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Highlights In the Philippines, inflation is breaking out while the central bank is well behind the curve. Financials markets remain at risk. As a play on surging interest rates: Go short Philippine property stocks. We appraise and modify our investment strategy across all central European markets in general and Hungary in particular - where a monetary policy shift is in the making. A new trade: We recommend paying 3-year swap rates in Hungary and receiving 3-year swap rates in the euro area. Feature The Philippines: Short Real Estate Stocks Philippine stocks are on the verge of a major breakdown (Chart I-1, top panel). Meanwhile, local currency bond yields are surging (Chart I-1, bottom panel). Chart I-1Philippine Stocks Are On The Edge Of A Breakdown The Philippine economy continues to overheat, and the Bangko Sentral ng Pilipinas (BSP) has fallen well behind the curve. The top panel of Chart I-2 shows that both headline and core inflation measures are rising precipitously and have breached the central bank's upper target of 4% by a wide margin. Chart I-2The Central Bank Is Far Behind The Curve Odds are that inflation will continue to climb higher. Overall domestic demand remains reasonably strong. Noticeably, both the current and fiscal accounts are in deficit and widening (Chart I-3). A current account deficit is a form of hidden inflation. The basis is that it gauges the degree of excess domestic demand relative to the productive capacity of the economy. Chart I-3The Philippines: A Large Twin Deficit The roots of these macro problems stem from ultra-easy monetary and fiscal policies pursued by Filipino authorities. The BSP has kept borrowing costs low and for much longer than was warranted, and has been slow to hike rates. As a result, credit has been booming relentlessly (Chart I-4). Chart I-4Bank Loans Have Boomed... The fiscal authorities, on the other hand, have vigorously pursued growth-at-all-costs programs. Government spending is now growing at an annual rate of 22% (Chart I-5). Chart I-5...So Have Government Expenditures Consequently, these populist policies have created excessive domestic demand that has stoked an inflation breakout. Given Philippine President Rodrigo Duterte's reluctance to cut back on fiscal expenditures, it will be up to the monetary authorities to tighten sufficiently enough to curb inflation.1 The currency was depreciating against the U.S. dollar in 2017, even as its EM peers rallied. A falling currency amid strong economic growth is generally a symptom of an overheating economy; it signals that real interest rates are low and the central bank is behind the curve. Today, the monetary authorities need to hike borrowing rates aggressively, otherwise the currency will plunge much further. The country's financial markets are quickly approaching a riot point, and local currency bond yields are already selling off as creditors are rebelling (see bottom panel of Chart I-1 on page 1). Another option the BSP could take to defend the peso without hiking rates much is to sell foreign exchange reserves. Doing so, nevertheless, will still lead to higher domestic interest rates - especially at the short end of the curve. When a central bank sells its dollar reserves, it absorbs local currency liquidity - i.e. commercial banks' excess reserves at the central bank decline. Interbank rates then rise, which pushes up short-term rates and potentially long-term ones too. This is how financial markets naturally force macro adjustments on an overheating economy when policymakers are reluctant to act. As such, Filipino share prices are now facing a major risk. Higher domestic rates amid strong loan growth will cause the economy to decelerate significantly. Certain interest rate-sensitive sectors such as vehicle sales are already shrinking. The property sector - the segment of the economy that has benefited the most from the credit binge - will be the next shoe to drop: The supply of residential real estate buildings has been booming - floor space built has risen 2.4-fold since 2003. As interest rates continue to rise, real estate and construction loans - which are still growing at a 19% annual rate - will slump. Higher borrowing costs will hurt real estate prices. Meanwhile, rent growth will decline as the economy decelerates. The slowdown in the property sector will take a heavy toll on real estate development and management companies: First, these firms' revenues and income - property sales, rental and other types of income - will decelerate significantly (Chart I-6, top panel). Chart I-6Listed Real Estate Companies Will Face Major Headwinds Second, higher interest rates will raise their interest expenses (Chart I-6, bottom panel). Remarkably, Philippine real estate stocks have remained quite resilient, despite the broad selloff in financial markets. While the former are down by 18% in dollar terms from their early 2018 peak, Chart I-7 suggests rising interest rates herald a much more pronounced drop in their prices. Chart I-7Filipino Property Stocks Are On A Cliff Besides, these property companies are also still expensive. Their price-to-book value (PBV) currently stands at 2.9. Between the years 2000 and 2005, their PBV averaged 1.6. We are therefore initiating a new trade: Short Philippine real estate stocks in absolute U.S. dollar terms. Crucially, the real estate sector makes up 27% of the Philippines MSCI index, and will therefore have a significant impact on the Philippine stock market. As to bank stocks - the other large segment of the equity market - a couple of points are in order. Commercial banks in the Philippines are exposed to the real estate sector. Hence, a slowdown in the property sector will culminate in the form of higher NPLs and provisions for bad loans on banks' balance sheets. Real estate and construction loans account for 25% of total bank loans. Crucially, NPLs and provision levels - at 1.3% and 1.9%, respectively - are very low, and have so far not risen. This is unsustainable given the magnitude of the ongoing credit boom and rising interest rates. Higher provisions will cause banks' profits and share prices to suffer materially. This will come on top of plunging net interest margins (Chart I-8). Chart I-8Philippines Commercial Bank Profits Are Getting Squeezed As to equity valuations, this bourse is not cheap, neither in absolute terms nor relative to the EM equity benchmark - both valuation measures are neutral (Chart I-9). Chart I-9Equity Valuations Are Not Attractive Overall, the outlook for Philippine equities as a whole remains unattractive both in absolute terms, as well as relative to the EM benchmark. Bottom Line: EM equity portfolios should continue underweighting this bourse. We are also initiating a new trade: Going short Philippine real estate stocks in absolute U.S. dollar terms. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com Strategy For Central European Markets Our presiding macroeconomic theme for central Europe - which we first elaborated on in a Special Report titled, Central Europe: Beware Of An Inflation Outbreak2 - has been as follows: An accommodative policy stance in the context of strong growth and tight labor markets warrants higher inflation. Our proxy for labor shortages - calculated as the number of job vacancies divided by the number of unemployed looking for a job - is continuing to surge across all central European countries as well as in Germany. This foreshadows higher wage growth ahead (Chart II-1). Chart II-1Tight Labor Markets Means Higher Wage Growth Furthermore, monetary policy in central European countries remains accommodative - policy rates are negative in real (inflation-adjusted) terms. Consistently, private credit (bank loan) growth and domestic demand remain robust. Today, we appraise and modify our investment strategy across all central European markets in general and Hungary in particular, where a policy shift is in the making. Hungary: Moving Away From Ultra-Accommodative Monetary Policy? Last month, the NBH (National Bank of Hungary) modified its monetary policy statement to include a new paragraph explaining that the council is prepared for the gradual normalization of monetary policy, depending on the outlook for inflation.3 Given our view that inflation in Hungary will continue to rise, the NBH is likely to move away from ultra-accommodative monetary policy sooner rather than later. Besides mounting inflationary pressures, several factors lead us to believe that the NBH is more comfortable normalizing policy today than in the past: First, after seven years of deleveraging, private credit is finally on the rise, and money supply growth is booming (Chart II-2, top and middle panel). Chart II-2Hungary: Easy Monetary Conditions Will Lift Inflation Second, capital expenditures are recovering and business confidence is making new highs (Chart II-3, top and middle panel). Furthermore, construction is firing on all cylinders (Chart II-3, bottom panel). Chart II-3Hungary: Capex Is Robust Lastly, core consumer inflation is rising and the real deposit rates is at -2%, the lowest in 20 years (Chart II-2, bottom panel). Given the genuine need for rate normalization in Hungary and the central bank's readiness to do so, we are adjusting our strategy: We are taking profits of 72 basis points on our Hungarian yield curve steepening trade that we initiated on June 21, 2017. Hungary's yield curve is already the steepest yield curve in Europe. The slope of the 10/1-year yield curve is 320 basis points in Hungary, versus 200 in Poland, 100 in the Czech Republic and 105 in Germany. We are closing our long PLN / short HUF trade with a 7.7% gain since its initiation on September 28, 2016 (Chart II-4). The cross rate is close to an all-time high and will likely reverse. Chart II-4Book Profits On Long PLN / Short HUF A new trade: We recommend paying 3-year swap rates in Hungary and receiving 3-year swap rates in the euro area (Chart II-5). Chart II-5A New Trade: Pay Hungarian / Receive Euro Area 3-year Swap Rates First, not only is final domestic demand in Hungary much more robust than in the euro area, but Hungary's output gap is positive while the euro area's is still negative (Chart II-6,top and middle panel). This foreshadows a widening gap in inflation between Hungary and the euro area (Chart II-6, bottom panel). As this transpires, policy rate expectations will rise faster and by more in Hungary than in the euro area. Chart II-6Hungarian Economy Will Overheat Faster Than Euro Area's Second, ultra-accommodative monetary policy in Hungary has served its purpose and has generated an overflow of liquidity. In effect, with broad money supply in Hungary now growing considerably faster than in the euro area, the NBH will likely tighten its policy at a faster pace and by more than the ECB (Chart II-7). This warrants a widening 3-year swap rate differential between Hungary and the euro area. Chart II-7Hungary Vs. Euro Area: Money Growth And Swap Rates Third, as global trade continues to slump, affecting German manufacturing, the European Central Bank will be fast to reiterate its readiness to keep policy accommodative longer than expected. This could push back expectations of the first ECB rate hike. Finally, Italy remains a risk and European banks are exposed to weakening developing countries. With euro area bank share prices plunging close to their 2008 and 2012 lows, the ECB will be both slow and cautious in signaling rate normalization in the immediate future. While Hungary is a very open economy and will feel the pinch from a slowdown in European manufacturing, its currency may depreciate further against the euro as it typically does amid global risk-off periods. A cheap currency will reduce the NBH's worries about the pass-through of a global slowdown and disinflation into its domestic economy. In short, given that both economies have different inflationary backdrops, Hungarian interest rate expectations will increasingly diverge from those of the euro area. As such, fixed-income investors should bet on a rising 3-year swap rate differential between Hungary and the euro area. Our Other Positions In Central European Markets Within the fixed income and currency space: Stay overweight CE3 within EM dedicated fixed-income portfolios. Predicated on our view that the epicenter of the ongoing global growth slowdown is China, emerging Asian and commodity leveraged markets are at much bigger risk than their Central European counterparts. Consistent with this theme, stay short IDR versus PLN. Book profits of 109 basis points on the following trade initiated on July 26, 2017: Pay Czech / receive Polish 10-year swap rates (Chart II-8). In line with our expectations,4 the Czech National Bank has been responding to rising domestic inflationary pressures and has been tightening monetary policy faster than the National Bank of Poland. There now remains little upside in Czech rates relative to Polish ones, so we are booking profits. Chart II-8Book Profits On Pay Czech / Receive Polish 10-year Swap Rates Stay long CZK against the EUR. Widening growth and inflation gaps between the Czech Republic and the euro area justify higher rates and a stronger currency in the former relative to the latter. Regarding the equity space: Stay long CE3 banks / short euro area banks. CE3 banks are less leveraged and have a higher return on assets than euro area banks. Continue overweighting CE3 within EM dedicated equity portfolios. CE3 stocks have staged a double bottom relative to their emerging market peers, both in common and local currency terms (Chart II-9). Given emerging markets are saddled with credit excesses, unresolved economic imbalances and looming currency weakness, central Europe is likely to continue outperforming. Chart II-9CE3 Equities Will Outperform EM A summary of all our trades and asset allocations can be found on page 14 and 15. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com 1 Please see Emerging Markets Strategy/Geopolitical Strategy Special Report, "The Philippines: Duterte's Money Illusion," dated April 25, 2018, available at ems.bcaresearch.com 2 Please see Emerging Markets Strategy Special Report "Central Europe: Beware Of An Inflation Outbreak," dated June 21, 2017, available at ems.bcaresearch.com. 3 http://www.mnb.hu/en/monetary-policy/the-monetary-council/press-releases/2018/press-release-on-the-monetary-council-meeting-of-18-september-2018 4 Please see Emerging Markets Strategy Weekly Report "Follow The Money, Not The Crowd," dated July 26, 2017, available at ems.bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Economic data and policy announcements over the past month reflect the view that policymakers are serious about restraining credit growth, and that they will attempt to combat any weakness in external demand by boosting domestic consumption. A review of historical episodes of "outsized" investment intensity shows that policymakers have good reason to try and shift the composition of China's economy towards consumption, as it suggests that China's current experience probably cannot be sustained. A shift even somewhat away from heavy investment-led growth means that the "strike price" of the China put option has fallen relative to past economic slowdowns, implying that it will take more pain before investors can cash in. It is too soon to move towards an outright long position favoring domestic stocks, even though considerable bad news has been priced in. CNY-USD likely has further downside, and investors allocating among Chinese stocks should only favor domestic over investable equities in currency-hedged terms. Feature September's total social financing data, released earlier this month, provided important evidence supporting our view that Chinese policymakers are not aiming for a significant acceleration in private sector credit growth. Chart 1 highlights that the year-over-year growth rate of adjusted total social financing (TSF) actually ticked modestly lower in September, in clear contrast to the bet of many investors that China is following its "old stimulus rulebook". Chart 1Chinese Policymakers Are Not Pumping The Credit Taps Some market participants have pointed to the fact that adjusted TSF is rising sharply on a 3-month annualized basis after adjusting for seasonality (Chart 2), and have concluded from this fact that a sustained expansion in credit growth is forthcoming. However, Chart 3 illustrates that the pickup shown in Chart 2 is due to a surge in special local government bond issuance, which reflects front-loading of fiscal spending. Financial news outlets have reported that "provincial authorities had by the end of September already raised 92 percent of the 1.35 trillion yuan ($195 billion) worth of special infrastructure bonds that the central government has targeted for the entire year",1 implying that local government bond issuance in Q4 will drop off significantly relative to the past three months. Chart 2A Near-Term Pickup... Chart 3...Caused By Front-Loaded Fiscal Spending The September credit data aside, we acknowledge that there have been several small-scale stimulus announcements from the Chinese government over the past month. But the bottom line for now is that developments over this period reflect the view that policymakers are serious about restraining credit growth, and that they will attempt to combat any weakness in external demand by boosting domestic consumption.2 Restraining Credit Growth: Wisdom Or Folly? China's unwillingness to resort to a significant acceleration in credit growth to help stabilize its economy has surprised some investors, and raised criticism in some corners that the country is making a policy mistake. A recurring argument in this vein, particularly among perennial China bulls, is that policymakers should not be concerned about China's elevated levels of private sector debt because it is the natural and inevitable result of a high savings rate. According to this view, restraining credit growth and attempting to boost consumption merely dooms China's ability to escape the middle-income trap, because higher per capita income can only be achieved by further growth in the stock of capital. BCA's China Investment Strategy service does not dispute the notion that a high savings rate can lead to a high leverage ratio, particularly among small, fast-growing economies. But in the case of China, the sharp rise in private sector debt that has occurred since 2010 was not natural, and certainly was not inevitable. Instead, our view is that it was the result of an explicit "least-bad" choice made by policymakers to weather the reality of poor external demand following the global financial crisis. Chart 4 presents, in a nutshell, the theoretical support for the "keep investing" view. The chart depicts real per capita GDP for 80 countries in 2014 as a function of the average share of gross capital formation to GDP from 1960 to 2014. The chart clearly shows that richer countries today have tended to invest more on average in the past, which is entirely consistent with textbook economic theory. Chart 4Higher Investment Has Led To Higher Per Capita GDP Growth... However, there are two reasons why the simple inference from Chart 4 that China should just "keep investing" is deeply flawed. First, while investment as a share of GDP in China has recently declined from its 2011-2014 peak, it remains close to 45%. This is a massive rate of investment, and a historical review points to the conclusion that it probably cannot be sustained: 45% is nearly off the x-axis scale shown in Chart 4, suggesting that China's current rate of investment is not achievable over extended periods of time. In fact, the chart suggests that 30% is the highest realistic rate of investment as a share of GDP that a country can maintain over an extended period. In 2014, based on the definition of the data from the Penn World Table (GDP share of gross capital formation at current purchasing power parity), China had maintained its investment share above 30% for 12 years. At first blush, there appears to be some precedent suggesting that China's outsized investment run can go on for longer: among the 80 countries included in Chart 4, 14 of them have experienced a longer continuous run of investment as a share of GDP. However, Chart 5 shows that most of these experiences occurred in the 1960s and 1970s, when global exports as a share of GDP were rising from a very low base. This implies that historical examples of outsized investment runs have largely reflected export-driven catch-up stories, which bodes poorly for China's ability to continue to invest at its recent massive scale given that global exports to GDP appear to have peaked. Chart 5...But Very High Rates Of Investment Have Driven By Exports Second, the relationship shown in Chart 4 captures the potential gains of profitable and rational investment, or in other words the accumulation of a "useful" stock of capital. But an unfortunate reality facing savers is that while one can choose to save or invest, one cannot necessarily choose the accompanying rate of return. If China invests heavily at very low or negative rates of return, the idea that investment will lead China out of the middle-income trap is very likely wrong. As we have discussed in previous reports, there is good evidence to suggest that the marginal gains from investment in China have been falling. The private sector debt-to-GDP ratio features prominently in the case against profitable investment in China: despite a massive rise in investment and debt from 2002-2007, the private sector debt-to-GDP ratio barely rose, because this debt was used to accumulate capital that verifiably delivered nominal GDP growth. Yet following 2010 the ratio rose sharply, implying that the returns from the investment that has taken place over the past decade have been (at least so far) considerably lower than those of the prior decade. Also, we noted in our August 29 Special Report that state-owned enterprises (SOEs) have accounted for a sizeable portion of the private sector leveraging that occurred after 2010,3 and that the marginal operating gain from debt for SOEs has become negative (Chart 6). A gap between the cost/return on borrowed funds strongly implies that the investment channeled through SOEs over the past several years does not represent, on balance, the accumulation of useful capital. Chart 6Strong Evidence Against Productive SOE Investment In our view, a cohesive story emerges from the above analysis, one that counters the view that China is making a policy mistake by trying to avoid another significant episode of private sector leveraging. China's enormous catchup in per capita GDP over the past 20 years was initially export-led, but was sustained after 2010 by quasi-fiscal spending in the form of a material leveraging of state-owned enterprises. This shadow government spending was aimed at preventing large-scale job losses, but proved to be considerably less productive than the private, export-driven investment-boom that preceded it. This suggests that China is simply investing too much for an economy that needs to accumulate capital for the purposes of domestic production, and that any further, aggressive leveraging of the private sector will simply raise the odds or the cost of the eventual bailout. While investors who are hoping to profit from China's credit excesses may wish for a different outcome, the bottom line is that Chinese policymakers will act in the best interests of their country, and they have good reason to try and shift China's economy away from extremely high rates of investment towards more consumption. Implications For Investment Strategy As would be the case in any other major country, we have no doubt that Chinese policymakers will eventually move to a maximum reflationary stance (which would imply a significant reacceleration in credit growth) if they feel that the existing slowdown will lead to deep, threatening economic instability. The key point for investors is that a desire of policymakers to shift even somewhat away from heavy investment-led growth means that the "strike price" of the China put option has fallen relative to past economic slowdowns, implying that it will take more pain before investors can cash in. Within the universe of Chinese financial assets, there are three pertinent investment strategy questions that arise from this reality: Even if there is more pain to come, Chinese domestic stocks have fallen 30% in local currency terms, and close to 40% in U.S. dollar terms (Chart 7). Is it time to go outright long? Should investors allocating among Chinese stocks favor domestic or investable equities? What is the outlook for CNY-USD? For now, our answers are as follows: 1) not yet, 2) domestic over investable in currency-hedged terms, and 3) weaker (possibly significantly so). Chart 7The Bear Market In A-Shares Is Advanced... We agree that 30% is a reasonable estimate of the likely decline in domestic earnings over the coming year, which normally would suggest that A-shares have fully priced the bad news and that investors should consider buying. However, there are two key reasons why we think this conclusion is premature: We noted in our September 19 Weekly Report that the lesson of 2014/2015 was Chinese stocks needed both policy stimulus and earnings clarity before bottoming.4 For now, China's stimulative response has been measured, and we have yet to see any decline in domestic 12-month forward earnings (Chart 8). While it is not the only factor contributing to the decline, the escalation in the trade war with the U.S. acted as a clear negative catalyst for the Chinese stock market. We have argued that the evolution of the trade positions of both sides suggests that the imposition of a third and final round of import tariffs covering all Chinese exports to the U.S. is likely, which would further reduce Chinese earnings visibility for investors. News reports this week suggested that an announcement to this effect could occur in early-December, if a meeting between Presidents Trump and Xi is called off or fails (as we expect). Chart 8...But Forward EPS Have Yet To Start Falling Chart 9 presents our framework for forecasting CNY-USD as a function of various U.S. import tariff scenarios, which we used to argue that a break above the psychologically-important level of 7 for USD-CNY appeared likely barring strong action from the PBOC4. The RMB has weakened in line with our view over the past month, and Chart 9 shows that it stands to weaken further, potentially significantly, if the U.S. does move ahead with a 25% import tariff on all imports from China. Chart 9Further Downside In CNY-USD Is Likely Finally, our negative outlook for the currency informs our view that a relative position favoring domestic over investable stocks should be currency-hedged. Chart 10 shows that an uptrend in relative performance does appear to be forming in local currency terms, but not in U.S. dollar terms (due to the recent renewed weakness in CNY-USD). Chart 10Relative To Investable Stocks, Only Favor A-Shares In Hedged Terms We opened a shadow trade in our July 5 Weekly Report of being long the MSCI China A Onshore index / short MSCI China index,5 which we said we would consider implementing in response to a 5% rally in relative performance. Our intention was to structure this trade in unhedged terms (consistent with most of the trades in our trade book), and our judgement is that it is simply too early to do so despite the fact that a 5% relative rise in U.S. dollar terms has indeed occurred. Signs of a durable bottom in CNY-USD, or an assessment of minimal further downside coupled with strong outperformance of domestic stocks in local currency terms, are likely catalysts for a green light. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 "China Is Struggling To Find Projects To Spend Bond Splurge On", Bloomberg News, October 22, 2018. 2 Pease see China Investment Strategy Special Reports "China: How Stimulating Is The Stimulus?", dated August 8, 2018, and "China: How Stimulating Is The Stimulus? Part Two", dated August 15, 2018, available at cis.bcaresearch.com. 3 Pease see China Investment Strategy Special Report "Chinese Policymakers: Facing A Trade-Off Between Growth And Leveraging", dated August 29, 2018, available at cis.bcaresearch.com. 4 Pease see China Investment Strategy Weekly Report "Investing In The Middle Of A Trade War", dated September 19, 2018, available at cis.bcaresearch.com. 5 Pease see China Investment Strategy Weekly Report "Standing On One Leg", dated July 5, 2018, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights Growth Scare: Despite the recent pickup in global equity market volatility, bond volatility remains subdued. Until there is more decisive evidence of a deeper pullback in global growth that is impacting the mighty U.S. economy, yields on government bonds - which remain overvalued in all major developed economies - will have difficulty falling much more even if equity markets continue to correct. Stay below benchmark on global duration exposure, while maintaining only a neutral allocation to global credit. Canada: The Bank of Canada remains on a hawkish path to a more neutral policy rate, even with the lingering concerns over household debt and global trade tensions. Stay underweight Canadian government bonds in hedged global bond portfolios. Feature Just like that other great October tradition, Halloween, market volatility has returned to spook investors. Both the MSCI All-Country World Index and S&P 500 index are officially in correction territory, down -10% from the highs reached in September. The causes for the pullback range from high-profile third quarter U.S. earnings disappointments to increased evidence that the U.S.-China tariff war is negatively impacting U.S. investment spending. Yet the reaction from global bond markets has been relatively muted for such a large pullback in stocks. Benchmark 10-year government bond yields for the major developed markets are down from their peaks, but the declines have been smaller in countries where central banks are in a rate hiking cycle (U.S. -14bps, Canada -19bps) relative to countries where central banks are on hold (Germany -20bps, U.K. -31bps). One possible reason for this discrepancy is that the downtrend in data surprises appears to have stabilized in the U.S. and, even more importantly, China, while European data continues to disappoint relative to expectations (Chart of the Week). Chart of the WeekNoisy Equities, Calm Bonds We still do not believe that global bond yields have peaked for the cycle. We continue to recommend a below-benchmark strategic bias on overall duration exposure, but with only a neutral allocation to global corporate bonds that favors U.S. credit. On a more shorter-term tactical basis, there is a risk that yields could decline further, with more credit spread widening than seen during the current risk-off episode, if economic data starts to disappoint in the U.S. where growth has so far been resilient. Staying up in credit quality within an allocation to U.S. corporates is one way to hedge against such an outcome. Bond Yields Are Normalizing, Bond Volatility Is Not The selloff in risk assets has resulted in a pickup in widely-followed market volatility measures like the U.S. VIX index. Yet when looking at the level of realized total return volatility across all major asset classes, the current bout of turbulence has been unimpressive outside of global equities. In Chart 2, we present an update of a chart from our 2018 global bond outlook report, showing the current levels of realized volatility across different asset class benchmarks compared to their historical ranges. The vertical lines in each chart represent the range between 1999 and 2017 of annualized monthly volatilities for global government bonds, credit, equities, currencies and commodities. The red triangles represent the most recent 13-week annualized volatilities for those same asset classes. What stands out in the chart is that volatilities are off the historical lows for global equities, Italian government bonds and industrial commodities, yet volatilities remain subdued for developed market government bonds, global corporate debt and currencies. Chart 2Bond Volatility Remains Subdued, Despite More Volatile Equities We have long argued that the shift to a structurally higher level of volatility across all asset classes will show up first with a rise in bond volatility. In the U.S., in particular, sustained periods of elevated volatility for both Treasuries (as measured by the MOVE index) and stocks (as measured by the VIX index) have occurred alongside episodes of greater variance in nominal GDP growth (Chart 3). When the latter rises, that also triggers more uncertainty about the future path of monetary policy which feeds into a rise in expected bond volatility. That, in turn, impacts volatility in growth sensitive assets like equities, credit and commodities. Chart 3Equity Vol Responding To Growth Uncertainty Right now, nominal GDP volatility has picked up in the U.S. but still remains low by historical standards (middle panel). Some of that increased growth volatility can be attributed to the Trump fiscal stimulus coming at a time of full employment, which has helped boost both real GDP growth and U.S. inflation. Interest rate markets have moved to discount more Fed hikes in response, but the Fed's steady pace of well-telegraphed, 25bps-per-quarter rate increases is likely acting to dampen Treasury market volatility. As we have written about extensively throughout the course of 2018, the hurdle for central banks (not just the Fed) to shift to a less hawkish or more dovish policy stance is much higher when unemployment is low and inflation is closer to central bank targets. In such an environment, the correlation between equity and bond returns should be weaker than during periods of excess capacity and low inflation when central banks can stay dovish. That can be seen in Chart 4, which plots the trailing 52-week correlation of total returns for equities and government bonds for the major developed markets (top panel), along with the 10-year market-based inflation expectations for each country (bottom panel). For almost all countries shown, the stock/bond correlation has risen to zero away from the negative correlations that dominated the post-crisis years. That move in correlations has occurred alongside a more stable backdrop for inflation expectations, which are much closer to central bank targets. The lone exception is, of course, Japan, where inflation remains disappointingly low and the Bank of Japan continues to keep a tight lid on interest rates. Chart 4More Stable Inflation Means Less Correlated Stock & Bond Returns Besides more stable inflation, another factor preventing yields from falling as much as implied by the declines in equity markets is that global bond yields remain overvalued relative to trend economic growth. One way to assess this is to look at the level of real bond yields relative to a moving average of actual GDP growth. We show this for the major developed economies in Charts 5 & 6, which plot rolling 3-year moving averages of real GDP growth (a proxy for "trend" or potential growth) versus real 5-year government bond yields, 5-years forward. For the latter, we take the nominal 5-year/5-year forward yield and subtract a five-year moving average of realized headline inflation for each country, rather than market-based inflation-linked instruments like CPI swaps or TIPS, to allow for a longer history of real yields in the charts. Chart 5Real Bond Yields Are Still Too Low ... Chart 6... Compared To Real Economic Growth For all countries show, real bond yields remain below the level of real growth. The gap between the two is smallest in the U.S. and Canada - unsurprising, as central bankers have been tightening monetary policy, and helping push up real interest rates, in both countries. Bonds look most overvalued in core Europe, Japan and Sweden where policymakers have been using negative interest rates and quantitative easing (QE) to hold down bond yields. Real yields in those countries are between 200-300bps below our proxy for trend real growth. With such a large gap between actual growth and interest rates, it becomes harder for policymakers to consider easing monetary policy, or at least slow the pace of policy normalization, in response to more volatile financial markets. It should not be a surprise that last week, during a period of global market turmoil, the European Central Bank and Sweden's Riksbank both signaled that they remain on pace to end QE and begin hiking interest rates within the next 6-12 months, while the Bank of Canada delivered another 25bp rate hike. In the absence of a VERY large global growth shock, global real yields should be expected to increase over at least the next year, and a defensive posture on global duration exposure should be maintained. One such shock could come from a deeper downturn in China than has already occurred in 2018, which would feed into a bigger slowdown in non-U.S. growth. Another shock could come from the U.S. if the recent pullback in core durable goods orders (Chart 7) is a sign that a) U.S. companies are becoming more worried about the impact of U.S.-China trade tariffs on global growth; and/or b) the impact of the Trump fiscal stimulus is already starting to fade. Such a move could be exacerbated by a larger downturn in housing activity than seen already in response to rising mortgage rates. Chart 7Treasuries Are Exposed To A U.S. Growth Scare These shocks, if large enough, could trigger a short-covering rally in U.S. Treasuries, where sentiment remains very depressed (bottom panel). However, with leading economic indicators still pointing to above trend U.S. growth, and with U.S. consumer spending holding firm alongside a tight labor market and faster wage growth, such a pullback in yields would likely be short-lived and difficult for investors to time successfully. Bottom Line: Despite the recent pickup in global equity market volatility, bond volatility remains subdued. Until there is more decisive evidence of a deeper pullback in global growth that is impacting the mighty U.S. economy, yields on government bonds - which remain overvalued in all major developed economies - will have difficulty falling much more even if equity markets continue to correct. Stay below benchmark on global duration exposure, while maintaining only a neutral allocation to global credit. Canada Update: The BoC Stays Hawkish The Bank of Canada (BoC) delivered another rate hike last week, lifting the policy rate by 25bps to 1.75%. The language used to explain the hike was surprisingly hawkish. In the press conference following the BoC meeting, Senior Deputy Governor Carolyn Wilkins noted that the policy rate remains negative in real terms and is still below the central bank's estimate of neutral (between 2.5% and 3.5%). She also noted that the term "gradual" was no longer used to describe the pace of monetary tightening, so as not to give the impression that policy was following a steady predetermined path similar to the Fed's tightening cycle - potentially, a sign that more hawkish surprises could be in the offing. The BoC also sounded more optimistic on the outlook for the Canadian economy, while sounding less concerned about the two factors that should cause the most worry - high consumer debt levels and uncertainty over global trade. The more upbeat tone is at odds with the current pace of economic growth in Canada, which has slowed. GDP growth has decelerated to 1.9% from 3.0% at the end of 2017, while the OECD's leading economic indicator for Canada is also in a downtrend (Chart 8). In the Monetary Policy Report (MPR) that was also released last week, the latest BoC forecasts for Canadian real GDP growth for 2019 and 2020 were essentially left unchanged. Chart 8Is The BoC's Growth Optimism Justified? The BoC noted that the composition of demand within the Canadian economy was shifting away from consumption and housing towards business investment and exports. That can be seen in the most recent data that shows sluggish consumer spending (middle panel) and rebounding export growth (bottom panel). The central bank attributes the softer path for consumption to its own interest rate increases and changes to housing market policies, both of which have forced households to adjust their spending patterns. That is evident in the sharp decline in house price growth, deceleration of household credit growth and the softening trends in housing starts and residential investment spending (Chart 9) Chart 9Canadian Housing Has Cooled Off The BoC is of the view, however, that consumer spending will rebound (but not overheat) on the back of strong household income growth and a pickup in net immigration inflows that is boosting population growth. The other area of diminished concern for the central bank is investment spending, which has been negatively impacted by the uncertainty over the renegotiation of the North America Free Trade Agreement (NAFTA). That smooth acronym is now gone, to be replaced by the more awkward "USMCA", or United States-Mexico-Canada Agreement. That new trade deal has reduced the immediate uncertainty over the impact of U.S. trade policy on Canada, although the BoC did note in the MPR that there was still the potential for lingering uncertainty based on previous U.S. trade actions (i.e. on steel and aluminum imports to the U.S.) and because the USMCA has not yet been ratified. The BoC did make an upward adjustment to its assumptions regarding the hit to Canadian growth from U.S. trade policy compared to the July MPR. The level of exports is now only expected to fall by -0.3% over the next two years (vs -0.7% in the July MPR) and business investment is expected to decline by -0.7% over the same period (vs -1.4% in the July MPR). The reduction in trade uncertainty should be expected to free up demand for capex in Canada. The Q3/2018 BoC Senior Loan Officers' Survey reported a further easing of lending standards from the Q2 survey (Chart 10). The central bank's Q3 Business Outlook Survey also noted that firms' investment intentions continued to strengthen to the highest level in eight years (middle panel). This was primarily due to increased expectations for future sales growth, coming at a time of high reported capacity pressures (bottom panel). Importantly, the Business Outlook Survey took place before the USMCA deal was reached, suggesting that the data may actually understate sales expectations. This bodes well for future gains to overall GDP growth from business investment spending. Chart 10Canadian Companies Need To Invest & Hire That same Business Outlook Survey also reported that firms are continuing to experience labor shortages, most notably in sectors such as construction, transportation and information technology. This is a sign that employment growth should remain firm in Canada. Coming at a time when the unemployment rate at 5.9% remains well below estimates of full employment, this suggests that there could be some upward pressure on inflation. Canadian headline CPI inflation currently sits at 2.2%, while core CPI inflation is at 1.8% (Chart 11). That is a sharp decline from the 3% inflation seen in July, which was the result of an unexpected surge in airline fares. Yet at current levels, Canadian inflation sits right at the midpoint of the BoC's 1-3% target range. Furthermore, the BoC's own assessment is that the output gap is in a range of -0.5% to +0.5%, in line with the estimates from the IMF and OECD (middle panel). Although headline wage growth has cooled in recent months, the BoC's preferred measure that incorporates several wage measures ("Wage-Common"), has been stable near the same 2% levels as seen for CPI inflation. Chart 11Canadian Inflation At BoC Target Expect More BoC Hikes With the Canadian economy operating at full employment and with inflation at target, the BoC seems determined to push the policy rate back up towards their estimated 2.5%-3.5% range for the neutral rate. This means another 75-175bps of additional rate increases. At the moment, there are only 49bps of hikes over the next year discounted in the Canadian Overnight Index Swap (OIS) curve (Chart 12). This leaves Canadian bond yields exposed to additional rate increases. This is especially true given our forecast of continued Fed interest rate increases in 2019, as the BoC has been playing a game of "Follow the Leader" with the Fed during the current tightening cycle (top panel). Chart 12Stay Underweight Canadian Government Bonds In terms of our recommended fixed income investment strategy, we continue to favor: an underweight stance on Canadian government bonds for global bond investors a below-benchmark duration stance within dedicated Canadian bond portfolios long positions in Canadian inflation protection (CPI swaps or inflation-linked bonds) While we expect the Canadian yield curve to flatten as the BoC delivers more rate hikes than currently discounted over the next year, we do not see the 2-year/10-year curve flattening by more than is currently priced in the forwards. This is not the case for an outright duration bet, where the forwards are currently priced for very little upward movement in Canadian bond yields over the next year. Therefore, we prefer to stick with directional bets on Canadian yields (higher) and Canadian relative bond performance versus global peers (worse). Bottom Line: The Bank of Canada remains on a hawkish path to a more neutral policy rate, even with the lingering concerns over household debt and global trade tensions. Stay underweight Canadian government bonds in hedged global bond portfolios. Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, CFA, Research Analyst ray@bcaresearch.com Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Duration: The current strength of the U.S. economy suggests that, as was the case in February, the sell-off in risk assets may not result in much of a drop in Treasury yields. Weak foreign economic growth still presents a risk, but it should be hedged by adopting a more defensive stance on credit, not by increasing portfolio duration. Corporate Bonds: Weak foreign economic growth will impact U.S. corporate profits and investment spending before hitting U.S. consumer spending and overall GDP. This means it is better to hedge the risk from weak foreign growth by scaling back exposure to corporate bonds, while maintaining below-benchmark duration. Credit Curve: Favoring the long-end of the credit curve is a way to increase the average spread of a bond portfolio without taking on extra credit risk. Rather, the long-end of the credit curve outperforms when Treasury yields rise and underperforms when they fall. In the current environment we prefer going after the extra spread at the long-end of the credit curve, while maintaining an up-in-quality bias and only a neutral allocation to corporate bonds. Feature We're not out of the woods yet. Risk assets continued their decline last week, the VIX remains elevated and the 10-year yield has fallen off its highs (Chart 1). In the context of our Fed Policy Loop, lower bond yields are a positive sign for risk assets. Chart 1How Much Worse Will It Get? In our Fed Policy Loop framework, higher yields and the perception of increasingly hawkish Fed policy cause credit spreads to widen and stock prices to fall. Then, tighter financial conditions eventually lead to perceptions of more dovish Fed policy and lower bond yields. At some point, yields fall far enough to put a floor under risk assets (Chart 2). Chart 2The Fed Policy Loop We are now at the stage of the loop where we must determine how large a decline in Treasury yields will be necessary to halt the slide in risk assets. To make that determination, it is helpful to think about why risk assets are falling. Is it a simple correction driven by investors re-assessing appropriate valuations? Or is the market sniffing out a future slowdown in economic growth? Chart 3 shows why the difference is meaningful. In February 2018, a sharp increase in Treasury yields caused the stock-to-bond total return ratio to decline. However, the ratio quickly recovered once investor sentiment toward the stock market became somewhat less bullish. Importantly, Treasury yields did not need to fall to support a rebound in risk assets, they only needed to level-off for a time. Chart 3Lower Yields Required? In contrast, a meaningful decline in Treasury yields was required to arrest the drop in the stock-bond ratio that occurred in late-2015/early-2016. The difference between that period and the February 2018 period is obvious. In late-2015/early-2016, the U.S. Manufacturing PMI had just dipped below the 50 boom/bust line. This year the PMI has been closer to 60 (Chart 3, bottom panel). The current strength of the U.S. economy suggests that, as was the case in February, the sell-off in risk assets may not result in much of a drop in Treasury yields. With the market only priced for 54 bps of rate hikes during the next 12 months, and no signs of softening in the U.S. economic data, we are reluctant to abandon our cyclical below-benchmark portfolio duration stance at this time. That is not to say there are no risks on the horizon. In past reports we flagged the risk that slowing foreign economic growth will eventually impact the U.S. economy, causing it to slow as we head into next year.1 However, we think it makes more sense to hedge this risk by adopting a more defensive allocation to corporate credit versus Treasuries, rather than by shifting portfolio duration to look for lower yields. Hedge Economic Risk In Credit, Not Duration As was stated above, U.S. economic growth remains strong and the biggest risk on the horizon is that weak foreign growth eventually migrates stateside via a stronger dollar. Last week's third quarter GDP report confirmed that overall growth is solid, but also showed some evidence of weak foreign growth impacting the U.S. figures. Overall, real GDP grew by a healthy 3.5% (annualized) in the third quarter, supported mostly by consumer spending which contributed 2.7% to overall growth, the most since Q4 2014 (Chart 4). However, weakness was found in nonresidential investment spending which contributed only 0.1% to real growth, down from 1.2% in the prior quarter (Chart 4, bottom panel). Chart 4Parallels With Early 2015 This distribution of growth between consumer spending and investment is identical to what occurred in 2015, the last time that weak foreign growth infiltrated the U.S. economy. The more globally-exposed investment sector contributed almost nothing to growth in the first two quarters of 2015, while overall GDP growth stayed elevated, driven by strong consumer spending. Eventually, consumer spending also weakened and GDP growth plunged in the second half of the year, but the warning sign that weak foreign growth was negatively impacting the U.S. economy came from investment spending in the first half of 2015. We draw the distinction between U.S. investment spending and U.S. consumer spending for two reasons. The first is that investment spending is more influenced by global factors than the U.S. consumer. The second is that investment spending is tightly linked to corporate profit growth (Chart 5). In other words, weak foreign economic growth is likely to negatively impact U.S. corporate profits before it hits overall U.S. GDP. This makes credit spreads more exposed to global weakness than Treasury yields, which take their cues from overall GDP growth. Chart 5Investment Spending And Profits Are Linked While we think that weak foreign growth will weigh on corporate profits in the coming quarters, presenting a clear negative for corporate bond spreads. We must also consider that spread widening during the past two weeks means that valuation has improved. Our measure of the excess spread available in the High-Yield index after accounting for expected default losses now stands at 274 bps, up from 212 bps a month ago and slightly above the historical average (Chart 6). However, we must also point out that our calculation embeds expected default losses of only 1.04% for the next 12 months. This low default loss expectation, which is derived from Moody's baseline default rate forecast and our own forecast of the recovery rate, means that there is a high risk that default losses surprise investors to the upside during the next 12 months (Chart 6, bottom panel). Any moderation in profit growth would make such an upside surprise even more likely. Chart 6Junk Value Has Improved... Another way to think about our default-adjusted high-yield spread is that if we assume that default losses occur in line with our forecast and that junk spreads remain flat at current levels, then junk bonds will outperform duration-matched Treasuries by 274 bps during the next 12 months. If spreads tighten by enough to bring the default-adjusted spread back to its historical average of 247 bps, then junk will outperform duration-matched Treasuries by 380 bps. However, at the current juncture we are more worried about spread widening during the next 6-12 months than spread tightening. Chart 7 shows that junk spreads tend to predict changes in capacity utilization. At current spread levels, this means we should expect capacity utilization to rise back to the 80% level during the next six months. If weak foreign economic growth starts to weigh on U.S. corporate profits, then such a large gain is very much in doubt (Chart 7, bottom panel). Chart 7...But Spreads Embed Strong IP Growth Bottom Line: Weak foreign economic growth will impact U.S. corporate profits and investment spending before hitting U.S. consumer spending and overall GDP. This means it is better to hedge the risk from weak foreign growth by scaling back exposure to corporate bonds, while maintaining below-benchmark duration. Extend Maturity In Credit, Not Treasuries Given the risk to corporate profits that is posed by weak foreign economic growth, we recommend investors maintain only a neutral allocation to corporate bonds and also maintain an up-in-quality bias across credit tiers.2 In the current environment we think the best way to pick-up spread within a neutral allocation to corporate bonds is to favor the long-end of the maturity spectrum. This will need to be offset by maintaining very low duration within your Treasury allocation to ensure that overall portfolio duration stays below benchmark. The rationale for favoring the long-end of the corporate credit curve is twofold. First, there is extra spread available at the long-end of the credit curve compared to the short-end. In fact, the long-maturity investment grade corporate bond index carries an average option-adjusted spread that is 107 bps greater than that of the intermediate-maturity index (Chart 8). Second, the extra spread available at the long-end of the credit curve is purely compensation for the extra duration risk. The bottom panel of Chart 8 shows that there is no spread advantage at the long-end on a "per unit of duration" basis. Chart 8Favor The Long-End Of The Corporate Credit Curve The fact that the extra spread at the long-end of the credit curve is purely compensation for duration is important because it means that when Treasury yields rise and average index duration falls, investors should demand less compensation for the extra duration risk at the long-end of the curve. In other words, rising Treasury yield environments should coincide with spread compression at the long-end of the credit curve versus the short end. We tested this idea empirically by looking at monthly excess returns in long-maturity corporate bonds versus short-maturity corporate bonds. Using a sample of monthly returns going back to 2000, we divide the months based on whether the Treasury curve bear-steepened, bear-flattened, bull-steepened or bull-flattened (Table 1). The results show that while changes in the slope of the yield curve don't have much impact, the long-end of the credit curve outperforms when Treasury yields rise and underperforms when they fall. Table 1Monthly Excess Return In Long Maturity Vs. Short Maturity Corporate Bonds (2000-Present) Bottom Line: Favoring the long-end of the credit curve is a way to increase the average spread of a bond portfolio without taking on extra credit risk. Rather, the long-end of the credit curve outperforms when Treasury yields rise and underperforms when they fall. In the current environment we prefer going after the extra spread at the long-end of the credit curve, while maintaining an up-in-quality bias and only a neutral allocation to corporate bonds. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Waiting For Peak Divergence", dated October 23, 2018, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "Rigidly Defined Areas of Doubt And Uncertainty", dated June 19, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights The correction in global equities is not yet over, but we would turn more constructive if stocks retreated about 6% from current levels. Among the many things bothering investors, the fate of the Chinese economy remains high on the list. Chinese growth continues to slow, with the impact of the trade war yet to be fully felt. Investors are likely to end up being disappointed by both the size and the composition of Chinese stimulus. High debt levels and excess capacity limit the prospective benefits of traditional fiscal/credit easing. Stimulus measures aimed at boosting consumption, which is what the authorities are increasingly focusing on, would help the Chinese economy. However, they would generate only small gains for the rest of the world. A weaker yuan would be outright negative for other economies. Cyclically and structurally, we expect the bond bear market to continue, but slower Chinese growth and a stronger dollar could temporarily cap Treasury yields over the coming months. Feature Correction Slightly More Than Halfway Through We argued in our October 5th report that "prudent investors should consider scaling back risk if they are currently overweight risk assets" because the market was at an elevated risk of a "phase transition" from unbridled optimism to a more sober appreciation of the risks presently facing the global economy.1 The good news is that the ongoing correction will be just that, a correction. Both monetary and fiscal policy in the U.S. remain highly accommodative. The next recession will not occur until late-2020 at the earliest. U.S. equities, which account for over half of global stock market capitalization, rarely enter sustained bear markets outside of recessions (Chart 1). Chart 1Recessions And Bear Markets Usually Overlap The bad news is that we have yet to reach a capitulation point. As we noted last week, corrections usually end when investors stop believing that they are witnessing a correction and start thinking that a bear market is afoot.2 Normally, stocks need to break through prior support levels several times before "buy the dip" investors throw in the towel. This week saw the S&P 500 fall below its October 11th lows. A few more iterations of this pattern may be necessary. To repeat what we wrote before, barring any major new developments, we would turn bullish on global equities again if the MSCI All-Country World Index were to fall by 12% 10% 8% 6% from current levels. With that in mind, we are putting in a limit order to buy the ACWI ETF at $64.3 Emerging Markets: Time To Pay The Piper Even if we were to turn more positive on global equities, we would maintain our preference for developed market stocks over emerging markets, despite the latter's higher beta nature. The wave of liquidity created by the Fed and other major central banks over the past decade ended up flowing into places where it was not needed. Emerging markets were a prime destination: Dollar-denominated debt in emerging markets now stands at levels reached just before the late-1990s Asian Crisis (Chart 2). Chart 2EM Dollar Debt At Late-1990s Levels While EM valuations have cheapened considerably, they are not yet at washed out levels. The latest BofA Merrill Lynch Global Fund Manager Survey showed that managers were slightly net overweight emerging market equities in October. This is a far cry from 2015, when a net 30% of managers were underweight EM stocks. Chinese Stimulus To The Rescue? China figures heavily into the equation. If the Chinese government were to deliver a massive dose of traditional fiscal/credit easing, this would boost fixed-asset investment and thus commodity prices, helping emerging markets in the process. Such a dollop of stimulus would also lift global growth. As a countercyclical currency, the U.S. dollar tends to weaken when global growth accelerates (Chart 3). The reflationary impulse from higher commodity prices and a softer dollar would be manna from heaven for emerging markets. Chart 3Decelerating Global Growth Tends To Be Bullish For The Dollar If we had strong confidence that such a burst of stimulus were forthcoming, we would be comfortable in calling the end of the global stock market correction now and going overweight EM assets. Unfortunately, the evidence so far suggests that while the Chinese authorities are stimulating the economy, they are not doing so by enough to reignite growth (Chart 4). Chart 4Chinese Growth Remains Soft Real GDP increased at a weaker-than-expected pace in the third quarter. Industrial production surprised on the downside in September, echoing declines in the manufacturing PMI. Home sales are running well below housing starts, suggesting downside risk for the latter in the months ahead. Goldman's China Current Activity Indicator has continued to grind lower, while the economic surprise index remains mired in negative territory. Our conversations with clients suggest that most are expecting the recently announced stimulus measures to arrest and then reverse the downward trend in growth. We are not so sure. As our geopolitical team has stressed, the Chinese government has expended a lot of political capital on its reform agenda.4 Abandoning it now would not only cause the government to lose credibility, but it would undermine the very reasons it was implemented in the first place. Waves of stimulus have caused total debt to soar from 140% of GDP in 2008 to 260% of GDP at present (Chart 5). Since most of the new credit has been used to finance fixed-asset investment, China has ended up with a severe overcapacity problem. The rate of return on assets in the state-owned corporate sector has fallen below borrowing costs (Chart 6). Our China team estimates that 15%-to-20% of apartments are sitting vacant.5 Chart 5China: Debt And Capital Accumulation Went Hand In Hand Chart 6Rate Of Return On Assets Below Borrowing Costs For Chinese SOEs Today, Chinese banks are being told that they must lend more money to support the economy, while ensuring that their loans do not sour. This has become an impossible feat. As such, we are skeptical that the recent acceleration in credit growth will have long legs (Chart 7). Anecdotal evidence suggests that some companies which are receiving credit are simply holding on to the cash, rather than running the risk of being accused of investing in money-losing projects. Monetary policy in China is increasingly pushing on a string. Chart 7China: Only A Modest Acceleration In Credit Growth Rebalancing: Be Careful What You Wish For This does not mean that China will not try to prop up its economy. It will. But the form of stimulus the government pursues may not be to foreign investors' liking. For example, consider the recently announced income tax reforms, which raise the threshold at which households need to start paying taxes while increasing deductions for education, health, housing, and eldercare. In and of themselves, these measures are admirable and long overdue. The Chinese income tax system is fairly regressive. Poor households face an effective income tax rate exceeding 40%. This is well above OECD norms (Chart 8).6 A more progressive tax system would boost consumption among poorer households. Chart 8High Tax Burden For Low-Income Households In China The snag is that raw materials and capital goods comprise 85% of Chinese imports. As Arthur Budaghyan, BCA's Chief EM strategist, has long noted, policies that boost Chinese consumption are simply less beneficial to the rest of the world than policies that boost investment.7 Pundits who talk about the virtue of "rebalancing" the Chinese economy away from fixed-asset investment and towards consumer spending should be careful what they wish for! The Trade War Will Heat Up One of the more notable aspects of China's recent slowdown is that it has been concentrated in domestic demand rather than in net exports. Remarkably, Chinese exports to the U.S. actually increased by 12% in dollar terms in the first nine months of the year, compared to the same period in 2017. However, judging from the steep drop in the export component of both the official and private-sector Chinese manufacturing PMI, the export sector is likely to come under increasing pressure over the next few quarters as the headwinds from higher tariffs fully manifest themselves (Chart 9). Chart 9China: An Ominous Sign For Exports Investors hoping that U.S. President Donald Trump and his Chinese counterpart Xi Jinping will reach a deal to end the trade war on the sidelines of the G20 leaders' summit in Buenos Aires on November 29 are likely to be disappointed. As we have stressed in the past, Trump's fiscal policy is completely inconsistent with his trade agenda. Fiscal stimulus in a full-employment economy will suck in imports. It will also force the Fed to raise rates more aggressively than it otherwise would, leading to a stronger dollar. The result will be a larger trade deficit. Trump will not be able to blame Canada or Mexico for a deteriorating trade position because he just signed a "big, beautiful" trade agreement with them (incidentally, the new USCAM USMCA agreement is remarkably similar to the "horrible" one that it replaced with the notable exception that it contains a clause barring Canada and Mexico from negotiating bilateral trade deals with China). This means Trump needs a patsy who will take the blame for America's burgeoning trade deficit. Reaching a deal with China would actually be a strategic mistake for Trump's political career. A Weaker RMB Ahead A weaker Chinese currency would blunt some of the pain inflicted on China's export sector from Trump's tariffs. There is obviously a limit to how far China can let its currency slide, but last week's decision by the U.S. Treasury to refrain from labeling China a currency manipulator will probably embolden the Chinese to allow the currency to depreciate some more from current levels.8 A weaker Chinese currency would be a cold shower for the rest of the world. Not only will it make other economies less competitive in global markets; it will also reduce Chinese imports. Concluding Thoughts Investors spend a lot of time debating the magnitude of China's stimulus plans and not enough time thinking about the composition of that stimulus. Credit/fiscal easing of the sort China has historically engaged in is good for other emerging markets because it sucks in raw materials and capital goods. In contrast, consumption-based stimulus is only modestly beneficial to the rest of the world, while a weaker Chinese currency is an outright negative for other economies. If China focuses more on the latter two types of stimulus and less on the former, global investors are likely to be disappointed. Emerging market assets have cheapened considerably over the past few months and will likely find a bottom in the first half of next year. For now, however, investors should overweight developed market stocks relative to their EM peers. Consistent with our July 5, 2016 call declaring "The End Of The 35-Year Bond Bull Market," both the cyclical and structural trend in bond yields is firmly to the upside. Tactically, however, bonds are deeply oversold (Chart 10). The combination of slower EM growth, disappointments over the magnitude and composition of Chinese stimulus, and a stronger dollar will put a lid on yields over the next few months. Chart 10Treasurys Are Oversold Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "The Next U.S. Recession: Waiting For Godot?" dated October 5, 2018. 2 Please see Global Investment Strategy Weekly Report, "Phase Transitions In Financial Markets: Lessons For Today," dated October 19, 2018. 3 Valid during extended trading hours. 4 Please see Geopolitical Strategy and China Investment Strategy Special Report, "How Stimulating Is The Stimulus? Part Two," dated August 15, 2018. 5 Please see Emerging Market Strategy Special Report, "China Real Estate: A Never-Bursting Bubble?" dated April 6, 2018. 6 Please see Global Investment Strategy Special Report, "Is China Heading For A Minsky Moment?" dated April 13, 2018. 7 Please see Emerging Markets Strategy Weekly Report, "The Dollar Rally And China's Imports," dated May 24, 2018. 8 Ironically, while China may not be manipulating its currency based on the Treasury's legal definition, economic logic suggests it is. True, China is no longer buying dollars in a bid to weaken the yuan. In fact, its reserves have actually declined significantly since 2015. However, the value of the yuan is determined not just by current dollar purchases; it is also determined by those that have taken place in the past. If a central bank buys dollars, this bids up the value of those dollars relative to its own currency. If it then stops buying dollars, its currency does not instantly fall back to its original level. All things equal, it just stays where it is. The best parallel is with quantitative easing. Both theory and evidence suggest that it is the stock of bonds that a central bank owns, rather than the flow of bonds in and out of its balance sheet, that determines the level of yields. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Policy easing is a necessary but not sufficient condition for a bottom in the business cycle. For monetary easing to become effective, there should be loan demand, banks should be willing to lend, and businesses and consumers should be keen to spend more. In China, risks to both the money multiplier and the velocity of money are to the downside. This will hinder the effectiveness of monetary policy easing in generating economic growth. Eroding business and consumer confidence in China will - for now - negate the budding improvement in its broad money impulse. Emerging markets risk assets and currencies are set to drop further. Stay put. Feature The selloff in EM and Chinese stocks has begun to weigh heavily on DM share prices. The global equity index has broken below its January lows, entailing further downside. Importantly, global cyclical equity sectors such as global industrials, materials and semiconductors are underperforming, and are breaking down in absolute terms. This confirms global trade is in a full downturn swing (Chart I-1). Chart I-1Global Trade Is Decelerating What is required to turn around this global trade slowdown? Our bias is that this growth slump has roots in China/EM and trade tensions are dampening business and investor sentiment on top of that. Consequently, a reversal in the equity selloff is largely contingent on an improvement in China's economy. It is in this context that we devote this week's report to an extensive discussion surrounding the issues of policy stimulus, deleveraging and growth in China. In this report, we answer the questions we think are most pertinent to investors at this moment. Question: Why are financial markets rioting, even though China has announced stimulus? Answer: The market's interpretation is that these stimuli are insufficient to turn around China's business cycle immediately. We agree with this assessment. Policy easing does not always immediately translate into higher share prices and improving growth. For example, amid China's 2015 stock market crash, the Chinese authorities began aggressively stimulating in the middle of 2015, yet Chinese and global markets continued to riot until February 2016 (Chart I-2). Chart I-2China In 2015: Money Growth Preceded Bottom In Markets By Seven Months Indeed, there was a period of seven months when EM and DM stocks plummeted, despite on-going and very aggressive policy easing in China. In short, these stimulus measures did not preclude a considerable drawdown in global and EM share prices. Outside China, there have been other examples where policy easing did not preclude a full-fledged bear market. For instance, in 2001-'02 and 2007-'08, the Federal Reserve was cutting interest rates aggressively, yet the bear market in U.S. equities did not reverse (Chart I-3). Chart I-3AFed's Easing Did Not Prevent Equity Bear Market Chart I-3BFed's Easing Did Not Prevent Equity Bear Market Similarly, the ECB was expanding its balance sheet from the onset of the euro area debt crisis in 2011, yet the region's share prices did not bottom until the middle of 2012, 12 months later (Chart I-4). Chart I-4ECB Balance Sheet Expansion Did Not Prevent Equity Bear Market Question: It is clear there could be a time lag between policymakers stimulating and financial markets and the business cycle turning the corner. What is causing these time lags, and how should one handicap them? Answer: Indeed, monetary and fiscal policies affect the economy with time lags. These lags vary from cycle to cycle. In China, the broad money impulse has improved of late (Chart I-5). Historically, this has led the mainland's business cycle by about nine months on average. Hence, it signifies a tentative bottom early next year. Chart I-5China: Money Impulse Has Bottomed The credit impulse, however, has not improved at all (Chart I-6). The current divergence between credit and money impulses is due to a plunge in shadow (non-bank) credit (Chart I-7). The distinction between broad money and credit is as follows: money is originated by commercial banks when they lend to or acquire an asset from non-banks. Meanwhile, total credit also includes lending and bond purchases by non-banks. Chart I-6China: Credit Impulse Has Not Yet Bottomed Chart I-7Bank And Non-Bank Credit Have Diverged Importantly, money/credit fluctuations are not the sole factors that generate swings in economic activity. Companies' and households' willingness to consume and invest matter too. We have written extensively in the past that changes in the velocity of money mirror fluctuations in the marginal propensity to consume and invest.1 Technically speaking, nominal GDP growth is a product of money growth and change in the velocity of money. Nominal GDP = Money Growth x Velocity Of Money When a decline in the velocity of money - stemming from eroding business and consumer confidence - overwhelms an acceleration in money growth, economic growth weakens, despite improvement in the money impulse. Notably, money and credit have led previous business cycles in China by varying time periods. In other words, the velocity of money has not been constant on the mainland. In particular, both the money and credit impulses were early - by about 12 months - in forecasting a growth slowdown in China and global trade at the beginning of 2017. The reason why a growth slowdown did not commence at that time was due to the surge in the velocity of money. The latter is akin to confidence among economic agents. In short, companies and households turned their money balances faster, which offset the impact of weak money/credit impulses on economic activity. Concerning fiscal policy, time lags differ because of implementation delays and varying fiscal multipliers. In China, aggregate fiscal spending, including central, local governments and managed funds, has not yet accelerated (Chart I-8). Chart I-8China: No Rebound In Broad Fiscal Spending While special bond issuance by local governments spiked in August and September, overall credit flows in the economy have not yet improved - please refer to Chart I-6. As an aside, there are reports that 42% of the amount raised via special bond issuance will be used to purchase land rather than for infrastructure spending.2 This will not benefit economic growth much. Question: Do you think the time lag between the bottom in China's money/credit impulses and the business cycle will be longer or shorter this time around? Answer: Our bias is that the time lag between the bottom in money/credit impulses and the resultant pickup in growth will be longer than before. Presently, there is some evidence that both business and consumer sentiment in China are beginning to whither at the hands of the trade wars, tanking domestic share prices and budding deflation in real estate prices. Eroding business and consumer confidence in China will - for now - negate the improvement in the broad money impulse. Chart I-9 depicts the velocity of money in China. After rising over the past two years, our bias is that it will drop again. It is critical to realize that forecasting the direction and magnitude of swings in the velocity of money - the marginal propensity to spend - is a dismal science. It reflects business and consumer sentiment, and any assessment on this is very subjective. This is why economic forecasting and investment calls are more of an art. Chart I-9China: The Velocity Of Money Among many variables we are monitoring to gauge the turn in the mainland's business cycle is the marginal propensity to invest among mainland industrial companies. This indicator is falling, suggesting that monetary policy easing is facing formidable hurdles in re-igniting investment appetite among Chinese companies (Chart I-10). Chart I-10Companies' Marginal Propensity To Spend The BCA Emerging Markets Strategy team's assessment is that China-related financial markets are in an air pocket. Investors should not try to catch falling knives. On the contrary, there is still meaningful downside. Question: But the People's Bank of China has been injecting a lot of liquidity into the system via various facilities. Would this liquidity not find its way into financial markets and the real economy? Answer: When a central bank injects liquidity into the banking system, it creates excess reserves. Excess reserves also rise when a central bank cuts the required reserve ratio (RRR). It is essential to differentiate money that households and business use to conduct transactions from reserves of commercial banks at the central bank. Required and excess reserves are not a part of narrow and broad monetary aggregates. Excess reserves are the banking system's liquidity held at the central bank. Importantly, banks do not lend reserves, and do not use reserves to pay for assets they purchase from non-banks. Banks use reserves to settle transactions/payments among themselves. Reserves are "manufactured" solely by central banks. Commercial banks cannot create reserves. They do, however, create the overwhelming majority of money when they lend to or purchase an asset from non-banks. Central banks create broad money - that circulates in the economy - only when they lend to or buy assets from non-banks. Given central banks typically do few transactions with non-banks, central banks originate a very small portion of the broad money supply. For example, as a part of quantitative easing efforts, new money is originated only when a central bank buys bonds from a non-bank (say, an insurance company). In contrast, no money is created when a central bank buys bonds from a bank. In brief, there is no automatic leakage of reserves into the real economy and financial markets. Banks need to be willing to lend to and purchase assets from non-banks for the money supply to expand. Question: But won't expanding excess reserves - banking system liquidity - eventually encourage banks to lend and purchase financial assets? Answer: It will at some point, but it is not imminent. The mainland banking system's excess reserves ratio is depicted in Chart I-11. A few observations are in order: Chart I-11China: Excess Reserves Not Are Growing First, the excess reserve ratio - excess reserves (ER) as a share of total deposits - is currently rather low (Chart I-11, top panel). The absolute level of ER is not elevated either (Chart I-11, middle panel). To adjust the absolute level of ER for seasonality, we show the annual change of this measure - it has dropped to zero in September (Chart I-11, bottom panel). This is in contrast to the prevailing market narrative that the PBoC is injecting a lot of liquidity into the system. While they have been injecting liquidity via RRR cuts, at the same time many lending facilities have been maturing without renewal. Does the low level of ER ratio mean the PBoC has been tightening? No, it has not been tightening. Shrinking excess reserves that lead to higher money market rates would qualify as tightening. Provided money market rates are low and are not rising in China, there has been no de-facto tightening, despite the low level of reserves (Chart I-12). Chart I-12China: Excess Reserves And Interest Rates Second, any central bank can simultaneously target either quantity of reserves or short-term interest rates, but not both. Before 2014, the PBoC was targeting the level of ER. As a result, short-term interest rates fluctuated a lot to equilibrate demand and supply for ER. Since early 2014, the PBoC has switched to targeting interest rates. Therefore, the level of ER is no longer a policy objective, but rather a tool to navigate interest rates. Chart I-13 illustrates what drives PBoC policy in terms of interest rates and liquidity management. The PBoC sets interest rates based on the strength in the economy - i.e., interest rates rise when loan demand is improving and fall when loan demand is weakening (Chart I-13, top panel). Chart I-13China: What Drives Interest Rates? Then, the central bank adjusts the amount of ER to achieve its desired level of short-term interest rates. Hence, the amount of ER is a function of demand for reserves by banks at the current level of interest rates. The current low level of ER is indicative of weak demand for ER by banks. As loan origination has diminished, economic activity has cooled off and the number of transactions by companies and consumers has dwindled, demand for reserves among banks has declined. Third, declining/expanding ER do not always cause a slowdown/acceleration in money/credit growth, as demonstrated on Chart I-14. There is another variable that stands between ER and money/credit: the money multiplier (MM). The latter is defined as how much broad money/credit banks create per one unit of ER. A rising money multiplier reflects banks' willingness and ability to expand their balance sheets aggressively. A falling multiplier signifies growing risk aversion among banks, or their inability to expand their balance sheets. Chart I-14China: Excess Reserves And Money/Credit Impulses Notably, the credit boom in China since 2009 has been driven not by rapidly expanding ER but primarily by a surging MM. The MM has skyrocketed from 40 in 2008 to 65 presently (Chart I-15). This was the manifestation of excessive risk taking by banks. Chart I-15China: Money Multiplier Why is it sensible to expect the MM in China to decline? With ongoing regulatory tightening, falling asset prices and rising defaults, the odds are non-trivial that mainland banks will be reluctant to expand their balance sheets aggressively. We are not implying they will not boost lending forever, but they may be slower to do so compared to previous downturns. Following the peak in their respective credit bubbles and experiencing deteriorating asset quality, banks in Japan, the U.S., the U.K. and euro area shrunk their balance sheets - even though their respective central banks provided enormous amount of excess reserves, and interest rates were at zero. We do not expect bank credit growth to contract in China like it did in those countries. In fact, bank assets and broad credit are still growing at an annual rate of 7% and 12%, respectively (Chart I-16 and Chart I-7 above). Our point is that deleveraging in China has barely begun, and it still remains a policy priority. Consequently, money and credit growth will languish longer in this downturn than in previous ones. Chart I-16China: Bank Asset Growth To Stay Tame Question: So, how would you summarize the key known unknowns to gauge whether and when monetary policy easing will translate into stronger economic growth? Answer: For monetary policy easing to translate effectively into economic growth, the MM and the velocity of money should rise. Both are driven by sentiment and marginal propensity to lend, borrow and spend. Hence, variations in the MM as well as the velocity of money are contingent on sentiment and behavior among bankers, companies and households. The regulatory clampdown on banks and non-bank financial institutions will hamper their willingness and ability to lend, despite sufficient liquidity and low interest rates. Hence, the MM could surprise on the downside. A combination of the ongoing crackdown on leverage, the starting point of high indebtedness, falling asset prices and trade confrontations, will likely weigh on corporate and consumer sentiment, curb their spending and, thereby, dampen the velocity of money. All in all, risks to both the MM and the velocity of money are to the downside rather than upside at the moment. This will hinder the transmission mechanism from policy easing to economic growth. Question: What is your take on financial markets? Are we close to the bottom in EMs and China-related plays? Answer: EMs and China-plays are in a genuine bear market as we have argued in past.3 BCA's Emerging Markets Strategy service reckons there is still meaningful downside in EM risk assets and currencies. The EM/China bear market will continue. The Fed is not about to come to markets' rescue, because U.S. growth is very robust and inflation is rising. A very important market to watch is the RMB exchange rate. If the RMB depreciates further - which is our baseline scenario - Asian and other EM financial markets will continue plunging. The RMB/USD exchange rate has been closely tracking the interest rate differential between China and the U.S. (Chart I-17). As the Fed continues to raise rates and China maintains rates at their current level or reduces them to stimulate, the RMB will depreciate. Chart I-17RMB/USD And Interest Rate Differentials Yuan depreciation will lead to a decline in other Asian currencies. In fact, the Korean won is at a critical technical juncture, and a major move is in the cards. Our bias is it will likely break down, consistent with our bearish view on EM risk assets and currencies. As the RMB depreciates, the amount of U.S. dollars that China emits to emerging economies via imports will decline. This will hurt EM exports to China, their currencies and commodities prices. Overall, the U.S. dollar has more upside. The growth disparity between the U.S. and the rest of world warrants a stronger greenback. The latter and a slowdown in EM/China herald a considerable drop in commodities prices. Question: One commodity that has defied the dollar rally and slowdown in China is oil. Will crude continue to float higher? Answer: Oil prices have risen much further and for far longer than we expected.That said, it appears that oil prices are finally beginning to crack, and we see considerable downside.4 China's imports of oil and petroleum products has decelerated substantially (Chart I-18, top panel). This is occurring at a time when Chinese oil strategic and commercial inventories are very elevated (Chart I-18, bottom panel). Chart I-18China's Oil Imports To Weaken Further Oil prices in local currency terms are at record highs in many developing countries. Given oil and fuel subsidies have been removed or reduced in recent years, high oil prices are curbing oil demand in many emerging economies. Global oil production has been outpacing global oil demand since May (Chart I-19, top panel). Typically, this heralds a rollover in oil prices (Chart I-19, bottom panel). Chart I-19A Risk To Oil Prices Finally, oil output has been surging in the U.S. and strong in Russia (Chart I-20); further, Saudi Arabia could boost its crude output as per its recent pledge. Chart I-20Global Oil Output Has Been Surging While geopolitics remains a supportive factor for crude prices, it seems a lot of good news is already priced in the oil market and investors are very long. In short, oil prices are probably heading south. This will contribute to the negative investment sentiment toward EM financial markets. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Lin Xiang, Research Analyst linx@bcaresearch.com 1 Please see Emerging Markets Strategy Weekly Report, "Questions For Emerging Markets," dated November 29, 2017, available at ems.bcaresearch.com. 2https://www.bloomberg.com/news/articles/2018-10-21/china-s-195-billion-debt-splurge-has-less-bang-than-you-think 3 Please see Emerging Markets Strategy Weekly Report, "EMs Are In A Bear Market," dated October 18, 2018; the link is available on page 17. 4 This is BCA's Emerging Markets Strategy team's view and differs from the BCA house view on oil. Equity Recommendations Fixed-Income, Credit And Currency Recommendations