cap. This strategy has not worked out and has produced a 4.4% loss since its recommendation on November 20, 2013. We are downgrading Colombian equities from neutral to underweight. Please refer to pages 17-20 for a detailed analysis. Instead, we are upgrading the Peruvian bourse from underweight to a neutral allocation within an EM equity portfolio. Our view remains that gold prices will continue outperforming oil.2 Peru benefits from higher gold and silver prices while Colombia is largely an oil play. Consistently, the Peruvian currency will depreciate less than the Colombian peso. These justify this allocation shift between these two bourses.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Philippines: The Currency Holds The Key Government expenditures, in general, and infrastructure investment, in particular, will rise meaningfully in the next few months. Chart II-1Philippine Current Account Deficit Funded By Volatile Portfolio Flows Declining U.S. interest rates coupled with slumping oil prices have supported Philippine financial markets. However, the country’s balance of payments dynamics are still precarious. In particular, Philippine’s wide current account (CA) deficit will need to be funded by volatile foreign portfolio inflows as the basic balance – the sum of CA balance and net FDI – has turned negative (Chart II-1). Critically, the already wide current account deficit is set to balloon even further: First, the 2019 fiscal spending was back-loaded because a Congress impasse delayed the government budget approval to April. Hence, government expenditures, in general, and infrastructure investment, in particular, will rise meaningfully in the next few months. Higher infrastructure spending will drive imports of capital goods higher (Chart II-2). The latter accounts for 32% of total imports. Second, Philippine export growth is likely to contract anew as global trade is not recovering (Chart II-3). Chart II-2Philippine Government Infra Spending Will Accelerate Chart II-3Philippine Exports Will Contract We continue to expect broad portfolio capital outflows from EM. Potential for foreign outflows from the Philippines is large. Foreign ownership of local equities is high at 42%. As to foreign ownership of local currency bonds, it stands at around 13%. A renewed decline in the peso will drive away portfolio flows reinforcing additional currency depreciation. The falling peso will prevent the central bank from reducing interest rates further. Even if the central bank does not hike rates to support the peso, market-driven local rates could rise for a period of time. This is bad news for property stocks – which account for about 27% of the MSCI Philippines index. Having rallied considerably, they are at major risk as local interest rates rise. In addition, these stocks have benefited from strong real estate demand emanating from the Philippine Offshore Gaming Operators (POGO) sector – which itself has been largely driven by Chinese capital flows. Both the Chinese and Philippine authorities have begun cracking down fiercely on these operations because they are link to capital flight out of China. This crackdown will curtail capital flows into these areas and depress revenues of Philippine real estate companies. This will occur at a time when the residential market is experiencing weak demand. We continue to recommend shorting/underweighting property stocks. Finally, small cap stocks are in a bear market and are sending an ominous signal (Chart II-4). Furthermore, this bourse is neither attractive in absolute terms nor relative to EM (Chart II-5). Chart II-4Small-Cap Stocks Are In A Bear Market Chart II-5Philippine Equities Are Expensive Bottom Line: We continue recommending to short the Philippine peso against the U.S. dollar. Overall, EM dedicated investors should continue underweighting the Philippine equity, fixed income and sovereign credit markets within their respective EM universes. Ayman Kawtharani, Editor/Strategist ayman@bcaresearch.com Colombia: A Top In The Business Cycle? Colombia’s business cycle has reached a top and growth will slow considerably in the next 12 months. Falling oil prices and fiscal tightening will cause the Colombian economy to slow down in the next 12 months. What’s more, a depreciating peso and sticky inflation will prevent the central bank (Banrep) from frontloading rate cuts to mitigate the downtrend. The Colombian peso is making new cyclical lows and more weakness is in the cards. While the currency is slightly cheap according to the real effective exchange rate based on unit labor costs (Chart III-1), our negative view on oil prices entails further currency depreciation. Colombia is still very heavily reliant on oil exports – the current account deficit is 4.3% of GDP with oil, but 8.4% excluding it (Chart III-2). Moreover, a chunk of FDIs are destined for the energy sector, and foreign portfolio flows are contingent on exchange rate stability. Therefore, falling oil prices and a weaker peso will result in diminishing FDIs and foreign portfolio flows, reinforcing downward pressure on the currency. Chart III-1The Colombian Peso Is Not That Cheap Chart III-2Current Account Deficit Is Large And Widening Notably, there is a significant pass-through effect from the currency to inflation (Chart III-3). Even though Banrep does not target the exchange rate, having both headline and core inflation above the 3% central target will constrict it from cutting interest rates soon. On the whole, odds are that Colombia’s business cycle has reached a top and growth will slow considerably in the next 12 months. The yield curve is signaling an economic slowdown ahead (Chart III-4). Chart III_3The Exchange Rate And Inflation Chart III-4Domestic Demand Is About To Roll Over Our credit and fiscal spending impulse might be peaking, signifying a top in domestic demand growth (Chart III-5). The impulse is rolling over primarily due to the substantial fiscal tightening. Duque’s administration has slashed expenditures and the latter are contracting in inflation-adjusted terms (Chart III-6). Chart III-5A Top In The Business Cycle? Chart III-6Severe Fiscal Tightening   Government revenues are highly dependent on oil exports, and the recent fall in oil prices will bring about a contraction in fiscal revenues. This, and the government’s strong adherence to fiscal surplus, implies no loosening up on the fiscal side. Finally, our proxy for marginal propensity to spend for businesses and households is indicating that growth is about to roll over (Chart III-7). Auto sales are also weakening, and housing sales are contracting (Chart III-8). Chart III-7The Business Cycle Is Peaking Chart III-8Colombia: Certain Segments Have Turned Over Given that both fiscal and monetary policies are unlikely to be relaxed soon, the peso will come under renewed selling pressure, acting as a release valve for the Colombian economy. Investment Recommendations We are downgrading this bourse from neutral to an underweight allocation within a dedicated EM equity portfolio. In its place, we are upgrading Peruvian stocks from underweight to neutral. Continue shorting COP versus RUB. This trade has generated a 14% return since its initiation on May 31st of last year. Finally, within EM local currency bond and sovereign credit portfolios, Colombia warrants a neutral allocation. We also recommend fixed-income investors continue to bet on further yield curve flattening: receive 10-year / pay 1-year swap rates.   Juan Egaña, Research Associate juane@bcaresearch.com   Argentina: Do Not Catch A Falling Knife The latest rout in Argentine markets has brought fears of another sovereign debt default or restructuring. Are conditions right for buying Argentine markets? Politics complicate the assessment of a debt restructuring and we do not recommend bottom fishing in Argentine financial markets. Looking at the profile of past financial crises and debt defaults, there might be more downside in Argentine asset prices. Sovereign U.S. dollar bond prices remain well above their 2002 and 2008 lows (Chart IV-1). Compared with previous EM financial crises, Argentine stocks might still have considerable downside in U.S. dollar terms (Chart IV-2). Chart IV-1Things Could Get Worse Chart IV-2Historical Patterns Suggest More Downside In Bank Stocks The equity market index has relapsed below its 2018 lows in dollar terms, which technically qualifies as a breakdown and entails fresh lows ahead (Chart IV-3). Chart IV-3A Technical Breakdown In Argentine Equities In addition to political uncertainty and rising possibility of a left-wing run government, the nation’s ability to service its foreign currency debt has deteriorated with the currency plunging to new lows. Specifically, the country has large foreign debts of $275 billion. Foreign obligation payments in the next 12 months are about $40 billion. The government lacks foreign currency reserves and export revenues necessary to service its external debt. The central bank’s net foreign exchange reserves (excluding FX swaps and gold) are about $17 billion. The country’s annual exports are $77.5 billion. With agricultural commodities prices falling, exports will likely shrink. By and large, our downbeat stance from April remains intact. Bottom Line: Investors should continue avoiding and underweighting Argentine financial markets.   Andrija Vesic, Research Analyst andrijav@bcaresearch.com   Footnotes 1      Please note this is the view of BCA’s Emerging Markets Strategy service and is different from BCA’s house view. Clients can read the debate between various BCA strategists in the report What Goes On Between Those Walls? BCA’s Diverging Views In The Open. Please click on the link to access it. 2    We recommended the long gold / short copper and oil trade on July 11, 2019 and this position remains intact. Equities Recommendations Currencies, Fixed-Income And Credit Recommendations

Falling oil prices and fiscal tightening will cause the Colombian economy to slow down in the next 12 months. What’s more, a depreciating peso and sticky inflation will prevent the central bank (Banrep) from frontloading rate cuts to mitigate the downtrend. The Colombian peso is making new cyclical lows and more weakness is in the cards. While the currency is slightly cheap according to the real effective exchange rate based on unit labor costs (Chart III-1), our negative view on oil prices entails further currency depreciation. Colombia is still very heavily reliant on oil exports – the current account deficit is 4.3% of GDP with oil, but 8.4% excluding it (Chart III-2). Moreover, a chunk of FDIs are destined for the energy sector, and foreign portfolio flows are contingent on exchange rate stability. Therefore, falling oil prices and a weaker peso will result in diminishing FDIs and foreign portfolio flows, reinforcing downward pressure on the currency. Chart III-1The Colombian Peso Is Not That Cheap Chart III-2Current Account Deficit Is Large And Widening Notably, there is a significant pass-through effect from the currency to inflation (Chart III-3). Even though Banrep does not target the exchange rate, having both headline and core inflation above the 3% central target will constrict it from cutting interest rates soon. On the whole, odds are that Colombia’s business cycle has reached a top and growth will slow considerably in the next 12 months. The yield curve is signaling an economic slowdown ahead (Chart III-4). Chart III_3The Exchange Rate And Inflation Chart III-4Domestic Demand Is About To Roll Over Our credit and fiscal spending impulse might be peaking, signifying a top in domestic demand growth (Chart III-5). The impulse is rolling over primarily due to the substantial fiscal tightening. Duque’s administration has slashed expenditures and the latter are contracting in inflation-adjusted terms (Chart III-6). Chart III-5A Top In The Business Cycle? Chart III-6Severe Fiscal Tightening Government revenues are highly dependent on oil exports, and the recent fall in oil prices will bring about a contraction in fiscal revenues. This, and the government’s strong adherence to fiscal surplus, implies no loosening up on the fiscal side. Finally, our proxy for marginal propensity to spend for businesses and households is indicating that growth is about to roll over (Chart III-7). Auto sales are also weakening, and housing sales are contracting (Chart III-8). Chart III-7The Business Cycle Is Peaking Chart III-8Colombia: Certain Segments Have Turned Over Given that both fiscal and monetary policies are unlikely to be relaxed soon, the peso will come under renewed selling pressure, acting as a release valve for the Colombian economy. Investment Recommendations We are downgrading this bourse from neutral to an underweight allocation within a dedicated EM equity portfolio. In its place, we are upgrading Peruvian stocks from underweight to neutral. Continue shorting COP versus RUB. This trade has generated a 14% return since its initiation on May 31st of last year. Finally, within EM local currency bond and sovereign credit portfolios, Colombia warrants a neutral allocation. We also recommend fixed-income investors continue to bet on further yield curve flattening: receive 10-year / pay 1-year swap rates.   Juan Egaña, Research Associate juane@bcaresearch.com

Chart III-1Fiscal Policy Will Tighten In 2019 The Colombian economy is set to undergo another phase of growth retrenchment: The government is planning to reduce the overall fiscal deficit from 4.5% to 2.4% of GDP by the end of 2019 (Chart III-1). Oil-related revenues make up under 10% of total government revenues, and they are shrinking as both oil production and prices have plunged. As a result, the government should undertake major fiscal cutbacks and hike taxes to achieve the overall budget deficit target of 2.4%. Such substantial fiscal tightening will hurt domestic demand. Regarding the exchange rate, the central bank is pursuing a “hands-off” approach, which is likely to continue. Therefore, the currency is set to depreciate due to the large current account deficit and lack of sufficient foreign funding. Notably, the current account deficit excluding oil is -7% of GDP (Chart III-2, top panel), and the plunge in oil prices and weak domestic demand will cause FDI inflows to drop meaningfully (Chart III-2, bottom panel). Together, this points to further currency depreciation. Meanwhile, the central bank is not in a position to ease policy to offset the impact of fiscal tightening, as a weaker exchange rate historically leads to higher inflation (Chart III-3, top panel). In fact, given core inflation is at the upper end of the central bank’s target range (Chart III-3, bottom panel), a considerable currency depreciation could lead to rate hikes. Raising rates amid weakening growth is a recipe for considerable yield curve flattening. Chart III-2BoP Dynamics Are Deteriorating Chart III-3Weaker Currency = Higher Inflation   Lending rates remain well above nominal GDP growth, and the banking system is still restructuring following years of a credit boom. Credit growth will remain weak, reinforcing weakness in domestic demand stemming from substantial fiscal tightening. Finally, consumer and business confidence seem to be faltering due to the negative attention surrounding Colombian President Iván Duque Márquez’s policies. The negative terms-of-trade shocks and the imminent fiscal tightening will reinforce worsening sentiment among economic agents. Profound cyclical headwinds to growth indicate that the economy is set to return to a growth recession – a very low but slightly positive growth rate. With respect to investment strategy, we recommend the following: First, we are downgrading this bourse from overweight to neutral within an EM equity portfolio. While overweighting Latin American stocks as a whole within an EM equity portfolio, we believe that Brazilian, Chilean and Mexican share prices offer a better risk-reward profile than Colombian ones (Chart III-4). Second, as to sovereign credit investors, we are reiterating an overweight stance because fiscal tightening and monetary policy orthodoxy as well as low government debt levels will help Colombian sovereign credit to outperform. Third, two opposing cross-currents will shape the domestic bond market. On the one hand, weak growth is positive for bonds. On the other hand, currency depreciation is negative. Net-net, investors in local currency government bonds should be slightly overweight or neutral this market within an EM local bond portfolio. For fixed-income investors, we recommend a new trade: position for yield curve flattening (Chart III-5). This is a bet on a considerable growth slowdown amid looming fiscal austerity. Chart III-4Colombia Is Unlikely To Outperform LATAM Chart III-5Colombia: Bet On Yield Curve Flattening   Andrija Vesic, Research Analyst andrijav@bcaresearch.com

Highlights Please note that country sections on Mexico and Colombia published below. The policy stimulus in China could produce a growth revival in the second half of 2019, but there are no signs of an imminent bottom in China’s growth over the next several months. The lack of policy support for real estate is the key difference between the current stimulus program and previous ones. Crucially, the property market holds the key to consumer and business sentiment and hence, their willingness to spend. Continue to overweight Mexico within EM currency, fixed-income and equity portfolios. Colombia warrants a neutral weighting. A new trade: bet on yield curve flattening. Feature China has been undertaking both fiscal and monetary stimulus since last summer. A key question among investors is: At what point will the cumulative effects of these efforts become sufficient to revive the mainland’s business cycle and produce a rally in China-related plays akin to 2016-’17? This report helps investors dissect China’s stimulus, and reviews the indicators that will likely help identify the turning point in the mainland’s business cycle, as well as in China-exposed financial markets. Chart I-1 conveys the main message: Our credit and fiscal spending impulse is still falling, indicating that the slump in the Chinese industrial sector will persist for now with negative ramifications for EM corporate profits and other segments of the global economy that are leveraged to China. Looking forward, odds are reasonably high that the credit and fiscal spending impulse will bottom sometime in the first half of 2019. Yet, a bottom in China-plays in global financial markets is likely be several months away from now and potential downside could still be substantial. Monetary Stimulus On the monetary policy front, there has been multifaceted easing: Several cuts to banks’ reserve requirement ratios (RRRs) have been implemented; Lower interest rates for SME borrowers and a reduction in funding costs for the banks that originate these loans; The use of preferential liquidity provisions to encourage banks to purchase bonds issued by private companies. Monetary easing in of itself is not a sufficient condition to produce an economic revival. There are two variables standing between easing liquidity/lower borrowing costs, on the one hand, and the performance of the economy on the other: The first one is the money multiplier, which is calculated as a ratio of broad money supply (or banks assets) to excess reserves. It measures the willingness of banks to expand their balance sheets at a given level of excess reserves, assuming there is loan demand. Chart I-2 shows that China’s money multiplier has risen substantially since 2008 but has recently rolled over. A further drop in the money multiplier could offset the positive effect of monetary easing. Chart I-2China: Money Multiplier Is Falling In other words, the central bank is injecting more liquidity into the banking system and interbank rates are falling, but commercial banks may be unwilling or unable to originate more loans due to financial regulations, lack of loan demand or for other reasons. Notably, the growth rate of bank assets (including policy banks) remains lackluster, while non-bank (shadow) credit is decelerating (Chart I-3). Chart I-3China: Bank Credit And Non-Bank Credit The second variable is the willingness of companies and households to spend. This is captured by our proxies for marginal propensity to spend by companies and consumers. Chart I-4 denotes that both propensity measures are dropping, signifying a diminishing willingness to spend among these two sectors. Chart I-4China: Diminishing Propensity To Spend By Consumers And Companies If economic sentiment among businesses and households remains downbeat – which has been the case in China over the past six to nine months – their reduced expenditures could offset any positive impulse from increased credit origination. Economists think of nominal GDP (aggregate spending) as money supply times the velocity of money (Nominal GDP = Money Supply x Velocity of Money). New lending activity among banks increases money supply, while economic agents’ spending raises the velocity of money. If the velocity of money drops more than the rise in money supply, aggregate expenditure (nominal GDP growth) will decline. Chart I-5 illustrates that the velocity of money rose in 2017, supporting robust growth during this period, despite very lackluster money growth. The opposite phenomenon – a decline in the velocity of money offsetting faster money expansion – could be a risk to the positive view on Chinese growth in 2019. Chart I-5Velocity Of Money: Will It Resume Its Decline? Bottom Line: There is so far no clear evidence that the credit cycle has bottomed. Besides, a bottom in the credit impulse is not in and of itself sufficient to herald an economic recovery. Fiscal Stimulus Unlike in previous easing episodes, policymakers this time around have prioritized fiscal over monetary stimulus because of the already high leverage. In the past six months or so, the government has announced the following fiscal measures: A reduction in the personal income tax rate; Subtraction of certain household expenses from taxable personal income; A reduction in taxes and fees paid by small businesses; A potential VAT cut. These measures will certainly have a positive impact on small businesses and consumer spending. This is why we do not foresee a deepening slump in consumer spending. Nevertheless, the tax reductions and other policies benefiting small businesses and households are unlikely to boost industrial output and construction in China. The latter two are crucial for global investors because many countries are leveraged to China’s industrial and construction activity. For the industrial part of the economy, the most pertinent stimulus measure announced so far has been the issuance of local government special bonds. These bonds are used for infrastructure/public welfare projects. Chart I-6A shows the growth rates of aggregate fiscal spending and its components, which are expenditures by central and local governments as well as by government managed funds (GMFs). GMF spending – a form of quasi-government (off-balance sheet) spending – has surged in recent years and now accounts for 8.5% of GDP, which is more than twice larger than central government spending (Chart I-6B). Chart I-6AChina: Fiscal Spending Annual Growth... Chart I-6B…And As % Of Nominal GDP Although the 2019 budget has not yet been released – it will be announced in March during the National People's Congress – there have been some announcements that we can use to gauge the potential fiscal spending impulse in 2019. On the positive side, Beijing has recently authorized local governments to begin issuing bonds in early 2019 before the overall budget is released in March. Local governments are sanctioned to issue RMB 810 trillion of special bonds, which is 60% of their 2018 quotas. This contrasts with the previous years' practice, when local governments only started to issue bonds in April after obtaining directives from Beijing. The earlier-than-usual quota authorization will allow local governments to issue bonds from the beginning of the year. There is no timeline as to when these bonds will be issued, but it is safe to assume that their issuance will occur in the first half of 2019. This, in turn, should boost infrastructure investments throughout 2019. On the negative side, government managed funds (GMFs) derive 85% of their revenues from land sales. Land sales are tumbling due to previous credit tightening and scarce access to financing among property developers. Chart I-7 demonstrates that land sales lag the credit cycle by nine months. As developers are no longer acquiring land, GMF revenues and spending are set to shrink over the next 12 months. This will, to a certain degree, offset the augmented special bonds issuance. Chart I-7China: Credit Leads Land Sales And Quasi-Fiscal Spending We performed a simulation on what would be the aggregate fiscal impulse in 2019 using the following assumptions: Central and local government spending growth rates are held constant at 2018 levels. Local government special bond issuance is RMB 1.62 trillion. This is twice the recently authorized quota. Hence, our simulation assumes a 20% increase in local government special bond issuance in 2019 over 2018, respectively. GMF land revenues drop by 25% – a comparable drop in land sales occurred in 2015. Table I-1 reveals that using these assumptions, the fiscal spending impulse in 2019 will be 0.1% of GDP down from 4% in 2018 (Chart I-8, bottom panel).   Chart I-8China: Credit And Fiscal Spending Impulse The next step is to combine this with our credit impulse forecast. We assume the 2019 year-end growth rate of credit to companies and households will be 9% in our pessimistic scenario, 10% in our baseline scenario and 11% in our optimistic scenario, compared with the December 2018 recorded rate of 10%. This entails no deleveraging at all. Under these assumptions, our forecasts for aggregate credit and fiscal impulses are 0.2% of GDP (pessimistic), 2.3% (baseline) and 4.4% (optimistic) (Table I-1). Presently, the credit and fiscal impulse is close to zero (Chart I-8). Bottom Line: China’s credit and fiscal spending impulse will bottom in the first half of 2019 (Chart I-8). However, this does not mean that EM/China plays have already bottomed and investors should chase the latest rebound in China-plays worldwide. We discuss the historical correlation between the credit and fiscal impulse and China-related financial markets below. What Is Different From Previous Stimulus Programs? The lack of stimulus targeting the real estate sector is the key difference between the current stimulus programs and those implemented in the past 10 years. The central government has so far abstained from stimulating the property market due to already existing speculative excesses there. This is very different from the policy easing that took place in 2008-‘09, 2012 and 2015-’16, when the authorities boosted property markets along with other sectors of the economy. Chart I-9 reveals that the 2015-‘17 residential property market revival and following boom was facilitated by the Pledged Supplementary Lending (PSL) program conducted by the People’s Bank of China (PBoC) – which was de-facto the outright monetarization of real estate by the central bank.1 The authorities have so far been reluctant to use this PSL program again, and the odds are that housing sales and new construction will continue to decline (Chart I-10). Chart I-9Residential Property Market Is Deteriorating Chart I-10China: Construction Volumes Are Shrinking Importantly, the property market holds the key to consumer and business sentiment and, hence, their willingness to spend. The latter is crucial to the growth outlook. Overall, a deepening slump in real estate demand and prices could dent consumer and small business confidence as well as their spending. Meanwhile, shrinking construction volumes will dampen industrial sectors (Chart I-10). Investment Implications: A Replay Of 2016-‘17? How does the credit and fiscal impulse relate to financial markets globally that are leveraged to the Chinese economy? The top two panels of Chart I-11 show our money impulse as well as credit and fiscal spending impulse (CFI), while the bottom two panels contain EM share prices and industrial metals prices. There are a few observations to be made: Chart I-11China: Money And Credit/Fiscal Impulses, EM Stocks And Metals Prices First, the CFI has not yet bottomed – i.e., it has not confirmed the upturn in the money impulse. Second, as illustrated in this Chart, the bottoms in the money impulse as well as the CFI in July 2015 preceded the bottom in EM and commodities by six months, and their peaks led the top in financial markets - in January 2018 - by about 15 months. Besides, in 2012-‘13, the rise in both the money impulse and CFI did not do much to help EM stocks or industrial commodities prices. Third, the credit and fiscal impulse leads the global manufacturing PMI by several months as illustrated in Chart I-1 on page 1, as well as mainland’s capital goods imports (Chart I-12). Chart I-12China's Impact On Industrial Goods And Commodities On the whole, investors should consider buying China-related plays only after both the money impulse and the CFI bottom together which has not yet occurred. Besides, even if these indicators rise in tandem, the bottom in China-related financial market plays could be a few months later because these impulses have historically led markets. This is why we believe a final down leg in EM and China-related plays still lies ahead. Typically, the last/capitulation phase in bear markets is considerable and being early can be very painful. Bottom Line: We continue to recommend underweighting/playing EM and China-related risk assets on the short side. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Lin Xiang, Research Analyst linx@bcaresearch.com Mexico: Reiterating Our Overweight Stance Mexican financial markets have rebounded, outperforming their EM counterparts since mid-December. This outperformance has further upside because the AMLO administration is proving to be less populist and more pragmatic, especially relative to investors’ expectations. We are reiterating our recommendations to overweight Mexican markets, especially the currency, local fixed-income and sovereign credit, within respective EM portfolios due to the following considerations: The 2019 budget is a prime example of sensible rather than populist policies by the AMLO administration. The budget targets a primary surplus of 1% of GDP versus 0.8% of GDP in 2018 (Chart II-1). Notably, the 2019 budget envisages an absolute decline in nominal expenditures in 29 out of 56 categories. Chart II-1Fiscal Tightening In 2019 Such a restrained budget follows the conservative fiscal policy of the previous administration. In brief, the nation’s fiscal policy and public debt profile remain sound. Public spending will be increased mostly in the areas that are critical to boosting productivity. These include infrastructure spending, vocational training, promoting “financial deepening” and competition, eliminating graft and improving security. These efforts are critical to boosting business confidence, investment and ultimately productivity. On the revenue side, the budget has become much less reliant on oil revenues than before. The share of oil revenues in total government revenues historically hovered around 30%, but in 2018 it declined to 18%. The 2019 budget assumes an average oil price of $55 per barrel, a conservative projection. Investors have also been somewhat alarmed by the 16% hike in minimum wages, but this should be put into historical context. Chart II-2 illustrates that the minimum wage in real terms (deflated by consumer price inflation) dropped by 70% since its peak in 1976, before rising in the recent years. Chart II-2Historical Perspective On Minimum Wage Importantly, Mexico’s competitiveness problem does not stem from high wages but from a lack of productivity gains. Productivity has been stagnant, and wages in real terms have not risen in many years. Hence, the true test for the nation is to raise productivity, not curb wages. Remarkably, the Mexican peso is very cheap, as measured by the real effective exchange rate based on unit labor costs (Chart II-3). Hence, the minimum wage hike can be viewed as payback after decades of dramatic declines in the minimum wage in real terms. Chart II-3The Mexican Peso Is Cheap The central bank has overdone it with hiking interest rates: interest rates are currently among the highest of the mainstream EM economies, both in nominal and real terms (Chart II-4). Hence, local rates offer great value relative to other EMs (Chart II-4, bottom panel). Chart II-4High Real And Nominal Interest Rates Tight fiscal and monetary policies will curb domestic demand and promote disinflation. Money and credit growth remain very sluggish (Chart II-5). This is negative for consumer and business spending, but positive for investors in local currency bonds. Chart II-5Monetary Growth Is Weak The basis is that a retrenchment in domestic demand and thereby imports will help stabilize the trade balance amid low oil prices. Hence, this is on the margin a positive for the peso as well as for local currency bonds relative to their EM counterparts. Finally, Mexico will benefit from its ties to the U.S. economy, unlike many other EMs that are more exposed to China. Investment Recommendation We continue to recommend overweighting the peso and local currency bonds within an EM fixed-income portfolio. Currency traders should maintain our long MXN / short ZAR trade (Chart II-6, top two panels). Chart II-6Remain Overweight Mexican Currency And Fixed-Income Credit market investors should continue to overweight Mexican sovereign credit within an EM credit portfolio (Chart II-6, bottom panel). Finally, we are also reiterating our long Mexico position within an EM equity portfolio. While domestic demand growth and corporate profits will continue to disappoint, the declining risk premium on Mexican assets due to a re-assessment among investors of AMLO’s policies warrants a mild overweight in large caps and a sizable overweight in small caps relative to their EM peers. Colombia: Headed Into Another Downtrend The Colombian economy is set to undergo another phase of growth retrenchment: The government is planning to reduce the overall fiscal deficit from 4.5% to 2.4% of GDP by the end of 2019 (Chart III-1). Oil-related revenues make up under 10% of total government revenues, and they are shrinking as both oil production and prices have plunged. Chart III-1Fiscal Policy Will Tighten In 2019 As a result, the government should undertake major fiscal cutbacks and hike taxes to achieve the overall budget deficit target of 2.4%. Such substantial fiscal tightening will hurt domestic demand. Regarding the exchange rate, the central bank is pursuing a “hands-off” approach, which is likely to continue. Therefore, the currency is set to depreciate due to the large current account deficit and lack of sufficient foreign funding. Notably, the current account deficit excluding oil is -7% of GDP (Chart III-2, top panel), and the plunge in oil prices and weak domestic demand will cause FDI inflows to drop meaningfully (Chart III-2, bottom panel). Together, this points to further currency depreciation. Chart III-2BoP Dynamics Are Deteriorating Meanwhile, the central bank is not in a position to ease policy to offset the impact of fiscal tightening, as a weaker exchange rate historically leads to higher inflation (Chart III-3, top panel). In fact, given core inflation is at the upper end of the central bank’s target range (Chart III-3, bottom panel), a considerable currency depreciation could lead to rate hikes. Raising rates amid weakening growth is a recipe for considerable yield curve flattening. Chart III-3Weaker Currency = Higher Inflation Lending rates remain well above nominal GDP growth, and the banking system is still restructuring following years of a credit boom. Credit growth will remain weak, reinforcing weakness in domestic demand stemming from substantial fiscal tightening. Finally, consumer and business confidence seem to be faltering due to the negative attention surrounding Colombian President Iván Duque Márquez’s policies. The negative terms-of-trade shocks and the imminent fiscal tightening will reinforce worsening sentiment among economic agents. Profound cyclical headwinds to growth indicate that the economy is set to return to a growth recession – a very low but slightly positive growth rate. With respect to investment strategy, we recommend the following: First, we are downgrading this bourse from overweight to neutral within an EM equity portfolio. While overweighting Latin American stocks as a whole within an EM equity portfolio, we believe that Brazilian, Chilean and Mexican share prices offer a better risk-reward profile than Colombian ones (Chart III-4). Chart III-4Colombia Is Unlikely To Outperform LATAM Second, as to sovereign credit investors, we are reiterating an overweight stance because fiscal tightening and monetary policy orthodoxy as well as low government debt levels will help Colombian sovereign credit to outperform. Third, two opposing cross-currents will shape the domestic bond market. On the one hand, weak growth is positive for bonds. On the other hand, currency depreciation is negative. Net-net, investors in local currency government bonds should be slightly overweight or neutral this market within an EM local bond portfolio. For fixed-income investors, we recommend a new trade: position for yield curve flattening (Chart III-5). This is a bet on a considerable growth slowdown amid looming fiscal austerity. Chart III-5Colombia: Bet On Yield Curve Flattening Andrija Vesic, Research Analyst andrijav@bcaresearch.com Footnotes 1      Please see Emerging Markets Strategy Special Report "China Real Estate: A Never-Bursting Bubble?" dated April 6, 2018, available on ems.bcaresearch.com   Equity Recommendations Fixed-Income, Credit And Currency Recommendations

We published a Special Alert report titled Turkey: Book Profits On Shorts yesterday. The link is available on page 18. This report is Part 2 of an overview of the cyclical profiles of emerging market (EM) economies. This all-in-charts presentation illustrates the business cycle conditions of various developing economies. The aim of this report is to provide investors with a quick assessment of where each EM economy stands. In addition, we provide our view on each market. The rest of the countries were covered in Part 1, published last week (the link to it is available on page 18). Chart I-1 Malaysia: Keep Underweight For Now As... Malaysia: Keep Underweight For Now As...Malaysia: Keep Underweight For Now As... Malaysia: Keep Underweight For Now As... ...Bank Shares Have Significant Downside ...Bank Shares Have Significant Downside ...Bank Shares Have Significant Downside...Bank Shares Have Significant Downside Indonesia: Underweight Equities & Bonds Indonesia: Underweight Equities & Bonds Indonesia: Underweight Equities & Bonds Indonesia: Underweight Equities & Bonds Indonesia: Underweight Equities & Bonds Indonesia: The Sell-Off Is Not Over Yet Indonesia: The Sell-Off Is Not Over Yet Indonesia: The Sell-Off Is Not Over Yet Indonesia: The Sell-Off Is Not Over Yet Indonesia: The Sell-Off Is Not Over Yet Thailand: Stay Overweight Thailand: Stay Overweight Thailand: Stay OverweightThailand: Stay Overweight Thailand: Better Positioned To Weather The EM Storm Thailand: Better Positioned ##br##To Weather The EM Storm Thailand: Better Positioned ##br##To Weather The EM Storm Thailand: Better Positioned ##br##To Weather The EM Storm Thailand: Better Positioned ##br##To Weather The EM Storm Philippines: Inflation Breakout Philippines: Inflation BreakoutPhilippines: Inflation Breakout Philippines: Inflation Breakout Philippines: Neutral On Equities Due To Oversold Conditions Philippines: Neutral On Equities ##br##Due To Oversold Conditions Philippines: Neutral On Equities ##br##Due To Oversold ConditionsPhilippines: Neutral On Equities ##br##Due To Oversold Conditions Central Europe: Labor Shortages & Wage Inflation Central Europe: Labor Shortages & Wage Inflation Central Europe: Labor Shortages & Wage Inflation Central Europe: Robust Growth - Overweight Central Europe: Robust Growth - Overweight Central Europe: Robust Growth - OverweightCentral Europe: Robust Growth - Overweight Chile: Robust Growth - Overweight Equities Chile: Robust Growth - Overweight Equities Chile: Robust Growth - Overweight Equities Chile: No Inflationary Pressures Chile: No Inflationary PressuresChile: No Inflationary PressuresChile: No Inflationary Pressures Chile: No Inflationary Pressures Colombia: Currency Will Be A Release Valve Colombia: Currency Will Be A Release Valve Colombia: Currency Will Be A Release Valve Colombia: Currency Will Be A Release Valve Colombia: Currency Will Be A Release Valve Colombia: Credit Growth Remains A Headwind For Economy - Neutral Colombia: Credit Growth Remains ##br##A Headwind For Economy - Neutral Colombia: Credit Growth Remains ##br##A Headwind For Economy - NeutralColombia: Credit Growth Remains ##br##A Headwind For Economy - Neutral Peru: Vulnerable To External Developments Peru: Vulnerable To External Developments Peru: Vulnerable To External Developments Peru: Vulnerable To External Developments Peru: Vulnerable To External Developments Peruvian Equities - Underweight Peruvian Equities - Underweight Peruvian Equities - UnderweightPeruvian Equities - Underweight

The structural long-term outlook for Colombia is positive, as a combination of pro-market orthodox policies and reform initiatives amid positive tailwinds from demographic should ensure a reasonably high potential GDP growth rate. In the first round of presidential elections held last weekend, the gap between right wing candidate Ivan Duque and left-wing candidate Gustav Petro came out large enough to make a Duque victory highly likely in the second round to be held on June 17. His election would entail a positive backdrop for the reform agenda and business investment over the coming years. Yet despite the positive structural backdrop, Colombia is still facing a major imbalance - excessive reliance on oil in sustaining stable balance of payments (BoP) dynamics. The trade balance deficit - including oil - is $8 billion, while excluding oil it stands at $20 billion, or 7.5% of GDP (Chart III-1). Hence, if oil prices drop materially in the second half of this year - as we expect - Colombia's balance of payments will be strained. Consequently, the currency will come under depreciation pressure. The peso is presently fairly valued as the real effective exchange rate based on unit labor costs is at its historical mean (Chart III-2).   The central bank has adopted a "hands-off" approach toward the exchange rate, and is likely to allow the peso to depreciate if the BoP deteriorates. Weak economic conditions will likely prevent it from hiking interest rates to bolster the peso: Even though the central bank has reduced its policy rate by 350 basis points since the end of 2016, lending rates remain restrictive when compared with the nominal GDP growth rate (Chart III-3, top panel). Fiscal policy has been tight, with government expenditures subdued and the primary deficit narrowing (Chart III-3, bottom panel). This is unlikely to change for now if conservative candidate, Ivan Duque, wins the election. Consumer and business demand has failed to pick up, and shows little sign of recovery (Chart III-4). Non-performing loans (NPL) continue to rise, forcing banks to raise their NPL provisioning (Chart III-5). Weak nominal GDP growth suggests provisions may rise further.       Overall, banks' balance sheets remain impaired, hampering their ability to extend loans. Investment Recommendations Despite a favorable structural outlook, Colombia's cyclical growth and financial market outlooks remain poor. Chances are that the peso will come under selling pressure as the external environment deteriorates - i.e., the currency will act as a release valve. We recommend staying neutral on Colombian stocks and local bonds relative to their EM peers, and to overweight Colombian sovereign credit within an EM credit portfolio. The basis is that sound and tight fiscal policies and a continuation of supply side reforms will benefit this credit market. To capitalize on potential currency depreciation while hedging for the uncertainty of oil price decline, we recommend shorting the peso against the Russian ruble. Although Colombia's structural outlook is more promising than Russia's, the latter's BoP dynamics is healthier and its cyclical growth outlook is better than Colombia's.   Andrija Vesic, Research Analyst AndrijaV@bcaresearch.com

Highlights The global trade slowdown will intensify, even if U.S. domestic demand remains robust. The large emerging Asian bourses will recouple to the downside with their EM peers. Market-neutral EM equity portfolios should consider going long consumer staples while shorting banks. In Chile, receive 3-year swap rates. Continue to overweight stocks relative to the EM benchmark. Short the Colombian peso versus the Russia ruble. Stay neutral on Colombian equities and local bonds but overweight sovereign credit within their respective EM universes. Feature Performance of large equity markets in north Asia - Korean, Taiwanese and Chinese investable stocks -- has been relatively resilient compared with other EM bourses. Specifically, the EM ex-China, Korea and Taiwan equity index has already dropped 16% in U.S. dollar terms, while the market cap-weighted index of investable Chinese, Korean and Taiwanese stocks is down only 8% from its peak in late January.1 These three markets account for 60% of the MSCI EM stock index. A pertinent question is whether these North Asian markets will de-couple from or re-couple with the rest of EM. Our bias is that they will re-couple to the downside. Global equity portfolios should continue to underweight Asian stocks versus the DM bourses in general, and the S&P 500 in particular. That said, dedicated EM equity portfolios should overweight Korea and Taiwan and maintain a neutral stance on China and Hong Kong relative to the EM and Asian equity benchmarks. The Global Trade Slowdown Will Intensify Emerging Asian stock markets are very sensitive to global trade cycles. Slowing global trade is typically negative for them. There is growing evidence that the global trade deceleration will intensify: The German IFO index for business expectations in German manufacturing - a good leading indicator for global trade - is pointing to a further slowdown in global exports (Chart I-1). Chart I-1Global Trade Slowdown Will Persist Export volume growth has already slowed across manufacturing Asia (Chart I-2). The most recent data points for these series are as of April. Asia's booming tech/semiconductor industry is also slowing. Both Taiwan's export orders growth and Singapore's technology PMI new orders-to-inventory ratio have relapsed (Chart I-3). Chart I-2Asian Exports Growth: Heading Southward Chart I-3Asian Tech: Feeling The Pinch One of the causes of weakness in the global semiconductor cycle could be stagnating global auto sales (Chart I-4). The latter are being weighed down by weakness in auto sales in China and the U.S. Cars require a significant amount of semiconductors, and lack of improvement in global auto sales will suppress semiconductor demand. So far, China has not been at the epicenter of investors' concerns, but this will soon change as its growth slowdown intensifies. Credit conditions continue to tighten in China, which entails downside risks to mainland capital spending and consequently imports. China's imports are set to slump considerably, reinforcing the global trade downturn.2 First, China's bank loan approvals have dropped considerably in the past 18 months, suggesting a meaningful slowdown in bank financing and in turn the country's investment expenditures (Chart I-5). Chart I-4Global Auto And Semiconductor Sales Chart I-5China: Bank Loan Approval And Capex Second, not only are bank loan standards tightening but costs of financing are also rising. The share of loans extended above the prime lending rate has risen to a 15-year high (Chart I-6, top panel). This represents marginal tightening. Finally, onshore corporate bond yields as well as offshore U.S. dollar-denominated corporate bond yields have broken to new highs in this cycle (Chart I-6, bottom panels). Mounting borrowing costs and tighter credit standards in China point to further deceleration in credit-sensitive spending such as investment expenditures and property purchases. On the whole, rising interest rates and material currency depreciation in EM ex-China and credit tightening in China will prompt a considerable slump in imports, depressing world trade. EM including Chinese imports account for 30% of global imports, while the U.S. and EU together make up 24% of global imports values. Hence, global trade will disappoint if and as EM and Chinese imports stumble. A final word on the history of de-coupling among EM regions is in order. There have been a few episodes when emerging Asian and Latin American stocks de-coupled: In 1997-'98, the home-grown Asian crisis devastated regional markets, but Latin American stocks continued to rally until mid-1998 - when they plummeted (Chart I-7, top panel). Chart I-6China: Rising Borrowing Costs Chart I-7De-coupling Between Asia And Latin America In 2007-'08, emerging Asian equities tumbled along with the S&P 500, but Latin American bourses fared well until the middle of 2008 due to surging commodities/oil prices (Chart I-7, middle panel). Finally, the bottom panel of Chart I-7 illustrates that in early 2015, Asian stocks performed well, supported by the inflating Chinese equity bubble. Meanwhile, Latin American stocks plunged. In all of these episodes, the de-coupling between Asia and Latin America proved to be unsustainable, and the markets that showed initial resilience eventually re-coupled to the downside. Bottom Line: Global trade is set to head southward, even if U.S. demand remains robust. China's growth slump will be instrumental to this global trade slowdown. Consequently, Chinese, Korean and Taiwanese equities will be vulnerable. Heeding To Market Signals Financial markets often move ahead of economic data, and simply tracking data is not always helpful in gauging turning points in business cycles. By the time economic data change course, financial markets would typically have already partially adjusted. Besides, past economic and financial market performance is not a guarantee of future performance. This is why we rely on thematic fundamental analysis and monitor intermediate- and long-term trends in financial markets to navigate through markets. There are presently several important market signals that investors should be heeding to: EM corporate bond yields are surging, which typically foreshadows falling EM share prices (Chart I-8). Meanwhile, there is no robust correlation between EM equities and U.S. bond yields. Chart I-8EM Share Prices Always Decline When EM Corporate Bond Yields Rise The basis: So long as the rise in U.S. bond yields is offset by compressing EM credit spreads, EM corporate bond yields decline and EM share prices rally. But when EM corporate (or sovereign) yields rise, irrespective of whether this is due to rising U.S. Treasury yields or widening EM credit spreads, EM equity prices come under considerable selling pressure. Lately, both EM credit spreads have been widening, offsetting the drop in U.S. bond yields. Hence, a drop in U.S. bond yields is not in and of itself sufficient to halt a decline in EM share prices. So long as EM corporate and sovereign credit spreads are widening by more than the decline in U.S. Treasury yields, EM corporate and sovereign bond yields will rise, heralding lower EM share prices. The ratio of total return (including carry) of six commodities currencies relative to safe-haven currencies3 is breaking below its 200-day moving average after having bounced from this technical support line several times in the past 12 months (Chart I-9). This could be confirming that the bull market in EM risk assets is over, and a bear market is underway. Chinese property stocks listed onshore have broken down, and those trading in Hong Kong seem to be forming a head-and-shoulder pattern (Chart I-10). In the latter case, such a technical formation will likely be followed by a considerable down-leg. Chart I-9An Important Breakdown Chart I-10Chinese Property Stocks Look Very Vulnerable Further, China's onshore A-share index has already dropped by 15% from its cyclical peak in late January. Finally, both emerging Asia's relative equity performance against developed markets, as well as the emerging Asian currency index versus the U.S. dollar (ADXY) seem to be rolling over at their long-term moving averages (Chart I-11). The same technical pattern is presenting itself for global energy and mining stocks in absolute terms, and also in the overall Brazilian equity index (Chart I-12). Chart I-11Asian Equities And Currencies Are ##br##At Critical Juncture Chart I-12Commodity Equities And Brazil ##br##Are Facing Technical Resistance The failure of these markets to break above their long-term technical resistance levels may be signalling that their advance since early 2016 has been a cyclical - not structural - bull market, and is likely over. These technical chart profiles so far confirm our fundamental analysis that the EM and commodities rallies since early 2016 did not represent a multi-year secular bull market. If correct, the downside risks to EM including Asian markets are substantial, and selling/shorting them now is not too late. Bottom Line: EM including Asian stocks, currencies and credit markets are at risk of gapping down. Absolute-return investors should trade these markets on the short side. Asset allocators should underweight EM markets relative to DM in general and the U.S. in particular. A complete list of our currency, fixed-income and equity recommendations is available on pages 20-21. An EM Equity Sector Trade: Long Consumer Staples / Short Banks EM consumer staples have massively underperformed banks as well as the overall EM index since January 2016 (Chart I-13). The odds are that their relative performance is about to reverse. Equity investors should consider implementing the following equity pair trade: long consumer staples / short banks: Consumer staples are a low-beta sector because their revenues are less cyclical. As EM growth downshifts, share prices of companies with more stable revenue streams will likely outperform. Bank stocks are vulnerable as local interest rates in many EMs rise in response to the selloff in their respective currencies (Chart I-14). Consumer staples usually outperform banks when local borrowing costs are rising. Chart I-13Go Long EM Consumer Staples / ##br##Short EM Banks Chart I-14EM Banks Stocks Are Inversely Correlated With##br## EM Local Bond Yields We expect more currency depreciation in EM, which will exert further upward pressure on local rates, including interbank rates. Further, growth weakness in EM economies typically leads to rising non-performing loan (NPL) provisions. Chart I-15A and Chart I-15B demonstrates that weakening nominal GDP growth (shown inverted on the charts) leads to higher provisioning. Hence, a renewed EM growth slowdown will hurt bank profits. Chart I-15AWeaker Nominal GDP Growth Entails ##br##Higher NPL Provisions Chart I-15BWeaker Nominal GDP Growth Entails ##br##Higher NPL Provisions Our assessment is that banks in many EM countries have provisioned less than what is probably necessary following years of a credit boom. Indeed, in the last 12-18 months or so, many banks have even been reducing their NPL provisions to boost profits. Hence, a reversal of these dynamics will undermine banks' earnings. Bottom Line: Market-neutral EM equity portfolios should consider going long consumer staples while shorting banks. This is in addition to our long-term strategy of shorting EM banks versus U.S. banks as well as shorting banks in absolute terms in individual markets such as Brazil, Turkey, Malaysia and small-cap banks in China. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 These calculations are done using MSCI investible stock indexes in U.S. dollars terms. 2 Please see Emerging Markets Strategy Weekly Report, "The Dollar Rally And China's Imports", dated May 24, 2018, available at ems.bcaresearch.com. 3 Average of cad, aud, nzd, brl, clp & zar total returns (including carry) relative to average of jpy & chf total returns (including carry). Chile: Stay Overweight Equities, Receive Rates 31 May 2018 Chart II-1Chilean Equities Relative Performance And Copper Prices It is often assumed that Chilean financial markets are a play on copper. While this largely holds true for the Chilean peso, it is not always correct regarding its stock market's relative performance to its EM peers. Chile has outperformed in the past amid declining copper prices (Chart II-1). Despite our negative view on copper prices, we are reiterating our overweight allocation to this bourse within an EM equity portfolio. There are convincing signs that growth in the Chilean economy is moving along fine for now (Chart II-2). While weakness in global trade will weigh on the economy, the critical variable that makes Chile stand out from other commodities producers in the EM universe is its ability to cut interest rates amid currency depreciation. Chart II-3 illustrates that interest rates in Chile can and do fall when the peso depreciates. This stands in stark contrast with many others economies in the EM universe. There are a number of factors that suggest inflationary pressures will remain dormant for some time. This will allow the Central Bank of Chile (CBC) to cut rates as and when required. Chart II-2Chile: Economic Conditions Chart II-3Interest Rates In Chile Can Fall When Peso Depreciates First, the output gap is negative and has been widening, which has historically led to falling core inflation (Chart II-4). Second, a wide range of consumer inflation measures - services and trimmed-mean inflation rates - are very low and remain in a downtrend (Chart II-5). Chart II-4Chile: Output Gap And Inflation Chart II-5Chile: Inflation Is Very Low And Falling Finally, there are no signs of wage inflation, which is the key driver of genuine inflation. In fact, wage growth is decelerating sharply (Chart II-6). Odds are that this disinflationary rout will go on for longer, given Chile's demographic and labor market dynamics. The country's labor force growth has accelerated and the economy does not seem able to absorb this excess labor supply (Chart II-7). Consistently, our labor surplus proxy - calculated as the number of unemployed looking for a job divided by the number of job vacancies - has surged to all-time highs (Chart II-8). Chart II-6Chile: Wage Growth Is Very Weak Chart II-7Chile: Rising Labor Force Chart II-8Chile: Excessive Labor Supply... Interestingly, this is not happening because of weak employment. Chart II-9 shows that the employment-to-working population ratio is at a record high, while employment growth is robust. This upholds that decent job growth is not sufficient to absorb the expanding supply of labor. All in all, a structural excess supply of labor as well as a cyclical slowdown in global trade and lower copper prices altogether will likely warrant a decline in interest rates in Chile. Consequently, we recommend a new fixed income trade: Receive 3-year swap rates. The recent rise provides a good entry point (Chart II-10). Chart II-9...Despite Robust Employment Growth Chart II-10Chile: Receive 3-Year Swap Rates The ability to cut interest rates will mitigate the effect of weaker exports on the economy. We recommend dedicated EM investors maintain an overweight allocation in Chile in their equity, local currency bond and corporate credit portfolios. For absolute return investors, the risk-reward profiles for Chilean stocks and the currency are not attractive. The peso will depreciate considerably, and shorting it versus the U.S. dollar will prove profitable. Consistent with our negative view on copper prices, we have been recommending a short position in copper with a long leg in the Chilean peso. This allows traders to earn some carry while waiting for copper prices to break down. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Colombia: The Currency Will Be A Release Valve The structural long-term outlook for Colombia is positive, as a combination of pro-market orthodox policies and reform initiatives amid positive tailwinds from demographic should ensure a reasonably high potential GDP growth rate. In the first round of presidential elections held last weekend, the gap between right wing candidate Ivan Duque and left-wing candidate Gustav Petro came out large enough to make a Duque victory highly likely in the second round to be held on June 17. His election would entail a positive backdrop for the reform agenda and business investment over the coming years. Yet despite the positive structural backdrop, Colombia is still facing a major imbalance - excessive reliance on oil in sustaining stable balance of payments (BoP) dynamics. The trade balance deficit - including oil - is $8 billion, while excluding oil it stands at $20 billion, or 7.5% of GDP (Chart III-1). Hence, if oil prices drop materially in the second half of this year - as we expect - Colombia's balance of payments will be strained. Consequently, the currency will come under depreciation pressure. The peso is presently fairly valued as the real effective exchange rate based on unit labor costs is at its historical mean (Chart III-2). Chart III-1Colombia's Achilles' Hill: Trade Balance Excluding Oil Chart III-2The Colombian Peso Is Fairly Valued The central bank has adopted a "hands-off" approach toward the exchange rate, and is likely to allow the peso to depreciate if the BoP deteriorates. Weak economic conditions will likely prevent it from hiking interest rates to bolster the peso: Even though the central bank has reduced its policy rate by 350 basis points since the end of 2016, lending rates remain restrictive when compared with the nominal GDP growth rate (Chart III-3, top panel). Fiscal policy has been tight, with government expenditures subdued and the primary deficit narrowing (Chart III-3, bottom panel). This is unlikely to change for now if conservative candidate, Ivan Duque, wins the election. Consumer and business demand has failed to pick up, and shows little sign of recovery (Chart III-4). Non-performing loans (NPL) continue to rise, forcing banks to raise their NPL provisioning (Chart III-5). Weak nominal GDP growth suggests provisions may rise further. Chart III-3Colombia: Little Sign Of Recovery Chart III-4Colombia: Little Sign Of Recovery Chart III-5Colombian Banks: NPL And NPL Provision Continue Rising Overall, banks' balance sheets remain impaired, hampering their ability to extend loans. Investment Recommendations Despite a favorable structural outlook, Colombia's cyclical growth and financial market outlooks remain poor. Chances are that the peso will come under selling pressure as the external environment deteriorates - i.e., the currency will act as a release valve. We recommend staying neutral on Colombian stocks and local bonds relative to their EM peers, and to overweight Colombian sovereign credit within an EM credit portfolio. The basis is that sound and tight fiscal policies and a continuation of supply side reforms will benefit this credit market. To capitalize on potential currency depreciation while hedging for the uncertainty of oil price decline, we recommend shorting the peso against the Russian ruble. Although Colombia's structural outlook is more promising than Russia's, the latter's BoP dynamics is healthier and its cyclical growth outlook is better than Colombia's. Andrija Vesic, Research Analyst AndrijaV@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Special Report

Feature Valuations, whether for currencies, equities, or bonds, are always at the top of the list of the determinants of any asset's long-term performance. This means that after large FX moves like those experienced this year, it is always useful to pause and reflect on where currency valuations stand. In this context, this week we update our set of long-term valuation models for currencies that we introduced in February 2016 in a Special Report titled, "Assessing Fair Value In FX Markets". Included in these models are variables such as productivity differentials, terms-of-trade shocks, net international investment positions, real rate differentials and proxies for global risk aversion.1 The models cover 22 currencies, incorporating both G10 and EM FX markets. Twice a year, we provide clients with a comprehensive update on all of these long-term models in one stop. These models are not designed to generate short- or intermediate-term forecasts. Instead, they reflect the economic drivers of a currency's equilibrium. Their purpose is therefore threefold. First, they provide guideposts to judge whether we are at the end, beginning, or middle of a long-term currency cycle. Second, by providing strong directional signals, the models help us judge whether any given move is more likely be a countertrend development or not, offering insight on potential longevity. Finally, they assist us and our clients in cutting through the fog and understanding the key drivers of cyclical variations in a currency's value. The U.S. Dollar Chart 1The Dollar's Overvaluation Is Gone After its large 7.5% fall in trade-weighted terms since the end of 2016, the real effective dollar is now trading at a 2% discount vis-à-vis its fair value based on its principal long-term drivers - real yield differentials and relative productivity between the U.S. and its trading partners (Chart 1). The U.S. dollar's equilibrium - despite having been re-estimated higher earlier this year due to upward revisions by the Conference Board to its U.S. productivity series - has flattened as of late, as real rate differentials between the U.S. and the rest of the world have declined. While 2017 has been an execrable year for dollar bulls, glimmers of hope remain. First, the handicap created by expensive valuations has been purged. Second, the excessive bullishness toward the greenback that prevailed earlier this year has morphed into deep pessimism. Third, U.S. real interest rates have fallen as investor doubts that the Federal Reserve will be able to increase interest rates as much as it wants to in the face of paltry inflation have surged. However, the U.S. economy is strong and at full capacity, suggesting that inflation will hook back up at the end of 2017 and in the first half of 2018. This should once again lift the U.S. interest rate curve, the dollar's fair value, and the dollar itself. That being said, this story is unlikely to become fully relevant over the next three months. The Euro Chart 2The Euro's Fair Value Is Now Rising On a multi-year time horizon, the euro is driven by the relative productivity trend of the euro area with its trading partners, its net international investment position, terms-of-trade shocks and rate differentials. Thanks to its powerful rally this year, the euro's discount to its fair value has narrowed from 7% in February to 6% today (Chart 2). This narrowing is not as great as the rally in the trade-weighted euro itself as its fair value has also improved, mainly thanks to continued improvement in the euro area's net international position - a development driven by the euro zone's current account of 3% of GDP. Nonetheless, the EUR's current discount to fair value is still not in line with previous bottoms, such as those experienced in both early 1985 or in 2002. We do expect a new wave of weakness in the EUR to materialize toward the end of the year and in early 2018 as markets once again move to discount much more aggressive tightening by the Fed than what will be executed by the European Central Bank: U.S. inflation is set to move back towards the Fed's target, but European inflation will remain hampered by the large amount of labor market slack still prevalent in the European periphery. What's more, euro area inflation is about to suffer from the lagged effects of the tightening in financial conditions that have been created by a higher euro. However, the fact that the euro's fair value has increased implies it is now very unlikely for the EUR/USD to hit parity this cycle. The Yen Chart 3The Yen Is Very Cheap, But It May Not Count For Much The yen's long-term equilibrium is a function of Japan's net international investment position, global risk aversion, and commodity prices. The JPY discount to this fair value has deepened this year, despite the fall in USD/JPY from 118 to 108 (Chart 3). This is mainly because the euro and EM as well as commodity currencies have all appreciated against the Japanese currency. Low domestic inflation has been an additional factor that has depressed the Japanese real effective exchange rate. While valuations point to a higher yen in the coming year, this will be difficult to achieve. The Bank of Japan remains committed to boosting Japanese inflation expectations. To generate such a shock to expectations, the BoJ will have to keep policy at massively accommodative levels for an extended period. As global growth remains robust, global bond yields should experience some upside over the next 12 months. With JGB yields capped by the Japanese central bank, this will create downside for the yen. However, because the yen is so cheap, it is likely to occasionally rally furiously each time a risk-off event, such as any additional North Korean provocations, puts temporary downward pressure on global yields. The British Pound Chart 4The Pound Is Attractive On A Long-Term Basis The pound has fallen 6% against the euro this year, the currency of its largest trading partner. This has dragged down the GBP's real effective exchange rate to a large 11% discount to its fair value, the largest since the direct aftermath of the Brexit vote (Chart 4). Because Great Britain has entered a paradigm shift - the exit from the European Union will change the nature of the U.K. relationship on 43% of its trade - assessing where the pound's fair value lies is a more nebulous exercise than normal. However, signs are present that the pound is indeed cheap. British inflation remains perky, the current account has narrowed to 4% of GDP, and despite large regulatory uncertainty, net FDI into the U.K. has hit near record highs of 7% of GDP. Movements in cable are likely to remain a function of the gyrations in the U.S. dollar. However, at this level of valuation, the pound is attractive against the euro on a long-term basis. We had a target on EUR/GBP at 0.93, which was hit two weeks ago. This cross is likely to experience downside for the next 12 months. The biggest risk for the pound remains British politics - and not Brexit itself but its aftershock. The EU has made clear the transition process will be long, leaving time for the British economy to adjust. However, the conservative party has been greatly weakened, and Jeremy Corbyn's popularity is increasing. This raises the specter that, in the not-so-distant future, a Labour government could be formed. Under Corbyn's leadership, this would be the most left-of-center administration in any G10 country since François Mitterrand became French president in 1981. The early years of the Mitterrand presidency were marked by a sharp decline in the franc as he nationalized broad swaths of the French private sector, increased taxes and implemented inflationary policies. Keep this in mind. The Canadian Dollar Chart 5The CAD Has Lost Its Valuation Advantage The loonie's fair value is driven by commodity prices, relative productivity trends, and the Canadian net international position. In February, the CAD was trading in line with its fair value. However, after its blistering rally since May, when the Bank of Canada began to hint that policy could be tightened this year, the Canadian dollar is now expensive vis-à-vis its long-term fundamental drivers (Chart 5). In a Special Report two months ago, we argued that the BoC was one of the major global central banks best placed to increase interest rates.2 With the Canadian economy firing on all cylinders, and with the output gap closing faster than the BoC anticipated in its July Monetary Policy Statement, the two interest rate hikes recorded this year so far make sense, and another one is likely to materialize in December. However, while the CAD could continue to rise until then, traders have moved from being massively short the CAD to now holding very sizeable net long positions. Additionally, interest rate markets are now discounting more than two hikes in Canada over the next 12 months, while expecting less than one full hike in the U.S. over the same time frame. If this scenario were to pan out, the tightening in monetary conditions emanating from a massive CAD rally would likely choke the Canadian recovery. Instead, we expect U.S. rates to increase more than what is currently embedded in interest rate markets, thus limiting the downside in USD/CAD. We prefer to continue betting on a rising loonie over the next 12 months by buying it against the euro and the Australian dollar. The Australian Dollar Chart 6The AUD Is Very Expensive The fair value of the Aussie is driven by Australia's net international position and commodity prices. Even with the tailwind of stronger metal prices, the AUD's rallies have been beyond what fundamentals justify, leaving it at massively overvalued levels (Chart 6). This suggests the AUD is at great risk of poor performance over the next 24 months. Timing the beginning of this decline is trickier, and valuations offer limited insight. One of the key factors that has supported the AUD has been the large increase in fiscal and public infrastructure spending in China this year - a move by Beijing most likely designed to support the economy in preparation for the 19th National Congress of the Communist Party of China, where the new members of the Politburo are designated. As this event will soon move into the rearview mirror, China may abandon its aggressive support of the industrial and construction sectors - two key consumers of Australia's exports. The other tailwind behind the AUD has been the very supportive global liquidity backdrop. Global reserves growth has increased, dollar-based liquidity has expanded and generalized risk-taking in global financial markets has generated large inflows into EM and commodity plays.3 While U.S. inflation remains low and investors continue to price in a shy Fed, these conditions are likely to stay in place. However, a pick-up in U.S. inflation at the end of the year is likely to force a violent re-pricing of U.S. interest rates and drain much of the global excess liquidity, especially as the Fed will also be shrinking its balance sheet. This is likely to be when the AUD's stretched valuations become a binding constraint. The New Zealand Dollar Chart 7No More Premium In The NZD Natural resources prices, real rate differentials and the VIX are the key determinants of the kiwi's fair value, highlighting the NZD's nature as both a commodity currency and a carry currency. Both the fall in the VIX and the rebound in commodities prices are currently causing gradual appreciation in the New Zealand's dollar equilibrium exchange rate. However, despite these improving fundamentals, the real trade-weighted NZD has fallen this year, and now trades in line with its fair value (Chart 7). Explaining this performance, the NZD began 2017 at very expensive levels, even when compared to the already-pricey AUD. Also, despite a very strong New Zealand economy, the Reserve Bank Of New Zealand has disappointed investors by refraining from increasing interest rates, as the expensive currency has tightened monetary conditions on its behalf. Going forward, the recent weakness in the real effective NZD represents a considerable easing of policy, which could warrant higher rates in New Zealand. As a result, while a tightening of global liquidity conditions could hurt the NZD in addition to the AUD, the kiwi is likely to fare better than the much more expensive Aussie, pointing to an attractive shorting opportunity in AUD/NZD over the next 12 months. The Swiss Franc Chart 8The CHF Is Cheap, The SNB Is Happy Switzerland's enormous and growing net international investment position continues to be the most important factor lifting the fair value of the Swiss franc. The recent sharp rally in EUR/CHF has now pushed the Swissie into decisively cheap territory (Chart 8). The decline in political risk in the euro area along with the lagging economic and inflation performance of the Swiss economy fully justify the discount currently experienced by the Swiss franc: money has flown out of Switzerland, and the Swiss National Bank is doing its utmost to keep monetary policy as easy as it can. For a small open economy like Switzerland, this means keeping the exchange rate at very stimulative levels. The continued growth in the SNB's balance sheet is a testament to the strength of its will. For the time being, there is very little reason to bet against SNB policy; the CHF will remain cheap because the economy needs it. However, this peg contains the seeds of its own demise. The cheaper the CHF gets, the larger the economic distortions in the Swiss economy become. Already, Switzerland sports the most negative interest rates in the world. This directly reflects the large injections of liquidity required from the SNB to keep the CHF down. These low real rates are fueling bubble-like conditions in Switzerland real estate and are threatening the achievability of return targets for Swiss pension plans and insurance companies, forcing dangerous risk-taking. But until core inflation and wage growth can move and stabilize above 1%, these conditions will stay in place. The Swedish Krona Chart 9The Swedish Krona Has More Upside Even after its recent rebound, the Swedish krona continues to trade cheaply, even if its long-term fair value remains on a secular downward trajectory (Chart 9). Yet the undemanding valuations of the SEK hide a complex picture. It is approximately fairly valued against the GBP and expensive against the NOK, two of its largest trading partners. However, the SEK is cheap against the USD and the euro. We expect the SEK to continue appreciating. While Swedish PMIs have recently softened, the Swedish economy is running well above capacity, and the Riksbank resources utilization indicator suggests the recent surge in inflation has further to run. Moreover, Sweden is in the thralls of a dangerous real-estate bubble that has pushed nonfinancial private-sector debt above 228% of GDP. With many amortization periods on new mortgages now running above 100 years, the Swedish central bank is concerned that further inflating this bubble could result in a milder replay of the debt crisis experienced in the early 1990s. The shift in leadership at the Riksbank's helm at the beginning of 2018 is likely to be the key factor that prompts the beginning of the removal of policy accommodation in that country. We like buying the krona against the euro. The USD/SEK tends to be a high-beta play on the greenback, and thus is very much a call on the USD. However, EUR/SEK displays a much lower correlation, and thus tends to be a more effective medium to isolate the upcoming tightening in monetary policy we expect from the Riksbank. The Norwegian Krone Chart 10The NOK is The Cheapest Commodity Currency The Norwegian krone remains the cheapest commodity currency in the world, along with the Colombian peso (Chart 10). The slowdown in Norwegian inflation and a very negative output gap of 2% of GDP implies that the Norges Bank will remain one of the most accommodative central banks in the G10. Thus, the NOK should remain cheap. However, we continue to like buying the krone against the euro. EUR/NOK has only traded above current levels when Brent prices have been below US$40/bbl. Not only is Brent currently trading above US$50/bbl, but the outlook for oil remains bright: production is in control as the agreement between Russian and OPEC is still in place. Additionally, the recent carnage and refinery shutdowns caused by hurricane Harvey should result in large drawdowns to finished-products inventories in the coming months. This will contribute to an anticipated normalization in global excess petroleum inventories, which have been the most important headwind to oil prices. Finally, the fact that the Brent curve is now backwardated also represents a support for oil prices, as this creates a "positive carry" for oil investors. The Yuan Chart 11The Yuan Can Rise On A Trade-Weighed Basis Despite the recent strength in both the trade-weighted RMB and the yuan versus the U.S. dollar, the renminbi still trades at a discount to its long-term fair value (Chart 11). Confirming this insight, China continues to sport a sizeable current account surplus, and its share of global exports is still on an expanding path. With the RMB being cheap, now that China is once again accumulating reserves instead of spending them to create a floor under its currency, the downside risk to the CNY has decreased significantly. Thus, since the People's Bank of China targets a basket of currencies when setting the yuan's value, to legitimize any bullish view on USD/CNY one needs to have a bullish view on the USD. While we do anticipate the dollar to rally toward the end of the year, our expectation that it will remain flat until then implies that we do not see much upside for now to USD/CNY. However, our bullish medium-term USD view, along with the cheapness of the CNY, suggests that the RMB could continue to appreciate on a trade-weighted basis going forward. While Chinese policymakers have highlighted their desire to make their currency a more countercyclical tool, the recent stability in Chinese inflation implies there is no need to let the CNY depreciate to reflate China. In fact, at this point, elevated PPI readings would argue that the Chinese authorities do have a built-in incentive to let the CNY appreciate on a trade-weighted basis for the coming six to 12 months. The Brazilian Real Chart 12The BRL is Vulnerable To A Pullback In Global Liquidity Hampered by poor productivity trends, which weigh on the Brazilian current account balance, the fair value of the real remains quite depressed, even as commodity prices have sharply rebounded since early 2016. In fact, the violent rally in the BRL over the same timeframe has made it one of the most expensive currencies tracked by our models (Chart 12). This level of overvaluation points to poor returns for the BRL on a one-to-two-year basis, however, it gives no clue to timing. The strong sensitivity of the Brazilian real to EM asset prices implies that the BRL is unlikely to weaken significantly so long as EM bonds remain well-bid. Moreover, because the BRL still offers an elevated carry, until U.S. interest rate expectations turn the corner, U.S. market dynamics will continue to put a floor under the real. However, this combination suggests the BRL could become one of the prime casualties of any rebound in U.S. inflation. Such a development would cause global liquidity to fall, hurting EM bonds in the process and making the BRL's high-risk carry much less attractive. Confirming this danger, the fact that the USD/BRL has not been able to breakdown for more than a year despite the weakness in the USD suggests momentum under the BRL is rather weak. The Mexican Peso Chart 13Mexican Peso: From Bargain To Luxury In the direct aftermath of Trump's electoral victory, the Mexican peso quickly became one of the cheapest currencies in the world. However, the peso's 25% rally versus the U.S. dollar since January has eradicated this valuation advantage to the point where it is now one of the most expensive major currencies in the world (Chart 13). As the peso was collapsing through 2016, the Mexican central bank fought back, increasing interest rates. The massive surge in the prime lending rate points to a protracted period of weakness in the growth of nonfinancial private credit, which should weigh on consumption and investment. Actually, the growth in retail sales volumes has already begun to weaken. This could force the Banxico to cut rates, especially as inflation will slow in the face of peso's rebound this year. Lower Mexican rates, in the face of stretched long positioning in MXN by speculators, could be the key to generating a weakening in the peso over the next 12 months. To see real fireworks in the peso, one would need to see a resumption in the U.S. dollar bull market. Mexico has external debt equivalent to 66% of GDP, the highest among large EM nations. This makes the Mexican economy especially vulnerable to a strong dollar, as such a move would imply a massive increase in debt servicing costs. Thus, while the MXN may not be as vulnerable as the BRL, it could still suffer greatly if global liquidity becomes less generous next year. The Chilean Peso Chart 14CLP Needs HIgh Copper Prices The Chilean peso real effective exchange rate is driven by the country's productivity trend relative to its trading partners and the real price of copper - which proxies Chilean terms-of-trade. Thanks to the CLP's rally since the winter of 2015, the real peso is at a four-year high and is now in expensive territory (Chart 14). We expect copper to see downside from now until the end of the year, pulling down the CLP with it. Current dynamics in the Chinese real estate market and the Chinese credit cycle, which tend to be leading indicators of industrial metals prices, point to an upcoming selloff. Moreover, Chinese monetary conditions have begun to tighten, and are set to continue doing so. This will weigh on Chinese credit growth and capex, creating headwinds for copper and the peso. That being said, the CLP will likely outperform the BRL and the ZAR. M1 money growth is back in positive territory after contracting last year, while industrial activity seems to have hit a bottom and is now picking up. Moreover, since Chile's economy does not have the credit excesses of its other EM peers, we expect the CLP to show more resilience than other currencies linked to industrial metals. The Colombian Peso Chart 15COP: A Rare Bargain Among EM The real COP's fair value is driven by Colombia's relative productivity trends and the price of oil, the country's main export. The fall in oil prices since the beginning of the year have caused a small decline in the fair value of the COP. Nevertheless, the peso is still one standard deviation below fair value (Chart 15). This partly reflects the premium demanded by investors to compensate for Colombia's large current account deficit of 6.3% of GDP. Overall the COP looks attractive, particularly against other commodity currencies. Historically a discount of 20% or more, like what the peso has today, marks a bottom in the real effective exchange rate. Furthermore, our Commodity and Energy Strategy Service expects Brent prices to climb to US$60/bbl towards the end of year, as OPEC's and Russia's production controls translate into oil inventory drawdowns. This should further increase the value of the COP against the ZAR and the BRL. Domestic dynamics also point to outperformance of the peso against other EM currencies. As opposed to countries like Brazil, where private debt stands at nearly 85% of GDP, Colombia has a more modest 60% leverage ratio - the byproduct of an orthodox banking system. Thus, the peso should be able to withstand a liquidity drawdown in EM better than its peers. The South African Rand Chart 16Lack Of Productivity And Politics Are The Greatest Risk To The Rand South Africa's dismal productivity trend continues to be the greatest factor pulling the rand's long-term fair value lower. Due to this adverse trend, while the ZAR has been broadly stable this year, it is now slightly more expensive than it was in February (Chart 16). Not captured by the model, the political risks in South Africa remain elevated, creating a further handicap for the rand. The story behind the ZAR is very similar to the one underpinning the gyrations in the BRL. Both currencies, thanks to their elevated carries and deep liquidity - at least by EM currency standards - will continue to be buoyed by very generous global liquidity conditions. However, global real rates seem dangerously low and could move sharply higher, especially when U.S. inflation picks up at the end of the year and in early 2018. Such a move would cause the currently very supportive reflationary conditions to dissipate. This would put the expensive ZAR in a very precarious position. An additional danger for the ZAR is the price of gold. Gold and precious metals have also benefited from these generous global liquidity conditions. This has helped the South African terms of trade. However, gold is likely to be a key victim if U.S. interest rates rise because it is negatively correlated with both real interest rates and the U.S. dollar. Thus, while we do not see much upside for the expensive ZAR for the time being, it is likely to suffer greatly once U.S. inflation turns around, suggesting the ZAR possesses a very poor risk/reward ratio. The Russian Ruble Chart 17The Ruble Is Expensive But Russia Has The Best EM Fundamentals The RUB is currently trading at a very large premium to fair value (Chart 17). The risk created by such an overvaluation is only likely to materialize once U.S. inflation turns the corner and U.S. interest rates pick up - a scenario we've mentioned for late 2017 and early 2018. This risk is most pronounced against DM currencies, the U.S. dollar in particular. The RUB remains one of our favorite currencies within the EM space, especially when compared to other EM commodity producers. The Russian central bank is pursuing very orthodox policy, despite the fall in realized inflation, and is maintaining very elevated real interest rates in order to fully tame inflation expectations. Moreover, oil prices are likely to experience upside in the coming months as oil inventories are drawn down. This could result in an increase in the ruble's equilibrium exchange rate, which would help correct some of the RUB's overvaluation. The Korean Won Chart 18KRW Is Where You Can Really See The North Korean Tensions The fair value of the Korean won continues to be lifted by the combined effect of lower Asian bond spreads and Korea's current account surplus. Yet, the KRW is trading at an increasingly large discount to its equilibrium (Chart 18). At first glance, this seems highly surprising as global trade is growing at its fastest pace in six years - a situation that always benefits trading nations like South Korea. Instead, political developments are to blame. Not only is North Korea ramping up its tests of intercontinental ballistic missiles and nuclear devices, but also Seoul is within range of Pyongyang's conventional artillery. BCA's Geopolitical Strategy service does not expect the current standoff to result in military conflict. Ultimately, North Korea is no match for the military might of the U.S. and its allies. Moreover, the capacity for Pyongyang's actions to shock financial markets is exhibiting diminishing returns. This suggests the risk premium imbedded in the won should dissipate. However, the won will remain very exposed to dynamics in the USD, global liquidity and global trade. Instead, a lower-risk way for investors to take advantage of the KRW's cheapness is to buy it against the Singapore dollar. While just as exposed to global liquidity as the won, the SGD is currently trading at a premium to fair value. The Philippine Peso Chart 19The PHP Has Over-Discounted The Fall In The Current Account The fair value of the Philippine peso is driven by the country's net international investment position and commodity prices. After falling 6% this year, the real effective PHP now trades at a 13% discount to its fair value (Chart 19). A deteriorating current account, which is now in deficit, has fueled a selloff in the peso, making the Philippine currency one of the worst performing in the EM space. Worryingly, this has occurred alongside faltering foreign exchange reserves. However, the deficit is mainly the mirror image of large capital inflows, fueled by the government's ambitious infrastructure spending. Remittances are growing again and, with a weaker peso, will support consumer spending going forward. Employment had a setback last year, but is growing again. Higher investment and consumer spending will likely push rates up. As inflation rebounded alongside commodity prices last year, it is now at its 3% target. Bangko Sentral ng Pilipinas will need to rein in inflationary pressures to avoid overheating the economy. While the Philippines economy should expand further, the 'Duterte Discount' remains in place. Negative net portfolio flows reflect negative investor sentiment, as policy uncertainty remains elevated. The Singapore Dollar Chart 20SGD Remains Expensive The fair value of the Singapore dollar is driven by commodity prices. This is because the exchange rate is the main policy tool used by the Monetary Authority of Singapore. As a result, when commodity prices rise, which leads to inflationary pressures, MAS tightens policy by spurring appreciation in the SGD. The opposite holds true when commodity prices weaken. Based on this metric, the SGD is currently 4.2% overvalued (Chart 20). Domestically, dynamics are quite mixed. Retail sales have picked up. However, both manufacturing and construction employment are contracting and labor market slack is increasing, pointing to continued subdued wage growth. Additionally, property prices are contracting and vacancy rates are on the rise, led by the commercial property sector. Thus, the recent pickup in inflation could soon vanish, especially as it has been driven by the rebound in oil prices in 2016. This combination suggests that Singapore still needs easy monetary conditions. USD/SGD closely follows the DXY. While the Fed will be able to increase interest rates by more than the 35 basis points priced over the next 24 months, Singapore still needs a lower exchange rate to maintain competitiveness and alleviate deflationary pressures. The Hong Kong Dollar Chart 21The Fall In The USD Has Helped The HKD The HKD remains quite expensive. However, being pegged to the USD, its valuation premium has decreased this year (Chart 21). The fall in the greenback has driven the HKD - which itself has fallen 0.75% versus the U.S. dollar - lower against the CNY and other EM currencies. If the U.S. dollar does resume its uptrend over the next six months, the valuation improvement in the HKD will once again dissipate. However, this does not spell the end of the HKD peg. With reserves of US$414 billion, or 125% of GDP, the Hong Kong Monetary Authority has the firepower to support the peg, which has been one of the cornerstones of Hong Kong economic stability since 1983. Instead, the HKMA will tolerate deep deflationary pressures that will cause a fall in the real effective exchange rate. This is the path that Hong Kong picked in the 1990s, and it will be the path followed again in the face of any broad-based USD appreciation. This suggests that Hong Kong real estate prices could experience significant downside in the coming years. The Saudi Riyal Chart 22The Riyal Is Still Expensive The Saudi riyal remains prohibitively expensive, even as its valuation premium has decreased this year (Chart 22). The SAR is afflicted by similar dynamics as the HKD: its peg with the USD means the greenback's gyrations are the main source of variation in the SAR's real effective exchange rate on a cyclical basis. However, on a structural horizon, the fair value of the riyal is dominated by Saudi Arabia's poor productivity. An economy dominated by crude extraction and processing and living on one of the most sizable economic rents in the world, Saudi Arabia has not endured the competitive pressures that are often the source of productivity enhancement in most nations. Additionally, Saudi capital expenditures are heavily skewed to the oil sector, a sector whose output growth has been limited for many decades by natural constraints. We do not believe the current valuation premium in the riyal will force the Saudi Arabian Monetary Authority to devalue the SAR versus the USD. Saudi Arabia, like Hong Kong, possesses copious foreign exchange reserves, and growth has improved now that oil prices have rebounded. Additionally, the KSA is also likely to tolerate deflationary pressures. Not only has it done so in the past, but Saudi Arabia imports most of its household products, especially its food needs. A fall in the SAR would cause a large amount of food inflation, representing a massively negative price shock for a very young population. This is a recipe for disaster for the royal family of a country with no democratic outlet. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Haaris Aziz, Research Assistant haarisa@bcaresearch.com Juan Manuel Correa, Research Analyst juanc@bcaresearch.com 1 For a more detailed discussion of the various variables incorporated in the models, please see Foreign Exchange Strategy Special Report, "Assessing Fair Value In FX Markets", dated February 26, 2016, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy and Global Alpha Sector Strategy Special Report, "Who Hikes Next?", dated June 30, 2017, available at fes.bcaresearch.com 3 For a more detailed discussion on the global liquidity environment, please Foreign Exchange Strategy Weekly Report, "Dollar-Bloc Currencies: More Than Just China", dated August 18, 2017, available at fes.bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Closed Trades

Highlights Duration: An environment characterized by strong global growth and a weak dollar is very bearish for U.S. bonds. According to our model, fair value for the 10-year Treasury yield is 2.6%. Stay at below-benchmark duration. The Fed & The Dollar: A weak dollar eases financial conditions and supports higher core goods inflation. All else equal, this will strengthen the Fed's hawkish resolve in the near term. However, a rebound in core services (excluding shelter and medical care) inflation will be necessary for core inflation to reach the Fed's target on a sustained basis. USD Sovereigns: USD-denominated sovereigns are not attractive compared to domestic Baa-rated U.S. credit. At the country level, Finland, Mexico and Colombia offer the most attractive spreads and Finnish debt offers the best risk/reward trade-off. Feature Please note there will be no U.S. Bond Strategy report next week. Our regular publishing schedule will resume on August 29, 2017. Chart 1Firm Growth, Despite Weaker $ Escalating tension between the U.S. and North Korea captured the market's attention during the past week, causing investors to ignore what in our view is a more important economic development: Global growth has managed to stay firm even in the face of significant dollar depreciation. Not only does this break the pattern of the past few years when periods of substantial dollar weakness were associated with slowing global growth (Chart 1), but in our view it sends a very bearish signal for U.S. bonds. Above all else, a weak dollar amidst strong global growth suggests that the breadth of the economic recovery is improving. This intuition is confirmed by the fact that our Global Manufacturing PMI Diffusion Index, which measures the net percentage of countries with PMIs above the 50 boom/bust line, is fast approaching 90% (Chart 2). Not only that, but PMIs from the four most important economic blocs are all showing signs of strength. Both the Eurozone and Japanese PMIs are holding firm at high levels, while the U.S. and Chinese PMIs have recently reversed their year-to-date downtrends (Chart 2, bottom two panels). Why is the breadth of the global recovery important? Precisely because a more synchronized recovery prevents the dollar from appreciating too quickly. All else equal, a stronger dollar causes investors to reduce their forecasts for future U.S. growth and inflation. This implies a slower expected pace of rate hikes and lower Treasury yields. Conversely, a weaker dollar causes investors to revise up their growth and inflation forecasts, leading to a quicker expected pace of rate hikes and higher yields. To capture the importance of both global growth and the exchange rate we turn to our 2-factor Treasury model (Chart 3). This is a simple model of the 10-year Treasury yield based on the Global PMI and bullish sentiment toward the dollar. A stronger Global PMI pressures the model's fair value higher, as does increasingly bearish dollar sentiment. Chart 2Synchronized Global Growth Chart 310-Year Treasury Yield Fair Value At present, the model pegs fair value for the 10-year Treasury yield at 2.6%, meaning the current 10-year Treasury yield of 2.22% is 38 bps below fair value. This is the most expensive Treasuries have appeared on our model since the immediate aftermath of last year's Brexit vote. Political Uncertainty & Flights To Quality While our 2-factor model does a good job, there is one important driver of Treasury yields it does not capture. That is the tendency for political events to drive a flight to safety into Treasuries (Chart 4). Typically, if it is possible to identify a purely politically-driven flight to safety - one that is unlikely to exert a meaningful economic impact during the next 6-12 months - then the correct strategy is to heed our model's message and position for higher yields. This strategy worked out perfectly following the Brexit vote, and we anticipate it will work again this time around. Chart 4Policy Uncertainty Is A Driver Of Bond Yields With regards to the catalyst for last week's flight to safety, our Geopolitical Strategy service wrote in a recent Special Report1 that a pre-emptive strike by the U.S. on North Korea is extremely unlikely. The theatrics of the past week demonstrate only that the U.S. needs to establish a "credible threat" if it wants to eventually open a new round of negotiations over North Korea - not unlike the Iranian nuclear negotiations of the past decade. Looking further down the road, if those talks eventually fail then the potential for military conflict is high. We therefore conclude that there is not much potential for U.S. / North Korean tensions to exert a meaningful economic impact during the next 6-12 months, and view the recent bond rally as an opportunity to position for sharply higher yields in the near-term. Bottom Line: An environment characterized by strong global growth and a weak dollar is very bearish for U.S. bonds. According to our model, fair value for the 10-year Treasury yield is 2.6%. Stay at below-benchmark duration. How The Fed Views A Weaker Dollar Financial Conditions Chart 5Weak $ Eases Financial Conditions The Fed views the 7% year-to-date depreciation of the dollar as a significant easing of financial conditions. In fact, most broad indicators of financial conditions have eased this year, even though the Fed has lifted rates by 75 bps since December (Chart 5). In the Fed's framework, this means that the pace of rate hikes might need to increase in order to tighten financial conditions as much as desired. New York Fed President William Dudley summed up this approach in a 2015 speech:2 All else equal, if financial conditions tighten sharply, then we are likely to proceed more slowly. In contrast, if financial conditions were not to tighten at all or only very little, then - assuming the economic outlook hadn't changed significantly - we would likely have to move more quickly. In the end, we will adjust the policy stance to support financial market conditions that we deem are most consistent with our employment and inflation objectives. Of course, all else is not equal. Core inflation has disappointed so far this year and our current assessment of monetary policy is that while the Fed will take action to start shrinking its balance sheet next month, rate hikes are on hold until inflation turns higher. We remain optimistic that inflation will show sufficient strength in time for the Fed to lift rates in December.3 Inflation Chart 6Weak $ = Higher Inflation A weaker dollar also increases the Fed's confidence that inflation will head higher. Although so far we have not seen much evidence that this is occurring. Last Friday's July CPI report showed that core CPI rose only 0.1% month-over-month, while the year-over-year growth rate held flat at 1.7%. However, evidence is mounting that core inflation will soon put in a bottom. Our CPI diffusion index bounced back into positive territory in July (Chart 6) and our PCE diffusion index is at its highest level since last October.4 Both of these measures have excellent track records capturing the near-term swings in core inflation. The year-to-date weakness in the dollar has led to a surge in import prices. Stronger import prices will soon translate into higher core goods inflation (Chart 6, panels 2 and 3). Unfortunately, any increase in core goods inflation is unlikely to be sustained beyond the next 12 months. If the year-to-date dollar weakness starts to reverse, as our currency strategists anticipate,5 then import prices will decline anew. Eventually, this will translate into a deceleration in core goods inflation. For core inflation to sustainably reach the Fed's target, improvement in the lagging core services (excluding shelter and medical care) component will be required. Historically, this component is the most tightly linked to wage growth (Chart 6, bottom panel). A Rising Wage Growth Environment Two related methods do an excellent job predicting the direction of wage growth on a cyclical horizon. First, wages accelerate when the unemployment rate is falling, and second, wages accelerate when the prime-age (25-54) employment-to-population ratio is increasing. The top two panels of Chart 7 show the relationship between wage growth and the unemployment rate. The shaded regions in both panels correspond to periods when the unemployment rate is falling. As can be seen, wage growth always rises during these periods. That being the case, we calculate that non-farm employment needs to grow by more than 125k per month (on average) for the unemployment rate to continue its downtrend, assuming the labor force participation rate remains flat. Chart 7A Rising Wage Environment Of course it is not guaranteed that the labor force participation rate will stay flat. In a recent report we discussed the risk that a large cyclical increase in the participation rate might cause the unemployment rate to rise even as the economy continues to recover.6 This is why we also look at the shaded regions in the bottom two panels of Chart 7 and see that wages always rise during periods when the prime-age employment-to-population ratio is rising. By looking at the employment-to-population ratio instead of the unemployment rate we do not need to make an assumption about the trend in labor force participation. Using this method, we calculate that monthly employment growth must exceed 140k (on average) for the prime-age employment-to-population ratio to keep increasing. Non-farm payroll growth has averaged 184k per month so far in 2017 and averaged 187k per month in 2016. In other words, the U.S. jobs machine is running at a fairly steady pace, well above the thresholds we see as necessary for the recovery in wage growth to continue. Bottom Line: A weak dollar eases financial conditions and supports higher core goods inflation. All else equal, this will strengthen the Fed's hawkish resolve in the near term. However, a rebound in core services (excluding shelter and medical care) inflation will be necessary for core inflation to reach the Fed's target on a sustained basis. Sovereigns Not Buying The Weak Dollar USD-denominated sovereign bonds should benefit from a falling dollar. A weaker U.S. dollar makes the debt obligation cheaper in the issuing nation's local currency. However, the USD Sovereign index has actually underperformed the duration-matched Baa U.S. Credit index during the past six months, despite a depreciating U.S. currency (Chart 8). The duration-matched Baa-rated U.S. Credit index is the closest comparable we can find for the Sovereign index. It matches the Sovereign index in terms of duration and average credit rating, although historically it also delivers less excess return volatility (Chart 8, bottom panel). The two main factors we consider when deciding whether to add USD-denominated sovereigns to our portfolio at the expense of domestic U.S. credit are relative valuation and the outlook for the dollar. Historically, spread differential has been an important driver of relative returns. Attractive starting valuations even allowed sovereigns to outperform credit in 2014 and 2015 despite the dollar's surge. But at the moment, relative value is skewed heavily in favor of domestic U.S. credit (Chart 8, panel 1). Chart 8Sovereigns Too Expensive Added to that, with U.S. growth likely to remain strong and U.S. inflation poised to rebound, we think there is a high likelihood that the Fed will deliver more rate hikes than are currently priced in. This will make it difficult for the dollar to decline further from current levels. Taken together, poor relative valuation and a bullish outlook for the dollar lead us to continue underweighting USD-denominated sovereigns in our portfolio. The Sovereign Index: Country Breakdown Even though the overall index is unappealing, opportunities might still exist at the country level. Chart 9 shows a risk/reward picture for each country in the Bloomberg Barclays Sovereign index. The upper panels show the option-adjusted spread for each country relative to its duration and credit rating. The lower panels show a risk-adjusted spread on the y-axis. This risk-adjusted spread is the excess spread that remains after we adjust for differences in credit rating and duration using a cross-sectional model. What sticks out immediately is that Finland, Colombia and Mexico all offer compelling spreads after adjusting for differences in credit rating and duration. The outlook for each country's currency versus the U.S. dollar is obviously also important. And in fact, the lower-right panel of Chart 9 shows that exchange rate volatility is positively correlated with the risk-adjusted spreads from our cross-sectional model. This implies that the extra compensation available in Mexican and Colombian sovereigns is probably compensation for assuming highly volatile currency risk. By this measure, Finland looks even more attractive given the euro's slightly lower volatility. Chart 9USD Sovereign Index: Country Breakdown Bottom Line: USD-denominated sovereigns are not attractive compared to domestic Baa-rated U.S. credit. Remain underweight. At the country level, Finland, Mexico and Colombia offer the most attractive spreads and Finnish debt offers the best risk/reward trade-off. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see Geopolitical Strategy Special Report, "North Korea: Beyond Satire", dated April 19, 2017, available at gps.bcaresearch.com 2 https://www.newyorkfed.org/newsevents/speeches/2015/dud150605 3 For further details on our outlook for the near-term path of monetary policy please see U.S. Bond Strategy Portfolio Allocation Summary, "On Hold, But Not For Long", dated August 8, 2017, available at usbs.bcaresearch.com 4 For a chart of the PCE diffusion index please see page 11 of U.S. Bond Strategy Portfolio Allocation Summary, "On Hold, But Not For Long", dated August 8, 2017, available at usbs.bcaresearch.com 5 Please see Foreign Exchange Strategy Weekly Report, "Fade North Korea, And Sell The Yen", dated August 11, 2017, available at fes.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "Three Scenarios For Treasury Yields In 2017", dated June 20, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification