大中華

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Highlights Slower nominal GDP growth explains virtually all of the increase in China's debt-to-GDP ratio over the past ten years. The authorities were unwilling to restrain debt growth as it became obvious that nominal income was decelerating because this would have only exacerbated the economic downturn. Excess private-sector savings forced the Chinese government to rely on debt-financed investment by state-owned companies (SOE) and local governments in order to keep aggregate demand elevated. Financial deregulation also encouraged debt accumulation. Debt growth linked to speculative activity can be curbed without endangering the economy, but a lasting solution to the surplus savings problem will require consumers to spend more. This will take a while. At some point over the next few years, the central government will transfer a large fraction of SOE and local government debt onto its own balance sheet. The risk to investors is that this "debt nationalization" happens reactively rather than proactively. Feature If there are too many pro-cyclical factors in the economy, cyclical fluctuations are magnified and there is excessive optimism during the period, accumulating contradictions that could lead to the so-called Minsky Moment. - Zhou Xiaochuan, Former Governor of the People's Bank of China, October 19, 2017 The Calm Before The Storm? Stability begets instability. That is the nature of business cycles, Hyman Minsky famously argued. Rising confidence leads to excessive risk-taking, higher asset prices, and mounting economic imbalances. Eventually the mood sours. Like Wile E. Coyote running off a cliff, investors look down and see that there is nothing but thin air between them and the ground below. Panic ensues. Is China on the verge of its own Minsky Moment? A glance at the evolution of its debt-to-GDP ratio would certainly say so. But before running towards the exit door, consider the following: People have been fretting about spiraling Japanese government debt levels for over twenty years now. And yet, interest rates remain at rock-bottom levels in Japan. China's Savings Glut In many respects, China finds itself facing similar problems to those that have haunted Japan. The simultaneous bust in equity and real estate prices in 1990 sent Japan's private sector into a prolonged deleveraging cycle (Chart 1). In order to prop up demand, the Japanese government was forced to run large budget deficits. In effect, the government had to absorb the excess savings of the private sector with its own dissavings. The abundance of domestic private-sector savings forestalled a financial crisis, but it also led to today's gross government debt-to-GDP ratio of 240%. Like Japan, China suffers from a dearth of spending, or equivalently, an abundance of savings. The IMF estimates that Chinese gross national savings reached 46% of GDP in 2017. While this is down from a peak of 52% of GDP in 2008, it is still abnormally high for any major economy, even by emerging market standards (Chart 2). Chart 1 Japan Relied On Large Fiscal Deficits And Current Account Surpluses To Offset The Rise In Private-Sector Savings Chart 2China's Savings Rate Stands Out Even By EM Standards By definition, whatever a country saves must either be invested domestically or channeled abroad via a current account surplus. China's savings rate has edged lower over the past ten years, but its current account surplus has dropped even more, falling from nearly 10% of GDP in 2007 to 1.4% of GDP at present. As a result, investment as a share of GDP has actually risen to 44%, a three-point increase since 2007 (Chart 3). The decline in China's current account surplus was inevitable (Chart 4). In 2007, China accounted for 6% of global GDP in dollar terms. Today it accounts for 15%. Having a massively undervalued currency, as China had in 2007, is just not politically tenable anymore, especially with Donald Trump in the White House. Simply put, China has become too big to continue exporting its way out of its problems. Chart 3Since The Great Financial Crisis, Chinese Savings Have Been Channeled Into Domestic Investment, Not Funneled Abroad Chart 4Undervalued Currency And Massive Current Account Surplus: Modus Operandi Of The Past Debt As The Conduit Between Savings And Investment How does a country transform savings into investment? In an economy like China where the stock market at times appears to be little more than a casino, the answer is that credit markets must play the dominant role. Households or firms with surplus savings park their funds in banks or other financial institutions. These institutions channel the savings to willing borrowers. Debt ends up being the natural byproduct of surplus savings. China is still a relatively poor country with a lot of catch-up potential. Capital-per-worker is a fraction of what it is among advanced economies (Chart 5). Even with its bleak demographics, China would need to grow by around 6% per year over the next few years just to converge with South Korea in output-per-worker by 2050 (Chart 6). All this means that China needs to invest more than most other economies, which is only possible if it saves more than other economies. Chart 5China Has More Catching Up To Do (1) Chart 6China Has More Catching Up To Do (2) Unfortunately, one can have too much of a good thing. The fact that China's capital stock-to-output ratio has risen dramatically in recent years means that the economy is already investing too much. And the optimal amount of investment will only fall over time as potential GDP growth continues to decelerate. Unless savings come down, China will find itself increasingly awash in excess capacity. Chart 7If Only GDP Growth Did Not ##br## Decelerate Over The Past Ten Years Slower trend growth will also make deleveraging more difficult to achieve. The overall stock of nonfinancial debt grew at an annualized rate of 18.8% between 2008 and 2017. Notably, this growth rate was not much higher than the one of 16.5% between 2003 and 2007 - a period when the debt-to-GDP ratio was broadly stable. The main difference between the two periods lies in the denominator of the debt-to-GDP ratio, not in the numerator: Nominal GDP expanded at an annualized rate of 11.2% between 2008 and 2017, a sizable retreat from the pace of 18.4% between 2003 and 2007. Chart 7 shows that the debt-to-GDP ratio today would be virtually identical to its end-2007 level had nominal GDP continued to grow at its 2003-2007 pace over the past ten years. Financial Deregulation Has Exacerbated The Debt Problem The Chinese government's reluctance to crack down on credit growth was motivated by the desire to support aggregate demand. However, in turning a blind eye to what was happening in credit markets, a lot of debt was generated that was not directly tied to the intermediation of savings into investment. Chart 8Debt And Capital Accumulation Went Hand In Hand Debt can be created when someone borrows money to finance the purchase of goods or services. Debt can also be created when someone borrows money to finance the purchase of pre-existing assets. Crucially, while the former typically requires additional "savings" (i.e., someone needs to reduce their spending relative to their income), the latter does not.1 Granted, savings can still play an indirect role in facilitating debt-financed asset purchases. Financial assets are typically backed by something of value. A mortgage is backed by a piece of property. A corporate bond is backed by both the tangible and intangible capital that a firm possesses. The more a country has been able to save over time, the larger its capital stock will be. China, of course, has been saving like crazy for years. It is thus no surprise that its debt-to-GDP ratio has soared as its capital stock has expanded (Chart 8). Financial deregulation in China has allowed a large share of its capital stock to repeatedly shift hands. Debt has often been created in the process. The problem is that debt-financed asset purchases drive up asset prices, sometimes to unsustainable levels. And the higher the price of the asset, the greater the risk that it will not yield enough income to cover the borrowing costs. When asset prices are rising, borrowers and lenders are apt to disregard this risk, figuring that they can always sell the asset at a high enough price to pay back the loan. But once prices start falling, reality sets in very quickly. Stability begets instability. Consumers Need To Step Up The authorities are keenly aware of the risks discussed above. This is the key reason why they are clamping down on the shadow banking system, which has increasingly become the main source of speculative lending in China. We expect the pressure on shadow banks to persist in 2018. This will continue to weigh on credit growth. The more vexing challenge is how to reduce excessive household savings. The government's current strategy of cramming down the capital stock by taking out excess capacity from sectors such as steel, coal, and solar may be better than nothing, but it still pales in comparison to a strategy of encouraging consumer spending. Higher consumer spending would obviate the need for state-owned companies and local governments to keep people employed in make-work projects. The good news is that there are plenty of ways that China can boost household consumption. Government spending on education, health care, and pensions as a share of GDP is close to half of the OECD average (Chart 9). Increasing social transfer payments would give households the wherewithal to spend more. Unlike in most countries, the poor in China are net savers (Chart 10). Expanding the social safety net would discourage precautionary savings. Chart 9Chinese Social Welfare Spending ##br##Is Lagging The OECD Average Chart 10Low Income Households Are Net ##br##Savers In China The Chinese income tax structure is fairly regressive. Poor households face an effective income tax rate exceeding 40%. This is well above OECD norms (Chart 11).2 A more progressive tax system would boost spending among poorer households. It would also curb inequality, which has increased sharply over the past few decades (Chart 12). The saving rate among the richest 10% of Chinese earners is close to 50%. Policies that shift income from the rich to the poor would reduce overall household savings. Chart 11High Tax Burden For ##br##Low Income Households In China Chart 12Shifting Income To Poorer Households Would Reduce ##br##China's Household Savings Rate Debt Nationalization Is Inevitable Chart 13Ratio Of Workers-To-Consumers Is Peaking,##br## And China Is No Exception Realistically, reforms aimed at encouraging consumption will take a while to implement. In the meantime, debt levels are likely to keep rising. Much of China's debt burden remains on the books of state-owned companies and local governments. At some point over the next few years, the central government will transfer a large fraction of this debt onto its own balance sheet. This would ease concerns about a mass wave of defaults. The key question for investors is whether this de facto "debt nationalization" is done proactively or reactively in response to a crisis. If the latter occurs, investors should steer clear of Chinese assets, as well as China-related plays such as commodities and commodity currencies. If the former pans out, global risk assets could rally. While the truth will fall somewhere between those two extremes, our bet is that the proactive view will prove closer to the mark, at least relative to market expectations (keep in mind that Chinese banks are trading below book value, so a lot of bad news has already been priced in). The Chinese authorities talk a lot about the importance of reducing moral hazard, but in practice, they have shown very little tolerance for defaults. Just as they did in the early 2000s, government leaders could commission state-owned asset management companies to purchase distressed debt from banks and other lenders at inflated prices. Chinese financials, which are nearly 70% of the H-share index, will benefit. Will investors balk at the prospect of the Chinese government blowing out the budget deficit in order to rescue insolvent borrowers? There might be some short-term panic, but as has been the case with Japan, as long as there are plenty of excess domestic savings to go around, the risk of a debt crisis will remain minimal. Indeed, the issuance of more government debt would help alleviate what has become a critical problem for Chinese savers: The lack of safe, liquid domestic assets available for purchase. What is true, from a longer-term perspective, is that the combination of higher debt and slower growth will eventually create a strong incentive for the Chinese government to inflate away debt. As in many other countries, China's "support ratio" -- broadly defined as the ratio of workers-to-consumers -- has peaked (Chart 13). As the growth of output and income falls behind consumption growth, China's savings glut will become a thing of the past. Rather than raising rates, the PBOC will just let the economy overheat. Such a day of reckoning is probably still at least five years away, but eventually inflation will return to China. Concluding Thoughts On The Current Market Environment A true "Minsky moment" in China - one where the financial sector seizes up due to spiraling fears of bankruptcies and defaults - is not in the cards. Nevertheless, China's economy is slowing, and growth is likely to decelerate further over the next few quarters as the authorities restrain credit growth and the property market continues to cool. The slowdown in Chinese growth is occurring at the same time as the economic data has been deteriorating around the world. The equity component of our MacroQuant model - which is highly sensitive to changes in the direction of growth - has been in bearish territory for two straight months (Chart 14). Our base case remains that global growth will stabilize over the next few months at an above-trend pace. Global bond yields are still near record-low levels and fiscal policy is moving in a more stimulative direction (Chart 15). It would be odd for the global economy to deteriorate sharply in such an environment. Chart 14MacroQuant Model Suggests Caution Is Warranted Trade protectionism is an obvious risk to this sanguine cyclical view. BCA has long argued that globalization is under threat from the combination of rising populism and the end of America's role as the world's sole superpower. However, the retreat from globalization will occur in fits and starts. Just as investors were overly complacent about protectionism a few months ago, they have become overly alarmist now. Both the U.S. and China have a strong incentive to reach a mutually-satisfying agreement over trade. President Trump has been able to shrug off the decline in equities because his approval rating has actually risen during the selloff (Chart 16). However, if the problems on Wall Street begin to show up on Main Street - as is likely to happen if stocks continue to fall - Trump will change his tune. Chart 15Global Economy Buttressed By ##br##Accommodative Fiscal And Monetary Policy Chart 16Trump's Approval Rating Has ##br##Actually Risen During Equity Selloff For its part, the Chinese government is also looking to strike a deal. The U.S. exported only $131 billion in goods to China last year. This is already less than the $150 billion in Chinese goods that Trump has targeted for tariffs. China simply cannot win a tit-for-tat trade war with the United States. Bottom Line: The near-term picture for global equities and other risk assets is murky, but the 12-month cyclical outlook is still reasonably upbeat. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 For instance, if someone buys stock on margin or takes out a second mortgage on their house, new debt is created without anyone having to cut back on spending. In the context of China, imagine a financial institution which funds the purchase of a building by issuing a certificate of deposit or by selling a "wealth management" product. Both the asset and liability side of the financial institution's balance sheet go up (i.e., new debt is created). Suppose further that the company that sold the building puts the proceeds into a certificate of deposit or wealth management product. The entire transaction is self-financing. The example above illustrates that debt can go up in some situations even if everyone's spending habits remain the same. The need to intermediate savings is one source of debt growth, but it does not have to be the only one. 2 Please see "People's Republic Of China: Selected Issues," IMF Country Report, dated August 15, 2017.

特別レポート

Highlights Slower nominal GDP growth explains virtually all of the increase in China's debt-to-GDP ratio over the past ten years. The authorities were unwilling to restrain debt growth as it became obvious that nominal income was decelerating because this would have only exacerbated the economic downturn. Excess private-sector savings forced the Chinese government to rely on debt-financed investment by state-owned companies (SOE) and local governments in order to keep aggregate demand elevated. Financial deregulation also encouraged debt accumulation. Debt growth linked to speculative activity can be curbed without endangering the economy, but a lasting solution to the surplus savings problem will require consumers to spend more. This will take a while. At some point over the next few years, the central government will transfer a large fraction of SOE and local government debt onto its own balance sheet. The risk to investors is that this "debt nationalization" happens reactively rather than proactively. Feature If there are too many pro-cyclical factors in the economy, cyclical fluctuations are magnified and there is excessive optimism during the period, accumulating contradictions that could lead to the so-called Minsky Moment. - Zhou Xiaochuan, Former Governor of the People's Bank of China, October 19, 2017 The Calm Before The Storm? Stability begets instability. That is the nature of business cycles, Hyman Minsky famously argued. Rising confidence leads to excessive risk-taking, higher asset prices, and mounting economic imbalances. Eventually the mood sours. Like Wile E. Coyote running off a cliff, investors look down and see that there is nothing but thin air between them and the ground below. Panic ensues. Is China on the verge of its own Minsky Moment? A glance at the evolution of its debt-to-GDP ratio would certainly say so. But before running towards the exit door, consider the following: People have been fretting about spiraling Japanese government debt levels for over twenty years now. And yet, interest rates remain at rock-bottom levels in Japan. China's Savings Glut In many respects, China finds itself facing similar problems to those that have haunted Japan. The simultaneous bust in equity and real estate prices in 1990 sent Japan's private sector into a prolonged deleveraging cycle (Chart 1). In order to prop up demand, the Japanese government was forced to run large budget deficits. In effect, the government had to absorb the excess savings of the private sector with its own dissavings. The abundance of domestic private-sector savings forestalled a financial crisis, but it also led to today's gross government debt-to-GDP ratio of 240%. Like Japan, China suffers from a dearth of spending, or equivalently, an abundance of savings. The IMF estimates that Chinese gross national savings reached 46% of GDP in 2017. While this is down from a peak of 52% of GDP in 2008, it is still abnormally high for any major economy, even by emerging market standards (Chart 2). Chart 1 Japan Relied On Large Fiscal Deficits And Current Account Surpluses To Offset The Rise In Private-Sector Savings Chart 2China's Savings Rate Stands Out Even By EM Standards By definition, whatever a country saves must either be invested domestically or channeled abroad via a current account surplus. China's savings rate has edged lower over the past ten years, but its current account surplus has dropped even more, falling from nearly 10% of GDP in 2007 to 1.4% of GDP at present. As a result, investment as a share of GDP has actually risen to 44%, a three-point increase since 2007 (Chart 3). The decline in China's current account surplus was inevitable (Chart 4). In 2007, China accounted for 6% of global GDP in dollar terms. Today it accounts for 15%. Having a massively undervalued currency, as China had in 2007, is just not politically tenable anymore, especially with Donald Trump in the White House. Simply put, China has become too big to continue exporting its way out of its problems. Chart 3Since The Great Financial Crisis, Chinese Savings Have Been Channeled Into Domestic Investment, Not Funneled Abroad Chart 4Undervalued Currency And Massive Current Account Surplus: Modus Operandi Of The Past Debt As The Conduit Between Savings And Investment How does a country transform savings into investment? In an economy like China where the stock market at times appears to be little more than a casino, the answer is that credit markets must play the dominant role. Households or firms with surplus savings park their funds in banks or other financial institutions. These institutions channel the savings to willing borrowers. Debt ends up being the natural byproduct of surplus savings. China is still a relatively poor country with a lot of catch-up potential. Capital-per-worker is a fraction of what it is among advanced economies (Chart 5). Even with its bleak demographics, China would need to grow by around 6% per year over the next few years just to converge with South Korea in output-per-worker by 2050 (Chart 6). All this means that China needs to invest more than most other economies, which is only possible if it saves more than other economies. Chart 5China Has More Catching Up To Do (1) Chart 6China Has More Catching Up To Do (2) Unfortunately, one can have too much of a good thing. The fact that China's capital stock-to-output ratio has risen dramatically in recent years means that the economy is already investing too much. And the optimal amount of investment will only fall over time as potential GDP growth continues to decelerate. Unless savings come down, China will find itself increasingly awash in excess capacity. Chart 7If Only GDP Growth Did Not ##br## Decelerate Over The Past Ten Years Slower trend growth will also make deleveraging more difficult to achieve. The overall stock of nonfinancial debt grew at an annualized rate of 18.8% between 2008 and 2017. Notably, this growth rate was not much higher than the one of 16.5% between 2003 and 2007 - a period when the debt-to-GDP ratio was broadly stable. The main difference between the two periods lies in the denominator of the debt-to-GDP ratio, not in the numerator: Nominal GDP expanded at an annualized rate of 11.2% between 2008 and 2017, a sizable retreat from the pace of 18.4% between 2003 and 2007. Chart 7 shows that the debt-to-GDP ratio today would be virtually identical to its end-2007 level had nominal GDP continued to grow at its 2003-2007 pace over the past ten years. Financial Deregulation Has Exacerbated The Debt Problem The Chinese government's reluctance to crack down on credit growth was motivated by the desire to support aggregate demand. However, in turning a blind eye to what was happening in credit markets, a lot of debt was generated that was not directly tied to the intermediation of savings into investment. Chart 8Debt And Capital Accumulation Went Hand In Hand Debt can be created when someone borrows money to finance the purchase of goods or services. Debt can also be created when someone borrows money to finance the purchase of pre-existing assets. Crucially, while the former typically requires additional "savings" (i.e., someone needs to reduce their spending relative to their income), the latter does not.1 Granted, savings can still play an indirect role in facilitating debt-financed asset purchases. Financial assets are typically backed by something of value. A mortgage is backed by a piece of property. A corporate bond is backed by both the tangible and intangible capital that a firm possesses. The more a country has been able to save over time, the larger its capital stock will be. China, of course, has been saving like crazy for years. It is thus no surprise that its debt-to-GDP ratio has soared as its capital stock has expanded (Chart 8). Financial deregulation in China has allowed a large share of its capital stock to repeatedly shift hands. Debt has often been created in the process. The problem is that debt-financed asset purchases drive up asset prices, sometimes to unsustainable levels. And the higher the price of the asset, the greater the risk that it will not yield enough income to cover the borrowing costs. When asset prices are rising, borrowers and lenders are apt to disregard this risk, figuring that they can always sell the asset at a high enough price to pay back the loan. But once prices start falling, reality sets in very quickly. Stability begets instability. Consumers Need To Step Up The authorities are keenly aware of the risks discussed above. This is the key reason why they are clamping down on the shadow banking system, which has increasingly become the main source of speculative lending in China. We expect the pressure on shadow banks to persist in 2018. This will continue to weigh on credit growth. The more vexing challenge is how to reduce excessive household savings. The government's current strategy of cramming down the capital stock by taking out excess capacity from sectors such as steel, coal, and solar may be better than nothing, but it still pales in comparison to a strategy of encouraging consumer spending. Higher consumer spending would obviate the need for state-owned companies and local governments to keep people employed in make-work projects. The good news is that there are plenty of ways that China can boost household consumption. Government spending on education, health care, and pensions as a share of GDP is close to half of the OECD average (Chart 9). Increasing social transfer payments would give households the wherewithal to spend more. Unlike in most countries, the poor in China are net savers (Chart 10). Expanding the social safety net would discourage precautionary savings. Chart 9Chinese Social Welfare Spending ##br##Is Lagging The OECD Average Chart 10Low Income Households Are Net ##br##Savers In China The Chinese income tax structure is fairly regressive. Poor households face an effective income tax rate exceeding 40%. This is well above OECD norms (Chart 11).2 A more progressive tax system would boost spending among poorer households. It would also curb inequality, which has increased sharply over the past few decades (Chart 12). The saving rate among the richest 10% of Chinese earners is close to 50%. Policies that shift income from the rich to the poor would reduce overall household savings. Chart 11High Tax Burden For ##br##Low Income Households In China Chart 12Shifting Income To Poorer Households Would Reduce ##br##China's Household Savings Rate Debt Nationalization Is Inevitable Chart 13Ratio Of Workers-To-Consumers Is Peaking,##br## And China Is No Exception Realistically, reforms aimed at encouraging consumption will take a while to implement. In the meantime, debt levels are likely to keep rising. Much of China's debt burden remains on the books of state-owned companies and local governments. At some point over the next few years, the central government will transfer a large fraction of this debt onto its own balance sheet. This would ease concerns about a mass wave of defaults. The key question for investors is whether this de facto "debt nationalization" is done proactively or reactively in response to a crisis. If the latter occurs, investors should steer clear of Chinese assets, as well as China-related plays such as commodities and commodity currencies. If the former pans out, global risk assets could rally. While the truth will fall somewhere between those two extremes, our bet is that the proactive view will prove closer to the mark, at least relative to market expectations (keep in mind that Chinese banks are trading below book value, so a lot of bad news has already been priced in). The Chinese authorities talk a lot about the importance of reducing moral hazard, but in practice, they have shown very little tolerance for defaults. Just as they did in the early 2000s, government leaders could commission state-owned asset management companies to purchase distressed debt from banks and other lenders at inflated prices. Chinese financials, which are nearly 70% of the H-share index, will benefit. Will investors balk at the prospect of the Chinese government blowing out the budget deficit in order to rescue insolvent borrowers? There might be some short-term panic, but as has been the case with Japan, as long as there are plenty of excess domestic savings to go around, the risk of a debt crisis will remain minimal. Indeed, the issuance of more government debt would help alleviate what has become a critical problem for Chinese savers: The lack of safe, liquid domestic assets available for purchase. What is true, from a longer-term perspective, is that the combination of higher debt and slower growth will eventually create a strong incentive for the Chinese government to inflate away debt. As in many other countries, China's "support ratio" -- broadly defined as the ratio of workers-to-consumers -- has peaked (Chart 13). As the growth of output and income falls behind consumption growth, China's savings glut will become a thing of the past. Rather than raising rates, the PBOC will just let the economy overheat. Such a day of reckoning is probably still at least five years away, but eventually inflation will return to China. Concluding Thoughts On The Current Market Environment A true "Minsky moment" in China - one where the financial sector seizes up due to spiraling fears of bankruptcies and defaults - is not in the cards. Nevertheless, China's economy is slowing, and growth is likely to decelerate further over the next few quarters as the authorities restrain credit growth and the property market continues to cool. The slowdown in Chinese growth is occurring at the same time as the economic data has been deteriorating around the world. The equity component of our MacroQuant model - which is highly sensitive to changes in the direction of growth - has been in bearish territory for two straight months (Chart 14). Our base case remains that global growth will stabilize over the next few months at an above-trend pace. Global bond yields are still near record-low levels and fiscal policy is moving in a more stimulative direction (Chart 15). It would be odd for the global economy to deteriorate sharply in such an environment. Chart 14MacroQuant Model Suggests Caution Is Warranted Trade protectionism is an obvious risk to this sanguine cyclical view. BCA has long argued that globalization is under threat from the combination of rising populism and the end of America's role as the world's sole superpower. However, the retreat from globalization will occur in fits and starts. Just as investors were overly complacent about protectionism a few months ago, they have become overly alarmist now. Both the U.S. and China have a strong incentive to reach a mutually-satisfying agreement over trade. President Trump has been able to shrug off the decline in equities because his approval rating has actually risen during the selloff (Chart 16). However, if the problems on Wall Street begin to show up on Main Street - as is likely to happen if stocks continue to fall - Trump will change his tune. Chart 15Global Economy Buttressed By ##br##Accommodative Fiscal And Monetary Policy Chart 16Trump's Approval Rating Has ##br##Actually Risen During Equity Selloff For its part, the Chinese government is also looking to strike a deal. The U.S. exported only $131 billion in goods to China last year. This is already less than the $150 billion in Chinese goods that Trump has targeted for tariffs. China simply cannot win a tit-for-tat trade war with the United States. Bottom Line: The near-term picture for global equities and other risk assets is murky, but the 12-month cyclical outlook is still reasonably upbeat. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 For instance, if someone buys stock on margin or takes out a second mortgage on their house, new debt is created without anyone having to cut back on spending. In the context of China, imagine a financial institution which funds the purchase of a building by issuing a certificate of deposit or by selling a "wealth management" product. Both the asset and liability side of the financial institution's balance sheet go up (i.e., new debt is created). Suppose further that the company that sold the building puts the proceeds into a certificate of deposit or wealth management product. The entire transaction is self-financing. The example above illustrates that debt can go up in some situations even if everyone's spending habits remain the same. The need to intermediate savings is one source of debt growth, but it does not have to be the only one. 2 Please see "People's Republic Of China: Selected Issues," IMF Country Report, dated August 15, 2017. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Apart from rising geopolitical tensions, our main macro themes remain a growth slowdown in China and a rise in U.S. core inflation. This combination bodes ill for EM financial markets. Continue underweighting EM stocks, credit and currencies versus their DM peers. Subsiding NAFTA risks argue for overweighting Mexican stocks within an EM equity portfolio. This is in line with our recent upgrade of Mexican local and U.S. dollar sovereign bonds as well as the peso's outlook versus their EM peers. A new trade: Fixed-income trades should bet on yield curve steepening in Mexico by paying 10-year swap rates and receiving 2-year rates. Close overweight Russian markets positions in the wake of escalating U.S. sanctions. Feature Before discussing Mexico and Russia, we offer an update on our thoughts on the overall market outlook. EM: Looking Under The Hood Investor sentiment remains buoyant on global risk assets, and the buy-on-dips mentality remains well entrenched. On the surface, investors are not finding enough reasons to turn negative on global or EM risk markets. Nevertheless, when looking under the EM hood, we see several leading and coincident indicators that are beginning to flash red. Not only do geopolitics and the U.S.-China trade confrontation pose downside risks, there are also several macro developments that are turning from tailwinds to headwinds for EM risk assets. Specifically: EM manufacturing and Asian trade cycles have probably topped out. The relative total return (carry included) of three equally weighted EM1 (ZAR, BRL and CLP) and three DM (AUD, NZD and CAD) commodities currencies versus an equally weighted average of two safe-haven currencies - the Japanese yen and Swiss franc - has relapsed since early this year, coinciding with the rollover in the EM manufacturing PMI index (Chart I-1). This currency ratio is herein referred to as the risk-on/safe-haven currency ratio. Chart I-1Risk On / Safe-Haven Currency Ratio And EM Manufacturing PMI The risk-on/safe-haven currency ratio also correlates with the average of new and backlog orders components of China's manufacturing PMI (Chart I-2). The latter does not herald an upturn in this currency ratio at the moment. Share prices of global machinery, chemicals and mining companies have so far underperformed the overall global equity index in this selloff, as exhibited in Chart I-3. Chart I-2China's Industrial Cycle Has Rolled Over Chart I-3Global Cyclicals Have Underperformed, Though Not Tech Potential trade wars, the setback in technology stocks and a resurgence of volatility in global equity markets have recently dominated news headlines. Yet, the underperformance of China-exposed global sectors and sub-sectors signifies that beneath the surface Chinese growth is weakening. Meanwhile, global tech stocks have not yet underperformed much (Chart I-3, bottom panel), implying the selloff has not been driven by this high-flying sector. The combination of weakening global trade amid still-robust U.S. domestic demand bodes well for the U.S. dollar, at least against EM and commodities currencies. U.S. and EU imports account for only 13% and 11% of global trade, respectively (Chart I-4). Meanwhile, aggregate EM including Chinese imports account for 30% of world imports. Hence, global trade can slow even with U.S. and EU domestic demand remaining robust. We addressed the twin deficit issue in the U.S. in our February 21 report,2 and will add the following: If U.S. fiscal stimulus coincides with abundant global growth, the greenback will weaken. If on the contrary, the U.S. fiscal expansion overlaps with weakening global trade, U.S. growth will be priced at a premium and the U.S. dollar will appreciate especially against the currencies of economies where growth will fall short. The majority of EM exchange rates will likely be in the latter group. The relative performance of EM versus DM stocks correlates with the relative volume of imports between China and the DM (Chart I-5). The rationale is that EM countries and their publically listed companies are much more leveraged to China's business cycle than DM. The opposite is true for DM-listed companies. Our view is that China's industrial recovery and growth outperformance versus DM since early 2016 is about to end. This, if realized, should undermine EM equities and currencies versus their DM counterparts. Last week, we published a Special Report on the Chinese real estate market.3 We documented that despite a drawdown in housing inventories over the past two years, both residential and non-residential inventories remain very elevated. This, along with poor affordability and the implementation housing purchase restrictions for investors, will dampen housing sales, which in turn will lead to a contraction in property development and construction activity. Chart I-4Global Trade Is More Leveraged To EM Not DM Chart I-5EM Underperforms When Chinese Imports Lag DM Ones Combined with a slowdown in infrastructure investment due to tighter controls on local government finances, this poses downside risks to China's demand for commodities, materials and industrial goods. This is the main risk to EM stocks and currencies, and the primary reason we continue to maintain our negative stance on EM risk assets. Last but not least, it is widely believed that Chinese households are not indebted and that there is a lot of pent-up demand for household credit. Chart I-6 reveals that this conjecture is simply not true - the household debt-to-disposable income ratio has surged to 110% of disposable income in China. The same ratio is currently 107% in the U.S. Given borrowing costs in general and mortgage rates in particular are higher in China than in the U.S. (the mortgage rate is 5.2% in China versus 4.4% in the U.S.), interest payments on debt account for a larger share of households' disposable income in China than in America right now. In the U.S., the surprise on the macro front in the coming months will likely be both rising wage growth and core inflation. Chart I-7 highlights that average hourly earnings in manufacturing and construction have been accelerating. This underscores that wages are rising fast in these cyclical sectors. This will spread to other sectors sooner rather than later. Core inflation in America is rising and has already moved above 2% (Chart I-8). The rise is broad-based as all different core consumer price measures are rising and heading toward 2%. Chart I-6Chinese Households Are As Leveraged As Americans Chart I-7U.S. Wages Are Accelerating Chart I-8U.S. Core Inflation Is Above 2% While this does not entail that the U.S. is heading into runaway inflation, rising core inflation and wage growth will likely lead many investors to believe that the Federal Reserve cannot back off too fast from rate hikes, particularly when the U.S. fiscal thrust remains so positive, even if the drawdown in share prices persist. This may especially weigh on EM risk assets, where growth will be subsiding due to their links with Chinese imports. Bottom Line: Our main macro themes remain a slowdown in China and a rise in U.S. core inflation. This combination bodes ill for EM financial markets. Continue underweighting EM stocks, credit and currencies versus their DM peers. Upgrade Mexican Equities To Overweight In our March 29 report,4 we upgraded our stance on the Mexican peso, local currency bonds and U.S. dollar sovereign credit from neutral to overweight. The main rationale was receding odds of NAFTA abrogation and the country's healthy macro fundamentals. In addition, we instituted a new currency trade: long MXN / short BRL and ZAR. Continuing with this theme, we today recommend upgrading Mexican stocks to overweight within an EM equity portfolio: The odds of NAFTA retraction are rapidly subsiding as the U.S. is shifting its focus to China. Hence, chances are that NAFTA negotiations will be completed this summer, and a deal will be signed off before Mexico's presidential elections on July 1st. A more benign outcome together with an early end to NAFTA negotiations will reduce uncertainty and the risk premium priced into Mexican financial markets. This will help the latter outperform their EM peers. A final note on Mexican politics: The leftist presidential candidate Andres Manuel Lopez Obrador has high chances of winning the presidential elections in July. Yet Our colleagues at BCA's Geopolitical Strategy service believe political risks are overstated.5 The basis is that Obrador will balance the left-leaning preferences of his electorate with the prudent policies needed to produce robust growth. While political uncertainty in Mexico is subsiding, it is rising in many other EM countries such as Russia, China and Brazil. In brief, geopolitical dynamics favor Mexico versus the rest of EM. We expect dedicated EM managers across various asset classes to rotate into Mexico from other EM countries. We outlined two weeks ago that a stable exchange rate will bring down inflation, opening a door for the central bank to cut interest rates no later than this summer. As local interest rate expectations in Mexico continue to subside both in absolute terms as well as relative to EM, Mexican share prices will outpace their EM peers (Chart I-9). Consistently, tightening Mexican sovereign credit spreads versus EM overall should also foster this nation's equity outperformance (Chart I-10). Chart I-9Relative Equity Performance Tracks Relative ##br##Local Bond Yields Chart I-10Relative Equity Performance Tracks Relative ##br##Sovereign Spreads Domestic demand growth has plunged following monetary and fiscal tightening in the past two years (Chart I-11). As both fiscal and monetary policy begin to ease, domestic demand will recover later this year. Chances are that share prices will sniff this out and begin their advance/outperformance sooner than later. Consumer staples and telecom stocks together account for 50% of the MSCI Mexico market cap, while the same sectors make up only 11% of overall EM market cap. Hence, Mexico's relative equity performance is somewhat hinged on the outlook for these two sectors in general and consumer staples in particular. EM consumer staple stocks have massively underperformed the EM benchmark since early 2016 (Chart I-12, top panel), and odds are this sector will outperform in the next six to 12 months as defensive sectors outperform cyclicals. This in turn heralds Mexico's relative outperformance versus the EM benchmark, which seems to be forming a major bottom (Chart I-12, bottom panel). Chart I-11Mexico: Economic Downturn Is Well Advanced Chart I-12Mexican Bourse Is A Play On Consumer Staples Unlike many EM countries, the Mexican economy is much more leveraged to the U.S. than to China. One of our major themes remains favoring U.S. growth plays versus Chinese ones. Finally, Mexican equity valuations have improved quite a bit both in absolute terms and relative to EM. Chart I-13 shows our in-house CAPE ratios for Mexican stocks in absolute terms and relative to the EM overall benchmark: Mexican equity valuations are not cheap but they are no longer expensive. Consistent with upgrading our economic outlook on Mexico, fixed-income investors should bet on yield curve steepening in local rates. We initiated this strategy on January 31 but hedged the NAFTA risk by complementing it with a yield curve flattening leg in Canada. Now, we are closing that trade and initiating a new one: fixed-income traders should consider paying 10-year swap rates and receiving 2-year swap rates. The yield curve is as flat as it typically gets (Chart I-14, top panel). Moreover, 2-year swap rates are not yet pricing enough rate cuts (Chart I-14, bottom panel) but will soon begin gapping down pricing in a large (potentially close to 200 basis points) rate cut cycle. Chart I-13Mexican Equities Are No Longer Expensive Chart I-14Bet On Yield Curve Steepening In Mexico Bottom Line: In line with our recent upgrade of Mexican local and U.S. dollar bonds as well as the currency outlook versus their EM peers, this week we recommend EM dedicated equity portfolios shift to an overweight position in Mexican stocks. Fixed-income trades should bet on yield curve steepening by paying 10-year swap rates and receiving 2-year rates. Investors who are positive on global risk assets should consider buying Mexican local bonds outright. Russia: Geopolitics Trumps Economics Chart I-15Russian Assets Relative To EM Benchmarks:##br## Various Asset Classes The sudden crash in Russian financial markets this week following the imposition of new U.S. sanctions has reminded us that geopolitics can often eclipse economics. Our overweight recommendation on Russian assets versus their EM peers was based on two pillars: (1) healthy and improving macro fundamentals and an unfolding cyclical economic recovery; and (2) easing tensions between Russia and the West. Clearly, the second part of our assessment is wrong, or at least premature. While BCA's Geopolitical Service team maintains that on a 12-month horizon tensions between Russia and the West will subside, the near-term risks are impossible to assess. For this reason we are closing our overweight allocation in Russian financial markets and recommend downgrading it to neutral. In particular, we are shifting Russia to a neutral allocation within the EM equity, sovereign and corporate credit and local currency bonds portfolios (Chart I-15). Consistently, we are closing the following trades: Long Russian / short Malaysian stocks (27.6% gain); Long Russian energy / short global energy stocks (2.8% gain); Long RUB / short MYR (3.1% loss); Short COP / long basket of USD & RUB (16.2% loss); Long RUBUSD / short crude oil (29.1% loss). Sell Russian 5-year CDS / buy South African 5-year CDS (317 basis points gain); Long Russian and Chilean / short Chinese Corporate Credit (12% gain); Long Russian 5-year bonds / short Brazilian 5-year bonds (flat). Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 We have removed the Russian ruble from the version of this chart shown in March 29, 2018 EMS report to assure that the recent idiosyncratic developments - the selloff triggered by the U.S. sanctions - in Russia's financial markets do not impact the reading of this indicator. 2 Pease see Emerging Markets Strategy Weekly Report "EM Local Bonds And U.S. Twin Deficits", dated February 21, 2018, Page 14. 3 Pease see Emerging Markets Strategy Weekly Report "China Real Estate: A Never-Bursting Bubble?", dated April 6, 2018, Page 14. 4 Pease see Emerging Markets Strategy Weekly Report "EM: Perched On An Icy Cliff", dated March 29, 2018, available at ems.bcaresearch.com. 5 Pease see Geopolitcial Strategy Weekly Report "Expect Volatility... Of Volatility", dated April 11, 2018, available at gps.bcaresearch.com. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Capacity cuts in China's steel and aluminum industries over the winter produced little in the way of output reductions, confounding our expectations. The resulting unintended inventory accumulation in Asian markets, reflecting high production relative to demand, and slowing Chinese steel exports are a downside risk to our neutral view. U.S. sanctions against Russian oligarchs close to President Putin could tighten the aluminum market, countering the unintended inventory accumulations. For now, we remain neutral base metals. Energy: Overweight. We are closing our long put spread position in Dec/18 Brent options at tonight's close. The fast-approaching May 12 deadline for President Trump to renew sanctions waivers against Iran shifts the balance of price risks to the upside. Base Metals: Neutral. COMEX copper rallied above $3.10/lb on the back of Chinese President Xi's remarks at the Boao Forum earlier this week, which re-hashed plans to open China's economy to imports. Precious Metals: Neutral. Gold likely becomes better bid as the May 12 deadline to waive Iran sanctions nears. Our long gold portfolio hedge is up 8.9%. Ags/Softs: Underweight. European buyers are scooping up U.S. soybeans, as Chinese purchases of Brazilian beans makes U.S.-sourced crops relatively cheaper, according to Reuters.1 China also announced plans to start selling corn stocks from state reserves this week, offering an alternative protein for animals to partially offset the price impact of tariffs on their imports of U.S. soybeans. Feature Chart of the WeekAluminum Rebounds On U.S. Sanctions Despite much-ballyhooed capacity reductions in China's steel and aluminum capacity, these markets - both in China and globally - remained relatively well supplied over the winter. Higher global supplies, and falling Chinese steel exports, will result in unintended inventory accumulation, which already is showing up in Shanghai Futures Exchange (SHFE) inventories. While we remain neutral base metals, continued unintended inventory accumulation could cause us to downgrade the sector. The MySteel Composite Index we use to track steel prices is down more than 10% since the beginning of the year (Chart of the Week). Similarly, the first-nearby primary aluminum contract on the LME was down ~ 12% year-to-date (ytd) early last week, before regaining most of these losses on news of U.S. sanctions against Russian oligarchs, which hit shares of Rusal very hard. Given that these sanctions will restrict access to up to 6% of global aluminum supply, ex-China supply dynamics will dominate the aluminum market this year making the outlook relatively favorable, putting a floor beneath the London Metal Exchange Index (LMEX).2 Ex-Post Winter Production Production cuts over the winter - when Chinese mills in 28 smog-prone northern cities were ordered to reduce capacity by up to 50% - did not live up to our expectations.3 China's steel and aluminum sectors have undergone major supply-side reforms, particularly re the removal of outdated capacity, most of which has been completed. In addition to the winter capacity cuts, past reforms that have already been implemented, and have shaped current market conditions, are as follows: In an effort to eliminate outdated and unlicensed facilities, China removed an estimated 3-4 mm MT of annual capacity in 2017 - amounting to approximately 10% of total aluminum smelting capacity. In the case of steel, Beijing announced plans to shut down 150 mm MT of annual steel capacity between 2016 and 2020. To date, 115 mm MT of capacity have already been eliminated. Another estimated 80-120 mm MT of induction furnace capacity was shuttered in 1H17. Going forward, China's steel and aluminum markets will be driven by: An estimated 3-4 mm MT of updated aluminum capacity is expected to come on line this year, offsetting constraints from last year's supply cuts. 30 mm MT of steel capacity shutdowns are planned this year, putting Beijing on track to meet its five-year target two years ahead of schedule. The Chinese National Development and Reform Commission (NDRC) has communicated its resolve to keep shuttered capacity offline. Major steelmaking cities in Hebei province - accounting for 22% of 2017 Chinese crude steel output - have announced plans to extend the capacity cuts to November 2018. The mid-November to mid-March capacity cuts implemented this past season are expected to be a recurring event. Winter Shutdowns Minimally Impact China's Steel Output ... According to steel production data released by the World Steel Association (WSA), winter capacity closures in China did not significantly affect overall output levels. Crude steel output from China was up 3.9% year-on-year (y/y) in the November to February period (Chart 2). At the same time, production from the rest of the world increased by 3.6% y/y in the November to February. Thus global crude steel supply remained in excess over the winter season, as global steel output increased 3.8% y/y. A caveat to these data: China does not account for the historical output of induction furnaces, which produced an estimated ~30-50 mm MT of steel in 2016. As mentioned in our previous research, the output of these furnaces was illegal and thus not carried in statistics we use to track supply.4 These data problems mean it is possible that actual output in the November 2016 to February 2017 period was higher than suggested by the data, and as a result, actual output during this year's winter season may actually be lower than last year. As induction-furnace data lie in the statistical shadows, we cannot ascertain this with certainty. Nevertheless, a buildup in China inventories - which we discuss below - indicates an oversupplied market. It is also likely producers - incentivized by high steel prices earlier this year - kept capacity utilization at maximum levels throughout the winter. ... And Aluminum Output According to International Aluminum Institute data, primary aluminum output in China fell 2.3% y/y in the November to February period, suggesting the winter cuts likely had an impact on aluminum supply (Chart 3). Data from the World Bureau of Metal Statistics (WBMS) show an even sharper decline in winter aluminum output: primary production in China fell 8.7% y/y in the November to January period. Chart 2Steel Output Grew##BR##Amid Winter Cuts Chart 3China Aluminum Market In Surplus##BR##Despite Production Decline Both sources reveal an especially pronounced contraction in November, at the onset of the winter cuts. Despite reduced supply, WBMS data indicate a positive Chinese aluminum market balance throughout the winter. A large contraction in demand offset the supply shortfall, and kept primary aluminum in a physical surplus throughout the winter, ultimately leading to a buildup in domestic inventories. A Look At The Trade Data Despite our disappointment regarding the impact of the winter cuts on steel and aluminum markets, trade data increasingly suggests China's steel exports have peaked. Aluminum exports from China, on the other hand, are likely to continue rising. Chinese Steel Exports Continue To Fall ... Chinese steel product net exports have been falling since mid-2016, and have continued falling in y/y terms throughout the winter. According to Chinese customs data, steel product net exports fell 35.1% y/y in the November to February period, driven by both falling exports as well as rising imports (Chart 4). Steel product exports plunged 30% y/y in the November to February period, more or less in line with the 2017 average. The decline mirrors the 2017 contraction in domestic supply, bringing exports to their lowest level since 2012. This indicates fears of a China slowdown leading to a flood of metal onto global markets have not materialized, at least not yet. In fact, Customs data show a 1.7% y/y increase in Chinese steel imports during the November to February period - a reversal from falling imports prior to the winter season. The conclusion we draw from this is that, while in the past, China was a source of supply for the world, ongoing capacity cuts and production controls could mean China will lack the ability to ramp up output in case of a global physical supply deficit. If this becomes the new normal, price volatility will likely increase. This trend is important, especially given our expectation of strong world ex-China demand this year. As such, global steel prices may find support amid this new normal. ... But Aluminum Exports Move Higher In the case of aluminum, Chinese net exports were up 28.7% y/y during the winter, continuing their upward trend. Customs data show a 14.8% y/y increase in aluminum exports in November to February, bringing exports in this period to their highest level since 2014/15 (Chart 5). At the same time, imports of aluminum have come down during this period - by 37.2% y/y. According to China customs data, 2017 imports over these winter months registered their lowest level since 1994. Chart 4Steel Exports Continue Falling ... Chart 5...While Aluminum Exports Are On the Uptrend The combination of growing exports amid falling imports puts China's net exports in expansionary territory. This will be especially true given the planned increase in capacity this year amid weak Chinese demand. All in all, ceteris paribus global supply of aluminum looks set to increase. However, we do not live in a ceteris paribus world and, as we explore below, sanctions against the top aluminum producer outside of China will have massive implications on the global aluminum supply chain. Are Inventories Due For A Turnaround? Chart 6Larger Than Expected##BR##Seasonal Inventory Buildup China Iron and Steel Association data indicate that since the beginning of the year, steel product inventories have been re-stocked to levels last seen in 1Q14. Inventories of the five main steel products we track have more than doubled since the beginning of the year (Chart 6). Although the Q1 build is seasonal, the re-stocking since the beginning of the year has been especially pronounced. This buildup occurred in an environment of stable supply - with minimal impact from the winter capacity cuts - amid weak exports, indicating domestic demand for the metal was subdued. However, steel inventories have turned around, and we expect further destocking as demand accelerates post the Chinese New Year. The question remains whether this destocking will bring inventories back down to their 5-year average. Aluminum inventories on the SHFE show similar dynamics. However in this case, it is part of the larger trend of rising stocks since the beginning of last year. Aluminum inventories at SHFE warehouses are up more than nine-fold - or 0.87 mm MT - since the end of 2016. In fact, the pace of buildup seems to have accelerated: the average weekly build of 16.6k MT of aluminum coming into warehouse inventories since the beginning of the year stands above the 2017 average weekly build of 12.6k MT. This brought SHFE aluminum inventories to almost 1 mm MT, more than double their previous record in 2010. Although the Chinese physical aluminum surplus weighed down on prices in 1Q18, we expect global aluminum prices to remain supported from here due to the impact of U.S. sanctions on world ex-China aluminum supply. U.S. Russian Sanctions Could Be A Game-Changer Chart 7Sanctions Will Restrict##BR##Marketable Aluminum Supply Last Friday, the U.S. announced sanctions on Russian oligarchs close to President Vladimir Putin. Among those sanctioned is Oleg Deripaska who controls EN+ Group, which owns a controlling interest in top aluminum producer United Company Rusal. Given that UC Rusal accounts for ~6% of global aluminum production, we view this move as significant to global aluminum markets. As the top producer of the metal outside China, Rusal aluminum likely makes up the majority of Russian supply, which account for 14% of U.S. imports (Chart 7). In fact, almost 15% of Rusal's revenues comes from its business with the U.S. While it is clear that these sanctions will, in effect, terminate aluminum trade between Russia and the U.S., more significant are the implications on the global supply chain. A clause in the U.S. Treasury Department's order extending the restrictions to non-U.S. citizens dealing with U.S. entities means the impact could be far-reaching, requiring a major re-shuffle in global aluminum trade. Earlier this week, the LME announced that it will no longer accept Rusal aluminum produced after April 6, effectively preventing the company's products from being delivered on the LME. These sanctions will likely turn global aluminum buyers off from Rusal products, as they can no longer deliver it to the LME. The net effect will be a contraction in global usable aluminum supply. Furthermore, these sanctions will likely disrupt supply chains as aluminum users scramble to avoid purchasing metal from the Russian producer. While the details of these restrictions are still unclear, the sanctions are a game changer in the global aluminum market - effectively restricting access to a major source of the metal. As such, primary aluminum on the LME is up more than 10% since the announcement last Friday. Bottom Line: While China's crude steel output increased y/y during government-mandated output cuts over the winter, seasonally weak demand meant that the metal piled up in inventories. Falling exports indicates that at least for now, the domestic surplus is not flooding global markets. The main risk to our neutral view here is that demand in China remains weak, and that this will lead to the offloading of Chinese metal to global markets, i.e. a pickup in exports. This has not yet materialized, so we are holding on to our neutral view for now. China's primary aluminum production declined y/y during the winter cuts. However the decline in domestic demand was greater - likely due to the decline in auto production and sales following the loss of tax credit incentives. Consequently, China's aluminum market remained in surplus throughout the winter. Some of the excess supply was exported, but SHFE inventories continued building. Our outlook on the aluminum market had been bearish, due to additional capacity coming online this year amid an uncertain China demand environment. However, the sanctions on Rusal could be a game changer, putting a floor beneath aluminum prices. This improves our near term outlook for the aluminum market. This makes our outlook on aluminum prices much more favorable. Roukaya Ibrahim, Associate Editor Commodity & Energy Strategy RoukayaI@bcaresearch.com 1 Please see "As U.S. and China trade tariff barbs, others scoop up U.S. soybeans," published by reuters.com on April 8, 2018. 2 The six non-ferrous metals represented in the LMEX and their respective weights are as follows: aluminum: 42.8%, copper: 31.2%, zinc: 14.8%, lead: 8.2%, nickel: 2.0%, and tin: 1.0%. 3 China's winter smog "battle plan" targeted polluting industries in the northern China region by mandating cuts on steel, cement and aluminum production during the smog-prone mid-November to mid-March months. Steel and aluminum production cuts targeted a range between 30-50% during this period. This event is expected to be an annually recurring event until 2020. 4 Please see BCA Research's Commodity & Energy Strategy Weekly Report titled "China's Environmental Reforms Drive Steel & Iron Ore," dated January 11, 2018, available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017

Highlights In China, the central bank and commercial banks conducted outright monetization of real estate inventories, which caused the property markets' recovery post 2015. Despite destocking, aggregate property inventories remain excessive. Elevated inventories, poor affordability, and policy tightening will depress property demand and lead to a contraction in construction activity. Slumping construction, along with a slowdown in infrastructure investment, pose downside risks to China's demand for commodities, materials and industrial goods. This is the main risk to EM stocks and currencies and the primary reason we maintain our negative stance on EM risk assets. Continue shorting Chinese property developers stocks versus U.S. homebuilders. Feature With a flurry of policy tightening directed at the real estate market in the past year, property demand in China has weakened. The latter typically leads property starts and real estate investment, and is coincident with real estate prices (Chart I-1). Is China entering another property downturn, and if so will it be shallow, or severe? Answers to these questions are important not only for Chinese stocks, but also for China-plays throughout the rest of the world. To shed light on this issue, this week we re-examine how large the imbalances in the Chinese real estate market actually are - with respect to both affordability and supply (the stock of housing and inventories). We also discuss policy objectives and investment implications. Proper Measures Of Inventories And Housing Stock Both purchases and prices of Chinese residential properties surged between 2015 and 2017, when the authorities implemented a property de-stocking policy. As a result, housing inventories declined significantly. Does this mean that one of the major imbalances, namely swelling inventories, has been eliminated? If imbalances, namely inventories and prices, in a property market are very minor, one can expect an ensuing adjustment to be benign. Conversely, if imbalances are large, it is reasonable to bet on a meaningful property market downturn. With respect to China's real estate inventory levels, data from the National Bureau of Statistics (NBS) which many analysts follow, indicates inventories of residential buildings have indeed declined, with a significant 33% drop in residential vacant floor space for sale (Chart I-2). The term "vacant" is used by the data provider to denote the floor space completed but not sold. Clearly, China's de-stocking strategy since 2015 has worked well. However, data from the NBS on vacant space for sale is not all-encompassing. First, it includes only commodity buildings - i.e., those developed by real estate developers - and does not include buildings built by non-real estate developers. For example, companies, universities, organizations and even a group of individuals can construct both residential and non-residential buildings for their own use. Commodity buildings are just a small subset of total constructed buildings in China. According to NBS data, residential buildings by property developers account for only 26% of total constructed residential buildings in terms of floor space area completed. In brief, the inventory data that the majority of analysts use covers only a part of property construction (Figure I-1). Second, the vacant floor space data - shown in Chart I-2 and used by many analysts - only measures commodity buildings that have been completed but not sold. It does not account for those units that are under construction and have not been sold. The latter should also be counted as inventory because in China both residential and non-residential properties can be sold even when they are in the construction phase. Unlike advanced economies, in China the housing market is by far dominated by new construction. In particular, about 80% of residential commodity floor space sold are properties that are still under construction. This is drastically different from real estate markets in the U.S. and other developed countries, where the secondary housing market is a major source of supply. Given the above,1 we propose several alternative measures that aim to more accurately reflect the real picture of Chinese property inventory. Real Estate Inventory To capture the flow of the entire residential property supply in China, we calculate the difference between cumulative floor space started and cumulative floor space sold over the period of 1995-2017. This produces a new measure of total space not yet sold (i.e., available for sale), which includes areas both under construction and completed. This is a much more comprehensive measure of the total inventory than other commonly used measures. It is important to note that this measure takes into account both types of floor space available for sale: under construction and completed. The top panel of Chart I-3 illustrates that our derived measure of residential inventory - cumulative floor space started minus cumulative floor space sold - currently stands at 2.5 billion square meters or 27 billion square feet. This is about eight times greater than the NBS measure of vacant floor space - completed by property developers but not sold, which presently amounts to only 0.3 billion square meters or 3.23 billion square feet. On the bottom panel of Chart I-3, we estimate how many months of sales it will take to clear this housing inventory. Our findings reveal that even though our new inventory measure for the residential sector has fallen sharply due to the de-stocking policy, it still takes 22 months of last year sales to clear it. This is much higher than the completed by property developers but unsold vacant space, which presently stands at 2.5 months of last year sales. Provided that (1) most housing for sale in China is new construction, and (2) it can be sold at any stage of the construction cycle, we believe our new estimate of residential inventory that is equal to 22 months of last year sales is a more accurate reflection of reality. We computed a similar measure of inventory for non-residential properties that includes malls, offices, and warehouses. The top panel of Chart I-4 shows that the proper inventory levels for the non-residential sector have kept rising to new record highs in absolute terms. Relative to floor space sold last year, inventories still stand at 170 months of sales (Chart I-4, bottom panel).   Clearly, China's non-residential markets still carry excessive inventories. It would be misleading to use completed but unsold data for the non-residential sector, which accounts for roughly 14 months of sales. Similar to the residential commodity buildings market, about 65% of non-residential commodity buildings sold are those that are still under construction. In short, despite the decline from 2015's exceptionally high levels, inventories for both residential and commercial properties are still extremely elevated. Furthermore, the inventory-to-sales ratio is not a good indicator for the property market outlook because it is heavily influenced by sales. When sales - the denominator of this ratio - are weak, this inventory ratio is high, and vice versa. In particular, this ratio has been a poor indicator for the property market in China, where sales of properties have been deeply influenced by government policies. Whenever sales dropped and this ratio surged, the authorities would begin easing policies, spurring sales to rise and allowing the market - prices, floor space starts and construction - to recover. As a final note, these inventory data show floor space built by property developers only. Stock Of Housing The measure of per-capita living space gauges the existing stock of housing. Hence, it is a structural measure. Still being a low-income country, China is often perceived to offer enormous construction potential. However, some statistics on per-capita living space are revealing. The NBS data show that the 2016 per-capita living space for both urban and rural area has risen to 36.6 square meters and 45.8 square meters, respectively (Chart I-5). By comparison, in Korea and Japan, living space per capita (the entire population average) is only 33 and 22 square meters, respectively. Our calculation of per-capita urban living space based on the NBS building construction data also show similar results - 38 square meters for 2017. Consequently, these statistics on per-capita living space are supported by historical construction data, and hence are reliable. Both NBS per-capita living space data and our calculated per-capita living space data confirm that there is already massive stock of residential property in China - the nation's current existing residential floor space area already amounts to 30.8 billion square meters (332 billion square feet). Furthermore, the stock of housing is relatively new with 88% of this living space built in the past 20 years. Assuming the floor space area of each house is on average 90 square meters (970 square feet), we infer that on average every urban household already owns 1.3 houses. This is actually in line with the results of several domestic household surveys, which conclude that 20-25% of houses owned by urban residents are neither being used for living nor for renting out. Provided not every household in China owns a house, and that a meaningful share of the population still lives in smaller and older housing, these data suggest there have been considerable speculative/investor purchases of housing over the past 10 years. Many high-income individuals own multiple properties (that are often kept vacant) while a still-considerable number of families live in poor conditions. Bottom Line: China has constructed enormous amounts of real estate since 2002. Furthermore, inventories are vast for residential and non-residential sectors alike. Such an oversupply of properties poses a considerable risk to construction activity going forward. Property Demand Weakness: Cyclical Or Structural? Very poor affordability, slowing rural-to-urban migration, demographic changes, tightening mortgage lending, a successful government-led clampdown on speculative activity and the promotion of the rental housing all point to both a cyclical and structural slippage in housing purchases in China. House Price-Income Ratios and Affordability House prices in China remain extremely high relative to disposable income. By using NBS 70-city residential average price, our calculation shows for an average household (assuming double income earners) it will take 10.5 years of its disposable income to buy a 90-square-meter (equivalent to 970 square feet) house at current prices (Chart I-6). The same ratio for the U.S. is presently 3.4 and at the peak of U.S. housing bubble in 2006 it was 4. In regard to the ability to service mortgage payments, annual interest costs account for 45% of average household disposable income (assuming a double income household) when buying a 90 square meter house and assuming 20% down payment (Table I-1). If we use another data provider - Choice, covering 100 cities, house price per a square meter is 60% higher than the NBS 70-city residential average price. Using Choice house price data, the house price-to-income ratio is 17, and affordability - the share of interest payments as a percentage of disposable household income - is 72%. Clearly, there is a huge gap between these two aggregate measures of residential property prices. In this report, we use conservative (low) prices from the NBS, which still reveals that house prices and interest payments are exceptionally high relative to disposable income for a double-income family. Table I-1 contains house price-to-income ratios and affordability ratios for 31 provinces using the house prices from NBS. Given the average urban household already owns more than one property, it is reasonable to expect that a considerable proportion of potential future demand for housing will come from rural residents as urbanization continues, or as rural residents seek to buy homes in the city for access to better quality education in the urban areas for their children. However, rural residents' current and potential (when they move to cities) disposable income is much lower than the urban's. Therefore, housing affordability is a bigger challenge for them. Rural-to-Urban Migration Even though urbanization is an ongoing process in China and will continue for many years, the pace is slowing (Chart I-7). The number of individuals moving from rural areas to cities as a percentage of the urban population is decreasing. This will translate into decelerating growth rate in demand for urban residential properties. The second panel of Chart I-7 illustrates that rural-to-urban net migration accelerated in the early 1990s and has been between 15-18 million people per year over the past 20 years. However, as a share of the urban population, net migration has fallen from 4.5% in the late 1990s to 2% today (Chart I-7, third panel). Overall, urban population growth has slowed below 3% (Chart I-7, bottom panel). In brief, the slowdown in net migration and, consequently, decelerating urban population growth will cap structural housing demand that has been booming over the past 20 years. Poor Demographics The Chinese population is aging rapidly. The proportion of citizens who are over the age of 65 has risen from 8% of the population in 2007 to 11.4% as of last year and will continue rising rapidly. Given Chinese life expectancy is currently at about 76 years, senior citizens cohort will leave a large number of houses to their children or grandchildren over the next 10-15 years. The reason behind this is because the former demographic cohort (11.4% of the total population) is larger than the 10-19-year-age group which accounts for only 10.5% of the total population. The latter would have been a major source of property demand over the next 10 years, as Chinese tradition requires them to own a house before marriage. However, this is no longer the case. For this generation - born in the late 1990s and 2000s and by the time they get married (in general at the age of around 25 or a bit later), each newly-formed family could potentially inherit four houses from their parents and grandparents. Tightening mortgage lending As part of the current property related restrictive policies, mortgage interest rates have been on the rise for both first- and second-home buyers. Mortgage rates have risen by 74 basis points in the past 12 months - from 4.52% to 5.26%. Additionally, banks have been tightening credit standards. Given house prices are very high relative to income, a small increase in mortgage rates meaningfully increases the share of disposable income that must be allocated to interest payments on mortgages. For example, with the house price-to-income ratio at 10.5 and down payment of 20% of house price for the average home buyer in China, a 75-basis-point increase in mortgage rates would lift the share of interest payments on a mortgage from 45% to 51% of disposable income. Hence, higher borrowing costs over the past year as well as the ongoing tightening in credit standards will continue to discourage property buyers. Mortgage loan growth has rolled over after booming between 2015 and 2017, yet at a 22% annual growth rate, it remains very high (Chart I-8). Policy-led clamp-down of speculation President Xi Jinping's mantra that "housing is for living in, not for speculation" - proclaimed in December 2016 - is the focal point of the government's current policies. Many regulations implemented by both the central government and local governments over the past 15 months have been aimed at reducing speculative purchases. The promotion of the housing rental market In large cities residential rental yields fluctuate between 1-2.5% (Chart I-9). This compares with mortgage rate of 5.3%. Currently, renting is significantly cheaper than buying. This may encourage renting in the long term. Rising demand for rental housing might be met by the available stock of empty apartments that investors have been accumulating over the years. If this occurs, it will reduce demand for new home purchases.   Meanwhile, the central government is determined to develop a rental market by constructing rental housing. If building of rental housing offsets the potential decline in property construction, it will make our negative view on construction volumes widely off the mark. The crucial factor to watch is financing. If credit supply slows meaningfully, there will be less available financing for overall construction, including rental. Any gains by rental construction will be overwhelmed by a decline in the building of residential and commercial real estate. In turn, financing is contingent on the government deleveraging campaign. If the authorities adhere to their pledge of deleveraging, a slowdown in credit growth will dampen overall construction activity. There can be no construction without credit. Furthermore, it takes only a deceleration in credit growth, i.e., a negative credit impulse, to depress construction volumes. That is why we cover China's credit cycle dynamics in such details in our regular reports. Bottom Line: Chinese property demand is facing numerous cyclical and structural headwinds. Policy Driven Market China's central and local government policies have over time and in different combinations substantially influenced the country's housing market on both the supply and demand sides. Over the past two decades, each time the government implemented restrictive policies (for example, raising down-payment ratios, increasing policy or mortgage rates, setting restrictions on mortgage lending, and so on), the real estate market slowed and housing prices softened. The opposite has also held true - each time the government introduced stimulus, housing prices surged as buyers quickly dove into the market. Chart I-10 illustrates the interaction between government property related regulations and the domestic housing market. The biggest problem with such policies in the long run is that the authorities want to control both prices and volume - they want flat prices and moderately rising volumes. However, no government can control both prices and volumes simultaneously in any industry. China's real estate market is not an exception. Even in a completely closed socialist system, controlling prices and volume simultaneously is almost impossible. As the authorities adhere to their policy objectives of controlling financial risks and unwinding financial excesses, thereby focusing on property price control over the next 12 months, we believe property starts and construction activity will shrink. Monetization of Housing Inventories In 2015-'17 Understanding what was behind the housing market's strong recovery since late 2015 is critical to assessing the outlook. Since the summer of 2015, authorities were not only easing purchasing restrictions and lowering mortgage rates, but they were also implementing outright monetization of housing inventories. After inventories of both residential and non-residential properties swelled, the central government commenced a de-stocking strategy in 2015, mainly through a monetized slum reconstruction program and by encouraging migrant workers to buy housing in smaller cities near their hometowns. The de-stocking strategy focused on smaller cities where inventories had mushroomed. Given tier-1 cities account for only 6% of floor space started by property developers, and most construction in recent years has been taking place in tier-2 and smaller cities, these policies had a substantial positive impact on national sales, as well as drawing down inventories - ultimately spurring a construction recovery. 1. The government's slum area reconstruction policy has been the major driver behind de-stocking within the residential property market. The People's Bank of China (PBoC) has provided a significant amount of financing in the form of pledged supplementary lending (PSL) directly to homebuyers that was intermediated by three policy banks (China Development Bank, Agricultural Development Bank of China and Export-Import Bank of China). To shed more detail on the PSL mechanism, the central bank lends credit to the three policy banks at very low interest rates. These policy banks in turn lend directly to local government and regional property developers (mainly in tier-2 and smaller cities). These entities then turn and buy slums from their owners which puts cash in the hands of these sellers. Consequently, a large number of households suddenly receive large cash infusions - essentially disbursed by the central bank - that can be used to purchase new and better properties. The outstanding amount - total financing - via the PSL has risen from RMB 383 billion in 2014 to RMB 971 billion in 2016. The total amount of the PSL disbursed for the slum reconstruction program over 2014-2017 amounted to 3 trillion, or 3.6% of 2017 GDP, as of March 31, 2018. The interest rate on the PSL currently stands at a mere 2.75%. It appears that huge amounts of cheap money have been directly injected into the real estate market by the central bank alone. This slum reconstruction program has had a material impact on construction activity. Chart I-11 portends that slum area reconstruction accounted for about 20% of floor space sold in 2017. 2. In addition to the PSL financing, Chinese housing mortgages have increased by 85%, or by 11 trillion RMB in the past two and a half years - since the beginning of China's de-stocking policy. The sum of PSL financing and mortgage lending has been RMB 14 trillion (or $2.2 trillion) during the same period. Hence, not only has the PBoC financed the real estate market directly, but it has also allowed banks to flood the system with money to liquidate housing inventories. As we have argued in our series of reports, bank credit does not come from anyone's savings. Commercial banks originate loans out of thin air.2 In short, altogether these actions constitute outright monetization of real estate inventories and that caused the property markets' recovery post 2015. A Downturn Ahead? Since early 2017 and especially in the wake of last October's Party Congress, the authorities have shifted their policy focus from "de-stocking" to "eliminating speculative demand". Recent weakness in both demand and prices are a reflection of the current policy focus. This time, the government seems to have more determination to break popular perception that property prices will rise forever, and that investing in property markets cannot go wrong. Therefore, we sense the government's objective is to achieve flat or mildly declining property prices to prevent the return of speculators. In order to avoid a further ballooning of the real estate bubble, the government will raise the bar for another round of property stimulus. Therefore, if the authorities are successful in persuading speculators that prices will not rise much further in the years to come, speculative demand will wane. At the same time, not many first-time homebuyers can afford to buy at current prices. This will create an air pocket in sales and prices will deflate, at least modestly. Facing shrinking revenues and being overleveraged, real estate developers will reduce new starts, and property construction volumes will likely contract by 10% or so. Notably, floor space started by property developers in aggregate declined by 27% between 2012 and 2016 (Chart I-12). The construction slump in China, in tandem with rising supplies of commodities, led to a collapse in commodities prices in 2012-'15 (Chart 12). Hence, a decline in property construction is not unprecedented, even amid robust national income growth. We believe the acute structural imbalances will likely result in a property market downturn commensurable if not worse than those that occurred in 2011-'12 and 2014-'15. While the government will try to avoid a sudden bust, a 10% decline in both property prices and construction volumes in the next 12-18 months is our baseline scenario. The budding contraction in cement and plate glass production suggests that overall construction activity is already decelerating (Chart I-13).   Bottom Line: The Chinese authorities will for now maintain their current restrictions on the property market to contain financial excesses and risks in the system. This, amid lingering elevated inventories and price excesses, poses considerable downside risks to the mainland real estate market. Investment Implications Our view remains that construction activity in China is set to slump from a cyclical perspective, at least. At 13.2 billion square-meter (142 billion square-feet) the total 2017 residential and non-residential floor area under construction was immense (Chart I-14). This, along with a slowdown in infrastructure investment due to tighter control on local government finances, pose downside risks to China's demand for commodities, materials and industrial goods. This is the reason why we have been and remain bearish on commodities, Asian trade and EM risk assets. It appears that several commodities prices are finally beginning to roll over which is consistent with a slowdown in the mainland's construction activity (Chart I-15). China's construction activity is much larger than exports to the U.S. and EU combined. Hence, overall industrial activity in China is set to decelerate dragging down Asian trade flows and commodities prices despite robust domestic demand in the U.S. and EU. This heralds underweighting/shorting EM stocks, currencies and credit versus their DM counterparts.   We also reiterate our long-standing recommendation of shorting Chinese property developers versus U.S. homebuilders. Chart I-16 depicts that the Chinese property developers listed in A-share market have a debt-to-equity ratio of 6 and the cash flow from operations for the median of 76 property developers has begun contracting again. Further relapse in property sales will cause their financial position to deteriorate and limit their ability to launch new or complete existing construction. In regard to U.S. homebuilders, the fundamentals in the U.S. housing market are much better than those in China. While rising U.S. interest rates could be a headwind for U.S. homebuilder share prices, they stand to resume their outperformance versus Chinese property developers (Chart I-17).   Ellen JingYuan He Senior Editor/Associate Vice President EllenJ@bcaresearch.com Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Footnotes 1 Other oft-used measures of inventories are not correct either. Some analysts use floor space under construction data as a proxy for inventory - this is technically not correct as the data includes both the area that has already been sold in advance and the area that has been completed and sold. Others use cumulative floor space started minus cumulative floor space completed - this is also not correct as cumulative floor space completed includes areas that have not yet been sold. 2 Please see Emerging Markets Strategy Weekly Report "Is Investment Constrained By Savings? Tales Of China And Brazil," dated March 22, 2018, the link is available on page 20.  

特別レポート

Highlights In China, the central bank and commercial banks conducted outright monetization of real estate inventories, which caused the property markets' recovery post 2015. Despite destocking, aggregate property inventories remain excessive. Elevated inventories, poor affordability, and policy tightening will depress property demand and lead to a contraction in construction activity. Slumping construction, along with a slowdown in infrastructure investment, pose downside risks to China's demand for commodities, materials and industrial goods. This is the main risk to EM stocks and currencies and the primary reason we maintain our negative stance on EM risk assets. Continue shorting Chinese property developers stocks versus U.S. homebuilders. Feature With a flurry of policy tightening directed at the real estate market in the past year, property demand in China has weakened. The latter typically leads property starts and real estate investment, and is coincident with real estate prices (Chart I-1). Is China entering another property downturn, and if so will it be shallow, or severe? Answers to these questions are important not only for Chinese stocks, but also for China-plays throughout the rest of the world. To shed light on this issue, this week we re-examine how large the imbalances in the Chinese real estate market actually are - with respect to both affordability and supply (the stock of housing and inventories). We also discuss policy objectives and investment implications. Proper Measures Of Inventories And Housing Stock Both purchases and prices of Chinese residential properties surged between 2015 and 2017, when the authorities implemented a property de-stocking policy. As a result, housing inventories declined significantly. Does this mean that one of the major imbalances, namely swelling inventories, has been eliminated? If imbalances, namely inventories and prices, in a property market are very minor, one can expect an ensuing adjustment to be benign. Conversely, if imbalances are large, it is reasonable to bet on a meaningful property market downturn. With respect to China's real estate inventory levels, data from the National Bureau of Statistics (NBS) which many analysts follow, indicates inventories of residential buildings have indeed declined, with a significant 33% drop in residential vacant floor space for sale (Chart I-2). The term "vacant" is used by the data provider to denote the floor space completed but not sold. Clearly, China's de-stocking strategy since 2015 has worked well. Chart I-1China: Real Estate Is Slowing Down Chart I-2Property Developers' Inventories: ##br##Completed But Not Sold However, data from the NBS on vacant space for sale is not all-encompassing. First, it includes only commodity buildings - i.e., those developed by real estate developers - and does not include buildings built by non-real estate developers. For example, companies, universities, organizations and even a group of individuals can construct both residential and non-residential buildings for their own use. Commodity buildings are just a small subset of total constructed buildings in China. According to NBS data, residential buildings by property developers account for only 26% of total constructed residential buildings in terms of floor space area completed. In brief, the inventory data that the majority of analysts use covers only a part of property construction (Figure I-1). Figure I-1The Breakdown Of Residential ##br##Real Estate Inventory Second, the vacant floor space data - shown in Chart I-2 and used by many analysts - only measures commodity buildings that have been completed but not sold. It does not account for those units that are under construction and have not been sold. The latter should also be counted as inventory because in China both residential and non-residential properties can be sold even when they are in the construction phase. Unlike advanced economies, in China the housing market is by far dominated by new construction. In particular, about 80% of residential commodity floor space sold are properties that are still under construction. This is drastically different from real estate markets in the U.S. and other developed countries, where the secondary housing market is a major source of supply. Given the above,1 we propose several alternative measures that aim to more accurately reflect the real picture of Chinese property inventory. Real Estate Inventory To capture the flow of the entire residential property supply in China, we calculate the difference between cumulative floor space started and cumulative floor space sold over the period of 1995-2017. This produces a new measure of total space not yet sold (i.e., available for sale), which includes areas both under construction and completed. This is a much more comprehensive measure of the total inventory than other commonly used measures. It is important to note that this measure takes into account both types of floor space available for sale: under construction and completed. The top panel of Chart I-3 illustrates that our derived measure of residential inventory - cumulative floor space started minus cumulative floor space sold - currently stands at 2.5 billion square meters or 27 billion square feet. This is about eight times greater than the NBS measure of vacant floor space - completed by property developers but not sold, which presently amounts to only 0.3 billion square meters or 3.23 billion square feet. On the bottom panel of Chart I-3, we estimate how many months of sales it will take to clear this housing inventory. Our findings reveal that even though our new inventory measure for the residential sector has fallen sharply due to the de-stocking policy, it still takes 22 months of last year sales to clear it. This is much higher than the completed by property developers but unsold vacant space, which presently stands at 2.5 months of last year sales. Provided that (1) most housing for sale in China is new construction, and (2) it can be sold at any stage of the construction cycle, we believe our new estimate of residential inventory that is equal to 22 months of last year sales is a more accurate reflection of reality. We computed a similar measure of inventory for non-residential properties that includes malls, offices, and warehouses. The top panel of Chart I-4 shows that the proper inventory levels for the non-residential sector have kept rising to new record highs in absolute terms. Relative to floor space sold last year, inventories still stand at 170 months of sales (Chart I-4, bottom panel). Chart I-3Our Measure Of Residential Inventories: ##br##Floor Space Available For Sale Chart I-4Our Measure Of Non-Residential Inventories: ##br##Floor Space Available For Sale Clearly, China's non-residential markets still carry excessive inventories. It would be misleading to use completed but unsold data for the non-residential sector, which accounts for roughly 14 months of sales. Similar to the residential commodity buildings market, about 65% of non-residential commodity buildings sold are those that are still under construction. In short, despite the decline from 2015's exceptionally high levels, inventories for both residential and commercial properties are still extremely elevated. Furthermore, the inventory-to-sales ratio is not a good indicator for the property market outlook because it is heavily influenced by sales. When sales - the denominator of this ratio - are weak, this inventory ratio is high, and vice versa. In particular, this ratio has been a poor indicator for the property market in China, where sales of properties have been deeply influenced by government policies. Whenever sales dropped and this ratio surged, the authorities would begin easing policies, spurring sales to rise and allowing the market - prices, floor space starts and construction - to recover. As a final note, these inventory data show floor space built by property developers only. Stock Of Housing The measure of per-capita living space gauges the existing stock of housing. Hence, it is a structural measure. Still being a low-income country, China is often perceived to offer enormous construction potential. However, some statistics on per-capita living space are revealing. The NBS data show that the 2016 per-capita living space for both urban and rural area has risen to 36.6 square meters and 45.8 square meters, respectively (Chart I-5). By comparison, in Korea and Japan, living space per capita (the entire population average) is only 33 and 22 square meters, respectively. Chart I-5China: Per Capita Living ##br##Has Grown Dramatically Our calculation of per-capita urban living space based on the NBS building construction data also show similar results - 38 square meters for 2017. Consequently, these statistics on per-capita living space are supported by historical construction data, and hence are reliable. Both NBS per-capita living space data and our calculated per-capita living space data confirm that there is already massive stock of residential property in China - the nation's current existing residential floor space area already amounts to 30.8 billion square meters (332 billion square feet). Furthermore, the stock of housing is relatively new with 88% of this living space built in the past 20 years. Assuming the floor space area of each house is on average 90 square meters (970 square feet), we infer that on average every urban household already owns 1.3 houses. This is actually in line with the results of several domestic household surveys, which conclude that 20-25% of houses owned by urban residents are neither being used for living nor for renting out. Provided not every household in China owns a house, and that a meaningful share of the population still lives in smaller and older housing, these data suggest there have been considerable speculative/investor purchases of housing over the past 10 years. Many high-income individuals own multiple properties (that are often kept vacant) while a still-considerable number of families live in poor conditions. Bottom Line: China has constructed enormous amounts of real estate since 2002. Furthermore, inventories are vast for residential and non-residential sectors alike. Such an oversupply of properties poses a considerable risk to construction activity going forward. Property Demand Weakness: Cyclical Or Structural? Very poor affordability, slowing rural-to-urban migration, demographic changes, tightening mortgage lending, a successful government-led clampdown on speculative activity and the promotion of the rental housing all point to both a cyclical and structural slippage in housing purchases in China. House Price-Income Ratios and Affordability House prices in China remain extremely high relative to disposable income. By using NBS 70-city residential average price, our calculation shows for an average household (assuming double income earners) it will take 10.5 years of its disposable income to buy a 90-square-meter (equivalent to 970 square feet) house at current prices (Chart I-6). The same ratio for the U.S. is presently 3.4 and at the peak of U.S. housing bubble in 2006 it was 4. In regard to the ability to service mortgage payments, annual interest costs account for 45% of average household disposable income (assuming a double income household) when buying a 90 square meter house and assuming 20% down payment (Table I-1). Chart I-6House Price-Income Ratio: ##br##China & The U.S. Table I-1House Price-To-Income Ratios ##br##And Affordability If we use another data provider - Choice, covering 100 cities, house price per a square meter is 60% higher than the NBS 70-city residential average price. Using Choice house price data, the house price-to-income ratio is 17, and affordability - the share of interest payments as a percentage of disposable household income - is 72%. Clearly, there is a huge gap between these two aggregate measures of residential property prices. In this report, we use conservative (low) prices from the NBS, which still reveals that house prices and interest payments are exceptionally high relative to disposable income for a double-income family. Table I-1 contains house price-to-income ratios and affordability ratios for 31 provinces using the house prices from NBS. Given the average urban household already owns more than one property, it is reasonable to expect that a considerable proportion of potential future demand for housing will come from rural residents as urbanization continues, or as rural residents seek to buy homes in the city for access to better quality education in the urban areas for their children. However, rural residents' current and potential (when they move to cities) disposable income is much lower than the urban's. Therefore, housing affordability is a bigger challenge for them. Rural-to-Urban Migration Even though urbanization is an ongoing process in China and will continue for many years, the pace is slowing (Chart I-7). The number of individuals moving from rural areas to cities as a percentage of the urban population is decreasing. This will translate into decelerating growth rate in demand for urban residential properties. Chart I-7China: The Pace Of Urbanization Is Slowing The second panel of Chart I-7 illustrates that rural-to-urban net migration accelerated in the early 1990s and has been between 15-18 million people per year over the past 20 years. However, as a share of the urban population, net migration has fallen from 4.5% in the late 1990s to 2% today (Chart I-7, third panel). Overall, urban population growth has slowed below 3% (Chart I-7, bottom panel). In brief, the slowdown in net migration and, consequently, decelerating urban population growth will cap structural housing demand that has been booming over the past 20 years. Poor Demographics The Chinese population is aging rapidly. The proportion of citizens who are over the age of 65 has risen from 8% of the population in 2007 to 11.4% as of last year and will continue rising rapidly. Given Chinese life expectancy is currently at about 76 years, senior citizens cohort will leave a large number of houses to their children or grandchildren over the next 10-15 years. The reason behind this is because the former demographic cohort (11.4% of the total population) is larger than the 10-19-year-age group which accounts for only 10.5% of the total population. The latter would have been a major source of property demand over the next 10 years, as Chinese tradition requires them to own a house before marriage. However, this is no longer the case. For this generation - born in the late 1990s and 2000s and by the time they get married (in general at the age of around 25 or a bit later), each newly-formed family could potentially inherit four houses from their parents and grandparents. Tightening mortgage lending As part of the current property related restrictive policies, mortgage interest rates have been on the rise for both first- and second-home buyers. Mortgage rates have risen by 74 basis points in the past 12 months - from 4.52% to 5.26%. Additionally, banks have been tightening credit standards. Given house prices are very high relative to income, a small increase in mortgage rates meaningfully increases the share of disposable income that must be allocated to interest payments on mortgages. For example, with the house price-to-income ratio at 10.5 and down payment of 20% of house price for the average home buyer in China, a 75-basis-point increase in mortgage rates would lift the share of interest payments on a mortgage from 45% to 51% of disposable income. Hence, higher borrowing costs over the past year as well as the ongoing tightening in credit standards will continue to discourage property buyers. Mortgage loan growth has rolled over after booming between 2015 and 2017, yet at a 22% annual growth rate, it remains very high (Chart I-8). Policy-led clamp-down of speculation President Xi Jinping's mantra that "housing is for living in, not for speculation" - proclaimed in December 2016 - is the focal point of the government's current policies. Many regulations implemented by both the central government and local governments over the past 15 months have been aimed at reducing speculative purchases. The promotion of the housing rental market In large cities residential rental yields fluctuate between 1-2.5% (Chart I-9). This compares with mortgage rate of 5.3%. Currently, renting is significantly cheaper than buying. This may encourage renting in the long term. Rising demand for rental housing might be met by the available stock of empty apartments that investors have been accumulating over the years. If this occurs, it will reduce demand for new home purchases. Chart I-8China: Mortgage Lending Has Been Booming Chart I-9China: Residential Rental Yields Are Very Low Meanwhile, the central government is determined to develop a rental market by constructing rental housing. If building of rental housing offsets the potential decline in property construction, it will make our negative view on construction volumes widely off the mark. The crucial factor to watch is financing. If credit supply slows meaningfully, there will be less available financing for overall construction, including rental. Any gains by rental construction will be overwhelmed by a decline in the building of residential and commercial real estate. In turn, financing is contingent on the government deleveraging campaign. If the authorities adhere to their pledge of deleveraging, a slowdown in credit growth will dampen overall construction activity. There can be no construction without credit. Furthermore, it takes only a deceleration in credit growth, i.e., a negative credit impulse, to depress construction volumes. That is why we cover China's credit cycle dynamics in such details in our regular reports. Bottom Line: Chinese property demand is facing numerous cyclical and structural headwinds. Policy Driven Market China's central and local government policies have over time and in different combinations substantially influenced the country's housing market on both the supply and demand sides. Over the past two decades, each time the government implemented restrictive policies (for example, raising down-payment ratios, increasing policy or mortgage rates, setting restrictions on mortgage lending, and so on), the real estate market slowed and housing prices softened. The opposite has also held true - each time the government introduced stimulus, housing prices surged as buyers quickly dove into the market. Chart I-10 illustrates the interaction between government property related regulations and the domestic housing market. Chart I-10China: Policy-Driven Property Market The biggest problem with such policies in the long run is that the authorities want to control both prices and volume - they want flat prices and moderately rising volumes. However, no government can control both prices and volumes simultaneously in any industry. China's real estate market is not an exception. Even in a completely closed socialist system, controlling prices and volume simultaneously is almost impossible. As the authorities adhere to their policy objectives of controlling financial risks and unwinding financial excesses, thereby focusing on property price control over the next 12 months, we believe property starts and construction activity will shrink. Monetization of Housing Inventories In 2015-'17 Understanding what was behind the housing market's strong recovery since late 2015 is critical to assessing the outlook. Since the summer of 2015, authorities were not only easing purchasing restrictions and lowering mortgage rates, but they were also implementing outright monetization of housing inventories. After inventories of both residential and non-residential properties swelled, the central government commenced a de-stocking strategy in 2015, mainly through a monetized slum reconstruction program and by encouraging migrant workers to buy housing in smaller cities near their hometowns. The de-stocking strategy focused on smaller cities where inventories had mushroomed. Given tier-1 cities account for only 6% of floor space started by property developers, and most construction in recent years has been taking place in tier-2 and smaller cities, these policies had a substantial positive impact on national sales, as well as drawing down inventories - ultimately spurring a construction recovery. 1. The government's slum area reconstruction policy has been the major driver behind de-stocking within the residential property market. The People's Bank of China (PBoC) has provided a significant amount of financing in the form of pledged supplementary lending (PSL) directly to homebuyers that was intermediated by three policy banks (China Development Bank, Agricultural Development Bank of China and Export-Import Bank of China). To shed more detail on the PSL mechanism, the central bank lends credit to the three policy banks at very low interest rates. These policy banks in turn lend directly to local government and regional property developers (mainly in tier-2 and smaller cities). These entities then turn and buy slums from their owners which puts cash in the hands of these sellers. Consequently, a large number of households suddenly receive large cash infusions - essentially disbursed by the central bank - that can be used to purchase new and better properties. The outstanding amount - total financing - via the PSL has risen from RMB 383 billion in 2014 to RMB 971 billion in 2016. The total amount of the PSL disbursed for the slum reconstruction program over 2014-2017 amounted to 3 trillion, or 3.6% of 2017 GDP, as of March 31, 2018. The interest rate on the PSL currently stands at a mere 2.75%. It appears that huge amounts of cheap money have been directly injected into the real estate market by the central bank alone. This slum reconstruction program has had a material impact on construction activity. Chart I-11 portends that slum area reconstruction accounted for about 20% of floor space sold in 2017. Chart I-11China: Slum Reconstruction ##br##Has Had Meaningful Impact 2. In addition to the PSL financing, Chinese housing mortgages have increased by 85%, or by 11 trillion RMB in the past two and a half years - since the beginning of China's de-stocking policy. The sum of PSL financing and mortgage lending has been RMB 14 trillion (or $2.2 trillion) during the same period. Hence, not only has the PBoC financed the real estate market directly, but it has also allowed banks to flood the system with money to liquidate housing inventories. As we have argued in our series of reports, bank credit does not come from anyone's savings. Commercial banks originate loans out of thin air.2 In short, altogether these actions constitute outright monetization of real estate inventories and that caused the property markets' recovery post 2015. A Downturn Ahead? Since early 2017 and especially in the wake of last October's Party Congress, the authorities have shifted their policy focus from "de-stocking" to "eliminating speculative demand". Recent weakness in both demand and prices are a reflection of the current policy focus. This time, the government seems to have more determination to break popular perception that property prices will rise forever, and that investing in property markets cannot go wrong. Therefore, we sense the government's objective is to achieve flat or mildly declining property prices to prevent the return of speculators. In order to avoid a further ballooning of the real estate bubble, the government will raise the bar for another round of property stimulus. Therefore, if the authorities are successful in persuading speculators that prices will not rise much further in the years to come, speculative demand will wane. At the same time, not many first-time homebuyers can afford to buy at current prices. This will create an air pocket in sales and prices will deflate, at least modestly. Facing shrinking revenues and being overleveraged, real estate developers will reduce new starts, and property construction volumes will likely contract by 10% or so. Notably, floor space started by property developers in aggregate declined by 27% between 2012 and 2016 (Chart I-12). The construction slump in China, in tandem with rising supplies of commodities, led to a collapse in commodities prices in 2012-'15 (Chart 12). Hence, a decline in property construction is not unprecedented, even amid robust national income growth. We believe the acute structural imbalances will likely result in a property market downturn commensurable if not worse than those that occurred in 2011-'12 and 2014-'15. While the government will try to avoid a sudden bust, a 10% decline in both property prices and construction volumes in the next 12-18 months is our baseline scenario. The budding contraction in cement and plate glass production suggests that overall construction activity is already decelerating (Chart I-13). Chart I-12China: Property Cycles ##br##And Commodities Prices Chart I-13China: Nascent Contraction In Cement ##br##And Plate Glass Production Bottom Line: The Chinese authorities will for now maintain their current restrictions on the property market to contain financial excesses and risks in the system. This, amid lingering elevated inventories and price excesses, poses considerable downside risks to the mainland real estate market. Investment Implications Our view remains that construction activity in China is set to slump from a cyclical perspective, at least. At 13.2 billion square-meter (142 billion square-feet) the total 2017 residential and non-residential floor area under construction was immense (Chart I-14). This, along with a slowdown in infrastructure investment due to tighter control on local government finances, pose downside risks to China's demand for commodities, materials and industrial goods. This is the reason why we have been and remain bearish on commodities, Asian trade and EM risk assets. It appears that several commodities prices are finally beginning to roll over which is consistent with a slowdown in the mainland's construction activity (Chart I-15). Chart I-14China's Total Building Construction: ##br##Level And Annual Growth Chart I-15A Budding Downtrend In ##br##Commodities Prices China's construction activity is much larger than exports to the U.S. and EU combined. Hence, overall industrial activity in China is set to decelerate dragging down Asian trade flows and commodities prices despite robust domestic demand in the U.S. and EU. This heralds underweighting/shorting EM stocks, currencies and credit versus their DM counterparts. We also reiterate our long-standing recommendation of shorting Chinese property developers versus U.S. homebuilders. Chart I-16 depicts that the Chinese property developers listed in A-share market have a debt-to-equity ratio of 6 and the cash flow from operations for the median of 76 property developers has begun contracting again. Further relapse in property sales will cause their financial position to deteriorate and limit their ability to launch new or complete existing construction. In regard to U.S. homebuilders, the fundamentals in the U.S. housing market are much better than those in China. While rising U.S. interest rates could be a headwind for U.S. homebuilder share prices, they stand to resume their outperformance versus Chinese property developers (Chart I-17). Chart I-16China: Median Property Developer's ##br##Financial Ratios Are Worsening Chart I-17Short Chinese Property Developers / ##br##Long U.S. Homebuilders Ellen JingYuan He Senior Editor/Associate Vice President EllenJ@bcaresearch.com Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Other oft-used measures of inventories are not correct either. Some analysts use floor space under construction data as a proxy for inventory - this is technically not correct as the data includes both the area that has already been sold in advance and the area that has been completed and sold. Others use cumulative floor space started minus cumulative floor space completed - this is also not correct as cumulative floor space completed includes areas that have not yet been sold. 2 Please see Emerging Markets Strategy Weekly Report "Is Investment Constrained By Savings? Tales Of China And Brazil," dated March 22, 2018, the link is available on page 20. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights R-star is higher in the U.S. than in most other large economies. This includes China, where an elevated savings rate has depressed the neutral rate of interest. Countries with relatively high neutral rates like the U.S. will tend to run structural current account deficits, whereas countries with relatively low neutral rates will tend to run surpluses. The failure of the Trump administration to understand this basic economic lesson could inflame the ongoing trade spat between the two countries, at a time when populism is on the rise and China is challenging the U.S. for global influence. Fortunately, trade protectionism is less attractive when jobs are plentiful, as is the case in the U.S. today. Thus, we continue to see a market-friendly resolution to the ongoing conflict. Our base case remains that another global recession is still about two years away, which should keep the bull market in global equities intact. However, with global growth decelerating, financial conditions tightening at the margin, and the near-term signal from our proprietary MacroQuant model stuck in bearish territory for the second month in a row, the tactical picture for stocks remains rather murky. Feature Blame It On The Neutral Rate If the world of macroeconomics were set in a superhero universe, the real neutral rate of interest, otherwise known as R-star, would undoubtedly be cast as an arch-villain. R-star is the interest rate consistent with full employment and stable inflation. A depressed R-star has made the zero lower-bound constraint on nominal rates a vexing problem for central bankers. Not long after the Global Financial Crisis began, policy rates fell to ultra-low levels. But even this was not enough to engender a strong recovery. Most economies needed negative real rates. However, with inflation stuck at low levels, there was a limit to how far below zero real rates could go. Japan, of course, has been no stranger to this problem. Policy rates have been close to zero for over 20 years, yet inflation remains stubbornly low (Chart 1). Some commentators have dismissed this issue, noting that real per capita GDP has still managed to grow at a reasonably healthy clip. Unfortunately, this misguided optimism ignores the fact that Japan was only able to keep the economy from sinking into a depression by relying on massive budget deficits. With Japanese monetary policy rendered impotent, fiscal policy had to pick up the slack. High levels of excess private-sector savings were absorbed with continued government dissavings (Chart 2). The result is a gross government debt-to-GDP ratio of 240%. A low R-star has also been a major problem in the euro area. Before the European sovereign debt crisis erupted, Germany was able to export its excess savings to the peripheral countries, who were more than happy to load up on cheap debt so that they could live beyond their means (Chart 3). Chart 1Japan: Even Zero Interest Rates ##br##Were Not Enough To Spur Inflation Chart 2Japan Relied On Large Fiscal Deficits And Current Account Surpluses To Offset The Rise In Private-Sector Savings Chart 3The European Periphery Is No Longer ##br##Absorbing Germany's Excess Savings Those days are over. Today, Germany's current account surplus stands at a gargantuan 8% of GDP, but much of Germany's savings are exported to the rest of the world. Consequently, the euro area current account balance has gone from roughly breakeven in the pre-crisis period to a surplus of 3% of GDP. This likely means that the neutral rate in the euro area has fallen further. R-Star In China Chart 4China Saves A Lot What about China? One might think that China's fast trend GDP growth rate would translate into a high neutral rate. However, the neutral rate is not just a function of trend growth. Most economic models state that the savings rate also affects the neutral rate.1 The more income people wish to save at any given interest rate, the lower the neutral rate will be. For a variety of institutional and cultural reasons, the Chinese save a lot (Chart 4). The national savings rate has averaged 50% of GDP for the past decade. In fact, despite an investment-to-GDP ratio of 44%, China still manages to run a current account surplus (remember the current account balance is just the difference between savings and investment). A Simple Thought Experiment The earth does not trade with Mars. As a result, the global current account balance must be zero; current account surpluses in one set of countries must be offset by current account deficits in another set of countries. Interest rates and exchange rates play a vital role in ensuring that this identity is satisfied. Imagine a bunch of island economies - all with different neutral rates - that do not trade with one another. Now suppose a technological breakthrough occurs that permits free trade and capital mobility. What would you expect to happen? Standard economic theory says that capital will flow towards the islands with relatively high interest rates. As shown in Chart 5, the flood of capital will push down the interest rate in those economies. A lower interest rate, in turn, will discourage saving and encourage investment, leading to a current account deficit. Capital inflows will also drive up the currency, while higher spending will push up consumer prices. Such a "real appreciation" of the exchange rate is necessary to ensure that increased spending falls primarily on foreign-made goods.2 Chart 5Interest Rates And Current Account Balances In An Open Economy On the flipside, capital will flow out of economies with low neutral rates, putting upward pressure on interest rates. A higher interest rate will lead to more savings and less investment, translating into a current account surplus. Countries with relatively low neutral rates will also see a real depreciation of their exchange rates. If there is complete free trade and capital mobility, the final equilibrium will be one where interest rates are equalized across all islands and the current account deficits of the islands with relatively high neutral rates are exactly offset by the current account surpluses of the islands with low neutral rates. In addition, countries with relatively high neutral rates will end up with exchange rates that appear somewhat overvalued relative to their fair value, while those with low neutral rates will have exchange rates that appear somewhat undervalued. U.S.-China Trade Tensions: An Inevitable Conflict There are many structural reasons why the U.S. and China are at loggerheads over trade these days. We predicted that Trump would win the presidency largely because we thought the political/media establishment was underestimating the importance of the populist wave sweeping across the U.S. and much of the world. Our geopolitical analysts share this view. They have also argued that China's growing economic, military, and technological prowess will inevitably put it into conflict with the U.S., which has been the world's sole hegemon ever since the Soviet Union collapsed.3 This week's report adds another structural reason to the list. While R-star in the U.S. is fairly low by historic standards, it is higher than in most other countries, reflecting America's favorable demographics, large fiscal deficit, and relatively spendthrift culture. This means that the U.S. must run a structural current account deficit. This, of course, is at odds with the Trump administration's stated objectives. Efforts by China or any other country to "talk up" their currencies in the hopes of placating Trump will fail. The U.S. economy is already operating at close to full employment. A weaker dollar would only shift the composition of spending towards domestically-produced goods. The U.S., however, does not have enough spare labor to produce these additional goods. All that would happen is that inflation would rise, rendering U.S. exporters less competitive. More stimulative fiscal policy will further increase the neutral rate of interest in the United States. Chart 6 shows that the budget deficit is set to widen to nearly 6% of GDP by 2019 even if the unemployment rate continues to decline. A larger budget deficit will drain national savings, shifting the savings schedule in the savings-investment diagram discussed earlier to the left. This will result in a bigger current account deficit (Chart 7). Chart 6The U.S. Budget Deficit Is Set To Widen Even If The Unemployment Rate Continues To Decline Chart 7A Bigger U.S. Budget Deficit Will Cause The U.S. Neutral Rate To Rise, ##br## Leading To A Larger Current-Account Deficit Investment Considerations The specter of trade protectionism is here to stay, as is the prospect of escalating U.S.-China geopolitical tensions. Fortunately, beggar-thy-neighbor policies are less attractive when jobs are plentiful, as is the case in the U.S. today. Trump also remains constrained by the stock market's view of his actions. After all, this is a president who likes to measure the success of his economic agenda by the value of the S&P 500. As such, we expect both the U.S. and China to follow a two-pronged approach to trade issues over the coming months. Publicly, they will snipe at one another, threatening each other with tariffs and other trade barriers. Privately, they will seek out a compromise that avoids a full-out trade war. China's announcement this week that it will retaliate in kind to the U.S. decision to impose tariffs on $50 billion in Chinese imports should not have taken anyone by surprise. The Chinese government had repeatedly said that they would do precisely this. Importantly, U.S. tariffs do not kick in until June. Between now and then, negotiators from both sides will try to hammer out a deal. Just as with the steel and aluminum tariffs, the final set of tariffs will be a watered-down version of the original proposal. Political theatre will be the name of the game. As discussed in last week's Q2 Strategy Outlook, our base case remains that another global recession is still about two years away, which should keep the bull market in global equities intact.4 We warned investors to "Take Out Some Insurance" on February 2nd, one day before the VIX spike began.5 Now that the S&P 500 is 7% off its highs, our bet is that the path of least resistance for global equities over the next 12 months is up. Nevertheless, with global growth decelerating, financial conditions tightening at the margin, and the one-month ahead signal from the beta version of our forthcoming proprietary MacroQuant model stuck in bearish territory for the second month in a row, the tactical picture for stocks still looks rather murky (Chart 8). For the time being, short-term investors should sell the rallies and buy the dips. Chart 8MacroQuant Model: Tactical Picture For Stocks Still Looks Rather Challenging Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 2 The real exchange rate can be thought of as the volume of foreign goods and services that can be acquired by selling a basket of U.S. goods and services. Mathematically, the real exchange rate between two currencies is the product of the nominal exchange rate and the ratio of prices between the countries. A real appreciation tends to make a country less competitive, either through a nominal increase in its currency or through an increase in domestic prices relative to foreign prices. 3 Please see Geopolitical Strategy Special Report, “Sino-American Conflict: More Likely Than You Think, Part II,” dated November 6, 2015; and Global Investment Strategy Special Report, “The Looming Conflict In The South China Sea,” dated May 29, 2012. 4 Please see Global Investment Strategy Q2 Strategy Outlook, “It’s More Like 1998 Than 2000,” dated March 30, 2018. 5 Please see Global Investment Strategy Weekly Report, “Take Out Some Insurance,” dated February 2, 2018, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights The U.S. and China have a roughly 60-day period to prevent the current trade "skirmish" from metastasizing into a full-blown trade war; The revised U.S.-Korea trade deal suggests that Trump's trade negotiators are credible and are targeting China, not U.S. allies; The U.S. will demand that China's recent RMB appreciation is backed by a long-term reduction in foreign exchange intervention; Tariff reciprocity is not significant, but market access and investment reciprocity are; China will offer concessions first, and will only go to a trade war if Trump imposes sweeping tariffs anyway; Short Chinese technology stocks; remain short China-exposed S&P500 stocks in expectation of further volatility. Feature The market is coming to terms with the fact that President Trump is willing to put his policies where his campaign rhetoric was, at least on trade policy. U.S. equities are down 5.7% since the White House announced Section 232 tariffs on steel and aluminum and 2.34% since it announced forthcoming Section 301 tariffs against China. Although we have cautioned clients since November 2016 that protectionism is a real risk to global growth and risk assets,1 we believe that the current set of U.S. demands on China justify the moniker of a "trade skirmish," rather than a full-out war.2 That said, the 5.7% drawdown is appropriate, if a bit sanguine. Our "trade skirmish" view is low-conviction. President Trump remains unconstrained on trade policy, giving him leeway to be tougher than the market expects. As such, it is appropriate for the market to price a 20%-30% probability of a full-blown trade war. Given that the market drawdown in such a scenario could be 20% or more, the current market action is appropriately pricing the worst-case scenario. Why would a trade war between the U.S. and China elicit a bear market in U.S. equities if a similar confrontation between Japan and the U.S. did not in the late 1980s? For three reasons. First, the overvaluation of stocks is much greater today. Second, interest rates are much lower, restricting how much policymakers can react to adverse risks. Third, supply chains are much more integrated today, globally and between China and the U.S. Nearly every major S&P 500 multinational corporation is in some way exposed to these supply chains. As such, we think the current drawdown is appropriate. That said, the administration's policy is not haphazard. President Trump and U.S. Trade Representative (USTR) Robert Lighthizer are on the same page, making China - and not NAFTA trade partners or South Korea - the main target of U.S. protectionism (Chart 1). The rapid pace at which the administration pivoted from global tariffs to targeting China gives a clear indication of what is afoot. The U.S. is using the threat of tariffs to cajole its allies into tougher trade enforcement against China (Table 1).3 We think this strategy can work, as outlined last week, but there is plenty of room for mistakes that could derail it. Chart 1China, Not NAFTA, In The Crosshairs Table 1U.S. Gradually Exempting Allies From Tariffs Trump also wants to change U.S. policy on immigration and could use the NAFTA negotiation to gain leverage over Mexico. There is therefore still some probability that Trump triggers Article 2205 to leave NAFTA, but we believe it has declined substantively since we put it at 50% in November, particularly given the U.S.-South Korea negotiations we discuss below.4 This week we take a look at the revised U.S.-Korea trade deal and what it suggests about the Trump administration's trade agenda more broadly. Then we update the status of the U.S.-China trade frictions, which are only temporarily subsiding, if at all. Lessons From The KORUS Talks The just-completed renegotiation of the U.S.-Korea free trade agreement (the "KORUS FTA") offers some clues to the Trump administration's trade tactics that may be relevant for future negotiations with NAFTA partners, China, and others. President Trump has repeatedly criticized the KORUS FTA, as the U.S. trade deficit with South Korea has ballooned since its implementation in March 2012 (Chart 2). Trump used the threat of withdrawing from the deal to pressure South Korean President Moon Jae-in not to ease sanctions on North Korea too rapidly. Chart 2Why Trump Likes Tariffs Now USTR Lighthizer and his South Korean counterpart, Hyun Chong-Kim, have agreed to the outlines of a revised deal.5 The key points are as follows: Steel tariff waiver for Korea: South Korea will receive a country-level exemption from the U.S.'s recently imposed steel tariffs.6 Going forward, Korean steel exports will be subject to quotas equivalent to 70% of the average annual import volume during 2015-17. Greater market access for U.S. autos: Korea will double the number of autos it imports on the basis of U.S. safety standards, from 25,000 to 50,000 per year from each U.S. carmaker. It can import more subject to its own safety standards. It will refrain from any new emissions-standards tests, will accept U.S. safety standards on auto parts, and will ease ecological policies and the customs process of verifying the origin of exports. Delayed market access for Korean trucks: The U.S. will retain the existing 25% tariff on Korean trucks through 2041, instead of 2021 (Chart 2, second panel). Fair treatment of U.S. pharmaceutical imports: Korea promises not to discriminate against U.S. drugs but to grant them fair treatment under KORUS provisions. Ancillary currency agreement: The two sides appended a "gentleman's agreement" on currency policies, which is not a formal part of the deal and not subject to legislative confirmation. South Korea agreed not to devalue the won competitively, or to manipulate it more broadly, and to provide greater transparency regarding its interventions in foreign exchange markets. There are three main takeaways from the above. First, the U.S. is obviously focusing on non-tariff barriers to trade, the main hindrance to trade in a world with already low tariff rates. The grievances with Korea were primarily due to safety standards, environmental policies, and burdensome administration that hindered U.S. exports despite the reduction of tariffs under the KORUS agreement. Second, USTR Robert Lighthizer - the seasoned negotiator of the historic 1980s trade disputes with Japan, and the man in charge of the current NAFTA and China negotiations - deserves his reputation as a competent policymaker. He apparently makes concrete demands and is capable of compromising to conclude deals. This reduces the risk, overstated by the media, that the inexperienced U.S. president is driving the trade negotiations. Third, the U.S. is not deliberately trying to punish its allies in pursuit of some mercantilist fantasy of closing every single trade imbalance. Strategic logic dictated that Washington and Seoul needed to conclude a deal quickly so as to better coordinate on North Korea, and they did so. It is highly unlikely that the concluded deal will end the U.S. trade imbalance with South Korea, but it will likely improve it substantively. Moon Jae-in continues to be a pragmatist in his dealings with Trump and Trump is joining Moon's "Moonshine" policy of engagement with North Korea. Talk of the U.S. abandoning its allies did not materialize. (Japan and Taiwan are likely to get deals soon.) Most importantly, this deal is a strong indication that the U.S. will continue to pressure China on its foreign exchange practices. It would make no sense for the U.S. to require its allies to disavow competitive devaluation and reduce currency interventions while not demanding similar assurances from China. On this front, China's recent appreciation of the yuan will not ultimately satisfy the U.S., as it is arbitrary. The U.S. will need to extract deeper guarantees, with the implicit threat of tariffs to prevent China from backsliding. Otherwise the U.S. would yield Chinese exporters a foreign exchange advantage relative to American trade partners who agree to stop intervening to preserve a favorable exchange rate with the USD. A simple comparison of these countries currency moves over the past eight years reveals how they have allowed less appreciation relative to the U.S. than in trade-weighted terms, and how China would benefit if the others were forced to stop this practice while it was left off the hook (Chart 3). Chart 3The U.S. Will Demand Currency Appreciation This last conclusion fits with our study of previous cases of U.S. trade protectionism, in which the end-game was dollar depreciation relative to key trade partners.7 The KORUS case can be considered alongside Lighthizer's and the Trump administration's handling of the Section 301 investigation into China's forced tech transfer and intellectual property theft. The Trump administration came out swinging with unilateral 25% tariffs on about $60 billion worth of goods, to be listed on April 6 and enacted sometime in June. But it also signaled that it would allow a consultation period, and initiated a case through the World Trade Organization, thus reinforcing (rather than undermining) the global trading system. These developments give some grounds for optimism in the NAFTA negotiations and (less so) in the China negotiations. While China is preempting U.S. demands on its currency policy, it will be averse to providing any permanent guarantees, or to painful structural demands. This is due to its concerns about overall stability and its suspicion that the U.S. is pursuing a broader strategic containment policy against it. We discuss these issues below. Bottom Line: The preliminary conclusions of the KORUS FTA negotiation suggest that the Trump administration's trade leadership is credible, while Trump himself is looking for quick and concrete trade "wins" that can be presented to his domestic voter base. This is a marginally market-positive sign. But its ramifications are limited with regard to China, where strategic tensions and geopolitical competition will make it much harder to strike a similar deal quickly. U.S.-China: Fade The "Mirror Tax," Focus On Market Access And Tech China announced tariffs on roughly $3-$3.5 billion worth of U.S. goods on April 2 - ranging from fruits and nuts to wine and pork - in retaliation for the steel and aluminum tariffs that the U.S. imposed in March under Section 232 of the Trade Expansion Act of 1962. China used the exact same tariff rates as the U.S. - 25% and 10% - while selecting the product list so as to produce roughly the same net trade impact in USD terms (Chart 4). The implication is that China will retaliate in kind to deter the U.S., but does not wish to "up the ante." This is largely what we expected, but the implication is significant: the U.S. is about to release a preliminary list on April 6 of $50-$60 billion worth of goods on which it will slap tariffs. This second round of tariffs - which is China-specific - follows from the probe under Section 301 of the Trade Act of 1974. China's recent decision suggests that if negotiations fail, it will respond with tariffs worth roughly the same amount, which is a much bigger exchange of fire for these two economies. The actual retaliatory action would most likely occur in June, when the U.S.'s list is finalized and implemented, though China may hint at its product list much sooner, adding to trade fears and market volatility.8 The Trump administration claims that its product list will be chosen by an algorithm to maximize the impact on Chinese exporters while minimizing the impact on the American consumer. Consistent with this aim, some reports indicate that the goods will be advanced technological products set to benefit from China's "Made in China 2025" plan, in which China has laid down aggressive domestic content requirements (Chart 5). Chart 4Tit For Tat Chart 5China's High-Tech Protectionism What is the Trump administration's goal? Treasury Secretary Steve Mnuchin declared at the G20 finance ministers' meeting that he did not want to penalize Chinese imports so much as promote U.S. exports. Is this a credible basis for assessing the administration's policy? Yes and no. We think Mnuchin is telling the truth, but not the whole truth. When it comes to blocking imports or boosting exports, Mnuchin is right: the U.S. goal is not simply to punish Beijing for past unfair trade practices by blocking imports of Chinese goods. True, the Trump administration has focused on a lack of reciprocity in tariff rates. But a "mirror tax" or "mirror tariff" with China, which Trump has referred to, would not make much of a difference to the trade balance: Chart 6AThe U.S. Exports Soybeans And Cars To China Chart 6BChina Exports Phones And Computers To The U.S. Taking a look at the top ten exports of the U.S. and China to each other (Chart 6 A&B), it is quite clear that China imposes higher tariffs on U.S. goods than the U.S. imposes on Chinese goods (Chart 7 A&B). This follows from World Trade Organization rules and the relative level of economic development of the two countries. Chart 7AAmerican Exports To China Face Higher Tariffs... Chart 7B... Than Chinese Exports To America If we equalize these tariffs by raising U.S. tariffs to the same level as their Chinese counterparts for the same good, we wind up with a very small $6.2 billion gain to the U.S. trade balance (Chart 8). If we focus only on the top ten goods that both countries export to each other, and impose a hypothetical mirror tax, we wind up with an even smaller gain for the U.S. of $3.9 billion (Chart 9). This is small fry and cannot be the administration's goal (at least not its main goal). The real goal is to gain greater market access for U.S. exports in China. Here the U.S. may have a case, as China lags both its developed and emerging market peers in sourcing its imports from the U.S. (Chart 10). While China comprises 24% of total EM imports, it comprises only 15% of U.S. exports to EM. Even in commodity exports, where the U.S. has made major inroads in China, Beijing has recently limited the American share (Chart 10, middle panel). Chart 8Equalizing Tariffs Has Little Impact Chart 9Equalizing Tariffs Has Little Impact (2) Chart 10U.S. Grievance Is About Market Access A simple, back-of-the-envelope comparison of the U.S.'s top exports to China and EM ex-China suggests that the U.S. can make a case that its exports are suffering unduly in China: China's share of top U.S. exports is lower than one might expect it to be relative to EM or EM-ex-China (Chart 11 A&B). The U.S.'s market share of China's imports in key goods is lower than it is in EM or EM-ex-China (Chart 12 A&B). The U.S. share of China's top imports is smaller than the DM-ex-U.S. share (Chart 13 A&B). Chart 11AChina Is Not A Large Enough Share Of U.S. Exports (Broad) Chart 11BChina Is Not A Large Enough Share Of U.S. Exports (Detailed) Chart 12AU.S. Is Not A Large Enough Share Of Chinese Imports (Broad) Chart 12BU.S. Is Not A Large Enough Share Of Chinese Imports (Detailed) Chart 13AU.S. Has Less Market Access In China Than Other Exporters Chart 13BU.S. Has Less Market Access In China Than Other Exporters China has granted the legitimacy of U.S. complaints by pledging several times in the last few months to open market access. The latest news from the negotiations suggests that some progress is being made.9 Clearly the above is a very rough measure. Chinese consumers may not want to buy as much stuff from the U.S. as from Europe and Japan. The U.S. doubtless needs to improve its global competitiveness, and even then it may not gain as much market share in China as its DM peers. Nevertheless, Washington sees itself as the power that brought China into the global economy and allowed it to join the WTO. If China wants the U.S. to allow it to play a greater role in running the world, the U.S. is demanding a beneficial economic relationship in return. One way China is offering to deal with the problem is by buying American goods at the expense of U.S. allies' goods. For instance, Beijing has offered to buy more semiconductors from the U.S. and fewer from Taiwan and South Korea. This would alleviate the U.S. trade deficit a little, but at a greater expense to U.S. allies (Table 2). It would open up an opportunity for China to make more strategic acquisitions in those weakened, neighboring industries. It is not clear that the Trump administration will accept such a "concession," unless it is coupled with much greater concessions as compensation for selling out the allies. Table 2China's Trade Concessions To The U.S. Could Impose Costs On U.S. Allies Similarly, China's concessions that have been offered so far - like lowering the 25% tariff on car imports - are tokens in the right direction but not sufficient to satisfy the U.S. at the current juncture. This means that the U.S. will demand structural changes that increase market access, from a stronger RMB to a more consumer-oriented economy, as part of what will be a drawn-out effort to encourage China to rebalance its macroeconomy. Of course, Treasury Secretary Mnuchin was only telling half the truth: the U.S. also wants to prevent China from stealing too much of America's market share too fast. When we look at China's comparative advantage - the goods categories in which China's export growth has been fastest in recent years, weighted by contribution to the total - the U.S. is the country that has the largest global market share in these very goods (Chart 14). For instance, telecoms equipment, car parts, TVs, electrical circuits, etc. The U.S.'s export mix is not as dependent on these goods as that of China's neighbors (Taiwan, Vietnam, Malaysia, Singapore, South Korea), but it is the chief exporter of these goods nevertheless. Because many of China's most competitive goods are still low value-added (toys, plastics, textiles, furniture), China is pursuing tech upgrades, innovation, and intellectual property: it would eat away at the U.S. share of more advanced goods. Chart 14China's Comparative Advantage Threatens U.S. Global Market Share The Trump administration is trying to slow China's advance and put a stop to China's aggressive poaching of foreign tech and IP.10 This will include restrictions on Chinese direct investment and acquisitions to be announced by Mnuchin on May 21. We expect him to intensify an inherently stringent vetting process. The administration has already taken a proactive stance by blocking Canyon Bridge Capital Partners from acquiring Lattice Semiconductor and Singaporean company Broadcom's attempted acquisition of Qualcomm.11 Rumor has it that the administration is now considering invoking the International Emergency Economic Powers Act of 1977, which authorizes the president to take actions "to deal with any unusual and extraordinary threat, which has its source in whole or substantial part outside the United States, to the national security, foreign policy, or economy of the United States, if the President declares a national emergency with respect to such threat." Trump would be able to cite China's use of state-backed companies, corporate espionage, and cyber-attacks in pursuit of technology and IP (Table 3). Table 3Trump Lacks Legal Constraints On Trade Issues... Especially When National Security Is Involved This is entirely aside from legislation pending in Congress, which the White House appears to support, that would provide the Committee on Foreign Investment in the United States (CFIUS) with the ability to block investments across entire industries, rather than on a case-by-case basis, and with a broader definition of national security and sensitive property and technologies.12 While American presidents have historically vetoed similar legislation against China, the Trump administration may not, depending on the outcome of talks. The key point is that the U.S. political establishment - across the spectrum - is alarmed about China's economic mercantilism. As Senator Elizabeth Warren recently declared to a group of top policymakers in Beijing: "Now U.S. policymakers are starting to look more aggressively at pushing China to open up the markets without demanding a hostage price of access to U.S. technology."13 Warren, a staunchly liberal senator from the Democratic stronghold of Massachusetts, is entirely on the same page as Trump. The takeaway for investors? China's tit-for-tat response to Trump's steel and aluminum tariffs should not be dismissed out of hand. The market is sensitive to trade fears and there is a clear avenue for them to get worse if the 60-day consultation period lapses without any major Chinese concessions. True, negotiations are ongoing and Trump's trade team has been shown to be both credible and willing to pursue trade disputes through the WTO. Nevertheless there are substantial measures aimed at China coming down the pike and the usual restraints on U.S. policy, centered on the U.S. business establishment lobbying policymakers, are not as effective as in the past. Bottom Line: The U.S.'s primary economic goal in the China negotiations is not to equalize tariffs but to open market access. The strategic goal is much larger. The U.S. wants to see China's rate of technological development slow down. As such, Washington will expect robust guarantees to protect intellectual property and proprietary technology. Investment Conclusions Several clients have asked about the constraints on the different players if trade conflict should escalate over the coming months. On the surface the U.S. is in a stronger position because its outsized deficit with China means that measures constricting bilateral trade are inherently more damaging to China's output (Chart 15). Even some of China's best retaliatory options are difficult to put into practice, including selling U.S. treasuries or imposing sanctions on U.S. commodities (Table 4).14 Chart 15China More Exposed To Trade Than U.S. Table 4China's Retaliation Options Are Limited... Even In Agriculture The U.S. also faces a constraint in imposing measures on China because manufacturing value chains today sprawl across various countries and multinational corporations. Tariffs therefore punish countries, including U.S. allies, that provide inputs to China or American companies that profit from them - think Apple. Moreover, tariffs will not in themselves change the U.S.'s fundamental savings-investment balance, suggesting that demand for foreign goods will simply shift to other producers and the trade deficit will be unaffected. However, supply chain risk is ultimately not prohibitive for the U.S. China has long ranked among the most exposed to supply-chain disruptions, while the U.S. ranks among the least (Chart 16). Moreover, U.S. allies in Europe and ASEAN stand to benefit if supply chains are rerouted from China (Chart 17). While the U.S. and allies would suffer higher initial costs as a result, they would gain the strategic advantage of reducing China's centrality to global supply chains. The latter has given Beijing an advantage in acquiring technology and moving up the value chain. Chart 16China Most Exposed To Supply-Chain Risk Chart 17U.S. Allies Benefit If Supply Chains Move While the Xi Jinping administration is weaning China off export reliance and U.S. reliance, the country still employs 28% of its workers in the manufacturing sector, which leaves it more exposed to disruptions than the U.S. if trade frictions should spiral out of control and weaken overall demand (Chart 18). While American workers are intimately familiar with the boom-and-bust cycle of free labor markets, China has not struggled with significant unemployment since 2003 (Chart 19). Its middle class was much smaller then. Chart 18Employment Is A Constraint On China Chart 19China Unfamiliar With Large-Scale Job Loss In short, China will first attempt to appease the Trump administration through market access (and keeping the RMB strong) to maintain its supply-chain centrality and overall stability. If Trump accepts China's concessions, trade frictions will not spiral out of control - at least not this year. China will only accept a full-fledged trade war if Trump rejects its concessions and imposes punitive measures that threaten its stability. At that juncture, Xi would probably find it useful to demonize Trump and execute long-term changes to make China more self-sufficient, blaming the U.S.-initiated trade war for the painful consequences. This is why it matters if Trump's demands go beyond foreign exchange rates, improved market access, and IP enforcement - for instance, if they extend to capital account liberalization, the holy grail of American trade negotiations with China. Thus far, Trump's team has not raised this demand, but it is a subject we will revisit soon as it is likely to be China's red line, at least within the economic sphere. In light of our expectation for further trade-war related volatility, we would recommend shorting Chinese tech stocks15 and remaining short China-exposed U.S. stocks. The latter trade has been in the black by over 5% in just a week, but is currently up only 0.7%. It is a way to hedge the risk of further tensions between U.S. and China. Risks to this view are: if the U.S. reduces the Section 301 tariffs that it is threatening on or after April 6; if Treasury Secretary Mnuchin's investment restrictions due on May 21 are watered down; or if the U.S. makes no structural demands on China's economy but merely accepts temporary RMB appreciation and some big-ticket import orders. Otherwise the risk that trade tensions spiral out of control will remain elevated at least through the U.S. midterm elections on November 6. By then, Trump will need either to have cut a small-scale deal with China that he can tout for voters or to have taken more aggressive trade action pursuant to the Section 301 findings. Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 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 Please see BCA Geopolitical Strategy Weekly Report, "We Are All Geopolitical Strategists Now," dated March 28, 2018, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "NAFTA - Populism Vs. Pluto-Populism," dated November 10, 2017, available at gps.bcaresearch.com. 5 A 60-day consultation period with both legislatures will follow but the deal will probably remain in more or less the same form. 6 Aluminum was not included, but South Korea is not a major source of aluminum products for the U.S. 7 Please see footnote 2 above. 8 Please see David Lawder, "Trump to unveil China tariff list this week, targeting tech goods," Reuters, April 2, 2018, available at www.reuters.com. 9 Treasury Secretary Steve Mnuchin spoke with Politburo member Liu He, who is Xi Jinping's top economic policymaker, and they reportedly pledged that they are "committed" to a solution on reducing the U.S. trade deficit. The U.S. is asking for a $100 billion reduction to the trade deficit within the year, as well as some progress on intellectual property enforcement. Supposedly the specific demands involve reducing the Chinese tariff on car imports and raising the foreign ownership cap on Chinese financial companies, the latter of which China has previously promised to do. Please see Andrew Mayeda, "U.S. Pushes China On Cars And Finance In Tariff Talks," Bloomberg, March 26, 2018, available at www.bloomberg.com. 10 Please see the U.S. Trade Representative, "Findings of the Investigation into China's Acts, Policies, and Practices Related to Technology Transfer, Intellectual Property, and Innovation under Section 301 of the Trade Act of 1974," March 2018, available at ustr.gov. 11 In September 2017, the White House and Department of Treasury intervened in the attempt by a group of investors, including the state-owned China Venture Capital Fund, from acquiring Lattice, on the advice of CFIUS. Lattice makes computer chips that are highly versatile and can be used in military functions; the Chinese SOE was suspected of pursuing China's state-backed efforts to improve its semiconductor industry. Separately, in March 2018, President Trump blocked Singapore-based Broadcom's attempt to acquire Qualcomm, which would have been a hugely consequential tech merger due to the two companies' dominance in making processors. The Treasury Department feared that Chinese state entities might get access to Qualcomm's IP or that the merger might otherwise hinder Qualcomm's "technological leadership." Please see "CFIUS Case 18-036: Broadcom Limited (Singapore)/Qualcomm Incorporated," dated March 5, 2018, available at www.sec.gov. 12 Please see Andrew Mayeda, Saleha Mohsin, and David McLaughlin, "U.S. Weighs Use of Emergency Law to Curb Chinese Takeovers," March 27, 2018, available at www.bloomberg.com. 13 She was speaking with Liu He, seasoned diplomat Yang Jiechi, and Defense Minister Wei Fenghe. Please see Michael Martina, "Senator Warren, in Beijing, says U.S. is waking up to Chinese abuses," April 1, 2018, available at www.reuters.com. 14 Please see BCA Commodity & Energy Strategy Weekly Report, "Ags Could Get Caught In U.S. Tariff Imbroglio," dated March 15, 2018, and "Oil Price Forecast Steady, But Risks Expand," dated March 22, 2018, available at ces.bcaresearch.com. 15 Please see BCA China Investment Strategy Weekly Report, "After The Selloff: A View From China," dated February 15, 2018, available at cis.bcaresearch.com. Geopolitical Calendar

Highlights Global growth has peaked, but will remain firmly above trend for the remainder of the year. The composition of global growth is shifting back towards the U.S. As often happens in the late stages of business-cycle expansions, asset markets have entered a more volatile phase. A global recession is likely in 2020. Equities: The correction is nearing an end, which will set the stage for a blow-off rally into year-end. For the time being, favor DM over EM stocks, Europe over the U.S., and value over growth. The "real" bear market will start next year. Government bonds: Global bond yields will trend higher over the next 12 months, but will begin moving lower by the middle of next year as recession risks mount. Over the long haul, yields are going higher - much higher. Credit: Spread product will eke out small gains relative to government bonds over the next 12 months. Spreads will blow out as the recession approaches. Investors will be shocked to learn that a lot of what they thought is investment-grade debt is really junk (or worse). Currencies: The U.S. dollar will bounce before resuming its bear market next year. The yen could weaken slightly against the dollar in 2018, but will hold its own against most other currencies. Energy-sensitive currencies such as the CAD will outperform other commodity currencies. Feature Booyah Writing frantically on October 8, 1998, CNBC commentator and former hedge fund manager Jim Cramer entitled his TheStreet.com piece with the indelible words "Get Out Now". Long-Term Capital Management had just imploded. Emerging Markets were crashing. Coming off the heels of a stratospheric ascent, the S&P 500 was down 22% from its highs. The tech-heavy NASDAQ had swooned 33%. The equity bull market had finally ended. Or so he thought. As fate would have it, the S&P 500 bottomed literally the very same minute that Cramer's piece came out.1 It went on to rise 68% before ultimately peaking in March 2000. Cramer would go on to avenge his 1998 call, wisely counseling his readers on October 6, 2008 to "take your money out of the stock market right now, this week." But on that fateful day in 1998, he was wrong. There are many differences in the economic environment between now and then, but on the crucial question of which way global equities are heading, history is likely to rhyme. As was the case in the late 1990s, the shakeout this year may be a prelude to a blow-off rally that takes stocks to new highs. Historically, equity bear markets and recessions almost always overlap (Chart 1). In fact, the most useful lesson I have learned over the past 25 years studying macro and markets is that unless you think a recession is around the corner, you should overweight stocks. It's as simple as that. Chart 1Recessions And Bear Markets Usually Overlap Fortunately, another recession is not around the corner. Interest rates are rising but are not yet in restrictive territory. Fiscal policy is being loosened, particularly in the U.S. Easy fiscal policy and still-accommodative monetary policy rarely produce recessions. As we discuss below, a global recession will eventually arrive - probably in 2020 - but that is still two years away. Stocks normally sniff out recessions before they start. However, the lead time is usually about six months. As Table 1 illustrates, equities typically do well in the second-to-last year of business-cycle expansions. We are probably in that window now. Table 1Too Soon To Get Out A Whiff Of Stagflation So why the newfound angst? Partly, it is because markets were technically overbought and due for a correction. We warned clients as much in a report entitled "Take Out Some Insurance", published on February 2nd, one day before the VIX spike began.2 Fears of stagflation are also escalating. Inflation appears to be rising at the same time as global growth is slowing. Real potential GDP has increased at a snail's pace in the G7 economies over the past decade, the result of disappointing productivity gains and sluggish labor force growth (Chart 2). If the world is running out of spare capacity - and GDP growth is forced to climb down towards what many fear is an anemic trendline - then revenue and earnings growth are apt to decelerate. Chart 2Lackluster Productivity Gains And Anemic Labor##br## Force Growth Have Weighed On Potential GDP Escalating protectionism has further exacerbated anxieties about stagflation. President Trump has threatened to hike tariffs on steel and aluminum, go after China for allegedly stealing U.S. intellectual property, and pull out of NAFTA if a new deal is not negotiated in America's favor. An all-out global trade war would raise consumer prices and reduce output by impairing the efficient allocation of resources across countries. Investors have taken notice. None of these stagflationary concerns can be summarily dismissed, but they are less worrisome than they might appear. Let's start with trade wars. A Trade Spat, Not A Trade War We have long thought that we are in a secular bull market in populism. This is why we argued that investors were greatly understating the risks of Brexit in the weeks leading up to the referendum. It is also why we ignored the derision of others and predicted that Trumpism would prevail back in 2015 and that Trump himself would win the presidency by securing a larger-than-expected share of disgruntled white blue-collar workers in the Midwest.3 Trade protectionism, of course, is a major part of most populist agendas. However, the attractiveness of protectionism tends to ebb and flow depending on the state of the business cycle. There is a reason why the Smoot-Hawley tariff act was introduced during the Great Depression and not the Roaring Twenties. Both economically and politically, beggar-thy-neighbor policies are more appealing when unemployment is high and one more job abroad means one less job at home. That is not the case today, at least not in the U.S. Moreover, while the U.S. legal system gives the president free rein to impose tariffs and other trade barriers, Donald Trump is still constrained by the reaction of the business community and financial markets. After all, this is a president who likes to measure his self-worth by the value of the S&P 500. Needless to say, investors do not like protectionism. It is not surprising, therefore, that Trump has watered down his tariff rhetoric every time the stock market has sold off. It also not surprising that Trump has increasingly focused his wrath on China, a country with which the U.S. business community has had a love-hate relationship. A blue-ribbon commission recently estimated that intellectual property theft - most of it originating from China - costs the U.S. $225 billion-to-$600 billion per year.4 That is a lot of money that American companies could be making but aren't. China will undoubtedly complain that it is being unfairly singled out. It will also threaten retaliatory measures if the Trump administration imposes trade barriers on Chinese imports. In the end, those threats are likely to ring hollow. A war is only worth fighting if you think you can win. China has a very asymmetric trading relationship with the U.S., and one that gives it very little leverage. U.S. exports to China amount to less than one percent of U.S. GDP. That's peanuts - in some cases literally: Nearly half of U.S. goods exports to China consist of soybeans, wheat, cotton, nuts, and other agricultural products and raw materials. It would be difficult to tax them without hurting Chinese consumers. Of course, China could try to punish the U.S. by dumping Treasurys. But why would it? This would only drive down the value of the dollar, giving U.S. exporters a greater advantage. Trump wants that! Saying that you will retaliate against Trump's tariffs by no longer manipulating your currency is not exactly a credible threat.5 In the end, far from retaliating, China will try to placate Trump by easing restrictions on trade and foreign investment and making some politically-calculated purchases of U.S.-made goods. Boeing's stock sold off in the wake of escalating trade tensions. It probably should have risen. Peak Growth? In contrast to last year, global growth is no longer accelerating. Our Global Leading Economic Indicator is still rising, but the diffusion index, which measures the proportion of countries with rising LEIs, is down from its October 2017 high (Chart 3). Changes in the diffusion index have often foreshadowed changes in the composite LEI. An even more worrisome picture is painted by the OECD's LEI, which has actually dipped slightly over the past two months. The OECD's LEI diffusion index has also fallen below 50%. The Chinese economy appears to be slowing on the back of tighter monetary conditions (Chart 4). The Keqiang index, which combines data on electricity production, freight traffic, and bank lending, has come off its highs and our leading indicator for the index is pointing to further weakness. Property price inflation in tier 1 cities has fallen to zero. A number of clients noted during my visit to China last week that a wave of supply has hit the market over the past month following President Xi's warning that homes are for living and for not investing. A weaker Chinese property market could drag down construction spending, with adverse knock-on effects to commodity prices. Slower Chinese growth is rippling across the global economy (Chart 5). Korean exports - a bellwether for global trade - have decelerated. Japanese machinery orders have rolled over. The Baltic dry index has plunged by 40% from its December highs. The expectations component of the German IFO index has fallen to its lowest level since January 2017. Chart 3Global Growth Will Remain Above Trend,##br## But Has Probably Peaked For This Cycle Chart 4China's Industrial Sector Is Set ##br##To Slow Further China Is Slowing Chart 5Signs Of Slowing##br## Global Growth So far, the slowdown in global growth has been fairly modest. Goldman's global Current Activity Indicator (CAI), which combines both soft and hard data to gauge underlying economic momentum, was still up 4.9% in March, only slightly below recent cycle highs (Chart 6). The deterioration in a number of leading economic indicators suggests that the slowdown may have further to run. However, we would be surprised if it proves to be especially deep or long-lasting. Global financial conditions are still quite accommodative (Chart 7). Bank balance sheets are in good shape and rising capex intentions should support credit demand over the coming months, even in the face of somewhat higher borrowing costs. Improving labor markets should also bolster consumer confidence. Chart 6But Global Slowdown Has Been Fairly Modest Chart 7Global Financial Conditions Are Still Fairly Easy Back To The USA If global growth were decelerating because capacity constraints were starting to bite, this would be more worrying because it would mean any effort to stimulate demand would simply lead to more inflation rather than stronger economic growth. Reassuringly, that does not appear to be the case. The U.S. has slowed less than other large economies, even though it is closer to full employment. Notably, the manufacturing PMI has continued to rise in the U.S., but has dipped most everywhere else. Both Citigroup's and Goldman's economic surprise indices are still positive for the U.S., but have fallen into negative territory in Europe and Japan (Chart 8). Granted, Bloomberg consensus estimates suggest that U.S. growth will edge down to 2.5% in the first quarter. However, this may reflect ongoing seasonal adjustment problems. First quarter growth has averaged 1.7 percentage points less over the past decade than in the rest of the year. We are particularly skeptical of recent data showing that consumer spending has slowed, which is completely at odds with strong employment growth, rising home prices, and near record-high levels of consumer confidence. Looking out, U.S. demand growth should benefit from all the fiscal stimulus coming down the pike. We expect the fiscal impulse to rise from 0.3% of GDP in 2017 to 0.8% of GDP in 2018, and 1.3% of GDP in 2019 (Chart 9). The actual numbers could be even higher as our estimates do not include any additional expenditures on infrastructure, the possible restoration of earmarks (which could inflate pork-barrel spending), or the high likelihood that recent changes to the tax code will spawn all sorts of unforeseen loopholes, leading to lower-than-expected tax receipts. Chart 8U.S. Is The Standout Chart 9Fiscal Stimulus Bode Well For Growth Unfortunately, all this fiscal stimulus is coming at a time when the economy does not need it (Chart 10). The U.S. unemployment rate currently stands at 4.1%, 0.4 percentage points below the Fed's estimate of NAIRU. Given the prospect of continued above-trend growth, the unemployment rate is likely to be close to 3.5% by early next year, which would be below the 2000 low of 3.8%. Chart 10Now Is Not The Time For Fiscal Profligacy Rebalancing Global Demand: The Role Of The Dollar What happens when fiscal stimulus pushes aggregate demand beyond an economy's productive capacity? One possibility is that imports go up, thereby allowing the additional demand to be satiated with increased production from the rest of the world. For this to happen, however, the prices of foreign-made goods sold in the U.S. need to decline relative to the prices of domestically-produced goods. U.S. imports account for only 15% of GDP. Thus, if the prices of U.S.-made goods do not change relative to the prices of foreign-made goods, only 15 cents or so of every additional dollar of income will fall on imports. After all, consumers do not care about the intricacies of balance of payments statistics when they are deciding whether to buy a foreign or domestic automobile. They care about relative prices. This means that either the nominal trade-weighted dollar must appreciate or the U.S. price level must rise relative to foreign prices. Both outcomes imply a "real appreciation" in the dollar exchange rate, which can be thought of as the volume of foreign goods and services that can be acquired by selling a basket of U.S. goods and services.6 In theory, one can envision a scenario where the nominal dollar exchange rate depreciates while the real exchange rate appreciates over the long haul because inflation rises significantly in the U.S. relative to its trading partners. Much of the market commentary has implicitly focused on just such an outcome. Massive fiscal stimulus, as the story goes, will lift U.S. inflation by so much that the dollar will fall over time. The problem with this narrative is that it is difficult to square with the facts. Long-term inflation expectations have actually risen more in the euro area and Japan since Trump got elected (Chart 11). The true puzzle is that rising U.S. real yields have not translated into a stronger dollar (Chart 12). Chart 11Long-Term Inflation Expectations Have ##br##Risen More In Japan And The Euro Area##br## Than The U.S. Since Trump Took Over Chart 12The Dollar Has ##br##Decoupled From Interest##br## Rate Differentials A Trump Risk Premium? What happened, as Hillary Clinton might ask? One answer is that Trump happened. Larry Summers has argued that political uncertainty around Trump's antics (protectionism, the Mueller probe, the porn stars, etc.) has made holding U.S. assets more risky.7 This risk has been exacerbated by the prospect of large current account and fiscal deficits - the so-called "twin deficits" - stretching for as far as the eye can see. If this theory is correct, the increase in U.S. real bond yields may be less the result of better growth expectations and more the consequence of a rising risk premium on long-term government debt. It's an intriguing hypothesis, but it cannot explain why business confidence is near all-time highs or why the S&P 500, despite this year's selloff, has risen by 23% since the U.S. presidential election. It also cannot explain why the yield curve has flattened recently, which is not what you would expect if investors were shunning long-term bonds. Perhaps it is best not to overthink things. The dollar is a high-momentum currency (Chart 13). At the start of 2017, the greenback was overbought (Chart 14). Then global growth began to accelerate, which has historically has been bad news for the dollar (Chart 15). The lion's share of that growth also came from outside the U.S. None of this is true today, but the downward trend in the dollar has remained intact, and that is proving hard to break. Chart 13USD Is A Momentum Winner Chart 14USD Was Overbought At The Start Of 2017 Hard but not impossible. The dollar could get a bit of a reprieve. USD Libor has broken out recently (See Box 1 for details). As Chart 16 illustrates, there has been an extremely close relationship between the dollar index and the 3-month lagged value of the Libor-OIS spread. The cost of shorting the dollar is about to spike as borrowing rates linked to Libor reset over the next few weeks. The Libor spread will eventually come down, but perhaps not before the negative momentum against the dollar has turned into positive momentum. Chart 15Slowing Global Growth Tends##br## To Be Bullish For The Dollar Chart 16Shorting The Dollar Is About##br##To Get A Lot More Expensive Fixed-Income: Hedged Or Unhedged? Chart 17Bond Yields, Currency-Hedged When European investors buy U.S. bonds, they take on exposure to both the value of the bond and what happens to the euro-dollar exchange rate. If they do not want to assume the currency risk, they can sell the dollar forward, effectively locking in the number of euros they will receive for every dollar sold. The purchase of the bond increases the demand for dollars, while the commitment to sell the dollar increases the supply of dollars. For the value of the dollar, it is largely a wash.8 Likewise, if U.S. investors do not want to bear currency risk when purchasing German bunds, they can sell the euro forward. This also entails two offsetting transactions: One that boosts the demand for euros and one that raises the supply of euros. The spike in USD Libor has increased the currency-hedged return of non-U.S. bonds relative to U.S. bonds. Chart 17 shows that the yield on 10-year Treasurys, hedged into euros, has fallen to 0.06%, which is below the 0.5% yield offered by German bunds. In contrast, the 10-year bund yield, hedged into dollars, has risen to 3.16% - which is above the 2.78% yield offered by Treasurys. All things equal, it becomes less attractive for foreign investors who wish to buy U.S. bonds to hedge currency risk as USD Libor rises. In contrast, it becomes more attractive for U.S. investors to currency-hedge their overseas bond purchases when USD Libor goes up. Unhedged bond purchases bid up the currency of the issuer, but hedged purchases do not. If a smaller share of foreign investors decide to hedge currency risk when buying Treasurys, while a larger share of U.S. investors decide to hedge currency risk when purchasing foreign bonds, the net demand for dollars will rise. This could help the dollar over the coming months. Go Long Treasurys/Short German Bunds, Currency-Unhedged The correlation between the German-U.S. 30-year bond spread and EUR/USD was extremely tight in 2017 but has completely broken down this year (Chart 18). At this juncture, betting on a normalization of this correlation - effectively, a bet that U.S. Treasurys will outperform bunds in currency-unhedged terms - has become too good to resist. In fact, it is almost a "can't lose" wager. Consider the fact that 30-year Treasurys are yielding 182 basis points above comparable-maturity bunds. The euro would have to rise to 1.23*(1.0182)^30=2.11 against the dollar over the next 30 years for investors to lose money on this investment. Chart 18Unsustainable Divergence? Granted, inflation is likely to be lower in the euro area. CPI swaps are forecasting that euro area inflation will be roughly 40 bps lower compared to the U.S. over the next three decades. However, this would only lift the Purchasing Power Parity (PPP) value of EUR/USD from its current level of 1.32 to 1.49. In other words, long-term investors betting on the euro are effectively betting on a major euro overshoot. The discussion above raises a more fundamental point. Investors often equate their view about the direction in which a currency is heading with whether to be bullish or bearish on it. We completely agree that the trade-weighted dollar will weaken over the long haul because most valuation metrics suggest that the greenback is still expensive. However, given the carry advantage the U.S. enjoys, long-term investors would still be better off overweighting U.S. fixed-income assets. Regional Equity Allocation U.S. equities have outperformed their global peers since the start of 2017 in local-currency terms but have underperformed in common-currency terms (Chart 19). If the dollar rebounds over the next few months, as we expect, this should boost the local-currency value of European stocks since many large multinational European companies generate sales in dollars. Sector skews should also work in Europe's favor. Financials are the largest overweight in euro area bourses, while technology is the biggest overweight in the U.S. (Table 2). Chart 19U.S. Equities Have Outperformed In Local-Currency Terms, But Not In Common-Currency Table 2Global Sector Skews: Tech Resides In The U.S. And Growth Indexes,##br## Financials Live In The Eurozone And Value Indexes While global growth has peaked, it will remain firmly above trend. This will ensure that spare capacity continues to shrink, taking global bond yields higher. Since the ECB will not raise rates for at least another year, the yield curve in the euro area will steepen, boosting the profitability of European banks (Chart 20). Tech companies are particularly sensitive to changes in discount rates since they often trade on the assumption that most of their earnings will be realized far into the future. As such, higher long-term real bond yields will adversely affect U.S. tech names, especially in an environment where the dollar is strengthening (more than 50% of U.S. tech sales are derived from abroad). Recent concerns over the way Facebook and other tech companies have handled privacy issues could further sour sentiment towards the sector. The outlook for Japanese stocks is a tough call. Japan, like Europe, is trading at a discount relative to the U.S. based on our in-house valuation metrics (Chart 21). However, we do not see much downside for the yen, even after its recent appreciation. The currency remains very cheap by historic standards, Japan's current account surplus has widened to 4% of GDP, and unlike the euro, speculative positioning is short. While Japanese corporate earnings have been able to expand rapidly over the past 16 months without the support of a weaker currency, now that profit margins are near record highs (Chart 22), further gains in profits and equity prices are likely to be limited. Chart 20Euro Area Yield Curve ##br##Steepening Will Boost Banks Chart 21Japanese And Euro Area##br##Stocks Are Relatively Cheap The combination of higher U.S. rates, a stronger dollar, and weaker Chinese growth will weigh on EM equities over the coming months. There is $17 trillion in U.S. dollar-denominated debt held outside the U.S., most of it in emerging markets. Ironically, weaker Chinese growth will hurt other EMs more than it hurts China. China accounts for more than 50% of base metal demand compared to only 13.5% for oil (Chart 23). This means that the outlook for metal producers such as Brazil, South Africa, Chile, and Australia is more challenging than for energy producers such as Canada and Norway. Chart 22Global Profit ##br##Margin Picture Chart 23Base Metals Are More Sensitive##br## To Slower Chinese Growth Favor Value Over Growth We expect global value stocks to start outperforming growth stocks after more than a decade of deep underperformance (Chart 24). The valuation measures constructed by Anastasios Avgeriou and his global equity sector strategy team suggest that value stocks are trading more than two standard deviations cheap relative to growth stocks. Earnings revisions are also starting to move in favor of value names9. Similar to the U.S./euro area equity split, financials are overrepresented in value indices, while technology is overrepresented in growth indices. The weights of the energy and consumer discretionary sectors in the U.S. index are roughly the same as the weights of those two sectors in the euro area index. However, energy is overrepresented in global value indices while consumer discretionary is overrepresented in growth indices. Despite our outlook for a somewhat stronger dollar, our commodity strategists see upside for oil prices this year thanks to continued discipline by OPEC 2.0. This should help energy stocks. On the flipside, consumer discretionary stocks often struggle in a rising rate environment, so this should tilt the playing field in favor of value (Chart 25). Chart 24Value Versus Growth: ##br##Compelling Entry Point Chart 25Consumer Discretionary Stocks Do##br## Poorly In A Rising Rate Environment With all this in mind, we are initiating a trade recommendation to go long the All-Country World Value Index relative to the corresponding Growth Index starting today. Investment Conclusions Volatility typically rises in the late stages of business-cycle expansions, as inflation picks up and monetary policy becomes progressively less accommodative (Chart 26). We have entered such a phase. This does not mean that equities cannot go higher. Chart 27 shows that the VIX rose in the late 1990s, even as stocks zoomed to new highs. We are probably at the tail end of an equity correction now. A blow-off rally into year-end is likely. Chart 26A More Hawkish Fed Usually Means A Higher VIX Chart 27Volatility Can Increase As Stock Prices Rise We expect the fed funds rate to move into restrictive territory in the second half of 2019. Given the usual lags between changes in monetary policy and the real economy, this would place the next recession in 2020. By then, the U.S. fiscal impulse will have dropped back to zero. It is the change in the fiscal impulse that matters for growth. If growth has already slowed to a trend-like pace by late 2019 due to increasingly binding supply-side constraints, the economy could easily stall out in 2020. The extent to which investors may wish to participate in any blow-off rally this year is a matter of personal preference. As was the case in the late 1990s, long-term expected returns have fallen to fairly low levels. A comparison between the Shiller PE ratio and subsequent 10-year returns over the past century suggests that the S&P 500 will deliver a total nominal annualized return of only 3% over the next decade (Chart 28). A composite valuation measure incorporating both the trailing and forward PE ratio, price-to-book, price-to-cash flow, price-to-sales, market cap-to-GDP, dividend yield, and Tobin's Q shows only modestly higher expected returns for stock markets outside the U.S. (Appendix A). As such, while we recommend overweighting global equities over a 12-month horizon, we would not fault investors for taking some money off the table now. A somewhat more defensive posture would certainly be warranted. Recall that the NASDAQ bubble burst in March 2000, but the S&P 500, excluding the technology sector, did not peak until May 2001. During the intervening period, S&P tech stocks underperformed the rest of the market by 70% (Chart 29). As was the case back then, a shift away from tech leadership may be afoot. This would support our value over growth, and euro area over the U.S., recommendations. Chart 28Demanding U.S. Valuations Point##br## To Low Long-Term Returns Chart 29The Force Of Tech At ##br##The Turn Of The Century Spread product should be able to eke out small gains relative to government bonds over the next 12 months. Ratings migration has improved markedly following the energy related downgrades in 2014 and 2015. An improving rating migration ratio is usually associated with corporate bond outperformance relative to Treasurys (Chart 30). Spreads will blow out as the recession approaches. In this month's issue of The Bank Credit Analyst, my colleague Mark McClellan simulated the effect on investment grade credit from: 1) A 100 basis-point increase in interest rates across the curve; and (2) A more severe scenario where interest rates rise by 100 basis points and corporate profits fall by 25% peak- to-trough. Mark's calculations suggest that the next recession will see the interest coverage ratio drop more than in previous downturns (Chart 31).10 Investors may be shocked to discover that a lot of what they thought is investment-grade debt is really junk (or worse). Chart 30Ratings Migration Is Supportive For Credit But... Chart 31...Corporate Leverage Will Take Its Toll We suggested going long the dollar in August 2014. This view worked well for a while but struggled mightily last year. However, the broad trade-weighted dollar index has been fairly stable since September, and is actually up 2.3% since its January lows (Chart 32). The greenback is due for another rally, one that no doubt would catch many traders by surprise. After a heated internal debate, BCA shifted its house view on bonds towards a more bearish stance in July 2016. As fate would have it, our note entitled "The End Of The 35-Year Bond Bull Market" came out on the same day that the U.S. 10-year yield reached an all-time closing low of 1.37%.11 We observed in February that bond positioning had become extremely short and, thus, tactically, yields could come down a bit. This has indeed happened. Over a 12-month horizon, however, we continue to see yields rising more than what is currently priced in. Both the TIPS 10-year and 5-year/5-year forward breakeven rates are 20-40 basis point below the 2.3%-to-2.5% range that prevailed in the pre-recession period (Chart 33). Somewhat higher oil prices should also boost inflation expectations. Chart 32Up Then##br## Down Chart 33Breakevens Still Below Levels Consistent##br## With 2% Inflation Mandate In addition, the real yield component could rise as the market revises up its expectation of the terminal rate. Revealingly, the mean and median terminal dots in the Fed's Summary of Economic Projections increased by 8.3 and 12.5 bps, respectively, in March, but are still more than 100 bps below where they were five years ago. Bond yields will increase in the euro area, as the ECB continues to taper asset purchases. We see less scope for yields to rise in the U.K., as the Brexit hangover continues to weigh on growth. Yields in Japan will remain repressed due to the continuation of the Bank of Japan's Yield Curve Control regime. As the next recession approaches, global bond yields will fall, but are unlikely to take out their 2016 lows. As we discussed in a series of recent reports, both yields and inflation will make a series of "higher highs" and "higher lows" in the U.S. and most other countries over the next decade and beyond.12 Appendix B shows stylistic diagrams of how we expect returns across the major asset classes to evolve over the next decade. The spike in the U.S. Libor-OIS spread appears to be driven by the confluence of a couple of factors. First, Congress raised the debt ceiling on February 9th. This has allowed the U.S. Treasury to rebuild its cash reserves by issuing more T-bills. The sale of these T-bills has drained cash from the overnight market. Second, U.S. corporations have started to repatriate dollars held overseas following the passage of the tax bill. This has further exacerbated the dollar shortage abroad. Libor represents unsecured lending, and hence embeds a credit risk premium. Banks and other financial institutions have been reluctant to put up capital to arbitrage the difference between the rate on Libor and OIS (the latter being a good risk-free proxy for the market's expectation of where short-term policy rates will be). This reluctance reflects regulatory changes, rather than systemic financial risk of the sort experienced during the Global Financial Crisis and the European Sovereign Debt Crisis. The 3-month TED spread - the difference between Libor and Treasury yields - has moved up only modestly due to the fact that short-term Treasury yields have also risen relative to short-term interest rate expectations. Bank CDS spreads have barely increased at all. The Libor-OIS spread will probably fall over the remainder of this year. However, the cost of shorting the dollar will still rise as the Fed continues to raise policy rates. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Box 1 What's Up With Libor? The spike in the U.S. Libor-OIS spread appears to be driven by the confluence of a couple of factors. First, Congress raised the debt ceiling on February 9th. This has allowed the U.S. Treasury to rebuild its cash reserves by issuing more T-bills. The sale of these T-bills has drained cash from the overnight market. Second, U.S. corporations have started to repatriate dollars held overseas following the passage of the tax bill. This has further exacerbated the dollar shortage abroad. Libor represents unsecured lending, and hence embeds a credit risk premium. Banks and other financial institutions have been reluctant to put up capital to arbitrage the difference between the rate on Libor and OIS (the latter being a good risk-free proxy for the market's expectation of where short-term policy rates will be). This reluctance reflects regulatory changes, rather than systemic financial risk of the sort experienced during the Global Financial Crisis and the European Sovereign Debt Crisis. The 3-month TED spread - the difference between Libor and Treasury yields - has moved up only modestly due to the fact that short-term Treasury yields have also risen relative to short-term interest rate expectations. Bank CDS spreads have barely increased at all. The Libor-OIS spread will probably fall over the remainder of this year. However, the cost of shorting the dollar will still rise as the Fed continues to raise policy rates. 1 In his book, Confessions Of A Street Addict, which I highly recommend, Cramer wrote: On October 8, a dreary, chilly rainy Thursday in New York ... the stock market bottomed. At eighteen minutes after 12:00 P.M. I ought to know. I caused it. At 12:18 P.M. I capitulated. I couldn't take it anymore. I gave up both literally, at my fund, and virtually, on my website, TheStreet.com, where I penned a piece entitled "Get Out Now". And the prop wash from that article marked the low point in the most vicious bear market of the last century. 2 Please see BCA Global Investment Strategy Weekly Report, "Take Out Some Insurance," dated February 2, 2018, available at gis.bcaresearch.com. 3 Please see BCA Global Investment Strategy reports, "Trumponomics: What Investors Need To Know," dated September 4, 2015; "Worry About Brexit, Not Payrolls", dated June 10, 2016; "Three (New) Controversial Calls", dated September 30, 2016, available at gis.bcaresearch.com. Also see BCA New York Investment Conference presentations: "Five Controversial Calls - Call #5: The Trumpists Will Win" (September 2015), and "Three Controversial Calls - Call #1: Trump Wins And The Dollar Rallies" (September 2016). 4 Please see "Update To The IP Commission Report - The Theft Of American intellectual Property: Reassessments Of The Challenge And United States Policy," The Commission on the Theft of American Intellectual Property (The National Bureau of Asian Research), (2017). 5 The fact that China's foreign exchange reserves have been trending sideways since early last year does not mean that past interventions should be disregarded. Just as both theory and evidence suggest that quantitative easing affects bond yields primarily through the "stock channel" (how many bonds central banks own) rather than the "flow channel" (the purchase or sales of bonds in any given period), the yuan's value is also more affected by the stock of foreign assets the PBOC controls rather than its recent interventions. This makes intuitive sense. If a central bank drives down its currency by buying a lot of foreign assets, and then suspends further purchases, one might expect the currency to stop falling, but one would not expect it strengthen to where it was before the intervention began. 6 Expressed mathematically, the real exchange rate between two currencies is the product of the nominal exchange rate and the ratio of prices between the countries. A real appreciation tends to make a country less competitive, either through a nominal increase in its currency or through an increase in prices in that country relative to those of its trading partners. 7 Larry Summers, "Currency Markets Send A Warning On The US Economy," March 5, 2018. 8 We say "largely" a wash because while selling the dollar forward is not exactly the same as short-selling it in the spot market due to the presence of the so-called currency basis swap spread, it is economically similar. When European investors short-sell the dollar, they are effectively borrowing dollars at Libor, selling them for euros, and parking the proceeds in a short-term account that pays Euribor. Three-month U.S. Libor is 230 bps these days, while three-month Euribor is -33 bps. Thus, European investors lose 263 bps by currency-hedging their U.S. bond purchases. Conversely, when U.S. investors go short the euro, they are effectively borrowing euros, selling them for dollars, and then parking the proceeds in a short-term account paying Libor. Thus, they gain the equivalent amount from the decision to currency-hedge purchases of euro area bonds. 9 Please see BCA Global Alpha Sector Strategy Weekly Report, "Global Size And Style Update," dated March 9, 2018, available at gss.bcaresearch.com. 10 Please see BCA The Bank Credit Analyst, "U.S. Twin Deficits: Is The Dollar Doomed?" dated March 29, 2018, available at bca.bcaresearch.com. 11 Please see BCA Global Investment Strategy Special Report, "End Of The 35-Year Bond Bull Market," dated July 5, 2016; and Strategy Outlook, "Third Quarter 2016: End Of The 35-Year Bond Bull Market," dated July 9, 2016. 12 Please see BCA Global Investment Strategy Weekly Report, "What Central Bankers Don't Know: A Rumsfeldian Taxonomy," dated March 16, 2018; Weekly Report, "A Structural Bear Market In Bonds," dated February 16, 2018. Appendix A APPENDIX A CHART 1Long-Term Return Prospects Are Slightly Better Outside The U.S. APPENDIX A CHART 2Long-Term Return Prospects Are Slightly Better Outside The U.S. APPENDIX A CHART 3Long-Term Return Prospects Are Slightly Better Outside The U.S. APPENDIX A CHART 4Long-Term Return Prospects Are Slightly Better Outside The U.S. Appendix B APPENDIX B CHART 1Market Outlook: Bonds APPENDIX B CHART 2Market Outlook: Equities APPENDIX B CHART 3Market Outlook: Currencies APPENDIX B CHART 4Market Outlook: Commodities Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

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Highlights With North Korean diplomacy on track, Taiwan is the country most exposed to U.S.-China trade and strategic tensions. The Taiwanese public supports the status quo; however, a majority sees itself as exclusively Taiwanese, and the desire for independence may grow over time. Domestic political changes in mainland China and in the United States are also conducive to greater geopolitical tensions affecting Taiwan. Beijing will likely refrain from excessive pressure in the lead-up to Taiwan's November local elections ... but an independence-leaning outcome could change that. Stay overweight Taiwan within Emerging Market portfolios, but be prepared to downgrade if latent geopolitical risks begin to materialize. Feature The decision by the United States to toughen its enforcement of trade rules with China marks a shift that will have lasting ramifications.1 The U.S. is concerned not only about the trade imbalance but also the national security risk posed by China's economic might and increasing technological prowess. Hence President Donald Trump has imposed trade measures on China despite Chinese President Xi Jinping's cooperation on North Korea. Xi has enforced sanctions on the North and thus forced Kim Jong Un to the negotiating table, even getting him to consider denuclearization (Chart 1). Global financial markets may "climb the wall of worry" about the latest tariffs because the Trump administration has moderated its rhetoric in practice, notably by choosing to prosecute China in the World Trade Organization. However, the protectionist shift in U.S. policy is a lasting one. American power is declining relative to China, and the two countries no longer share the same economic interdependency that acted as a deterrent to conflict in the past (Chart 2).2 Chart 1China Gives Kim To Trump Chart 2Structural Increase In U.S.-China Tensions Taiwan is the country that is most exposed to both trade and strategic tensions between the U.S. and China (Chart 3). Indeed, BCA's Geopolitical Strategy has held since January 2016 that Taiwan is a potential geopolitical black swan.3 Does this warrant shifting to an underweight stance in EM portfolios? Not yet. But it is a left tail risk that investors should have on their radar. Taiwan Is Filled With Dry Powder There are three reasons to suspect that Taiwan geopolitical risk is understated. First, Chinese President Xi Jinping has consolidated power and made himself into Chairman Mao Zedong's peer in the Communist Party's ideological hierarchy. He is in power indefinitely. Xi has also followed his predecessor Jiang Zemin, in the 1990s, in taking a tough approach to security and defense. Implicitly he wants to make sure that unification occurs by 2049, but some argue that he wants to achieve it within his lifetime, namely by 2035. The Taiwanese public is resolutely opposed to any timetable. The fundamental risk is that economic slowdown could disappoint the aspirations of a big and ambitious middle class, which could force Xi to pursue nationalism and foreign aggression as a way to maintain domestic control (Chart 4). Beijing is still unlikely to attack Taiwan other than as a last resort, due to the American alliance system protecting it: this remains a hard constraint for now. But aggressive economic sanctions and military posturing with the intention to coerce Taiwan are much more likely than investors realize today. Chart 3Taiwan's Economy As Well As Security On The Line Chart 4China's Stability Vulnerable To Growth Slowdown Second, Taiwan's independence-leaning Democratic Progressive Party (DPP) has gained control of every level of government on the island - the presidency, the legislature, the municipalities - since the large-scale, anti-mainland "Sunflower" protests of 2014. President Tsai Ing-wen, who replaced the outspokenly pro-China President Ma Ying-jeou, is vocally uncomfortable with the status quo. She has refused to positively affirm the "1992 Consensus," which holds that there is only "One China" but two interpretations. Beijing sees this idea as the basis of smooth cross-strait relations. Tsai has not in practice tried to break the status quo, but she is clearly interested in enhancing Taiwan's autonomy. Moreover, a youthful "Third Force" has emerged in Taiwanese politics, with the backing of former presidents Lee Teng-hui and Chen Shui-bian, arguing for independence and the right to hold popular referendums on the question of sovereignty. Any success of this movement will provoke a massive response from China. Third, U.S. President Trump has suggested in several poignant ways that his tougher approach to China will entail a more robust American guarantee of Taiwan's security. While he has promised Xi to uphold the "One China policy," he is actively upgrading diplomatic and possibly naval relations with Taiwan and considering more substantial arms sales to Taiwan.4 His negotiation style suggests that he is not afraid to touch this "third rail" in Sino-American relations. Moreover, in the wake of the 1995-96 Third Taiwan Strait Crisis, and again in the wake of the Global Financial Crisis, a hugely important shift in Taiwanese national identity accelerated. Today the public mostly identifies solely as Taiwanese, as opposed to both Taiwanese and Chinese (Chart 5). This trend has abated somewhat since the DPP rose to full control in 2014-16, but a 55% majority still sees itself as exclusively Taiwanese. Among the youth, that number is 70%. This dynamic raises the possibility that a political independence movement could one day emerge. Beijing, at any rate, is watching with great concern. Of course, this shift in national identity does not imply that Taiwanese want to declare independence for the state of Taiwan anytime soon. Only about 22% want the country to move toward formal independence, and only 5% want to declare independence today. Whereas 69% are comfortable maintaining the status quo for a long time (Chart 6). The Taiwanese want to preserve their de facto independence and continue to prosper. But support for independence has grown faster than support for the status quo since the 1994 consensus. The status quo barely, if at all, holds majority support if one removes from its ranks those who eventually want to see the country declare independence. And younger cohorts have larger majorities than older cohorts in favor of independence. Chart 5Majority Of Taiwanese Are Exclusively Taiwanese ... Chart 6... Yet Majority Support Status Quo For Now The point is that there is a lot of "dry powder" in Taiwanese public opinion that could be ignited against China in the event of a change of circumstances, i.e. another military crisis or economic shock. Essentially, China is worried that someday this national identity could be weaponized. Chart 7China Gains Leverage Over Time How will China respond to the situation? So far it has not overreacted. Xi Jinping has launched more intimidating military drills and has hardened his rhetoric - including in key reports at the 2017 party congress and this year's National People's Congress. His administration has also pursued policies to emphasize its dominance, such as setting up new air traffic routes over the strait that Taiwan claims violate its rights.5 Nevertheless, the cross-strait status quo has not yet changed in any fundamental way that would suggest relations are about to explode. And this is fitting because the status quo is beneficial to the mainland, having created a vast imbalance of economic influence over Taiwan (Chart 7). This imbalance gives China the ability to use economic coercion to dissuade Taiwan's leaders from trying anything too daring. This year, in particular, there is reason to think that Xi Jinping may want to limit any provocations. Taiwan will hold local elections on November 24, an opportunity for the pro-China Kuomintang (KMT) to at least begin to claw back the political stature it has lost (Chart 8). A good showing in 2018 is essential for the KMT if it is to rebuild momentum for the 2020 general election. Tsai's and the DPP's approval ratings have fallen precipitously since her inauguration (Chart 9). Xi may deem that saber-rattling would be counterproductive by giving Tsai and the DPP a foil, when in fact the tide is already working against them. If the KMT's performance is abysmal in the November elections, then Beijing faces a problem. Its strategy of gaining influence over Taiwan through economic integration has not prevented the emergence of an exclusively Taiwanese identity. So far Beijing has not given up on this strategy but that might become a concern if the Xi administration treads softly this year and yet the DPP broadens its control of local offices. Worse still for Beijing would be sweeping gains for outspoken, pro-independence candidates, since China cannot expel them from the legislature as easily as it did their peers in Hong Kong. Chart 8Kuomintang Needs A Win In 2018 Chart 9DPP Only Leads KMT By A Little Now Bottom Line: Political changes in China, Taiwan, and the United States are conducive to souring relations across the strait. Moreover, Taiwanese national identity is dry powder that Beijing fears could be exploited by independence-leaning politicians - potentially with American backing from an aggressive President Trump. This three-way dynamic means that Taiwanese geopolitical risk is understated, despite the fact that these powers are all familiar with the dynamics and Beijing may not want to overly provoke voters ahead of local elections, knowing that heavy-handedness in 1995-96 encouraged Taiwanese uniqueness. Macro Backdrop And Trade Tensions Undermine DPP The problem for President Tsai and the ruling DPP, as local elections approach, is that the Taiwanese economy faces headwinds as Chinese and Asian trade slows down and as the Trump administration converts its protectionist rhetoric into action. Since last year, China has tightened financial conditions and regulation and has cracked down on corruption in the financial sector. The result is a slump in broad money supply that is now pointing to a drop in EM and Taiwanese exports (Chart 10). Indeed, a cyclical slowdown is emerging in Taiwan: The short-term loans impulse is weakening which suggests that Taiwanese export growth will slow further (Chart 11, top panel). The basis for this relationship is that short-term loans are used by Taiwanese businesses to fund their working capital needs as well as purchase inputs to fill their export orders. Further, broad money is also weak (Chart 11, bottom panel). Chart 10China Slowdown Spells Trouble For Taiwan Chart 11Taiwanese Money/Credit Growth Slowing The manufacturing sector is slowing, with the shipments-to-inventories ratio weak and manufacturing PMI dipping sharply (Chart 12). Worryingly, the new orders, export orders, and electronic-sector employment components of the manufacturing PMI are approaching a precarious level. Various prices of semiconductors are also starting to show signs of weakness globally which does not bode well for a market that relies heavily on this trade. The semiconductor shipment-to-inventory ratio has rolled over (Chart 13). Taiwanese exports to ASEAN are also slowing, which signifies that final demand for semiconductors is softening, as ASEAN economies lie at the final stage of the semiconductor supply chain process. Chart 12Manufacturing Indicators Rolling Over Chart 13Softness In Key Semiconductor Exports Further, global trade tensions have the potential to harm global growth and especially heavily trade-exposed economies like Taiwan. Taiwan is not guaranteed to benefit from the U.S.'s more aggressive posture toward China. Theoretically, if the U.S. imposes tariffs on goods from China that can be substituted by Taiwan, then Taiwan will benefit. But in practice, the U.S. is using tariffs as a threat to force China to open its market more to U.S. exports. One way that Beijing may respond is by purchasing American goods instead of goods that come from American allies like Taiwan. Beijing has already attempted this strategy by offering to increase imports of American semiconductors at the expense of Taiwan and South Korea. At the moment there are no details on how much of an increase China is proposing. In Table 1 we show several scenarios to assess the damage that could be inflicted on Taiwan if China substituted away from it. The impact on Taiwan's exports is not negligible. For instance, under the benign scenario, if U.S.'s share of semiconductor exports to China rise from 4%6 to 10%, then Taiwan's share of semiconductor exports to China would drop from 15% to 12%. That would amount to a $4 billion loss for Taiwan, approximately, which represents 1.4% share of its total exports and 4% of its overall semiconductor exports. This analysis assumes that the trade losses resulting from China's shift to its semiconductor import mix would harm Taiwan somewhat more than Korea. The latter holds a competitive advantage on Taiwan as Korea designs and manufactures unique semiconductors that are not as easily substitutable. At any rate, the damage to Taiwan's geopolitical and trade outlook would be more concerning than the loss of revenue. Table 1China's Trade Concessions To U.S. Could Impose Costs On U.S. Allies It is unlikely that the Trump administration is willing to accept such a deal, which is flagrantly designed to appease the U.S. at the expense of its allies. But the exercise illustrates a broader dynamic in which U.S. negotiations with China threaten to disrupt trade relationships and supply chains that have benefited Taiwan in recent decades. The result will be greater uncertainty and a higher potential for negative shocks. Chart 14China Punishes Taiwan For 2016 Election Moreover, the Trump administration has not entirely exempted allies from trade pressure. For instance, Taiwan has appreciated the dollar a bit in response to the threat of punishment for currency manipulation from the U.S. Washington has also just secured assurances from South Korea that it will not competitively depreciate the won. If agreements like these stand, and yet China makes less robust or less permanent agreements regarding its own currency, South Korea and Taiwan could suffer marginal losses of competitiveness. Taiwan is also exposed to coercive economic measures from China. Since Tsai's election, Beijing has made a notable effort to reduce tourist travel to Taiwan, which is reflected in tourism and flight data (Chart 14). Given the context of political tensions, the risk of discrete sanctions will persist and could flare up at any time if an incident occurs that aggravates the distrust between the two governments. How will investors know if Taiwanese geopolitical risk is about to spike upwards? At the moment, geopolitical risk is subdued, according to a proxy based on USD/JPY and USD/KRW exchange rates and relative Taiwanese/American inflation (Chart 15). This indicator tracks well with previous cross-strait crises. It even jumped upon the heightened tensions around the 2016 election of Tsai, and her controversial phone call with Donald Trump after his election. At the moment it suggests that cross-strait tensions have subsided significantly, despite the cutoff in formal diplomatic communication. However, the low point of the measure, and the underlying political factors outlined in the previous section, suggest that it should rise going forward. Chart 15Taiwanese Geopolitical Risk Likely To Rise From Here In the short run, it will be important to watch the Trump administration's handling of diplomatic visits and arms sales to Taiwan. Trump's signing of the Taiwan Travel Act has elevated diplomatic exchanges in a way that is mostly symbolic but could still spark an episode of heightened tension with China that would result in economic sanctions. An unprecedented naval port call could turn into an incident. At the same time, the U.S. guarantees Taiwan's security and in token of that guarantee periodically provides Taiwan with weapons packages. Beijing, for its part, always protests these sales, more or less vigorously depending on the military capabilities in question. The currently slated one is not too big but there is a rumor that it will include F-35 stealth fighter jets; other surprises could occur. Traditionally, the biggest spikes in sales have fallen under Democratic, not Republican, administrations. However, Trump may change that. There is a consensus in Washington that policy toward China should get tougher. The Taiwan Travel Act, upgrading diplomatic ties, passed with unanimous consent in both the House and Senate. Taiwanese governments have a record of increasing military spending when Republican presidents sit in Washington. And the first DPP government, under Chen Shui-bian from 2000-08, marked a clear upturn in Taiwanese military spending growth (Chart 16). If the Trump administration decides to sell Taiwan weapon systems that make a qualitative difference in the military balance, it will raise tensions with Beijing and likely prompt economic sanctions against Taiwan. Chart 16Arms Sales Could Reemerge As An Irritant In the long run, there are three key negotiations taking place in the region that could increase Taiwanese geopolitical risk: U.S.-China trade negotiations: Taiwan has benefited from China's engagement with the U.S., and with the West more broadly, and stands to suffer if they disengage. That would herald rising strategic tensions that would put Taiwan's trade and security in jeopardy. Geopolitical risk would go up. North Korean diplomacy: Kim Jong Un has met with Xi Jinping and formally agreed to hold bilateral summits with Presidents Trump and Moon Jae-in of South Korea. He has also indicated that denuclearization is on the table. If the different parties enter onto a path towards a peace treaty and denuclearization, then Taiwan might worry that the U.S. will eventually remove troops from the peninsula - far-fetched but not out of the question. Taiwan would fear abandonment and could attempt to entangle the U.S. For its part, China could believe that cooperation on North Korea requires the U.S. to give China greater sway over Taiwan. Geopolitical risk would go up. The South China Sea: These sea lanes are vital to Taiwan as well as China, South Korea, and Japan. If the U.S. washes its hands of the matter, ceding China a maritime sphere of influence, Taiwan will face both greater supply risk and greater anxiety about American commitment to its security. Beijing might be emboldened to pressure Taiwan, or Taiwan might act out to try to secure American support. Geopolitical risk would go up. Bottom Line: Taiwan's economy is entering a cyclical slowdown on the back of China's slowdown and rollover in the semiconductor industry. At the same time, trade tensions emanating from the U.S.-China negotiations and political tensions emanating from the other side of the strait suggest that Taiwan's geopolitical risk premium will rise. Over the short term, Taiwan's local elections, the referendum movement, or U.S. diplomacy or arms sales could provide a catalyst for a cross-strait crisis. Over the long term, significant changes in U.S.-China relations, North Korea, or the South China Sea could put Taiwan in a more precarious position. Investment Conclusions While the absolute outlook for Taiwanese stock prices is negative, the potential downside in share prices in U.S. dollar terms is lower than for the EM benchmark. BCA's Emerging Markets Strategy recommends that EM-dedicated investors remain overweight Taiwanese risk assets relative to the EM benchmark. First, the epicenter of China's slowdown is capital spending in general and construction in particular. Various Chinese industrial activity indicators have already begun decelerating. This is negative for industrial commodity prices and countries that produce them. Taiwan is less exposed to China's construction slump than many other EM economies. Second, China's spending on technology will not slow much. As a part of its ongoing reforms, Beijing will encourage more investment in technology as well as upgrading industries across the value-added curve. Hence, China's tech spending will outperform its expenditure on construction and infrastructure. Taiwan is poised to benefit from this relative shift in China's growth priorities. Third, there are no fresh credit excesses in Taiwan like in some other EMs. Taiwan's banking system worked out bad assets extensively following the credit excesses of the 1980s-90s. Hence it is less vulnerable than its peers in the developing world. Finally, Taiwan has an enormous current account surplus of 14% of GDP and, contrary to many other EMs, foreign investors hold few Taiwanese local bonds. When outflows from EM occur, the Taiwanese currency will fall under less pressure and its financial system under much less stress. This will allow Taiwanese stocks to act as a low-beta defensive play. Crucially, despite some appreciation to appease Trump, the Taiwanese dollar is among the cheapest currencies in EM (Chart 17). Chart 17Cheap Taiwanese Dollar Removes Risk As for heightened geopolitical risk, BCA's Geopolitical Strategy would note that while we view Taiwan as a potential "black swan," nevertheless tail risks are not the proper basis for an investment strategy. We will continue to monitor the situation so that we can alert clients when a major, market-relevant deterioration in cross-strait relations appears imminent, based largely on the factors highlighted above. If the DPP remains dominant after the local elections later this year, or if "Third Forces" make notable gains, we would suspect that the Xi administration will shift to using more sticks than carrots. This could include economic sanctions and military saber-rattling. The question then will be whether Beijing (or Washington or Taipei) attempts a material change to the status quo. Ultimately - from a bird's eye point of view - a war is more likely in the wake of Xi Jinping's elimination of term limits, consolidation of power, and the secular slowdown in China's economy and rise of Chinese nationalism. But we see no reason to fear such a catastrophic outcome in the near term. Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Ayman Kawtharani, Associate Editor ayman@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "We Are All Geopolitical Strategists Now," dated March 28, 2018, available at gps.bcaresearch.com. 2 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. 3 Please see BCA Geopolitical Strategy Special Report, "Taiwan's Election: How Dire Will The Straits Get?" dated January 13, 2016, and "Scared Yet? Five Black Swans For 2016," dated February 10, 2016, available at gps.bcaresearch.com. 4 Trump began, as president-elect, by holding an unprecedented telephone call with the Taiwanese president. His administration has since requested a new $1.4 billion arms package, opened legal space for port calls (including potentially naval port calls) in the 2018 Defense Authorization Act, and for higher-level diplomatic meetings via the Taiwan Travel Act, which became public law on March 16, 2018. 5 Please see BCA Geopolitical Strategy Weekly Report, "Watching Five Risks," dated January 24, 2018, available at gps.bcaresearch.com. Military drills have involved symbolic shows, like sailing China's only operational aircraft carrier along the mid-line of the Taiwan Strait, as well as more poignant maneuvers, like drilling north and south of Taiwan simultaneously. As for rhetoric, Xi omitted from his 2017 party congress speech any reference to hopes that the Taiwanese "people" would bring about unification; in his speech after the March National People's Congress, he warned of the "punishment of history" for those who would promote secession. 6 Shown as the average of 2015 and 2017.