Equities

Special Report

Geopolitical tensions in the South China Sea are here to stay; China has reached the ability to impose massive costs on any state that tries to roll back its control; U.S. advantages in the region are significant, but declining and overrated. We put together a portfolio of stocks that give investors exposure to the ongoing tensions in the South China Sea. Dear Client, Today's Special Report is jointly authored by BCA's Geopolitical Strategy and Emerging Markets Equity Strategy services and focuses on the tail risks around the South China Sea conflict. In this report, our colleagues Matt Gertken of the Geopolitical Strategy and Oleg Babanov of the Emerging Markets Equity Sector Strategy ask whether China has "won" the South China Sea, and what the implications might be for investors. At the end of the report, we provide detailed investment recommendations for both EM-dedicated as well as global investors. Kindest Regards, Garry Evans Senior Vice President EM Equity Sector Strategy Marko Papic Senior Vice President, Geopolitical Strategy "We're going to war in the South China Sea in five to 10 years ... There's no doubt about that." - Steve Bannon, prior to becoming President Donald Trump's Chief Strategist, Breitbart News, March 2016 The South China Sea is a headline grabber that has failed to produce any market-disruptions despite years of rising tensions. In fact, it would appear that the issue has been relegated to the backburner, with the Trump administration laying off its earlier aggressive rhetoric and America's Asian allies focusing on building a trade relationship with China. Compared to the Koreas, in particular, where geopolitical risk is spiking due to political turmoil in the South and weapons advances in the North, the South China Sea seems relatively calm.1 We are not so sanguine, however, and advise investors to take the tail-risk of a conflict in the South China Sea seriously. First, there has been a general "rotation" of global geopolitical risk from the Middle East to Asia Pacific, as BCA's Geopolitical Strategy has chronicled over the years.2 China's transformation into a "peer" or "near-peer" competitor to the United States, and the U.S.'s various reactions, are transforming the region and sowing the seeds of a new Cold War. Second, despite a thaw in the relationship between China and the Trump Administration, the latest positive signals have not extended to the South China Sea.3 In North Korea, China is offering to enforce sanctions. In Taiwan, Trump has backed away from hints of encouraging independence. But in the South China Sea, the two sides have increased activity even as they have made reassuring statements.4 Third, fact remains that despite headline grabbers, China has managed to expand its military installations in the region over the past half-decade and now possesses a layered-defense system in the region. In this report, we ask whether China has "won" the South China Sea, and what the implications might be for investors, particularly EM-dedicated investors, on the sectoral level. We find that China has reached the ability to impose massive costs on any state that should try to roll back its control of the disputed islands. We also do not think that the U.S. is ready to accept this new Chinese "sphere of influence." This means that the two countries are in a "gray zone" in which policy mistakes could occur. This uncertainty is driving the odds of a crisis higher. China is flush with recent victories in the islands, and yet the United States will continue to insist on free passage and the defense of allies and partners. Nationalism and rising jingoism in both countries also raises the odds of misunderstanding and miscalculation. Until the Trump and Xi administrations agree to a robust strategic deal that arranges for de-escalation, the South China Sea will remain a source of low-probability, high-impact geopolitical risk for investors. It is only one aspect of a broader deterioration in U.S.-China relations that we see as the ultimate driver of a secular rise in geopolitical risk in Asia Pacific.5 Unfortunately, history also teaches us that such "strategic resets" are normally motivated by a dramatic crisis. At the end of this report, we provide investment recommendations for investors in emerging markets (and a couple for the U.S. as well). Why Not Ignore The South China Sea? Map 1Nine-Dash Line Reaches Far Beyond China Maritime territorial disputes between China and several of its neighbors - Taiwan, Vietnam, the Philippines, Malaysia, Brunei, and partly Indonesia - have a long history. China declared its "Nine Dash Line," an expansionist claim of sovereignty over almost the entirety of the sea, in 1947 (Map 1). Since then, conflicts have flared up sporadically. The most notable skirmishes illustrate that the maritime disputes are always simmering but tend to boil over only when larger geopolitical issues heat up.6 Since the 1990s, China and the other claimants have raced to "grab what they can," particularly in the Spratly Islands. However, conflicts have especially intensified since the mid-2000s (Charts 1 and 2). A major factor has been the rise in competition for subsea resources: Chart 1Territorialism Rising In South China Chart 2Rising Number Of Confrontations Energy and minerals - Although estimates vary widely, the South China Sea contains respectable reserves of oil and natural gas (Chart 3) and there are also hopes of extracting other minerals from the sea floor. Most of the region's states are net importers. Several conflicts have been sparked by exploration, test drilling, and unilateral development.7 It is a fact that the past decade's buildup in tensions has coincided with a global bull market for energy prices and offshore energy investment and capex (Chart 4). Chart 3Not Insignificant Reserves Of Oil And Gas In South China Sea Fishing Grounds - The South China Sea holds vast fish resources, a source of food security, exports, and jobs for littoral countries. It is estimated that over 10% of global fishing catches come from here. Fishing as a whole accounts for about 1-3% of GDP for the countries involved in the disputes (Chart 5), and the South China Sea is a large chunk of that. A quick glance at recent skirmishes reveals that fishing rights are a major cause of conflict (Table 1). Chart 4Offshore Oil Production In Decline Chart 5Fisheries Non-Negligible For Asian States Table 1Notable Incidents In The South China Sea (2010-16) Nevertheless, resource extraction is not the main driver of discord. Frictions spiked in 2015-16 despite the collapse in China's and other countries' offshore rig counts (Chart 6). And fishing rights are also clearly a pretext for attempts to assert control over waters and rocks.8 Chart 6Energy Interest Declining, Tensions Still Elevated Moreover, China's conversion of the sea's various geographical features into artificial islands through a process of land reclamation, and its construction of military facilities and stationing of armaments on these islands, points not to strictly economic interests but to broader strategic security interests. Similarly, the United States' enforcement of international rights of free navigation and overflight is not related to oil and fish. What is really at stake is national security, supply-line control, and international prestige. First, the United States has long executed a grand strategy of preventing any country from forming a regional empire and denying the U.S. access. China has the long-term potential to make this happen, and the South China Sea is its earliest foray into empire-building abroad. (Taiwan, Xinjiang, and Tibet are all old news and expand Chinese hegemony into the largely useless Eurasian hinterland.) Second, the main global trading lines from Eurasia and Africa to and from Asia mostly go through the South China Sea and the Spratly Islands. We illustrate this process through our diagram of the sea as a large traffic roundabout (Diagram 1). China is attempting to control the centerpiece of the roundabout, which - in combination with China's southern mainland forces - would eventually give it veto power over transit. Diagram 1South China Sea As A Vital Supply Roundabout The economic value of the trade potentially affected by power struggles is what makes this all highly market relevant if a full-blown war ever occurs. We estimate that roughly $4.8 trillion worth of trade flowed through this area in 2015, which is comparable to the $5.3 trillion estimate from 2012 frequently cited in news media.9 Moreover, the trade does not consist merely of manufactured goods from Asian manufacturing centers but also basic commodities vital to the Asian countries' economic and political stability. Essential commodities account for about 20-35% of Northeast and Southeast Asian imports, and almost all of this by definition flows through the South China Sea (Charts 7 and 8). Chart 7Commodity Imports Go Through South China Sea... Chart 8...And Greatly Affect Asian Economies The numbers belie how vital the supply lanes are for individual countries: Japan, for instance, gets 80% of its oil via the South China Sea. A total cutoff would be devastating after strategic reserves were exhausted; and even a marginal hindrance of energy imports would bite into the current account surpluses that grease the wheels of high-debt Asian economies. The South China Sea is therefore vital even to countries like Japan and South Korea that are not party to the maritime-territorial disputes. A commerce-destroying war could strangle their economies. Military access is another reason states seek control. This is separate but related to the need to secure economic supplies. Chinese military planners are clear that they want to be able to deny access to foreign powers if need be, in order to secure the southern half of the country, or cut off Taiwan's or Japan's supply lines. American military planners are equally clear that they will not allow a state to deny them access to international commons, or to coerce others through supply-lane control.10 Finally, there are political and legal aspects to the South China Sea disputes. China's successful alteration of the status quo in the face of opposition from the U.S., Asian neighbors, and a high-profile international tribunal (the Permanent Court of Arbitration at the Hague), has undermined international legal institutions and the U.S. prestige in the region. Over time, regional states, perceiving that "might makes right," may feel the need to cling more closely to China or the U.S., giving rise to proxy battles.11 With supply security and national defense at risk - and China in the process of "militarizing" the islands - there is a rising probability of a major "Black Swan" incident. The involvement of a number of major powers and minor allies means that a small incident could escalate into something significant. The friction between U.S. global dominance and China's rising regional sway is the chief source of instability. China could agree to a "Code of Conduct" with the Asian states possibly as early as this year. But without improvement in U.S.-China relations, the geopolitical consequences of such a code will be moot. Southeast Asian risk assets could benefit temporarily, but the chief tail-risks of the U.S. and China falling out would be unresolved. Bottom Line: He who controls the sea routes controls the traffic. China has made an overt bid for the ability to govern the sea routes and deny foreign powers access to the sea. The U.S. has threatened forceful responses to acts of "area-denial" or military coercion. Thus, geopolitical uncertainty and risks in the region remain elevated. How Do The Contenders Size Up? If China had clearly achieved full control of the waterways, airways, and geographical features of the South China Sea, then geopolitical risk over the area might decline. Countries would adjust to Beijing's rules of the game and the region would enter a period of hegemonic stability. The reason we are in a gray area today is that China has not yet reached dominance. China's advantages are significant, growing rapidly, and underrated; meanwhile the U.S.'s advantages are significant, declining, and overrated. A simple comparison of the U.S.'s and China's military advantages and disadvantages will make this clear. China Considering that the South China Sea is China's backyard, the country has a major advantage of playing on its "home court" versus the United States. China can afford to concentrate its military capabilities and planning specifically on its near seas, whereas American resources are dispersed globally and reduced to an "expeditionary force" when operating in China's neighborhood.12 Even so, the People's Liberation Army (PLA), Navy (PLAN), and Air Force (PLAAF) have major obstacles to overcome if they are to contend with American forces. Until relatively recently, China's defense buildup focused on traditional ground capabilities, creating weak spots in its ability to project military power over the South China Sea. What matters is whether China has addressed these shortfalls sufficiently to raise the costs of U.S. intervention to a prohibitive level. So far, it is attempting to do so in the following ways: Sea Power - China's naval capabilities have generally lagged far behind those of the U.S. and Japan. An important step was the commissioning of China's first aircraft carrier, the Liaoning, in 2012. It is a renovated Soviet carrier of the type that Russia has recently used in Syria. A second carrier, Shandong, is 85% complete and set to be commissioned in 2018 - it is an indigenously produced copy of the former. It is set to be stationed in Hainan, which will influence the balance of power given that the U.S. only has one carrier permanently in the region (though several more dock in San Diego). A third carrier is slated for 2022 and expected to be stationed in the South China Sea. The navy has also significantly increased China's logistic and support capabilities in the area, with amphibious warships and air cover. China has also vastly expanded its destroyers and smaller ships. Only its submarine capabilities face serious doubts about the degree of improvement and capability. Air Transport - China's naval and air force lifting capabilities, necessary to transport troops and equipment quickly to disputed territories, were initially very limited. But in recent years, China has improved these capabilities. Considering satellite pictures of the Spratly and Paracel Islands with new hangars and landing strips, China has made considerable progress toward the goal of quick material and troop supply for the islands. Of course, it is notoriously difficult to resupply small scattered islands amid enemy disruptions, but it is also difficult to disrupt without committing more than one aircraft carrier wing to the problem. Clearly China's capacity has improved. Infrastructure - China has converted Hainan, its southernmost island (and smallest province) into a major military and logistics base. Its new Yulin Naval Base can host up to 20 nuclear submarines as well as two carrier groups and several assault ships. This is China's "Pearl Harbor," and unlike the American version, it is in the South China Sea. Meanwhile, on the disputed islands, China had not built infrastructure until very recently. It was in fact the last of the island claimants to pave an airstrip. But its construction has been bigger, faster, and more ambitious - including for air transport, fighter jets, and surface-to-air and anti-ship missiles, all of which have added greatly to its ability to deny the U.S. access to the sea. Air Power - One of the main issues the PLAAF had over the years was the limited radius of its fighter planes, which would not allow full air superiority in the South China Sea. Airfield infrastructure was built on the disputed islands so that fighter planes could be stationed closer to the area. China therefore does not possess just one aircraft carrier, but rather numerous ones if we think of islands as aircraft carriers. Also, Russia is delivering to China a number of multirole fighters that can cover the South China Sea from bases on the mainland. And China's fifth-generation fighter is coming along. By far the most significant military development in China's arsenal, however, is its development of short- and medium-range missiles. This development greatly increases the danger to American ships and aircraft seeking access to the region. First, China has concentrated on building short-range, DF-21D "Carrier Killer" anti-ship missiles, which pack enough punch to take out an American aircraft carrier with one hit, and which the U.S. has limited means to defend against.13 China has also paraded around the DF-26 intermediate-range ballistic missile, or "Guam Killer," which can reach as far as Guam, can carry a nuclear charge, and has a mobile launch platform that would be difficult for U.S. forces to detect and knock out before the launch. In turn, the U.S. has deployed Terminal High-Altitude Area Defense (THAAD) missile systems in Guam and South Korea in preparation for precisely this kind of attack.14 Second, China has amassed around 500 surface-to-air missiles on Hainan Island, waiting to be shipped to the disputed rocks. The armory consists of a combination of short-, medium-, and long-range missiles to create a layered air-defense perimeter. Satellite images of the islands show that China has also positioned short-range and medium-range missile systems on some of the islands, namely Woody Island in the Paracels. Finally, China has fielded better radar systems to gain full coverage of the South China Sea (as well as other nearby waters) in order to find or guide friendly or hostile ships or planes and to support the various activities of its air and ship defenses. This combination of radar and missile capabilities amounts to a game changer. They make it possible for China to raise the costs of conflict to such a level that the United States might balk. Will the U.S. seek to change the balance of power with force? No. But Washington has reaffirmed its "red lines" in the region, namely freedom of passage. This was the takeaway from Secretary of Defense James Mattis's first foreign trip, not incidentally to Japan and South Korea. Mattis indicated that freedom of passage is "absolute" not only for the U.S. merchant fleet but also for the navy. However, he also said the U.S. will exhaust "diplomatic efforts" and eschew "any dramatic military moves" in the South China Sea, while maintaining the U.S.'s neutrality on sovereignty disputes. This is status quo, and the status quo favors China's rapidly growing ability to deny others' access to the area. The United States The U.S. has several bases in the Indo-Pacific area, with ground, air, naval, and marine assets. It also has extensive experience conducting wars and special operations in East Asia. Yet despite this dispersed and historic basing, China poses a challenge the likes of which it has not seen in the region. The distances to be covered, the complexities of the logistics, and China's growing strengths, make any U.S. intervention in the South China Sea harder than is typically assumed. The U.S.'s key five bases make these advantages and disadvantages clear: Guam, with almost 6,000 troops, will most likely be the first base to respond to a threat in the South China Sea, or to become engaged in a conflict there. It hosts part of the Seventh Fleet, including a ballistic-missile submarine squadron. It would be a key launch pad for regional operations. It could also be an early target for China's long-range ballistic missiles in a major conflict. Guam sits almost 3,000km from the South China Sea. South Korea hosts one of the U.S.'s oldest and largest regional deployments, with about 28,000 troops. Korea hosts the Eighth U.S. Army and Seventh Air Force, as well as Special Operations Command Korea. Its chief advantage is its proximity to China. However, assuming a conflict involves no direct engagement with mainland China, Korea comes with some disadvantages. Most of the ground staff is located around the North Korea border. The U.S. command in the region will be wary of lifting troops from the border and exposing its northern flank. North Korea (or conceivably China itself) could take advantage of U.S. distraction in the South China Sea. At the same time, the operational radius of planes on the Osan Air Base would not allow direct engagement in the South China Sea, though they could cover the southeast to hinder any maneuvers of the Chinese air force. Japan is the United States' largest overseas deployment with about 49,000 troops - heavily tilted toward naval and air power. The Fifth U.S. Air Force is spread across three main bases in Misawa, Yokota, and Kadena, while the Seventh Fleet is the largest forward-deployed U.S. fleet. It has several powerful task forces including the aircraft carrier USS Ronald Reagan and naval special warfare, amphibious assault, mine warfare, and marine expeditionary forces. The strong presence and firepower of this fleet as well as its maneuverability make it the prime candidate for any sort of engagement in the South China Sea (or East China Sea for that matter). The air bases around Tokyo and Okinawa can provide air support down to Taiwan and run airlift operations down to China's Hainan Island, the base of China's southern fleet. The only disadvantages stem from vulnerability to layered air defense and long supply lines for the navy, which will become targets after any lengthy engagement. Moreover, U.S. Forces Japan lack large ground units to organize landing operations, which will need to be sourced from South Korea or Hawaii. Hawaii is the home of the U.S. Pacific Command, which oversees regional forces, and contains sizable ground units to reinforce regional bases. It hosts the U.S. Army Pacific, U.S. Pacific Air Forces, and the U.S. Pacific Fleet stationed in Pearl Harbor (with a second base in San Diego). Hawaii has a large ground troop presence, which, together with U.S. air-lift capabilities, would provide the main ground forces for offensive operations. The large fleet secures U.S. presence in the region. Hawaii would host and resupply the core of any naval operations in the South China Sea. The only disadvantage is geographic: the distance to any U.S. ally's territory is significant, and main operational areas in the South China Sea cannot be reached in a single lift. This means that troop and equipment movement will take time and will not go unmolested. In any scenario involving land operations, the redeployment of troops will give the other side time to prepare. Alaska is also worth mention as it houses infantry brigades and air force combat units, albeit no significant naval presence. We only give small consideration to the base here because of its proximity to Russia. Assuming the neutrality of Russia during a hypothetical conflict, the U.S. would still be unlikely to draw resources from Alaska to aid operations in the South China Sea, since that would leave its own territory exposed to some degree. Other Allied Bases - We do not feature other allied bases in the region mainly because of the small numbers of troops that can be deployed and the low capabilities of U.S. allies. Some countries, such a Singapore, which has a respectably army, could disappoint the U.S. by trying to remain neutral. The most reliable help would come from Japan and Australia, but even Australia would face a very intense internal dilemma as a result of its economic dependency on China. South Korea would also be preoccupied with North Korea's ability to take advantage. A quick survey of the "order of battle" of the U.S. and China in the region would make our assertion that China has gained supremacy laughable. Then again, geopolitics does not work in ceteris paribus terms. Yes, the U.S. maintains military hegemony in the region, but China's abilities to impose real pain on American naval forces creates a complicated political dilemma for the U.S.: is Washington prepared to expend blood and treasure to defend allies and their supply lines in case of a conflict over this area? China is not yet looking to project power globally. It is not actively trying to compete for supremacy with the U.S. in the Persian Gulf, Indian Ocean, or Caribbean Sea. As such, it can concentrate its forces in the South and East China Seas and dedicate its entire naval strategy to the sole purpose of denying the U.S. navy access there. The U.S., meanwhile, has to plan for a global confrontation and then dedicate a portion of its forces to China's home court. Japan may very well hold the balance of power in a potential conflict over the region. Its import dependency is at the core of its national psyche and it would view a Chinese blockade of the South China Sea as an existential threat - not unlike the American threat of oil embargo that precipitated war in the early 1940s. Japan is not likely to go rogue, but it would be a tremendous addition to the American effort, even in a situation where other states refrained from action out of fear. However, while China will see the above as a reason not to initiate armed conflict with the United States, it will not be able to retrench in the South China Sea in the face of domestic nationalism either. These pressures virtually ensure that it is locked into the assertive foreign policy it has pursued over the past ten years. Bottom Line: A simple analysis of the current disposition shows that the military capabilities of the two countries - in this limited theater - are not as disparate as one might think. Both sides have weaknesses: the U.S. is bound to a handful of distant bases and has a global range of obligations and constraints, while China lacks technology, experience, and cooperation among its military branches. Nevertheless, China is approaching full air and sea cover of the area within the Nine Dash Line (Map 1) and is rapidly gaining greater ability through radar and missiles to inflict politically unacceptable damage on the U.S. The U.S.'s interest in the South China Sea is ultimately limited to free passage and the defense of treaty allies. The Trump administration is primed to strengthen the country's rights and deterrence, namely through a large increase in defense spending that focuses heavily on the navy - aiming at a 600-ship fleet - and likely on Asia Pacific. In the context of a massive new assertion of U.S. regional presence and power, it is significant that China has not yet given any concrete indication of slowing down its island reclamation, militarization, or control techniques. Investment Implications BCA's Geopolitical Strategy has been warning clients of the rising risks in the South China Sea, and East China in general, since 2012. However, it has been a challenge to construct an investment strategy based on our view. For starters, it is unclear when the crisis could emerge. It is difficult to know when accidents and miscalculations will happen. What we can say with some degree of certainty, however, is that the window of opportunity for any realistic campaign to reverse the militarization of the disputed islands will probably be closed by the end of this year. By "realistic," we mean operations that would promise control over the disputed territory with a calculated degree of risk and an acceptable degree of casualties. At the same time, the U.S. still has the ability to win a full-blown war with China. We have not addressed scenarios like cutting off China's oil supplies at the Strait of Hormuz, for instance, but have limited our discussion to a conflict in the South China Sea over control of the newly militarized islands. In that context, the American threshold for pain is low and its military advantages are narrowing. We are therefore entering a danger zone now because both China and the U.S. stand at risk of becoming overly assertive in the near future: Chart 9Will Trump Seek Political Recapitalization Via Conflict? China because it has domestic nationalist pressures that the Communist Party needs to vent as the economy slows; The U.S. because it has an unpopular (Chart 9), nationalist leadership that seeks to increase its defense presence in the region and may fall to brinkmanship in order to extract major trade concessions from Beijing. The tail-risk in the South China Sea suggests that global investors should also continue to hedge their exposure to risk assets with exposure to safe-haven assets receptive to geopolitical risk, like gold, Swiss bonds, though perhaps not U.S. Treasuries. The persistence of Sino-American distrust - beyond whatever happy encounter Trump and Xi may have at Mar-a-Lago in April - suggests that Chinese economic policy uncertainty will remain elevated and global financial volatility to rise. U.S.-China tension also feeds our broader narrative of rising mercantilism and protectionism. Investors will want to overweight domestic-oriented economies, consumer-oriented sectors, and small cap companies relative to their export-oriented, manufacturing, and large cap counterparts. We also recommend that EM-dedicated investors be wary about Asian states caught in the middle of de-globalization and vulnerable to geopolitical tail-risks. We are neutral to bearish on South Korea, Taiwan, and the Philippines. Our long Vietnam equities trade has been downgraded to tactical. We prefer Thailand and Japan, U.S. allies that are removed from conflict zones (Thailand) or domestically oriented and reflationary (Japan). We are also long China relative to Hong Kong and Taiwan, given the risks of both de-globalization and Chinese political troubles for the latter two. We are bullish on U.S. defense stocks.15 The U.S. defense establishment is conducting extensive reviews of the navy's force structure and future strategic needs - the fleet peaked in 1987 and fell below 300 battle force ships in 2003, but has projected that 355 battle force ships is necessary. This would require a major injection of funds in the coming decade. The Trump administration has endorsed this assessment in principle and is planning a significant increase in defense spending, marked by a requested increase of $50 billion in his first annual budget. Trump has signaled that defense manufacturing, notably shipbuilding, will be one of the ways in which he seeks to boost American manufacturing and jobs. This plays to his blue-collar base of support and could move the needle in battleground states like Virginia. It should be beneficial on the margin for U.S. defense companies.16 Below are our corporate-level recommendations for both EM-dedicated and global investors. The Companies Given the likelihood that tensions in the SCS will continue, and the projected build up in defense spending in both the U.S. and China, EMES recommends investors look to take exposure to defense stocks. We have put together a portfolio of such stocks that is intended to give exposure to the developments between China and the U.S. in the South China Sea. We recommend the following basket of companies: AviChina Industry & Technology (2357 HK); AVIC Jonhon Optronic (002179 CH); AVIC Helicopter Company (600038 CH); AVIC Aviation Engine Corporation (600893 CH); China Avionics Systems (600372 CH); Huntington Ingalls Industries (HII US); General Dynamics Corporation (GD US). The basket consists of four Chinese defense companies, mostly centered around the aviation industry. The choice of listed companies in China is constrained and hence we have been forced to gain exposure through aviation companies rather than naval. We recommend two companies in the U.S. that are involved in military vessel production for the U.S. Navy. We believe that the main ramp-up in defense spending from the U.S. side will come through a significant increase in the number of ships in the Asian region. Chart 10Performance Since March 2016: ##br## AviChina Vs. MSCI EM AviChina Industry & Technology (2357 HK): Chinese aviation holding company (Chart 10). AviChina is the listed subsidiary of the government-controlled Aviation Industry Corporation of China (AVIC). Airbus is another large shareholder, with over 11% of the free float. The company produces dual-purpose aircraft - civil and military -- including helicopters, trainers, parts and components (including radio-electronic), avionics and electrical products and components. AviChina itself is a holding company with a rather complicated structure, which makes it difficult for investors to access its market value. Listed subsidiaries include AVIC Helicopter Company (600038 CH), China Avionics (600372 CH), AVIC Jonhon Optronic (002179 CH) and Hongdu Aviation (600316 CH). In terms of the revenue stream, 49% is generated from whole aircraft production, 28% from engineering services and another 23% from parts and components manufacturing. The company reports semi-annual results. The latest full-year report released on March 15 came out mixed. Revenues were strong, up 39% year over year, but costs accelerated at a faster pace (+45% year over year). Operating income was still strong, growing 12.3% year over year, but margins declined across the board. EBITDA margin contracted by 257 basis points to 9.94%, while operating margin fell by 170 basis points to 7.32%. Despite this, the bottom line still managed to grow by 18.75% year over year. AviChina is currently trading at a forward P/E of 21.2x, whilst the market estimates an EPS CAGR of 9.5% for the next three years. Chart 11Performance Since March 2016: ##br## AVIC Jonhon Optronic Vs. MSCI EM AVIC Jonhon Optronic (002179 CH): Profiting from growing military and EV spending (Chart 11). A subsidiary of AVIC and AviChina, the company specializes in production of optical and electric connectors (third largest in China), and cable components. Jonhon is unrivalled in the defense market. It profits from rising electronic content and from supplying major components to other parts of the AVIC group, shipbuilders, railways and aerospace. It is also successfully developing its civil offering, specifically for the fast-growing electric vehicle market and the 4G space in the telecoms industry. Looking at the revenue composition, 54% is generated by sales of electric connectors, a further 24% from fiber-optic cables, and 19% from conventional cable and assembly products. As for the civil-military split, the company is expected to receive 60% of total revenues from its civil applications, growing approximately 10% per annum. Jonhon Optronics reported its full-year results on March 15. Revenues saw a strong increase, jumping 23.7% year over year. Cost growth was also higher, though it slowed from the previous year (up 23.8% year over year). This led to an operating profit increase of 19.7%, but slight margin deterioration. EBITDA margin fell by 77 basis points to 16.98%, and operating margin was down 5 basis points to 14.32. On the other hand, profit margins improved to 12.6% (up 54 basis points) as the bottom line grew by 29.8% year over year. Jonhon Optronics is currently trading at a forward P/E of 24.4x, whilst the market estimates an EPS CAGR of 15.2% for the next three years. Chart 12Performance Since March 2016: ##br## AVIC Helicopter Company Vs. MSCI EM AVIC Helicopter Company (600038 CH): AVIC's helicopter arm (Chart 12). As the name already suggests, the company specializes in helicopter production, which accounts for almost 100% of the overall revenue stream. The main helicopters currently marketed are from the AC series, in particular the AC311, AC312 and AC313, the Z series - Z-8, Z-9 and Z-11. We expect further tailwinds for the company stemming from China's future defense budget. The country's helicopter fleet is still only a tenth of the size of the U.S.'s fleet. It will continue to ramp up production. Export contracts will also support revenue growth for AVIC Helicopter Co. With a strong advance on the Asian military helicopter market, the company is looking to expand in the region. Furthermore, we see some promising developments in the civil helicopter space, with Chinese emergency services and the Civil Aviation Administration ramping up demand. The main headwind might come from the transition to new models, with the new production cycle to be in full force in 2018. AVIC Helicopter Co reported full year results on March 15, which came out weaker than expected. Revenues were virtually flat, contracting by 0.3% year over year, while cost of revenue grew 1.3% year over year. Operating income was also stable relative to last year, contracting 0.4% year over year, helped by an operating expense reduction of 12% year over year. Nevertheless, EBITDA margin declined slightly by 19 basis points to 6.77%, while operating margin fell by 131 basis points to 13.99%. A marginally lower income tax in FY16 allowed the firm to eke out 1.3% year-over-year bottom-line growth. AVIC Helicopters is currently trading at a forward P/E of 48.2x, whilst the market estimates an EPS CAGR of 13.8% for the next two years. Chart 13Performance Since March 2016: ##br## AVIC Aviation Engine Vs. MSCI EM AVIC Aviation Engine Corporation (600893 CH): Sole leader in Chinese engine production (Chart 13). Aviation Engine Corporation is part of the government-controlled Aeroengine Corporation of China (AECC), which was established in August 2016 and contributes just under 50% to Being in a monopolistic position on the Chinese market, the company profits from rising military aircraft procurement and prices. As part of the AECC, the company also receives tailwinds from scale effects within the company as well as cost savings in the supply chain. AVIC Aviation Engine Corporation reported weak full year results on March 16. Revenue slid 5.5% year over year, but management kept costs under control (down 7.3% year over year). Operating expenses grew only marginally (up 5.2% year over year), which left operating profit flat compared to last year. Margin trends have been strong; EBITDA margin improved by 78 basis points to 13.05%, while operating margin grew by 42 basis points to 7.78%. However, high net interest expense depressed the bottom line, which fell 13.3% year over year. At the same time the company managed to decrease its debt level for the fourth year in a row. AVIC Aviation Engine Corporation is currently trading at a forward P/E of 52.0x, whilst the market estimates an EPS CAGR of 14.4% for the next two years. Chart 14Performance Since March 2016: ##br## China Avionics Systems Vs. MSCI EM China Avionics Systems (600372 CH): Leading developer and producer of avionics equipment (Chart 14). China Avionics Systems is also a subsidiary of AviChina, which controls 43% of the free float. The company is active in R&D, running several research institutes in the fields of radar, aviation and navigation control as well as aviation computers and software. China Avionics enjoys a near-monopoly on the Chinese aviation electronics market, and also controls over 90% of the military market for air data systems. Looking at the revenue breakdown, 80% of total revenues come from military contracts, while it is expected that the share of civil revenues will increase with the development of civil aircraft in the country. Aircraft data acquisition devices contribute the most to overall revenue, at 25% of total, followed by airborne sensors at 15%, auto-pilot systems at 14%, distance-sensing alarm systems at 9.5%, and air data systems at 9%. The company reported full year results on March 16. Revenues experienced a mild increase of 1.9% year over year, while costs increased at the same pace (2% year over year). On the operating side, costs increased by 3% year over year, suppressing income by 1% year over year. EBITDA margin fell 37 basis points to 15.15%, while operating margin contracted 30 basis points to 10.60%. The bottom line contracted 3.5% year over year. China Avionics Systems is currently trading at a forward P/E of 55.0x, whilst the market estimates an EPS CAGR of 13% for the next two years. Chart 15Performance Since March 2016: ##br## Huntington Ingalls Industries Vs. S&P 500 Huntington Ingalls Industries (HII US): Largest listed U.S. military shipbuilder (Chart 15). Initially a part of Northrop Grumman, Huntington was spun off and listed in 2011. Huntington enjoys a monopolistic market position, as over 70% of the current U.S. Navy fleet was designed and built by the company's Newport News or Ingalls divisions in Virginia and Mississippi. Huntington is currently the sole designer, builder and re-fueler of nuclear-powered aircraft carriers in the U.S. In the nuclear submarines space, the company has one competitor: the Electric Boat unit of General Dynamics. The company also provides a range of services through its Technical Solutions division, centered around fleet support, integrated missions solutions and nuclear and oil and gas operations. Huntington reported full-year results on February 16. Full year revenue was virtually flat (+1% on quarterly basis), while costs increased slightly by 1.6% year over year. The company managed to reduce operating expenses, which fell by 16% to the lowest level since 2010. This helped boost operating profit by 13% year over year. EBITDA margin improved by an impressive 125 basis points to 14.77%, and operating margin was up by 119 basis points to 12.14%. New orders grew by US$5.2 billion, bringing the total pipeline to US$21 billion. The bottom line jumped by 45% year over year, helped by a lower income tax bill and a one-off after-tax adjustment. Huntington Ingalls Industries is currently trading at a forward P/E of 18.1x, whilst the market estimates an EPS CAGR of 4.2% for the next two years. Chart 16Performance Since March 2016: ##br## General Dynamics Vs. S&P 500 General Dynamics (GD US): Primary contractor for U.S. Navy submarines (Chart 16). General Dynamics is a multinational defense corporation and currently the fourth-largest defense company in the world. The company has four business segments, from which we are mainly interested in the marine systems segment, contributing 25% of overall group revenue. The marine systems segment is represented by General Dynamics' unlisted subsidiary, GD Electric Boat. Electric Boat has long been the main builder of nuclear submarines for the U.S. Navy out of Connecticut, and is expected to be one of the main beneficiaries of the U.S. Navy expansion program under the Trump administration. General Dynamics reported full-year results on January 27, which generally came in flat. Revenue fell by a marginal 0.4% year over year (after the adoption of a new revenue-recognition standard), but the company did a good job in managing costs, which contracted by 1% year over year. Operating income grew by 4% year over year, helped by lower operating costs. Margins improved across the board; EBITDA margin went up 45 basis points to 15.19%, while operating margin was up 54 basis points to 13.74%. The bottom line grew 5% year over year. Management seem confident in their guidance through 2020, including detailed but conservative estimates. Especially promising was the good pipeline visibility in the marine segment, driven by the company's Columbia-class submarine sales. General Dynamics is currently trading at a forward P/E of 19.3x, whilst the market estimates an EPS CAGR of 6.5% for the next two years. How To Trade? The GPS/EMES team recommends gaining exposure to the sector through a basket of the listed equities, which would consist of five Chinese companies and two U.S. companies. The main goal is active alpha generation by excluding laggards and including out-of-benchmark plays, to avoid passive index hugging via an ETF. Direct: Equity access through the tickers (Bloomberg): AviChina Industry & Technology (2357 HK); AVIC Jonhon Optronic (002179 CH); AVIC Helicopter Company (600038 CH); AVIC Aviation Engine Corporation (600893 CH); China Avionics Systems (600372 CH); Huntington Ingalls Industries (HII US); General Dynamics Corporation (GD US). ETFs: At current time there is one listed ETF covering the China defense sector: Guotai CSI National Defense ETF (512660 CH); And three listed ETFs covering the U.S. defense sector: iShares U.S. Aerospace & Defense ETF (ITA US); SPDR S&P Aerospace & Defense ETF (XAR US); PowerShares Aerospace & Defense Portfolio (PPA US). Funds: At current time there are no funds with significant defense sector exposure. Please note that the trade recommendation is long-term (1Y+) and based on a straight long trade. We don't see a need for specific market timing for this call (for technical indicators please refer to our website link). For convenience, the performance of both market cap-weighted and equally-weighted equity baskets will be tracked (please see upcoming updates as well as the website link to follow performance). Risks To The Investment Case The largest risk to our investment case - leaving aside company-specific risks - would be an unexpected fading away of the tensions in China's near seas, and of China's and America's military spending ambitions. Such a development - which would require a robust diplomatic agreement and an about-face from what the leaders have stated - would hit the weapons producers. Though such a settlement would not necessarily occur overnight, or receive immediate publicity, it would be observable over the course of negotiations between the Trump and Xi administrations. A key event to watch is the upcoming April summit between the two leaders. At the same time, the large momentum in the defense industry (with very long production pipelines), and the very low flexibility of defense budgeting, means that we are comfortable in terms of timing an exit should geopolitical tensions begin to recede. Another risk might come from a slowdown in economic growth in China or the U.S., which could lead to cuts in defense budgets. Nevertheless, in a case of a further escalation in China's near-abroad, we would most likely see defense spending continue to grow despite any weak economic performance, warranted by strategic needs. This is a key dynamic that investors should understand. Strategic distrust between the U.S. and China has worsened since the Great Recession, indicating that the preceding period of strong growth helped keep a lid on U.S.-China tensions. Now the two countries have entered a dilemma in which relations have soured despite their economic recoveries, since both sides are using growth to fuel military development, yet an economic relapse would fuel further distrust. Only a high-level political settlement can break this spiral and such settlements between strategic rivals traditionally require a "crisis." Matt Gertken, Associate Editor mattg@bcaresearch.com Oleg Babanov, Editor/Strategist obabanov@bcaresearch.co.uk Marko Papic, Senior Vice President marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Donald Trump Is Who We Thought He Was," dated March 8, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Monthly Report, "The Great Risk Rotation," dated December 11, 2013, and Geopolitical Strategy Special Report, "Power And Politics In East Asia: Cold War 2.0?" dated September 25, 2012, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "How To Play The Proxy Battles In Asia," dated March 1, 2017, available at gps.bcaresearch.com. 4 The United States sent the USS Carl Vinson carrier group to the South China Sea as part of Freedom of Navigation Operations that the Trump administration may intensify; China is involved in a new spat about "environmental" monitoring stations in the Paracel Islands and in Scarborough Shoal, and is also increasing activity east of the Philippines; it is threatening to impose a new law that would govern foreign ships' access; the question of a Chinese Air Defense Identification Zone lingers; and China has also begun sending large tourist groups to the Paracels. 5 Please see BCA Geopolitical Strategy Strategic Outlook, "We Are All Geopolitical Strategists Now," dated December 14, 2017, and Geopolitical Strategy Special Reports, "Sino-American Conflict: More Likely Than You Think," dated October 4, 2013 and "Sino-American Conflict: More Likely Than You Think, Part II," dated November 6, 2015, available at gps.bcaresearch.com. 6 Most notably in 1971, 1974, 1988, 1995, 2001, and 2011-14. In the two biggest "battles," 1974 and 1988, China kicked Vietnamese forces out of the Paracel Islands and parts of the Spratly Islands, respectively. These conflicts took place in the context of Vietnam's wars with itself, the U.S., and China, just as the recent rise in tensions takes place in the context of China's emergence as a global power - in other words, international tensions are the cause and maritime-territorial disputes are but a symptom. 7 Most notably the HS981 showdown between China and Vietnam in 2014, which occurred when China National Offshore Oil Corporation (CNOOC) moved a large mobile drilling rig into the farthest southwest island of the Paracel Islands, near Triton Island, triggering a months-long skirmish with Vietnamese coast guard ships and fishermen that involved Chinese warships and aircraft and the sinking of at least one Vietnamese fishing boat. 8 In fact, officers from China's People's Liberation Army-Navy's southern fleet have recently written publicly and approvingly of the well-known Chinese tactic of fighting "behind a civilian front" to establish control over the sea - which has involved a host of private and public actions covering fishing, energy, coast guard, administration, science and environment, and tourism. Please see "Chinese Military's Dominance in S. China Sea Complete: Report," Kyodo News, March 20, 2017. 9 Please see Bonnie S. Glaser, "Armed Clash In The South China Sea," Council on Foreign Relations, Contingency Planning Memorandum No. 14, April 2012, available at cfr.org. Separately, an American diplomatic estimate from 2016 claims that "more than half the world's merchant fleet tonnage" passes through these waters; see Colin Willett, "Statement ... Before the House Foreign Affairs Committee ... 'South China Sea Maritime Disputes,'" July 7, 2016, available at docs.house.gov [http://docs.house.gov/meetings/AS/AS28/20160707/105160/HHRG-114-AS28-Wstate-WillettC-20160707.pdf]. A Chinese study estimates that 47.5% of China's total foreign trade in goods transited the sea in 2014; see Du D. B., Ma Y. H. et al, "China's Maritime Transportation Security And Its Measures Of Safeguard," World Regional Studies 24:2 (2015), pp. 1-10. 10 When President Trump's Secretary of State Rex Tillerson clarified remarks at his senate confirmation hearing in which he threatened that the U.S. would deny China's access to the islands in the South China Sea, he reformulated his statement to say that in the event of a contingency the U.S. needed to be "capable of limiting China's access to and use of its artificial islands" to threaten the U.S. and its allies and partners. 11 Please see footnote 3 above. Another potential implication might be a weaker U.S. position in the partition of the Arctic shelf (which has far more hydrocarbon reserves than the South China Sea), which U.S. rivals like Russia will pursue next against the claims of the U.S. and its allies Norway, Canada, and Denmark. 12 Please see Robert Haddick, Fire on the Water: China, America, and the Future of the Pacific (Annapolis, MD: Naval Institute Press, 2014). 13 It is understood by multiple sources that these missiles cannot be defended successfully against by current anti-missile technology, with one potential exclusion - the recently tested SM-6 Dual I. Otherwise, possible defense methods would lie in the realm of electronic countermeasures. 14 We believe, with medium conviction, that the incoming administration in South Korea will remove the THAAD missile defense sometime in 2017 or 2018 in what would be a major diplomatic quarrel between Seoul and Washington. This is because the soon-to-be ruling Minjoo Party (Democratic Party) will seek to engage North Korea and mend relations with China, and the latter countries' top demand will be removal of the missile defense system that was only put in place in a rushed manner in the final days of the discredited and impeached Park Geun-hye administration. Such a removal would illustrate the U.S.'s disadvantages relative to China in having to deal with alliances, basing, and force structure in a foreign region. 15 Please see BCA Geopolitical Strategy and Global Alpha Sector Strategy Joint Special Report, "Brothers In Arms," dated January 11, 2017, available at gps.bcaresearch.com. 16 Please see "2016 Navy Force Structure Assessment (FSA)," dated December 14, 2016, and Ronald O'Rourke, "Navy Force Structure and Shipbuilding Plans: Background and Issues for Congress," Congressional Research Service, September 21, 2016.

Highlights Portfolio Strategy Internal dynamics warn that a broad market consolidation phase has begun. The jump in growth vs. value stocks has provided an opportunity to shift to a neutral style bias. Transports have sold off sharply, but downside risks have not yet been fully expunged, especially for the airline group. Recent Changes Growth Vs. Value - Shift to a neutral stance. Table 1Sector Performance Returns (%) Feature The perceived dovish Fed shift and doubts about the achievability of Trump's policy goals are causing equity market consternation. To the extent that the run up in stocks has largely reflected an improvement in sentiment and other 'soft' economic data, the lack of follow through in 'hard' data has created a validation void. While a weaker U.S. dollar, lower oil prices and less hawkish Fed imply easier monetary conditions, which are ultimately positive for growth, profits and the stock market, a digestion phase still looms. Financials, and banks in particular, had been market leaders, driven up by hopes for a meaningful upward shift in the yield curve and unleashing of animal spirits. But these assumptions are being challenged and there is limited fundamental support. Indeed, bank lending growth remains non-existent and there is no tailwind from improving credit quality. Our view remains that banks carry the most downside risk of all financial groups (please see the March 6 Weekly Report for more details). Regional banks are now down on a year-to-date relative performance basis (Chart 1). In fact, our newly constructed gauge of the equity market's internal dynamics suggests that additional tactical broad market turbulence lies ahead. A composite of relative bank stock, relative transport, small/large cap and industrials/utilities share prices has been a good coincident to leading market indicator in recent years (Chart 2). While no indicator is infallible, the message is that overall market risk is elevated and a choppy period lies ahead, reinforcing our defensive vs. cyclical bias. Nevertheless, it will be important to put any corrective action into a longer-term context. Over the years, we have kept an eye on several qualitative 'unconventional indicators' that have helped time major market turning points. They are meant to augment rather than replace fundamental factors. Chart 1Market Leaders Are Stumbling Chart 2A Yellow Flag From Internal Dynamics Below we highlight five critical variables to gauge whether a correction will devolve into a sustained sell-off. Each of the indicators measures either; profits; business confidence; investor confidence; and/or reflects how liquidity conditions are impacting market dynamics. Investor confidence can be measured through margin debt. While extremely elevated (Chart 3), there is no concrete sign that access to funds is being undermined by the modest backup in interest rates. When the cost of borrowing becomes too onerous, it will manifest in reduced margin debt and forced selling, which will be a serious threat to stocks given that leverage is challenging levels experienced at prior peaks, as a share of nominal income. M&A activity is losing momentum (Chart 4). A peak in merger activity typically coincides with a rising cost of capital. If corporate sector capital availability becomes a pressing issue, then M&A activity will decline further, signaling that the corporate sector is facing growth headwinds. Economic signals are mostly positive. Durable goods orders have tentatively perked back up (Chart 5), reinforcing that profits and confidence have improved after a soft patch. Temporary employment continues to rise (Chart 5). When temp workers shrink, it is often an early warning sign that companies are entering retrenchment mode, given the ease and low cost of reducing this source of labor costs. If temporary employment falls at the same time as share prices, that would be a red flag. The relative performance of consumer discretionary to consumer staples can provide a read on purchasing power and/or the marginal propensity to spend. This share price ratio does not suggest any consumption concerns exist (Chart 4, bottom panel). If consumer staples begin to outperform, then it would warn of a more daunting economic outlook. Chart 3Borrowing Costs Are Not Yet Restrictive Chart 4M&A Is Starting To Labor Chart 5Economic Signals Are Decent In all, these indicators suggest that any pullback will be corrective rather than a trend change. If the profit cycle continues to improve and the Fed has no inflationary need to become restrictive, then any broad market correction could provide an opportunity to selectively add cyclical exposure to portfolios in the coming weeks. In the meantime, we are revisiting our growth vs. value view and providing an update on transports. Growth Vs. Value: Shifting To Neutral Our last style bias update in the December 19 Weekly Report concluded that we would likely recommend moving to a neutral stance over the coming weeks/months from our current growth vs. value (G/V) stance, but expected to do after growth stocks had staged a comeback. That recovery is now well underway and so we are revisiting the outlook. Growth indexes have outperformed value since the depths of the Great Recession. The preference for growth reflected central bank interest rate suppression, which boosted the multiple investors were willing to pay for perceived growth at a time when growth was scarce. In addition, the composition of the growth index is much longer duration than that of the value space. The surge in long-term earnings growth expectations suggests that investors have increased conviction in the durability of the expansion, which has aided the G/V recovery (Chart 6). That monetary experiment has recently begun to pay off, as global economic growth has finally demonstrated evidence of self-reinforcing traction, led by developed countries. As a result, most central banks are well past the point of maximum thrust, which would mean the loss, albeit not a reversal, of the primary support for the secular advance in growth vs. value indexes. Keep in mind that growth benchmarks have a massive technology sector weight, at just over 1/3 of the total index capitalization. Value indices carry only a 7% weight. As shown in previous research, the technology sector underperforms when economic growth is fast enough to create inflationary pressure and therefore, the interest rate structure. Furthermore, value benchmarks have more than 25% of their weight in the financials sector vs. less than 5% for growth indexes. The upshot is that a meaningful interest rate increase would pad the profits of financials-rich value indices while having little to no impact on growth benchmarks by virtue of their tech-dependence. It is no surprise that the G/V ratio trends with technology/financials relative sector performance (Chart 7). The latter has clearly peaked, with an assist from the renormalization in Fed policy. Chart 6Time To Shift Chart 7Two Key Sector Influences These sector discrepancies mean that a critical question for the style decision is what is the path for government bond yields? The U.S. economy is exhibiting signs of self-reinforcing behavior. The small business sector's hiring plans have surged, and the ISM employment index remains solid (Chart 8). Chart 8Economy No Longer Favors Growth Chart 9A Mixed Bag While at least a modest employment slowdown is probable given that the corporate sector is feeling the profit margin pinch from higher wage costs, these gauges do not suggest a major crunch is imminent. The personal savings rate is drifting lower, supporting consumption growth (Chart 8). Value indexes have a higher economic beta than growth benchmarks, owing to their exposure to shorter duration sectors. The gap between growth and value operating margins tends to close when the economy enjoys a meaningful acceleration (Chart 8). Chart 10Volatility Is A Style Driver Other markers of global economic growth are more mixed. The global manufacturing PMI survey is very strong, but oil and other commodity prices have started to diverge negatively (Chart 9). That may soon change if the U.S. dollar has crested, which would provide a much needed fillip to emerging markets and remove a source of deflationary pressure. Real global bond yields are grinding higher, suggesting that in all, economic prospects have improved, and alleviating a major constraint on value stocks. Against this backdrop, it is timely to shift to a neutral style preference after the sharp rebound in the G/V ratio since late last year. Why not a full shift into value indexes? Developing countries are conspicuously lagging developed countries, which caps the outlook for commodities and their beneficiaries. EM capital spending is still very weak in real terms. Deep cyclical sectors are much more heavily-weighted in value benchmarks. A global recovery that has a greater thrust from consumption than investment, at least at the outset, argues against expecting value stocks to outperform. Moreover, the fallout from potentially protectionist U.S. trade policies remains unknown, which could restrain economic growth momentum and unleash volatility in the equity markets. The latter has been incredibly muted in recent months. In fact, BCA's VIX model, which incorporates corporate sector health and interest rate expectations, is heralding a higher VIX. Clearly, elevated volatility has supported the G/V ratio over meaningful periods of time (Chart 10). Bottom Line: Shift to a neutral style bias. A full shift to a value preference would require BCA to forecast a much weaker U.S. dollar and/or demand-driven inflationary pressure. Transports: Stuck In Neutral The S&P transports index peaked in mid-December versus the broad market, the first major sub-group to fizzle after the post-election sugar high (Chart 11). The recent setback has been broad-based. We had been overweight both the rails and air freight & logistics industry sub-groups, but booked gains in both prior to their respective pullbacks. Is it time to get back in? Transportation equities are ultra-sensitive to swings in global economic growth. Chart 12 shows that the relative share price ratio is an excellent leading indicator of both the ISM manufacturing survey and Citi's economic surprise index. The message is that at least a mild mean reversion in both of these indexes looms in the coming months, i.e. beware of some form of economic cooling. Chart 11Transports Have Cracked... Chart 12... Signaling Economic Cooling Ahead Against this backdrop, we are revisiting our last remaining underweight, the S&P airlines index. While rails and air freight & logistics stocks are directly linked to global trade, the same does not hold true for the S&P airlines index. Business and consumer travel budgets are the key drivers of industry demand. A revival in animal spirits and a healthy U.S. consumer could be clear positives for air travel. Moreover, the recent pullback in fuel costs should cushion profit margins for unhedged airline operators (Chart 13). Finally, renowned investor Warren Buffett has recently become a major shareholder in the U.S. airline industry, raising its profile. While betting against Buffett is always fraught with risk, our cautious take on the airline industry boils down to our view that excess capacity will continue to hold back profitability. If the overall transport index is accurately signaling that some loss of economic momentum looms, then a rapid expansion in business and travel spending may not be quick to materialize. A pricing war has already gripped the industry, as airlines are scrambling to fill up planes. Revenue-per-available-seat-mile and U.S. CPI airfare are contracting (Chart 14), reflecting a fight for market share. That is a serious impediment to profit margins. Chart 13Airlines Are Losing Altitude... Chart 14... As Price Wars Persist The headwinds extend beyond the U.S. Chart 15 shows that global airfare deflation also bodes ill for top line industry growth. The lags from previous U.S. dollar strength could compound this source of drag. Absent a decisive recovery in total travel spending, there does not appear to be any catalysts to reverse deflationary conditions. Carriers are still allocating an historically high portion of cash flow to capital spending. While upgrading aging fleets to become more fuel-efficient in an era of low interest rates is a long-term positive, the payback period may be extended. Revenue has failed to keep up with the increase in capital expenditures (Chart 16, bottom panel), suggesting that capacity growth continues to outpace industry demand, a recipe for ongoing pricing pressure. Chart 15Deflation Is Global Chart 16Too Much Capacity This difficult backdrop has begun to infect analyst earnings estimates. Net earnings revisions have nosedived. Relative performance momentum is tightly lined with the trend in earnings estimates (Chart 16). The message is that the breakdown in cyclical momentum has further to run. Indeed, the 52-week rate of change rarely troughs until it reaches much lower levels, warning of additional downside relative performance risks. Bottom Line: The S&P transports group is heralding a period of economic cooling, but the airline sub-component has not yet fully discounted such an outcome. Stay underweight. The ticker symbols for the stocks in the S&P airlines index are: UAL, AAL, DAL, LUV & ALK. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

Special Report

The aim of this Special Report is to elaborate on and explain the different views on China that have coexisted at BCA in recent years. Although BCA strives to achieve consensus among its strategists, this is not always possible, as has been the case with China. Peter Berezin of the Global Investment Strategy service and Yan Wang of China Investment Strategy have been positive, while Arthur Budaghyan of Emerging Markets Strategy has been negative on both China's business cycle and China-related plays. The focal points of divergence are centered on how Peter, Yan, and Arthur view and explain the relationship between savings, debt, and the misallocation of capital, as well as how they see China's potential roadmap going forward. The debate is moderated by BCA Global Strategist Caroline Miller. Caroline: Peter and Yan, the world - including the Chinese government - is climbing a wall of worry about China's debt load. Why are you guys still smiling? How many Maotai did you have last night? Peter: I don't know what a Maotai is, but I am sure that if I had more than one I wouldn't be smiling this morning. But yes, I am not as worried as Arthur that China is in the midst of an unsustainable credit bubble. Genuine credit bubbles tend to happen during periods of euphoria. U.S., Spanish, and Irish banks all traded at lofty multiples to book value on the eve of the financial crisis, having massively outperformed their respective indices in the preceding years. That's obviously not the case for Chinese banks today, which remain one of the most loathed sectors in the global equity market (Chart 1). The U.S., Spanish, and Irish housing booms also occurred alongside ballooning current account deficits, something that doesn't apply to China (Chart 2). One can debate whether China is in the midst of a property bubble, but even if it is, it looks a lot more like the one Hong Kong experienced in the late 1990s. When that bubble burst, property prices plummeted by 70%. Yet, Hong Kong banks were barely affected (Chart 3). Chart 1Chinese Banks: Unloved And Unwanted Chart 2Recent Credit Bubbles Developed ##br##Amid Widening Current Account Deficits Chart 3Hong Kong Is The Correct Analogy Yes, there is a lot of debt in China. But there is a lot of savings too. In fact, to a large extent, China's high debt levels are just a function of its high saving rate. The evidence suggests that national saving rates and debt-to-GDP ratios are positively correlated across emerging economies (Chart 4). China sits close to the trend line, implying that its debt stock is roughly what you would expect it to be. Chart 4Positive Correlation Between National Savings And Indebtedness Arthur: Allow me to both agree and disagree with Peter. No, there is no bubble in Chinese equities, but yes, there is a bubble and euphoria in China's property market. Property prices have risen exponentially and are extremely high by any metric. Chinese bank equity valuations have already adjusted, but bank stocks could still sell off if their profits shrink considerably, as I expect. Bank shares are not expensive, but not cheap either, if one adjusts for non-performing loans. I concur that China's property market adjustment will likely resemble that of Hong Kong as opposed to that of the U.S. As Peter noted, in Hong Kong in the late 1990s, property prices plunged by 70%, but few homeowners defaulted on their mortgages. Yet property starts/construction also collapsed by 80% (Chart 5). Chart 5Hong Kong's Property: ##br##Few Mortgage Defaults ##br##But Collapse In Construction Presently in China, the risk is not mortgage defaults but a renewed drop in property construction as well as other types of capital spending. Less construction/capital spending entails less demand for commodities, materials/chemicals and industrial goods. China's residential and non-residential construction activity will contract anew as speculative/investment demand for property weakens. Yan: I agree with Peter that China's rising debt is fundamentally a function of the country's abundant savings. Moreover, the fact that the country's massive savings pool is primarily intermediated via the banking sector and other debt instruments exacerbates the debt buildup. If a country's savings are primarily intermediated by the stock market through equity financing, then high savings do not necessarily lead to high debt, as "savers" become "shareholders" rather than "creditors." In China's case, the country's still relatively undeveloped and volatile equity market has not yet been able to play a meaningful role in financial intermediation. Instead, banks still play a dominant role channeling financial resources. In other words, China's high savings and a banking-centric financial intermediation system are key drivers of the ever-rising debt level. In fact, as long as these two features persist, the country's debt will inevitably continue to rise, as it simply reflects the accumulated savings. Caroline: Arthur, does this line up with how you think about the relationship between savings and debt? Arthur: My thesis has been that China's abnormal credit growth has been the result of speculative, euphoric behavior among Chinese banks and the shadow banking system - and not the natural result of the country's "excess savings," as Peter and Yan have argued. What economists call "savings" or "excess savings," non-economists refer to as "overproduction" or "excess capacity." This is about concepts, not about China. In economic science, the term "savings" is used to denote the number of goods and services that a nation has produced but not consumed - i.e., they can be used for investment or exports. Peter and Yan are using this textbook definition of "savings." Hence, by "savings" or "excess savings" they mean "excess production." Logically, the glut of goods and services does not flow to banks and create deposits. In brief, "savings" or "excess savings" are real economic variables and have nothing to do with bank deposits - i.e., "monetary savings." Peter, Yan and many other commentators make this mistake by mixing up national savings - which is literally output of goods and services that were not consumed by households and government - with "monetary savings," i.e., deposits in the banking system. I have no doubt China has had a high savings rate, i.e., it has had overcapacity and over-production in a number of sectors. The textbook concept of national savings is calculated as a residual from the national accounts and balance of payments. In particular: Savings - Investments = Current Account Balance and Savings = Investments + Current Account Balance A few remarks on the economic interpretation of this equation are in order. First, in any country, "excess" national savings over investment, i.e., current account surpluses, lead to an accumulation of net foreign assets, but has no implication on domestic loan creation.1 Second, a country that invests a lot and does not run a large current account deficit will have a high savings rate as per the economic textbook's definition of national savings. The opposite also holds true. Critically, national or household savings are in no way linked to the amount of deposits at banks. When households decide to save a part of their income, they do not create new deposits or "monetary savings." They save deposits that already exist in the banking system. To sum up, the amount of deposits in the banking system does not change as a result of households' decision to save a part of their income. When a person gets paid in cash and deposits that cash in a bank as a savings deposit, there is no new money created either. That cash was a deposit and was withdrawn from a bank a few days before, and now this cash returns to the banking system as a deposit again. In this case, the amount of total outstanding money supply in the economy (cash plus deposits) has not changed. In general, when a bank receives a deposit, it does not create new money, or "monetary savings." The deposit simply moves from one bank to another or from cash to deposit. The amount of money supply does not change. When a country enjoys a lot of overcapacity, strong bank loans or money growth will not cause inflation and interest rates will stay low, encouraging more borrowing. This is why in Peter's Chart 4 there is a positive correlation between the national savings rate and debt-to-GDP ratio across countries. Overcapacity entails low inflation; the latter keeps nominal interest rates low, which in turn entices more borrowing and debt build-up. In brief, the linkage between national savings/excess capacity and the credit-to-GDP ratio is indirect via subdued inflation and low interest rates that encourage debt build-up. Caroline: Arthur, you have made the case that savings are not a constraint to loan origination. Can you elaborate? Arthur: The banking system does not intermediate "savings" or "excess savings" from the real economy into loans. The commercial banking system as a whole creates deposits at the time it originates loans. This is true of all countries. Indeed, whenever commercial banks make a loan, they simultaneously create a matching deposit in the borrower's bank account, therefore creating new money in the process (Chart 6). In other words, bank loan origination creates deposits and money.2 Chart 6Commercial Banks: Credit Origination Creates Deposits China's banking system has a lot of deposits because banks have created too many loans. In addition, a bank does not need liquidity (reserves at the central bank) for each loan it originates. It still requires some liquidity to settle its net balance with other banks or to meet minimum reserve requirements. If a bank creates a loan but still has excess reserves at the central bank, it may not require liquidity to "back up" the loan. There are many variables that constrain bank loan origination, but they do not include national savings or "excess savings." We discussed these constraints in detail in our EMS report titled Misconceptions About China's Credit Excesses.3 Finally, when central banks opt to keep short-term interest rates steady, they must provide commercial banks with as much liquidity as the latter demands. This point is greatly relevant to China. For the past few years, China's central bank has silently moved away from controlling money growth (the quantity of money) to targeting interest rates (the price of money) (Chart 7). As a result, nowadays the People's Bank of China (PBoC) has very little quantitative control over money/credit creation by commercial banks. Chart 7The PBoC Has Begun Targeting Rates In Recent Years It is Chinese commercial banks that effectively drive money/credit/deposit creation. The PBoC decides whether or not to accommodate banks' liquidity needs by allowing interest rates to rise or fall, or by keeping them steady.4 To conclude, what habitually drives credit booms in any country are the "animal spirits" of banks and borrowers - not national savings. This has been the case in China too. Caroline: Peter, do you agree with Arthur's assessment? Peter: I don't want to get bogged down in the weeds of monetary theory, but let me briefly address two distinct points that I think Arthur is making. The first is the claim that the ability of banks to create money "out of thin air" is somehow not constrained by the volume of bank reserves and cash in circulation (the so - called "monetary base"). The second is the claim that there is no meaningful link between savings and deposits. I think Arthur is wrong on both counts. On the first claim, it is true that when a bank issues a loan, it also creates a deposit. To the extent that bank deposits are treated as "money," this expands the money supply. This is simply the "money multiplier" taught in introductory economics classes. Where Arthur's logic falls short is in his implicit assumption that all lending translates into additional bank deposits. It doesn't have to. Some of the deposits will be withdrawn and kept as cash. Governments have complete control over how much cash there is in circulation by virtue of their monopoly over the printing press. As long as cash exists, central banks can influence the broad money supply via open market operations. By the way, this is true even in banking systems where there are no reserve requirements. Regarding Arthur's claim that lending can occur without savings, this is often true when someone is borrowing money to buy an asset. However, it is generally not true if they are borrowing money to finance new spending. Let me offer a concrete, albeit somewhat whimsical, example to illustrate this point. Suppose I am living in a closed economy where no one saves anything. Now, let's imagine that I decide to throw a party for myself and need to borrow $1000 to do this. Who is going to provide me with the resources? Well, we just said that no one wants to save, so "something" has to adjust for me to have my party. That "something" is the interest rate. In order to entice someone to spend a bit less, the bank (on my behalf) will offer depositors a higher interest rate. If rates rise by enough, someone will decide to forego a bit of consumption today in order to have more consumption tomorrow. In other words, my decision to borrow must result in someone else's decision to save. So do savings create debt or does debt create savings? The answer is both: interest rates adjust to ensure that the two end up being different sides of the same coin. Caroline: Yan, what's your perspective on China's high debt profile? What could you be missing? Yan: As you can see Arthur and I view China's debt profile through different theoretical lenses. I don't think we can fully reconcile our different frameworks on the matter, but we hope our debate can deepen clients' own understanding of this issue, so they can make up their own minds. What I do want to stress is that those analysts who fear that China's corporate debt problem constitutes an alarming systemic financial risk focus exclusively on the rapid increase in the country's debt-to-GDP ratio. While undoubtedly there is merit to this ratio, I think it is also important to validate this judgement by looking at other indicators. In our previous research, we looked beyond this widely cited conventional indicator for corroborating evidence of a "debt bubble." Our findings suggest that the level of Chinese corporate sector leverage is not as precarious as widely perceived. For example, in the Chinese corporate sector, the area of China's economy where investors worry most about leverage, the debt-to-asset ratio of China's industrial sector has been falling since the late 1990s, down to 56% from 62%, contrary to popular belief (Chart 8). State-owned enterprises have witnessed an increase in their debt-to-asset ratio since the global financial crisis, but it has barely reached late 1990s levels, and has actually rolled over in recent years. Meanwhile, SOEs are a shrinking part of the overall economy and therefore, when looked at in conjunction with the private sector, have not moved the needle on the broader trend of corporate balance sheet "deleveraging." This stands in stark contrast to Japan's corporate sector at the peak of its debt bubble. In the early 1990s, Japan's corporate sector debt-to-asset ratio topped out at 78% when the country's "balance sheet recession" began (Chart 9). Even after two decades of deleveraging, Japan's current corporate debt-to-asset ratio is comparable to China's. To validate this conclusion, we also calculated several other key ratios to compare the leverage situation of Chinese listed companies relative to their global peers. Ratios such as liability-to-assets, net debt-to-EBITDA and interest coverage assess both leverage levels and debt servicing capacity. As Chart 10 shows, our extensive survey, both from the top down and the bottom up, suggests that China's leverage situation is comparable if not superior to its global peers. Chart 8The Leverage Picture From A Balance Sheet Perspective Chart 9Japan's Debt Bubble And Deleveraging Chart 10Leverage Ratios: How China Compares Therefore, I think we should be skeptical about the widely held view that China's corporate sector leverage is precariously high. It is at a minimum inaccurate, if not misleading, to rely solely on the debt-to-GDP ratio to reach such an ominous conclusion. Caroline: Arthur, I take it you don't agree? Arthur: Since January 2009, China's corporate and household debt has risen by RMB 130 trillion (about US$ 19 trillion) or by 100% of GDP (Chart 11). I do not believe even the most sophisticated financial/credit systems can allocate such amounts of credit in such a short time and not misallocate capital. By capital misallocation, I am implying investments in projects that do not generate sufficient cash flow to service debt. The accounting value (valuation) of assets is irrelevant in these cases; the cash flow generation is critical. The debt-to-GDP ratio is a much more superior measure to debt-to-asset-ratio. The basis is that the GDP is a proxy for cash flow, while accounting value of assets could be extremely inflated during a credit bubble. To be sure, I am not suggesting that all investments in China have gone sour. Nobody knows the extent of capital misallocation in China. But I suspect it is large enough to make a difference for the macro outlook/business cycle. Caroline: Peter, you have made the comparison between China today and Japan in the 1990s. Could you expand on that? Peter: Starting in the early 1990s, Japan entered an extended era where the private sector was trying to spend less than it earned (Chart 12). In order to keep unemployment from rising, the Japanese government was forced to run large budget deficits. In effect, the government ended up having to absorb the private sector's excess savings through its own dissaving. The same sort of fiscal trap now stalks China. Up until the Great Recession, China was able to export much of its excess savings. The current account surplus hit a record high of nearly 10% of GDP in 2007. The subsequent appreciation of the RMB undermined this strategy, forcing the government to take steps to boost domestic demand. It is no surprise that China's debt stock began to grow rapidly just as its current account surplus started to dwindle (Chart 13). Chart 11China: The Credit Boom Chart 12Japan Relied On Fiscal Largesse And Current Account Surpluses To Offset The Rise In Private-Sector Savings Chart 13China: Debt Increased When ##br##The Current Account Surplus Began Its Descent Keep in mind that fiscal policy in China entails much more than adjustments to government spending and taxes. Central government spending accounts for a fairly small share of GDP. The vast majority of fiscal stimulus is done via the banking system. This makes Chinese fiscal policy nearly indistinguishable from credit policy. From this perspective, China's so-called "debt mountain" is not much different from Japan's debt mountain once we acknowledge that the bulk of China's corporate debt is, in fact, quasi-fiscal debt. As evidence, note that in sharp contrast to the SOE sector, the ratio of liabilities-to-assets among private Chinese companies has actually been trending lower over the past decade (please see Chart 8). In effect, China's money-losing SOEs are the equivalent of Japan's fabled "bridges to nowhere": They are a necessary evil. Caroline: Arthur, your thoughts? Arthur: What Peter and Yan in effect propose is that Chinese banks should continue creating credit/money "out of thin air" in order to create demand for these "excess" goods, i.e., overcapacity sectors. In a nutshell, a number of Chinese companies made bad decisions by over expanding capacity, and now banks have to continue lending/creating demand to justify these bad investments. As a result, persisting explosive credit growth has allowed these unviable or zombie enterprises to survive, and they are not compelled to restructure. This is not how capitalism and markets work. This is de facto socialism. Socialism usually does not lead to prosperity. One of the key reasons behind the failure of socialist economic models is that productivity growth in socialist systems is very low, often close to zero. The basis is that productivity growth is generated not by government officials but by the private sector and entrepreneurs. China's economic success over the past 35 years or so has been due to allowing private enterprises to function and flourish - not because government officials necessarily made correct business and investment decisions. I am for countercyclical fiscal and monetary policies. However, the credit boom in China has gone well beyond the countercyclical policy framework. The concept of countercyclical policies does not suggest that the government or public banks should continue to spend in perpetuity to support fundamentally unviable businesses that invested too much and created excess capacity. Besides, "countercyclical" means for a couple of years. China has been expanding bank/credit/money for about nine years - since January 2009. Peter and Yan argue that they should keep doing it further. If the authorities do what Peter and Yan propose, investors should be structurally - not cyclically - bearish on Chinese stocks. Chart 14There Has Been No Shortage ##br##Of Demand Since 2010 The basis is that a socialist growth model is not friendly for shareholders. Shareholders often lose money when companies operate for maximizing employment rather than profits. This is why Chinese SOEs and bank stocks trade at low multiples - because they destroy capital and value for their shareholders. Notably, "overproduction" and "excess capacity" could be an outcome of either a demand downturn or oversupply/overproduction. Keynes recommended countercyclical policies to fill the gaps when demand shrinks. Chart 15Fiscal Outlays & Credit Origination ##br##Are Close To 50% Of GDP In China's case, there has been no domestic demand downturn to warrant multi-year countercyclical policies. China did the right thing in early 2009 to offset its export plunge amid the Global Financial Crisis, and it helped the global economy recover. However, since 2010 global demand and mainland exports have been stable (Chart 14), making the extended and ongoing credit boom in China unwarranted and excessive. As to the argument that most credit should be counted as a form of fiscal spending, I do not think Chinese policymakers themselves would agree with this statement. In fact, if this is correct, it would mean that government officials are allocating about 50% of GDP each year. Chart 15 illustrates general (central plus local) government spending and annual credit origination as a share of GDP. How fast would productivity grow in an economy where government bureaucrats allocate 50% of GDP annually? It is true that China's central government has a low debt load so it can afford to take over a large chunk of corporate debt. If and when they do so, I will change my view. So far, they have not done this, and will likely only contemplate such a policy move when things get really messy. Investors do not want to be long China plays going into such a scenario. That said, a tactical buying opportunity could emerge when the government takes over a large chuck of corporate debt. Caroline: Yan, how worried should we be about the misallocation of capital in China? Yan: Every economy experiences some level of capital misallocation. The real question is whether China's level of capital misallocation is more serious than that of its global peers. Theoretically, if a country has a bigger capital misallocation problem than others, the economy should have systemically lower capacity utilization, weaker pricing power, and lower profitability. These metrics are easily cross-referenced: Chart 16 contextualizes China's industrial sector capacity utilization ratio relative to global peers. By and large, most countries' capacity utilization ratios hover around 80%, not much different from China's, especially since the 2000s. In fact, barring some obvious outliers, capacity utilization ratios across countries have been largely synchronized, reflecting the ebb and flow of the global business cycle. Chart 16Capacity Utilization: A Global Perspective Industrial sector output prices have shown similar swings (Chart 17). Almost all countries suffered producer price deflation in recent years, and are now experiencing a synchronized upturn in wholesale pricing power. China's falling PPI was widely regarded as a tell-tale sign of misallocation of capital. Conversely, this was in fact more a reflection of stagnating global aggregate demand and weak resource prices worldwide than structurally weak pricing power among Chinese manufacturers. Chart 17Producer Prices: A Global Perspective Similarly, Chinese listed companies' deteriorating Return on Equity (ROE) was again singled out as a sign of capital misallocation. This view is easily debunked by Chart 18, as ROEs have fallen in all major markets. In fact, Chinese companies' ROEs have been structurally higher than the global averages. Even some Chinese sectors that have been derided as being plagued by massive overcapacity and inefficiency such as materials and energy exhibit ROEs almost identical to their global peers. The important point is that we should put China in a global context, rather than analyzing it in isolation. Some Chinese firms' efficiency and profitability have weakened notably over the past several years, but to me, this is more of a reflection of the sluggish global macro backdrop, rather than an indictment of China's discrete growth model. Caroline: Turning to the investment implications, Yan, how does the debt bubble concern impact your view on Chinese equities? Yan: Global investors' widespread concerns over Chinese debt levels and other macro issues have contaminated Chinese stocks with a broad-brushed bearish undertone. Chinese equities have been unduly punished, underweighted and under-owned for many years. As shown in Chart 19, Chinese investable stocks' ROEs have been structurally higher than the global benchmark, and have followed similar cyclical fluctuations. However, their stock prices are trading at massive discounts to the global benchmarks, based on conventional yardsticks (Chart 19). This in my view represents the "China risk premium," which is unjustified and unsustainable. I expect the misperception will eventually unwind, and Chinese shares will be re-rated. This is the fundamental factor supporting my positive view on Chinese equities. Strategically it makes sense to overweight Chinese stocks against their global peers. Chart 18Chinese ROEs Are Not Inferior To Global Peers Chart 19Chinese Equities' Large Valuation Gap Caroline: Arthur, how does your view impact your outlook for investment prospects in China and the rest of the emerging markets space? Arthur: There has not been any adjustment in China's corporate leverage. Deleveraging in China has not yet started. On the contrary, the credit bubble is getting larger. I mean the credit-to-GDP ratio continues rising exponentially and credit and bank loan growth remain in double digits (Chart 20). It is very risky to be bullish on financial assets linked to a bubble when the adjustment has not yet begun. It is like running in front of a steamroller trying to collect pennies. Besides, when there is a major imbalance in the system like the credit bubble happening in China now, I tend to overplay the importance of marginal policy tightening and underplay the significance of easing. Recent marginal policy tightening in China - in particular the clampdown on shadow banking, including banks' off-balance-sheet asset expansion - will cause credit growth to decelerate. This is a major risk to Chinese and EM growth in the second half of this year (Chart 21). Chart 20China: Money/Credit Is Still Booming Chart 21Is China's Recovery At Risk? Even if China does not have a full-blown crisis, we are likely to experience another down leg in China plays, commodities and EM risk assets similar to the second half of 2015, when Chinese import volumes contracted and global markets tanked. A few words about the potential adjustment trajectory are in order. I have been negative on China's growth and China-related plays in global financial markets since 2010, but I have never used the word "crisis." China may or may not have a crisis, but investors holding risk assets exposed to China's growth will suffer considerable losses again similar to the 2011-16 period. It is essential to differentiate cyclical from structural growth drivers. If the government does not allow credit growth to slow, cyclical growth will hold up. However, in this scenario, China will move toward a socialist model and structural growth will tumble. That said, the growth deceleration would be gradual, as depicted in Chart 22. Chart 22Toward Socialism = Secular Stagnation And Inflation If we assume China's productivity is currently growing at a rate of about 5.5-6% (which is already very high and hard to sustain), and if the country embarks on a socialist path, odds are that productivity growth will drop by 50-100 basis points in each of the following years. In five years or so, productivity growth would be only around 1-3%. This path is the ultimate recipe for economic stagnation in China. The only thing the authorities can do in this scenario is to boost growth from time to time via credit and fiscal stimulus. This will produce mini-cycles around a falling primary growth trend. The latest acceleration in China's growth is probably one of these mini-cycles. How can investors invest in this scenario? The stylized mini-cycles depicted in Chart 22 look nice, because we drew them ourselves. In reality, they will not be symmetric or smooth. In short, investing around economic mini-cycles is difficult because it assumes near-perfect timing. Caroline: Peter, is it all that bad? Peter: I think Arthur is too pessimistic. Investors have been predicting a Japanese debt crisis for years. It hasn't materialized and probably won't. They are making the same mistake about China. If China averts a debt crisis, as I think is likely, that's good news for global equities. In the developed market universe, Europe and Japan stand to benefit the most, given the cyclical bent of their stock markets. We are overweight both regions in local-currency terms. For global bonds, the implications are somewhat mixed. On the one hand, the high probability that the Chinese government can maintain the status quo of continued credit expansion for the foreseeable future means that a hard landing for the economy - and the associated drop in safe-haven developed economy government bond yields that this would trigger - is unlikely to occur. On the other hand, high levels of Chinese savings will continue to fuel the global savings glut, keeping real long-term bond yields lower than they would otherwise be. On balance, investors should maintain a modest underweight allocation toward global bonds. Caroline: Yan, do domestic politics play into your outlook for the RMB versus the dollar and on a trade-weighted basis? What is your outlook for monetary policy given recent signs of improving economic momentum? Yan: How President Donald Trump will deal with China on the RMB issue is a wildcard. Recent rhetoric suggests that the new U.S. administration intends to follow normal legal protocol to decide if China is manipulating its currency. This is a significant departure from Candidate Trump's repeated campaign trail promises. If the U.S. Treasury follows the formal process laid out in the statute, it is unlikely to label China a currency manipulator in the next semi-annual assessment to be published in April, simply because the country does not meet all the criteria for that label at the moment. The odds of an immediate clash between the U.S. and China on the RMB have ebbed. From China's domestic perspective, how the People's Bank of China intends to manage the exchange rate is also a thorny issue. From a long term point of view, the PBoC clearly wants to achieve a free-floating exchange rate, but the recent downward pressure on the RMB due to elevated capital outflows has forced the PBoC to heavily intervene to prevent a vicious, disorderly cycle, in which currency depreciation and capital flight reinforce each other. In terms of monetary policy, China's improving economic momentum has allowed the PBoC to follow the Fed in raising short-term interest rates. However, tighter capital account control measures will remain in place until the downward pressure on the RMB from capital outflow dissipates. Moreover, investors have been overwhelmingly focused on the negative economic effects of a weaker RMB, somehow ignoring the reality that as the world's largest manufacturer and exporter, China also stands to benefit from a weaker currency. In my view, the depreciation of the trade-weighted RMB since 2015 has played a critical role in reflating the Chinese economy (Chart 23). A weaker RMB has helped producer prices to reflate, and lowered the real cost of funding for manufacturers, which in turn has eased China's monetary conditions and supported cyclical growth improvement. In this vein, the downside of the RMB should be self-limiting, as the reflationary impact of a weaker exchange rate will help boost Chinese growth, which in turn will reduce downward pressure on the currency. Caroline: Peter and Arthur, is rampant capital flight still a risk? Where do you see the RMB heading over the coming 12-18 months? Peter: I think the RMB will weaken somewhat over the coming year, but that is more a reflection of my bullish view on the dollar than a bearish view on the yuan. Much of the capital flight that China has experienced recently has just been an unwinding of the hot money flows that entered the country over the preceding four years. Despite all the talk about a credit bubble, Chinese corporate external debt has fallen by around $400 billion since its peak in mid-2014 - a decline of over 50% (Chart 24). At this point, most of the hot money has exited the country and hence, I expect the pace of capital outflows to subside. Chart 23A Weaker RMB Leads Cyclical Recovery Chart 24The Rise And Fall Of Corporate Foreign Credit Nevertheless, the chronic shortfall of domestic demand that I described earlier will keep pressure on the Chinese government to try to export excess production abroad by running a larger current account surplus. This requires a weak currency. Thus, while I don't expect the yuan to plummet, I don't expect it to soar either. Arthur: I believe the RMB is set to depreciate by 10% or more against the U.S. dollar in the next 12 months or so. The Chinese yuan is not expensive, but it will stay under downward pressure because the mainland banking system has created too many yuan. When the supply of money goes vertical, its price drops. It seems the Chinese people are sensing there is too much RMB floating around, and they are trying to get rid of local currency. They have been overpaying for properties and have been shifting their wealth into foreign currencies. Finally, in China, the real deposit rate has turned negative (Chart 25, top panel). In the past, when the real deposit rate turned negative, the central bank hiked interest rates (Chart 25, bottom panel). If households do not get a more attractive deposit rate, they will opt for foreign currency, real assets like property or riskier investments domestically. All of this entails negative consequences for China's financial stability. Chart 25Real Deposit Rate Is Negative In brief, I expect capital outflows to persist and policymakers to allow the currency to depreciate further. Caroline: Peter/Yan/Arthur: Final thoughts: What are each of you watching for signs that China's macro landscape is evolving as you expect? Conversely, what would signal that your assessment has missed the mark? Peter: I am watching for signs of a policy mistake. Until China can reorient its economy towards one that is more consumer-centric, it will have to rely on high levels of investment to sustain aggregate demand. Any attempt to aggressively curb debt growth will only backfire. Arthur talks about resource misallocation from subpar investment projects, but there is no worse resource misallocation than a person who wants a job but can't find one. I am also watching trade policy. I don't think a trade war between China and the U.S. is in the cards for the time being, but if the U.S. economy turns down in 2019, as I expect, Trump will be backed into a corner. And with another election looming, he will strike out at China. That could trigger a global trade war. Yan: I agree with Peter that we should watch for policy mistakes and some sort of "Trump shock," both of which constitute downside risks. A less talked-about risk is potential growth overheating, which could require much tighter policy, leading to greater economic volatility. In fact, some cyclical indicators that are tightly linked to industrial activity have rebounded sharply, which is also reflected in the rebound in some raw materials prices. If exports get a further boost from continued improvement in the U.S. economy, the possibility of China's economy overheating cannot be completely dismissed. Another potential trouble spot is the housing market. The Chinese authorities have begun to tighten housing policy, but developers appear to be gearing up for another construction cycle. Sales of construction equipment such as heavy trucks and excavators have soared. Historically, construction machine sales have been tightly correlated with real estate development (Chart 26). If history is any guide, the renewed strength in construction equipment sales could be a harbinger of an impending boom in new home construction. This is good news for business activity and GDP growth, but probably antithetical to policymakers' broad agenda. We will follow up on these issues closely in our future reports. Arthur: The key variables to watch are various interest rates, credit/loan growth and inflation - in addition to keeping an eye on lending standards and credit demand. Recent increases in borrowing costs amid the enormous credit overhang give me confidence to argue that China's credit origination and economic growth are bound to decelerate later this year. A billion-dollar question is whether the recent rise in China's consumer inflation is transitory or the beginning of a notable uptrend (Chart 27). If consumer price inflation rises to 3% and higher, the game will be over - interest rates will need to go up and credit growth will tumble. If interest rates do not rise amid intensifying inflationary pressures, capital outflows will escalate and the currency will depreciate a lot. Chart 26An Upturn In Housing Construction? Chart 27China: Inflation Is Picking Up I will be wrong if policymakers manage to slow down credit growth from 11-12% toward 7-8% or so without generating notable economic weakness. This can occur only if productivity growth in China accelerates meaningfully. It is difficult to observe productivity growth in real time - it is a black box. 1 Please see Emerging Markets Strategy Special Report, titled "Do Credit Bubbles Originate From High National Savings?" dated January 18, 2017, available at ems.bcaresearch.com. 2 Please see Emerging Markets Strategy Special Report, titled "Misconceptions About China's Credit Excesses," dated October 26, 2016, available at ems.bcaresearch.com. 3 Please see Emerging Markets Strategy Special Report, titled "Misconceptions About China's Credit Excesses," dated October 26, 2016, available at ems.bcaresearch.com. 4 Please see Emerging Markets Strategy Special Report, titled "China's Money Creation Redux And The RMB," dated November 23, 2016, available at ems.bcaresearch.com.

Bank stocks are being jettisoned from portfolios almost as fast as they were added after the election, on the back of the perceived dovish Fed shift and concerns about the efficacy of Trump's policy goals. The latter has raised the specter of a cooling in economic growth, which would remove the major source of support for bank stocks. Indeed, there is little fundamental support to drive earnings outperformance. Total bank credit growth is contracting and credit quality is no longer adding to profitability. Bank productivity growth is sinking quickly, because balance sheet expansion has ended but banks are adding to their cost structures. If the yield curve begins to narrow on fears of economic disappointment, it will remove the primary driver of capital inflows into banks. Regional banks have been particularly hard hit, but the entire banking group is at risk of a letdown. Bottom Line: Continue to shy away from banks, and please see the March 6 Weekly Report for more details on our banking view. The ticker symbols for the stocks in the S&P Banks index are: BLBG: S5BANKX - WFC, JPM, BAC, C, USB, PNC, BBT, STI, MTB, FITB, CFG, RF, KEY, HBAN, CMA, ZION, PBCT.

Special Report

The aim of this Special Report is to elaborate on and explain the different views on China that have coexisted at BCA in recent years. Although BCA strives to achieve consensus among its strategists, this is not always possible, as has been the case with China. Peter Berezin of the Global Investment Strategy service and Yan Wang of China Investment Strategy have been positive, while Arthur Budaghyan of Emerging Markets Strategy has been negative on both China's business cycle and China-related plays. The focal points of divergence are centered on how Peter, Yan, and Arthur view and explain the relationship between savings, debt, and the misallocation of capital, as well as how they see China's potential roadmap going forward. The debate is moderated by BCA Global Strategist Caroline Miller. Caroline: Peter and Yan, the world - including the Chinese government - is climbing a wall of worry about China's debt load. Why are you guys still smiling? How many Maotai did you have last night? Peter: I don't know what a Maotai is, but I am sure that if I had more than one I wouldn't be smiling this morning. But yes, I am not as worried as Arthur that China is in the midst of an unsustainable credit bubble. Genuine credit bubbles tend to happen during periods of euphoria. U.S., Spanish, and Irish banks all traded at lofty multiples to book value on the eve of the financial crisis, having massively outperformed their respective indices in the preceding years. That's obviously not the case for Chinese banks today, which remain one of the most loathed sectors in the global equity market (Chart 1). The U.S., Spanish, and Irish housing booms also occurred alongside ballooning current account deficits, something that doesn't apply to China (Chart 2). One can debate whether China is in the midst of a property bubble, but even if it is, it looks a lot more like the one Hong Kong experienced in the late 1990s. When that bubble burst, property prices plummeted by 70%. Yet, Hong Kong banks were barely affected (Chart 3). Chart 1Chinese Banks: Unloved And Unwanted Chart 2Recent Credit Bubbles Developed ##br##Amid Widening Current Account Deficits Chart 3Hong Kong Is The Correct Analogy Yes, there is a lot of debt in China. But there is a lot of savings too. In fact, to a large extent, China's high debt levels are just a function of its high saving rate. The evidence suggests that national saving rates and debt-to-GDP ratios are positively correlated across emerging economies (Chart 4). China sits close to the trend line, implying that its debt stock is roughly what you would expect it to be. Chart 4Positive Correlation Between National Savings And Indebtedness Arthur: Allow me to both agree and disagree with Peter. No, there is no bubble in Chinese equities, but yes, there is a bubble and euphoria in China's property market. Property prices have risen exponentially and are extremely high by any metric. Chinese bank equity valuations have already adjusted, but bank stocks could still sell off if their profits shrink considerably, as I expect. Bank shares are not expensive, but not cheap either, if one adjusts for non-performing loans. I concur that China's property market adjustment will likely resemble that of Hong Kong as opposed to that of the U.S. As Peter noted, in Hong Kong in the late 1990s, property prices plunged by 70%, but few homeowners defaulted on their mortgages. Yet property starts/construction also collapsed by 80% (Chart 5). Chart 5Hong Kong's Property: ##br##Few Mortgage Defaults ##br##But Collapse In Construction Presently in China, the risk is not mortgage defaults but a renewed drop in property construction as well as other types of capital spending. Less construction/capital spending entails less demand for commodities, materials/chemicals and industrial goods. China's residential and non-residential construction activity will contract anew as speculative/investment demand for property weakens. Yan: I agree with Peter that China's rising debt is fundamentally a function of the country's abundant savings. Moreover, the fact that the country's massive savings pool is primarily intermediated via the banking sector and other debt instruments exacerbates the debt buildup. If a country's savings are primarily intermediated by the stock market through equity financing, then high savings do not necessarily lead to high debt, as "savers" become "shareholders" rather than "creditors." In China's case, the country's still relatively undeveloped and volatile equity market has not yet been able to play a meaningful role in financial intermediation. Instead, banks still play a dominant role channeling financial resources. In other words, China's high savings and a banking-centric financial intermediation system are key drivers of the ever-rising debt level. In fact, as long as these two features persist, the country's debt will inevitably continue to rise, as it simply reflects the accumulated savings. Caroline: Arthur, does this line up with how you think about the relationship between savings and debt? Arthur: My thesis has been that China's abnormal credit growth has been the result of speculative, euphoric behavior among Chinese banks and the shadow banking system - and not the natural result of the country's "excess savings," as Peter and Yan have argued. What economists call "savings" or "excess savings," non-economists refer to as "overproduction" or "excess capacity." This is about concepts, not about China. In economic science, the term "savings" is used to denote the number of goods and services that a nation has produced but not consumed - i.e., they can be used for investment or exports. Peter and Yan are using this textbook definition of "savings." Hence, by "savings" or "excess savings" they mean "excess production." Logically, the glut of goods and services does not flow to banks and create deposits. In brief, "savings" or "excess savings" are real economic variables and have nothing to do with bank deposits - i.e., "monetary savings." Peter, Yan and many other commentators make this mistake by mixing up national savings - which is literally output of goods and services that were not consumed by households and government - with "monetary savings," i.e., deposits in the banking system. I have no doubt China has had a high savings rate, i.e., it has had overcapacity and over-production in a number of sectors. The textbook concept of national savings is calculated as a residual from the national accounts and balance of payments. In particular: Savings - Investments = Current Account Balance and Savings = Investments + Current Account Balance A few remarks on the economic interpretation of this equation are in order. First, in any country, "excess" national savings over investment, i.e., current account surpluses, lead to an accumulation of net foreign assets, but has no implication on domestic loan creation.1 Second, a country that invests a lot and does not run a large current account deficit will have a high savings rate as per the economic textbook's definition of national savings. The opposite also holds true. Critically, national or household savings are in no way linked to the amount of deposits at banks. When households decide to save a part of their income, they do not create new deposits or "monetary savings." They save deposits that already exist in the banking system. To sum up, the amount of deposits in the banking system does not change as a result of households' decision to save a part of their income. When a person gets paid in cash and deposits that cash in a bank as a savings deposit, there is no new money created either. That cash was a deposit and was withdrawn from a bank a few days before, and now this cash returns to the banking system as a deposit again. In this case, the amount of total outstanding money supply in the economy (cash plus deposits) has not changed. In general, when a bank receives a deposit, it does not create new money, or "monetary savings." The deposit simply moves from one bank to another or from cash to deposit. The amount of money supply does not change. When a country enjoys a lot of overcapacity, strong bank loans or money growth will not cause inflation and interest rates will stay low, encouraging more borrowing. This is why in Peter's Chart 4 there is a positive correlation between the national savings rate and debt-to-GDP ratio across countries. Overcapacity entails low inflation; the latter keeps nominal interest rates low, which in turn entices more borrowing and debt build-up. In brief, the linkage between national savings/excess capacity and the credit-to-GDP ratio is indirect via subdued inflation and low interest rates that encourage debt build-up. Caroline: Arthur, you have made the case that savings are not a constraint to loan origination. Can you elaborate? Arthur: The banking system does not intermediate "savings" or "excess savings" from the real economy into loans. The commercial banking system as a whole creates deposits at the time it originates loans. This is true of all countries. Indeed, whenever commercial banks make a loan, they simultaneously create a matching deposit in the borrower's bank account, therefore creating new money in the process (Chart 6). In other words, bank loan origination creates deposits and money.2 Chart 6Commercial Banks: Credit Origination Creates Deposits China's banking system has a lot of deposits because banks have created too many loans. In addition, a bank does not need liquidity (reserves at the central bank) for each loan it originates. It still requires some liquidity to settle its net balance with other banks or to meet minimum reserve requirements. If a bank creates a loan but still has excess reserves at the central bank, it may not require liquidity to "back up" the loan. There are many variables that constrain bank loan origination, but they do not include national savings or "excess savings." We discussed these constraints in detail in our EMS report titled Misconceptions About China's Credit Excesses.3 Finally, when central banks opt to keep short-term interest rates steady, they must provide commercial banks with as much liquidity as the latter demands. This point is greatly relevant to China. For the past few years, China's central bank has silently moved away from controlling money growth (the quantity of money) to targeting interest rates (the price of money) (Chart 7). As a result, nowadays the People's Bank of China (PBoC) has very little quantitative control over money/credit creation by commercial banks. Chart 7The PBoC Has Begun Targeting Rates In Recent Years It is Chinese commercial banks that effectively drive money/credit/deposit creation. The PBoC decides whether or not to accommodate banks' liquidity needs by allowing interest rates to rise or fall, or by keeping them steady.4 To conclude, what habitually drives credit booms in any country are the "animal spirits" of banks and borrowers - not national savings. This has been the case in China too. Caroline: Peter, do you agree with Arthur's assessment? Peter: I don't want to get bogged down in the weeds of monetary theory, but let me briefly address two distinct points that I think Arthur is making. The first is the claim that the ability of banks to create money "out of thin air" is somehow not constrained by the volume of bank reserves and cash in circulation (the so - called "monetary base"). The second is the claim that there is no meaningful link between savings and deposits. I think Arthur is wrong on both counts. On the first claim, it is true that when a bank issues a loan, it also creates a deposit. To the extent that bank deposits are treated as "money," this expands the money supply. This is simply the "money multiplier" taught in introductory economics classes. Where Arthur's logic falls short is in his implicit assumption that all lending translates into additional bank deposits. It doesn't have to. Some of the deposits will be withdrawn and kept as cash. Governments have complete control over how much cash there is in circulation by virtue of their monopoly over the printing press. As long as cash exists, central banks can influence the broad money supply via open market operations. By the way, this is true even in banking systems where there are no reserve requirements. Regarding Arthur's claim that lending can occur without savings, this is often true when someone is borrowing money to buy an asset. However, it is generally not true if they are borrowing money to finance new spending. Let me offer a concrete, albeit somewhat whimsical, example to illustrate this point. Suppose I am living in a closed economy where no one saves anything. Now, let's imagine that I decide to throw a party for myself and need to borrow $1000 to do this. Who is going to provide me with the resources? Well, we just said that no one wants to save, so "something" has to adjust for me to have my party. That "something" is the interest rate. In order to entice someone to spend a bit less, the bank (on my behalf) will offer depositors a higher interest rate. If rates rise by enough, someone will decide to forego a bit of consumption today in order to have more consumption tomorrow. In other words, my decision to borrow must result in someone else's decision to save. So do savings create debt or does debt create savings? The answer is both: interest rates adjust to ensure that the two end up being different sides of the same coin. Caroline: Yan, what's your perspective on China's high debt profile? What could you be missing? Yan: As you can see Arthur and I view China's debt profile through different theoretical lenses. I don't think we can fully reconcile our different frameworks on the matter, but we hope our debate can deepen clients' own understanding of this issue, so they can make up their own minds. What I do want to stress is that those analysts who fear that China's corporate debt problem constitutes an alarming systemic financial risk focus exclusively on the rapid increase in the country's debt-to-GDP ratio. While undoubtedly there is merit to this ratio, I think it is also important to validate this judgement by looking at other indicators. In our previous research, we looked beyond this widely cited conventional indicator for corroborating evidence of a "debt bubble." Our findings suggest that the level of Chinese corporate sector leverage is not as precarious as widely perceived. For example, in the Chinese corporate sector, the area of China's economy where investors worry most about leverage, the debt-to-asset ratio of China's industrial sector has been falling since the late 1990s, down to 56% from 62%, contrary to popular belief (Chart 8). State-owned enterprises have witnessed an increase in their debt-to-asset ratio since the global financial crisis, but it has barely reached late 1990s levels, and has actually rolled over in recent years. Meanwhile, SOEs are a shrinking part of the overall economy and therefore, when looked at in conjunction with the private sector, have not moved the needle on the broader trend of corporate balance sheet "deleveraging." This stands in stark contrast to Japan's corporate sector at the peak of its debt bubble. In the early 1990s, Japan's corporate sector debt-to-asset ratio topped out at 78% when the country's "balance sheet recession" began (Chart 9). Even after two decades of deleveraging, Japan's current corporate debt-to-asset ratio is comparable to China's. To validate this conclusion, we also calculated several other key ratios to compare the leverage situation of Chinese listed companies relative to their global peers. Ratios such as liability-to-assets, net debt-to-EBITDA and interest coverage assess both leverage levels and debt servicing capacity. As Chart 10 shows, our extensive survey, both from the top down and the bottom up, suggests that China's leverage situation is comparable if not superior to its global peers. Chart 8The Leverage Picture From A Balance Sheet Perspective Chart 9Japan's Debt Bubble And Deleveraging Chart 10Leverage Ratios: How China Compares Therefore, I think we should be skeptical about the widely held view that China's corporate sector leverage is precariously high. It is at a minimum inaccurate, if not misleading, to rely solely on the debt-to-GDP ratio to reach such an ominous conclusion. Caroline: Arthur, I take it you don't agree? Arthur: Since January 2009, China's corporate and household debt has risen by RMB 130 trillion (about US$ 19 trillion) or by 100% of GDP (Chart 11). I do not believe even the most sophisticated financial/credit systems can allocate such amounts of credit in such a short time and not misallocate capital. By capital misallocation, I am implying investments in projects that do not generate sufficient cash flow to service debt. The accounting value (valuation) of assets is irrelevant in these cases; the cash flow generation is critical. The debt-to-GDP ratio is a much more superior measure to debt-to-asset-ratio. The basis is that the GDP is a proxy for cash flow, while accounting value of assets could be extremely inflated during a credit bubble. To be sure, I am not suggesting that all investments in China have gone sour. Nobody knows the extent of capital misallocation in China. But I suspect it is large enough to make a difference for the macro outlook/business cycle. Caroline: Peter, you have made the comparison between China today and Japan in the 1990s. Could you expand on that? Peter: Starting in the early 1990s, Japan entered an extended era where the private sector was trying to spend less than it earned (Chart 12). In order to keep unemployment from rising, the Japanese government was forced to run large budget deficits. In effect, the government ended up having to absorb the private sector's excess savings through its own dissaving. The same sort of fiscal trap now stalks China. Up until the Great Recession, China was able to export much of its excess savings. The current account surplus hit a record high of nearly 10% of GDP in 2007. The subsequent appreciation of the RMB undermined this strategy, forcing the government to take steps to boost domestic demand. It is no surprise that China's debt stock began to grow rapidly just as its current account surplus started to dwindle (Chart 13). Chart 11China: The Credit Boom Chart 12Japan Relied On Fiscal Largesse And Current Account Surpluses To Offset The Rise In Private-Sector Savings Chart 13China: Debt Increased When ##br##The Current Account Surplus Began Its Descent Keep in mind that fiscal policy in China entails much more than adjustments to government spending and taxes. Central government spending accounts for a fairly small share of GDP. The vast majority of fiscal stimulus is done via the banking system. This makes Chinese fiscal policy nearly indistinguishable from credit policy. From this perspective, China's so-called "debt mountain" is not much different from Japan's debt mountain once we acknowledge that the bulk of China's corporate debt is, in fact, quasi-fiscal debt. As evidence, note that in sharp contrast to the SOE sector, the ratio of liabilities-to-assets among private Chinese companies has actually been trending lower over the past decade (please see Chart 8). In effect, China's money-losing SOEs are the equivalent of Japan's fabled "bridges to nowhere": They are a necessary evil. Caroline: Arthur, your thoughts? Arthur: What Peter and Yan in effect propose is that Chinese banks should continue creating credit/money "out of thin air" in order to create demand for these "excess" goods, i.e., overcapacity sectors. In a nutshell, a number of Chinese companies made bad decisions by over expanding capacity, and now banks have to continue lending/creating demand to justify these bad investments. As a result, persisting explosive credit growth has allowed these unviable or zombie enterprises to survive, and they are not compelled to restructure. This is not how capitalism and markets work. This is de facto socialism. Socialism usually does not lead to prosperity. One of the key reasons behind the failure of socialist economic models is that productivity growth in socialist systems is very low, often close to zero. The basis is that productivity growth is generated not by government officials but by the private sector and entrepreneurs. China's economic success over the past 35 years or so has been due to allowing private enterprises to function and flourish - not because government officials necessarily made correct business and investment decisions. I am for countercyclical fiscal and monetary policies. However, the credit boom in China has gone well beyond the countercyclical policy framework. The concept of countercyclical policies does not suggest that the government or public banks should continue to spend in perpetuity to support fundamentally unviable businesses that invested too much and created excess capacity. Besides, "countercyclical" means for a couple of years. China has been expanding bank/credit/money for about nine years - since January 2009. Peter and Yan argue that they should keep doing it further. If the authorities do what Peter and Yan propose, investors should be structurally - not cyclically - bearish on Chinese stocks. Chart 14There Has Been No Shortage ##br##Of Demand Since 2010 The basis is that a socialist growth model is not friendly for shareholders. Shareholders often lose money when companies operate for maximizing employment rather than profits. This is why Chinese SOEs and bank stocks trade at low multiples - because they destroy capital and value for their shareholders. Notably, "overproduction" and "excess capacity" could be an outcome of either a demand downturn or oversupply/overproduction. Keynes recommended countercyclical policies to fill the gaps when demand shrinks. Chart 15Fiscal Outlays & Credit Origination ##br##Are Close To 50% Of GDP In China's case, there has been no domestic demand downturn to warrant multi-year countercyclical policies. China did the right thing in early 2009 to offset its export plunge amid the Global Financial Crisis, and it helped the global economy recover. However, since 2010 global demand and mainland exports have been stable (Chart 14), making the extended and ongoing credit boom in China unwarranted and excessive. As to the argument that most credit should be counted as a form of fiscal spending, I do not think Chinese policymakers themselves would agree with this statement. In fact, if this is correct, it would mean that government officials are allocating about 50% of GDP each year. Chart 15 illustrates general (central plus local) government spending and annual credit origination as a share of GDP. How fast would productivity grow in an economy where government bureaucrats allocate 50% of GDP annually? It is true that China's central government has a low debt load so it can afford to take over a large chunk of corporate debt. If and when they do so, I will change my view. So far, they have not done this, and will likely only contemplate such a policy move when things get really messy. Investors do not want to be long China plays going into such a scenario. That said, a tactical buying opportunity could emerge when the government takes over a large chuck of corporate debt. Caroline: Yan, how worried should we be about the misallocation of capital in China? Yan: Every economy experiences some level of capital misallocation. The real question is whether China's level of capital misallocation is more serious than that of its global peers. Theoretically, if a country has a bigger capital misallocation problem than others, the economy should have systemically lower capacity utilization, weaker pricing power, and lower profitability. These metrics are easily cross-referenced: Chart 16 contextualizes China's industrial sector capacity utilization ratio relative to global peers. By and large, most countries' capacity utilization ratios hover around 80%, not much different from China's, especially since the 2000s. In fact, barring some obvious outliers, capacity utilization ratios across countries have been largely synchronized, reflecting the ebb and flow of the global business cycle. Chart 16Capacity Utilization: A Global Perspective Industrial sector output prices have shown similar swings (Chart 17). Almost all countries suffered producer price deflation in recent years, and are now experiencing a synchronized upturn in wholesale pricing power. China's falling PPI was widely regarded as a tell-tale sign of misallocation of capital. Conversely, this was in fact more a reflection of stagnating global aggregate demand and weak resource prices worldwide than structurally weak pricing power among Chinese manufacturers. Chart 17Producer Prices: A Global Perspective Similarly, Chinese listed companies' deteriorating Return on Equity (ROE) was again singled out as a sign of capital misallocation. This view is easily debunked by Chart 18, as ROEs have fallen in all major markets. In fact, Chinese companies' ROEs have been structurally higher than the global averages. Even some Chinese sectors that have been derided as being plagued by massive overcapacity and inefficiency such as materials and energy exhibit ROEs almost identical to their global peers. The important point is that we should put China in a global context, rather than analyzing it in isolation. Some Chinese firms' efficiency and profitability have weakened notably over the past several years, but to me, this is more of a reflection of the sluggish global macro backdrop, rather than an indictment of China's discrete growth model. Caroline: Turning to the investment implications, Yan, how does the debt bubble concern impact your view on Chinese equities? Yan: Global investors' widespread concerns over Chinese debt levels and other macro issues have contaminated Chinese stocks with a broad-brushed bearish undertone. Chinese equities have been unduly punished, underweighted and under-owned for many years. As shown in Chart 19, Chinese investable stocks' ROEs have been structurally higher than the global benchmark, and have followed similar cyclical fluctuations. However, their stock prices are trading at massive discounts to the global benchmarks, based on conventional yardsticks (Chart 19). This in my view represents the "China risk premium," which is unjustified and unsustainable. I expect the misperception will eventually unwind, and Chinese shares will be re-rated. This is the fundamental factor supporting my positive view on Chinese equities. Strategically it makes sense to overweight Chinese stocks against their global peers. Chart 18Chinese ROEs Are Not Inferior To Global Peers Chart 19Chinese Equities' Large Valuation Gap Caroline: Arthur, how does your view impact your outlook for investment prospects in China and the rest of the emerging markets space? Arthur: There has not been any adjustment in China's corporate leverage. Deleveraging in China has not yet started. On the contrary, the credit bubble is getting larger. I mean the credit-to-GDP ratio continues rising exponentially and credit and bank loan growth remain in double digits (Chart 20). It is very risky to be bullish on financial assets linked to a bubble when the adjustment has not yet begun. It is like running in front of a steamroller trying to collect pennies. Besides, when there is a major imbalance in the system like the credit bubble happening in China now, I tend to overplay the importance of marginal policy tightening and underplay the significance of easing. Recent marginal policy tightening in China - in particular the clampdown on shadow banking, including banks' off-balance-sheet asset expansion - will cause credit growth to decelerate. This is a major risk to Chinese and EM growth in the second half of this year (Chart 21). Chart 20China: Money/Credit Is Still Booming Chart 21Is China's Recovery At Risk? Even if China does not have a full-blown crisis, we are likely to experience another down leg in China plays, commodities and EM risk assets similar to the second half of 2015, when Chinese import volumes contracted and global markets tanked. A few words about the potential adjustment trajectory are in order. I have been negative on China's growth and China-related plays in global financial markets since 2010, but I have never used the word "crisis." China may or may not have a crisis, but investors holding risk assets exposed to China's growth will suffer considerable losses again similar to the 2011-16 period. It is essential to differentiate cyclical from structural growth drivers. If the government does not allow credit growth to slow, cyclical growth will hold up. However, in this scenario, China will move toward a socialist model and structural growth will tumble. That said, the growth deceleration would be gradual, as depicted in Chart 22. Chart 22Toward Socialism = Secular Stagnation And Inflation If we assume China's productivity is currently growing at a rate of about 5.5-6% (which is already very high and hard to sustain), and if the country embarks on a socialist path, odds are that productivity growth will drop by 50-100 basis points in each of the following years. In five years or so, productivity growth would be only around 1-3%. This path is the ultimate recipe for economic stagnation in China. The only thing the authorities can do in this scenario is to boost growth from time to time via credit and fiscal stimulus. This will produce mini-cycles around a falling primary growth trend. The latest acceleration in China's growth is probably one of these mini-cycles. How can investors invest in this scenario? The stylized mini-cycles depicted in Chart 22 look nice, because we drew them ourselves. In reality, they will not be symmetric or smooth. In short, investing around economic mini-cycles is difficult because it assumes near-perfect timing. Caroline: Peter, is it all that bad? Peter: I think Arthur is too pessimistic. Investors have been predicting a Japanese debt crisis for years. It hasn't materialized and probably won't. They are making the same mistake about China. If China averts a debt crisis, as I think is likely, that's good news for global equities. In the developed market universe, Europe and Japan stand to benefit the most, given the cyclical bent of their stock markets. We are overweight both regions in local-currency terms. For global bonds, the implications are somewhat mixed. On the one hand, the high probability that the Chinese government can maintain the status quo of continued credit expansion for the foreseeable future means that a hard landing for the economy - and the associated drop in safe-haven developed economy government bond yields that this would trigger - is unlikely to occur. On the other hand, high levels of Chinese savings will continue to fuel the global savings glut, keeping real long-term bond yields lower than they would otherwise be. On balance, investors should maintain a modest underweight allocation toward global bonds. Caroline: Yan, do domestic politics play into your outlook for the RMB versus the dollar and on a trade-weighted basis? What is your outlook for monetary policy given recent signs of improving economic momentum? Yan: How President Donald Trump will deal with China on the RMB issue is a wildcard. Recent rhetoric suggests that the new U.S. administration intends to follow normal legal protocol to decide if China is manipulating its currency. This is a significant departure from Candidate Trump's repeated campaign trail promises. If the U.S. Treasury follows the formal process laid out in the statute, it is unlikely to label China a currency manipulator in the next semi-annual assessment to be published in April, simply because the country does not meet all the criteria for that label at the moment. The odds of an immediate clash between the U.S. and China on the RMB have ebbed. From China's domestic perspective, how the People's Bank of China intends to manage the exchange rate is also a thorny issue. From a long term point of view, the PBoC clearly wants to achieve a free-floating exchange rate, but the recent downward pressure on the RMB due to elevated capital outflows has forced the PBoC to heavily intervene to prevent a vicious, disorderly cycle, in which currency depreciation and capital flight reinforce each other. In terms of monetary policy, China's improving economic momentum has allowed the PBoC to follow the Fed in raising short-term interest rates. However, tighter capital account control measures will remain in place until the downward pressure on the RMB from capital outflow dissipates. Moreover, investors have been overwhelmingly focused on the negative economic effects of a weaker RMB, somehow ignoring the reality that as the world's largest manufacturer and exporter, China also stands to benefit from a weaker currency. In my view, the depreciation of the trade-weighted RMB since 2015 has played a critical role in reflating the Chinese economy (Chart 23). A weaker RMB has helped producer prices to reflate, and lowered the real cost of funding for manufacturers, which in turn has eased China's monetary conditions and supported cyclical growth improvement. In this vein, the downside of the RMB should be self-limiting, as the reflationary impact of a weaker exchange rate will help boost Chinese growth, which in turn will reduce downward pressure on the currency. Caroline: Peter and Arthur, is rampant capital flight still a risk? Where do you see the RMB heading over the coming 12-18 months? Peter: I think the RMB will weaken somewhat over the coming year, but that is more a reflection of my bullish view on the dollar than a bearish view on the yuan. Much of the capital flight that China has experienced recently has just been an unwinding of the hot money flows that entered the country over the preceding four years. Despite all the talk about a credit bubble, Chinese corporate external debt has fallen by around $400 billion since its peak in mid-2014 - a decline of over 50% (Chart 24). At this point, most of the hot money has exited the country and hence, I expect the pace of capital outflows to subside. Chart 23A Weaker RMB Leads Cyclical Recovery Chart 24The Rise And Fall Of Corporate Foreign Credit Nevertheless, the chronic shortfall of domestic demand that I described earlier will keep pressure on the Chinese government to try to export excess production abroad by running a larger current account surplus. This requires a weak currency. Thus, while I don't expect the yuan to plummet, I don't expect it to soar either. Arthur: I believe the RMB is set to depreciate by 10% or more against the U.S. dollar in the next 12 months or so. The Chinese yuan is not expensive, but it will stay under downward pressure because the mainland banking system has created too many yuan. When the supply of money goes vertical, its price drops. It seems the Chinese people are sensing there is too much RMB floating around, and they are trying to get rid of local currency. They have been overpaying for properties and have been shifting their wealth into foreign currencies. Finally, in China, the real deposit rate has turned negative (Chart 25, top panel). In the past, when the real deposit rate turned negative, the central bank hiked interest rates (Chart 25, bottom panel). If households do not get a more attractive deposit rate, they will opt for foreign currency, real assets like property or riskier investments domestically. All of this entails negative consequences for China's financial stability. Chart 25Real Deposit Rate Is Negative In brief, I expect capital outflows to persist and policymakers to allow the currency to depreciate further. Caroline: Peter/Yan/Arthur: Final thoughts: What are each of you watching for signs that China's macro landscape is evolving as you expect? Conversely, what would signal that your assessment has missed the mark? Peter: I am watching for signs of a policy mistake. Until China can reorient its economy towards one that is more consumer-centric, it will have to rely on high levels of investment to sustain aggregate demand. Any attempt to aggressively curb debt growth will only backfire. Arthur talks about resource misallocation from subpar investment projects, but there is no worse resource misallocation than a person who wants a job but can't find one. I am also watching trade policy. I don't think a trade war between China and the U.S. is in the cards for the time being, but if the U.S. economy turns down in 2019, as I expect, Trump will be backed into a corner. And with another election looming, he will strike out at China. That could trigger a global trade war. Yan: I agree with Peter that we should watch for policy mistakes and some sort of "Trump shock," both of which constitute downside risks. A less talked-about risk is potential growth overheating, which could require much tighter policy, leading to greater economic volatility. In fact, some cyclical indicators that are tightly linked to industrial activity have rebounded sharply, which is also reflected in the rebound in some raw materials prices. If exports get a further boost from continued improvement in the U.S. economy, the possibility of China's economy overheating cannot be completely dismissed. Another potential trouble spot is the housing market. The Chinese authorities have begun to tighten housing policy, but developers appear to be gearing up for another construction cycle. Sales of construction equipment such as heavy trucks and excavators have soared. Historically, construction machine sales have been tightly correlated with real estate development (Chart 26). If history is any guide, the renewed strength in construction equipment sales could be a harbinger of an impending boom in new home construction. This is good news for business activity and GDP growth, but probably antithetical to policymakers' broad agenda. We will follow up on these issues closely in our future reports. Arthur: The key variables to watch are various interest rates, credit/loan growth and inflation - in addition to keeping an eye on lending standards and credit demand. Recent increases in borrowing costs amid the enormous credit overhang give me confidence to argue that China's credit origination and economic growth are bound to decelerate later this year. A billion-dollar question is whether the recent rise in China's consumer inflation is transitory or the beginning of a notable uptrend (Chart 27). If consumer price inflation rises to 3% and higher, the game will be over - interest rates will need to go up and credit growth will tumble. If interest rates do not rise amid intensifying inflationary pressures, capital outflows will escalate and the currency will depreciate a lot. Chart 26An Upturn In Housing Construction? Chart 27China: Inflation Is Picking Up I will be wrong if policymakers manage to slow down credit growth from 11-12% toward 7-8% or so without generating notable economic weakness. This can occur only if productivity growth in China accelerates meaningfully. It is difficult to observe productivity growth in real time - it is a black box. 1 Please see Emerging Markets Strategy Special Report, titled "Do Credit Bubbles Originate From High National Savings?" dated January 18, 2017, available at ems.bcaresearch.com. 2 Please see Emerging Markets Strategy Special Report, titled "Misconceptions About China's Credit Excesses," dated October 26, 2016, available at ems.bcaresearch.com. 3 Please see Emerging Markets Strategy Special Report, titled "Misconceptions About China's Credit Excesses," dated October 26, 2016, available at ems.bcaresearch.com. 4 Please see Emerging Markets Strategy Special Report, titled "China's Money Creation Redux And The RMB," dated November 23, 2016, available at ems.bcaresearch.com.

Special Report

The aim of this Special Report is to elaborate on and explain the different views on China that have coexisted at BCA in recent years. Although BCA strives to achieve consensus among its strategists, this is not always possible, as has been the case with China. Peter Berezin of the Global Investment Strategy service and Yan Wang of China Investment Strategy have been positive, while Arthur Budaghyan of Emerging Markets Strategy has been negative on both China's business cycle and China-related plays. The focal points of divergence are centered on how Peter, Yan, and Arthur view and explain the relationship between savings, debt, and the misallocation of capital, as well as how they see China's potential roadmap going forward. The debate is moderated by BCA Global Strategist Caroline Miller. Caroline: Peter and Yan, the world - including the Chinese government - is climbing a wall of worry about China's debt load. Why are you guys still smiling? How many Maotai did you have last night? Peter: I don't know what a Maotai is, but I am sure that if I had more than one I wouldn't be smiling this morning. But yes, I am not as worried as Arthur that China is in the midst of an unsustainable credit bubble. Genuine credit bubbles tend to happen during periods of euphoria. U.S., Spanish, and Irish banks all traded at lofty multiples to book value on the eve of the financial crisis, having massively outperformed their respective indices in the preceding years. That's obviously not the case for Chinese banks today, which remain one of the most loathed sectors in the global equity market (Chart 1). The U.S., Spanish, and Irish housing booms also occurred alongside ballooning current account deficits, something that doesn't apply to China (Chart 2). One can debate whether China is in the midst of a property bubble, but even if it is, it looks a lot more like the one Hong Kong experienced in the late 1990s. When that bubble burst, property prices plummeted by 70%. Yet, Hong Kong banks were barely affected (Chart 3). Chart 1Chinese Banks: Unloved And Unwanted Chart 2Recent Credit Bubbles Developed ##br##Amid Widening Current Account Deficits Chart 3Hong Kong Is The Correct Analogy Yes, there is a lot of debt in China. But there is a lot of savings too. In fact, to a large extent, China's high debt levels are just a function of its high saving rate. The evidence suggests that national saving rates and debt-to-GDP ratios are positively correlated across emerging economies (Chart 4). China sits close to the trend line, implying that its debt stock is roughly what you would expect it to be. Chart 4Positive Correlation Between National Savings And Indebtedness Arthur: Allow me to both agree and disagree with Peter. No, there is no bubble in Chinese equities, but yes, there is a bubble and euphoria in China's property market. Property prices have risen exponentially and are extremely high by any metric. Chinese bank equity valuations have already adjusted, but bank stocks could still sell off if their profits shrink considerably, as I expect. Bank shares are not expensive, but not cheap either, if one adjusts for non-performing loans. I concur that China's property market adjustment will likely resemble that of Hong Kong as opposed to that of the U.S. As Peter noted, in Hong Kong in the late 1990s, property prices plunged by 70%, but few homeowners defaulted on their mortgages. Yet property starts/construction also collapsed by 80% (Chart 5). Chart 5Hong Kong's Property: ##br##Few Mortgage Defaults ##br##But Collapse In Construction Presently in China, the risk is not mortgage defaults but a renewed drop in property construction as well as other types of capital spending. Less construction/capital spending entails less demand for commodities, materials/chemicals and industrial goods. China's residential and non-residential construction activity will contract anew as speculative/investment demand for property weakens. Yan: I agree with Peter that China's rising debt is fundamentally a function of the country's abundant savings. Moreover, the fact that the country's massive savings pool is primarily intermediated via the banking sector and other debt instruments exacerbates the debt buildup. If a country's savings are primarily intermediated by the stock market through equity financing, then high savings do not necessarily lead to high debt, as "savers" become "shareholders" rather than "creditors." In China's case, the country's still relatively undeveloped and volatile equity market has not yet been able to play a meaningful role in financial intermediation. Instead, banks still play a dominant role channeling financial resources. In other words, China's high savings and a banking-centric financial intermediation system are key drivers of the ever-rising debt level. In fact, as long as these two features persist, the country's debt will inevitably continue to rise, as it simply reflects the accumulated savings. Caroline: Arthur, does this line up with how you think about the relationship between savings and debt? Arthur: My thesis has been that China's abnormal credit growth has been the result of speculative, euphoric behavior among Chinese banks and the shadow banking system - and not the natural result of the country's "excess savings," as Peter and Yan have argued. What economists call "savings" or "excess savings," non-economists refer to as "overproduction" or "excess capacity." This is about concepts, not about China. In economic science, the term "savings" is used to denote the number of goods and services that a nation has produced but not consumed - i.e., they can be used for investment or exports. Peter and Yan are using this textbook definition of "savings." Hence, by "savings" or "excess savings" they mean "excess production." Logically, the glut of goods and services does not flow to banks and create deposits. In brief, "savings" or "excess savings" are real economic variables and have nothing to do with bank deposits - i.e., "monetary savings." Peter, Yan and many other commentators make this mistake by mixing up national savings - which is literally output of goods and services that were not consumed by households and government - with "monetary savings," i.e., deposits in the banking system. I have no doubt China has had a high savings rate, i.e., it has had overcapacity and over-production in a number of sectors. The textbook concept of national savings is calculated as a residual from the national accounts and balance of payments. In particular: Savings - Investments = Current Account Balance and Savings = Investments + Current Account Balance A few remarks on the economic interpretation of this equation are in order. First, in any country, "excess" national savings over investment, i.e., current account surpluses, lead to an accumulation of net foreign assets, but has no implication on domestic loan creation.1 Second, a country that invests a lot and does not run a large current account deficit will have a high savings rate as per the economic textbook's definition of national savings. The opposite also holds true. Critically, national or household savings are in no way linked to the amount of deposits at banks. When households decide to save a part of their income, they do not create new deposits or "monetary savings." They save deposits that already exist in the banking system. To sum up, the amount of deposits in the banking system does not change as a result of households' decision to save a part of their income. When a person gets paid in cash and deposits that cash in a bank as a savings deposit, there is no new money created either. That cash was a deposit and was withdrawn from a bank a few days before, and now this cash returns to the banking system as a deposit again. In this case, the amount of total outstanding money supply in the economy (cash plus deposits) has not changed. In general, when a bank receives a deposit, it does not create new money, or "monetary savings." The deposit simply moves from one bank to another or from cash to deposit. The amount of money supply does not change. When a country enjoys a lot of overcapacity, strong bank loans or money growth will not cause inflation and interest rates will stay low, encouraging more borrowing. This is why in Peter's Chart 4 there is a positive correlation between the national savings rate and debt-to-GDP ratio across countries. Overcapacity entails low inflation; the latter keeps nominal interest rates low, which in turn entices more borrowing and debt build-up. In brief, the linkage between national savings/excess capacity and the credit-to-GDP ratio is indirect via subdued inflation and low interest rates that encourage debt build-up. Caroline: Arthur, you have made the case that savings are not a constraint to loan origination. Can you elaborate? Arthur: The banking system does not intermediate "savings" or "excess savings" from the real economy into loans. The commercial banking system as a whole creates deposits at the time it originates loans. This is true of all countries. Indeed, whenever commercial banks make a loan, they simultaneously create a matching deposit in the borrower's bank account, therefore creating new money in the process (Chart 6). In other words, bank loan origination creates deposits and money.2 Chart 6Commercial Banks: Credit Origination Creates Deposits China's banking system has a lot of deposits because banks have created too many loans. In addition, a bank does not need liquidity (reserves at the central bank) for each loan it originates. It still requires some liquidity to settle its net balance with other banks or to meet minimum reserve requirements. If a bank creates a loan but still has excess reserves at the central bank, it may not require liquidity to "back up" the loan. There are many variables that constrain bank loan origination, but they do not include national savings or "excess savings." We discussed these constraints in detail in our EMS report titled Misconceptions About China's Credit Excesses.3 Finally, when central banks opt to keep short-term interest rates steady, they must provide commercial banks with as much liquidity as the latter demands. This point is greatly relevant to China. For the past few years, China's central bank has silently moved away from controlling money growth (the quantity of money) to targeting interest rates (the price of money) (Chart 7). As a result, nowadays the People's Bank of China (PBoC) has very little quantitative control over money/credit creation by commercial banks. Chart 7The PBoC Has Begun Targeting Rates In Recent Years It is Chinese commercial banks that effectively drive money/credit/deposit creation. The PBoC decides whether or not to accommodate banks' liquidity needs by allowing interest rates to rise or fall, or by keeping them steady.4 To conclude, what habitually drives credit booms in any country are the "animal spirits" of banks and borrowers - not national savings. This has been the case in China too. Caroline: Peter, do you agree with Arthur's assessment? Peter: I don't want to get bogged down in the weeds of monetary theory, but let me briefly address two distinct points that I think Arthur is making. The first is the claim that the ability of banks to create money "out of thin air" is somehow not constrained by the volume of bank reserves and cash in circulation (the so - called "monetary base"). The second is the claim that there is no meaningful link between savings and deposits. I think Arthur is wrong on both counts. On the first claim, it is true that when a bank issues a loan, it also creates a deposit. To the extent that bank deposits are treated as "money," this expands the money supply. This is simply the "money multiplier" taught in introductory economics classes. Where Arthur's logic falls short is in his implicit assumption that all lending translates into additional bank deposits. It doesn't have to. Some of the deposits will be withdrawn and kept as cash. Governments have complete control over how much cash there is in circulation by virtue of their monopoly over the printing press. As long as cash exists, central banks can influence the broad money supply via open market operations. By the way, this is true even in banking systems where there are no reserve requirements. Regarding Arthur's claim that lending can occur without savings, this is often true when someone is borrowing money to buy an asset. However, it is generally not true if they are borrowing money to finance new spending. Let me offer a concrete, albeit somewhat whimsical, example to illustrate this point. Suppose I am living in a closed economy where no one saves anything. Now, let's imagine that I decide to throw a party for myself and need to borrow $1000 to do this. Who is going to provide me with the resources? Well, we just said that no one wants to save, so "something" has to adjust for me to have my party. That "something" is the interest rate. In order to entice someone to spend a bit less, the bank (on my behalf) will offer depositors a higher interest rate. If rates rise by enough, someone will decide to forego a bit of consumption today in order to have more consumption tomorrow. In other words, my decision to borrow must result in someone else's decision to save. So do savings create debt or does debt create savings? The answer is both: interest rates adjust to ensure that the two end up being different sides of the same coin. Caroline: Yan, what's your perspective on China's high debt profile? What could you be missing? Yan: As you can see Arthur and I view China's debt profile through different theoretical lenses. I don't think we can fully reconcile our different frameworks on the matter, but we hope our debate can deepen clients' own understanding of this issue, so they can make up their own minds. What I do want to stress is that those analysts who fear that China's corporate debt problem constitutes an alarming systemic financial risk focus exclusively on the rapid increase in the country's debt-to-GDP ratio. While undoubtedly there is merit to this ratio, I think it is also important to validate this judgement by looking at other indicators. In our previous research, we looked beyond this widely cited conventional indicator for corroborating evidence of a "debt bubble." Our findings suggest that the level of Chinese corporate sector leverage is not as precarious as widely perceived. For example, in the Chinese corporate sector, the area of China's economy where investors worry most about leverage, the debt-to-asset ratio of China's industrial sector has been falling since the late 1990s, down to 56% from 62%, contrary to popular belief (Chart 8). State-owned enterprises have witnessed an increase in their debt-to-asset ratio since the global financial crisis, but it has barely reached late 1990s levels, and has actually rolled over in recent years. Meanwhile, SOEs are a shrinking part of the overall economy and therefore, when looked at in conjunction with the private sector, have not moved the needle on the broader trend of corporate balance sheet "deleveraging." This stands in stark contrast to Japan's corporate sector at the peak of its debt bubble. In the early 1990s, Japan's corporate sector debt-to-asset ratio topped out at 78% when the country's "balance sheet recession" began (Chart 9). Even after two decades of deleveraging, Japan's current corporate debt-to-asset ratio is comparable to China's. To validate this conclusion, we also calculated several other key ratios to compare the leverage situation of Chinese listed companies relative to their global peers. Ratios such as liability-to-assets, net debt-to-EBITDA and interest coverage assess both leverage levels and debt servicing capacity. As Chart 10 shows, our extensive survey, both from the top down and the bottom up, suggests that China's leverage situation is comparable if not superior to its global peers. Chart 8The Leverage Picture From A Balance Sheet Perspective Chart 9Japan's Debt Bubble And Deleveraging Chart 10Leverage Ratios: How China Compares Therefore, I think we should be skeptical about the widely held view that China's corporate sector leverage is precariously high. It is at a minimum inaccurate, if not misleading, to rely solely on the debt-to-GDP ratio to reach such an ominous conclusion. Caroline: Arthur, I take it you don't agree? Arthur: Since January 2009, China's corporate and household debt has risen by RMB 130 trillion (about US$ 19 trillion) or by 100% of GDP (Chart 11). I do not believe even the most sophisticated financial/credit systems can allocate such amounts of credit in such a short time and not misallocate capital. By capital misallocation, I am implying investments in projects that do not generate sufficient cash flow to service debt. The accounting value (valuation) of assets is irrelevant in these cases; the cash flow generation is critical. The debt-to-GDP ratio is a much more superior measure to debt-to-asset-ratio. The basis is that the GDP is a proxy for cash flow, while accounting value of assets could be extremely inflated during a credit bubble. To be sure, I am not suggesting that all investments in China have gone sour. Nobody knows the extent of capital misallocation in China. But I suspect it is large enough to make a difference for the macro outlook/business cycle. Caroline: Peter, you have made the comparison between China today and Japan in the 1990s. Could you expand on that? Peter: Starting in the early 1990s, Japan entered an extended era where the private sector was trying to spend less than it earned (Chart 12). In order to keep unemployment from rising, the Japanese government was forced to run large budget deficits. In effect, the government ended up having to absorb the private sector's excess savings through its own dissaving. The same sort of fiscal trap now stalks China. Up until the Great Recession, China was able to export much of its excess savings. The current account surplus hit a record high of nearly 10% of GDP in 2007. The subsequent appreciation of the RMB undermined this strategy, forcing the government to take steps to boost domestic demand. It is no surprise that China's debt stock began to grow rapidly just as its current account surplus started to dwindle (Chart 13). Chart 11China: The Credit Boom Chart 12Japan Relied On Fiscal Largesse And Current Account Surpluses To Offset The Rise In Private-Sector Savings Chart 13China: Debt Increased When ##br## The Current Account Surplus Began Its Descent Keep in mind that fiscal policy in China entails much more than adjustments to government spending and taxes. Central government spending accounts for a fairly small share of GDP. The vast majority of fiscal stimulus is done via the banking system. This makes Chinese fiscal policy nearly indistinguishable from credit policy. From this perspective, China's so-called "debt mountain" is not much different from Japan's debt mountain once we acknowledge that the bulk of China's corporate debt is, in fact, quasi-fiscal debt. As evidence, note that in sharp contrast to the SOE sector, the ratio of liabilities-to-assets among private Chinese companies has actually been trending lower over the past decade (please see Chart 8). In effect, China's money-losing SOEs are the equivalent of Japan's fabled "bridges to nowhere": They are a necessary evil. Caroline: Arthur, your thoughts? Arthur: What Peter and Yan in effect propose is that Chinese banks should continue creating credit/money "out of thin air" in order to create demand for these "excess" goods, i.e., overcapacity sectors. In a nutshell, a number of Chinese companies made bad decisions by over expanding capacity, and now banks have to continue lending/creating demand to justify these bad investments. As a result, persisting explosive credit growth has allowed these unviable or zombie enterprises to survive, and they are not compelled to restructure. This is not how capitalism and markets work. This is de facto socialism. Socialism usually does not lead to prosperity. One of the key reasons behind the failure of socialist economic models is that productivity growth in socialist systems is very low, often close to zero. The basis is that productivity growth is generated not by government officials but by the private sector and entrepreneurs. China's economic success over the past 35 years or so has been due to allowing private enterprises to function and flourish - not because government officials necessarily made correct business and investment decisions. I am for countercyclical fiscal and monetary policies. However, the credit boom in China has gone well beyond the countercyclical policy framework. The concept of countercyclical policies does not suggest that the government or public banks should continue to spend in perpetuity to support fundamentally unviable businesses that invested too much and created excess capacity. Besides, "countercyclical" means for a couple of years. China has been expanding bank/credit/money for about nine years - since January 2009. Peter and Yan argue that they should keep doing it further. If the authorities do what Peter and Yan propose, investors should be structurally - not cyclically - bearish on Chinese stocks. Chart 14There Has Been No Shortage ##br##Of Demand Since 2010 The basis is that a socialist growth model is not friendly for shareholders. Shareholders often lose money when companies operate for maximizing employment rather than profits. This is why Chinese SOEs and bank stocks trade at low multiples - because they destroy capital and value for their shareholders. Notably, "overproduction" and "excess capacity" could be an outcome of either a demand downturn or oversupply/overproduction. Keynes recommended countercyclical policies to fill the gaps when demand shrinks. Chart 15Fiscal Outlays & Credit Origination ##br##Are Close To 50% Of GDP In China's case, there has been no domestic demand downturn to warrant multi-year countercyclical policies. China did the right thing in early 2009 to offset its export plunge amid the Global Financial Crisis, and it helped the global economy recover. However, since 2010 global demand and mainland exports have been stable (Chart 14), making the extended and ongoing credit boom in China unwarranted and excessive. As to the argument that most credit should be counted as a form of fiscal spending, I do not think Chinese policymakers themselves would agree with this statement. In fact, if this is correct, it would mean that government officials are allocating about 50% of GDP each year. Chart 15 illustrates general (central plus local) government spending and annual credit origination as a share of GDP. How fast would productivity grow in an economy where government bureaucrats allocate 50% of GDP annually? It is true that China's central government has a low debt load so it can afford to take over a large chunk of corporate debt. If and when they do so, I will change my view. So far, they have not done this, and will likely only contemplate such a policy move when things get really messy. Investors do not want to be long China plays going into such a scenario. That said, a tactical buying opportunity could emerge when the government takes over a large chuck of corporate debt. Caroline: Yan, how worried should we be about the misallocation of capital in China? Yan: Every economy experiences some level of capital misallocation. The real question is whether China's level of capital misallocation is more serious than that of its global peers. Theoretically, if a country has a bigger capital misallocation problem than others, the economy should have systemically lower capacity utilization, weaker pricing power, and lower profitability. These metrics are easily cross-referenced: Chart 16 contextualizes China's industrial sector capacity utilization ratio relative to global peers. By and large, most countries' capacity utilization ratios hover around 80%, not much different from China's, especially since the 2000s. In fact, barring some obvious outliers, capacity utilization ratios across countries have been largely synchronized, reflecting the ebb and flow of the global business cycle. Chart 16Capacity Utilization: A Global Perspective Industrial sector output prices have shown similar swings (Chart 17). Almost all countries suffered producer price deflation in recent years, and are now experiencing a synchronized upturn in wholesale pricing power. China's falling PPI was widely regarded as a tell-tale sign of misallocation of capital. Conversely, this was in fact more a reflection of stagnating global aggregate demand and weak resource prices worldwide than structurally weak pricing power among Chinese manufacturers. Chart 17Producer Prices: A Global Perspective Similarly, Chinese listed companies' deteriorating Return on Equity (ROE) was again singled out as a sign of capital misallocation. This view is easily debunked by Chart 18, as ROEs have fallen in all major markets. In fact, Chinese companies' ROEs have been structurally higher than the global averages. Even some Chinese sectors that have been derided as being plagued by massive overcapacity and inefficiency such as materials and energy exhibit ROEs almost identical to their global peers. The important point is that we should put China in a global context, rather than analyzing it in isolation. Some Chinese firms' efficiency and profitability have weakened notably over the past several years, but to me, this is more of a reflection of the sluggish global macro backdrop, rather than an indictment of China's discrete growth model. Caroline: Turning to the investment implications, Yan, how does the debt bubble concern impact your view on Chinese equities? Yan: Global investors' widespread concerns over Chinese debt levels and other macro issues have contaminated Chinese stocks with a broad-brushed bearish undertone. Chinese equities have been unduly punished, underweighted and under-owned for many years. As shown in Chart 19, Chinese investable stocks' ROEs have been structurally higher than the global benchmark, and have followed similar cyclical fluctuations. However, their stock prices are trading at massive discounts to the global benchmarks, based on conventional yardsticks (Chart 19). This in my view represents the "China risk premium," which is unjustified and unsustainable. I expect the misperception will eventually unwind, and Chinese shares will be re-rated. This is the fundamental factor supporting my positive view on Chinese equities. Strategically it makes sense to overweight Chinese stocks against their global peers. Chart 18Chinese ROEs Are Not Inferior To Global Peers Chart 19Chinese Equities' Large Valuation Gap Caroline: Arthur, how does your view impact your outlook for investment prospects in China and the rest of the emerging markets space? Arthur: There has not been any adjustment in China's corporate leverage. Deleveraging in China has not yet started. On the contrary, the credit bubble is getting larger. I mean the credit-to-GDP ratio continues rising exponentially and credit and bank loan growth remain in double digits (Chart 20). It is very risky to be bullish on financial assets linked to a bubble when the adjustment has not yet begun. It is like running in front of a steamroller trying to collect pennies. Besides, when there is a major imbalance in the system like the credit bubble happening in China now, I tend to overplay the importance of marginal policy tightening and underplay the significance of easing. Recent marginal policy tightening in China - in particular the clampdown on shadow banking, including banks' off-balance-sheet asset expansion - will cause credit growth to decelerate. This is a major risk to Chinese and EM growth in the second half of this year (Chart 21). Chart 20China: Money/Credit Is Still Booming Chart 21Is China's Recovery At Risk? Even if China does not have a full-blown crisis, we are likely to experience another down leg in China plays, commodities and EM risk assets similar to the second half of 2015, when Chinese import volumes contracted and global markets tanked. A few words about the potential adjustment trajectory are in order. I have been negative on China's growth and China-related plays in global financial markets since 2010, but I have never used the word "crisis." China may or may not have a crisis, but investors holding risk assets exposed to China's growth will suffer considerable losses again similar to the 2011-16 period. It is essential to differentiate cyclical from structural growth drivers. If the government does not allow credit growth to slow, cyclical growth will hold up. However, in this scenario, China will move toward a socialist model and structural growth will tumble. That said, the growth deceleration would be gradual, as depicted in Chart 22. Chart 22Toward Socialism = Secular Stagnation And Inflation If we assume China's productivity is currently growing at a rate of about 5.5-6% (which is already very high and hard to sustain), and if the country embarks on a socialist path, odds are that productivity growth will drop by 50-100 basis points in each of the following years. In five years or so, productivity growth would be only around 1-3%. This path is the ultimate recipe for economic stagnation in China. The only thing the authorities can do in this scenario is to boost growth from time to time via credit and fiscal stimulus. This will produce mini-cycles around a falling primary growth trend. The latest acceleration in China's growth is probably one of these mini-cycles. How can investors invest in this scenario? The stylized mini-cycles depicted in Chart 22 look nice, because we drew them ourselves. In reality, they will not be symmetric or smooth. In short, investing around economic mini-cycles is difficult because it assumes near-perfect timing. Caroline: Peter, is it all that bad? Peter: I think Arthur is too pessimistic. Investors have been predicting a Japanese debt crisis for years. It hasn't materialized and probably won't. They are making the same mistake about China. If China averts a debt crisis, as I think is likely, that's good news for global equities. In the developed market universe, Europe and Japan stand to benefit the most, given the cyclical bent of their stock markets. We are overweight both regions in local-currency terms. For global bonds, the implications are somewhat mixed. On the one hand, the high probability that the Chinese government can maintain the status quo of continued credit expansion for the foreseeable future means that a hard landing for the economy - and the associated drop in safe-haven developed economy government bond yields that this would trigger - is unlikely to occur. On the other hand, high levels of Chinese savings will continue to fuel the global savings glut, keeping real long-term bond yields lower than they would otherwise be. On balance, investors should maintain a modest underweight allocation toward global bonds. Caroline: Yan, do domestic politics play into your outlook for the RMB versus the dollar and on a trade-weighted basis? What is your outlook for monetary policy given recent signs of improving economic momentum? Yan: How President Donald Trump will deal with China on the RMB issue is a wildcard. Recent rhetoric suggests that the new U.S. administration intends to follow normal legal protocol to decide if China is manipulating its currency. This is a significant departure from Candidate Trump's repeated campaign trail promises. If the U.S. Treasury follows the formal process laid out in the statute, it is unlikely to label China a currency manipulator in the next semi-annual assessment to be published in April, simply because the country does not meet all the criteria for that label at the moment. The odds of an immediate clash between the U.S. and China on the RMB have ebbed. From China's domestic perspective, how the People's Bank of China intends to manage the exchange rate is also a thorny issue. From a long term point of view, the PBoC clearly wants to achieve a free-floating exchange rate, but the recent downward pressure on the RMB due to elevated capital outflows has forced the PBoC to heavily intervene to prevent a vicious, disorderly cycle, in which currency depreciation and capital flight reinforce each other. In terms of monetary policy, China's improving economic momentum has allowed the PBoC to follow the Fed in raising short-term interest rates. However, tighter capital account control measures will remain in place until the downward pressure on the RMB from capital outflow dissipates. Moreover, investors have been overwhelmingly focused on the negative economic effects of a weaker RMB, somehow ignoring the reality that as the world's largest manufacturer and exporter, China also stands to benefit from a weaker currency. In my view, the depreciation of the trade-weighted RMB since 2015 has played a critical role in reflating the Chinese economy (Chart 23). A weaker RMB has helped producer prices to reflate, and lowered the real cost of funding for manufacturers, which in turn has eased China's monetary conditions and supported cyclical growth improvement. In this vein, the downside of the RMB should be self-limiting, as the reflationary impact of a weaker exchange rate will help boost Chinese growth, which in turn will reduce downward pressure on the currency. Caroline: Peter and Arthur, is rampant capital flight still a risk? Where do you see the RMB heading over the coming 12-18 months? Peter: I think the RMB will weaken somewhat over the coming year, but that is more a reflection of my bullish view on the dollar than a bearish view on the yuan. Much of the capital flight that China has experienced recently has just been an unwinding of the hot money flows that entered the country over the preceding four years. Despite all the talk about a credit bubble, Chinese corporate external debt has fallen by around $400 billion since its peak in mid-2014 - a decline of over 50% (Chart 24). At this point, most of the hot money has exited the country and hence, I expect the pace of capital outflows to subside. Chart 23A Weaker RMB Leads Cyclical Recovery Chart 24The Rise And Fall Of Corporate Foreign Credit Nevertheless, the chronic shortfall of domestic demand that I described earlier will keep pressure on the Chinese government to try to export excess production abroad by running a larger current account surplus. This requires a weak currency. Thus, while I don't expect the yuan to plummet, I don't expect it to soar either. Arthur: I believe the RMB is set to depreciate by 10% or more against the U.S. dollar in the next 12 months or so. The Chinese yuan is not expensive, but it will stay under downward pressure because the mainland banking system has created too many yuan. When the supply of money goes vertical, its price drops. It seems the Chinese people are sensing there is too much RMB floating around, and they are trying to get rid of local currency. They have been overpaying for properties and have been shifting their wealth into foreign currencies. Finally, in China, the real deposit rate has turned negative (Chart 25, top panel). In the past, when the real deposit rate turned negative, the central bank hiked interest rates (Chart 25, bottom panel). If households do not get a more attractive deposit rate, they will opt for foreign currency, real assets like property or riskier investments domestically. All of this entails negative consequences for China's financial stability. Chart 25Real Deposit Rate Is Negative In brief, I expect capital outflows to persist and policymakers to allow the currency to depreciate further. Caroline: Peter/Yan/Arthur: Final thoughts: What are each of you watching for signs that China's macro landscape is evolving as you expect? Conversely, what would signal that your assessment has missed the mark? Peter: I am watching for signs of a policy mistake. Until China can reorient its economy towards one that is more consumer-centric, it will have to rely on high levels of investment to sustain aggregate demand. Any attempt to aggressively curb debt growth will only backfire. Arthur talks about resource misallocation from subpar investment projects, but there is no worse resource misallocation than a person who wants a job but can't find one. I am also watching trade policy. I don't think a trade war between China and the U.S. is in the cards for the time being, but if the U.S. economy turns down in 2019, as I expect, Trump will be backed into a corner. And with another election looming, he will strike out at China. That could trigger a global trade war. Yan: I agree with Peter that we should watch for policy mistakes and some sort of "Trump shock," both of which constitute downside risks. A less talked-about risk is potential growth overheating, which could require much tighter policy, leading to greater economic volatility. In fact, some cyclical indicators that are tightly linked to industrial activity have rebounded sharply, which is also reflected in the rebound in some raw materials prices. If exports get a further boost from continued improvement in the U.S. economy, the possibility of China's economy overheating cannot be completely dismissed. Another potential trouble spot is the housing market. The Chinese authorities have begun to tighten housing policy, but developers appear to be gearing up for another construction cycle. Sales of construction equipment such as heavy trucks and excavators have soared. Historically, construction machine sales have been tightly correlated with real estate development (Chart 26). If history is any guide, the renewed strength in construction equipment sales could be a harbinger of an impending boom in new home construction. This is good news for business activity and GDP growth, but probably antithetical to policymakers' broad agenda. We will follow up on these issues closely in our future reports. Arthur: The key variables to watch are various interest rates, credit/loan growth and inflation - in addition to keeping an eye on lending standards and credit demand. Recent increases in borrowing costs amid the enormous credit overhang give me confidence to argue that China's credit origination and economic growth are bound to decelerate later this year. A billion-dollar question is whether the recent rise in China's consumer inflation is transitory or the beginning of a notable uptrend (Chart 27). If consumer price inflation rises to 3% and higher, the game will be over - interest rates will need to go up and credit growth will tumble. If interest rates do not rise amid intensifying inflationary pressures, capital outflows will escalate and the currency will depreciate a lot. Chart 26An Upturn In Housing Construction? Chart 27China: Inflation Is Picking Up I will be wrong if policymakers manage to slow down credit growth from 11-12% toward 7-8% or so without generating notable economic weakness. This can occur only if productivity growth in China accelerates meaningfully. It is difficult to observe productivity growth in real time - it is a black box. 1 Please see Emerging Markets Strategy Special Report, titled "Do Credit Bubbles Originate From High National Savings?" dated January 18, 2017, available at ems.bcaresearch.com. 2 Please see Emerging Markets Strategy Special Report, titled "Misconceptions About China's Credit Excesses," dated October 26, 2016, available at ems.bcaresearch.com. 3 Please see Emerging Markets Strategy Special Report, titled "Misconceptions About China's Credit Excesses," dated October 26, 2016, available at ems.bcaresearch.com. 4 Please see Emerging Markets Strategy Special Report, titled "China's Money Creation Redux And The RMB," dated November 23, 2016, available at ems.bcaresearch.com.

Highlights Either go long Eurodollar / short Euribor June 2019 interest rate futures. Or long the U.S. 5-year T-bond / short German 5-year bund. Or long euro/dollar (though our preferred long euro expression is long euro/pound near term and long euro/yuan structurally). All three of the above are just one big correlated trade. Long-term equity investors should consider a 50:50 combination of Germany (DAX) and Sweden (OMX) as a superior alternative to the Eurostoxx50 or Eurostoxx600. But near term, remain cautious on risk-assets. Feature On the face of it, the ECB has committed to leave interest rates where they are for a very long time. "The Governing Council continues to expect the key ECB interest rates to remain at present or lower levels for an extended period of time, and well past the horizon of the net asset purchases"1 But take a closer look at this commitment, and an extended period of time could mean as little as a year. As things stand, "the horizon of the net asset purchases" has only nine more months to run, and "well past" could justifiably mean just six months or less beyond that. Furthermore, at the last press conference Draghi emphasized that forward guidance "is an expectation" and that the probabilities of the ECB's expectations are constantly changing. Remember also that the ECB has three policy interest rates:2 the deposit rate (-0.4%), the repo rate (0%) and the marginal lending rate (0.25%) - and the ECB doesn't have to move all three in tandem. Indeed in 2015, the ECB cut the deposit rate before the other two rates (Chart I-2). So it is quite conceivable that the ECB could hike the deposit rate before the other two rates and as soon as a year or so from now. Chart of the WeekGermany/Sweden Combination Has Run A Good Race With The U.S. Chart I-2The ECB Could Hike Its Deposit Rate Early ECB council member Ewald Nowotny hinted as much in a Handelsblatt interview last week, saying that all interest rates wouldn't have to be increased simultaneously nor to the same extent. "The ECB could raise the deposit rate earlier than the prime rate." A Major Mispricing: ECB Versus Fed This neatly brings us to one of the most extreme pricings in financial markets at the moment. The expected difference between ECB looseness and Fed tightness two years ahead stands at a 20-year extreme (Chart I-3). Chart I-3An Extreme Pricing: ECB Versus Fed Yet the percentage of the euro area population in employment is at an all-time high (Chart I-4), while on an apples for apples comparison, there is no difference between economic growth, inflation, or inflation expectations in the euro area and the U.S.3 Moreover, Draghi points out that "the risks surrounding euro area growth relate predominantly to global factors." If these global risks do materialise, it would prevent both the ECB and the Fed hiking rates through 2018. But if these global risks do not materialise, allowing the Fed to continue hiking through 2018, is it really conceivable that the ECB just sits pat? We think not. On this basis, investors should either go long Eurodollar / short Euribor June 2019 interest rate futures. Or long the U.S. 5-year T-bond / short German 5-year bund. Or long euro/dollar (though we prefer long euro/pound near term and long euro/yuan structurally). We say "either or" because all three positions are just one big correlated trade (Chart I-5). Chart I-4Percentage Of Euro Area Population In##br## Employment Near An All-Time High! Chart I-5Correlated Trade: Interest Rate Futures,##br## Bond Yield Spreads, Ans EUR/USD The French Election: "System 1" And "System 2" The looming risk to this big correlated trade takes the form of the upcoming French Presidential Election. Two data points do not make a trend, but some people are worried that the same dynamic that delivered shock electoral victories for Brexit and Donald Trump in 2016 could propel Marine Le Pen to the Elysée Palace in 2017. This worry is overdone. In explaining the Brexit and Trump shock victories, an important point has been understated. These days many voters care more about politicians' personalities than policies. Emotional appeal arguably matters more than rational appeal. Behavioural psychologist and Nobel Laureate Daniel Kahneman calls the emotional way of thinking "System 1", and the colder rational way of thinking "System 2". Both the Brexit and Trump campaigns resonated strongly with emotional System 1. A lot of voters warmed to Boris Johnson, a leader of the Brexit campaign, and to Donald Trump. By contrast, the Bremain and Hillary Clinton campaigns tried to appeal mainly to cold rational System 2. But as Kahneman explains, when cold rational System 2 competes with emotional System 1, emotional System 1 almost always wins. In this regard, the dynamic of the French Presidential election is very different to the U.K.'s EU Referendum and the U.S. Presidential Election. Charles Grant, director of the Centre for European Reform, points out that "Emmanuel Macron's personality, and notably his charm, calm authority and courage may well (emotionally) appeal to more voters than Marine Le Pen's simplistic remedies and bitterness." Therefore, a final run off between Le Pen and Macron - as now seems highly likely - does not give us sleepless nights. But we would be concerned if the final run off were between Le Pen and the much less emotionally appealing François Fillon (Chart I-6 and Chart I-7). Chart I-6A Final Run Off Between Le Pen & Macron... Chart I-7...Does Not Give Us Sleepless Nights Incidentally, both Daniel Kahneman and Charles Grant will be speaking at our forthcoming New York Conference on September 25-26, and promise to provide fascinating investment insights from their areas of expertise. So book your places now! A Better Way To Invest In Europe: Germany And Sweden All of this might suggest that the Eurostoxx50 should outperform the S&P500. Not necessarily. Extreme economic and political tail-events aside, there is almost no connection between national or regional economic relative performance and stock market relative performance. As we demonstrated in the Fallacy Of Division,4 by far the biggest driver of Eurostoxx50 versus S&P500 performance is its sector skew. The Eurostoxx50 has a major 15% weighting to banks and a minor 7% weighting to tech. The S&P500 is the mirror image; a minor 7% weighting to banks and a major 22% weighting to tech. Furthermore, this overarching driver is captured in just the three largest euro area banks versus the three largest U.S. tech stocks. So relative performance simply reduces to whether Banco Santander, BNP Paribas and ING outperform Apple, Microsoft and Google,5 or vice-versa. Everything else is largely irrelevant. But this begs the question: can a different combination of European markets neutralise the sector skew and thereby provide a fairer head-to-head contest with the tech-heavy S&P500? At first glance, the answer seems to be no. Europe simply does not have the same type of technology companies that the U.S. has. So no combination of European markets can match the S&P500 tech exposure. On the other hand, Europe is the world-leader in a different type of technology: innovative industrial equipment and materials. It turns out that a 50:50 combination of Germany (DAX) and Sweden (OMX) matches the exposure to European industrial equipment and materials with the exposure to American tech. At the same time, the DAX/OMX combination largely removes Europe's bank overweight. The upshot is that the DAX/OMX combination has run a very good race with the S&P500 through the past 10 years, while the Eurostoxx50 has failed to keep the pace (Chart of the Week). In effect, DAX/OMX versus S&P500 reduces to Siemens, Bayer and Atlas Copco versus Apple, Microsoft and Google (Chart I-8). Compared to the euro area banks, Europe's innovative industrial equipment and materials are a much better long-term match-up against U.S. tech (Chart I-9). Indeed, my colleague, Brian Piccioni, BCA Technology strategist, points out that Bayer is a good play on the revolutionary new genetic modification technology CRISPR-Cas9.6 Chart I-8DAX/OMX Vs. S&P500 = Siemens, Bayer & Atlas Copco ##br##Vs. Apple, Microsoft & Google Chart I-9European Innovative Industrial Equipment & Materials ##br##Is A Good Match-Up Against American Tech Investors who want a long-term equity exposure to Europe should consider a 50:50 combination of Germany (DAX) and Sweden (OMX) as a superior alternative to the Eurostoxx50 or Eurostoxx600. Nevertheless, those who can fine-tune their timing should await a better entry-point for all risk-assets. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 From the ECB introductory statement to the press conference, March 9 2017. 2 The deposit rate (-0.4%) is the rate at which commercial banks park their excess liquidity; the repo rate (0%) is the usually quoted policy rate for the ECB's standard money market operations; and the marginal lending rate (0.25%) is the rate at which commercial banks borrow from the central bank, usually when they cannot access interbank funding. 3 Please see the European Investment Strategy Weekly Report 'Fake News In Europe' January 26, 2017 available at eis.bcaresearch.com 4 Published on March 9, 2017 and available at eis.bcaresearch.com 5 Listed as Alphabet. 6 Please see the Technology Strategy and Global Investment Strategy Special Report 'CRISPR-Cas9: Investment Implications' March 17, 2017 available at www.bcaresearch.com Fractal Trading Model* There are no new trades this week. We are expressing a tactical short position in equities through a short exposure to the Netherlands AEX. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations

Highlights Please note that today we are publishing an abbreviated Weekly Bulletin as tomorrow we will publish Great Debate: Does China Have Too Much Debt Or Too Much Savings? The latter report will elaborate on long-standing view differences on China within BCA. I will be debating my colleagues Peter Berezin and Yan Wang on the issues surrounding China's savings and debt as well as the growth outlook. Arthur Budaghyan Feature Singapore: MAS Will Cap Interest Rates Higher U.S. interest rates will temporarily place upward pressure on Singaporean local interest rates (Chart I-1). However, Singapore is not in position to tolerate higher borrowing costs due to lingering credit excesses and deflationary pressures that currently prevail in its economy. The Monetary Authority of Singapore (MAS) will therefore respond by injecting liquidity to keep interbank rates low. The MAS operates monetary policy by guiding the exchange rate - and by default - often allowing interest rates to fluctuate freely. Yet higher interest rates are not an optimal policy option at the moment. If and as U.S. interest rates and the U.S. dollar rise, the MAS will intervene to cap local rates even if it entails a weaker Singapore dollar. While there is a recovery going on in non-oil export volumes and narrow money (M1) (Chart I-2), many other cyclical indicators are still negative. Chart I-1Rising Libor Rates Will Exert ##br##Upward Pressure On Singaporean Rates Chart I-2Singapore: Non-Oil ##br##Exports Are Picking Up The exchange rate-targeting system was introduced in the early 1980s when exports stood at 150% of GDP. Today, exports relative to GDP have fallen substantially to 115% of GDP (Chart I-3). On the other hand, total private non-financial sector debt levels have risen to 180% of GDP (Chart I-3). Therefore, the Singaporean economy has become much more leveraged to interest rates and somewhat less exposed to global trade. Improving exports will not be sufficient to offset the negative impact of rising borrowing costs. Moreover, our proxy for interest payments on domestic debt has also surged and now stands at close to 10% of GDP (Chart I-4). What is precarious is that the rise in interest payments relative to income has occurred in a period when rates are close to record-low levels. Chart I-3Singapore: Debt Is ##br##Overshadowing Exports Chart I-4Singapore: Interest Payments Are ##br##Large Despite Record Low Rates If borrowing costs rise, it will likely cause major debt deflation concerns. The MAS will not allow this to happen. Employment is stagnating, while employment in the construction and manufacturing sectors is contracting (Chart I-5). Weak employment has weighed on the consumer sector. Retail and department store sales are still shrinking (Chart I-6). Chart I-5Singapore: Employment Is Weak Chart I-6Retail Spending Is Contracting Importantly, the real estate sector, one of the major pillars of the Singapore economy, is depressed. Property prices across the board are deflating, while vacancy rates are rising (Chart I-7). Bank loan growth to property developers has also stalled (Chart I-7, bottom panel). Weak economic growth should be reflected on banks' balance sheets. Surprisingly, non-performing loans (NPLs) among Singapore's three largest banks still stands at a low 1.4%. If and as loan losses begin to rise, commercial banks will rush to increase provisioning for these losses, which will hurt their profits and keep credit growth subdued. Furthermore, Singaporean banks are also very exposed to Malaysia. Singapore's largest banks have extended loans to Malaysia of approximately 67 billion Singapore dollars - or 16% of GDP. Aggregate external loans stand at 137% of GDP (Chart I-8). Economic fundamentals are currently very weak and will continue to deteriorate in Malaysia. This warrants more assets write-offs among Singapore banks and less appetite to expand their balance sheet. Chart I-7Property Sector In Singapore Chart I-8Singaporean External Loans Are Enormous On the whole, if Singaporean interest rates begin to rise due to either depreciation of the Singapore dollar or higher U.S. interest rates, the central bank will intervene to bring local rates down. It would not be the first time the MAS has intervened to bring down interest rates. In 2015 when EM risks escalated, local interbank rates spiked. The MAS promptly injected liquidity in the banking system by buying back its outstanding MAS bills, and by also purchasing government securities, supplying liquidity to the banking system. This essentially placed a cap on interbank rates. Chart I-9Go Long Singapore Real ##br##Estate Stocks Vs. Hong Kong What is noteworthy is that the Singapore dollar weakened as a result of the intervention, although the MAS's official monetary policy stance was not stimulative - i.e. the monetary authorities did not target to weaken the trade-weighted SGD. In that instance, the MAS decided to focus on interest rates/funding market stability and ignore the exchange rate's response. This highlights that despite the MAS's official monetary policy framework of guiding the exchange rate, it will not allow interest rates to rise. Unlike Singapore, Hong Kong does not operate an independent monetary policy and as such will be forced to import higher U.S. rates. As a bet on higher interest rates in Hong Kong and the U.S. relative to Singapore, investors should consider going long Singaporean real estate stocks and shorting Hong Kong real estate stocks. Chart I-9 shows that Singaporean real estate stocks outperform Hong Kong's when the latter's interest rates/bond yields rise relative to Singapore and when Singapore's M1 growth accelerate relative to Hong Kong. As discussed above, the MAS has the capacity and will to inject liquidity to lower interest rates. Hong Kong, however, does not have this privilege due to the currency's peg to the greenback. Besides, Singapore's property correction is now much more advanced than Hong Kong's. In fact, Hong Kong property prices are still rising, i.e., the real estate market adjustment in Hong Kong has not yet started. While both city states are vulnerable to a potential slowdown in Chinese inflows, Hong Kong real estate prices will ultimately fall from a higher starting point. Bottom Line: A rising U.S. dollar and U.S. interest rates may exert upward pressure on Singaporean local interest rates. However, the Singaporean central bank will respond by injecting liquidity, which will cap rates relative to the U.S. and Hong Kong. This opens a tactical trade opportunity (for the next 3 months): Long Singapore real estate stocks / short Hong Kong real estate shares. Asian equity portfolio investors should have a neutral allocation to Singapore stocks within the EM/emerging Asian benchmarks. Ayman Kawtharani, Research Analyst ayman@bcaresearch.com Colombia: Not Out Of The Woods Yet Even though global economic growth has been improving and commodities prices have rallied, Colombia's growth is still bound to disappoint. We remain structurally bullish on the nation's longer-term prospects. That said, there will still be more downside this year. Credit growth will continue to decelerate, despite the beginning of a rate cut cycle (Chart II-1). Interest rates are still high, both in nominal and real terms (Chart II-2). This along with poor consumer and business confidence (Chart II-3) will depress credit demand and spending. Chart II-1Colombia: Negative Credit Impulse Chart II-2Borrowing Costs Are Still High Chart II-3Consumer & Business Confidence Are Weak Furthermore, the central bank's liquidity injections into the banking system have dropped considerably (Chart II-4). In the past few years, abundant liquidity provisioning by the central bank had allowed commercial banks to sustain robust credit growth. Hence, a withdrawal of banking system liquidity will cap loan origination. The current account deficit remains wide at $12.5 billion, or 5.2% of GDP. Financing such a wide deficit will prove challenging. Besides, BCA's Emerging Markets Strategy team believes oil prices are at risk of additional declines. Hence, we are bearish on the Colombian peso. Fiscal policy is set to tighten as the budget deficit has ballooned due to strong spending and shrinking revenues (Chart II-5). Recently introduced tax reforms represent a step forward with respect to the country's structural reforms agenda, as it will simplify the tax code and reduce corporate tax rates. Chart II-4Withdrawal Of Liquidity Will Cap Credit Growth Chart II-5Government Fiscal Balance Is Deteriorating However, redistributing the tax burden onto individuals, mainly by increasing the VAT from 16% to 19%, will reinforce the slump in household spending. In terms of high frequency data, there are little signs of economic revival (Chart II-6). Retail sales volume remain tame. The latest bounce in this series most likely reflects consumers front running the impending VAT hike. Furthermore, oil production is likely to decline further, and non-oil exports are still contracting. In terms of financial markets, we recommend the following: We are closing our bet on yield curve flattening - receive 10-year/pay 1-year swap rates. Initiated on September 16, 2015, this trade has produced a 190 basis-point gain (Chart II-7). At the moment, the risk-reward for this position is no longer attractive. Chart II-6Cyclical Economic Activity Remains Subdued Chart II-7Take Profits On The Yield Curve Trade We remain neutral on Colombian equities and sovereign credit relative to their respective EM universes. Even though our long Colombian bank stocks/short Peruvian banks bet has been deep in the negative, we are reluctant to cut it. The basis is that Colombia's central bank may opt to cut rates further, even if the peso depreciates anew. In contrast, the Peruvian central bank is more likely to hike rates if its currency comes under downward pressure. Bank share prices will likely react to marginal shifts in relative interest rates between the two countries. Andrija Vesic, Research Assistant andrijav@bcaresearch.com Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Cable stocks continue to demonstrate market leadership, largely on the back of the industry ability to persistently raise selling prices at a rate much faster than overall inflation. Cable operators' ability to continually evolve offerings and provide attractive content is reflected in the recovery in consumer spending on cable services, which has unfolded despite cord cutting. Importantly, content inflation rates have remained within the range of the past few years, underscoring that threats to robust profit margins remain limited. Relative valuations remain sufficiently attractive to expect ongoing better-than-market performance. Stay overweight. The ticker symbols for the stocks in the S&P cable & satellite index are: BLBG: S5CBST - CMCSA, CHTR, DISH.

The S&P managed care index is testing new highs relative to the broad market, aided by optimism that an ACA overhaul will mean less pressure for insurers to cover high risk, high cost subscribers. Regardless of the proposed changes, the outlook for managed care stocks remains upbeat. They still command less than a market multiple, despite a solid growth outlook. The labor market remains strong, which is conducive to ongoing membership growth. Importantly, premiums are set on a trailing cost basis, and the previous surge in medical costs implies that a period of higher premiums looms just as costs are falling. Indeed, our proxy for medical costs has dropped sharply, heralding a steep decline in the medical loss ratio. There are high odds that this trend will be sustained, given that spending on overall health care is decelerating relative to total spending, an environment that has typically been associated with managed care outperformance. The less consumers are spending on procedures, the fewer claims that will be made, all else equal. That is particularly evident in the easing in pharmaceutical shipment growth and inflation rates. The bottom line is that the S&P managed care index remains a core portfolio overweight. The ticker symbols for the stocks in the S&P managed care index are: BLBG: S5MANH - UNH, AET, ANTM, CI, HUM, CNC.