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Highlights There are many things that central bankers know they don't know. "Known unknowns" include the outlook for growth (both actual and potential), NAIRU, the neutral rate of interest, and the true shape of the Phillips curve. "Unknown unknowns" are, by definition, unknowable, but are often at the heart of economic downturns. Central bankers, like military leaders, tend to fight the last war. They have tirelessly waged a battle against deflation over the past decade, so it is logical to conclude that they will err on the side of keeping monetary policy too loose rather than too tight. This will prolong the recovery, but it also means that economic and financial imbalances will be greater by the time the next downturn rolls around, most likely in 2020. Keep a close eye on credit spreads. Stay overweight risk assets for now, but look to move to neutral later this year and outright underweight in the first half of 2019. Bond yields will fall as the next recession approaches, but they will do so from higher levels than today. Feature Reports that say that something hasn't happened are always interesting to me, because as we know, there are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns - the ones we don't know we don't know. And if one looks throughout the history of our country and other free countries, it is the latter category that tend to be the difficult ones. - Donald Rumsfeld, former Secretary of Defense under George W. Bush Uncertainty Galore Central bankers know many things. They know that growth is currently strong across most of the world, unemployment is falling and inflation, while still low, has been slowly trending higher. Unfortunately, there are also many things they don't know. These include things they know they don't know, as well as things that are not even on their radar screens - the "unknown unknowns" that Donald Rumsfeld famously warned about. Known Unknowns Let's start with five "known unknowns." 1. Will Growth Stay Strong? Global growth has likely peaked, but should remain comfortably above-trend over the remainder of this year (Chart 1). The OECD's Global Leading Economic Indicator (LEI) has leveled off, while the diffusion index, which tabulates the share of countries with rising LEIs, has dropped below 50 percent. A fall in the diffusion index has often foreshadowed outright declines in the composite LEI. Consistent with this prognosis, the Citi global Economic Surprise Index has swooned, the Chinese Keqiang index has decelerated, and Korean export growth - a leading indicator for global trade - has slowed. Global manufacturing PMIs have also edged off their highs (Chart 2). The one exception is the U.S., where the ISM index continues to power higher. Despite the occasional blip such as this week's retail sales report - which was probably depressed by tax refund delays - recent U.S. economic data have been reasonably upbeat. Goldman Sachs' Current Activity Indicator remains near cycle highs, implying strong momentum going into the second quarter. Chart 1Global Growth Has Peaked ##br##But Will Remain Above Trend Chart 2Global Manufacturing PMIs ##br##Are Off Their Highs Changes in financial conditions tend to lead growth by about six-to-nine months. U.S. financial conditions have eased a lot more since the start of 2017 than elsewhere (Chart 3). In addition, U.S. fiscal policy is likely to be much more expansionary over the next two years than in the rest of the world (Chart 4). All this suggests that the composition of global growth will shift in favor of the U.S. over the coming months. Chart 3Composition Of Global ##br##Growth Will Shift To The U.S. ... Chart 4U.S. Fiscal Policy Will Become More ##br##Expansionary Than In R.O.W. 2. Will Potential Growth Accelerate? The U.S. unemployment rate has declined from a high of 10% in 2009 to 4.1% in February 2018, even though real GDP growth has averaged a meager 2.2% over this period. Extremely weak productivity growth explains why the output gap has managed to contract in the face of subdued GDP growth. Sluggish capital spending has exacerbated the productivity downturn, but probably did not cause it. Chart 5 shows that productivity growth began to decelerate well before the financial crisis erupted. The slowdown has been pervasive across countries and sectors. Economists have a poor track record of predicting productivity trends. Not only did they fail to predict the productivity revival in the late 1990s, but because of data lags and subsequent revisions, they did not even know it had happened until the early 2000s. It is too early to say whether robotics and AI will yield the same sort of productivity windfall that the Internet did. My colleagues, Mark McClellan and Brian Piccioni, have cast a skeptical eye on some of the alleged revolutionary breakthroughs in both fields.1 If it turns out that the late 1990s was the exception rather than the rule, and that we are going back to the lackluster productivity performance of the 1970s, this will make life more challenging for central bankers. 3. What Is The True Level Of NAIRU? Spare capacity has diminished in most countries, but questions linger over how much slack remains. No one truly knows where NAIRU - the so-called Non-Accelerating Inflation Rate of Unemployment - really stands. The Fed and the Congressional Budget Office believe that NAIRU has fallen from over 6% in the late 1970s to around 4.5%-to-4.7% today (Chart 6). Chart 5Productivity Growth Slowdown ##br##Has Been Pervasive Chart 6NAIRU Is Low By Historic Standards An aging workforce has reduced frictional unemployment because older workers are less likely to switch jobs than younger ones. The internet has also made it easier for employers to find suitably qualified workers. On the flipside, globalization, automation, and the opioid crisis have likely made it difficult for a growing list of workers to hold down a job for long. Our best guess is that the U.S. economy is operating at close to full employment. This is confirmed by various employer surveys, which show that companies are struggling to find qualified workers (Chart 7). The fact that the share of people outside the labor force who want a job has fallen to pre-recession levels also suggests that labor slack is running thin (Chart 8). Chart 7U.S. Economy: Operating At ##br##Close To Full Employment Chart 8Few People Left Who Are Eager ##br##To Rejoin The Labor Force There is more slack outside the United States. Labor underutilization is still 2.5 percentage points higher in the euro area than it was in 2008. Taking Germany out of the picture, labor underutilization is nearly six points higher (Chart 9). A number of major emerging markets, most notably Brazil and Russia, also have a lot of excess cyclical unemployment. The Japanese labor market has tightened significantly in recent years, but there is probably a fair amount of hidden underemployment left, particularly in the service sector (factoid of the week: there are more police officers in Tokyo than in New York City).2 4. Where Is The Neutral Rate Of Interest? One of the most vexing questions facing central banks is how high interest rates can go before they move into restrictive territory. There are a variety of reasons for thinking that the neutral real rate of interest - the rate consistent with full employment and stable inflation - is lower today than it was in the past. Trend real GDP growth has fallen. This has reduced the need for firms to expand capacity. The shift to a capital-lite economy - where value-added increasingly takes the form of bits and bytes rather than factory output - has further reduced the need for fresh investment. Meanwhile, a reluctance to take on new debt has restrained spending. Rising inequality has shifted more wealth into the hands of people who tend to save a lot. Globally, savings must equal investment. If desired savings go up and desired investment goes down, interest rates must fall to push down the former and push up the latter (Chart 10). Chart 9Euro Area: There Is Still Labor ##br##Market Slack Outside Of Germany Chart 10Interest Rates Must Fall If Desired Savings ##br##Increase And Desired Investment Declines None of these forces are immutable, however. Investment demand appears to be picking up, as judged by capex intention surveys (Chart 11). Consumer credit is rising anew. The U.S. personal saving rate is back near an all-time low (Chart 12). A tighter labor market is likely to cause labor's share of income to rise, just like it did in the late 1990s (Chart 13). This should boost aggregate demand. An unprecedented increase in the U.S. budget deficit should help absorb much of the savings from cash-rich corporations (Chart 14). Meanwhile, savings are likely to decline over the long haul as well-paid baby boomers retire en masse. All this is causing the neutral rate to move higher. Chart 11Upswing In Global Capex Is Underway Chart 12U.S. Consumer Credit Revival Chart 13Tight Labor Market And Rising Labor ##br##Share Of Income: A Replay Of The 1990s? Chart 14Now Is The Time For Fiscal Consolidation, Not Profligacy 5. What Is The Shape Of The Phillips Curve? Central bankers assume that dwindling spare capacity will lead to higher inflation, a relationship immortalized by the so-called Phillips curve. The fact that inflation has barely risen over the past few years is an obvious challenge to this theory. It may simply be that the Phillips curve is "kinked" at very low levels - it only steepens when the economy has gone beyond full employment. The fact that it has taken this long to reach the kink could explain why inflation has not taken off sooner. The success that central banks have enjoyed in anchoring long-term inflation expectations is another reason why the Phillips curve has become flatter. Chart 15An Overheated Economy Led To ##br##Rising Inflation In The 1960s The problem is that there is no God-given reason why inflation expectations should stay well anchored. Core inflation was remarkably low and stable in the first half of the 1960s. However, the combination of low real interest rates and increased fiscal spending associated with Lyndon Johnson's Great Society programs and the Vietnam War led to a surge in inflation starting in 1966 (Chart 15). Inflation kept climbing thereafter, rising to 6% in 1970. This was three years before the first oil shock occurred, suggesting that an overheated economy, rather than OPEC, was the main inflationary culprit. Unknown Unknowns Then there are the things central bankers are not even thinking about, or even worse, the things they think are true but aren't.3 In the lead-up to the Great Recession, U.S. policymakers blithely assumed that house prices could not fall at the nationwide level. This caused them to turn a blind eye to soaring home prices and the deterioration of underwriting standards in the mortgage market. Warren Buffet once said, "Only when the tide goes out do you discover who's been swimming naked." Our guess is that rising rates will expose a lot of things one would rather not see in the corporate debt market. In the latest issue of the Bank Credit Analyst, my colleague Mark McClellan estimated that the interest coverage ratio for U.S. companies would drop from 4 to 2.5 if rates increased by 100 basis points across the corporate curve. Such a move would take the coverage ratio to the lowest level in the 30-year history of our sample (Chart 16A and Chart 16B).4 Consumer staples, tech, and health care would be the most adversely affected. Chart 16AU.S. Interest Coverage Ratio ##br##Breakdown By Sector (I) Chart 16BU.S. Interest Coverage Ratio ##br##Breakdown By Sector (II) Political shocks are also very difficult for policymakers to foresee. President Trump's decision to impose steel and aluminum tariffs spooked the markets. NAFTA negotiations remain stalled and the odds are high that the U.S. will pursue trade sanctions against China for alleged intellectual property theft. That said, as we noted last week, an all-out trade war would cause equities to crater.5 Trump remains focused on the value of the stock market as a gauge of the success of his presidency. This will curb his hawkishness. Unemployment is also very low these days, which limits the attractiveness of protectionist policies. The specter of trade wars will escalate if a recession causes stocks to tumble and unemployment to rise in key midwestern swing states. Other "unknown unknowns" include another flare-up in sovereign debt markets in Europe, a hard landing in China, and a supply-induced spike in oil prices. Investment Conclusions It may be tempting to think that central banks can calibrate monetary policy as events unfold in order to keep economies on an even keel. If only it were so easy. Monetary policy affects the economy with a lag of 12-to-24 months. By the time it is clear that either more or less monetary stimulus is needed, it is often too late to act. Central bankers have to work with incomplete or inaccurate data. One of the reasons that inflation spiraled out of control in the 1970s was because the Federal Reserve systematically overstated the size of the output gap (Chart 17). This led the Fed to falsely conclude that slower growth was the result of inadequate demand rather than a deceleration in the economy's supply-side potential. It is impossible to know what mistakes central banks will make in the future, but it is almost certain that something will go awry. Central bankers, like military leaders, tend to fight the last war. They have tirelessly waged a battle against deflation over the past decade, so it is logical to conclude that they will err on the side of keeping monetary policy too loose rather than too tight. This will prolong the recovery, but it also means that economic and financial imbalances will be greater by the time the next downturn rolls around. As we discussed several weeks ago, the next recession is most likely to arrive in 2020.6 Investors should stay overweight risk assets for now, but look to move to neutral later this year and outright underweight in the first half of 2019. Bond yields will fall as the next recession approaches, but they will do so from higher levels than today. Similar to the 1970s, investors should expect inflation and bond yields to make a series of "higher highs" and "higher lows" with every boom/bust episode (Chart 18). Chart 17The Fed Continuously Overstated The ##br##Magnitude Of Economic Slack In The 1970s Chart 18A Template For The Next Decade? Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Technology Sector Strategy Special Report, "The Coming Robotics Revolution," dated May 16, 2017; The Bank Credit Analyst, "Did Amazon Kill The Phillips Curve?" dated August 31, 2017; and The Bank Credit Analyst, "The Impact Of Robots On Inflation," dated January 25, 2018. 2 "As crime dries up, Japan's police hunt for things to do," The Economist, May 18, 2017. 3 Mark Twain is often credited for saying that "It ain't what you don't know that gets you into trouble. It's what you know for sure that just ain't so." It's a great quote, but there's only one problem: There is no evidence that he ever said it. 4 Please see The Bank Credit Analyst, "Leverage And Sensitivity To Rising Rates: The U.S. Corporate Sector," dated February 22, 2018. 5 Please see Global Investment Strategy Weekly Report, "Trump's Tariffs: A Q&A," dated March 9, 2018. 6 Please see Global Investment Strategy Weekly Report, "The Next Recession: Later But Deeper," dated February 23, 2018. Tactical Global Asset Allocation Recommendations Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Escalating trade tensions - most notably between the U.S. and China, and the U.S. and its NAFTA partners - threaten the outperformance ags posted in 1Q18, which was driven by unfavorable weather and transportation disruptions in major producing regions, along with a weak dollar. Energy: Overweight. The IPO of Saudi Aramco apparently will be delayed into 2019, according to various press reports. New York, London and Hong Kong remain in contention for the foreign listing of KSA's national oil company. Base Metals: Neutral. China's iron ore and copper imports in January - February 2018 were up 5.4% and 9.8% y/y, respectively. China's year-to-date (ytd) steel product exports are down 27.1% y/y, while ytd aluminum exports are up 25.8% y/y. The aluminum data are consistent with our assessment that the global aluminum deficit will likely ease this year.1 Precious Metals: Neutral. A global trade war would boost gold's appeal, and we continue to recommend it as a strategic portfolio hedge. Ags/Softs: Underweight. Weather and transport disruptions boosted global ag markets in 1Q18. However, this outperformance is under threat as global trade tensions build (see below). Feature Chart of the WeekAgs Are Off To A Good Start Weather concerns in highly productive regions of South America as well as the U.S. have supported ag prices since the beginning of the year (Chart of the Week). Corn and wheat bottomed in mid-December, and have since gained 14.8% and 25.4%, respectively, while soybeans bottomed mid-January and have since gained 10.6%. This pushed the Grains and Oilseed CCI up 12.6% since the beginning of the year. Drought ... And Flooding In The U.S. Erratic weather in the U.S. could affect yields. The chief areas of concern are the U.S. mid-South and lower Midwest, which have recently experienced flooding, and are raising fears of lower yields of winter wheat. At the same time, the area from Southwestern Kansas to Northern Texas experienced unusually dry weather, causing winter grains to suffer. On top of that, high water levels in the Ohio River also led to shipping disruptions. Although the U.S. Department of Agriculture (USDA) did not lower its 2017/18 estimates of U.S. wheat yields in its latest World Agricultural Supply and Demand Estimates (WASDE), yield estimates stand significantly lower than those of the last crop year (Chart 2). In addition, American wheat farmers are expected to harvest the smallest area recorded in the history of the series, which dates back to the 1960/61 crop year. U.S. wheat production is expected to be the lowest since 2002/03 - a 25% year-on-year (y/y) drop in output. As a result, the U.S. supply surplus will likely be the smallest since 2002, weighing on U.S. exports. The U.S. generally accounts for only ~8% of global wheat production, and increases elsewhere, primarily in Russia and India, are expected to more than offset the fall in U.S. output. Despite the poor conditions in the U.S., global supply is expected to continue growing this year with the wheat market in surplus and inventories swelling to record levels (Chart 3). Chart 2Depressed Yield, Record Low Acreage In U.S. Chart 3World Remains Well Supplied Drought In Argentina Supporting Soybean, And To A Lesser Extent Corn Prices In addition to the unfavorable North American weather, warm and dry weather in Argentina have resulted in a fall in estimated yields of Argentine corn and soybeans.2 Argentina accounts for 14% and 3% of global soybean and corn production, respectively. The USDA cut back its estimate of Argentine soybean production by 13% in the latest WASDE, causing a downward revision of ~4 mm MT in global inventories (Chart 4). Although Argentina's estimated corn output was also reduced, the resulting decline in its exports is expected to be picked up by U.S. exports. American farmers thus are benefitting from the unfavorable weather in Argentina. As is the case with soybeans, the net effect on corn is a 4 mm MT downwards revision to global inventories. In addition, grain exports from Argentina's main agro-export hub of Rosario were stalled last month due to a truckers' strike. While the strike has now eased, it led to transportation bottlenecks and contributed to limited global supply earlier this year. Back in the U.S., the Trump administration's lack of clarity regarding where it stands on the Renewable Fuel Standard (RFS), which mandates refiners blend biofuels like corn-based ethanol into the nation's fuels, is worrying farmers. While the energy industry is unsatisfied with the current policy, claiming that the RFS is unfair and costly, it gives a lifeline to corn farmers with excess stock. Bottom Line: Unfavorable weather and transportation disruptions, primarily in the U.S. and Argentina, have been bullish for ags since the beginning of the year. Lower production is expected to push both soybeans and corn to deficits in 2017/18 (Chart 5). The longevity of the impact of these forces hinges on whether the weather will improve between now and harvest, causing yields to come in better-than-expected. Chart 4Weather Weighs On Soybean And Corn Yields Chart 5Corn And Soybeans In Deficit This Year "We Can Also Do Stupid"3 In addition to the impact of his domestic immigration policy on the availability of farm workers, President Trump's controversial trade policies are threatening to spill into ags.4 In direct response to the 25% and 10% tariff Trump slapped on steel and aluminum imports, several of America's key ag trading partners have already reacted by communicating the possibility of imposing similar tariffs on their imports of American goods - chiefly agricultural goods. Among the commodities rumored to be at risk are Chinese soybean, sorghum and cotton imports, and EU agriculture imports including corn and rice imports. While President Trump's stated aim is to make America great again by reviving industries hurt by cheap imports and unfair trade, his strategy is proving risky as many of the trade partners he is threatening to rock ties with are in fact major consumers of U.S. agricultural products (Chart 6). In fact, the top three importers of U.S. ag products - collectively accounting for 42%, or $58.7 billion worth of U.S. ag exports in 2017 - are Canada, China, and Mexico (Charts 7A and 7B). Chart 6Risky Strategy, Mr. President Chart 7ASoybeans Appear To Be At Risk... Chart 7B... As Is Cotton However, when it comes to the bulk commodities we cover, China is by far the U.S. ag industry's biggest customer - importing more than 30% of all U.S. exports, equivalent to $14.9 billion. Thus, China appears to have significant leverage in the case of a trade war, and U.S. farmers are worried of the impact from trade disputes. China has already indicated that it is investigating import restrictions on sorghum. Chinese trade restrictions - if implemented - will have a significant impact on U.S. sorghum farmers. In value terms, sorghum exports contributed less than 1% to U.S. agricultural product exports last year, but exports to China made up more than 80% of all U.S. sorghum exports. Sino-American Trade Dispute Would Hurt U.S. Ags...But Not As Much As Is Feared Chart 8Relatively Low Soybean Inventories The biggest fear among U.S. farmers is not the loss of sorghum exports, but that China will impose restrictions on its imports of U.S. soybeans. Soybeans are the U.S.'s largest ag export - contributing 16% to the value of all agricultural product exports. Nearly 60% of U.S. soybean exports, and more than a third of U.S. soybeans, end up in China. Thus it may appear that China has some leverage there. In fact, Brazil, which is already China's top soybean supplier, has already communicated that it would be willing to supply China with more soybeans. However, China's ability to find alternative suppliers is questionable. While China imported ~32 mm MT of soybeans from the U.S. last year, Brazil's total soybean inventories stand at ~22 mm MT. Brazil simply does not have enough excess supply to cover all of China's needs. In fact, global soybean inventories are ~95 mm MT - only three times the amount of China's annual imports from the U.S. On top of that, although China generally tries to shield itself from supply shocks by building large inventories, its soybean inventories - measured as stocks-to-use - are significantly lower than that of other ags (Chart 8). In fact, Beijing has already tightened its scrutiny on U.S. soybeans, announcing at the beginning of the year that it would no longer accept shipments with more than 1% of foreign material. Half of last year's shipments reportedly would have failed this criterion, and the net effect of this new policy is higher costs for U.S. farmers. Cotton is another agricultural commodity that China has indicated may be caught up in a trade dispute. 16% of U.S. cotton exports went to China last year, but although the U.S. is the dominant global cotton exporter, its value accounts for less than 5% of total U.S. agricultural products exports. Given that China's inventories are extremely high - enough to cover a year's worth of consumption - and that Chinese imports from the U.S. are equivalent to ~3% of global inventories, there is significant opportunity for China to diversify its imports and find an alternative supplier to the U.S. Bottom Line: Although China would be better able to implement restrictions on cotton imports from the U.S. compared to soybeans, the impact on U.S. farmers would be less painful given that they are not as dependent on China as U.S. soybean farmers are. U.S. Ags Dominate Exports, But Substitutes Abound The U.S. is the world's top exporter of corn and cotton, and the second largest exporter of wheat and soybeans. While it remains a dominant player in global export markets, its share of global agriculture exports has been declining sharply over time (Chart 9). While in levels, the general trend for U.S. agriculture exports - with the exception of wheat - appears to be upward, the share of U.S. exports as a percentage of global exports has actually been falling. Compared to the year 2000, the global share of U.S. corn and wheat exports has almost halved, going from 64% to 36%, and 29% to 14%, respectively. In the soybean market, U.S. soybean exports now account for 37% of exports, down from half of global trade. Lastly, U.S. rice exports now account for 7% of global exports, a fall from 11% in 2000. Unlike most other ag commodities, U.S. cotton has captured a larger share of the global market - currently at almost 50%, from 26% in 2000. Russian, Canadian, and European wheat farmers have been tough competitors. This crop year, Russia is expected to surpass the U.S. as the top wheat exporter for the first time (Chart 10). In addition, while the U.S. was the dominant wheat exporter just 10 years ago, more recently, Canada and the EU have on some occasions exported more wheat than the U.S. Chart 9U.S. Exports Relatively Less Attractive Chart 10U.S. Exports Face Growing Competition In the case of soybeans, Brazilian exports have grown significantly since 2010, consistently exporting more than the U.S. since 2012. Brazilian corn exports are also catching up to the U.S., as are Argentine corn exports which have been growing steadily. If these trade disputes prove to be an ongoing trend, we see two potential scenarios panning out: U.S. farmers could move away from farming crops most impacted by trade restrictions, and instead increase the farmland allocated to crops that are consumed domestically, and thus insulated from the Trump administration's trade policy decisions. In this scenario, the longer term impact would be an increase in the supply of locally consumed ags and a decrease in the U.S. supply of exportable ags. Global ag trade flows could shift, such that U.S. allies begin importing more of their ag products from the U.S., while countries that are in trade disputes with the U.S. switch to other ag suppliers. NAFTA Is Still At Risk The ongoing re-negotiation of NAFTA ultimately could lead to an abrogation of the treaty. Should this evolve with no superseding bilateral trade agreements, it would mark a significant blow to the U.S. agricultural industry. Mexico is the second-largest destination for U.S. agricultural exports after China, accounting for 13% of all U.S. exports of agricultural bulks, while Canada makes up a much smaller 2% share. Nearly 30% of U.S. corn exports and 23% of U.S. rice exports end up in Mexico. As a result, these two bulks are especially vulnerable in the event of a treaty abrogation. Wheat, cotton and soybeans - Mexico accounts for 14%, 7%, and 7% of these exports, respectively - would also be impacted by a trade dispute. In the interest of diversifying its sources of ag imports, Mexico has already started exploring other suppliers from South America. Its corn imports from Brazil are reported to have increased 10-fold last year. Furthermore, government officials and grain buyers have been visiting Brazil and Argentina to investigate other ag suppliers for Mexico. BCA Research's Geopolitical Strategy service assign a 50/50 probability to a breakdown in the NAFTA negotiations. In the event of a NAFTA abrogation, they assign a 25% chance of a failure to strike bilateral agreements - resulting in a conditional probability of only 12.5%. Bottom Line: The shrinking role of the U.S. as a global ag supplier at a time when global storage facilities are well-stocked will - in most cases - allow its global consumers to diversify away from U.S. exports. In the case of soybeans, however, this is less certain. A Weaker USD Also Helped Buoy Ag Prices In 1Q18 Chart 11A Stronger Dollar Would Weigh On Ags A weaker dollar has been supportive of commodities prices so far this year (Chart 11). The recent bout of U.S. import restrictions has investors expecting the USD to further weaken on the back of a trade war. However, our FX Strategists believe the current set of tariffs will have a muted effect on the dollar.5 In fact, given that the U.S. economy is currently at full employment, and their expectation that the Fed will be proactive, tariffs will likely generate inflationary pressures, causing the tighter monetary policy, which does not support further weakening of the USD. Bottom Line: A pick-up in the dollar along with an escalation in trade disputes or the scrapping of NAFTA would be bearish for ags. For now, bullish weather forecasts prevail, and are keeping prices well supported. Roukaya Ibrahim, Associate Editor Commodity & Energy Strategy RoukayaI@bcaresearch.com 1 Please see BCA Research's Commodity & Energy Strategy Weekly Report titled "Global Aluminum Deficit Set To Ease," dated March 1, 2018, available at ces.bcaresearch.com. 2 Soybean and corn plantings are reported to be half their typical height. Please see "Argentina Drought Bakes Crops Sparks Grain Price Rally," available at reuters.com. 3 As expressed by EU Commission President Jean-Claude Juncker's about the potential tit-for-tat retaliatory measures in response to steel and aluminum import tariffs. 4 According to Chuck Conner, president of the National Council of Farm Cooperatives, and former deputy agriculture secretary during the George W. Bush administration, roughly 1.4 million undocumented immigrants work on U.S. farms each year, or roughly about 60% of the agriculture labor force. 5 Please see BCA Research's Foreign Exchange Strategy Weekly Report titled "Are Tariffs Good Or Bad For the Dollar?," dated March 9, 2018, available at fes.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017

Highlights The protectionist option in U.S. policy is here to stay; President Trump is likely to impose punitive measures on China before the U.S. midterm elections; The U.S. Section 301 investigation into China's intellectual property theft is about national security more than trade; China's NPC session suggests the Communist Party is downshifting growth rates; The North Korean diplomatic breakthrough is real ... stay focused on U.S.-China tensions. Feature "I won't rule out direct talks with Kim Jong Un. I just won't ... As far as the risk of dealing with a madman is concerned, that's his problem, not mine." - U.S. President Donald J. Trump, March 4, 2018 Two of our key 2018 views came to the fore over the past two weeks. First, U.S. President Donald Trump took protectionist action that rattled the markets.1 Second, North Korean diplomacy surprised to the upside, with Trump accepting an invitation to meet with Kim Jong Un by this May.2 The nuclear program is allegedly up for discussion. Markets recovered quickly from Trump's steel and aluminum tariffs, with the VIX falling and American and global equities continuing to rally (Chart 1). Trump's formal tariff proclamation was not as disruptive as some had feared. He provided exemptions for entire countries - rather than merely companies - based on an appeals process that will include economic as well as geopolitical criteria. But while he struck an optimistic note on NAFTA (on which Canada's and Mexico's exemptions will depend), he struck a pessimistic note on trade talks with China. Chart 1Markets Shrugged Off Protectionism China is quickly becoming the foremost political and geopolitical risk of the year, as we discuss in this report. First, diplomacy with North Korea will not remove the risk of serious U.S. protectionism toward China.3 Second, China's domestic reforms are proceeding, posing downside risks to Chinese imports and hence global growth. We conclude with a brief word on why investors should take the North Korean diplomacy as a hugely positive development. There may be some volatile episodes during the upcoming negotiations, but U.S.-China relations are the real risk and North Korea remains largely a derivative of the emerging "Warm War" between the two global behemoths. "Death By China" In the past few weeks, the Trump administration has moved swiftly to begin implementing its protectionist platform.4 Trump's formal announcement of global tariffs on steel and wrought and unwrought aluminum products marked the shift, although investors got a foreshadowing with the January announcement of washing machine and solar panel tariffs. The latest tariffs are insignificant in macroeconomic terms. They will affect less than 0.3% of global exports and less than 2% of U.S. imports.5 The market has thus far cheered the limited scope of the tariffs and the numerous exemptions that will surely follow. But the danger is that investors are underestimating the political shifts that underpin Trump's move. In fact, there is little reason to think that protectionism will fade when Trump leaves office: Americans are susceptible to it, according to opinion polling (Chart 2). Now that the seal has been broken - and that by a president who hails from the "pro-free trade" Republican Party - the danger is what happens when the next recession occurs. Politicians of all stripes will be more likely to propose protectionist solutions. The long trend of decline in U.S. tariffs since the 1930s may gradually begin to reverse (Chart 3), confirming our key decade theme that globalization has reached its apex. Chart 2Americans Not Immune To Protectionism Chart 3U.S. Tariffs: Nowhere To Go But Up! How far will the protectionist threat go in the short term? Investors should focus on two bellwethers. First, the outcome of NAFTA re-negotiations.6 Second, a decision by the Trump administration on how to respond to the U.S. Trade Representative Section 301 of the Trade Act of 1974 investigation into China's practices on technology transfer, intellectual property, and innovation, discussed below. China is an industrial powerhouse that is becoming more technologically adept, which threatens the core advantage of the United States in what could soon become a "Warm War" between the two global hegemons. Trump was elected on a pledge to get aggressive on China and is relatively unconstrained on trade policy (Table 1). U.S.-China economic interdependency has declined, reducing the two countries' ability to manage tensions.7 Table 1Trump Lacks Legal Constraints On Trade Issues Moreover, Trump is relatively unpopular - which jeopardizes the GOP Congress in November - and he will need to take actions to remain relevant ahead of the November 6 midterm elections (Chart 4). The U.S. and China are currently bickering about the size of the trade imbalance (Chart 5), not to mention the causes and solutions. What will the U.S. demand? This was the question of Xi Jinping's top economic adviser, Politburo member Liu He, when he visited Washington D.C. on March 1-3 for emergency meetings with the U.S. administration. He was rebuffed with the announcement on tariffs. Washington has been arguing that high-level dialogues with China - that investors cheered after the Mar-a-Lago Summit - have failed and that punitive measures will go forward unless China makes quick and concrete improvements to the trade balance, starting with $100 billion worth of new imports.8 Chart 4Trump's Low Approval Jeopardizes Control Of Congress In November Chart 5U.S.-China: Disagreeing Even On The Facts In response, Liu has promised that China will redouble its economic "reform and opening up" process and has asked the United States for an official list of demands. Our sense is that there are broadly two types of demands: Cyclical demands: Beijing often does one-off purchases of big-ticket items to ally Washington's ire over trade. This time, it would have the added benefit for Trump of coming right ahead of the midterm election. Trump's request on March 8 for an immediate $100 billion reduction in the trade deficit could fall in this category. Structural demands: If Trump seeks to be a game changer in the U.S.-China relationship, then he will demand accelerated structural reforms: for instance, a lasting decrease in the deficit due to a permanent opening of market access. He could also begin pushing a "mirror tax" on trade (reciprocal tariffs) so as to reduce the gap between the U.S. and China, which is less justifiable now that China is an economic juggernaut (Chart 6). Trump could also demand action on several long-standing U.S. requests: Chart 6Not All That Much Daylight On U.S.-China Tariff Rates Opening foreign investment access to a broad range of sectors (beyond finance), such as transportation, logistics, information technology, or even telecommunications; The right to operate wholly U.S.-owned companies in China; An open capital account and truly free-floating currency; Subsidy cuts for state-owned enterprises (SOEs); Full digital access for U.S. tech companies; An improved arbitration system for legal disputes. Since rapidly implementing many of these demands could threaten China's stability or even undermine the Communist Party, Trump may have to use the threat of sweeping tariffs to try to force them through. The current news flow suggests that Trump is favoring cyclical solutions. At the same time, we expect China to make at least some significant structural compromises: China does not want a trade war. China is more exposed to the U.S. than the U.S. is to China (Chart 7). Moreover, China's political system is rigid and opposed to mass unemployment. The last time China allowed mass layoffs was in 1999, and even then the state controlled the process. A trade war, by contrast, would threaten 223 million manufacturing employees with uncontrolled job losses. The central government is focused on stability; while it will insist on "saving face" internationally through tit-for-tat measures, it will go to great lengths to avoid a negative spiral. This will require compromises. China wants structural reform. Xi Jinping is rebooting a reform agenda that requires transitioning away from old industries. These reforms are long overdue and Xi can parlay many of them to pacify Trump. For instance, China has improved the market-orientation of the renminbi, causing Trump to cease his complaints about currency manipulation (Chart 8). China currently claims it is about to increase imports and open its financial sector further to foreign investment. Chart 7China More Exposed To U.S., But Not By Much Chart 8China: Structural Reform As Trade Concession The jury is still out on the deepest structural issues. We expect Xi's latest reform push to surprise to the upside, but it is not clear how far he will go. For instance, while Beijing might begin to ease capital controls imposed in 2016, it would be a shock if it agreed to rapidly liberalize the capital account. The same goes for granting extensive access to strategic sectors, downgrading state support for SOEs, or moderating cyber controls that punish U.S. companies. Any promises of gradual progress on these issues will likely be seen by the U.S. as no different from past promises to past presidents. Hence everything depends on whether Trump will be satisfied by token Beijing actions that look good ahead of the midterms. It is ominous that China has already drastically cut steel and aluminum overcapacity, and yet Trump imposed tariffs anyway. This kind of delayed retribution could become a pattern. Bottom Line: China has the means to prevent a trade war through significant compromises that Trump can advertise as "wins" to his domestic audience this November. If Trump accepts these concessions, the risk of trade war will effectively be removed until the next major electoral test in 2020. However, Trump lacks constitutional and legal constraints on the use of tariffs, which means that he can override China's offers and instigate a trade war anyway. This risk has a fair probability, given midterm politics and the fact that overall U.S.-China interdependency, the key economic constraint to conflict, has eroded over the past decade. A Bellwether: The Intellectual Property Investigation The immediate bellwether for the Trump administration's appetite for trade war will be Trump's handling of the Section 301 investigation on technology transfer, intellectual property (IP), and innovation. A ruling is due no later than August 18, but reports indicate action could come quickly.9 Section 301 of the U.S. Trade Act of 1974 is the prime law by which the U.S. seeks to enforce trade agreements, resolve disputes, and open markets. Under this law, the U.S. executive - i.e. the president - can impose trade sanctions against countries deemed to be violating trade agreements or engaging in unreasonable or discriminatory trade practices. The law is specific in addressing intellectual property violations and closed market access, and yet broad in giving the executive leeway to interpret "unjustifiable" practices and mete out punishment. It does, however, require negotiations with the foreign trading partner to remedy the situation before the U.S. imposes duties or other remedies. We expect the U.S. to draw a hard line. A close look reveals that this Section 301 probe is primarily addressing strategic problems, not trade problems. To be fair, the U.S.'s trade grievances have merit. Clearly there is room for China to improve the IP trade balance. The ratio of IP receipts versus IP payments shows that the U.S. is a world-leader, while China is an extreme IP laggard, as one would expect (Chart 9). And yet the U.S. barely runs a trade surplus with China in IP, and far less of a surplus than with Taiwan and Korea, which are more advanced than China and thus ought to be more competitive with the U.S. than China (Chart 10). The U.S. appears particularly disadvantaged in the Chinese market when it comes to computer software and trademarks (Chart 11), judging by its IP exports to similar Asian partners. Chart 9China Is An Innovation Laggard... Chart 10... Yet Its IP Deficit With U.S. Is Small Also, in many cases Chinese companies have gained a dominant share of new markets, like e-commerce, where the U.S. would have a larger share if it had been allowed to compete fairly in the nascent stages. The U.S. wants to prevent this from happening again. The "Made In China 2025" program, for example, combines ambitious goals in supercomputers, robotics, medical devices, and smart cars, while setting domestic localization targets that would favor Chinese companies over foreigners (Chart 12). China will have to compromise on this program to stave off tariffs. Chart 11China Skirting Fees On U.S. Software? Chart 12China's High-Tech Protectionism Nevertheless, China is a large and growing market for U.S. high-tech goods, intellectual property, and services exports (Chart 13). A comparison with Taiwan and South Korea suggests that China could open up greater access to these U.S. exports (Chart 14). The truth is that, unlike with staunch ally Japan, the U.S. harbors deep misgivings about China's strategic intentions. This is why it limits high-tech exports to China - which, as Beijing often points out, creates an abnormal imbalance in this column of the trade book (Chart 15). Chart 13U.S. Tech And IP Exports To China Growing Chart 14China Could Give U.S. More Market Share Chart 15U.S. Deficit Due To Security Concerns Thus while the trade concerns above are not to be scoffed at, the Section 301 probe is clearly about U.S. security. The main practices under investigation are: Forced technology transfer by means of joint-venture (JV) requirements, ownership caps, government procurement, and administrative or regulatory interventions; Unfair licensing and contracting pricing, and abuses of proprietary technology; State-backed investment and/or acquisitions in the U.S. to acquire cutting-edge tech and IP; Cyber-espionage and intrusion to acquire tech and IP. Only one of these is about market pricing. The others speak to the U.S. belief that the Communist Party has orchestrated a "techno-nationalist" agenda that combines aggressive and illegal acquisitions with domestic protectionism. In particular, Chinese companies have made strategic acquisitions in the U.S. through shell companies with state funds or state guidance to access critical technologies and IP, while forcing American companies operating in China to transfer over the same as a precondition to operate there.10 Washington fears that if Beijing' strategy continues unabated, high-tech Chinese companies will be able to gain the best western technology, grow uninhibited in the massive domestic market with state financial support, and then launch competitive operations on a global scale. Moreover, the lack of division between China's ruling party, state apparatus, and corporate sector means that technologies acquired by Chinese companies can be directly appropriated by the country's military and intelligence apparatus to the detriment of the strategic balance with the U.S. How will the U.S. retaliate? We are unsure, and therein lies the risk for the market.11 Trump has floated the idea of levying a large "fine" or indemnity on China for past IP violations. The U.S. believes that IP theft amounts to a "second trade deficit" with China, with estimates of annual losses ranging from $200 billion to nearly $600 billion.12 U.S. remedies will become clearer when the USTR offers its recommendations. Bottom Line: The Section 301 probe is not about the trade deficit alone. It is about the growing tension between U.S. and China in a broader strategic context. We would expect the USTR to propose trade remedies that are more significant than the recent steel and aluminum tariffs. And we would expect Trump to impose some punitive measures. This is a source of near-term risk to markets, as the U.S. and China are less likely to manage their disputes smoothly than in the past. We are short China-exposed U.S. stocks relative to their domestic-oriented peers. China's NPC Session: On Track For Downside Risk Surprises Chart 16Downward Revisions In Chinese Growth China's NPC session is not yet over but some preliminary takeaways are in order. The headlines focused on Xi Jinping's power grab, but for us the real relevance was economic policy. Signs of economic policy tightening are not as hawkish as we expected, but the bias remains in favor of slower growth and tighter monetary, fiscal, and financial policy. The 6.5% GDP growth target was not a surprise. China has various economic targets to meet in 2020 under existing economic plans; only after that does it say it will scrap GDP targets altogether. The GDP target is a fabrication but the point is that the direction is down. Local government GDP targets suggest downward revision as well (Chart 16). To put a point on it, there is no evidence that China's cyclical slowdown is on the cusp of reversing (Table 2).13 Table 2No Convincing Signs Of An Impending Upturn In China's Economy In this context, it is notable that the government got rid of official targets for monetary growth (M2). This confirms the view of our colleagues at BCA's Emerging Markets Strategy that China has been targeting interest rates instead of the quantity of money since 2015 (Chart 17).14 This means that M2 growth can rise or fall as high or as low as necessary to meet the PBoC's interest rate targets. The takeaway for now is that M2 growth can go lower than the recent 8%-9% range in which it has been moving, since the current policy is to "control" money growth and avoid systemic risk. The new leadership at the People's Bank of China will have a challenge to establish its credibility, which means that accommodative compromises may not come as quickly as some expect. Chart 17A New Monetary Policy Regime On the fiscal front, China implied some tightening by lowering its official budget deficit target to 2.6%. Past reports show that China always meets its budget deficit targets perfectly (Chart 18), suggesting that the target is either meaningless or Beijing has a steely discipline unseen in the rest of the world. The IMF publishes an augmented budget deficit which, at 12% of GDP, gives a better indication of why authorities want to maintain control, if not outright tighten the reins (Chart 19).15 The Finance Ministry rushed to dampen speculation that this budget deficit reduction would amount to austerity. Approximately 550 billion yuan of additional "special purpose bonds" - issued by local governments to finance infrastructure projects - will be issued in 2018. This could amount to new spending worth 2% of last year's total spending, i.e. not a negligible sum. The purpose may be to smooth over the conclusion of the local government debt swap program that began in 2014. The debt swap program was a "game changer" by allowing local governments to exchange high-interest or short-term debt for low-interest, long-term, government-backed debt. Now Beijing is winding down the program and telling local governments that new bond issuance will not have the implicit guarantee of the central government, and will face higher interest rates. Chart 18China's Budget Deficit Target Is Meaningless Chart 19China's Real Budget Deficit Is Large Similarly, Beijing has been attempting to provide formal banks more freedom to lend to offset its crackdown on shadow banks. Pursuant to this goal, it announced that required provisions for non-performing loans (NPLs) will be reduced from 150% of NPLs to 120%. Banks are already holding excess provisions, and provisions have been trending upwards. Meanwhile China's official NPL count is unbelievably low, warranting higher provisions. So it is not clear to what extent banks will lend more as a result of lower requirements. January and February credit numbers imply that credit policy remains tight even aside from the wind-down of the local government debt swap (Chart 20). The dust has not yet settled on the NPC session and we will soon examine some of the other policy announcements, like tax cuts for small businesses and infrastructure spending reductions. However, the implication so far is that the Communist Party wants to keep the fiscal deficit and total social financing flat this year. If this policy were executed faithfully, the fiscal and credit impulse would be zero this year. Simultaneously, new data revealed that, in keeping with the reform reboot, the Xi administration is allowing creative destruction to improve efficiency in the corporate sector. Bankruptcies rocketed upward in 2017 and this trend should continue (Chart 21). This is a notable development given the widespread perception that China does not know how to deal with social consequences of structural reforms. It suggests that policymakers have a higher threshold for economic pain. Chart 20Credit Growth Is Slowing Chart 21Creative Destruction Is Rising Finally, the new anti-corruption super-ministry, the National Supervisory Commission, has now received legislative clearance. It is still unclear how the new body will operate in practice. We maintain that on the margin it should be negative for economic growth due to the micro-level impact of corruption probes on local government officials and local state enterprises. Notably, some of the provinces whose GDP-weighted economic growth targets were the most aggressively revised downwards (Tianjin, Chongqing, Inner Mongolia) are also provinces that have been hit heavily with anti-corruption probes, accusations of falsifying data, and canceled infrastructure projects over the past year. The anti-corruption campaign is a tool for enforcing central party dictates more effectively, and at present those dictates call for minimizing systemic financial risk, including misallocation of capital by local authorities (Chart 22). Chart 22Anti-Corruption Campaign Encourages Downward GDP Revisions? Bottom Line: Policy settings in China will continue to constrain growth this year. Now that the policy shift toward accelerated reform is more evident, the downside risks of that move will become apparent. We are closing our long China H-shares versus EM trade for a gain of 3%. North Korea: This Time Is Different A brief concluding word on North Korea. While we did not expect that Trump and Kim would arrange to meet so soon, we are not surprised by the fact that the diplomatic track is moving forward. As we wrote in January, Trump demonstrated a credible military threat, forcing China to implement sanctions, which subsequently caused North Korea to stop testing missiles. Trump effectively called Kim Jong Un's bluff, daring him to go beyond missile and nuclear device tests. Instead of ratcheting up tensions, Kim declared victory on the nuclear deterrent and proclaimed the end of the crisis. This is the "Arc of Diplomacy" about which we have written (Chart 23).16 We reject the view in the media that Trump's policy has been erratic and that China is getting left on the sidelines of a Trump-Kim meet-up. China has cut off exports to North Korea (Chart 24), which in turn has cut off the regime's access to hard currency. Because of China, Kim literally cannot afford not to negotiate. Chart 23Credible Threat Cycle: North Korea Mirrors Iran Chart 24China Gives Kim To Trump For the same reason, Kim is not likely to be bluffing or stalling: with limited conventional military capabilities, Kim cannot dial up and dial down the level of tensions at will. If he provokes the U.S. anew, he risks provoking a war that would destroy his regime. Moreover, from the moment he came to power, Supreme Leader Kim established a desire to elevate the importance of economic reforms within state policy, which is impossible without dealing with China and the U.S. to create a favorable international setting. From the U.S. side, Trump has likely notched up a major national security victory that will enhance his credibility in the 2018 midterms and especially 2020 elections. A clear risk to our view that Trump will take protectionist action toward China this year is that he will need China's continued cooperation, as it could relax sanctions enforcement. However, the strategic significance of the Section 301 investigation means that Trump cannot afford to sacrifice his trade agenda so soon. While bad news from North Korea seldom has a substantial impact on markets, our South Korean curve steepener benefited. So far it has returned 2.9%. The JPY/EUR has fallen back from a strong February rally, but we remain long. Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," dated April 12, 2017, Weekly Report, "Geopolitics - From Overstated To Understated Risks," dated November 22, 2017, and Special Report, "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 2 In September we highlighted that the North Korean threat cycle had peaked. Please see BCA Geopolitical Strategy Weekly Report, "Can Equities And Bonds Continue To Rally?" dated September 20, 2017, and Special Report, "BCA Geopolitical Strategy 2017 Report Card," dated December 20, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "Five Black Swans In 2018," dated December 6, 2017, available at gps.bcaresearch.com. 4 The Apprentice-style personnel reshuffle that has seen Peter Navarro, director of the National Trade Council, elevated above the departed Gary Cohn, has signaled the return of the protectionist agenda. 5 Please see BCA Global Investment Strategy Weekly Report, "Trump's Tariffs: A Q&A," dated March 9, 2018, available at gis.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Special Report, "NAFTA - Populism Vs. Pluto-Populism," dated November 10, 2017, available at gps.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Special Report, "Sino-American Conflict: More Likely Than You Think, Part II," dated November 6, 2015, available at gps.bcaresearch.com. 8 Not $1 billion, as Trump erroneously tweeted! 9 One year after the date of initiation is likely August 18, the date used in the USTR's description in the Federal Register, although President Trump signed off on August 14 which could mark an earlier deadline. Please see Andrew Restuccia and Adam Behsudi, "Trump Eyes Another Trade Crackdown," Politico, March 7, 2018, available at www.politico.com. Note that according to the text of the law, by late May, the U.S. Trade Representative could report that China is making sufficient progress and further action unnecessary (but this is unlikely). The recent handling of the Section 232 investigation into steel and aluminum suggests that punitive measures will be foreshadowed by public statements from U.S. officials. 10 For detailed assessments, please see USTR, "2017 Special 301 Report," which puts China at the top of the priority watch list; USTR, "2017 Report To Congress On China's WTO Compliance," January 2018; U.S.-China Economic and Security Review Commission, "2017 Report To Congress," November 2017. 11 As a frame of reference, in the dispute over U.S. beef exports to the EU, a prominent Section 301 case, the U.S. imposed 100% ad valorem tariffs on 34 products from the EU in 1999 until 2009. However, Trump's actions are likely to go well beyond this due to the strategic nature of the dispute. Not only can he impose tariffs on 100 or more specific goods - since Chinese IP violations run the gamut - but also he can impose restrictions on Chinese investment through the Committee on Foreign Investment in the U.S. (CFIUS), which is tightening scrutiny on China in general. 12 The $600 billion "high water mark" estimate comes from the former Director of National Intelligence Dennis C. Blair and former director of the National Security Agency Keith Alexander. They also emphasize that the U.S. has additional retaliatory options (outside of the 1974 trade law) under the Economic Espionage Act, Section 5 of the Federal Trade Commission Act, and the National Defense Authorization Act. Please see "China's Intellectual Property Theft Must Stop," The New York Times, August 15, 2017, available at www.nytimes.com. 13 Please see BCA China Investment Strategy Weekly Report, "China And The Risk Of Escalation," dated March 7, 2018, available at cis.bcaresearch.com. 14 Please see BCA Emerging Markets Strategy Special Report, "China's Money Creation Redux And The RMB," dated November 23, 2016, available at ems.bcaresearch.com. 15 At the same time, the government issued guidelines suggesting that scrutiny of local government budgets, and specifically expenditures, will get stricter. The cancellation of subway/metro projects is already a trend that is well underway, but other inefficient projects and capital misallocation could be targeted next. 16 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," dated April 19, 2017, available at gps.bcaresearch.com. Geopolitical Calendar

Dear Client, Following up on last week's report, my colleagues Caroline Miller, Mathieu Savary, and I held a webcast on Wednesday to discuss the outlook for the dollar along with recent events. If you haven't already, I hope you find the time to listen in. Best regards, Peter Berezin, Chief Global Strategist Highlights Protectionism is popular with the American public in general, and Trump's base specifically. The sabre-rattling will persist, but an all-out trade war is unlikely. Trump is focused on the stock market, and equities would suffer mightily if a trade war broke out. The Pentagon has also warned of the dangers of across-the-board tariffs that penalize America's military allies. The rationale for protectionism made a lot more sense when there were masses of unemployed workers. That's not the case today. The equity bull market will eventually end, but chances are that this will happen due to an overheated U.S. economy and rising financial imbalances, not because of escalating trade protectionism. Investors should remain overweight global equities for now, but look to pare back exposure later this year. Feature Q: What prompted Trump's announcement? A: Last week began with President Trump proclaiming that he would seek re-election in 2020. Then came a slew of negative news, including the resignation of Hope Hicks, Trump's White House communications director, and the downgrading of Jared Kushner's security clearance. All this happened against the backdrop of the ever-widening Mueller probe. Trump needed to change the subject. Fast. However, it would be a mistake to think that the tariff announcement was simply a distractionary tactic. Turmoil in the White House might have been the immediate trigger, but events had been building towards this outcome for some time. The Trump administration had imposed tariffs on washing machines and solar panels in January. Hiking tariffs on steel and aluminum - two industries that had suffered heavy job losses over the past two decades - was a logical next step. In fact, the 25% tariff on steel and 10% tariff on aluminum were similar to the 24% and 7.7% tariff rates, respectively, that the Commerce Department proposed as one of three options on February 16th.1 Protectionism is popular with the American public. This is especially true for Trump's base (Chart 1). Indeed, it is safe to say that Trump's unorthodox views on trade are what handed him the Republican nomination and what allowed him to win key swing (and manufacturing) states such as Ohio, Michigan, and Pennsylvania. Trump made a promise to his voters. He is trying to keep it. Q: Wouldn't raising trade barriers hurt the U.S. economy, thereby harming the same workers Trump is trying to help? A: That's the line coming from the financial press and most of the political establishment, but it's not as clear cut as it may seem. An all-out trade war would undoubtedly hurt the U.S., but a minor skirmish probably would not. The U.S. does run a large trade deficit. Economists Katharine Abraham and Melissa Kearney recently estimated that increased competition from Chinese imports cost the U.S. economy 2.65 million jobs between 1999 and 2016, almost double the 1.4 million jobs lost to automation.2 This accords with other studies, such as the one by David Autor and his colleagues, which found that increased trade with China has led to large job losses in the U.S. manufacturing sector (Chart 2).3 Chart 1Trump Is Catering ##br##To His Protectionist Base Chart 2China's Ascent Has Reduced##br## U.S. Manufacturing Employment Granted, China does not even make it into the top ten list of countries that export steel to the United States. But that is somewhat beside the point. As with most commodities, there is a fairly well-integrated global market for steel. Due to its proximity to Asian markets, China exports most of its steel to the rest of the region (Chart 3). That does not stop Chinese overcapacity from dragging down prices around the world. Chart 3Most Of China's Steel Exports Don't Travel That Far Q: Wouldn't steel and aluminum tariffs simply raise prices for American consumers, thereby reducing real wages? A: That depends. If Trump's gambit reduces the U.S. trade deficit, this will increase domestic spending, putting more upward pressure on wages. As far as prices are concerned, the U.S. imported $39 billion of iron and steel in 2017, and an additional $18 billion of aluminum. That's only 2% of total imports and less than 0.3% of GDP. If import prices went up by the full amount of the tariff, this would add less than five basis points to inflation. And even that would be a one-off hit to the price level, rather than a permanent increase in the inflation rate. In practice, it is doubtful that prices would rise by the full amount of the tariff (if they did, what would be the purpose of retaliatory measures?). Most econometric studies suggest that producers will absorb about half of the tariff in the form of lower profit margins. To the extent that this reduces the pre-tariff price of imported goods, it would shift the terms of trade in America's favor. Chart 4Does Trade Retaliation Make Sense ##br## When Most Trade Is In Intermediate Goods? There is an old economic theory, first elucidated by Robert Torrens in the 19th century, which says that the optimal tariff is always positive for countries such as the U.S. that are price-makers rather than price-takers in international markets. Put more formally, Torrens showed that an increase in tariffs from very low levels was likely to raise government revenue and producer surplus by more than the loss in consumer surplus. So, in theory, the U.S. could actually benefit at the expense of the rest of the world by imposing higher tariffs.4 Q: This assumes that there is no trade retaliation. How realistic is that? A: That's the key. As noted above, a breakdown of the global trading system would hurt the U.S., but a trade spat could help it. Trump was trying to scare the opposition by tweeting "trade wars are good, and easy to win." In a game of chicken, it helps to convince your opponent that you are reckless and nuts. Trump's detractors would say he is both, so that works in his favor. Trump has another thing working for him. Most trade these days is in intermediate goods (Chart 4). It does not pay for Mexico to slap tariffs on imported U.S. intermediate goods when those very same goods are assembled into final goods in Mexico - creating jobs for Mexican workers in the process - and re-exported to the U.S. or the rest of the world. The same is true for China and many other countries. This does not preclude the imposition of targeted retaliatory tariffs. The EU has threatened to raise tariffs on Levi's jeans and Harley Davidson motorcycles (whose headquarters, not coincidently, is located in Paul Ryan's Wisconsin district). We would not be surprised if high-end foreign-owned golf courses were also subject to additional scrutiny! But if this is all that happens, markets won't care. The fact that the United States imports much more than it exports also gives Trump a lot of leverage. Take the case of China. Chinese imports of goods and services are 2.65% of U.S. GDP, but exports to China are only 0.96% of GDP. And nearly half of U.S. goods exports to China are agricultural products and raw materials (Chart 5). Taxing them would be difficult without raising Chinese consumer prices. Simply put, the U.S. stands to lose less from a trade war than most other countries. Chart 5China Stands To Lose More From A Trade War With The U.S. Q: Couldn't China and other countries punish the U.S. by dumping Treasurys? A: They could, but why would they? Such an action would only drive down the value of the dollar, giving U.S. exporters an even greater advantage. The smart, strategic response would be to intervene in currency markets with the aim of bidding up the dollar. Chart 6Slowing Global Growth Is Bullish##br## For The Dollar Q: So the dollar could strengthen as a result of rising protectionism? A: Yes, it could. This is a point that even Mario Draghi made at yesterday's ECB press conference. If higher tariffs lead to a smaller trade deficit, this will increase U.S. aggregate demand. The boost to demand would be amplified if more companies decide to relocate production back to the U.S. for fear of being shut out of the lucrative U.S. market. The U.S. economy is now operating close to full employment. Anything that adds to demand is likely to prompt the Fed to raise rates more aggressively than it otherwise would. That could lead to a stronger greenback. Considering that the U.S. is a fairly closed economy which runs a trade deficit, it would suffer less than other economies in the event of a trade war. A scenario where global growth slows because of rising trade tensions, while the composition of that growth shifts towards the U.S., would be bullish for the dollar (Chart 6). Q: What are the implications for stocks and bonds? A: Wall Street will dictate what happens to stocks, but Main Street will dictate what happens to bonds. The stock market hates protectionism, so it is no surprise that equities sold off last week. It is this fact that ultimately got Trump to soften his position. Trump is used to taking credit for a rising stock market. If stocks flounder, this could make him think twice about pushing for higher trade barriers. As far as bonds are concerned, they will react to whatever happens to growth and inflation. As noted above, a trade skirmish could actually boost growth and inflation. Given that the economy is near full capacity, the latter is likely to rise more than the former. This, too, could cause Trump to cool his heels. After all, if higher inflation pushes up bond yields, this will hurt highly-levered sectors such as, you guessed it, real estate. Q: In conclusion, where do you see things going from here? A: Trade frictions will continue. As my colleague Marko Papic highlighted in a report published earlier this week, NAFTA negotiations are likely to remain on the ropes for some time.5 The Trump administration is also investigating allegations of Chinese IP theft. The U.S. is a major exporter of intellectual property, but these exports would be much larger if U.S. companies were properly compensated for their ingenuity. Chinese imports of U.S. intellectual property were less than 0.1% of Chinese GDP in 2017, an implausibly small number (Chart 7). If China is found to have acted unfairly, this could lead the U.S. to impose across-the-board tariffs on Chinese goods and restrictions on inbound foreign direct investment. Nevertheless, as noted above, worries about a plunging stock market will constrain Trump from acting too aggressively. The rationale for protectionism made a lot more sense when there were masses of unemployed workers. Today, firms are struggling to find qualified staff (Chart 8). This suggest that Trump will stick to doing what he does best, which is taking credit for everything good that happens under the sun. Chart 7China Is Importing More IP From The U.S., ##br##But The "True" Number Is Probably Higher Chart 8Protectionism Makes Less Sense ##br##When The Labor Market Is Strong Ironically, the latest trade skirmish is occurring at a time when the Chinese government is taking concerted steps to reduce excess capacity in the steel sector, and the profits of U.S. steel producers are rebounding smartly (Chart 9). In fact, the latest Fed Beige Book released earlier this week highlighted that "steel producers reported raising selling prices because of a decline in market share for foreign steel ..."6 Chart 9Chinese Steel Exports Falling, U.S. Steel Profits Rising Meanwile, German automakers already produce nearly 900,000 vehicles in the U.S., 62% of which are exported. In fact, European automakers have a smaller share of the U.S. market than U.S. automakers have of the European one.7 A lot of what Trump wants he already has. The Pentagon has also warned that trade barriers imposed against Canada and other U.S. military allies could undermine America's standing abroad. This is an important point, considering that Trump invoked the rarely used Section 232 of the Trade Expansion Act of 1962, which gives the President broad control over trade policy in matters of national security, to justify raising tariffs. Trump tends to listen to his generals, if not his other advisors. He probably was not expecting their reaction. All this suggests that a major trade war is unlikely to occur. As we go to press, it appears that the White House will temporarily exclude Canada and Mexico from the list of countries subject to tariffs. We suspect that the EU, Australia, South Korea, and a number of other economies will get some relief as well. White House National Trade Council Director Peter Navarro has also said that some "exemptions" may be granted for specific categories of steel and aluminum products that are deemed necessary to U.S. businesses. That is a potentially very broad basket. The bottom line is that the equity bull market will end, but chances are that this will happen due to an overheated U.S. economy and rising financial imbalances met with restrictive monetary policy, not because of escalating trade protectionism. Investors should remain overweight global equities for now, but look to pare back exposure later this year. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see "Secretary Ross Releases Steel and Aluminum 232 Reports in Coordination with White House," U.S. Department of Commerce, February 16, 2018. 2 Katharine G. Abraham, and Kearney, Melissa S., "Explaining the Decline in the U.S. Employment-to-Population Ratio: A Review of the Evidence," NBER Working Paper No. 24333, (February 2018). 3 David H. Autor, Dorn, David and Hanson, Gordon H., "The China Shock: Learning from Labor-Market Adjustment to Large Changes in Trade," Annual Reviews of Economics, dated August 8, 2016, available at annualreviews.org. 4 A graphical illustration of this point is provided here. 5 Please see BCA Geopolitical Strategy, "Market Reprices Odds Of A Global Trade War," dated March 6, 2018. 6 Please see "The Beige Book: Summary of Commentary on Current Economic Conditions By Federal Reserve District,"Federal Reserve, dated March 7, 2018. 7 Please see Erik F. Nielsen, "Chief Economist's Comment: Sunday Wrap," UniCredit Research, dated March 4, 2018. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

My colleagues Caroline Miller, Peter Berezin and I broadcasted a webcast this past Wednesday to discuss the outlook for the dollar along with recent market-relevant fiscal and trade policy pronouncements. If you haven't already, I hope you find time to listen in. Best regards, Mathieu Savary, Vice President Foreign Exchange Strategy Highlights On the one hand, because the Federal Reserve targets inflation and because tariffs are inflationary, when the economy is at full employment, tariffs could lift the USD. On the other hand, investors have been conditioned to the reality that tariffs are a tool used by previous U.S. administrations to weaken the dollar. Also, tariffs bring back memories of the 1970s stagflation, a very dollar-bearish period. Tariffs also raise the risk that the USD share of global reserves declines. Even if protectionist rhetoric raises the probability of a global trade war, we do not believe the set of tariffs proposed now are the beginning of such a catastrophe. However, we remain worried that Sino-American tensions will only escalate going forward. If a global trade war were to unfold, the USD would likely suffer down the road, and EUR/JPY could get hit. The short-term impact of Sino-U.S. trade tensions should be more limited; however, the AUD would suffer from this conflict. We are closing our short CAD/NOK trade at a 4.55% profit this week. Feature Last week, U.S. President Donald Trump announced that America would be slapping tariffs of 25% on steel imports and 10% on aluminum imports. True to himself, he then proceeded to tweet that "trade wars are good and easy to win." In response to this bravado, investors began to worry about the growing risk of a global trade war - a replay of the disastrous Smoot-Hawley tariffs of the 1930s - and the USD weakened anew. This obviously begs the following questions: Are tariffs and trade wars good or bad for the dollar? What is the real likelihood of a trade war engulfing the globe? What signposts should investors monitor to judge whether the world economy is regressing to a 1930s-like nationalist period? We think the current set of proposed tariffs will have a limited impact on the USD, especially as the Fed seems increasingly dead set on tightening policy. However, we need to monitor how NAFTA negotiations evolve. A breakdown in NAFTA negotiations would indicate a rising threat of a global trade war, which down the road would threaten the reserve currency status of the USD. Intellectual property trade disputes with China are another barometer to follow, as Sino-American tensions could intensify markedly. An escalation of these tensions would likely weigh on EM and commodity currencies. The SEK could suffer as well. How Could Tariffs Help The USD? There are two competing hypotheses out there, with diametrically opposed conclusions for investors. One school of thought argues that tariffs could help the dollar; another, that it would hurt the dollar. Chart I-1No Slack In The U.S. Let's begin by exploring how tariffs could help the dollar. Last July, the IMF published an in-depth study of the dynamics that may be associated with tariffs being implemented by any economy.1 Based on the assumption of the imposition of a 10% import tariff across the board, various interesting conclusions emerged. The imposition of imports tariffs should have an inflationary impact on the economy. The first stage is a one-off adjustment with a transitory impact, reflecting the sudden upward adjustment in the price of imports proportional but not equal to the size of the tariffs. If, however, the economy is at full employment, the higher price of foreign-sourced goods incentivizes repatriation of some production onshore. This repatriation brushes up against capacity constraints in the economy's production function, lifting prices over many quarters. The U.S. economy is at full employment, with aggregate capacity utilization at its tightest level since 2005. The U.S. could experience a second-round inflationary effect if broader tariffs are implemented (Chart I-1). The most important conclusion of the IMF study relates to interest rates. Tariffs put upward pressure on domestic nominal interest rates, especially if the economy is already at full employment (Chart I-2A). This is because the central bank presumably wants to counter the inflationary impact of the tariffs. On the other hand, because import tariffs hurt foreigners' exports, the tariffs hurt foreign economies. This makes the foreign output gap more negative than it would otherwise be. In this context, U.S. interest rate differentials rise relative to trading partners (Chart I-2B). Chart I-2A & BAt Full Employment, Import Tariffs Raise Rates The IMF also explores the impact of a global trade war, where tit-for-tat behavior proliferates globally. Unsurprisingly, the IMF's models show that global output declines by roughly 1% over five years after the implementation of the original tariffs (Chart I-3A), and global trade contracts by roughly 2% of GDP over the same time frame (Chart I-3B). Chart I-3A & BGlobal Trade Wars Hurt Trade And Growth The U.S. is a relatively closed economy, as exports constitute approximately 8% of GDP compared to 20% of GDP in major European economies and 16% of GDP in China and Japan (Chart I-4). Hence, the U.S. economy is likely to experience a smaller contraction of output in a global trade war than other major economies. Moreover, as the Global Financial Crisis illustrated, when global trade contracts, economies with deep current account deficits tend to experience an improvement in their trade balance. This means that for an economy like the U.S., which sports a current account deficit of 2.3% of GDP, contracting global trade will shrink the current account deficit, further mitigating some of the negative impact on GDP. Thus, the U.S. output gap would deteriorate less than in countries sporting large current account surpluses like Germany, Japan, or China. U.S. interest rates would rise relative to the rest of the world, causing the dollar to appreciate. Bottom Line: On the one hand, when an economy is at full employment, the imposition of tariffs can generate systemic inflationary pressures. The response of an inflation-targeting central bank would be to tighten policy. This describes the U.S. today, suggesting the USD could rise if tariffs are imposed. Moreover, if a full-fledged trade war ensues, the U.S. economy's lower sensitivity to global trade would limit the negative impact relative to its more globally exposed trading partners - another plus for the dollar. Chart I-4U.S. Growth Is Less Exposed To Global Growth Chart I-5History: Trade Spats Have Hurt The Dollar But The Dollar Is Falling, So What Gives? The analysis above is theoretical, and flies in the face of the real world, where the dollar has been weakening since President Trump announced his intention to impose tariffs. This analysis relies on two words: Ceteris Paribus, and the world is anything but Ceteris Paribus. Investors are having qualms about the dollar because of the history of tariffs. As Marko Papic highlighted in a recent special client note in BCA's Geopolitical Strategy service, tariffs and the threat of tariffs are often used by U.S. administrations to force an upward adjustment in the currencies of U.S. trading partners.2 This worked very well in 1971, when Nixon imposed a 10% surcharge on all imported goods. The 1985 Plaza Accord materialized amid threats of large tariffs by the U.S. on German and Japanese exports, which made those two nations much more willing to see their exchange rates appreciate sharply against the USD. Even more recent trade spats such as the U.S.-Japan tensions in the early 1990s or President George W. Bush's steel tariffs in 2002 were also associated with a weakening dollar (Chart I-5). History has another lesson in store: Investors fear a return of stagflation. The U.S. has a populist president, and fiscal policy is becoming expansionary despite the economy being at full employment - an environment very reminiscent of the late 1960s and early 1970s (Chart I-6). Tariffs too are inflationary and hurt output. Finally, while it remains to be seen if Fed Chairman Jerome Powell will be as malleable to the White House's demands as then Fed Chairman Arthur Burns was, Powell is still perceived as an untested Trump appointee. These apparent similarities with the 1970s are prompting investors to sell the USD. Stagflation was unkind to the dollar as the DXY fell 29% from the 1971 Smithsonian Agreement to December 1979. Chart I-6Like the Late 1960's: Full Employment And Fiscal Stimulus A theoretical concept is also frightening investors: Will Trump's policies prompt a decline of the dollar's share of global reserves? The U.S. dollar is the premier global reserve currency, accounting for 63% of allocated FX reserves. However, a paper from Harvard University highlighted that the dollar is in fact over-represented in global reserves based on trade flows.3 One of the key factors explaining the large role of the USD in global reserves is that many economies have dollarized financial systems, where the greenback represents a large share of their banks' liabilities. Since many of these economies have little access to direct financing from the Fed, as a matter of precaution these nations keep many more dollars in their FX reserve pools for rainy days. If the dollar increasingly becomes a weapon used by the White House, and the U.S. also wants to shrink its current account deficit through aggressively nationalist trade policy, the supply of dollars to the global financial system will decrease and become more volatile. This will make dollar-based financial systems around the world more unstable and dangerous. In the near-term, this uncertainty may support the dollar, but over the longer-run, growing trade restrictions by the U.S. could spur countries to abandon the USD as a source of financing. If they stop financing themselves in USD, they can diversify their FX reserves away from the dollar and mitigate geopolitical risk emanating from the U.S. Chart I-7Is The Exorbitant Privilege Ending? Why is this a problem? As Chart I-7 illustrates, the U.S. has a negative net international investment position of -40% of GDP - i.e. it owes much more money to foreigners than it is owed by foreigners. Yet, the U.S. still manages to eke out a positive primary international income balance of 1.1% of GDP. This is because foreigners are willing to hold dollar bonds at derisively low rates for such an indebted nation. Foreigners are willing to do so because they want to hold dollars as reserves. If the global demand for USD reserves declines, financing the U.S.'s current account deficit and negative net international investment position will become more expensive. The simplest and fastest way to make dollar assets more attractive for foreigners is to weaken the USD today, which lifts expected returns on U.S. assets down the road. Bottom Line: On the other hand, the dollar has responded negatively to the suggestion of new tariffs. The world is not a ceteris paribus environment, and investors are worried that tariffs could plunge the U.S. economy back into 1970's style stagflation. Moreover, the weaponization of the USD decreases its attractiveness as the premier reserve currency of the world, potentially endangering a crucial source of demand for the USD. So What? Both sides of the debate make some valid arguments. But as was the case with the twin deficit, the outlook for the dollar will hinge on the Fed's response to the impact of tariffs on inflation.4 If the Fed ignores the inflationary impact of the repatriation of production onshore, then, investors are correct to replay the stagflation story of the 1970s. However, the Fed doesn't seem to be so inclined. Chairman Powell has acknowledged accelerating U.S. economic momentum, and even perennial doves like Lael Brainard have highlighted the positive impact of stronger global growth, a weaker dollar, and fiscal stimulus on the U.S. growth outlook. The Fed seems ready to hike and does not want to fall behind the curve. There is another dimension to the question. What is the likelihood that Trump tariffs are the opening salvo of a protracted trade war? To be clear, tariffs on steel and aluminum only affect 1% of U.S. imports, or 0.15% of GDP. Tariffs will only have a macro impact if they are broadened or if widespread retaliation ensues. So far, these new tariffs barely affect the long-term trend of declining obstruction to trade, and they remain a far cry from the levels hit in the 1930s (Chart I-8). So, while the probability of a global trade war has risen, it is not a base-case scenario. Instead, it remains to be seen if Trump will become much more aggressive on the trade front. Canada - the top exporter of both steel and aluminum to the U.S. - would have been the country most negatively affected by these tariffs (Table I-1). However, key allies like Canada, Mexico, Australia, Korea and the EU will be exempted from the tariffs. This does not yet point to an all-out trade war between U.S. and the rest of the entire planet. Chart I-8Steel And Aluminum Tariffs: No Smoot-Hawley Table I-1Target Is Locked, Is It? While the probability of a generalized trade war with advanced economies is low, a continued toughening of relations with China is much more likely. President Trump wants greater access for U.S. firms to Chinese markets, and is likely to apply increasing pressure in that direction. For investors, it is important to evaluate if the U.S. is pursuing isolationist policies on a global level or if the impact will be limited to the Sino-American relationship. BCA's Geopolitical Strategy service recommend investors track the following signposts: NAFTA: Marko Papic and his team see a 50% probability that NAFTA will be abrogated as Trump is constitutionally unconstrained from abrogating the deal. If the White House continues negotiating with Mexico and Canada, it increases the likelihood that the tariffs are a shot across the bow directed at China. If NAFTA is not only abrogated but if the trade relationship reverts back to WTO rules, this would signal that the U.S. will remain highly belligerent, raising the risk of implementation of a broader spectrum of tariffs. China Intellectual Property Theft: China only imports US$8 billion in intellectual property from the U.S., suggesting that large-scale theft is happening. The Trump Administration is investigating Chinese technology transfers and Intellectual property theft under Section 301 of the Trade Act of 1974. This could lead to penalties imposed on China, including tariffs, an indemnity for past IP theft, and limitations to Chinese investments in the U.S. This would constitute a massive ratcheting up in Sino-U.S. tensions. This scenario has a much higher probability than a global trade war and it would have a meaningfully negative impact on the Chinese economy, as 19% of its exports are shipped to the U.S. The inflationary impact on the U.S. would be real as well. A global trade war would ultimately hurt the dollar as it would cause the dollar's share of global FX reserves to decline. However, commodity currencies, the Swedish krona and key EM currencies would suffer as global trade contracts (Chart I-9). The yen could perform especially well in this environment, rallying even against the euro (Chart I-10). But again, we see this scenario as a tail risk, not a base case. Chart I-9Key Losers From Falling Global Trade Chart I-10EUR/JPY Could Suffer If A Trade War Materializes Meantime, a bilateral conflict with China is likely to have a more limited impact on currency markets. However, the AUD would be the big loser in such a scenario as the Australian and Chinese economies are tightly linked (Chart I-11). This is an additional reason to underweight the AUD as the probability of growing Sino-American tensions is elevated. Finally, our short EUR/SEK trade is being very negatively affected by the current environment of trade tensions, as EUR/SEK rallies when global trade recedes (Chart I-12). Since we expect tensions to decrease over the coming months, EUR/SEK is likely to weaken, ultimately. Chart I-11China's Boost Is Dissipating Australia Is Tied To The Hip With China Chart I-12SEK At Odds With Trump Bottom Line: The current set of tariffs proposed by the White House is not the beginning of a global trade war. However, it shows that the probability of such an event has grown. Since we are anticipating that the Fed will fight inflationary forces created by further tariff impositions, we are fading the dollar's recent weakness. Yet, we worry that tariffs aimed more specifically at China could become more of a focus. So while we fade the impact of tariffs on the USD, risks are building up for EM currencies and the Australian dollar. Global trade tensions are also a major headwind to the Swedish krona. Housekeeping We are closing our short CAD/NOK trade at a 4.55% profit. Our target was hit, and the exemption of steel and aluminum tariffs for Canada is a positive outcome that could at least temporarily reduce the discount imputed on the CAD. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Linde, Jesper and Andrea Pescatori (2017). "The Macroeconomic Effects of Trade Tariffs: Revisiting the Lerner Symmetry Result." IMF Working Paper No. 17/151, International Monetary Fund. 2 Please see BCA Geopolitical Strategy Special Report, "Market Reprices Odds Of A Global Trade War", dated March 6, 2018, available at gps.bcaresearch.com. 3 Shah, Nihar. "Foreign Dollar Reserves and Financial Stability"(2017) 4 Please see Foreign Exchange Strategy Weekly Report, "Twin Deficits: Bearish Or Not, The Fed Holds The Trump Card", dated March 6, 2018, available at fes.bcaresearch.com. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. has been positive for the dollar: PCE yearly inflation came in at 1.7%, outperforming expectations. ISM Manufacturing PMI and ISM prices paid both outperformed expectations, coming in at 60.8 and 74.2 respectively. Finally, unit labor costs yearly growth outperformed expectations, coming in at 2.5%. The only blip were initial jobless claims that surprised to the upside, coming in at 210 thousand. The dollar has depreciated by roughly 1.2% in the month of March so far. Overall, we continue to see upside for the dollar in the short term. However, this will be a countertrend rally within a cyclical bear market. Report Links: The Dollar Deserves Some Real Appreciation - March 2, 2018 Who Hikes Again? - February 9, 2018 A Cold Snap Doesn't Make A Winter - January 5, 2018 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the Euro area has been mixed: Producer price inflation came in at 1.5%, underperforming expectations. It also declined from 2.2% the previous month. Moreover, Markit services PMI AND Markit Composite PMI both underperformed expectations Finally, both the gross domestic product yearly growth and the unemployment rate came in line with expectations, at 2.7% and 8.6% respectively. After falling below 1.22, the euro has rallied by 2% in the month of March. However, in contrast to last year, data in the euro area is starting to disappoint expectations, as the effects of the tightening in financial conditions resulting from the higher euro are starting to be felt in the real economy. Report Links: Who Hikes Again? - February 9, 2018 The Euro's Tricky Spot - February 2, 2018 From Davos To Sydney, With a Pit Stop In Frankfurt - January 26, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: Consumer confidence came in at 44.3, surprising to the downside. Moreover Markit Services PMI also surprised negatively, coming in at 51.7. However, the unemployment rate came in at 2.4%, surprising positively. It also decreased from 2.8% the previous month. Q4 2017 GDP growth was also revised up to 2.2% from 0.5%, thanks to strong capex. The yen has appreciate further in March, at one point even trading below 106 as investors were still digeseting the impact of Trump's tariffs. Overall, while we expect further upside to the yen in the current volatile environment, the BoJ will be forced to combat this strength. At 102, USD/JPY will be a buy Report Links: The Yen's Mighty Rise Continues... For Now - February 16, 2018 Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been positive: PMI construction came in at 51.4, outperforming expectations. Moreover, Markit Services PMI came in at 54.4, also beating expectations. Finally, house price yearly growth also surprised positively, coming in at 1.8% After falling at the end of February, the pound has rallied by nearly 1%. Overall we expect the upside to the pound to be limited, given that Brexit negotiations are heating up and that any potential tightening by the Bank of England is already well priced in. Report Links: Who Hikes Again? - February 9, 2018 The Euro's Tricky Spot - February 2, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia has been mixed: Gross domestic product yearly growth underperformed expectations, coming in at 2.4% Moreover, retail sales month-on-month growth underperformed expectations coming in at 0.1%. However, company gross operating profits quarterly growth outperformed expectations, coming in at 2.2%. AUD/USD has rallied roughly 1.3% since the beginning of the month. Overall, we continue to be bearish on the Australian dollar, as the economy is still not generating enough endogenous inflationary pressures to justify hiking rates. Moreover, a slowdown in economic activity in China would also weigh on this cross. Report Links: Who Hikes Again? - February 9, 2018 From Davos To Sydney, With a Pit Stop In Frankfurt - January 26, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand has been mixed: The trade balance came in at NZD -3.2 billion, underperforming expectations. However, thanks to robust dairy prices, the terms-of-trade index outperformed expectations, coming in at 0.8%. NZD/USD has rallied by nearly 1% in the month of March. Overall, upside to the kiwi will be limited, given that this currency will suffer amid the persistence in volatility. Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada has been mixed: Housing starts surprised to the upside, coming in at 229.7 thousand. Moreover, the Ivey Purchasing Managers Index also outperformed expectations, coming in at 59.6. However, gross domestic product quarter on quarter growth underperformed, coming in at 1.7%. The Bank Of Canada left rates unchanged on Wednesday. Overall, the Canadian interest rates curve prices the policy outlook appropriately, the CAD has now cheapened in response to the risk of a full abrogation of NAFTA. While we do agree that the risk of NAFTA being abrogated is elevated, a return to the previously standing Canada-U.S. Free Trade Agreement would have a limited impact on the Canadian economy. The downside risk to the CAD is now much more limited. Report Links: Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has generally been positive: The KOF leading indicator surprised to the upside, coming in at 108, and increasing from the previous month. Moreover, the unemployment rate also surprised positively, declining from 3% to 2.9%. However, retail sales growth underperformed expectations, coming in at -1.4% per annum. EUR/CHF has rallied by more than 1.5% since the beginning of the month. Overall, we expect this trend to continue, given that inflationary pressures in Switzerland are too weak for the SNB to back off from its ultra-loose monetary policy stance. Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway has been mixed: Registered unemployment came in line with expectations at 2.5%. However, it did go down from the previous month. Nevertheless, manufacturing output surprised negatively, coming in at -2%. USD/NOK has fallen by roughly 0.8% in the month of March. We are positive on the krone within the commodity currencies. This is because there are less hikes priced into the Norwegian curve than in other countries. Moreover, oil should outperform metals given than oil is less sensitive to a shock from China. Report Links: Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden has been mixed: Retail sales yearly growth underperformed expectations, coming in at 1.2%. Gross Domestic Product annual growth also underperformed expectations, coming in at 1.2%. However, the Manufacturing PMI surprised to the upside, coming in at 59.9. USD/SEK has been relatively flat this this month. Overall, we believe the Riksbank will be forced to lift rates in the face of rising prices. This will push EUR/SEK lower. Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Global trade data we track as indicators of current and expected commodity demand - particularly EM import volumes - will provide a lift to oil prices over the course of 1H18. We continue to expect global oil demand growth, led by EM growth, to rise by 1.7mm and 1.6mm b/d this year and next, respectively. Against this still-positive backdrop, heightened geopolitical tensions are ratcheting up volatility in our outlook. A global trade war - now a factor following the Trump administration's bellicose rhetoric - would reduce our oil demand forecasts. That said, our Geopolitical Strategy team notes past U.S. administrations have used the threat of trade wars to cheapen the USD, which would be bullish commodities.1 Energy: Overweight. Even though it is not a surprise, the anti-trade rhetoric coming out of Washington is a wake-up call for oil markets. Trade is deeply entwined with EM income growth, which drives commodity demand globally. A shock to global trade would be a shock to aggregate demand and oil demand, hence oil prices. Base Metals: Neutral. President Trump announced 25% and 10% tariffs on steel and aluminum last week. Markets are fretting over the possibility of a full-blown trade war if the U.S. zeroes in on China, as it apparently is doing, and Washington's allies impose retaliatory tariffs, should the Trump administration level tariffs on their exports.2 Precious Metals: Neutral. A global trade war would boost gold's appeal, and we continue to recommend it as a strategic portfolio hedge. Ags/Softs: Underweight. In a series of tweets earlier this week, President Trump suggested concessions on steel and aluminum tariffs to Canada and Mexico in exchange for concessions on NAFTA. Neither Mexico nor Canada supported this link. Feature Our short-term models of global trade volumes continue to indicate EM imports - a key variable in our analysis of industrial commodity demand - will continue to grow (Chart of The Week).3 This will be supportive of commodity prices generally, particularly oil, in 1H18. In 2H18 and beyond, the outlook is getting cloudier. And more volatile. A fundamental underpinning of our oil-demand expectation for this year and next is that a slowdown in China in 2H18 will be offset by a pickup in EM and DM aggregate demand - and trade volumes - ex-China, in line with the IMF's expectation for EM and DM growth this year and next (Chart 2).4 DM markets and India likely will take up the slack created by China's slight slowdown. In fact, India already is moving out ahead: Based on official data, India's economy grew at a 7.2% rate in December, topping China's 6.8% rate, according to a Reuters survey at the end of February.5 Chart 1EM Import Volumes Will Continue To Grow Chart 2EM Growth Ex-China Keeps Oil Demand Strong EM Import Volumes Are Important To Oil Prices EM demand drives global oil demand. Over the long haul, the relationship between oil prices and EM import volumes has been strong: A 1% increase in EM import volumes has translated into roughly a 1% increase in Brent and WTI prices since 2000 (Chart 3).6 These variables all are linked: EM economic growth correlates with higher incomes, higher commodity demand and higher import volumes. All else equal (i.e., assuming supply is unchanged), this increases oil prices (via higher demand). The biggest weight in the EM import volume variable is China's imports, so the sustainability of the current Chinese growth is important, as is how smoothly policymakers there slow the economy in 2H18 as we expect. Chinese imports are sensitive to industrial output, which is captured by the Li Keqiang index, global PMIs, and FX markets (Chart 4). Provided policymakers can maintain income growth as the country pivots - once again - away from heavy industrial-export-led growth to consumer- and services-led growth, oil demand will not be materially affected, and should continue growing. At present, China's import volume growth has leveled off as Chart 4 shows, indicating income growth is holding up. China recently guided toward a GDP growth target of 6.5% for this year. Given they have a solid track record of achieving such targets, this indicates that they do not expect a severe slowdown. However, a hard economic landing - always a risk in transforming such a huge economy - would force us to reconsider our growth estimates. Chart 3EM Imports Supportive Of Prices Chart 4Growth In China's Import Volumes Levels Off In our analysis, we do not yet have enough information to determine whether the Trump administration will launch a trade war with China. The impact of President Trump's proposed steel and aluminum tariffs on China is de minimis: Chinese exports of these commodities to the U.S. amount to less than 0.2% of China's total exports, as our colleagues at BCA Research's China Investment Strategy note in this week's analysis.7 The big risk from these tariffs lies in what happens next. If they are the first step in additional tariffs directed at industries far more important to China, they could invite retaliation.8 If the recently announced tariffs expand to a global trade war - already the EU, Canada and Mexico have indicated they will not sit idly by while tariffs are imposed on exporters in their countries - the threat to world trade, and EM imports in particular, rises considerably. This would threaten crude oil prices. Trade Wars And Oil Flows Other than exports from the U.S., which could be targeted by states retaliating against tariffs, it is difficult to imagine the flow of oil being affected by a trade war in the short term: Oil is an internationally traded commodity, and traders adapt quickly to disruptions - e.g., re-routing crude flows in response to events affecting production, consumption, inventories or shipping.9 However, it does not require much of an intellectual leap to see EM trade volumes being significantly impacted by a trade war via the slowing in income growth globally. Such a turn of events would reduce aggregate demand in that part of the market - EM - that is responsible for the bulk of commodity demand growth. Falling EM trade volumes would be the natural result of falling incomes. This would be disinflationary, as well, which is not unexpected (Chart 5). We have found a long-term relationship with strong co-movement properties between EM import volumes and U.S. CPI and PCE inflation indexes. Our modelling indicates a 1% decrease (increase) in EM import volumes translates into a decrease (increase) in these U.S. inflation indexes of 15 to 20bp with a 6- to 12-month lag. These are non-trivial quantities: For instance, a decline in EM import volumes of 10% or more could shave as much as 2 points from U.S. inflation (Chart 6). Such a disinflation impulse once again coming from the real economy would, in all likelihood, force the Fed to throttle back on its interest-rate normalization policy or reverse course. Chart 5Lower EM Import Volumes##BR##Would Take U.S. Inflation Lower Chart 6EM Trade Volumes##BR##Over Time Volatility Likely To Pick Up As we noted above, our Geopolitical Strategy (GPS) colleagues point out the threat of tariffs and quotas has been used by U.S. administrations in the past to get systemically important central banks to support a weaker USD.10 The end game always is to spur exports to boost economic growth. The downside risk from trade wars discussed above is fairly obvious. Not so obvious is the upside commodity-price risk arising from a depreciation in the USD, which falls out of a strategy of using the threat of tariffs to ultimately weaken the USD. Our GPS colleagues quote Paul Volcker's summary of a similar gambit by Richard Nixon, who also ran a mercantilist presidential campaign in the late 1960s, to ultimately weaken the USD: The conclusion reached by some that the United States shrugged off responsibilities for the dollar and for leadership in preserving an open world order does seem to me a misinterpretation of the facts ... The devaluation itself was the strongest argument we had to repel protectionism. The operating premise throughout was that a necessary realignment of exchange rates and other measures consistent with more open trade and open capital markets could accomplish the necessary balance-of-payments adjustment. It is impossible to say whether such a depreciation is the Trump administration's end-game. However, if it is, this would be bullish commodities generally, gold and base metals in particular. For oil, a weaker USD would be bullish, but, as we have shown recently, fundamentals now drive oil price formation.11 Bottom Line: Current and expected EM import volumes indicate oil prices will continue to be supported by rising demand over the course of 1H18. We continue to expect global oil demand growth, led by EM growth, to rise by 1.7mm and 1.6mm b/d this year and next, respectively. Still, heightened geopolitical tensions brought on by bellicose trade signaling from the U.S. are ratcheting up volatility in our outlook. A global trade war would force us to lower our forecast for Brent and WTI crude oil from our current $74 and $70/bbl expectations for this year. However, as our Geopolitical Strategy team notes, past U.S. administrations have used the threat of trade wars to cheapen the USD. Should this turn out to be the Trump administration's strategy, the weaker USD would be bullish for commodity prices. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 Please see BCA Research's Geopolitical Strategy Weekly Report "Market Reprices Odds Of A Global Trade War," published March 6, 2018. It is available at gps.bceresearch.com. Our colleagues note, "Import tariffs ought to be bullish for the greenback, given that they lead to higher domestic policy rates as inflationary pressures rise (and not just passing ones). However, as the previous two examples of U.S. protectionism teach us, the U.S. uses threats of tariffs so that it can get a cheaper USD. From Washington's perspective, both accomplish the same thing. Intriguingly, the U.S. dollar has sold off on the most recent news of protectionism." (Emphasis added.) 2 Please see BCA Research's Commodity & Energy Strategy Weekly Report "Global Aluminum Deficit Set To Ease," published March 1, 2018, particularly the discussion beginning on p. 7. It is available at ces.bcaresearch.com. 3 Our 3-month ahead projections are based on two components: (1) the first principal component of a basket of currencies exposed to global growth; and (2) lagged U.S. monetary variables. Our modeling shows that exchange rates are forward-looking variables containing information of future fundamentals. Therefore, by selecting currencies exposed to global and EM growth, this allows us to run short-term forecasts of EM import volumes. The analysis is also confirmed using Granger-causality tests. 4 Please see "Brighter Prospects, Optimistic Markets, Challenges Ahead," in the IMF's January 22, 2018, World Economic Outlook Update, which notes its revised forecast calling for stronger global growth reflects improved DM growth expectations. 5 Please see "India regains status as fastest growing major economy," published by reuters.com on February 28, 2018. 6 These results fall out of co-integration regressions. 7 Please see BCA Research's China Investment Strategy Weekly Report "China And The Risk Of Escalation," published March 7, 2018. It is available at cis.bcaresearch.com. See also footnote 2 above. 8 President Trump reportedly is considering broadening the tariffs on a range of Chinese imports and limiting Chinese investment in the U.S., to punish the country for "its alleged theft of intellectual property," according to Bloomberg. Please see "U.S. Considers Broad Curbs on Chinese Imports, Takeovers," published by Bloomberg.com, March 6, 2018. 9 The U.S. is exporting a little over 1.5mm b/d of crude oil and 4.6mm b/d of refined products at present, according to EIA data. A drawn-out trade war resulting in U.S. oil exports being hit with retaliatory tariffs or quotas could derail the expansion of crude exports brought on by the growth in shale-oil output in America. The IEA expects the U.S. to account for the largest increase in crude exports in the world between now and 2040, "propelling the region above Russia, Africa and South America in the global rankings." This has the effect of reducing net U.S. crude imports to 3mm b/d by 2040 from 7mm b/d at present. An increase in product exports - from 2mm b/d to 4mm b/d - makes the U.S. a net exporter of crude and product, based on the IEA's analysis. The largest demand for crude imports comes from Asia over this period, which grows 9mm b/d to 30mm b/d in total. Please see "WEO Analysis: A sea change in the global oil trade," published by the IEA February 23, 2018, on its website at iea.org. 10 We urge our readers to pick up BCA Research's Geopolitical Strategy Weekly Report cited in footnote 1 above, which lays out our GPS team's analytical framework regarding trade wars. They note, "If constraints to trade protectionism were considerable, Trump would not have the ability to surprise the markets with bellicose rhetoric on a whim. BCA Research's Geopolitical Strategy cannot predict individual triggers for events. But our framework allows us to elucidate the constraint context in which policymakers operate. On protectionism, Trump operates in a poorly constrained context. This is why we have been alarmist on trade since day one." 11 We found that the more backwardated oil forward curves are the less impact the USD has on the evolution of prices. Please see BCA Research's Commodity & Energy Strategy Weekly Report "OPEC 2.0 Getting Comfortable With Higher Prices," published on February 22, 2018. It is available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017

Highlights The direct impact of recently proposed U.S. import tariffs on steel and aluminum is likely to be small, both for China and the world. In isolation, this development is not very relevant for investment strategy. However, the lessons learned from studying the game of Prisoner's Dilemma suggest that investors should be legitimately concerned about an iterative "tit-for-tat" exchange of retaliation between the U.S. and its major trade partners if the Trump administration continues to pursue aggressively protectionist trade policies. Recent data releases show that the ongoing economic slowdown continues. While the Caixin manufacturing PMI is a bright spot, it is not likely heralding a major turning point for the Chinese economy. Investors should closely watch three bellwethers to judge the likelihood of a full-blown global trade war. Barring a major deterioration on this front, or a sharp further slowdown in Chinese economic growth, investors should stay overweight Chinese ex-tech stocks vs global. Feature The looming threat of U.S. protectionism came into full force over the past week, as President Trump stated that sweeping tariffs on all U.S. imports of steel and aluminum would soon be formalized. The tariff situation continues to evolve as we go to press, but the facts as they currently stand are the following: The proposed tariffs would be 25% on steel, and 10% on aluminum imports No exceptions are planned for any country, although statements from U.S. leadership on Monday suggested that Canada and Mexico may be exempt if NAFTA is renegotiated in the U.S.' favor Key European Union leaders threatened to retaliate against the U.S.' proposed tariffs, and the U.S. threatened to counter-retaliate China has taken a more cautious stance on the issue of retaliation, and is strongly seeking to negotiate with the Trump administration Minimal Direct Impact The developments over the past week raise two questions about China's economy that matter for investment strategy: What is the direct impact of the tariffs on China's exports likely to be? What is the implication for global growth? On the first question, the answer is fairly clear that the direct impact is likely to be small. The proposed tariffs do not disproportionately target China, and Chinese exports of steel and aluminum to the U.S. account for less than 0.2% of total exports (Chart 1). Exports of these products to all countries as a share of total exports is still quite small (panel 2). The second question is much more difficult to answer, and it has wide implications for both the Chinese economy and for investment strategy. When approaching the question, it is first important to note that the threat to the global economy from the imposition of the proposed tariffs comes from the potential for a series of retaliations from major trading partners, not the tariffs themselves. U.S. imports of steel and aluminum make up less than 1% of global goods exports, and Chart 2 presents a long-term history of average U.S. tariff rates along with our estimate of the impact of the U.S.' proposal. While the imposition of the announced tariffs would certainly change the trend that has been in place for some time, the rise is not very significant. Critically, even after the tariffs are imposed, U.S. tariffs rates will still be fractional when compared with those that prevailed during the early-1930s, when the Smoot-Hawley Tariff Act materially exacerbated the Great Depression. Chart 1Chinese Steel And Aluminum Exports##br## Are Not Significant Chart 2We're A Long, Long Way Away##br## From Smoot-Hawley China's cautious stance towards retaliation is, at first blush, an encouraging development, but it may not be as hopeful of a sign as it seems. First, despite a general feeling among investors that China was the intended target of the U.S.' proposed tariffs, a global tariff on steel and aluminum is likely to disproportionately affect developed countries rather than China. It is therefore not surprising that China has signaled a somewhat conciliatory stance. In our view, the likelihood of Chinese retaliation is considerably higher if further tariffs are announced on goods that make up a larger share of their exports. In addition, as we noted above, the European Union has already highlighted some U.S. goods that may be subject to higher retaliatory tariffs in response to the news (which already elicited a threat of counter-retaliation from the U.S.), and both Canada and Mexico have also threatened retaliation if they are not granted an exemption from the proposed tariffs. In our view, these threats should be treated seriously, especially after revisiting the lessons of one of the most famous experiments in game theory. Bottom Line: The direct impact of proposed U.S. import tariffs on steel and aluminum is likely to be small, both for China and the world. Retaliation Risk And The Prisoner's Dilemma The dynamics of trade renegotiations can be examined, at least conceptually, through the lens of game theory. It is difficult to model these dynamics precisely because of the complexity of the relationship between trade and potential growth, but it is worth revisiting the lessons learned by the repeated playing of Prisoner's Dilemma, one of the most well-known examples of the application of game theory. To summarize, the Prisoner's Dilemma scenario describes two criminals who have been arrested, and whose statement to the authorities affects the manner in which punishment (if any) is distributed between the two of them. The standard payoff structure of the game is set up such that one prisoner is able to largely avoid punishment if (s)he accuses the other of the crime and the other prisoner remains silent, but that both prisoners receive a punishment if they both accuse each other that is greater than the punishment received if they both remain silent (Table 1). Given that tariffs and other forms of trade protectionism can only durably succeed at improving net domestic economic outcomes if they do not result in retaliation, from the perspective of trade renegotiation, accusing the other player in the game of Prisoner's Dilemma is tantamount to restricting trade, and remaining silent is equivalent to allowing existing trade relationships to persist. Table1In The Prisoner's Dilemma, It's Better To Return Defection With Defection The success of strategies employed in repeated games of Prisoner's Dilemma was studied most famously by Robert Axelrod in 1980.1 The winning strategy (in both of Axelrod's tournaments) was "Tit for Tat", which follows two very simple rules: cooperate initially, and thereafter copy the other player's decision in the previous round. This strategy has three attributes that Axelrod showed to be highly successful when playing repeated games of Prisoner's Dilemma: niceness (not being the first player to accuse/defect/renege), being provocable (responding to defections with in-kind retaliation), and forgiveness (not allowing one-time defections to impact future choices beyond a one-time retaliation). Chart 3 illustrates the performance of the "Tit for Tat" strategy in the first Axelrod tournament, along with the average scores of several other strategies. The most important lesson from both tournaments is summarized nicely in the chart: the average score of a series of "nice" strategies was considerably higher than those that were not nice. But Chart 4 also highlights that niceness is only a relatively successful strategy because of its ability to produce an optimal outcome with other nice strategies: all strategies, nice or not, tend to generate poor outcomes when played against strategies that are not nice. This is because the payoff structure of Prisoner's Dilemma is such that, compared with defection, co-operation makes a player worse off if their opponent defects. Chart 3In Repeated Games Of Prisoner's Dilemma,##br## "Nice" Strategies Pay Off... Chart 4...But Only Because They Do Well Against ##br##Other "Nice" Strategies In the context of global trade, this can be seen as the likelihood of outsized job losses (or the lack of job gains in a protected industry) from a failure to retaliate. The key point for investors is that the most basic lesson of the Prisoner's Dilemma suggests that market participants should be legitimately concerned about retaliation from the U.S.' trade partners (and subsequent counter-retaliation) if it continues to pursue a protectionist agenda, because it can be a rational response for an individual country even if it leads to poor outcomes for everyone involved. In addition, three assumptions of the Prisoner's Dilemma game are not valid in the real world (or the current environment), which in two of these cases further increases the risk of an iterative exchange of retaliation: Chart 5The U.S. Has A Trade Deficit ##br##With Many Trading Partners In terms of the payoffs associated with the game, Prisoner's Dilemma assumes an equal starting position (of zero "points") on both sides, which is not the case in the current environment. The U.S. has a sizeable trade deficit with the world (Chart 5), and several important trading partners with the U.S. (especially China) maintain significant non-tariffs barriers to trade. Regardless of whether this inequity has been caused by an unfair trading relationship, in the parlance of Axelrod's tournaments, this implies that the U.S. strategy is likely to be not nice due to the perception on the part of the Trump administration of an unequal starting position. The implication is that the odds of an escalation of the imposition of relatively small tariffs into a full-blown trade war are higher than would normally be the case. Prisoner's Dilemma has clear and symmetric payoffs, which is also not the case in the current environment. The Trump administration apparently feels that the payoff to the U.S. of certain trade restrictions is a net positive even assuming retaliation, which raises the possibility of a negative outcome for the global economy. Worryingly, in our view the chances are high that calculations of the net benefit of any trade restriction are being done on a political basis, rather than an economic one. Prisoner's Dilemma assumes that the participants are unable to communicate, which is a limitation that does not exist in a real-world trade negotiation scenario. This lowers the probability that the U.S. and its major trading partners will engage in a spiraling tit-for-tat trade war relative to what the game of Prisoner's Dilemma would imply, even if the recently announced tariffs on steel and aluminum stand and major partners do retaliate. Bottom Line: The lessons learned from studying the game of Prisoner's Dilemma suggest that investors should be legitimately concerned about an iterative "tit-for-tat" exchange of retaliation between the U.S. and its major trade partners if the Trump administration continues to pursue aggressively protectionist trade policies. No Help From The Domestic Economy A protectionist agenda from the U.S. is also coming at an inconvenient time for Chinese policymakers, even if they were not blindsided by the move. Policymakers already have to contend with managing the impact of renewed reforms on economy's financial and industrial sectors, and the potential addition of the external sector to this list of problems needing attention is unwelcome. While a cooling of the economy was an inevitable result from the government's deleveraging campaign and shadow banking crackdown, Table 2 highlights how broadly leading economic indicators have decelerated. The table presents recent data points for several series that we identified in November Special Report as having leading properties for the Chinese business cycle,2 as well as the most recent month-over-month change, an indication of whether the series is currently above its 12-month moving average, how long this has been the case. Table 2No Convincing Signs Of An Impending Upturn In China's Economy Among the components of the BCA Li Keqiang Leading Indicator (an index designed to lead turning points in the Li Keqiang index), all six series are in a downtrend and 5 out of these 6 fell in January (the growth in M2 was the exception). A similar story is borne out in the housing price data, with a variety of diffusion indexes having also fallen in January.3 The Caixin Manufacturing PMI remains the one bright spot, having recently risen above its 12-month moving average and having risen in January, in stark contrast to the official PMI (which fell a full point). But as Chart 6 highlights, following the last four episodes when the Caixin PMI exceeded the official PMI by this magnitude, the subsequent trend in the average of the two was down in every case. The implication is that the outlier nature of the current Caixin PMI shown in Table 2 is just that, and not a heralding a major upturn in China's economy. Chart 6The Caixin PMI Is Probably The Noise, Not The Signal Bottom Line: Recent data releases show that the ongoing economic slowdown continues. While the Caixin manufacturing PMI is a bright spot, it is not likely heralding a major turning point for the Chinese economy. Conclusions For Investment Strategy Chart 7 illustrates the decision tree for Chinese stocks that we presented in our first report of the year. While there has been a modest further deterioration in the industrial sector, the pace of the decline is still consistent with the controlled slowdown scenario that we outlined in an October Weekly Report.4 As such, the recent softness in the data is not significant enough to cause us to change our recommended investment strategy. The key change over the past week has been the threat posed by U.S. protectionism to the global economy, which is the very first question to answer in our decision tree. The now high-beta nature of the Chinese stock market underscores that U.S. protectionism can significantly (negatively) impact the relative performance of Chinese equities if it destabilizes the global stock market, even if Chinese exports were to emerge from the exchange relatively unscathed. For now, we judge the likelihood of a full-blown tit-for-tat trade war to be a risk, and thus not a probable event. For now, market participants seem to agree: U.S. and global equities rebounded earlier this week in response to a feeling that the negative repercussions for global growth are likely to be minimal. Nonetheless, this is a risk that needs to be monitored closely, and to facilitate this our Geopolitical Strategy service has highlighted the following three bellwethers that they will be watching in order to judge the likelihood of a major escalation:5 Chart 7The Chinese Equity "Decision Tree" Tariff exceptions for allies: Given the national security basis for the steel and aluminum tariffs, it is likely that exceptions will be made for allies such as Canada and Europe. If yes, then the measure is unlikely to be part of a truly "America First" mercantilist strategy and is instead a veiled swipe at China to satisfy Trump's base ahead of the midterm elections NAFTA: Our geopolitical team has argued that the probability of NAFTA abrogation is around 50%.6 If the administration continues the negotiations in light of tariff announcements, however, it suggests that the revealed preference of the White House is less protectionist than it appears. Chinese intellectual property (IP) theft: The Trump administration is investigating Chinese technology transfer and IP theft under Section 301 of the Trade Act of 1974. If China is found to have acted unfairly, penalties would likely include a combination of tariffs and restrictions on Chinese investment in the U.S. This might include an indemnity for cumulative losses from past violations, which would be rare, if not unprecedented, and which China would reject outright. This could produce across-the-board tariffs of a sort that the U.S. has not imposed since the Nixon shock. Chart 8China Is Outperforming Global In Ex-Tech Terms In the meantime, Chart 8 highlights that investable Chinese ex-technology stocks (proxied by the MSCI China Index ex-technology) remain in an uptrend versus their global peers, which underscores that investors should have a high threshold for reducing exposure to China. This underscores that investors should have a high threshold for reducing exposure to China. While the ongoing slowdown in China's economy is likely to cause earnings growth to decelerate over the coming year, the continued likelihood of decently positive earnings growth coupled with a sizeable valuation discount relative to global signals that Chinese ex-tech stocks are remain attractive on a risk/reward basis. Investors should stay overweight. Bottom Line: Investors should closely watch three bellwethers to judge the likelihood of a full-blown global trade war. Barring a major deterioration on this front, or a sharp further slowdown in Chinese economic growth, investors should stay overweight Chinese ex-tech stocks vs global. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 "Effective Choice in the Prisoner's Dilemma" and "More Effective Choice in the Prisoner's Dilemma" by Robert Axelrod, The Journal of Conflict Resolution, Vol. 24 Nos.1 and 3, March and September 1980. 2 Please see China Investment Strategy Special Report, "The Data Lab: Testing The Predictability Of The Chinese Business Cycle", dated November 30, 2017, available at cis.bcaresearch.com. 3 However, as discussed in our February 8 Weekly Report, we are keeping an eye on residential floor space sold given its history of leading China's housing market cycles. 4 Please see China Investment Strategy Weekly Report, "Tracking The End Of China's Mini-Cycle", dated October 12, 2017, available at cis.bcaresearch.com. 5 Please see Geopolitical Strategy Special Report, "Market Reprices Odds Of A Global Trade War", dated March 6, 2018, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Special Report, "NAFTA - Populism Vs. Pluto Populism", dated November 10, 2017, available at gps.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

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Highlights Trump faces few constraints to further protectionism. His tariff announcement confirms our constraints-based methodology. Previous examples of U.S. protectionism show that the end game was not trade war, but USD depreciation. Key bellwethers for further protectionism are: waivers for allies, NAFTA, and China. The USD's global reserve currency status is at risk over the long run due to geopolitical multipolarity. Stay long defense stocks; short China-exposed S&P500 versus domestic-oriented companies; short EM assets. Feature "The import duty delights me..." - President Richard Nixon, August 2, 1971 (Oval Office Tapes) "Trade wars are good and easy to win." - President Donald Trump, March 2, 2018 The market has proven to be a terrible geopolitical analyst. It lost faith in Trump's overtly stated populism quickly into his presidency: What did the market do when Congress failed to pass repeal/replace of Obamacare? It immediately reduced the odds that the Republican-held Congress would get tax cuts or anything else done. What did the market do when Trump presented an austere "skinny budget," a budget that is normally ignored when any other president announces it? It immediately faded the odds of more deficit spending. What did the market do when Trump had a pleasant first meeting with Chinese President Xi Jinping at the Mar-a-Lago resort?1 It faded the odds of a trade war. It is becoming increasingly clear that the market has no framework for analyzing politics. It got the profligate tax cuts, extraordinary fiscal stimulus, and now Trump's protectionism wrong. In this Client Note, we explain how we got the odds of a trade war right, why market repricing is instructive, and how investors should position themselves for the coming volatility. Constraints Versus Preferences The mantra of BCA's Geopolitical Strategy is that preferences are optional and subject to constraints, whereas constraints are neither optional nor subject to preferences. When making our forecasts, we focus on the constraints that bind policymakers and we ignore their preferences. President Trump did not announce that he would impose a 25% tariff on all imported steel and a 10% tariff on all imported aluminum because he was "unglued" or "angry" any more than World War One started because a Serb nationalist shot an Austrian archduke! He did so because he can. President Trump faces scant political, constitutional, and economic constraints when it comes to pursuing protectionist policies. Hence we have warned our clients to prepare for higher odds of trade wars and protectionism since the moment he was elected.2 There are three broad reasons why we have expected trade protectionism to re-emerge as a headline risk in 2018:3 Chart 1America Belongs To The Anti-Globalization Bloc Overstated political constraints: President Trump's base is anti-trade. We would argue that all Americans are far more protectionist than our clients wish to admit (Chart 1). Higher prices of Chinese made T-shirts and aluminum beer cans will not deter his supporters, nor will economic and market effects (short of a recession) change his voters' minds before the 2020 election. After all, President Trump was fully transparent during his presidential campaign when he promised a 45%-across-the-board tariff on Chinese imports and condemned NAFTA as a "disaster." It was this rhetoric that allowed him to outperform his opinion polls in the Midwest (Chart 2). Overstated constitutional constraints: The U.S. Congress has punted its responsibility for trade to the executive branch via several legislative acts over the decades. Most relevant at this juncture are: The Trade Expansion Act Of 1962: Allows the president to impose tariffs or quotas to offset any adverse impact of trade on national security;4 The Trade Act Of 1974: Allows the president to impose tariffs or quotas in order to deal with a serious U.S. balance of payments deficit or the unjust trade practices of another state; The International Emergency Economic Powers Act Of 1977: Allows the president to regulate all commerce and freeze all foreign assets in the case of a National Emergency.5 Overstated geopolitical constraints: Investors have continuously discounted the probability of Sino-American tensions, or even open conflict. Our clients know that we have been alarmists on this issue since 2012.6 In fact, it has been a key theme of BCA's Geopolitical Strategy that geopolitical risk is rotating to East Asia and that the constraints to U.S.-China conflict are falling as the symbiosis between the two economies fades (Chart 3). Chart 2Protectionism Boosted Trump In The Rust Belt Chart 3U.S.-China Symbiosis Has Died Bottom Line: If constraints to trade protectionism were considerable, Trump would not have the ability to surprise the markets with bellicose rhetoric on a whim. BCA's Geopolitical Strategy cannot predict individual triggers for events. But our framework allows us to elucidate the constraint context in which policymakers operate. On protectionism, Trump operates in a poorly constrained context. This is why we have been alarmist on trade since day one. Another Reason To Worry: Trump Is Not Unique The U.S. has a relatively recent tradition of bellicose protectionist rhetoric - under Presidents Richard Nixon, Ronald Reagan, and even at times George W. Bush and Barack Obama - perhaps due to the fact that it is the least globally exposed advanced economy (Chart 4). It is difficult to retaliate against the "consumer of last resort," which gives Washington D.C. considerable leeway in bullying global trade partners. Chart 4The U.S. Is Least Exposed To Trade President Nixon famously closed the gold window on August 15, 1971 in what came to be known as the "Nixon shock."7 Less understood, but very much part of the "shock," was a 10% surcharge on all imported goods, the purpose of which was to force U.S. trade partners to appreciate their currencies against the USD. Much like Trump, Nixon had campaigned on a mercantilist platform in 1968, promising southern voters that he would limit imports of Japanese textiles. Also like Trump, he staffed his cabinet with trade hawks. Most notable amongst these was the Treasury Secretary John Connally, who wanted not only to close America's trade deficit but also to reduce U.S. military presence in Europe and Japan.8 Again, just like today, the economists in Nixon's cabinet opposed the surcharge, fearing retaliation from trade partners, while the politicians favored brinkmanship.9 We know from taped conversations of the Nixon White House that he and his advisors worried that the import surcharge could strengthen the dollar. But they decided to impose it anyway because of political expediency - Connally stressed that "it's more understandable to the American people to put on a border tax." They also saw it as a negotiating tactic. The eventual surcharge was said to be "temporary," but there was no explicit end date. The U.S. ultimately forced other currencies to appreciate, mostly the deutschmark and yen. This is unsurprising given Germany's and Japan's total subservience to the U.S. in the early 1970s. Critics in the administration - particularly the powerful National Security Advisor Henry Kissinger - feared that brinkmanship would hurt transatlantic relations and thus impede Cold War coordination between allies. As such, the U.S. removed the surcharge by December without meeting most of its other objectives, which included increasing allied defense-spending and reducing trade barriers to U.S. exports. Even the exchange-rate outcomes of the deal dissipated within two years. Summing up the episode, then Undersecretary of the Treasury, Paul Volcker, remarked that: The conclusion reached by some that the United States shrugged off responsibilities for the dollar and for leadership in preserving an open world order does seem to me a misinterpretation of the facts ... The devaluation itself was the strongest argument we had to repel protectionism. The operating premise throughout was that a necessary realignment of exchange rates and other measures consistent with more open trade and open capital markets could accomplish the necessary balance-of-payments adjustment.10 Volcker's point was that the devaluation of the USD ultimately staved off protectionism. But he also reveals that the U.S. was close to abandoning its role as global defender and consumer of last resort due to domestic economic pressures. What does the 1971 "Nixon shock" teach us? FX depreciation obviates the need for protectionism: In both the case of the "Nixon shocks" and Reagan's 1985 "Plaza Accords," the rest of the world accommodated the U.S. and avoided a global trade war by allowing the USD to depreciate; Politics trumps economics: President Nixon ignored the advice about the economic effects of protectionism and used the import surcharge as a negotiating strategy - a successful negotiating strategy, we should add; Americans are not globalists: Not only is the U.S. economy largely insulated from the rest of the world, but Americans are not unequivocally pro-trade. Nixon was never hurt politically by the surcharge, and it even proved widely popular with the public. President Trump has come under withering criticism for using tariffs in 2018. However, his predecessors did so successfully as part of wider negotiations without ending global trade, all the while remaining popular with the public. The only question the history leaves unanswered is why Trump hasn't used tariffs sooner! What if the rest of the world does not play ball this time around? Two keystone themes of BCA's Geopolitical Strategy suggest that this time may be different: Apex of Globalization: The U.S. could negotiate the 1971 and 1985 currency agreements in part because the promise of increased trade remained intact. Europe and Japan agreed to a tactical retreat to get a strategic victory: ongoing trade liberalization and deeper access to U.S. markets. In 2018, however, this promise has been muted, with global trade as percent of GDP having peaked (Chart 5) and trade growth continuing to trail global GDP growth (Chart 6). America's trade partners may be far less willing to give in to U.S. protectionist threats in a world where the global trade pie is growing at a much slower pace. Multipolarity: During the Cold War, the U.S. had far greater leverage over Europe and Japan than it does today over Europe and China. While the U.S. still guarantees European defense, and thus could see some concessions from its ally, its geopolitical relationship with China is practically hostile. And, at the end of the day, it is Chinese trade policies that have had an adverse effect on U.S. manufacturing, not European. Chart 5Globalization Has Reached Its Apex Chart 6Trade Growth Trails Output Growth If this time is different, American policymakers will be left with only one lever: FX devaluation. Our current view that the USD will rally amidst domestic fiscal stimulus is predicated on the Fed hiking rates faster as inflation picks up. But what if Jay Powell, untested and facing political pressure from the White House, decides to respond to higher nominal GDP growth by hiking rates more slowly? Bottom Line: History teaches us that Trump's bellicose rhetoric is not unique to recent American presidents, let alone to world leaders. Previous times that the U.S. has threatened serious protectionism against trade partners the effect was USD depreciation, not trade wars. In addition, global trade boomed after each U.S. threat of protectionism, it was not derailed. What Matters (And What Does Not)? According to our calculation, Trump's suggested steel and aluminum tariffs would, in the most liberal estimate, impact just 0.3%-0.8% of global trade.11 As such, the proposed tariffs are insignificant from a macro perspective. They would also ostensibly have a much greater impact on U.S. allies, with China and Russia impacted only on aluminum (Chart 7). That said, the market is looking beyond the announced measures as it quickly reprices the greater risk of a global trade war that it ignored for the past 18 months. This, however, does not mean that the probability of a global trade war is high, just that the market was caught unaware due to complacency. We suggest three bellwethers for investors. If all three of these lean towards mercantilism, then the probability of global trade war is indeed high. Exceptions for allies: Given the national security basis for the steel and aluminum tariffs, it is likely that exceptions will be made for U.S. allies Canada and Europe. If yes, then the measure is unlikely to be part of a truly "America First" mercantilist strategy and is instead a veiled swipe at China and a political one-off to satisfy Trump's base ahead of the midterm elections; NAFTA: We have argued that the probability of NAFTA abrogation is around 50%, much higher than what the market is currently pricing in, for similar reasons as those outlined in this report.12 In short, we do not see any constraints - neither legal-constitutional nor political nor economic - preventing President Trump from ending the deal. If the administration continues the negotiations in light of tariff announcements, however, it suggests that the revealed preference of the White House is far less protectionist. It would also suggest that any Trump tariffs are really about China (Chart 8). China intellectual property (IP) theft: The Trump administration is investigating Chinese technology transfer and IP theft under Section 301 of the Trade Act of 1974. If China is found to have acted unfairly, penalties would likely include a combination of tariffs and restrictions on Chinese investment in the U.S.13 This might include an indemnity for cumulative losses from past violations, which would be rare, if not unprecedented, and which China would reject outright. Trump's rhetoric - and China's verifiably severe violations on IP - could produce across-the-board tariffs of a sort that the U.S. has not imposed since the Nixon shock. That would be a game changer in Sino-American tensions. Such a tariff could come to be remembered as the moment the Second Cold War began. Chart 7U.S. Allies Are Most Exposed Chart 8China, Not NAFTA, In Trump's Crosshairs Bottom Line: We would largely discount individual cases of tariffs that target specific goods, depending on the magnitude. These are largely within the realm of the expected and accepted. Trump's proposal would at most affect 0.8% of total global trade and that is assuming that no exemptions are made for allies. The real game changers would be if the U.S. began to think of "national security" in a narrow sense, no longer exempting geopolitical allies from an aggressive trade policy. A combination of both mercantilism and isolationism would imperil the transatlantic alliance and thus the American anchor in Eurasia. The loss of that alliance and that anchor, if pursued to its logical conclusion, would usher in the collapse of America's global hegemony.14 We would watch carefully whether the U.S. goes after China with broad, across-the-board tariffs. An all-out trade assault on China by the U.S. would avoid a global trade war, but would likely usher in a new Cold War, as China's internal stability would be threatened. Investment Implications Our forecast that Trump's protectionism would become investment-relevant in 2018 has come true. Now comes the hard part of forecasting how it plays out. It is tempting to simply replay the 1971 and 1985 episodes. After all, the U.S. is as closed of an economy today as it was then, largely immune to protectionist retaliation from the rest of the world. However, the U.S. economy is a third smaller as a percentage of global GDP than in both those episodes (Chart 9). And its geopolitical relevance to Europe is waning, whereas China remains a potent rival that may not "play ball." In fact, Chinese policymakers may be forced to accept a trade war in order to blame the painful effects of structural reforms on the Trump administration.15 Chart 9The U.S. Is Not As Dominant As It Was Before we assign high probability to any particular investment recommendation based on a higher probability of trade wars, we want to see how the NAFTA negotiations play out, whether the U.S. hits geopolitical allies with tariffs, and how the China IP case plays out. Nonetheless, the following three trades appear cogent even without such evidence: Long defense stocks: Our highest conviction investment call on the theme of "Apex of Globalization" is to go long defense stocks.16 We have recommended a vanilla trade to articulate this view, long S&P 500 aerospace and defense / short MSCI ACW, up 14.56% since initiation in December 2016. For a higher risk, higher reward strategy, we would suggest investors go long a basket of U.K., German, French, Italian, and Japanese major defense companies. In a world where the U.S. ceases to be a defender of last resort, countries will look to diversify their security portfolio away from America, and that will mean demand for non-U.S. military exports. Short U.S.-China plays: Investors should go long the most domestically-focused U.S. sectors - financials and telecoms17 - and go short our index of China-exposed S&P 500 companies. We were stopped out of this trade in March 2017 and again in September 2017, as we bet too early that the market would reprice the probability of a trade war. Short EM: Emerging markets have the most to lose in a potential trade war, especially amid higher U.S. bond yields. However, not all emerging markets are equally exposed. For example, India is largely insulated. A long India / short Brazil equity market position should reap returns in a de-globalized world (and BCA's Emerging Markets Strategy would endorse this trade based on macroeconomic factors). What about the U.S. dollar? Import tariffs ought to be bullish for the greenback, given that they lead to higher domestic policy rates as inflationary pressures rise (and not just passing ones). However, as the previous two examples of U.S. protectionism teach us, the U.S. uses threats of tariffs so that it can get a cheaper USD. From Washington's perspective, both accomplish the same thing. Intriguingly, the U.S. dollar has sold off on the most recent news of protectionism. Or are they already pricing in the likely conclusion of the current impasse (dollar falls) based on historical precedent? Or could it be a more ominous sign that the greenback's days as the global reserve currency are numbered? If the U.S. abandons its twin roles as the world's defender and consumer of last resort, then foreigners may decide that they should no longer reflexively store their wealth in U.S. assets. Think this is all merely geopolitical hogwash? Think again. Chart 10, courtesy of our colleague Mathieu Savary (BCA's chief FX strategist), is probably the best geopolitical chart we have ever published. It illustrates how the U.S. can manage to have a positive net international income despite a deeply negative net international investment position (NIIP). How is this possible? Because foreigners are willing to hold onto U.S. assets (U.S. Treasuries) for largely geopolitical reasons. It is too early to tell if this paradigm shift in global finance is underway. In the short term, Trump's rhetoric is likely to face the same constraints as Nixon's surcharge: geopolitical alliances will force him to carve out exemptions and focus on China. And if a trade war envelopes U.S. and China - rather than the world - we would bet that the U.S. dollar would rally, given that it would remain the safe-haven currency. Remain long DXY for now. Chart 10Exorbitant Privilege Chart 11Multipolarity Undermined The Pound Sterling But our view is that - over the long term - a multipolar world entails a multipolar currency regime. Such a development may come faster than most of us think. For example, the U.K. pound lost nearly a quarter of demand as the global reserve currency between just 1899 and 1913 (Chart 11).18 Financial markets move faster today. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 And served him chocolate cake that was this big. 2 Please see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com, and "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Reports, "Political Risks Are Understated In 2018," dated April 12, 2017, and "Geopolitics - From Overstated To Understated Risks," dated November 22, 2017. 4 The Supreme Court is unlikely to counter U.S. executive action undertaken on the grounds of national security. 5 Such as perhaps the ongoing "American carnage"? 6 Please see BCA Geopolitical Strategy Special Reports, "Power And Politics In East Asia: Cold War 2.0?" dated September 25, 2012, and "Sino-American Conflict: More Likely Thank You Think," dated October 4, 2013, available at gps.bcaresearch.com. 7 Please see Douglas A. Irwin, "The Nixon shock after forty years: the import surcharge revisited," World Trade Review 12:01 (January 2013), pp. 29-56, available at www.nber.org, and Berry Eichengreen, "Before the Plaza: The Exchange Rate Stabilization Attempts of 1925, 1933, 1936 and 1971," Behl Working Paper Series 11 (2015). 8 Treasury Secretary John Connally makes Commerce Secretary Wilbur Ross look like a "globalist." Connally was famous for quipping that "foreigners are out to screw us, our job is to screw them first," and "the dollar may be our currency, but it is your problem." 9 Paul Volcker, then Undersecretary of the Treasury, provided some color on this divide: "As I remember it, the discussion largely was a matter of the economists against the politicians, and the outcome wasn't really close." In fact, the decision to impose the surcharge was made at a secret Camp David meeting on August 13, 1971 at a meeting to which officials from the State Department and the National Security Council were not even invited. 10 Paul A. Volcker, "The Political Economy of the Dollar," Federal Reserve Bank of New York Quarterly Review 1-12 (1978-79), quoted in Irwin (2013) (see footnote 7). 11 The sum of U.S. nominal imports by end-use category with steel and aluminum as part of the description was about US$56 billion in 2017, or roughly 0.32% of global goods exports according to the IMF's Direction of Trade statistics. An alternative and more liberal estimate using UNCTAD data and including a broader range of U.S. metals imports ("iron and steel," all "nonferrous metals," and all "manufactures of metal") yields 0.77%, or about $127 billion out of $16.5 trillion worth of total global imports. The former is more likely than the latter. The executive order raising the tariffs has not yet been issued so details are not known. 12 Please see BCA Geopolitical Strategy Special Report, "NAFTA - Populism Vs. Pluto Populism," dated November 17, 2017, available at gps.bcaresearch.com. 13 President Trump, when commenting on the potential U.S. action, has described the coming punishment as "We're talking about big damages. We're talking about numbers that you haven't even thought about." 14 Please see BCA Geopolitical Strategy Weekly Report, "The Trump Doctrine," dated February 1, 2017, available at gps.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Weekly Report, "Politics Are Stimulative, Everywhere But China," dated February 28, 2018, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy and U.S. Equity Strategy Special Report, "How To Profit From De-Globalization," dated December 9, 2016, and "Trump, Day One: Let The Trade War Begin," available at gps.bcaresearch.com. 17 Please see BCA U.S. Equity Strategy Special Report, "Top 10 Reasons We Still Like Banks," dated March 5, 2018, available at uses.bcaresearch.com. 18 Please see Barry Eichengreen, et al, "Mars or Mercury? The Geopolitics of International Currency Choice," dated December 2017, available at nber.org.

Highlights We re-examine our Yield and Protector portfolios to find out which assets will hold up best if there is a material correction. Our tactical view on gold is neutral, but the risk in gold prices will remain skewed to the upside this year. Are tariffs on aluminum and steel the start of a trade spat or a trade war? Feature Fears of a trade war and a hawkish tone from Fed Chair Jay Powell at his first Humphrey Hawkins testimony to Congress pushed the U.S. equity market lower last week. The ten-year Treasury yield barely budged however, buffeted by a more hawkish Fed on one side and a trade-induced slowdown in global growth on the other. The dollar was modestly higher last week, but oil and gold prices moved lower. The S&P 500's 4% loss in February was the worst single month since October 2016 and worst February since 2009. Both investment-grade and high-yield credit spreads widened last week, and have yet to return to their late January lows. Moreover, at 22, the VIX remained elevated relative to start of the year, consistent with our view that markets have entered a more volatile, late-cycle phase. With the 2.8% run-up in the S&P 500 since the February 8 low, investors are less concerned that the early February pullback in risk assets was a signal that the equity bull market is over and a recession is right around the corner. Nonetheless, some clients with a more strategic outlook are considering paring back risk now. Others want to know how to protect gains while still participating in the bullish tone for the market BCA expects in the next 12 months. Our Yield and Protector portfolios might provide a way for investors to protect against the downside while still participating in the S&P 500. Preparing For A Pullback BCA recommends investors stay overweight on equities and U.S. spread product, but expects that positions should be moved to neutral later this year and then to underweight sometime in 2019.1 Long-term investors should already consider paring back their exposures to both asset classes given that valuations are stretched. We have periodically recommended that a variety of investments be added as portfolio "insurance" to help guard against a material correction in equities. We recently highlighted two forms of insurance: our Yield and Protector Portfolios. We introduced the Yield Portfolio in October 20142 and first discussed the Protector Portfolio in October 2015.3 This week, we revisit the issue by comparing both portfolios with a more common form of insurance: shifting from cyclical to defensive stocks within an equity allocation. The Yield Portfolio (YP) emphasizes "high quality carry", along with some protection via TIPS (25% of the Portfolio), if inflation begins to surprise on the upside after investors are conditioned to expect only deflation shocks. The YP performs well in an environment of slow nominal growth, no recession and gradual interest-rate hikes. On the other hand, the Protector Portfolio (PP) is designed to provide insulation against both deflationary (gold and trade-weighted dollar) and inflationary (TIPS) tail risks. Therefore, the PP may underperform risk assets for a time if tail risks keep receding. Still, it has done well during the equity rally and conservative investors should consider adopting it. As discussed in the section below, our tactical view on gold is neutral, but the BCA Commodity & Energy Strategy notes that the risk in gold prices will remain skewed to the upside this year. Charts 1, 2, and 3 show a breakdown of the relative performance of S&P 500 defensives along with our Yield and Protector Portfolios. Panels 2 and 3 of Charts 1, 2 and 3 present the rolling one-year beta and alpha of each strategy versus the S&P 500. Alpha is presented as the difference between the actual year-over-year excess return of the portfolio (versus short-term Treasury bills) and what would have been expected given the portfolio's beta. This measure is also referred to as "Jensen's alpha." Chart 1S&P 500 Defensives##BR##A Modestly Low Beta Option Chart 2A Lower Beta##BR##Than Defensives Chart 3A Beta Near Zero,##BR##And Positive Alpha Based on the historical beta of the three portfolios versus the S&P 500, defensive stocks are the most correlated with the overall equity market. Our PP had a negative correlation to the broad market until earlier this year, when it turned slightly positive. BCA's YP is somewhere in between, with a positive but relatively low beta. This is consistent with the equity composition of the three portfolios (shown in Table 1). Note that our protector portfolio is composed entirely of non-equity assets. Table 1A Breakdown Of Three##BR##Portfolio Insurance Options After accounting for their lower betas, all three portfolios have outperformed the S&P in risk-adjusted terms since the onset of the global economic recovery. However, the three portfolios have experienced a relative decline versus the S&P 500 since Trump's election. This has occurred due to passive rather than active underperformance. In other words, they have underperformed because they failed to keep up with the S&P 500 rather than because of losses in absolute terms. We draw two important conclusions from Charts 1, 2 and 3 for U.S. multi-asset investors. First, the lower beta of our YP and PP compared with S&P defensives means that the former represent a better insurance against a sell-off in the equity market rather than the latter. Secondly, the persistently positive volatility-adjusted returns for our insurance portfolios highlights an investor preference for these assets in the past few years. However, since late 2017 when investors began to significantly upgrade the prospects for global growth and U.S. corporate profits, all three portfolios struggled to outperform the S&P 500 on a risk-adjusted basis. BCA's forecast implies that these portfolios may continue to struggle in the next year or so. For now, our investment bias towards equities over government bonds makes us less inclined to favor a low beta position within a balanced portfolio. Our analysis suggests that clients who anticipate the need for portfolio insurance in the coming year should back our YP and PP over a defensive-sector allocation. We would likely extend this recommendation to all clients if there is any material progression towards the sell-off triggers identified in the Bank Credit Analyst's February 2018 publication.4 Bottom Line: Investors seeking protection against a potential equity market sell-off should look to our Yield and Protector Portfolios over defensive-sector positioning. We do not currently recommend these portfolios for all clients, but we may do so if our key sell-off triggers are breached. Gold Bugged Our tactical view on gold is neutral, but the BCA Commodity & Energy Strategy notes that the risk in gold prices will remain skewed to the upside this year. The yellow metal is supported by increasing inflation and inflation expectations, heightened geopolitical risks and greater volatility in equity markets.5 However, the higher inflation and inflation expectations will be countered by Fed rate hikes, which will boost the U.S. dollar and lift real rates in our base case. Strategically, we expect that gold will provide a good hedge against any downturn in equities when the bull market turns bear in 2H19. Chart 4 shows that the price of gold in real terms is still very expensive. On a nominal basis, gold is at the top end of a trading channel initiated in early 2012 (Chart 5). There has been a significant gap between the model value and the actual price of gold for the past four years. The real price of gold remains elevated, although inflation has been well contained. Chart 4Model Suggests Gold Is Overvalued Chart 5Testing Top End Of A Downward Channel However, the macro environment BCA envisions for 2018 is also supportive for gold (Table 2). Gold tends to perform well when oil prices rise and as the 2/10 Treasury curve steepens. Moreover, gold prices tend to go up when the U.S. economy benefits from fiscal thrust and tax cuts. Furthermore, the soundings on the February ISM manufacturing index support higher gold prices. When the headline index is above 60 as it was in February (60.8), gold climbs by an average of 31%. Even 12 months after ISM is above 60, gold returns are over 20%. The elevated level of ISM new orders (64.2) and price (74.2) indices in February also suggest solid increases for gold. Finally, gold prices climb in the late stages of an economic expansion, such as the current one that began in 2009.6 Even so, our 6 to 12-month view on gold is that it will take its cues from Fed policy and policy expectations. The Fed is not behind the curve on inflation, and inflation expectations and measured inflation remain low. Our CPI and PCE models (Chart 6) show only a modest acceleration in inflation by year-end, which will be sufficient to keep the Fed on track this year as it continues to shrink its balance sheet and boost rates four times. Thus, there is no pressing need to hold gold as a hedge against inflation in the next year. Nonetheless, for those investors too concerned about a pullback that turns into a correction or a bear market, we note that gold has a 33% weight in our Protector Portfolio. Table 2Favorable Macro Backdrop For Gold Chart 6BCA's Inflation Models Show Only##BR##Modest Acceleration Through Year-End Bottom Line: Gold is expensive in real terms relative to a set of fundamentals that have explained its real price since 1970. However, it may have a better value on a strategic basis or as part of a portfolio designed to protect against falling equity prices. Moreover, our macro backdrop forecast for the next 12 months supports higher gold prices. Keep gold as a strategic portfolio hedge. Trade Off BCA's Geopolitical Strategy team has long argued that two sources of geopolitical risk this year are China's trade surplus and Trump's position on trade relations with China, Canada and Mexico. Specifically, the view is that weak poll numbers may lead Trump to trigger trade disputes with important trading partners such as China, Mexico and Canada. However, our geopolitical analysts also point out that investors should not confuse a trade spat with a trade war. There are very few legal or constitutional constraints on Trump over trade issues (Table 3). It will be his decision whether to adopt sweeping tariffs (trade war) as opposed to a more targeted approach (trade spat). Clearly, the former is more disruptive and raises more uncertainty, so this is the key distinction to keep in mind. Presidents Nixon, Reagan, Bush (II) and Obama all imposed temporary tariffs on items (including steel and aluminum, and including by citing national security concerns) without triggering a trade war. Late last week, Trump indicated that he would announce tariffs on steel and aluminum this week. He implied that he would go for a broad-based approach of penalizing all steel and aluminum imports, which points toward the more aggressive approach. But the details (whether he exempts U.S. allies and partners or narrows the scope of goods) will not be certain until he issues his official proclamation. Table 3Trump Faces Few Constraints On Trade Steel and aluminum get the headlines, but account for only a small share of U.S. trade and GDP7 (Chart 7). BCA is more concerned about the Administration's stance on more deeper issues, like the WTO, NAFTA, or (in China's case) intellectual property and state-owned enterprises.8 The issues here are harder to quantify, have few precedents, and have more structural and ideological issues which are at stake. The U.S. has a massive trade surplus in services and in intellectual property,9 so a prolonged disruption would pose a serious threat to the U.S. economy, at least in the short term. Trump's decision on intellectual property trade with China is due on August 12, but could occur earlier. BCA's stance on U.S.-China relations is bearish in the long run.10 We place high odds on an eventual trade war, but the timing is a tougher call. Investors should not view China's proportional retaliation on an item-by-item basis as the start of a trade war. BCA's view is that China's leadership will try to offer reforms and investment opportunities to pacify Trump. However, there is a risk either that China offers no reforms (in which case Xi Jinping's rampant Communism exacerbates trade conflicts) or that Trump may introduce broad sweeping measures that give China no choice but to respond in kind, leading to a trade war. Our Geopolitical Strategy service notes that the probability of Trump abrogating NAFTA is as high as 50%. The seventh round of NAFTA talks concludes this week; an eighth round is scheduled for late March. Negotiations could drag on right to the Mexican election on July 1, but if they are not looking more optimistic by this spring then the risk of the U.S. (or Mexico) walking away will rise. The U.S. economy has been largely unaffected by NAFTA and would likely experience no disruption if Trump abrogated the deal and began negotiations on bilateral trade agreements with Canada and Mexico (Chart 8). Chart 7Steel And Aluminum In Perspective Chart 8U.S. Economy: Largely Unaffected By NAFTA Bottom Line: Elevated trade tensions with China,11 Canada and Mexico are near-term risks to global growth. From now through April could be a decisive time for the Trump Administration with China and NAFTA. We are bearish on U.S.-China relations in the long term. If Trump abandons NAFTA, the implications for the U.S. economy would be muted, although U.S. inflation may push higher. Such a decision would also send a clear signal to other key U.S. allies. However, if Trump stands by NAFTA, then it signals that he has sided with the establishment on trade. This would be bullish for risk assets and would lower geopolitical risk premia. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Research's Global Investment Strategy Weekly Report, "The Next Recession: Later But Deeper," published February 23, 2018. Available at gis.bcaresearch.com. 2 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Ice Storm", published October 20, 2014. Available at usis.bcaresearch.com. 3 Please see BCA Research's U.S. Investment Strategy Weekly Report, "A Tenuous Relief Rally", published on October 12, 2015. Available at usis.bcaresearch.com. 4 Please see BCA Research's Bank Credit Analyst Monthly Report, February 2018. Available at bca.bcaresearch.com. 5 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "Gold Still Shines Despite Threat Of Higher Inflation", published February 1, 2018. Available at ces.bcaresearch.com. 6 Please see BCA Research's U.S. Investment Strategy Weekly Report, "The Late Cycle View", published October 16, 2017. Available at usis.bcaresearch.com. 7 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "Global Aluminum Deficit Set To Ease", published March 1, 2018. Available at ces.bcaresearch.com. 8 Please see BCA Research's Geopolitical Strategy Weekly Report, "America Is Roaring Back", published January 31, 2018. Available at gps.bcaresearch.com. 9 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Can The Service Sector Save The Day?", published June 5, 2017. Available at usis.bcaresearch.com. 10 Please see BCA Research's Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin", published January 18, 2017. Available at gps.bcaresearch.com. 11 Please see BCA Research's Geopolitical Strategy Weekly Report, "Politics Are Stimulative, Everywhere But China", published February 28, 2018. Available at gps.bcaresearch.com.

Highlights China's new exchange rate regime has significantly weakened the link between the U.S. dollar and the broad RMB trend, at the expense of a stronger (negative) relationship between CNY/USD and the dollar. Our metrics to gauge the impact of broad RMB movements on exports suggest that the recent rise is not yet a threat to China's economy. A further 5% depreciation in the U.S. dollar would cause a meaningful further increase, but not one large enough for our metrics to flash a warning sign. Several factors argue against the probability of an August 2015-style CNY/USD devaluation. Even if the PBOC were to do so, global investors would likely react very differently than they did in 2015, given the underlying strength of the global economy. Stay overweight Chinese investable stocks over the cyclical investment horizon, despite a likely dollar-driven retracement in CNY/USD over the coming months. Feature Chart 1A Sharp Rise In CNY/USD The Chinese Renminbi (RMB) has risen over 4% versus the U.S. dollar since mid-December, and global investors have begun to take notice (Chart 1). The sharp acceleration in the RMB has raised several questions in the minds of market participants: What is the likely economic impact of the rise, and how does this fit into the view that China's ongoing growth slowdown is likely to be benign and controlled? How will policymakers respond to the strength in the exchange rate? Is there a risk of a 2015-style depreciation that would roil global financial markets? In this week's report we offer our perspective on these issues, and provide investors with forecasts for the RMB assuming a 5% appreciation or depreciation of the U.S. dollar versus major currencies over the coming 6-12 months. While it is true that the broad RMB trend has risen non-trivially over the past year, we conclude that is too early to view this rise as a threat to the export sector. This supports our view of a benign, controlled economic slowdown in China, as well as a cyclical overweight stance towards Chinese equities. Putting Recent Exchange Rate Movements In Context In order to answer the questions noted above, it is important to examine recent exchange rate movements in the context of China's ongoing efforts to internationalize the RMB, as they have had a substantial impact on the relationship between the RMB and the U.S. dollar over the past few years. Beijing has been taking steps for years to promote the global use of the RMB, but these efforts came into sharp focus on August 11-12, 2015, when the PBOC devalued the currency versus the U.S. dollar (Chart 2). In addition to the devaluation, the PBOC changed the way that the daily fixing rate would be set, in a fashion that increased the sensitivity of the rate to market forces. The PBOC made these changes at the time that they did for two specific reasons: The IMF was in the process of deciding whether to include the RMB in the SDR basket, after having stated that a more market-based RMB rate was a precondition for inclusion. The policy to link the RMB to the U.S. dollar was causing significant appreciation of the former during a period of enormous dollar strength. Given the decision to alter the fixing rate mechanism, the PBOC decided to devalue the exchange rate by a modest amount in one, bundled policy change. The important point for investors is that the market turmoil that followed the August 2015 changes to the exchange rate overshadowed a much more consequential announcement on December 11, 2015 that precipitated a shift in the link between the RMB and the US dollar (USD) towards multiple currencies.1 At first blush, the "decision" made by the PBOC in December was trivial: they announced that the China Foreign Exchange Trade System (CFETS) would publish an index for the RMB measured against a basket of foreign currencies. But the implication of the announcement was that the PBOC was shifting its focus from managing CNY/USD to managing the value of the RMB versus the currencies of many trading partners. Essentially, December 2015 marked the beginning of a new exchange rate policy in China. The effect of this new policy change can clearly be seen in the relationship between CNY/USD and the trade-weighted RMB versus the U.S. dollar (Chart 3). The chart highlights that the beta of J.P. Morgan's nominal trade-weighted RMB versus the Bloomberg U.S. Dollar Spot Index was strongly positive prior to 2016, whereas the beta of CNY/USD to the Dollar Index was weak. Following the PBOC's policy shift, these relationships traded places: the beta between CNY/USD and the dollar became much more negative, whereas the strength of the U.S. dollar / trade-weighted RMB link weakened considerably. Chart 2The August 2015 Deval Significantly##br## Impacted Global Markets Chart 3A New Exchange Rate Regime Began##br## In December 2015 Bottom Line: China's new exchange rate regime has significantly weakened the link between the U.S. dollar and the broad RMB trend, at the expense of a stronger (negative) relationship between CNY/USD and the broad dollar trend. The Economic Implications Of China's New Exchange Rate Policy Chart 4The Recent Rise In CNY/USD ##br##Has Been Dollar-Driven Given our discussion above, the recent strength of the CNY/USD exchange rate should not be surprising: Chart 4 highlights that its sharp rise is largely the mirror image of recent U.S. dollar weakness. Panel 2 illustrates another way of observing this effect; EUR/USD typically trades inversely to the broad dollar trend, and CNY/EUR has been little changed over the past six months. The key questions for investors are 1) how to assess what impact the broad RMB appreciation over the past year will have on Chinese export growth, and 2) what future dollar movements might imply for the broad RMB trend. We use two metrics to gauge the likely impact of broad exchange rate movements on export growth: a fair value assessment (Chart 5), and the rise of an export-weighted RMB index relative to its high and low points over the past few years, when the exchange rate was clearly negatively and positively contributing to monetary conditions (Chart 6). The charts highlight that the real effective RMB is currently cheap, and that a nominal export-weighted index is only marginally above the median value since 2015. Neither of these measures implies that the rise in the RMB has reached levels that would be restrictive for exports. Chart 7 shows that the annual growth rate of our export-weighted RMB index has been predicted quite well by that of the dollar index and the CNY/USD exchange rate over the past two years. Based on this regression, Chart 8 presents what is likely to occur to our export-weighted RMB index in a 5% appreciation & depreciation scenario. The chart shows that the impact of a 5% appreciation (which we expect) will be muted, whereas a 5% depreciation in the dollar would cause a meaningful further rise in the export-weighted RMB. Still, it would not be enough to push the index to a new high, nor would it cause the real effective RMB shown in Chart 5 to rise into expensive territory. Bottom Line: Our metrics to gauge the impact of broad RMB movements on exports suggest that the recent rise is not yet a threat to the export sector. A further 5% depreciation in the U.S. dollar would cause a meaningful further increase, but not one large enough for our metrics to flash a warning sign. Chart 5The RMB Is Cheap In REER Terms Chart 6Rising, But Not Yet Near Previous Highs Chart 7The Dollar and CNY/USD Explain ##br##The Broad RMB Trend Chart 8Further Dollar Depreciation Would Bite, ##br##But Not Disastrously So August 2015, Redux? Given that the PBOC's devaluation of the RMB in August 2015 roiled global financial markets, it seems natural to ask whether the Chinese central bank could cause another shock by again depreciating the CNY/USD exchange rate. In our view, the answer is no. First, there are several reasons why the PBOC is unlikely to intervene to limit a rise in CNY/USD barring material further strength: Trade frictions with the U.S. remain, and a stronger CNY/USD could reduce the likelihood that the Trump administration will levy across-the-board tariffs on Chinese imports The PBOC recently reduced the influence of the "counter-cyclical factor" that was included in the CNY/USD midpoint formula. Since the factor was introduced to lessen the impact of market forces on the yuan's reference rate, the PBOC would likely have refrained from making any changes to it if they were unduly worried about the upward impact of recent dollar declines on CNY/USD If the PBOC becomes uncomfortable with the extent of the RMB rise in trade or export-weighted terms, it could aim to lower the yuan versus other key trading partners, including the euro area. As noted above, CNY/EUR has recently remained flat during the euro's sharp recent upleg versus the dollar. We noted that the RMB is now cheap in real effective terms (Chart 5), unlike in August 2015 when the deviation from fair value was the highest that it had been since mid-2000. Chart 92015 Vs Today: A Completely Different ##br##Global Economic Backdrop Second, even if the PBOC were to depreciate the CNY/USD exchange rate over the coming months, we doubt that investors would react in the same way as they did to the initial devaluation. As we reviewed in a Weekly Report last October,2 the global economy was suffering from a synchronized slowdown, and the surprise decision caused global investors to speculate heavily that additional devaluations were likely. The current condition of the global economy is clearly quite different than that which prevailed in the summer of 2015. Global PMIs are the most synchronized that they have been since the earliest phase of the economic cycle (Chart 9), which suggests that a significant slowdown is not imminent. Even if the pace of growth becomes narrower or slows modestly, it is difficult to envision the same kind of panicked response absent a separate and highly impactful accompanying shock. Bottom Line: Several factors argue against the probability of an August 2015-style CNY/USD devaluation. Even if the PBOC were to do so, global investors would likely react very differently than they did in 2015, given the underlying strength of the global economy. Investment Strategy Implications Chart 10Export Impact Of The RMB Appreciation##br## Is Non-Trivial, But Manageable Over a 6-12 month time horizon, there are two investment strategy implications of our above discussion. First, our analysis suggests that investors should focus on the broad RMB trend rather than the CNY/USD exchange rate when determining the likely impact of currency fluctuations on China's growth picture. It is true that an export-weighted RMB index has risen by a greater amount over the past year than a typical trade-weighted RMB (or the CFETS RMB index) would suggest (Chart 10), but for now it is too early to conclude that this represents a threat to the export sector. This conclusion is consistent with our view that China's ongoing economic slowdown will be benign, and controlled in nature. Second, given the tight (negative) link between CNY/USD and the U.S. dollar, and our view that USD is more likely to appreciate than depreciate over the coming months, it is true that the US$ relative performance of Chinese equities may be somewhat negatively impacted by a retracement in CNY/USD. But as we noted when presenting our "decision tree" for Chinese stocks at the beginning of the year,3 the cyclical condition of China's business cycle is the dominant factor that investors should consider when judging the appropriate allocation to Chinese equities. As such, our focus on China's exchange rate remains on how it impacts the growth outlook, and our judgement on this question continues to support a favorable stance towards the equity market. Bottom Line: Stay overweight Chinese investable stocks over the cyclical investment horizon, despite a likely dollar-driven retracement in CNY/USD over the coming months. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 http://www.pbc.gov.cn/english/130721/2988680/index.html 2 Please see China Investment Strategy Weekly Report, "China's Economy - 2015 Vs Today (Part I): Trade", dated October 26, 2017, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Weekly Report, "The Decision Tree For Chinese Stocks", dated January 4, 2018, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations