Emerging Markets

Highlights Global Inflation has upside on a cyclical basis, but this narrative is well known and investors have already placed their bets accordingly, buying inflation protection in a wide swath of markets. However, global growth has not yet found its footing, suggesting a mini-deflation scare, at least relative to expectations, is likely this summer. The U.S. dollar will benefit in such a scenario, and NOK/SEK will depreciate. While GBP/USD has downside, the pound should rally versus the euro. Weakness in EUR/CAD has not yet fully played out; the recent bout of strength was only a countertrend move. Feature Inflation is coming back, and this will obviously have major consequences for both asset and currency markets. However, macro investing is not just about forecasting fundamentals correctly; often, just as importantly, it is about understanding how other investors have priced in these expected economic developments. Therein lies the problem. While we understand why inflation could pick up, so too have most investors, and they have positioned themselves accordingly. With global growth currently looking shaky, we believe a better entry point for long-inflation plays will emerge in the coming months. In the meanwhile, a defensive, pro-U.S. dollar posture still makes sense. Investors Are Long Inflation Bets We have long argued that inflation was likely to make a cyclical comeback, a return that would begin in the U.S. before spreading to the rest of the globe. This story is currently playing out. However, in response these developments, investors have placed their bets accordingly, and the story currently seems well baked in. Prices of assets traditionally levered to inflation have already moved to discount a significant pick-up in inflation. The most evident dynamics can be observed in the U.S. inflation breakevens. Both the 10-year breakevens as well as the 5-year/5-year forward breakevens just experienced some of their sharpest two-year changes of the past 20 years, notwithstanding the pricing out of a post-Lehman, depression-like outcome (Chart I-1). Breakevens are not alone. Other assets have displayed similar behavior. In the U.S., investors have aggressively sold their holdings of utilities stocks, which have been greatly outperformed by industrial stocks. Traditionally, investors lift the price of XLI relative to that of XLU when they anticipate global inflation to pick up (Chart I-2). Chart I-1Markets Are Positioning Themselves##br## For Higher Inflation Chart I-2U.S. Sectoral Performance Suggests Investors ##br##Have Already Bet On Higher Inflation... It is not just intra-equity market dynamics that support this assertion. The behavior of the U.S. stock market relative to Treasurys further buttresses the idea that investors have already aggressively discounted an upturn in global consumer prices (Chart I-3). Potentially, the best illustration of investors' preference for inflation protection is currently visible in EM assets. A seemingly paradoxical phenomenon has been puzzling us: How have EM equities managed to avoid the gravitational pull that has caused EM bonds to nearly flirt with the nadir of early 2016? After all, EM equities, EM currencies and EM bonds are normally closely correlated, driven by investors' wagers on the direction of global growth. A simple variable can explain this strange dichotomy: anticipated inflation. As Chart I-4 illustrates, the performance of a volatility adjusted long EM stocks / short EM bonds portfolio tends to anticipate fluctuations in global inflation. The current price action in this basket indicates that investors have made their bets, and they think inflation is going up. Chart I-3...So Does The Stock-To-Bond Ratio Chart I-4Inflation Bets Explain Why EM Stocks And EM Bond Prices Have Diverged Anecdotal evidence suggests that in recent quarters, pension plans have been aggressive buyers of commodities - a move that normally coincides with these long-term investors putting in place some inflation hedges. Moreover, positioning in the futures markets corroborates these stories: speculators are still very long commodities like copper and oil - commodities traditionally perceived as efficient protectors against inflation spikes (Chart I-5). Finally, despite the potentially deflationary risks created by Italy three weeks ago, speculators remain short U.S. Treasury futures, bond investors are underweight duration, and sentiment toward the bond market remains near its lowest levels of the past eight years (Chart I-6). Again, this behavior is consistent with investors being positioned for an inflationary environment. Chart I-5Money Has Flown Into Resources Chart I-6Bond Market Positioning Is Still Very Short Bottom Line: There is a well-defined case to be made that a global economy that was not so long ago defined by the presence of deflationary risks is now morphing into a world where inflation is on the upswing. However, based on inflation breakevens, sectoral relative performance, equities relative to bonds in both DM and EM as well as on the positioning of investors in commodity and bond markets, this changing state has been quickly discounted by investors. The Decks Are Stacked, But Where Does The Economic Risk Lie? The problem facing investors already long inflation protection every which way they can be is that the global economy is slowing, which normally elicits deflationary fears, not inflationary ones. This seems a recipe for disappointment, albeit one that is likely to help the dollar. Our global economic and financial A/D line, which tallies the proportion of key variables around the world moving in a growth-friendly fashion, has fallen precipitously. This normally heralds a slowdown in global economic activity (Chart I-7). Chart I-7Global Growth Is Losing Traction In similar vein, global leading economic indicators have also begun to roll over - a trend that could gain further vigor if the diffusion index of OECD economies experiencing rising versus contracting LEIs is to be believed (Chart I-8). The global liquidity picture has also deteriorated enough to warrant caution. Currency carry strategies - as approximated by the performance of EM carry trades funded in yen - have sagged violently. This tells us that funds are flowing out of EM economies and moving back to countries already replete with excess savings like Japan or Switzerland (Chart I-9). Historically, these kinds of negative developments for global liquidity have preceded industrial slowdowns, as EM now accounts for the lion's share of global IP growth. Finally, China doesn't yet look set to bail out the world's industrial sector. This month's money and credit numbers were weaker than anticipated, and our leading indicator for the Li-Keqiang index - our preferred gauge of industrial activity in the Middle Kingdom - points to further weakness (Chart I-10). This makes it unlikely that China's imports will rise, lifting global growth. Additionally, China has re-stocked in various commodities, suggesting it is front-running its own domestic demand, highlighting the risk that its commodities intake could become even weaker than what domestic growth implies. Chart I-8More Weakness In LEIs Chart I-9Global Liquidity Tightening Chart I-10China Not Yet Set To Bail Out The World With this kind of backdrop, we expect the current slowdown in global growth to run further before ebbing, probably in response to what will be a policy move out some kind from China to put a floor under growth. As a result, the current infatuation with inflation hedges among investors may wane for a bit as slower growth could shock inflation expectations downward, especially in a global context that has been defined by excess capacity since the late 1990s. An environment where global inflation expectations could be downgraded in response to slower growth is likely to be an environment where the dollar performs well, particularly as U.S. growth continues to outperform global growth (Chart I-11). This also confirms our analysis from two weeks ago that showed that when bonds rally the dollar tends to outperform most currencies, with the exception of the yen.1 Moreover, with the Federal Open Market Committee upgrading its path for interest rates by one additional hike in 2018, this reinforces the message from our previous work noting that once the fed funds rate moves in the vicinity of r-star, the dollar performs well, nearly eradicating the losses it incurred when the fed funds rate rises but is well below the neutral rate (Table I-1). This is especially true if vulnerability to higher rates rests outside - not inside - the U.S., as is currently the case.2 Chart I-11The Dollar Likes Lower Global Inflation Table I-1Fed And The Dollar: Where We Stand Matters As Much As The Direction Beyond the dollar, one particular currency cross has historically been a good correlate to investors betting on higher inflation: NOK/SEK. As Chart I-12 illustrates, when investors buy inflation hedges such as going long EM equities relative to EM bonds, this generates a rally in NOK/SEK. These dynamics played in our favor when we were long this cross earlier this year. However, not only are EM equities extended relative to EM bonds, the current economic environment portends a growing risk of investors curtailing these kinds of bets. The implication is bearish for NOK/SEK, and we recommend investors sell this cross at current levels. Chart I-12NOK/SEK Suffers If Inflation Bets Are Unwound Bottom Line: Investors have quickly and aggressively positioned themselves to protect their portfolios against upside inflation risks. However, the global economy is still slowing - a development that has further to run. As a result, this current anticipation of inflation could easily morph into a temporary fear of deflation, at least relative to lofty expectations. This would undo the dynamics previously seen in the market. This is historically an environment in which the dollar performs well, suggesting the greenback rally is not over. Moreover, NOK/SEK could suffer in this environment. The Bad News Is Baked Into The Pound There is no denying that the data flow out of the U.K. has been poor of late. In fact, despite what was already a low bar for expectations, the U.K. economy has managed to generate large negative surprises (Chart I-13). One of the direct drivers of this poor performance has been the complete meltdown in the British credit impulse (Chart I-14). Additionally, the slowdown in British manufacturing can be easily understood in the context of slowing global growth (Chart I-15). Chart I-13Anarchy In The U.K. Chart I-14The Credit Impulse Has Bitten Chart I-15U.K. Exports Are Slowing Because Of Global Growth But, the bad new seems well priced into the pound, especially when compared to the euro. Not only is the GBP trading at a discount to the EUR on our fundamental and Intermediate-term timing models, speculators have accumulated near-record short bets on the pound versus the euro (Chart I-16). This begs the question: Could any positive factor come in and surprise investors, resulting in a fall in EUR/GBP? We think the answer to this question is yes. First, despite the negatives already priced in, incremental bad news have had little traction in dragging the pound lower versus the euro in recent weeks, suggesting that EUR/GBP buying has become exhausted. Second, a falling EUR/USD tends to weigh on EUR/GBP, as the pound tends to act as a low-beta version of the euro (Chart I-17). Chart I-16Investors Are Well Aware Of Britain's Problems Chart I-17EUR/GBP Sags When EUR/USD Weakens Third, the economic outlook for the U.K. is improving. It is true that in the context of slowing global growth, the manufacturing and export sectors are unlikely to be a source of positive surprises for Great Britain. However, the domestic economy could well be. As Chart I-14 highlights, the credit impulse has collapsed, but the good news is that outside of the Great Financial Crisis it has never fallen much below current levels, suggesting that a reversion to the mean may be in offing. Additionally, U.K. inflation is peaking, which is lifting British real wages (Chart I-18). In response, depressed consumer confidence is picking up. This is crucial as consumer spending, which represents roughly 70% of the U.K.'s GDP, has been the key drag on growth since 2016. Any improvement on this front will lift the whole British economy, even if the manufacturing sector remains soft. Fourth, Brexit is progressing. This week's vote in the House of Commons was confusing, but it is important to note than an amendment that gives Westminster the right to force a renegotiation between the U.K. and the EU if no deal is reached in 2019 has been passed. This also decreases the risk of a completely economically catastrophic Brexit down the road, but increases the risk that PM Theresa May could be ousted over the next 12 months. Our positive view on the pound versus the euro (or negative EUR/GBP bias) is not mimicked in cable itself. Ultimately, despite the GBP/USD's beta to EUR/GBP being below one, it is nonetheless greater than zero. As such, it is unlikely that GBP/USD will be able to rally if the DXY rallies and the EUR/USD weakens (Chart I-19). Therefore, while we recommend selling EUR/GBP, we are not willing buyers of GBP/USD. Chart I-18A Crucial Support To Growth Chart I-19Cable Will Not Avoid The Downward Pull Of A Strong Dollar Bottom Line: The British economy has undergone a period of weakness, which is already reflected in the very negative positioning of investors in the GBP versus the EUR. However, the bad data points are losing their capacity to push EUR/GBP higher, and the British economy may begin to heal as consumer confidence is rebounding thanks to improving real wages. The low beta of GBP/USD to the euro also implies that a falling EUR/USD will weigh on EUR/GBP. However, while the pound has upside against the euro, it will continue to suffer against the dollar if EUR/USD experiences further downside. What To Do With EUR/CAD? One weeks ago, we were stopped out of our short EUR/CAD trade. Has EUR/CAD finished its fall, or was the recent rally a pause within a downward channel? We are inclined to think the latter. Heated rhetoric on trade has hit the CAD harder than the EUR, as exports to the U.S. represent a much larger share of Canada's GDP than of the euro area, forcing the pricing of a risk premium in the loonie. However, even after a rather explosive G7 meeting, we do believe that a compromise is still feasible and that NAFTA is not dead on arrival. A deal is still likely because, as Chart I-20 demonstrates, Canadian tariffs on U.S. imports are not only marginally in excess of U.S. tariffs on Canadian imports, they are also in line with international comparisons. This suggests only a small push is needed to arrive to a deal that salvages NAFTA, which ultimately is much more important to Canada than the dairy industry. Chart I-20Canada And The U.S. Can Find A Compromise Despite this reality, we cannot be too complacent, U.S. President Donald Trump is likely to be playing internal politics ahead of the upcoming mid-term elections. U.S. citizens are distrustful of free trade (Chart I-21), a trend especially pronounced among his base. However, a good result for the GOP in November is contingent on the Republican base showing up at the polls. Firing this base up with inflammatory trade rhetoric is a sure way to do so. This means that risks around NAFTA are still not nil. Chart I-21America Belongs To The Anti-Globalization Bloc However, EUR/CAD continues to trade at a substantial premium to fair-value on an intermediate-term horizon (Chart I-22). Moreover, as the last panel of the chart illustrates, speculators remain massively short the CAD against the EUR. This creates a cushion for the CAD versus the EUR if global growth slows. Moreover, technicals are still favorable of shorting EUR/CAD. Not only is EUR/CAD still overbought on a 52-week rate-of-change basis, it seems to be in the process of forming a five-wave downward pattern, with the fourth one - a countertrend wave - potentially ending (Chart I-23). Chart I-22EUR/CAD Is Still Vulnerable Chart I-23Wave Pattern Not Completed Finally, EUR/CAD tends to perform poorly when the USD strengthens, which fits with our current thematic for the remainder of 2018. Bottom Line: The headline risk surrounding NAFTA has weighed on the loonie against the euro, stopping us out of our short EUR/CAD trade with a small profit. However, the valuation, positioning and technical dynamics suggest the timing is ripe to short this cross once again. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, titled "Rome Is Burning: Is It The End?", dated June 1, 2018, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report, titled "This Time Is NOT Different", dated May 25, 2018, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 U.S. data was stellar: NFIB Business Optimism Index climbed to 107.8, outperforming expectations; the price changes and good times to expand components are also very strong; Headline and core PPI both outperformed expectations, auguring well for future consumer inflation; Headline and core retail sales grew by 0.8% and 0.9% in monthly terms, beating expectations; Both initial and continuing jobless claims also came out below expectations, highlighting that the labor market is still tightening, and wage growth could pick up further. The Fed raised interest rates this week to 2%, and added one additional rate hike to its guidance for 2018. FOMC members once again highlighted the "symmetric" target, suggesting that the Fed expects the economy to overheat slightly. An outperforming U.S. economy relative to the rest of the world is likely to propel the greenback this year. Report Links: This Time Is NOT Different - May 25, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Economic data was largely disappointing: Italian industrial output contracted by 1.2% on a monthly basis, and grew only by 1.9% on a yearly basis; The German ZEW Survey declined substantially across all metrics; European industrial production increased by 1.7% annually, less than the expected 2.8% increase; However, Spanish headline inflation spiked up from 1.1% to 2.1%. Yesterday, ECB President Mario Draghi announced the ECB's plan to taper asset purchases to EUR 15 bn a month in September, and phase them out completely by year-end. Moreover, Draghi highlighted that the ECB was not anticipating to implement its first hike until after the summer of 2019. Furthermore, the ECB President highlighted the current slowdown in global growth, as well as the rising protectionist risk from the U.S. potentially negatively impacting the European economy and the ECB's decisions going forward, suggesting that the plans are not set in stone. 2018 is likely to remain a volatile year for the euro. Report Links: Rome Is Burning: Is It The End? - June 1, 2018 This Time Is NOT Different - May 25, 2018 Updating Our Intermediate Timing Models - May 18, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Japanese data has been strong this week: Machine orders increased on a 9.6% annual basis, and a 10.1% monthly basis, in April, outperforming expectations by a large margin; The Domestic Corporate Goods Price Index also increased by 2.7% annually, higher than the expected 2.2% increase. As political and economic risks in Europe and South America having subsided for now, the yen has lost some of its glitter. However, with ongoing uncertainty on trade and populism across the globe, we maintain our tactically bullish stance on the yen, especially against commodity currencies and the euro. However, beyond the short-term horizon, the BoJ will remain determined to cap any excess appreciation in the yen, as a strong JPY tightens Japanese financial conditions, weighing on the BoJ's ability to hit its inflation target. This will ultimately limit the yen's upside on a cyclical basis. Report Links: Rome Is Burning: Is It The End? - June 1, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Data from the U.K. was somewhat disappointing: Manufacturing and industrial production both increased less than expected, at 1.4% and 1.8%, respectively; The goods trade deficit widened to GBP 14.03bn from GBP 12bn, and the overall trade deficit widened to GBP 5.28bn from GBP 3.22bn; Average earnings grew by 2.8%, less than the expected 2.9%; However, headline inflation came in at 2.4%, less than the expected 2.5%, while retail price inflation also underperformed expectations. This means that the uptrend in real wages continues. Given the limited movement in the pound, it seems that a lot of the bad news was already priced in by last month's depreciation. However, Theresa May's ongoing blunders in parliament represent a continued source of risk for the pound. While the GBP has downside against the EUR, it is unlikely to see much upside against the greenback. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Do Not Get Flat-Footed By Politics - March 30, 2018 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Australian data was weak: NAB Business Confidence and Conditions surveys both declined, also underperforming expectations; Australian employment grew by 12,000, less than expected. Moreover, full-time employment contracted. While the unemployment rate dropped as a result, this was largely due to a fall in the participation rate. RBA's Governor Lowe, in a speech on Wednesday, announced that any increase in interest rates "still looks some time away" as the slack in the labor market does not seem to be diminishing. Annual wage growth has been constant at 2.1% for the past three quarters, and did not pick up despite an improvement in full-time employment earlier this year. We remain bearish on the AUD. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Who Hikes Again? - February 9, 2018 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 The NZD is likely to face significant downside against the greenback along with the other commodity currencies as global growth slows down. However, due to its weaker linkages to Chinese industrial demand, the kiwi is likely to see less downside than the AUD. Nevertheless, it is likely to weaken against the CAD and the NOK as the NZD is expensive against these oil currencies, and oil's is likely to continue to outperform other commodities will support this view. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Who Hikes Again? - February 9, 2018 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 USD/CAD has been on an uptrend given the greenback generally strong performance since February year, a force magnified by the volatile rhetoric surrounding NAFTA negotiations. However, the Canadian economy has been accelerating this year, thanks to robust growth in the U.S., to a strong Quebecer economy, and to a pickup in Alberta. In addition, the Canadian labor market is tightening further and wage growth is above 3%. Furthermore, risks surrounding NAFTA seem already reflected in the CAD's behavior and valuation. There is more clarity on the CAD versus its crosses than on the CAD versus the USD. Outperforming U.S. and Canadian growth relative to the rest of the world mean that the CAD should outperform most other G10 currencies. Report Links: Rome Is Burning: Is It The End? - June 1, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data out of Switzerland was decent: Industrial production increased by 9% in annual terms, albeit less than the previous 19.6% growth; Producer and import prices increased by 3.2% year on year, in line with expectations, however the monthly increase underperformed markets anticipations. With global trade tensions rising, and Germany having entered President Trump's line of sight, the CHF could experience additional upside against the euro in the coming months. However, the SNB is unlikely to deviate from its ultra-accommodative stance, which means that any downside in EUR/CHF will proved to be short lived. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 The SNB Doesn't Want Switzerland To Become Japan - March 23, 2018 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Both headline and core inflation underperformed, coming in at 2.3% and 1.2%, respectively. However, the Regional Network Survey hinted at a pickup in capacity utilization as expectations for industrial output remained robust, as well as at an additional strength in employment. This led to a forecast of a resurgence in inflationary pressures. We expect the NOK to outperform the EUR. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Who Hikes Again? - February 9, 2018 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Swedish inflation rose from 1.7% to 1.9%, coming in line with expectations. Additionally, Prospera 1-year inflation expectations survey rose to 1.9% from 1.8% in the March survey. This is likely to provide the Riksbank with reasons to turn gradually more hawkish, which should support the very cheap krona. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Who Hikes Again? - February 9, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Major and drawn-out financial market downturns usually occur in phases and often resemble a domino effect. There have been a number of noteworthy divergences in the EM space of late. They are probably part of a domino effect - some tiles have begun to drop, but other tiles down the chain still remain standing. The selloff in EM risk assets will broaden and intensify. A defensive positioning is warranted. India's relative equity performance has by and large been undermined by rising oil prices. A potential roll-over in crude prices will aid the Indian bourse's relative performance versus its EM peers. The South African rand remains on shaky foundation; stay short. Feature There have been a number of noteworthy divergences in financial markets of late, in particular between emerging markets (EM) and commodities, as well as between Chinese investable stocks trading outside the mainland and equity prices listed domestically. In our view, these divergences are part of a domino effect - some tiles have begun to drop, but other tiles down the chain still remain standing. In dominos, tiles do not all fall simultaneously. They fall one by one, and there is a time lag between the first domino and the last-standing domino to drop. Also, unlike in natural sciences, time lags and speed in economics and finance vary with each experiment - because they are contingent on complex human psychology and behavior, not on well defined natural phenomena such as gravity or motions of objects. Hence, they are impossible to forecast with much precision. A Message From Our Risky Versus Safe-Haven Currency Ratio Although U.S. share prices have lately been firm, EM stocks have broken below their 200-day moving average (Chart I-1, top panel). So has our risky versus safe-haven currencies ratio 1 (Chart I-1, bottom panel). Indeed, while having held up at its 200-day moving average several times in the past two years, the ratio has recently decisively broken below this technical support line. This indicator correlates extremely well with EM share prices, and its message is presently unambiguous: The rally in EM is over, and a bear market has likely commenced. Crucially, this ratio measures commodities currencies versus the average of the Japanese yen and Swiss franc - two defensive currencies - not against the U.S. dollar. Hence, it is not impacted by the greenback's trend. Given that all six risky currencies used in the numerator of this ratio - AUD, CAD, NZD, BRL, ZAR and CLP - are commodity currencies, it is not surprising that the ratio also correlates with commodities prices. In this context, it currently suggests the outlook for both industrial metals and oil is troublesome (Chart I-2). Chart I-1Beware Of These Breakdowns Chart I-2A Red Flag For Commodities Prices The common denominator that links all these financial variables is global growth. The risky versus safe-haven currencies ratio typically leads world trade cycles by several months, and it currently points to a notable slowdown in global export volumes (Chart I-3). Chart I-3Global Export Growth Is Set To Slow Further, commodities prices have exhibited a rare decoupling from the U.S. dollar. It is very unlikely that this divergence can be sustained for much longer. Our bias is that global trade will slow as China/EM demand weakens despite robust U.S. growth. Growth dynamics shifting in favor of the U.S. entails that the greenback will continue to appreciate. Consistently, EM/China growth disappointments and U.S. dollar's persisting strength suggest that commodities will reverse their current trend sooner rather than later. A relapse in commodities prices will reinforce EM currency depreciation, triggering more outflows from EM equities and fixed-income markets. Decoupling Or A Time Lag? Chart I-4Domino Effect In 2007-08 Major and drawn-out financial market downturns usually occur in phases and often resemble a domino effect. The EM crises in 1997-98 did not occur simultaneously across all EM countries. It began in July 1997 with Thailand, then it spread to Korea, Malaysia and Indonesia and finally, to the rest of Asia. In August 1998, Russian financial markets collapsed triggering the LTCM debacle. The last leg of this crisis appeared in Brazil and culminated in the real's devaluation in January 1999. Similarly, the U.S. financial/credit crisis commenced with the selloff in sub-prime securities in March 2007. Following that, corporate spreads began widening and bank share prices rolled over in June 2007. In the meantime, the S&P 500 and EM stocks peaked on October 9 and 29, 2007, respectively. Despite all of these developments, commodities prices and EM currencies continued rallying until summer of 2008 and then quickly collapsed in the second half of that year (Chart I-4). Finally the Lehman crash took place on September 29 of 2008. That marked the apogee of the crisis, causing a complete unravelling of financial markets and the global economy, and lasting until March of 2009. It seems some sort of domino effect is now taking hold of the EM universe. Initially, it started with Turkey and Argentina. Then, it spread to Indonesia, India and Brazil. The currency weakness across the wider EM universe has already led to EM credit spread widening. Yet, there are a few EM financial markets, particularly Chinese, Korean and Taiwanese, that are still holding up relatively well. Moreover, U.S. share prices and high-yield credit spreads have done quite well too. How should investors interpret these divergences? Our view has been, and remains, that EM risk assets will do poorly regardless of the direction of the S&P 500. In fact, an escalation in EM turmoil and a slowdown in developing economies are among the main risks to American share prices themselves. The primary link from EM financial markets to the S&P 500 is via the exchange rate - a strong dollar along with an EM/China growth slump will weigh on American multinationals' profits. The following three questions are presently vital for investors: 1. Can EM and U.S. risk assets de-couple from each other, and has a sustainable divergence happened in the past? Although short-term moves in U.S. and EM equity indexes often appear correlated, from a big-picture perspective there have been considerable divergences. The overall EM stock index is now at the same level it was in 2007 (Chart I-5). Meanwhile, the S&P 500 index is a hair below its all-time high. Chart I-5EM Share Prices And The S&P 500: A Long-Term Perspective The same is true for many EM currencies and the S&P 500. A substantial decoupling did occur in the not-so-distant past: EM currencies depreciated from 2011 to early 2016, while U.S. share prices rallied strongly from late 2011 until 2015 (Chart I-6). With respect to U.S. credit spreads, Chart I-7 illustrates that EM and U.S. credit spreads have had a much higher correlation than their respective equity indexes. During the 1997-'98 EM crises and the 2014 -'15 EM turmoil, U.S. high-yield corporate spreads widened. In brief, there has historically been little decoupling between U.S. and EM credit markets. Hence, the U.S. high-yield credit market's latest resilience in the face of widening in EM credit spreads is historically exceptional. Chart I-6EM Currencies And The S&P 500 Chart I-7EM Sovereign And U.S. Corporate Credit Spreads: A Long-Term Perspective As EM currencies continue to depreciate versus the U.S. dollar, EM sovereign and corporate credit spreads will widen. Given their past high correlation with U.S. credit markets, odds point to widening corporate credit spreads in the U.S. On the whole, if EM risk assets continue to sell off, which is our baseline scenario, the S&P 500 and U.S. credit markets could defy gravity for a while, but not forever. At some point, risks stemming from EM turbulence will cause a selloff in American stocks and corporate bonds. It is impossible to know when and by how much U.S. stocks will suffer. Our bias is that a U.S. equity selloff will likely be on par with the 2015-'16 episode. 2. Can North Asian equity markets such as China, Korea and Taiwan remain relatively resilient if the turbulence in other EM countries continues? Based on history, they can, but only for a short period of time. There have been a few episodes when emerging Asian and Latin American stocks de-coupled: In 1997-'98, the home-grown Asian crisis devastated regional markets, but Latin American stocks continued to rally until mid-1998 - at which point they began plummeting (Chart I-8, top panel). In 2007-'08, emerging Asian equities started tumbling along with the S&P 500 in late 2007, but Latin American bourses fared well until the middle of 2008 due to surging commodities prices (Chart I-8, middle panel). Finally, the bottom panel of Chart I-8 illustrates that in early 2015, Asian stocks performed well, supported by the inflating Chinese equity bubble. Meanwhile, Latin American stocks plunged. In all of these episodes, the de-coupling between Asia and Latin America proved to be unsustainable, and the markets that showed initial resilience eventually re-coupled to the downside. Regarding Asia's business cycle conditions, the slowdown is already taking place and will likely intensify. 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 I-9). Chart I-8Asian And Latin American Equities: ##br##Unsustainable Divergences Chart I-9Asia's Export Slowdown Is In Making 3. Is there any other notable financial market decoupling that investors should be aware of? Chart I-10China: A Decoupling In Various Equity Segments Since early this year, there has been substantial decoupling between Chinese investable stocks and the onshore A-share market. First, the overall A-share index has dropped since early this year, but the MSCI Investable Chinese stock index has so far been resilient (Chart I-10). Second, while it might be tempting to explain this decoupling by discrepancies in the sectors' weights in these indexes, this has not been the case this time around. The fact remains that there has been considerable divergence between share prices of the same sectors. For example, onshore and offshore equity prices have diverged for the following sectors: real estate stocks, materials, industrials, technology, utilities and consumer discretionary (Chart I-11A and Chart I-11B). Only defensive sectors such as consumer staples and health care have done well in both universes. Share prices of financials and telecoms have dropped in both the onshore and offshore markets. Chart I-11AChinese Equity Sectors: Puzzling Decoupling Chart I-11BChinese Equity Sectors: Puzzling Decoupling Finally, a similar performance gap has appeared between Chinese small cap stocks trading onshore and in Hong Kong (Chart I-12). Chart I-12China's Small-Cap Stocks: A Perplexing Gap How do we explain these divergences? Our bias is that local investors in China are much more concerned about the mainland growth outlook than foreign investors. This is the opposite of what occurred in 2015. Back then, international investors were somewhat cautious on China - commodities prices and other China-related global financial market plays were in a bear market. Meanwhile, local investors were caught up in a full-fledged equity mania that ended with a crash. Given our downbeat outlook on China's capital spending and related plays in financial markets, we reckon that domestic investors in China will be proven right in the months ahead, while the international investment community will be left flat-footed. Importantly, there has been an unexplainable mismatch between monetary/credit tightening in China and complacency among international investors about the outlook for the mainland economy. Specifically, the cost of borrowing has gone up, and credit standards have tightened. Chart I-13 illustrates that both onshore and offshore corporate bond yields have risen to new cycle highs, Chinese banks' lending rates are rising, while banks' loan approvals are dropping. Consistently, money and credit growth have plunged. Importantly, this is occurring in an economy with immense credit excesses. Nevertheless, commodities prices have so far defied such a pronounced deceleration in money and credit aggregates in China (Chart I-14). Chart I-13China: Ongoing Credit Tightening Chart I-14China's Money/Credit And Commodities Prices All in all, we interpret these divergences by varying lead and lags rather than as a fundamental breakdown in the relationship between money/credit and the real economy. We continue to expect tightening liquidity and credit to escalate the growth slowdown in China. As a result, there continues to be considerable downside risks for Chinese investable stocks and commodities prices. Bottom Line: The dominos have begun to fall. We continue to recommend a defensive strategy and an underweight position in EM equities, credit and currencies versus their U.S./DM peers. High-yield local currency bonds that are a de-facto bet on the underlying currencies are vulnerable too. For investors willing to go short, it is not too late to short EM stocks and currencies. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Average of cad, aud, nzd, brl, clp & zar total return (including carry) indices relative to average of jpy & chf total returns. India's Equity Underperformance: Blame It On Oil Indian stocks have been underperforming their EM counterparts. Rising oil prices have created a toxic macro mix for India, triggering the equity underperformance (Chart II-1): Rising crude prices have led to widening current account and trade deficits. Oil price swings are often instrumental to trends in India's current account balance (Chart II-2). The deterioration in the nation's external accounts has been behind the rupee's poor performance. Chart II-1Higher Crude Oil Prices Hurt Indian Stocks Chart II-2Crude Oil And Current Account Deficit Given that India is a major oil importer, falling commodities prices - especially crude oil - will benefit India's stock market. The recent surge in oil prices has also reinforced inflation dynamics in India (Chart II-3). Chart II-3Higher Crude Oil Boosts Inflation The basis for the high correlation between core consumer price inflation (excluding energy and food) and oil prices is due to the fact that core inflation includes components that are heavily influenced by fluctuations in oil prices. For instance, the transportation and communication component of inflation is very sensitive to changes in oil prices. This component accounts for 18% of core consumer price index. Further, the personal care and effects component also correlates with crude oil. Personal care goods use petroleum products as an important input in their production process. This component accounts for 8% of core consumer price index. Together these components account for a non-trivial 26% of core consumer price index, and will likely subside as oil prices fall. On the inflation front, we highlighted in our April 19 Weekly Report that risks to inflation are tilted to the upside due to strong consumer and government spending in an otherwise under-invested economy.1 Domestic demand has been accelerating, providing tailwinds for higher inflation (Chart II-4). Higher inflation and currency weakness has led to a considerable rise in both government and corporates local currency bond yields (Chart II-5). Chart II-4Domestic Economy Is Strong Chart II-5Rising Borrowing Rates Given the very high equity valuations, share prices in India are especially sensitive to rising local borrowing costs. All in all, India's relative equity performance has by and large been undermined by rising oil prices. BCA's Emerging Markets Strategy team believes the risk-reward for oil prices is skewed to the downside due to the expected deterioration in EM/China oil demand, investors' extremely high net long positions in crude and appreciating dollar.2 That is why we are still reluctant to downgrade Indian stocks within the EM equity universe. It is vital to emphasize, however, that our overweight call is relevant to dedicated EM equity portfolios. We have been, and remain, negative on Indian share prices in absolute U.S. dollar terms. Bottom Line: Odds are that commodities prices will drop meaningfully in the months ahead and that will support India's relative equity performance versus the EM benchmark. EM dedicated investors should keep an overweight stance on Indian equities for now. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com 1 Please see Emerging Markets Strategy Weekly Report "Country Perspectives: India And Turkey," dated April 19, 2018, link available on page 21. 2 The Emerging Markets Strategy team's view on oil differs from BCA's house view which remains bullish. The South African Rand Remains On Shaky Foundations Although the rand has not been among the worse hit EM currencies, investors should remain cautious on it. The currency presently finds itself resting on very shaky foundations, raising odds of substantial depreciation for the remainder of the year: First, South Africa's external funding has solely been driven by portfolio inflows, leaving the exchange rate highly exposed to potential portfolio outflows. As illustrated in Chart III-1, net portfolio inflows reached all-time highs while net FDIs reached all-time lows at the end of 2017 (the latest available statistics). Meanwhile, foreign ownership of domestic bonds has reached new highs (Chart III-2). The total return in dollar terms on South Africa's local currency bond index1 has failed to break above its previous highs and has relapsed (Chart III-3). It seems this asset class has entered a new bear market. Further decline in the total return of bonds will spur more selling or hedging of currency risks by international bond investors. Chart III-1South Africa: Highly Exposed To Portfolio Flows Chart III-2Foreign Holdings Of South African Local Bonds Is Elevated Chart III-3South African Bonds Were Unable To Break Out Second, the country's trade balance is set to deteriorate. Despite continued episodes of currency weakness throughout last decade, there has been little to no import substitution in South Africa. Consequently, a reviving domestic demand will prompt higher imports. That, and a potential relapse in export (raw materials) prices, will lead to a widening trade balance. Chart III-4The Rand Is Not Cheap Finally, the rand is not cheap; its valuation is neutral (Chart III-4). When an exchange rate is close to its fair value, it can either appreciate or depreciate. In short, the rand's valuation is not extreme enough to be a major factor in driving the market right now. Bottom Line: Currency traders should stay short the ZAR versus both the USD and the MXN. Relative trade balance dynamics and valuations continue to play in favor of the Mexican peso relative to the South African rand. Predicated by our negative view on the rand, we recommend EM dedicated equity and fixed-income investors to maintain an underweight allocation to South Africa. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com 1 JP Morgan GBI-EM Global Diversified Emerging Markets Government Bond Index for South Africa. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights China's ongoing industrial sector slowdown will not likely lead to a global growth shock, but investors should recognize that China's relative stability is supported by strong global demand. A negative surprise to export growth could materially shift global investor sentiment about the trajectory of China's economy, which would bode poorly for Chinese ex-tech stocks versus their global peers. Stay overweight for now, but with a short leash. The recent inclusion of Chinese A-shares in the MSCI Emerging Markets index may lead to heightened investor attention over the coming months, but we still recommend a neutral allocation. Within the domestic market, a factor approach suggests that financials are a good bet, and that real estate stocks have great potential as a contrarian trade if housing sales begin to durably trend higher. Index inclusion may also be a factor leading to increased global investor attention towards China's bond market over the coming two years. The comparatively high-yield and short duration of China's corporate bond market makes for an attractive investment opportunity, despite recent concerns about defaults. Stay long/overweight over the coming 6-12 months. Feature We have presented the following views about China's economy and its financial markets over the past several months: China's industrial sector is slowing, and is set to slow further based on our proprietary leading indicators for the Li Keqiang index. This will cause a further deceleration in Chinese nominal import growth and suggests that Chinese ex-tech earnings per share growth will soon peak. Residential investment has potential to provide a tailwind to domestic growth if home sales sustainably pick up, but there are no firm signs that this is occurring. Robust export growth will help China's economy from slowing sharply, but there are several risks to the external demand outlook that need to be monitored. Given the poor growth momentum in the industrial sector, fiscal or monetary stimulus will likely be required if China suffers a sudden export shock. China's consumer-oriented tech sector ostensibly stands out as a shelter from an old economy slowdown, but it is extremely expensive, earnings momentum is very stretched, and it may be adversely impacted by the U.S.' section 301 investigation. We have recommended avoiding exposure since mid-February. China's ex-tech equity market is comparatively cheap, high-beta vs the global benchmark, and technically robust. While the risks to the economic outlook are clear, investors should continue to overweight Chinese ex-tech stocks vs their global peers. For global investors who are perennially concerned that a slowdown in China's economy will culminate in a significant shock to the global economy, Chart 1 provides a helpful visual representation of our view. The chart depicts two scenarios: first, the ongoing industrial sector slowdown in China results in an outright subtraction from global growth momentum via a contraction in imports, despite positive growth impulses from the U.S. and euro area. In our view, Chinese import growth is likely to remain positive, but will largely be driven by strong demand in the developed world (scenario 2). Chart 1Two Different Scenarios Concerning China's Contribution To The Global Economy Chart 1 highlights that our view is more positive for the global economy than one might otherwise think, but it is important for investors to understand the nature of China's relative stability in the event that export growth surprises to the downside over the coming months. In fact, Chart 2 highlights that the most salient data development over the past two weeks has been a fairly significant deceleration in smoothed nominal export growth, which is our preferred method of analyzing Chinese trade data. Despite the relative stability of China's PMIs over the past few months, a 3-month moving average of US$ exports decelerated from 17.5% to 7% in May, or from 10% to -1% in RMB-terms. Sequentially, Chinese export growth improved in May (vs April's reading) in both US$ and RMB-terms, and both beat market expectations. As a result, we are sticking with the second scenario depicted in Chart 1 as the more likely of the two for the coming 6-12 months. However, the reliance on strong external demand to prop up China's import growth is somewhat of a "shaky ladder" for global investors to climb, given the clear risks from U.S. protectionist action, the headwinds to Chinese export competitiveness from a strong currency (or, alternatively, the punishing impact of translation effects on exporter revenue), and the potential for robust export growth to embolden Chinese policymakers to push forward with even more aggressive reforms over the coming year. Still, Chart 3 highlights that many investors are perfectly willing to climb this ladder, shaky or otherwise. The chart shows that the relative performance of Chinese ex-tech stocks versus their global peers remains firmly within the ascending trend channel that has been in place since early-2017, despite the ongoing slowdown in the industrial sector. As we noted in our May 30 report,1 this message is consistent with the view that any recent negative relative performance of Chinese ex-tech stocks has been in response to global rather than idiosyncratic, China-specific risk. Chart 2A Nontrivial Slowdown In Chinese Export Growth Chart 3Investors Are Fine Climbing A Shaky Ladder We remain nervous bulls concerning Chinese ex-tech stocks, and continue to recommend an overweight stance. But our reading of China's macro dynamics suggests that investors should not be dogmatic about their equity allocation to China, and should be prepared to cut exposure in response to a material shift in sentiment towards the Chinese economy. As a final point, while we have clearly presented our framework over the past several months for thinking about and analyzing China, investors attending BCA's Annual Investment Conference in September will get an opportunity to hear additional perspectives about the cyclical trajectory of its economy. Leland R. Miller, CEO of the China Beige Book, will be presenting his thoughts on the outlook for Chinese growth and risk assets. Based on his firm's unique insights into China's economic and financial market developments, Mr. Miller's panel will certainly be among those not to miss. Bottom Line: China's ongoing industrial sector slowdown will not likely lead to a shock to global demand, but investors should recognize that China's relative stability is supported by strong global demand. A negative surprise to export growth could materially shift global investor sentiment about the trajectory of China's economy, which would bode poorly for Chinese ex-tech stocks versus their global peers. Stay overweight for now, but with a short leash. A-Shares: EM Inclusion, Factor Analysis, And A Contrarian Shadow Trade The beginning of June marked a milestone for Chinese equities, as MSCI added over 226 large-cap A-shares to their Emerging Markets index. Box 1 provides some brief details about the inclusion, and also notes how it affects several of the trades in our trade book. Chart A1A-Share Inclusion Added 10% Market Cap ##br##To The MSCI China Index Box 1 The Inclusion Of Chinese A-Shares In The MSCI Emerging Markets Index On May 31 2018, 226 China large-cap RMB-denominated A-shares were included in the MSCI Emerging Markets Index. The change represented a 1.4% increase in the market capitalization of the MSCI Emerging Markets index, and 10% increase in the MSCI China Index (Chart A1). We have often referred to the MSCI China Index as the "investable" index in previous reports and in our trade table, but this index now includes some domestic stocks as a result of the recent inclusion. We plan to continue to use the MSCI China Index (or its ex-tech equivalent) as the main outlet for our investment recommendations, which means that the benchmark for five of our trades will be re-labeled in our trade table (from China investable to MSCI China Index). One exception is our trade favoring the MSCI China ESG Leaders Index, as MSCI has yet to publish an ESG rating index for Chinese domestic stocks. We last wrote about the outlook for A-shares in our March 14 Weekly Report,2 and noted that the significant underperformance of A-shares relative to global stocks over the past few years was due to the legacy effects of an enormous, policy-driven speculative bubble in 2014-2015. We highlighted that while domestic stocks have worked off some of this bubble and multiples are no longer extreme, that a neutral allocation was still warranted due to an uninspiring earnings outlook and, at best, a very modest valuation discount relative to global stocks. Chart 4 illustrates this latter point; based on all four trailing valuation ratios that we track, ex-tech onshore stocks are either on par or considerably more expensive than global ex-tech stocks. By contrast, the MSCI China Index (excluding technology) is cheaper than their global peers by all measures, in some cases considerably so. Nevertheless, while we continue to recommend that investors maintain a neutral stance towards A-shares within a global equity portfolio, the inclusion of A-shares in the EM index may force some investors to increase their exposure to domestic stocks beyond the level that they otherwise would have maintained. In order to provide some perspective of what domestic stocks to favor, we have taken a quantitative approach to analyzing A-shares that is loosely inspired by the Fama-French three-factor model. More precisely, we have examined the historical relative performance of three separate factor strategies for A-shares and global stocks, both relative to their respective broad market. The three factors tested are as follows: Return On Equity (ROE): Replacing market beta in the F&F model, we have built a historical portfolio for both Chinese domestic and global stocks that favors level 1 GICS sectors with above-median ROE. Within high-ROE sectors, the portfolio allocates to the sectors on a value-weighted basis to maximize the investability of the strategy. Sector Weight: Our second approach favors GICS sectors with a below-median sector weight, which conceptually mimics the firm size factor in the F&F model. In reality, this strategy is selecting among sectors made up of large cap firms, meaning that investors should regard the performance of this strategy as reflecting the success or failure of investing in potentially underowned or unloved sectors. Value: Our third factor is exactly in line with the F&F model, with portfolios using this approach favoring sectors with above-median dividend yields. We have chosen a cash flow-based valuation measure instead of the book value yield to assuage potential investor concerns about accrual quality. Chart 5 presents the cumulative returns of these strategies, for both global and Chinese domestic stocks. Several important observations are noteworthy: Chart 4A-Shares Are Not Cheap Vs##br## Global Stocks In Ex-Tech Terms Chart 5ROE, Sector Weight, and Value Are ##br##All Successful Factors In China's Domestic Market Favoring high-ROE sectors has been a more profitable strategy when allocating among global sectors than those of the domestic Chinese market, but we have seen similar returns from the strategy in both markets since early-2011. This is consistent with an important conclusion that we made in our March report: the perception among some global investors that domestic Chinese stocks are a "casino" market disconnected from fundamentals does not appear to be supported by the data over the past several years. A strategy of favoring sectors with a low market cap weight has fared better for Chinese A-shares than for the global market, albeit with considerable volatility. We suspect that the underperformance of smaller-than-average sectors at the global level has been affected over the past four years by the underperformance of resources, but the outperformance of the strategy in China also makes sense: underowned or unloved sectors should have more abnormal return potential in smaller, less scrutinized markets. Favoring cheap stocks has been an abysmally poor strategy at the global level over the past decade, due to the chronic underperformance of the financial sector. But cheaper sectors have outperformed China's domestic equity market at a modest pace over the past several years, which is good news for value-oriented investors. Chart 6 highlights where each of China's domestic equity sectors currently sits in the ROE/size/value spectrum. There are three sectors exhibiting two of the factors employed in our analysis: health care, financials, and real estate. For now, we would caution investors against buying domestic health care stocks, as Chart 7 shows that the sector has become heavily overbought over the past several months. Domestic financials would appear to be a better bet: despite underperforming financials in the MSCI China Index, domestic financials have outperformed the domestic broad market over the past year and have not broken materially below their trend line despite a recent selloff. Chart 6Health Care, Financials, And Real Estate Are At The Intersection Of Successful Factors Chart 7Financials Are A Better Bet Than Health Care; Watch For A Housing Catalyst To Buy Real Estate Finally, real estate stocks have the potential to become a fantastic contrarian trade if Chinese home sales do sustainably pick up. The sector is cheap, profitable, and highly unloved given the view among many investors that the Chinese government's structural reforms will weigh on performance for some time to come. But as we have noted in previous reports, the persistent gap between home sales and housing construction over the past few years may very well be over, implying that the latter may rise in lockstep with the former if sales begin to trend higher. Chart 7 shows that investors are not even remotely pricing in such a scenario, as domestic real estate companies have underperformed the domestic benchmark since early-2016 and remain in a relative downtrend. We would not recommend fighting negative investor sentiment towards the sector for now, but domestic real estate companies should clearly be on an investor's watch list, alongside the trend in residential sales volume. Bottom Line: The recent inclusion of Chinese A-shares in the MSCI Emerging Markets index may lead to heightened investor attention over the coming months, but we still recommend a neutral allocation. Within the domestic market, a factor approach suggests that financials are a good bet, and that real estate stocks have great potential as a contrarian trade if housing sales begin to durably trend higher. An Update On China's Corporate Bond Market China's equity market may not be the only financial market segment to garner more addition from increased index inclusion over the coming year: Bloomberg recently announced that it will add Chinese RMB-denominated government and policy bank bonds to the Bloomberg Barclays Global Aggregate Index over a 20-month period beginning in April 2019, conditional on the implementation of certain "operational enhancements" to the market by the PBOC and Ministry of Finance.3 China's total bond market (government and corporate) is the third-largest in the world, with a record of 79 trillion yuan ($12.7 trillion) outstanding. Yet foreign investors have little exposure to Chinese bonds, due to frictions concerning investability, a lack of transparency on issuers/index components, and concerns about the quality of domestically-issued credit ratings (95% of China's corporate bonds are rated AA- or higher). Chart 8The Recent Uptick In Yields Has Had A Paltry Impact On Total Returns While the proportion of foreign ownership of Chinese bonds may rise slowly over time, our sense is that it will indeed rise. First, there is a clear yield advantage for Chinese relative to global bonds, in a world where high long-term absolute return prospects are scarce. Second, Chinese policymakers continue to (slowly) open China's financial markets to the rest of the world, and global investors can now gain access to China's onshore bond market through four channels without quota: the qualified foreign institutional investors program (QFII), the renminbi qualified foreign institutional investor program (RQFII), the China interbank bond market (CIBM), and the Bond Connect program.4 Third, China's regulators allowed foreign-owned ratings agencies to set up shop in China last year, in an attempt to address the ratings quality issue. BCA's China Investment Strategy service initiated our long China onshore corporate bonds trade on June 22 last year, which has since earned a 3.7% return in spite of widening yield spreads and a spike in default concerns over the past several weeks. Indeed, Chart 8 highlights that the recent rise in corporate yields has had a minimal impact on the index total return profile. There is one critical factor driving this apparent discrepancy that is not well understood by global investors: compared with corporate issues in the developed world, China's corporate bond market has considerably shorter duration. Table 1 highlights that most of the corporate bonds issued in China have a maturity of three years or less, and the duration for the ChinaBond Company Credit Index, the benchmark that we have used for our corporate bond trade, is approximately 2.3 years. By contrast, U.S. investment- and speculative-grade bonds currently have an effective duration of 7.5 and 4 years, respectively. Chart 9 illustrates the 12-month breakeven spread for the Company Credit Index, unadjusted for default. The breakeven spread represents the rise in yields that would be required for investors to lose money over a 12-month horizon (i.e. the yield change that exactly erases the income return from the position), assuming no defaults. The chart shows that Chinese corporate bond yields would have to rise approximately 250 bps over the coming year before investors suffer a negative total return, which would be an enormous rise that is totally inconsistent the PBOC's monetary policy stance. Table 1Maturity Distribution Of China's Bond Market Chart 9A Compelling Cushion Against Potentially Higher Rates Another way to gauge the attractiveness of a corporate bond position is to look at the spread relative to comparable duration government bonds in order to calculate the default loss that would be required to erase the spread (which is also roughly 250 bps today). Using the relatively conservative assumption of a 35% recovery rate, a 2.5% default loss implies a default rate of close to 4%. We noted in our May 23 Special Report that recent corporate defaults in China amounted to only 0.1% of the outstanding corporate bond market,5 implying that the ultimate scope of corporate bond defaults in China would have to be 40 times larger than currently observed to wipe out the spread relative to Chinese government bonds of comparable duration. While we cannot rule such an event from occurring, there is no evidence to suggest that such a dramatic escalation in defaults is about to occur. Bottom Line: Index inclusion may also be a factor leading to increased global investor attention towards China's bond market over the coming two years. The comparatively high-yield and short duration of China's corporate bond market makes for an attractive investment opportunity, despite recent concerns about defaults. Stay long/overweight over the coming 6-12 months. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com Lin Xiang, Research Analyst linx@bcaresearch.com 1 Pease see China Investment Strategy Weekly Report "11 Charts To Watch", dated May 30, 2018, available at cis.bcaresearch.com. 2 Pease see China Investment Strategy Weekly Report "A-Shares: Stay Neutral, For Now", dated March 14, 2018, available at cis.bcaresearch.com. 3 These enhancements include the implementation of delivery vs. payment settlement, the ability to allocate block trades across portfolios, and clarification on tax collection policies. 4 The first three programs have a clear statement that no quotas apply, whereas the bond connect program has no specific statement concerning quotas. 5 Pease see China Investment Strategy Special Report "Messages From BCA's China Industry Watch", dated May 23, 2018, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights Fed: The Fed will not automatically slow the pace of rate hikes as the funds rate approaches current estimates of its neutral level. Rather, estimates of that neutral level will be revised depending on the outlook for the economy. For the time being investors should continue to expect a rate hike pace of 25 bps per quarter. Credit Cycle: For the time being both our monetary and credit quality indicators recommend an overweight allocation to corporate bonds. Inflation expectations are not yet anchored around the Fed's target, and gross leverage is trending sideways. Both of these measures will likely send a more negative signal later this year, and we will reduce exposure to corporate credit at that time. Emerging Market Debt: Despite the recent weakness in emerging market currencies, U.S. corporate credit still looks more attractive than USD-denominated emerging market sovereign debt. At the country level, only Russian debt warrants an overweight allocation relative to U.S. corporates. Feature The Federal Reserve meets this week and will deliver the second rate hike of the year, bringing the target range for the federal funds rate up to 1.75% - 2%. With that hike already fully discounted, investors will be more concerned with parsing the post-meeting statement, Summary of Economic Projections, and Chairman Powell's press conference for clues about the future path of rates. We expect only minor changes to the statement, though the Committee could decide to tweak its promise that "the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run". Such a change would simply acknowledge that if gradual rate hikes continue, then the federal funds will move close to most estimates of its neutral (or equilibrium) level within the next 12 months. This touches on an important question for bond investors. Would the Fed actually start to slow the pace of rate hikes once the funds rate reaches its estimated neutral level? Or will it need to see some evidence of decelerating economic growth before slowing the pace of rate hikes below its current 25 bps per quarter pace? Chart 1 shows why this question is important. The shaded boxes in that chart outline a "gradual" rate hike path of 25 bps per quarter. The Fed has been lifting rates at this pace since late 2016. The "x" markings denote the median expected fed funds rate from the Fed's Survey of Primary Dealers, and the "F" markings denote the Fed's own median projections. Notice that there are two "F"s shown at the end of 2018. This is because an equal number of FOMC participants (6) expect a fed funds rate of 2% - 2.25% as expect one of 2.25% - 2.5%. We expect the median will coalesce around the 2.25% to 2.5% range by the end of tomorrow's meeting. Chart 1The Outlook For Rate Hikes Notice in Chart 1 that both primary dealers and the Fed expect to deviate from the quarterly rate hike pace around the middle of next year. This would be consistent with the pace of hikes starting to slow as the fed funds rate approaches its currently anticipated neutral level near 3%. But how confident is the Fed in its estimate of that neutral rate? We would argue that its confidence should be quite low. We are not alone in this assessment. In one of Janet Yellen's final speeches as Fed Chair she warned against placing too much confidence in estimates of the neutral rate.1 [T]he neutral rate changes over time as a result of the interaction of many forces, including demographics, productivity growth, fiscal policy, and the strength of global demand, so its value at any point in time cannot be estimated or projected with much precision. We expect that the current FOMC will heed this warning, and if there are no signs of economic deterioration by the middle of next year, then the Fed will continue to hike rates at a pace of 25 bps per quarter and estimates of the neutral rate will be revised higher. We examined what could potentially make the Fed deviate from its 25 bps per quarter rate hike pace, by hiking either more quickly or more slowly, in a recent report.2 Crucially, Chart 1 shows that not only is the market priced for the Fed to slow its pace of rate hikes as we reach the middle of next year, it is also priced for a slower pace of rate hikes than is expected by the Fed or the primary dealers. This divergence means that below-benchmark portfolio duration continues to make sense on a 6-12 month horizon. Bottom Line: The Fed will not automatically slow the pace of rate hikes as the funds rate approaches current estimates of its neutral level. Rather, estimates of that neutral level will be revised depending on the outlook for the economy. For the time being investors should continue to expect a rate hike pace of 25 bps per quarter. A Quick Update On Our Tactical Long Position On May 22 we advised clients with a short-term (0-3 month) horizon to position for lower U.S. bond yields in the near term.3 This call was premised on two catalysts. First, bond market positioning had become excessively net short. That picture now looks more mixed (Chart 2). Net speculative positions in 10-year Treasury futures remain deep in "net short" territory and the Marketvane survey of bond sentiment is still "bearish", but the JP Morgan Duration Surveys for both "all clients" and active clients" have moved somewhat closer to neutral. The second catalyst was that our auto-regressive model pointed to strong odds of a negative reading from the U.S. Economic Surprise Index during the next month (Chart 3). This remains the case, but the reading from our model has moved much closer to the zero line. Chart 2Positioning Now Closer To Neutral Chart 3Surprise Index Still Low Taken together, our two indicators no longer send a resounding "buy bonds" signal. But given the deeply net short Treasury futures positioning and the low level of the surprise index, we are inclined to maintain our tactical buy recommendation for another week. We will re-assess again next week based on trends in the surprise index and the positioning data. The Fed & The Credit Cycle The Powell Fed has so far not been kind to credit spreads. Since February our index of financial conditions has tightened considerably, driven by a combination of falling equity prices, wider quality spreads and a stronger dollar (Chart 4). Yet, the Fed seems relatively unconcerned and is broadly expected to lift rates this week. All in all, the Powell Fed seems less concerned with responding to tighter financial conditions than was the Yellen Fed. Chart 4How Much Pain Can The Fed Take? There is some truth to this observation, though we think the difference has more to do with recent trends in inflation than with any change in approach between the two Fed Chairs. As inflation pressures mount, the Fed is marginally less concerned with responding to weakness in financial markets and marginally more concerned with preventing an inflation overshoot. This is why we will reduce our allocation to corporate bonds once our monetary indicators tell us that inflation expectations are well anchored around the Fed's target. Monetary Indicators Long maturity TIPS breakeven inflation rates are the primary indicators we are monitoring in this regard. When both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates reach a range between 2.3% and 2.5%, that will be consistent with past periods of well-anchored inflation expectations and we will start reducing exposure to corporate credit (Chart 5). But we should not rely solely on one indicator. It is conceivable that the financial crisis ushered in a structural shift (possibly due to stricter banking regulations) and that the level of TIPS breakevens consistent with well-anchored inflation expectations is now slightly lower.4 For this reason we also pay attention to the St. Louis Fed's Price Pressures Measure (Chart 5, bottom panel). This model is designed to output the percent chance that inflation will exceed 2.5% during the next 12 months, and we have found that corporate bond excess returns decline significantly when it exceeds 15%.5 It currently sits at 13%. Finally, it's also a good idea to pay attention to core PCE inflation itself. The year-over-year rate of change in core PCE inflation jumped sharply in recent months, but it has not yet returned to the Fed's 2% target (Chart 6). It is therefore still reasonable to expect that inflation expectations are not consistent with target inflation. It is likely that many investors still have doubts about whether inflation will recover to the Fed's target. Chart 5Credit Cycle: Monetary Indicators Chart 6The Fed's Inflation Model Those doubts would probably fade if the year-over-year rate of change in core PCE inflation actually rose to 2% and stayed there for several months. At that point we would have to conclude that inflation expectations are well anchored, whatever the level of TIPS breakeven rates. Incidentally, the recent bounce in core inflation brought it back in line with the reading from Janet Yellen's Phillips Curve model that she presented in a speech from 2015.6 In the context of this model, a continued decline in the unemployment rate will pressure inflation slowly higher, meaning that we expect to receive a signal from our monetary indicators sometime this year. We will pare exposure to corporate bonds at that time. It will be very interesting to hear from Chair Yellen herself when she visits the BCA Conference in September, and we hope to gain insight not only about her inflation forecast but also about how the Fed thinks about its responsiveness to financial markets, and most importantly, about how the Fed is likely to manage the tightening cycle as the funds rate approaches its estimate of neutral. Credit Quality Indicators Outside of Fed policy and the inflation outlook, we are also closely monitoring the relationship between profit growth and debt growth for the nonfinancial corporate sector. Leverage rises whenever debt growth exceeds profit growth and rising leverage tends to coincide with widening credit spreads (Chart 7). Nonfinancial corporate debt grew at an annualized rate of 4.4% in the first quarter, while pre-tax profits actually contracted at an annualized rate of 5.7%. As a result, our measure of gross leverage ticked higher from 6.9 to 7.1. More broadly, profits grew 5.8% in the four quarters ending in Q1 2018, only slightly faster than the 5.2% increase in corporate debt. This does not provide much of a buffer, and it will not take much to send profit growth below debt growth on a sustained basis. In fact, we expect that if labor compensation costs continue to accelerate we will see leverage start to rise more meaningfully in the second half of this year. Our overall Corporate Health Monitor improved noticeably in the first quarter (Chart 8). But this large move will almost certainly reverse in Q2. The improvement was concentrated in the components of the Monitor that use after-tax cash flows, and as such they were influenced by the sharp decline in the corporate tax rate. Profit margins, for example, increased from 25.8% to 26.4% on an after-tax basis in Q1 (Chart 8, panel 2), but would have fallen to 25.5% if the effective corporate tax rate had remained the same as in 2017 Q4. As the effective corporate tax rate levels-off around its new lower level (Chart 8, bottom panel), last quarter's improvement in the Corporate Health Monitor will start to unwind. Chart 7Leverage Is Poised To Head Higher Chart 8Tax Cuts Helped Balance Sheets In Q1 Bottom Line: For the time being both our monetary and credit quality indicators recommend an overweight allocation to corporate bonds. Inflation expectations are not yet anchored around the Fed's target, and gross leverage is trending sideways. Both of these measures will likely send a more negative signal later this year, and we will reduce exposure to corporate credit at that time. Still No Opportunity In Emerging Market Debt We pointed out in a recent report that a persistent divergence between U.S. and non-U.S. economic growth was the most likely catalyst that could cause the Fed to slow its pace of rate hikes.7 A divergence between strong U.S. growth and weaker growth in the rest of the world puts upward pressure on the U.S. dollar, and this is a particular problem for many emerging markets that carry large balances of U.S. dollar denominated debt. Our Emerging Markets Strategy service published a Special Report last week that explains in detail this particular problem faced by emerging markets and shows which countries face the most pressing debt concerns.8 For U.S. fixed income investors another important question is whether the recent strength in the U.S. dollar, and weakness in emerging market currencies, has resulted in an opportunity to shift out of U.S. corporate credit and into USD-denominated emerging market sovereign debt. On that note, Chart 9 shows that the average option-adjusted spread for the Baa-rated U.S. Corporate bond index recently dipped below the average spread for the investment grade USD Emerging Market (EM) Sovereign index. However, we think it is still too soon to move into emerging market debt. After adjusting for differences in duration and spread volatility between the two indexes, we come up with a measure of "Months-To-Breakeven". This indicator shows the number of months of spread widening required for each index to lose money relative to U.S. Treasuries. By this measure, U.S. Corporate bonds still look attractive compared to investment grade EM Sovereigns. At the country level, Chart 10 shows the 12-month breakeven spread for the USD-denominated sovereign debt of several major EM countries. It also shows each country's foreign funding requirement, a measure of the foreign capital inflows required in the next 12 months for each country to cover any shortfall in current account transactions and service its foreign currency debt. Chart 9EM Sovereigns Are Still Expensive Chart 10USD-Denominated Emerging Market Debt: Risk/Reward At The Country Level For the Baa-rated countries, Colombia, Mexico and Indonesia all offer spreads similar to what can be found in the Baa-rated U.S. Corporate bond market. The Philippines looks quite expensive, but Russia looks cheap compared to U.S. Corporates and has one of the lowest foreign funding requirements of any EM country. In High-Yield space, Turkey is fairly priced relative to Ba-rated U.S. junk, while Brazil and South Africa both look expensive. Argentina also looks expensive relative to B-rated U.S. junk. Bottom Line: Despite the recent weakness in emerging market currencies, U.S. corporate credit still looks more attractive than USD-denominated emerging market sovereign debt. At the country level, only Russian debt warrants an overweight allocation relative to U.S. corporates. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 https://www.federalreserve.gov/newsevents/speech/yellen20170926a.htm 2 Please see U.S. Bond Strategy Weekly Report, "Breaking Points", dated May 29, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "Pulling Back And Looking Ahead", dated May 22, 2018, available at usbs.bcaresearch.com 4 We explored some possible reasons for such a shift in the U.S. Bond Strategy Weekly Report, "Will Breakevens Ever Recover?", dated April 25, 2017, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Risk Rally Extended", dated June 27, 2017, available at usbs.bcaresearch.com 6 https://www.federalreserve.gov/newsevents/speech/yellen20150924a.htm 7 Please see U.S. Bond Strategy Weekly Report, "Breaking Points", dated May 29, 2018, available at usbs.bcaresearch.com 8 Please see Emerging Markets Strategy Special Report, "A Primer On EM External Debt", dated June 7, 2018, available at ems.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Special Report

Highlights Since the end of the Bretton Woods system in 1971 there have been five major episodes where U.S. dollar moves were not uniform across all currencies. These episodes share common features: a rallying broad trade-weighted U.S. dollar, desynchronized global growth and falling commodity prices. The above conditions will likely be met in the coming months, producing a period of global currency divergence. Commodity and EM currencies will weaken the most against the U.S. dollar, then against the yen, and finally depreciating the least against the euro. Feature It is often assumed that the dollar behaves like a monolith. However, this is not always the case: some currencies do manage to occasionally buck the dollar's general trend (Chart 1). Interestingly, the yen is most often the currency that manages to avoid the broad dollar's general directionality. Chart 1Episodes Of Currency Divergence ##br##Versus the Dollar Our view has been and remains that the broad trade-weighted U.S. dollar still has meaningful upside this year, and that the EM currency complex will be under heavy selling pressure in the coming months. That said, it is worth asking whether all other currencies will share the same fate against a rising broad trade-weighted U.S. dollar, or whether some could diverge from the general dollar trend. This is essentially akin to trying to understand the pecking order of currencies outside the USD. To address these challenges, we believe it is important to understand how global growth will evolve, how relative growth dynamics among regions will shift, and how commodity prices will perform over the coming six to 12 months. When The Dollar Wears Many Masks There have been five major periods of currency divergence versus the U.S. dollar. These have lasted anywhere from one to three years (Table 1). Table 1Summary Of Currency Divergence Episodes Interestingly, they share some common features, heeding important insights for global investors. These features are as follows: 1) Common feature #1: A Rising Broad Trade-Weighted Dollar With the exception of the 2005-2007 episode, all other episodes where some currencies diverged from the general trend in the USD occurred when the broad trade-weighted U.S. dollar was in a bull market. 2) Common feature #2: Desynchronized Global Growth All episodes of divergence in the FX market occurred when global growth was desynchronized. This underscores the importance of growth as a key driver of FX movements. During the 1991-1993 period, the yen was able to buck the dollar's strength (Chart 2) even though Japanese growth was falling quite fast relative to the U.S. Explaining this seeming inconsistency was the policy conducted by the Bank of Japan at the time. The BoJ was cutting rates, from 6% in 1991 to below 2% in 1993, but it was not doing so fast enough to alleviate budding deflationary pressures. As a result, Japanese real interest rates did not fall. This caused real rate differentials to move firmly in favor of the yen. In the final months of 1991, Japanese 2-year and 10-year real rate spreads versus the U.S. were 50 basis points and -75 basis points respectively, but by June 1993, these spreads became 145 basis points and 115 basis points. In the 1995-1996 episode, all the economic blocks experienced a slowdown in growth relative to the U.S. While this time the yen plunged versus the dollar, commodity currencies managed to appreciate against the dollar. This was because commodity prices rose during this timeframe, creating a positive terms-of-trade tailwind that lifted these currencies (Chart 3). Chart 2Episode 1: The Yen Diverges Chart 3Commodity Currencies Diverge In 1997 and 1998, the euro was the currency that managed to remain stable versus the U.S dollar, while the yen and commodity currencies sagged meaningfully (Chart 4).The euro was able to defy the gravity of a strong dollar because the euro area's relative growth differential versus the U.S. remained stable. Essentially, in the late '90s, as the euro area periphery was enjoying the full dividend of convergence toward the living standards of core Europe, European domestic demand was left unaffected by the Asian crisis. Meanwhile, commodity producers and Japan - two groups with much deeper links with EM economies - were experiencing deeper repercussions from the EM economic contraction. The 2005-2007 period of de-synchronized currency action against the dollar is somewhat of an outlier (Chart 5). First, this particular episode of currency divergence materialized in an environment where the dollar was weak. Chart 4Episode 3: The Euro Diverges Chart 5Episode 4: The Yen Diverges Again Second, the outlier was the yen, which managed to depreciate against the dollar while all other currencies were strengthening against the greenback. Chart 6Episode 5: The Euro Diverges again Third, while Japanese growth was below that of the U.S. it was not falling versus the U.S. However, this still caused Japan to be the odd man out in terms of growth performance, as other economic blocs delivered better growth than the U.S. Moreover, Japan was not experiencing the same growth dividend from China's miraculous boom as emerging Asian or commodity producers were. Adding fuel to the fire was the endemic implementation of carry trades. The low FX and rate volatility of that era was an invitation to engage in this kind of strategy.1 But Japan's deflation, along with its sub-par economic performance when compared to non-U.S. economies, re-assured investors that the BoJ would keep rates at rock-bottom levels for the foreseeable future. This was an invitation to investors to sell the yen to fund these carry trades in EM and commodity currencies as well as the euro. Finally, during the 2012-2013 episode the euro area was the global growth laggard. However, the euro was the currency that was able to strengthen against the dollar, defying the greenback's broad appreciation (Chart 6). It is true that euro area domestic demand growth was slightly improving versus the U.S. More importantly though, this was the time period that followed European Central Bank President Mario Draghi's "whatever it takes" speech. These soothing words caused the break-up risk premia across euro area member states to collapse, lifting the euro in the process. 3) Common feature #3: Commodity Prices Were Falling In three out of five episodes, commodity prices were falling, which is consistent with the fact that four out of the five episodes were periods of broad trade-weighted U.S. dollar strength. The only exceptions were the 1995-1996 and 2005-2007 episodes, where commodities rallied. The latter period was further marked by a weak broad trade-weighted U.S. dollar. Bottom Line: Looking back at history, there have been five episodes where some major currencies diverged from the U.S. dollar's broad trend. In the majority of these episodes, the broad trade-weighted U.S dollar was rising, global growth was desynchronized, and commodity prices were falling. When Is The Next Episode On The Air? The aforementioned three common features can be thought of as pre-conditions for some currency divergence to transpire. So, when can investors expect the next episode to hit the proverbial airwaves? In our view, this scenario is most likely to materialize over the coming six to 12 months. Our main macro themes have been and remain2 that the global macro landscape over the coming months will be shaped by two tectonic shifts: on the one hand, America's fiscal stimulus will sustain robust U.S. growth, and on the other hand, the continued slowdown in money and credit in China will culminate in a relapse in capital spending. The Chinese leg of the scenario will depress commodity prices and consequently emerging market economies; meanwhile, thanks to considerable fiscal stimulus, easy financial conditions and relative economic insularity, U.S. growth will remain steady, leaving it as the global growth outperformer. These dynamics are bullish for the broad trade-weighted U.S. dollar: The U.S. economy is growing robustly despite rising interest rates. In fact, interest rate-sensitive sectors are showing no signs of slowing down, confirming the resilience of the economy at this stage of the cycle. Both the housing market and commercial lending standards are not flagging growth risks (Chart 7). Chart 8 demonstrates that BCA's broad money measure (M3) for China leads import volumes and industrial metals prices by about six months. Based on the indicator's track record, odds are that industrial commodity prices will fall meaningfully over the coming months. Chart 7U.S. Economy Is Weathering##br## Rising Interest Rates Chart 8China's Money/Credit Is Bearish ##br##For Industrial Metals While oil prices could hold out for longer due to supply dynamics and geopolitics, positioning remains extremely elevated. As such, we are not ruling out a meaningful pullback in crude as traders head for the exits - all in the context of slowing global demand. Bottom Line: Pieces are falling in place to create the conditions necessary for some currency decoupling: global growth is set to become desynchronized, and commodity prices are likely to weaken - all in the context of a rising broad trade-weighted U.S. dollar. A Reverse Currency Pecking Order Slowing global trade as well as a growth deceleration in China's capital spending and demand for commodities will have the biggest repercussions for commodity and EM Asian currencies (Chart 9). This leaves the euro and the yen as the two most likely candidates to potentially diverge from the broad U.S. dollar in this coming episode. In our view, we think the yen could win this title. First, while the euro area economy is less leveraged to a slowdown in China/EM than Japan, it is still extremely vulnerable. Investors are still very long the euro, and therefore are vulnerable to negative surprises. Euro area industrial production could be the impulse to continue generating underwhelming economic numbers, as it is very much leveraged to China (Chart 10), mainly due to Germany's own deep trade links with EM and China. Notably, the German IFO index for business expectations in German manufacturing - a good leading indicator for global trade - is pointing to a further slowdown in global exports (Chart 11, top panel). Furthermore, German manufacturing new orders from non-euro area countries are starting to roll over, suggesting German exports will weaken imminently (Chart 11, middle panel). Lastly, the Swiss KOF leading indicator has come in below 100 (Chart 11, bottom pane Chart 9EM Asia & Commodity Currencies To Remain Weak Chart 10When China Decelerates, So Does Europe Chart 11Global Trade Is Slowing Down Second, it seems that historically the yen has a greater ability to rally than the euro when commodity prices are falling or when the broad trade-weighted U.S. dollar is in a bull market, highlighting the counter-cyclical nature of the Japanese currency. This happened in the early to mid-'90s and in 2008 (Chart 12). The only exception was in 1998, when the euro was able to rally amid a selloff in commodity prices and a strengthening dollar because domestic growth was so resilient. Today, euro area domestic growth is healthier than it was in 2012-2013, but it is still much weaker than is the case in the U.S., especially as the latter is receiving a shot in the arm thanks to a large dose of late-cycle stimulus. Chart 12The Yen Has Counter Cyclical Attributes Chart 13Euro Long Positioning Is Higher Than For The Yen As such, we believe the euro has more downside than the yen against the U.S. dollar in this coming episode. Furthermore, speculators remain too long the euro versus the yen (Chart 13). Third, the yen is a crucial funding currency in global carry trades, while the euro has not been used by traders for this purpose over the past 18 months.3 As such, a selloff in EM and commodity currencies, which is our base case, could spur a rush to the exits for short yen positions, while the euro is not likely to benefit from a similar short squeeze. Additionally, Japan sports a large positive net international investment position of US$3.1 trillion, while Europe's stands at -US$0.6 trillion. Consequently, Japanese investors have proportionally more funds held abroad than European investors to repatriate home in the event of an upsurge in global/EM market volatility, adding a further impetus for the yen to buck the dollar trend. One of the best currency valuation metrics is the real effective exchange rate based on unit labor costs, because it takes into account both wages and productivity. Unfortunately, this data set does not exist for all countries. On this metric, the U.S. dollar is not expensive (Chart 14, top panel). Adding credence to our view that the yen will be more resilient than the euro this year, according to the unit labor costs-based measures, the JPY appears to be cheap in trade-weighted terms and relative to the EUR (Chart 14, bottom panel). Chart 14The Yen Is Cheaper Than the Euro,##br## Dollar Is Fairly Valued Chart 15The Korean Won##br## Is Expensive Chart 16Commodity Currencies ##br##Are Not Cheap The Korean won - the only emerging Asian currency for which this measure is available - seems to be expensive (Chart 15). Chart 16 demonstrates that commodity currencies including those of Australia, New Zealand and Chile are on the expensive side, while the Canadian dollar and the Colombian peso are fairly valued. Bottom Line: Putting all the pieces together, our reverse pecking order for global investors from the weakest to strongest currency against the U.S. dollar is as follows: commodity currencies, non-commodities EM currencies (primarily Asian), the euro, and the yen. Investment Conclusions We recommend the following strategy to best navigate the coming global currency divergence episode over the coming six to 12 months: Global asset allocators should underweight the following currencies, from most to least, in the following order: First, the extremely vulnerable commodity currencies (BRL, IDR, ZAR, CLP, COP, AUD, NZD, NOK, and CAD); second, the EM Asian currencies (KRW, MYR, SGD, TWD, and PHP); third, the euro; and lastly, the yen. Currency traders stand to benefit the most in this coming episode by going short commodity and EM Asian currencies versus the U.S. dollar. That said, Japanese and European investors also stand to benefit by selling or underweighting commodity and EM currencies. The yen and the euro will depreciate significantly less than commodity and EM currencies, with the yen potentially ending flat versus the U.S. dollar. To capture these dynamics we suggest a new currency trade: long JPY / short SGD. The rationale behind this trade is that the Monetary Authority of Singapore (MAS) manages the Singapore dollar against a basket of currencies of its major trading partners. Consequently, if as we anticipate the Japanese yen strengthens versus all other currencies with the exception of the greenback, the MAS will likely have to depreciate the Singapore dollar versus the yen. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Special Report, titled "Carry Trades: More Than Pennies And Steamrollers", dated May 6, 2016, available at fes.bcaresearch.com 2 Please see Emerging Markets Strategy Weekly Report, titled "Two Tectonic Macro Shifts", dated January 31, 2018, available at ems.bcaresearch.com 3 Please see Foreign Exchange Strategy Weekly Report, titled "Euro: Risk On Or Risk Off?", dated November 17, 2017, available at fes.bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Special Report

Highlights North Korea is a geopolitical opportunity more than a risk to markets - the key regional risk comes from U.S.-China tensions; China's geopolitical rise, and the fear of a U.S. attack on North Korea, is driving the two Koreas together; The U.S. can accept something less than complete denuclearization - such as inspections and a missile freeze; The path of peace and eventual unification removes the risk of disruption to the global economy and is positive for South Korea's currency and certain assets. Feature We at BCA's Geopolitical Strategy have been optimists about the diplomatic tack in North Korea since September 2017.1 Our optimism stands in stark contrast to our pessimism about U.S.-China relations. U.S.-China trade tensions will create an ongoing headwind for assets linked to the status quo of Sino-American engagement (Chart 1). U.S. President Donald Trump's threat to move forward with tariffs on $50 billion worth of Chinese goods - and his decision to impose steel and aluminum tariffs on China and others - lends credence to our long-held view that globalization has peaked.2 The seal on protectionism has been broken by the country known as the guarantor of free trade (Chart 2). Chart 1Trade Tensions Far From Resolved Chart 2The U.S. Has Broken The Seal On Protectionism Trade tensions are also spilling out into strategic areas of disagreement, as we expected.3 This week, Defense Secretary James Mattis warned China that the U.S. will maintain a "steady drumbeat" of freedom of navigation operations in the South China Sea (Diagram 1). The goal is to reject China's claims of sovereignty over the sea and the rocks and reefs within it.4 The potential for a geopolitical incident or "Black Swan" event to occur in the South China Sea - or even the Taiwan Strait - is high. Diagram 1The U.S. Is Pushing Back Against China's Maritime-Territorial Claims For investors, the secular decline in U.S.-China ties and the "apex of globalization" are much more relevant than what happens on the Korean peninsula - as long as the peninsula does not become the central battleground between the two great powers in a replay of the devastating 1950-53 war. In this report we argue that it will not. The current round of diplomacy between the U.S. and North Korea is likely to bear fruit in a diplomatic settlement of some kind, even a peace treaty, by 2020.5 Investors should see North Korea as a geopolitical opportunity rather than a geopolitical risk. While North Korea can still contribute to volatility, we recommend investors monitor U.S.-China trade tensions, the East and South China Seas, and Taiwan as the chief sources of market-relevant geopolitical risk in this region going forward. Elsewhere, U.S.-Iran tensions are the key understated geopolitical risk to markets. China: Hiding In Plain Sight The current diplomatic effort in the Koreas has a powerful tailwind behind it: the rise of China. China's re-emergence simply cannot be overstated. It is on track to reclaim its historic role as the world's largest economy (Chart 3A) and is developing naval, air, space and cyber-space capabilities that are rapidly eroding the U.S.'s military supremacy (Chart 3B). The rise of China vis-à-vis the U.S. is the single biggest difference between today's attempts to resolve the Korean issue and previous attempts in the 1990s and 2000s. China is reaching a critical mass that is changing the behavior of the states around it (Chart 4). Chart 3AChina's Economic Revival: ##br##The Long View Chart 3BChina's Comprehensive ##br##Geopolitical Power Rising Chart 4EM Economic ##br##Reliance On China As a result, a number of anomalies are occurring throughout the region: The United States is trying to revive its Pacific presence, yet cannot decide how: From 2010-16, the U.S. sought a historic deal with Iran that would enable it to wash its hands of the Middle East and "pivot to Asia." The Trans-Pacific Partnership (TPP) was envisioned as an advanced trade deal - excluding China - that would integrate the Pacific Rim economies under a new trade framework; China would have to reform its economy in order to join. Under President Trump, however, the U.S. canceled the TPP and revoked the Iranian deal,6 while maintaining the pivot to Asia through "hard power" tactics. The Washington establishment is unified in its desire to toughen policy on China, but it is divided about how to do so - a sign of the enormity of the challenge. Japan is taking drastic, 1930s-style measures to reflate its economy, which is necessary to revive its overall strategic capability. Military spending is on the rise (Chart 5). Symbolically, the pacifist Article Nine in the post-WWII constitution may be revised next year.7 Taiwan is distancing itself from China, with Beijing-skeptic candidates dominating every level of government since the 2014 and 2016 elections. The Taiwanese increasingly see themselves as exclusively Taiwanese, not also Chinese (Chart 6) - making Taiwan a potential source of "Black Swan" events.8 Chart 5Japan's 'Re-Militarization' Chart 6Majority Of Taiwanese Are Exclusively Taiwanese Southeast Asian states are vacillating. Filipinos and South Koreans recently voted against confrontation with China while Malaysians have voted against excessive Chinese influence; Thailand's junta has warmed up to Beijing while Myanmar's junta has sought some distance. The common thread is the desire to do something about China.9 India, long known for its independent foreign policy and "non-aligned" status in the Cold War, has begun courting deeper relationships with the U.S., Japan, and Australia, for fear of China. Even Russia, one of Beijing's closest partners, is engaged in talks with Japan that could result in a peace treaty, allowing these two to bury the hatchet and create economic and strategic options outside of China's control.10 Australia - the country with the most favorable view of China in the West (Chart 7) - is in the midst of an internal crisis over China that has recently broken out into a direct diplomatic spat resulting in Beijing imposing discrete economic sanctions. It goes without saying that China's rise is being felt with extreme sensitivity on the Korean peninsula. Korean kingdoms have historically struggled either to maintain their independence from China or to avoid becoming the battleground in China's conflicts with outside powers. North Korea has taken this dependency to the extreme. Trade data shows that its links to China have grown substantially since the Global Financial Crisis. China's stimulus-fueled economic boom increased commodity imports, while international sanctions cut off Pyongyang's access to most other foreign capital. The strategic vulnerability is revealed both before and after China's enforcement of sanctions in 2017 (Chart 8).11 Chart 7Australia And Russia Are China's Best Friends Chart 8North Korea's Over-Reliance On China Chinese President Xi Jinping's ascendancy - marked by his strict personal control of the ruling party and scrapping of term limits - has reinforced the North's vulnerability. Like his predecessor Jiang Zemin (1992-2004), Xi represents a faction in the Communist Party of China that sees Pyongyang as more of a liability than an asset. North Korea's anxiety can be marked by Kim Jong Un's attempts to reduce the "pro-China" faction within the North Korean state. For instance, he has ordered the execution of his uncle, Jang Song Taek, who was close to Beijing, and his half-brother, Kim Jong Nam, who lived in Macao and was China's "alternative" to Kim.12 In effect, the next few years offer what is probably North Korea's last chance to create some new strategic options with South Korea and the rest of the world if it is to avoid being a mere vassal state for the coming centuries. Pyongyang's chief security threat is the United States and it has pursued a nuclear deterrent for decades in order to be able to negotiate with the U.S. for regime survival. The deterrent gives the North some independence, but normalizing ties with South Korea and the U.S. would enable the North to diversify its economy and reduce its dependence on China. South Korea is also fearful that the coming decades will bring a Chinese empire that effectively swallows North Korea and surrounds Seoul. Eventually the North must liberalize and industrialize its economy: will South Korea have a part in this process, or will China take it all? South Korean President Moon Jae-in wishes to reduce the risk of war prompted by North Korea's conflict with the United States, but he also wishes to gain leverage over the North so that China does not absorb its economy. In short, the historic re-emergence of China is encouraging Korean integration, as the two Korean states begin to reconsider their relationship and national needs in the face of global "multipolarity" and great power competition.13 The strategic logic is thus pushing toward Korean unification, even if unification is in practice a long way away. A unified Korean peninsula would rise toward the level of Japan in comprehensive geopolitical power (see Chart 3B above). With a population of 75 million, South Korean technological prowess, and at least nuclear potential (if not outright capability), the Koreas would be better prepared to defend their interests against China and other neighbors than they are separately. In a multipolar world, strength in numbers has an appealing strategic logic. Unification, however, will be extremely costly for the ruling elites of both North and South Korea, possibly prohibitive. It is not within our five-year forecast horizon. Instead, economic engagement will be the main focus, a necessary but not sufficient step toward unification. Bottom Line: China's rise, as it pertains to Korea, is underestimated by investors. It is putting pressure on the two Koreas to cooperate, create some solidarity, and expand their economic and strategic options over the long run. It is also putting pressure on the U.S. to encourage this process and try to remove or reduce the nuclear threat through economic engagement rather than war. How Is "Moonshine" Different From "Sunshine"? South Korean President Moon Jae-in won a sweeping victory in the election of May 2017 on a promise to renew South Korea's engagement with the North. His agenda has been nicknamed "Moonshine policy."14 Will Moonshine actually work? In addition to China's rise, several of today's political trends are supportive of a diplomatic settlement: North Korean leadership change: Power succession and consolidation: Kim is not the rash and inexperienced youth that many feared upon his coming to power in 2011. Instead he has consolidated power within the regime and waged high-stakes international negotiations with the U.S. and China. He is also overseeing a generational change in the upper ranks of the party and state. Such a change is necessary if North Korea is ever to revamp its relations with the world.15 Economic reform: In March 2013, not long after coming to power, Kim signaled a shift in national policy. The North Korean governing philosophy under his father was called juche, or "self-reliance," and had a heavy emphasis on putting the military first. But Kim has promised to develop the economy alongside nuclear weapons, creating a governing philosophy known as byungjin, or "parallel development."16 There is substantial evidence of marketization in North Korea, which was formally allowed in 2003 but has been growing faster since the Global Financial Crisis and the country's failed currency reforms at that time. Official statistics, such as they are, do not capture this organic and informal market process (Chart 9). Farmers have been allowed to keep some of their profits; official and unofficial marketplaces have cropped up; informal banking is developing; mobile phones and televisions are more prevalent.17 Foreign policy and strategic deterrence: Kim has demonstrated to the world that his country's nuclear and missile capabilities are more advanced than previously thought (Diagram 2). The American defense and intelligence establishment have been forced, during Kim's rapid phase of tests in 2016-17, to revise upward their expectations of the North's ability to strike the U.S. homeland with a nuclear weapon. This creates a new environment in which the U.S. can no longer ignore North Korea. Yet Kim has also proven himself to be a rational actor by discontinuing missile tests when tensions approached a boil in late 2017 and offering an olive branch to the South Koreans and Americans in early 2018.18 Chart 9North Korea: Rising From A Very Low Level Diagram 2North Korea's Proven Missile Reach American leadership change: Pivot to Asia: The United States has attempted to "rebalance" its strategic posture by reducing its commitment to the Middle East and "pivoting" to East Asia. This is to confront the China challenge. President Trump's North Korea and China policies are aggressive, despite the fact that Trump is also ramping up pressure on Iran.19 International sanctions tightened: The U.S. has responded to North Korea's nuclear and missile advances by redoubling the international sanctions regime (Chart 10). A credible military threat: The Trump administration has also established a "credible threat" through its use of military drills, aircraft carrier deployments in the region, and Trump's hawkish speeches to the United Nations General Assembly and South Korean National Assembly. The demonstration that the military option is "on the table" is reminiscent of the Iranian nuclear negotiations from 2011-15 (and those to come) (Chart 11).20 Trump's maneuvering room: Few people doubt the current U.S. president's willingness to do something unpredictable, "out of the box," or even "crazy," such as preemptively attacking North Korea, or, on the other hand, withdrawing U.S. troops from South Korea (Trump has often expressed dissatisfaction with the cost of U.S. troop commitments). For better or worse, the U.S. has much greater room for maneuver than it used to in making a deal with North Korea. Chart 10U.S.-Led Sanctions Tightened The Noose Chart 11U.S. Demonstration Of Credible Military Threat Causes Market Jitters Chinese leadership change: Xi's irritation with Kim: President Xi Jinping wants to create a Chinese sphere of influence in the region, which includes depriving the U.S. of a reason to bulk up its Asia Pacific presence. However, North Korea's threats and provocations give the U.S. good reason to build up its military assets, including missile defense.21 Pyongyang as an obstacle to Chinese power projection: Xi also wants to focus China's military and strategic development toward new dimensions of defense (sea, air, space, cyber) and improve China's ability to project power globally. But the potential for a crisis in North Korea - whether regime collapse or American invasion - ties China down to a 1950s-style military posture with a heavy focus on its army in the northeast. China enforces sanctions on the North: The above factors, combined with President Trump's sanctions on Chinese companies for dealing with the North, have prompted China to change its policy toward North Korea. China has been enforcing stringent sanctions since mid-2017 (Chart 12). China benefits from North Korean economic opening: China also has an interest in North Korea's economic opening - it has pioneered this process and has also clearly benefited from the recent opening of formerly closed neighboring states like Myanmar and Cambodia (Chart 13). China wants to remain the biggest player in the North's economy as it opens further. China seeks leverage over South Korea: Direct trade and infrastructure links to South Korea will also increase China's leverage over the South. Already President Moon has given China assurances of stopping U.S. missile defense deployments in exchange for the removal of economic sanctions against South Korean companies.22 Xi Jinping is not going anywhere: Xi has consolidated power and removed limits on his term in office, so China's policy shift toward the Koreas cannot be assumed to be easily reversible. Chart 12Even China Enforces Sanctions This Time Chart 13China Gains When Neighbors Open Up South Korean leadership change: The fall of the right-wing: The right-of-center parties and politicians in South Korea have suffered a cyclical drop in support. First, their hawkish policies since 2008 failed to prevent North Korea's belligerence. Second, former President Park Geun-hye was impeached and removed from office in early 2017 due to scandals that marred the right wing's popular standing. The legislative elections of 2016 and the post-impeachment presidential election of 2017 show that the major center-left party (the Minjoo Party) has made a big comeback. Local elections to be held on June 13, 2018 - the day after the planned Trump-Kim summit in Singapore - are likely to reinforce this trend (Chart 14 A&B). Thus the Moon administration is benefiting from a popular tailwind that will support its dovish approach to the North and could last for several years (Chart 15). The next election, for the legislature, is not until April 15, 2020, giving Moon time to implement his policies. Fear of abandonment: President Trump's policies threaten South Korea with the risk of preemptive war or American abandonment, making engagement with the North all the more necessary. Chart 14ASouth Korea's Right-Wing Faltered In 2016... Chart 14B... And Left-Wing Will Likely Win In 2018 Chart 15Ruling Minjoo Party Has Plenty Of Momentum The only other significant players are Russia and Japan, neither of which is willing or able to derail a diplomatic process pursued by both Koreas and the U.S. and China.23 Critically, this peace process is being driven by constraints, not preferences. True, Xi Jinping may be irritated by Kim Jong Un and Donald Trump may yearn for a Nobel peace prize. But the underlying factors are the following constraints on these policymakers: North Korea's regime cannot allow foreign domination, whether through war or economics; The U.S. regime cannot allow its homeland to be attacked by North Korea or its regional presence to be eliminated; China's regime cannot allow a Syria-style influx of North Korean refugees into China's Rust-Belt northeast or an American occupation of North Korea; South Korea's regime cannot allow anyone to trigger a war in which Seoul will be the first to be decimated. In each case, these states are bumping up against their constraints, such that the "Moonshine" diplomatic initiative is supported from all angles. Not only are the current U.S. and North Korean leaders planning to meet for the first time in the history, to build on the Moon-Kim summits, but they have already overcome a moment of cold feet that nearly quashed the June 12 summit.24 If the summit falls through, another summit will be scheduled; such is the underlying pressure of the above constraints. South Korean opinion polls demonstrate the pent-up demand for diplomacy that brought Moon and the Minjoo Party to power. The number of South Koreans who "trust" North Korea to denuclearize and pursue peace has shot up from 15% to 65% in recent polls (Chart 16A). Chart 16ASouth Koreans More Trusting Toward North... Chart 16B... Yet Doubt Full Denuclearization Will Occur Chart 17South Koreans Want Unification... Eventually Of course, "denuclearization" is a slippery term - about 64% of South Koreans doubt that the North will really give up its nuclear program. And yet even that number has fallen from 90% at the beginning of this year (Chart 16B). These numbers are volatile but reveal a deeply held public preference for some kind of deal that removes the threat of armed conflict. Indeed, 78% of South Koreans say they ultimately want not only peace but unification with the North (Chart 17). Subjectively, we think the probability of some kind of diplomatic settlement is 95% and the probability of war 5%. The next question is what kind of a settlement will it be? Bottom Line: The current diplomatic track on the Korean peninsula has greater potential than the previous two diplomatic pushes in 2000 and 2007. The different powers remain constrained by the lack of palatable or tolerable options other than diplomacy, yet China's rise and North Korea's missile capabilities have made the status quo unacceptable. Therefore we expect some kind of settlement that reduces tensions and allows for economic engagement. The U.S. Can Accept Less Than Full Denuclearization What about the critical issue of North Korea's strategic standoff with the United States? Will North Korea give up its nuclear program? Can the U.S. accept a deal that does not include complete and verifiable denuclearization? Subjectively, we would put full denuclearization at a 15% probability. It is three times more likely than a war (5% chance), but five times less likely than a lesser settlement (80% chance). The question boils down to whether the United States is capable of a preemptive military strike on North Korea that denies it the ability to inflict devastating casualties on South Korea. Such a strike would require the U.S. to use numerous tactical nuclear weapons on North Korean nuclear and chemical sites as well as artillery units deeply embedded in the hills overlooking Seoul.25 If the U.S. is believed capable of such an attack, then the North will need to retain some of its nuclear deterrent so that it can deter the U.S. from such an attack directly, by threatening U.S. cities. If the U.S. is not believed capable, then the North can afford to trade away its nuclear program and rely on its conventional deterrent of decimating Seoul as its chief security guarantee. Our assessment is that the U.S. is broadly capable of executing such an attack, however little it intends to do so. The U.S. would need to be politically willing to accept the devastation of Seoul, nuclear fallout over Japan, and potentially a second war with China (which might intervene more readily this time than in 1950). This is extremely unlikely to say the least. But given President Trump's hawkishness and the drastic vacillations of today's polarized U.S. public opinion and foreign policy, North Korea cannot gamble that the U.S. would under no circumstances, ever, adopt such a course of action. In other words, North Korea has developed a nuclear deterrent not to trade it away for concessions but to maintain it at some level. National Security Adviser John Bolton said it all in one word: Libya. Libyan President Mohammar Qaddafi unilaterally abandoned his country's nuclear program in 2003, in the wake of the 9/11 attacks, to improve relations with the West. This worked until the Arab Spring, when Qaddafi was brutalized and executed after his regime collapsed under pressure of popular rebellion and a NATO bombing campaign. NATO struck his personal convoy, leaving him exposed to rebel militias. In other words, North Korea could be fully compliant and yet the U.S. could betray it. Regime change would be more likely for the U.S. to pursue if the North did not have a nuclear deterrent. In the negotiations, even an offer of total U.S. troop withdrawal from South Korea for denuclearization - which is extremely unlikely - probably cannot convince Kim Jong Un of his personal safety and his regime's security in an era of Iraq 2003, Libya 2011, Syria 2011, Ukraine 2014, and "Zero Dark Thirty."26 Finally, if it is true that North Korea also fears Chinese domination over the long run, then maintaining a nuclear deterrent is all the more important to secure the regime's independence, as it also constrains China. Thus we highly doubt that Pyongyang will fully, verifiably, and irreversibly denuclearize. We reserve a 15% chance simply because its ability to strike Seoul with artillery does give it greater leverage than Libya or other states that faced U.S.-imposed regime change. This fact combined with the possibility of an irresistible package of economic and political benefits from the Americans could conceivably cause the North to change course dramatically. But this is not our baseline case. More likely, Pyongyang can offer, and Washington can accept, mothballing reactors, holding nuclear inspections, freezing the ballistic missile program, and committing to a non-belligerent foreign policy, along with gradual normalization of diplomatic and economic relations. Washington can accept a sub-optimal deal because such a deal preserves the raison d'être for U.S. forces in Korea, yet reduces the threat to the homeland and helps dilute China's influence on the peninsula. As for the 5% chance of war, even if Pyongyang eschews any and all denuclearization, the U.S. may still opt for containment rather than war.27 Bottom Line: The U.S. can settle for "containment" against North Korea, whereas North Korea probably cannot give up its rudimentary nuclear deterrent given its twin fears of American invasion or Chinese domination. The U.S. gains from normalizing relations with the North, given that it enables North Korea to diversify its foreign policy away from China and yet Washington retains its overwhelming nuclear preemptive strike capability in the event that an attack is deemed imminent. North Korea Is The Most Promising Pariah State It is useful to remember how badly communism has served North Koreans relative to their capitalist neighbors. Chart 18 explains the unsustainability of the North's system and the impetus to change. At the same time, South Korea's development path suggests that North Korea has economic potential. There is considerable room to increase basic capital stock - roads, buildings, and basic equipment, etc. - even assuming that North Korea's pace of liberalization prevents the same kind of economic boom that fully capitalist South Korea witnessed in the second half of the twentieth century (Chart 19). Won't liberalizing the economy fatally undermine Kim's totalitarian regime? History teaches otherwise. The reform of communist East Asian regimes like China (1978) and Vietnam (1986) shows that partial liberalization can be pursued without fatally undermining the regime, as long as the regime is willing to do whatever it takes to stay in power, i.e. use domestic security and intelligence forces to suppress opposition and dissent. Communist states in other parts of the world - such as Cuba - also attest to this fact. This is not to say that liberalization poses no threat to Pyongyang. First, liberalization itself can lead to economic consequences, like inflation, that trigger instability, as China experienced in the 1980s. Second, successful liberalization increases household wealth, which can result in growing demand for civil rights and political participation, as occurred under South Korea's right-wing military dictatorship in the 1970s-80s, and as will eventually occur even in China.28 Still, North Korea today is faced with the same predicament that Iran, Myanmar, Cambodia, Cuba, and Zimbabwe face. All of them are trying gingerly to open up their economies, as their sclerotic regimes face a greater threat of social instability from economic opportunity costs than from popular political opposition. They are changing not a moment too soon. Global labor force, trade, and productivity have all slowed in recent decades, marking a contrast to the exuberant external environment that the emerging and frontier markets faced when opening their economies in the late twentieth century (Chart 20). They may still have a cheap labor advantage but they will struggle to develop as rapidly with global potential growth falling. Chart 18A Reason To Reform And Open Up Chart 19North Korea Could Follow This Path Chart 20North Korea Joins Global Market As Potential Growth Slows North Korea is better situated than any of these late-bloomers. Its immediate neighbors, South Korea, China, and Japan, each sport current account surpluses and positive international investment positions (Chart 21), giving the North a ready pool of capital to tap as it opens its doors. The global search for yield persists more or less (Chart 22), motivating investors to explore the riskiest and worst-governed countries, and yet North Korea sits in a prosperous corner of the world. South Korean investors can envision high returns from basic productivity-enhancing investments in the North, while accepting that unification and its immense fiscal costs are still a long way away. Chart 21Ample Sources Of Investment For North Korea Chart 22North Korea: Don't Miss The Search For Yield This means that North Korea - if it calms its quarrels with the West - will have alternatives to China's outward investment push (Chart 23), albeit with China remaining the biggest player. North Korea is not a large enough economy to have a major global impact when it opens up, but it is big enough to affect South Korea. It will make available a pool of cheap labor for a country that is otherwise suffering from the worst of low fertility and a shrinking workforce (Chart 24). The North's reserves of thermal coal, which are comparable to Indonesia's (Chart 25), and other commodities, are also likely to be exploited given that South Korea and its neighbors are already scouring the globe for resource plays. Chart 23China's Belt And Road Initiative Chart 24Reunification Would Increase Labor Force Chart 25North Korea Has Sizable Coal Reserves In reality, of course, it is the North's overexposure to commodities that is putting pressure on the regime to reform (in addition to international sanctions). China's economy is transitioning to a less resource-intensive model, putting the North's coal and metals exports in long-term jeopardy. The North lacks capital to industrialize and develop a manufacturing sector, and it risks missing out on the new wave of industrialization that is rewarding neighbors like Vietnam, Cambodia, and Myanmar. The slowdown in global trade and globalization threatens to close the window of opportunity for the North. Bottom Line: Oppressive communist regimes have proved capable of selectively opening up to outside trade and investment while maintaining the regime. North Korea is attempting to create a favorable foreign policy environment to take its nascent economic reforms further. The global search for yield, especially by Northeast Asian states, may still offer an opportunity to attract capital. China's economic transition adds a sense of urgency, given North Korea's need to diversify. Investment Conclusions North Korea is small, but independent, and it is pivoting to South Korea and the United States to increase its strategic and economic options. China has an interest in letting this happen, but will try to remain the dominant power. Almost every peace treaty or major diplomatic settlement in human history has involved a series of dramatic ups and downs in the lead-up to the agreement. Diplomatic volatility should increase the closer the different parties get to an agreement, due to the fears and hesitations of losing out in the final compromise. Investors should stay focused on the structural factors. North Korea is more of a geopolitical opportunity than a geopolitical risk for markets today. War is especially unlikely over 2018-19. Hence the North Korean issue is unlikely to disrupt the global economy or threaten a bullish global equity view over this time period. That would be up to other factors. Only if the new round of diplomacy completely and utterly collapses will the tail-risk of war reemerge. U.S.-China tensions, North Korea's nuclear program, and Trump's re-election bid could conceivably lead to a breakdown of diplomacy by 2020. The Trump administration would then return to its "maximum pressure" campaign and the probability of military strikes would rise. However, we put a low probability on such a breakdown occurring and would argue that the grave implications should be seen as a strong constraint driving the different parties to cut a deal. Assuming diplomacy succeeds, it should provide a small tailwind for South Korea's currency and risk assets, which at the moment face a negative environment due to slowing global growth, Chinese reforms, and a strengthening U.S. dollar. First, the end-game itself - Korean unification - is implicitly a positive for removing the risk and uncertainty of conflict and increasing Korea's potential GDP. Germany's unification remains the best analogy, for better or worse. German unification led to a brief decline in total factor productivity, but also a multi-year rally in equities, the deutschmark, and a bullish curve-steepening relative to world markets (Chart 26A). Chart 26AGermany Benefited From Reunification... Chart 26B...South Korea Is Not There Yet South Korea is not yet at the cusp of unification, so the analogy with German assets is premature, but it is not a foregone conclusion that South Korea will suffer as it embarks on the path toward unification. Of course, this year's diplomatic progress has coincided with renewed EM financial turmoil that has clouded any benefits from improved North-South relations (Chart 26 B). Moreover, the burden of unification will be immense given that North Korea is much larger and poorer relative to the South than East Germany was to West Germany, and markets will have to price in this burden by expecting larger South Korean budget deficits in future. Still, we would expect KRW/USD to benefit on the margin, especially given Korea's simultaneous promise to the Trump administration not to engage in competitive devaluation. Second, certain Korean sectors are poised to benefit from integration with the North. Looking at how the different sectors have performed before and after the April 27 inter-Korean summit, relative to their EM counterparts, reveals that industrials, energy, consumer staples, and telecoms are the relative winners (Chart 27).29 Chart 27Winners And Losers Of Inter-Korean Engagement Chart 28AReal Estate Near The DMZ... Chart 28B...Is Optimistic Once Again Third, the signal from real estate along the DMZ is loud and clear. Paju is known as the best proxy for improved Korean relations and transaction volumes have spiked since Moon and Kim met on April 27 and declared an end to the Korean War. The move is particularly notable when contrasted with the rest of Gyeonggi province, which is not inherently a "unification" play (Chart 28A & 28B). Similar moves happened in Paju real estate around the time of the first and second inter-Korean summits in 2000 and 2007, but as this report has shown, there is more reason to be optimistic today. This example speaks to the many opportunities for specialized funds to generate returns as development projects get underway. Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Can Equities And Bonds Continue To Rally?" dated September 20, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, "The Apex Of Globalization - All Downhill From Here," dated November 12, 2014, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Special Report, "The South China Sea: Smooth Sailing?" dated March 28, 2017, available at gps.bcaresearch.com. 4 Mattis criticized China's militarization of the South China Sea rocks at the annual Shangri-La Dialogue, accusing Chinese President Xi Jinping of violating his word on this matter. He also criticized China's Belt and Road Initiative. The same week, Marine Corps Lt. Gen. Kenneth McKenzie told a reporter that "the United States military has had a lot of experience in the Western Pacific, taking down small islands," in a thinly veiled hint to China's South China Sea activity. Finally, a report surfaced suggesting that the U.S. is considering sending a warship through the Taiwan Strait. Please see Ben Westcott, "US plans 'steady drumbeat' of exercises in South China Sea: Mattis," CNN, May 31, 2018, available at www.cnn.com; Laignee Barron, "Pentagon Official Says U.S. Can 'Take Down' Man-Made Islands Like Those in the South China Sea," Time, June 1, 2018, available at time.com; "Exclusive: At delicate moment, U.S. weighs warship passage through Taiwan Strait," Reuters, June 4, 2018, available at www.reuters.com. 5 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," dated April 19, 2017, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Special Report, "Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize," dated May 30, 2018, available at gps.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Weekly Report, "Northeast Asia: Moonshine, Militarism, And Markets," dated May 24, 2017, available at gps.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Special Report, "Taiwan Is A Potential Black Swan," dated March 30, 2018, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Weekly Report, "How To Play The Proxy Battles In Asia," dated March 1, 2017, available at gps.bcaresearch.com. 10 Please see BCA Geopolitical Strategy Weekly Report, "Vladimir Putin, Act IV," dated March 7, 2018, available at gps.bcaresearch.com. 11 Satellite imagery reveals that international sanctions have hindered manufacturing development and increased reliance on trade with China. Please see Yong Suk Lee, "International Isolation and Regional Inequality: Evidence from Sanctions on North Korea," Stanford University, Center on Global Poverty and Development, Working Paper 575 (October 2016), available at globalpoverty.stanford.edu. 12 North Korea's disagreements with China have given rise to a host of academic articles and studies in recent years. For an overview please see Philip Wen and Christian Shepherd, " 'Lips and teeth' no more as China's ties with North Korea fray," Reuters, September 8, 2017, available at www.reuters.com. See also Sebastian Harnisch, "The life and near-death of an alliance: China, North Korea and autocratic military cooperation," Heidelberg University, WISC Conference, Taipei, April 2017; and Weiqi Zhang, "Neither friend nor big brother: China's role in North Korean foreign policy strategy," Palgrave Communications 4:16 (2018), available at www.nature.com. 13 Please see BCA Geopolitical Strategy Monthly Report, "Multipolarity And Investing," dated April 9, 2014, available at gps.bcaresearch.com. 14 The term is a pun on the original "Sunshine" engagement policy of Moon's predecessors Kim Dae-jung and Roh Moo-hyun. President Kim's engagement attempt culminated in the first Inter-Korean summit in 2000, but was ultimately derailed by a hawkish turn in U.S. and North Korean policies and the inclusion of North Korea among the "Axis of Evil" following the 9/11 attacks. "Sunshine policy" revived again under President Roh Moo-hyun, leading to the second Inter-Korean summit in 2007. Roh's protégé, Moon, is now reviving the policy. Unfortunately, "moonshine" is saddled with the connotation of fraud and/or poison! 15 The major challenge to his rule came in late 2013 but he nipped it in the bud by executing his uncle Jang Song Taek and purging Jang's faction. He had his half-brother Kim Jong Nam assassinated in Malaysia in 2017. He promoted his sister, Kim Yeo-jong, to deputy chief of the Propaganda Department in the Korean Worker's Party. Kim has taken steps to empower the State Affairs Commission (cabinet), the Korean Worker's Party, and the legislature, the Supreme People's Assembly, vis-à-vis the long-dominant military. He has also reshuffled the military extensively, prior to a significant reshuffle this week that signaled a willingness to compromise with the Americans. See Thomas Fingar et al, "Analyzing The Structure And Performance Of Kim Jong-un's Regime," Shorenstein Asia-Pacific Research Center, Stanford University, June 2017, available at fsi.stanford.edu; and Hyonhee Shin, "North Korea's Three New Military Leaders Are Loyal To Kim, Not Policies," Reuters, June 4, 2018, available at reuters.com. 16 William Brown, "Is 'Byungjin' Working? A Look at North Korea's Money," The Peninsula, Korea Economic Institute of America, September 7, 2016, available at keia.org. 17 Please see Andrei Lankov, "The Resurgence of a Market Economy in North Korea," Carnegie Endowment for International Peace, January 2016, available at carnegieendowment.org; Sunchul Choi and Mark A. Myers, "Marketization in North Korea," United States Department of Agriculture, Global Agricultural Information Network Report KS1545, December 9, 2015, available at www.fas.usda.gov. 18 This diplomacy also reinforces Kim's reformist bent. In April 2017 he appointed Ri Su-yong, a close ally, to oversee foreign relations, and resurrected the Foreign Relations Committee within the country's legislature, the Supreme People's Assembly. See Fingar in footnote 15. 19 Please see footnote 6 above. 20 Please see BCA Geopolitical Strategy Special Report, "Trump Re-Establishes America's 'Credible Threat'," dated April 7, 2017, available at gps.bcaresearch.com. 21 Please see BCA Geopolitical Strategy Special Report, "Does It Pay To Pivot To China?" dated July 5, 2017, available at gps.bcaresearch.com. 22 Presidents Moon and Xi agreed to improve bilateral relations, with China removing economic sanctions, on the basis of South Korea promising the "Three No's" - no additional THAAD deployments, no expansion of U.S. missile defense, and no trilateral military alliance with Japan and the U.S. Please see Park Byong-su, "South Korea's "three no's" announcement key to restoring relations with China," Hankyoreh, dated November 2, 2017, available at english.hani.co.kr. 23 Indeed, Russia shares China's desire to prevent North Korea from provoking the U.S. into a greater Pacific military presence, while Japan shares the American desire to reduce the North Korean nuclear and military threat to its homeland. 24 North Korea publicly aired misgivings about the upcoming Trump-Kim summit after the new National Security Adviser, John Bolton, implied that the administration would seek "the Libya model" (unilateral and total nuclear disarmament and dismantlement by North Korea) in its negotiations. North Korea criticized Bolton, a war-hawk who has a negative history with North Korea going back to the George W. Bush administration, putting the summit in jeopardy. The North was also angry about the U.S. and South Korean decision to proceed with annual military exercises ahead of the summit. Further, Chinese President Xi Jinping may have urged Kim Jong Un to tread more carefully, or cancel the summit, during a second meeting between these two presidents in early May. The White House rebuked Bolton's comments, saying the negotiations would follow "the Trump model." 25 Please see Christopher Woolf, "The only effective arms against North Korea's missile bunkers are nuclear weapons, says a top war planner," Public Radio International, August 10, 2017, available at www.pri.org; and Uri Friedman, "North Korea: The Military Options," The Atlantic, dated May 17, 2017, available at www.theatlantic.om. 26 Iraq set a precedent for U.S. preemptive invasion; Syria was a fellow nuclear aspirant and member of the Axis of Evil that suffered both Israeli strikes against its nuclear facilities and economic and political collapse due to mismanagement and international isolation; Ukraine gave up its Soviet nuclear weapons in 1994 with the Budapest Memorandum as a guarantee of its security only to suffer Russian invasion in 2014; and "Zero Dark Thirty" refers to the U.S. Seal Team Six covert raid into the heart of Pakistan to capture or kill Osama Bin Laden. 27 Our own analysis of the "bloody nose" military strike option, which is more likely than a full-blown war but very difficult to prevent from escalating, can be found in BCA Geopolitical Strategy Weekly Report, "Insights From The Road - The Rest Of The World," dated September 6, 2017, available at gps.bcaresearch.com. 28 Please see BCA Geopolitical Strategy Special Report, "A Long View Of China," dated December 28, 2017, available at gps.bcaresearch.com. 29 Please see BCA Geopolitical Strategy Special Report, "South Korea: A Comeback For Consumer Stocks?" June 28, 2017, available at gps.bcaresearch.com.

Special Report

Highlights The degree of external debt stress in EM is primarily contingent on the magnitude of both currency depreciation and economic downtrend. So long as EM currencies depreciate against the greenback, EM FX debt stress will mount, and EM corporate and sovereign credit spreads will widen. This will occur irrespective of whether U.S. Treasury yields rise or drop. Global fixed-income portfolios should underweight EM sovereign and corporate credit relative to U.S. investment-grade corporate credit. Within EM sovereign credit, our overweights are Russia, Mexico, Korea, Thailand, Poland, Hungary and Argentina. Our underweights are Brazil, Turkey, South Africa, Malaysia, Indonesia and Venezuela. Feature A Primer On EM External Debt Concerns about EM external debt have re-surfaced as EM currencies have depreciated. In this week's report we offer a qualitative analysis on the drivers of EM external debt risks, as well as present quantitative vulnerability rankings for developing countries. External or foreign currency1 debt is borrowing (loans and bonds) by governments, banks/financial institutions and companies that is denominated in foreign currency. In this vein, foreigners' holdings of local currency bonds or non-residents' deposits in local banks do not constitute external debt. Debt Becomes A Problem In Downturns Investors often ask how worrisome the situation with EM external debt currently is - specifically, who might default, and when? There are no easy answers to these questions. The reason is that the responses to these questions are often contingent on the magnitude of both EM currency depreciation and economic slowdown. Debt stress recedes in economic upswings and rises in economic downturns (Chart I-1). The reason is that debtors' cash flows shrink in downturns and grow in economic expansions. In Chart I-1 we use Germany's IFO manufacturing business expectations as a proxy for global trade; it has been a great leading indicator for global exports.2 It also correlates well with EM credit spreads. Chart 1-1Global Manufacturing Cycle And EM Sovereign Credit Spreads When dealing with foreign currency (FX) debt, the exchange rate becomes a critical factor in terms of affecting creditworthiness. Local currency depreciation increases (appreciation reduces) the burden of foreign debt servicing for debtors whose revenues are in domestic currency. This is why when currencies depreciate, both foreign debt burdens (the degree of indebtedness) and debt servicing stresses mount. Among EM companies issued U.S. dollar bonds, there are a few exporters. Many of them are in fact commodities producers. Although their export revenues are in U.S. dollars, their export proceeds fluctuate enormously as commodities prices swing. Typically, when the U.S. dollar rallies, commodities prices drop. Chart I-2 exhibits sector weights in the EM J.P. Morgan CEMBI Corporate Bond Index. The largest issuers are banks/financials, which along with real estate companies account for 37% of the index. Resources - oil/gas, metal mining, pulp and paper - make around 26% of the index. This confirms that only a few non-commodities exporters have issued foreign currency bonds. Chart I-2Financials And Resource Producers Make Up More Than 60% Of EM Corporate Bond Index We expect revenue growth for EM debtors (both governments and companies/banks) to recede as EM economic growth slumps. Chart I-3 illustrates that manufacturing PMI for EM has declined, pointing to a further relapse in EM corporate profits and share prices. The feedback loop between EM growth and currencies works both ways. First, EM currencies are pro-cyclical - they appreciate during economic recoveries and depreciate during business-cycle downturns (Chart I-4, top panel). Chart I-3EM Manufacturing PMI Is In A Downtrend Chart I-4EM Currencies Are Pro-Cyclical Second, in the case of many vulnerable developing economies, plunging currencies push up local interest rates. This in turn reinforces growth deceleration in these economies. Notably, EM manufacturing growth has begun to downshift since early this year while their currencies have only started plunging - and interest rates rising - since early April. Hence, the latest drop in the EM manufacturing PMI cannot be attributed to the recent hikes in EM policy rates. Interest rates impact growth with a time lag longer than a few weeks. Rather, it has been cracks in global growth primarily and higher U.S. interest rates partially that have caused EM currencies to plunge in recent months (Chart I-4, bottom panel). There is also a strong positive correlation between commodities prices and EM currencies (Chart I-5, top panel). Not only do commodities producers' currencies plunge when commodities prices decline, but non-commodity dependent countries' currencies also exhibit a positive correlation with resource prices. For example, the Korean won and commodities prices often move in tandem (Chart I-5, bottom panel). The underlying factor driving various EM currencies and commodities prices is the global business cycle. This common denominator explains why all EM exchange rates - including those of non-commodity producers - are positively correlated with resource prices. On the whole, global growth downturns not only hurt EM country/company revenues, but also weigh on their currencies - making foreign currency debt more difficult to service. Altogether, this triggers a widening in EM sovereign and corporate spreads and weighs on capital flows to EM, exacerbating the cycle. Contrary to the mainstream view, neither nominal nor real EM interest rate differentials over the U.S. rates explain the trend in EM currencies, as shown in Chart I-6. Further, neither the level nor the change in interest rate differentials explains trends in EM exchange rates. On the contrary, it is the trend in EM exchange rates that drives local interest rates in high-yielding EM. This is why gauging currency movements correctly is of paramount importance to investors in various EM asset classes. Chart I-5All EM Currencies Correlate ##br##With Commodities Prices Chart I-6Nominal And Real Interest Rates Differential ##br##Over U.S. Rates Do Not Drive EM Currencies On the whole, exchange rate trends are critical to the creditworthiness of debtors with large FX liabilities: currency appreciation improves and deprecation worsens their ability to service debt. Given EM currencies are pro-cyclical and their depreciation often leads to higher domestic interest rates, the ability of EM FX debtors to service their external liabilities fluctuates with both the global business cycle and their own domestic economic performance. This is why we pay a lot of attention to the global business cycle trajectory as well as that of EM and China. Bottom Line: Apart from some basket cases like Venezuela, which is careening toward debt default, the degree of external debt stress in EM is primarily contingent on the magnitude of currency depreciation. We expect EM currencies to continue to plunge, heightening debt stress and warranting a widening in EM corporate and sovereign credit spreads. What Is More Imperative: Exchange Rates Or Interest Rates? EM debtors with dollar debt are much more vulnerable to an appreciating dollar than rising U.S. interest rates. Table I-1 illustrates this point using the following hypothetical simulation: We consider a conjectural Brazilian debtor with $1,000 in debt with five years remaining to maturity, and a starting point exchange rate of 4 BRL per USD. Table I-1A Hypothetical Simulation: FX Debt Burden Is More Sensitive To Exchange Rate Than Borrowing Costs In our example, a 5% depreciation in local currency against the dollar boosts the overall debt burden by 200 BRL (please refer to row 2 of Table I-1). This does not include the rise in local currency costs of interest payments. It reflects only the increased burden of principal. Chart I-7EM Credit Spreads Have Higher Correlation ##br##With EM FX Than U.S. Bonds Yields An equivalent rise in debt servicing costs in local currency will require a 100-basis-point increase in U.S. dollar borrowing costs. In brief, U.S. dollar rates should rise by 100 basis points for interest payments to increase by BRL 200 over a five-year period, the time remaining to maturity. This simulation reveals that a 5% dollar appreciation versus local currency is as painful as a 100 basis points rise in U.S. dollar rates and is more burdensome if the cost of coupon payments is accounted for. Provided there are higher odds of 5% currency depreciation in many EMs than a 100-basis-point rise in U.S. dollar borrowing costs, we infer that EM FX debtors' creditworthiness is more sensitive to exchange rates than to U.S. Treasury yields. As Chart I-7 clearly demonstrates, EM corporate and sovereign credit spreads correlate much more strongly with EM exchange rates than with U.S. bond yields. Consequently, the trend in EM exchange rates versus the U.S. dollar is much more important for EM credit spreads than fluctuations in U.S. bond yields. As to the currency composition of EM FX debt, about 82% of EM external debt is in U.S.-dollar terms. Bottom Line: So long as EM currencies depreciate against the greenback, EM FX debt stress will mount, and EM corporate and sovereign credit spreads will widen. This will occur irrespective of whether U.S. Treasury yields rise or drop. EM FX Debt: A Quantitative Snapshot In this section, we present a snapshot of EM ex-China FX debt and its composition, and discuss China's external debt separately. As of the end of 2017, EM ex-China external debt of $5.32 trillion was comprised of the following: government borrowings of $1.53 trillion; non-financial company borrowings of $1.7 trillion; financial organization/bank borrowings of $1.17 trillion; and inter-company loans of $0.77 trillion (Table I-2). Since early 2016, EM external debt has risen only marginally by $400 billion, largely due to borrowing by governments and companies (Chart I-8). Table I-2EM External Debt Snapshot Chart I-8Evolution Of EM External Debt Please note that all of these data are from the Bank of International Settlements (BIS) joint external debt hub and dated as of December 31, 2017. There was a non-trivial issuance of foreign currency bonds by EM issuers in the first quarter of this year that is not included in these calculations. At $1.7 trillion, China's foreign currency debt is substantial. China's banks/financial institutions and non-financial companies account for $850 billion and $460 billion of the nation's total external debt, respectively (Table I-2). Yet, the mainland's foreign currency debt is small relative to both the size of its GDP (only 11%), but not small relative to exports (60%) and the nation's FX reserves (47%). Further, China's strong corporate leverage is domestic not external - companies' local currency borrowing stands at RMB 132 trillion, equivalent to $20 trillion. Often debt stress arises when short-term debt - due in the next year - is large. Table I-3 presents the distribution of short-term debt for EM ex-China and China. Table I-3EM: Short-Term (Due In 2018) FX Debt For EM ex-China, the short-term FX debt due in 2018 is $491 billion for banks/financials and $396 billion for non-financial companies. For China, the same measure is $670 billion for banks/financials and $333 billion for non-financial companies (Table I-3). These are large amounts and, as such, escalating funding stress is likely, especially if EM/China growth disappoints and the dollar continues climbing. How does the current EM FX indebtedness for the private sector (banks and companies) compare with FX indebtedness before the EM crises of the late 1990s? Table I-4 reveals foreign debt as a share of GDP was not large before the 1996 EM/Asian crises, except for Thailand. However, as EM currencies plunged in 1997-'98, foreign debt burdens skyrocketed. This underscores the above discussion that debt vulnerability is not static. Rather, it is a dynamic concept, changing as the key variables fluctuate. This also confirms the importance of exchange rate trajectory in FX debt vulnerability. Table I-4EM Private Sector FX Debt: 1996 Versus Today Vulnerability Assessment On a macro level, foreign debt vulnerability can be measured by both foreign debt service obligations (FDSO) and foreign funding requirements (FFR). FDSOs are the sum of interest payments and amortization of all types of external debt in the next 12 months. FFRs are calculated as the current account deficit plus FDSO in the next 12 months. It measures the amount of foreign capital inflows required in the next 12 months for a country to cover any shortfall in current account transactions as well as to service its foreign currency debt (both principals and interest). Given these data from BIS are as of December 31, 2017, the next 12 month is for the entire 2018, which is technically not 12 months from today. Exports are a country's foreign currency earnings (cash flow) that can be used to service FX debt. Central banks' FX reserves are a stock of liquid foreign currency assets that can be used by the central bank to plug the gap in balance of payments, if needed. Chart I-9 and Chart I-10 rank countries in terms of their FDSO as a share of exports of goods and services, and FFR as a share of central bank FX reserves, respectively. Not surprisingly, Turkey, Argentina and Indonesia are the most vulnerable in both measures. Chart I-9FX Debt Vulnerability Ranking 1: Foreign Debt Service Obligations ##br##(FX Debt Service In Next 12 Months) Chart I-10FX Debt Vulnerability Ranking 2: Foreign Funding Requirements ##br##(FX Debt Service In Next 12 Months Plus Current Account Balance) Chart I-11 combines these two measures on a scatter plot to identify the most- and least-vulnerable countries. In addition to Turkey, Argentina and Indonesia, Brazil, Colombia, Chile and Peru also appear quite vulnerable. In the meantime, Thailand, Russia and Korea are the least vulnerable. Chart I-11Combining FX Debt Vulnerability Ranking 1 And 2 To also identify investment opportunities, we compare the FDSO/exports ratio with corporate spreads across EM countries (Chart I-12), and the FFR/FX reserves ratio with sovereign spreads across EM countries (Chart I-13). Chart I-12EM Corporate Spreads: Fundamentals Versus Valuations Chart I-13EM Sovereign Spreads: Fundamentals Versus Valuations With respect to corporate spreads, Chart I-12 displays that after adjusting for their respective fundamentals, corporate spreads in Brazil, Indonesia, Peru, Chile and Colombia are too tight. Turkey seems to be fairly valued at the moment, while Russia, Mexico and South Africa are cheap in relative terms. In terms of sovereign spreads, Chart I-13 reveals that sovereign credit is overpriced relative to fundamentals in Chile, Indonesia, Mexico and Colombia. Turkey has a neutral valuation, while Brazil, Russia and South Africa offer relative value. A caveat of this analysis is that it is static. If EM currencies continue to plummet, EM external debt matrices will worsen. In countries where their currencies depreciate more, debt vulnerability will rise and current pricing of sovereign and corporate credit will likely become inadequate. For example, if the South African rand depreciates considerably, in turn underperforming its EM peers - which is our view - its corporate and sovereign FX debt vulnerability will rise, and credit spreads will have to be re-priced both in absolute terms, as well as relative to the EM benchmark. More detailed numerical information on EM FX debt is presented in the Appendix on page 16. Investment Conclusions EM sovereign and corporate credit spreads will continue widening, pushing up their respective bond yields in the process. Rising EM corporate and sovereign U.S. dollar bond yields are typically bearish for EM stocks. This does not only hold for vulnerable EMs running current account deficits, but for emerging Asia as well. Although the selloff in emerging Asian equities has so far been moderate, rising high-yield corporate bond yields in Asia point to trouble for the regional bourses (Chart I-14). Chart I-14A Message From Emerging Asian High-Yield Corporate Bonds Furthermore, emerging Asian high-yield corporate bonds have begun underperforming their investment grade peers. This typically warrants lower share prices in Asia (Chart I-15). Chart I-15Emerging Asia: Beware Of Junk Outperforming ##br##Investment Grade Corporate Credit Global fixed-income portfolios should underweight EM sovereign and corporate credit relative to DM corporate credit in general, and U.S. investment-grade corporate credit in particular. As we have discussed in the past, asset allocators should not compare EM U.S. dollar bonds (EM credit markets) to EM local currency bonds or EM equities. EM U.S. dollar bonds should be compared to U.S. corporate bonds. Within the EM sovereign credit space, our overweights are Russia, Mexico, Korea, Thailand, Poland, Hungary and Argentina. This investment strategy combines low-beta markets with some high-beta ones where either fundamentals are healthy - such as in Russia and Mexico - or where valuation is attractive - such as in Argentina. Our recommended underweights are Brazil, Turkey, South Africa, Malaysia, Indonesia and Venezuela. Finally, Colombia, Chile, Peru and India warrant a neutral allocation within an EM credit portfolio. Modifications to our past allocation/positions are as follows: Close short Turkey / long Philippines sovereign credit trade. We also downgraded Philippines to neutral on April 25 consistent with our analysis elaborated in our Special Report.3 We moved Russia from overweight to neutral after the new sanctions were announced in April but we are now moving it back to overweight. Move Peruvian sovereign credit from overweight to neutral. Close long Peru / short Brazil sovereign credit and long Peru sovereign / short Peru corporate positions. Close long Argentina / short Venezuela sovereign credit but maintain long Argentina / short Brazil sovereign credit position. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Andrija Vesic, Research Analyst andrijav@bcaresearch.com 1 For the purposes of this report, we use external and foreign currency debt interchangeably. 2 The chart showing the correlation between German IFO manufacturing business expectations was published as Chart 1 in last week's report titled "Will Emerging Asia De-Couple Or Re-Couple?"; the link is available on page 23. 3 Please see Emerging Markets Strategy/Geopolitical Strategy Special Report "The Philippines: Duterte's Money Illusion," dated April 25, 2018, link available on page 23. Appendix: A Snapshot Of EM FX Debt External Debt Statistics Government External Debt Ranking Non-Financial Corporate External Debt Burden Financials External Debt Burden Outstanding External Inter-Company Loans Short-Term External Debt Statistics (Does Not Include Intercompany Debt) Short-Term External Debt Composition Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Special Report

Highlights Investors are underestimating the risks of U.S.-Iran tensions; The Obama administration's 2015 deal resulted in Iran curbing aggressive regional behavior that threatened global oil supply; The U.S. negotiating position vis-à-vis Iran has not improved; Unlike North Korea, Iran can retaliate against the Trump administration's "Maximum Pressure" doctrine - particularly in Iraq; U.S.-Iran conflicts will negatively affect global oil supply, critical geographies, and sectarian tensions - hence a geopolitical risk premium is warranted. Our Commodity & Energy Strategy (CES) desk is using a new ensemble forecast, which takes its 2H18 Brent forecast to $76/bbl from an average $78/bbl, and WTI to $70/bbl from $72/bbl. For next year, CES's Brent forecast goes to $73/bbl from $80/bbl, and WTI goes to $67/bbl from $72/bbl. CES expects higher volatility, as well. Feature Following the roll-out of our oil-price ensemble model last week, we are publishing a Special Report written by our colleague Marko Papic, who runs BCA's Geopolitical Strategy (GPS) service. This report explores the more nuanced aspects of the U.S. - Iran sanctions conflict, and why the contest for Iraq is important for investors. We also summarize our latest forecast. We trust you will find this analysis informative, Robert P. Ryan, Chief Commodity Strategist Commodity & Energy Strategy Tensions between the U.S. and Iran snuck up on the markets (Chart 1), even though President Trump's policy agenda was well telegraphed via rhetoric, action, and White House personnel moves.1 Still, investors doubt the market relevance of the U.S. withdrawal from the Joint Comprehensive Plan of Action (JCPOA), the international agreement between Iran and the P5+1.2 Chart 1Iran: Nobody Was Paying Attention! Several reasons to fade the risks - and hence to fade any implications for global oil supply - have become conventional wisdom. These include the alleged ability of OPEC and Russia to boost production and Washington's supposed ineffectiveness without an internationally binding sanction regime. Chart 2BCA's Updated Ensemble Forecast:##BR##Brent Averages /bbl in 2H18 Our view is that investors and markets are underestimating the geopolitical, economic, and financial relevance of the U.S.-Iran tensions. First, the ideological rhetoric surrounding the original U.S.-Iran détente tends to be devoid of strategic analysis. Second, Iran's hard power capabilities are underestimated. Third, OPEC 2.0's ability to tap into its spare capacity is overestimated.3 CES's updated ensemble forecast takes its 2H18 Brent forecast to $76/bbl from an average $78/bbl previously, and its WTI forecast to $70/bbl from $72/bbl (Chart 2). For next year, CES's Brent forecast goes to $73/bbl from $80/bbl, and its WTI expectation goes to $67/bbl from $72/bbl. CES expects higher volatility, as well, as markets continue to process sometimes-conflicting news flows. This means spike to and through $80/bbl for Brent are more likely than markets currently anticipate. Why Did The U.S.-Iran Détente Emerge In 2015? Both detractors and defenders of the 2015 nuclear deal often misunderstand the logic of the deal. First, the defenders are wrong when they claim that the deal creates a robust mechanism that ensures that Iran will never produce a nuclear device. Given that the most critical components of the deal expire in 10 or 15 years, it is simply false to assert that the deal is a permanent solution. More importantly, Iran already reached "breakout capacity" in mid-2013, which means that it had already achieved the necessary know-how to become a nuclear power.4 We know because we wrote about it at the time, using the data of Iran's cumulative production of enriched uranium provided to the International Atomic Energy Agency (IAEA).5 In August 2013, Iran's stockpile of 20% enriched uranium, produced at the impregnable Fordow facility, reached 200kg (Chart 3). Chart 3Iran's Negotiating Leverage At that point, Israeli threats of attacking Iran became vacuous, as the Israeli air force lacked the necessary bunker-busting technology to penetrate Fordow.6 As we wrote in 2013, this critical moment gave Tehran the confidence to give up "some material/physical components of its nuclear program as it has developed the human capital necessary to achieve nuclear status."7 The JCPOA forced Iran to stop enriching uranium at the Fordow facility altogether and to give up its stockpile of uranium enriched at 20%. However, Iran only agreed to the deal because it had reached a level of technological know-how that has not been eliminated by mothballing centrifuges and "converting" facilities to civilian nuclear research. Iran is a nuclear power in all but name. Second, the detractors of the JCPOA are incorrect when they claim that Iran did not give up any regional hegemony when it signed the deal. This criticism focuses on Iran's expanded role in the Syrian Civil War since 2011, as well as its traditional patronage networks with the Lebanese Shia militants Hezbollah and with Yemen's Houthis. However, critics ignore several other, far more critical, fronts of Iranian influence: Strait of Hormuz: In 2012, Iran's nearly daily threats to close the Strait of Hormuz were very much a clear and present danger for global investors (Map 1). Although we argued in 2012 that Iran's capability was limited to a 10-day closure, followed by another month during which they could threaten the safe passage of vessels through the Strait, even such a short crisis would add a considerable risk premium to oil markets given that it would remove about 17-18 million bbl/day from global oil supply (Chart 4).8 Since 2012, Iran's capabilities to threaten the Strait have grown, while the West's anti-mine capabilities have largely stayed the same.9 Map 1Saudi Arabia's Eastern Province Is A Crucial Piece Of Real Estate Chart 4Geopolitical Crises And Global Peak Supply Losses Iraq: The key geographic buffer between Saudi Arabia and Iran is Iraq (Map 2). Iran filled the power vacuum created by the U.S. invasion almost immediately after Saddam Hussein's overthrow. It deployed members of the infamous Quds Force of the Iranian Revolutionary Guard Corps (IRGC) into Iraq to support the initial anti-American insurgency. Iran's support for Prime Minister Nouri al-Maliki was critical following the American withdrawal in 2011, particularly as his government became increasingly focused on anti-Sunni insurgency. Map 2Iraq: A Buffer Between Saudi Arabia And Iran Bahrain: Home of the U.S. Fifth Fleet, Bahrain experienced social unrest in 2011. The majority of Bahrain's population are Shia, while the country is ruled by the Saudi-aligned, Sunni, Al Khalifa monarchy. The majority of Shia protests were at least rhetorically, and some reports suggest materially, supported by Iran. To quell the protests, and preempt any potential Iranian interference, Saudi Arabia intervened militarily with a Gulf Cooperation Council (GCC) Peninsula Shield Force. Eastern Province: Similar to the unrest in Bahrain, Shia protests engulfed Saudi Arabia's Eastern Province in 2011. The province is highly strategic, as it is where nearly all of Saudi oil production, processing, and transportation facilities are located (Map 1). Like Bahrain, it has a large Shia population. Saudi security forces cracked down on the uprising and have continued to do so, with paramilitary operations lasting into 2017. While Iranian involvement in the protests is unproven, it has been suspected. Anti-Israel Rhetoric: Under President Mahmoud Ahmadinejad, Iran threatened Israel with destruction on a regular basis. While these were mostly rhetorical attacks, the implication of the threat was that any attack against Iran and its nuclear facilities would result in retaliation against U.S. interests in the Persian Gulf and Iraq and direct military action against Israel. Both defenders and detractors of the JCPOA are therefore mistaken. The JCPOA does not impact Iran's ability to achieve "breakout capacity" given that it already reached it in mid-2013. And Iran's regional influence has not expanded since the deal was signed in 2015. In fact, since the détente in 2015, and in some cases since negotiations between the Obama administration and Tehran began in 2013, Iran has been a factor of stability in the Middle East. Specifically, Iran has willingly: Stopped threatening the Strait of Hormuz (the last overt threats to close the Strait of Hormuz were made in 2012); Acquiesced to Nouri al-Maliki's ousting as Prime Minister of Iraq in 2014 and his replacement by the far more moderate and less sectarian Haider al-Abadi; Stopped meddling in Bahraini and Saudi internal affairs; Stopped threatening Israel's existence (although its material support for Hezbollah clearly continues and presents a threat to Israel's security); Participated in joint military operations with the U.S. military against the Islamic State, cooperation without which Baghdad would have most likely fallen to the Sunni radicals in late 2014. The final point is worth expanding on. After the fall of Mosul - Iraq's second largest city - to the Islamic State in May 2014, Iranian troops and military advisors on the ground in Iraq cooperated with the U.S. air force to arrest and ultimately reverse the gains by the radical Sunni terrorist group. Without direct Iranian military cooperation - and without Tehran's material and logistical support for the Iraqi Shia militias - the Islamic State could not have been eradicated from Iraq (Map 3). Map 3The Collapse Of A Would-Be Caliphate How did such a dramatic change in Tehran's foreign policy emerge between 2012 and 2015? Iranian leadership realized in 2012 that the U.S. military and economic threats against it were real. Internationally coordinated sanctions had a damaging effect on the economy, threatening to destabilize a regime that had experienced social upheaval in the 2009 Green Revolution (Chart 5). It therefore began negotiations almost immediately after the imposition of stringent economic sanctions in early and mid-2012.10 Chart 5Iran's Sanctions Had A Hard Bite To facilitate the negotiations, the Guardian Council of Iran disqualified President Ahmadinejad's preferred candidate for the 2013 Iranian presidential elections, while allowing Hassan Rouhani's candidacy.11 Rouhani, a moderate, won the June 2013 election in a landslide win, giving him a strong political mandate to continue the negotiations and, relatedly, to pursue economic development. Many commentators forget, however, that Supreme Leader Ayatollah Sayyid Ali Hosseini Khamenei allowed Rouhani to run in the first place, knowing full well that he would likely win. In other words, Rouhani's victory revealed the preferences of the Iranian regime to negotiate and adjust its foreign policy. Bottom Line: The 2015 U.S.-Iran détente traded American acquiescence in Iranian nuclear development - frozen at the point of "breakout capacity" - in exchange for Iran's cooperation on a number of strategically vital regional issues. As such, focusing on just the JCPOA, without considering the totality of Iranian behavior before and since the deal, is a mistake. Iran curbed its influence in several regional hot spots - almost all of which are critical to global oil supply. The Obama administration essentially agreed to Iran becoming a de facto nuclear power in exchange for Iran backing away from aggressive regional behavior. This included Iran's jeopardizing the safe passage of oil through the Strait of Hormuz either by directly threatening to close the channel or through covert actions in Bahrain and the Eastern Province. The U.S. also drove Iran to accept a far less sectarian Iraq, by forcing out the ardently pro-Tehran al-Maliki and replacing him with a prime minister far more acceptable to Saudi Arabia and Iraqi Sunnis. Why Did The U.S. Chose Diplomacy In 2011? The alternative to the above deal was some sort of military action against Iranian nuclear facilities. The U.S. contemplated such action in late 2011. Two options existed, either striking Iran's facilities with its own military or allowing Israel to do it themselves. One reason to choose diplomacy and economic sanctions over war was the limited capability of Israel to attack Iran alone.13 Israel does not possess strategic bombing capability. As such, it would have required a massive air flotilla of bomber-fighters to get to the Iranian nuclear facilities. While the Israeli air force has the capability to reach Iranian facilities and bomb them, their effectiveness is dubious and the ability to counter Iranian retaliatory capacity with follow-up strikes is non-existent. Chart 6Great Power Competition The second was the fact that a U.S. strike against Iran would be exceedingly complex. Compared to previous Israeli strikes against nuclear facilities in Iraq (Operation Opera 1981) and Syria (Operation Outside The Box 2007), Iran presented a much more challenging target. Its superior surface-to-air missile capability would necessitate a prolonged, and dangerous, suppression of enemy air defense (SEAD) mission. In parallel, the U.S. would have to preemptively strike Iran's ballistic missile launching pads as well as its entire navy, so as to obviate Iran's ability to retaliate against international shipping or the U.S. and its allies in the region. The U.S. also had a strategic reason to avoid entangling itself in yet another military campaign in the Middle East. The public was war-weary and the Obama administration gauged that in a world where global adversaries like China and Russia were growing in geopolitical power, avoiding another major military confrontation in a region of decreasing value to U.S. interests (thanks partly to growing U.S. shale oil production) was of paramount importance (Chart 6). Notable in 2011 was growing Chinese assertiveness throughout East Asia (please see the Appendix on page 24). Particularly alarming was the willingness of Beijing to assert dubious claims to atolls and isles in the South China Sea, a globally vital piece of real estate (Diagram 1). There was a belief - which has at best only partially materialized - that if the United States divested itself of the Middle East, then it could focus more intently on countering China's challenge to traditional U.S. dominance in East Asia and the Pacific. Diagram 1South China Sea As Traffic Roundabout Bottom Line: The Obama administration therefore chose a policy of military posturing toward Iran to establish a credible threat. The military option was signaled in order to get the international community - both allies and adversaries - on board with tough economic sanctions. The ultimate deal, the JCPOA, did not give the U.S. and its allies everything they wanted precisely because they did not enter the negotiations from a position of preponderance of power. Critics of the JCPOA ignore this reality and assume that going back to the status quo ante bellum will somehow improve the U.S. negotiating position. It won't. What Happens If The U.S.-Iran Détente Ends? The Trump administration is serious about applying its Maximum Pressure tactics on Iran. Buoyed by the successful application of this strategy in North Korea, the White House believes that it can get a better deal with Tehran. We do not necessarily disagree. It is indeed true that the U.S. is a far more powerful country than Iran, with a far more powerful military. On a long enough timeline, with enough pressure, it ought to be able to force Tehran to concede, assuming that credible threats are used.14 Unlike the Obama administration, the Trump administration will presumably rely on Israel far less, and on its own military capability a lot more, to deliver those threats, which should be more effective. The problem is that the timeline on which such a strategy would work is likely to be a lot longer with Iran than with North Korea. This is because Iran's retaliatory capabilities are far greater than the one-trick-pony Pyongyang, which could effectively only launch ballistic missiles and threaten all-out war with U.S. and its regional allies.15 While those threats are indeed worrisome, they are also vacuous as they would lead to a total war in which the North Korean regime would meet its demise. Iran has a far more effective array of potential retaliation that can serve a strategic purpose without leading to total war. As we listed above, it could rhetorically threaten the Strait of Hormuz or attempt to incite further unrest in Bahrain and Saudi Arabia's Eastern Province. The key retaliation could be to take the war to Iraq. The just-concluded election in Iraq appears to have favored Shia political forces not allied to Iran, including the Alliance Towards Reform (Saairun) led by the infamous cleric, Muqtada al-Sadr (Chart 7). Surrounding this election, various Iranian policymakers and military leaders have said that they would not allow Iraq to drift outside of Iran's sphere of influence, a warning to the nationalist Sadr who has fought against both the American and Iranian military presence in his country. Iraq is not only a strategic buffer between Saudi Arabia and Iran, the two regional rivals, but also a critical source of global oil supply, having brought online about half as much new supply as U.S. shale since 2011 (Chart 8). If Iranian-allied Shia factions engage in an armed confrontation with nationalist Shias allied with Muqtada al-Sadr, such a conflict will not play out in irrelevant desert governorates, as the fight against the Islamic State did. Chart 7Iraqi Elections Favored Shiites But Not Iran Chart 8Iraq Critical To Global Oil Supply Instead, a Shia-on-Shia conflict would play out precisely in regions with oil production and transportation facilities. In 2008, for example, Iranian-allied Prime Minister Nouri al-Maliki fought a brief civil war against Sadr's Mahdi Army in what came to be known as the "Battle of Basra." While Iran had originally supported Sadr in his insurgency against the U.S., it came to Maliki's support in that brief but deadly six-day conflict. Basra is Iraq's chief port through which much of the country's oil exports flow. Iraq may therefore become a critical battleground as Iran retaliates against U.S. Maximum Pressure. From Iran's perspective, holding onto influence in Iraq is critical. It is the transit route through which Iran has established an over-land connection with its allies in Syria and Lebanon (Map 4). Threatening Iraqi oil exports, or even causing some of the supply to come off-line, would also be a convenient way to reduce the financial costs of the sanctions. A 500,000 b/d loss of exports - at an average price of $70 per barrel (as Brent has averaged in 2018) - could roughly be compensated by an increase in oil prices by $10 per barrel, given Iran's total exports. As such, Iran, faced with lost supply due to sanctions, will have an incentive to make sure that prices go up (i.e., that rivals do not simply replace Iranian supply, keeping prices more or less level). The easiest way to accomplish this, to add a geopolitical risk premium to oil prices, is through the meddling in Iraqi affairs. Map 4Iran Needs Iraq To Project Power Through The Levant It is too early to forecast with a high degree of confidence precisely how the U.S.-Iran confrontation will develop. However, Diagram 2 offers our take on the path towards retaliation. Diagram 2Iran-U.S. Tensions Decision Tree The critical U.S. sanctions against Iran will become effective on November 4 (Box 1). We believe that the Trump administration is serious and that it will force European allies, as well as South Korea and Japan, to cease imports of oil from Iran. China will be much harder to cajole. Box 1: Iranian Sanction Timeline President Trump issued a National Security Presidential Memorandum to re-impose all U.S. sanctions lifted or waived in connection with the JCPOA. The Office of Foreign Assets Control expects all sanctions lifted under the JCPOA to be re-imposed and in full effect after November 4, 2018. However, there are two schedules by which sanctions will be re-imposed, a 90-day and 180-day wind-down periods.1 Sanctions Re-Imposed After August 6, 2018 The first batch of sanctions that will be re-imposed will come into effect 90 days after the announced withdrawal from the JCPOA. These include: Sanctions on direct or indirect sale, supply, or transfer to or from Iran of several commodities (including gold), semi-finished metals, and industrial process software; Sanctions on the purchase or acquisition of U.S. dollar banknotes by the government of Iran; Sanctions on trade in Iranian currency and facilitation of the issuance of Iranian sovereign debt; Sanctions on Iran's automotive sector; Sanctions on export or re-export to Iran of commercial passenger aircraft and related parts. Sanctions Re-Imposed After November 4, 2018 The second batch of sanctions will come into effect 180 days after the announced Trump administration JCPOA withdrawal decision. These include: Sanctions on Iranian port operators, shipping, and shipbuilding activities; Sanctions against petroleum-related transactions with the National Iranian Oil Company (NIOC), Naftiran Intertrade Company (NICO), and National Iranian Tanker Company (NITC); Sanctions against the purchase of petroleum, petroleum products, or petrochemical products from Iran; Sanctions on transactions and provision of financial messaging services by foreign financial institutions with the Central Bank of Iran; Sanctions on Iran's energy sector; Sanctions on the provision of insurance, reinsurance, and underwriting services. 1a Please see the U.S. Treasury Department, "Frequently Asked Questions Regarding the Re-Imposition of Sanctions Pursuant to the May 8, 2018, National Security Presidential Memorandum Relating to the Joint Comprehensive Plan of Action (JCPOA)," dated May 8, 2018, available at www.treasury.gov. By Q1 2019, the impact on Iranian oil exports will be clear. We suspect that Iran will, at that point, have the choice of either relenting to Trump's Maximum Pressure, or escalating tensions through retaliation. We give the latter a much higher degree of confidence and suspect that a cycle of retaliation and Maximum Pressure would lead to a conditional probability of war between Iran and the U.S. of around 20%. This is a significant number, and it is critical if President Trump wants to apply credible threats of war to Iran. Bottom Line: Unlike North Korea, Iran has several levers it can use to retaliate against U.S. Maximum Pressure. Iran agreed to set these levers aside as negotiations with the Obama administration progressed, and it has kept them aside since the conclusion of the JCPOA. It is therefore easy for Tehran to resurrect them against the Trump administration. Critical among these levers is meddling in Iraq's internal affairs. Not only is Iraq critical to Iran's regional influence; it is also key to global oil supply. We suspect that a cycle of Iranian retaliation and American Maximum Pressure raises the probability of U.S.-Iran military confrontation to 20%. We will be looking at several key factors in assessing whether the U.S. and Iran are heading towards a confrontation. To that end, we have compiled a U.S.-Iran confrontation checklist (Table 1). Table 1Will The U.S. Attack Iran? Investment Implications Over the past several years, there have been many geopolitical crises in the Middle East. We have tended to fade most of them, from a perspective of a geopolitical risk premium applied to oil prices. This is because we always seek the second derivative of any geopolitical event. In the context of the Middle East, by "second derivative" we mean that we are interested in whether the market impact of a new piece of information - of a new geopolitical event - will amount to more than just a random perturbation with ephemeral, decaying, market implications. To determine the potential of new information to catalyze a persistent market risk premium or discount, we investigate whether it changes the way things change in a given region or context. In 2015, we identified three factors that we believe are critical for a geopolitical event in the Middle East to have such second derivative implications, and thus global market implications.16 These are: Oil supply: The event should impact current global oil supply either directly or through a clear channel of contagion. Renewed sanctions against Iran do so directly. So would Iranian retaliation in Iraq or the Persian Gulf. Geography: The event should occur in a geography that is of existential significance to one of the regional or global players. Re-imposed sanctions obviously directly impact Iran as they could increase domestic political crisis. A potential Iranian proxy-war in Iraq would be highly relevant to Saudi Arabia, which considers Iraq as a vital buffer with Iran. Sectarian contagion: The event should exacerbate sectarian conflict - Sunni vs. Shia - which is more likely to lead contagion than tribal conflict such as the Libyan Civil War. A renewed U.S.-Iran tensions check all of our factors. The risk is therefore real and should be priced by the market through a geopolitical risk premium. In addition, Iranian sanctions could tighten up the outlook for oil markets in 2019 by 400,000-600,000 b/d, reversing most of the production gains that Iran has made since 2016 (Chart 9). This is a problem given that the enormous oversupply of crude oil and oil products held in inventories has already been significantly cut. BCA's Commodity & Energy Strategy and Energy Sector Strategy teams believe that global petroleum inventories will be further reduced in 2019 (Chart 10). Chart 9Current And Future Iran##BR##Production Is At Risk Chart 10Tighter Markets And Lower Inventories,##BR##Keep Forward Curves Backwardated What about the hints from the OPEC 2.0 alliance that they would surge production in light of supply loss from Iran? Oil prices fell on the belief OPEC 2.0 could easily restore 1.8 MMb/d of production that they agreed to hold off the market since early 2017. Our commodity strategists have always considered the full number to be an illusion that consists of 1.2 MMb/d of voluntary cuts and around 500,000 b/d of natural production declines that were counted as "cuts" so that the cartel could project an image of greater collaboration than it actually achieved (Chart 11). In fact, some of the lesser "contributors" to the OPEC cut pledged to lower 2017 production by ~400,000 b/d, but are facing 2018 production levels that are projected to be ~700,000 b/d below their 2016 reference levels, and 2019 production levels are estimated to decline by another 200,000 b/d (Chart 12). Furthermore, renewed Iran-U.S. tensions may only be the second-most investment-relevant geopolitical risk for oil markets. Our commodity team expects Venezuelan production to fall to 1.2 MMb/d by the end of 2018 and to 1 MMb/d by the end of 2019, but these production levels could turn out to be optimistic (Chart 13). Chart 11Primary OPEC 2.0 Members Are Producing##BR##1.0 MMb/d Below Pre-Cut Levels Chart 12Secondary##BR##OPEC 2.0 Chart 13Venezuela Is##BR##A Bigger Risk 2H18, 2019 Oil Forecasts BCA's Commodity & Energy Strategy updated its forecast last week, after the leaders of OPEC 2.0 indicated member states would be considering putting as much as 1mm b/d back on the market, following the price run-up accurately called from the beginning of this year. KSA and Russian are not being explicit about what they intend to do. In the background are the U.S.'s renewed Iran sanctions discussed above, which could remove ~ 500k b/d from the export markets by the end of 1H19, and the increasingly likely collapse of Venezuela's exports, which could remove ~ 1mm b/d. Against this, we have production in the U.S. shales increasing this year and next by ~ 1.3 - 1.4mm b/d to offset these potential losses, but even there we're seeing problems getting the shale oil out of the U.S.17 That's why CES went to an ensemble forecast, and will keep it in place as the market continues to process these conflicting signals (Chart 14). While some production will be restored to the market this year, it will be a drawn-out process, given CES's view OPEC 2.0 does not want to undo the hard work it took to drain OECD oil inventories (Chart 15). CES's Brent forecast was lowered $2/bbl in 2H18 and $7/bbl in 2019 to $76/bbl and to $73/bbl, respectively. CES's WTI forecast for 2H18 also was lowered $2/bbl to $70/bbl, while our 2019 forecast is now at $67/bbl, down $5/bbl vs. our previous forecast. Chart 14Factors In BCA's Ensemble Forecast Chart 15Balances Will Loosen If Supply Increases CES continues to expect continued strength on the demand side, with global oil consumption growing 1.7mm b/d. This will be driven by steady income growth in EM economies. One of the principal gauges CES uses to assess EM demand - import volumes - continues to move higher on a year-on-year basis, signaling incomes continue to expand (Chart 16). EM growth accounts for 1.3 of the 1.7mm b/d of growth we're expecting in 2018 and 2019. In forthcoming research, CES will be looking more deeply into the evolution of demand and the threat - if any - higher prices pose for EM growth. As was noted in last week's CES publication,17 consumers in many states no longer are shielded from high oil prices, as they were in the past: Governments around the world used the collapse in prices beginning in 2014 to remove/reduce fuel subsidies. This changes the dynamics of EM oil demand considerably, even if governments feel compelled to step into markets and order suppliers to not pass through the entire price increase. OPEC 2.0's leaders - KSA and Russia - appear united in their view of what is required to keep oil markets balanced over the long haul, so as not to disincentivize consumers from purchasing cars and trucks and the motor fuel required to run them. But over the short term, their goals differ. KSA is looking to IPO Saudi Aramco - next year, according to the latest reports - and this sale would most definitely benefit from higher prices. Indeed, KSA's oil minister Khalid al-Falih appeared to be comfortable with prices pushing toward $80/bbl recently. Russia's energy minister, Alexander Novak, has said in the past he favors an oil price somewhere between $50 and $60/bbl. CES continues to believe the dominant price risks remain on the upside - at 28.31% and 12.12%, markets continue to underestimate the probability Brent prices will trade above $80 and $90/bbl this year and next (Chart 17). Chart 16Strong EM Commodity Demand Expected,##BR##As Incomes And Imports Continue To Grow Chart 17Oil Markets Continue To Underestimate##BR##Upside Price Risks In 2H18 And 2019 Bottom Line: A renewal of U.S. - Iran tensions throws up real risks that are not being fully priced by the oil markets at present. They raise the probability global oil supplies out of the Middle East will be directly threatened, and that tensions in Iran and Iraq will flare into proxy wars. Such an outcome would be highly relevant to Saudi Arabia, which considers Iraq as a vital buffer with Iran. Lastly, rising tensions could exacerbate sectarian conflict in the Middle East as a whole, particularly along the Sunni - Shia divide, which is more likely to lead contagion than tribal conflict such as the Libyan Civil War. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Conlan, Senior Vice President Energy Sector Strategy mattconlan@bcaresearchny.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Watching Five Risks," dated January 24, 2018, available at gps.bcaresearch.com. 2 The JCPOA was concluded in Vienna on July 14, 2015 between Iran and the five permanent members of the United Nations Security Council (China, France, Russia, the United Kingdom, and the United States), plus Germany (the "+1" of the P5+1). 3 BCA's Senior Commodity & Energy Strategist Robert P. Ryan has given the name "OPEC 2.0" to the Saudi-Russian alliance that is focused on regaining a modicum of control over the rate at which U.S. shale-oil resources are developed. Please see BCA Commodity & Energy Strategy Weekly Report, "KSA's, Russia's End Game: Contain U.S. Shale Oil," dated March 30, 2017; and "The Game's Afoot In Oil, But Which One?" dated April 6, 2017, available at ces.bcaresearch.com. 4 "Breakout" nuclear capacity is defined here as having enough uranium enriched at lower levels, such as at 20%, to produce sufficient quantities of highly-enriched uranium (HEU) required for a nuclear device. The often-reported amount of 20% enriched uranium required for breakout capacity is 200kg. However, the actual amount of uranium required depends on the number of centrifuges being employed and their efficiency. In our 2013 report, we gauged that Iran could produce enough HEU within 4-5 weeks at the Fordow facility to develop a weapon, which means that it had effectively reached "breakout capacity." 5 Please see International Atomic Energy Agency, "Implementation Of The NPT Safeguards Agreement And Relevant Provisions Of Security Council Resolutions In The Islamic Republic Of Iran," IAEA Board Report, dated August 28, 2013, available at www.iaea.org. 6 Although, in a move designed to increase pressure on Iran and its main trade partners, the Obama administration sold Israel the GBU-28 bunker-busting ordinance. That specific ordinance is very powerful, but still not capable enough to penetrate Fordow. 7 Please see BCA Geopolitical Strategy Special Report, "Middle East: Paradigm Shift," dated November 13, 2013, available at gps.bcaresearch.com. 8 Please see BCA Special Report, "Crisis In The Persian Gulf: Investment Implications," dated March 1, 2012, available at gps.bcaresearch.com. 9 There are four U.S. Navy Avenger-class minesweepers based in Bahrain as part of the joint U.S.-U.K. TF-52. This number has been the same since 2012, when they were deployed to the region. 10 Particularly crippling for Iran's economy was the EU oil embargo imposed in January 2012, effective from July of that year, and the banning of Iranian financial institutions from participating in the SWIFT system in March 2012. 11 The Guardian Council of the Constitution is a 12-member, unelected body wielding considerable power in Iran. It has consistently disqualified reformist candidates from running in elections, which makes its approval of Rouhani's candidacy all the more significant. 12 Please see BCA Geopolitical Strategy Special Report, "Reality Check: Israel Will Not Bomb Iran (Ever)," dated August 14, 2013, available at gps.bcaresearch.com. 13 The NATO war with Yugoslavia in 1999 reveals how challenging SEAD missions can be if the adversary refuses to engage its air defense systems. The U.S. and its NATO allies bombed Serbia and its forces for nearly three months with limited effectiveness against the country's surface-to-air capabilities. The Serbian military simply refused to turn on its radar installations, making U.S. AGM-88 HARM air-to-surface anti-radiation missiles, designed to home in on electronic transmissions coming from radar systems, ineffective. 14 Please see BCA Geopolitical Strategy Special Report, "Trump Re-Establishes America's 'Credible Threats,'" dated April 7, 2017, available at gps.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Weekly Report, "Insights From The Road - The Rest Of The World," dated September 6, 2017, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Special Report, "Middle East: A Tale Of Red Herrings And Black Swans," dated October 14, 2015, available at gps.bcaresearch.com. 17 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "OPEC 2.0 Guiding To Higher Output; Volatility Set To Rise ... Again," published May 31, 2018.It is available at ces.bcaresearch.com. Appendix Notable Clashes In The South China Sea (2010-18) 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 The recent weakness in emerging markets (EM) has not yet altered the Fed's view of the U.S. economy. Capital spending in the U.S. remains upbeat despite a slowdown in economic momentum outside the country. May's Beige Book continued to highlight labor shortages, especially among skilled workers in key areas of the economy. Feature Chart 1The Labor Market Continues To Tighten U.S. risk assets dipped along with Treasury yields last week as investor worry about Italy, emerging markets and global trade mounted. BCA's stance is that despite the increase in financial market and economic stress overseas, the Federal Reserve will stick to its gradual pace of rate hikes for now. Policymakers at the central bank would need to see a direct and prolonged impact on U.S. financial conditions before adjusting the path of rate hikes. Data released last week on housing, capital spending and the labor market confirmed that the U.S. economy is growing well above its long-term potential in 1H 2018 and that inflation remains at the Fed's 2% target (see section below). The U.S. added 223,000 jobs in May. The 3-month average, at almost 180,000, is well above the expansion in the labor force. Thus, the unemployment rate ticked down to 3.8%, matching the low seen during the height of the tech bubble in 2000 (Chart 1). For the FOMC, the unemployment rate has already reached the level policymakers had projected for the end of the year (3.8%). Indeed, by later this year unemployment is likely to drop below the FOMC's projection for the end of 2019 (3.6%). The Fed has signaled that it is comfortable with an overshoot of the 2% inflation target, but it will likely be forced by early 2019 to transition from simply normalizing monetary policy at a "gradual" pace to targeting slower growth. This would set the stage for a recession in 2020. Julia Coronado, a panelist at BCA's upcoming 2018 Investment Conference in Toronto, noted recently that inflation may fall short of the Fed's target and cause the Fed to scale back its planned hikes.1 Italy remains a key source of concern for markets. BCA's Geopolitical Strategy service notes that a new election is likely in Italy after August, prolonging the political uncertainty there. BCA's stance is that while Italian policymakers' fight with Brussels, Berlin, and the ECB will last throughout 2018, they are not looking to exit the euro area yet. Over the next ten years, however, BCA's Geopolitical Strategy service expects Italy to test the markets with a euro area exit attempt. We are sticking to our view that such an event is far more likely to occur following a recession than it is today.2 The Trump Administration re-ignited the trade war last week. We discuss below, in the context of the Fed's Beige Book, which noted an uptick in uncertainty surrounding trade. Is EM Weakness A Risk? The recent weakness in emerging markets has not altered the Fed's view of the U.S. economy. Chart 2, Chart 3 and Chart 4 show the performance of key U.S and EM financial market earnings and economic metrics indexed to the peak of MSCI's Emerging Market Index in mid-1997, late 2014 and early 2018. Chart 2 (panel 1) shows that the dollar's strength since the EM markets peaked last year is modest compared with prior cycles. Moreover, oil prices are rising today; in 1997-98 and 2014-15 prices collapsed. The implication is that rising oil prices suggest that global economic activity is in an uptrend. Last week, BCA's Commodity and Energy Service team revised their forecasts for oil prices in 2018 and 2019 warning investors to expect more volatility in oil markets.3 U.S. financial conditions (panel 3) have eased since the EM peak in early 2018. This contrasts with 1997-98 and in 2014-2016 when financial conditions tightened considerably. S&P 500 forward EPS estimates (panel 4) have climbed since the top in EM equities, but the rise is related to the 2017 tax bill. Analysts' estimates for U.S. large cap earnings also rose during the EM crisis in the late 1990s, but then fell in 2014 and 2015 as oil prices dropped. U.S. real final demand climbed after EM equities peaked in 1997 and 2014. BCA's view is that the U.S. economy will accelerate in the final three quarters of 2018 and run well above its long-term potential of 1.8%. Chart 2U.S. Financial Conditions, ##br##Oil And EPS During EM Stress Chart 3EM Assets 1997-98, ##br##2014-15 And Today Chart 4U.S. Stocks, Treasuries, ##br##Spread Product And EM Stress The rise in the dollar and Fed rate hike expectations have pressured some EM currencies, financial markets and economies. That said, the response is muted relative to previous cycles. A Boston Fed paper4 found that during recent bouts of international financial market turmoil, EM economies with fewer economic vulnerabilities performed better than economies that were more exposed. However, the paper also noted that during crises in the late 1990s and early 2000s, there was little differentiation in EM market performance. Chart 3 shows that in the late 1990s and between 2014 and 2016, EM currencies declined about 8.2% in the first few months after EM equity prices peaked. Today, EM currencies are down just 3.8% versus the dollar since the EM equity peak (panel 1). Panel 2 shows EM stocks relative to U.S. stocks since the EM summit and panel 3 shows the global LEI (ex the U.S.) is tracking the mid-1990s episode, but not the 2014-2016 experience. China's Li Keqiang Index (LKI) is also following the late 1990s episode. BCA's China Investment Strategy service states that China's economy will continue to weaken, but that the deceleration will not be as severe as the 2014-2016 slowdown (panel 4).5 U.S. Treasury yields are on the rise; in the late 1990s and 2014-2016 (Chart 4, panel 1) they headed downhill. That said, the yield on the 10-year Treasury note has dipped 3 bps in the past week as investor worry about EM, global trade and Italy more than offset a strong batch of U.S. economic data. Panels 2 and 3 show that the S&P 500 and the U.S. stock-to-bond ratio dipped after the peak in EM stocks this year and in the earlier episodes. We note that at this point in the previous two instances, both U.S. equity prices and the stock-to-bond ratio began to climb and soon surpassed their prior heights. BCA's view is that some caution is warranted on U.S. stocks in the next few months. However, in the next 12 months, the U.S. stock-to-bond ratio will move higher. Investment-grade (panel 4) and high-yield spreads (panel 5) climbed this year after the top in EM stock prices. Moreover, the escalation in high-yield spreads is muted relative to the increase in 2014 as oil prices peaked. We also note that current spread levels are well above those in the late 1990s. BCA's U.S. Bond Strategy service recommends investors overweight high-yield bonds relative to Treasuries.6 Previous periods of EM-related stress in the financial markets led to shifts in the relationship between the dollar and certain U.S. asset classes. The top panel of Chart 5 shows that the correlation between changes in U.S. stock prices and the dollar tends to increase during these episodes. The relationship is more consistent prior to 2000. Since that time, the dollar and U.S. equities have moved in opposite directions during intervals of EM stress. There is no clear pattern in the relationship between the stock-to-bond ratio and the dollar when EM stress intensifies (panel 2). There is a very choppy correlation between S&P operating earnings and the dollar (panel 3). Chart 5U.S. Financial Markets' Correlation With The Dollar During EM Stress Likewise, there is no consistent interconnection between bond yields and the dollar (Chart 5, panel 4) as EM stress increases. However, as the pressure mounts, we note that the correlation between the dollar and the 10-year begins to shift. Oil and gold prices and the dollar tend to move in opposite directions during times of EM stress (not shown). Moreover, since the early 2000s, there is a consistently negative relationship between the dollar, gold and oil. In recent years, an escalating dollar has been aligned with small cap stocks outperforming large caps. Larger companies have more exposure to overseas sales than small cap firms in the S&P 500.7 Bottom Line: Dollar strength and rising U.S. bond yields are a classic late-cycle combination that often spells trouble for emerging market assets. Escalating turmoil in EM financial markets could potentially lead the Federal Reserve to put the rate hike campaign on hold. However, that would require some signs of either domestic financial stress or slowing growth. Stay short duration over a 12 month horizon. BCA's U.S. Bond Strategy service is looking for a trough in economic surprise and a capitulation in speculative positioning in the Treasury market to signal the end to the recent pullback in yields.8 Dollar Impact Capital spending in the U.S. remains upbeat despite a slowdown in economic momentum outside the country. BCA's view is that global growth will cool for the next few months and then reaccelerate. Chart 6 shows that global capital goods imports have rolled over (panel 1), but that new capital goods orders in the G3 remain in an upward trend (panel 2). Nonetheless, most of the strength in the G3 is from the U.S. BCA's model for nominal and real business investment (panel 3) suggests that capex is poised to rocket in the coming quarters. Moreover, CEO confidence measured by Duke and the Business Roundtable remain at cycle highs (Chart 7, panel 1) while business spending plans in the regional Fed surveys are still elevated (panels 2 and 3). Higher oil prices are not the only story behind the boom in U.S. business spending. Chart 8 shows that energy capex troughed (panel 3) a few months after oil prices (panel 1) in early 2016. Business spending outside the oil patch never turned negative on a year-over-year basis (panel 2) and it is still on the upswing. The 2017 tax bill and corporations' search for labor-saving machinery as wage and compensation metrics rise are behind the surge in spending. Robust corporate earnings also provide a tailwind for capex (panel 4). Chart 6Global Growth Is Rolling Over... Chart 7..But U.S. Growth Is Poised To Lift Off Chart 8Oil Is A Tailwind For Capes, ##br##But Not The Whole Story Last week's report on corporate profits allows us to compare the trajectory of the S&P 500's profits and margins to the NIPA measures (Chart 9). Both metrics indicate that earnings jumped in recent quarters (panel 1) to record heights (panel 2). Any disconnect between the two indicators has disappeared.9 Chart 10 shows that S&P 500 revenues dipped in Q1 (panel 1), but NIPA-based sales measures continued to climb (panel 2). However, panel 2 shows a divergence in margins. The BEA sounding leaped ahead in Q1 while the S&P 500 version levelled off. BCA's view is that S&P 500 earnings growth on a trailing four-quarter basis will peak later this year (Chart 11). Moreover, we anticipate the secular mean reversion of margins to re-assert itself in the S&P data, perhaps beginning later in 2018. Chart 9S&P And NIPA Profit Measures Are Aligned Chart 10NIPA And S&P Sales And Profit Margins The dollar's recent strength is not yet a threat to U.S. corporate profits nor the U.S. equity market. BCA's view is that the dollar will advance by 5% in the next 12 months. The appreciation would trim EPS growth by roughly 1 to 2 percentage points, although most of this would occur in 2019 due to lagged effects. Indeed, the dollar would only climb in the context of robust U.S. economic growth and an expanding corporate top line. Nonetheless, the stronger greenback is not yet evident in forward EPS estimates for 2018 or 2019. (Chart 12). Chart 11Strong S&P 500 EPS Growth Ahead, ##br##Will Start To Slow Soon Chart 12Is the Stronger Dollar Starting To Impact 2019 EPS Estimates? Bottom Line: BCA's view is that the slowdown in growth outside the U.S. is not the start of a more significant downturn. Monetary policy is still accommodative worldwide, U.S. fiscal policy is loose and governments outside the U.S. are no longer tightening policy. The implication is that a big slide in global growth is not likely and that by the end of the summer, global growth will probably reaccelerate. Therefore, risks to the dollar are much more balanced and we do not foresee much more upside in the greenback. Stay long stocks versus bonds. However, investors with longer horizons should begin to prepare for lower real returns in the 2020s after a recession early in that decade. Beige Book Update The Beige Book released last week ahead of the FOMC's June 12-13 meeting suggested that uncertainty surrounding U.S. trade policy remained an important headwind in April and May. The Fed's business and banking contacts mentioned either tariffs or trade policy 34 times in the Beige Book. This was below 44 mentions in the April edition, but well above the 3 mentions in March. Moreover, uncertainty came up 13 times in May (Chart 13, panel 5); 10 were related to trade policy. There were nine mentions of trade in April and only two in March. Chart 13Rise Of Inflation Words ##br##And Uncertainty Stand Out BCA's view is that trade-related uncertainty will persist at least until the midterm elections in November.10 The Trump administration announced a new round of tariffs on Chinese products last week. Moreover, the U.S. plans to end the exemptions it provided to E.U. steelmakers on the tariffs that the U.S. imposed earlier this year. BCA's Geopolitical Strategy service notes that the U.S.-China trade war is back on. The significance of the administration's about-face on trade is that it invalidates the conventional view that President Xi and Trump would promptly make a deal to ease tensions. President Trump's election, however, has revealed the preference of the median voter in the U.S. on trade. That preference is far less committed to free trade than previously assumed. Despite the headwind from trade, BCA's quantitative approach to the Beige Book's qualitative data continues to point to underlying strength in the U.S. economy, a tighter labor market and higher inflation. Moreover, references to a stronger dollar have disappeared from the Beige Book. Chart 13, panel 1 shows that at 67% in May, BCA's Beige Book Monitor ticked up from April's 55% reading, which was the lowest level since November 2017 when doubts over the tax bill weighed on business sentiment. The number of weak words in the Beige Book remained near four-year lows. On the other hand, the number of strong words climbed in May, but remains below last fall's post-hurricane highs. The tax bill was noted 3 times in the latest Beige Book, down from 12 in April and 15 in March. The legislation was cast in a positive light in two of the three mentions. BCA's stance is that the dollar will move modestly higher in 2018. The trade-weighted dollar is up 4.1% since mid-April, but the elevated value of the greenback is not yet a concern for Beige Book respondents. Furthermore, based on the minimal references to a robust dollar (only eight in the past eight Beige Books), the dollar should not be an issue for corporate profits in Q2 2018. The handful of recent references sharply contrasts with the surge in comments during 2015 and early 2016 (Chart 13, panel 4). The last time that eight consecutive Beige Books had so few remarks about a strong dollar was in late 2014. Table 1Labor 'Shortages' Identified In The Beige Book The disagreement on inflation between the Beige Book and the Fed's preferred price metric narrowed in May (Chart 13, panel 3). The number of inflation words rose to a fresh cycle zenith, surpassing the July 2017 peak. Core PCE also increased in early 2018. However, in the past year, inflation measured by the PCE deflator, failed to match the escalation in inflation references. In the past, increased remarks about inflation have led measured inflation by a few months, suggesting that the CPI and core PCE may still climb. May's Beige Book continued to highlight labor shortages, especially among skilled workers in key areas of the economy. Shortages of qualified workers were reported in various specialized trades and occupations, including truck drivers, sales personnel, carpenters, electricians, painters and information technology professionals. The Beige Book noted that many firms responded to the lack of qualified workers by increasing wages and compensation packages. Moreover, the word "widespread", which is part of BCA's inflation words count, was used 11 times in May, to describe both labor shortages and rising input costs. Table 1 shows industries with labor shortages. In the year ended April 2018, the gain in average hourly earnings in most of the industries was faster than average. Moreover, in nearly all these categories, labor market conditions are the tightest since before the onset of the 2007-2009 recession. More details can be found in a recent Fed study on labor shortages in the manufacturing sector.11 BCA's Beige Book Commercial Real Estate (CRE) Monitor12 remains in a downtrend (Chart 14). The Fed has highlighted valuation concerns in CRE and BCA's Global Investment Strategy service recently stated that the sector is increasingly vulnerable.13 Chart 14Beige Book Commercial Real Estate Monitor Bottom Line: May's Beige Book supports our stance that inflation will lead to at least three more Fed rate hikes by the end of the year. Moreover, labor shortages may be spreading from highly skilled to moderately skilled workers, and rising input costs are widespread. The nation's tax policy still gets high marks from the business community, but ongoing concerns over trade policy will restrain growth. The Fed may back off from this gradual path if stress in the emerging markets leads to tighter U.S. financial conditions. Still, it will take more than the recent spate of EM turmoil to deter the Fed. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 https://www.rutgersrealestate.com/blog-re/low-inflation-the-good-and-the-bad/ 2 Please see BCA Research's Geopolitical Strategy "Italy, Spain, Trade Wars... Oh My!", published May 30, 2018. Available at gps.bcaresearch.com. 3 Please see BCA Research's Commodity And Energy Strategy "OPEC 2.0 Guiding To Higher Output; Volatility Set To Rise ... Again", published May 31,2018. Available at ces.bcaresearch.com. 4 https://www.bostonfed.org/-/media/Documents/Workingpapers/PDF/rpa1702.pdf 5 Please see BCA Research's China Investment Strategy Weekly Report, "11 Charts to Watch", published May 30, 2018. Available at cis.bcaresearch.com. 6 Please see BCA Research's U.S. Bond Strategy Portfolio Allocation Summary, "Coming To Grips With Gradualism", published May 8, 2018. Available at usbs.bcaresearch.com. 7 Please see BCA Research's U.S. Equity Strategy Weekly Report, "Too Good To Be True", published January 22, 2018. Available at uses.bcaresearch.com. 8 Please see BCA Research's U.S. Bond Strategy Weekly Report, "Pulling Back And Looking Ahead", published May 22, 2018. Available at usbs.bcaresearch.com. 9 Please see BCA's U.S. Investment Strategy Weekly Report, "Summer Stress Out", July 3, 2017. Available at usis.bcaresearch.com. 10 Please see BCA Research's Geopolitical Strategy Weekly Report, "Trump's Demands On China," April 4, 2018. Available at gps.bcaresearch.com. 11 https://www.federalreserve.gov/econres/notes/feds-notes/evaluating-labor-shortages-in-manufacturing-20180309.htm 12 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Summer Stress Out", dated July 3, 2017. Available at usis.bcaresearch.com. 13 Please see BCA Research's Global Investment Strategy Weekly Report, "Three Tantalizing Trades - Four Months On", dated January 19, 2018. Available at gis.bcaresearch.com.