Emerging Markets

Special Report

Dear client, Our publishing schedule will be shifting over the next two weeks. Next Friday, we will publish a Special Report aggregating various pieces from our colleague Matt Gertken of BCA's Geopolitical Strategy detailing the reforms taking place in China and their past and future evolution, and the economic and investment implications for China and the rest of the world. Matt argues that Chinese reforms are in place and here to stay, which should deepen the malaise in EM and support the dollar. We will not publish any report on August 31st. We will resume our regular publishing schedule on September 7. I hope you enjoy the rest of your summer. Best regards, Mathieu Savary Highlights The 1997 Asian Crisis was a deflationary event, causing commodity prices, commodity currencies and the yen to fall against the dollar, but it had a limited impact on the euro. When Russia collapsed in 1998, the LTCM crisis hit the U.S. banking system, with fears of solvency dragging Treasury yields lower, hurting the dollar against the yen and the euro. Today is not 1997, but the tightness of the U.S. economy suggests the Federal Reserve will need a large shock before abandoning its current pace of a hike per quarter; additionally, global liquidity conditions are tightening and China is slowing. The EM crisis is therefore not over, and vulnerable Brazil, Chile, Mexico, Colombia and South Africa could still experience significant pain. Unlike in 1998, the hot potato is not hiding in the U.S. but in Europe. A contagion event is therefore more likely to hurt the euro than 20 years ago; meanwhile, the yen stands to benefit. DXY could hit 100, and commodity currencies still have ample downside, the AUD in particular. Continue to monitor our China Play Index to gauge if Chinese stimulus could delay the day of reckoning for EM; this index can also be employed as a hedge for investors long the dollar or short EM plays. Feature "Misfortune tests the sincerity of friends." - Aesop This summer is oddly reminiscent of that of 1997. The Federal Reserve is tightening policy because the U.S. economy is not only at full employment but is also growing strongly and generating increasing domestic inflationary pressures. But the most familiar echoes come from outside the U.S. Specifically, emerging market trepidations are once again front page news as the Turkish lira, which had already fallen by 24% between January 2018 and July 31st, dropped by an additional 28% at its worst in a mere two weeks. Consequently, investors are now fretting about the risks of contagion across EM markets, one that could reverberate among G10 economies as well. We too worry that the echoes of 1997 are becoming increasingly louder. EM economies have built up large stocks of debt, and have financed themselves heavily by tapping foreign investors. However, these investors can be rather fickle friends, and we are set to test their sincerity. In this piece, we review how the events of 1997-'98 unfolded, what it meant for G10 currencies, and whether the same lessons can be applied today. We find that in 2018, an EM crisis could ultimately be more supportive for the dollar versus the euro, as unlike in 1998, where the hot potatoes were held by U.S. hedge funds, this time the mess sits squarely in Europe. Tom Yum Goong Goes Viral Initiated in the second half of the 1980s, the peg of the Thai baht seemed like a very successful experiment. The stability created by this institutional setup not only contributed to keeping Thai inflation at manageable levels, but by incentivizing capital inflows in the country it also helped Thailand build up its capital stock. At the time, this yielded a large growth dividend, with real GDP growth averaging 9% from 1985 to 1996. However, the economic boost generated by this cheap financing had a dark side. The Thai current account balance ballooned to a deficit of 8% of GDP in 1995-'96. As Herb Stein famously expressed, if something cannot go on forever, it will stop. Like in Aesop's fable where one of two travelers climbed up a tree to avoid a bear, leaving his friend to fend off the bear on his own, foreign investors abandoned Thailand, which was left on its own to finance its large current account deficit. While the Bank of Thailand was able to fend off the attacks for a few weeks, on July 2nd, 1997, it abandoned its efforts. The THB was left to float freely and dropped 56% against the USD over the subsequent six months. Other EM countries including Malaysia, Brazil and Korea, to name a few, had implemented similar U.S. dollar pegs. They too enjoyed stable inflation, growing money inflows and improved growth, but also experienced growing current account deficits and foreign currency debt loads. It did not take long for investors to extrapolate Thailand's woes to other countries. The Malaysian ringgit and the Indonesian rupiah began falling soon after the THB, while the Korean won began its own steep descent four months later (Chart 1). The economic pain was felt globally. The collapse in EM Asian exchange rates and the deep recessions experienced in these countries caused their export prices to collapse, which created a global deflationary shock (Chart 2). This shock was compounded by a fall in commodity prices that materialized as market participants realized that demand for commodities from the crisis-stricken countries was set to evaporate (Chart 2, bottom panel). Chart 1How The Thai Crisis Morphed Into An Asian Crisis Chart 2The Asian Crisis Was A Deflationary Shock Not only did this deflationary shock lift the USD against EM currencies and commodity currencies, it also caused inflation breakevens in the U.S. to fall significantly (Chart 3). However, because the U.S. economy remained robust through the second half of 1997 and in the early days of 1998, real rates did not respond much (Chart 3, bottom panel). Markets where not very concerned that this shock would force the Fed to cut rates, as it did not seem to affect the outlook for U.S. growth and employment. However, this combination of stable real rates in the face of weaker growth in EM, as well as the collapse in commodity prices ended up having large second-round effects. Russia defaulted in August 1998, prompting a collapse in the ruble. To patch up its finances, Russia began pumping ever more oil out of the ground, causing oil prices to fall below US$10/bbl in December 1998, deepening the malaise in commodity prices. This caused the Brazilian real to collapse in 1999, and the Argentinian peso to follow in 2002 (Chart 4). Chart 31997: Falling Breakevens, Stable Real Yields Chart 4Asian Crisis Goes Global Among these contagions, the Russian default was the event with the greatest systemic impact. This was because it was a direct hit to the U.S. banking system. Long Term Capital Management, a large Connecticut-based hedge fund, had accumulated massive bets on Russia. The country's default plunged the fund into the abyss. However, LTCM had liabilities to banks to the tune of US$125 billion. The exposure was perceived as an existential threat to the banking sector, and the market began to anticipate a repeat of the 1907 panic.1 Junk bond spreads jumped, the S&P 500 fell by 18%, and U.S. government bond yields collapsed by 120 basis points (Chart 5). The Fed was forced to respond, coming out of hibernation and cutting rates by 75 basis points between September and November of 1998. As the Fed forcefully responded to this shock and 10-year Treasury yields fell, the dollar, which had managed to stay somewhat stable against the synthetic euro from July 1997 to August 1998, fell 11%. Within the same one-year window starting in July 1997, the yen dropped 23%, dragged lower by the competitive pressures created by weaker Asian currencies. However, as soon as U.S. bond yields collapsed, the yen began to surge, rising by 36% from August 1998 to January 1999 (Chart 6). Only once the Fed started increasing rates anew did the euro and the yen level off. Chart 5The Russian Default Was The Real Shock For The U.S. Chart 6The Dollar Buckled After LTCM In aggregate, the dollar's performance through the 1997-1998 period was very mixed. The trade-weighted dollar managed to rise from July 1997 to August 1998. Nevertheless, this was a complex picture. During this timeframe the dollar rose against EM currencies - against the CAD, the AUD, the NZD and the JPY - but was flat against the euro. The USD then fell against everything from August 1998 to the first half of 1999. Only once the Fed started hiking again in the summer 1999, was the greenback able to resuming its broad ascent, one that lasted all the way until late 2001. Bottom Line: In 1997, the first domino to fall was Thailand. Since many East Asian economies suffered the same ills - current account deficits, foreign currency debt loads and falling foreign exchange reserves - Asian currencies followed, dragging the yen lower in the process. This generated a deflationary shock that hurt commodity prices and commodity currencies, leading to the infamous Russian default of 1998. The associated LTCM bankruptcy threatened the survival of the U.S. banking system, forcing bond yields much lower as the Fed cut rates three times. The dollar suffered because of this policy move, especially against the yen. However, once the Fed resumed its hiking campaign, the dollar recovered across the board, making new highs all the way to late 2001 and early 2002. Is 2018: 1997, 1998, Or 2018? In one key regard, today is not the late 1990s: Dollar pegs are few and far between. However, in many respects, similarities abound. First and most obviously, EM foreign currency debt loads, as measured against exports, GDP or reserves, are at similar levels to those prevailing in the late 1990s (Chart 7). This means that EM economies suffer when the dollar rises, as it represents an increase in their cost of capital, and thus a tightening in financial conditions. Second, the Fed has been increasing interest rates. Most importantly, the Fed is growingly concerned that domestic inflationary pressures in the U.S. are intensifying, courtesy of strong growth - at least relative to potential; a high degree of capacity utilization, especially in the labor market (Chart 8); and, unique to today, the U.S. has received a large degree of unneeded fiscal stimulus. Chart 7EM Dollar Debt Is High EM Have More ##br##Foreign-Currency Debt Than In The 1990s Chart 8The Foreign Pain Threshold For The Fed Is Much Higher ##br##Now Than In 2015 or 2016 This means it will take a lot of pain to derail the Fed from its desire to hike rates once a quarter. This also makes the current environment very different from 2015, the most recent episode of EM tumult. In 2015-2016, the Fed easily abandoned its hiking campaign. When it hiked rates in December 2015, the Fed anticipated increasing rates four times over the following 12 months. It delivered only one hike in December 2016. The reason was straightforward: Unlike today, the U.S. economy was still replete with slack (Chart 8) and was not on the receiving end of a large fiscal stimulus program, suggesting the Fed could not tolerate the deflationary impact of tightening financial conditions. Third, global liquidity is tightening, which is hurting the global growth outlook. Today, global excess money, as defined by the growth of broad money supply above that of loan growth in the U.S., the euro area and Japan, is contracting. Today, as in 1997, this indicator forebodes important weaknesses in global industrial production (Chart 9). U.S. liquidity is particularly important. Not only is dollar-based liquidity crucial to financing the large stock of dollar-denominated foreign debt, but the U.S. is also driving the fall in global excess money. The pick-up in U.S. economic activity is sucking liquidity from both the rest world and from the financial system to finance U.S. loan growth (Chart 10). This phenomenon was also at play in 1997. Chart 9Excess Money Is Contracting Global Excess ##br##Money Contracting, Just Like In Early 1997 Chart 10The U.S. Economy Is ##br##Sucking In Liquidity Why does this matter? Simply put, U.S. financial liquidity; built as a composite of 3-month T-bills, total bank deposits minus bank loans, bank investments, and M2 money supply; is a wonderful leading indicator. The current collapse in financial liquidity suggests that the global economy is about to hit a rough patch. As Chart 11 illustrates, the weakness of this indicator points to declines in our Global Leading Economic Indicators and in global commodity prices. This suggests the indicator is foretelling that a deflationary scare could materialize, an event normally also associated with a stronger dollar and downside in EM export prices (Chart 12). In a logically consistent fashion, the liquidity indicator is also warning that the AUD, CAD and NZD have substantial downside, while EM equity prices could also suffer more (Chart 13). Finally, it also highlights that even the U.S. stock market may not be immune to upcoming troubles (Chart 14). Chart 11U.S. Financial Liquidity Points To Weaker Growth... Chart 12...And A Stronger Dollar But Weaker EM Export Prices... Chart 13...Falling EM Stocks And Commodity Currencies... Chart 14...And Maybe Even A Correction In U.S. Stock Prices Fourth, gold is sending a similar signal as in the late 1990. As we have argued in the past, gold is a very good gauge of global liquidity conditions. During the Asian Crisis and the Russia/LTCM fiasco, industrial commodity prices only experienced a serious decline after the Thai baht had dragged down Asia into a tailspin. However, gold had been falling since 1996, a move predating the fall in Asian currencies (Chart 15). The precious metal was confirming that global liquidity was tightening and being sucked back into the booming U.S. economy. Today, gold prices are sending an ominous signal. After forming a large tapering wedge from 2011 to 2018, gold prices have broken down below the major upward-sloping trend line that had defined the bull market that began in 2001 (Chart 16). This indicates that gold may be starting another leg of a major bear market. Moreover, as the bottom panel of Chart 16 illustrates, it is true that net speculative positions in the yellow metal have plunged, but they remain far above the large net short positions that prevailed in the late 1990s. If gold is indeed entering another major down leg, this would confirm that tightening liquidity will further hurt EM asset prices, commodity prices and non-U.S. economic activity. Chart 15As Early As 1996, Gold Warned Of Upcoming Problems In Asia Chart 16Is A Secular Bear Market In Gold Beginning? Finally, adding insult to injury is China. The current communist party leadership is hell-bent on reforming the Chinese economy, moving it away from its dependence on capex and leverage. Consequently, China is in the midst of a major deleveraging campaign concentrated in the shadow banking sector, which has already caused money growth and total social financing to plumb to new lows (Chart 17). This is deflationary for the global economy as weaker Chinese credit weighs on capex, which in turns weighs on Chinese imports, as 69% of China's intake from the rest of the world are commodities and intermediate as well as industrial goods. Chart 17Chinese Monetary And Credit Conditions Remain ##br##Tight China Deleveraging Is Biting Chart 18No Capitulation ##br##Yet Moreover, the recent wave of renminbi weakness is exacerbating these deflationary pressures. The 9% fall in the yuan versus the dollar since April 11th represents a competitive devaluation that will hurt many EM countries. It also implies downside in China's import volumes, as it increases the prices paid by Chinese economic agents for foreign-sourced industrial goods and commodities.2 All these forces suggest that the pain that started in Argentina and Turkey could continue to spread across other vulnerable EM economies. It is doubtful that economies with large debt loads, large upcoming debt rollovers and other underlying economic problems will find it easy to receive financing in an environment of declining global liquidity, a strong dollar, budding deflationary pressures and a slowing China. Making this worry even more real, EM investors have not capitulated, as bottom-fishing has prompted massive inflows into Turkey in recent days (Chart 18). 2018 may not be 1997 or 1998, but it is likely to be a year to remember. Bottom Line: EM currency pegs to the dollar may not be as prevalent as they were back in the 1990s, but enough risks are present that contagion from Argentina and Turkey to other EM economies is a very real risk. Specifically, the domestic economic situation in the U.S. warrants higher interest rates, which suggests the Fed is unlikely to be fazed by EM market routs unless they become deep enough to present a threat to U.S. growth itself. Moreover, global liquidity conditions are tightening as the U.S.'s economic strength is sucking in capital from around the world. This combination means that EM countries with large dollar debt loads are likely to find debt refinancing a very onerous exercise. Finally, China is slowing and letting the RMB fall, which is exerting a deflationary impact on the world. Investment implications An environment of slower global economic activity, tightening global liquidity conditions and a potential deflationary scare is positive for the dollar. But 1998 shows that if the hot potato hides in the U.S. and the Fed is forced to ease aggressively, the dollar could nonetheless suffer. In order to get a sense as to whether the dollar can continue to strengthen or not, it is important to get a sense of where the exposure to an EM accident may lie. To begin this exercise, we need to first assess which EM countries are most vulnerable to catching the "Turkish Flu." To do so, we collaborated with our colleague Peter Berezin and his team at BCA's Global Investment Strategy to build a heat map of vulnerable EM economies. This heat map is based on the following factors: current account balance, net international investment position, external debt, external debt service obligation, external funding requirements, private sector savings/investment balance, private sector debt, government budget balance, government debt, foreign ownership of local currency bonds, and inflation. This method shows that after Turkey and Argentina, the next six most vulnerable countries are Colombia, Brazil, Mexico, Chile, South Africa, and Indonesia in this order (Chart 19). Chart 19Vulnerability Heat Map For Key EM Markets While our long-term valuation models show that the Colombian peso is already trading at a significant discount to its fair value, the BRL, the CLP, the ZAR, and the MXN are not (Chart 20). This highlights that these markets could provide serious fireworks in the coming months. Moreover, they all have their own idiosyncrasies that accentuate these risks. Brazil will soon undergo elections that will likely not result in a market-friendly outcome.3 Chile has an extremely large dollar-debt load, copper prices are tanking and the CLP is very pricey. Finally, South Africa is contemplating the kind of land expropriations reminiscent of those that plunged Zimbabwe into chaos - not a good optic for a still-expensive currency. So, who is most exposed to this potential mess? The answer is the euro area, most specifically, Spain. As Chart 21 shows, the exposure of Spanish banks to the most vulnerable EM markets totals nearly 170% of the banking system's capital and reserves. This means that 30% of the capital and reserves of the banking systems in the euro area's five largest economies is exposed to these markets. Making the risk even more acute, French banks have large exposure to Spain, and German banks to France. This combined exposure dwarfs the exposure of the U.K., Japan or the U.S. to the most vulnerable EM economies. To be fair to Spain, Spanish banks often have set up their foreign affiliates as separate legal entities. This means that the impact on the balance sheets of the Spanish banking system of defaults in vulnerable EM countries may be more limited than seems at face value. Yet, this is far from certain. Chart 20BRL, CLP, ZAR, And MXN Are Too Expensive##br## In Light Of Their Vulnerabilities Chart 21Who Has More Exposure To EM? As a result, we would not be surprised if the European Central Bank is forced by an EM accident to back away from its desire to abandon its extraordinary accommodative stance. The ECB would first use forward guidance to message that a hike will be delayed ever further in the future. The ECB may even be forced to resume government and corporate bonds purchases past 2018. This is a potential nightmare scenario for the euro. In fact, as Chart 22 illustrates, a euro at parity may not be a far stretch. Historically, the euro bottoms when it trades 10% below our fair value model, based on real short rate differentials, relative yield curve slopes and the ratio of copper to lumber prices. Such a discount would correspond to EUR/USD at parity. Because under such circumstances the Fed could be forced to pause its own hiking cycle for a quarter or two, a move to EUR/USD between 1.10 and 1.05 seems more likely than a collapse to parity right now. This also means that in conjunction with BCA's Geopolitical Strategy team, we recommend our clients close overweight positions in Spanish assets. Chart 22The Euro Still Has Downside If EM Go Bust What about the yen? In the late 1990s, the yen fell against the U.S. dollar as Asian currencies were collapsing, but surged once the Fed backtracked and bond yields tanked in 1998. This time could follow a different road map. Japan does not compete against Brazil, Colombia, Mexico, Chile and South Africa in the same way as it was competing against industrial companies in countries like Taiwan, Singapore or South Korea. This means that Japan is unlikely to need to competitively devalue to remain afloat if the BRL, COP, MXN, CLP and ZAR collapse further. However, since an EM shock is likely to prove to be a deflationary event, this means that bond yields could experience downside, especially as positioning in the U.S. bond market is massively crowded to the short side (Chart 23). A countertrend bull market in bonds would greatly flatter the yen. As a result, we are maintaining our short EUR/JPY bias over the coming months. The G10 commodity currency complex is also at risk. Not only does tightening dollar liquidity imply further weakness in this group of currencies, so does slowing EM activity and a deflationary scare. Additionally, the CAD and the NZD are not trading at much of a discount to their fair value, and the AUD trades at a premium (Chart 24). This means we would anticipate these currencies to suffer more in the coming quarters, led by the AUD, which is not only the most expensive of the group, but also the most geared to EM economic activity. Being short AUD/CAD still makes sense. Chart 23A Bond Rally Would ##br##Support The Yen Chart 24TDollar-Bloc Currencies Offer Limited Cushion##br## In The Event of An EM Selloff Finally, the pound is its own animal. GBP/USD is now quite cheap, but the U.K.'s large current account deficit of 3.9% of GDP, which is not funded through FDIs anymore, means that Great Britain remains vulnerable to tightening global liquidity conditions. Moreover, Brexit negotiations will heat up in the fall, as the March 2019 deadline for reaching a deal with the EU looms large. This means that political tumult in the U.K. will remain a large source of risk for the pound. We will explore the outlook for the pound in an upcoming report this September. Currently, our long DXY trade is posting an 8.5% profit, with a target at 98. The above picture suggests that the dollar could move well past 98, especially as the momentum factor that is so important to the greenback still plays in favor of the USD.4 As a result, we are upgrading our target on the dollar to 100. However, we are also tightening our stop loss to 94.88. We will update our stop loss to 97 if the DXY hits 98 in the coming weeks, in order to protect gains while still being exposed to the dollar's potential upside. Bottom Line: Beyond Turkey and Argentina, the EMs most vulnerable to tightening global liquidity conditions are Brazil, Colombia, Mexico, Chile and South Africa. Spanish banks have outsized exposure to these markets, which means the euro area is at risk if the "Turkish Flu" becomes contagious. As such, the ECB could be forced to remain easier than it wants to. The euro is still at risk. The yen could strengthen if global bond yields suffer. Hence, it still makes sense to be short EUR/JPY. While the CAD, AUD and NZD are also all vulnerable to a deflationary scare, the Aussie is the worst positioned of the three. Shorting AUD/CAD still makes sense. The DXY is likely to experience significant upside from here, with a move to 100 becoming an increasingly probable scenario. Risks To Our View Chart 25A Gauge And A Hedge Against Chinese Stimulus The biggest risk to our view is China. In 2016, a vicious EM selloff was staunched by a large wave of stimulus that put a floor under Chinese economic activity, and caused China to re-lever. The impact was felt around the world, lifting commodity prices and EM assets while plunging the dollar into a vicious selloff in 2017. It is conceivable that such an outcome materializes anew, especially as China is, in fact, injecting stimulus into its economy. However, as we wrote two weeks ago, the current stimulus still pales in comparison to what took place in 2015. Moreover, reforms and deleveraging have much greater primacy now than they did back then.5 BCA believes that the current wave of stimulus is not designed to cause growth to surge again, as was the case in 2015, but is instead aimed at limiting the negative impact of the ongoing trade war with the U.S. Yet, we cannot be dogmatic. Not only is it hard to gauge the actual degree of stimulus currently applied to the Chinese economy, there is a heightened risk that the flow of policy announcements causes a shift in the dominant narrative among market participants. Such a shift in attitudes could easily cause a mass buying of EM assets and commodities, delaying the day of reckoning for vulnerable EM. As a result, we continue to promulgate that investors track the behavior of our China Play Index, introduced two weeks ago (Chart 25).6 Not only does this index provide a live read on how traders are pricing in Chinese developments, but it also provides a great hedge for investors long the dollar, short EM, or short the commodity complex. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 In the panic of 1907, the Knickerbocker Trust Company went bankrupt, threatening the health of the U.S. banking system. The stock market crashed, money markets went into paralysis, and a consortium of bankers led by J.P. Morgan himself ended up acting as a lender of last resort, staunching the crisis. As a consequence of this panic, the Federal Reserve System was born in 1913. 2 For a more detailed discussion of the deflationary risk created by the RMB, please see Foreign Exchange Strategy Weekly Report, "What Is Good For China Doesn't Always Help The World", dated June 29, 2018, available at fes.bcaresearch.com 3 Please see Emerging Markets Strategy Special Report, "Brazil: Faceoff Time", dated July 27, 2018, available at ems.bcaresearch.com 4 Please see Foreign Exchange Strategy Special Report, "Riding The Wave: Momentum Strategies In Foreign Exchange Markets", dated December 8, 2017, available at fes.bcaresearch.com 5 Please see Foreign Exchange Strategy Weekly Report, "The Dollar And Risk Assets Are Beholden To China's Stimulus", dated August 3, 2018, available at fes.bcaresearch.com 6 Ibid. Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Dear Client, We had intended to send you the second part of our two-part special report on long-term inflation risks this week, but given the sharp moves in the dollar and emerging market assets, we decided to write this bulletin instead. Barring any further major market turbulence, we will send you the sequel to the inflation report next week. Best regards, Peter Berezin, Chief Global Strategist Highlights The dollar rally and EM selloff have further to go. The U.S. economy is firing on all cylinders, while the rest of the world is sputtering. Turkey is not an isolated case. Emerging markets as a whole have feasted on debt over the past decade, and now will be held to account. We remain neutral on global equities, while underweighting EM relative to DM and overweighting defensives relative to deep cyclicals. Brewing EM stresses could cause the 10-year Treasury yield to temporarily fall to 2.5%, leading to a further flattening of the yield curve. However, the long-term path for yields is up. Feature King Dollar Reigns Supreme Our expectation going into this year was that the dollar would strengthen, triggering turmoil in emerging markets. This thesis has panned out, raising the question of whether it is time to declare victory and move on. We don't think so. While market positioning has clearly shifted closer towards our own views, we still think that the stronger dollar/weaker EM story has further to run. To understand why, it is useful to review the reasoning behind our thesis. Our bullish dollar view was based on a simple observation, which is that the U.S. had finally reached a point where aggregate demand was starting to outstrip supply. This implied that the dollar would need to strengthen in order to shift demand away from the United States. It is amazing how many commentators still think that the U.S. can divert spending towards imported goods without any change in the value of the dollar. Americans do not care what the CBO's or IMF's estimate of the domestic output gap is when they are deciding whether to buy U.S. or foreign-made goods. They care about relative quality-adjusted prices. Since the U.S. is a fairly closed economy - imports are only 15% of GDP - we reckoned that the dollar would need to strengthen considerably in order to displace a significant amount of domestic production with foreign-made goods. This is exactly what happened. Still More Upside For U.S. Rates Currency values tend to track interest rate differentials (Chart 1). As such, our prediction of a stronger dollar entailed the expectation that investors would increasingly price in a more hawkish path for the fed funds rate. This has indeed occurred. Since the start of the year, the expected fed funds rate has risen by 34 basis points for end-2018 and by 65 basis points for end-2019 (Chart 2). Chart 1Historically, The Dollar Has Moved In Line With Interest Rate Differentials Chart 2Rate Expectations Have Increased, ##br##But There Is Still A Long Way To Go Our sense is that U.S. interest rate expectations can rise further. Faster wage growth will boost consumption. The household savings rate can also fall from its current elevated level, which will give consumer spending an additional boost (Chart 3). Business investment should remain firm. Chart 4 shows that capex intentions are strong, while bank lending standards for commercial and industrial loans, which tend to lead loan growth, continue to ease. Fiscal stimulus will also goose the economy. Chart 3Consumption Could Accelerate As The Savings Rate Drops Chart 4U.S. Capex Investment Going Strong Could interest rate expectations move up more in the rest of the world than in the U.S., causing the dollar to tumble? It is possible, but unlikely. In contrast to most other central banks, the Fed wants to tighten financial conditions in order to keep the economy from overheating. A weaker dollar would entail an easing of financial conditions, and hence would require an even more hawkish response from the Fed. Currency Intervention Is Unlikely To Succeed Some have speculated that the Trump administration will intervene in the foreign exchange market in order to drive down the value of the dollar. We doubt this will happen, but even if such interventions were to take place, they would not be successful. Presumably, currency interventions would take the form of purchases of foreign exchange, financed through the issuance of Treasurys. The purchase of foreign currency would release U.S. dollars into the financial system, but the sale of Treasury securities would suck out those dollars from the financial system. The net result would be no change in the volume of U.S. dollars in circulation - what economists call a "sterilized" intervention. Both economic theory and years of history show that sterilized interventions do not have lasting effects on currency values. The Fed could, of course, provide funding for the Treasury's purchases of foreign exchange, leading to an increase in the monetary base. This would be tantamount to an unsterilized intervention. However, such a deliberate attempt to weaken the dollar by expanding the money supply would fly in the face of the Fed's efforts to cool growth by tightening financial conditions. We highly doubt the Fed's current leadership would go along with this. Emerging Markets In The Crosshairs This brings us to emerging markets. EM equities almost always fall when U.S. financial conditions are tightening (Chart 5). One can believe that emerging market stocks will go up; one can also believe, as we do, that the Fed will do its job and tighten financial conditions. But one cannot believe that both of these things will happen at the same time. Some pundits think that the plunge in the Turkish lira is not emblematic of the problems facing emerging markets. We are skeptical of this sanguine conclusion. Chart 6 shows that as a share of both GDP and exports, EM dollar-denominated debt is now as high as it was in the late 1990s. Turkey may be the worst of the lot, but it is hardly an isolated case. Chart 5Tightening U.S. Financial Conditions Do Not Bode Well For EM Stocks Chart 6EM Dollar Debt Is High Chart 7 presents a vulnerability heat map for a number of key emerging markets.1 We consider fourteen variables (expressed as a share of GDP, unless otherwise noted): 1) Current account balance; 2) Net international investment position; 3) External debt; 4) Change in external debt during the past five years; 5) External debt-servicing obligations coming due over the next 12 months as a share of exports; 6) External funding requirements over the next 12 months as a share of foreign exchange reserves; 7) Private sector savings-investment balance; 8) Private-sector debt; 9) Change in private-sector debt over the past five years; 10) Government budget balance; 11) Government debt; 12) Change in government debt over the past five years; 13) Share of domestic debt held by overseas investors; and 14) Inflation. Our analysis suggests that Turkey, Argentina, Colombia, Brazil, Mexico, Chile, South Africa, and Indonesia are all vulnerable to balance of payments stresses. Chart 7Vulnerability Heat Map For Key EM Markets Of course, asset markets in some of these economies have already moved quite a bit over the past few months, so it is useful to benchmark their stock markets and currencies to the underlying macro risks they face. For stock markets, we do this by comparing the heat map score with a composite valuation measure that incorporates price-to-book, price-to-sales, price-to-forward earnings, price-to-cash flow, and the dividend yield. Our analysis suggests that stocks in Russia and Korea are rather cheap, while equities in Indonesia, Mexico, South Africa, and Argentina are still quite expensive (Chart 8, top panel). Chart 8Some EM Stock Markets And Currencies Have Not Fully Priced In Macro Risks For currencies, we compare the heat map score with the level of the real effective exchange rate relative to its ten-year average. The Mexican peso, Brazilian real, Chilean peso, Indonesian rupiah, and South African rand still look pricey on this basis (Chart 8, bottom panel). In contrast, the Turkish lira and the Argentine peso are starting to look fairly cheap, although they could still get quite a bit cheaper before finding a floor. The China Wildcard The last time emerging markets seemed at risk of melting down was in 2015. Fortunately for them, China came to the rescue, delivering a massive double dose of fiscal and credit easing. Things may not be so straightforward this time around. China does not want to let its economy falter, but high debt levels and an overvalued housing market have made the usual policy prescriptions less appealing. As such, we would not necessarily conclude that the recent decline in the Chinese three-month interbank rate is a signal that the authorities want to see much faster credit growth (Chart 9). They may simply want to see a weaker currency. This is an important distinction because while faster credit growth would boost demand for EM exports, a weaker yuan would hurt other emerging markets by giving China a leg up in competitiveness. A weaker yuan would also make it more expensive for Chinese companies to import natural resources, thus putting downward pressure on commodity prices. It is too soon to know what policy mix the Chinese authorities will choose to pursue. Investors should pay close attention to the monthly data on the growth rates of social financing and local government bond issuance. So far, the combined credit and fiscal impulse has continued to weaken, suggesting that the authorities are in no hurry to open the stimulus floodgate (Chart 10). Chart 9Is China Trying To Stimulate Credit ##br##Growth Or Weaken The Yuan? Chart 10China Has Been Slow To Open The Credit And Fiscal Spigots Worries About The Euro Area Slower EM growth is likely to take a bigger toll on the euro area than the United States. Exports to emerging markets account for only 3.6% of GDP for the U.S., compared to 9.7% of GDP for the euro area. Euro area banks also have more exposure to emerging markets than U.S. banks. Notably, Spanish banks have sizeable exposure to Turkey and other vulnerable emerging markets (Chart 11). Meanwhile, worries about Italy have resurfaced. The 10-year Italian bond yield has moved back above 3%, not far from its May highs. The gap in fiscal policy between what Italy's new populist government has promised voters and what the European Commission is willing to accept remains a mile wide. Italian banks have become increasingly wary of financing their spendthrift government. With the ECB stepping back from asset purchases, two critical buyers of Italian debt are moving to the sidelines. The credit impulse in the euro area turned negative even before concerns about emerging markets and Italian politics came to the fore. As Chart 12 shows, the credit impulse has reliably tracked euro area growth. Right now, there is little reason to think that European banks will open the credit spigots, suggesting that euro area growth will be lackluster. Chart 11Who Has More Exposure To EM? Chart 12Euro Area Credit Impulse Suggests Growth Will Remain Lackluster Investment Conclusions If last year was the year of global growth resynchronization, this year is turning into one of desynchronization. The U.S. economy is outperforming the rest of the world, and the dollar is benefiting in the process. As we go to press, the broad trade-weighted dollar is up 6.1% year-to-date and stands only 2.2% below its December 28, 2016 high (Chart 13). From a long-term perspective, the greenback has become expensive, so we are inclined to close our strategic long DXY trade for a potential carry-adjusted profit of 15.7% if it reaches our target of 98 (as of the time of writing, the DXY is at 96.5). However, even if we were to close this trade, our tactical bias would be to remain long the dollar until clearer evidence emerges that the brewing EM crisis is about to abate. We moved from overweight to neutral on global equities on June 19. The MSCI All-Country World index has fluctuated a lot since then, but is currently up only 0.7% in dollar terms. Developed markets have gained 1.4%, while emerging markets have lost 3.8% (Chart 14). We have yet to reach a capitulation point for EM equities. The number of shares in the iShares MSCI Turkey ETF has almost doubled since August 3rd, as a stampede of bottom fishers have plowed into the fund (Chart 15). Equity investors should maintain our recommendation to underweight emerging markets relative to DM and to favor defensive sectors over deep cyclicals. We expect euro area stocks to perform in line with their U.S. peers in local-currency terms, but to underperform in dollar terms over the remainder of the year. Chart 13The Dollar Is Back Near Its Highs Chart 14Stock Market Performance: Roller Coaster Ride Chart 15Foreign Investors And Turkish Stocks: ##br##Trying To Catch A Falling Knife In the fixed-income realm, the long-term trend in global bond yields remains to the upside, but near-term EM stresses could cause the 10-year Treasury yield to temporarily fall back towards 2.5%. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 We collaborated with our colleague Mathieu Savary and his team at BCA’s Foreign Exchange Strategy to build this heat map. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

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

Highlights Our antennae are twitching wildly, as the Kingdom of Saudi Arabia (KSA) walks back a widely telegraphed commitment to surge production. This occurs against the backdrop of a possible loss of as much as 2mm b/d in exports from Iran and Venezuela next year, with demand expected to remain fairly strong. U.S. President Donald Trump remains silent. We believe the proximate cause of KSA's reversal boils down to one or all of the following: President Trump told KSA to expect an SPR release ahead of November mid-terms; KSA found it difficult to maintain higher production; or Short-term demand for KSA's output is falling, so they reduced production. We have questioned the ability of KSA to sustain production above 10.5mm b/d for an extended period in the past. However, we believe July's 200k b/d cut was produced by a combination of No. 1 and No. 3. We expect KSA to build storage ahead of Iran sanctions. On the back of our updated balances modeling we are maintaining our 2H18 Brent ensemble forecast of $70/bbl, and raising our 2019 forecast to $80/bbl from $75/bbl (Chart of the Week): The front-loaded production increase we expected from OPEC 2.0 could be less than expected. Highlights Energy: Overweight. The U.S. EIA reported U.S. crude and product inventories rose 17.4mm barrels for the week ended August 10, 2018. Markets traded sharply lower as a result, falling more than 3% in WTI and 2% in Brent. As we went to press, October Brent was trading just above $70/bbl. We are maintaining our $70/bbl Brent forecast for 2H18. Base Metals: Neutral. Union leaders at BHP's Escondida mine in Chile, the largest in the world, will take proposed contract terms to members this week.1 We were stopped out of our tactical Dec18 copper call spread with a 10.2% loss. Precious Metals: Neutral. Gold remains under pressure as the broad trade-weighted USD rises. We remain long as a portfolio hedge. Ags/Softs: Underweight. USDA export data show year-to-date wheat and soybean exports are down 20% and 10% y/y in the Oct17 - Jun18 period. Feature Forward guidance from OPEC 2.0's leadership and its predecessor, the regular old OPEC, has not been helpful of late.2 This complicates our balances assessment this month (Chart of the Week), and raises the odds volatility will increase sooner than we expected. Chart of the Week2H18 Brent Forecast Stays At $70/bbl, 2019 Moved Up To $80/bbl KSA's reversal in July of its earlier, widely telegraphed decision to sharply raise production in response to aggressive tweeting from U.S. President Donald Trump beginning in May - to as much as 11mm b/d from just over 10mm b/d in the first five months of this year - was followed by an abrupt output cut of ~ 200k b/d last month. Last month, we expected KSA's crude production to average 10.60mm b/d in 2H18, and 10.50mm b/d next year. In our current balances estimate (Table 1), we now expect the Kingdom's output to average 10.28mm b/d in 2H18 and 10.35mm b/d in 2019, down 300k b/d and 150k b/d, respectively. Table 1BCA Global Oil Supply - Demand Balances (MMb/d) (Base Case Balances) Russia, OPEC 2.0's other putative leader, also is complicating assessments of liquids production by the producer coalition. Given the signaling it and KSA were providing over the past couple of months, we expected Russia to raise production 80k b/d in 2H18 to 11.27mm b/d, and by 160k b/d in 2019 to 11.35mm b/d. We still expect Russia to raise its production and revised our baseline estimates to 11.32mm b/d and to 11.43mm b/d for this year and next, respectively. However, it is difficult to reconcile our expectation with the 11.13mm b/d 2H18 liquids production expected by OPEC for Russia in its August Monthly Oil Market Report (MOMR), as we are highly confident Russia signed off on that estimate before it was published. Chart 2Physical Deficit Worsens Our global liquids supply estimate for 2H18 now stands at 101.08mm b/d, down 680k b/d from last month's estimate. For 2019, we lowered our supply estimate by 800k b/d to 101.01mm b/d. But this could end up overstating supply, given what we're seeing from OPEC 2.0 presently. On the demand side, we've lowered our 2018 and 2019 expectations slightly - to 1.67mm b/d and 1.62mm b/d, respectively, or ~ 50k b/d on average versus our previous estimates. This is still relatively stout demand growth - supported by still-strong global trade, particularly in the EM economies - which means storage will be forced to draw harder next year than we expected even a month ago (Chart 2). Physical Deficit Worsens In 2019 We expected OPEC 2.0's supply increase would persist at a higher level during 2H18, which would allow refiners to build precautionary inventories going into next year. This no longer is a tenable assumption, given what is being reported for OPEC 2.0's largest producers - KSA and Russia. In addition, we have amended our base case supply model, to reflect the loss of 1mm b/d of Iranian exports to U.S. sanctions for most of next year; we have this occurring in 250k b/d increments in the Nov18 - Feb 19 period, leaving production from March 2019 on at 2.8mm b/d. This replaces our earlier assumption of a 500k b/d by the end of 1H19. We took this action on the back of the increasingly strident rhetoric from the U.S. administration, and press reports indicating widespread compliance with the sanctions is expected - particularly reports suggesting China and India will not be looking to increase purchases of Iranian crude. Offsetting the higher Iranian export losses we foresee, our base case includes a re-start of Neutral Zone production in 2Q19.3 We expect KSA and Kuwait to each bring 175k b/d back on line, for a total of 350k b/d. It is not clear this is counted in both countries' spare capacity, but if it is, then spare capacity will become tighter within OPEC 2.0 next year. In our scenario analysis, we continue to give a relatively high weight to the loss of Venezuela's exports - anywhere from 800k to 1mm b/d - as that country's oil industry continues to degrade. Our ensemble analysis indicates OECD storage will draw more than previously estimated (Chart 3), on the back of these higher assumed Iranian export losses, and a reduction in OPEC 2.0's front-loaded production increases, particularly in 2019. As storage draws, days-forward-cover (DFC) also will contract (Chart 4). In addition to steepening the backwardation in crude forward curves, we expect implied option volatility to increase in 2019 (Chart 5). Chart 3Storage Will Draw##BR##Harder Next Year Chart 4Days-Forward-Cover##BR##Will Fall In 2019 Chart 5Implied Volatilities Will Rise,##BR##As OECD Storage Falls Ensemble Forecast Update In addition to moving the 1mm b/d loss of Iranian exports from a scenario and into our base case - offset somewhat by higher Neutral Zone production - we expect transportation bottlenecks in the Permian Basin to slow production growth in the U.S. shales even more. We have lowered our expected U.S. production growth to 1.21mm b/d this year and 1.22mm b/d in 2019, versus earlier estimates of 1.30mm b/d and 1.34mm b/d, as a result (Chart 6 shows the trajectory we expect from this scenario).4 Coupled with the lower-than-expected production increase from OPEC 2.0 and still-strong demand growth globally, this will lead to tighter markets in 2019. Chart 6Higher Volatility = Wider Expected Price Range We also are including a scenario showing a slowdown in demand growth, which takes y/y growth to 1.43mm b/d in 2018 and 2019, versus our current estimates of average growth of 1.64mm b/d over the two-year interval. Bottom Line: Numerous conflicting data have entered the oil pricing picture over the past month, which greatly complicates our analysis and forecasting. The fact that OPEC 2.0's leadership - KSA and Russia - is providing little in the way of forward guidance does not make this any easier. We admit to being puzzled by KSA's apparent decision to walk back its production increase going into 2019, when the likelihood of losing close to 2mm b/d of exports from Iran and Venezuela becomes markedly higher. Based on our current modeling we expect higher prices next year ($80/bbl vs. our earlier estimate of $75/bbl for Brent), and a steepening of the Brent and WTI backwardations next year. We continue to expect WTI to trade $6/bbl below Brent in 2H18 and 2019. The steepening backwardation will lift implied volatility, particularly next year. We remain long call option spreads along the Brent forward curve in 2019, in expectation prices and volatility will move higher. We continue to believe the balance of price risk is to the upside. However, as the lower-demand scenario in our ensemble forecast shows, an unexpected slowdown in growth can have profound effects on prices. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 Please see "Chile's Escondida union to take new labor proposal to members," published by reuters.com August 15, 2018. 2 OPEC 2.0 is the name we coined for the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia. At the end of June, the coalition's member states agreed to increase production to bring it into line with the originally agreed deal to remove 1.8mm b/d of output from the market. 3 Please see "Kuwait, Saudi to resume output from Neutral Zone in 2019 - Toyo Engineering," published by reuters.com July 2, 2018. 4 We place our scenarios within the context of a market-generated confidence interval, which we calculate using implied volatilities derived from Brent and WTI options markets. Please see Ryan, Bob and Tancred Lidderdale (2009), "Energy Price Volatility and Forecast Uncertainty," particularly Appendix 1 beginning on p. 18, for a derivation of the confidence intervals. The article was published by the U.S. EIA. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017

Special Report

Highlights China's policy headwinds have begun to recede, but Beijing is not riding to the rescue for emerging markets; While monetary policy has eased substantively, credit growth will be hampered by the government's financial crackdown; Potential changes to China's Macro-Prudential Assessment framework could be significant, but the impact on credit growth is overestimated at present; The recognition of non-performing loans (NPLs) and cleansing of China's banking system is still in early innings and will weigh on banks' risk appetite; The anti-corruption campaign is another reason to be cautious on EM. Geopolitical Strategy recommends clients stay overweight China (ex-tech) relative to EM. Feature In the first part of this two-part Special Report, we concluded that policy headwinds to China's economic growth have begun to recede, but recent easing measures will likely disappoint the markets.1 Chart 1Money Growth Bottomed, Credit Still Weak In essence, China is girding for a trade war with the United States, which favors stimulus. But it is still attempting to reduce systemic financial risk. As a result, fiscal stimulus may surprise to the upside, but credit growth will be lackluster. The problem for investors - especially for emerging market (EM) assets and the commodity complex - is that Chinese fiscal stimulus typically operates with a six-to-ten month lag, as opposed to credit stimulus which only takes about three months to kick in.2 July statistics confirm our suspicion that credit stimulus will be hampered by the government's crackdown on shadow banking. Total credit growth remains weak, although broad money (M2) does appear to be bottoming (Chart 1). Thus far, BCA's China Investment Strategy has been correct in characterizing the latest developments as "taking the foot off the brake" rather than "pressing down on the accelerator."3 In this report we take a deeper dive into the policy factors that cause us to limit our "stimulus overshoot" scenario to a 10% subjective probability. The three chief reasons are: overstated easing of macro-prudential controls; the continuing process of cleansing the banking sector of non-performing loans; and the anti-corruption campaign in the financial sector. A Preemptive Dodd-Frank Since the Xi administration redoubled its efforts to tackle systemic financial risk last year, we have urged investors to be cautious about Chinese growth.4 The creation of new institutions and new regulatory requirements set in motion processes that would be hard to reverse quickly. While these institutions are now making several compromises for the sake of stability, their operations will continue to weigh on credit growth. In July 2017, China's government held the National Financial Work Conference to address the major issues facing the country's financial system. This conference takes place once every five years and has often occasioned significant shakeups in financial regulation. In 1997, it initiated a sweeping purge of the banking system, and in 2002, it saw the creation of three financial watchdogs that would become critical institutional players throughout the 2000s.5 Chart 2Crackdown On Informal Credit Continues One of the skeletons in the closet from 2002 was the debate over whether financial regulation should be heavily centralized or divided among different, specialized, state agencies. Former Premier Wen Jiabao won the argument with the creation of the three watchdogs covering banking, securities, and insurance. After a series of controversies and conflicts, the Xi administration decided that these agencies had failed in their primary purpose of curbing systemic risk and ordered a reorganization with greater centralization. At the 2017 financial conference, Xi announced the creation of the Financial Stability and Development Committee (FSDC) to act as a centralized watchdog over the entire financial system. The FSDC would coordinate with the central bank, oversee macro-prudential regulation, and prevent systemic risk. Liu He, Xi's right-hand man on the economy and a policymaker with a hawkish reputation, was soon promoted to the Politburo and given the top job at the FSDC.6 As a second step, the Xi administration announced that it would combine the banking and insurance regulators into a single entity - the China Banking and Insurance Regulatory Commission (CBIRC). The CBIRC, to be headed by Xi ally, and notable hawk, Guo Shuqing, would continue and escalate the crackdown on shadow lending that Guo had begun at the helm of the bank watchdog in 2017 (Chart 2). The merging of the agencies would also close the regulatory gap that had seen the insurance regulator increase its dominion and rent-seeking by encouraging "excessive" financial innovation and risky pseudo-insurance products.7 The FSDC was expected, rightly, to bring a more hawkish tilt to Chinese macro-prudential regulation. In reference to the U.S.'s Financial Stability Oversight Council, we dubbed these moves a "Preemptive Dodd-Frank."8 We also argued, however, that the purpose was to bring unified command and control to financial regulation and that China would continue to prize stability above all. Therefore the degree of tightening or loosening should vary in accordance this goal.9 After a series of announcements in July and August, it is clear that China's government has shifted to a more accommodative posture (Chart 3). As usual, there are rumors of high-level political intrigue to go along with the policy shift: some argue that Premier Li Keqiang is making a comeback while Xi's golden boy, Liu He, has been sidelined due to his failure to forestall tariffs during his trade talks with Donald Trump this spring.10 Such rumors are valuable only in revealing the intensity of the policy debate in Beijing. Chart 3Monetary Policy Has Eased Substantively What is certain, however, is that the FSDC, with Liu He as chairman, only met for the first time as a fully assembled group in early July, just before the major easing measures were taken. This implies that any initial conclusions were pragmatic (i.e. not excessively hawkish). Moreover, Guo Shuqing is not only the CBIRC head but also the party secretary of the PBOC, meaning that central bank chief Yi Gang cannot have adopted easing measures without Guo's at least condoning it. Chinese policymakers see the recent easing measures as "fine-tuning" even as they continue the rollout of new regulatory institutions and systems. It is thus too soon to claim that Xi Jinping or any of these government bodies have thrown in the towel on their attempts to contain excessive leverage. Both the Politburo and the State Council - the highest party and state decision-makers - have made clear that they do not intend to endorse a massive stimulus on the magnitude of 2008-09 or 2015-16.11 They have also insisted that the "Tough Battle" against systemic financial risk, and the campaign to "deleverage" the corporate sector, will continue. What does this mean in practical terms? While new regulations will be compromised, they will also continue to be implemented. For example, authorities have watered down new regulations governing the $15 trillion asset management industry, yet the regulations are still expected to go into force by 2020. These rules will weigh on shadow banking activity (e.g. wealth management products) as banks prepare to meet the requirements.12 Two other examples are critical and will be discussed below: first, the potential easing of rules under the Macro Prudential Assessment (MPA) framework for stress-testing banks; second, this year's changes to rules governing non-performing loans (NPLs). In the former case, the degree of financial easing is potentially significant but at present overestimated by investors; in the latter case, the degree of tightening is already significant and widely underestimated. Bottom Line: New financial regulatory institutions will inherently suppress credit growth, especially by dragging on informal or non-bank credit growth. Macro-Prudential Assessments: Less Easing Than Meets The Eye A key factor in determining China's credit growth going forward will be banks' responses to any softening of the Macro Prudential Assessment (MPA) requirements. News reports have suggested that a relaxation of these rules may occur, but authorities have not finalized such a move. Furthermore, the impact on credit growth may be far less than the astronomical sums being floated around the investment community. The MPA framework began in 2016. It is an evaluative system of "stress-testing" China's banks each quarter. As such it is part of the upgrade of macro-prudential systems across the world in the aftermath of the global financial crisis, comparable to the American Financial Stability Oversight Committee or the European Systemic Risk Board.13 It is managed by the PBOC and the FSDC. The MPA divides banks into systemically important financial institutions and common institutions, and subdivides the former into those of national and regional importance. The evaluation method contains seven major criteria for assessing bank stability: Capital adequacy and leverage ratios; Bank assets and liabilities; Liquidity conditions; Pricing behavior for interest rates; Quality of assets; Cross-border financing; Execution of credit policy. The first and fourth of these criteria (capital adequacy and leverage ratios, and pricing behavior for interest rates) are in bold font because they result in a "veto" over the entire assessment: if a bank fails to maintain a sufficient capital buffer, or deviates too far from policy interest rates, it can fail the entire stress-test. Otherwise, failure of any two of the other five categories results in overall failure. A system of rewards and punishments awaits banks depending on how they perform (Diagram 1). Diagram 1China's Macro Prudential Assessment Framework Explained On July 20, the PBOC published a document saying that "in order to better regulate assets of financial institutions, during Macro Prudential Assessment (MPA), relevant parameters can be reasonably adjusted." Subsequently Reuters reported that the PBOC would reduce the "structural parameter" and the "pro-cyclical contribution parameter" of the capital adequacy ratio (CAR) requirements, thereby easing rules on one of the veto items. The structural parameter would fall from 1.0 to 0.5. Rumors suggest that the pro-cyclical parameter could fall from 0.4-0.8 to 0.3. No such changes have been finalized - only a few banks actually claim to have received notification of a change and there are regional differences. Clearly a general change of the rule would reduce regulatory constraints on bank credit. But how big would the impact be? Under the MPA, banks' CARs are not allowed to fall too far below the "neutral CAR," or C*, a variable that is calculated using the formula outlined in Diagram 2. Most of the variables in this formula will not change often: for instance, the minimum legal CAR will be slow to change, as will the capital reserve buffer and the bonus buffer for systemically important institutions. The one factor that can change frequently is the "discretionary counter-cyclical buffer," as it responds to the country's current place in the business cycle. Diagram 2China's Macro-Prudential Assessment Framework: Capital Adequacy Ratios The key input to this factor is broad credit growth. Thus, if authorities should reduce the CAR's cyclical parameter from a simple average of 0.6 to 0.3, broad credit growth could go higher without creating an excessive increase in the pro-cyclical buffer. In other words, at present about 60% of bank credit expansion in excess of nominal GDP growth counts toward a counter-cyclical capital buffer, which is added to other capital buffers. A tweak to this parameter could decrease that proportion to 30%, meaning that bank lending could go twice as high with the same impact on the counter-cyclical buffer. More significantly, if authorities should reduce the CAR's structural parameter from 1.0 to 0.5, any increase in credit growth would have a less dramatic impact on C*. Hence banks would be able to lend more while still keeping their neutral CAR within the appropriate range relative to their actual CAR. Banks could theoretically lend twice as much with the same impact on the assessment.14 On paper these changes could result in unleashing as much as 41.4 trillion RMB in new lending in 2018, or 28 trillion (33% of GDP) on top of what could have been expected without any adjustment to the macro-prudential rules. This is because broad credit growth would theoretically be allowed to grow as fast as 30% instead of 17%.15 But in reality this growth rate is extremely unlikely. Why? Because it assumes that banks will grow their lending books as rapidly as they are allowed. In fact, banks are currently increasing broad credit at a rate of about 10%, which is considerably lower than either today's or tomorrow's permitted rate of growth under the MPA framework (Chart 4). If tweaks to the MPA increase this speed limit to 30%, it does not mean that banks will drive any faster than they are already driving. They are lending at the current pace for self-interested reasons (and there is fear of excessive debt, default, or insolvency due to the government's ongoing regulatory and anti-corruption crackdown).16 Chart 4Banks Are Not Lending To The Regulatory Maximum Still, if the MPA rules are tweaked, then it will send a signal that macro-prudential scrutiny is abating and banks can lend more aggressively - this would have some positive effect on credit growth, at least for major banks that are secure in meeting their CARs. Moreover, there will be a practical consequence in that fewer banks will be punished for having insufficient CARs. At present, only rarely do banks fail the evaluations. But a strict CAR requirement during an economic downturn could change that. The proposed MPA adjustment would show that banks are graded on a sliding rule: the authorities would slide the grading scale downward to enable more banks to pass the test. This means fewer failures, which means fewer punitive measures that could upset liquidity or stability in the banking system. Ultimately, in order for the new system to have any credibility at all, punishment will have to be meted out to banks that fail the stress tests. A key punishment within the MPA system is exclusion from medium-term lending facility (MLF) loans from the PBOC. This is a regulatory action with teeth, as this is one of the PBOC's major means of injecting liquidity (Chart 5). A misbehaving bank could face short-term liquidity shortage or even insolvency. Therefore the authorities are opting to soften the rules so that the new regulatory system is preserved yet the harshest implications are avoided (for now). Chart 5Regulators Can Deprive Banks Of MLF Access This would be short-term gain for long-term pain, the opposite of what China needs from the standpoint of an investor looking for improvements to productivity and potential GDP growth. But it would not necessarily be a great boon for global risk assets in the near term. While it could help stabilize expectations for China's domestic growth, it is not clear that it would unleash a mass wave of new bank loans that would reaccelerate China's economy and put wings beneath EM assets and commodity prices. Bottom Line: Tweaking the MPA parameters is a clear example of policy easing. Yet the MPA system itself is a fairly rigorous means of stress-testing banks that is part of a much larger expansion of financial sector regulation. The results of the easier rules - if implemented - will not be as reflationary as might be expected from the headline 41 trillion RMB in new loans that could legally be created. Banks are already expanding loans more slowly than they are allowed to do, so increasing the speed limit will have little effect. The real purpose of the macro-prudential tweaks is to make it more difficult for banks to fail their stress tests in a downturn. As such, any tweaks would actually reveal that Chinese policymakers are expecting a more painful downturn, not that they are asking for a credit splurge. NPL Recognition Will Weigh On Credit Growth Another factor that we have highlighted that separates today's easing measures from outright stimulus: the growing recognition of non-performing loans (NPLs) in China's banks and the financial cleansing process. The government's reform push has already led to two trends that are relatively rare and notable in the Chinese context: rising corporate defaults (Chart 6) and rising bankruptcies (Chart 7). While the impact may be small relative to China's economic size, the direction of change is significant in a country that has been extremely averse to recognizing losses. Chart 6Defaults Are Rising Chart 7Creative Destruction In China These changes reflect the tightening of financial conditions and restructurings of various industries and as such are evidence of Xi's attempt to make progress on reforms while maintaining stability. They also reflect a general environment that is conducive to the realization of bad loans. Two recent policy decisions are affecting banks' accounting of bad loans. First, the CBIRC issued new guidance that eases NPL provision requirements for "responsible" banks (banks with good credit quality) while maintaining the existing requirements for "irresponsible" banks.17 Since the major state-controlled banks will largely meet the standards, they will be able to lend somewhat more (we estimate around 600 billion RMB or 0.7% of GDP). This would support the recent trend in which traditional bank lending rises as a share of total credit growth. Second, however, the CBIRC is requiring banks to reclassify all loans that are 90-or-more-days delinquent as NPLs, resulting in upward revisions of bank NPL ratios. This will send the official rate on an upward march toward 5%, from current extremely low 1.9% (Chart 8). It is the direction of change that matters, as NPL recognition can take on a life of its own. While many state banks may already have recognized the 90-day delinquent loans, many small and regional banks probably have not. Anecdotally, a number of small banks are reporting large NPL ratios as a result of the regulatory clampdown and definition change. Rural commercial banks, in particular, are in trouble with several showing NPLs in double digits (Chart 9). These small and regional banks will have until an unspecified date in 2019 to reclassify these loans and raise provisions against them. The result will hamper credit growth. Chart 8Bad Loan Ratios Set To Rise Chart 9City And Rural Commercial Banks Most At Risk Of Rising Bad Loans To get a more detailed picture of the NPL recognition process, we have updated our survey of 16 commercial banks listed on the A-share market.18 This research reveals that banks have continued to increase the amount of bad loans they have written off. While the NPL ratio has remained roughly the same, cumulative loan-loss write-offs combined with NPLs have reached 7% of total loans and are still rising (Chart 10). This shows that a cleansing process is well underway. It is concerning that write-offs have reached nearly 50% of pre-tax profits. And even as losses mount, the proportion of each year's losses to the previous year's NPLs has fallen, implying that the previous year's NPLs had grown bigger (Chart 11). Chart 10The Bank Cleansing Process Continues Chart 11Write-Offs Almost 50% Of Bank Profits Furthermore, while loan losses grow, the surveyed banks' profit growth has been reduced to virtually zero (Chart 12). Our updated "stress test" for Chinese banks, which is based on the same sample of 16 commercial banks, suggests that if total NPLs rise to a pessimistic, but still quite realistic, ratio of 13% (a weighted average of NPL ratio assumptions per sector, ranging from 10%-30%), then total losses could amount to 10.4 trillion RMB, or 12% of GDP (Table 1). Chart 12Write-Offs Weigh On##br## Bank Profit Growth Table 1Pessimistic Scenario Analysis ##br##For Commercial Bank NPLs In this scenario, banks' net equity would be impacted by 38% as this amount surpasses the buffer of net profits (1.75 trillion RMB) and NPL provisions (3 trillion). China's banks are well provisioned, but they would be less so after a hit of this nature. A similar stress-test by BCA's Emerging Markets Strategy found that equity impairment could range from 33%-49%, implying that Chinese banks were roughly 29% overvalued on a fair price-to-book-value basis.19 Looking at different economic sectors, it is apparent that domestic trade, manufacturing, and mining have seen the highest incidence of loans going sour (Table 2). In all three cases, it is reasonable to conjecture that the NPL ratio can continue to expand - and not only because of the definitional change. First, wholesale and retail (4.7%) consists largely of SMEs, and the government is publicly concerned about their ability to get credit. Second, manufacturing (3.9%) has been hit by changing trade patterns and rising labor costs and has not yet suffered the impact from recently imposed U.S. trade tariffs. Third, mining (3.6%) has felt the first wave of the impact from the government's cuts to overcapacity in recent years, but has seen very extensive restructuring and the fallout may continue. Table 2China: Troubled Sectors Can Produce More Bad Loans More realistic NPL recognition is an important and positive development for China over the long run. Over the short run, banks' efforts to write-off NPL losses will weigh on their willingness to lend and could pose a risk to overall economic activity. Bottom Line: The government's reform and restructuring efforts are initiating a process of creative destruction in the Chinese economy. This is most notable in the government's willingness to recognize NPLs, which will continue to weigh on credit growth. The government is trying to control the pace and intensity of this process, but we expect credit stimulus to be disappointing relative to fiscal stimulus as long as the financial regulatory crackdown is at least half-heartedly implemented. Anti-Corruption Campaign Is Market-Negative Another reason to expect total credit growth to remain subdued comes from the anti-corruption campaign and its probes into local government finances and the financial sector. Chart 13Anti-Corruption Campaign Trudges Onward One of the new institutions created in China's 2017-18 leadership reshuffle was the National Supervisory Commission (NSC). This is a powerful new commission that is capable of overseeing the highest state authority (the National People's Congress). It is also ranked above the formal legal system, the Supreme Court and the public prosecutor's office. It is charged with formalizing the anti-corruption campaign and extending it from the Communist Party into the state bureaucracy, including state-owned enterprises.20 Having operated for less than a year, it is not possible to draw firm conclusions about the doings of the NSC, let alone any macro impact. Tentatively, the commission has focused on financial and economic crimes that have the potential to create a "chilling effect" among government officials and bank executives.21 Notably, the NSC has investigated Lai Xiaomin, former chief executive of Huarong, the largest of the big four Asset Management Corporations (AMCs), i.e. China's "bad banks." There is more than one reason for Huarong to attract the attention of investigators, but it is notable that it had extensive investments in areas outside its official duty of acquiring and disposing of NPLs. The implication could be that the government wants the AMCs to focus on their core competency: cleaning up the coming deluge of NPLs. The anti-corruption is also targeting local government officials for misappropriating state funds. These investigations involve punishment of provincial officials for false accounting as well as embezzlement and other crimes. We have noted before that the provinces that revised down their GDP growth targets most aggressively this year were also some of the hardest hit with anti-corruption probes into falsifying data and misallocating capital.22 On several occasions it has appeared as if the anti-corruption campaign was losing steam, but the broadest tally of cases under investigation suggest that it is still going strong despite hitting a peak at the beginning of the year (Chart 13). The campaign remains a potential source of disruption among the very officials whose risk appetite will determine whether central government policy easing actually results in additional bank lending and local government borrowing. Bottom Line: While difficult to quantify, the anti-corruption campaign will dampen animal spirits within local governments and the financial sector as long as the new NSC is seeking to establish itself and the Xi administration remains committed to prosecuting the campaign aggressively. Investment Conclusions We would be surprised if credit growth did not perk up at least somewhat as a result of the past month's easing measures. But as outlined above, these measures may disappoint the markets as a result of the ongoing financial regulatory drive, the baggage of NPL recognition, and any negative impact on risk appetite due to the anti-corruption campaign. And this is not even to mention the dampening effects of ongoing property sector and pollution curbs.23 In lieu of a credit surge, Beijing is likely to rely more on fiscal spending to stabilize growth. Fiscal spending also faces complications, of course. In recent years, China's local governments have built up a potentially massive pool of off-balance-sheet debt due to structural factors limiting local government revenue generation (Table 3). Beijing is now attempting to force this debt into the light. The local government debt maturity schedule suggests a persistent headwind in coming years as hidden debt is brought onto the balance sheet and governments scramble to meet payment deadlines (Chart 14). In addition, the local government debt swap program launched in 2014-15 will wrap up this month. Table 3Estimates Of Hidden Local Government Debt Chart 14Local Governments Face Rising Debt Payments Nevertheless Beijing has introduced a new class of "refinancing bonds" in 2018 to help stabilize the fiscal situation. These bonds are separate from brand new bonds that have the potential to increase significantly over the second half of this year. China's Finance Ministry has also reportedly asked local governments to issue 80 percent of net new special purpose bonds by the end of September. Since only about a quarter of the year's 1.35 trillion RMB quota was issued in H1, this order would mean that about half of the quota (675 billion RMB out of 1.35 trillion RMB) would be issued in August and September alone - implying a significant surge to Chinese demand, albeit with a lag of six months or so.24 The latest data releases from July suggest that Beijing is trying to do two things at once: ease liquidity conditions while cracking down on excess leverage. Until we see a spike in credit growth, we will continue to expect the policy turn to be only moderately reflationary, with the ability to offset existing headwinds but not spark a broad-based reacceleration of the economy. Going forward, data for the month of August will be very important to monitor, as many of the easing measures were not announced until late July. For all the reasons outlined in this two-part Special Report, we would view a sharp increase in total credit as a game-changer that would point toward a "stimulus overshoot" (Table 4). Such an overshoot is less likely if the government relies more heavily on fiscal spending this time around, which is what we expect. Table 4Will China Over-Stimulate This Time Around? Meanwhile, turmoil in emerging markets - which we fully anticipated based on China's policy headwinds this year and our dollar bullish view - will only be exacerbated by China's unwillingness to stimulate massively.25 Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Qingyun Xu, Senior Analyst qingyun@bcaresearch.com Yushu Ma, Contributing Editor yushum@bcaresearch.com 1 Please see BCA Geopolitical Strategy and China Investment Strategy Special Report, "China: How Stimulating Is The Stimulus?" dated August 8, 2018, available at gps.bcaresearch.com. 2 Please see BCA China Investment Strategy Special Report, "The Data Lab: Testing The Predictability Of China's Business Cycle," dated November 30, 2017, available at cis.bcaresearch.com. 3 Please see BCA China Investment Strategy Weekly Report, "China Is Easing Up On The Brake, Not Pressing The Accelerator," dated July 26, 2018, available at cis.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," dated April 12, 2017, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Special Report, "Geopolitics - From Overstated To Understated Risks," dated November 22, 2017, available at gps.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Special Report, "Politics Are Stimulative, Everywhere But China," dated February 28, 2018, available at gps.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Special Report, "The Wrath Of Cohn," dated July 26, 2017, available at gps.bcaresearch.com. 9 Please see footnote 8 above. 10 Please see BCA Geopolitical Strategy Weekly Report, "Italy, Spain, Trade Wars... Oh My!" dated May 30, 2018, available at gps.bcaresearch.com. 11 Please see Part I of this series in footnote 1 above. 12 Please see BCA China Investment Strategy Weekly Report, "Now What?" dated June 27, 2018, available at cis.bcaresearch.com. Note that according to the new asset management rules, financial institutions will be required to have a risk reserve worth 10% of their fee income, or corresponding risk capital provisions. When the risk reserve balance reaches 1% of the product balance, no further risk provision will be required. We estimate that setting aside these funds will be a form of financial tightening worth about 1.2% of GDP. 13 Please see Liansheng Zheng, "The Macro Prudential Assessment Framework of China: Background, Evaluation and Current and Future Policy," Center for International Governance Innovation, CIGI Papers No. 164 (March 2018), available at www.cigionline.com. 14 Recall that the second category of the MPA consists of bank assets and liabilities. This category also has a rule for broad credit growth, which is that it should not exceed broad money (M2) plus 20%-25%. Therefore passing this part of the exam already requires banks to meet a 28%-33% speed limit on new credit. Assuming that that the pro-cyclical parameter of the CAR category remains at its current minimum of 0.4, then the structural parameter cannot be effectively pushed any lower than 0.6-0.8. The bottom line is that pushing the CAR structural parameter lower is not going to yield a significant increase in the allowable rate of credit growth. 15 To reach this estimate, we began with the fact that the outstanding level of broad credit growth was around 207 trillion RMB by the end of 2017 (that is, loans plus bonds plus equities plus wealth management products and other off-balance-sheet assets). The 2017 growth rate was about 10% and is assumed to be the same in 2018. Therefore broad credit should reach 227.7 trillion by the end of the year. Then, if we assume that all banks lend at the maximum weighted growth rate allowed by adjusting the structural parameter in the MPA CAR requirement (which is 30%), outstanding broad credit would reach 269.1 trillion by the end of the year. Hence an extra 41.4 trillion RMB in broad credit growth would be released. For comparison, please see CITIC Bond Investment, "Deep Analysis: Impact of Parameter Adjustments in the MPA Framework," July 30, 2018, available at www.sohu.com. 16 Based on actual CARs in 2017, the limit to broad credit growth was 17%-22% for large state-owned banks, 10%-20% for joint-equity banks, and 15%-20% for city or rural commercial banks. However, the actual broad credit growth for most banks was a lot lower than that. For example, for all five state-owned banks (nationally systemically important financial institutions), it was below 10%, well beneath the 17%-22% determined by their actual CARs and C*. 17 Under current regulations, the loan provision ratio is 2.5% while the NPL provision coverage ratio is 150%. The higher of the two is the regulatory standard for commercial banks. On February 28, 2018, the China Banking Regulatory Commission issued a notice declaring that the coverage requirement would change to a range of 120%-150%, while the loan provision requirement would change to a range of 1.5%-2.5%. Banks would qualify for the easier requirements according to how accurately they classified their loans, whether they disposed of their bad loans, and whether they maintained appropriate capital adequacy ratios. This could result in a release of about 800 billion RMB worth of provisions that can be kept as core tier-1 capital or support new lending. 18 Please see BCA China Investment Strategy Special Report, "Stress-Testing Chinese Banks," dated July 27, 2016, available at cis.bcaresearch.com. 19 Please see BCA Emerging Markets Strategy Weekly Report, "Mind The Breakdowns," dated July 5, 2018, and Special Report, "Long Indian / Short Chinese Banks," dated January 17, 2018, available at ems.bcaresearch.com. 20 Please see Jamie P. Horsley, "What's So Controversial About China's New Anti-Corruption Body?" The Diplomat, May 30, 2018, available at thediplomat.com. 21 The NSC is operationally very close to the Central Discipline Inspection Commission (CDIC), which is the Communist Party corruption watchdog formerly headed by heavyweight Wang Qishan. It received only a 10% increase in manpower over the CDIC in order to expand its target range by 200% (covering all state agencies and state-linked organizations). It has allegedly meted out 240,000 punishments in the first half of 2018, up from 210,000 during the same period last year and 163,000 in H1 2016. About 28 of these cases were provincial-level cases or higher. The controversy over the "rights of the detained" has been highlighted by the beating of a local government official's limousine driver in one of the organization's first publicly reported actions. The NSC has also arrested local government officials tied to "corruption kingpin" Zhou Yongkang and known for misappropriating budgetary funds, and has secured the repatriation of fugitives who fled abroad and recovered the assets that they stole or embezzled. 22 The provinces include Tianjin, Chongqing, Liaoning, Inner Mongolia, etc. Please see BCA Geopolitical Strategy "Trump, Year Two: Let The Trade War Begin," dated March 14, 2018, available at gps.bcaresearch.com. There is empirical evidence that anti-corruption probes are correlated with debt defaults. Please see Haoyu Gao, Hong Ru and Dragon Yongjun Tang, "Subnational Debt of China: The Politics-Finance Nexus," dated September 12, 2017, available at gcfp.mit.edu. 23 Please see BCA Emerging Markets Strategy Special Report, "China Real Estate: A Never-Bursting Bubble?" dated April 6, 2018, available at ems.bcaresearch.com, and Commodity & Energy Strategy Weekly Report, "Blue Skies Drive China's Steel Policy," dated August 9, 2018, available at ces.bcaresearch.com. 24 Please see "As economy cools, China sets deadline for local government special bond sales," Reuters, dated August 14, 2018, available at www.reuters.com. For more on local government bond issuance, see Part I of this series in footnote 1 above. Note also rumors in Chinese media suggesting that a new local government debt swap program could be launched with the responsibility of tackling off-balance-sheet debts that are guaranteed by local governments. The program has thus far only swapped debts that local governments were obligated to pay. It is not clear what would happen to a third class of local debt, that which is neither an obligation upon local governments nor guaranteed by them but that nevertheless is deemed to serve a public interest. 25 Please see BCA Geopolitical Strategy Weekly Report, "The EM Bloodbath Has Nothing To Do With Trump," dated August 14, 2018, available at gps.bcaresearch.com.

Special Report

Turkey's unorthodox macroeconomic policies have backfired. The pursuit of economic growth at all costs has created major macroeconomic imbalances including surging inflation, a large current account deficit, extreme reliance on foreign portfolio inflows and foreign borrowing as well as an over-expansion of domestic credit. The nation's financial markets have been in freefall since early this year, hit by external shocks as well as investors' realization that President Erdogan is reluctant to adopt requisite and orthodox macroeconomic policies. The political spat between Turkey and the U.S. over the detention of American pastor Andrew Brunson in the past two weeks was a trigger - not the cause - of the selloff in Turkish financial markets. The basis for the ongoing selloff since early this year has been unsustainable macro policies, and the resulting macroeconomic imbalances. The key questions for investors are whether these ongoing adjustments in Turkey's financial markets and economy have further to go, and how to position in terms of investment strategy going forward. Valuations Have Become Attractive With share prices having dropped by 60% in U.S. dollar terms since their peak at the beginning of the year, Turkish equity valuations have become utterly depressed. The same can be said about the lira. In brief, there is now good value in Turkish financial markets. The lira has reached two standard deviations below fair value, according to the unit labor cost-based real effective exchange rate - which is our favorite currency valuation measure (Chart 1). At the moment, the lira is cheap. That said, if high inflation persists (Chart 2), the currency will appreciate in real terms, even if the nominal exchange rate stays around these levels. Chart 3 demonstrates that the cyclically-adjusted P/E (CAPE) ratio for Turkish stocks is now, two standard deviations below the historical average. Chart 1The Lira Has Become Cheap Chart 2Turkey: Inflation Breakout Chart 3Turkish Equities Are Cheap Nevertheless, it is essential to recognize that the CAPE ratio is a structural valuation measure - i.e., it is intended to work in the long term, beyond short-term business cycle fluctuations. Furthermore, structural valuation measures assume there is no structural shift in financial markets or the economy. If the Turkish authorities move to impose capital controls and double down on their unorthodox macro policies, there will arguably be a structural shift in the nation's economy and financial markets, and any indicator based on the past, including this CAPE ratio, will lose its relevance. In short, investors who buy Turkish stocks now will have a high probability of making money in the long run - possibly in the next three years or beyond barring structural regime shift. That said, the CAPE ratio is not a useful gauge for investors with short- and medium-term time horizons. Turkish U.S. dollar credit spreads are now the widest in the EM corporate space (1300 basis points). Sovereign spreads have also spiked to 590 basis points, the widest in 9 years, although still below levels that prevailed in the early 2000s (Chart 4). Local currency bonds are yielding 23%, and their total return in U.S. dollars have plunged to new lows (Chart 5). Bottom Line: Valuations, especially for equities and the currency, have become cheap. Chart 4Turkish Sovereign ##br##Spreads Have Broken Out Chart 5Turkish Local Currency ##br##Bonds Have Collapsed Adjustment: How Complete Is It? From a macroeconomic perspective, Turkey has been over-spending, especially on foreign goods. Thus, a cheaper currency and higher borrowing costs were needed to force an adjustment - i.e. squeeze spending in general and imports in particular. Although the Turkish exchange rate has weakened dramatically, making imports more expensive, an adjustment in interest rates is still pending. The policy rate - the one-week repo rate - still stands at 17.75% while 3-month interbank rates have spiked to 22% compared with core inflation of 15%. Provided core inflation will rise further following the latest plunge in the lira's value, it is reasonable to conclude that the policy rate in Turkey in real (inflation-adjusted) terms is still low. As we have argued in the past,1 the pre-conditions for turning bullish on Turkey are (1) a very cheap currency (as well as low valuations for other asset classes), (2) reasonably high real policy rates (say between 2-4%) and (3) a switch and an adherence to orthodox macro policies, including the elimination of capital control risks. The first pre-condition - valuations - has been met, as we discussed above. The second pre-condition - high real interest rates - has only partially been met: market-driven interest rates have spiked, yet policy rates are still low. Finally, there has been no sign that Turkish policymakers have embraced more orthodox macro policies. Consequently, the risk of capital controls or additional unorthodox measures remains reasonably high. In term of the real economy, there is presently little doubt that it is heading into a major recession with the banking system under siege. This necessitates considerable bad-asset restructuring. However, financial market valuations have probably already priced these developments in. Bottom Line: Out of three pre-conditions for turning positive, only one and a half have been met. Investment Strategy: Book Profits On Shorts The investment strategy with respect to Turkish financial markets should take into account that valuations have become very attractive, yet uncertainty over policy remains unusually high. In particular, in the case of imposition of capital controls, investors will suffer more losses. Capital controls or other unorthodox measures would represent a structural breakdown, and historical valuation metrics will be of little value. It is impossible to forecast and quantify the probability of capital controls being imposed by Turkey because it is a decision only one individual can take: President Erdogan. Nevertheless, disciplined investors should never ignore extreme valuations. As shown in Charts 1 and 3 above, the currency and equities now trade at two standard deviations below their fair value. Therefore, balancing cheap valuations on the one hand and lingering risks of further unorthodox policies (capital controls in particular) on the other, we recommend the following: 1. Investors who are short should take profits. We are doing this on the following positions: Short TRY / long USD - we reinstated this position on April 19, 2017, and it has generated a 41% gain since that time. The cumulative gain on our short lira position is 65% since January 17, 2011 (Chart 6, top panel). Short Turkish bank stocks - we recommended this trade on April 19, 2017; it has produced a 65% gain since. Prior to this, we shorted banks from June 4, 2013 to January 25, 2017. The cumulative gain on our short bank stocks is 124% in U.S. dollar terms since June 4, 2013 (Chart 6, bottom panel). 2. For absolute return investors, we do not yet recommend going long Turkish assets, even if they are in distressed territory. Domestic policy uncertainty remains high, the U.S. dollar will advance further and the broad EM selloff will continue. It will be difficult for Turkish markets to rally meaningfully in absolute terms amid these headwinds. 3. As to dedicated EM equity and fixed income portfolios (both credit and local currency bonds), we recommend shifting from an underweight to neutral allocation. The odds of continued underperformance and risk of capital controls are somewhat offset by cheap valuations and oversold conditions (Chart 7). Chart 6Book Profits On Turkish Shorts Chart 7Turkish Fixed Income Markets ##br##Have Been Slammed A neutral stance on Turkey within fully invested EM portfolios would mean that dedicated investors eliminate the risk of being on the wrong side of the market in the case of either potential outperformance or continued underperformance. A Word On Contagion Although the plunge in Turkish markets this past week has certainly unnerved investors and caused selloffs in other vulnerable EMs, it is a mistake to blame this selloff on Turkey alone. BCA's Emerging Markets Strategy team maintains that many EM economies have poor fundamentals and are vulnerable for various reasons.2 In fact, a broad-based selloff in EM financial markets had already commenced earlier this year before the latest events in Turkey began to unfold. In short, recent events in Turkey have acted as an additional trigger - not a cause - for the EM carnage. For example, on the surface, it may seem that the South African rand has plunged due to the turmoil in Turkey. However, this is an incorrect rationalization. Chart 8 demonstrates that the rand and metals prices are very highly correlated. Therefore, the rand's selloff since early this year should be attributed to the broad strength in the U.S. dollar, falling metals prices (negative terms of trade) and poor domestic economic fundamentals that we have discussed extensively in our reports on South Africa. As we outlined in our June 14 report,3 bear markets and crises often develop in phases, where some markets plunge while others show temporary resilience. However, if our big-picture view - that EMs are in a bear market - is correct, then it is only a matter of time before the markets that are still resilient re-couple to the downside with the rest. That said, there are always going to be outperformers and underperformers. Our country allocation recommendations are presented at the end of each report (please refer to pages 9 and 10). Furthermore, investors should not focus solely on the impact of the Turkish crisis on developed financial markets. BCA's Emerging Markets Strategy team maintains that EM financial markets will continue to sell off, and that the downturn will eventually affect DM markets. Remarkably, DM ex-U.S. share prices have failed to recover from the January selloff along with the U.S. equity markets and still hover around their lows for the year (Chart 9). Chart 8The Rand Is Driven By ##br##Metal Prices Not By Turkey Chart 9No Recovery In DM ##br##ex-U.S. And EM Stocks Bottom Line: Woes in EM markets will persist, weighing on DM equities as well. The headwinds are slower global trade (for DM ex-U.S.) and a strong U.S. dollar for the S&P 500. The path of least resistance for the U.S. dollar is up, and U.S. stocks will continue to outperform European and Japanese equities in common currency terms. EM will be the worst performer among all regions. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy & Frontier Markets Strategy arthurb@bcaresearch.com Stephan Gabillard, Senior Analyst stephang@bcaresearch.com 1 Please see the section on Turkey in Emerging Markets Weekly Report titled "The Dollar Rally And China's Imports," dated May 24, 2018, available on page 11. 2 Please see Emerging Markets Strategy Weekly Report titled "Understanding The EM/China Cycles," dated July 19, 2018, available on page 11. 3 Please see Emerging Markets Strategy Weekly Report titled "EM: Sustained Decoupling, Or Domino Effect?" dated June 14, 2018, available on page 11.

Highlights President Trump has little to do with the ongoing EM selloff; The macro backdrop is the real culprit behind Turkey's woes, particularly the strong dollar... ... Which is a product of global policy divergence, with the U.S. stimulating while China pursues growth-constraining reforms; Chinese stimulus is important to watch, as it could change the game, but we do not expect China to save EM as it did in 2015; Turkey's troubles are a product of its late-stage populist cycle and will not end with Trump's magnanimity; The positive spin on the EM bloodbath is that it may force the Fed to slow its rate hikes, prolonging the business cycle. Feature Chart 1EM: Bloodbath Markets are selling off in Turkey and the wider EM economies (Chart 1), with the financial media focusing on the actions taken by the U.S. President Donald Trump in the escalating diplomatic spat between the two countries. Investors should be very clear what it means to ascribe the ongoing selloff to President Trump's aggressive posture with Ankara in particular and trade in general. If President Trump started EM's troubles with his tweets, he can then end them with another late-night missive. This is not our view. Turkey is enveloped in a deep morass of populism and weak fundamentals since at least 2013. What is worse, the ongoing selloff is likely going to ensnare at least the other fragile EM economies and potentially take down EM as an asset class. In this Report, we recount the pernicious macro backdrop - both geopolitical and economic - that EM economies face today. We then focus on Turkey itself and show that President Trump has little to do with the current selloff. The Bloodbath Is Afoot, Again Every financial bubble, and every financial bust, begins with a compelling story grounded in solid fundamentals. The now by-gone EM "Goldilocks Era" (2001-2011) was primarily driven by exogenous factors: a generational debt-fueled consumption binge in DM; an investment-fueled double-digit growth rate in China that kicked off a structural commodity bull market; and the unleashing of pent-up EM consumption/credit demand (Chart 2).1 These EM tailwinds petered out by 2011. Subsequently, China and EM economies entered a major downtrend that culminated in a massive commodity rout that began in 2014. But before the bloodbath could motivate policymakers to initiate painful structural reforms, Chinese policymakers stimulated in earnest. In the second half of 2015, Beijing became unnerved and injected enormous amount of credit and fiscal stimulus into the mainland economy (Chart 3). The intervention, however, did not change the pernicious fundamentals driving EM economies but merely caused "a mid-cycle recovery, or hiatus, in an unfinished downtrend," as our EM strategists have recently pointed out (Chart 4).2 Chart 2Goldilocks Era##BR##Is Over For EM Chart 3Is China About To Cause Another##BR##EM Mid-Cycle Recovery? Take Brazil, for example. Instead of using the 2014-2015 generational downturn to double-down on painful fiscal and pension reforms, the country's politicians declared President Dilma Rousseff to be the root-cause of all evil that befell the nation, impeached her in April 2016, and then proceeded to unceremoniously punt all painful reforms until after this year's election (if ever). They were enabled to do so by the "mid-cycle recovery" spurred by Chinese stimulus. In other words, Brazil's policymakers did nothing to actually deserve the recovery in asset prices but got one anyway. The country now will experience "faceoff time" with the markets, with no public support for painful reforms (Chart 5) and hardly an orthodox candidate in sight ahead of the October general election.3 Chart 4Where Are China/EM In The Cycle? Chart 5Brazil's Population Is Not Open To Fiscal Austerity Could Brazilian and Turkish policymakers be in luck, as Chinese policymakers have blinked again?4 Our assessment is that the coming stimulus will not be as stimulative as in 2015. First, President Xi's monetary and fiscal policy, since coming into office in 2012, has been biased towards tightening (Chart 6). Second, Chinese leverage has plateaued (Chart 7). In fact, "debt servicing" is now the third-fastest category of fiscal spending growth since Xi came to power (Table 1). Third, the July 31 Politburo statement pledged to make fiscal policy "more proactive" and "supportive," but also reaffirmed the commitment to continue the campaign against systemic risk. Chart 6Xi Jinping Caps##BR##Government Spending And Credit Chart 7The Rise And Plateau##BR##Of Macro Leverage Whether China's mid-year stimulus will be globally stimulative is now the question for global investors. The key data to watch out of China will be August credit numbers, to be released September 9th through 15th. Is President Trump not to be blamed at all for the EM selloff? What about the trade war against China? If anything, tariffs against China have caused Beijing to "blink" and implement some stimulative measures this summer. If one must find fault in U.S. policy, it is the double dose of fiscal stimulus that has endangered EM economies. A key theme for BCA's Geopolitical Strategy this year has been the idea that global policy divergence would replace the global growth convergence.5 Populist economic stimulus in the U.S. and structural reforms in China would imperil growth in the latter and accelerate it in the former, forming a bullish environment for the U.S. dollar (Chart 8). Table 1Total Government Spending Preferences (Under Leader's General Control) Chart 8U.S. Outperformance Should Be Bullish USD As such, the White House is partly responsible for the EM selloff, but not in any way that can be changed with a tweet or a handshake. Furthermore, we do not see the upcoming U.S. midterm election as somehow capable of altering the global growth dynamics.6 It is highly unlikely that Democrats will seek to spend less, and they cannot raise taxes under Trump. Bottom Line: EM economies have never adjusted to the end of their Goldilocks era. A surge in global liquidity pushed investors further down the risk-curve, propping up EM assets despite poor macro fundamentals. China's massive 2015-2016 stimulus arrested the bear market, giving investors a perception that EM economies had recovered. This mid-cycle hiatus, however, has now been overtaken by the global policy divergence between Washington and Beijing, which is bullish USD. President Trump's trade tariffs and aggressive pressure on Turkey do not help. However, they are merely the catalyst, not the cause, of the selloff. As such, investors should not "buy" EM on a resolution of China-U.S. trade tensions or of the Washington-Ankara diplomatic dispute. Contagion Risk BCA's Emerging Market Strategy is clear: in all episodes of a major EM selloff, the de-coupling between different regions proved to be unsustainable, and the markets that showed initial resilience eventually re-coupled to the downside (Chart 9).7 One reason to expect contagion risk among all EM markets is that the primary export market for China and other East Asian exporters are other EM economies, particularly the commodity producers (Chart 10). As such, it is highly unlikely that East Asian EM economies will be able to avoid a downturn. In fact, leading indicators of exports and manufacturing, such as Korea's manufacturing shipments-to-inventory ratio and Taiwan's semiconductor shipments-to-inventory ratio herald further deceleration in their respective export sectors (Chart 11). Chart 9Asian And Latin American Equities:##BR##Unsustainable Divergences Chart 10EM Trades##BR##With EM Chart 11Asia Export##BR##Slowdown Is Afoot In respect of foreign funding requirements of EM economies, our EM strategists have pointed out that there is a substantive amount of foreign currency debt coming due in 2018 (Table 2), with majority EM economies facing much higher foreign debt burdens than in 1996 (Table 3).8 Investors should not, however, rely merely on debt as percent of GDP ratios for their vulnerability assessment. For example, Malaysia's private sector FX debt load stands at 63.7% of GDP, the second highest level after Turkey. But relative to total exports (a source of revenue for its indebted corporates) and FX reserves (which the central bank can use to plug the gap in the balance of payments), Malaysia actually scores fairly well. Table 2EM: Short-Term (Due In 2018) FX Debt Table 3EM Private Sector FX Debt: 1996 Versus Today Chart 12 shows the most vulnerable EM economies in terms of foreign currency private sector debt exposure relative to FX reserves and total exports. Unsurprisingly, Turkey stands as the most vulnerable economy, along with Argentina, Brazil, Indonesia, Chile, and Colombia. Chart 12BCA's Emerging Markets Strategy Has Already Pinned Turkey As The Most Vulnerable EM Economy Will the EM selloff eventually ensnare DM economies as well, particularly the U.S.? We think yes. The drawdown in EM will bid up safe-haven assets like the U.S. dollar. The dollar can be thought of as America's second central bank, along with the Fed. If both the greenback and the Fed are tightening monetary conditions, eventually the U.S. economy will feel the burn. As such, it is dangerous to dismiss the ongoing crisis in Turkey as a merely localized problem that could, at its worst, spread to other EM economies. In 1997, Thailand played a similar role to that of Turkey. The Fed tightened rates in early 1997 and largely remained aloof of the developing East Asia crisis that eventually spread to Brazil and Russia, ignoring the tumult abroad until September 1998 when it finally cut rates three times. Fed policy easing at the end of 1998 ushered in the stock market overshoot and dot-com bubble, whose burst caused the end of the economic cycle. The same playbook may be occurring today. The Fed, motivated by the strong U.S. economy and fears of being too close to the zero-bound ahead of the next recession, is proceeding apace with its tightening cycle. It is likely to ignore troubles in the rest of the world until the USD overshoots or U.S. equities are impacted directly. At that point, perhaps later this year or early next year, the Fed will back off from tightening, ushering the one last overshoot phase ahead of the recession in 2020 - or beyond. Bottom Line: Research by BCA's EM strategists shows that EM contagion is almost never contained in just a few vulnerable economies. For investors who have to remain invested in EM economies, we would recommend that they go long Chinese equities relative to EM, given that Beijing policymakers are stimulating the economy to ensure that Chinese growth is stabilized. While this will be positive for China, it is likely to fall short of the 2015 stimulus that also stimulated non-China EM. An alternative play is to go long energy producers vs. the rest of EM - given our fundamentally bullish oil view combined with rising geopolitical risks regarding sanctions against Iran.9 We eventually expect EM risks to spur an appreciation in the USD that the Fed has to lean against by either pausing its tightening cycle, or eventually reversing it as it did in the 1997-1998 scenario. This decision will usher in the final blow-off stage in U.S. equities that investors will not want to miss. What About Turkey? Chart 13Turkey: Volatile Politics, Volatile Stocks In 2013, we called Turkey a "canary in the EM coal mine" arguing that its historically volatile financial markets would mean-revert as domestic politics became turbulent (Chart 13).10 Turkey is a deeply divided society equally split between the secularist cities, which are primarily located on the Mediterranean (Istanbul, Izmir, Bursa, Adana, etc.), and the religiously conservative Anatolian interior. This split dates back to the founding of the modern Turkish Republic in the post-World War I era (and in truth, even before that). The ruling Justice and Development Party (AKP), a religiously conservative but initially pro-free-market party, managed to appeal to the conservative Anatolia while neutering the most powerful secularist institution in Turkey, its military. Investors hailed AKP's dominance because it reduced political volatility and initially promised both pro-market policies and even accession to the EU. However, the AKP has struggled to win more than 50% of the popular vote in a slew of elections and referendums since coming to power (Chart 14), a fact that belies its supposed iron-grip hold on Turkish politics since it came to power in 2002. The vulnerability behind AKP's hold on office has largely motivated President Recep Tayyip Erdogan's attempt to consolidate political power. While we disagree with the consensus view that Erdogan's constitutional changes have turned Turkey into a dictatorship, some of his actions do suggest a deep fear of losing power.11 Populist leadership is characterized by a strategy of "giving people what they want" so that the policymakers in charge remain in office. Erdogan's perpetually slim hold on power has motivated several populist policy decisions that have stretched Turkey's macro fundamentals. First, Turkey's central bank has essentially been conducting quantitative easing since 2013 via net liquidity injections into the banking system (Chart 15). Notably, these injections began at the same time as the May 2013 Gezi Park protests, which saw a huge outpouring of anti-government sentiment across Turkey's large cities. Essentially, politics has been motivating Ankara's monetary policy over the past five years. Chart 14AKP's Stranglehold On Power Is Overstated Chart 15Turkey's Populist Policies Began##BR##With Gezi Park Protests Second, Turkey's current account balance has suffered under the weight of rising energy costs, with no attempt to improve the fiscal balance (Chart 16). The government has done little in terms of structural reforms or fiscal austerity, instead President Erdogan has continued to challenge central bank independence on interest rates, despite a clear sign that the country is experiencing a genuine inflationary breakout (Chart 17). Chart 16Populism Means No Austerity Is In Sight Chart 17Genuine Inflation Breakout Overall, Turkey is a classic example of how populism in a highly divided and polarized country can get out of control. Foreign investors have long assumed that Erdogan's populism was benign, if not even positive, given the presumably ample political capital at the president's disposal. However, with every election or referendum, the government did not double-down on pro-market structural reforms. Instead, the pressure on the central bank only increased while Turkey's expensive and extravagant geopolitical adventures in neighboring Syria accelerated. In this pernicious macro context, it has not taken much to knock Turkey's assets off balance. President Trump's threats to expand sanctions to Turkish trade are largely irrelevant, given that the vast majority of Turkey's exports and FDI sources are non-American (Chart 18). However, given past behavior - such as after the shadowy Gülen "plot" to take over power or the 2016 coup d'état - markets are by now conditioned to expect that Turkish policymakers will double-down on populist policies in the face of renewed pressure. Chart 18Turkey-U.S. Relationship Is Not Economic What of Turkey's membership in NATO? Should investors fear broader geopolitical instability due to the domestic crisis? No. Ankara has used its membership in NATO, and particularly the U.S. reliance on its Incirlik air base in southern Turkey, as levers in previous negotiations and diplomatic spats with Europe and the U.S. If Ankara were to renege on its commitments to the Western military alliance, it would likely face a united front from Europe and the U.S. As such, we would expect Turkey neither to threaten exit from NATO, which it has not done in the past, nor even to threaten U.S. operations in Incirlik, which Erdogan's government has threatened before. The most likely outcome of the ongoing diplomatic spat, in fact, would be to see Ankara give in to U.S. demands, given the accelerating financial and economic crisis. Such an outcome, however, will not arrest the downturn. Turkey's economy and assets are fundamentally under pressure due to the realization by investors that this year's main macro theme is not the resynchronized global growth recovery, but rather the global policy divergence between the U.S. and China, which has appreciated the U.S. dollar. No amount of kowtowing by Ankara will change this macro trend. Bottom Line: The list of Turkish policy sins is long. Erdogan's reign has been characterized by deep polarization and populism, leading to suboptimal policy choices since at least 2013. The latest U.S.-Turkey spat is therefore merely one of many problems plaguing the country. As such, its resolution will not be a buying opportunity for investors. Investment Implications Our main investment theme in 2018 was that the global policy divergence between the U.S. and China - emblematized by fiscal stimulus in the U.S. and structural reforms in China - would end the global growth resynchronization. As the U.S. economy outperformed the rest of the world, the U.S. greenback would appreciate, imperiling EM economies. The best cognitive roadmap for today is the late 1990s, when the U.S. economy continued to grow apace as the rest of the world suffered from an EM crisis. The problems eventually washed onto American shores in the form of a stronger dollar, forcing the Fed to back off from tightening in mid-1998. Policy easing then led to the overshoot phase in U.S. equities in 1999. Investors should prepare for a similar roadmap by being long DXY relative to EM currencies, long DM equities (particularly U.S.) relative to EM equities, and tactically cautious on all global risk assets. Strategically, however, it makes sense to remain overweight equities as a Fed capitulation would be a boon for risk assets. If the current selloff in EM gets worse, we would expect that the Fed would again back off from tightening as it did in 1998, ushering in a blow-off stage in equities ahead of the next recession. Once the dollar peaks and EM assets bottom, U.S. equities will become the laggard, with global cyclicals outperforming. A secondary conclusion is that President Trump's trade rhetoric in general, and aggressive policies towards Turkey in particular, are merely a catalyst for the selloff. As such, if President Trump changes his mind, we would fade any rally in EM assets. The fundamental policy decisions that have led to the greenback rally have already been taken in 2017 and early 2018. The profligate tax cuts and the two-year stimulative appropriations bill, combined with Chinese policymakers' focus on controlling financial leverage, are the seeds of the current EM imbroglio. Finally, a small bit of housekeeping. We are booking gains on our long Malaysian ringgit / short Turkish lira trade for a gain of 51.2% since May. We are also closing our speculative long Russian equities relative to EM trade for a loss of -0.9% as a result of the persistent headwind from U.S. sanctions. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "The Coming Bloodbath In Emerging Markets," dated August 12, 2015, available at gps.bcaresearch.com. 2 Please see BCA Emerging Markets Strategy Weekly Report, "Understanding The EM/China Cycles," dated July 19, 2018, available at ems.bcaresearch.com. 3 Please see BCA Emerging Markets Special Report, "Brazil: Faceoff Time," dated July 27, 2018, available at ems.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "China: How Stimulating Is The Stimulus?" dated August 8, 2018, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Strategic Outlook, "Three Questions For 2018," dated December 13, 2017, and Weekly Report, "Upside Risks In U.S., Downside Risks In China," dated January 17, 2018, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Weekly Report, "Will Trump Fail The Midterm?" dated April 18, 2018, available at gps.bcaresearch.com. 7 Please see BCA Emerging Markets Strategy Weekly Report, "EM: Sustained Decoupling, Or Domino Effect?" dated June 14, 2018, available at ems.bcaresearch.com. 8 Please see BCA Emerging Markets Strategy Special Report, "A Primer On EM External Debt," dated June 7, 2018, available at ems.bcaresearch.com. 9 Please see BCA Geopolitical Strategy and Commodity & Energy Strategy Special Report, "U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic," dated July 19, 2018, available at gps.bcaresearch.com. 10 Please see BCA Geopolitical Strategy Monthly Report, "Turkey: Canary In The EM Coal Mine?" in "The Coming Political Recapitalization Rally," dated June 13, 2013, available at gps.bcaresearch.com. 11 Please see BCA Geopolitical Strategy and Emerging Markets Strategy Weekly Report, "Turkey: Deceitful Stability," in "EM: The Beginning Of The End," dated April 19, 2017, available at ems.bcaresearch.com.

This week we are publishing Part 1 of an overview of the cyclical profiles of emerging market (EM) economies. This all-in-charts presentation illustrates the business cycle conditions of the largest EMs. 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 will be covered in next week’s Part 2. Chart A Chart B Korea: Overweight Equities Korea: Overweight Equities Korea: Overweight EquitiesKorea: Overweight Equities ...But Negative On Currency ...But Negative On Currency ...But Negative On Currency ...But Negative On Currency ...But Negative On Currency Taiwan: Overweight Equities But... Taiwan: Overweight Equities... Taiwan: Overweight Equities... Taiwan: Overweight Equities... Taiwan: Overweight Equities... ...Absolute Return Investors Should Mind Cracks In Semi Sector ...Absolute Return Investors Should ##br##Mind Cracks In Semi Sector ...Absolute Return Investors Should ##br##Mind Cracks In Semi Sector India: Remain Overweight India: Remain Overweight India: Remain Overweight India: Remain Overweight India: Remain Overweight India: Strong Domestic Growth & Advanced NPL Recognition India: Strong Domestic Growth & ##br##Advanced NPL Recognition India: Strong Domestic Growth & ##br##Advanced NPL Recognition India: Strong Domestic Growth & ##br##Advanced NPL Recognition India: Strong Domestic Growth & ##br##Advanced NPL Recognition South Africa: On Shaky Foundations - Underweight South Africa: On Shaky Foundations South Africa: On Shaky Foundations South Africa: On Shaky Foundations South Africa: On Shaky Foundations South Africa: Strong Consumption, No CAPEX And No Competitiveness South Africa: Strong Consumption, ##br##No CAPEX And No Competitiveness South Africa: Strong Consumption, ##br##No CAPEX And No Competitiveness South Africa: Strong Consumption, ##br##No CAPEX And No Competitiveness South Africa: Strong Consumption, ##br##No CAPEX And No Competitiveness Brazil: Heading Towards A Fiscal Debacle - Underweight Brazil: Heading Towards A Fiscal Debacle Brazil: Heading Towards A Fiscal DebacleBrazil: Heading Towards A Fiscal Debacle Brazil: More Downside In Financial Assets Brazil: More Downside In Financial Assets Brazil: More Downside In Financial Assets Brazil: More Downside In Financial Assets Brazil: More Downside In Financial Assets Mexico: Domestic Fundamentals Are Improving - Overweight Mexico: Domestic Fundamentals Are Improving Mexico: Domestic Fundamentals Are ImprovingMexico: Domestic Fundamentals Are Improving Mexico: External Sector Is Faring Well Mexico: External Sector Is Faring Well Mexico: External Sector Is Faring WellMexico: External Sector Is Faring Well Russia: Orthodox Monetary And Fiscal Policies Russia: Orthodox Monetary And Fiscal Policies Russia: Orthodox Monetary And Fiscal Policies Russia: Orthodox Monetary And Fiscal Policies Russia: Orthodox Monetary And Fiscal Policies Russia: Gradual Cyclical Improvements - On Upgrade Watchlist Russia: Gradual Cyclical Improvements Russia: Gradual Cyclical ImprovementsRussia: Gradual Cyclical Improvements Turkey: A Genuine Inflation Breakout Amidst Credit Excesses Turkey: A Genuine Inflation ##br##Breakout Amidst Credit Excesses Turkey: A Genuine Inflation ##br##Breakout Amidst Credit Excesses Turkey: A Genuine Inflation ##br##Breakout Amidst Credit Excesses Turkey: A Genuine Inflation ##br##Breakout Amidst Credit Excesses Turkey: A Genuine Inflation ##br##Breakout Amidst Credit Excesses Turkey: Still In Dangerous Territory - Underweight Turkey: Still In Dangerous Territory Turkey: Still In Dangerous TerritoryTurkey: Still In Dangerous TerritoryTurkey: Still In Dangerous Territory Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Seasonal capacity restrictions in China during the winter heating months - when pollution from steel mills is particularly high - and continued efforts to limit particulate emissions in major cities will drive steel prices higher. The steel rebar market in China is backwardated, indicating physical markets are tight; inventories have been falling since mid-March. We expect prices to remain elevated going into the winter months, when capacity restrictions kick in. Ongoing capacity reductions in steelmaking will favor higher-grade iron ores, which will widen price differentials versus lower-grade ores. We are recommending a long China rebar futures on the SHFE in 1Q19 vs short 62% Fe iron ore futures on the Dalian DCE in 1Q19 at tonight's close, based on our research. Energy: Overweight. Loadings of Iranian crude are expected to be curtailed beginning this month, as the November 4 deadline for the imposition of U.S. secondary sanctions kick in. Our base case calls for the loss of 500k b/d of exports from Iran; our ensemble forecast includes an estimate of 1mm b/d. Base Metals: Neutral. BHP asked the Chilean government to intervene in the strike called by unions at its Escondida mine. Union officials delayed strike action while talks are being held. Negotiators have until August 14 to reach an agreement. Reuters reported Chile's copper production was up 12.3% y/y in 1H18 to 2.83mm MT.1 Precious Metals: Neutral. U.S. sanctions on trading gold and precious metals with Iran went into effect earlier this week. Ags/Softs: Underweight. Chinese imports of U.S. soybeans could fall 10mm MT over the next year, if pig and chicken farmers switch to lower-protein feed and substitutes like sunflower seeds, and boost local production of the legume, state-run news service Xinhua reported.2 The USDA expects U.S. exports of 55.52mm MT of soybeans in the 2018 - 19 crop year, down 1.22mm MT from last year. Feature Steel prices have performed exceptionally since the beginning of 2Q18, seemingly oblivious to Sino - U.S. trade tensions, a stronger USD, and risks to China's economy roiling other metal markets (Chart of the Week). The MySteel Composite Index we use to track steel prices is up 7% since the beginning of April. With demand growth leveling off, steel's price dynamics highlight the continued relevance of the market's supply-side developments. Most notably, Beijing's battle for blue skies: Winter capacity curbs, and, to a lesser extent, ongoing efforts to retire older, highly polluting capacity will keep prices elevated over the next 9 months. Winter Curbs: China's New Normal As we highlighted in our April 12 weekly, despite the much-ballyhooed reductions in China's steel capacity over the 2017 - 18 winter months, markets in China and globally remained relatively well supplied over the winter.3 However, several key changes this year suggest the impact of these measures will intensify this time around, keeping producers constrained in their ability to ramp up production of the metal. For one, the data suggest strong production levels amid the anti-pollution curbs last winter were a result of an increase in output from regions unaffected by the capacity restrictions (Chart 2). This went a long way in muting the impact of the restrictions in the heavily industrialized Beijing-Tianjin-Hebei region of northern China. Chart of the WeekSteel Oblivious To Pessimism Chart 22017/18 Winter Cuts: A Net Non-Event This year's curbs will broaden the regions targeted by anti-pollution restrictions. The campaign will encompass 83 cities, up from last year's 28, thereby reducing the potential production ramp up from regions not covered by these measures (Chart 3). This coming winter's closures will cover regions where producers traditionally account for 68% of China's steel output (Chart 4). Chart 3Second Annual Winter Capacity ##br##Restrictions Will Broaden Coverage... Chart 4...And##br## Impact The anti-pollution campaign is one of the three battles prioritized in Xi Jinping's plan for the coming years. These curbs will be implemented during the October 1, 2018 to March 31, 2019 heating season, extending the duration from last year's mid-November to Mid-March period. Because the minimal effect observed per last year's closures was due to specifying too narrow a range of plants and regions, not to non-compliance, we expect the measures announced for this coming winter to be fully implemented. These measures come amid already-tight market conditions. The steel rebar market in China is in backwardation - meaning a physical shortage is pushing up prompt prices relative to those further out the curve. Inventories have been falling since mid-March, reflecting supply-demand dynamics in other steel product markets. Thus, we expect prices to remain elevated going into the winter months. Capacity Impacts Are Difficult To Gauge Opaqueness and discretionary authority in the new rules clouds the outlook on how anti-pollution reforms will impact the steel market. This makes it difficult to estimate their impact with precision. This time around, China's State Council announced that curbs will be implemented in a more scientific and targeted approach, ensuring maximum efficiency to attain the targets. This means the constraints this year will depend on emissions in each region, which will be set at the discretion of local authorities.4 For example, steel mills in six key cities including Tianjin, Shijiazhuang, Tangshan, Handan, Xingtai and Anyang will be asked to keep capacity below 50% this winter, while producers in the rest of the Beijing-Tianjin-Hebei region will keep production running at less than 70% of capacity. Furthermore, a draft plan by the city of Changzhou - which planned to implement the curbs beginning August 3 - suggests production curbs may vary by company, depending on operational situations and emission levels.5 These restrictions are applied to capacity, rather than production. Without up-to-date and accurate information on crude steel-making capacity across the different regions, it is extremely difficult to accurately quantify the impact. Specifics of the plans are up to the discretion of local authorities. Thus, these restrictions can be applied to different stages in the steel-making process (Diagram 1), impacting furnaces, pig iron or sintering plants. In some cases, the output curbs are not only restricted to the winter heating months. Several regions have been implementing curbs throughout the year on an as-needed basis. The cities of Tangshan and Changzhou are two such examples, implementing restrictions during the summer months as well. Furthermore, all industrial plants in the city of Xuzhou remain shut. High profit margins at steel mills may incentivize the shuttered illegal furnaces to restart. The industry ministry acknowledges this threat, and claims it will carry out checks on these producers to ensure they do not come back online. Diagram 1Steelmaking Production Process: Restrictions Can Be Applied To Different Stages Without full knowledge of these details, quantifying the impact of these restrictions is a challenge. Morgan Stanley estimates the impact of these curbs on steel output to be 78mm MT during the winter period by assuming capacity utilization is restricted to 50% in the key cities, while the rest of the areas cut capacity by 30%. The estimated production loss from these restrictions accounts for 9% of China's 2017 crude steel output.6 China's Ongoing Capacity-Reduction Reforms Most of the planned permanent capacity shutdowns have already taken place. Of the targeted 150mm MT of cuts between 2016 and 2020, 115mm MT have already taken place over the past two years. Furthermore, 1H17 witnessed the closure of all illegal induction furnaces producing sub-par quality steel, estimated to account for 140mm MT of crude steel capacity (Table 1).7 Table 1De-Capacity Reforms Still Ongoing We expect the magnitude of cutbacks to slow considerably. Even though the industry ministry issued a statement in February that it plans to meet steel capacity reduction targets this year - two years ahead of schedule. Furthermore, mills face restrictions on new steel capacity. China's State Council announced it intends to prevent new steel capacity additions in the Beijing-Tianjin-Hebei, Guangdong province, and Yangtze River Delta regions, and a cap set at 200mm MT in Hebei by 2020. The capacity replacement plan, which allows a maximum of 0.8 MT of new capacity for each MT of eliminated capacity, will ensure capacity does not grow going forward. In fact, not all mills are eligible to take advantage of the replacement policy. Among others, now-shuttered induction furnace capacity, as well as producers that previously benefited from cash and policy support will not meet the requirements for this program. Steel And Iron Ore Prices Will Not Reconverge As a result of China's reform policies in the steel industry, iron ore prices have diverged from steel. Reduced steel production lowers demand for raw materials, including iron ore. This is reflected in falling Chinese iron ore imports amid contracting production (Chart 5). Chart 5Weak Demand For Iron Ore Chart 6EAF Penetration In China: Still Some Catching Up To Do China's reform and anti-pollution campaigns have had serious consequences on iron ore markets. For starters, China is encouraging the adoption of electric arc furnaces (EAF), rather than additional new blast furnaces.8 While the latter primarily uses iron ore, the former uses scrap steel. EAF penetration in China's steel industry significantly lags the rest of the world (Chart 6). This means that even if the capacity-replacement program allows eliminated furnaces to be replaced with newer, more up-to-date capacity, this will not spur demand for iron ore. Instead, we expect to see higher scrap steel prices (Chart 7). Furthermore, as we first highlighted in our January report, China's anti-pollution campaign coupled with high steel profit margins has incentivized the use of higher grade iron ore and iron ore pellets, widening the price spread between high- and low- grade ores (Chart 8).9 Chart 7EAFs Support Scrap Steel Demand Chart 8IO Grade Premiums Will Remain Elevated While high-grade ores are more expensive, they emit less pollution in the steelmaking process. Similarly, unlike fines, pellets which are direct charge feedstock, are not required to undergo the highly polluting sintering stage and can be fed directly into the furnace. China's Steel Dynamics Overshadow Global Markets The ongoing supply-side reforms in China are overshadowing events in other markets. Globally, steel is expected to remain in physical deficit this year (Chart 9). This is largely on the back of an increase in world ex-China demand, and the decline in Chinese supply, despite expectations of weaker Chinese demand, and increased supply from the rest of the world (Table 2). Chart 9Physical Steel Deficit Will Persist... Table 2...Despite Weaker Chinese Demand And Stronger RoW Supply These figures do not consider the impact of the ongoing Sino - U.S. trade dispute, which could evolve into a full-blown trade war, weighing on EM incomes and demand. In such a scenario, global demand for steel would take a hit, potentially shifting global markets into surplus. In theory, trade barriers on U.S. steel imports could lead to weaker domestic supply for American users and at the same time, leave more of the metal for use by the rest of the world. The net effect of that would be a higher price for American steel relative to the rest of the world. However, since May, 20,000 requests for steel tariff exemptions have been filed in the U.S., of which the Commerce Department has denied 639. To the extent that American steel users are able to obtain tariff exemptions, the impact of the barriers on global steel markets will be muted. Bottom Line: We expect China's steel market to tighten as we go into the winter season, during which capacity cuts will be broadened to 82 cities, from last year's 28. This will keep steel prices elevated. At the same time, we expect prices of 62% Fe material and lower iron ore grades to weaken, as appetite for the steelmaking raw material contracts during these months. Mills still running in the mid-November to mid-March period will have a preference for higher-grade ores and pellets, keeping premiums on these grades elevated. Barring a significant demand-side shock, expect more upside to steel prices and downside to iron ore prices over the coming 9 months. Based on our research, we are recommending a long China rebar futures on the SHFE in 1Q19 vs. short 62% Fe iron ore futures on the Dalian DCE in 1Q19 at tonight's close. Roukaya Ibrahim, Editor/Strategist Commodity & Energy Strategy RoukayaI@bcaresearch.com 1 Please see "BHP asks for government mediation in talks at Chile's Escondida," published August 6, 2018, by uk.reuters.com. 2 Please see "Economic Watch: China can cut soybean imports in 2018 by over 10 mln tonnes," published August 5, 2018, by xinhuanet.com. 3 Please see Commodity & Energy Strategy Weekly Report titled "Chinese Steel, Aluminum Markets Well Supplied Despite Winter Capacity Cuts," dated April 12, 2018, available at ces.bcaresearch.com. 4 Please see "Chinese steel output cuts to vary from mill to mill next winter," dated July 21, 2018, available at reuters.com. 5 The restrictions will not only apply to the city's steel mills, but also to copper smelters, chemical makers as well as cement producers. Please see "China's Changzhou plans to enforce output curbs in steel, chemical plants," dated July 30, 2018, available at reuters.com. 6 Please see "Shanghai steel resumes rise, coke rallies as China eyes winter curbs," dated August 2, 2018, available at reuters.com. 7 Low-quality steel produced by induction furnaces, also referred to as ditiaogang, is made by melting scrap steel using induction heat, preventing sufficient control over the quality of the steel. Platts estimates ditiaogang production in 2016 to be 30-50mm MT. As we explain in our September 7, 2017 Weekly Report titled "Slow-Down In China's Reflation Will Temper Steel, Iron Ore In 2018," given that ditiaogang is illegal, these closures are not reflected in official steel production figures. Thus the closures of these mills have no impact on actual steel production, but instead raise the capacity utilization rates for Chinese steel producers. 8 China launched a carbon trading system in January 2018, which penalizes blast furnace operators with higher environmental taxes relative to EAF processes. 9 Please see Commodity & Energy Strategy Weekly Report titled "China's Environmental Reforms Drive Steel & Iron Ore," dated January 11, 2018, available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017

Highlights China is turning moderately reflationary, but Xi's reform agenda will remain a drag on the economy, as China will not entirely abandon the "Reform Reboot" that began last October. Fiscal spending, rather than a sharp acceleration in credit growth, will dominate China's reflationary efforts, and even a strong fiscal response would involve more "soft infrastructure" than in the past. Consequently, expectations that Chinese reflation will dramatically reverse both the looming export shock as well as the underlying slowdown in China's old economy are not likely to be met. The goal of policymakers is merely to prevent a substantial, uncontrolled downturn in domestic demand. Convincing signs that China is likely to end up overstimulating in a way that results in a net positive for the global economy would cause us to advocate a more pro-cyclical investment stance. There is a small chance this may occur, but it is far from our base case view. For now, stay neutrally positioned towards Chinese stocks within a global equity portfolio, and favor low-beta sectors within the Chinese investable universe. Feature Today's Weekly Report is abridged, as we are sending you part 1 of a 2-part report written by my colleague Matt Gertken, Associate Vice President of BCA's Geopolitical Strategy (GPS) service. Last year our geopolitical team made the case that China's General Secretary Xi Jinping would double down on his reform agenda in 2018, specifically the bid to control financial risk. This view has played out quite well, and today's report presents an assessment of the likely impact of China's recent stimulus announcements along with the implications for investors. Matt's report concludes that China is turning moderately reflationary: a substantial boost to fiscal thrust, and possibly a smaller boost to credit growth, is in the works. Yet Xi's reform agenda will remain a drag on the economy, as China will not entirely abandon the "Reform Reboot" that began last October. This will be discussed next week in the second-part of the two-part series. Today's GPS report is quite timely, as the intensity of China's reflationary efforts is at the forefront of investor attention. BCA's China Investment Strategy (CIS) argued in our July 26 Weekly Report that China is taking its foot off of the brake rather than pressing the accelerator,1 meaning that so far the stimulus announced has fallen short of a substantially reflationary response that would dramatically reverse both the looming export shock as well as the underlying slowdown in China's old economy. Chart 1 shows that market signals are so far consistent with this view, at least in terms of fiscal and/or infrastructure spending. The chart shows how domestic infrastructure stocks are outperforming the broad domestic market (in response to news two weeks ago of stepped up infrastructure spending), but that their performance remains anemic relative to global stocks. Presumably, "big bang" fiscal spending in China would cause the earnings outlook for domestic infrastructure stocks to brighten considerably relative to the global average. Matt notes in today's joint report that even a strong fiscal response would involve more "soft infrastructure" than in the past, and for now investors do not seem to be betting on an intense, "hard infrastructure" boom. Chart 1The Performance Of Infrastructure Stocks Does Not Herald "Big Bang" Stimulus Chart 2At First Blush, This Implies Maximum Reflationary Efforts However, one development that is not consistent with CIS' "foot off the brake" view is the extraordinary decline in interbank interest rates that has occurred over the past month. Chart 2 shows that the 3-month interbank repo rate (China's "de-facto" policy rate) has collapsed even further than it had when we published our July 26 report which, at first blush, suggests that the PBOC has turned the policy dial to maximum reflation. Chart 3 presents a stylized view of the possible PBOC reactions to the imposition of U.S. tariff imposition against China. In scenario 1, the PBOC eases policy in a way that is proportional to the tariff-induced deterioration in the growth outlook, which would stabilize the economy but not result in an acceleration in growth from conditions in place prior to the impact of tariffs on exports. In scenario 2, the PBOC stimulates disproportionately, giving investors license to expect that monetary easing will result in a growth outcome that is net positive. Chart 3A Proportional Monetary Response To A Deceleration In Growth Isn't A Net Positive For The World As Matt notes in his report, the decline in interbank interest rates may not feed through into significantly stronger credit growth if banks are afraid to lend, which could occur as long as the Xi administration remains even partially committed to its crackdown on the financial sector. The decline in the repo rate may not reflect the PBOC's intention to forcefully stimulate credit growth via lower borrowing rates, but rather is a necessary consequence of substantially increasing liquidity in the banking system to avoid any financial system instability stemming from a major shock to exports. We agree that the collapse in the 3-month repo rate is more consistent with scenario 2 than scenario 1, although there are two important counterpoints to consider: Chart 4Possibly Due To Rising NIMs, Rather Than A Significant Acceleration In Credit Growth On the second point, the crackdown on shadow banking over the past 18 months has substantially (negatively) impacted small Chinese banks, and it is conceivable that the PBOC has acted to prevent a liquidity problem from become an outright solvency problem for some financial institutions. If true, this suggests that the extent of the decline in the repo rate may be temporary, or that policymakers will employ other tools to limit the feedthrough from lower interbank borrowing costs to lending rates in the real economy in order to limit the resulting pickup in credit growth. The latter option would, in effect, purposely engineer an expansion in bank net interest margins, a scenario that could explain the recent uptick in domestic bank relative performance without resorting to a forecast of surging credit growth (Chart 4). What does this all mean for investors? Were we to see convincing signs that China is likely to end up overstimulating in a way that results in a net positive for the global economy, we would recommend a more pro-cyclical investment stance. This could likely include the constituent assets of the China Play Index presented by my colleague Mathieu Savary, Vice President of BCA's Foreign Exchange Strategy service in his last Weekly Report,2 and we plan on employing the index as a gauge of investors' stimulus expectations. But for now, we are comfortable with our existing recommendations: investors should remain neutrally positioned towards Chinese stocks within a global equity portfolio, and should favor low-beta sectors within the Chinese investable universe. We will be monitoring the upcoming export shock as well as further policymaker responses continually over the coming weeks and months, and invite investors to come along for the ride. Stay tuned! Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Please see BCA Research's China Investment Strategy Special Report "China Is Easing Up On The Brake, Not Pressing The Accelerator," published July 26, 2018. Available at cis.bcaresearch.com. 2 Please see BCA Research's Foreign Exchange Strategy Weekly Report "The Dollar And Risk Assets Are Beholden To China's Stimulus," published August 3, 2018. Available at fes.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations